PPG – Attractive Value; Unattractive Recent Story – New Catalyst

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

October 17th 2018

PPG – Attractive Value; Unattractive Recent Story – New Catalyst

  • PPG was becoming a more attractive relative value story before the stock movements of the last week or so, and while nowhere near a relative or absolute extreme, for a historically high-quality company, valuation is becoming a stand-out.
    • This is in part a function of very little capital growth, allowing return on capital to remain on trend while earnings disappoint versus consensus expectations.
    • It is also because of a sharp decline in relative PE – stepping down in October despite the fall in the broader market – Exhibit 1.
  • We generally view relative PE as a measure of relative confidence – even as the market multiples move up and down, those Industrials and Materials companies with good stories and investor confidence tend to have less pronounced volatility than shown below.
    • The new PPG (post the chlor-alkali and glass exits) was not supposed to have the current level of volatility, with past lows highly influenced by the fortunes of chlor-alkali as well as broader market strength (especially in 2000).
    • The current low is a real red flag that things are not as they should be.
  • We believe that PPG needs a strategy and most likely a management refresh (a view likely shared by Trian), but we do not see a simple or short-term fix. A change in leadership and strategy would likely be welcomed by shareholders and could generate long-term value.
    • Near-term options (excluding a sale) are likely either dilutive and possibly top of the cycle (buy Akzo) or too small to move the needle much (costs cutting and smaller deals).
    • We see the opportunity and would be buyers of PPG on any further 2H 2018 weakness but are cautious on the cycle and on what might be a protracted “debate” with Trian.

Exhibit 1

Source: Capital IQ and SSR Analysis

The Valuation Stagnation Argument.

Note that on a related topic, Dan Oppenheim picked up coverage of the Housing/Home/Consumer related sectors for SSR this week. Dan is someone I spent many days trying to recruit at a different company 11 years ago and I respect his thoughtful approach. His work is linked here, and we will follow up with a related piece shortly on what some of his conclusions mean for our companies that supply the housing market, including PPG. Please contact your SSR sales person, or Dan directly (doppenheim@ssrllc.com) for more information.

While the scale on the chart in Exhibit 2 makes it a little difficult to read, PPG had a stunning share price recovery from the financial crisis, helped by the stronger economic backdrop, but also by some smart acquisitions in coatings and the divestment of its commodity chemicals and glass businesses. Despite that, even at the time, its performance was overwhelmed by SHW. However, since 2015, PPG’s trajectory has essentially flatlined, while SHW and the market have kept going. Since September of 2015, PPG has underperformed the S&P500 by around 35% and SHW by more than 60%.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

The underperformance has taken PPG from a relatively expensive stock to a relatively cheap one – Exhibit 3 (on the prior page) – although not yet to some of the cheap extremes we have seen in the past. However, this largely history-based analysis in Exhibit 3 includes the PPG that also owned a commodity chlor-alkali business and a commodity glass business. Today’s PPG should not see either the volatility or the stock discount that we see today – yet here we are – therefore investor frustration is rising, and this is likely why Trian now holds a large position.

In Exhibits 4 and 5 we show how PPG stacks up against the rest of the chemical group on both a relative and absolute basis. Note that a number of the relatively attractive names are there because of recent acquisitions – driving a step up in capital, which in turn drives up “normal value”. This includes DWDP, FUL, SHW and OLN. The only company that has already returned to trend return on capital in this group is DWDP – another cheap stock but a very different story.

Despite the recent weakness in the sector, nothing looks that exciting on an absolute basis, although the sector in aggregate is beginning to get interesting – see recent work. Most stocks look interesting on a relative basis because the S&P500 is still at a high multiple.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

The problem is a lack of growth in the capital base since 2015 – Exhibit 6, with capital per share – Exhibit 7, only growing because of share buyback. One of the reasons why SHW has done so well is that the company has not only increased its capital base – Exhibit 8 – but has already started to show improving returns on capital on that higher capital base (Exhibit 9), while PPG’s returns are stagnant and took a step down with the recent earnings adjustment. With PPG, FUL, RPMs and other earnings misses, we would not be surprised to see an adjustment from SHW and the stock has declined meaningfully already in October in anticipation.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

While PPG may have been one of the catalysts of underperformance this month – its decline is not out of line with others in the same sector or with similar channels to market – Exhibit 10. There are bargains in the space – unless you believe that 2019 estimates are due a significant haircut.

Exhibit 10

Source: Capital IQ and SSR Analysis

So, What Could The Trian Wish List Look like

PPG stock has risen by less than 5% since Michael McGarry took over as CEO in September of 2015 (we are pricing from mid-Month). During the same period the S&P 500 is up almost 40% and SHW is up more than 60%. Consequently, it is understandable why there might be a level of frustration, especially when you consider the following in addition:

  • The failed bid for Akzo – while both sides blamed the other for handling the negotiations poorly – discussions with both sides and other interested parties leave us with the view that PPG could have done a much better job of “knowing their counterpart” prior to the outreach.
  • Very little other M&A, while others in the sector have done plenty – PPG keeps looking but others keep buying.
    • JW Ostendorf in Germany would have been a good fit for PPG at almost any price, but sold to Hempel. PPG might have an opportunity to buy Hempel – but if so it would be paying a double premium for Ostendorf.
  • The accounting issues – even though the issue appears to have been put to bed it is unusual in such cases for no senior executives to face some sort of consequence.
  • Quite a lot of senior staff turnover – often not a good sign.
  • A major earnings miss – clearly after Trian built a stake – some of the reasons for which suggest poor internal communication: PPG has had a terrible “optimism” track record for the last three years consistently missing early quarter numbers – Exhibit 11

Exhibit 11

Source: Capital IQ, PPG Press Release and SSR Analysis

In the exhibits below (12 and 13), we show stock timelines for DuPont and PPG – DuPont from 2014 through the Dow deal and for PPG 2014 to-date. It is worth noting that Trian did not really make a great return with DuPont even if the company sold close to the top.

Like DuPont, prior to the Trian investment, PPG has had a period of bad performance. Whether or not either company has/had poor leadership is partly reflected in the numbers, optimism (which has been appalling for PPG recently – Exhibit 13), etc., but given that there are many external and internal factors that are hard to quantify, management quality is always partly subjective.

Where we struggle with Trian’s task is in predicting what an end-game might look like. Trian is not in this to break-even, and unlike DuPont, PPG has been well run for decades and has more limited “fat” in the organization than DuPont, or Dow for that matter, when activists got involved. We are not going to see an agreement between Trian and PPG that leads to $1bn of cost reduction, because there is not $1bn available – probably not even $100m. We have been quite public about a need for change at the top at PPG, and while Trian might be the catalyst that brings that change – then what?

  • Demand may be peaking – especially in Autos and housing – see piece linked above.
  • Raw materials may have some downside, but Trian is not buying in because the company thinks it understands the TiO2 cycle better than most.
  • New leadership may bring a fresh perspective to M&A – which would be good – but:
    • Buying Akzo at a premium to current values may generate some longer-term value but is not likely to help much short term given the premium – especially if we are at the top of an economic or housing cycle.
    • Smaller deals – something PPG has been missing for the last few years but will likely not move the needle enough.
      • If we are in a housing downcycle – patience, and a strong balance sheet could allow PPG to pick off some businesses at a cyclical low – is Trian willing to be patient, especially if PPG does not at the same time change whatever approach to deal making has been the recent impediment?
    • Berkshire would want a high price for Benjamin Moore – and does not sell anything.
    • Maybe the end-game is to sell to Berkshire.
    • We have used this one once before and it worked – maybe (new) Dow is a buyer! It would have made more sense if Dow had kept the Automotive business – makes less sense today – perhaps there is a PPG and DuPont Automotive hook-up.
    • Maybe it is a break-up opportunity – architectural to Akzo or Berkshire – Industrials to AXTA – Auto’s to SHW or DuPont Auto?
    • All of these sale/divestment options seem complex and unlikely.
  • Or a recap and a larger buyback – which does not seem that exciting.

Current PPG shareholders would likely benefit from a change at the top – see prior research – if that change brought more M&A success – but we do not see a silver bullet creating 50% upside in two years – looking at the DuPont chart, the period before the departure of the CEO was one of considerable stock decline.

We backed Trian aggressively in its attempts to fix DuPont and depending on when you bought into our argument you either made some money or a lot of money. We are going to back Trian again, but while we saw the cost opportunity and the Dow opportunity with DuPont, we struggle a bit here. As we have written about extensively, we believe that Q3 earnings season is going to be challenging for Materials, we would be buyers of PPG on further weakness.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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