PPG Industries Solid Quarter

The global economy has rarely seen so much variation in geographic and industry growth prospects, and the latest results from PPG Industries (NYSE:PPG) were no different. The results and narrative around each region and end market contained a range of positives and negatives. The end result was a generally positive management outlook that belied fears that the economy is about to enter a recession. Let's take a closer look at the earnings and what to expect going forward.

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Is PPG Industries a Dividend Stock to Buy?

The nice thing about paintings and coatings company PPG Industries (NYSE: PPG  ) is that the stock offers something for growth- and income-seeking investors alike. One one hand, analysts expect the stock to grow its earnings in the mid-teens for the next couple of years. On the other, the company is a Dividend Aristocrat, having raised its payout for 42 years in a row. If you're an income investor, is now the time to buy into PPG Industries? Let's take a closer look.

A Dividend Aristocrat, but also a cyclical stock

The key to growing a dividend is a combination of generating good return on equity, or ROE, and having the earnings and free cash flow to reinvest in the business. In other words, companies need to generate good ROE (net income from shareholder equity) and then use whatever earnings are left over, after dividends have been paid, to reinvest so as to generate growth.


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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.

Alcoa's Earnings and What They Mean to the Market

The symbolic start to the earnings season kicked off with a disappointing set of earnings from aluminum and alumina producer Alcoa (NYSE: AA  ) . The company always provides useful end market guidance for the industrial sector, and this time around it produced a mix of good and bad news.

Alcoa gives its market outlook
The first notable aspect of its outlook is that Alcoa is relatively less dependent on China this year. This is a due to a combination of three factors. First, China's industrial growth appears to be moderating. Second, North American growth is picking up. And third, European growth is somewhat stabilizing as the region starts to come up against some weak comparables from previous years.

Source: Company Presentations.

Aerospace and automotive
These two sectors were the powerhouse of the industrial sector last year. According to Alcoa's management, growth will remain strong this year as well. The International Air Traffic Association (IATA) recently gave its aerospace industry outlook for 2014, and the forecast is for a strong increase in North American airline profitability. This is good news for Boeing (NYSE: BA  ) and Airbus. Moreover, along with the IATA, Alcoa made some bullish noises about future regional and business jet demand. This is a good sign for the global economy, because demand for these types of jets tends to be more cyclical. With passenger load factors (airplane capacity utilization) forecast to grow, Airbus and Boeing can expect orders to remain strong in 2014.

Unlike 2013, automotive growth is expected to be positive in each region for 2014 (though there are some warning signs in North America). On the recent conference call, Alcoa's CEO Klaus Klienfeld outlined that U.S. automotive production levels were now at almost pre-recession levels, but car inventories were 14% higher than last year. Consequently, automakers have pushed up incentives by 8%. This is a slightly worrying indicator, but with ongoing gains in employment in the U.S. and greater availability of credit it's unlikely to prove a lasting effect.

Meanwhile, growth in the automobile sector in China remains strong.

Source: China Association of Automobile Manufacturers

Two companies set to do well, and one that could disappoint
Paintings and coatings company PPG Industries (NYSE: PPG  ) and seeing machines company Cognex (NASDAQ: CGNX  ) both look set to do well, if Alcoa's report is a useful guide. PPG's industrial coatings business has heavy exposure to the aerospace and automotive sectors, and the company looks set to continue to benefit from favorable end markets in 2014. In fact, PPG even did well with European automotive manufacturers in 2013, because its management believes its clients were those doing relatively well in a down market. Given that European car production is expected to be better overall this year, PPG should do well. In addition, Alcoa expects the North American commercial building and construction market to improve by 3% to 4%, and this is good news for PPG's paintings division.  

One of Cognex's aims for 2014 is to expand its sales outside its core automotive sector and into areas such as pharmaceuticals, consumer products, and the food and beverage industry. The company specializes in seeing machine systems that monitor automated processes. Given that China's automotive sector is expected to remain strong and areas like beverage can packaging are forecast to grow at 8% to 12%, opportunities for Cognex to expand its industry reach should remain significant in 2014.

There was disappointing news for General Electric (NYSE: GE  ) shareholders in Allcoa's report, however. Allcoa's management forecast a 8% to 12% decline in industrial gas turbines. Quoting from the conference call, Alcoa's management said:

In Europe, gas fired power generation is squeezed between low priced coal and subsidized renewals. In the U.S., gas prices have increased and this has allowed coal to claw back some of the share gains. Gas now stands in terms of energy production share here in the U.S. at 27.8 versus 30.4 in 2012

Indeed, GE reported that it only took 27 heavy duty gas turbine orders in its third quarter versus a year ago, while delivering 22 versus 35 last year. In addition, if gas turbines are being utilized relatively less, then GE's service orders to the industry should also decrease. Gas turbine revenue is a large part of GE's power & water division, which has generated nearly 29% of GE's industrial profits so far in 2013.

The bottom line
In conclusion, it was a mixed outlook with the main disappointment coming from the industrial gas turbine outlook. However, Europe looks set to improve, and North American industrial growth prospects look solid. China is subject to uncertainty this year, but Alcoa continues to give a positive reading on the country. Aerospace and automotive demand remains strong, and prospects look good for U.S. commercial construction.

Which Stocks to Buy IF China bounces

China remains one of the great imponderables in the investing world. Is it about to roll of a cliff or return to 10%-plus growth rates in the next few years? It's hard to answer these questions, but we do know that the Chinese government is determined to generate more growth in 2014. It's time to look at which sectors might benefit.

China to bounce back in 2014
By now, everyone will have realized that China's growth is slowing. Indeed, the 7.6% GDP growth target that economists have penciled in for 2013 represents the slowest growth in more than 14 years. Interestingly, the OECD predicts that China's growth will improve to 8.2% in 2014 thanks to a "small fiscal stimulus." Essentially, China has responded to slowing growth by initiating a round of stimulus spending, alongside measures to add liquidity into its system.

This time it's different
Old habits die hard, so whenever there's talk of China and spending, many investors simply go back to the mining and energy-based plays that worked so well in the last decade. However, it's different this time. Following its huge stimulus plan in 2008, China now has overcapacity in many heavy industries, including shipbuilding, solar energy, and cement and steel production. In addition, the government is trying to shift the Chinese economy away from its reliance on housing investment and exports (which are slowing anyway due to the current austerity in the West) and toward domestic consumption.

All told, these trends mean that the sectors likely to bounce in 2014 are not the ones we've seen skyrocket before. Indeed, the old commodity plays like Caterpillar and mining-equipment company Joy Global  have been under pressure this year. China's demand for base metals isn't what had been expected. In its latest quarterly earnings, released back in August, Joy Global reported orders down 28% on a constant-currency basis, with aftermarket bookings down 7%. Furthermore, increasing use of gas in the U.S. is holding back Joy Global's core coal market.

Aerospace and autos
However, there are areas of the industrial sector that are benefiting from this economic shift. For example, China's plans involve building 70 new airports in the next few years and expanding 100 existing airports. And if airports are built, routes usually follow. Indeed, a quick look at Boeing's  order book reveals that net orders of 1,054 (to the start of December) represents one of its strongest results in recent years. There is little doubt that Asia has been a major driver of order growth for Boeing. For example, according to the IATA, the Asia-Pacific region will generate 6.6% passenger traffic growth in 2014, compared to 5% in Europe and only 2.5% in North America.

In addition, Chinese car sales have bounced nicely in the second half of this year.

Source: China Association of Automobile Manufacturers.

All of this suggests that aerospace and automobiles will continue to benefit from China in 2014. In this regard, paintings and coatings company PPG Industries  is worth a look. PPG is heavily exposed to the automotive and aerospace sectors, and this year's acquisiton of the U.S. household paints division of Akzo Nobel is well-timed for the ongoing housing recovery.

A word of warning
All told, China looks capable of bouncing back in 2014, but investors need to focus on the long term. There is no guarantee that any stimulus measures or fiscal loosening will lead to tangible return on investment.

It may turn out that China's economy bounces slightly and then slips back again as these investments turn sour. The 2008 investment in industries like steel and shipbuilding could end up simply being mirrored with airports, roads, and transport infrastructure in 2014. Pause for thought.

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.

Ametek Offers Aerospace Upside

It’s been a mixed earnings season for industrial-based stocks and Ametek’s (NYSE: AME) last set of results provided a pretty good microcosm of what has been going on. In short, companies with heavy exposure to industries like automotive and aerospace have done well, while almost everything else has found things difficult. So what makes Ametek interesting and what can we read across for other companies?

Ametek generates growth across the cycle

The company is attractive for a few reasons. Firstly although it is not a pure-play aerospace company, it has heavy exposure and as the industry is looking set for good long-cycle growth, it has good prospects. Secondly, Ametek has long been a company categorized by its management’s ability to make earnings-enhancing acquisitions without damaging its return on invested capital (ROIC).

As the chart indicates, Ametek has done a pretty good job of consistently generating ROIC even when market conditions are not great. An acquisition-led growth strategy does have its advantages and disadvantages. On the plus side, the company can carry on generating growth by getting companies cheaper in the downswing (and benefiting from the hopeful upswing in the economy); but on the downside its management will be under pressure to make the right acquisitions. And making the wrong decision can occur irrespective of where the economy is positioned.

Recent results

The good news is that Ametek’s management has a strong track record in this regard and acquisitions are a key part of the focus for 2013 as well. Even in the latest Q1 results we saw organic sales decline 2% but acquisitions contribute 9% and –even in a weaker environment for aerospace- its sales were up 7%.

As ever with this type of company, cost management and lean manufacturing will be a strong focus. Indeed cost reductions were made in the quarter, without which, EPS would have been up 18%. There was good news on the cost-cutting front with estimates for total full-year savings rising to $95 million from $85 million previously. Operating cash flow rose 11% and full-year EPS guidance was raised at the low end to imply 11% to 13% growth. Moreover the commentary on linearity was positive with April cited as looking ‘good’. Like many in the industrial sector it saw some weakness in March.

Industry background

As usual with earnings season, Alcoa (NYSE: AA) tends to set the tone for the industrials. A brief look at the conclusions from its earnings reveals that areas like aerospace and automotive remain relatively positive. Europe remains weak on the whole and the heavy truck and trailer market is experiencing a sharp slowdown. Moreover much of Alcoa’s growth is predicated on stronger conditions in China. The surprising thing was that Alcoa did not alter its full-year end-demand outlook by much even though the consensus is that Q1 did get weaker overall for industrials.

Alcoa’s trends were confirmed by Ametek when it discussed some softness in its power and industrial business created by the North American heavy truck market, so no surprises there. Furthermore within its process business segment the strongest performer was oil and gas while metals analysis revenue was relatively weaker.

The key strength in the business was from aerospace. Its electronic instruments group (EIG) saw aerospace (commercial, business and regional jets) revenue rise by low double digits and growth is expected to remain solid for the rest of the year inline with build-out rates at Boeing and Airbus. Overall EIG sales were up 3%.

It was a similar story in the other segment. The electromechanical group (EMG) saw its differentiated business sales up in the mid-teens with particular strength cited in its aerospace maintenance, repair and overhaul (MRO) operations.  However, overall sales for EMG only rose 3% thanks to a 14% contribution from acquisitions.

Which stocks read across well?

Frankly I think investors should try and stick to the themes that are working well and try and find value in them. If aerospace and automotives are doing well and companies like Alcoa and Ametek are confirming this, then why not stick to the idea? Three names that I like are Heico (NYSE: HEI), Precision Castparts (NYSE: PCP) and PPG Industries (NYSE: PPG).

Heico recently reported strong results and the business clearly has good long term prospects from helping airlines to try and reduce costs by outsourcing flight support activities. Even though Heico argued that its success in the quarter (its flight support group saw sales and income rise 10% and 14%, respectively) was largely a consequence of internal execution rather than industry growth, I think that there are enough positive signs within its performance to suggest further growth this year.

Its space-related sales may well be variable and its defense sales will be subject to sequestration effects so now may not be the best time to buy into the stock. But if you can tolerate these fears, the stock is attractive.

Precision Castparts is attractive because of its heavy exposure to commercial aerospace (75% of its market) and its opportunities to generate synergies from its acquisitions. In addition, it is ramping up production in order to meet demand from Boeing on the 737 and 787.

My one concern with this company is the cyclicality of its cash flows. The aerospace industry is cyclical but there is evidence to suggest that it is likely to experience better conditions in this cycle. However companies like Precision Castparts always need to make significant capital expenditures in order to service demand.

This is great when demand is good but it leaves them exposed should demand start to weaken. You can make the argument for making an evaluation based on assessing its long-term earnings or cash flow performance but in reality I think the market just trades these stocks based on momentum.

My favored play on this theme would be PPG Industries. The company has good exposure to aerospace and automotive and its purchase of Akzo Nobel’s US household paints operation is timely. Costs appear to be moderating and it has some cost synergies coming from the acquisition. Margins are expanding thanks to its restructuring efforts (such as selling some of its commodity-based businesses) and its cash flow generation remains very strong.

Meanwhile the recent court order over the Pittsburgh Corning (a joint venture with Corning) has somewhat de-risked the stock from uncertainty over future asbestos claims. Earnings growth is being held back this year thanks to some of the issues discussed above but, this is a business which has generated an average $1.1 billion in free cash flow over the last three years and trades on an EV/Ebitda multiple of 9.5x. Looks like good value to me.

Where next for Ametek?

This is an impressive company and a real ‘go to’ option for a pick in the industrial sector. Unfortunately its trailing PE of around 22x plus its EV/Ebitda multiple of 13.1x suggest it is largely pricing in the good news. It’s well worth monitoring and hoping for a dip because $42 looks like a fair price for the stock. Given any kind of market retraction it's worth a close look.