Coatings (PPG) A Safer Bet than Industrial Gas

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 27th , 2016

Coatings (PPG) A Safer Bet than Industrial Gas

  • Both Coatings and Industrial Gas have traditionally been viewed as relative safety plays, but we see more support for the Coatings group, particularly PPG, in the current environment
    • Valuation metrics modestly more attractive
    • More consumer/less industrial related demand and more geographic upside
    • Less balance sheet leverage – net debt/EBITDA 1.2 for PPG versus 2.6 for PX and 1.9 for APD
    • Greater raw material benefits – lower oil/gas but also TiO2
    • More self-help levers – APD is in the later innings of exploiting its cost opportunities, PPG has plenty of Comex-related synergy opportunities ahead and more opportunity for further bolt on acquisitions
  • Revenues and earnings per share in the Coatings sector have been far stronger and less volatile over the past several years compared to Industrial Gas
    • SHW gets a lot of attention but indexed to Q1 ’13 PPG has grown EPS at a faster pace
  • PPG looks cheaper than either APD or PX on 2016 earnings estimates, but is more notably a standout on a free cash flow basis
    • Stocks are comparable on EV/EBITDA basis
  • Historical relative valuations do not suggest any potential pair trades
    • On normalized earnings, PPG modestly cheap versus APD, modestly expensive versus PX, but note that normal valuation models are based on historic models that show strong stable growth for the gas companies and volatility for PPG
  • While we are more positive on Coatings versus Industrial Gas, within Coatings we continue to prefer PPG to SHW on valuation and diversification

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

The Industrial Gas companies have outperformed the group YTD (PX much more so than APD) and have historically generally fared better in weak markets than the rest of the materials space. The driver has been lack of commodity exposure, broad industry exposure and some unique growth opportunities that resulted in generally positive earnings trajectories and limited volatility. But, while the volatility remains limited, driven mostly by currency effects rather than dramatic swings in pricing or volume, growth has gone away, as some of the unique drivers have matured and the industrial economy is a mess. The other positive driver for the gas companies was consolidation, something else which probably ends (on a large scale) with the Air Liquide/Airgas deal.

Enter the coatings industry – the new “old” industrial gas industry! Coatings is more focused on the consumer than the industrial or manufacturing segment and consequently has some more positive drivers in the current economy than the gas companies. This is reflected in the relative volume growth in Exhibit 1 but at the same time the segment offers some of the factors which made the gases industry appealing in the past:

  • Consolidation: Despite the deals done in the recent past, mainly by PPG, there is still fragmentation in coatings globally and more opportunity for M&A
  • Some unique growth drivers, such as the changing nature of the US resale market, such that sellers are needing to “clean up”, i.e. paint, in order to get a sale, often to buyers who paint again
  • Very limited price volatility

In addition the sector has raw material tailwinds in part from the continued weakness in the TiO2 market, but likely more important in 2016 from other key ingredients made from ethylene and propylene – where pricing is falling because of the declines in crude oil. While industrial gas companies do see lower costs from lower natural gas and electricity pricing, these savings are more often than not passed through to customers. Furthermore, the energy sector is a customer of the industrial gas companies and the current energy markets will be challenging for the gas companies from a volume perspective.

While none of the coatings or industrial gas companies have issues with cash flow, PPG has much less debt – Exhibit 2 – giving the company more strategic flexibility and allowing for greater cash return to shareholders.

Exhibit 2

Source: Capital IQ and SSR Analysis

Returns on capital in the coatings space are rising quickly, recently more for PPG than for SHW, though this is not reflected in relative valuation, and so far investors appear far more willing to bet on the growth at SHW than at PPG. PPG is not the simple architectural story that SHW investors can get their hands around quickly, but exposure to the auto sector should remain a good thing for PPG as long as the company can maintain its share of new model wins.

We would expect to see more relative growth from PPG than either PX or APD during 2016, unless there is a dramatic improvement in US and global industrial production growth and in addition we would expect further quarters of limited volatility at PPG to drive incremental improvements in relative multiple. At the same time, lack of growth at the gas companies could continue to erode relative multiples – as best seen in the PX chart – Exhibit 3 – something APD has started seeing in the last 12 months – Exhibit 4.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

By contrast – PPG is seeing the opposite trend and we expect this to continue. There has been some recent volatility around the departure of the outgoing CEO and what appears to be a Q3 inventory driven volume correction in architectural paint in the US, but we think this is just noise in what is otherwise a likely continued upward trend – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

We think that PPG is likely to grow earnings faster than the industrial gas companies – by as much as 10% – in any economic scenario except a quick global manufacturing recovery – centered in the US. With that and the possible relative move in multiple, we expect PPG to be a better bet than the gas companies in 2016.

Valuation & Return on Capital

PPG looks more reasonably valued on 2016 EPS estimates than either APD or PX and EV/EBITDA metrics are comparable. More notably, PPG looks interesting on a free cash flow basis versus the historically cash generative gas companies – Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

APD has been a well-publicized recent turnaround story, but PPG showed similarly rapid improvement in its return on capital coming out of the recession and the trend has continued upward since – Exhibit 7. We could argue that the path higher from here is easier for PPG, which has further consolidation opportunities ahead. APD is likely pushing the limit of its cost opportunities and the degree of consolidation in Industrial Gas is much higher.

Exhibit 7

Source: Capital IQ and SSR Analysis

On our normalized earnings models derived from these return on capital trends, PPG is about fairly valued, PX is marginally cheap and APD marginally expensive. The relative valuation histories do not indicate any extreme valuation pairs – Exhibit 8. PPG is much more fairly valued relative to PX versus five years ago but well off the relative lows of the mid-90s. The closing of the gap has been a function of positive momentum at PPG and negative momentum at PX. Note that these “normal” models are driven by history – a history in which the gas companies were the non-volatile growth stories and PPG had all the volatility (from its chlor-alkali and commodity glass businesses – now gone). Things are very different now.

Exhibit 8

Source: Capital IQ and SSR Analysis

End Market & Geographies

15 years ago, PPG was less geographically diversified than either of the gas companies. Now the reverse is true – Exhibit 9. Proportionally higher European exposure has been a drag for PPG but offers significant operating leverage upside – further QE from the ECB a potential catalyst. Coatings volumes in Europe are still 17% off the 2008 peak.

Exhibit 9

Source: Capital IQ and SSR Analysis

Growth

For the last two years the growth story has been with the coatings companies rather than with the industrial gas companies – Exhibit 10. We do not expect this to change in 2016. Our preference for PPG over SHW is driven primarily by valuation.

Exhibit 10

Source: Capital IQ and SSR Analysis

Performance

As implied in Exhibit 11, the last decade was spectacular for PX shareholders and good for PPG and APD shareholders. The last few years have seen the PX story grind to a halt, while APD has gained by following some of PX’s playbook in recent years. With the momentum in coatings from a volume growth, raw materials and consolidation perspective, we believe that PPG can pick up the pace from here.

Exhibit 11

Source: Capital IQ and SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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