Description

Investment Thesis

Axalta Coating Systems (“Axalta”) was written up in March of last year by AtlanticD. That analysis was excellent and provides a great reference for a discussion of historical margins and the ability to capture benefits from lower commodity prices, specifically oil, among other topics. This write-up will revisit the business and provide an update of the last year or so. At current prices ($23.75), I believe Axalta shares are compelling – trading at ~12x 2016E FCF for a business earning 30%+ ROIC (per Magic Formula calculation) and benefitting from market share gains, lower oil prices and further cost cuts. Additionally, I think a Berkshire acquisition is a possibility, although hopefully it is not a de facto take under like with Precision Castparts.

Overview

Axalta is comprised into two segments: Performance Coatings (59% of sales / 22% EBITDA margins) and Transportation Coatings (41% of sales / 18% EBITDA margins). Geographically, sales are split between North America (34%), EMEA (35%), Asia Pacific (17%) and Latin America (14%). Costs are comprised of raw materials (65%-75%), packaging and logistics (5%-10%), labor (7%-8%) and fixed costs (10%-20%).

Performance Coatings consists of liquid and powder coatings provided to a fragmented and local customer base. The refinish business (42% of total sales) captures coating systems and matching technologies sold to body shops (independents, MSOs and dealerships). Refinish serves 80,000 body shops via 4,000 independent distributors and provides 180,000 active color variations, a significant barrier to entry (along with increasing environmental regulations* in parts of North America and the EU). Axalta’s market position is #1 (25%) and growing as smaller players still account for 33% of the space. Industrial (17% of total sales) is comprised of coatings sold for general industrial, electrical insulation, architectural, transportation and oil & gas. The industrial sub-sector provides insulation**, corrosion protection, chemical resistance and serves as basecoats.

*Shift to more complex waterborne coatings in lieu of formulations with VOCs (volatile organic compounds).

**Supplies insulation coatings to >50% of electrical motors produced for electrical vehicles today.

Transportation Coatings (41% of sales) provides coating technologies to light and commercial vehicle OEMs. Products consist of four main coatings layers - electrocoat, primer, basecoat and clear coat. The Light Vehicles (31% of total sales) sub-segment provides OEMs with consistent standards (specifications, standardized colors, compatibility with substrates and environmentally responsible coatings) and on-sight technical support. Commercial Vehicles (10% of total sales) include heavy-duty trucks, bus, rails, ag construction equipment, trailers, RVs, etc. Axalta’s market share position is #2 (19%) in light vehicles and #1 (>30%) in heavy duty truck and bus.

Competitors: PPG, BASF, Akzo Nobel, Sherwin-Williams, Valspar, Nippon and Kansai, among others.

Drivers

The main drivers consist of miles driven and accident rates, light and commercial vehicle production, global GDP and industrial production. Additionally, I believe further industry consolidation will drive profit margins higher, and considering recent market movements Axalta is poised to benefit from lower acquisition prices.

In general, I believe the coatings business is somewhat misunderstood as categorized within chemicals. Management argues Axalta is more of a service-led business model and points out that paint provides critical functionality at a fraction of the cost of a car (<1% of total cost*) or repair job (5%-10% of total cost). Furthermore, the coatings business exhibits a high variable cost structure (50% raw material** inputs + variable labor force) and maintenance capex is limited - only 1.4% of sales.

*E-coat, primer, base coats and clear coats are in the $100 area for light vehicles.

**Raw materials: TiO2 @ 10%-15%, resin and monomer @ 40%-60%, additives @ 10%, solvents @ 15-20% and other @ 20%.

   There is an estimated 2-3 quarter lag until raw material deflation is reflected in the numbers, all else equal.  

Financial Commentary

Compared to prior targets in 2015 of local currency sales growth of 5%-7% and EBITDA of $870-$900 MM, Axalta expects to report 5% sale growth and EBITDA in the $865 MM range. While lower raw material costs helped a bit, results were impacted by foreign currency and continued softness in Latin America and a weak 3Q in China.

Organic growth through 3Q is 5.5% based on volume (business wins across all segments) and price. And this is not growth for the sake of growth as reinvestment economics on new projects are based on ~50% IRR targets. Going forward, growth targets are 10% for the next five years based on 4%-5% organic growth and the balance inorganic (mostly in performance coatings segment). I believe this is achievable as Axalta captures incremental volumes (i.e. new business wins) from prior periods of under investment and focus. Margins should expand by at least 100 bps in 2016 due to volume growth, price increases and continued cost savings ($60 million + raw material savings*).

*Using the March futures contract, the average price of Brent oil is 45% lower yoy.

  More specifically, propylene is over 20% lower yoy.

The global refinish market is projected to grow 3% annually through 2019 due to MSO* expansion, emerging market growth (China refinish grew double digits in 2015 and China car parc is <60% of US) and new distribution channels. Note that the top four players control 67% of the market. Previous estimates for coatings growth in emerging markets were in the 9% range as a function of increased vehicle penetration which grew car parc, and elevated collision rates.

*See Service King, Boyd Group, Caliber Collision Centers, Abra Auto Body & Glass. Market share of 44% with top four players.

http://www.wsj.com/articles/private-equitys-latest-fix-auto-body-repair-1406129444

Industrial is expected to grow ~5% but that seems unlikely considering end-market difficulties. Asia-Pacific represents >50% of demand and growth of ~6% is projected. Axalta’s strong position in powder coatings* bodes well due to an increased environmental focus as these products do not contain VOCs.

*Axalta’s powder coatings business grew at 1.5x and 2.0x the market in 2014 and 2015, respectively.

  Awarded Panama Canal coatings projects over next four years; I am unsure of revenue magnitude but it sounds good.

Light vehicle wins is another key source of growth on top of market growth. The transportation market is expected to grow in the 3.5% range – split between light vehicle (3.0%) and commercial vehicle (4.5%), respectively.

On the cost savings front, management implemented two programs – Fit-For-Growth (Europe) and The Axalta Way. Fit-For-Growth targets staffing, wages, manufacturing footprint, logistics and automation, whereas the Axalta Way is more of a lean/continuous improvement program, including SG&A reductions (corporate overhead). Despite significant margin expansion already, management believes Axalta is in the early innings of cost reductions (facility consolidation*, automation, and procurement savings). Axalta Way is expected to provide incremental cost savings of $40 and $45 million in 2016 and 2017, whereas Fit-for-Growth adds $20 and $7 million, respectively. From a raw materials perspective, I believe Axalta will see incremental savings, although management sounds cautious. My sense here is the company is sandbagging in order to use savings to offset potential sales weakness in outer periods. Net, net,  margins are expected to expand 100 bps annually for the next few years.

*Of 200 total sites only 36 are actually for manufacturing. The remainder is sales offices, distribution centers and training sites.

2016 Guidance Targets

Sales are expected to grow between 4%-6% (constant currency basis) and EBITDA margins are guided to 22%+, up from 21% in 2015. One source of additional upside is interest expense. Guidance is for $180-$190 million but looks very conservative as it does not assume any refinancing or prepayments. This also exceeds the cash number due to non-cash amortization expense. Admittedly, the sales guidance is “optimistic” so my numbers are lower.

Management

From a management perspective, the team presents well and is very ROIC-focused. I guess that is not surprising considering Carlyle’s and Berkshire’s involvement. I would urge you to read conference call transcripts. Simply put, the magnitude of the financial improvement post DuPont ownership is staggering. Based on the quality of management and the cash flow characteristics of the business, I think this is a great asset for Berkshire.

Valuation

Axalta shares currently trade for 9.6x 2016E EBITDA, 11.5x unlevered FCF (10.3x on maintenance capex) and 11.8x FCF. I believe a high quality business such as Axalta with decent growth prospects merits at least a market multiple of 15x. This implies a share price north of $30, and while we wait, investors receive a FCF yield of 9% invested in debt reduction and bolt-on acquisitions. Rolling this multiple forward a few years and baking in expected growth leads to IRRs in excess of 30%.

Risks

Driverless cars:

This clearly is a big risk to accident rates. I do not believe this is a near-term phenomenon but it could impact the terminal multiple down the road (as one VIC questioner pointed out). The penetration of autonomous vehicles likely hits the US first before other markets, and this business is global. The company cites a current parc of over 11 years (annual demand) as a data point to highlight that any change would take considerable time to impact the composition of the fleet. I am sure you could think of multiple potential hedges.

General macroeconomic risks:

In the US, over 90% of collision revenue is reimbursed by insurance. This results in very stable market revenues, albeit limited growth in developed markets since accident rates are flattish. North American class 8 production is a concern as management even acknowledges this market is near a peak, although market share gains should be a partial or full offset. For light vehicles, the Auto Nation commentary was disconcerting for the US, but similarly, I believe incremental business should help offset any weakness. Previously announced new business wins should add nearly $200 million in years to come.

Pricing:

Price givebacks as a consequence of lower raw materials and/or increased competitive activity is always a risk. The auto refinish business is stickier than the OEM business. The CFO did recently mention that pricing on the transportation side is becoming more challenging as players are bidding new contracts at lower prices, specifically in China. Additionally, as MSOs continue to win market share, there is a concern they could extract pricing concessions from coatings suppliers. Currently, the EBITDA margins (lower gross margins / less SG&A) are similar across this segment and as noted earlier paint remains a small percentage of the cost of repairs (and largely covered by insurance so drivers are less price sensitive). Similarly, the CEO insists volumes (and turnaround times) are more for the focus than the cost of an extra can of paint.

FX:

For every 1% drop in the Euro versus the dollar, EBITDA is reduced by $3 million.

Emerging markets:

EM represents 31% of total sales. I am not sure what to say here...it’s a risk. The Morgan Stanley report from December discusses coatings capacity additions in China outpacing growth. China was weak in 3Q but 4Q is expected to be better along with 2016. The Chinese auto stimulus (i.e. reduction in registration taxes) should help. Latin America (Brazil is ~5% and Venezuela is ~3% of sales) is also a risk.

Oil & gas exposure:

Oil & gas only represents 7% of Axalta’s industrial sales and I think a small amount is specific to drillers. This business includes midstream (i.e. pipelines) and management points to 40% growth in volumes in 2015, specific to Axalta.

Leverage:

Higher than peers (3.7x net leverage on 2015E EBITDA) but I do not believe this should be a big concern as interest coverage is >5x (post capex). Management has guided to debt repayment and targets an IG rating. I know some analysts apply lower multiples because of this but I think that is overly cautious. The coatings business can support leverage.

Carlyle Ownership:

30% holdings could be sold and provide short term pressure to shares.

Catalyst

-Delivery of growth targets

-Cash generation

-Accretive acquisitions

-Debt repayment