Description

Axalta Coatings Systems Ltd. (AXTA) – Long, $46/share ~12-24 month target

Market Cap: $7.6b (Last Sale: $30.99)

TEV: $10.9b ($3.3mm Net Debt inc. preferred shares)

3-month Avg Daily Volume: 2.3mm shares/day ($72mm)

Investment Horizon: ~12-24 months

Summary

Axalta Coating Systems (AXTA), the former DuPont (DD) Performance Coatings business that was formed in Carlyle’s 2013 LBO, is a world class coatings maker that generates >90% of its earnings in auto/industrial end markets where it is either the number 1 or 2 global player.  Post-LBO, AXTA’s management team has implemented comprehensive changes to improve AXTA’s cost structure, rekindle deteriorated customer relationships, and strategically expand investment in high growth markets, most notably in China where AXTA is consistently winning new business.  Within the consolidating global coatings industry, I believe AXTA is strategically in a ‘win-win’ position; the company is clearly a takeout candidate for several larger peers, and, in the case where they are not bought, AXTA is in a ripe position to continue purchasing assets under very favorable scenarios (like their 2017 purchase of Valspar’s (VAL) wood coatings business).  The stock trades materially cheap to peers for several reasons that I view as relatively short-sighted; under my base case scenario AXTA trades at a 2020 fcf yield of ~9%, while global coatings peers tend to trade closer to a ~5%-7% yield.  With a 12-24-month timeframe in mind, I believe AXTA is worth $46/share, almost 50% above the stocks last sale.

Valuation

Base Case: $46/share (+48%) – AXTA trades at 6% ’20 FCF yld on my base case estimate (~$675mm)

Down Case: $26/sh (-16%) – AXTA trades at 12x ’20 FCF yld on my down case estimate (~$530mm)

Bull Case: $54/share (+74%) – AXTA trades at 5.5% ’20 FCF yld on my up case estimate (~$725mm)

Thesis

Given above trend medium-term growth prospects and an undeniably strong strategic position within the global coatings industry, I believe AXTA remains substantially undervalued on both a relative and absolute basis.  Looking out 24 months, and assuming the stock trades at a ~6% 2020 fcf yield I believe AXTA is worth $46/share, almost 50% higher than where the stock currently trades.

The main tenets of my long AXTA case are:

a)       AXTA is a high quality global coatings business.

o   Strong market position – AXTA is the global market leader in Refinish Coatings, and Heavy Truck and Bus Coatings.  AXTA is the #2 player in OEM Light Vehicle Coatings. Overall, ~90% of sales are to end-markets where AXTA is either #1 or #2.

o   AXTA’s margin profile is superior to that of its peers thanks to its Refinish Coatings business (discussed below) – on a consolidated basis, EBITDA margins will run in the low-20% range, at least several hundred basis points higher than peers.

o   Cash flow conversion capability is very strong given the capital-light nature of the coatings business.

§  D&A massively overstates the capital cost of running the business – Total capex typically runs ~$150-$160mm per annum, which is <50% of D&A (which is running ~$330mm).  This dynamic is much different than its coatings peers who will all see capex levels at 100%-120% of D&A.

§  Maintenance capex runs at $60mm per annum, just ~1.5% of sales.

b)       The automotive Refinish Coatings business, which I estimate comprises 55%-60% of consolidated operating earnings, is a gem of a business and one of the top franchises in the entire coatings complex.

o   Refinish is a stable growth market – Growth in Refinish sales is primarily determined by the size of the car parc and the aggregate number of miles driven.

o   Refinish has demonstrated significant pricing power over time – my diligence indicates positive pricing of 3%-4% (+4% in 2017) per annum with little customer pushback.  A high degree of refinish pricing power is due to:

§  The global Refinish market is highly consolidated with the top 5 players holding close to 3/4ths market share (AXTA, PPG Industries (PPG), Akzo Nobel (AKZA.NA), BASF (BAS.GR), Sherwin Williams (SHW)).  AXTA is the #1 Refinish business with ~25% global market share.

§  Highly fragmented customer base – 80k body shops in 130 countries.

§  Small ticket size – Refinish coatings is just 5%-10% of the total collision bill (which on avg is~$2,800 in the US).

o   95% customer retention rate – hugely sticky customer base.

§  AXTA’s sales force is not just selling paint to body shops.  The sales force has a periodic physical presence in the shop as they install or upgrade color matching/mixing equipment, customize the system for the specific customer, and provide technical support and ongoing training.

§  Once a coating and color system is installed, a body shop almost exclusively uses its specific supplier’s products.  The proprietary nature of a coatings supplier’s color systems, the substantial inventory needed to support a body shop and the body shop’s familiarity with an established brand lead to high levels of customer retention.

o   Though AXTA does not disclose Refinish profitability, industry sources estimate EBITDA margins at an impressive 25%-30% (and gross profit margins >70%).  Assuming 25% EBITDA margins Refinish would comprise about 55% of AXTA’s ’17 EBITDA.

c)        AXTA is enjoying a renaissance thanks to its birth as a standalone company.  Highlights include:

o   Efficiency initiatives started in 2014 that translated to ~$200mm of cumulative savings at the end of 2017.  Restructuring efforts won’t stop after this year, and management indicates AXTA is only in the ‘middle innings’ of its restructuring potential.  Indeed, the company laid out a new ~$200mm cost savings plan at their March 2018 Investor Day that they aim to complete within 4 years.

o   New contract wins in their Light Vehicle business - since its separation from DD, AXTA disclosed that is has won business at >30 new auto plants (China represents the bulk of the won plants).  Management stopped disclosing new plant wins in 2016, however, my conversations with them indicate AXTA continues to win new plants, and thus, market share.

d)       AXTA has robust medium-term growth prospects.

o   Solid organic medium-term growth prospects – Consultants Orr and Boss estimate that the major end-markets AXTA is exposed to will grow at a 3%-5% CAGR from ’16-’20.  AXTA should outgrow these end markets as they gain market share.

o   Moreover, the business is positively predisposed to key megatrends including the increasing car parc in emerging markets. 

§  In particular, AXTA has a strong and growing presence in China; despite comprising only ~10% of total sales China has represented about 1/3^rd of AXTA capex spend over the last couple of years.  Over the next several years, AXTA expects China sales to grow at a high-single digit % rate.

§  Overall, AXTA expects global auto sales to grow from ~88mm this year to 110mm over the next five years; this growth is being very much driven by the emerging markets.

o   AXTA has a very strong position on electrical vehicle (EV) platforms.  During their February 2017 Investor Day management stated that more than 60% of the EV’s that are produced globally each year are coated with AXTA’s Voltatex electrical insulation products.

o   Management has stated aspirational goals of reaching $6b sales by 2020.  This goal represents an ~11% sales CAGR and assumes mid-single digit % organic growth plus the deployment of free cash flow in return accretive M&A.

e)       AXTA is in a ‘win-win’ position in the consolidating coatings industry.

-          AXTA is a clear takeout target given demonstrated interest by AKZA.NA and Nippon over the last 12 months.  Other potential suitors include Berkshire Hathaway (BRK), which already owns ~10% of AXTA’s common stock, and BAS.GR, which continues to build out their auto coatings business with its recent purchase of Chemetall from Albemarle (ALB).  SHW is a potential acquirer as well, though given their recent purchase of VAL, the company will most likely focus on de-levering their balance sheet during the next couple of years.

-          AXTA could also very well be the beneficiary of further coatings industry M&A.  Should PPG ultimately be successful in buying AKZA.NA, I believe there could be >$2b in forced divestitures.   As they demonstrated when buying VAL’s wood coatings business (which was a forced divestiture for antitrust reasons), AXTA would be in a prime position for strategic M&A in this case.

Under a reasonable upside scenario, I can envision AXTA generating ~$725mm free cash in 2020.  Along with modestly above trend organic growth rates, my assumptions for this upside scenario includes the benefits of deploying free cash flow for M&A in an accretive fashion that is typical of AXTA’s history.  Assuming the stock trades at 5.5% free cash flow yield my target value for AXTA would be $54/share, more than 70% higher than where the stock currently trades.

Risks

The main risks to AXTA are:

-          General deterioration in the global economy and key industries.  In particular:

o   Global automobile production deteriorates (as my base case assumes a low-single-digit % increase per annum through the forecast period).

o   Global truck production declines (in particular my base case assumes a continued rebound in global truck output through 2019).

-          F/x & Geographic Exposure

o   With only ~30% of sales in the US, AXTA is highly exposed to f/x fluctuations.

§  % of 2016 Sales: NA 35%, EMEA 36%, AsiaPac 18%, LatAm 11%.

§  Key sales sensitivities to 1% move in USD:  EUR=$12mm, CNY=$5mm, BRL=$2.5mm.

o   Costs – With the exception of Brazil (which accounts for ~5% of sales), costs are local currency, creating only a translation impact for f/x.  And, in Brazil, AXTA typically hedges about 50% of US dollar cost exposure.

-          Increased input prices – Most notably AXTA spends ~$1bln on oil-related raw materials, and therefore is highly exposed to fluctuations in energy prices.  An unexpected material rise in the price of oil derivatives like propylene could impact AXTA (at least in the short term).

-          Improved Driving Technology / Autonomous Driving – the advent of technology has actually been a near term tailwind for AXTA as accident rates have increased given the prevalence for ‘texting while driving’ and other technological distractions.  Longer term, autonomous vehicles will in all likelihood be a headwind for AXTA’s refinish business, however, the magnitude and cadence at which such changes occur is highly debatable right now.

-          Multi-Shop Operator (MSO) consolidation – The North American body shop market is consolidating, and MSO’s now account for ~15% of the market vs 8% in 2008.  While still very early, a material increase in the level of consolidation could impact AXTA’s ability to increase prices.

-          Execution on ‘Fit for Growth’ and procurement savings initiatives.

-          Spike in interest rates given that the majority of AXTA’s debt is floating rate.

The bear case on AXTA centers around poor execution on restructuring initiatives and/or recessionary global macro conditions.  Under a reasonable down-case scenario that includes assumptions such as a low-single-digit organic decline in Refinish sales, a ~10% decline in both Light Vehicle and Commercial Vehicle coatings sales, and minimal cost savings realized from AXTA’s restructuring initiatives, I derive normalized 2020 free cash flow of ~$530mm.  Using an ~8% fcf yield my downside target for AXTA is $26/share (-16%).

VARIANT PERCEPTION

My variant view of AXTA is based upon:

-          The market is focusing on two near-term dynamics impacting AXTA:

o   Softness in the US auto cycle.  This is a small piece of AXTA’s total sales (<10%), and I believe earnings will prove relatively resilient from a softer US auto demand environment.

o   Modest margin pressure demonstrated over the last year.  AXTA and comps (i.e. PPG) are actively working to push through price hikes here, and I believe it is only a matter of time before these hikes are accepted and evident in the P&L.

-          AXTA is a world-class coatings business and I believe that there is no great reason for it to sustainably trade at a material discount to comps like PPG, SHW, and AKZA.NA on free cash flow multiples.

-          Given that D&A runs 2x capex I believe it’s correct to value the stock a) primarily on free cash flow and b) secondarily on EV/(EBITDA less Maint Capex).  P/E and EV/EBIT distorts valuation given that the capital cost of running the business is much lower than D&A.

-          Given commentary from a variety of sources, I believe management will largely be successful in their efficiency program initiatives, and that further improvements in the cost structure will come in the 2018-2020 period.

-          AXTA is a clear takeout candidate in the medium/long term.

-          And, should AXTA not be bought, they will benefit from further coatings industry M&A as there could be forced divestitures to look at.

Capital Allocation

AXTA is a relatively low capital intensity business.  Maintenance capex runs ~$60mm per annum, and based on management commentary I believe total capex will run ~$150-$160mm annually for the next several years.  With D&A (currently running ~$330mm per annum) running well in excess of total capex, free cash flow is all but certain to exceed net income for the foreseeable future.

AXTA’s short/medium term capital allocation priorities are simple – their primary aim is to allocate to accretive M&A opportunities.  To that end they’ve done several bolt-on deals over the last couple of years, and one more notable transaction for VAL’s wood coatings business.  Secondarily, the company recently announced an open-ended $600mm share repurchase program (though to date has only repurchased a modest amount of shares).

The company targets net leverage in the 2.5x-3.0x (net debt / EBITDA) range.  For the right deal, management has said they could take their leverage back to ~5x (which was where leverage was during the LBO).

Off balance sheet, the company has a modest-sized pension plan – as of 12/31/17 company-wide pension obligations were under-funded by $272mm.

Catalysts

Over the next 24 months I believe the catalysts for AXTA will be:

-          Earnings reports as I believe AXTA will prove very resilient to increasing raw material costs.  Additionally, I believe operating margins will modestly expand as management moves into their second phases of restructuring.

-          Coatings industry M&A

o   AXTA clearly remains an M&A target for several larger coatings peers including AKZA.NA, Nippon, BAS.GR, BRK, and SHW (once their leverage comes back down to a more normal level).

o   AXTA could also very well be the beneficiary of coatings industry M&A.  In a scenario where PPG is ultimately successful in buying AKZA.NA, I believe there could be >$2b in forced divestitures.   As they demonstrated when buying VAL’s wood coatings business (which was a forced divestiture for antitrust reasons), AXTA would be in a prime position for strategic M&A in this case.

Business Overview

AXTA is effectively DD’s former Performance Coatings business.  In February 2013, DD sold this business to Carlyle for $4.9bln in cash and the assumption of $250mm in pension-related liabilities.  The rationale for DD to sell this business was simple – they viewed it as a non-core business and essentially ran it for cash which they then reinvested into DD’s growth platforms, such as agriculture and life sciences.  As evidence, capex ran just $70-$80mm per annum (barely above maintenance levels) during 2011 and 2012, the final two years that DD owned AXTA.

The company currently operates under two business segments – Performance Coatings and Transportation Coatings. 

1)       The Performance Coatings segment is broken down into two sub segments:

o   Refinish Coatings (41% ’16 sales) – Serves independent body shops, dealers and multi-shop operators.  AXTA is the global leader in Refinish.  2016 sales by geography:  EMEA=43%, NA=30%, AsiaPac=15%, LatAm=12%.

o   Industrial Coatings (18% ’16 sales) – Serves end-markets for a range of applications including machinery, automotive components, architectural cladding, appliances, and oil & gas pipelines. 2016 sales by geography:  EMEA=48%, NA=17%, AsiaPac=21%, LatAm=14%.

2)       The Transportation Coatings segment is also broken down into two sub segments:

o   Light Vehicle (33% ’16 sales) – AXTA is the #2 player in this industry (#1 is PPG).  This sub segments two largest customers are VOW.GR (25% of sales) and F (20%).  2016 sales by geography:  EMEA=33%, NA=30%, AsiaPac=21%, LatAm=16%.

o   Commercial OEM (8% ’16 sales) – AXTA is the #1 maker of coatings for commercial vehicles (include heavy trucks, buses, ag equipment, etc.).  2016 sales by geography:  EMEA=30%, NA=45%, AsiaPac=7%, LatAm=18%.

Management / Key Shareholders

A.       Management / Board of Directors

-          Chairman and CEO Charles Shaver (58 years old) joined AXTA in 2013.  Prior to joining AXTA, Shaver was CEO for the TPC Group, a North American petrochemical producer, from 2004 to 2011.  Earlier in his career, he spent 16 years with Dow Chemical.  He is currently a member of the board of directors of US Silica and Taminco. 

o   Per the 2017 proxy statement: Change in Control – in such a scenario Shaver would receive $20.6mm in total comp ($15.6mm of which is equity based).

-          CFO Robert Bryant (48 years old) assumed his role in 2013.  Before joining AXTA, he served as CFO of Roll Global, a diversified holding company, from 2004-2007. 

o   Per the 2017 proxy statement: Change in Control – in such a scenario Bryant would receive $8.1mm in total comp ($6.0mm of which is equity based).

-          Performance Based Compensation:

o   Managers can earn up to 200% of their annual salary in a performance based bonus.  Bonus calculations are based on adjusted EBITDA (50%), adjusted free cash flow (15%), adjusted constant currency net sales (15%) and individual performance metrics (20%).  In 2016, members of the management team earned in the range of 101%-114% of their target award.

-          In total, AXTA management controls about 5.5mm shares (through outright share ownership and options), or ~2.3% of shares outstanding.

-          AXTA’s Board of Directors consists of nine members; only one of those members (Shaver) is an AXTA manager.

B.       Key Shareholders

-          Carlyle completely exited their AXTA position in August 2016.  The continue to have one employee (Greg Ledford) on AXTA’s Board.

-          BRK owns 9.6% of shares outstanding.  This is notable not only because of Berkshire’s reputation as an astute long-term investor, but also because Berkshire owns Benjamin Moore, a leading maker of architectural coatings.

Catalyst

Over the next 24 months I believe the catalysts for AXTA will be:

-          Earnings reports as I believe AXTA will prove very resilient to increasing raw material costs.  Additionally, I believe operating margins will modestly expand as management moves into their second phases of restructuring.

-          Coatings industry M&A

o   AXTA clearly remains an M&A target for several larger coatings peers including AKZA.NA, Nippon, BAS.GR, BRK, and SHW (once their leverage comes back down to a more normal level).

o   AXTA could also very well be the beneficiary of coatings industry M&A.  In a scenario where PPG is ultimately successful in buying AKZA.NA, I believe there could be >$2b in forced divestitures.   As they demonstrated when buying VAL’s wood coatings business (which was a forced divestiture for antitrust reasons), AXTA would be in a prime position for strategic M&A in this case.