Sherwin Williams Has Painted a Path Toward Higher and Sustainable Profits

Industry heavyweight Sherwin Williams is finding that demand for its paint products is not only propelling its profits higher but also helping to improve pricing and make those earnings more sustainable.

The recovery of the U.S. housing market has been one of the biggest phenomena shaping stock market returns for 2012, and one of the most significant economic trends to partially offset the gloomy news from the unemployment market. While some of its biggest beneficiaries have included homebuilding stocks, the ripple effects have reached as far as Sherwin Williams Cos. (SHW.N), as demand for the company’s paints, coatings and related products has jumped. Whether North Americans are buying paint to do up their houses before putting them on the market, or whether new homeowners are picking up gallons of paint as part of a renovation of the properties they have just bought, Sherwin Williams is a beneficiary.

That strong demand has bolstered the company’s earnings, which jumped 31% in the third quarter over year-earlier levels; Sherwin Williams also boosted its guidance for profits for the full year when it released its most recent quarterly results in late October. Even better: the StarMine Earnings Quality (EQ) model, which awards Sherwin Williams a score of 98 out of a possible 100, suggests that the company’s strong cash flow and operational efficiency will translate into earnings that are sustainable over the coming several quarters.

One reason the company’s EQ score is so high is that it registers a 98 on the operating efficiency component of this model. The chart below portrays the three most commonly used measures of this metric: the gross margin (portrayed in red), the operating margin (in green) and the net margin (in blue). The company’s gross margin has increased from 43.7% in the third quarter of 2011 to 45.9% by the end of the quarter ended September 30, 2012. The improvements in the operating margin and the net margin in the last four quarters are even more significant. At the end of September 2011, the company’s net margin was a mere 0.7%; now it stands at 9%. Also significant is that all three of these margin measures register well above the industry median, with both the net margin and the operating margin beating that median by more than two percentage points and the gross margin boasting a still larger differential. The company is operating so efficiently that its net margin and the operating margin are at the highest levels recorded in the last five years.

The chart below shows the company’s trailing four-quarter return on net operating assets (RNOA). That metric tells us how well Sherwin Williams is faring in generating a return on its assets. The blue line on the chart depicts that RNOA, which has risen to a five-year high of 36.4%, well above the industry median of 22.1%. Some of that can be attributed to the growth in demand: as same-store sales have grown along with homeowner interest in refurbishing their properties, so Sherwin Williams has been able to take advantage of that to raise prices.

The additional foot traffic in the company’s own stores, which account for the lion’s share of Sherwin Williams’s sales, and the improving housing market also explain why the company’s inventory levels have fallen. Sherwin Williams has trimmed the number of inventory days on a year-over-year basis in each of the last four quarters: by 1.7 days in the third quarter, 7.7 days in the second quarter of 2012, 14 days in the first quarter of the year, and 5.5 days in the final quarter of 2011. That encouraging pattern is a sign that the company’s better performance isn’t just due to increased demand but also that management is doing a better job of managing inventory.

Sherwin Williams has been in the news lately, with its $2.3 billion proposed acquisition of Mexican coatings manufacturer Consorcio Comex S.A. expected to close in the first quarter of 2013, once all regulatory approvals have been received. Comex, which has eight manufacturing sites in the United States and Canada, has another eight facilities in Mexico. Its ownership will give Sherwin Williams an opportunity to boost sales in a region where it currently has a smaller market share, and is part of the company’s broader expansion plans. But Sherwin Williams is a stand out on a standalone basis when it comes to earnings quality – and the additional debt that the company will have to take on to finance the transaction – an estimated $2 billion, according to CFO Sean Hennessy – shouldn’t alter that picture, given the company’s ability to finance that debt with its strong cash flow.

In the last two quarters alone, Sherwin Williams generated more than $650 million in free cash flow, which indicates that it will be well positioned to pay down that debt over time. Hennessy said that the company would be able to take advantage of the low interest rate environment to raise the fresh capital, and acknowledged that the company’s debt to EBITDA ratio would increase from 1 to 3. Nonetheless, he also said that Sherwin Williams will have cut that ratio back to 2.3 to 2.5 by the end of next year, and back down to 1.25 by 2018, without threatening the company’s dividend payments.

If anything, this acquisition is likely to be a net positive, further strengthening the company’s earnings and reinforcing its earnings quality by diversifying its customer base and its geographical footprint. While three large rating agencies have reacted to the Mexican deal by putting the company’s debt on creditwatch, it’s important to put any possible downgrade in perspective. Given the fact that both S&P and Fitch give the company bonds an A rating, a one-notch cut in those ratings will still leave the bonds squarely in investment-grade territory.