PPG – Historical Anchors Away

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 11th, 2016

PPG – Historical Anchors Away

  • PPG is currently trading at 19.5x LTM EPS (using Q1 consensus), higher than its 17-year average of 16.6x but investors should not be anchored in history!
    • This is a very different company than the one behind the historical analysis
  • Earnings growth moving forward could be similar to or better than the 10% per year seen over this time period, but the volatility profile is completely different than in the past given the portfolio transformation away from commodity businesses
    • Over this longer timeframe, EPS has grown 10% with a standard deviation of 26%
    • Over the past three years (since chlor-alkali divestiture) EPS growth has been 13% +/- 7%
    • Going forward consensus reflects something more like 10% growth +/-1%
  • Returns on capital have increased to prior peak levels but returns on tangible capital (ROTC), unencumbered by acquisition-related goodwill and intangibles, have broken out
    • While PPG looks fairly valued versus a comp group on current returns, as the company continues to grow in a less capital intensive manner returns should continue to migrate upwards and multiples can be expected to climb
    • Mid-sized bolt-on acquisitions ($500 million to $1 billion of revenues) will drive this growth, and the SHW-VAL deal clears the way for PPG by removing two key potential bidders
    • Auto has been a strength and content per vehicle should continue to increase given trends toward light-weighting (structural adhesives replacing metal)
    • Europe is an intriguing source of opportunity – volumes are still significantly below 2008 levels and operating leverage to incremental gains is significant
  • There is room for PPG to close valuation gaps with more highly valued companies like SHW and ECL as returns climb
    • Improvement in ROTC to 33% from the current 26% implies 35% upside to the share price all else equal – we think this is achievable within three years
    • PPG already looks good comparatively on other metrics like EPS growth and its earnings already have high free cash flow content
  • Risks from elements outside PPG’s control probably still result in the stock outperforming peers and the Chemical group
    • Self-inflicted wounds could only come from deviation from a business model which not only works well, but also appears to have several years to play out

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

PPG has been a strong performer in 2016 year to date, ahead of both the market and the chemical sector. This has pushed the stock’s trailing P/E multiple to a level that has historically represented a ceiling – Exhibit 2 – but the historical results do not reflect PPG’s recent portfolio shifts away from commodity businesses, which have removed significant volatility from its earnings streams.

Exhibit 2

Source: Capital IQ, SSR Analysis

Return on capital has ostensibly been flat for the past four years but the true improvement is obscured by the inclusion of acquisition goodwill and intangibles in the capital base – using tangible capital employed, there has been a clear break-away – Exhibit 3. As important as the break-away itself is the fact that for the last three years this is not driven by the cyclical recovery of a commodity business. This is a key distinction given the company’s strategy of adding mid-sized businesses in the revenue range of $500 million to $1 billion. Synergies from deals of this size help to counteract the impact of a higher capital base and maintain returns on capital – but tangible return on capital should continue to trend higher. The risk of overpaying for deals is much lower with SHW and VAL now otherwise occupied for the immediate future, removing two prospective bidders from the equation.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4 plots return on tangible capital versus an enterprise value/tangible capital employed multiple for stocks in the chemical space. SHW and ECL are outliers – we include them on the chart but exclude them from the line of best fit calculation and analysis. PPG looks fairly valued on this basis but the real opportunity lies in the potential for the company to move higher along the line of best fit (Exhibit 1). PPG may never catch up with SHW’s returns on tangible capital given the latter’s (off balance sheet leased) storefront-heavy approach, but with a less capital intensive portfolio than in the past, PPG’s returns should continue to climb as it pursues bolt-on acquisitions, and the multiple should expand accordingly. Exhibit 5 summarizes the potential upside to various levels of return on tangible capital using the average annual improvement in ROTC over the past five years (2.2%)

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Growth – Expectations & Volatility

Forward expectations for earnings growth are not showing any improvement (or deterioration) in historical patterns for PPG – around 10% per year, as shown in Exhibit 6. What has changed is the volatility of that earnings growth – Exhibit 7. In the three years since the company sold its chlor-alkali business to AXLL, earnings volatility has been notably subdued. Note it is likely that consensus underestimates earnings growth substantially if there is a recovery in Europe from the stagnation of the last several years. PPG derives around 25% of its revenue from Europe and has very high incremental margins here as it does in the US.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Cash Flow Characteristics

Importantly, PPG shows a high cash content to its earnings – Exhibit 8. For every $1 of earnings the company generates $0.98 of free cash, a ratio which is among the best in the non-commodity chemical space. Earnings with a high cash content should arguably be valued higher than an equivalent amount of earnings with a lower cash content.

While the company has a very clear M&A strategy in the coatings sector, and plenty of properties to look at, the high level of free cash flow should allow the company to raise its dividend more substantially and given the current very low yield such a move might be well received by investors.

Exhibit 8

Source: Capital IQ, SSR Analysis

Sources of Upside: M&A, Autos, Europe

M&A

Before we talk about acquisitions, the company still has one very well publicized potential divestment – fiberglass. This may be a dilutive move for the company, but we would encourage haste rather than finesse in this case as we do not like the potential of more capacity and more exports from China. This may be one of those cases where the value of the business is declining every day in absolute terms and waiting to try and create something elegant and tax efficient may be the wrong move.

PPG has indicated several areas of interest for further M&A (adhesives for instance) but we would not expect the company to make a major acquisition as a response to the SHW-VAL combination, and any future deals will likely be of medium size. The path for future acquisitions is seemingly clearer for PPG in the wake of the SHW-VAL deal, as both companies should be focused on their merger in the near-term and are unlikely to be bidders. In total these two companies have made 17 acquisitions since 2010, mostly of smaller size – Exhibit 9.

Exhibit 9

Source: Capital IQ, SSR Analysis

Auto

PPG has steadily gained market share in the auto space in recent years, growing faster than the industry as its technological edge has increased content per vehicle. There is some concern that the US auto surge is in its later stages, but China is still a massive auto opportunity on a vehicle per capita basis despite concerns of slowing growth.

Europe

PPG has a significant degree of operating leverage to a rebound in European coatings volumes. The region has yet to recover from the fallout of the global recession in 2008-2009 and volumes are 17% below ’08 levels. PPG’s growth in the face of this multi-year headwind is impressive given its proportionally higher European exposure versus competitors. By comparison, legacy SHW has mostly US exposure (still more than 80%) and the bulk of its foreign exposure is in Latin America.

Exhibit 10

Source: Company Presentations

Comparison to Broader Industrial Space

PPG also compares favorably to an extended group of Industrial stocks with similar return volatility and market cap.

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

Risks

PPG would likely outperform the chemical sector in the case of an exogenous macro shock – stock has outperformed year to date in a shaky environment and the company’s business model is sound and appears to have several years of momentum remaining. The real risk would come from an off-piste acquisition or divergence from the current strategy – an improbable scenario in our view.

From a high level quantitative perspective, an extreme case of two standard deviations in PPG’s historical earnings volatility – so earnings down 15% – would result from a revenue decline of ~7% assuming decremental margins of 30%. This requires some combination of declines in pricing (perhaps in the range of -2%/-3%) and volumes (slightly more sensitive, perhaps a range of -4%/-5%). To get here we would likely need to see Europe fall back into recession, 1-2% growth in the US turn to the current stagnation in Europe, and some incremental weakness in emerging markets – OR – massive dollar appreciation – in this case PPG would likely underperform SHW, but would still fare well versus the broader group.

©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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