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July 17, 2017
By: Kevin McCarthy
Chemicals Anyalyst, Vertical Research Partners
• Completion of the Valspar deal marks a major milestone for Sherwin. After a 14-month long regulatory and review process, Sherwin completed the acquisition of Valspar on 1 June 2017 making Sherwin the largest coatings company in the world with pro forma 2016 sales of $15.9bn as shown in Figure 1. At $11.3bn, the deal is the largest in Sherwin’s history and significantly increases the company’s exposure to markets such as industrial coatings and consumer DIY retail. We have a balanced view of the transaction. While we appreciate the synergies and EPS accretion of the deal, we are less sanguine about returns. With a price tag of 15.6x EBITDA, the estimated ROI of ~6.5% is below Sherwin’s 7.6% WACC, and dilutes what we feel is the strongest part of Sherwin’s business model in the Paint Stores Group (PSG). As a result, we are not inclined to “chase” SHW shares, which have appreciated an impressive 32.9% year to date. • We raise estimates to reflect earnings accretion. We update our estimates to account for two separate issues. First, we adjust the legacy Sherwin tax rate lower to account for ASU 2016-09, which relates to employee stock-based compensation accounting. The result of this new tax accounting (implemented in 2Q16) is a structurally lower tax rate, which increases our 2017 EPS estimate to $15.10 from $14.25 and our 2018 EPS estimate to $16.30 from $15.50. This increase is larger than the one laid out in Sherwin’s guidance as we have not retroactively increased our 2016 numbers to reflect the prior benefits of the tax methodology. Second, we increase our estimates to account for the newly integrated Valspar deal. As a result of the Valspar integration, we increase our 2017 EPS estimate further by $0.75 to $15.85. Our 2018 EPS estimate also moves higher to $18.05 from $16.30. This $0.75 contribution to 2017 is higher than our prior estimate of $0.50 given… • We increase our price target by $19 to $335, and continue to rate SHW shares Hold. Our new SHW price target reflects downside potential of 5% after considering a 1.0% dividend yield. At current prices, Sherwin now trades at 22.5x 2017 EPS and 19.8x 2018 EPS. This represents a 10% and 8% premium to peers, respectively. On an EBITDA basis, this multiple premium widens to 25% and 21% for 2017 and 2018 as SHW trades at a 3.1x premium to peer 2017 EBITDA multiples and 2.4X premium to peer 2018 EBITDA multiples. As a reminder, our valuation of SHW is based on an average of two methodologies: DCF analysis and a relative P/E framework. Our DCF analysis suggests a warranted stock price of $349. Using our relative P/E framework wherein we now apply a 15% premium to the S&P500 multiple (down from 20%), we calculate warranted value of $320 per share. We have reduced the warranted premium over the S&P 500 to reflect the tax driven nature of a portion of our EPS estimate revision as well as the new business mix. When applying a current PPG multiple to the Valspar EBITDA and EPS contributions to the overall Sherwin entity, the new business’s valuation should see a… • Synergies appear achievable. In March 2016 Sherwin agreed to acquire VAL for $113 per share in cash or a 41% premium to Valspar’s volume-weighted average price for the 30 days through March 18, 2016. The deal creates a global coatings industry leader with pro forma 2017 sales and adjusted EBITDA (including estimated annual synergies) of… • Our read on VAL is that volumes have fared better than margins. Consistent with management commentary at our 2017 Materials Conference (click here), we know that legacy Valspar margins have compressed y-y, especially in… • 2Q earnings will reflect a “stub” quarter with limited guidance. At this juncture there are still many unknowns pertaining to how Sherwin will account for the various Valspar businesses… • Recent oil price weakness bodes well for gross margin in 2H17+. Raw material inflation has been a headwind to paint company results over the past 6-9 months. That said.. • Pro forma mix skews away from Sherwin’s high multiple Paint Stores Group (PSG). The key driver of Sherwin’s long-term success vs. most peers has been the power of its PSG’s controlled distribution model… For the full report please click here.
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