Sherwin-Williams Company (SHW: Hold, $375 PT) 
Time to Make Lemonade; Trimming EPS on Margin Pressure, D&A
• Legacy VAL restrains earnings growth. While Sherwin is “more bullish than ever” on the Valspar deal, we must confess that we are increasingly skeptical. Challenges at legacy Valspar may take longer to fix relative to 3Q margin pressure in The Americas Group (TAG), which we view as manageable and perhaps short-lived given double-barreled price contributions in October and November (older price hike on 12/1/16 plus a new round on 10/1/17). As we see it, four key events have transpired since Sherwin agreed to acquire Valspar for $11.3bn in March 2016: (A) anti-trust review was prolonged, which we believe compromised operations to some degree in the 14+ months needed to close the deal; (B) the deal necessitated the divestiture of wood coatings at ~9x EBITDA, which magnified the multiple on the balance of VAL to 16.5x 2016 EBITDA; (C) raw material costs inflected upward in 2016, followed by a more recent natural disaster-driven surge in September 2017; and (D) industry-wide demand for architectural coatings has weakened in the DIY space, where it takes longer to recover cost inflation. As a result, Sherwin has paid approximately $10.9bn net of wood coatings divestiture proceeds, or 19.7x for a business that we now expect to contribute only $555mn of EBITDA in 2018 pre-synergies. After taking into account projected cumulative synergies of $340mn in 2019, the multiple drops to 11.5-12.0x. So, Sherwin has a lot of work ahead to restore margins, although we are encouraged that execution on synergies is running ahead of schedule and that management has slashed 2017 capex in recognition of ample capacity. On balance, we find Sherwin’s 3Q17 results uninspiring following Sherwin’s more upbeat investor day (click here), so we maintain our Hold at 14.9x our 2018 EBITDA.
• Top 10 takeaways: (1) In a messy 3Q characterized by natural disasters and deal-related accounting considerations, SHW posted 3Q17 EPS of $4.17, excluding purchase accounting inventory adjustments but including deal-related amortization expense; (2) 3Q17 EBITDA of $775mn came in well less than the $872mn that we had modeled and consensus of $835mn; (3) purchase accounting inventory adjustments depressed pretax earnings by $79mn in 3Q17; we do not expect similar adjustments to recur in 4Q17; (4) earnings came in short of our forecast in all segments with the largest variance in Performance Coatings, followed by Consumer Brands; (5) SHW now sees Valspar deal-related synergies of...
• Changes to our model: We are reducing our 4Q17 EPS estimate by $0.21, to $2.99 from $3.20, given lower expectations for legacy Valspar results and a higher D&A to reflect an increase in deal-related amortization to $300mn from $270mn. Partially offsetting these adjustments is a reduction in expected corporate costs given the better than anticipated performance in 3Q17. Due to margin contraction at legacy Valspar and the elevated amortization, we reduce our 2018 EPS estimate by $0.80, to $17.00 from $17.80. Higher deal-related amortization is responsible for $0.23 of this reduction, while the remaining $0.57 is mainly the result of lower expectations at legacy Valspar. We note that our 2017 EPS estimate excludes the effects of $115mn inventory-related purchase accounting adjustments in June through August 2017, of which $79mn or $0.58 occurred in 3Q17. Likewise, our 3Q17 financials exclude $34.5mn in transaction- and integration-related costs pretax, which translates to $0.26 in EPS. Finally, we have made a retroactive adjustment to our 2Q17 EPS to maintain consistent treatment of inventory-related purchase accounting. The result of this adjustment is a $0.15 reduction to our prior 2Q17 EPS calculation of $4.52.
• We rate SHW shares Hold with a price target of $375. Our target suggests limited upside including a 0.9% dividend yield. SHW shares trade for 14.9x our estimate of 2018 EBITDA, which represents a 26% premium to coatings peers, and 22.9x our 2018 EPS estimate, or a premium of 16% vs. the peer average of 19.8x and a premium of 25% vs. Buy-rated PPG. 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 $373, which declined modestly on lower earnings partially offset by lower capex and net debt. Using our relative P/E framework, we calculate warranted value of $377 per share, which increased modestly based on a slightly higher market multiple and a higher 20% premium to the S&P500 multiple vs. 15% previously.  
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Sherwin-Williams (SHW: Hold, $375 PT) 
EPS Leaking with VAL Weakening
• 3Q earnings came in below our expectation. In a messy 3Q characterized by natural disasters and various deal-related accounting considerations, SHW posted 3Q17 EPS of $4.17 including purchase accounting inventory adjustments but excluding deal-related amortization expense. This compares to our $4.66E. Sales of $4.51bn came in a shade ahead of our $4.50bn, but operating margins came in weaker than we had anticipated in every segment. SHW posted 3Q adjusted EBITDA of $772mn vs. the $872mn that we had modeled and consensus of $835mn. For context SHW posted EBITDA of $623mn in 3Q16 without the benefit of Valspar (we estimate that VAL generated ~$190mn in EBITDA ex wood coatings in 3Q16). To be fair, SHW suffered in 3Q17 from various natural disasters, which reduced sales and EPS by $50mn and $0.27, respectively. Also, we estimate that purchase accounting inventory adjustments depressed pretax earnings by ~$77mn in 3Q17. On balance, earnings came in short of our forecast in all segments with the largest variance in Performance Coatings, followed by Consumer Brands. In The Americas Group (TAG) same-store sales (SSS) growth grew +5.2% in 3Q17 similar to the SSS growth of 5.5% that we had expected. Net debt declined $553mn in 3Q17 to $9.68bn or 2.9x our estimate of 2018 EBITDA.
• EPS range is a touch lower on lower accretion from VAL. Sherwin trimmed its 2017 EPS guidance range slightly to a range of $14.85-15.15, or a midpoint of $15.00 ex an upwardly revised $3.21 in acquisition costs and a charge of $0.44 following the divestiture of wood coatings. This range includes expected EPS accretion of $0.75-0.85 from the closure of the Valspar transaction on 1 June, down from a range of $0.75-0.95 previously. Incremental D&A related to the Valspar acquisition has also increased to approximately $300mn per annum vs. the prior target of $270mn. On an apples-apples basis, the new 2017 EPS range compares to a prior range of $14.80-15.30, or a midpoint of $15.05, so the midpoint is $0.05 lower on balance. Management also put forth a range for 4Q17 EPS of $2.95-3.25 (ex $0.98 in acquisition costs), which brackets our $3.20E and consensus of $3.05. As highlighted in our recent note on investor day (link), Sherwin had raised its Valspar deal synergy target to a range of $385-415mn, although the release does not address this range.
• TAG missed on higher costs. North American Paint Stores Group (PSG) SSS grew 5.2% vs. the 5.5% increase that we had modeled. Management had indicated that leading up to the hurricanes SSS was tracking up 6.7% for July and August, which would imply a rate of ~2.2% for September. Margins missed our mark with EBIT a drag of $0.18 vs. our estimate. The variance comes from weaker results in PSG, as EBIT for Latin America was modestly positive, an encouraging turn from the -$12mn reported in 2Q17. We suspect that the majority of the hurricane-related headwinds were felt in TAG with management flagging $36mn in elevated costs, which is larger than the $20mn we had modeled.  Adjusting for this, TAG EBIT would have only been light by $8mn vs. our estimate, or $0.06/share. However, this still implies somewhat weaker results for PSG given the better performance in Latin America.
• Consumer Brands came in light. Sales of $723mn came in below our $787mn estimate, primarily due to weaker sales at legacy Valspar. The weakness is not too surprising though given the continued negative industry commentary on the performance of paint sales among big box retail customers. Sherwin’s legacy consumer business actually trended quite well in this environment, with EBIT improving 4% sequentially. Performance at legacy Valspar appears to have slipped, though results do not look as dire after adding back an estimated $31mn for inventory related charges.  
• Performance Coatings margin compressed. Sales of $1.24bn came in ahead of our $1.17bn estimate driven by better growth from legacy VAL, up 8.5% vs. our estimate of 5.3%. EBIT margins disappointed however, as both legacy Sherwin EBIT and particularly Valspar EBIT underperformed. Legacy EBIT of SHW at $57mn missed our $68mn and VAL EBIT of $2.4mn came in well below the $66mn we had estimated. If we were to adjust this number higher by $46.2mn in estimated inventory related charges, the results are still worse than anticipated though the differential is not as large. We would note that this result comps against an estimated ~$115mn in F3Q16 EBIT as adjusted for divestiture of wood coatings. However that number is likely low on an apple-to-apples basis as the current Performance Coatings division, includes the Valspar auto refinish business, which was actually held in the Paints division of legacy Valspar. Somewhere in the Sherwin results should be initial synergy capture as well, although this figure was not quantified in the press release.
• We rate SHW shares Hold with a price target of $375. Our target suggests limited upside including a 0.9% dividend yield. SHW shares trade for 14.5x our estimate of 2018 EBITDA, which represents a 22% premium to coatings peers, and 21.7x our 2018 EPS estimate, or a premium of 10% vs. the peer average of 19.8x and a premium of 19% vs. Buy-rated PPG. 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 $375. Using our relative P/E framework wherein we apply a 15% premium to the S&P500 multiple, we calculate warranted value of $375 per share as well.
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W.R. Grace and Co. (GRA: Buy, $82 PT) 
Impressive 3Q Earnings Plus a New Price Hike in FCC
• Grace beat even our pre-Harvey number. Grace reported 3Q17 adjusted EPS of $0.90, a substantial beat vs. the $0.81 we had forecast and consensus of $0.83E. In light of Hurricane Harvey, we had trimmed our 3Q17 EPS estimate by $0.07 heading into the quarter, whereas Grace quantified the actual earnings hit in Catalysts at $4mn or $0.04. Sales grew 6% in 3Q to $430mn, which likewise exceeded our (diminished) forecast of $394mn. On a segment basis, Grace posted operating upside in both Catalysts and Materials Technologies, while equity earnings (ART JV) came in ~$2mn less than we anticipated and elevated corporate costs represented an additional $4mn headwind. Insurance proceeds of $12mn make $25mn YTD, which is Grace’s policy limit, so it appears that insurance has been “maxed out” entering 4Q17, whereas we thought this would occur at some point during 4Q17. In this sense there may be $0.02-0.03 of EPS “pulled forward” into 3Q. A lower 3Q tax rate of 30.0% added $0.01-0.02 vs. our forecast rate of 31.3%. Importantly, Grace announced a new FCC catalyst price increase of +3-9% effective 1 January 2018, which comes as a pleasant surprise and should reflect positively on Hold-rated Albemarle (ALB) as well. We would expect GRA shares to respond favorably based on A) operational upside; B) the FCC price hike and C) tepid investor expectation entering the print.
• 2017 guidance appears mixed. Grace now sees 2017 EPS in a range of $3.36-3.41 vs. $3.30-3.45 previously. We view this glass as half full given the Harvey-related impact of at least $0.04 since the prior range was put forth. Sales growth expectation were increased to +6-7% from +3-4% previously, but EBIT was reduced to $412-417mn, consistent with the lower end of Grace’s prior range of $415-430mn. EBITDA of $525-540mn compares to our most recent estimate of $516mn and our pre-Harvey bogey of $526mn.  FCF expectations remain unchanged at $265-275mn.
• Catalysts beat our estimate. EBIT of $104mn provided a $0.10 tailwind vs. our estimate of $94mn. This number includes $4mn in Hurricane Harvey related headwinds, a smaller impact than the $6mn EBIT cut we made for the catalyst segment ahead of the quarter. However this $104mn would have still registered as a beat against our pre-Harvey forecast. Grace indicated it has maxed out its insurance claims related to business interruption at FCC customer Takreer (Abu Dhabi). This represents a somewhat faster pace than we anticipated. Earnings also include a $2.2mn headwind vs. our estimates from lower equity earnings from ART. We hesitate to draw any conclusions from this decline y-y given the inherently lumpy nature of the HPC business. Overall, we are encouraged by 140bps of sequential expansion of EBITDA margin. Looking ahead, the guidance implies an additional $2mn EBIT headwind from Hurricane Harvey, which we suspect would fall into the Catalyst segment. However, we believe the proposed FCC price hike will be taken positively by investors who have all but written off a price-cycle thesis while Takreer is down.
• Materials Technologies improves from 2Q17 lows. Sales and margins both came in ahead of our expectations, driving upside of $2mn, or $0.02 per share vs. the $24mn we had penciled in.  Encouragingly, gross margins expanded both y-y and sequentially despite a more elevated raw material environment. In historical context, $26mn in EBIT is no great shakes, but it is a sign of progress as the company rebounds from a disappointing result in 2Q17.   
• We rate GRA shares Buy with a price target of $82. Our target suggests total upside potential of 17%, including a dividend yield of 1.2%. GRA shares now trade at a 2018 P/E multiple of 19.7x, unadjusted for the $6/share in present value of Net Operating Losses, and 18.0x our 2018 EPS inclusive of the NOLs.  This NOL adjusted value represents a discount of 3.7x or 17% vs. the average specialty chemical company, and only a 0.6x or 3% premium to our coverage average 2018 P/E multiple of 17.4x. Our valuation of GRA 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 $84. Using our relative P/E framework wherein we apply a 20% premium to the S&P500 multiple, we calculate warranted value of $79 per GRA share.
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