Geoff Gannon February 27, 2006

On Sherwin-Williams’ Profitabilit

Sherwin Williams (SHW) scores well on just about every profitability measure. Some companies I’ve mentioned in the past are more profitable than Sherwin-Williams. For instance, Timberland (TBL) scores much higher than SHW on just about every measure of profitability. The clearest difference between the two businesses is their pre-tax returns on non-cash assets (PTRONCA).

This is one of my favorite profitability measures. For the last five years, Timberland has consistently had a PTRONCA of 35 – 55%; Sherwin-Williams’ PTRONCA has been in the 12 – 16% range. This post isn’t intended to be a comparison between Timberland and Sherwin-Williams. I wanted to introduce you to my preferred method of calculating return on assets, and Timberland is the obvious choice for a PTRONCA comparison. Very few businesses earn a pre-tax return on non-cash assets greater than 25%.

The easiest way to earn a very high pre-tax return on non-cash assets is to have very few tangible assets. Businesses with very high PTRONCAs can grow without retaining earnings. Generally, maintenance cap ex is minimal, and little investment is required beyond additions to working capital.

Sherwin-Williams’ pre-tax return on non-cash assets of 12-16% is very good. The company has not kept much cash on hand during the last few years, so SHW’s PTRONCA of 12-16% translates almost perfectly into the expected (traditional) ROA of 7.2 – 9.6%. I say “expected”, because a pre-tax ROA of 12-16% translates into an after-tax ROA of 7.2-9.6% at an effective tax rate of 40%.

In other words, my adjustments to the return on assets computation make little difference in this case. It’s clear Sherwin-Williams consistently earns an above average return on assets whether you use the traditional ROA measure or the pre-tax measure with the cash adjustment.

Sherwin-Williams’ has consistently earned a good return on equity while employing little debt. Over the last ten years, the company’s ROE has usually been in the 15-25% range. Sherwin-Williams has regularly bought back stock. The number of shares outstanding is about 20% less than it was a decade ago. Share repurchases and dividend payments have helped Sherwin-Williams increase its ROE year after year. For several years, the company’s ROE has been following a clear upward trend.

Sherwin-Williams has also been putting retained earnings to good use. Obviously, there is a correlation between a company’s return on retained earnings and its return on equity, because retained earnings increase shareholder’s equity. Looking at the amount of retained earnings in relation to EPS growth over various time periods can sometimes provide clues regarding the relationship between a company’s return on capital and its return on incremental capital. Sherwin-Williams’ returns on retained earnings match the company’s returns on equity very closely. Both the range (15-25%) and the trend (upward) of SHW’s return on retained earnings serve to confirm the company’s return on equity data.

Finally, as Rick of Value Discipline noted, Sherwin-Williams has regularly increased its dividend. I believe this year will be the 27th consecutive year in which the company raised the dividend. It is interesting to note that while the company has always increased its dividend payment per share of common stock, the actual dollar amount of dividends paid by the company has not always increased. Some of the dividend increases are attributable to share buybacks.

I’ve decided to stop providing intrinsic value estimates for the businesses I discuss, because some readers seemed a bit confused by these estimates. It can sometimes be difficult to explain that while I may say a company is worth x that does not mean I would consider purchasing it at 100% of x. While I think most readers fully understood both the discounted cash flow concept and the margin of safety concept, I’m afraid a few couldn’t get the intrinsic value number out of their head.

I also know most readers would prefer any estimates be provided in terms of share prices rather than enterprise values. Therefore, I am making a slight adjustment. I will sometimes provide my best estimate of the compound annual growth rate (CAGR) to be realized by an investor who buys shares today and holds them for 10 years.

If it were not for the lawsuit, I would be fairly confident that a holder of Sherwin-Williams common stock could expect a CAGR of no less than 12% and no more than 17.5%, over the next ten years. This is a very wide range. But, it is not so wide as to be meaningless. I am not at all confident that the holder of an U.S. index can expect a CAGR of 12% over the next five years.

It seems Sherwin-Williams is right on the cusp of being a very attractive long-term investment. The likely 10 year CAGR looks to be very close to the magic 15% number. If you are as pessimistic about the long term risks of higher inflation and higher taxes as I am, fifteen percent is a hurdle that must be cleared to give you any shot at the 3-5% after-tax real return that I’m looking for.

Right now, I have nothing to say about the lawsuit, except to say that even a very large adverse judgment is unlikely to substantially reduce Sherwin-Williams’ earnings power, because the business does not require much reinvestment. However, there would still be the issue of (at least) a one-time destruction of equity and the costs of any debt that had to be raised.