Valspar Corporation overview and business operations

Valspar Corporation

Industry supply and demand

The coating industry has grown considerably since 1993. However, as companies became larger their margin squeezed although the margin of other "players" along the value chain maintained or increased during this time (see fig.1).

FIG.1 - MARKET CAPITALIZATION - COATINGS VALUE CHAIN

Dow Chemical Company News Center, 2005.

According to Dow Chemical's senior vice-president the margin squeeze that coatings manufacturers had to face in the last 7 years is mainly generated by two forces: big oil and big boxes. The latest market trends show that despite market growth and sales growth companies register decreasing margins that lead to lower profitability.

Additionally, the coatings manufacturers have to cope with an increasing demand and tightening supply. The reasons behind this last trend are the underinvestment in chemical industry and the capacity rationalization. The supply failed to keep up with the growing demand and currently there is a gap between these two.

2. The company's costs and competitiveness

Valspar's manufacturing costs strongly depend on exogenous factors, such as:

The energy - the market trend for its costs is toward increasing; the supply and demand for energy influence its price to consumers and the government's attitude towards the energy regime (e.g. stimulate more/less consumption).

FIG. 2 - FEEDSTOCK DRIVERS for HYDROCARBON and ENERGY PRICES

Source: Dow Chemical Company News Center, 2005.

Fig. 2 shows an increasing price trend for the main feedstock drivers. In other words the energy consumer prices have increased in the last year.

TABLE 1 - NATURAL GAS PRICES - 2005

Country

Price $/MM Btu

US

Germany

Canada

Mid East

Malaysia

Source: Dow Chemical Company News Center, 2005.

Besides resources availability, natural gas industry is subject of change due to the environmental activists. Their lobby refers to replacing coal or nuclear power with natural gas, which would increase the gas demand. However, since consumption is limited, that would lead to a further increase in the gas' consumer price.

The demand and supply for intermediate products.

The demand and supply for specialty chemicals. All first tier manufacturers have specialty coatings production as it allows them to cover market niches or satisfy the demand for products to which competitors have restricted access.

The company's average cost is affected by the increasing raw material prices and gas is an ingredient for raw materials used to produce coatings, such as: vinyl, polyurethanes, latex, acrylates, solvents, etc. The energy that is involved in the manufacturing process contributes as well to the increase of the average cost.

Besides raw materials and utilities, the company incurs labor costs as variable costs. These costs are stable in the U.S. market and decreasing globally as companies have increased their manufacturing mobility, which allowed them to relocate their production facilities to low cost locations.

The company's fixed costs include: building related costs, equipment related costs, tooling related costs, the labor needed to maintain the equipment, tools and building and the time value of the financial resources invested in the first 3 fixed cost items. The increasing demand in the real-estate industry increased related prices (rents and land/building prices), which had a negative impact on Valspar's fixed costs.

Moreover, as demand is increasing and energy prices follow the same trend, coatings manufacturers have to engage more efficient technologies in terms of costs. Technological upgrade may lead to the increase of the fixed costs.

Cycle time is very important when calculating either fixed or variable costs. Cycle time refers to the time needed by a machine to perform a given task and it is a key predictor for technological upgrade costs. Thus, a low time cycle may reduce the average costs by allowing for a greater throughput, but increase fixed costs as a better technology is likely to be more expensive.

Depending on the average cost, more specifically on the company's ability to exploit its location advantages on a global level, the marginal costs can increase, decrease or maintain. Thus, if production takes place in a low cost location, the marginal cost is expected to be less than the average cost. Conversely, if production takes place in U.S. where the market demand/price for oil are high, and where production is restricted, the marginal costs is expected to be above the average cost.

The cost items as previously described are characteristic for all companies in this industry and those may find themselves in different situations (e.g. increasing average cost and increasing marginal cost). The situations vary with the company's ability to manage these costs globally.

The company's average cost can be calculated as the total cost to total output. The total cost is calculated as the difference between revenues and profit.

Valspar's total revenue (2007) = $2,978,062,000

Valspar's Gross Profit (2007) = $307,437,ooo

Valspar's total cost = revenue - profit = $2,978,062,000 - $307,437,000 = $2,670,625,000

Valspar's variable cost = cost of goods sold = $1,542,100,000

Valspar's fixed cost = total cost - variable cost = $2,670,625,00 - $1,542,100,000 = $1,128,525,000

Assumptions:

Price per unit = $100

Valspar's total output (2007) = total revenue/price per unit = $2,978,062,000/$100 = 29,780,620

Valspar's average unit cost = total cost/total output = $2,670,625,000/29,780,620 = 89.67

The total cost function will be:

Cq = Cfix + average unit cost*q = Cfix + 89.67*q = $1,128,525,000 + 89.67*q

The revenue function will be:

Rq = price per unit*q = 100*q

The profit function will be:

Pq = Rq - Cq = 100*q - $1,128,525,000-89.67*q = 10.33*q - $1,128,525,000

The break even point will be given by the following equation:

Rq = Cq

100*q = $1,128,525,000 + 89.67*q q = 109,247,338 units see fig. 3 for function representation)

The average cost will be:

Cq/q = ($1,128,525,000 + 89.67*q)/q = 89.67 + $1,128,525,000/q

Valspar is a second tier coating manufacturer. In 2006, the company achieved a 3% global market share, which accounted for over $2.6 billion. Table 2 is summarizing the competitors' activity in the last year and as it can be seem the top 10 manufacturers accounted for $47.5 million - more than half of the global production.

TABLE 2 - COATING INDUSTRY SALES RANKINGS - 2006

Company - tier I

Annual sales 2006 ($'bn)

Market share %

AKZO (includes ICI)

PRG (includes Sigma Kalon)

Sherwin Williams

Total tier I

Company - tier II

Dupont

Valspar

RPM

BASF

Kansai

Nippon

Masco

Total tier II

10 manufacturers

Estimated global market

Source: Valspar, corporate website (2007)

Phase 2

1. Firm and industry equilibrium

In 2006, the market seemed to be in a stable equilibrium on a global level with a compound annual growth rate (CAGR) of 3-4% year on year. The top 10 manufacturers' CAGR was close to 8% and Valspar's CAGR was 13% (Valspar - Investor Relations, 2006). The company's operating income growth was 11%, whereas the competitors reported: Sherwin Williams - 12.9%, RPM - 12.4%, Masco - 8.5%, ICI - 7.9%, PPG - 7.5%, AKZO - 3.9% and Dupont Coatings - 0%.

The neoclassical growth theory suggests that a market is in equilibrium when production has constant return to scale and there are diminishing returns to scale for any additional input (Hornstein, 2004). In the current case, the top 10 manufacturers seem to have increasing returns to scale (return rates>growth rates), which suggests that the coating market has not reach a maturity point. Rather, by diving deeper in the global market trends, it becomes obvious that this industry is fast growing in some regions, namely emerging markets (see fig. 3). These regions are also known as low cost locations. This suggests further that the return rates should be high, thus explaining the increasing returns to scale.

FIGURE 3 - GLOBAL MARKET SHARE by REGION

Source: Euromonitor International Report, 2006

2. Firm valuation

FIG 4 - EARNINGS and DIVIDENDS VALSPAR 2006-2007

FIG. 5 - SECTOR COMPARATIVE RETURNS

Source: Bloomberg, 2007

The company's dividend yield was 2.03% and the P/E was 16.094. The relative values were 1.11% and 0.902. Both indicators suggest that the company is generating steady revenue, rather than growth.

Valspar also reported a large market cap of $2,573.291 millions and a return on equity larger than 0.1. The P/E seems to be slightly higher to an investor's best choice - value above 15. Overall, the company seems to be fairly valued.

3. The firm's resources

The company's resources fall into three categories:

Raw materials. The input materials are usually based on natural gas or water combined with a number of chemical substances. Some of the basic ingredients for coatings are: vinyl, polyurethanes, latex, acrylates, solvents.

Human resources. The coatings industry is rather specialized compared to other industries. The job requirements include high qualifications in several domains, such as: chemical, technological, R&D and engineering. Given the specialization level, the industry compensation is above the national average. A survey made by the Coatings World (2006) revealed that more than half of the respondents in the coatings industry had a bachelor degree and the majority of them were male (see fig. 5 for more details)