Omicron is starting to bite, and investors should brace themselves for a slew of near-term lousy news during the current earnings season. That's the initial conclusion from what management at paint and coatings companies PPG(NYSE: PPG), Sherwin-Williams(NYSE: SHW), and Axalta Coating Systems(NYSE: AXTA) are saying. Does that mean investors should dump the stocks or look to buy? Here's the lowdown.
Axalta and Sherwin-Williams
Axalta and Sherwin-Williams have already given preliminary fourth-quarter headline numbers, and PPG has reported full results. Unfortunately, it's not great news. Starting with the preliminary announcements, Sherwin-Williams met its sales guidance for Q4. However, overall earnings were weaker than expected due to a sales and earnings shortfall in its core Americas Group segment. It came down to a combination of a lack of raw material availability, supply chain issues, and labor challenges due to the omicron variant.
Image source: Getty Images
It's a similar story at Axalta Coating Systems, with management noting in a January 2022 news release: "Since Axalta's October guidance update, raw material inflation and logistics costs have continued to increase while the U.S. dollar has also continued to strengthen above our guidance expectations. Axalta now expects Q4 raw material inflation of approximately 24% versus the prior year compared with the assumption of approximately 20%."
PPG's earnings
These issues were confirmed in PPG's earnings report. PPG's Q4 sales rose 11.5% year over year and exceeded its previous guidance. However, its cost of sales rose a whopping 25.8% in the quarter, driven by a multitude of issues in connection with the pandemic. During the earnings call, management noted that its higher-than-expected sales and price increases failed to offset:
- Raw material price inflation (up 30% year over year in the quarter).
- Supply chain disruptions.
- Labor shortages due to COVID cases with its employee base.
- Elevated transportation costs due to shortages of trucks and drivers caused by the pandemic.
As you can see below, the increase in the cost of sales in the quarter is the key reason why pre-tax income declined in the quarter.
PPG Results | Fourth Quarter 2021 | Fourth Quarter 2020 | Change |
|---|---|---|---|
Net Sales | $4,190 million | $3,757 million | 11.5% |
Cost of sales, exclusive of depreciation and amortization | $2,692 million | $2,140 million | 25.8% |
Gross margin | 64.2% | 57% | 720 basis points |
Selling, general, and administrative costs | $984 million | $882 million | 11.6% |
Operating margin | 23.5% | 23.5% | flat |
Pre-tax income | $282 million | $345 million | (18.3%) |
Pre-Tax margin | 6.7% | 9.2% | (250 basis points) |
Data source: PPG presentations. 100 basis points equal 1%.
Unfortunately, conditions aren't expected to improve that much in the first quarter, with CEO Michael McGarry noting on the earnings call, "we're not seeing a whole lot of difference between what we experienced in the fourth quarter." As such, PPG is modeling 25% to 30% raw material price inflation. Throw in the ongoing uncertainty around omicron, and it all adds up to a challenging trading environment.
Given that many of these issues apply outside the paintings and coatings industry, it makes sense for all investors to brace themselves for some potentially bad news in the upcoming earnings season.
Three reasons why it will get better
That said, there's reason to believe that these coatings companies are close to the bottom in their fortunes.
First, end-demand trends are strong and are likely to remain so. As noted earlier, PPG's sales were ahead of its expectations in Q4. Moreover, management said they would have been even higher without supply chain disruptions. In addition, PPG has a growth opportunity from a recovery in its automotive original equipment manufacturer (OEM), aerospace, and automotive refinish end markets. Together those end markets make up 40% of PPG's sales, which are still 15% below pre-pandemic levels.
As the semiconductor shortage eases, the aviation recovery continues, and miles driven in the economy improves, all three end markets should grow. As a result, it's a key investment theme for 2022.
Image source: Getty Images.
Second, PPG is already taking pricing action, and McGarry is modeling price to "equal raw material inflation in Q1." It's something that encourages McGarry to outline that "every quarter from this point out, we should start to see improvement in the margins."
Third, raw material prices appear to be moderating. CFO Vincent Morales told investors that raw materials make up around 60% to 70% of its cost of goods, with logistics costs making "mid to high-single digits" of sales (low double digits of its cost of goods). However you look at it, the key is raw materials costs. While they are expected to remain elevated in the near future, McGarry said, "we're anticipating raw materials are flattening out right now."
Stocks to buy now
If you can close your eyes and ears to some potentially bad news, then PPG and Axalta are attractive stocks. Sherwin-Williams is less so as it has extra exposure to housing, a market that could cool with a slowing in housing starts and rising interest rates. PPG and Axalta both have heavy exposure to the auto OEM and refinish markets, and they should strengthen in 2022.
If the supply chain issues ease and raw material costs moderate (the two issues are strongly linked) as the world gets back to work, it will drop into meaningful margin expansion coupled with ongoing strength in sales. So there's a near-term risk, but PPG and Axalta remain attractive stocks for long-term investors.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends Sherwin-Williams. The Motley Fool has a disclosure policy.
