Description

SUMMARY

PPG Industries, Inc. (“PPG”) is an attractive, event-driven long opportunity.  Over the past few years, PPG has been embarking on a corporate restructuring, steadily becoming more of a “pure play” coatings company.  As part of this restructuring and by the middle of 2014, the Company should complete the sale of its 51% interest Transitions Optical for $1.5 billion in after-tax proceeds.  Post the closure of this transaction and combined with the Company’s free cash flow, the Company will have >$4.0 billion in cash on its balance sheet.  During the 4Q13 earnings call, management indicated that over the next 18-24 months they intend to direct $3-4 billion in cash toward growth initiatives and returning cash to shareholders, either of which should drive the stock upward.  Please note that this $3-4 billion (i) is in addition to PPG’s dividend distributions which amount to ~$350 million annually and (ii) is without the potential of PPG adding leverage to its balance sheet (total current leverage is only 1.4x EBITDA).  Very conservatively, management could return $3.7 billion ($3.0 billion plus $700 million in dividends) to shareholders over 24 months, equating to a 14% yield based on the Company’s market cap of $26 billion.  That’s the conservative case, suggesting that the risk/reward profile for PPG’s stock is highly skewed to the upside.  Further, from a fundamental perspective, the Company is performing well: (i) it’s businesses are experiencing growth and are leveraged to a recovery in non-residential construction, (ii) the Company should benefit from continued realization of cost synergies from its acquisition of Akzo Nobel’s Architectural Coatings business closed in April 2013, and (iii) volume trends in Europe are improving for PPG and any business recovery in the continent represents embedded upside “optionality” for earnings.

Management has indicated that their preferred use of cash is to pursue strategic M&A transactions, which given PPG’s track record will almost undoubtedly be accretive.  However, without the ability to incorporate “potential transactions” with any degree of accuracy into projected financials, I am projecting that PPG uses its cash to repurchase $4.0 billion worth of stock over the next 24 months.  Under this scenario, I have the Company earning ~$11.70 in EPS in 2015.  At 18x this (a multiple in-line with its peer average and where PPG has historically traded), I think the stock reaches $210, ~15% higher than current levels.  However, there are several “blue sky” scenarios which could drive the stock much higher.  Just two of these are: (i) the Company leveraging its balance sheet from 1.4x to just 2.0x Debt/EBITDA and buying back an additional $1.6 billion in stock or (ii) the Company conducting a Dutch tender offer which would drive it’s EPS higher by immediately lowering its average share count.

COMPANY DESCRIPTION

• PPG Industries, Inc. ("PPG") is a global specialty chemicals company.  The Company is composed of five operating segments:
  • Performance Coatings (39% of 2013 Revenues) – comprised of the refinish, aerospace, protective, marine and architectural coatings businesses.
  • Industrial Coatings (32% of 2013 Revenues) – comprised of the automotive OEM as well as the industrial and packaging coatings businesses.
  • Architectural Coatings - EMEA (14% of 2013 Revenues) – supplies a variety of coatings under a number of brands and purchased sundries to painting contractors and consumers in Europe, the Middle East and Africa.
  • Optical and Specialty Materials (8% of 2013 Revenues) – includes optical products and silicas businesses.  The primary optical products are Transitions lenses, optical lens materials and high performance sunlenses.  Other products include amorphous precipitated silicas for tire, battery separator and other end-use markets.
  • Glass (7% of 2013 Revenues) – composed of both PPG's flat glass and fiber glass businesses.  End markets for these glass products include commercial and residential construction and the wind energy, energy infrastructure, transportation and electronics industries.

INVESTMENT THESIS

• Sizeable, Near-Term Return of Capital to Shareholders – Due to a number of corporate transactions PPG will have ~$4.0 billion in cash on its balance sheet and a total debt/EBITDA leverage ratio of only 1.3x by the end of 1H14.  PPG has historically targeted a cash balance of only $1.0 billion.  Barring a large-scale acquisition which will almost certainly be accretive given management's track record, PPG has indicated its intention to return $3.0-4.0 billion in cash to shareholders over the next 18-24 months in addition to dividends ($350 million annually).  If the Company decides to raise its leverage ratio to a very reasonable 2.0x total debt/EBITDA, the Company could return $4.6-5.6 billion in cash to shareholders, or ~18-22% of its market capitalization.  On July 29, 2013 PPG announced the sale of its 51% interest in Transitions Optical to its partner in the joint venture, Essilor International SA (EI FP).  Transitions Optical makes polarizing lenses that adapt to changing light conditions and block harmful solar rays.  PPG will receive $1.5 billion in after-tax cash proceeds from the sale.  The transaction is subject to regulatory approvals and is projected to close within 1H14.
• Significant Business Restructuring – Over the past several years, PPG has pursued a significant corporate restructuring to shift its business portfolio towards its mainstay coatings business.  Most recently, the Company (i) completed the sale of its Commodity Chemical business to currently named Axiall Corporation (AXLL) for $1.3 billion on January 28, 2013, (ii) purchased the Architectural Coatings business of Akzo Nobel NV (AKZA NA) for $1.1 billion on April 1, 2013 and (iii) is in the process of divesting its Transitions Optical business to Essilor International for $1.9 billion expected to be completed in 1H14.  Internal estimates indicate that these transactions will cause a shift in PPG's revenues derived from coatings from 74% in 2012 to >90% in 2015.  This will enable the Company to be viewed as a pure play coatings business and should help its valuation multiple move closer to its main competitor The Sherwin-Williams Company (SHW).  Currently, PPG trades at 15.6x internal 2015E EPS vs. Sherwin-Williams which trades at 17.6x 2015E consensus estimates.

FUNDAMENTAL ANALYSIS

• Coatings– PPG's Coatings business, comprised of its Performance Coatings, Industrial Coatings and Architectural Coatings - EMEA segments, is an excellent business.  Key attributes of the business include:
  • Diversity of End Markets–  PPG's Coatings business serves numerous end markets providing it with a high degree of diversity:
    • Architectural (43% of the global coatings market) - PPG primarily produces coatings used by painting and maintenance contractors and by consumers for decoration and maintenance of residential and commercial building structures.  These coatings are sold under a number of brands and are sold through a combination of company-owned stores, home centers, paint dealers, and independent distributors and directly to customers.
    • Industrial (26% of the global coatings market) - PPG supplies a variety of coatings for industrial uses including the manufacture of appliances, heavy duty equipment, consumer electronics, metal building products, wood and other building products, and transportation equipment (buses, all-terrain vehicles, etc.) as well as general finishing applications (office furniture, radiators, metal housings, wires, fasteners, etc.)
    • Refinish (7% of the global coatings market) - PPG supplies coatings products for automotive and commercial transport/fleet repair and refurbishing, light industrial coatings for a wide array of markets and specialty coatings for signs.
    • Automotive OEM (6% of the global coatings market) - PPG supplies a variety of products to automotive OEMs including precoated finishes, electrocoats, primers, scratch-resistance clearcoats and weather resistant bedliners.
    • Protective and Marine (13% of the global coatings market) - PPG supplies coatings and finishes for the protection of metals and structures to metal fabricators, heavy duty maintenance contractors and manufacturers of ships, bridges, rail cars and shipping containers.
    • Aerospace (2% of the global coatings market) - PPG supplies sealants, coatings, technical cleaners and transparencies for commercial, military, regional jet and general aviation aircraft and transparent armor for military land vehicles.
    • Packaging (3% of the global coatings market) - PPG supplies coatings and inks to the manufacturers of aerosol, food and beverage containers.
  • Positive End Market Dynamics– The outlook is positive for the main end markets PPG's Coatings business serves:
    • Non-Residential Construction – Non-residential construction (Bloomberg: CNSTNRES) is now 13% higher from its recent low in January 2011 yet still >20% below its peak in October 2008.  The Architecture Firms Billings Index (Bloomberg: ARCHWOTB), a leading indicator for non-residential construction for the next 9-12 months, was at 48.5 as of December 2013.  While the index is currently below 50, it has been above 50 for 14 of the past 17 months, suggesting activity for non-residential construction should continue to expand.
    • Residential Construction – In residential construction US Housing Starts (Bloomberg: NHSPSTOT) are now at 999,000 as of December 2013, up 110% from their April 2009 lows of 476,000 but still well below what is considered a more “normal” level of 1.5 million.
    • Automotive – US Seasonally Adjusted Auto Sales (Bloomberg: SAARTOTL) have been steadily rising from 9.0 million in February 2009 to 15.16 million as of January 2014.  Automotive sales in the U.S. are still well below the more normal 17.0 million level experienced from 1999 through 2007, suggesting that sales should continue to increase.
  • Market Leading Position – PPG holds the #1 global market position in the Architectural, Refinishing, Automotive OEM and Aerospace coatings markets as well as the #2 position in the Industrial, Protective and Marine and Packaging coatings markets.  This strong market position provides PPG's Coatings business with scale advantages and hence pricing power over both its customers and suppliers.
  • Exposure to Emerging Markets with Strong Growth Potential – In 2013 PPG generated its revenues from the following geographies:  US & Canada - 46%, Europe - 32%, Asia - 17% and Latin America - 5%.  Overall, PPG has ~35% of its revenues being generated from emerging regions (Eastern Europe, Asia and Latin America) which should enable faster growth than the overall coatings industry.
  • Low Capital Intensity - Capital expenditure requirements for PPG's coatings business have typically been 2.5-3.0% of revenues.  This relatively low level of capital intensity provides the business with strong cash flow.

• In addition to these key attributes, another positive consideration for PPG's Coatings business is:

  • Embedded Call Option on European Economic Recovery - With ~40% of PPG’s Coatings Business revenues being generated from Western and Eastern Europe, PPG's Coatings business holds an embedded call option on a European economic recovery.  For the past few years, economic growth in Europe has been negatively impacted by the sovereign debt crisis occurring in the continent.  However, a variety of data points indicate economic activity in the region is improving.  For example, the latest value of the Eurozone Manufacturing PMI Index (Bloomberg: PMITMEZ), a measure of manufacturing activity in Europe, was 54.0 as of January 2014 and has been above 50 for the past 7 months, a sign that manufacturing activity in Europe is now starting to increase.  The European economic recovery can be seen within the results of PPG's Coatings business.  Specifically, year-over-year volume trends in Coatings for Europe have gradually been improving from (8%) in 1Q13, to (4%) in 2Q13, to (2%) in 3Q13 and 0% in 4Q13.  Further, for PPG’s European exposure overall, pre-tax earnings improved 8% in 2013 over 2012.  If the level of economic activity in Europe recovers to pre-sovereign debt crisis levels, PPG's Coatings business should experience strong revenue and earnings growth.

KEY RISK

• Raw Material Inflation – The largest risk facing PPG is raw material inflation.  Coatings raw materials include both organic, primarily petroleum based, materials and inorganic materials, including titanium dioxide.  These comprise 70-80% of cost of goods sold in most coatings formulations and represent PPG’s single largest production cost component.  This risk is mitigated by three main factors.  First, the Company's size and scale provides it with considerable pricing power over suppliers of certain raw materials, particularly titanium dioxide which has few alternative uses other than coatings.  Second, PPG can access the petroleum-based raw materials it needs from multiple suppliers and thus is not held captive by any one supplier for key ingredients.  Third, PPG's size and scale provide it with considerable pricing power over customers, onto which it can generally pass any significant raw material prices it might encounter.

Catalyst

CATALYSTS

• 1Q14 Earnings – Scheduled to be released April 21, 2014.
• Accretive Acquisitions – PPG is actively pursuing acquisitions in the coatings industry to augment its current market leading position.  The global coatings industry is quite large with just under $100 billion in annual revenues and is relatively fragmented with the leading participants, PPG, Akzo Nobel and Sherman-Williams, only holding a combined market share of about 33%.  Accordingly, PPG has significant room to grow through acquisitions.  PPG has proven itself to be a disciplined buyer of assets and it appears highly likely that any future acquisitions will be earnings accretive in nature.  As PPG completes these acquisitions, they should provide positive incremental impacts on the Company's earnings going forward.