Painting By Numbers – Still Too High

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SHW missed estimate and guided lower today, taking a stock which has already underperformed for the last 12 months down further.  The paint industry in general and SHW in particular was identified by us this time last year as a sub-sector that in our view had got caught up in its own euphoria.  Better housing demand and a better market structure had allowed earnings to grow quickly in 2012, and it was very easy to make a bull case, based on expected housing demand improvements and momentum.  SHW further impressed the market with its bold attempt to acquire Comex – a move that has so far been thwarted by the Mexican competition authorities.

A year ago we argued that the paint market was indeed strong and better structured but that the valuations in the sector for the most part already reflected the view.  We maintain the view that; not only with US home starts not return close to any prior peak, but that new home builds are not much of a needle mover for the group – existing home sales is the more important proxy and this number has improved and could improve further.

During the course of 2013 we talked about how analyst enthusiasm for the sector was growing, perhaps because of the relative underperformance, but that in order to maintain and increase enthusiasm, estimates had to rise to justify target prices that suggested further upside.  Here to an extent SHW is the victim as estimates have clearly become a bridge too far, based on today’s announcement.

The paint industry has average annual earnings growth in the 10-11% range looking at the three main purer plays in the US.  While the improving cycle and improving structure of the market has resulted in some very strong growth years recently, we should not be surprised to see a return to trend or perhaps something slightly better than trend, but not the 33% seen for SWH in 2012 and the 23% for VAL in 2012.   SHW’s mid-point for 2014 guidance is for recurring earnings growth of around 17%, which still seems high to us.    If we paid 20x earnings for this growth, we would be at around $175 per share today – 3% lower than today’s price and well below current consensus target price of around $200 per share.

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VAL is trading at 17x 2014 earnings estimates and RPM at 19x.  RPM in particular looks expensive if we are returning to more normalized earnings growth.

An added concern that we have for all three stocks is an emerging theme – that of the cold weather in the US and its possible impact on consumer spending and economic activity.  Our college Rob Campagnino wrote about heating spending yesterday, and today ARG guided lower for the current quarter in part due to demand slowing as a result of the weather.  ARG’s business is an accurate coincident indicator of US broad manufacturing activity.

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