We Won't Paint Over Our View of Overvalued Sherwin-Williams

Charles Gross: Narrow-moat Sherwin-Williams is among the largest producers of architectural and industrial paint in the world. We assign a $340 per share fair value, well below the prevailing market price of $590. With shares trading well into 1-star territory, we strongly recommend clients avoid purchasing shares, or divest their current holdings.

The market price currently bakes in two key assumptions that we disagree with. The first is that Sherwin-Williams will gain unrealistic amounts of market share over the coming decade. The second is that the company will achieve record-breaking adjusted EBITDA margins and sustain them over the economic cycle. Both outcomes appear highly unlikely to play out.

Digging into the first argument--Sherwin-Williams grows its share of the coatings market by opening new stores. Over the last two decades, the company has been able to grow its footprint by about 2% to 2.5% annually. In order for us to generate a fair value comparable with the current market price, we have to assume that the company can accelerate that opening pace to 3.5% per year--more than 200 new stores each year--into an increasingly saturated market for paint. The constraints that will prevent the company from reaching those expectations come down to labor constraints and only so many attractive new storefront locations. Management has already noted how challenging it is to maintain current growth rates of new store growth, let alone opening twice as many stores going forward.

On margins, today's market price implies substantial profit gains on both the retail and industrial side of Sherwin's business. On the retail side, Sherwin would need to achieve and maintain EBITDA margins of 27%--that's not only well above the best-ever performance Sherwin has generated, but it's well above the best performance we've seen in the entire industry over the last 20 years. On the industrial side of the business, the company would need to maintain EBITDA margins consistent with the highest levels seen across the industry since 1999 indefinitely. We think neither outcome is realistic.

We think future energy or pigment price shocks will be enough to shake Sherwin's share price back to earth. About half of each can of paint is linked to energy prices. Even though paint companies are often thought of as industrial businesses, their margins are clearly correlated with changing input prices. The company benefited significantly from the energy price collapse in 2014 and 2015, which we think is part of why investors are so optimistic about future margin levels. Even in the absence of an input price shock, we think competition over market share will be enough to prevent record-high margins from lasting indefinitely.