PPG Industries, Inc. — Form 10-Q Summary
Business context and reporting period
PPG is a multinational coatings and specialty materials manufacturer reporting two segments: Performance Coatings and Industrial Coatings. This filing covers the three months ended March 31, 2018, with comparisons to March 31, 2017. The 2017 comparative amounts were restated.
Key financial metrics
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Net sales | $3,781 million | $3,486 million | +8.5% |
| Income before taxes | $421 million | $446 million | -5.6% |
| Net income attributable to PPG | $334 million | $337 million | -0.9% |
| Net income from continuing operations | $328 million | $331 million | -0.9% |
| Diluted EPS from continuing operations | $1.31 | $1.28 | +2.3% |
| Effective tax rate | 20.7% | 24.7% | Down 4.0 points |
| Cash used in operating activities | $228 million | $1 million | Use increased $227 million |
Sales growth reflected $203 million of favorable foreign-currency translation, higher prices, acquisitions and modestly higher volumes. Cost of sales increased 14.7% to $2,181 million, causing the cost-of-sales ratio to rise to 57.7% from 54.6%. SG&A increased 3.5% to $906 million, but declined to 24.0% of sales from 25.1%.
- Performance Coatings sales increased 7.1% to $2,160 million; segment income decreased 1.8% to $280 million.
- Industrial Coatings sales increased 10.3% to $1,621 million; segment income decreased 13.4% to $239 million, primarily because of raw-material, logistics, wage and overhead inflation.
- Adjusted diluted EPS from continuing operations was $1.36 in 2018 versus $1.34 in 2017, excluding specified charges and discrete tax items.
- Cash and short-term investments totaled approximately $1.4 billion at March 31, 2018. Total debt was approximately $5.2 billion, compared with $4.1 billion at December 31, 2017; the debt-to-capital ratio increased to 49% from 43%.
- PPG issued $1.0 billion of notes in February 2018 and received net proceeds of $992 million. It repurchased $600 million of stock, paid $112 million of dividends and spent $96 million on acquisitions.
Material changes versus the prior comparable period
- Reported pretax income declined despite higher sales, primarily because of raw-material and logistics inflation, environmental remediation charges, and higher operating costs.
- Q1 2017 included a $22 million pretax pension settlement charge; Q1 2018 included $34 million of environmental remediation charges.
- The 2018 effective tax rate benefited from a $15 million reduction in tax expense associated primarily with the release of unrecognized tax benefit reserves.
- Operating cash flow deteriorated substantially because of higher receivables, inventories, taxes paid and other working-capital requirements.
- PPG adopted the new revenue recognition standard using the modified retrospective method. The adoption changed income-statement classifications but did not affect pretax income or opening retained earnings.
Restatement, controls and unusual items
PPG concluded that its 2017 financial statements and quarterly results should no longer be relied upon and restated the March 31, 2017 comparison. Restated Q1 2017 continuing-operations income increased by $3 million, or $0.01 per diluted share. The adjustments related primarily to customer rebates, stock-based compensation, an environmental reserve and related taxes.
An internal investigation identified additional Q1 2018 accounting errors and accrual issues. Corrections reduced Q1 2018 pretax continuing-operations income by $5.7 million relative to the initially released results. The company disclosed a material weakness in internal control over financial reporting involving improper overrides during the financial close process. The former Vice President and Controller was terminated, other personnel were reassigned, and remediation efforts include enhanced segregation of duties, journal-entry controls, expense-accrual procedures, inventory controls, training and internal-audit reviews. Disclosure controls were ineffective as of March 31, 2018.
Guidance, outlook and risks
- Management expected Q2 sales to improve sequentially with normal seasonality, while raw-material costs were expected to remain elevated and pricing actions were planned to recover margins.
- The discontinuation of Olympic paint and stain sales at Lowe’s was expected to reduce U.S. architectural-coatings sales; Lowe’s represented less than $270 million of annual sales. A Home Depot Olympic stain launch was not expected to fully offset the decline.
- On April 23, 2018, PPG approved a restructuring program expected to produce an $80 million to $85 million pretax charge in Q2 2018, additional cash costs of up to $35 million to $40 million and approximately $15 million of accelerated depreciation. The program targets approximately 1,100 position reductions by the end of Q2 2019.
- PPG expected 2018 capital spending of approximately 3% of sales and at least $2.4 billion of acquisition and share-repurchase activity.
- Environmental reserves and contingencies remain significant. The filing reports $276 million of environmental reserves at March 31, 2018 and discloses a further $34 million increase related to New Jersey Chrome and legacy glass and chemical sites that was required to be recorded as of March 31. Reasonably possible unreserved environmental losses were estimated at $100 million to $200 million.
- PPG reported approximately 475 open and active asbestos-related claims and approximately $180 million of reserves for asbestos liabilities not covered by the Pittsburgh Corning trust.
- Other risks include raw-material availability and pricing, foreign exchange, integration of acquisitions, environmental regulation, litigation, tax changes, margin recovery, restructuring execution and further costs or governmental and shareholder actions relating to the restatement.
- The SEC investigation related to the accounting matters was continuing, and a putative securities class action was filed on May 20, 2018.
Most important facts for investors to verify
- Whether management successfully remediates the disclosed material weakness and whether additional control deficiencies or restatements emerge.
- The final effect and timing of the Q2 restructuring charge, cash costs, workforce reductions and expected savings.
- Whether pricing actions offset raw-material, logistics and wage inflation, particularly in Industrial Coatings.
- The sales and margin impact of the Lowe’s assortment change and the effectiveness of the Home Depot distribution expansion.
- The sustainability of operating cash flow given the sharp increase in receivables, inventories and operating working capital.
- The ultimate cost of environmental remediation, asbestos claims and related litigation, including the disclosed unreserved environmental exposure.
- The continuing SEC investigation, securities litigation and any related legal, regulatory or financial consequences.