PPG - PPG Industries: Near-Term Outlook Seems Positive

2023-04-26 15:44:58 ET

Summary

• Despite a drop in volume and the effects of FX, the company's profit margin is expected to increase once the current cost of raw materials is factored in.
• While price increases are expected to have a positive effect on PPG's margins in the coming quarters, there is a risk of losing volumes if prices go up too much.
• Margins are expected to remain under pressure as the company works through higher-cost inventory, but the effect should diminish over time.

Thesis

PPG Industries ( PPG ) produces a wide variety of coatings and glassware, as well as continuous-strand fiber glass, flat glass, fabricated glass, industrial and specialty chemicals, etc. PPG had a better-than-expected start to FY23 with the release of their 1Q23 results last week. However, I feel it's important to be up front about the fact that a portion of 2Q23's beat was brought forward to 1Q23. Most importantly, I believe that price, COGS, and freight inflation are beginning to have their intended effects. In fact, a hint of this was seen in 1Q23 results as well, and I anticipate a more pronounced effect in 2Q23. In my opinion, price increases will have an effect for a few more quarters, and when combined with stable volume and reduced COGS, this will lead to higher margins as profits trickle down. All in, I recommend buying the stock as I think the 1Q23 results were pretty strong and we should see the stock price continue to fade upwards through the next 2 to 3 quarters.

1Q23 results

Positive results were seen in 1QY23, with EPS coming in at $0.25. Despite a drop in volume and the effects of foreign exchange, revenues increased by 2% to $4.38 billion. Once the current cost of raw materials is factored into PPG's bottom line, I anticipate seeing a sizable increase in the company's profit margin. In 2022, paint raw materials accounted for approximately $7 billion (60+%) of the cost of goods sold, which totaled $11.1 billion. To illustrate the impact, a 10% drop in paint raw materials costs would be beneficial to earnings to the tune of about $700 million.

End markets demand trend

As the tightening credit situation puts more pressure on industrial firms and consumers alike, I anticipate a slowdown in North America. The construction and automotive industries are two end-markets that should feel the effects of this. While demand in Europe is still weak, it has shown signs of stabilization, and if this pattern maintains, the region could experience an upward trend going forward. While I do not yet see signs of an uptick in demand in Asia, I anticipate that we will see growth as a result of the region's growth against an easy comp from last year's and a sequential recovery in underlying demand. Given the non-linear nature of China's expected recovery, we may also experience growth surges. Therefore, I would be more wary of projecting Asia's growth rates onto those of other regions. However, the demand for aerospace products is expected to rise further as stocks are replenished and Asian tourists plan to resume their overseas travel. Demand for refinishing, on the other hand, is unlikely to be affected by consumers' tightening purse strings, especially in light of imminent restocking.

ASP & Margins

Although I expect price inflation to be profitable for PPG in the coming quarters, it is important to remember that price deflation is inevitable and will impact the P&L eventually. The bull case assumes demand holds up, and consequently, volume remains healthy long enough and eventually turns positive, offsetting the price deflation. Readers should also be aware of another risk associated with faster price deflation. Higher interest rates have made stockpiling less appealing, so it stands to reason that purchasers in the Chemicals industry will try to reduce their inventory holdings as a result. In my opinion, margins will remain under pressure as the company works through higher-cost inventory, though the effect will diminish over time. The combined effects of this and the price increases should be net-beneficial to profit margins. Enhancements to the product mix and increased productivity should maintain healthy margins well into FY23.

Risks

The weak macro appears to be a risk for volume - which has direct impact on margins in the short (as mentioned above) and med-term (decremental margins could cause blended margins to fall). To counteract the effects of price increases, PPG has also increased prices across the board for its products. In my opinion, there is a breaking point beyond which PPG runs the risk of losing more volumes than not if prices remain unchanged, which could have a devastating impact on margins. The next potential issue is PPG's capacity to integrate and execute on newly acquired targets. First, I'll admit that PPG has an impressive record of M&A, but the fact that it needs acquisitions to fuel its growth always makes for a slightly more precarious acquisition. Last but not least, the potential danger posed by autonomous driving is still some way off. PPG's auto refinish paint business is substantial, with the majority of revenue coming from insurance claims following vehicle accidents. PPG's sales in this sector may be harmed if, in the long run, collision rates are significantly reduced thanks to autonomous driving and driver assisted safety products.

Conclusion

In conclusion, PPG Industries had a strong start to FY23, with better-than-expected 1Q23 results. While a portion of the beat was brought forward from 2Q23, I anticipate a more pronounced effect of price, COGS, and freight inflation in the coming quarters, leading to higher margins and profits. However, there are also risks associated with the weak macro environment, and potential breaking points in pricing. Overall, I recommend buying the stock as I believe the positives outweigh the risks, and we should see the stock price continue to rise over the next 2 to 3 quarters.

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