PPG - PPG Industries: Coatings Have Taken A Margin Cut

Summary

• PPG has seen a tough 2022 amidst real inflation, and thus margin pressure.
• Earnings have taken a beating so far this year, taking shares lower with it.
• Right now, the outlook is far from certain amidst slower economic outlook while peaking inflationary pressures might be offset down the road.
• Shares look more compelling with a long-term horizon in mind. I will be buying on bigger dips from here.

Shares of PPG Industries ( PPG ) have seen some tougher times. In the summer of 2021, I believed that investors were painting a fair picture for PPG after the company got more involved with M&A, supported by a resilient balance sheet. Nonetheless, a valuation at a small premium to the market was more than fair in my eyes.

Paint Giant

PPG has seen a tougher 2020 for obvious reasons, a year in which sales were down by 9% to $13.8 billion and GAAP earnings fell as much from $1.24 billion to $1.06 billion, with earnings per share down to $4.47 per share. Adjusted earnings fell in a less pronounced manner, being down 52 cents to $5.70 per share.

Net debt of $3.8 billion was very reasonable with EBITDA coming in at $2.1 billion in a down year, while operating performance revealed a return to annual growth in the fourth quarter of 2020.

Given this backdrop, the company started 2021 with some deal-making efforts, including a deal for VersaFlex which added $70 million in sales and the purchase of German-based Worwag which would add $265 million in sales. More important, the company hiked its offer for Finnish-based peer Tikkurila to $1.8 billion, eventually ending up acquiring the business after a short bidding war.

On the back of these deals and a genuine recovery, the company saw strong growth at the start of 2021. Following a solid start to the year, earnings power might come in at $8 per share as EBITDA might even rise to $3 billion in my book, important as deal-making resulted in a pro forma net debt load of around $6 billion. With shares trading at $168 at that point in time, a 21 times multiple and 2 times leverage ratio looked more than fair in my eyes as some execution on the deals was required as well. Moreover, I recognized that shares have historically seen longer periods of stagnation as PPG has not been a huge high flier, but generally a decent name with solid long term capital allocation practices.

Coming Down

With shares still trading at $170 towards the end of 2021, PPG was hit hard by the war in Russia and Ukraine in early 2022 as shares directly fell to $120. Due to concerns on growth, inflation and reduced demand, shares have been pretty much range bound between $110 and $140, currently trading at $125 per share.

Early in 2022 it turned out to be that 2021 has been a very strong year. Sales rose 21% to $16.8 billion yet adjusted earnings were up a mere 12% to $1.6 billion, with earnings up sixty-five cents to $6.77 per share. Net debt came in at $5.5 billion, a bit lower than seen in the summer of 2021 following some early deleveraging efforts. EBITDA was seen around $2.4 billion, a bit softer than I hoped as the reported earnings came in soft to my $8 per share estimates as well.

The company has seen a very tough first quarter , even as first quarter sales growth of 11% to $4.3 billion look quite strong. The reality is that pricing was responsible for reported revenue growth, as massive disruptions in supply chains and 25% inflation rate in input costs meant that adjusted earnings per share fell 27% to $1.37 per share.

Over the summer, the company announced a three cent hike in the quarterly dividend to $0.62 per share, for an annual payout of $2.48 per share. Second quarter sales rose 8% to $4.7 billion, again driven by pricing, as input inflation slowed down to 20%, which made that adjusted earnings per share fell just 7% to $1.81 per share.

In October, the company issued another profit warning. The company guided for earnings to fall quite a bit short compared to an initial third quarter earnings guidance between $1.75 and $2.00 per share amidst continued inflation, a strong dollar and economic headwinds. Later in the month it was apparent that third quarter sales rose just two percent to $4.5 billion with adjusted earnings per share down 2% to $1.66 per share, amidst negative volume developments.

With fourth quarter earnings only seen between $1.05 and $1.20 per share, we can easily call this somewhat of a lost year, as net debt is quite stable at $5.7 billion amidst lower earnings, higher dividends and worsening working capital trends, with earnings seen around $6 per share this year. With shares now down to $120 per share, the multiples have compressed to around 20–21 times earnings, yet at a much lower earning number. After all, the pro forma earnings number has fallen from $8 at the time of the dealmaking spree in 2021 to just $6, down a quarter which means that if $8 per share is attainable, appeal is apparent.

Concluding Thought

The truth is that PPG is somewhat of a soft performer on the operational front, being hit hard by the pandemic and supply chains.

The reality is that shares have come down quite a long way as they are back to pre-pandemic levels. In fact, PPG was already a $110 stock in 2015. This means that share price appreciation has been limited since that point in time, albeit the company has seen some sales growth, driven by inflationary pressures over the past two years. On the other hand, we have to observe that the company has reduced the outstanding share base by around 15% over this same period of time, in part because margins have taken a beating mostly this year.

The dividend yield of 2% is not too compelling, despite the modest dividend hike and decline in the share price, as capital appreciation should be the driver for the shares here. The issue is that cost inflation has outpaced pricing by a huge degree, creating an inflationary lag which hopefully reverses next year, potentially providing room for margin expansion, needed in likely a tougher economic environment.

Hence, appeal is likely gradually appearing here, not just a timing element but as a long-term play, believing this is a GDP play which should see higher margins on average (or at least at a good point in the cycle). That being said, real heavy lifting has to be done for that and shares are still not dirt cheap, now carrying some debt as well. All of this makes me a cautious investor, waiting on renewed dips to the $110-$120 range.

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