Many chemical companies, including Huntsman (NYSE:HUN), are trying hard to divest commodity businesses in favor of higher-margin and more consistent specialty or differentiated product lines. With an upcoming transaction with Georgia Gulf (NYSE:GGC) that will see it shed its commodity chlor-alkali business, PPG (NYSE:PPG) is taking another strong step in that direction. Although PPG's strong share in specialty coatings and growth potential in areas such as optical and specialty materials are quite attractive, the stock's strong performance this year seems to discount a lot of this already.
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With Georgia Gulf, Is It Spin or Split?
PPG is divesting its chlor-alkali business in a somewhat complicated reverse Morris trust transaction with Georgia Gulf. For Georgia Gulf, the company will now have an attractive chlor-alkali and vinyls business with better scale to compete with the likes of Dow (NYSE:DOW) or Olin (NYSE:OLN).
For PPG, the deal brings multiple benefits. It allows the company to shed an economically cyclical commodity business and generate some cash proceeds in the process. It also may lead to what is tantamount to a non-cash "stealth" share buyback. PPG may opt to let investors keep their PPG shares and distribute 0.23 GGC shares for each PPG share that an investor holds. Alternatively (and many believe this will be the company's choice), the company can give shareholders the option to keep their PPG shares or tender them for shares in GGC at a 5 to 10% discount. If that's the choice and investors go along with it, then it could lead to a meaningful (perhaps more than 6%) reduction in share count without draining cash.
Coatings Will Drive the Story
PPG's specialty coatings (largely paints and protective coatings) has been the driving force at PPG for a while now, and will continue to be after the GGC transaction. PPG is presently the second-largest global coatings producer, trailing Akzo Nobel (OTC:AKZOY) by a few percentage points, with strong share in architectural markets, auto coatings and specialized coatings used in industrial and aerospace applications.
Certainly, there are growth possibilities in the business as it is today. DuPont's (NYSE:DD) sale of its auto refinishing business to Carlyle (Nasdaq:CG) could help PPG, as independent auto body shops may turn from DuPont as Carlyle will own both an auto paint business and an auto repair chain (Service King). Elsewhere, the company could grow its share of the beverage and food can lining/coating market as the industry continues to grow in Asia and transition away from BPA in the U.S.
I would be surprised if PPG didn't also look to grow through acquisitions, particularly in emerging markets. Companies like India's Berger Paints, Jordan's National Paints, Slovenia's Helios or Turkey's Betek could be worthwhile considerations, as well as numerous companies in China and Southeast Asia.
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Will PPG Put More Capital to Work in Other Areas?
PPG still has an architectural and automotive glass business (the company's original name was "Pittsburgh Plate Glass"), but the optical and specialty materials is a more interesting opportunity in my mind.
In additional to Teslin (a proprietary substrate for cards, tags, labels and the like) and a line of silicas, PPG has the Transitions line of contact lenses - a product that reportedly holds about 20% of the North American lens market (and 75% to 80% of the photochromic lens sub-market). I don't think PPG will go all out, say by buying a company like Cooper Companies (NYSE:COO) to offer a wider array of lens products, but there are ample opportunities to develop specialized optical products for end markets such as healthcare and tech.
The Bottom Line
I do like the changes that PPG has made to the business, and I think the company will stand up well against companies like Valspar (NYSE:VAL), Sherwin-Williams (NYSE:SHW), DuPont and Akzo Nobel in its large coatings operations.
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What I don't like so much is the nearly 60% appreciation in the stock over the past year. Today's valuation seems to imply about 8% forward free cash flow growth (even after including the benefits of the Georgia Gulf transaction), and I think that's a little aggressive. Likewise, the company's current EV/EBITDA ratio of nine times is near the upper end of the range even for specialty chemical companies and already discounts a lot of progress. Consequently, I don't think this is an ideal pick for investors looking for market-beating returns over the next few years.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.