85: Watchlist Update: Adding Sherwin-Williams

The leading paint company is worth getting to know.

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Excerpts from the recent 20-page Deep Dive

Sherwin-Williams

Sherwin-Williams continues the home improvement theme started last month by Home Depot and Lowe’s (HD, LOW | Disclosure: None). SHW is the dominant player in the architectural coatings industry. The scientific-sounding industry classification translates into paint for the interior and exterior of buildings.

While the business is simple and the industry mature, there is lots to get excited about. From a technological and consumer’s perspective it’s incredible to learn just how much research goes into improving something so simple as paint. On the business side it’s a value investor’s classic moat business, one whose product has an outsize impact on aesthetics but a disproportionately smaller cost, all of which leads to pricing power.

I have a few qualms with management buying stock at seemingly expensive prices. Overall, however, it’s a company I want to continue to follow as the latest addition to the Watchlist.

INDUSTRY OVERVIEW:

SHW’s primary business is architectural paint, a market estimated to be about $32 billion per year in the United States. According to SHW, in 2021 the US architectural paint industry sold 868 million gallons of paint. That’s over 1,300 Olympic-sized swimming pools worth. Good luck keeping your 200m butterfly record in a pool of Drift of Mist, Michael Phelps…

On a very high level, the paint industry follows cyclical patterns of home building and remodeling activity, ebbing and flowing as economic conditions change. On a structural basis, however, a more linear relationship to building stock exists. That is, the more residential and commercial space in existence the higher long-term demand for painted walls. That logic is rock-solid and one we can rely on as long-term investors to serve as a backdrop for sustainable competitive advantage.

Competitive landscape:

SHW holds the largest share of the worldwide market for architectural paint and the largest share of the North American market.

Though interesting as a statistic, worldwide market share isn’t as relevant as local share. The reason comes down to the drivers of competitive advantage, which in this case are very much brand based and do not translate well from one market to the next. Brand coupled with economies of scale in manufacturing and distribution drive profitability, and this does not require worldwide scale to achieve.

KEY VARIABLES-METRICS:

Ideally, we would have information on gallons sold, but unfortunately, SHW does not provide data on volume. Absent this data we must fall back on the basic two-pronged approach of revenues to average capital and EBIT margins. I considered including store count as a key metric but that could potentially be misleading if store count increased but volume/store declined. Better to stick to the few variables that can provide insight.

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The relative attractiveness of each of SHW’s main businesses can be seen in its margins. The Americas Group segment with the company’s namesake brand commands 20% EBIT margins. The Performance Coatings Group struggles to break a 10% margin – evidence of the relative degree of competitiveness (and SHW’s disadvantage) in that market. Consumer Brands falls in the middle.

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CAPITAL ALLOCATION:

With SHW we find another have-my-cake-and-eat-it-too story. The decade ended in 2021 featured a 100% return of net income to shareholders in the form of dividends and buybacks and acquisitions totaling three-quarters of net income. How was this funded? Debt, of course.

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My one gripe about capital allocation is the use of buybacks. Management seems to have a penchant for repurchasing shares at high valuations. I’d much rather see a continued focus on deleveraging than spend 30x to 40x EBIT on buybacks.

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Stay rational! —Adam

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