PPG Industries Acquisition Strategy Fails To Deliver Growth (NYSE:PPG) (2024)

Investment Thesis

PPG Industries, Inc. (NYSE:PPG) operates in a low-growth sector and has adopted an acquisition strategy to drive growth. Despite continuous annual acquisitions, it achieved only a 2.7% CAGR in revenue over the past decade. Profits and returns declined, and there was no sign of improving operating or capital efficiency.

My valuation assuming a major acquisition in year 6 does not provide a 30% margin of safety. However, the market seems to have priced the company as if it will undertake another major acquisition next year. I don’t think this is realistic. As such I do not see this as an investment opportunity.

Business background

PPG is a paints, coatings, and surface solutions company. This is a global company in the sense that only about 40% of its revenue is from North America, with the balance from various parts of the world. Refer to the left part of Chart 1.

The company has two reporting segments, as shown in the right part of Chart 1:

• Performance coatings. This is the bigger segment, accounting for about 2/3 of the 2023 revenue. This segment’s products are aimed at specific end-use applications such as architecture, protective, and traffic solutions. The distribution methods are more retail and customer-direct focused.
• Industrial coatings cater primarily to manufacturing companies with specific needs, such as automotive and packaging. The segment focused on direct manufacturing and on-site services.

Over the past 10 years, both segments had about the same 15% net income margin.

PPG's growth model seems to be one with continuous acquisitions. Over the past 20 years, there have been cash acquisitions every year. They ranged from USD 26 million in 2009 to USD 2.1 billion in 2021 with an average of USD 587 million per year. This is about 4% of the average total assets over the past 20 years.

This growth model is acknowledged by the company.

“Growth through acquisitions is an important component of the Company’s strategy. Over the last decade, we have successfully completed more than 50 acquisitions.” 2023 Form 10k.

Operating trends

An analysis of the operating trends over the past decade showed the following:

• While revenue had grown at 2.4% CAGR over the past decade, PAT over the past few years was lower than that in 2014. Refer to the left part of Chart 2.
• While there was an initial improvement in gross profitability, this began to decline in 2016. As such, by 2023 gross profitability was lower than that in 2014.

Acquisitions may have driven topline growth, but there was no profit growth or improvements in capital efficiency.

Given the profit trends, we see similar declining return trends, Refer to the right part of Chart 2. Over the past decade,

• ROIC declined from its 2016 peak of 19% to currently 13% with an average of 15%.
• ROE declined from its 2017 high of 41% to 16% in 2023 with an average of 24%.

Notwithstanding the declining returns, the average ROIC and ROE were higher than the current 9% WACC and 10% cost of equity. In other words, the company created shareholders’ value.

To dig deeper into the profit trends, I broke down the operating profits into various components. Refer to the left part of Chart 3. I also carried out a DuPont analysis of the ROIC, as shown in the right part of Chart 3.

The contribution margin trend seemed to have the same pattern as that for gross profitability. This meant that there was no improvement in productivity or operating efficiency.

This is also a company with high operating leverage. Over the past decade, fixed costs accounted for about 40% of the total cost (fixed + variable). As such, a small change in revenue will have a big impact on profits.

The DuPont analysis supported my view that there was no improvement in operating efficiency.

• Operating margin and asset turnover were flat over the past decade.
• The declining ROIC was attributed to declining leverage. This was the result of relatively more invested capital than total assets as the company grew. Again, this is not a good sign of capital efficiency.

Note to Op Profit Profile. I broke down the operating profits into fixed costs and variable costs.

• Fixed cost = SGA, Depreciation & Amortization and Others.
• Variable cost = Cost of Sales – Depreciation & Amortization.
• Contribution = Revenue – Variable Cost.
• Contribution margin = Contribution/Revenue.

Growth

From 2014 to 2023, revenue grew at 2.4% CAGR. As can be seen from Chart 2, there was a significant jump in 2021. This is because the company incurred about USD 2.1 billion for cash acquisitions that led to 9% acquisition growth.

Based on the data provided by the company on its annual acquisition growth, I estimated that over the past decade, revenue growth due to acquisitions was 2.7% CAGR. This was higher than the total revenue growth of 2.4% CAGR.

This was because there was a decline in organic growth and forex losses in certain years. If nothing else, it suggests that the company is operating in a mature sector. This is in line with the following market research reports.

“…The global paints and coatings market… is expected to grow at a CAGR of 5.1% during the forecast period of 2023 – 2033.” World Pipelines

“The Paints and Coatings Market size is...growing at a CAGR of 4.09% during the forecast period (2024-2029).” Mordor Intelligence

Reinvestments

Growth needs to be funded and one metric for this is the Reinvestment. This is defined as CAPEX & Acquisitions – Depreciation & Amortization + Increase in Net Working Capital

From 2014 to 2023, PPG’s Reinvestment amounted to USD 4.4 billion. This would be reduced to USD 0.2 billion without the acquisitions.

To compare the Reinvestment with the NOPAT, I use the Reinvestment rate that is defined as Reinvestment/NOPAT. This was 32% with acquisitions and 2% without acquisitions.

There is another perspective of growth from the fundamental growth equation.

Growth = ROIC X Reinvestment rate = 15% X 32% = 5%.

If I excluded the acquisitions in estimating the Reinvestment rate, the fundamental growth rate would be negligible. This reinforces my point that PPG is not a high-growth company, even with acquisitions.

Financial position

PPG is financially sound based on the following rationales:

It had USD 1.2 billion in cash at the end of Mar 2024, equal to about 6% of its total assets.

It was able to generate positive cash flow from operations every year over the past decade. Over this period, it generated a total of USD 17.0 billion cash flow from operations compared to its total PAT of USD 13.6 billion. Well done for this cash conversion ratio.

It is a cash cow with relatively low CAPEX compared to the cash flow from operations. Refer to Table 1.

As for its capital allocation track record, I would rate it as good. PPG was able to cover the CAPEX and acquisitions with the cash flow from operation. Excess was returned to shareholders as dividends and share buybacks. Refer to Table 1. The Reinvestments (including CAPEX and acquisitions) generated returns that were greater than the cost of funds.

The main negative point was its debt level. As of the end of Mar 2024, it had a debt-capital ratio of 45%. This was higher than the building materials sector ratio of 15% as per the Damodaran Jan 2024 data set.

Summary of findings

What are the key takeaways?

PPG is not a high-growth company in a sector that is not considered a high-growth one globally. It would have to continue with acquisitions if it wants to grow at its historical growth rate.

I would consider its fundamentals as mixed.

• There have not been improving operating and capital efficiencies.
• Although the returns were declining, they were greater than the current cost of funds indicating that PPG created shareholders’ value.
• It is financially sound. It is a cash cow with a good capital allocation plan.

Valuation

PPG's business model is such that acquisition is part of its DNA. The challenge here is that while it has annual acquisitions, the size varies yearly. Once in a couple of years, it undertakes a major acquisition that boosted its revenue by double-digits.

I thus looked at 2 Scenarios when valuing PPG:

• Scenario 1. This assumes a “low-level” continuous acquisition that results in a long-term average growth rate of 3%.
• Scenario 2. I assumed that there would be a sizeable acquisition in year 6 that would boost its revenue by 21.5%. This is similar to the revenue growth in 2021. From year 1 to year 5, the company would just have the “low-level” acquisitions.

Under Scenario 1, I obtained an intrinsic value of USD 29 per share.

Under Scenario 2, I obtained an intrinsic value of USD 141 per share.

The market price of PPG as of 2 June 2024 was USD 131 per share.

There is no margin of safety under Scenario 1. The margin of safety under Scenario 2 was only 7%. This is less than my target 30% margin of safety.

The market is pricing PPG as if there is another major acquisition soon.

Valuation model – Scenario 1

The valuation is based on the single-stage Free Cash Flow to the Firm (FCFF) model where:

Value to the Firm = FCFF X (1 + g) / (WACC – g).

FCFF = EBIT(1- t) X (1 – Reinvestment rate).

EBIT(1-t) was estimated based on the operating profit model, as shown in the left part of Chart 3.

The Reinvestment rate was based on the fundamental growth equation.

In this valuation model, I assumed the base revenue to be the 2023 revenue with a 3% perpetual growth rate. The growth rate was in line with the average growth rate over the past decade.

There are 2 key parameters – contribution margin and capital turnover (revenue/total capital employed). For these 2 parameters, I used the average 2022 and 2023 values to account for the changes following the 2021 major acquisition.

Details are shown in Table 2.

The WACC was based on the first page results of the Google search for “PPG WACC” as shown in Table 3.

Valuation model – Scenario 2

The valuation model is illustrated in Table 4. It comprises of 2 parts:

• A steady growth rate for the first 5 years. The input for this stage is determined from Table 2.
• An acquisition in year 6. Table 5 details the computation for this stage.

The multi-stage valuation model

This model was used to determine the value of acquisition.

Notes

a) Straight-line reduction.

b) Starting revenue based on 2023. Pegged to the growth rate.

c) Assumed Scenario 1 rate and there is no improvement.

d) Assumed Scenario 1 as a start. Assumed growth at a terminal rate.

e) Revenue X Net Margin and after accounting for Fixed costs.

f) Assumed Scenario 1 rate and there is no improvement.

g) Revenue X (Revenue/TCE) ratio. TCE = total capital employed.

h) Based on the growth equation.

i) FCFF for each year = e X (1-h).

j) Assumed constant D/E ratio. Refer to the WACC table.

k) NPV for each year = (i X j).

l) Terminal for the year discounted at 3% growth rate.

m) 5 years NPV + terminal value

Risks and limitations

Under Scenario 2, the timing of the major acquisition would impact the estimate of intrinsic value.

I assumed that the major acquisition would be in year 6. This was on the basis that it would take time for the company to “digest” the 2021 acquisitions. This is not an unreasonable assumption, given that before 2021, the last USD 2 billion acquisition was in 2014.

The timing of the acquisition would affect the valuation due to the discounting process. Because of the discount rate (time value of money), the intrinsic value would be smaller the further out in time the major acquisition takes place.

If you assumed that the major acquisition takes place next year, the intrinsic value would be USD 228 per share under Scenario 2. In other words, there would be a sufficient margin of safety.

Conclusion

I would not consider PPG a wonderful company in the Buffett sense. While its financial position is sound, its other fundamentals are nothing to shout about:

• Despite acquisition every year, there was only a 2.4% CAGR in revenue over the past decade.
• Over the past decade, PAT declined. This led to declining returns.
• There was no sign of improving operating or capital efficiencies.

The main positive point is that it is a cash cow with a good capital allocation track record.

The main challenge is that the paints and coatings sector is not a high-growth one. To obtain a double-digit growth rate for a particular year, the company would have to undertake a sizeable acquisition.

Unfortunately, a valuation assuming a major acquisition in year 6 does not provide my target 30% margin of safety. As such, I do not consider this an investment opportunity.

There is only more than a 30% margin of safety if you assume that the company will undergo USD 2 billion acquisitions next year. I do not see this happening.

Hong Chew Eu