Trimming EPS; Stores Outpace Consumer and Performance Coatings Again
• Operations are under pressure outside of company-owned stores. The power of Sherwin’s controlled distribution model continued to shine in 4Q with same-store sales (SSS) growth of 8.4%, albeit largely in line with consensus. However, the combination of an inflationary cost environment and sluggish demand in the DIY channel has conspired to create persistent pressure elsewhere in the company’s portfolio. On balance, 4Q17 EPS ex deal-related amortization of $3.16 missed our $3.58E despite an EPS tailwind of $0.14 from lower tax rate of 25% vs. the 28.8% we had modeled. Margins remain under pressure as raw material costs continue to escalate, while pricing lags and we suspect is harder to manage in a softer DIY environment. In Performance Coatings (PC), we are encouraged by the stronger top line performance, although the legacy Valspar business ended 4Q with margins near 13%, down from 17% in the prior year. While Sherwin is taking actions to address raw material headwinds, inflation remains a step ahead. Meanwhile, management continues to extract cost synergies following the June 2017 acquisition of Valspar. We estimate that Sherwin extracted synergies of $60mn in 2017 to be followed by $140-160mn in 2018 on the way to an upsized target of $320mn. Finally, we now anticipate an additional non-cash headwind of $40mn to our base EPS estimate as Valspar-related amortization is now expected to rise to $340mn in 2018, up from ~200mn originally, $275mn at deal closure, and $300mn as of the 3Q17 call.
• Our top 10 takeaways: (1) 4Q17 EPS of $3.16, excluding $0.24 in transaction costs and $7.00 in deferred income tax reductions, missed our $3.58E, though modestly outperformed the $3.15 consensus; (2) an adjusted tax rate near 25% was a $0.14 tailwind against our estimates; (3) decremental margins in the legacy Sherwin Consumer business were 73% as EBIT fell 30% on a 7% decline in top line; (4) legacy Valspar’s consumer sales declined 3.2% in contrast to better 4Q sales trends at competitors RPM and PPG in the “big box” channel; (5) consolidated EBIT for PC and Consumer sank $30mn y-y, or 12% ex deal-related amortization, despite an estimated $30mn in synergy capture (implying a $60mn or roughly 24% decline excluding synergies); (6) raw material cost inflation is expected to be...
• Changes to our model: Given the continued underperformance in the legacy Sherwin Consumer and legacy Valspar Industrial Coatings businesses, as well as the increase in deal-related amortization of $40mn, we trim our 2018 EBIT estimate to $2.4bn from $2.6bn. These headwinds are partially offset by lower interest and tax expense (now at 23.0% from 23.6% in our prior model). The net result is a 2018 EPS estimate of $16.60, or $19.25 after adding back acquisition-related amortization expense vs. our prior estimate of $18.00, or $20.00 after adjusting for acquisition-related amortization. Our 2019 EPS estimate moves lower accordingly, now $19.00 (or $21.65 ex VAL amortization adjustments), down from $20.55 (or $22.56 ex VAL amortization adjustments).
• We rate SHW shares Hold and maintain our price target of $412. Our target suggests limited upside including a 0.8% dividend yield. SHW shares trade for 16.6x our estimate of 2018 EBITDA, which represents a 37% premium to coatings peers, and 25.3x our 2018 EPS estimate, or a premium of 28% vs. the peer average of 19.8x and a premium of 38% 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 $429. Using our relative P/E framework, we calculate warranted value of $394 per share, which incorporates a slightly higher market multiple and a premium of 35% vs. the S&P500 index multiple which is supported by elevated non-cash amortization expense following the company’s $11.3bn acquisition of Valspar in June 2017.
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