PPG – The Best of the Bunch (McGarry) For 2016

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 6, 2016

PPG – The Best of the Bunch (McGarry) For 2016

  • We like the coatings space as it ticks boxes that we think are going to be important in 2016:
    • A beneficiary of commodity oversupply – raw materials based on ethylene and propylene and of course TiO2
    • No real China threat – paint does not travel well!
    • Demand which is more driven by the consumer than by industrial production and manufacturing
    • Companies with strong cash flows and strong balance sheets and further opportunities for consolidation
  • PPG now has 93% of its portfolio in coatings (by sales), up from 40% in 1995. The company has divested other businesses over time and acquired aggressively in the coatings space:
    • The most important divestment was probably the chlor-alkali business, which removed much of the unpredictability and cyclicality from PPG’s earnings
    • Since this divestment PPG has experienced the strongest earnings growth in the group
  • While PPG has been a well-run company for many years we believe that current returns on capital can be improved, in part because of further work on acquisition consolidation
    • The business mix makes SHW’s returns too much of a stretch goal, but PPG should be able to add 100-150 basis points of improvement a year, with an aggressive focus, in our view.
    • This supports consensus earnings for 2016 without factoring in any revenue growth and consequently we see upside to estimates
  • Valuations are high in the sector, but likely warranted by the strength of recent earnings growth and the relative safety and the limited volatility of the business
    • PPG has more growth levers than the rest, in part because of acquisition driven synergies, and should command at least a 20x multiple of 2016 earnings because of the growth
    • This would suggest 20-30% upside from current levels – likely a standout in the broad chemical sector in 2016

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

We have made our preferred DOW/DD position clear in the Chemicals and Materials space for 2016, but we also believe that PPG could be a way to find outperformance. The stock is well off its highs, and it has underperformed the weaker overall market over the last few months, with a fair degree of volatility. The underperformance has come despite strong earnings and minimal negative revisions, making PPG quite a contrast to most of the sector and the rest of the materials group.

The portfolio is now predominantly coatings and while PPG has a greater Industrial exposure than SHW it still has a significant architectural base but has a margin structure and return on capital profile that lags SHW significantly. We think that this is part of the opportunity, but new leadership will have to chase costs and production efficiencies at least as hard as prior management to unlock some of this opportunity.

PPG, SHW and other coatings producers should get a raw materials tailwind in 2016 as not only should TiO2 remain weak, but lower oil prices mean lower latex input prices and we would expect the coatings producers to get at least as much benefit from this as the latex manufacturers.

PPG’s earnings growth, while not as spectacular as others over the longer term has been very strong since the chlor-alkali divestment (Exhibit 2) which has also taken much of the volatility out of earnings – something we do not believe is yet appropriately reflected in valuation (Exhibit 3).

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

PPG’s return on capital, while on a good upward trend lags SHW’s significantly and while there are likely plenty of structural reasons why PPG cannot get to a 30+% return on capital, it is probably not unreasonable to assume a stretch target of 18-20%. This would drive potential earnings, assuming a constant capital base, of around $9.00 per share and a “normal value” of roughly $180 per share, without assuming any multiple expansion because of the growth. SHW is currently trading at a 65% premium to “normal.” The valuation divergence between the two names is at an extreme seen in the past only very briefly around the time of the financial crisis – Exhibit 4.

Exhibit 4

Source: Capital IQ and SSR Analysis

How Much Better Can PPG Do?

It is important to recognize the portfolio transformation at PPG in order to think about what can change from here. When we first began coverage of PPG coatings was only 40% of the mix, with a very large glass component and a significant commodity chemical piece – the chlor-alkali business originally part of an integration play with glass, which was a major consumer of both products.

PPG today is almost a pure play coatings company, (Exhibit 5) with only a small glass business remaining focused on high quality flat glass – all banded – and fiberglass.

While PPG may covet the margins and returns on capital at Sherwin Williams, it is mostly a business mix issue, with SHW almost exclusively focused in architectural coatings through branded stores and PPG spread across all of the coatings segments, many of which do not offer the “asset lighter” model at SHW – Exhibit 6.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: PPG Presentations and SSR Analysis

Valuation Depends On Trajectory

Exhibit 7 shows PPG’s return on capital for the last 45 years. For the most part, the volatility in the time series was caused by commodity supply/demand and pricing swings in the chemicals business and the glass business, but despite that the trend was generally positive, suggesting a strong focus on asset productivity and cost control.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 shows the return on capital trend for SHW for comparison and Exhibit 9 summarizes the structural reasons that will prevent PPG from catching up.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

While a 35% return on capital may be too much of a stretch goal, PPG appears to have a clear path for an annual improvement of 100-150 basis points – improving the sales/asset ratio will be key. The Comex acquisition more than tripled PPG’s existing North American store base – a move in the direction of SHW. There are also indications that coatings volumes in Europe, while still off nearly 20% from the pre-crisis peak, are turning a corner – even a small increase would be significant given the degree of operating leverage.

Currently more or less fairly valued – Exhibit 10 – PPG lags the peer group today and has much more robust earnings growth and lower volatility than the history imbedded in the normal value analysis. We believe that the stock has 20-30% upside in 2016 – more obviously on a relative basis than an absolute basis given the macro headwinds that the market and the sector look likely to face this year. Growth from acquisition integration will be hard to find elsewhere – other than DOW/DD. Estimates have held in while the broader sector has seen significant negative cuts – Exhibit 11 – and we noted the stock looks particularly attractive relative to SHW – Exhibit 12.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Risks

There was clearly softness in the architectural markets in the US are around the world in Q3 2015, shown in the volume data that PPG provides each quarter – Exhibit 13. PPG has talked about customer inventory moves as a primary driver, while others have not given much color. Housing resale numbers weakened in Q4 2015 (Exhibit 14) but were strong in Q3 and both Home Depot and Lowes had reasonable third quarters, suggesting that PPG’s inventory explanation may have been accurate. The weaker resale numbers in Q4 do suggest some risk to Q4, particularly if any inventory correction extended into October. It is possible that the overhang on PPG today is a function of short term concerns of a Q4 miss, or a specific US volume issue again. While rising interest rates may impact mortgage borrowing costs, and this may in turn impact the resale market, the borrowing cost increase is incremental at this point, and no one is predicting a rapid rise in rates in 2016.

We believe that the margin expansion story is the thing to focus on at PPG and that any Q4 results based weakness should be seen as an opportunity.

Exhibit 13

Source: PPG Presentations and SSR Analysis

Exhibit 14

Source: National Association of Realtors 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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