PPG Industries, Inc. (PPG) Analyst: Dung Nguyen. Recommendation: HOLD Estimated Fair Value: $95 - $120 * 1. Reasons for the Recommendation

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1 Recommendation: HOLD Estimated Fair Value: $95 - $120 * 1. Reasons for the Recommendation As the global economy starts to recover, it is estimated that the demand for diversified chemicals will be stronger. PPG Industries Inc. is taking advantage of this opportunity by diversifying products, increasing its overseas investments, and investing in R&D to improve existing products and create new ones. Demand for the company s products is expected to be stronger. North America is forecasted to continue to recover with higher industrial activity and modest improvement in construction markets. Additionally, more than 25% of sales come from emerging markets, which helps drive the company s growth while the recovery of many developed economies remain slow. The company is taking advantage of high growth in Asia and Latin America by increasing its production in these regions. PPG has formed a joint venture with Harsha Exito Engineering Private Ltd. of India to make fiberglass. The joint venture's products will be for infrastructure, transportation and wind energy. PPG also acquired Colpisa Colombiana de Pinturas, a Columbian manufacturer and distributor of coatings for automotive original equipment manufacturers and refinish, and architectural coatings. The company's products serve a wide array of customers across industrial, consumer products, transportation, and construction markets and after markets 1. The diversification in product lines enables PPG to supply to a large number of customer segments and lessen the significant impact on the company if something bad happens to any one of the product categories. PPG has invested a significant amount of capital on research and development activities. PPG owns and operates several facilities to conduct research and development relating to new and improved products and processes. PPG also has its process and product research and development work undertaken at its manufacturing plants. Because of this strong focus on research and development activities, PPG can strengthen its new product development and enhance its product line. PPG is expected to have higher earnings through the company s efforts in reducing cost. The company s operating margin was about 10.18% in 2010, 7.32% in 2009 and 8.73% in 2008 while the weighted average for the diversified chemical sub-industry was 8.33%, 5.35% and 5.31%, respectively. The company is taking initiatives to lower raw material costs. These initiatives include reformulation of some products and finding additional suppliers from lower cost regions of the world. Furthermore, by operating a laboratory in China, PPG has a small portion of its research effort funded by the government and PPG will keep pursuing more government funding 2. The company s restructuring plan has shown good results. In 2010, PPG s selling, general and administrative costs as a percentage of sales dropped to 22.0%, which was 2% less than However, I am skeptical of the company s recent decision to buy the European architectural coating manufacturer, Dyrup A/S. According to PPG, the acquisition of Dyrup will enable PPG to continue to expand its geographic reach within Europe, as well as expand its product portfolio. 3 However, the economy in the European areas is recovering slowly and construction markets in Western and Eastern Europe are expected to improve only slightly. Therefore, I also believe that demand for many of the company s products that serve the commercial and residential construction will remain low in Europe because of low activity levels of this market in these regions. Therefore, this acquisition result may not be a good decision. Using multiples analysis, I find that PPG is slightly undervalued. Comparing to firms in the same industry with close growth rate, the forward P/E ratio of PPG is lower than the industry average. Even though PPG 1 PPG K report 2 PPG K report 3 PPG To Acquire Dyrup A/S

2 has the highest growth rate (g) (12.30% in the group having the growth rates range from 10.93% to 12.30%), it has the lowest forward P/E Other firms have lower growth rates but higher P/E such as Sherwin-Williams Company (g = 11.10% and P/E = 15.42) and FMC Corporation (g = 10.94% and P/E = 12.56). Moreover, the forward P/E ratio is currently below the historical average of the past ten years. PPG also has a PEG ratio lower than the industry average. In addition, PPG s P/S ratio has the same value as the median P/S of firms having similar profit margin, and it is a little bit lower than its own historical average for the least ten years. Only P/B is overvalued when comparing to the historical average and fairly valued when comparing to the median P/B of firms having close rate of return on equity. 2. Company Analysis PPG Industries Inc. was founded in 1883 with headquarters incorporated in Pennsylvania. It is a global supplier of paints, coatings, optical products, specialty materials, chemicals, flat glass and fiberglass. The company has 150 manufacturing facilities and equity affiliates in more than 60 countries around the world. It has six business segments: Performance Coatings, Industrial Coatings, Architectural Coatings EMEA (Europe, Middle East and Africa), Optical and Specialty Materials, Commodity Chemicals and Glass. The company generated 31.87% of the total company's revenue in 2010 from the Performance Coatings segment, 27.6% from the Industrial Coatings segment, 13.96% from the Architectural Coatings segment, 8.52% from the Optical and Specialty Materials segment, 10.73% from the Commodity Chemicals segment and 7.33% from Glass segment. Their main competitors in the US are E.I. du Pont de Nemours and Co. (DuPont), Dow Chemical Co, FMC Corp, and Eastman Chemical. These companies have both commodity and specialty chemical products, thus their business strategies usually combine cost reduction and differentiated products. PPG has been a leader in technology innovation. The company has always invested a significant amount of capital in research and development activities to bring new products and new technology to its customers. The company also continues to work on cost reduction. Strengths: PPG minimizes the risks associated with a specific geographical region and cyclical downturn by establishing a global presence and diversifying product lines. The company operates 121 manufacturing facilities in around 41 countries. In addition to the manufacturing facilities, it has research and development centers, sales offices and distribution centers worldwide. Adding to that, with six different segments, the company is serving a wide array of customers, including industrial, consumer products, transportation, and construction markets and after markets. The diversification in product lines enables PPG to supply to a large number of customer segments and offset cyclical downturns in any one of the product categories. Moreover, because of this strong focus on research and development activities, PPG can strengthen its new product development and enhance its product line. Weaknesses: Weak sales in Architectural Coatings could be a setback for future growth and profitability of the company. Furthermore, PPG is involved in a number of lawsuits and claims, both actual and potential. The most significant of them are related to patent, contract, product liability, environmental, antitrust and other related issues. As of December of 2010, PPG had reserves for environmental contingencies totaling $272 million, of which $83 million was classified as current liabilities. The company expects cash outlays for environmental remediation costs to be approximately $80 million in 2011 and to range from $50 million to 70 million annually from 2012 to Opportunities: The economy is expected to keep recovering from the recession. Most emerging markets have returned to prerecession levels. Therefore, the company pursues opportunities to further develop markets in Asia, Eastern Europe and Latin America. In addition to the Indian joint venture and the Columbian coating acquisitions is previously mentioned, in June of 2011, PPG acquired a the business of Ducol Coatings South Africa (PTY) Ltd., which has served as an importer and distributor of PPG s automotive refinish products in South Africa since This acquisition allows PPG to access to a proven distribution network in South Africa and surrounding market where many of the world s largest

3 automotive manufacturers has a presence. Therefore, PPG will be able to capture the future growth of the automotive refinish coatings market in the region. Threats: Any unexpected event, such as supply disruptions, natural disasters, severe weather or terrorism, that affect the availability and therefore the prices of raw material and energy could cause a significant impact on the company. Also, fluctuation of currency exchange rates could have a strong effect on PPG s financial result because PPG has many of its operation outside the US. Moreover, PPG is subject to many existing and evolving environmental regulations. Any change in these regulations could affect the company s ability to buy raw materials or sell certain products to its customers. 3. Industry Analysis PPG is classified as being in materials sector, chemical industry and diversified chemical sub-industry. The Diversified Chemical sub-industry has had an average revenue growth rate of 5.43% annually. The rate was quite stable during the last ten years. Hit hard by the recession in , revenues were reduced significantly in 2009 due to lower demand for the products. Furthermore, chemical companies consume large amounts of oil and natural gas. About 70% of the chemicals industry s energy consumption, mainly petroleum and natural gas, is used as raw materials. The rest is used as power to run manufacturing plants. Therefore, the high price of oil and natural gas played an important role in the decline in the growth of operating income from 2006 to Recently, lower energy prices helped diversified chemical companies reverse the severe cost increases that they had experienced for the previous couple of years. More importantly, the relatively less expensive US natural gas versus the global crude oil prices has improved the competitiveness of US firms. This advantage is going to last over the next several years. The S&P Diversified Chemical Sub-industry Index has a total market capitalization of $100, million 4. There are five major firms making up this sub-industry: E.I. du Pont de Nemours and Co. (DuPont), Dow Chemical Co, PPG Industries Inc, FMC Corp, and Eastman Chemical. Dow Chemical Co. is the largest US chemical company in terms of revenue (almost 50%), and the second largest firm in terms of market capitalization (31.88%). E.I. du Pont de Nemours and Co. (DuPont) is the largest firm in terms of market capitalization (44.60%) and the second largest firm in terms of sales (29.79%). PPG Industries Inc. is the third largest firm which contributes about 12% of market capitalization and revenue to the sub-industry. Consolidation has characterized the specialty chemical industry, especially in the coating segment during the last decade. PPG, as the second largest global producer, with strong cash position (more than $1 billion), is poised to capture additional share as consolidation continues. The main suppliers of diversified chemical companies are oil and gas producers. Therefore, if anything happens that affects supply or demand of these products, it will affect this sub-industry. For PPG, the most significant raw materials in the Coating business are titanium dioxide, solvents and epoxy and other resins. The main materials in Optical and Specialty Materials businesses are lenses, sand and soda ash, and the main materials in Commodity Chemicals business are brine and ethylene. In the Glass business, the main materials are sand, clay and soda ash. Energy cost plays a significant role in PPG s production cost, especially for the Commodity Chemicals and Glass segments. Therefore, changing the price of oil and gas has more impact on these two business lines than the others. The demand for diversified chemicals as well as chemicals in general is strongly dependent on macroeconomic conditions and industrial growth. The largest customers of the chemicals industry are manufacturing, automotive, agriculture, and housing sectors. Thus, strengthening growth of any one of these sectors is good for diversified chemicals. About half of all chemicals are used as raw material in production processes for US manufacturing industries. Automotives is also important to chemical companies. For PPG, its growth in the next couple years will be supplemented by the company position in 4 Bloomberg

4 high-growth businesses and regions, such as aerospace and Asia/Pacific and the resumption of automotive OEM production. Economies in Asia, Middle East, and Latin America are growing faster than in the US and Europe, so demand from chemical markets in these developing countries is also increasing faster. Hence, US chemical companies have increased their overseas investment to take advantage of lower gas and oil price in Middle East. Chemical producers planned to reduce the portion of their new investments from 60.5% in the US in 2006 to just 42.1% in 2011, according to the ACC survey. Most was expected to go to the Middle East, where investment should rise from 2.7% of total capital spending in 2006 to 24.3% in The capacity utilization of this sub-industry is expected to increase slightly over the next 1-5 years. Although the specialty chemicals is less capital intensive than the commodity chemicals, it may require these companies to have many manufacturing or distribution sites to meet their customer requirements. It also requires high technological capacities. Additionally, many companies are not interested in entering this industry because of potentially large safety and environmental liabilities. Specialty chemical customers also usually don t want to change suppliers or alter their raw materials. All of these elements together create a barrier to new competition. * Methodology: The estimated fair value was calculated using the discounted cash flow method, specifically the Free Cash Flow to Equity. The high growth rate and stable growth rate used in these calculations were 7.23% and 6.6%, respectively. These growth rates are nominal rates. The rates take into consideration how much the firm has been reinvesting back into its operations, industry factors as well as global economic conditions. 5 Industry Survey Chemicals

5 Appendix: Multiples Comparable Firms Firms P/E (ttm) Forward P/E PEG ratio P/B P/S EV/ EBIT DA EV/ Sales Growth (%) ROE (%) Profit Margin Operating Margin Georgia Gulf Corporation The Dow Chemical Company Eastman Corning Incorporated E.I. du Pont de Nemour RPM International Inc FMC Akzo Nobel N.V. (ADR) Sherwin-Williams Company N.a The Valspar Corporation PPG Industries, Inc OMNOVA Solutions Inc Southwall Technologies na na Average Median Sources: Google Finance and Yahoo! Finance *growth rates are average growth rates from analysts covering the stock. The growth rate used in the DCF are based on fundamental growth rates. Historical multiples Years Price/Earnings 2011 ttm Historical average PPG S&P Price/Book PPG S&P Price/Sales PPG S&P Source: Morningstar, Inc.