Sherwin-Williams (SHW) and the global paint industry

“We love good competition. It keeps us on our toes and running hard to stay ahead of them.” Christopher Connor, Sherwin-Williams Chairman/CEO (1999-2015)

Scientific evidence has shown that humanity has been decorating its living space with paint for more than 40,000 years. This natural paint was made up of soil, soot, and other organic materials mixed with animal fat and blood. Since then, innovation and technology have transformed the composition of paint materials and the industry in general, but no external disruption has displaced humanity's need for these products. Paint is still needed to color and protect every building, infrastructure, vehicle or object in any corner of the world, and most likely it will continue to be needed for centuries to come.

Currently, the global paint industry is divided into 3 market segments: architectural paints (40%), industrial OEM coatings (40%) and industrial coatings with special purpose (20%).

Sherwin-Williams is the world leader in the development, manufacture and sale of paints, coatings and derivatives. It has a 13.5% global market share in a $137 billion industry and 70% of revenue comes from categories where they own the #1 or #2 brand (ex: Sherwin-Williams® , Valspar®, Dutch Boy®, Krylon®, Minwax®…). In order to get an idea of the scale, the company has 61,000 employees; operations in more than 120 countries with 137 production and distribution plants and 3 operating segments: The Americas Group, Consumer Brands Group and Performance Coatings Group.

Despite their geographic revenue concentration (the US and Canada, two of the countries with the highest per capita consumption of paint in the world, make up 80%), their customer base is broad and diversified due to their extensive distribution network. Unlike other important competitors, such as Axalta or Akzo (with greater exposure to the OEM industrial coating market), no Sherwin-Williams customer makes up a significant percentage of their overall sales; neither in the architectural paint market nor in the industrial market (~ 2/3 and ~ 1/3 of the group's revenue, respectively).

Although the company is exposed to the residential, commercial and industrial market, Sherwin-Williams’ cyclicality is lower because of the unique characteristics of their business model, which protect the company in times of crisis. Paints and coatings are often recognized for their decorative properties, but they are also used because of their protective qualities. The industrial coating market requires coatings with greater protective properties than the architectural paint market, and seeks to fight the deterioration of facilities, machinery or surfaces caused by natural agents, extending their life cycle. Although the cost of these coatings represents a fractional part of the total value of the asset to be protected, customers can delay this maintenance capex in times of economic crisis. Sherwin-Williams can dilute this cyclical issue in some of their end products by diversifying the revenue base across multiple end markets, as some of these tend to perform better than others during such times. Architectural paints, industrial packaging, industrial wood and protective and marine businesses (among others) cushioned the impact of the oil and gas industry when prices plummeted in 2015 and companies were forced to reduce their maintenance capex.

Another particular characteristic that acts as a shield against customers‘ economic cycles is that Sherwin-Williams’ business model is not very capital intensive (maintenance capex of manufacturing facilities has barely exceeded 1.5% of the revenue historically), and is not very labor intensive (due to the high factory-automation levels), either. Paint manufacturers have a relatively low fixed cost structure. On the contrary, it is very raw materials intensive – around 70% of the costs of sold goods are due to the cost of raw materials. Most paints and coatings are made up of 4 elements: resins / latex, pigments, additives and solvents. Around 60 - 70% of the raw materials needed to make coats (depending on the end product) comes from titanium dioxide (China being the world's largest supplier) and oil derivatives. The price of both raw materials is driven mainly by imbalances between supply and demand. In periods of economic downturn, Sherwin-Williams' more cyclical operating segments impact the gallons of paint manufactured and weigh down utilization rates at production facilities. However, titanium dioxide and oil prices also tend to decrease in recessions, so the company's profitability is only slightly affected. Thus, even with an 11% drop in sales between 2007 and 2009, the gross margin expanded by 100 basis points. Paint manufacturers have the ability to shut down and resume operations without too much economic penalty because of their high variable cost and because, by working on customer demand, they do not have to stock up on inventory while idle. On the other hand, when raw material prices soar, favored by the impulse of global economic activity, the paint industry has historically been able to transfer this increase in production costs to the end customer. In 2010, with the resurgence of the architectural and industrial coating market, titanium dioxide prices increased by 16% annually and Sherwin-Williams was able to increase the price of their products up to 3 times during that same year.

The paint industry is characterized by being a stable and mature part of the economy that usually follows its growth. The demand side has a direct correlation with GDP growth and per capita consumption and has historically grown at the same rate. Since the beginning of the century, annual growth has oscillated between 2 and 4%, mainly favored by the acceleration in residential and commercial construction, automotive production and the increased interest in maximizing the life of industrial facilities. Sherwin-Williams' organic growth has been twice of the industry due to the accentuation of their competitive advantages as the company gains scale and due to their successful capital allocation (of one of the most competent management in the coating industry).

Sherwin-Williams is the leader in a oligopolistic industry with strong barriers of entry caused by distribution and brand power. The cost of replicating both involves large amounts of capital and time spent, especially in a market with national – or sometimes regional – character. Product differentiation and added value products are also key to succeed in an industry made up of multiple market segment or niches. For such reasons, more than 80% of the 30 largest companies in the world were founded between the late 19th or early 20th centuries (Sherwin-Williams being a benchmark with more than 150 years of history). Given how difficult it is to gain market share organically, growth is usually achieved through M&A operations. The 10 largest companies account for 50% of the world market share, whereas the other half is made up by more than 10,000 companies – most family-owned – that dominate niches where large ones have little to no presence ($60,000 million of potential market to consolidate). Sherwin-Williams and PPG (number one and two in world market share) have made more than 30 and 55 acquisitions respectively in the last 20 and 15 years. The number of companies has been decreasing and mergers will likely keep happening as a result of the large investments in technology the industry will have to assume to adapt to ever-changing environmental regulations. Inorganic growth is less expensive (in terms of time and capital), synergies have limited risk and are quite significant. Bargaining power with raw material suppliers (whose material cost represents 40% of total costs) is strengthened with scale, technology and patents on product composition are leveraged, and some of the manufacturing facilities acquired can be shut down to leverage the capacity of existing facilities (they usually work at 50 - 60% capacity while still being profitable).

Sherwin-Williams is committed to vertical integration and control of all production and logistics processes as a model to maximize efficiency in all internal operations. Through the consolidation of the entire value chain over the decades, facility utilization rates have been constantly increasing and unit costs of distribution have been reduced as the company increased its market share. They have also been optimizing previously outsourced production processes such as resins / latex production and a large percentage of the packaging for architectural paint products (~40% and ~15% of the production cost of final products respectively) as well as the development of internal acrylic polymers for some high-volume product lines. By consolidating the entire value chain, the company has gradually made all processes more efficient in order to better serve the customers. The management has always been focused on continuous improvement and lean manufacturing philosophy in order to satisfy customers who prioritize product availability, a wide range of products and quality over lower prices. Sherwin-Williams has their own transportation fleet to support the flexibility and immediacy required by the North American market and to be able to distribute end products at any point of sale. Unlike PPG, which outsources distribution, Sherwin-Williams controls this process not only to seek economies of scale, but also to mitigate any external risk that prevents the product from reaching the end customer intact in terms of quality. Coatings have a highly complex composition and, if the manufacturer's instructions are not followed during the whole distribution process, the quality of the end product can be altered, endangering the reputation of the brand.

Architectural paints

Sherwin-Williams operates in the architectural paint industry through The Americas Group and Consumer Brands Group divisions. Although they are present in some architectural paint markets in Asia-Pacific, EMEA, and Latin America, the heart of the company is in the Canadian and – above all – the United States market. Sherwin-Williams is the undisputed leader in the US architectural paint industry, a market with multiple categories and end customers. Paints are applied to all types of buildings (indoors and outdoors) and, apart from their decorative properties, they also have protective characteristics (although less complex than industrial coatings).

Residential and commercial painting comprise 70% and 30% of the architectural paint market, respectively. About 20% of architectural paint is intended for new construction (both residential and commercial) and is dependent on the development and the growth rate of the real estate market. This market segment is the most cyclical and generates the lowest gross margins. What's important to Sherwin-Williams is that 80% of the US architectural paint goes to residential and commercial repainting. This category not only generates recurring and predictable revenue, but also contributes with the highest gross margins to the group (it’s less intensive in R&D than the industrial coating market and it has a more diversified customer base with less bargaining power). The North American market is the crown jewel of the global architectural market and where Sherwin-Williams has had double-digit growth rate in 16 of the last 18 quarters. It is a unique market, where paint per capita consumption is one of the highest in the world and where repainting frequency has significantly decreased in recent decades (from 7 - 9 years to 4 - 6 years).

The company is more than 5 times the size of the second competitor (PPG) and more than 9 times the size of the third one (Benjamin Moore, owned by Berkshire Hathaway) in an industry where scale matters. Paint as a product is not easily transported (high volume and weight material). Its unique characteristics reinforce barriers of entry in a market with regional character (competing with international imports is not necessary because distribution costs would eat away operating margins), but force companies to have manufacturing presence close to their end market. Although manufacturing facilities are not very capital intensive, if the company fails to produce an adequate amount of gallons of paint, utilization rates will not be enough to generate a return on capital employed that exceeds the cost of capital. Sherwin-Williams has 46 manufacturing facilities in the US alone, handles 17.7 million annual orders (~ 50,000 per day), has more than 3,000 sales representatives and a fleet of ~ 3,100 trucks that make more than 5,000 deliveries per day.

Sherwin-Williams distributes paint, coatings, varnishes, derivatives and painting equipment in the US through thousands of points of sale (DIY stores, department stores and independent dealers) and directly to the consumer, through ~ 4,200 own specialized stores. The company has a catalog of brands whose popularity has continued growing over the years – many dominate their respective niches (Minwax®, Krylon®, Purdy®, Thompson's WaterSeal® ...). But the most valuable asset is the Sherwin-Williams® brand itself, that is sold exclusively in the company’s own stores. The quality and reputation of this brand has led to improved consumer loyalty and recognition as the brand of choice by professional contractors and designers according to the latest report from MarketVision Research and J.D. Power 2020 Paint Satisfaction Study. As a result of reinforcing a brand for more than 150 years, 23 of the 25 top homebuilders in the country use Sherwin-Williams® products almost exclusively. The customer base is fragmented and none of them represents a significant part of the group’s revenue. 85% of customers are mainly professional painters, contractors, and homebuilders who value paint quality, availability, and distribution capabilities over saving a few dollars with a secondary brand.

Sherwin-Williams® products are specifically designed for the way a contractor applies paint. The composition is ideal to obtain the best performance and reduce labor time as much as possible. 80 - 90% of the budget for a painting project has to do with labor costs, and only 10 - 20% represents the cost of paint itself. Sherwin-Williams has historically allocated 1.5% - 2% of revenues to R&D to develop new products (between 20 and 40 new launches each year) and to improve the quality of the final product and better meet the needs of professional customers (products with less preparation time, less need for second coats, fewer touch-ups and better finish). A contractor is willing to pay a little more for their preferred brand, which lets them finish a project sooner, get paid sooner and move on to the next one. Currently this is especially interesting because the number of projects exceeds the available manpower to carry them out without significant delays. During the last two decades, interest in premium products has grown to the detriment of cheaper alternatives, mainly due to the money contractors end up saving in labor throughout a project. Sherwin-Williams usually raises prices by 2-4% every 20-22 months as a maximum period (the latter being the longest period in the last decades without price increases) and the demand has proven to be quite inelastic. According to fixr.com, painting the exterior of a 1,500 square feet house can cost an average of $5,000, of which $500 - $1,000 are spent on paint. A 4% increase in the price of paint would barely increase the budget by 0.4% - 0.8% ($20 - $40). Even so, generally this price increase is not often correlated to supply and demand imbalance (expansion phase of the real estate market cycle ≠ increase in the price of paint), but to an increase in production costs. Technological developments are having a positive impact on end product quality and this improvement ends up being transferred to the sale price, so generally the price of the paint is a good indicator of quality. Maintaining stable gross margins and optimal overall profitability also depends on how quickly the company can implement such price increases. As most products are sold directly through the distribution network of 4,200 own stores, the company has total control when it comes to establishing simultaneous price increases in all stores across the country.

The architectural paint business is very focused on distribution, where having a national network – but local support and distribution – is key to dominating the industry. The company estimates that 90% of the US population lives within a radius of less than 50 miles from one of their stores. The network should have an optimal density to satisfy the demand and to be able to gain market share. Many professional customers start their day to day in one of Sherwin-Williams stores, where they are advised on the right paint for their next project and on the latest SKU in the catalog. Once the order is completed, they can select delivery time and place. Another important aspect in the shopping experience is that store staff is trained to understand the needs of customers with a high level of knowledge on the products to be purchased. In contrast to large DIY chains (Home Depot, Lowe’s…) or a local specialty store, all store managers in Sherwin-Williams have to undergo a 4-year internal training program to be able to work there. The company hires more than 1,400 college graduates each year to enter these training programs and later sends them to stores in their national network as they expand. The average salary of a Sherwin-Williams employee is higher than the competition and there are real career opportunities in a company where internal promotion is greatly encouraged (some top positions started 30 years ago as store managers).

Just as Costco, Sherwin-Williams has managed to create a work environment that makes employees want to stay with the company. The annual turnover of store managers and sales representatives is 5-6% and more than 7,000 employees have stayed with the company for more than 20 years. This is especially remarkable when the global average annual turnover of store staff is 20-25%. Having qualified staff improves customer experience, which leads to an increase in their purchase frequency (higher recurrence of sales, higher inventory turnover and higher ROIC for the store). Companies like Benjamin Moore, which do not control their distribution, cannot directly influence cross-selling or control the customer's shopping experience.

The outlook for the architectural paintings segment is positive. Paint consumption in North America is expected to continue growing at the same rate as GDP, and Sherwin-Williams intends to double this growth organically by expanding its national distribution network of owned stores. The company expects to reach a density level of 6,700 stores (1 store for every 35,000 households in some of the most important metropolitan areas in the country) without reaching saturation. They intend to expand the store base by ~2-3% per year over the next decade (~1,000 more stores) and reach 1,500 stores in Latin America (with currently 300 stores) in the longer term.

The Latin American market, where Sherwin-Williams has been operating for more than 80 years, is less mature and has better growth opportunities. Demographics have better prospects than in the US and residential demand will be higher over the next decade, favored by an increase in population, acceleration of urbanization, increase in the average per capita income, greater access to credit mortgage and government investments to expand infrastructure and build more public housing. On the other hand, it is more cyclical (less repainting frequency and more dependence on new construction investments), there is a currency risk and the gallons of paint manufactured by Sherwin-Williams’ factories are not enough to generate EBIT margins as attractive as the North American division (10% vs. 22%). The expansion of operating margins in this division (and in any other) will come from their ability to lean out the manufacturing processes, but above all, from producing more gallons of paint. By having a vertical integration strategy, the business model has a greater operating leverage, so that extra gallons manufactured will generate operating profits with a substantial incremental margin.

On the other hand, the US market is in a more mature phase, but Sherwin-Williams' strategic position allows it to enjoy some tailwinds. The architectural paint market is made up of 5 subcategories: “Do it Yourself” (41%), residential repaint (30%), commercial repaint (12%) new residential (12%) and new commercial (5%). 41% of the market is made up of non-professional customers (DIY) compared to the 59% of professional painters that make up the other 4 categories. The percentage of non-pro painters compared to professionals is decreasing. In 1980 the demand was 59% non-pro and 41% pro painters. The reversal of this percentage is mainly due to a change in the country's demographics, with a declining birth rate and ever increasing aging of the population. In the past 10 years, the population over 65 has grown from ~37 million to ~49 million and is expected to double to ~98 million by 2060. These people prefer to pay to get their houses painted due to the dedication and hard work required. Sherwin-Williams' distribution network was built with the goal of serving the professional customer, who now comprise 85% of their customer base. Professionals prefer to buy from specialized paint stores such as Sherwin-Williams and not from large DIY chains (the preferred option by retail consumers). Lowe’s, Home Depot or Walmart are struggling to attract these professional customers. Although they have succeeded in categories such as plumbing, electrical, and general DIY, paint is different. Most manufacturers of electrical, plumbing, and landscaping products do not control their distribution, and the paint shopping experience requires more customization and sales support.

Industrial OEM and special purpose coatings

Sherwin-Williams operates in the industrial coating industry primarily through The Performance Coatings Group division. The company develops, manufactures and sells paint and coatings for industrial maintenance, industrial wood and automobile maintenance and repainting (cars, airplanes, trucks and construction and agricultural machinery), as well as special coatings for ships and marine structures, industrial metal coils and packaging for the food industry. The industrial coating market is a $70 billion industry and Sherwin-Williams is present in 44 countries through 76 manufacturing and distribution facilities. Unlike the architectural market, Sherwin-Williams has always had a much lower market share than PPG, Akzo, Axalta and BASF in this market segment; although the acquisition of Valspar in 2017 improved their position by entering market categories where they previously had no presence.

Coatings have a wider and more diverse range of applications than architectural paints (from thermal or electrical insulation to protection against corrosion or chemicals). Demand is highly correlated with macroeconomic factors such as global GDP growth and industrial production growth, although many end markets have their own dynamics (oil and gas, ships and their industry capacity…). Sherwin-Williams has no exposure to the automotive OEM industrial coatings market (17% of the industrial coating market), this being the most cyclical category. Generally speaking, the industrial coatings market is more cyclical than the architectural coating market. On the contrary, recovery time after a recession is shorter, since some coatings are critical for the customer’s business operations. Coatings for the railroad industry reduce the chances of derailment by avoiding rail corrosion. The same happens with coatings for theme parks or the aeronautical sector to protect aircrafts or aircrafts’ components from degradation caused by UV rays. Internal coatings for cargo ships or oil tankers are not only necessary to fight corrosion, but also reduce the possibility of toxic spills. In addition, industrial coatings have more petroleum derivatives in their composition, and as with architectural paints, Sherwin-Williams’ decrease in sales during crisis periods can be cushioned with the decrease in raw material prices.

These coatings play a critical role in extending assets’ life in environments where steel, concrete or any other material is exposed to corrosion (i.e. a petrochemical plant, sewage treatment plan or manufacturing facilities in general), as maintenance may be significantly cheaper than replacements. Such places need large amounts of those coatings and customers value product technology and brand reputation. Although the cost of replacing a supplier for the customer is non-existent, customers often establish medium and long-term business relationships with suppliers they trust (Sherwin-Williams coatings have been protecting the Golden Gate Bridge for 20 years).

Economies of scale in this operating segment are lower, investment in R&D is significantly higher, and clients generally have greater bargaining power than those in the architectural repainting market. The difference between the EBIT margins of The Americas Group and The Performance Coatings Group divisions is 750 basis points (EBIT margin ~ 22% vs 14.5%). A significant percentage of Axalta and PPG’s sales are related to auto OEM customers. These customers select their suppliers based on the technological quality of their products, but above all based on price policies. The purchasing departments of these multinational companies, which operate in an oligopolistic industry, review contract conditions with paint manufacturers each year to adjust sale prices as much as possible. To preserve contracts with OEMs, paint manufacturers must also invest large capital in R&D to develop new paints or application processes that improve productivity and reduce manufacturing costs for customers. Paint manufacturers are in the crosshairs of competent OEM customers and environmental regulators, as paint processes account for the highest energy consumption of the entire car production process. Up to 2/3 of the energy costs in a car manufacturing plant are related to paint application operations (ventilation, air conditioning, treatment of generated emissions, paint drying, management of residual paint, etc.)

Investments in R&D are also focused on providing a greater variety of colors and finishes that improve appearance, protection and durability (self-repairing, repellent and waterproof properties) while meeting the strict criteria of environmental regulators. These finishes have to adjust to the material changes made by OEMs in order to reduce car weight. Paint manufacturers also have to provide on-site support services, so their teams of technicians are often integrated into the production lines of each plant. These technicians must also advise customers to seek operational efficiency and help them manage paint inventory based on their production schedule. The dynamics of this market category are changing and have a direct impact on the accounts of paint manufacturers.

Sherwin-Williams management has no interest in entering this market and has always made it clear that, beyond increasing the group's sales, they will continue to make capital allocation decisions focused on generating an acceptable ROIC. The company does have operations in the repair and maintenance market of cars, airplanes, trucks and industrial machinery, where margins are higher, the customer base is more diversified and cyclicality is lower, since revenues do not correlate with car production. Competition for this market segment comes from large-scale competitors or small regional companies focused exclusively on very specific categories of the industrial market. Entry barriers are high due to the technological complexity of paint. Aeronautical customers demand coatings that not only protect aircraft surfaces, but reduce their energy consumption from lighter products and prevent aircrafts from overheating when on the ground (especially those in dark colors). Manufacturers' technology is letting them launch coatings that significantly reduce energy consumption for aircraft cooling and coatings with smaller thicknesses that are reducing aircraft weight by up to 1,000 lbs.

This technological complexity is also significant in car repair markets. Sherwin-Williams' color matching system lets customers apply the original color of the vehicle or, in case paint needs to be used only in one part, the system should also be able to select the exact color even if the original has degraded after 5, 10 or 20 years. If the system fails to select the right color, the refinish job would negatively affect the auto body shop's productivity and profitability. These products are critical to vehicle finish and driver satisfaction and represent a very small percentage of the total cost of repair. Workshops (independent, large chains or official OEMs) are loyal to brands and once a color selection system from one supplier is installed it is very difficult for the customer to change it for another. Retention rates are typically above 90%.

Each market subcategory has its own outlook, operational risks, and risks associated with terminal value. In the repainting of cars, it is estimated that in the short and medium term both miles driven and accident records will continue to increase (mainly due to distractions), but autonomous driving will end up impacting the ratio of accidents and thus the group's sales in this segment. The analysis could be extended much further, but the conclusion at this point could be that if an investor wants to be exposed to the industry without too many surprises, perhaps betting on a company with diversified operations in multiple market categories would be the most sensible thing to do. Betting on the one with the lowest terminal value risk does not necessarily mean that it will be the one with the best IRR. Some competitors with worse unit economics than Sherwin-Williams may be strategic assets for larger players who want to complement their product portfolio and for which they will pay a significant premium over the stock price (the acquisition of Valspar had a premium of 41% on the stock price of the last 30 days). Technological innovation will take the quality of products to an unthinkable level today, but what we can be almost sure of is that the paint industry will continue to exist for decades (if not centuries) to come.

DISCLAIMER: This analysis is not an investment recommendation. Please, do your own due diligence.