Description

Summary

With investors bidding up valuations of both “good” businesses and cyclical recovery beneficiaries, we find shares in Axalta Coating Systems to be particularly attractive at current levels as the stock has lagged in recent months.  Axalta, a leading global coatings business operating in consolidated and attractive markets, is both a good business (strong margins and returns on capital) and a company poised to benefit significantly from improved levels of economic activity globally.  Despite this improving outlook, the stock has trailed the broader market in recent months and trades at a significant discount to peers (and remains the industry’s most logical acquisition candidate).

Situation Overview

Axalta operates in the consolidated global coatings market, with over 90% of its business coming from markets where it is either the number one or two global player.  The company’s crown jewel is its automotive refinish business (coatings systems used to repair or refurbish vehicles), where it has a roughly 25% market share.  The refinish business contributes around 40% of sales but well over 50% of profits.  The rest of the business serves automotive and commercial OEM customers and general industrial coatings markets around the world.  Key drivers of the business include miles driven and accidents, automotive production and general industrial activity.

We believe one investor concern likely relates to the short-term impacts of a difficult automotive production backdrop due to industry-wide chip shortages.  While certain auto OEMs have recently warned of production shortfalls due to the chip issue, it is important to recognize that any short-term production challenges that might affect Axalta are not due to either economic weakness or demand problems.  In fact, auto sales have remained strong during the pandemic, resulting in exceptionally low dealer inventories (June 2021 U.S. inventory levels of just under 1.4 million units is the lowest supply levels in over 35 years).  Therefore, we believe that as the chip shortage is alleviated, automotive production will have to meaningfully outstrip retail demand in order to rebuild inventories, which will benefit Axalta.  Absent a significant change in the economic outlook, it is likely that auto production will need to remain strong for the next couple of years to meet normal levels of consumer demand and to rebuild inventory levels.

Further, we think the above concerns for the auto OEM business is overstated in the context of the likely significant ongoing recovery in Axalta’s highly profitable refinish business.  The economy is continuing to improve and consumers appear to be rapidly returning to the roads for both work and pleasure.  With national parks setting visitation records (Yellowstone set a record in May and was 11% above May 2019 levels) and AAA estimating a record-high number of Americans hit the road over the July 4th weekend, Axalta’s refinish business should rapidly recover as this increased activity causes elevated accident levels and repair work.  One additional early indication of Q2 activity that is worth highlighting is public auto dealer Group 1 Automotive (GPI) reported preliminary results last week that included gross profit in its repair business ~10% above 2019 levels.  Consumers are clearly returning to the road, driving financial results in Axalta’s high margin refinish business.

Management’s Financial Targets

Axalta recently hosted an investor day on May 5th, where the company outlined its strategy and financial targets for 2024.  The company is expecting 4-5% organic sales CAGR, ~$1.3bn of EBITDA and ~$3 of EPS in 2024 (at the time, consensus EPS was ~$2.50).  At $1.3 billion of EBITDA, management’s $3 EPS target appears to embed conservatism and further assumes no capital deployment, which would leave Axalta with effectively $0 net debt by 2024.  Therefore, we believe that if the company achieves its EBITDA targets and uses its cash flow to repurchase shares, the resulting EPS would likely be roughly $1.00 above their targets (and still result in significant de-leveraging to 1.4x as EBITDA grows).

Valuation Disconnect vs Peers

Axalta currently trades at 10x 2021E EBITDA, the widest discount to its key peers since it became a public company.  By comparison, its closest peers (PPG, Akzo Nobel and RPM) trade at roughly 13-14.5x EBITDA and several Asia-based coatings businesses even trade at eye-watering multiples of 25x to 50x EBITDA.  

While not part of our investment case, Axalta has historically been a rumored acquisition target of other coatings companies.  While they terminated a strategic review in March 2020 during COVID, we think the current valuation disconnect makes any potential transaction more financially logical than ever before (with peers at their highest relative multiple to Axalta and borrowing costs exceptionally low, financial accretion would be significant).  For example, in 2017 Nippon Paint reportedly offered $37 per share for Axalta when Nippon was trading at ~11x EBITDA.  Since that time, Nippon Paint’s stock has doubled and is currently valued at 25x EBITDA while Axalta’s stock is 17% below the rumored 2017 purchase price.

What We Think It’s Worth

Very simply, we think Axalta is a very good business in the midst of a cyclical recovery that is too cheap to the market and its closest peers.  We believe the company should trade at a market multiple (or better), but even if the stock trades at 13x its 2024 EBITDA target of $1.3bn, which translates to less than 19x earnings and a greater than 6% FCF yield (as capex is lower than D&A), the stock would be worth $75 in 2.5 years, or 150% upside from current levels.  These target multiples remain below industry peer multiples and below overall market multiples.  Even in a more conservative operating case where organic revenue growth is in the 2.5% range and Axalta misses its EBITDA targets by 15%, the stock would be worth $63 in 2.5 years (or 110% upside from current levels) at the same target multiples outlined above.

Catalyst

Continued business recovery, market gaining confidence in management's ability to meet/exceed its targets, potential acquisition target if stock doesn't re-rate.