Value Investors Club / PPG INDUSTRIES INC (PPG)

Due to a recent yet rare negative earnings pre-announcement, PPG—a world class coatings business—is now trading at a historic discount to its main peer and the market at large. I believe this is a good entry to an equity-value compounder that is pricing in a more dire scenario than the market at large. PPG is a mid-to-high-teens ROIC business that grows earnings from mid-single to mid double digit rates depending on where we are in the economic cycle. Since 2005, the earnings CAGR here has been 11%.

I believe PPG will earn around $10/share by 2020 without adding to balance sheet leverage which is already low with leverage at ~1x ebitda and ~20x interest coverage. It won’t happen but if I were on the board, I’d recommend borrowing $7.5bln and buying back ~30% of the company around these levels…This company can probably borrow in Europe at less than 1% for 7- 10 years.

The basic earnings algorithm here is:

 Volumes: global industrial production

 Price: modestly outpaces inflation

 ~25% incrementals

 Balance sheet deployment

So figure ~1-4% global industrial production + 1% price + 25% incrementals = low to mid single digit EBIT growth. Balance sheet and free cash deployment leads to high single to low double digit eps growth. This should at least trade in line with the market---usually has traded a premium but the recent dislocation provides the opportunity.

The thesis has the following key tenets:

 Roughly 25-40% of the business is operating at below mid-cycle levels suggesting cyclical earnings upside in a meaningful part of the business mix or, at least, less downside that the shares reflect.

 The cash conversion is very high as free cash tends to hover around net income creating earnings optionality from investing free cash into value-accretive M&A and buybacks. This is a capital light business with 2-3% capex as a percentage of sales.

 Cycle over cycle earnings stability is higher than ever given the shedding of commodity businesses that used to be the swing drivers to PPG earnings.

Business Description

PPG is a very diversified manufacturer of paint and coatings. It now reports in 3 segments: Performance, Industrial, and Glass.

Performance Coatings is the largest segment and this is where the company reports its (1) refinish, (2) aerospace, (3) protective and marine, and (4) architectural businesses. (1) The refinish business basically is cars/trucks (repair and refurbish), light industrial coatings and is sold through independent distributors. (2) Aerospace coatings include coatings for commercial, regional, and military aircraft. It does this on an OE and aftermarket basis and does so through its own distribution network and direct to customers. (3) The protective and marine coatings business sells to hard core industrial production end markets (metal fabricators, heavy duty maintenance contractors, and ships, bridges, and rail cars). It does so through its company-owned stores, independent distributors, and directly to customers. (4) Architectural coatings basically sells paint for residential and commercial structures. This is the direct comp to SHW core business and products are sold through company-owned stors, home centers, and other retailers. PPG has 920 stores in North America, 685 stores in EMEA, 40 in Australia, and 100 on central America. In addition, they sell coatings to 4000 stores that are operated as franchisees in

Mexico.

The Industrial Coatings segment houses the automotive OEM, packaging coatings, and other specialty coatings end markets that have industrial end markets. A large number of the products here are formulated specifically for the customers’ needs and application methods. Most sales are made on a direct basis.

By geography, PPG has 44% exposure to the US and Canada, 29% to EMEA, 17% to Asia Pacific, and 10% to Latin America.

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Salient Points:

 The transformation the business has under-gone is represented in the slide above which shows that the higher multiple coatings business is basically the entire business now.

 Despite this, here is a Bloomberg shot of the company’s relative PE multiple. Equally notable is PPG vs SHW going back a decade. This 2nd picture below is a relative price graph that shows

how differently the companies are being valued right now. N.B. SHW + VAL is a lot more like PPG than legacy SHW vs. PPG

 European volumes are still 18% below 2008 levels for the end markets at large. PPG should show very strong (`40%) incremental margins here should we ever get a recovery but also should have less downside that the shares imply due to the lack of recovery we have seen.

Another key element here is the opportunity for M&A. In the slide below, management is trying to highlight their exposure to more consolidated end markets. But a key takeaway for me is the

M&A optionality here to move the ladder in multiple ways. Given the robust free cash and balance sheet condition, I believe this is highly attractive earnings upside optionality.

Earnings Trajectory and Scenarios thereof:

Given the diverse set of end markets and geographies, I will provide 4 scenarios here to show the earnings band as I see it.

Scenario 1

In this summary model, I show constant debt, 5% EBIT growth (which is 2.5-3% top line growth with 25% incrementals) with all free cash from the prior year deployed to buying back stock. I assume the stock price rises over time.

Scenario 1

Net Debt	3,443	3,443	3,443	3,443	3,443
Leverage	1.3	1.2	1.2	1.1	1.0

Share count	266	251	237	224	212
Buyback price		$ 105.00	$ 120.71	$ 138.49	$ 158.60
Implied Multiple		15.7	16.2	16.7	17.2

	2016	2017	2018	2019	2020
EBIT	$ 2,243	$ 2,333	$ 2,449	$ 2,572	$ 2,700
yoy		4.0%	5.0%	5.0%	5.0%

Interest	92	92	92	92	92
Pre-tax Income	$ 2,151	$ 2,241	$ 2,357	$ 2,480	$ 2,608
Taxes	538	560	589	620	652
Net Income	$ 1,613	$ 1,681	$ 1,768	$ 1,860	$ 1,956
EPS	$ 6.06	$ 6.69	$ 7.46	$ 8.30	$ 9.23
Multiple	15.3	13.8	12.4	11.2	10.0
EPS Growth		10.5%	11.4%	11.3%	11.2%

EBITDA	2,730	2,839	2,981	3,130	3,287
Interest	92	92	92	92	92
Taxes	538	560	589	620	652
Capex	500	500	500	500	500
Free Cash	1,600	1,687	1,800	1,918	2,043

Scenario 2:

This is a recession scenario defined as a 10% drop in sales with 25% decremental margins over the next 2 years. This is a 20% drop in EBIT. Again I keep debt constant here and model all free cash allocated to buybacks according to a presumed trajectory in stock price.

Scenario 2

Net Debt	3,443	3,443	3,443	3,443	3,443
Leverage	1.3	1.4	1.6	1.4	1.4

Share count	266.3	247.11	232.69	221.92	211.51
Buyback price		$ 83.40	$ 95.91	$ 110.30	$ 126.84
Implied Multiple		15.0	15.5	16.0	16.5

	2016	2017	2018	2019	2020
EBIT	$ 2,243	$ 2,019	$ 1,817	$ 1,953	$ 2,051
yoy		-10.0%	-10.0%	7.5%	5.0%

Interest	92	92	92	92	92
Pre-tax Income	$ 2,151	$ 1,927	$ 1,725	$ 1,861	$ 1,959
Taxes	538	482	431	465	490
Net Income	$ 1,613	$ 1,445	$ 1,294	$ 1,396	$ 1,469
EPS	$ 6.06	$ 5.85	$ 5.56	$ 6.29	$ 6.95
Multiple	15.3	15.8	16.7	14.7	13.3
		-3.5%	-4.9%	13.1%	10.4%

EBITDA	2,730	2,457	2,211	2,377	2,496
Interest	92	92	92	92	92
Taxes	538	482	431	465	490
Capex	500	500	500	500	500
Free Cash	1,600	1,383	1,188	1,320	1,414

Scenario 3

Same revenue and margin drivers as “Scenario 1” except in this scenario I limit buy back to $500mm per year and devote excess free cash to M&A according to an illustrated pre-tax return schedule.

Scenario 3:

Net Debt	3,443	3,443	3,443	3,443	3,443
Leverage	1.3	1.2	1.2	1.1	1.0

Share count	266.3	261.04	255.77	250.51	245.25

	2016	2017	2018	2019	2020
Organic EBIT	$ 2,243	$ 2,333	$ 2,449	$ 2,572	$ 2,700
yoy		4.0%	5.0%	5.0%	5.0%

M&A EBIT		211	392	660	785

Interest	92	92	92	92	92
Pre-tax Income	$ 2,151	$ 2,452	$ 2,749	$ 3,140	$ 3,393
Taxes	538	613	687	785	848
Net Income	$ 1,613	$ 1,839	$ 2,062	$ 2,355	$ 2,545
EPS	$ 6.06	$ 7.32	$ 8.70	$ 10.51	$ 12.00
Multiple	15.3	12.6	10.6	8.8	7.7
		20.9%	18.7%	20.9%	14.2%

Organic EBITDA	2,730	2,839	2,981	3,130	3,287
M&A EBIT	-	211	392	660	785
Interest	92	92	92	92	92
Taxes	538	613	687	785	848
Capex	500	500	500	500	500
Free Cash	1,600	1,845	2,093	2,414	2,631
Buyback	500	500	500	500	500
Excess Cash	1,100	1,345	1,593	1,914	2,131

Pre-tax Return on M&A
Year 1 Return	7.5%
Year 2 Return	10.0%
Year 3 Return	12.5%

EBIT from M&A
2017 M&A	83	110	138	142	146
2018 M&A		101	135	168	173
2019 M&A			120	159	199
2020 M&A	-	-	-	191	266
Cumulative EBIT	83	211	392	660	785

Scenario 4:

Same revenue and margin drivers as “Scenario 2” except in this scenario I limit buy back to $500mm per year and devote excess free cash to M&A according to an illustrated pre-tax return schedule.

Scenario 4:

Net Debt	3,443	3,443	3,443	3,443	3,443
Leverage	1.3	1.4	1.6	1.4	1.4

Share count	266.3	261.04	255.77	250.51	245.25

	2016	2017	2018	2019	2020
Organic EBIT	$ 2,243	$ 2,019	$ 1,817	$ 1,953	$ 2,051
yoy		-10.0%	-10.0%	7.5%	5.0%

M&A EBIT		187	309	479	559

Interest	92	92	92	92	92
Pre-tax Income	$ 2,151	$ 2,113	$ 2,034	$ 2,341	$ 2,518
Taxes	538	528	508	585	630
Net Income	$ 1,613	$ 1,585	$ 1,525	$ 1,755	$ 1,889
EPS	$ 6.06	$ 6.41	$ 6.55	$ 7.91	$ 8.93
Multiple	15.3	14.4	14.1	11.7	10.4
		5.9%	2.2%	20.7%	12.9%

Organic EBITDA	2,730	2,457	2,211	2,377	2,496
M&A EBIT	-	187	309	479	559
Interest	92	92	92	92	92
Taxes	538	528	508	585	630
Capex	500	500	500	500	500
Free Cash	1,600	1,523	1,420	1,679	1,834
Buyback	500	500	500	500	500
Excess Cash	1,100	1,023	920	1,179	1,334

Pre-tax Return on M&A
Year 1 Return	7.5%
Year 2 Return	10.0%
Year 3 Return	12.5%


2017 M&A	83	110	138	142	146
2018 M&A		77	102	128	132
2019 M&A			69	92	115
2020 M&A	-	-	-	118	167
Cumulative EBIT	83	187	309	479	559

Note that PPG typically executes their M&A on a 3 year target ROIC of 15% and has a good track record of disciplined buying and selling of assets.

The broader point is that there is material out year earnings upside if/when the company deploys its free cash to M&A—and at current levels, buybacks make tons of sense too.

			2016	2017
Price:	92.66	EPS	6.69	7.46
Shares Out. (in M):	266	P/E	13.8	12.4
Market Cap (in $M):	24,673	P/FCF	0	0
Net Debt (in $M):	3,443	EBIT	0	0
TEV (in $M):	28,203	TEV/EBIT	0	0

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