Dividend history is one of the most straightforward and accurate measures of business quality.

Intuitively, this makes sense – a company must have a significant and durable competitive advantage in order to raise its dividend every year for decades.

Sherwin-Williams (SHW) is one of the most high-quality, well-managed businesses in our stock universe.

The company has increased its annual dividend since 1979, which qualifies it to be a member of the Dividend Aristocrats – elite dividend stocks with 25+ years of consecutive dividend increases.

The company shows no sign of slowing down. On July 20, Sherwin-Williams reported financial performance for the second quarter ending June 30, 2017. Alongside double-digit revenue growth, Sherwin-Williams gave an update on the integration of its most recent acquisition – Valspar, a fellow manufacturer and distributor of paint and coating products.

This article will discuss Sherwin-Williams’ recent quarterly earnings release and the company’s  general investment prospects in detail.

Business Overview & Current Events

Sherwin-Williams is North America’s largest manufacturer of paints, varnishes, and industrial coatings. The company also manufacturers paint application equipment and other accessory items.

Sherwin-Williams delivers its products through more than 4,000 retail locations via its 60,000+ employees. Founded in 1866, Sherwin-Williams is headquartered in Cleveland, Ohio and has a market capitalization of approximately $33 billion.

As mentioned, Sherwin-Williams recently reported financial performance for the second quarter of fiscal 2017. Sherwin-Williams’ second quarter ends on June 30, in-line with the end of the calendar’s second quarter.

Results were generally quite strong during this reporting period.

The company’s consolidated net sales increased to $3.74 billion, a 16.0% from the same period a year ago. For the six month period ending June 30, Sherwin-Williams’ revenues increased 12.1% from 2016’s figure.

Naturally, the most important aspect of this Sherwin-Williams earnings release was the impact of the recently-acquired Valspar business.

Valspar was an international manufacturer of paints and coatings headquartered in Minneapolis, Minnesota. Valspar had annual revenues of ~$4 billion and about 11,000 employees on payroll at the time of the acquisition.

Sherwin-Williams’ acquisition of Valspar had a significant impact on the firm’s financial performance. The transaction created an 11.8% and 6.6% boost to quarterly and six-month sales, respectively.

The transaction also generated plenty of one-time financial charges which temporarily depressed the pro-forma company’s earnings-per-share.

For the full-year of fiscal 2017, the Valspar transaction is expected to create $2.50 per share of acquisition-related charges. This comes after Sherwin-Williams incurred $0.86 of acquisition-related expenses in fiscal 2016. This has not been a cheap transaction so far.

However, the Valspar acquisition remains highly accretive to per-share profits despite these expenses. Valspar operations increased earnings-per-share by $0.10 in the second quarter,  and are expected to increase earnings-per-share by $0.40-$0.60  and $0.75-$0.90 in the third quarter and full-year of fiscal 2017, respectively. These figures are all net of acquisition-related expenses.

Investors should also note that the Valspar transaction created meaningful changes to the segmented results that Sherwin-Williams now reports.

In the past, Sherwin-Williams operated in four segments:

• Paint Stores Group
• Consumer Group
• Global Finishes Group
• Latin America Coatings Group

This is changing significantly moving forward.

Sherwin-Williams’ Paint Stores segment is merging with its Latin America Coatings Group to form the pro-forma company’s ‘The Americas Group’.

In the second quarter, this segment reported sales of $2.4 billion and profit of $533 million. It will be the largest segment for the ‘new’ Sherwin-Williams.

Source: Sherwin-Williams Second Quarter Earnings Presentation

Sherwin-Williams’ Consumer Group is merging with Valspar’s Paint Segment to form the new company’s Consumer Brands Group.

In the second quarter, the Consumer Brands Group generated sales of $537 million and profit of $97 million. Note the stark contrast in financial results between The Americas Group and the Consumer Brands Group.

Source: Sherwin-Williams Second Quarter Earnings Presentation

Lastly, Sherwin-Williams’ Global Finishes segment will be merging with two of Valspar’s segments: the Coatings Segment and the Paint Segment.

The new segment called the Performance Coatings Group, generated $761 million of sales and $100 million of profit in the second quarter

Source: Sherwin-Williams Second Quarter Earnings Presentation

So, to sum up, Sherwin-Williams now reports financial results in the following three operating segments (along with 2Q17 financial performance):

• The Americas Group: $2.4 billion of sales and $533 million in profit
• The Consumer Brands Group: $537 million of sales and $97 million of profit
• The Performance Coatings Group: $761 million of sales and $101 million of profit

Also, note the difference in net margin between Sherwin-Williams different operating segments:

• The Americas Group: 22.2% net margin
• The Consumer Brands Group: 18.0% net margin
• The Performance Coatings Group: 13.2% net margin

Based on the large size and company-leading profitability of The Americas Group, I would not be surprised if Sherwin-Williams focuses most of its resources on growing this segment from this point onwards.

Competitive Advantage & Recessions Performance

Sherwin-Williams is far from being the most recession resistant Dividend Aristocrat.

The company’s sales are highly reliant on a healthy real estate market, which tends to crash during economic downturns.

With that said, the company does enjoy a compelling scale- and brand-based competitive advantage.

Customers are highly likely to purchase paint from Sherwin-Williams simply because it is the first brand that comes to mind when they begin shopping. And, Sherwin-Williams’ large size means it can generate economies of scale and pass the savings onto its customers, creating enduring brand loyalty.

These advantages can be seen in Sherwin-Williams’ historical recession performance. Despite being reliant on the real estate market, the company managed to maintain profitability during the massive 2007-2009 housing crash:

• 2007 adjusted earnings-per-share: $4.70
• 2008 adjusted earnings-per-share: $4.00 (14.9% decrease)
• 2009 adjusted earnings-per-share: $3.78 (5.5% decrease)
• 2010 adjusted earnings-per-share: $4.21 (11.4% increase)
• 2011 adjusted earnings-per-share: $4.14 (1.7% decrease)
• 2012 adjusted earnings-per-share: $6.02 (45.4% increase – new record)

Sherwin-Williams’ high-quality business model and its historical recession performance indicate that a downturn in the housing market would be the best time to accumulate this stock for long-term investors. 

Valuation & Expected Total Returns

The transformative characteristics of the Valspar acquisition mean that it is difficult to assess Sherwin-Williams’ valuation using 2016’s earnings.

Instead, we can look to the company’s 2017 guidance to assess its current valuation multiple.

In the company’s second quarter earnings release, Sherwin-Williams increased its full-year adjusted earnings-per-share guidance to $12.30 to $12.70, with a $0.75 to $0.95 benefit from the Valspar transaction net of a $2.50 per share impairment charge for acquisition-related costs.

Sherwin-Williams is currently trading at a stock price of $350.78. Using the middle of the new 2017 earnings-per-share guidance – $12.50 – gives a forward price-to-earnings ratio of 28.1.

The following diagram compares Sherwin-Williams’ current valuation to its long-term historical average.

Source: Value Line

Sherwin-Williams current PE ratio of ~28 is significantly above its long-term average of 17.4.

So why are investors paying such a premium for this stock today?

It is partially due to the current low interest rate environment. Low interest rates tend to inflate the valuation of stocks – particular dividend stocks – as investors sell fixed income instruments and look to other asset classes for the possibility of stronger risk-adjusted returns.

Another factor is the reassessment of Sherwin-Williams’ intrinsic value by the financial markets.

The company did not begin to sport a premium valuation overnight; instead, its valuation steadily increased over the years as investors began to realize the true quality of the Sherwin-Williams enterprise.

Looking again at the valuation chart, this trend can be seen beginning in roughly 2009.

Source: Value Line

The reappraisal of Sherwin-Williams’ ‘normal’ valuation by the financial markets was likely driven by the company’s impressive historical earnings growth.

Amazingly, Sherwin-Williams managed to compound its adjusted earnings-per-share at an annual rate of 14.0% per year between 2001 and 2016. All said, this grew the company’s bottom line from $1.68 to $11.99.

Source: Value Line

However, I believe Sherwin-Williams’ current valuation is not justified. The company is unlikely to deliver 14% growth per year moving forward, and even if it did, a PE of 28 significantly discounts future shareholder returns.

Thus, I believe that investors should wait for a better buying opportunity for Sherwin-Williams’ common stock. A recession would present a prime opportunity to pick up shares of this high-quality business on the cheap.

Final Thoughts

Sherwin-Williams is well-known among the investment community because of its long track record of rapid earnings growth and steady dividend increases.

However, the company’s stock appears overbought right now. A ~28 price-to-earnings ratio is excessive for even the most high-quality business.

Moreover, Sherwin-Williams’ historical financial performance suggests that recessions are a fantastic opportunity to accumulate its common stock. It is highly likely that there will be better chances to buy Sherwin-Williams in the future.

Investors should avoid this stock for now, but it remains a strong hold for existing investors, particularly those with a low cost basis on current holdings.