Description

THESIS SUMMARY:

• AXTA is a good business with high, sustainable ROIC and a structure for sustained long-term pricing power.

• AXTA is a specialty chemicals company, specifically paint and coatings, with estimated normalized cash ROIC ~14%.

• The company has strong pricing power and a fragmented customer base in 60% of its business, and is tightly integrated into its customers’ operations in the other 40% of its business. As far as we can tell, AXTA has never cut prices in Refinish or Industrial (60%) and has only slightly cut prices in Light Vehicle OEM/Commercial OEM (40%), the latter occurring in the 2008-9 crisis.

• Maintenance capex is approximately just 2% of sales as the business’ capital intensity is low.

• AXTA and its top three competitors have consolidated the auto refinish and light vehicle OEM markets and hold ~70% market share in both markets. AXTA is the #1 or #2 player in each market, indicating substantial brand recognition and trust in the marketplace.

• Switching costs are high across AXTA’s businesses.

• AXTA has a few of the qualities that we typically like as regards misunderstood companies.

• Since it was taken out of the hands of DuPont by Carlyle, the Company has been managed with more urgency and with more direct incentives in place especially with the recent IPO, we see more to come in the years ahead on market share, pricing, and cost.

• The optics of a P/E multiple are misleading for AXTA, with a huge spread between D&A (309m trailing) and Capex (188m and headed lower over time) and a lower cash tax rate than GAAP.

• The question of oil prices and their benefit to AXTA is a highly researchable one, although we believe many if not most investors have missed or underestimated this because the last oil price drop coincided with deep recession and also had an immediate snapback in oil. Meanwhile, AXTA was then a subsidiary of DuPont and it takes some legwork to understand that period.  Finally, management is understandably guarded as they don’t want to invite customer pushback.

• AXTA’s high financial leverage turns many off, but we see the potential for meaningful multi-year EBITDA growth which will make that leverage pay off handsomely for the equity.

• AXTA has been a public company for only four months and is still building an institutional following.  Meanwhile, there is the dreaded overhang of Carlyle shares.

• AXTA is poised to be the beneficiary of the first non-demand-driven oil crash in decades.

• AXTA has a lukewarm rating from the Street and is viewed by many as a slow-growth, market share gain story with a full valuation and FX headwinds. While each of these aspects of the company is true, the dialogue around the effect that AXTA will receive from cheap oil prices and oil derivatives misses the reality of the situation in our view. In fact, AXTA’s business model is positioned to capture significant margin expansion for multiple quarters at least from the crash in oil prices, and we believe it will not be an entirely fleeting benefit.

• AXTA could reap ~$150m in additional 2015 pre-tax profit from the fall in oil prices.

• Our industry research into this topic has been two-pronged: We have evaluated AXTA’s predecessor and comparable coatings companies’ results in previous oil downturns, and we have researched the dynamics of the industry that make AXTA’s oil-related gains sustainable.

• Given that oil-related price drops take up to six months to benefit AXTA and as of March 2015, oil and its derivatives have shown no signs of recovery, we expect that AXTA’s benefits will first show up for Q115 and will extend through at least Q315.  Few consider the possibility that it may last longer in big parts of AXTA’s business.

• We can get close to a double in AXTA stock off of 2017 earnings power.

• AXTA’s 5x net debt/EBITDA ratio makes a valuation on EV/unlevered free cash flow appropriate. We estimate that if AXTA re-rates to a valuation closer to its peer group average/median on this metric, this levered equity stands to rise substantially as the perception of the business and its balance sheet improves.

RISK/REWARD AND VALUATION:

• Our expected case calls for ~45% upside off of 2015, based on a re-rating of AXTA’s current multiple of 16x EV/our estimate of unlevered FCF to a level more comparable with its coatings peers VAL, PPG, RPM and SHW. We assume an EV/UFCF multiple of 20x, which is still below the average and median for this peer group. It is closer to VAL and PPG’s multiples of 21x than to the higher RPM and SHW multiples.

• 70% of AXTA’s sales are outside of the US. The company has told us that for every 1% drop in the euro against the dollar, its adjusted EBITDA suffers by approximately $3m annually.

FULL THESIS:

Axalta was formerly known as DuPont Performance Coatings (DPC). It makes paints and coatings for the following areas:

• Automotive refinish (body shops): 42% of sales

• Industrial (wide variety of industrial coatings applications): 17% of sales

• Light vehicle OEM (BMW, Ford, etc.): 32% of sales

• Commercial vehicle OEM (truck, bus, etc.): 9% of sales

As part of DuPont, DPC was considered a “cash cow.” It generated consistently positive earnings for the parent company except in 2008, when after a large restructuring charge it lost $8m on $4.4bn in sales. From the perspective of employees at DPC, the segment was neglected and starved of capital in favor of other, faster-growing parts of the DuPont portfolio.

In 2013, the Carlyle Group took DPC off of DuPont’s hands. Carlyle saw, and has since taken advantage of, substantial cost-cutting and growth opportunities for AXTA. Trian Partners, an activist fund that has criticized DuPont for poor capital allocation decisions, had this to say about the purchase of DPC by Carlyle in its white paper at

http://www.businesswire.com/news/home/20140917005190/en/Trian-Partners-Delivers-Letter-White-Paper-Summary#.VQbdbvnF_s8 :

“In 2012, DuPont announced the sale of its Coatings business to private equity. At the time, Coatings generated $339 million of EBITDA (earnings before interest, taxes, depreciation and amortization). Today, that same business (now called Axalta) generates $813 million of EBITDA, an improvement of 140% as the private equity owners have reduced unnecessary costs.

In August 2014, Axalta’s private equity owners filed an S-1 to take the company public. The Axalta S-1 discloses that pro forma EBITDA in 2011 was $568 million, $229 million (or 67%) higher than the $339 million originally reported by DuPont in the same year.3 This implies that DuPont burdened the Coatings segment with $229 million of excess corporate costs in 2011 (representing over 5% of Coatings sales at the time).”

Carlyle floated about 20% of AXTA in a Nov 2014 IPO; today it still owns 74% of the equity but is on its way to 59% in the short term.

Near-term earnings dynamics

AXTA gave its first official guidance on its earnings call on March 11, 2015. The adjusted EBITDA guidance for FY2015 was below Street consensus – midpoint of $880m vs expectation of $905m – and the Street revised estimates downward as of that result. The obvious reason for the miss was currency – AXTA called out an expectation for 5-7% constant-currency revenue growth along with better-than-expected cost cuts for 2015, but indicated that the impact of currency would bring sales growth to about 0% for 2015 at then-prevailing exchange rates.

Understandably, AXTA chose not to guide for any benefit to COGS of the drop in oil, as they don’t want to give a “freebie” to OEM customers who are sophisticated enough to listen to AXTA conference calls and follow the commodity indices. Guiding for this windfall would simply signal to OEM customers that it is time to start “knocking on AXTA’s door” to discuss price cuts, as AXTA’s IR described the situation to us. So, we won’t see the oil/related materials benefit start to show up until Q115 results are reported.

Given that we have addressed the likelihood of AXTA’s customers coming to ask for price cuts, why do we continue to insist that the oil benefit to AXTA will be in any way sustainable? Won’t AXTA be required to pass prices through, given that healthy competition exists in the various Coatings markets?

In fact, for most of AXTA’s business, it will almost certainly not be required to pass through any input cost drops, and for the rest of AXTA’s business there is no reason to believe it will have to pass through its entire input cost drop. In fact, both theory and historical precedent show us that AXTA will be able to hold onto the vast majority of its economic benefit from falling oil prices.

So first, the theory. For the purposes of considering AXTA’s pricing power we break the business down into two categories which after considerable debate and the application of our collective half a million dollar investment in an MBA, we named: low pricing power and high pricing power. In the “low pricing power” category we put all of the OEM business, which amounts to ~35% of EBITDA. In the “high pricing power” category we put Refinish and Industrial, which amounts to ~65% of EBITDA.

“Low pricing power” side: On the OEM side, there are elements of strong structural pricing power in AXTA’s niche, but overall Auto OEM’s can be tough customers.

On one hand, AXTA’s relationships with auto OEMs tend to be relatively sticky. AXTA does a lot more than just ship cans of paint to the OEM customers; it is heavily integrated into the OEM’s production processes. AXTA stations coatings technicians full-time at auto plants. The AXTA coatings are decided for the vehicles before production ever starts. In a nutshell, switching away from a coatings supplier can be a difficult and costly endeavor, and best of all, not that impactful, as the price of the paint and coatings are about 1% of the cost to build a car.

On the other hand, as we discussed above, auto OEMs drive a hard bargain at their suppliers. They are well aware of their suppliers’ margins and seek any and all opportunity to renegotiate supply arrangements. They buy enough stuff that they can afford a full-time purchasing person to stay on top of you and can credibly threaten to switch suppliers if the price is right. As such, there is good reason to expect them to demand price concessions once they see a gross margin tailwind affecting all of their suppliers.

Note that AXTA’s commercial OEM business probably has a bit more pricing power than the light vehicle OEM business does. The commercial OEM business is more fragmented, whereas the light vehicle OEMs have more bargaining power thanks to the consolidation of buying power in a smaller number of huge companies.  However, light vehicle is 3.5x the size of commercial.

For the purposes of our model we assume that AXTA will need to give away 50% of its pricing benefit to its auto OEM customers. We will show later some more information about why we think this is reasonable.

“High pricing power” side: The other 65% of EBITDA consists of Automotive Refinish and Industrial coatings applications. In the Refinish business, AXTA has 80,000 body shop customers served through 4,000 local distributors. To repair a car after a collision costs thousands of dollars – the way IR describes it, it’s $40 for paint, $400 for labor, and $4000 for the entire repair job.

What all this means is that AXTA’s refinish customer base is very fragmented and the cost of the paint is a tiny part of a repair job – so AXTA’s customers in refinish have neither the bargaining power nor a serious incentive to fight on price. AXTA has the ability to raise prices each year, and does so. (One former DPC employee we spoke to from the Refinish business told us that DPC had a simple philosophy on price: “Raise price whenever and wherever you can.” He also told us that it was nearly inconceivable that the Refinish business would cut price simply because the prices of oil and its derivatives had fallen.)

On the Industrial side, the pricing power appears to be similar given a similarly fragmented customer base and paint/coatings being a similarly low part of the bill of materials for oil and gas equipment, electrical insulation, etc. So we include Industrial in our “high pricing power” side of AXTA’s business but acknowledge it is “less high”.

We apply this low/high pricing power split to our estimate of how much of the gross margin benefit from the input cost correction AXTA will be able to keep while oil remains more than 50% lower than where it was two quarters ago. We assume that the high-powered side of the business keeps all of the input cost benefit and the low-powered side of the business keeps 50% of the input cost benefit.

UBS has a fairly comprehensive report on the impact of a change in oil price on the P&L for a typical coatings company. In his January 7, 2015 note entitled, “U.S. Chemicals Guidebook to the Drop in Oil Prices,” the UBS Chemicals sector analyst walks through the ingredients in a gallon of housepaint and shows how a drop in the price of oil works its way through the value chain. His argument is bearish – that is, he thinks the chemical companies will not benefit in any sort of lasting or meaningful way from the drop in oil prices. With this backdrop in mind he arrives at a $0.65 COGS benefit on a $20 gallon of paint from a halving of the price of oil. The analyst writes:

“Theoretically if oil doubled, or halved, the cost impact to the gallon of paint could be in the range of $1.30 (baseline cost). For a $20 gallon of paint that would appear to be a relatively modest impact for a 50% drop in oil, with 2/3rds of raws linked to oil.  But that’s how the math works out.”

Now we are admittedly a little bit greedy but a 3.3% of sales benefit to COGS in a 20% EBITDA margin business is not a relatively modest impact (especially on a levered balance sheet and in an attractive niche where you might keep all of it for businesses making up two-thirds of EBITDA). We dug deeper into the UBS analysis, and found that there are several supporting and offsetting factors that need to be considered to get closer to the truth.

First, the UBS analyst uses $55/barrel oil for his analysis of the COGS oil component, because that’s where oil was when the report was written (December 2014). But this number isn’t relevant as a baseline price. We are conducting a gross margin analysis that considers how much higher AXTA’s margins will go as a result of oil falling from $100 to $55. If gross margins are at 34% with oil at $100 and then oil swoons to $55, we need to consider $100 oil as a part of the bill of materials for our baseline with 34% gross margins. Using $100 oil in the analysis we get to $2.35 of contained value in a $20 can of housepaint.

Secondly, we can’t use housepaint for AXTA. We have to use the kind of automotive paint that AXTA sells, which is priced more like $45/gallon. We also have to consider the fact that the raw materials basket for automotive paint is substantially more oil-linked than the basket for housepaint. We refer to the RBC initiation report on PPG from October 8, 2014, page 20. TIO2 is a much bigger component of the bill of materials for architectural paint, leaving more room for the oil derivatives in industrial coatings.

Because the oil-linked COGS are almost 2x the percentage of the bill of materials in industrial coatings, we estimate that $2.35 contained value in a gallon of housepaint is worth closer to $4.70 in industrial coatings. $4.70 getting cut in half (actually more…$100 oil to $45 oil today) results in $2.35 of savings. On a $45 can of paint that’s 5.2% of sales – said differently, a 520bps boost to gross margin, which tracks with the fact that we saw low-to-mid-single-digit increases in gross margin for the industrial coatings players with volumes falling off a cliff in 2009. (More on this analysis below.)

Further, some of the important predecessors of COGS inputs for AXTA – ethylene and propylene, most notably – are seeing substantial capacity expansion around the world. These are hydrocarbon derivatives that closely track oil. But they may end up falling more, as supply of these chemicals is expanding, thanks to the miracle of natural gas fracking.

For our AXTA thesis, all of this means that while the oil price being in the tank – pardon the pun – is good for AXTA’s raw material costs, key elements feeding more directly into its raw materials basket may see further downward price pressure because of looming supply additions.  This would be all gravy to our thesis.

The other half of our conviction in the idea of AXTA’s keeping its oil benefit comes from our study of its and other specialty coatings companies’ financial performance in previous oil price crashes. We have two periods to study – the recession of 2008-9 (oil corrected almost 80% from peak to trough and quickly rebounded), and the oil collapse of 1997-98.

The 2008-9 period yields very encouraging insights, because the oil price crash was accompanied by a volumes crash for all of the coatings companies. We say this is encouraging because despite the awful collapse in volumes, the coatings companies actually saw increased gross margins and generally stable pricing year-over-year.

For instance, take VAL’s industrial coatings business, which is a good comparable to AXTA. This segment does not sell architectural paint, and it has an input cost profile similar to AXTA’s. Here’s a table showing VAL’s industrial coatings’ YOY sales, volume, and price changes:

We can also see that across its entire business, VAL experienced very little pricing pressure:

Again, oil corrected by 50-75% over this time period, and volumes fell dramatically, but VAL kept prices about flat. What’s not shown on this chart is the fact that gross margin increased by 400bps for the entire business – from 29% to 33%. This shows us that VAL did not have to pass through its input cost benefit in the form of lower prices to its customers. It also shows us that the benefit of an oil price drop is enough to drive up gross margins 400bps, NET OF the negative effects of fixed COGS as volumes fell off a cliff. What would VAL’s gross margin expansion have looked like had there not been a catastrophic drop in volumes?

RPM’s industrial coatings business tells a similar story, although there is some more noise given that the reporting is for EBIT ex-restructuring, rather than gross profit:

But most encouraging is a look at the 10-K filings for DuPont from pre-AXTA days, when DPC was broken out as a segment of the parent company. We calculate and estimate these rates of change from the SEC filings.

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In the table above, we can see that AXTA was able to raise prices during periods of strong oil prices and avoid lowering prices when oil and volumes were falling. Given the substantially better economy this time around, this pricing history is encouraging.

We don’t have gross margin information for DPC from the last recession. However, we gain comfort from the combination of several disparate facts. First, we know that falling oil prices clearly benefited gross margins for the other Coatings players. Secondly, we know that AXTA’s gross margins stayed at around 29% after 2009. We can infer that AXTA received a gross margin tailwind in 2009 but kept that tailwind after.

We also looked at 1998 results for the DPC business, and found that while DuPont mentioned pricing weakness in certain areas that year (polyester, crop protection, and commodity chemicals), Performance Coatings was not one of them. This was in the second year of a two-year oil correction and in a period of weak chemicals volumes overall.

We do think that a 520bps gross margin expansion from a 50%+ drop in oil with growing volumes and a credible cost-cutting plan is realistic, considering that we saw a 400bps gross margin expansion at VAL’s total business, and a 230bps gross margin expansion at RPM’s industrial business, from a short-lived 75% drop in oil when volumes were cliff-diving in 2009.

Other assumptions and modeling

We credit AXTA with $200m in annual restructuring savings (fully in the numbers in 2017), which it called out in its Q414 earnings call. We apply constant-currency growth rates consistent with management’s guidance for 2015e, and we hit AXTA for currency after that. As a reminder, AXTA estimates a $3m hit to EBITDA for every 1% move in the euro.

As for valuation, we consider both the absolute and the relative valuation approaches. On a relative-to-peers basis, AXTA trades at 16x EV/our estimate of unlevered free cash flow, well below peers – VAL is at 21x, PPG is at 21x, SHW is at 27x, and RPM is at 37x.

We see ~45% upside to AXTA on 2015 if AXTA re-rated to 20x, which would place AXTA below the average and median values for its four coatings peers. AXTA’s high debt load may place it in the penalty box with investors, but as the debt is paid down more quickly than expected thanks to the oil windfall, the stock should reflect a healthier balance sheet by this time next year.

For an intrinsic valuation approach, we consider a steady-state valuation year to be 2018 and model to arrive at valuation metrics off of that year. We find that at the current price AXTA offers an 11% FCF yield, a 7% unlevered FCF yield, and an 11x EV/EBITDA-less-capex multiple. We expect AXTA to have just under a 1x net debt/EBITDA multiple at the end of '18 if it uses its free cash flow to pay down debt. Given the high quality and stability that AXTA’s business offers, we think the potential for value-creating capital return becomes real before 2018.

We also sensitize our expectation with a more bullish and more bearish scenario. The bullish scenario assumes that AXTA achieves price hikes in the “high-pricing-power” 65% of its EBITDA in future years that enable it to bring its gross margin back to 39%. The bearish scenario assumes that AXTA’s oil tailwind is short-lived and gets reversed quickly, that growth is much weaker than expected, and that the EF/UFCF multiple contracts by an amount similar to that of the peers’ contractions during the 2008-9 financial crisis.

The bearish scenario assumes that AXTA’s oil tailwind is short-lived and gets reversed quickly, that growth is much weaker than expected, and that the EF/UFCF multiple contracts by an amount similar to that of the peers’ contractions during the 2008-9 financial crisis.

We are purposefully severe in our bearish scenario.

KEY RISK FACTORS:

1. Sharp increase in oil and/or oil derivative prices: While our bias on propylene and ethylene prices is against them recovering due to the capacity growth upstream, we are not hydrocarbon supply chain price forecasters. And if oil were to recover, for instance, to $95 or more, AXTA’s entire raw materials tailwind would likely disappear within 1-2 quarters. AXTA would need to raise prices aggressively and it may not be able to do this. Fortunately, at this time, there is plenty of room for oil, ethylene, propylene, etc. to recover and still allow AXTA to enjoy a tailwind.

2. Leverage: At 5x net debt/EBITDA, AXTA’s leverage risk is obvious. If things go the wrong way for any reason that we can or can’t foresee, the impact on the stock will be that much worse thanks to the post-LBO balance sheet.

3. Auto volumes globally: AXTA’s OEM customers live and die by auto production numbers, and these are very cyclical. We do not have a strong view on the direction of auto production – we know only that it is strong right now and AXTA is benefiting from this. In 2009, DPC’s volumes fell 20% due mainly to OEM motor and truck builds in what is now its Transportation segment (40% of its business).

4. Currency: 70% of AXTA’s sales are made overseas. The company says that every 1% move in the euro impacts revenue by $18m and adjusted EBITDA by $3m. Mitigating this risk to some extent is that as the USD strengthens, oil prices tend to decline, but this is not a hard and fast rule of economics by any means.

5. Carlyle sales: On March 17, 2015, the Carlyle Group filed an S-1 for a secondary offering of part of its stake in AXTA. The stock fell 5% that day. The Carlyle Group will continue to own close to 60% of AXTA and will be selling in the future.

6. Valuation of group: AXTA’s Coatings sub-sector sports EV/EBITDA multiples in the low double-digits. In a market correction this group will likely be hurt more than other subsectors as its high multiples make for easy targets. We partially hedged our position in AXTA with a basket short of select peers group to compensate for this subsector valuation risk.

7. Hedge fund crowding: While just 8% of AXTA’s shares are owned by hedge funds, this represents approximately one-third of the shares that float (that are not owned by Carlyle). It’s not hard to imagine periods of selling pressure or a run for the exits in the event of bad news. We worry less about this risk because we are comfortable with a multi-year holding period.

This report (this “Report”) on Axalta Coating Systems, Ltd. (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold long positions tied to the securities of the Company described herein and stand to benefit from an increase in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their long exposure to the Company’s securities or establish short positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Increasing investor familiarity and comfort level, earnings beats on the oil issue and revaluation towards peers once it is clear they retain some of the benefit in gross margin