Description

Upside/Downside: 4/1 with expected return of 40%.

Business Description and Background:

Akzo Nobel is the largest producer of paint and coatings globally with a #1 market share in Europe, #2 in the US and #2-3 in Asia.  The company also has a leading specialty chemical business serving general industrial, ag, energy, marine and pulp and paper markets.  Akzo Nobel has a market cap of €11 bn and a TEV of €15bn.  The company trades at a 3x discount to peers on P/E and 2x discount to EV/EBITDA.   

Despite having excellent assets, Akzo has been a perennial underperformer (300 bps lower operating income margins) largely due to subpar management execution and poor M&A integration.   Akzo acquired Imperial Chemicals Inc. in 2008 paying >12x EBITDA (significantly overpaid).  The acquisition expanded the decorative paint and chemicals segment by 50%; however the businesses were not well integrated - eg limited site closures, layoffs or bulk buying.  In late 2011 (4 years after the acquisition) the company has finally hired a new (far superior) CEO to restructure the business.  Upon his arrival, the company announced a €500 mm cost savings program (25% of EBITDA).

Investment Thesis:

1. Turnaround: Akzo has industry leading brands but subpar profitability due to poor historical management.  Hans Wijers (the Old CEO) was an empire builder with little operational experience before his time at Akzo (he was a civil servant and management consultant).   Ton Bucher (the new CEO) is a turnaround expert.  Ton is an engineer by trade and has an MBA.  He spent the early part of his career working in a factory building oil and gas infrastructure.  He later made his way to Sulzer (an industrial pumps business) where he worked his way from the factory floor to CEO.   From 2000-2011 Buchner drove revenue growth, cut costs improved free cash flow and returns on capital.  Buchner cut costs, divested non-core assets and drove new product expansion in the emerging markets.  Ton’s recent arrival is a clear turning point in Akzo’s strategy.  Akzo’s margins are significantly below peers due to poor execution.  The €500 million cost savings program is largely complete.  The company continues to resize its manufacturing footprint, renegotiate raw materials contracts for bulk purchasing, downsize unprofitable business lines and increase prices (which they have accomplished over the past 12 months).  As the largest paint manufacture in the world, you might expect economies of scale to drive superior margins to industry peers.  Instead, Akzo is under earning by 300 bps in decorative paints.  Furthermore, Ton has proven he is a wise capital allocator shedding the decorative paints business in the US and well as the Pakistan Specialty Chemicals business and they Building Adhesive business (in aggregate ~1.5bn of asset sales that have been used to delverage the business
2. Trough Volumes:  Volumes in Europe are weak as the housing market has struggled.  The paint market in turn has struggled with EU paint usage down 23% from its peak.   Despite paint volumes being down, Akzo has been able to increase prices (in fact the paint industry has experienced less than 5 quarters over the past 10 years where prices have declined).  While I cannot predict with certainty when the EU housing markets will turn, the EU housing market is showing signs of a rebound with paint volume +7% y-o-y in the latest quarter. My base case assumes volume growth of 5% is incredibly conservative given that 1/3 of revenue comes from high growth markets and that they are currently comping high single digits.  Paint gross margins are in the 40%+ range and coupled with SG&A take outs outlined above the incremental drop through on volume should be in the 40-50% range.  The Performance and Specialty Chemicals have historically been much bettermanaged.  They company is deploying capital to high growth markets (Indonesia, Turkey, Brazil) which should drive incremental growth in excess of EU GDP.  The street is miss modeling the incremental margins as they assume a linear recovery when in fact the volume will cause a step function change from a trough (pre incidental) EBITDA margin in 2013 of 12.2% to >14% in 2015. This will drive an EBITDA increase of 30% and earnings per share growth of ~70%.

Industry:

Paint is a strong business with significant pricing power as the cost of a paint job is 90% labor and 10% paints/coatings (high value for low price).  The paint market is bifurcated to “Do-It-Yourself” (DIY) and contractor.  In the case of the DIY buyer this is a one-time expense and the customer is not highly price sensitive. The contractors are able to push paint price increases through to the end customer.  The quality of the paint is more important to the end customer as they do not want to pay for a second paint job down the road as the labor costs will be very high. 

The relative pricing power is impacted by the distribution channel's used (owned retail has the strongest pricing, independent retailers next and big box retailers lowest).  Akzo's distribution is strong in Europe and Asia and weak in the US.  While Sherwin Williams and Benjamin Moore have concentrated retail foot prints that allow them to gain local economies of scale in distribution and good pricing (as there is no middle man), Akzo mostly distributes through 3^rd parties (only 300 stores in the US that are not concentrated) which has caused them to be lag the market.  In fact, Akzo was the bad actor and traditionally undercut the market on price in the US, however their strategy recently changed as Akzo pushed through a price increase in 2011.  This was a critical sign to the industry who all followed suit.  Despite ~€700 mm of revenue and a #2 market share, the US has traditionally been a loss maker for Akzo (€50 million loss in 2011).  Buchner’s turnaround plan will change this significantly as the company cuts costs, improves distribution and maintains/grows prices.  In Europe, Akzo has a much stronger distribution channel with in Asia and is building its own retail footprint in Asia.

Volumes in the paint industry are linked to new home sales, commercial building and renovation spending.   As mentioned above, paint volumes in the EU are down 23%.  Eurostat publishes this data monthly which allows you to track inter quarter swings.  The latest data suggests EU volumes have turned.  In Asia, Akzo continues to take share and volumes continue to increase. 1/3 of Akzo's businesses exposed to faster growing emerging markets.

Valuation:  Akzo trades at a 20-30% discount to peers on P/E and EV/EBITDA as the company has been an underperformer since its ICI acquisition.  While Sherwin, Valspar and PPG have all seen significant stock returns over the past decade, Akzo has largely been flat.  I believe that the turnaround will close the gap and that sentiment will improve as margins expand and earnings continue to grow.  To that end I apply a 16x multiple to my 2015 P/E to get to a base case price target of €75 or +40% with the dividend.  This implies an EV/EBITDA of 6.8x 2015E EBITDA.  The 16x is a discount to the best in class peer Sherwin Williams and PPG that trade at 17/18x.  One could argue that Akzo (once turned around) should have better margins and pricing power as it is the largest paint producer in the world and will have significant economies of scale, but I have not assumed this in the base case.

Cases:

Base Case: I have assumed that pricing is flat and volumes at 5% a year through 2015 in decorative paints.  For Performance Coatings and Specialty Chemicals I have assumed price flat and volume growth of 5%.  I assume incremental margins of 37.5% which is below where management is guiding (40-45%).  I have assumed incremental cost savings will compensate for inflation.  This implies earnings of €4.70, a stock price of €73 (+ the dividend) or 21% higher than consensus.

Bull Case: I have assumed volumes at +7% a year through 2015 in decorative paints.  For Performance Coatings and Specialty Chemicals I have assumed volume growth of 7%.  I assume incremental margins of 40%. I have also assumed cost savings initiatives offset inflation.  This implies earnings of €5.24, or 35% higher than consensus.  I use a 17x “best in class” multiple, implying a price of €89 for upside of 63%.  

Bear Case: I have assumed that flat pricing and volumes at -2% a year through 2015 I assume decremental margins of 30% I have also assumed $50m of inflation in excess of cost savings initiatives.  This implies earnings of €2.70, or 30% below consensus.  I use a 14x multiple (a 20% discount to current comps) which implies a downside of 16%.    

Risks:

The four major risks to the thesis are as follows:

1. Management is not able to execute a turnaround and improve the cost structure.  I think this is unlikely as I have spent a significant time going diligence on the cost plan as well as Ton Buchner’s track record. This is easily traceable as the company updates its progress quarterly.  Primary research on paint peers also suggest that Akzo has a significant runway to improve operations.
2. Raw Materials prices rise in excess of pricing power.  I have spent extensive time researching the TiO2 supply chain and it is clear that pricing is cracking as Chinese competition and excess inventories are now forcing pigment producers to throttle back production (see KRO and TROX earnings calls) in turn causing the ore makers to throttle back production (see ILU earnings calls).  Even if TiO2 prices do not recede, the company has significant pricing power (albeit at a lag).  Energy and petro chemical costs will be driven by oil/nat gas prices.  This is one area that is tough to handicap and provides a real risk, however the impact is likely temporary as the company will be able to pass through pricing over time.
3. EU housing double dips.  This is highly traceable.  Eurostat data suggests volumes are rebounding.  Akzo is largely insulated from the PIGs with the majority of their business in the UK, Netherlands and Germany. 
4. Price war.  This is unlikely as Sherwin has historically been a price leader and Valspar and PPG have followed.  Akzo was the bad actor but recent price increases suggest they have found religion. 

Catalyst

Earnings announcements:  The company will continue to beat expectations as they strive for their long-term guidance .  Cost savings plans will continue to improve earnings power, FCF and returns on capital.  Pension expenses will decline as the company has now made significant top up payments which will allow them to increase the dividend (3%+).

Early 2014 Capital Markets Day:  This will be the first time that the new heads of the business divisions addresses the buy and sell side.  They will provide an update on restructuring plans and I believe there is significant potential for them to pull forward the timing and increase the size of the plan.

EU volumes continue to rebound...this is the Key Investment Factor and should be watched closely