PPG's Horror Quarter Reveals The Nightmare Scenario For Q3 Earnings

Over the weekend, in his preview of Q3 earnings season, Goldman's chief equity strategist said that whereas company earnings will most likely be stellar for yet another quarter, with 3Q EPS for the S&P500 growing by 21% Y/Y, what investors should focus on is company guidance about Q4 and the longer term especially as pertains to profit margins, with Goldman laying out three key risk factors: 1) tariffs, 2) wage inflation, and 3) interest rates.

Just 24 hours later, on Monday afternoon Pittsburgh-based coatings giant PPG provided a case study in just how prescient Kostin's warning was by not only reporting a kitchen sink quarter, citing every concern investors have about the macro environment, but also cutting its earnings forecast for the third and fourth quarters of this year. The company weakness was widespread, and touched on all three aspects highlighted by Kostin.

"In the third quarter we continued to experience significant raw material and elevating logistics cost inflation, including the effects from higher epoxy resin and increasing oil prices,” PPG CEO Michael McGarry said in a press release on Monday after the close.

"These inflationary impacts increased during the quarter and, as a result, we experienced the highest level of cost inflation since the cycle began two years ago. Also, during the quarter, we saw overall demand in China soften, and we experienced weaker automotive refinish sales as several of our U.S. and European customers are carrying high inventory levels due to lower end-use market demand."

"Finally, the impact from weakening foreign currencies, primarily in emerging regions, has resulted in a year-over-year decrease in income of about $15 million. This lower demand, coupled with the currency effects, was impactful to our year-over-year earnings and is expected to continue for the balance of the year."

In other words between rising costs, slowing Chinese demand, higher inventories, and a strong dollar eating away at foreign sales, and suddenly what was the bedrock of US corporate stability is looking extremely shaky. And, as Yahoo Finance notes, "sometimes companies will flag one or two or these as weighing on business, but PPG’s third quarter was hampered by all four."

More importantly, PPG is hardly the only company dealing with these stresses. Expect many more to cite precisely the same litany of concerns in the coming weeks.

In any case, as a result of this wholesale disaster, PPG now expects to earn adj EPS $1.47-$1.51 in Q3, below consensus estimates of $1.59, and a sharp drop from the $1.90 the company reported in Q2. Q3 Revenue is forecast to be $3.8 billion, the same as a year ago and down from $4.1 billion in the second quarter.

But it was the guidance - as Goldman warned - that sent the stock crashing after hours: PPG now expects Q4 EPS to collapse to just $1.03-$1.13, nearly 30% below consensus estimates of $1.32.

"We are disappointed with the third quarter earnings results," McGarry said, and it is safe to say he won't be too proud of the fourth quarter either. "We continue to work proactively with our customers on higher selling prices to reflect the value of the products we sell and recover margins which have been negatively impacted by the raw material inflationary environment in all of our businesses. We will continue to aggressively manage our costs including accelerating restructuring activities wherever possible.”

Meanwhile, contrary to Fed presidents noting just how easy it is, in theory, for companies to pass through prices, in PPG's diametrically opposing reality it was forced to work "proactively with its customers on higher selling prices to recover margins." Hardly the stuff that keeps inflationary pressures at bay.

What is also notable is how unforgiving the market has become to both (soft) earnings beats, and certainly misses (coupled with a guidance cut). As Bank of America calculates, among the companies reporting results over the last few weeks have seen investors punish poor quarters, with the average one-day stock reaction to results coming in at -1.2%. For companies that miss expectations, the average reaction in the second half of September was a drop of 3.5%. With PPG, which is down 9% on the news, the trend is certainly holding.

Finally, if it took just one day for Goldman's ominous profit margin observation to be validated in practice, and with the market already having long priced in stellar Q3 earnings, peak earnings expectations may already have been reached, especially as many more companies will take advantage of what may be the last strong quarter to kitchen sink guidance in hopes of receiving a more lenient sentence by the market.