Planes, Paints, and Automobiles

Tesla (TSLA -1.92%) posts record profits in the second quarter. AerCap (AER -0.63%) wins regulatory approval to buy General Electric's (GE -3.19%) aircraft leasing business. Sherwin-Williams (SHW -1.10%) reports pretty good Q2 results. In this episode of MarketFoolery, Asit Sharma analyzes those stories and discusses the importance of finding management teams with strong capital allocation skills.

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This video was recorded on July 27, 2021.

Chris Hill: It's Tuesday, July 27th. Welcome to MarketFoolery. I'm Chris Hill. With me today, Asit Sharma. Thanks for being here.

Asit Sharma: Chris, thank you for having me.

Hill: Let me just say up front, I have no idea what the audio sounds like. Due to extenuating circumstances, Asit and I are flying solo on the audio. If the audio is not good, it'll be better tomorrow, I promise.

Sharma: Hey Chris, there is a really old French movie. It used to be famous, but time flows. I don't know if anyone's ever heard of this. But I think it's called Don't Shoot the Piano Player. I feel like that's the theme for our audio today. Don't shoot the piano player. 

Hill: I've not heard of that. But after this episode, I'm going to go to IMDb and look it up. We've got home improvement, we've got aircraft. We're going to start with automotive. Tesla's second-quarter profit was not only higher than expected, it came in north of $1 billion for the first time ever. There's always a lot to get to with Tesla, whether it's the actual results or comments on the conference call. I'm curious what stood out to you.

Sharma: Chris, I'm impressed by these results. Tesla, despite a lot of challenges, had a great quarter in sales, sales were up 98%. But the thing that really leaps off the page is its automotive gross margin, which has improved about 3% over the last four quarters, enabling them to generate that higher profit. They did it without a lot of these regulatory credits. In their automotive revenue, they're transferring credits, they're getting revenue from the sale of governmental credits. That's a smaller component of revenue. What you got here was a great sales increase in a supply constrained quarter in which the company had to swap out chips and rewrite firmware, rewrite software on its automobiles. They still managed to generate a bunch of net income, $600-plus million in free cash flow. Before we get to the more colorful details which always surround Tesla, let's give them an A for this report.

Hill: Then I want to know about the colorful details. Yes. Give an A for this report, just one other data point I'll add. Their profit was 10 times higher than a year ago. It's just staggering when you see that kind of growth, and even allowing for the pandemic, it's just incredible. But let's move onto the color.

Sharma: Yeah. One thing which I think some shareholders are going to feel sad about and some will appreciate. Yesterday, Elon Musk said that he is not going to participate in conference calls going forward. Now, I'm old enough to remember several quarters ago when Elon was dissing the very analysts who are responsible for the information flow that helps Tesla raise money in the capital markets. But I think everyone would agree with his mercurial temperament. Maybe for a couple of quarters, that's good to have less commentary, more results. I also like that Tesla is now proving out its ability to operate at scale. It looks like it could be less reliant on secondary stock offerings, debt. Hey, if you can plow this amount of profits and cash flow through each quarter, then you will begin to accumulate those on your balance sheet and self-fund all those new adventures. That's one part of it. I think the other bit of color for me was just the further delay in the Cybertruck. Of course, I think the reasoning is good. We're seeing this throughout the automotive industry and you and I've talked about this. The chip shortage is hammering the ability of automakers to innovate their latest models and produce. I guess we can give them a pass there. But in terms of Elon being mum on his quarterly reports, I'm actually all for it. What about you, Chris?

Hill: First of all, I wouldn't assume that this means he's never going to be on a conference call. It's perfectly within his purview to change his mind on that. I'm just reminded of the episode a couple of years ago with Twitter, him essentially backing off Twitter or at least calming down what he was posting on Twitter. That seemed to work out well for shareholders. Look, from an entertainment standpoint, yes, I would love him to be on every quarterly conference call. If you're a shareholder of Tesla, I don't think you're looking at this and thinking this is to the detriment of the business.

Sharma: True that. We'll see. Let's see, maybe next quarter he jumps back in. But at least that was the message after earnings.

Sharma: Let's move to the skies. AerCap is the largest aircraft leasing company in the world, and it is about to get even larger. Because earlier today, antitrust regulators in the European Union approved AerCap's $30 billion bid to buy General Electric's aircraft leasing business. This is not an industry I pay a whole lot of attention to. But you pointed this out. A deal like this between the two biggest companies in the industry. Are you at all surprised this got approved?

Sharma: Yeah, a little bit.

Hill: I'm not trying to tell the antitrust regulators how to do their job, and I have nothing against either of these businesses. Just on the surface, it's a little surprising, right?

Sharma: Yeah, I think so because this is a case of the really strong just getting stronger and bigger. AerCap had its financing already lined up for the deal. They didn't seem to have any concerns that there would be antitrust issues. The European regulators are known for raising their hand and saying, "Wait a minute, guys. Everyone, slow down here. We need to really take a look at this deal." To get this clean bill of slate in the merger, it's great for AerCap. They've got a very simple business model. Because they're already so big, they get huge discounts from the airplane manufacturers then they lease those planes back out to various airlines at a nice profit. They've had a focus over the last several years in decreasing the age of their fleet, focusing on newer technology aircraft. That business model's working very well for them. They took some hits last year when all travel stopped. But because they are so well diversified among wide-body and narrow-body jets, and among carriers of different sizes. It really was just a blip on the longer-term road to dominance in this industry. 

They had last quarter a record number of aircraft that they leased. They're going to benefit as now the world comes back closer to normal, delta variant notwithstanding. You've got a company here, if you like the business model, which may be poised to show some more of the strength that its fans have been advocating for. The last point that I want to say on this before hearing what your take on this is, our colleague, Jim Gillies and I have both been fans of this company. As a value play, we were chatting about it last year during the spring when everything went bleak during the pandemic. I think that robust, diversified business models proved out the points that our friend Jim was making and that I was making, too. Now with this deal, they just become bigger and stronger. It's hard to see anyone else ever being a viable challenger to their business. Now, the various other lessors will be vying for the No. 2 spot.

Hill: When you look at the market cap for AerCap, it's basically back where it was pre-pandemic. It'll be interesting to see as this deal progresses, as they close it, what this business looks like a year from now. Part of me looks at this deal and thinks, if you're a General Electric shareholder, I should just add the descriptor, long suffering, if you're a long-suffering GE shareholder, you're probably happy about this deal because it's one less thing in the conglomerate. For whatever good that may have done the bottom line for GE, it enables Larry Culp and his team to just get more focused about righting the ship that is GE. But from AerCap standpoint, yeah, I want to see where this business is in 12 months.

Sharma: Yeah, maybe we will revisit this time next year.

Hill: To borrow from Larry David, the second-quarter results for Sherwin-Williams were pretty good. Profits were a little lower than expected, revenue in line with the expectations. Shares of the paint maker are down about 2%, I don't know. This seems like a return to normalcy and I say that because shares of Sherwin-Williams even with the slight drop today are up more than 30% over the past year and this is about as slow and steady and boring a business as you can find. But if you're a shareholder, holy cow, this has been rewarding.

Sharma: Chris, when you're watching the paint dry, you're waiting and waiting. But when your guests finally come, they look at your beautiful walls, you feel so great and this is the case. If you've been a Sherwin-Williams shareholder for the last 10 years and reinvested your dividends, you are up 1,100%. Now, in these near-term periods, it can move around a little bit I think. This is just near-term shareholders taking profits. But a strong picture here, we had a 17% year-over-year increase in the quarter. This was a quarter in which things as you mentioned return to normal. The retail sales that they've been running off of for the last several quarters, took a breather because we're doing a little bit less of the do-it-yourself at-home projects as more of us are now having to either go back to work or start a more hybrid environment where maybe we're showing up a couple of times a week in person. 

The company thus saw a lot of solid strength in architectural paints, the types of paints and supplies that are associated with the economy, an economy that's kicking into gear which is exactly what the U.S. economy is doing. Here's another diversified business model. It's got that side which is very business-focused, it's got the consumer side. One drops off a little bit, the other takes over. You have to like that. I want to say, the ability of this company just to generate solid cash flow, maybe that's a theme for me today, is also extremely impressive. Before we came on air, I was looking at, just for the last year, its net income and cash flow generation. You're looking over the last trailing 12 months at $2.1 billion in net income, but $3.3 billion in free cash flow. This is a hugely strong business and I think too it's a company I want to look at, actually not next year but in five years. I want to see if Sherwin-Williams will continue to be this paint drying on the wall company where it's up another several 100% as you just take a periodic look at it.

Hill: Without dividends, it's up 10 times in the last 10 years. In the last 20 years, it's up more than 35 times in value. If I can ever shut up long enough about this business, I am going to buy some shares. It's very high on my watch list. As I've said before, nobody buys a home and thinks to themselves, this looks good to me. These colors are good, I'm not going to change anything. You think about the rise of extreme weather and what that does to exterior paint, I don't know. It seems like the life cycle for exterior paint for homes is getting shorter and that's only going to benefit the Sherwin-Williams of the world.

Sharma: That's a great point. I also want to point out that with that long-term demand that's just always there, they have a choice. Management can take their feet off the gas pedal, but they continue to invest their buying back shares which OK, is the investment when you're generating so much cash, you can repurchase quite a decent amount of shares. I think they bought back about 3.1 million shares in this quarter they just reported on, but they opened 25 new stores. They are continuing to get that retail footprint expansion, keep it in gear, and they're also really investing in technology. It's a company that you wouldn't think is a great R&D vehicle, but over the years that's exactly what Sherwin-Williams has done. Just one of the things they've done best is to keep up with the formulation of their products. Chris, when you and I, let's say, commercial builders have to go in and repaint the exterior of a house, they can sell a better formulation and at least show that this one will have a little bit longer shelf life. Now, of course they don't want to optimize it, where we don't want to replace it every few years. There's a certain amount of engineering you want to be very careful with. But I think Sherwin-Williams knows how to hit that sweet spot.

Hill: Well, and you pointed something out about the management at Sherwin-Williams that I think is so important for any business. We're talking about paint. We could be talking about a cloud business, software business. We could be talking about anything. It's one of those skills that's so important and doesn't really show up except with time. It is the way that they manage the business, the management of the money, the capital allocation. How good is the management team at deciding we're going to buy back shares, we're going to increase the dividend? How good are they at picking locations for their stores? It's the thing that you want that to matter and it's very important but it's only going to reveal itself, it's one of those things that you look back and you're like, "Oh, yeah. Now that we look back over the last 10 years, yeah, they really are good at that." It turns out this management team really is good at capital allocation.

Sharma: There's so many companies, Chris, that reach a state of stable cash flows and pretty nice growing revenue and profits, but fewer are the companies that can take that state and optimize it over a long period of time. Absolutely, it's a rare quality in the management team to do this for more than a few years let alone throw in some decades and just keep up great performance that pleases shareholders. We definitely have to give management kudos there. I think that's been a theme lately as we're looking at companies together. How good are they at allocating capital? This one gets some solid grades for me.

Hill: Asit Sharma, great talking to you. Thanks for being here.

Sharma: Thanks a lot, Chris, fun as always.

Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery. This show is mixed by Austin Morgan. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.