By Jeffrey Stafford
We have believed that a continued shift toward specialty coatings and optical products would improve PPG Industries' (NYSE:PPG) profitability and lower its capital intensity, giving the firm a better chance to consistently produce returns on invested capital that outpace its weighted average cost of capital. Recently, PPG took a big step in this direction with the proposed spin-off of its commodity chemical business to Georgia Gulf. After the transaction is complete, we estimate more than two-thirds of PPG's sales will be generated by specialty coatings, optical, and material products -- businesses characterized by close customer relationships. This has resulted in our awarding PPG a narrow economic moat rating.
Good Time to Say Goodbye to Chlor-Alkali
In a structure used for tax efficiency, PPG's commodity chemical business will be spun off to PPG shareholders and then immediately merged with Georgia Gulf. The deal, which is expected to close in late 2012 or early 2013, will remove capital-intensive chlor-alkali production from PPG's books, and we think PPG and its shareholders are receiving a reasonable value for the business.
PPG's commodity chemical business is a major producer of chlor-alkali chemicals. In chlor-alkali production, the main feedstocks, salt brine and electricity, are combined to create chlorine and caustic soda -- two commodity chemicals used in a variety of end markets, including construction, industrial, and paper. The company's chlor-alkali business has performed well over the past year or so, as lower North American natural gas prices have brought down the cost of a key input, electricity generated from natural gas. However, in the long run, we expect PPG's commodity chemical profitability to decline from recent operating margins of around 20%, as natural gas costs rise. As such, we view this as a good time to consummate a deal for the business.
We think PPG and its shareholders are getting a reasonable price for the commodity chemical business. The transaction is valued at about $2.1 billion, including $900 million of cash to be paid to PPG, $95 million of assumed debt, $87 million of minority interest, and 32.5 million Georgia Gulf shares sent to PPG shareholders. Using the $2.1 billion consideration and PPG's 2011 commodity chemical earnings before interest, taxes, depreciation, and amortization of $410 million, the deal values the business at just over 5 times EBITDA. If we use our 2016 estimate for commodity chemical EBITDA, the multiple climbs to more than 6 times.
Specialty Coating and Optical Businesses Are Moatworthy
Once the deal with Georgia Gulf is complete, we estimate more than two- thirds of PPG's sales will come from businesses with sustainable competitive advantages. Looking at 2011 sales on a pro forma basis, coatings would make up 83% of PPG's sales. We estimate that about 70% of coating sales come from specialty coating products, as opposed to architectural coatings (house paint). As such, we estimate (on a pro forma basis) that about 58% of sales will be generated by specialty coatings. Such products are characterized by close working relationships with customers. Customers work with PPG to develop specific products, making specialty clients stickier than a buyer of house paint. These relationships allow PPG to compete more on quality and innovation and less on price. As such, we think the company benefits from switching costs. Importantly, this pricing power allows PPG to pass through a larger portion of raw material cost increases.
In addition to greater pricing flexibility, specialty coatings are higher margin and have much better near- and medium-term growth prospects than architectural coatings. With the housing market still suffering, growth in architectural coatings has been hard to come by. Eventually, we think housing in developed markets will recover and PPG and other paint makers will benefit from pent-up demand in home improvements and new housing starts. In the meantime, we think sales in a handful of PPG's specialty segments will drive growth.
We also like PPG's optical and specialty materials segment. While the division only makes up about 8% of sales, it has posted stellar growth during the past decade. Transitions lenses, the firm's main product in the segment, have grabbed 20% of the North American lens market. We expect solid growth to continue as PPG focuses on increasing penetration outside the United States. This segment has posted impressive margins even through the recent downturn, as purchases of eyeglasses are less affected by market cycles. Despite competing products in the photochromic lens market, operating margins from the optical and specialty materials segment still track well above 20% on a consistent basis.
ROICs Should Consistently Outpace WACC in the Long Term
We think PPG's returns on invested capital will easily outpace its weighted average cost of capital over the long run, fueled by a more attractive business mix. PPG has a good record of producing ROICs above WACC, even with the commodity chemical and glass business as part of the portfolio. With the announcement of the Georgia Gulf transaction, we have even more confidence that PPG will create positive shareholder value over the long run. We expect ROICs to outpace WACC by a hefty margin during our five-year forecast period. In our base-case scenario, we think ROICs will average 19% over the next five years, compared with 12% over the past three years. Even in our bear-case scenario, which assumes tough operating conditions for the company and shrinking margins, we think ROICs will comfortably outpace WACC.
While sales growth in specialty coatings is currently outpacing architectural coatings growth (and improving mix from a moat standpoint), we think the major shift in business mix is already set to occur with PPG shedding its commodity chemical arm. Further, the construction market should eventually rebound, leading to faster growth in house paint, as pent-up demand from home improvements and new housing starts works its way through the system. While we think PPG will benefit from industry consolidation and strong growth in emerging markets, we don't see its competitive position changing all that much in the years to come.
Our fair value estimate of $100 per share accounts for the chlor-alkali spin-off and also includes our revised valuation methodology. Our fair value estimate implies a fiscal-year price/earnings ratio of 13 times and current enterprise value/EBITDA of about 8 times. Excluding the commodity chemical business, our five-year compound annual growth rate for sales is about 3.5%. We also expect price gains in 2012, as the company attempts to offset rising raw material costs by hiking sale prices. We think PPG will be fairly successful in executing this strategy, as a good portion of its customers are sticky. We think that after rebounding nicely in 2010, the operating margin will hold relatively steady in the neighborhood of 10%-12% during the next five years. While PPG's shift toward a smaller fixed asset base will lead to smoother profits, the decline in operating leverage will also give less of a boost to the bottom line as volume bounces back. Our estimated cost of capital for the company is about 10.5%.
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