Volume Issues Abound; Some Easier to Fix Than Others?
• Weaker organic volumes drive 2Q EPS below the Street. Adjusted 2Q EPS of $4.52 came in a bit below both our estimate and consensus. Perhaps the easiest thing to point to was the lack of volume growth relative to expectations. The ever important same-store-sales (SSS) number at 4.9% was weaker than hoped, although we attribute the variance to two transitory issues: persistent, seasonal labor constraints and inclement weather that curtailed sales of exterior paints during the latter half of June. Elsewhere in the portfolio, Sherwin’s Consumer business continues to struggle as evidenced by underwhelming sales and margin compression. We do appreciate that the DIY channel is losing ground to professional contractors (“do it for me”), but a 2Q sales decline of 12% y-y may reflect deeper issues than just inventory management, so we question the pace at which growth can be restored. Finally, with regard to the recent acquisition of Valspar (closed on 1 June), we do look favorably upon the synergy opportunity, but we’d rather not see this level of margin pressure given the price tag of $11.3bn. We estimate that Sherwin paid an acquisition multiple in excess of 16.5x Valspar’s 2016 EBITDA, as adjusted for the divestiture of wood coatings to Axalta for $420mn.
• Top 10 takeaways: (1) adjusted EPS of $4.52 missed our $4.72E, Factset consensus of $4.56, and Bloomberg consensus at $4.64; (2) SSS of 4.9% missed our estimate of 8.1%; (3) we estimate that organic volumes increased 0.5% all-in for legacy SHW, ex the benefit of revenue re-classification; (4) the largest top line drag came from the legacy Consumer business, where sales declined 12%; (5) encouragingly, the residential repaint contractor market grew...
• Changes to our model: We reduce our 2017 EPS estimate to $15.00 from $15.85 and trim our 3Q17 estimate to $4.82 from $5.10. The lower estimates reflect weaker than expected results in Latin America as well as a weaker earnings profile for the legacy Sherwin Consumer business. We have also adjusted lower our expectations for margin at the Paint business of legacy Valspar, given commentary from Sherwin that they now see the margin contracting y-y in the back half. Our new D&A step-up adjustment of $275mn is also higher than the $200mn that we had previously estimated. Accordingly, we reduce our 2018 estimate to $17.30 from $18.05.
• We rate SHW shares Hold and trim our target. We trim our price target from $341 to $335, which reflects a smaller percentage decline than our 2018 EPS due to the non-cash (amortization) component of the latter. Nevertheless, our new target suggests that shares are fully valued at 23.5x our 2017 EPS and 20.4x 2018 EPS. This represents a 14% and 10% premium to peers, respectively. On an EBITDA basis, this multiple premium widens to 21% for 2018 as SHW trades at a premium of 2.4X 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 $348. Using our relative P/E framework wherein we now apply a 20% premium to the S&P500 multiple, we calculate warranted value of $322 per share.
(Please see full report for details)