Weekly Findings – October 14th, 2018 – Macro and PPG

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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 14th , 2018

Weekly Findings – October 14th, 2018

Thought for the week: “A weaker economic outlook – no peace for the Materials sector”

  • Chart of the Week – An Economic Point Of Inflection
  • Materials Discount – Almost There – Thanksgiving or Presidents Day Sale
  • PPG – Like DuPont – But Different!
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – An Economic Point Of Inflection

The IMF Economic revision this week marks the first downgrade in its projections since July of 2016. The point of inflection in the forecast for 2015 caused a major period of underperformance for our value metrics as shown in the chart below – the underperformance started in mid-2014 as the economic projections started to decline and continued right through 2015. The slower economy caused negative revisions and negative surprises and the stock movements were exaggerated relative to earnings in most cases. In the second chart we show relative value for the Chemicals group and highlight the magnitude and the speed of the underperformance during that period. Note that while the stocks appear much cheaper on a relative basis today than they did in 2014, the market was trading below 19x earnings in mid-2014 versus more than 23x today. As discussed last week, and revisited in the next sections, while Materials look cheaper relative to Industrials – neither sector looks cheap on an absolute basis – especially if you believe that forward EBITDA estimates could be 10-20% too high.

The performance correlation is most pronounced with Metals in the 2014/2015 slowdown – first chart below – our metals stock index fell by more than 40% from early 2014 to the end of 2015. The real underperformance in Paper and Packaging and Chemicals was focused in 2015 – 2nd and 3rd charts, with initial stock reactions positive, most likely because of lower oil prices and the positive revisions that accompanied the lower oil costs. Ultimately, weaker demand was the more significant driver.

In the economic slowdown of 2015, the market was not expensive enough for a broad market collapse and the underperformance of the Materials and Industrials names – especially those with a more cyclical/value character was both absolute and relative. Today we have a much more expensive broader market, which begs the question as to whether value might outperform on a relative basis – as it did after the tech bubble collapse. So far it is not the case – this week our basket of I&M stock was down an average of 7.3% while the S&P 500 was down 4.1%. Over the last 30 days our group is down twice the decline in the S&P500.

This week we have begun to see a number of upgrades and recommendation reaffirmations, even if target prices have been lowered. Our experience tells us not to fight this macro move – more earnings revisions are coming – confidence is waning, and you are better to wait until all of the Q3 news is in the market before you try and identify real bargains – you might miss the very bottom in some names, but not by much.

  • Materials Discount – Almost There – Thanksgiving or Presidents Day Sale?

Last week we led with an analysis of whether Materials were cheap enough to trade against Industrials, concluding that we were probably not there yet. We subsequently found an error in our analysis and republish the charts here to give the correct data – the conclusions are unchanged but the shape of the charts are slightly different. Over the last week Industrials have underperformed Materials but only by a small margin – enough to show a downturn in the “gap” indicated in the chart below. Statistically, the peak we showed last week is slightly weaker today – second chart – but despite how compelling it looks and how compelling Materials are starting to look in absolute terms we would still be cautious, and believe that we are not at a bottom, either absolute or relative to Industrials – yet.

Materials and Industrials face a couple of related headwinds – which despite the valuation gap will likely impact Materials more than Industrials in our view.

    • Concerns about economic growth – see above.
    • Specific concerns about slowing demand in China – a substantial portion of global demand and the primary source of growth over the last few years.
    • Indications that inventories are high in some end markets and through the supply chain.
    • The potential for energy to weaken as focus shifts from supply concerns to demand concerns, although this could reverse if the current spat with Saudi Arabia escalates.

Just as raw material pressures are impacting earnings today, one might hope that a decline in oil would be a good thing – and it can help margins if pricing is pushed higher and then costs fall. Sadly, while this may help select sub-sectors, such as specialty chemicals, the more likely dominant impact of declining energy would be a further draw down of inventory. This reduces demand for primary production, causes supply/demand imbalances, and commodity prices can tumble. Note that the IMF economic downgrade in mid-2014 coincided with peak oil prices, which fell through the end of 2015 before finding a low – co-incidentally with the economic growth low.

During this period, absolute multiples were flat for Industrials and grew only slightly for Materials – Materials outperformed Industrials eventually, but within each group the more commoditized sub-sectors meaningfully underperformed the higher value more stable sub-sectors – hence the value underperformance shown in the section above.

Today – even with the correction this week – both sectors remain well normal in absolute terms first chart above (although Materials is beginning to look interesting in absolute terms) while cheap on relative terms. There is absolute downside in both and while the following triggers will likely apply to both, we expect that Materials will still be hit the worst:

    • More negative earnings surprises – especially if they confirm demand weakness in China.
    • Negative guidance for Q4 2018 and conservative projections for 2019 – which seem prudent.
    • Any significant movement in oil – Up and we worry about further economic pressure and raw material cost inflation – Down and we worry about destocking and its impact on commodity pricing.

We already have some very inexpensive stocks in the Materials sectors – less so if you believe that 2019 estimates are going to come down meaningfully – 15-20%. Our guess is that we will have even cheaper stocks by the end of earnings season – so just in time for Thanksgiving. There is a seasonality to Materials, although it is weaker than it used to be – Buy in December and Sell in April or May. If trade with China is resolved by Thanksgiving, then the entry point may well be at that time. If not, and the economic prognosis continues to deteriorate – it would probably be better to wait until there is a trade settlement, but it is also possible that 2019 could be a lost year for the sector much like 2015 was, not much further downside but no catalyst for improvement.

  • PPG – Like DuPont – But Different!

After the punishing this week, PPG stock has risen by less than 6% 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 67%. 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
  • Very little other M&A while others in the sector have done plenty
  • The accounting issues
  • 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: This and the stock performance are the only real comparables to DuPont in our view

In the exhibits below, 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, etc., but given that there are many external and internal factors that are hard to quantify, management quality is always partly subjective.

Here is the piece that is not subjective: Where we struggle with Trian’s approach with PPG is what an end game might look like. The company is not in this to break-even, and unlike DuPont, PPG has been well run for decades and has far 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 mightbe the catalyst that brings that change – then what?

  • Demand may be peaking – especially in Autos
  • 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 cycle.
    • Smaller deals – something PPG has been missing for the last few years will likely not move the needle enough
    • 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.
    • Maybe it is a break-up opportunity – architectural to Akzo or Berkshire – Industrials to AXTA – Auto’s to SHW?
    • All of these sale/divestment options seem unlikely
  • Or a recap and a larger buyback – 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 Train 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 above, we believe that Q3 earnings season is going to be challenging for Materials, we would be buyers of PPG on further weakness.

  • Weekly Winners and Losers

©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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