PPG Industries, Valspar, Sherwin-Williams or RPM Inteernational?

The painting and coatings sector is an interesting sector in 2016, not least because there is a large amount of differentiation between the end-market exposure of the leading companies. Let's look at the leading U.S.-listed companies and shed some light on which is the most attractive for 2016.

Valuations
Before delving into end-market details, let's start with a look at past performance and valuations for the four stocks we'll look at. A chart of stock price movements in the past two years shows how The Sherwin-Williams Company (NYSE:SHW) and, to a lesser extent, The Valspar Corporation (NYSE:VAL) have outperformed the stagnating PPG Industries, Inc. (NYSE:PPG) and RPM International Inc. (NYSE:RPM).

SHW data by YCharts.

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RPM International, not Cheap, but Possibly Good Value

First things first, specialty coatings company RPM International  $RPM   is not a cheap stock. Its current P/E ratio is close to 28, but investing isn't really about where a stock has been. In the case of RPM, Foolish investors are looking at a stock with significant leverage to any upside to the U.S. commercial construction markets. Moreover, its restructuring activities, new product launches and geographic growth initiatives promise more growth in the future. It's not cheap, but if you buy a recovery in commercial construction, then you might want to buy RPM.

Introducing RPM International
Paintings and coatings companies with large housing exposure like Valspar  $VAL  and Sherwin-Willliams  $SHW outperformedin 2013 thanks to a recovering U.S. housing market. Meanwhile, a company with more of an industrial focus like PPG Industries  $PPG also outperformed, partly due to its household paints products, and partly due to its convenient exposure to aerospace and automotive -- the standout areas in the industrial sector.

But why has RPM underperformed the sector?

SHW data by YCharts

The answer is that RPM has much more exposure to commercial construction, and growth in the industry has been lackluster at best. For reference, RPM's consumer businesses only made up 35.6% of its sales in the first half; it's the industrial business that counts.

The simple idea behind buying RPM is that, historically speaking, the commercial construction sector (which its industrial business is focused on) tends to lag behind residential. And since the residential market started a recovery in 2013, then commercial should follow.

Unfortunately, this argument has been somewhat weakened by recent falls in the commercial/industrial index from the Architectural Billings Index. However, this is possibly due to the unseasonally bad weather; a similar effect can be seen in the dip in the Spring of 2013.

Source: American Institute of Architects

Ultimately, it only makes sense to buy RPM if you believe that the commercial construction market will be stronger in 2014. However, there are many other reasons to like the stock.

Why RPM is attractive
First, the company has demonstrated an impressive ability to expand margins in its consumer segment.  For example, earnings before interest and taxes, or EBIT, margins have expanded more than 360 basis points over the last three years. This is partly due to new product introductions and restructuring initiatives, but it's also due to a stronger housing market pushing up its consumer sales up over the last two years. In fact, consumer sales rose an impressive 11.2% in the last quarter.

Meanwhile, industrial margins have been lackluster. However, if commercial construction picks up then it's reasonable to expect its industrial margins to do so as well. And margin expansion plus revenue growth equals larger profits.

Source: company presentation

Second, RPM has also restructured its European operations and, according to management on the conference call, " modest increases in this fiscal year in revenues are resulting in strong bottom line leverage." 

Third, in the commentary on the conference call, management gave a cautious outlook on U.S. commercial construction. When questioned on the matter in relation to its guidance for 2014, RPM's management answered:

We're not planning on any real pickup in end markets. I think we're planning on -- but we're not planning on any deterioration. I think you'll see continued sequential improvements, in part because, from a cost perspective, we're better positioned to leverage revenue growth to our bottom line

In other words, any upside from the U.S. commercial construction market isn't baked into RPM's full-year EPS guidance of $2.05-$2.10. =

Fourth, significant investments are being made to expand its product reach in Latin America, and since RPM starts from a low base, it should generate growth by grabbing market share alone.

Why RPM is unattractive
The headline risk is obviously concerning the commercial construction market, and it should be noted that RPM's management did not make positive noises on the state of the current market.

In addition, the weather has been a factor for construction activity, and RPM may disappoint in its next quarter. Furthermore, its free cash flow is a bit of a concern. Excluding the effects of a contingency payment, operating cash flow fell to $83.3 million in the first half from $127.6 million in last year's first half. Around $18.1 million of the difference is due to spending more on inventory (to support faster growth), but CEO, Frank Sullivan was candid that he wasn't "satisfied" with RPM's working capital management.

The bottom line
As noted above, RPM isn't conventionally cheap (cyclicals rarely are just before their cycle is about to turn), and if commercial construction doesn't pick up then the stock is likely to suffer.

On the other hand, it has raised guidance twice already this fiscal year, and it's operationally leveraged to a market that could turn up in 2014. If you like its end markets, then this is a stock well worth watching in order to buy some in the current market sell-off.

PPG Industries is One of the Best Positioned Stocks in the Industrial Sector

It's easy to think that industrial stocks slavishly follow GDP growth or some general measure of industrial output. In many cases, that assumption proves correct. However, sometimes there are companies whose specific end markets are hitting all the sweet spots within the economy. One recent case in point: coatings and paintings products company PPG Industries (NYSE: PPG  ) .

PPG Industries' favorable positioning

 Investors tend to closely follow results from aluminum producer Alcoa (NYSE: AA  )  because they give great color on industrial trends in the global economy. Here's Alcoa's current end market outlook; the cells in green represent where Alcoa upgraded expectations, and those in red are for downgrades.

Source: company accounts

Note that many of its end markets are in good areas of the global economy. And for PPG, that story looks even better.

Promising prospects? Good!

PPG Industries is seeing solid growth in the aerospace sector, with its performance coating segment reporting net sales growth of 10% in the third quarter. That figure's in line with what Alcoa and others are saying about a strong aerospace market.

In addition, it has managed to outperform an already strong automotive sector. PPG's industrial coatings segment increased volumes to its automotive original equipment manufacturers (OEMs) by 10% in the last quarter. Surprisingly, it noted that its automotive coatings growth saw "each major region delivering growth on a comparable scale."

Essentially, PPG finds itself well-positioned with specific European automakers that are generating growth, and it's seeing a pickup in demand from Japanese manufacturers shifting production outside Japan. Moreover, since it doesn't sell to Japanese OEMs in Japan, it isn't suffering any loss of business as a consequence of this shift.

Well-placed internationally, too

 Furthermore, PPG is well-positioned geographically, with its specific end markets looking strong within their own regions of the globe. For example, the Chinese economy is shifting toward domestic consumption, and away from fixed-asset investment in areas like housing and commercial construction. PPG is strong in the Chinese automotive, aerospace and packaging sectors, but according to the company, it doesn't have as significant a presence in the architectural market.

Europe remains a challenge, but PPG reported signs of stabilization there. Moreover, partly thanks to cost-cutting measures, the company managed to increase overall European pre-tax segment earnings by 13%. Similarly, its architectural coatings-EMEA segment grew earnings by 30% to $73 million.

source: company accounts.

North American construction

 PPG's performance coatings segment probably represents its greatest growth catalyst going into 2014. Unfortunately, the commercial construction market hasn't kicked in quite as strong as many had hoped so far this year. Indeed, on the conference call PPG described itself as being "more bullish on commercial construction coming into the year" than its actuall first-half performance could support.

Rival paint company Sherwin-Williams (NYSE: SHW  ) told a similar story in its most recent set of results. Sherwin-Williams noted that its comparable-store growth was outpacing the US paint market by growing 7%. But while it described the US residential market as "very strong," it said the non-residential market was lagging behind. Incidentally, in common with PPG, it cited the marine market as being weak.

Going forward, both PPG and Sherwin-Williams can expect the US non-residential market to improve; historically, the commercial construction market has tended to lag residential building. Moreover, PPG's acquisition of the U.S. household paints division of Akzo Nobel appears well-timed. It added $400 million to PPG's performance coatings segment sales, and PPG has already achieved 50% of the planned $200 million in synergy benefits. There are more savings to come in 2014.

Where next for PPG Industries?

 The indications from Alcoa and others are that PPG is placed in many of the right sectors of the global economy, and its momentum looks set to continue into 2014. Moreover, the stock remains at a discount to its peers.

PPG EV / EBITDA TTM data by YCharts

Analysts forecast PPG's EPS growth to come in at over 15% next year . Given a stronger US commercial construction market, it's not unreasonable to think that this stock could reach $200 in the not-too-distant future.

PPG Industries is a Stock to Buy

Investors in paintings and coatings company PPG Industries (NYSE: PPG) have enjoyed a nearly 45% rise over the last year, but the stock has remained in a tight $150-$160 range over the last few months. Is this a sign that it’s time to take profits on the stock?  Before you rush to hit the sell trigger, you should consider the upside potential in this stock. PPG can move higher in 2013, and here is why.

End market conditions

PPG’s prospects for 2013 will largely be governed by its performance within the industrial and architectural/construction end markets.

With regard to the industrial sector, it’s been a mixed earnings season so far. As a general rule, companies exposed to sub-sectors such as aerospace and automotive have done really well, while the rest of the industrial sector has faltered. For example, aluminum manufacturer Alcoa (NYSE: AA) started this trend in this earnings season by affirming its forecast for 9%-10% growth in its aerospace market, and also upgrading its expectations for the North American automotive market.

However, while Alcoa is seeing strength within some of its key end markets, companies exposed to general industrial trends like supply companies Fastenal (NASDAQ: FAST), and MSC Industrial (NYSE: MSM), are seeing weaker conditions. Both companies cited the softening Institute for Supply Management (ISM) survey data as being indicative of a difficult industrial environment. Fastenal reported disappointing industrial fastener sales (an indication of cyclical weakness), and announced plans to hire new staff in an effort to generate revenue growth. Similarly, MSC Industrial declared that it wouldn’t be pushing through its usual midyear price increase due to softening demand from its customers.

The architectural markets have also seen some mixed performances. A look at the data from the Architectural Billings Index from the American Institute of Architects (AIA) reveals the difference in performance between the residential and commercial markets in 2013.

Source: American Institute of Architects.

The idea is that a recovering residential market will lead to an improvement in commercial/industrial conditions, but it hasn’t happened so far in 2013.

How is PPG faring?

A brief look at its segmental income demonstrates that PPG is generating income growth from a variety of sources.

Source: PPG accounts.

In its recent earnings release, PPG disclosed that its performance coatings saw its automotive and aerospace refinish businesses deliver ”mid-to-high single digit sales increases”. PPG received a major contribution to sales and income growth, from its acquisition of Akzo-Nobel’s US household paints division.  However, its North American architectural coatings sales (excluding acquisitions) actually declined 5%. The decline was partly due to a major customer changing its product mix, but PPG also referenced some cautious purchasing patterns amongst independent dealers.

 Indeed, its rival Sherwin-Williams (NYSE: SHW) referenced similar market dynamics in its conference call on July 18. Sherwin-Williams spoke of the loss of business from a key retailer (in this case Wal-Mart), and outlined that its non-residential sales were lagging residential. In addition, its consumer group sales declined 1% even after a positive 3.2% contribution from an acquisition. 

Industrial coatings sales benefitted from a 12% rise in volumes from its automotive sales, and PPG was keen to highlight that this is partly a result of excellent long-term positioning within the leading car companies. It claims to be the number one player in automotive coatings in North America and China.

Perhaps the most surprising aspect of PPG's results were that its Europe, Middle East and Africa (EMEA) – architectural coatings income increased by $5 million to $69 million, despite sales declining 5%. This increase is a testimony to how well its management is implementing cost savings programs.

Where next for PPG?

The company has a number of good catalysts for growth. Input costs are moderating, the automotive and aerospace sectors are growing strongly, and investors can look forward to some improvement in the commercial/industrial construction market. PPG is a well-run company that has coped admirably with the slowdown in Europe. In addition, it plans for to generate around $200 million in synergies thanks to the Akzo-Nobel acquisition.

With regard to valuation, the stock trades on a discount to its peers:

In conclusion, I think the company is set for good growth going forward, and its valuation makes the stock attractive for the long term investor.