Sherwin-Williams (SHW) is one of 51 dividend aristocrats and has annually increased dividends each year since 1979 while outperforming the market by more than 9% per year over the last decade.
While watching paint dry has been anything but boring with coatings producer Sherwin-Williams, past performance is not necessarily indicative of future results.
Let’s take a closer look at Sherwin-Williams to learn more about its long-term competitive advantages, assess the potential of its large acquisition of Valspar, and see if the stock’s valuation could be attractive today for dividend growth investors.
Business Overview
Sherwin-Williams has been in business since 1866 and is the largest producer of paints and coatings in the U.S. and third-largest worldwide.
The company primarily serves the needs of architectural and industrial painting contractors and do-it-yourself homeowners through a network of more than 4,200 company-operated retail stores, but it also sells some industrial coatings, automotive finishes, and protective and marine coatings.
Segments
Sherwin-Williams previously operated in four segments: Paint Stores Group, Consumer Group, Global Finishes Group and Latin America Coatings Group.
Post the completion of its acquisition of Valspar in June 2017, Sherwin-Williams has reorganized its reportable segments as follows:
Americas Group (65% of Q2 17 sales) which comprises of the erstwhile Paint stores and Latin America groups.
Performance Coatings Group (15% of sales) which comprises of Valspar Coatings, Valspar Automotives and the erstwhile Global Finishes group.
Consumer Brands Group (20% of sales) which comprises of Valspar Paint and Sherwin-William’s erstwhile Consumer group.
Following its acquisition of Valspar, Sherwin-Williams derives close to 75% of its revenue from the U.S.
Business Analysis
Sherwin-Williams’ biggest competitive advantage is arguably its controlled distribution model. The company operates over 4,200 retail stores, about as many as Home Depot and Lowe’s combined and four times as many as PPG (see our analysis of PPG here.)
Controlled distribution accounts for the majority of Sherwin-Williams’ total sales and provides the company with greater control over its brand image, in-store product experience, pricing, customer relationships, and inventory.
The majority of Sherwin-Williams’ customers are contractors, and many of them prefer to deal with dedicated paint specialists rather than working with big box stores like Home Depot.
Sherwin-Williams can offer the best range and quality of paints, and its higher quality paints are more valued by contractors, which tend to be less price sensitive than consumers.
Contractors know that Sherwin-Williams’ paints can help them complete jobs faster because of their higher quality (e.g. faster dry time, fewer coats required, etc.), which means more money in their pockets.
Sherwin-Williams is also likely to have a convenient location for contractors almost anywhere around the country – more than 90% of the U.S. population lives within a 50-mile radius of a Sherwin-Williams store.
As contractors continue taking market share from do-it-yourself consumers, Sherwin-Williams’ business should continue to benefit.
However, that didn’t stop Sherwin-Williams from acquiring Valspar, a paint manufacturer primarily for do-it-yourselfers, for approximately $11 billion.
The merger between Sherwin-Williams and Valspar combines the third and fourth largest players in the industry and creates a company with more than $15 billion in sales that can better compete with PPG.
Source: Sherwin-Williams Investor Presentation
Valspar brings the number two do-it-yourself paint brand in the U.S., strong market share positions in packaging and coil segments, over 10,000 distribution points, and numerous new technologies.
The deal also gives Sherwin-Williams more exposure in international markets, which accounted for 50% of Valspar’s revenue, and can help the company sell more product through big-box retailers such as Lowe’s, Home Depot, and Ace, where Valspar already has a large presence.
The combination is expected to result in $320 million of estimated annual synergies within three years, largely from cutting overlapping expenses.
The above synergies have a good chance to materialize as the company has a sound track record of successfully integrating more than 20 acquisitions over the last decade, although Sherwin-Williams had to cut its guidance earlier this year as acquisition integration costs were running significantly ahead of expectations.
Source: Sherwin-Williams Investor Presentation
This cost overrun is likely just a hiccup in the grand scheme of things, and Sherwin-Williams’ core paint store business remains a valuable asset.
As a result of Sherwin-Williams’ large network of stores, long operating history, strong brands, and direct in-store relationships with customers, it has built up number one brands in architectural paint, stain & protective finish, aerosol paint, auto specialty paint, painting tools, and wood sealers.
In addition to strong pricing power, Sherwin-Williams’ margins also benefit from the company’s vertical integration. Big-box retailers must pay wholesale prices for their paint inventory, but Sherwin-Williams produces its own coatings, resulting in higher profits.
The business also requires little capital, helping Sherwin-Williams consistently generate excellent free cash flow:
Source: Simply Safe Dividends
Growing free cash flow is a sign of a very healthy business and tends to reward shareholders over long periods of time. Sherwin-Williams is no exception. As seen below, the stock compounded by 17.4% per year from 2007 through 2016, more than doubling from the market’s 8% annual return over this time period.
Management has created substantial value for shareholders, but can the company’s next decade of life come close to matching its last? The bar has certainly been set high.
The company’s next goal is to hit 5,000 stores in North America, which would be close to a 20% increase from where it ended in July 2017. Management insists this is not the end goal but rather a milestone along the way of Sherwin-Williams’ long-term growth path.
Given the high level of fragmentation in the paint market, Sherwin-Williams will likely have opportunities to continue its expansion, but the company is likely much closer to a saturation point (at least in the U.S.) than it was 10 years ago.
As previously mentioned earlier, Sherwin-Williams’ store count is already substantially higher than Home Depot, Lowe’s, and PPG, and its stores are close to almost all of the country’s population.
This might also explain why the company decided to acquire Valspar sooner rather than later to diversify its geographical footprint and customer base.
Sherwin-Williams has also invested in Latin America for international volume growth and continues expanding its product offering through R&D, acquisitions, and organic distribution growth (e.g. its first-ever architectural paint program in Lowe’s stores nationwide under the HGTV HOME by Sherwin-Williams label rolled out a couple of years ago).
This along with several efforts like expanding the company’s specialty paint store platform and increasing brand penetration of well-known product lines to independent retail outlets are being undertaken to strengthen the company’s brand position across retail channels.
Sherwin-Williams’ growth outlook looks good over the next 3-5 years and the company should benefit from a growing international presence, but the success of its acquisition of Valspar is by far the biggest milestone to watch.
Key Risks
The biggest risk to Sherwin-Williams’ long-term future is arguably market saturation in the U.S. The company has significantly more stores than its next largest peers and enjoys a strong presence in most regions already.
If Sherwin-Williams finds fewer opportunities for profitable store growth than it currently expects, the stock could find itself in trouble. Though the company’s international footprint has improved with the Valspar acquisition, it is still highly dependent on U.S. growth opportunities.
Additionally, Sherwin-Williams’ market seemingly has few barriers to entry – no one can stop Home Depot or other competitors from building new stores in a location and pressuring prices – but the company’s brands, reputation, and specialization (i.e. controlled channel model) help mitigate risk from new competition, including Amazon.
Finally, the state of the housing market, foreign currency exchange rates, and trends in raw material costs (e.g. oil-based materials and titanium dioxide) could impact Sherwin-Williams’ business results over the near-term, but these issues shouldn’t impair the company’s long-term outlook.
For example, given the recent recovery in oil prices, the company expects the average year-over-year raw material cost for paint and coatings industry to be up in low single-digits range in 2017.
The U.S. architectural coatings industry is still seeing volumes recover from the housing crisis, but demand trends have been choppy over the past 20 years.
Source: Sherwin-Williams Investor Presentation
Integrating Valspar and achieving the targeted synergies is a major risk as well, especially since most acquisitions fail to create shareholder value.
While the cost synergies are attractive, Sherwin-Williams took on substantial debt to fund this acquisition, and there are no guarantees that it can master the do-it-yourself paint business as well as it has its paint store and contractor model.
Sherwin-Williams’ Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Sherwin-Williams’ Dividend Safety Score of 91 indicates that the company’s dividend payment is one of the safest in the market.
As seen below, Sherwin-Williams’ payout ratios have remained low and steady over the last decade, providing plenty of cushion and room for growth. Even if Sherwin-Williams’ earnings were unexpectedly cut in half, its payout ratio would only increase to around 50%.
Looking at the cyclicality of Sherwin-Williams’ business, we can see that sales growth has remained within a relatively tight band over the last decade.
Sherwin-Williams’ revenue fell by just 11% during the financial crisis, and its free cash flow per share actually grew. The company’s stock outperformed the S&P 500 by over 40% in 2008, too.
Despite its exposure to the housing market, Sherwin-Williams’ business held up fairly well because homeowners continued to use paint for affordable redecorating projects, and the company had numerous opportunities to plant new store locations.
Despite selling a commodity (paint), Sherwin-Williams’ strong branding, vertical integration, and economies of scale have enabled it to generate outstanding returns on invested capital over the last decade.
High and stable returns suggest a business possesses a moat and help the company compound its earnings faster by squeezing more out of every dollar of capital reinvested back into the business.
The biggest knock against the dividend is Sherwin-Williams’ high financial leverage, resulting from its acquisition of Valspar (consisting of a bridge financing facility of $9.3 billion and Valspar debt of $2 billion).
The company has suspended its share repurchase program for the year and also modified its practice of paying 30% of trailing EPS in quarterly cash dividends (intends to resume once the debt is reduced to a more sustainable level) to retain cash on its balance sheet.
The good news is that Sherwin-Williams is expected to have an enhanced cash flow profile going forward, and management has made fast deleveraging a priority. Favorable credit market conditions also allow Sherwin-Williams to refinance its debt through low-interest term loans.
Sherwin-Williams’ Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Sherwin-Williams’ dividend growth prospects are excellent – the company has a Dividend Growth Score of 98 and raised its payout by 25% in 2016.
While Sherwin-Williams recorded its 39th consecutive dividend increase in 2017, it only raised its payout by 1.2%. As previously mentioned, Sherwin-Williams is conserving cash but plans to increase the payout ratio back to 30% trailing earnings once its debt is reduced.
As seen below, Sherwin-Williams’ dividend growth rate has accelerated over the last decade, increasing from 13% per year over its last 10 fiscal years to about 19% per year over the last three years.
Given Sherwin-Williams’ strong underlying earnings growth, low payout ratios and improved cash flow generation capacity after the Valspar acquisition, the company should be capable of registering double-digit dividend growth for many years.
However, investors should anticipate dividend growth in the low single-digit range until the debt is reduced to a more reasonable level.
Valuation
SHW trades at a forward P/E ratio of 21.9, above the S&P 500’s 17.4, and has a dividend yield of 1%, which is in line with its five-year average yield. Investors clearly believe Sherwin-Williams has compelling long-term earnings growth prospects by assigning this paint producer a premium multiple.
The market has re-rated Sherwin-Williams after the Valspar acquisition, sending the stock up more than 20% year-to-date. Investors have increased confidence that Sherwin-Williams will successfully integrate Valspar and grow earnings even faster thanks to substantial cost synergies and increased exposure to international markets.
While such growth is certainly possible and the company has proven many wrong over the last decade, I would prefer to take a wait-and-see approach given the stock’s premium valuation, the early stages of the Valspar integration, and some uncertainty about U.S. paint store saturation.
Conclusion
Sherwin-Williams is a blue chip dividend stock with several competitive advantages. However, its future shareholder returns will likely be driven by the long-term success of its recent acquisition of Valspar.
Given the size of the deal, some of the early integration challenges management has encountered, and the stock’s very low yield, my preference is to remain on the sidelines for now. Investors seeking higher current income can review some of the top high dividend stocks here instead.
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