On October 9th, Trian Partners filed an amended 13F which disclosed their newest investment, PPG Industries (PPG). Along with Sherwin-Williams (SHW) and AkzoNobel, PPG is one of the world’s largest coating companies.
The shares have underperformed and traded sideways over the last five years and the valuation has compressed. Recently, investors appear to be concerned with rising raw material costs and a peaking economic environment. In fact, PPG pre-announced a profit warning for the third quarter where they expect earnings to come in below expectations due to significant raw material inflation and weaker than expected demand in China.
However, the coatings industry is generally regarded as an attractive one that benefits from close customer relationships and low capital intensity which results in a mid-teens return on capital.
Trian has historically looked for companies that have unique characteristics (orphan businesses, conglomerate structures, underperforming operations, etc) where they can come in and be the catalyst for change.
In general, the standard activist playbook can involve a few different actions:
- Focusing business through spin-offs, carve-outs, or asset sales
- Improving underperforming operations
- Allocating capital away from lower return activities towards higher return opportunities
- Improving Corporate Governance
Activist Playbook Option #1: Focusing the Business
Over the past 10 – 15 years, PPG has undergone a significant business transformation. Historically, they were a conglomerate with many different business lines including coatings, optical, commodity chemicals, and glass.
Source: Company Filings
Today the company is a pure-play paints and coatings business serving key end markets through their two segments, Performance Coatings and Industrial Coatings.
Source: Company Filings
The Performance Coatings business serves end markets such as automotive refinish, aerospace, protective & marine, and architectural. On the other hand, Industrial Coatings serves end markets such as automotive OEM, industrial, packaging, and specialty.
Source: Company Filings
Since the entire business is now focused on coatings and not a conglomerate, there is not an obvious divestiture or spin-off within the portfolio to make PPG a pure-play company (more on this topic in Trian’s Potential Investment Thesis Section).
Activist Playbook Option #2: Improving the Underperforming Operations
Activist investors look for companies with margins, working capital, or sales growth well below peer levels. However, when comparing PPG to their competitors on these metrics, nothing stands out. In fact, PPG compares very well to the other public companies in the industry.
PPG generates margins above many companies in their peer group and appears to efficiently manage their capital spend and invested capital. As a matter of fact, they look to be one of the best run companies from an operating perspective because they generate some of the highest margins while also turning their capital over at a similar rate as industry peers. This combination results in an attractive return on tangible invested capital.
Therefore, Trian’s investment case is probably not predicated on PPG’s operations substantially improving.
Activist Playbook Option #3: Capital Allocation
Historically PPG has had a balanced capital allocation framework. They have deployed cash into capex, M&A, dividends (uninterrupted since 1899 and 46 consecutive years of increases), and share repurchases.
Source: Company Filings
Trian could push for them to buy back more stock through a levered recapitalization, but with the balance sheet already levered at ~2.0x gross debt/EBITDA, the company does not appear to be significantly underlevered so this probably isn’t an option.
In short, there doesn’t seem to be anything egregious with the way PPG has historically allocated capital.
Activist Playbook Option #4: Improving Corporate Governance
Another way activist investors can create value is through improving corporate governance. This includes getting fresh members on the board with relevant expertise, revamping the executive compensation program, implementing minimum stock ownership requirements, declassifying the board, and separating the Chairman and CEO roles.
In order to quickly get a sense of the quality of the corporate governance, you can look at the ISS Governance QualityScore put out by Institutional Shareholder Services, a leading proxy advisory firm. Scores range from 1 to 10 with 10 indicating higher governance risk.
PPG’s scores poorly with a score of 9. For the individual pillar scores, PPG receives a 5 for Audit, 9 for Board, 9 for Shareholder Rights, and 3 for Compensation. Investors need to be careful when looking at these scores because some well-regarded companies, such as Berkshire Hathaway, score poorly as well.
The board is comprised of 11 members, each bringing their own expertise. However, it looks like it could use a refresh. Five of the members have been on the board for 13 years or longer with Michele Hooper serving since 1995. Two other key factors stand out as well:
- The board is classified with directors serving in three-year terms before standing for reelection. This should be relatively easy to fix because the board has actually put forward proposals in the past to declassify itself, but it hasn’t passed because there was an insufficient number of votes to approve it (requires the affirmative vote of at least 80% of the shares outstanding to approve a proposal to amend the Articles of Incorporation). With a more engaged shareholder base, this proposal should pass.
- The Chairman and CEO roles are both filled by Michael McGarry. While most research indicates that a separation of these roles is not an indicator of company performance, it is still considered best practice by many investors and governance experts.
Shareholders appear to be happy with the executive compensation plan as the 2017 say-on-pay vote passed with 95% of shareholder votes cast in favor.
Annual incentive compensation for PPG executive officers is based on adjusted consolidated pre-tax income from continuing operations and personal goals with the performance payout component based on adjusted EPS (weighted at 70%), adjusted cash flow from operating activities (weighted at 20%), and sales/volume growth (weighted at 10%).
The long-term incentive awards are made up of options, total shareholder return shares (TSR shares), and performance based restricted stock units (PBRSUs).
- Options are granted to executives
- TSR shares are granted based on total shareholder return (PPG TSR relative to the S&P 500) over a three-year period
- Performance based RSU payouts are based on 10% growth in adjusted EPS and 12% cash flow return on capital.
While it would be great to see more of the executive compensation tied to metrics directly within an executives’ control, the executive compensation plan appears to be fine.
Minimum Ownership Guidelines
Non-employee directors are required to own stock with a value of at least five times the portion of the annual retainer paid in cash ($135,000 x 5 = $675,000).
Minimum ownership guidelines for named executive officers:
- CEO: 6x base salary (~$7.3 million)
- Other executive officers: 3x base salary
- Other officers: 1 -2x base salary
The Chairman and CEO, Michael McGarry, owns ~230,000 shares or ~$23 million worth of stock.
These ownership guidelines fall in-line with other Fortune 500 companies.
While there are some areas Trian could improve (refreshing and declassifying the board, separating Chairman and CEO roles, and revamping the executive compensation program), nothing stands out as utterly bad at PPG.
Trian’s Potential Investment Thesis
As discussed above, there doesn’t appear to be a whole lot for Trian to do from an operations or corporate governance perspective. The only two areas Train could push for major change is in its capital allocation policies and managing PPG’s portfolio of businesses (get larger and/or split-up).
The overall paints and coatings industry remains relatively fragmented with the largest players, including Sherwin-Williams, PPG, and AkzoNobel, making up just over 25% of the industry.
Source: Company Filings
There has been a long-term trend towards consolidation with each of the big guys consistently making acquisitions each year. The most recent large deal in the industry was Sherwin-Williams acquisition of Valspar that closed in the summer of 2017. They paid a multiple of over 14x EV/EBITDA for the business or over 20x earnings.
This consolidation trend has been going on for a long time with each of PPG, Akzo, and Sherwin making acquisitions. In general, coatings companies tend to be acquired for at least 10x EV/EBITDA.
PPG has done some major acquisitions in the past: SigmaKalon in 2008, AkzoNobel North America in 2013, and Comex in 2014-2015. However, the biggest deal PPG tried to make is the one that got away. In 2017, they offered to acquire all of Akzo for over $29 billion. They ultimately failed to get the deal done as Akzo rebuffered their proposal despite Akzo’s large activist shareholder, Elliott Management, urging them to negotiate with PPG.
Trian could come in and help PPG navigate the countless cultural differences involved with acquiring a Netherlands based company in order to get the deal done. PPG believes a combination with Akzo offers substantial operational synergies (“at least” $750 million) from raw material purchasing, supply chain management, and distribution optimization. Also, PPG already has experience in acquiring assets from Akzo. In 2013, they acquired Akzo’s North American Architectural Coatings business for $1.05 billion.
Trian could be thinking that a PPG/Akzo combination at the right price and with cheap financing is a very compelling investment opportunity.
Splitting Up PPG
As discussed above, PPG is comprised of two main segments: Performance Coatings and Industrial Coatings. While their businesses are coatings focused, each of their subsegments have different cost structures, go to market through different channel partners, serve vastly different customers, are exposed to different economic drivers, and have different capital deployment opportunities (fragmented vs consolidated industries).
Trian could see an opportunity to spin-off some of the smaller, more niche businesses into a separate company. This company would then have an opportunity to roll-up smaller coatings businesses while keeping the larger businesses that have more consolidated industries under the PPG umbrella.
As you can see in PPG’s segment reporting (table below), they have been deploying a lot more capital (capex + M&A) into the Industrial Coatings business relative to the Performance Coatings business over the last three years (~$1.25 billion vs $709 million).
Therefore, Trian could see an opportunity to push management to separate off some of the smaller, faster growing Industrial and Specialty businesses. This smaller, niche-focused spin-off company could be an attractive investment as the acquired businesses would have a larger impact on a smaller company, similar to the strategy executed by RPM International over the years.
This could be a somewhat similar opportunity as Trian’s investment in Pentair.
“Trian also believed that there was meaningful opportunity to enhance shareholder value by working closely with Pentair’s management to drive growth both organically and by considering various strategic alternatives, including acquisitions and the separation of Pentair’s water and electrical businesses.”
The obvious downside of a spin-off would be the lost synergies, such as raw material purchasing power, from being part of the sprawling PPG complex. However, it appears that the cost structure within PPG’s businesses is different. For instance, the cost structure for the average Architectural coatings product uses much more titanium dioxide and costs a lot more to distribute (sold in one-gallon paint cans and five-gallon buckets through company owned-stores, retailers, and independent distributors). On the other hand, the average Industrial coatings product uses much less titanium dioxide, but much more resin/latex and solvents/pigments. Also, the distribution costs are much lower (sold in 2,000 liter totes).
Source: Company Presentation
Since the cost structure, customers, and channel partners are different between PPG’s businesses, the dis-synergies from a spin-off or carve-out could be limited.
Even though Trian describes themselves as a highly engaged shareholder and not an activist investor, PPG doesn’t quite fit into any of these areas where Trian has historically pushed for improvement at companies. PPG is not a poorly run company with underperforming operations and egregious corporate governance issues nor have there been gross misallocations of capital.
Rather, Trian’s investment thesis could be predicated on making some improvements to corporate governance, but really focusing on PPG’s portfolio of businesses. They could push for PPG to make an accretive acquisition of Akzo Nobel and/or spin-off or carve-out some of the more unique, faster growing, specialty coatings businesses into a smaller company that could then roll-up fragmented coatings niches.
If Trian were to try to get on the board, it looks like they already have one member who could vouch for them in Michael Lamach. He has been the Chairman, President, and CEO of Ingersoll-Rand (IR) since 2010. Ingersoll-Rand is a former Trian investment where they helped facilitate the spin-off of Allegion (ALLE) in 2013.