M&A Math Paints Pretty Picture of Sherwin-Williams

My conclusion was that real (that is, after-inflation) house returns might turn negative over most of the next two decades. Prices won't necessarily plunge, but they might stay flat, in which case they'll lose a few percentage points a year to inflation. Since then we've seen for-sale house inventory swell, and the pace of new construction fall. Headlines are dominated by references to a housing "slump" and credit "crunch" — misnomers both, since houses are still overpriced and credit is still too easy.

Particularly hard hit have been housing stocks. Big builders like Toll Brothers (TOL), D.R. Horton (DHI) and Pulte Homes (PHM) have lost a quarter to half their market value over the past year. It should come as no surprise then that a recent stock screen for takeover targets — companies that look like bargains using merger-and-acquisition math — turned up three housing-related companies: a cabinet maker, a wire and cable specialist and a leading paint producer.

Favor the paint company, Sherwin-Williams (SHW). Its shares are down 5% or so year to date, but the company is actually having a pretty good year. Its performance is less correlated with home building than that of some of the other aforementioned companies. Sherwin makes the bulk of its money from makeovers (extreme or otherwise). It also makes industrial coatings, and does a brisk business in both paint and coatings overseas. Unlike home builders, for whom profits are expected to plunge this year, Sherwin is expected to boost its profits 13%.

Consider the company's progress during its third quarter, ended Sept. 30. Sales increased 4%, not exactly Google-esque, but respectable considering the conditions. Earnings per share increased a whopping 19%. The profit surge came from three events, two of which are excellent signs for shareholders. A lower tax rate during the quarter means little for the company's long-term prospects. Higher margins on price increases and cost controls, though, show that demand is still robust and that the company is using the current slow period to improve efficiency. And a 6% lower share count during the period means Sherwin is plowing its ample cash flow into its own shares, which helps make remaining shares more valuable. Year to date the company has retired 10 million shares. The board just approved the repurchase of 20 million more in coming years. That's more than 20% of Sherwin's outstanding share count.

Investors will pay just 12.7 times this year's earnings forecast for Sherwin-Williams shares at the moment. That's a discount of 20% to 30% to the S&P 500, depending on whether you're weighting the index for market values or not. You won't get astounding growth for that price, but this year's and next year's earnings forecasts suggest a long-term growth of around 10%, about what the broad market typically delivers.

Viewed as a takeover target, by the way, Sherwin looks equally compelling. It has an EV/Ebitda ratio of 7, which is about 30% below the median for the S&P 500. EV stands for enterprise value. That's the cost to buy all of a company's shares and retire its debt, while using its available cash toward the purchase. Ebitda stands for earnings before interest, taxes, depreciation and amortization. It's used to gauge underlying earnings potential that might be obscured at present by things like ongoing accounting charges for past investments. So think of EV/Ebitda as the ratio of a company's takeover price to its earnings potential. All eight of our screen survivors have low ones. That doesn't necessarily mean they're due for bids from suitors. But it's a sign their shares are sufficiently cheap to warrant a look from individual investors.