Stock in paint and coatings company PPG (PPG -0.70%) is up nearly 13% in 2021 as I write, but it's weakened lately on the back of a disappointing set of second-quarter earnings. Wall Street analysts have lowered earnings expectations on the back of the report, and many of the issues management identified in the second quarter (supply chain disruptions and raw material price increases) will be ongoing in the third quarter as well. Is now the time to bail out of the stock or think about buying in on a dip?
PPG, what went wrong?
In a nutshell, PPG got hit by the double whammy of rising raw material prices and supply chain disruptions. Unfortunately, it's going to become a familiar refrain in the current earnings season. It's not that PPG's management, and others, didn't see it coming. Instead, the magnitude of the impacts was much more than had been previously expected.
For example, during the earnings call, CEO Michael McGarry outlined that going into the quarter, he had expected a total impact of $70 million to $90 million from the supply chain disruption and raw material price increases. Instead, it totaled $200 million in the second quarter, and McGarry expects a further $150 million impact in the third quarter.
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Breaking out the impacts, the supply chain disruptions cost PPG $100 million in sales (whereas McGarry had previously expected $40 million). In comparison, the extra raw material costs also came in at $100 million ($30 million to $50 million had been expected previously). As such, PPG's adjusted earnings per share (EPS) was $1.94 in the second quarter compared to guidance for $2.15-$2.20.
Moreover, McGarry guided toward an adjusted EPS of $1.90-$1.95 for the third quarter compared to the market consensus for $2.22. Whichever way you look at it, as things stand now PPG isn't going to be as profitable in 2021 as the market previously thought it would be. In this context, it's not surprising to see the stock sold off.
Temporary issues?
Of course, the question now turns to whether these issues will prove to be temporary or not. If they are, then the dip could be a decent buying opportunity. If not, then there could be more pain to come.
The bulls' case argues that the most significant impact of supply chain disruptions comes from the automotive original equipment manufacturer (OEM) market. The well-documented semiconductor chip shortage has curtailed light vehicle production. McGarry said automotive industry production was 2 million vehicles short of his original expectations in the second quarter and would fall short by a further 1 million vehicles in the third quarter.
While that's not great news, everything points to a robust end demand environment for automotive. Indeed, the CEO of automotive retailer AutoNation, Mike Jackson, said on the company's recent earnings call that he believed demand would stay strong into 2022. As such, everything points to auto production ramping up as the industry works through the semiconductor shortage.
Image source: Getty Images.
As for the raw material price increases, PPG has responded by cutting costs and raising prices such that McGarry believes "we now fully expect to offset raw material cost inflation in the fourth quarter on 2021 on a run-rate basis." In other words, come the fourth quarter PPG should be fully offsetting the raw material price increases.
It looks like PPG will suffer a couple of tough quarters only to lead into the promised land of a ramp up in automotive production and the passing on of raw material costs. Meanwhile, the end demand environment across various industrial and architectural markets that PPG serves with paints and coatings should remain strong.
For example, McGarry referred to "very robust and broad-based demand globally, including in many industrial and OEM end-used markets and strong architectural coatings trade activity in the U.S." Also, he talked of the potential for customers to restock inventories that are running low.
The bears' case
The flip side of the argument is that no one knows where raw material prices will be in the future, and customers may put up resistance to price increases. Moreover, PPG's positive outlook is still dependent on ongoing economic growth, particularly in automotive, construction, general industrial, packaging, and aerospace.
Time to buy?
On balance, I think that the bulls' case is somewhat more robust. After all, the paint and coatings industry continues to consolidate -- PPG finalized three acquisitions in the second quarter alone and five since the end of 2020 -- and it has a history of rising profit margins and generating excellent returns for investors.
Painting and coating is an essential activity for a finished and refinished product, and that should give PPG the pricing power to pass on raw material price rises. At the same time, the supply chain issues will be ironed out by PPG in 2022. As such, the stock remains attractive for investors.
