A Lesson In Expectations – Is There a Bubble In My Paint?

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

January 10th, 2013

A Lesson In Expectations – Is There a Bubble In My Paint?

 

  • We use our Skepticism methodology to highlight the aggressive expectations that are currently priced into the Coatings industry in general and Sherwin Williams in particular. While possible, current expectation stretch all possible variables – market growth, market share, cost control and consistency – to extremes.
  • Our Skepticism index (SI) measures whether current profitability explains current valuation, and augments our mid-cycle or “normal” valuation work. Today the Coatings sector discounts a greater expected increase in returns on capital, from already high levels, than any other group within Industrials and Basic Materials. Within the group, SHW is the standout, though PPG is also at an extreme.
  • Sherwin Williams’ return on capital trend over the last 40 years would have the company at 19% today. Current returns on capital are around 27%; well above trend and part of the reason why the stock has done well.
  • However, our analysis suggests that the company would need a 39% return on capital at current revenues to provide a more normal relationship between returns and valuation. Our SI analysis is based on forward 2013 earnings, but even if we look forward to 2015 estimates, only VAL has expectations that support current values.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

We provide a regular analysis of valuation and deviations from valuation norms to help investors understand what is discounted in the sectors and individual stocks that they either own or are considering. Sometimes a valuation move away from what has been seen historically is fully justified by fundamentals and sometimes it is not. In the latter case it is important to get comfortable with what has to happen to justify current valuation and any valuation move from current levels.

 

  • If you own what looks like a historically expensive stock today, generally it is because you expect it to outperform further.
  • Likewise, if you ignore what appears to be a cheap stock today, it is because you believe there is risk that it will either get cheaper or stay cheap for a while.

We use our Skepticism analysis to explore what is discounted in the very high valuation for the Coatings sub-sector of the chemical space today and while we find that expectations are high for all companies, they are at historic extremes for SHW. For SHW, valuation today expects growth rates and improvements in return on capital that are unprecedented historically and hard to rationalize even with bullish views of market growth, market share gains, pricing and cost controls. While the company is doing all the right things and is clearly the beneficiary of favorable market structure trends and feedstock movements, it is hard to see what more can be done to justify valuation gains from current levels. Others in the group also have some impressive earnings/return on capital gains discounted in valuation, PPG particularly, but the return on capital expectation in PPG’s valuation is an improvement to the level already present at SHW and a level the company has seen before (albeit with the help of a chlor-alkali cycle which it will not have going forward).

Exhibit 2

Source: Capital IQ, Company Reports and SSR Analysis

There is a lot of discussion about the US housing cycle, but our estimates suggest that if we get back to a new build rate in the US of 1.5m homes per year, this will only add 14-15% to architectural coatings volume growth. Furthermore, if we look at longer-term expectations and take consensus estimates for 2015 which suggest strong growth for all four companies, only Valspar has expected earnings that drive a return on capital estimate that is higher than currently implied in share prices.

There has been some very good momentum in this group. Earnings have grown despite a relatively weak housing environment and margins have improved because of capital discipline and some formulation advances. This was certainly the sub-sector to be in for 2012. The companies are doing everything right, but at some point prices are too high.

What has happened in other sectors at times like these is that consensus estimates creep up, partly because analysts do not want to change their (successful) recommendations and need higher growth to justify a higher target price (in some cases simply to avoid a “sell” recommendation) . Eventually these estimates surpass what is possible, even from those companies who consistently guide conservatively. The result is negative guidance or an earnings miss and a correction in the stock price.

A Refresher on the Skepticism Analysis

Cyclical industries lend themselves to some sort of reversion to mean valuation analysis. Very few historically cyclical industries or companies have managed to shed their cyclical natures, and the confluence of events that cause a profitable up-cycle inevitably reverse and cause a down-cycle. Some normalized approach to valuation is justified over the long-term, and we use a very well tested return on capital methodology to drive a measure of mid-cycle earnings for each of the companies we cover and aggregate these to our industry composites. In Exhibit 3 we show the discount from normal value profile for capital goods and chemicals. The charts show that the sectors are currently on the expensive side of normal, chemicals more so than capital goods, but they also show the volatility around normal. Both sectors have had long periods of undervaluation and over valuation.

Exhibit 3

Source: Capital IQ and SSR Analysis

It is important to note that this is a “relative” analysis and takes into account the value of the S&P500. All industrials and basic materials had a prolonged period of relative undervaluation during the tech run up in the 1990s. Today, in our view, their aggregate relative overvalue is a function in part of the low interest rate environment for two reasons – first dividend yield is more important today, and second, financials are depressed (in part because of low net-interest margins), dragging down the S&P multiple.

The charts in Exhibit 3 also show the inherent problem with “normal” value analysis. It is very efficient at telling you whether stocks or sectors are expensive or cheap, but it is very poor at telling you whether that is about to change.

The Skepticism work was developed to help address this. It looks at how much of current valuation (expressed as deviation from mean) is explained by current profitability (also expressed as a deviation from mean). An overvalued stock that is also over-earning is less of a concern than an overvalued stock that is under-earning. To generate our “Index” we add the number of standard deviations a company is below its “normal” valuation to the number of standard deviations it is above its normal return on capital. If a stock is undervalued, the first number is positive and if the stock is under-earning the second number is negative. Consequently, a Skepticism Index of zero indicates that valuation is in phase with earnings.

  • A positive SI suggests that valuations are below the level justified by current returns on capital.
  • A negative SI suggests that valuations are above the level justified by current returns on capital.

One of the reasons why most of our sectors are currently trading above “normal” value is because they are all over-earning – Exhibit 4 – (the exception would be Agricultural Chemicals).

Exhibit 4

Source: Capital IQ and SSR Analysis

Coatings – Stretching the Limits

In the prior exhibit, Coatings is the stand-out, as it is not only the most expensive on a mid-cycle basis, but it only gets partial support for this with its current return on capital. By contrast, Paper, which we have highlighted as expensive for the last 10 months, is supported by its much higher than normal returns on capital. Paper had an SI of around -0.3 at the end of December, while Coatings is closer to -1.5. Exhibit 5 shows the SI for coatings from 1990 and clearly identifies the current extreme. Exhibit 6 shows return on capital over the same period. The last time the sector discounted this sort of increase in returns on capital was in the early 1990s and the SI fell to zero as returns increased in 1992 and 1993, so the very negative SI was appropriate. Today we have the same level of expectation but from a much higher (historic peak) level of returns on capital. A great deal is going to have to go right for this to work.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

If we then break-down the sector into the 4 composite stocks (Exhibit 7) we get even greater extremes and Sherwin Williams and PPG set the outer band. RPM is well above normal value, but this is more or less explained by its higher profitability. Valspar lags on both premium to normal value and premium return on capital, but the two are in phase.

Exhibit 7

Source: Capital IQ and SSR Analysis

Sherwin Williams – A Very Strong Run, But Expectations Now Very Lofty

With an SI below -2.0, despite a current return on capital that is way above trend – Exhibits 8 and 9 – Sherwin Williams looks like it has very little room for error in meeting investor expectations, The only time SWH has seen an SI significantly below zero was in 2000 when return on capital was dragged down well below normal because of a write down.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

PPG – Reshaped Portfolio Should Result In Improving Returns On Capital – Not Reflected In Estimates

PPG also has an extremely high SI – Exhibit 10 – with valuation well ahead of current returns on capital – Exhibit 11. The valuation move has come mostly since the announced divestment on the basic chemical business and expectations are clearly that returns on capital will improve post the divestment. On the negative side, returns on capital would have to almost double from the recent trend level to justify current valuation. On the positive side, that would only take PPG returns on capital to the levels that SHW are at today. PPG’s valuation is discounting a return on capital that the company has seen before in the mid-1990s. SHW is discounting a return on capital the company has never seen before.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Valspar – More Interestingly Valued and Forward Estimates Not Already Discounted In Current Valuation
VAL does not have a particularly high Skepticism Index – Exhibit 12. Valuation is above “normal” but so are earnings and to a similar degree. What sets VAL apart from the rest of the group is that the returns on capital reflected in current valuation are lower than the returns implied in 2015 estimates. If VAL can hit expectations for 2015, current valuation is well supported and the stock could even have some upside.

Exhibit 12

Source: Capital IQ and SSR Analysis

RPM – Very High Value But Very High Returns On Capital Also

RPM is at extremes of valuation and at extremes of returns on capital, but valuation is a closer reflection of returns on capital for RPM than for SHW or PPG. Like both PPG and SHW, RPM does not have forward estimates that reflect returns on capital implied in valuation today, but the gap for RPM to close is higher than for both SHW and PPG. Despite its lower SI (versus SHW and PPG) the odds of the company performing to justify current values appear lower than for SHW and PPG.

Exhibit 13

Source: Capital IQ and SSR Analysis

Can The Paint Industry Really Do This Well?

Let’s start with volume. If we simply look at the new housing data, housing starts fell from around 2m units in 2007 to 500,000 units in 2009 – a decline of 75% – Exhibit 14. Over the same period, architectural coatings volumes in the US fell by 17.5%, according to US Census data – Exhibit 15. Clearly new home building is not the major source of architectural coatings demand in the US. If we assume that the entire fall in volumes over that 2 year period was due to new home building – 134 million gallons = 1.5 million new homes. If you look at housing industry data you get a decline over the same period of a little under 100 million gallons – so we are in the right ball park and 100 million gallons may be more reasonable, given that existing home coatings demand probably fell also from 2007 to 2009. If we assume that the new home piece in 2009 was around 60 million gallons of paint, we have already seen a 50% increase in housing starts since 2009 – so current consumption is likely back in the 90-100 million gallon range.

No one is calling for housing to go back to the 2 m unit level, and perhaps an ambitious forecast is 1.5m. On this basis we could see new home based architectural paint volumes double. We would be adding 100 million gallons to an estimated 2012 architectural total base of 675 million gallons – so 14-15%.

Volume alone is not going to move returns on capital high enough to support SHW, but it might be enough for VAL.

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Consolidation. We have seen some meaningful consolidation moves in the last year with both PPG and SHW acquiring in North America. Prices are high, reflecting the improved profitability in the business, but there is a market structure argument here, that we will defer to others.

Manufacturing Costs. Falling TiO2 prices are good for the paint industry as they tend to use TiO2 as a price lever on the way up and generally do not give much back on the way down. Further, there

have been some interesting moves in latex formulation and choice, in part driven by the natural gas/crude oil differential in the US which has reduced the cost of ethylene relative to other latex raw materials such as propylene and butadiene. This has brought pricing of latexes closer together and increased the effective competition in the market, lowering costs for paint producers. However, both of these positives are either played out or soon to be played out, and the positive impact they have had on earnings growth in 2011 and 2012 may flow into the first half of 2013, but are unlikely to keep providing positive comps year on year thereafter.

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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