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Morningstar | PPG Faces Volume, Currency Headwinds in 2Q; Reducing FVE to $85 on Revised Long-Term Outlook

PPG's second-quarter results were uninspiring, with currency headwinds weighing on top- and bottom-line growth. Consolidated sales declined 2.6% year on year to $4.02 billion, while segment profit rose 1.7% thanks to acquisitions and pricing, which slightly widened margins. Besides second-quarter results, we've thoroughly reviewed and revised the core assumptions driving our PPG valuation. After we lowered our second-stage growth forecast and reduced our midcycle margin assumptions for the business, our valuation falls to $85 per share from $98. Our narrow-moat rating is unchanged.

The performance coatings segment sales fell by nearly 3% versus the prior year, driven by falling volumes and currency headwinds as the dollar strengthened. The single biggest operational challenge in the segment remains the lack of sales through Lowe's. This made up the bulk of volume weakness in the quarter. One bright spot was the successful advance of pricing by 2% versus the prior year. Taking all these things together, we expect growth rates to improve over the coming quarters, with margins gradually rising over the next year or two.

Weaker global industrial output led to a fairly significant 5% decline in industrial coatings volumes in the quarter. In combination with currency headwinds, this led to a 2.4% sales decline overall, despite a significant year-over-year benefit from acquisitions. We expect the remainder of 2019 will be challenging, but as currency headwinds subside, growth rates should improve gradually. Successful price increases remain a tailwind that should facilitate wider margins over the next year or more.

The key assumption changes to our downward revision in PPG's fair value estimate were a slower long-term EBI growth rate and narrower mid-cycle profit margins.

PPG's substantial breadth of product offerings and global exposure means the company is unlikely to grow materially faster than the broader economy. We've aligned our second-stage growth rate with our expectation that PPG will only be able to grow organic volumes at roughly 1.5%-2.0% annually, on top of our 2.25% inflation rate. Together, this leads us to expect EBI growth of roughly 4% in the second stage, down from 5.25% previously.

We also believe PPG will struggle to restore profit margins to the levels recently enjoyed across the broader coatings industry. In our view, the recent peak in profit margins was principally driven by a rapid decline in both energy and titanium dioxide prices. It took time before price pressure began to erode these margins, which management teams throughout the coatings space have struggled to recover with little success so far. We believe operating margins will level out at roughly 13% in mid-cycle conditions, whereas our previous forecast was 15%.