PPG Industries, Inc. — Q3 2018 Form 10-Q Summary
Business context and reporting period
PPG is a multinational coatings and specialty materials manufacturer operating through two reportable segments: Performance Coatings and Industrial Coatings. The filing covers the three and nine months ended September 30, 2018. Comparative 2017 amounts were restated following an investigation into accounting errors and improper period classification.
Financial performance and position
| Metric | Q3 2018 | Q3 2017 | 9M 2018 | 9M 2017 |
|---|---|---|---|---|
| Net sales | $3,817 million | $3,776 million | $11,729 million | $11,066 million |
| Income from continuing operations attributable to PPG | $368 million | $393 million | $1,067 million | $1,221 million |
| Diluted EPS from continuing operations | $1.51 | $1.52 | $4.32 | $4.72 |
| Net income attributable to PPG | $378 million | $610 million | $1,083 million | $1,443 million |
| Diluted EPS, total | $1.55 | $2.36 | $4.38 | $5.58 |
| Operating cash flow from continuing operations | Not separately provided for the quarter | Not separately provided for the quarter | $687 million | $1,018 million |
Q3 net sales increased 1.1%, driven by higher selling prices and acquired-business sales, partly offset by unfavorable foreign exchange. Cost of sales increased 7.1% to $2,253 million, or 59.0% of sales versus 55.7% in the prior-year quarter. SG&A decreased 3.0% to $867 million, or 22.7% of sales versus 23.7%.
Q3 income before taxes was $451 million and the effective tax rate was 17.5%, compared with 23.7% in the prior-year quarter. Management reported an adjusted Q3 effective tax rate of 20.5% and adjusted diluted EPS from continuing operations of $1.45, excluding specified unusual items and a $13 million tax benefit related to the Tax Cuts and Jobs Act.
- Performance Coatings sales were $2,289 million, essentially flat year over year; segment income declined 9.3% to $331 million.
- Industrial Coatings sales increased 2.8% to $1,528 million; segment income declined 24.9% to $169 million.
- For the first nine months, consolidated segment income declined 8.2% to $1,670 million, despite 6.0% sales growth.
- Cash and short-term investments totaled approximately $1.2 billion at September 30, 2018, compared with $1.5 billion at December 31, 2017.
- Total debt was approximately $5.0 billion of long-term debt plus $15 million of current debt; the debt-to-capital ratio was 50% versus 43% at year-end 2017.
- PPG issued $1.0 billion of notes in February 2018 and received $992 million of net proceeds.
- PPG paid $338 million of dividends and repurchased $1,313 million of common stock during the first nine months.
- The quarterly dividend increased 7% to $0.48 per share.
Material changes versus the prior comparable period
- Profitability deteriorated as raw-material and logistics inflation more than offset price increases, restructuring savings and volume growth. Nine-month cost of sales rose 11.9% against 6.0% sales growth.
- Q3 continuing-operations EPS declined modestly, while total EPS declined substantially because prior-year discontinued operations included a $343 million pretax gain on the divestiture of the North American fiber glass business.
- Q3 2018 included $10 million of discontinued-operations income, including a $13 million release of divestiture-related accruals, partly offset by a $20 million payment related to transferred pension obligations.
- PPG recorded an $83 million pretax restructuring charge in Q2 2018 and expects approximately $25 million of additional cash costs and $20 million of incremental accelerated depreciation. The program is expected to be substantially complete by Q2 2019.
- Nine-month operating cash flow from continuing operations fell $331 million, primarily because of higher working capital. Operating working capital increased to $2,593 million, or 17.0% of sales, from $2,071 million, or 14.1%, at December 31, 2017.
- PPG repurchased 11.8 million shares during the first nine months and had approximately 20.6 million shares remaining under its repurchase programs at September 30.
Guidance, outlook, risks and unusual items
- Management expects a full-year 2018 adjusted effective tax rate of 23.0% to 24.0%.
- PPG expects 2018 cash deployment for acquisitions and share repurchases of at least $2.4 billion. Total 2018 capital spending is expected to be up to 3.0% of full-year sales.
- Management expects modestly lower sequential Q4 sales because of seasonality, continued pressure from the U.S. architectural coatings customer-assortment change, unfavorable foreign exchange and elevated logistics costs.
- Raw-material inflation is expected to moderate in Q4 but remain elevated; management plans continued price increases and margin-recovery actions.
- Key operating risks include raw-material availability and costs, customer inventory levels, pricing execution, foreign exchange, global and emerging-market demand, acquisition integration, restructuring execution and the potential for weaker automotive, architectural and industrial markets.
- Environmental reserves totaled $249 million at September 30, including $130 million for New Jersey Chrome. Management identified additional reasonably possible but unreserved environmental losses of approximately $100 million to $200 million.
- PPG had approximately 440 open and active asbestos-related claims and reserves of approximately $180 million for asbestos liabilities not channeled to the Pittsburgh Corning trust. The company believes its reserves are adequate, but outcomes remain uncertain.
- Outstanding letters of credit and surety bonds totaled $159 million, and guarantees totaled $14 million.
- PPG disclosed a material weakness in internal control over financial reporting related to its financial close process. Disclosure controls were therefore deemed ineffective as of September 30, 2018. Remediation was underway but had not yet been fully implemented, tested and deemed effective.
- The company cooperated with an SEC investigation into the accounting matters and disclosed a pending putative securities class action concerning alleged misstatements and omissions.
Restatement and accounting matters
PPG restated 2017 annual and quarterly financial statements for errors involving pension expense, vacation pay, compensation, health-care claims, customer rebates, stock-based compensation, environmental reserves, taxes and the classification of continuing versus discontinued operations. For the nine months ended September 30, 2017, restated continuing-operations income decreased by $3 million and diluted continuing-operations EPS decreased by $0.01. The restatement had no net impact on reported cash flows, although certain operating-cash-flow captions changed.
PPG adopted the revenue-recognition standard using the modified retrospective method. The adoption changed the presentation of certain revenue, cost of sales, SG&A and other-income items but did not change pretax income. The company also early adopted guidance permitting reclassification of certain tax effects from accumulated other comprehensive income and transferred $107 million to retained earnings.
Most important facts for investors to verify
- Whether raw-material and logistics inflation is moderating sufficiently to restore segment margins.
- Progress and realized savings from the 2018 and 2016 restructuring programs, including remaining cash costs and workforce reductions.
- Working-capital conversion and whether operating cash flow recovers from the first-half decline.
- Debt-funded capital allocation, including the $2.4 billion 2018 target for acquisitions and share repurchases.
- Completion and effectiveness testing of remediation for the material weakness in financial reporting controls.
- Potential financial effects of the SEC investigation, securities litigation, asbestos claims and environmental contingencies.
- The sustainability of reported earnings excluding discontinued operations, restructuring, accounting-investigation costs, environmental charges and tax benefits.