Tuesday, January 22, 2013

PPG Industries an Attractive Play on China

Earnings season is just getting started but we are already seeing some patterns emerging in the industrial sector. Paint and coatings company PPG Industries (NYSE: PPG) gave results that defied the recent gloom over an industrial slowdown in the last quarter expressed by others. The stock has had a stellar run and any technical analysts out there would no doubt be in love with it right now. However, it’s time to ask where next for PPG and whether its earnings are reflective of the industrial sector at large.

PPG’s Results

PPG’s story over the last year has been a mix of execution with a restructuring program, favorable movements in input prices and some beneficial end markets. Not all companies have the same end markets and while all industries are cyclical to an extent, PPG has benefitted from some favorable movements in automotive and commercial aerospace. Indeed if we go back to what Alcoa (NYSE: AA) recently reported and look at the commentary on it, it’s clear that it is a mixed outlook this year. Alcoa is a good marker for PPG because one makes the aluminum and the other makes coatings.

Alcoa noted that it had been a good year for the aerospace sector, and automotive has been okay too, thanks to strong sales in the US. However I would urge a note of caution here. Alcoa’s outlook is very much reliant on growth in China and PPG (admittedly to a much lesser extent) is also hoping that China will get back to growth rates above 7.5%. Since this is not a bet I have a lot of faith in I would suggest investors be a little cautious here.

Other markets like packaging were given a mixed outlook by Alcoa, and a company like Ball Corp (NYSE: BLL) is worth following in this context. With Ball and the other packaging companies the challenge is always to get its fixed asset investment right. They need to be near their customers in order to service contracts, but if there are shifts in geographic production they will suffer disproportionately. You can’t just transport a beverage can manufacturing plant to the other side of the world because Coca-Cola wants to produce relatively more in Brazil than in, say, China!

I’d imagine PPG is faced with similar questions.

PPG’s Internal Execution

The story isn’t just about end markets. PPG has executed a very successful restructuring program which has seen an appreciable hike in margins even while top line growth was only 2.1% for the year. For example, industrial and performance coatings (which together make up around 60% of sales and income) margins saw a notable increase throughout the year.

Don’t forget to compare margins on a year on year basis in this chart.

It wasn’t just about restructuring. PPG also saw some moderation in raw material costs and declared that it expected more ‘balanced’ costs going into 2013. PPG’s management seem to feel that coatings margins can improve again in 2013.

Moreover, the acquisition of Akzo Nobel’s US household paints division is going to give greater exposure to some favorable trends in US housing. I would argue that the pick-up in housing activity is largely the reason for Sherwin-Williams (NYSE: SHW) super run. If you want to see an even better looking chart than PPG, I suggest you look at SHW. Housing looks like a good market to be in and PPG will surely generate synergies from the Akzo acquisition. As for SHW, its EV/EBITDA multiple of 15.3x suggests the evaluation is at least up with events.

Where Next for PPG?

In SHW’s case I am much more certain about its end market prospects (far great exposure to housing) but I am not so sure about PPG. Looking at the recent results from an industrial bellwether like MSC Industrial (NYSE: MSM), it does look like there was a bit of a slowdown in the calendar Q4 in the US. This might not have fed through into PPG’s numbers just yet so look out for some possible earnings volatility in future months. For the reasons expressed in the MSC article I think the US difficulties will be overcome, but then again MSC’s stock price has reacted to the negative news flow already. If PPG comes out and says things slowed in the US in future quarters (even if it is temporary) then the stock will surely drop.

Furthermore, PPG’s international exposure asks questions. For example PPG expects the global automotive market to grow in 2013 and the stimulus in China to feed through into the economy. This is far from a certainty, and even though its internal execution has been superb of late, there is a limit to how much margin expansion PPG can generate.

There is a lot to like about this stock, and investors who are positive on China will be greatly tempted by it, but for me it’s in the ‘wait and see on China’ list. I may regret this!

No comments:

Post a Comment