It’s been a couple weeks since two fierce competitors in the general building materials industry reported earnings; a mixed bag for both Masco (NYSE:MAS) and Sherwin-Williams (NYSE:SHW). With the economy continuing its sluggish pace, there could be more of the same in future quarters. However, for those investors interested in both of these companies, I’ll tell you the one to hold and the one to fold.
I happened upon an article in Seeking Alpha from Nov. 6 discussing eight overvalued, highly leveraged stocks that continue to do well. One of the eight is Masco, which the article mentions has a financial leverage ratio of 6.48. Value investor Ben Graham never considered a stock with anything over 2. I’m not suggesting that you should do the same, because times change. However, when compared with Sherwin-Williams — whose own financial leverage ratio is 3.76 — one needs to ask themselves why there’s such a difference. After all, only two years ago, Masco’s ratio was 3.49, a far healthier number. The answer is simple, really: Masco has achieved three straight years of losses totaling $1.6 billion, cutting book value in half.
Masco generated overall sales of $2 billion in the third quarter, flat year-over-year when adjusted for currency, with earnings of 10 cents per share. The first nine months of the year saw its revenues drop slightly at $5.8 billion and a loss of a penny per share, two cents better than the year before. When you consider Masco made almost $1 billion in net income in 2005, these numbers seem pitiful in comparison. Morningstar, in an effort to put a positive spin on an otherwise dreary outlook, suggested in its recap of Masco’s third quarter that its net debt-to-net capital sits at a manageable 62%. Maybe so, but it’s still 22 percentage points higher than Sherwin-Williams.
Where Masco shines is in its paint business. For those of you that aren’t aware, Masco owns Behr paints and stains, part of its decorative architectural products segment. Even with a 330 basis-point drop in its operating margins, they still were 19.3% in the third quarter — by far the best result of any of its segments. Certainly it and its plumbing products division are the core contributors to any profits Masco hopes to see.
Comparing those numbers to Sherwin-Williams is a little difficult because there are two segments to consider: its paint stores and consumer group. The consumer group sells to retailers, including its own paint stores. Combine them together excluding the inter-segment sales, and you get an operating margin of 15.7%.
Perhaps Masco is better served spinning off its paint division. Clearly the cabinet business is holding it back and might continue to do so for some time. Sherwin-Williams might have periods of slow growth, but its singular focus on paint is a big reason SHW has outperformed both MAS and the S&P 500 over the past decade.
How do you value a stock when it has lost money for three straight years? I suppose you could use price-to-sales as a starting point, just like during the dot-com craze. At least on that basis, Masco is a reasonable deal with a ratio of 0.42 compared to 1.05 for Sherwin-Williams.
One of my personal favorites is enterprise value-to-EBITDA. Masco’s is 14.22 times whereas Sherwin-Williams is 10.88. So, now we’re back to square one.
There has to be a way from a valuation standpoint to produce a clear winner, right? There is. Masco’s trailing 12-month EBITDA is $395 million. During the past five years, it has averaged capital expenditures of $220 million. Therefore, it spends $1 to make a $1.80. Sherwin-Williams’ trailing 12-month EBITDA is $959 million with average annual capital expenditures of $142 million. It spends $1 to make $6.75. On a free cash flow yield basis, they’re both 5% to 6%. In its best years, Masco could sweep the floors with Sherwin-Williams, but no longer.
Sherwin-Williams isn’t a perfect specimen. This I know. Its operating margins are as low as they’ve been in a decade, yet it still manages to generate good free cash flow. Quite simply, Sherwin-Williams has a much better chance of picking up its game than Masco ever will.
As of this writing, Will Ashworth did not own a position in any of the aforementioned stocks.