Much is made of the weak construction markets in North America and Western Europe when talking about specialty chemicals maker RPM International (NYSE:RPM), but that's only part of the story - and maybe not even the most important part. Although strong revenue growth is a goal of most companies, RPM arguably has a more clear and present danger in the form of rising input costs and limited pricing power. Although RPM is a fine company in many respects, valuation still doesn't point to this name as a must-own.
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A Fair Fiscal Second Quarter
RPM International's second quarter was alright, but with a few worrisome trends. Reported revenue did rise almost 11%, with about one-quarter of that growth coming from acquisitions. The industrial segment is still more than two-thirds of sales and revenue growth was a bit light here - up about 10% as reported, but about 40% of that growth was acquisition-related. Volume rose a bit more than 3%, with prices up about a similar amount. Consumer sales were stronger - up more than 12% on a better than 9% rise in volume. (For related reading on acquisitions, see Biggest Merger and Acquisition Disasters.)
Margins were not nearly so solid. Gross profit rose less than 9%, with gross margin falling almost a full point. Gross margin continues to be hit by rising input costs in petrochemical-related feedstocks like acrylics, as well as titanium dioxide (commonly used in paints).
These material costs were notably troublesome in the consumer segment, where it was about 70% responsible for the one-and-a-half point drop in segment margin (and 2% drop in profits). While materials costs hit industrial profits as well (as did acquisitions), operating profit was still up 14% here and the margin did expand. Overall GAAP operating income was down 2% for the quarter.
No New Builds Today ... but What About Repair?
Here's the thing about RPM - it's absolutely true that new construction activity is weak right now, but new build activity has recently been only about one-quarter of the company's business. Moreover, while activity has been down, new stricter standards in Europe (particularly relating to energy efficiency) should be creating a bit more opportunity for the company. Look to see what companies like Akzo Nobel (OTCBB:AKZOY) and BASF have to say about conditions to see if they may be gaining share.
Repair and maintenance seems to be holding up alright. RPM's annual-run rate of revenue is getting pretty close to its prior high (and that just after the peak in building), and that clearly hasn't been helped much by new builds.
Plenty of Threats
RPM is a fine company with over 50 internal operating units and some solid brand leverage. That doesn't mean that the company is not vulnerable to power-plays from retailers like Home Depot (NYSE:HD), Lowe's (NYSE:LOW) or Wal-Mart (NYSE:WMT). There's always a push-pull here (will customers shop elsewhere if a retailer stops carrying DAP or Rust-Oleum?), but definitely some risk as retailers look to preserve margins.
There's also just good old fashioned competition. PPG (NYSE:PPG), Sherwin Williams (NYSE:SHW), Valspar (NYSE:VAL) and DuPont (NYSE:DD) all have their own products in key categories like sealants, coatings and protectants, and DuPont and PPG are arguably better-integrated. None of these companies are likely to get stupid when it comes to pricing, but by the same token the better margin structure at PPG and DuPont may limit what RPM can achieve with price increases.
The Bottom Line
RPM International remains a fine company, but the trouble is that it's priced that way. It is not much of a bargain relative to its comparables on metrics like EV/EBTIDA, and a cash flow model suggests that the stock is fairly priced assuming mid-single-digit revenue growth and modest margin improvements. By all means consider RPM shares on a pullback, but there are few reasons to chase these shares. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.