Sherwin-Williams (SHW): A Dividend Aristocrat Painting High Returns

Sherwin-Williams (SHW) has annually increased dividends since 1979 and outperformed the market by nearly 14% per year over the last decade.

Watching paint dry has been quite rewarding with coatings producer SHW, but past performance is not necessarily indicative of future results.

As we review SHW for potential inclusion in our Top 20 Dividend Stocks portfolio, we will be paying close attention to the factors that have contributed to the company’s historical success and assess the likelihood of these factors persisting far into the future.

Business Overview

SHW has been in business since 1866 and is the largest producer of paints and coatings in the United States (80% of its revenue) 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 4,000 company-operated retail stores, but it also sells some industrial coatings, automotive finishes, and protective and marine coatings (around 20% of sales in 2014).

Business Analysis

SHW’s biggest competitive advantage is its controlled distribution model. The company operates over 4,000 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 75% of SHW’s 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 SHW’s customers are contractors, and many of them prefer to deal with dedicated paint specialists rather than working with big box stores like Home Depot. SHW 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 SHW’s 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.

SHW 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 SHW store. As contractors continue taking market share from do-it-yourself consumers, SHW’s business should continue to benefit.

As a result of SHW’s 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, SHW’s margins also benefit from the company’s vertical integration. Big box retailers must pay wholesale prices for their paint inventory, but SHW produces its own coatings, resulting in higher profits. The business also requires little capital, helping SHW 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. SHW is no exception. As seen below, the stock compounded by 21.1% per year from 2006 through 2015, nearly tripling the market’s 7.4% annual return over this time period.

Source: Simply Safe Dividends

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 about a 25% increase from where the company ended 2014. Management insists this is not the end goal but rather a milestone along the way of SHW’s long-term growth path.

Given the high level of fragmentation in the paint market, we believe SHW will 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 we mentioned earlier, SHW’s 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.

SHW 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 over the last year).

We think SHW’s growth outlook looks good over the next 3-5 years, but we are less sure beyond then due to the company’s relatively large store base and geographical concentration in the U.S. market.

Sherwin-Williams’ Key Risks

As we alluded to above, we believe the biggest risk to SHW’s long-term future is market saturation in the U.S. The company has significantly more stores than its next largest peers and a strong presence in most regions already.

Investors appear to be giving management the benefit of the doubt given the stock’s current earnings multiple (20x). If SHW finds fewer opportunities for profitable store growth than it currently expects, the stock will be in trouble. The company also has less exposure to faster-growing international markets, so it is especially dependent on U.S. growth opportunities.

Additionally, SHW’s 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 (controlled channel model) help mitigate risk from new competition.

Finally, the state of the housing market and trends in raw material costs (e.g. oil-based materials and titanium dioxide) could impact SHW’s business results over the near-term, but we don’t expect either issue to impair the company’s long-term outlook. As seen below, the U.S. architectural coatings industry is still seeing volumes recover from the housing crisis.

Source: Sherwin-Williams Investor Presentation

Dividend Analysis: Sherwin-Williams

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. SHW’s long-term dividend and fundamental data charts can all be seen by clicking here.

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

SHW’s Dividend Safety Score of 96 suggests that the company’s dividend payment is safer than 97% of all other dividend-paying stocks in the market. As seen below, SHW’s payout ratios have remained low and steady over the last decade, providing plenty of cushion and room for growth. Even if SHW’s earnings cut in half, its payout ratio would only increase to around 50%.

Source: Simply Safe Dividends

Source: Simply Safe Dividends

Looking the cyclicality of SHW’s business, we can see that sales growth has remained within a relatively tight band over the last decade. SHW’s 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, SHW’s 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.

Source: Simply Safe Dividends

Despite selling a commodity (paint), SHW’s strong branding, vertical integration, and economies of scale have enabled it to generate outstanding returns on invested capital over the last decade. High returns create economic value and help the company compound its earnings faster by squeezing more out of every dollar of capital reinvested back into the business.

Source: Simply Safe Dividends

SHW’s balance sheet looks alright. Its cash balance is lower than we like to see at $206 million compared to debt of $1.9 billion and dividend payments last year of $215 million, but the company’s dependable free cash flow generation helps alleviate these concerns.

Source: Simply Safe Dividends

Dividend Growth Score

Our 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.

SHW’s dividend growth prospects are excellent – the company has a Dividend Growth Score of 97. The company is a dividend aristocrat that recorded its 37^th consecutive dividend increase in 2015, and SHW plans on hiking the annual dividend by 25% in 2016.

As seen below, SHW’s dividend growth rate has accelerated over the last decade, increasing from 12.6% per year over its last 10 fiscal years to about 20% per year over the last three years. We anticipate double-digit dividend growth continuing for many years given SHW’s strong underlying earnings growth and its low payout ratios.

Source: Simply Safe Dividends

Valuation

SHW trades at 20x forward earnings and has a dividend yield of 1.1%, which is in line with its five year average yield. Investors clearly believe SHW has compelling long-term earnings growth prospects by assigning this paint producer a 20x multiple.

We like the business and believe it is very durable, but we are less sure of management’s long-term store growth expectations. If SHW runs into market saturation sooner than expected in the U.S. and moderates its store expansion pace, things could get ugly as the stock re-rates to account for less growth.

For now, we will remain on the sidelines and look to revisit the stock closer to $215 per share. To deliver an exceptional total return, SHW needs to continue growing earnings close to 10% per year.

While such growth is certainly possible and the company has proven many wrong over the last decade, we believe that SHW’s high earnings multiple leaves less margin of safety.

Conclusion

SHW is a blue chip dividend stock with a bright future and strong staying power. However, even the best businesses can make poor investments depending on the market’s implied expectations.

For now, we believe there are other more attractive dividend stocks that offer a higher initial yield, above average growth prospects, and somewhat lower expectations. We will keep watching SHW for a better price.

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