PPG – The Gloss Finish Is Fading

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 22, 2018

PPG – The Gloss Finish Is Fading

  • The Q1 earnings miss from PPG is somewhat surprisingly now in character for a company that has seen its fortunes change over the last couple of years.
    • After years of consistent under-promising and over-delivering (global financial meltdown aside) the last couple of years have seen missed expectations quite consistently.
  • We have correlated changes in the optimistic or conservative character of any company in the past with regime change, and while it may look that way here, there has also been a market shift that is likely the root cause.
    • The automotive paint market has become much more competitive since Axalta became independent and likely even more so since BASF acquired Chemetall.
    • Margins are declining in this business for both PPG and Axalta and we do not see a reason for this trend to abate – given more rapid model turnover by the automakers over the next three years (CAFÉ and European emission standard driven) – plus raw materials are higher.
  • If we extrapolate the margin trends that PPG is seeing today and assume that consensus EPS for 2018 is correct, PPG will need to grow revenues by more than 10% this year to meet EPS expectations – Exhibit 1.
    • Current consensus is for 5.6% revenue growth, and, adjusting for currency, Q1 was 2.4%.
    • If Q1 revenue growth is indicative for the year and the margin trends continue, PPG could miss estimates for 2018 by as much as 5-10%.
  • The accounting issues raised at the time of the Q1 release are likely immaterial, but with the scrutiny currently placed on GE and its board of directors, no audit committee can afford to do anything but a thorough job looking into the situation.
    • After tax, a $5 million adjustment to Q1 would be less than 2 cents per share.
  • The lack of growth (revenue and earnings), and frustration that it must bring, has PPG towards the top of our “likely to do a deal at any price” list. Akzo would be expensive.
    • While the stock is fairly valued based on our normalized metrics, negative revisions or a bad deal could drive another year of underperformance for PPG – we are more cautious.

Exhibit 1

Source: Company Reports and SSR Analysis

The Trends

While PPG’s return on capital is about where it should be (Exhibit 2), at a more granular level the business is not looking as good as it was. Volume growth in coatings was very poor in Q1 – Exhibit 3 – and margins have an ugly trend to them – Exhibit 4.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Company Reports and SSR Analysis

If we look at Axalta’s numbers we see a similar negative trend developing in the automotive coatings space and we believe it is a function of three things – a more level playing field on the focus and technology front, and both flat auto demand and high model turnover. Rising raw materials do not help either.

  • PPG had much of the 2000s to itself in terms of growth in the auto space largely because of technology offering and focus. The company consistently posted market share gains each year.
    • DuPont had the technology but not the focus – Axalta has the focus and the DuPont technology.
    • BASF has always been a serious player but adding the Chemetall portfolio improved BASF’s technology offering at the metal surface treatment stage.

There are now three strong competitors, with similar offerings chasing new business.

  • The business they are chasing has two negative components – slowing demand – generally the paint companies are paid per car – and more rapid model turnover as automakers adapt to tighter emission standards. A new model change is often a chance to compete for new business.
  • Add to this escalating raw material prices – see our recent Friday Findings and other work on the strength in the intermediate chemical industry – and margins are bound to decline.

The Overconfidence

There has been an interesting trend in PPG’s “optimism” over the last 7 years – Exhibit 5 – with over-confidence consistent in 2016 and 2017. Note that our optimism measure asserts that January 1st estimates for any company are a reflection of implicit or explicit company guidance and that companies would not intentionally guide to a number they were not confident of meeting. See our body of work on optimism – linked at the end of this report. The summary conclusion is that you do not want to own an optimist. Estimates have been off on a quarterly basis also – Exhibit 6 – but revisions for 2017/18 and 19 have been very negative – Exhibit 7.

In PPG’s defense, there has been a change in the automotive sector as suggested above, architectural paint growth in the US has been slow and raw material costs have escalated (cost of goods sold rose from 54.6% of revenue in 2016 to 55.6% in 2017). This might account for some of the earnings over-estimation.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

However, in defense of our optimism methodology, a “self-aware” conservative management would have anticipated the changes and given appropriate cautious guidance. As a word of caution, optimistic managements have a track record of poor capital deployment, which could show itself at PPG through a large over-priced acquisition. In the current environment of high priced deals, in part driven by cash availability and the behavior of private equity, we would rather see PPG step up its dividend and continue the share buy-back. With its Akzo bid it is clear that PPG is willing to take on significant leverage to do deals. While leverage has not changed much over the last couple of years – Exhibit 8 – PPG has been buying back stock and would today have zero net debt without the share buybacks in 2015/16 and 17.

Looking at others in the sector, PPG has plenty of borrowing dry powder for acquisitions – Exhibit 9 – and could easily raise $10+ billion for a cash bid.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

SSR Optimism Research:

©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. Sources: Capital IQ, Bloomberg, Government Publications.

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