Financial Strength vs. Lackluster Operations
• We see more upside in the former vs. incremental downside in the latter. Well, it wasn’t quite the quarter we had bargained for. Adjusted 2Q EPS of $1.83 was in line with consensus, but belied volume deceleration and margin compression in both Performance Coatings and Industrial Coatings. Operationally, PPG is fighting several battles: pricing that lags rising raw material costs, foregone sales of industrial coatings in an effort to defend price, persistent volume pressure in architectural coatings in DIY channels, and deceleration of global auto OEM production, just to name a few. The upshot is that operating margin remains under pressure with net volume growth languishing near zero. Looking ahead, 3Q prospects frankly don’t look too much better, although we’re more optimistic on margin restoration by 4Q. We see far better news on the financial front. PPG shares are relatively inexpensive, the company has substantial dry powder, and we expect management to put it to use forthwith via resumption of meaningful share repurchases in 3Q against an authorization of $1.7bn or 6.1% of equity market capitalization. As a result, we believe residual risk to EPS is rather low, so we’re sticking with PPG shares on the pullback.
• Our top 10 takeaways are: (1) sales of $3.81bn came in 1.1% below our $3.85bn; (2) EBIT of $650mn paled vs. our $670mn as margins compressed while volume growth stalled to flat from 1.9% in 1Q17; (3) earnings in both Performance Coatings and Industrial Coatings came in light, offset by lower than projected corporate expense due to a decline in variable comp; (4) PPG lost some business in Industrial in an effort to...
• Changes to our model: We decrease our 2017 EPS estimate by $0.22 to $6.00, including $1.60E for 3Q17. Drivers include lower projected sales at a lower operating margin, particularly in Industrial Coatings, partially offset by EPS accretion from the pending acquisition of Crown as well as more favorable FX. Likewise, we revised our 2018 EPS estimate lower to $6.45 from $6.60 for similar reasons.
• We rate PPG shares Buy with a price target of $120. Our target suggests total upside potential of 14%, including an upgraded dividend yield of 1.7% based on PPG’s payout increase of 12.5% to $0.45 per quarter. PPG shares now trade at a 2018 P/E multiple of 16.5x, which represents a discount of 3.0x or 15% vs. the average of three US coatings peers (SHW, AXTA and RPM). Importantly, we estimate that this discount would nearly double pro forma for deployment of PPG’s excess capital vs. coatings peers. Our valuation of PPG is based on an average of two methodologies: DCF analysis and a relative P/E framework. Our DCF analysis suggests a warranted stock price of $121. Using our relative P/E framework wherein we apply a 10% premium to the S&P500 multiple, we calculate warranted value of $119 per PPG share.
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