RPM International: Where Opportunity Meets Preparation
At Diamond Hill, analysts pride themselves on developing deep industry knowledge, allowing us to act with conviction when an attractive, long-term investment opportunity presents itself. We believe this was the case with RPM International, a long investment we made in early 2018. Previously, I have written favorably about the coatings industry, as the industry’s main publicly traded participants, including RPM, have generated strong returns on invested capital and shareholder returns over long periods of time.
RPM is an Ohio-based, industry-leading provider of coatings and stains, caulks and sealants, small project paints, and specialty chemical products serving the residential, non-residential, and industrial markets. The company is well known by both professional contractors and individual consumers for its strong family of brands including Rust-Oleum paints and stains, DAP caulks and sealants, Tremco roofing solutions, and Carboline performance coatings. CEO Frank Sullivan is the third generation of the Sullivan family to run RPM, succeeding his father Tom in 2002.
RPM has made many bolt-on acquisitions over its history, and in many cases the founders of the acquired companies continue running their businesses within RPM. Often, RPM acquires a strong brand or product, achieving higher revenues by folding that product into their extensive distribution network, allowing company founders to drive growth faster than they would on their own. RPM has historically run a decentralized operating model, allowing their numerous operating companies and acquired businesses to operate independently.
While mid-single digit top-line growth for RPM was not too dissimilar from peers over the last 10 years, the company’s operating margins lagged, as peers strongly expanded margins. By 2018, the company’s operating margins lagged peers by nearly 5%, a significant amount for a company with RPM’s scale. We followed RPM closely over the last five years and noticed a shift in management’s tone in late 2017 and early 2018, as they indicated a heightened focus on driving operational improvement. Sullivan began talking more aggressively about plans to run the business more effectively, including consolidating manufacturing locations and cutting general and administrative expenses. We believed that the significant operating margin gap compared to peers was driven by RPM not having integrated its bolt-on acquisitions as effectively as possible over time. Supporting this hypothesis was RPM’s 145 manufacturing facilities, which is more than PPG Industries, while generating only one-third of PPG’s revenue (see table on next page). In addition, RPM’s expenses as a percentage of sales lagged peers significantly.
Our initial investment and thesis for RPM was driven by a belief that the company was well-run from a top-line revenue perspective given the strength of its brands and strong track record of organic growth in the low- to mid-single digits. Our investment was also predicated on RPM’s product pricing eventually catching up to persistently high raw material inflation, the corresponding normalization of gross margins, and top-line organic growth consistent with historical growth. Importantly, our initial estimate of intrinsic value did not anticipate management closing the margin gap to peers as our base case, but we believed that there was an increasing probability of significant margin improvement given management’s more aggressive focus on structurally improving operating margins. If RPM operating margins were to approach peer levels, this would result in significant growth in earnings and free cash flow over the next five years, likely leading to strong returns for shareholders. At the time of our initial investment, coatings businesses were out of favor given the inflationary raw material environment in 2017 and 2018 which, in our view, temporarily compressed gross and operating margins, providing an attractive entry point for investment. Our experience covering the coatings industry, and RPM, gave us the conviction to act when we believed the business was undervalued.
Following our initial investment, RPM announced an agreement in June 2018 with activist shareholder Elliott Management, which included the formation of a board-level operating committee with several Elliott appointees, whose primary task is to expand operating margins significantly. At the company’s November investor day, RPM laid out a detailed “2020 Map to Growth” plan to drive $290 million in cost savings, improve operating margins by roughly 5.5%, and double operating earnings over the next two to three years. Several specific actions to achieve these targets included:
- Consolidating 45 enterprise resource planning platforms to four.
- Consolidating 31 plants and associated warehouses.
- Centralizing procurement functions to leverage RPM’s purchasing power.
- Streamlining back office functions, including 364 legal entities, 163 auditable entities, and 104 accounting locations.
We were encouraged by these detailed cost reduction plans and have increased our estimate of intrinsic value to reflect a higher probability of structural margin expansion over the next five years. These actions also supported our initial hypothesis that RPM’s operations had not been optimally structured following a large number of bolt-on acquisitions over the past several decades.
Given the current stock price, we believe RPM International remains an attractive long-term investment. We are closely following the company’s cost reduction actions and are monitoring their impact on top-line growth. Management’s goal is to insulate the sales and research and development organizations from these cost reduction plans as to not impair top-line growth. Should management not execute as planned on either its top-line or margin targets, we believe that the current management team could be replaced with a more capable team or that the business could be sold to an acquirer who believes they can run RPM’s operations significantly more efficiently. Consolidation has been a key theme within the broader chemicals sector over the last few years, and we believe RPM has a unique brand portfolio which could be attractive to several potential acquirers. Finally, Sullivan has publicly indicated in the past that he would be willing to entertain an offer for RPM at an acquisition multiple similar to other recent architectural paint deals.
|Axalta Coating Systems||Sherwin-Williams||PPG Industries||RPM International||Industry Average ex. RPM|
|Earnings Before Interest & Taxes*||$0.75B||$2.50B||$2.04B||$0.55B||—|
|Earnings Before Interest & Taxes (%)||16.0%||14.5%||13.4%||10.0%||14.6%|
|Number of Facilities||50||118||133||145||—|
|Earnings Before Interest & Taxes / Facility||$15M||$22M||$15M||$4M||$17M|
*Normalized operating earnings are Diamond Hill estimates.
Data shown is for trailing 12-month period for the most recent reporting period shown.
As of May 31, 2019, Diamond Hill owned shares of Axalta Coating Systems, RPM International, Inc. and Sherwin-Williams Co.
Originally published on JUne 26, 2019.
The views expressed are those of the research analyst as of June 2019, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.