Here is an opportunity to buy a great business at a reasonable price. Sherwin-Williams reached nearly $74/share in mid-July. Since then, the stock has dropped over 30% to $51.36 largely as a result of macroeconomic issues, specifically US residential and commercial construction concerns. At current market prices, Sherwin-Williams trades at 10.1x 2008 EPS guidance and at a significant discount to private-market value as evidenced by the Akzo-Nobel-ICI and PPG-SigmaKalon transactions. At this multiple, you get a dominant US player who is growing both domestically and internationally and earning pre-tax returns on incremental capital in excess of 30%. This is not a commodity chemical business that is currently over-earning. Even with a precipitous decline in sales and a reversion to historically low gross margins and high SG&A rates, the business should still earn nearly $3.25/share implying a trough multiple of under 16x EPS. In the meantime, the company continues to repurchase shares and pay a 2.73% dividend.  

 

Sherwin-Williams manufactures, distributes and sells architectural paints, industrial coatings and related products through three core business units: Paint Stores, Consumer and Global. The company’s customer base is diversified - Do-It-Yourself (DIY), residential repaint, new residential/commercial, property management, industrial & marine, OEM finishes and architects & designers. Approximately 88% of its business is domestic. The 12% international piece continues to grow and should hit 15% of total sales in the near future.

 

Paint Stores Group (62% sales / 65% EBIT):

Through its 3,325 stores in the US, Canada, Puerto Rico, Jamaica and the Virgin Islands, Sherwin-Williams sells branded paints (Dutch Boy, Krylon and Purdy), stains, painting tools and equipment to the retail and professional contractor markets, including the industrial and marine segments. The Paint Group sales breakdown (2006) is as follows: Paints (81%), wall covering (4%), floor covering (5%) and accessories (9%).

 

The Paint Stores Group operates three types of stores. The Type 1 store (4,000-5,000 square feet) serves DIY and small painting contractors in residential areas. This represents the bulk of its boxes (>85%). The Type 2 store supplies the large professional contractor with expanded product offerings, whereas the Type 3 store is a wholesale operation serving industrial customers and large contractors in industrial settings.

 

Consumer Group (16% sales / 20% EBIT):

This segment consists of a diversified brands division, which supplies national brands and private label products to US retail paint and coatings outlets and a paint and coatings division, which supports the Paint Stores Group with research and development, manufacturing, distribution and logistics. The company sells architectural paints, aerosol paints, wood care, painting supplies, pavement markers and buildings materials in 38,000 US paint and retail coatings outlets, or 68% of a total 56,000 boxes. Major customers are Home Depot, Lowe’s, Wal-Mart, Menards, Sears-Kmart, Ace Hardware, True Value, AutoZone and NAP.

 

Global Group (22% sales / 15% EBIT):

The Global Group (519 branches) encompasses the company’s automotive finishes (35% of sales), OEM coatings (25%) and international paint stores (40%) in Latin America, the UK, China and India. Over 50% of this business is international with the majority in Mexico, Brazil and Chile.

 

Through its 208 branches, the automotive finishes business supplies collision repair, production shops, fleet manufacturing, OEMs (automotive, truck, bus, RV) and the aerospace industry in the US and internationally. This is primarily an aftermarket business. The chemical coatings unit supplies paints, finishes, plastics and specialty materials for industrial and manufacturing applications, specifically to the furniture, appliance, heavy equipment, building products and computer industries. The international paint stores are similar to the company’s Paint Stores Group.

 

In 2006, 7.3 BN gallons ($88 BN dollars) were sold globally. Akzo Nobel-ICI and PPG-SigmaKalon own the largest global shares ahead of Sherwin-Williams, which leads in US share (25-28%). Its store base of 3,325 is over 5x larger than its closest competitor. An estimated 40% of Sherwin-Williams’ US sales come from residential, 28% from industrial business and 20% from commercial construction and remodeling. New residential construction accounts for approximately 8% of total sales. 

 

Since Sherwin-Williams is primarily a domestic company, I will focus on the US, which represents over 20% of coatings demand. The US coatings industry is comprised of architectural (58%), product finishes (31%) and special purpose products (11%). Architectural coatings demand is split 78% maintenance/repaint and 22% new construction (54% residential and 46% commercial and industrial). US product finishes serve OEMs, specifically automotive & other transportation (19%), furniture (21%), metal building products (9%), machinery & equipment (5%), powder (17%), container (9%) and other (19%). The special purpose segment is broken down as follows: Industrial maintenance (33% - 20% new construction / 80% industrial maintenance), marine (7%), auto refinish (31%), traffic marking (21%), aerosol paint concentrates (7%) and other (1%).

 

From 1998-2006, total US coatings gallons grew at a CAGR of 1.7% with architectural coatings leading the way at 2.5%. This rate increases to 4.2% if only professional contractor sales are measured. During this timeframe, professional contractor’s share versus DIY has grown from 45% to 63% and US demographics suggest this percentage should continue to increase. The incidence of painter work on a second home is significantly higher than a primary residence. Approximately 93% of contractor purchases are made at standalone paint stores due to the convenience, wide selections and superior service.

 

Sherwin benefits from a significant share lead in the US and the aforementioned secular trend of more contractor work and less DIY. Professional contractor sales represent 85% of the company’s paint store sales. Since roughly 90% of the cost of a paint job is labor, the higher-priced paint does not materially change the overall cost of the job. Since this “controlled” distribution (Sherwin-Williams stores) represents 75% of the company’s sales, Sherwin has an easier time raising prices to cover raw material increases.

AR Facility                            $0  

Revolver                                $250

Domestic CP                         $299

Foreign Borrowings               $108

Promissory Notes                  $9

7.375% Debentures              $137

7.45% Debentures                $147

Other Foreign Debt               $15    

Total Debt                             $965                      

Cash                                     ($27)

Environmental                        $194

Lead Paint                             $500

 

Equity Market Cap (FD)      $6,448   

Enterprise Value                   $8,080

*Cash is not pro forma for Becker Powder Coatings ($14 MM sales), certain Inchem assets ($30 MM) and Flex Group ($14 MM) purchases.

*Environmental is a pre-tax undiscounted figure. For an extra layer of conservatism EBITDA, EBIT & EPS are after I/S environmental costs. An additional $126.5 MM of environmental costs are possible if maximum point of the range is reached.

*Portions of potential lead paint liability in Rhode Island should be covered by insurance.

                                2005                        2006                        2007                        2008E - Consensus

Revenue                  $7,191                     $7,810                     $8,005                     $8,265

EBITDA                 $876                        $1,042                     $1,141                     $1,152

EBIT                       $732                        $896                        $978                        $980

EPS                         $3.28                       $4.19                       $4.70                       $5.01

 

*Company 2008 guidance is $5.00-$5.15.

 

Performance over the past several years has been excellent, but one concern is the sustainability of current margins in the face of falling demand. Over the past decade, gross margin and SG&A expenses ranged from 42.8% to 45.4% and 32.2% to 34.8%. Gross margins hit a high in 2003 before raw material costs spiked with SG&A troughing in 2006. From 2005-2007, gross margins increased 210 basis points as the company effectively raised price to compensate for higher raw materials, international volumes improved and operating efficiencies were realized from plant upgrades (Fernley, NV replaced Oakland, CA plant) and better expense control.

 

It is difficult to handicap how weak existing home sales, commercial construction and industry production can get, but here is an attempt at capturing additional macroeconomic downside. Compared to 2007, I reduced paint store sales by 5%, even considering acquisitions and 3% square footage growth. As a reference, during the early 1990s recession, the paint stores reported solid sales growth, whereas in 2001 comp store sales fell 1.3% before rebounding in 2002-2003. More recently, in 2007, industry volumes declined high-single digits, but the Paint Stores’ volumes fell only low-single digits (SSS) due to share wins. Moving on, I took the consumer group down 10% and brought Global Group sales down 2%, despite mid-to-high single digit growth expectations.

 

On the margin side, I reduced gross margins to 42.8% and increased SG&A to 34%. Using these assumptions, I calculate approximately $3.25 per share for my downside case. In 2001, the company earned $2.20 per share (using today’s share count), but since then, the company has increased its US paint store base by 29% and Global Group operations by over 100%. As such, I think $3.25 is a reasonable downside.

 

*Based on comments from Valspar and PPG, COGS appears largely variable. According to Valspar, roughly 80% of costs are variable.

 

At $51.36/share, Sherwin-Williams trades at 7.1x, 8.3x and 10.9x trailing EBITDA, EBIT and EPS. The enterprise value numbers include $500 MM for lead paint remediation, which I believe is conservative. Using 2008 consensus results in multiples of 7.0x, 8.2x and 10.3x EBITDA, EBIT and EPS. Historic forward PEs have ranged from 10-25x since 1991. Even if the company misses its guidance, this stock is still very cheap. 

 

*One thing to note is the company’s over-funded US pension plan. While this cash is inaccessible by the company, Sherwin-Williams could acquire a competitor with an under-funded pension plan to utilize this “hidden” asset.

 

Competitors consisting of Valspar, PPG (excluding non coating businesses), RPM International, Akzo Nobel and Rohm and Haas trade at 7.1-8.2x forward EBITDA, 8.6-10.9x EBIT and 10.8-14.5x EPS. Frankly, I think all of these stocks are cheap. Perhaps a more important data point is the ICI or SigmaKalon takeouts by Akzo Nobel and PPG. ICI was taken out for 10.9x EBITDA, but SigmaKalon appears to be a more appropriate comparable given its significant professional contractor distribution, even if the business is overseas. The purchase price of $3.2 BN implies 9.5-10x EBITDA and 12-13x EBIT multiples based on 2007 earnings, or 8.4x and 10.4x if using 2008 expectations. One thing to note is management’s discipline associated with the SigmaKalon sales process. Sherwin was involved in the final stage, but balked at the 9.5x-10x EBITDA multiple PPG was willing to pay, instead focusing on repurchasing its own, cheaper shares.

 

These comparable companies have less US exposure than Sherwin, but I would argue Sherwin’s “controlled” distribution business model is better. The company’s dominant retail position (3,325 boxes) provides a scale advantage and more customer contact, which drives brand loyalty. Sherwin has been around for over 140 years, so its brands and technology are well-known throughout the industry. The company seeks to have most knowledgeable person behind the counter, which is a huge advantage with professional contractors who require more service than DIY customers. Furthermore, since 90% of the cost of a paint job is labor, contractors are less price sensitive that DIY customers when it comes to a $35 gallon of better-quality paint versus a $10 gallon of paint from Wal-Mart.

 

For 2008, Sherwin-Williams guided to $5.00-$5.15. Sales are expected to increase in the low-to-mid-single digit range. More specifically, the company plans on low-to-mid-single digit sales for the Paint Group, flat-to-slightly higher sales at the Consumer Group and mid-to-high-single digit growth at the Global Group.

 

The company continues to roll-up local paint retailers and expand square footage by 3% annually. Management does not consider any states or major metropolitan markets to be saturated. Same store sales growth at its paint stores averaged nearly 4% over the past ten years. The Consumer Group should grow if home center growth picks up or if additional business is won. The Global Group continues to add branches (automotive finish branches forecast to grow at a 9% CAGR through 2010) and roll-up local businesses in Latin America and other regions, such as India via the Nitco Paints acquisition.

 

When I put this together, a 10.3x EPS multiple appears exceptionally cheap, even considering the uncertain macroeconomic outlook. Using the SigmaKalon multiple and discounting it a turn for conservatism to 8.5x gives me a high $60s share price or over 30% above current trading levels.

 

In a normalized housing environment, EPS should grow high-single to low-double digits. Figure square footage expansion (3%), comp store sales growth (3%) international expansion (mid-to-high-single digits) and bolt-on acquisitions drive high-single digit sales growth, which should lead to low-double digit EPS growth when considering average share reductions of 3%. Plus, the company pays a 2.73% dividend. Given these metrics, there is no reason why Sherwin-Williams should not merit an above market multiple in a normal housing environment. If we grow Sherwin’s 2005 earnings by low-double digits (i.e. more normal environment) and add a point of margin for raw material recovery, I calculate roughly $5.00 per share in normalized earnings. Placing a 15x multiple on that gets me to $75/share.  

 

Sherwin-Williams is a business you can own for the long term, especially for an investor with a five-year plus time horizon who does not have to worry about hiccups in housing or commercial construction. Management is well-regarded and disciplined as evidenced by their unwillingness to overpay for SigmaKalon. The sheer size of the company’s retail operations and brand strength are key differentiating factors. For a business that earns these kinds of returns on capital, it trades at a very reasonable multiple. This along with strong FCF generation and a 2.73% dividend provides a substantial margin of safety.

 

Lead Paint: The sellside has done a good job outlining lead paint risk, so I will only focus on the Rhode Island case.

 

Sherwin-Williams ceased manufacturing lead-pigment based paints in 1947. In 1955, the paint industry adopted voluntary standards to limit the use of lead paint on interior wall surfaces. Lead paint was not banned in the US until the Consumer Products Safety Commission took action in 1978. Several lawsuits from cities and states have been initiated against the company. Most have been dismissed, but the Rhode Island case lingers as the major lead paint risk for the company.

 

In February 2006, a Rhode Island jury found Sherwin-Williams, NL Industries and Millennium Holdings liable for public nuisance charges for lead paint abatement. The high-end estimate of potential liability appears to be the $2.4 BN the state of Rhode Island proposed in September 2007. If allocated equally, Sherwin would owe $800 MM before any insurance recoveries, but the company argues it had smaller market share than NL and Millennium. The company is appealing the verdict to the Rhode Island Supreme Court, which will hear oral arguments in mid-May. A decision is expected before July 4^th. An adverse decision will probably be appealed to the US Supreme Court further delaying any cash payments. A separate case against the company’s insurers to recover potential costs associated with lead paint abatement has been filed in Ohio.

 

The potential abatement costs in Rhode Island should decline from the $2.4 BN. This number is merely the amount of homes built before 1978 (240,000) in Rhode Island before lead paint was banned multiplied by per home abatement costs of $10,000. As an aside, discovery was not allowed on any property during the trial. A Brown University study supports a far lower number (i.e. 2,500 residences). Furthermore, the estimate of “lead-safe” abatement costs, as opposed to “lead-free” cost is closer to $5,000-$7,000 per home. Lead-safe appears to be a more realistic standard, especially from an abatement perspective.

 

Considering the aforementioned issues, my estimate for lead paint is far lower than the $500 MM included in my capital structure above. Between the appeals, potential insurance recoveries and other delays (some attorneys say no cash paid until 2010), I expect a total cost less than $100 MM on an after-tax present value basis.