PPG – What Do You Have To Believe

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 29th, 2013

PPG – What Do You Have To Believe

  • While the appreciation in PPG’s share price over the last 2 years is unprecedented, our view is that it is justified, by changes in the company’s portfolio and in the industries it serves. PPG is no longer a company with great growth businesses, hampered by commodity cycles in other businesses. It is now simply a collection of great growth businesses.
  • No company is without its challenges and distractions, but PPG’s are now small relative to the whole rather than large as they were in the past. Moreover, the industry structure is better in almost all of the end markets that matter.
  • In our view, to justify current values and further upside, PPG needs to achieve a 300 basis point improvement in return on capital within the next 36 months. Using SHW as a very approximate proxy, we think that this is achievable, and supports the current price at a market multiple and upside if the company can continue to command a premium multiple, as it does today.
  • While we would not expect PPG to achieve the level of returns that SHW sees today, we think that significant improvements can drive above consensus earnings for the next couple of years. However, without this sort of improvement, the stock looks more than fairly valued – as does everything else in the group. PPG has outperformed the group YTD – see Exhibit 1 – and we think that this outperformance can continue.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

PPG is an example of how to restructure a portfolio through acquisition and divestment in a way that gives you more control over your own destiny as well as enough (
but not too much
) diversification. These are subjects that
we have written about extensively
in the last 18 months.

PPG has had a remarkable 24 months. In early October 2011 the stock dipped below $69 per share for a day. Since that time it has been a steady climb to the northeast – Exhibit 2. The recent step change has been partly driven by the better than expected Q3 numbers and further positive revisions for 2014.

Exhibit 2

Source: Capital IQ and SSR Analysis

However, the stock appears to be way ahead of the fundamentals and a simple relative price to normal earnings chart shows where we are today – versus where we have been historically – Exhibit 3. In short, we are not at an all time peak and while that might be construed as positive, we must take note at how quickly the stock fell from the last peak. The rise to the current point is faster than anything we have seen before and consequently it is probably worth noting what may be the same as the mid 90s and what may be different:

Exhibit 3

Source: Capital IQ and SSR Analysis

  • Last time around it took the market 10 years to raise the PPG multiple from about 12x to 25x; this time it has taken 24 months. So something must be different.
  • Last time around PPG had three large businesses; Industrial Coatings, Commodity Chemicals and Glass. Consequently to get really excited about the story, you have to be excited about all three. In reality the peak multiple was driven by strong commodity chemical and glass margins, both of which were at cyclical peaks and subsequently collapsed.
  • This time around it is mostly a coatings story and we now tend to think about PPG differently, in terms of its end-markets; housing, automotive and aerospace – all three of which are in very good shape in the US, and improving in other regions. Demand may fluctuate, but you do not have the commodity pricing cycle that you had in flat glass and commodity chemicals to worry about.
  • Historically periods of above normal return on capital for PPG have coincided with cyclical strength in the cyclical businesses. Today we are above an historic rising trend in return on capital without the cyclical businesses. This has to be better!

We explore each of these topics in more detail below. Bottom line, PPG’s return on capital is improving quickly, and it is doing so without the cyclical levers of the past. This is important, because it needs to keep improving to justify current valuations, which today discount returns on capital 200 basis points higher than implied in estimates for 2014. The stock value today would suggest that consensus estimates for 2014, 2015 and 2016 are too low, but this is understandable as any traditional PPG sell side analyst is getting daily nose bleeds at these levels of valuation, and in our view, if the story works estimates are inevitably going to lag.

SHW has a “normal” return on capital in our model of 19% and a current return on capital of 22%, partly (but not fully) justifying SHW’s very lofty valuation. With its more focused portfolio and an aggressive focus on returns, we believe that PPG should have SHW’s “normal” returns as a stretch goal – on the same basis, PPG has a current return on capital of 12.2% in our model. Consequently we are talking about getting approximately 50% more earnings out of the same assets.

This is really a stretch goal – and a 15% target over the next 2 years is more reasonable, which would result in around $12.50 per share of earnings, assuming no horribly dilutive acquisition. This would fully justify the current price at a market multiple and would suggest 15-20% of further upside if the company can command a multiple premium commensurate with current growth.

This is Not Your Father’s PPG

This is a very different company to the one that most of us knew when we started in this business. Not only has the company changed, but the market its serves have also changed – all for the better. As analysts in the 1990s, most of us focused on understanding the cyclical pieces of PPG because these are what moved the stock – it was your upside opportunity and your downside risk. If you look at the volatility in PPG’s valuation there is cycle and a rising trend through 2006 – Exhibit 4. It looks as if the trend is now broken, particularly when you note that the current upswing is driven only by the very rapid recent appreciation of the stock. This chart is probably best looked at in conjunction with Exhibit 5, which shows earnings volatility over time, measured against a fixed measure of volatility. Earnings volatility peaked in the 1996-2003 period and has since declined. We expect it to decline further.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

However, We Need More Than Reduced Volatility

For reference, all of our normalized work is based on a return on capital reversion to trend methodology and we show the return on capital history in Exhibit 6. This is important as the chart shows that PPG has oscillated around a very consistent improving trend for more than 40 years. For PPG to be worth more than it is today, in fact even to justify today’s price we need to be convinced that the 40 year trend is no more and that PPG can move onto a much more accelerated trend. More limited volatility should help the multiple, but growth, based on higher returns, is needed to justify and maintain the step change that we are seeing today.

Exhibit 6

Source: Capital IQ and SSR Analysis

One possible proxy is SHW. The business models are not exactly the same as SHW is more focused on architectural coatings than PPG, is more focused in the Americas and has a store based business model. That said, both are in markets with more limited capital intensity and where there have been favorable shifts in market structure. SHW (partly because it has not had the distraction of large commodity business) has a much faster improvement trend to its return on capital – albeit from a worse starting point – Exhibit 7.

Exhibit 7

Source: Capital IQ and SSR Analysis

Like PPG, SHW appears to be on an accelerated trend over the last few years, with SHW held back by the housing upheaval in the US since 2008 and PPG held back by the economic slowdown and the slight dilution

of the chlor-alkali divestment. SHW has improved its return on capital by around 700 basis points from the low in 2011, in part because of the significant operating leverage inherent in the paint model.

Is it unreasonable to expect something similar from PPG?

In our view it is quite possible, as many of the same operating leverage opportunities exist for PPG as for SHW – but now without the risk of commodity cyclical volatility.

While our historic normalized framework would tell us to run for the hills here, we do think it is different this time and while we would not be aggressively adding to positions here, we would stick with the story a while longer.

Risks

No story is risk free and we outline below some event which would make us more cautious.

  • The coatings business is doing well, in part because demand is improving, in part because the US industry is better structured and in part because raw materials are inexpensive. The last condition could change if we were to see and aggressive upswing in pigment prices or latex prices. Neither seems particularly likely today and paint producers can probably pass on some increases, but a rise in costs would be a headwind.
  • Both Aerospace and Auto production is high and improving – there is a replacement cycle boost in both industries which is a major tailwind, helped by the high price of fuel and the introduction of new models with greater fuel efficiency, but these industries can cycle and have done in the past. For PPG in the past such cycles have been overwhelmed by some of the commodity cycles, but with the current portfolio they could certainly result in earnings drags.
  • As PPG becomes increasingly valued as a growth stock, it will be heavily penalized if the underlying growth is called into question. Consequently we should watch for changes in raw material costs, meaningful changes in home sales, car sales and aircraft orders.

©2013, 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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