Look Beyond Sherwin-Williams' Short Term

As a result of soft sales growth in the first half, Sherwin-Williams decreased its full-year revenue growth guidance to 3%-5% from high single digits and lowered its full-year earnings per share outlook to $10.60-$11.00 from $10.90-$11.10. Second-quarter revenue growth came in at 2.9% year over year, far lower than the 6%-8% the company had forecast. Earnings per share came in at $3.70 for the quarter, on the low end of the $3.70-$3.90 guidance. The paint store group reported fairly weak comparable sales growth for the quarter of 3.9%, a deceleration from the 6% or higher growth that it typically reports. For the quarter, the consumer group saw sales rise 13.1% year over year due to growth in HGTV paint sales through Lowe's; sales would have been weak otherwise.

Although 2015 results are likely to come in slightly worse than we previously expected, we think these lower growth rates are only short term in nature. We continue to believe that the company benefits from an improving housing market and growing market share. Given favorable demographic trends, we think new residential paint volume will grow faster than most anticipate.

Premier Provider of Premium Paint As the largest supplier of architectural coatings in the United States with approximately a third of the market, Sherwin-Williams is the go-to provider of premium paint for contractors in the industry. While U.S. paint volume has rebounded somewhat from its lows during the 2008-09 recession, it has yet to reach its previous peaks, despite a larger stock of structures that require repainting. We believe incremental paint volume will be driven by higher existing-home sales and housing starts. Residential repainting makes up the bulk of paint volume sold, so existing-home sales are a key driver of company revenue. Painting is seen as a low-cost way to spruce up a property for sale. The best type of transaction for the company is an owner occupant repainting walls to sell to a new owner occupant, who repaints them in different colors to fit his preferences.

Housing starts were among the hardest-hit construction activities during the recession and have yet to rebound. We believe they will be the key driver of incremental paint volume and see a strong decade to come due to a combination of favorable demographic trends, with millennials reaching homebuying age, and greater credit availability. We think Sherwin-Williams will continue to gain market share, driven by the continued transition from do-it-yourself to contractors.

The company benefits from favorable demographic trends, as people 60 and older are the fastest-growing homeowner segment. They tend to rely on contractors instead of painting themselves. Sherwin-Williams also has a strong foothold in the aging and growing Southern and Southeastern regions of the U.S. Contractors mostly shop at specialty paint stores like Sherwin-Williams rather than big-box locations because of the formers' paint quality and high service levels. Labor is a far more costly component of a painting job than the paint itself, which is often a pass-through. Contractors are willing to pay a premium for Sherwin-Williams brand paint, as its quality and ease of use decrease the amount of time needed on each job.

Intangible Assets Make the Moat Sherwin-Williams has the leading market share among professional painters, who value brand, quality, and store proximity far more than their consumer (do-it-yourself) counterparts.

Sherwin-Williams charges a premium for its paints. Of painting contractor costs, 80%-90% is labor, with just 10%-20% paint, so contractors are not especially price-sensitive about paint costs. Contractors save on overall costs by purchasing high-quality paint that decreases preparation and application time to lower labor costs. Paint is not a commodity to professional painters, so they purchase high-quality product. Sherwin-Williams paint is well known in the industry for having desirable characteristics, including coverage (fewer coats needed), durability (lasts longer), cure time (less waiting), and ease of application.

We believe the professional segment will continue to increase share, creating a larger market for Sherwin-Williams. Professional painting benefits from demographic tailwinds. The professional painter share has increased from 40% of the industry two decades ago to approximately 60% of the $7 billion U.S. paint market today. Residential repainting makes up two thirds of paint volume. Homeowners view repainting as a low-cost, high-return way of increasing the value of their home, especially before putting it on the market.

Older homeowners tend to hire professional painting services. As the share of homeowners who are 60 and older has increased from a third in the 1980s to around 40% today, the professional painter has taken a greater share of the market. We believe this demographic trend will continue over the next decade due to the aging baby boomer population, with the 60 and older segment growing to 46% by 2024. Sherwin-Williams is well positioned to take advantage of this trend, given its strong foothold in the Southern and Southeastern regions, which are aging more quickly than the rest of the country.

Housing Starts and Sales Dictate Volume Risks to our forecast include housing starts and existing-home sales. Existing-home sales could fall due to a drop in investor activity or falling mobility. Household formation could be delayed due to tight credit, burdensome debt, or millennial preference shifts. In either case, paint volume would suffer. During downturns, homeowners tend to shift to do-it-yourself versus using professional painter as their budgets are squeezed, and Sherwin-Williams would be disproportionately affected. The company's primary costs are petrochemical derivatives and titanium dioxide. If Sherwin-Williams is unable to pass on input cost increases to customers, then margins would contract.

Management Is Exemplary We think management has done an excellent job of returning capital to shareholders in a mature industry. Over the past five years, more than half of net operating cash has been spent on share repurchases and approximately 20% has been spent on dividends. The remaining 30% has been spent on moat-widening capital expenditures and acquisitions.

The company has an outstanding record of acquiring regional paint stores. We believe this strategy has widened Sherwin-Williams' moat, as it expands the lucrative paint contractor business into regions that would be difficult for the company to organically grow into. Through these purchases, the company has acquired paint stores with loyal followings of contractors that would have been difficult to lure away by simply opening a Sherwin-Williams store in the area.

In 2004, management purchased Duron for $253 million, approximately 0.7 times sales of $350 million. This strengthened the company's foothold in the Mid-Atlantic and Southeast with 229 additional paint stores. In 2007, the company purchased M.A. Bruder & Sons for $160 million, approximately 1.1 times sales of $146 million, increasing penetration in the Eastern and Southeastern regions with 132 additional stores. In hindsight, these acquisitions have been highly value-accretive. We think the company ended up with good deals, as it ultimately paid approximately 5-8 times normalized EBIT for these businesses, assuming the current mid- to high teens EBIT margins of the paint store segment.

In 2013, Mexican regulatory authorities thwarted the company's purchase of Comex Mexico, arguing that it would give Sherwin-Williams too much market power. Sherwin-Williams walked away with just the Canadian and U.S. businesses of Comex for $165 million, approximately 0.35 times sales of $476 million. This added 314 stores in high-growth states including California, Texas, Washington, and Florida. The company is still looking to expand in Latin America, where its margins would benefit from the operating leverage of higher sales volume. The company has said it is looking to continue acquiring regional players, with the limiting factor being when private owners of these businesses decide to sell.