Thesis
PPG Industries (NYSE:PPG) is a great cash generator and the cashflow potential seems to hold up into the future. It is a business that produces paint finishing on industrial equipment and products like aircraft. It is a good that is needed, and as the global economy expands, the company is well positioned to take advantage of increases in demand. The competitive landscape is stable, with several top producers controlling more than half of the market and having done so for the long term. The competitive environment and operating position of PPG are in its favour and contribute to a high-quality company that I would like to have in my portfolio. However, as described later on, I think the valuations are too high. Other investors also recognise the value at hand. Yet, as interest rates are cut and investors renew their focus on growth, this business may be offered at a good valuation. I will, therefore, follow the stock closely, waiting for an opportunity to invest.
The Competitive Landscape
PPG operates in the performative coatings and industrial coatings sectors globally. These provide opportunities, due to their similarity, for economies of scale that can deter entry. Both sectors are highly diversified and will likely continue to grow with GDP over the following decades. This creates a positive backdrop to the investment analysis of the company. Fortune Business Insight, for example, estimates a CAGR of 4.5% up to 2032.
Technological development does play a role in the industry, and that is often perceived as a risk to investors for the longevity of cash flows; fast changing technologies cause incumbents to fall out of favour quickly. However, in this case, I would say technology gives the company and other incumbents a competitive advantage against entrants. An entrant, to remain competitive, would have to spend similar amounts to the incumbents, and this is in the hundreds of millions of dollars per year. Yet without scale, this would make their businesses very unprofitable for a long time before they wrestle away customers from the incumbents.
Achieving scale is unlikely to be easy either, for within these sectors there are long-term contracts and buyers, who value reliability, have more trust for the established players with whom they have dealt with for years and even decades. Entrants would have to lower prices significantly to attract customers and maintain this over the course of initial contracts. Because they are not at scale yet and in addition to the R&D spend necessary, this ensures very hostile conditions for entry. PPG, along with its incumbent competitors, is therefore protected. These competitive conditions are a strong positive for PPG and a contributor to the longevity of its cashflow.
True competition, I believe, can only come from incumbent competitors, yet this too remains unlikely to become intense, other than during a slump in demand when there is excess capacity. Average operating margins have been around 11%-12% over the past five years for the top four industry leaders, including PPG. (See my table later on). These are not excessively high as they are in other sectors. They are likely a little higher than the cost of capital. So let’s say one of the companies wants to intensify competition because the industry is near full capacity, it would have to extend its capacity at the cost of capital. It would likely have to take a lower margin on any demand they wrestle away from its competitors because of the conditions described before. Therefore, intensifying competition would result in worse margins for all, and I believe each company knows this, which is why revenue shares have remained stable.
The growth of the sector comes from general global economic growth, and this may be more thoroughly competed over as each company tries to take new revenue. The real risk, however, is too much capacity, either from overinvestment or through a global recession. During these times, competition intensifies because every company has an incentive to fill their capacity by offering lower prices, rather than allowing unused assets. Lower margins from recessions are inevitable, and I have built it into my valuations. These do not present a fundamental risk to the company.
The competitive environment therefore is a stabiliser for PPG’s cashflows and this degree of certainty, matched by not many sectors, is something we all want in our portfolios.
Now that I’ve gone over the business economics and demonstrated why the company is likely to do well, we should ask, how much is it worth, and how much should we pay for it? The next section of the report is dedicated to the valuation of the company and revealing why I believe the company is overvalued.
Reproducible Asset Valuation
My first estimate of PPG’s intrinsic value is the cost to reproduce the company. This includes all the startup costs associated with training, technology related to production and the goods, and the administrative costs. Why is this a good representation of intrinsic value? Because this is how much the entrant would have to invest to become a competitor. In a reasonably competitive market, not accounting for operational efficiencies, a company could expect to earn the cost of capital on this asset value. If it were greater than entry would occur and this would intensify competition until the cost of capital was reached by the returns on capital. Of course, this is impacted by other factors, two of which are important: the time horizon and competitive advantages. The latter will be considered later, and I will argue that PPG has a slight competitive advantage, along with other incumbents, making entry hard. (Yet this is countered by operational inefficiency).
According to Macrotrends, the price to accounting book ratio for PPG is around 3.6x, which looks very expensive. This is not, however, the economic value, which I will estimate. In my analysis, I realise that it’s impossible to be highly accurate with the estimates given. My analysis, however, will arm investors with more actionable information because my valuation will more closely reflect the economic value of the company in comparison to accounting valuation. Accounting valuations are often very different, especially when a company has been around for a long time. (PPG has been around for over a hundred years). For example, accounts often depreciate property even though it goes up in value due to inflation. Further evidence will support the accuracy of my estimate.
The table below shows the adjustments I have made based on the analysis approach discussed.
Item |
Adjustment Figure |
Land |
$863 million |
Buildings |
$2.9 billion |
Machinery and Equipment |
$2.8 billion |
Technology |
$4.6 billion |
Goodwill |
Removed ($6.2 billion) |
Identifiable Intangible Assets |
Removed (2.42 billion) |
Sales Portfolio |
$4.0 billion |
Staffing Costs |
$5.5 billion |
Logistics Network |
$930 million |
Administrative Costs |
$2.4 billion |
Net Adjustment Figure |
$15.3 billion |
If we add this to the shareholder equity of $8 billion, as recorded on the company’s balance sheet, we arrive at a reproducible asset value of $23.2 billion, a vast difference. Investors should therefore feel a lot more comfortable with the current market capitalisation of $28.8 billion. And just to give the reader some comfort in being guided by my figures rather than the accountant’s, think of the following: it does not make sense that a company would cost $8 billion to set up then be valued $28 billion on the stock market. That kind of value inflation would attract every industrial investors to set up one.
The adjustments related to land and buildings were adjusted upward to account for market appreciation, as land values typically increase over time rather than depreciate. Buildings and machinery costs were also adjusted for inflation, as the cost to construct new facilities and purchase equipment today is significantly higher than their historical cost. Additionally, the economic life of machinery often exceeds its accounting life, so these assets were adjusted to reflect the true replacement cost.
Goodwill and identifiable intangible assets were removed because these represent premiums paid during acquisitions for things like brand value, customer relationships, and market position. These are accounted for in my analysis specifically. To account for the technological capabilities that PPG has developed, the sum of the last ten years of R&D spending was included, along with the value of acquired technology, as an entrant would need to invest similarly to develop proprietary technology and maintain competitiveness. This article gives a general overview of technology development within the coatings sectors. I summed the ten years of R&D which is in line roughly with the rate at which technology becomes outdated.
Staffing costs include average salary multiplied by the number of workers. Average salaries were increased by 10% to account for the premium needed to attract talent from competitors. This would likely be cheaper than training a workforce. The reason this is included as an additional item is that it requires significant time to get a business running and therefore wages must be paid. Logistics costs were estimated as a percentage of COGS, reflecting the investment required to build an efficient distribution network. The sales portfolio adjustment was included to account for the initial price cuts an entrant would need to offer to attract customers, and one year of operational costs (SAG) was added to cover the initial expenses of running the business.
The figure I have given are unlikely to have a very high degree of accuracy; they are there to guide investors to the right place. We must, therefore, account for this in the margin of safety. It seems as if the stock is overvalued. I would only invest in this company if there was a margin of safety of several billion to account for the possible variation in accuracy.
Earnings Power Value
Now let’s look at the earnings side of the company and see how that might impact the investment case. The company has very stable profits and cashflows, which is an attractive quality. It is a strong driver of the current valuation. Highly stable cashflow, in addition to long term predictability in the sector, leads to a low-risk factor and this reduces the company’s cost of capital.
The earnings power value I am about to estimate looks at the current company’s ability to generate cash for shareholders. It assumes the company is static rather than growing. This prevents us from contaminating the valuation with inaccurate forecasts of economic events. Fortunately, the company is quite stable, unlike other companies I have had to do this for. Growth is not so high that it disrupts the need for depreciation. We also have some information from competitors. This is all important because it increases the accuracy of the forecast and therefore its utility from an investment perspective.
Operating Margin (20-year average) |
10.81% |
Current revenue |
18,246,000,000.00 |
Stable earnings |
1972722484 |
Tax Rate |
0.26 |
Distributable Earnings |
1,459,814,637.97 |
Cost of equity |
8% |
Cost of debt (weighted average) |
1.73% |
Long Term Debt |
5,742,000,000 |
Reproducible Net Asset Value |
23,000,000,000 |
Funding |
28,742,000,000 |
Cost of Capital |
6.7% |
Earnings Power Value |
21,638,432,812 |
The only two assumptions I made were in regard to the tax rate and the cost of equity. The former is a higher estimate than I usually take because I averaged their long-term tax rate, and it was around 25%. This is higher than usual. I usually add a few percentage points to account for the fact that the US government has a very large deficit and will likely have to raise taxes. I really don’t venture further into the murky swamp of economic forecasts than this. The cost of equity I estimated by taking the yield on investment grade debt (5.21% according to the Fed), and found that required return demanded by equity investors in venture capital funds to be around 20%, for the lower risk ones. The range between these two figures is the range of the cost of equity for listed companies depending on their risk profile. I split this range into three, based on risk characteristics. PPG is certainly a lower risk company.
As said before, given the stability of the company’s operations, I am reasonably confident in this valuation. In fact, I think it’s likely more reliable than the reproducible asset value as that requires a more estimate.
The value to investors really comes when we compare the two valuations. The earnings power value is several billion below that of the reproducible asset value. This could, of course, be due to errors in calculation. But what it implies lines up with additional evidence. It reveals that for some reason or other the company is not deploying its capital as efficiently as the rest of the market. The following table shows five year gross and operating margins for PPG and its top competitors.
Company |
5-Year Average Gross Margin |
5-Year Average Operating Margin |
PPG Industries |
41.0% |
10.8% |
Sherwin-Williams |
48.0% |
13.9% |
Akzo Nobel |
44.4% |
11.6% |
Nippon Paint |
39.3% |
9.1% |
You will see that PPG is below average in both by a not insignificant amount. Whilst this is not a great reflection of management, it gives me more confidence in the valuations I have conducted. The intrinsic value of the company is quite likely in the $21 – $24 billion range. So far, that would imply a 20-30% reduction in the stock price before I would consider it a reasonable investment.
Management
My main concern with management is that they have not been able to successfully address efficiency. In the latest year they have divested from their European and Australian traffic solutions businesses in order to streamline operations. They also state they will reduce working capital. Yet, I have been following this company for some years now and the language in the reports is similar to previous years. The point is that efficiency has not been improved. Improvements in efficiency are constrained, heavily in my opinion, by the workforce and labour relations that have been developed over a long history and that a new company wouldn’t be constrained by. Therefore, I haven’t considered any improvements in margins in the valuation.
One positive of the current management is that they don’t seem to have been making value destroying acquisitions as many other companies do. This is one of my chief concerns when investing as overpriced acquisitions can significantly erode the intrinsic value of companies.
Conclusion
I will not be purchasing any of PPG’s stock at the current price because I think it is somewhat overvalued. It is not grossly overvalued, and the current price could be justified if you are bullish on the growth prospects rather than being more conservative like me. But I am quite confident in my valuation and I will be waiting for an opportunity to invest.
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