PPG Industries (PPG) issued a rare profit warning for the third quarter. While sales and adjusted earnings are lower than anticipated, investors seem to be dissatisfied with another large pension related charge as well.
The company has undergone a big transformation over the past decade, as it became a pure play on paint. This transition process is nearing completion, as the company is dealing with large asbestos and pension-related liabilities of the past as well. I applaud these moves, as the businesses face some headwinds at the moment.
With shares trading at the lower end of a 3-year trading range, valuations have become more realistic. Shares trade at a compelling 6% earnings yield which looks attractive in this interest rate environment given the pure focus and solid state of the balance sheet.
Even if operational momentum is not that appealing at the moment, there are a few reasons to own the shares. A strong presence in emerging markets, strong balance sheet and continuation of bolt-on paint acquisitions, should be very appealing in this slow growth and low rate environment.
Becoming A Pure Play On Paint
PPG has undergone a massive transition over the past decade. While paint generated roughly half of its $10 billion in sales back in 2005, the remaining half of sales were generated by chemicals and glass.
This diversification resulted in the company being active in many fields. Diversification results in a lack of focus and made it hard for PPG to maintain and gain leading market positions in all these different segments. Therefore, management decided to become a pure player in paint. This ten-year transition has grown PPG into a $15 billion business in the year 2015, with paint now making up 93% of total revenues.
Since 2005, PPG has acquired many businesses, as almost all expansion took place in the paint business. This includes higher profile transactions of SigmaKalon in 2008, Akzo Nobel in 2013 and the purchase of Comex last year. At the same time, the non-core activities have gradually been divested.
These portfolio moves created better geographical diversification as well, with less than half of sales now generated in North America. Emerging markets now make up 25% of sales, as the company only had a small presence in these markets a decade ago. This is very important as these markets are the only growth area since the recession of 2008. Cumulative paint volumes are up by 25% in emerging market versus that point in time. The US and Canada have seen paint volumes only recover towards their 2008 levels, as European markets continue to lag in a big way.
While diversification is to be applauded, a lot of PPG´s end markets are cyclical. Nearly half of sales are derived from new and maintenance construction activities, as automotive markets represent roughly 30% of sales. The remainder of revenues is generated from general industrial applications as well as aerospace & marine markets.
The Market Has Appreciated The Strategic Focus
Investors typically like companies which decide to focus on their core competencies as it removes the potential for value destructive deals. Scale and market power usually brings higher margins, as these profits tend to be more stable as well.
Shares of PPG have tripled over the past decade, having risen from $30 in 2005 towards $90 per share in a time frame of roughly 10 years. It should be said that recent advancements, in terms of shareholder returns have been lackluster. Shares have traded in a $90-$115 range since the middle of 2013, with shares being range bound for three years now, actually trading towards the low end of the range.
With shares trading flat for quite some time, valuation multiples have come down a bit as EBITDA and earnings multiples are in line with the historical average. The business trades at a 20% premium in terms of sales multiples but that is the result of the margin gains being achieved. The focus on paint, scale gains and divestiture of lower margin businesses resulted in improvements in operating margins. Margins now come in around 12% of sales, up 2-3 points from the average margins being reported since 2005.
What Has Gone Wrong?
PPG announced a big profit warning for the third quarter, sending shares down over 8%. That is a huge move given the predictability of the underlying business, and defensive nature of the stock.
The company expects a surprise loss of $0.74-$0.77 per share in the current third quarter. This loss comes on the back of a $615 million charge to settle pension liabilities, equivalent to $2.31 per share.
If not for this charge, earnings would have come in around $1.54-$1.57 per share. This is pretty flat compared to the adjusted earnings number of $1.54 per share which was reported in the third quarter of 2015. The flattish adjusted earnings number is disappointing, after adjusted earnings were up by 11% on an annual basis in the second quarter.
The flattish earnings developments are the result of sluggish worldwide economic growth, with volumes disappointing notably in Europe. Despite a 1.5% increase in overall volumes, management is not pleased with the performance and is looking to review and reduce the overall cost structure. I like the pro-active stance of management, looking to actively cut costs despite the fact that actual volumes are still up.
To support the shares on the back of this profit warning, the board has initiated a very large $2 billion share repurchase program on top of the current authorization of $520 million.
The New, Focused Business
PPG is rapidly becoming a pure focus play on paints. The company announced the divestment of its 50% stake in the PFG Fiber Glass joint venture in September. In October, it closed on the sale of the flat glass operations to Vitro in a $750 million deal. It furthermore closed the sale of the European fiber glass operations to Nippon, for an unspecified amount. Following these moves, PPG is in essence a pure player on paint.
The pro-forma balance sheet is somewhat complicated on the back of large legacy liabilities as well as recent divestments. The company ended the second quarter with $1.67 billion in cash and equivalents. Following the closure of the sale of Vitro and Nippon, cash holdings could increase to roughly $2.5 billion.
Regular debt holdings stood at $5.1 billion at the end of the second quarter. The company settled all of its asbestos liabilities during the second quarter following an $800 million Trust fund infusion. Pension-related liabilities of $1.0 billion result in a pro-forma net debt load of $3.6 billion, but these liabilities will come down in the third quarter, on the back of the large charge being taken.
The $15 billion business will lose little over a billion in terms of sales following the full divestment of the remaining glass business. This suggests that coating revenues trend at roughly $14 billion a year at the moment. Operating profits should come in at little above $2.0 billion. If we assume a 4% cost of debt on a $5 billion debt load, and assume a 25-30% tax rate, net earnings come in at roughly $1.3 billion. With 269 million shares outstanding, earnings might come in around $4.85 per share.
Note that these are GAAP earnings. The company has traditionally relied on adjusted earnings which often were much higher than GAAP earnings. While the company regularly excludes restructuring charges, GAAP earnings were often depressed by pension and asbestos-related charges as well. The company has made huge moves to settle and resolve these liabilities which have come down to just $1 billion as of now.
The current net debt load of $3.6 billion is furthermore very manageable, equivalent to 1.5 times adjusted EBITDA of nearly $2.5 billion. If the company would increase net debt towards $6 billion following a $2.5 billion buyback program, leverage ratios would come in around 2.5 times. Such a buyback program could buy back 26 million shares at $94 per share, equivalent to nearly 10% of the outstanding share base which could be reduced towards 243 million shares.
Such a move would increase the interest bill by $100 million pre-tax, but could boost after-tax earnings per share by some 20 cents. If executed at these levels, the buyback program could boost the GAAP earnings number to levels just above $5 per share.
I must say that I like PPG a lot. The company´s strategy to focus makes sense as long-term growth is impressive. The company appears to structurally outperform its peers in terms of sales, in part fueled by a $500 million annual R&D budget. Innovation is important with regards to weight, thermal performance, maintenance costs and critical applications, among others.
As the company is cleaning up its non-core activities and past liabilities, which means selling its last glass activities and dealing with large liabilities of the past, investors should appreciate this pure focus.
The real appeal can be found if all these charges and distractions become a thing of the past. Adjusted earnings totaled $5.69 per share in 2015 as reported earnings came in at $5.14 per share. I note that PPG´s adjusted earnings for the first half of 2016 come in $0.31 per share ahead compared to the number reported last year, equivalent to $80 million in dollar terms. These incremental gains could offset the $137 million in segment earnings being reported by the glass segment in 2015.
That suggests that a $5.69 per share number is realistic for PPG, assuming that the pure player no longer faces large ¨one-time¨ costs going forwards. Of course, such a number is only viable in 2017, as this year´s earnings will be hurt by a lot of charges. Such a $5.69 earnings per share number looks very realistic, for a 16-17 times earnings multiple. This is especially the case as the leverage position of 1.5 times EBITDA does allow for $2.5 billion in buybacks going forwards.
A 6% earnings yield for a pure play and strong defensive player looks appealing in this environment, even if headline sales are under pressure. The good thing is that global volumes were up by 1.5% as the strong dollar continues to provide headwinds, as does a sluggish world economy. That said, the earnings yield is very appealing at 3-4 times the yield on Treasury bonds, as these cash flows allow for bolt-on deal-making and continued share buybacks and a potential dividend hike going forward.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.