2012 was a pretty good year for investors prescient (or aggressive) enough to get in early to housing-sensitive names such as Louisiana-Pacific (NYSE:LPX), Mohawk (NYSE:MHK) and Valspar (NYSE:VAL). While housing hasn't really recovered just yet, investors seem happy enough with signs of a real bottom and the improving sales at the home improvement warehouse chains. Curiously, however, despite a meaningful exposure to these markets RPM International (NYSE:RPM) hasn't shared in all of the enthusiasm. Now the question is whether it should, and whether that catch-up trade can fuel further gains in the shares.
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Is OK Performance in the Second Quarter Good Enough?
RPM didn't really have a banner fiscal second quarter, but it was certainly no disaster either. Revenue rose 11% as reported, with growth in the consumer business of nearly 19% and growth in the industrial category of almost 8%. As has always been the case, acquisitions are a huge part of RPM's growth; the company's organic growth for the quarter was 6% in the consumer business and 3% in industrial. This industrial result was a little softer than expected, due in part to weaker conditions in Europe and commercial roofing in the U.S.
Where RPM did all right, however, was in the margins. Regrettably, the company did not provide volume/price performance information in its press release, but the 150 basis point improvement in gross margin strongly suggests that much of the company's organic growth was price-based. Operating income rose 9%, with strong growth in the consumer business (up 44%) and flat performance in industrial (up 7% excluding an investment write-down).
Is RPM's Residential Business Underappreciated?
As I indicated above, numerous stocks tied to the U.S. residential market had banner years for 2012, as investors have become far more confident that the worst has passed. Curiously, RPM doesn't seem to be getting full credit.
RPM gets about 30% of its revenue from the U.S. residential market, more in fact than Valspar or PPG (NYSE:PPG). While RPM does not have a paint business, products such as Zinsser, Rust-Oleum and DAP are all pretty likely to do well in that construction/remodeling/renovation recovery that has to come sooner or later. Along similar lines, while RPM is very likely to remain focused on serial tuck-in deals, I would completely rule out the possibility of organic growth simply because it's been so long since we've really seen much of that from the company.
Try, Try Again Overseas
RPM wrote down even more of its investment in Indian composite materials company Kemrock this quarter, as those shares continue to struggle in India. Indeed, 2012 was a nightmare for this company, as the shares plunged from about Rs 510 to around Rs 82 recently and sales have eroded by nearly 50% recently.
Still, I doubt that this one bad investment will, or should, dissuade the company from further emerging market ventures. There's plenty of growth to be had in markets such as India, Brazil and Turkey, and RPM can likely use select overseas acquisitions and investments not only as a way of adding local brands and capacity, but also using existing in-country channels to broaden foreign sales of its existing products.
The Bottom Line
By and large, I have generally thought that investors think too highly of RPM International and award the shares too high of a premium. Even so, the shares are still up more than 40% over the past five years, so it has hardly been a terrible holding.
At roughly 11 times trailing EBTIDA, I still believe these shares are likely too pricey. Even if revenue continues to grow at a 5% to 6% pace in the future (versus about 7% over the trailing decade) and free cash flow margins improve into the high single digits (consistent with, or superior to, PPG, Valspar and Sherwin-Williams (NYSE:SHW)), the 8% or so implied free cash flow growth suggests a fair value in the mid to high $20 range.
Given that these shares seem pretty fully valued, and the company has never been a tremendous performer in terms of metrics like return on invested capital (ROIC), I'm inclined to think that the market basically has this stock correctly valued for now.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.