The Sherwin-Williams Company (SHW) Earnings Call Transcript & Summary

Welcome, and thank you for standing by. [Operator Instructions] This call is being recorded. If you have any objections, you may disconnect at this time. I will now turn the call over to Mr. Jeff Zekauskas. Thank you. You may begin.

This is Jeff Zekauskas at JPMorgan. I'd like to welcome everyone to our virtual industrials conference. And we changed our format for 2020 to a virtual one in the interest of health and safety. And thank you very much for attending this morning. It's my pleasure to introduce Allen Mistysyn, the Chief Financial Officer of Sherwin-Williams. Al has been CFO of Sherwin since 2016. Previously, he was Sherwin's Corporate Controller, which seems a long time ago to me. Al has done exceptional work presiding over the integration of the Valspar acquisition into the operations of Sherwin-Williams. I will make some very brief remarks, and then we will move to a fireside chat format. Al?

Great. Thank you, Jeff, and I hope everyone out there on the line, you and your families are all healthy. As Jeff said, this is Al Mistysyn, I'm CFO. Along with me today is Eric Swanson, our VP of IR. And I think what I'll do is I'll start with the demand environment which remains solid in many of our businesses and geography. But I do first want to comment on the coronavirus. First and foremost, we're focused on the health and welfare of employees and their families. By and large, they're healthy, as we are taking every precaution we can with restricted travel such as this, sending supplies where necessary, whether that's masks, water, hand sanitizer. And then communicating our employees while staying focused on running our business. To keep sales in perspective, we're still 80% a North American-based company. All of our Asia Pacific sales are less than 5% of our consolidated sales, with China less than 3.5% of consolidated. On our year-end earnings call, we gave sales guidance for the first quarter to be up 2% to 5%, and for the full year, up 2% to 4%. We do not have any changes to that guidance at this time as the impact of the virus is not currently material to our consolidated results. For the Americas Group, we expect it to be at or above the high end of the first quarter sales guidance. We're on a track through that -- on track for that through February and March which is the largest month in the quarter, has started off as expected. The Consumer Brands Group first quarter and full year 2020 sales are expected to be flat to up slightly, excluding the impact of the Ace business we exited in 2019. We're seeing a short-term impact of sales due to the virus in China. But again, all of Asia Pacific sales for consumer represents approximately 7%. Our Performance Coatings Group sales in our first quarter and full year were expected to be up low single digits with industrial demand to remain variable by geography and end market. We are obviously seeing that in our first quarter. The virus will have an unfavorable impact on the first quarter sales for the segment, but we do not believe it is material enough to update our guidance. The Performance Coatings Group, to put it in perspective, Asia Pacific sales are less than 13%, of the overall sales with China less than 9%. For all our segments, the underlying fundamentals remain strong and unchanged by this short term situation. We will give an update to our full year sales guidance, if any, on our first quarter call, in which case, we'll have more time to assess the situation. But with that, let me talk at a higher level view of our segments, just to level-set everybody again, starting with the Americas Group, which is greater than 50% of our sales and will continue to be the growth engine of the company, we ended 2019 with 4,758 store locations in the Americas Group with 4,438 in the U.S. and Canada, an increase of 84 net new stores. And we'll continue to add 80 to 100 stores per year in the U.S. and Canada. Longer term, we believe we can grow our store count to approximately half of the current 12,000 specialty paint stores in the U.S. and Canada. This has been our stagnant number. And as we add stores, others ultimately exit the market. We implemented a price increase January 1 of 3% to 4%, and our effectiveness has been very consistent with past price increases. And this increase was implemented to help offset the increases we're experiencing in our total cost, whether that's wage inflation or our health care costs. As discussed on our year-end call, we believe the U.S. architectural demand in 2020 will be similar to what we saw in 2019, with household formations at 1.3 million per year. We expect this to continue for the foreseeable future as our millennials age. Over the last couple of years, we've talked about a supply issue, specifically at the affordable entry-level home segment of the market and the fact that the large national homebuilders would continue to work to fill this gap. And we believe with the numbers we are seeing, they're making good progress. Little early to tell, but lot of -- more favorable numbers coming out in December as we rolled into January. And we expect the long-term growth in this segment to be mid- to high single digits and to continue expanding our operating margins in the low 20%. Our Consumer Brands segment houses a strong portfolio of Hero Brands that are sold through home centers, dealers, co-ops. The addition of Valspar paint, which is a strong, well-known brand for both DIY and pros, gave us a more complete offering for our customers. We are excited about the exclusive partnership with Lowe's. We are entering our first full spring/summer selling season. We're looking forward to working with Lowe's to continue to drive gallons to the department. Last quarter, the paint department at Lowe's outcomped the store for the third consecutive quarter. This is a testament to the hard work going into the department between the combined Sherwin and Lowe's teams and we're making good progress. Long term, we expect this segment to grow a low single-digit percentage. And I'm confident in our ability to get to our target core operating margins for this segment of high teens to low 20s. In 2019, we made good progress on this metric, increasing our core operating margins 390 basis points to 17.5%. Performance Coatings Group, as everybody knows, is the global industrial arm of the company with great technologies across our 7 businesses. Valspar brought us scale outside the U.S., which will help our legacy Sherwin profitability. Long term, I expect mid single-digit growth in this group, including acquisitions. And again, I remain confident in our ability to expand our operating margins to the high teens to low 20s, we made good progress in '19 with our core operating margins increasing 120 basis points to 14.1%. I switch quickly to our adjusted EPS. I'm confident in our ability to grow market share across all our businesses. We have implemented price increases to continue to offset raw material inflation as we saw in '17 and '18, and the increase in total costs we're experiencing and along with good cost control, we expect to achieve a 9.4% increase in 2020 adjusted EPS at the midpoint. This implies gross margin expansion with some leverage on SG&A. A final comment I would like to make is that in '19, we returned to our historic capital allocation policy. We returned $1.2 billion to our shareholders in the form of dividends and share buybacks, an increase of over 28% compared to 2018. In 2020, we recommended an increase in the dividend of another 18.6%, if approved, in all 4 quarters. We'll continue to manage our core CapEx below 2%, and absent acquisitions, we'll buy back our stock. Our strong net operating cash generation gives me great confidence in our ability to maintain our policy going forward. Jeff, that completes my opening remarks. And I'll turn it back to you for Q&A.

Okay. Thanks for that very nice summary, Al. I thought I might begin with raw material costs. My impression has been, there's not been very much movement in domestic TiO2 prices and the China TiO2 prices might be a little bit higher. Is that your impression as well?

Yes, Jeff, this is Eric Swanson on the line. So our assumption going into the full year, in our fourth quarter call, we expected our raw material costs to remain fairly stable with a tailwind into the first quarter, possibly heading into the second quarter. And as part of that assumption, we expect the TiO2 prices to remain fairly stable throughout the year. And we continue to expect stable pricing. We have seen some nominations from a couple of the TiO2 producers here in the first quarter. But that being said, overall, we still think TiO2 pricing should remain fairly stable. I would question whether the demand environment with -- outside of coatings remained strong enough to support that increase. I know that inventory destocking across the TiO2 chain has remained -- has kind of come to an end. So we'll see. But overall, we remain pretty confident that pricing should remain stable throughout the year.

My impression is that Trilux now has the Yanbu facility that it's managing and Lomon is expanding its chloride-based TiO2. So my overall impression is that there's plenty of TiO2 for Sherwin and the other paint companies to buy at reasonable prices. Do you ever buy chloride-based TiO2 from offshore producers that imported into the United States? Or do you pretty much buy from domestic sources?

Yes, Jeff, the chloride outside of the U.S., we -- well, we -- it's by and large from the U.S. The chloride technology outside of the U.S. hasn't quite caught up to where we needed to be, both the particle size, consistency and that -- and as you know, we're very particular about what we're putting into our store bases to make sure we get the same color consistency every single time across the entire chain. So they're not there yet. We absolutely work with them and try to figure out how to help them develop it because -- obviously would be another source of supply that would overall help us in the long term.

So OPEC had this difficulty restraining production and oil prices have really sharply fallen. And in the United States, propylene is down maybe $0.02 or $0.03 a pound since the OPEC announcement. And I don't know if that would make very much different -- would make very much difference to your first half raw material costs, but it may make some difference to your second half raw material costs. My impression is that Sherwin-Williams has been relatively conservative in the way that it's thought about raw materials thinking that raw materials would decrease in the first half year-over-year, but maybe would be flat or even up a little bit in the second half. Even though if you had to do your raw material forecast all over again, would you be more optimistic?

Jeff, I think looking at where we stand right now, certainly, there's been a lot of volatility with crude oil and given the actions of Saudi Aramco and Russia, I certainly think it's a little bit too early to really update our raw material forecast, just given that we're in kind of day 3 of the shock from the prices of crude. I think if you look, we really need to think about the duration of prices, if they're going to last at the current levels and for how long. And then also how the downstream reactors are going to react to the additional capacity. So I think really, right now, certainly, if oil prices stay where they're at? Yes, it would provide some -- somewhat of a benefit for us in the second half of the year. Just to level-set investors, as a reminder, we've got roughly 43% of our raw material costs are resins and latex. So if you think about the acrylic resins, the epoxy resins, the alkyd resins, those would be the propylene and ethylene derivatives that could somewhat be tied to crude oil. So yes, certainly, if crude oil prices remain where they're at, we will see somewhat of a tailwind, but it's really too early to make that call.

Over the past 3 years, Dow Chemical has really written down its coatings intermediate segment because of changes that have occurred in paint markets. That is, it seems to be that the paint producers are producing more of their intermediates in themselves, more of their resins, is that something that's true for you? And has that been a benefit for you?

Yes, Jeff. We absolutely are producing more intermediates ourselves by design. And we picked up the EPS business with the Valspar acquisition with the idea that there's proprietary technology that we want to keep in-house and then there's the cost advantage by doing it yourself, if you can get enough scale. That being said, it's a balance. We have great partners in both Dow and others in that space. And they bring us technology and we work with them on developing technology as well. So we're never going to be 100%, at least looking out in the mid-term, long term. We're never going to be 100% -- internally sourced resins, because we want to continue to have the opportunity to work with our vendors and suppliers to build additional capabilities, new technologies that ultimately are going to help our customers.

Okay. Al, I was reading your 2019 10-K. And I think on Page 32, there is a comment about your pension expenses. In that, in 2018, you had various pension lump sum settlements and you had some annuity contract purchases in the first quarter of 2019. And the pension comment in the K is that your pension cost for 2020 should decrease significantly. What's the magnitude of decrease significantly?

Yes. I think, Jeff, what we're specifically talking about there is the onetime hits that we realized in 2019 and in 2018. If you look at our -- we've largely reduced our defined benefit plan down to really just the domestic hourly union employees and you're talking about a projected benefit obligation of around $100 million and fair value of plan assets around $123 million. So the go-forward adjustments related to the DB plan will be pretty small, but we're specifically talking about the reduction in hits, those onetime hits we took in '19 and '18.

Okay. And Sherwin exited 2019, I think with $315 million in cumulative savings and I think $75 million was achieved in 2019. What was the run rate at the end of the year for 2019? And is there an annualized benefit -- annualized cost reduction benefit to 2020 results of, I don't know, $70 million or so? I think your goal had been to get to $415 million run rate by 2020. Can you comment on that?

Yes, sure. And you're absolutely right. We exited with the $315 million through the P&L -- realized through the P&L. Our run rate is the $415 million and that remaining $100 million is going to be spread out over the next 3 years. It's predominantly going to impact Performance Coatings. But it's probably, Jeff, going to be more weighted in 2021 and 2022. There may be -- the estimate, and I don't think we gave an estimate for 2020 because we're rolling this as part of just our continuous improvement philosophy, if you will, but it won't be anywhere near $70 million in 2020. And because we're getting into the phase of -- we're looking at Europe, we're looking at Asia, we're looking at facility manufacturing site consolidation, reformulations that just, as you know, the close of site in Europe is challenging in the best environment. So even if I announced a factory closing today, I'm looking at mid to third quarter of next year before we start seeing the benefit. So I'd say we feel good about the $415 million run rate when we came out originally in the pro forma, we talked about a $320 million run rate. So we feel good about the progress we're making. It's just now we're getting into, what I would say, the more heavy lifting as we get into industrial sites and the formulations.

And if I remember right, there's another $100 million that you wish to remove from supply chain optimization efforts in Europe and Asia. So maybe there's another couple of hundred to go over a 3-year period. Is that fair?

I don't know, I'd go to a couple of hundred. It's the 100 is what we've been talking about. What's hard, quite honestly, is it's so ingrained and so integrated. Now it's just -- it's hard for me to say what's the synergy versus what's just normal right now for this procedure. So I'd stick to the 100, but you understand and that -- and everybody on the line understands we have a continuous improvement culture. We continue to look at opportunities for cost reductions, whether it's on margins or SG&A or wherever. But it's hard for me to say and pinpoint exactly how much more we would expect to get out of those regions.

Okay. Maybe what we can do is, we can move to the near-term and touch on the virus a little bit. There's now talk of empty stadiums for the NCAA basketball tournament and empty pro basketball arenas. It's hard to know what's going to happen with the baseball season, concerts are being canceled. Do these possible curtailments affect spending on maintenance coatings in the United States? Is that something that we might see in the second quarter? And is that a meaningful part of your stores business?

Yes. Our -- yes, our Protective & Marine business is about 15% of our overall stores business. It's more heavily weighted to oil and gas. It's not as heavily weighted as it was a few years ago when we went through the last cycle. But I think our -- the bigger demand impact for us will be on oil and gas and it's primarily maintenance. It's tanks, it's piping and the longer oil stays down where it is. These big oil refineries, even Exxon has come out, so we're going to cut maintenance spending. So that, I think, is the shorter-term impact that we're going to experience. To your point on stadiums and arenas and things like that, it's too hard to say at this point. But the good news is, if the -- it is oil and gas is less of a percentage of our total, we've refocused after the last cycle into flooring, water/wastewater and other segments understanding that we needed to get bigger and better at those. So when oil, which is cyclical, and we're going to see ups and downs were not as impacted overall. So we're making good progress in those off a small base. But the oil price being down is going to impact us more in the short-term than the virus at this point.

When you think about the virus and new home construction or you think about the virus and remodeling spending, do you think the virus will touch those markets? I don't know whether homeowners worry about having vendors in their houses or maybe it's the other way around that contractors don't want to go into people's houses. When you talk to your customer base, what's their commentary on that?

Yes. So far, this has not happened, and it's been -- but it's -- as you know, it's still relatively a new phenomenon. We're looking at -- we're -- we've got our 4,400 plus store managers and 3,500 reps out in the field talking to these customers every day. We are -- and by and large, their backlogs are still full. What impacts I would see is as you see a concentration like in Seattle, our stores are all open still. We're monitoring and talking to our district management team daily, talking to their customers. And so far, that phenomena has not occurred. But I want to be realistic, Jeff. I think it does have the possibility of occurring. My point would be, it's a short-term impact and the job isn't going to go away. I mean it's like the way I think about it is there's a large number of people in the country that get the flu every year. If they were going to paint their living room before they got the flu, they're going to paint their living room after they got the flu till they get over the flu. So I do -- I don't think that germs go away, I just think they get pushed.

In the new housing market, there are all kinds of materials that are imported from China from hinges to door knobs, all different kinds of materials. Do you detect any delays in builders receiving materials from China, is that in any way or slowing them down?

We're not seeing that per se, Jeff. I think still the biggest inhibitor to new housing growth is labor. And we have talked about how these national homebuilders are really working on how to be more efficient, how they plan and schedule their building of homes, almost like a campaign, if you will, to get the right contractors in at the right time. So nobody is waiting around. And I think, by and large, I feel pretty good about the progress they're making in that respect. I think if the virus in China continues for longer periods of time, that might be a risk on being able to get the right materials, but we haven't necessarily seen that yet. We'll see how the year continues to unfold. But right now, we're not hearing that specific issue. It's still labor.

Yes. My own impression has been that this year's winter has been mild, really in the Northeast, we've had barely any snow and average temperatures have been warmer. And it's not true for every part of the country. Is your impression that weather may be a positive factor -- weather effects may be a positive factor in Q1 demand?

Yes, it absolutely can be. Our first quarter is a small quarter. As we get changes in temperature in especially January and February, which are pretty small months, it could have an impact. If we're able to do exterior jobs in the Northeast and the Midwest, I'd just remind everybody that March is still by far the largest month in the quarter. And that's really how March unfolds will tell us how the quarter comes in. And March just started off as we've expected it to, but you do see some benefits to a warmer winter.

Is March about half of the demand for the first quarter in rough terms in the United States?

Not quite half, less than half, but it's still significant.

Growth in new housing really seems to have picked up maybe in the fourth quarter, U.S. housing starts are almost up 25%. And I think in January, housing starts were up 20%. What do you make of those sharper percentage changes? And do you think that, that will accrue to your benefit this year or in the coming months?

Yes, certainly, Jeff, looking at the new residential market, we feel very optimistic right now with a lot of the statistics we're seeing. I mean, as you indicated, January starts were up 21% year-over-year. Single-family was up. We saw pretty good growth in the South Midwest, which is -- obviously, we have a strong presence there. Both December and January, new home sales were also up to the tune of around 20%. We recently attended the Builders' Show in January and I'll tell you the level of optimism that our customers had there was pretty strong. I had a lot of meetings with our customers and overall it's just the strength and the optimism, it's pretty exciting. So we've got -- if you look at our total business for new residential, it's around, call it, 15%, 20% of our total business, and we feel really good about where we're at there.

Jeff, I would just add to that. We are exclusive in 18 of the top 20 national homebuilders. And we -- where we -- even though the market is where Eric said, we're a little heavier than maybe the overall market because of that. And just as we look at new construction, about 20% of the market, new res is about 2/3 of that. So we absolutely will see it. And we want to see this trend continue for a few more months and get -- give us more confidence about going into the back half because that's really where we're going to see it.

So in your opinion, if these housing numbers were to continue at this sort of level, you might see a difference in your demand in the second half or in the first half of next year?

That's correct. And just as you know, our first half last year was lighter than our second half, we saw momentum as the year went on. We coming out of the fourth quarter, we thought that would continue and I think this would new res pop or pump would certainly help us.

It sounds like your experience in North America is very different than your experience in South America. In that -- in reading your K, it seems that you shut down about 22 of your Latin American stores, which I think is about 6% of the total. Were these stores that were unprofitable. Can you describe your change in strategy in Latin America?

Yes. I think we have been pretty open about not being satisfied with our performance down there. We take a pretty rigorous and consistent view of our portfolio of businesses, brands, customers, and other investments. And we just have not been able to see a line of sight to above average growth, either in sales, margins or cash flow. So we had to take action. It's probably taken us a little longer to pull the trigger on this than we would have liked, partly it's cultural. When we're talking about closing stores, that goes against our DNA, the harder decision, we got caught up in the integration of Valspar, but the stores were not profitable. And we didn't see the path to getting there in a reasonable amount of time. That being said, it's not -- does not mean we're exiting those markets, but we're going to market through a different channel. And that could be through distributors, multi-brand dealers or dedicated dealers which gives us a lower cost structure that gets us a path to profitability faster than if we try to fix our own stores.

Is your -- are your revenues from your store -- how large are your store revenues relative to your revenues from sales through other people's stores in South America area?

Yes, it varies by country. But I would say...

Brazil.

Yes, Brazil. You're looking towards less than 50% of store sales. It is a Brazil specifically and certain parts of Brazil are predominantly multi-brand dealers or you got to go through a dedicated dealer. It's hard to have your own store network and compete. And it's partly how the customer buys paint. And that's what -- I think we're getting better at drilling into these markets. We talk about Brazil broadly. But there are many different markets, whether you're up Northeast and Recife or even in São Paulo, you can break São Paulo up into many different markets across the city. So I think we're -- the teams are doing a better job getting into the -- how do our customers buy paint, how do our customers want to buy paint, and who's making that decision? Is it the homeowner? Is it the contractor? And then taking that data, and then that's going to drive how we approach these markets going forward.

Okay. All right. The other element that was in your 10-K -- is there were some personal injury suits in Wisconsin. And I think one case has 146 plaintiffs. And then there are some other cases that were selected for discovery. And I think the first of 4 cases to come to trial will occur in June of this year. What kinds of entries are these? Are they serious or small? And can you frame what's happening in Wisconsin?

Yes, sure. And I'm going to give you a little bit more background and history than you probably care for, but I think it frames the cases. In the Federal Court cases, there were 3 single plaintiff cases that were tried on a consolidated trial which began May of 2019 and lasted a month. Jury found for the plaintiff against 3 defendants, us, DuPont and Armstrong Containers in the amount of $2 million each -- $2 million for each plaintiff. We filed a number of motions, some of which have been denied, some of which are pending because, honestly, we have our opinion, we have a bad judge, and they're just manipulating facts and law to what they want -- he wants the outcome to be. So we've appealed that case. Once -- but we have to -- before we can appeal that, we need to have all of the post-trial motions ruled upon and that hasn't been done yet. The cases that you're talking about the 4 -- that trial prep began in 2017. And to your point, they're set for June of this year. These are former children. These are now grown individuals who are claiming they've ingested paint chips that has impacted their mental capabilities, but they're using a market share theory that we don't believe is right. So they can't prove that it was our paint or somebody else's paint. And as California has trended, it's trending into a paint case versus a lead pigment case. So we feel like we have facts and circumstances in our favor, we will continue to appeal these, but to a higher court which ultimately will get to the Wisconsin Supreme Court in our view. But it's taken a long time. It will continue to take time as this judge has to get their ruling in. But the total, to your point, is approximately 146 plaintiffs. It's not a class action. They're treating them as individual cases and they're grouping them, but we'll continue to fight these going forward because we do believe we're on the right side of this.

I think that's our time limit. It was very nice to work with you on the chat, and we hope to see you next year alive and in personnel (sic) [ person ].

That would be great. Thank you so much, Jeff. Good talking to you.

Okay. Bye now.

That does conclude today's call. Thank you for participating. You may disconnect at this time.