Dividend Aristocrats Part 2 of 54: Sherwin-Williams

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Sep 25, 2014
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In part 2 of the 54-part "Dividend Aristocrats in Focus" series, we will look into the operations of Sherwin-Williams (SHW, Financial). Sherwin-Williams has been in business since 1866, and has increased its dividend each year since 1979. The company operates in the relatively slow-changing coatings industry. The bulk of Sherwin-William’s revenue and profits come from its paint stores, where it can best manage the entire customer experience.

Sherwin-Williams sells branded coating products under a variety of names including: Sherwin-Williams, Dutch Boy, Krylon, Minwax, Thompson’s Water Seal, and many more. Sherwin-Williams operates in four segments: paint stores, global finishes, consumers, and Latin America coatings. The bulk of Sherwin-William’s stores and sales come from within the United States. The company has made in-roads in Latin America, and is beginning to expand into Europe and Asia.

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Source: Sherwin-Williams Annual Report

Competitive Advantage

Sherwin-Williams generated about $780 million in income over the last 12 months on $10.7 billion in sales. Sherwin-Williams is the market share leader in the $12 billion+ U.S. architectural paint industry. The company has achieved its leadership position in the U.S. through excellent branding and easy access to its stores.

Competitive Advantage 1: Convenience

Sherwin-Williams has well over 3,600 paint stores in the U.S. For comparison, there are about 2,200 Home Depots (HD, Financial) in the U.S., and about 1,800 Lowe’s (LOW, Financial) stores. Consumers are more likely to be near a Sherwin Williams store than competing paint or home improvement stores. Painting often involves multiple trips to buy additional paint and/or supplies. Sherwin-Williams has positioned itself to be nearer to consumers than its competitors.

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Source: Sherwin-Williams 2014 Paint Store Presentation

Sherwin-Williams stores are substantially smaller than "big box" hardware stores. Consumers shopping specifically for paint have easier access to paint and supplies in Sherwin-Williams than in a Home Depot or Lowe’s. Smaller store footprints and ease of access are a big advantage for dollar stores and pharmacies. The same advantage applies to Sherwin-Williams as well.

Competitive Advantage 2: Strong Brands

Sherwin-William’s convenience advantage is a result of its growth and expansion over the last 140-plus years. The company has achieved this growth through easily identifiable brands that are synonymous with quality. The company is the leader in U.S. brand awareness in several coating products including architectural paint (Sherwin-Williams Paint), stain and protective finishes (Minwax), and aerosol paint (Krylon).

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Source: Sherwin-Williams 2014 Company Overview Presentation

Sherwin-Williams invests heavily in building its brands. The company spent about 5.7% of gross profits on advertising expenses in 2013. For comparison, Coca-Cola (KO, Financial) spent 11.5% of its gross profit on advertising and marketing in 2013. Coca-Cola is used as a comparison because it relies heavily on marketing to generate brand awareness. Coatings competitor PPG Industries (PPG, Financial) spent 5.3% of gross profit on advertising in 2013, and Lowe’s spent 4.3% of gross profit on advertising in 2013. Sherwin-Williams spends about half of what Coca-Cola does on advertising on a percentage basis, but outspends its competitors in the coatings industry.

Sherwin-William’s adverting spending over the last several decades has ingrained the company into the minds of consumers and contractors looking for painting supplies. The company will continue to benefit from the goodwill it has built up through its strong brands.

Growth Potential & Capital Allocation

Sherwin-Williams' growth going forward will come from organic growth in the U.S. driven by its strong brands and new store openings, and further expansion both domestically and abroad through acquisitions. The company’s shareholders will also benefit from continued share repurchases and rising dividend payments.

To understand Sherwin-Williams' future growth plans, analyzing their capital allocation policies is essential. Over the last five years, Sherwin-Williams has spent only 17% of operating cash flow on capital expenditures. The company generates large free cash flows which it uses to pay dividends and repurchase shares. Over the last five years, Sherwin-Williams has spent about 77% of operating cash flows on share repurchases (57%) and dividends (20%). The remainder of the company’s cash flows have been used on acquisitions to grow the business.

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Source: Sherwin-Williams 2014 Financial Overview Presentation

Sherwin-Williams' growth plans center on future acquisitions to expand the reach of the company. The company completed the partial acquisition of 306 Comex stores in 2013. The acquisition of the full company fell through this past April, and competer PPG Industries stepped in to acquire Comex. Despite this setback, Sherwin-Williams will likely look to grow through further acquisitions.

In the company’s most recent second quarter transcript, the company indicated it was looking to build scale in Latin America through a potential acquisition. CEO Chirs Connor said:

“So we're certainly not done thinking about building scale through M&A throughout Latin America.”

Expanding further into Latin America is the most logical international expansion plan for Sherwin Williams. The company is the industry leader in architectural paint in North America, and should be able to leverage its expertise and infrastructure to push into South America. The company has not announced any specific South American acquisitions, but I would not be surprised to see an announcement in the next year based on Connor’s statement.

Recession Performance

Sherwin-Williams' reliance on architectural paint products makes it somewhat susceptible to the cyclical housing industry in the U.S. The company’s earnings per share dipped from $4.70 in 2007 to $3.78 in 2009. Revenue dipped modestly from a high (at the time) of $68.18 in 2008 to $64.83 in 2009. The company is able to remain profitable through recessions thanks to its strong brands and solid margins despite fewer home purchases during times of economic uncertainty.

Fair Value

Sherwin-Williams appears to be significantly overvalued at this time. The company has a P/E ratio of about 27, well above its median P/E ratio over the last decade of about 15. The company is trading significantly above the P/E of the overall market; the S&P 500 has a P/E ratio of about 20 at this time. Further, the company is trading at a premium to its competitors PPG Industries (P/E ratio of 25), and Valspar (VAL, Financial) (P/E ratio of 23).

Sherwin-William is a high quality business that is experiencing strong growth. Despite this, it is susceptible to recessions and appears to be trading for a higher P/E multiple than its fundamentals warrant. I place the company’s fair P/E ratio somewhere between 15 and 18 based on its historical median P/E ratio and the excellent quality of its business.

Final Thoughts

Sherwin-Williams is an industry-leading company with high quality brands. The company is very focused on rewarding shareholders through growing dividends and share repurchases. Even better, the company operates in a slow-changing industry that is unlikely to go through rapid technological changes. The company is growing quickly now due to favorable macro-economic conditions, but is somewhat susceptible to recessions.

The biggest downside to Sherwin-Williams is not the underlying business, but the price of its shares. The company appears significantly overvalued. If Sherwin-Williams' price to earnings rate falls to about 15 (close to its long-term median P/E ratio), it will make an excellent purchase for long-term investors. Until then, I believe there are better options available for investors interested in Dividend Aristocrats.