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Roughly six months removed from my last update on PPG Industries (PPG), it’s clear that, bearish as I was on cost trends across the industry, even I underestimated how much worse the raw material cost pressures would get, to say nothing of the additional challenges created by labor difficulties (COVID and other factors), logistics difficulties, erratic customer order patterns, and so on.
I believe PPG management is doing a job of controlling (or at least managing) what is in their power to influence, but there are a lot of pressures on the business that they can’t do a lot about. On a brighter note, I do think the top-line progress and pricing power will prove more sustainable long term, leaving PPG in a good position whenever the cost headwinds ease.
These shares are down about 9% since my last update, and others in the coatings space (Akzo (OTCQX:AKZOY), Axalta (AXTA), and Sherwin-Williams (SHW)) have fared pretty similarly. While I do have some concerns that it could be too early for sentiment to turn, and there are still risks that initial FY’22 expectations are too high, the valuation is making this a more tempting idea for a later-stage recovery play.
Tough Numbers In Q4 Not Too Surprising On Balance
Between updates from Akzo, Axalta, and Sherwin-Williams ahead of PPG’s earnings report, the results here ended up not being much of a surprise even if there were deviations from analyst estimates (which weren’t updated in the interim). All told, it was a tough quarter, with several important markets still below pre-pandemic levels and pricing not enough to offset the cost pressures.
Revenue rose more than 11% as reported, or about 4% on an organic basis, good for a 4% beat versus Street numbers. Making up that 4% growth was a 4% decline in volume and an 8% increase in realized prices.
Hit by raw material costs (among other costs), gross margin declined more than seven points to 35.8%, missing expectations by 70bp. Segment profits declined 40%, missing by about 17%, and operating income declined 42%, missing by 17%, with operating margin nearly cut in half to 7.2%. With Axalta missing by 17% at the operating income line and Sherwin-Williams missing by 20%, PPG’s results were no worse than on par.
By segment, Performance Coatings grew 6% organically on a 2% volume decline, beating by 2%, while Industrial Coatings grew 1% on an 8% volume decline, beating by about 5%. Both segments saw profit declines, with Performance Coatings down 19%, missing by 11% and margin declining 410bp to 9.7%. Industrial Coatings saw even worse deleverage, with profits down 63%, missing by 28%, as margin dropped 1,150bp to 6.2%.
Ongoing Challenges, With The Light At The End Of The Tunnel Dependent On Production Challenges
Like many industrial companies (not just chemicals or specialty chemicals companies), PPG guided to weaker first quarter results and achieving FY’22 guidance is very much dependent on easing pressures on raw material cost, labor, and logistics challenges. While volume will likely be down year-over-year in Q1’22, pricing could be a 10-point tailwind to revenue. What’s more, in past cycles, pricing actions taken in the coatings sector have proven pretty durable even once cost pressures abate.
Turning to those costs, PPG saw raw material cost inflation of 30% (yoy) in the fourth quarter and expects something similar (25% to 30%) in the first quarter. That said, management talked of signs of costs “levelling off”, and while it may be premature to say that of titanium dioxide, it does seem to be true of resins. Still, with elevated oil prices, the risk of raw material pressures into 2023 aren’t entirely off the table.
Likewise with other pressures on the business. COVID-19 infection rates seem to be subsiding again, but it’s impossible to predict if another round will lead to further absenteeism, and labor shortages are still a challenge. Logistics, too, is getting better but isn’t back to normal.
There Are Still Positives To The Story
As much as costs and operational challenges have hurt results, there are some positives to discuss. As I said, I think at least some of these pricing actions will prove lasting, and that should help margins in 2023 and beyond.
PPG is also still leveraged to end-market recovery and growth. Management estimated that end-markets representing about 40% of sales (Auto OEM, Aero, and Refinish) are still below pre-pandemic levels, and Auto was rather weak in the quarter (down double-digits on well-known production issues in that industry). Aerospace should be ramping for a multiyear recovery cycle, and while auto production growth in 2022 is still hotly debated (IHS has modeled 9%, auto supplier Sensata (ST) is planning around 6%), it should recover as chip access improves. Refinish is already improving, as increased activity is leading to higher accident rates and improved body shop demand.
Beyond this are some product and marketing-driven opportunities as well. Management hosted a “deep dive” presentation on its Industrial Coatings business back in September, and there are some interesting drivers here. Various coatings, sealants, and other products to reduce the risk of EV battery fires could represent a $200/vehicle content opportunity (above the $100/vehicle or so opportunity for other paints/coatings), and cathode and anode binders could be another $100 on top of that, suggesting meaningful leverage to EVs.
Outside of EVs, the company highlighted progress with new powder coatings that provide performance and look similar to liquid coatings but without the concerning VOCs. Management also discussed new can coatings; in the move to offer non-BPA alternatives, PPG has developed a new non-epoxy formulation (in case other epoxies ultimately show other issues like BPA has), while Sherwin-Williams went with a different epoxy formulation.
On the marketing side, PPG and Home Depot (HD) are working a lot more closely now, with Home Depot looking to carry more PPG products targeted at professional contractors; an important “force multiplier” above and beyond the reach of PPG’s own stores.
The Outlook
With pricing more than offsetting volume issues, my revenue estimates for 2022 and 2023 are actually higher than before (about 2.5% and 3%, respectively), and I’m looking for the long-term growth rate of 4% to 5% to be closer to 5%, with possible upside if those EV initiatives really work out. I’ve meaningfully cut back my margin expectations for the next three years, but I do believe PPG will claw that back over time, and I still believe that low double-digit FCF margins are attainable on a sustained long-term basis.
Long-term revenue and FCF growth on either side of the mid-single-digits (revenue close to 5%, FCF growth above 6%) can support a solid high single-digit total annualized return from today’s price, and that’s not a bad prospective return. Looking at my margin/return-based EV/EBITDA approach, I’ve chosen to use 2023 numbers and discount back, as I don’t think 2022 numbers are representative of normal conditions. Doing that, PPG looks at least 15% undervalued.
The Bottom Line
I definitely see risks to the outlook over the next two years, but risks and rewards usually go together. PPG may well not have bottomed out yet and sentiment certainly hasn’t shifted, but I believe there will be a point where this is looked at as another later-recovery play. With the valuation getting better, this is becoming a more tempting idea.
