Kevin McCarthy, Chemicals Analyst, Vertical Research Partners09.13.17
PPG Industries (PPG: Buy, $124 PT)
Hikes Capital Deployment Goal; 2Q EPS in Line With Tough Mix
• 2Q EPS trended in line with Street, albeit with weaker than expected operations and mix. PPG posted adjusted 2Q17 EPS of $1.83A in line with consensus of $1.83 and shy of our $1.88E. Sales of $3.81bn came in 1.1% below our $3.85bn. However, EBIT of $650mn paled vs. our forecast of $670mn as margins compressed while volume growth decelerated to flat from 1.9% in 1Q17 and 1.5% in 4Q16. On a segment basis, earnings in both Performance Coatings and Industrial Coatings came in light, offset by lower than projected corporate expense. On balance, we consider operating results to be disappointing, although we expect certain pressures to ease in 2H17. Gross margin should fare better with 2Q having been a period of peak raw material cost pressure, and FX has already improved as we discussed in our earnings preview (click here).
• Silver lining: capital deployment target raised to $3.5bn+ through 2018. One piece of good news is that PPG committed to accelerate the pace of capital deployment to a minimum of $3.5bn in 2017 and 2018 combined from a range of $2.5-$3.5bn previously. We consider the subject of PPG’s future deployment of excess capital to be a prime focus of investors in the wake of the company’s withdrawal from the pursuit of Akzo on 1 June. With regard to Akzo, we see four reasons why future M&A (in some form) could be in the cards: (1) Elliott Advisors trebled its ownership stake in Akzo to 9.5% as of 7 July; (2) Elliott also brought a pending legal case to investigate management practices at Akzo, with a hearing scheduled for September 20; (3) Akzo CEO Ton Buchner announced his departure this week for health reasons; Thierry Vanlancker, a former executive at Chemours and DuPont will succeed him; and (4) there exists a persistent, substantial disparity between Akzo’s stock price and PPG’s most recent offer of €96.75 per Akzo share, which we attribute to investors’ skepticism regarding the merit of Akzo’s strategic plan. If PPG does not re-engage in pursuit of Akzo come December 2017, the company will have an awful lot of excess capital to deploy. Net debt dipped $32mn in the quarter to $3.0bn or 1.1x our 2017 estimate of EBITDA, and a pending divestiture should further strengthen PPG’s balance sheet.
• Performance Coatings sales and earnings came in light. Sales of $2.30bn missed our estimate of $2.35bn and segment EBIT margin of 17.9% came in 50bps less than we had modeled. Volume declined 2% y-y, due in part to a small headwind from timing of the Easter holiday. Weakness in marine coatings persists, down low double digits, while architectural coatings sales trended a bit weaker than we had modeled in EMEA as well as the DIY and independent dealer channels in the US. Commentary suggests that organic sales expanded in auto refinish, which could mute the read across to Hold-rated Axalta where we expect Performance Coatings segment sales to trend about flat as adjusted to incorporate recent acquisition activity.
• Industrial Coatings earnings also light on weak margins. EBIT of $264mn came in well short of our $299mn. Sales trended in line with our forecast but segment margin of 17.5% came in 250bps below our forecast of 20.0% as PPG experienced a rather painful lag between raw material cost increases and the ability to recover those costs from the company’s industrial customers. Average selling prices actually declined in the segment, despite initial price hike efforts to address inflation in raw material costs. Auto OEM volumes increased slightly, outpacing global auto industry production rates, which declined slightly y-y according to PPG. Packaging coatings volume trended flat against a tough comparison.
• We rate PPG shares Buy with a price target of $124. Our target suggests total upside potential of 11%, including a dividend yield of 1.4%. PPG now trades at a 2018 P/E multiple of 17.2x, which represents a discount of 2.8x or 14% vs. the average of three US coatings peers (SHW, AXTA and RPM). Importantly, we estimate that this discount would 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 $124. Using our relative P/E framework wherein we apply a 10% premium to the S&P500 multiple, we calculate warranted value of $123 per PPG share. As a reminder, we had trimmed our 2017 and 2018 EPS estimates by $0.08 and $0.10 to $6.22E and $6.60E, respectively, back on 5 June to reflect estimated dilution from the divestiture of two additional non-core businesses: the remainder of its fiberglass operations in the US as well as a small plasterboard and cement-board business that came along with PPG’s prior acquisition of Comex (Mexico) in November 2014.
(Please see full report for details)
Hikes Capital Deployment Goal; 2Q EPS in Line With Tough Mix
• 2Q EPS trended in line with Street, albeit with weaker than expected operations and mix. PPG posted adjusted 2Q17 EPS of $1.83A in line with consensus of $1.83 and shy of our $1.88E. Sales of $3.81bn came in 1.1% below our $3.85bn. However, EBIT of $650mn paled vs. our forecast of $670mn as margins compressed while volume growth decelerated to flat from 1.9% in 1Q17 and 1.5% in 4Q16. On a segment basis, earnings in both Performance Coatings and Industrial Coatings came in light, offset by lower than projected corporate expense. On balance, we consider operating results to be disappointing, although we expect certain pressures to ease in 2H17. Gross margin should fare better with 2Q having been a period of peak raw material cost pressure, and FX has already improved as we discussed in our earnings preview (click here).
• Silver lining: capital deployment target raised to $3.5bn+ through 2018. One piece of good news is that PPG committed to accelerate the pace of capital deployment to a minimum of $3.5bn in 2017 and 2018 combined from a range of $2.5-$3.5bn previously. We consider the subject of PPG’s future deployment of excess capital to be a prime focus of investors in the wake of the company’s withdrawal from the pursuit of Akzo on 1 June. With regard to Akzo, we see four reasons why future M&A (in some form) could be in the cards: (1) Elliott Advisors trebled its ownership stake in Akzo to 9.5% as of 7 July; (2) Elliott also brought a pending legal case to investigate management practices at Akzo, with a hearing scheduled for September 20; (3) Akzo CEO Ton Buchner announced his departure this week for health reasons; Thierry Vanlancker, a former executive at Chemours and DuPont will succeed him; and (4) there exists a persistent, substantial disparity between Akzo’s stock price and PPG’s most recent offer of €96.75 per Akzo share, which we attribute to investors’ skepticism regarding the merit of Akzo’s strategic plan. If PPG does not re-engage in pursuit of Akzo come December 2017, the company will have an awful lot of excess capital to deploy. Net debt dipped $32mn in the quarter to $3.0bn or 1.1x our 2017 estimate of EBITDA, and a pending divestiture should further strengthen PPG’s balance sheet.
• Performance Coatings sales and earnings came in light. Sales of $2.30bn missed our estimate of $2.35bn and segment EBIT margin of 17.9% came in 50bps less than we had modeled. Volume declined 2% y-y, due in part to a small headwind from timing of the Easter holiday. Weakness in marine coatings persists, down low double digits, while architectural coatings sales trended a bit weaker than we had modeled in EMEA as well as the DIY and independent dealer channels in the US. Commentary suggests that organic sales expanded in auto refinish, which could mute the read across to Hold-rated Axalta where we expect Performance Coatings segment sales to trend about flat as adjusted to incorporate recent acquisition activity.
• Industrial Coatings earnings also light on weak margins. EBIT of $264mn came in well short of our $299mn. Sales trended in line with our forecast but segment margin of 17.5% came in 250bps below our forecast of 20.0% as PPG experienced a rather painful lag between raw material cost increases and the ability to recover those costs from the company’s industrial customers. Average selling prices actually declined in the segment, despite initial price hike efforts to address inflation in raw material costs. Auto OEM volumes increased slightly, outpacing global auto industry production rates, which declined slightly y-y according to PPG. Packaging coatings volume trended flat against a tough comparison.
• We rate PPG shares Buy with a price target of $124. Our target suggests total upside potential of 11%, including a dividend yield of 1.4%. PPG now trades at a 2018 P/E multiple of 17.2x, which represents a discount of 2.8x or 14% vs. the average of three US coatings peers (SHW, AXTA and RPM). Importantly, we estimate that this discount would 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 $124. Using our relative P/E framework wherein we apply a 10% premium to the S&P500 multiple, we calculate warranted value of $123 per PPG share. As a reminder, we had trimmed our 2017 and 2018 EPS estimates by $0.08 and $0.10 to $6.22E and $6.60E, respectively, back on 5 June to reflect estimated dilution from the divestiture of two additional non-core businesses: the remainder of its fiberglass operations in the US as well as a small plasterboard and cement-board business that came along with PPG’s prior acquisition of Comex (Mexico) in November 2014.
(Please see full report for details)
