Waiting For Housing To Recover, Valspar's Recovery Already Arrived

By Stephen D. Simpson, CFA | May 15, 2013 AAA

Data on the residential housing market has been getting better. Prices and sales activity have both improved, and data from the major big-box home improvement stores Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) suggests that homeowners and contractors are back at work fixing up properties.

While the aforementioned data has been incremental, many housing-related stocks have already posted strong runs. One of them, paint and coatings manufacturer Valspar (NYSE:VAL) is already up 75% over the last two years and about 46% over the past year. While declining TiO2 prices and improving demand should both help results, as will a growing presence in emerging markets, the stock seems to already be testing the high end of its typical valuation range.

SEE: 8 Signs Of A Real Estate Rebound

Okay Results In Fiscal Q2

Valspar's second quarter results highlight some of that gap between present-day performance and investor expectations for a meaningful recovery in business. Revenue was flat this quarter, despite a 7% volume increase. About half of that volume increase was acquired growth tied to the company's deal with Ace Hardware. By segment, paint revenue increased 3%, while coatings revenue fell 1% on weaker industrial demand.

Margins were a little interesting. Although titanium dioxide suppliers like DuPont (NYSE:DD) and Huntsman (NYSE:HUN) have been seeing serious erosion in prices, Valspar saw a one-point decline in gross margin from last year. Keep in mind, though, that Valspar isn't as leveraged to TiO2 as Sherwin-Williams (NYSE:SHW) or PPG (NYSE:PPG) and TiO2 isn't the only relevant cost input. In any case, operating income did improve 4% on an adjusted basis, with double-digit growth in paints offsetting a high single-digit decline in coatings.

SEE: Zooming In On Net Operating Income

Overseas Growth Is Nice, But Should The Company Reinvest In The U.S.?

Normally investors cheer American companies that place a big emphasis on growing their international businesses, particularly their emerging markets business. Certainly Valspar has looked to position themselves accordingly – the company has the #2 decorative/architectural paint business in Australia and the #3 business in China. While that latter number sounds good, the Chinese market is extremely fragmented, and the #3 slot isn't worth as much in market share as you might think.

When it comes to the U.S., Valspar is a somewhat more distant rival to companies like PPG and Sherwin-Williams. Together, Sherwin-Williams and PPG (after completing the acquisition of Akzo Nobel's (OTC:AKZOY) U.S. paint business will have about three-quarters of the U.S. market, split roughly evenly.

As Akzo cited insufficient scale as its primary reason for selling the business, I do have some concerns about Valspar's position. Now, it's true that Valspar has a sizable overall business and there are some synergies with the coatings business. The company's deal with Ace Hardware could also help improve that share, and the company enjoys a relationship with Lowe's, but I think there's work to be done here at home if Valspar is going to really enjoy the benefits of the eventual improvement in residential demand.

SEE: Economic Indicators – Housing Starts

The Bottom Line

On its own, I would not be that worried about Valspar's market share position in the U.S.. I like the company's diversified offerings of paints and coatings (including the Cabot line and its large packaged goods coatings line), and I believe Valspar can benefit from improving input costs. What's more, this company has a solid record when it comes to paying (and raising) dividends.

Combined with valuation, though, I have more concerns about the stock. Stocks in this sector often trade at a range of EV/EBITDA multiples of 8x to 12x, and Valspar is already close to the high end of that range for its forecasted EBITDA over the next 12 months. Given the slow pace of the housing recovery (and the company's performance relative to expectations), I'm just not sure I see the reasoning for paying a premium.

I realize that stocks like PPG, Sherwin-Williams, and RPM International (NYSE:RPM) have done even better over the past year, but I also think they're better companies. I suppose I can understand investors who think there's a catch-up trade here, but I would prefer to go with different names to play that much-awaited housing recovery.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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