Sherwin-Williams: Great Business, Still Too Expensive (NYSE:SHW)

Sherwin-Williams (NYSE:SHW) shares plunged 9% yesterday following a disappointing earnings report. The stock has sold off 23% over the past year, underperforming the broader market.

Sherwin-Williams has a dominant position in the US decorative paint business and is well positioned for the long term, the stock remains expensive at 27x 2023e EPS. While this is a business I’d love to own, I see shares as overvalued (discussed below). Those seeking exposure to the US residential repair and remodeling industry may wish to consider DIY retailer Lowe’s (LOW) which benefits from many of the same long-term tailwinds, but trades at a much lower multiple (14.5x 2023e EPS).

Sherwin-Williams is a long-term winner

Sherwin-Williams holds an estimated 50% market share of the US residential paint market and a 70% market share amongst professional painters. The company is vertically integrated and distributes paint through 4,500 retailers in the US, Canada, and Latin America. The broad distribution network is a key competitive advantage as paint must be mixed at the point of sale to achieve the right tone.

Sherwin-Williams’ unrivaled market position has resulted in excellent performance over the past decade – the business has increased sales and operating profit at 9% and 11% CAGRs, respectively. Its dominant market position enables Sherwin-Williams to offset inflationary pressure through price increases. Further, with labor comprising ~85% of the cost of a paint job, there is little sensitivity to increases in the cost of paint (a 10% increase in the cost of paint increases the total job cost by only 1.5%).

Over the medium and long term Sherwin-Williams will continue to benefit from the aging US housing stock which is now approaching ~40 years old (shown below). An estimated 80% of paint demand comes from repair and renovation which ensures relatively stable demand going forward.

Current Conditions

While Sherwin-Williams is primarily exposed to the more stable renovation market, it is not immune to the slowdown being seen across the US housing market. As noted above, the company expects to see a significant slowdown in sales related to new home construction.

Further, the dislocation in the housing market caused by significantly higher mortgage rates has led to lower re-sale volumes. This presents a headwind to the renovation market as housing transactions typically lead to an increase in renovation (prepping for sale or changes made by new owners).

Slowing demand across the US housing landscape coupled with weakness in other geographies (and industrial paint business) lead Sherwin-Williams to introduce 2023 EPS guidance nearly 18% (at the midpoint) below consensus estimates.

Valuation

Sherwin-Williams is a fantastic business which is well positioned for the long term. As such I believe that the business warrants a premium valuation to the overall market. The broad S&P 500 (SPY) trades at roughly 17-18x 2023 earnings estimates. With a dominant market position, strong operating margins (13.5%) and returns on invested capital (14% return on total capital employed; 40% return on tangible capital), and ample growth potential, I believe the stock should trade at a 25% premium to the broader market. This implies a 22x P/E multiple.

At $225 per share, Sherwin-Williams is currently priced at 27x 2023 expected EPS and 24x 2024e EPS. At 22x 2024e EPS, I estimate a fair value of $200-$205 per share for Sherwin-Williams suggesting the stock is ~10% over valued.

Investors looking for exposure to high quality businesses which are poised to benefit from the positive long-term tailwinds in the market for US home renovation may wish to consider shares of home improvement retailer Lowe’s (LOW). Lowe’s has a strong market position (#2 behind Home Depot) and has demonstrated an impressive track record of growth in revenue and EPS. While Lowe’s is also likely to see a slowdown, shares trade at a much more modest valuation (14.5x 2023e EPS), a significant discount to Sherwin-Williams and Home Depot (HD) which trades at 18x 2023e EPS. Interestingly, though it trades at a much lower valuation, Lowe’s has increased operating profit at a 14% CAGR over the past decade, ~3% faster than Sherwin-Williams.

Conclusion

Sherwin-Williams is an excellent business which I would like to add to my portfolio someday. However, the company currently trades ~10% above my fair value estimate. As a value investor, I typically look to buy shares trading at a 30% or greater discount which means I’d be interested in purchasing shares of Sherwin-Williams below $145. I see Lowe’s as a reasonable alternative for investors looking for exposure to US home renovation.