PPG INDUSTRIES INC quarterly report, Q2 FY2018

PPG Industries, Inc. — Form 10-Q Summary

Business context and reporting period

PPG Industries is a global manufacturer of coatings and related specialty products, organized into Performance Coatings and Industrial Coatings. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2018. Comparable 2017 amounts are presented as restated following identified accounting misstatements.

Financial performance and position

Metric	Three months ended June 30, 2018	Three months ended June 30, 2017	Six months ended June 30, 2018	Six months ended June 30, 2017
Net sales	$4,131 million	$3,804 million	$7,912 million	$7,290 million
Income from continuing operations attributable to PPG	$371 million	$497 million	$699 million	$828 million
Diluted EPS from continuing operations	$1.51	$1.92	$2.81	$3.19
Operating cash flow from continuing operations	Not separately provided	Not separately provided	$131 million	$432 million
Capital expenditures	Not separately provided	Not separately provided	$118 million	$135 million

Second-quarter sales increased 8.6%, driven by higher volumes, pricing, favorable currency translation and acquisitions. Six-month sales increased 8.5%.
Second-quarter pretax income was $479 million, compared with $659 million in the restated prior-year period. The effective tax rate was 21.7%, compared with 23.8%.
Cost of sales increased 14.2% in the quarter and represented 57.6% of sales, versus 54.8% previously. Raw-material and logistics inflation materially pressured margins.
Performance Coatings second-quarter sales increased 8.7% to $2,498 million and segment income increased 5.7% to $428 million.
Industrial Coatings sales increased 8.5% to $1,633 million, but segment income declined 15.5% to $223 million because of raw-material and logistics cost inflation.
Cash and short-term investments totaled approximately $1.1 billion at June 30, 2018, compared with $1.5 billion at December 31, 2017.
Cash and cash equivalents were $1,020 million at June 30, 2018, versus $1,436 million at year-end 2017. Receivables and inventories increased materially, contributing to weaker operating cash flow.
Long-term debt was $5,048 million, compared with $4,134 million at December 31, 2017. The total debt-to-capitalization ratio, as defined by the company, increased to 51% from 43%.
PPG issued $1.0 billion of notes in February 2018 and received net proceeds of $992 million. The notes comprise $300 million of 3.2% notes due 2023 and $700 million of 3.75% notes due 2028.
PPG repurchased $1,063 million of common stock and paid $222 million of dividends during the first six months. The company expects 2018 acquisitions and share repurchases of at least $2.4 billion.

Material changes versus the prior comparable period

Reported diluted EPS from continuing operations fell 21.4% in the second quarter and 11.9% for the six-month period. Adjusted diluted EPS, excluding specified unusual items, increased 5.6% in the quarter to $1.90 and 5.8% for the six months to $3.31.
Second-quarter results included an $83 million pretax restructuring charge, $5 million of accelerated depreciation related to restructuring, $10 million of customer-assortment-change costs, $9 million of accounting investigation costs and a $9 million asset impairment.
Six-month results included $34 million of environmental remediation charges and the same restructuring, assortment-change, investigation and impairment items.
Industrial Coatings profitability declined despite higher sales, while Performance Coatings profitability increased modestly.
Operating cash flow from continuing operations declined by $301 million year over year, primarily because of higher working capital. Operating working capital as a percentage of sales increased to 16.3% from 14.1% at December 31, 2017.
PPG adopted the revenue-recognition standard ASC 606 using the modified retrospective method. The adoption changed presentation among sales, cost of sales, SG&A and other income but did not change pretax income for the periods presented.
PPG early adopted guidance permitting reclassification of stranded tax effects from accumulated other comprehensive income to retained earnings, recording a $107 million reclassification.

Restatement, controls and unusual items

PPG restated 2017 annual and quarterly financial statements for customer rebates, expense accrual timing, compensation, health-care claims, discontinued-operations classification, stock-based compensation, environmental reserves and related tax effects.
For the quarter ended June 30, 2017, restatement reduced continuing-operations income by $7 million and diluted EPS from continuing operations by $0.03. For the six months, continuing-operations income was reduced by $4 million and diluted EPS by $0.02.
An internal investigation identified approximately $5.7 million of net pretax errors affecting the March 31, 2018 quarter. PPG incurred $9 million of second-quarter accounting investigation costs.
Management concluded that disclosure controls and procedures were ineffective at June 30, 2018 because of a material weakness in the financial close process. Remediation includes personnel changes, enhanced journal-entry and accrual controls, improved segregation of duties, additional training and targeted internal-audit reviews.
The company terminated its former Vice President and Controller and appointed a permanent Controller on July 19, 2018.

Guidance, outlook and risks

PPG expects a full-year 2018 effective tax rate of 23.0% to 24.0% and capital spending of up to 3.0% of full-year sales.
Management expects additional restructuring-related cash costs of approximately $25 million and incremental noncash accelerated depreciation of approximately $20 million; substantially all actions are expected to be completed by the end of the second quarter of 2019.
The 2016 restructuring program is expected to generate approximately $125 million of annual savings when fully implemented, with at least $60 million expected in 2018. The newer program is expected to generate approximately $85 million of annual savings upon full implementation.
Raw-material and logistics inflation is expected to remain elevated in the third quarter. PPG plans further price increases and margin-recovery actions.
Management expects unfavorable foreign-currency translation in the third quarter, potential lower DIY volumes following a customer assortment change, seasonal automotive production shutdowns and continued uncertainty from global trade policies.
Environmental reserves totaled $259 million at June 30, 2018, including $141 million for New Jersey Chrome. Management identified reasonably possible but unreserved environmental losses of approximately $100 million to $200 million.
PPG had approximately 420 open and active asbestos-related claims and reserves of approximately $180 million for non-channeled asbestos liabilities. The company also had $162 million of letters of credit and surety bonds and $14 million of guarantees.
A putative securities class action was filed in May 2018 concerning alleged disclosures between April 2017 and May 2018. The company is cooperating with an SEC investigation relating to the accounting matters.
Key risks include raw-material availability and pricing, execution of price increases and restructuring savings, foreign exchange, acquisitions, trade and economic conditions, environmental and asbestos liabilities, litigation, tax changes, and the continuing material weakness in internal controls.

Important facts investors should verify

Whether management remediates and independently validates the material weakness in financial close controls.
The scope and potential financial impact of the SEC investigation, shareholder litigation and any additional accounting-control deficiencies.
Whether pricing actions and restructuring savings offset raw-material, logistics, wage and currency pressures.
The sustainability of operating cash flow given elevated receivables, inventories and planned shareholder returns.
Debt reduction plans and the effect of the higher leverage following the February 2018 debt issuance.
Actual environmental, asbestos and other litigation cash payments compared with recorded reserves and reasonably possible exposures.
Whether the Lowe’s assortment change and broader DIY weakness affect architectural coatings sales beyond management’s current expectations.