PPG - PPG Industries Has More To Offer Than The Current Price Suggests

2023-10-20 17:17:20 ET

Summary

• PPG Industries beat expectations on price and margin, but missed expectations on volume in Q3. Gross margin improved due to lower input costs, but the EPS beat was largely non-core.
• Weak volumes are a concern, but volume comps are expected to get easier; aerospace remains strong, and architectural markets are likely to stabilize.
• Margin leverage may be underrated heading into 2024, as PPG's accounting creates a delay between commodity prices and margin improvement.
• Low single-digit revenue growth, mid-single-digit FCF growth, and low-to-mid-teens margin and ROIC can support a fair value between $148 and $160.

These are challenging times for specialty chemical companies focusing on coatings, as the market seems unimpressed with the combination of weak volumes, waning price leverage, and slow recognition of price/cost benefits. In the case of PPG Industries ( PPG ), the shares are up about 8% over the last year (underperforming industrials by about 6%) and down 17% since my last update on the company, underperforming industrials, the Vanguard Materials ETF ( VAW ), and other coating companies like Sherwin-Williams ( SHW ), Axalta ( AXTA ), and RPM ( RPM ) by 6% to 30%.

Weak volumes are indeed a concern, but I think the Street is too bearish at this point. Volume comps are going to get easier, and while short-cycle industrial markets are indeed likely to stay weak a while longer, aerospace remains healthy and the architectural markets seem likely to stabilize. On top of this, LIFO accounting should drive more margin leverage as commodity costs continue to come down.

I see a fair value range of around $148 to $160 today, and while there are definitely macro risks that could drive underperformance, I think it’s reflected in today’s share price to an excessive degree.

A Decent Q3, But Not As Good As It May Seem

A headline beat of 8% on EPS is nice to see, but that’s not really the true story of the quarter. PPG beat expectations on price and margin, but missed expectations on volume and the beat at segment profits was around $0.04/share (and a <1% beat at EBITDA). With most of the relative outperformance coming from taxes, it’s not as impressive of a performance as it may otherwise seem. Still, a beat is a beat and it beats the alternative.

Revenue rose 1% in organic terms, with volume down 2% and price up 3%. Volume declines appear to have stabilized and the comps will start getting easier from here. The Performance Coatings business reported 3% organic growth on flat volume (versus -3% in Q2’23), while Industrial Coatings declined 2% on a 4% volume decline (versus -1% in Q2’23).

Gross margin did improve almost four points (to 40.7%), as the company benefits from lower input costs on a delay due to LIFO accounting. EBITDA rose 19%, with margin up more than two points to 16.2%, and reported operating income rose 26%, with margin up 230bp to 12.8%.

At the segment level, overall profits rose 26% (margin up 240bp to 15%), with Performance up 25% (margin up 230bp to 15.7%) and Industrial up 28% (margin up three points to 13.9%).

A Lot Of Moving Parts To Consider Now

Management’s guidance for the fourth quarter was consistent with prior expectations, which considering the increased evidence of slowing global industrial markets and the potential impact of the UAW strikes, is a positive in my book. A quarter ago the Street seemed disappointed that the company wasn’t hiking guidance more aggressively, and now it seems that conservatism was prudent.

There are definitely some challenging cross-currents in the market right now.

Aerospace is the easiest – it’s growing, growing well, and almost certainly going to continue growing well in 2024. Air travel has continued to recover and aerospace OEMs have seen their suppliers work through the kinks that were limiting production expansion. Now the majors go into 2024 with a good outlook for expanding narrowbody and widebody production rates.

Auto is more mixed. Refinish demand looks okay now, and given that most of this is driven by collision repair work (not exactly discretionary), I don’t think weaker consumer spending in 2024 will be an issue; I’d consider weaker job numbers (fewer people commuting) to be a bigger concern. On the OEM side, though, there’s definitely some near-term risk if the UAW strikes drag on, as it will start impacting volumes in a more meaningful way.

Industrial demand is not likely to be all that strong in most of 2024. I don’t think the U.S. economy is going to go off the edge of a cliff, but industrial orders and activity have definitely slowed and are likely to stay soft at least through the first half of 2024 and possibly even until late in 2024 given higher credit costs and elevated political turbulence.

Architectural is a more interesting market. On one hand, the slowing U.S. residential market is an issue, and the benefits that PPG has gained from its new professional program at Home Depot ( HD ) and private label sales at Walmart ( WMT ) are going to wane. On the other hand, I expect housing to “bump along the bottom”, so I don’t expect demand to get much worse. I also found management’s comment about stabilization in Europe to be interesting and possibly a preface to better results there.

The most positive moving part is likely to be the COGS line. Raw material availability is significantly better now and costs declined at a high single-digit rate in the third quarter, while underlying component costs declined even more (propylene was down about 20% in Q3, titanium dioxide was down about 10%). Remember, LIFO accounting means a delay in recognizing these benefits. Although I do see some risk from higher oil prices (propylene and other petro-derivatives), I still see these as a positive driver.

The Outlook

I don’t expect material self-help from PPG in 2024, but I do still see opportunities to improve. The company consistently invests in R&D, driving recent new products like powder coatings (that have fluid-like finishes), wet-on-wet spray technologies, and new mixing products. I see ongoing opportunities to innovate, as well as to drive more cross-selling across what have historically been more “silo’ed” business units.

I’m looking for revenue to increase just 1% in 2024, which is about 2% below the sell-side average (though estimates may not be fully up to date yet as the company just reported). I expect ongoing pressure on housing and industrial markets in 2024, and aerospace (and maybe marine) can only do so much. I expect a rebound in 2025 and 2026, though (mid-single-digit growth), and long-term growth around 3%.

On the margin side, I’m expecting a point of operating and EBITDA margin improvement in ’24 and another half-point in ’25, largely on price/cost leverage. At the FCF line, I expect double-digit margin in FY’25, with ongoing low double-digit margins thereafter driving growth. This could ultimately prove too bullish; while PPG has done a lot to improve its operations, historically high single-digit FCF margins have been the norm and consistent double-digit margins have never happened.

Discounting those cash flows and using other margin/return-driven multiples-based approaches, I get a fair value range of $148 to $160.

The Bottom Line

I’m not thrilled about buying into declining volumes and waning price leverage, but the reality is that I think volumes will be bottoming out and improving exiting 2024. On top of that, I think the margin leverage is underrated, as is the company’s opportunity to leverage innovation. All in all, I think this is an out-of-favor name to consider.

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