Description

Company Background

AkzoNobel (“AKZA”) is one of the largest producers of paints and coatings. This industry is highly consolidated, which enables solid pricing power during normal environments; this feature is particularly valuable in the current landscape given unusually high cost inflation in the mid to high single digit range.

AKZA operates across two segments: Performance Coatings (~60% of 2021E sales) and Decorative Paints (~40%).

Performance Coatings includes Industrial Coatings (packaging and building products), Powder Coatings (construction equipment, automotive components / wheels, and appliances), Automotive & Specialty Coatings (auto refinish & OEM and aerospace OEM & maintenance), and Marine & Protective Coatings (commercial vessels, yachts, mining, and O&G applications). Industrial is the largest business line within Performance Coatings at ~20% of group sales, with the other three businesses each comprising 12-15% of AKZA’s group sales.

Decorative Paints is segmented across EMEA (25% of group sales), Asia (10%), and South America (5%). AKZA sells architectural paint through both the professional and DIY / retail channels.

Current Investment Opportunity

Our investment thesis for AKZA is built on three tenets:

1)      AKZA has meaningful margin upside vs. Street estimates.

AKZA management has been steadily improving group margins by (i) shifting its focus away from volumes and toward value (i.e., shedding low-margin business), (ii) consolidating its manufacturing and warehouse footprint, and (iii) modernizing its production processes with the latest technology.

Field contacts highlighted to us that when Thierry Vanlancker took over as CEO in 2017, one of the first things he did was invest in building out an experienced supply chain team.  Under new supervision, AKZA has been getting out of outdated facilities and spending capex on state-of-the-art facilities around which it can consolidate its operations – the High Point, NC facility they started in 2019 is one example of this strategy.

This strategy is clearly taking shape – from 2018 to 2020 gross margins improved 220bps, with the “Purchases and Other Costs” component of COGS falling from 50.8% of sales to 47.6%. Field contacts noted that management has plenty of these opportunities left (COVID delayed some of these efficiency projects) and AKZA has an internal goal of catching PPG from a margin perspective.

AKZA is generating exceptional margin improvement even as its highest margin businesses (e.g. auto refinish) are still recovering vs. pre-COVID levels. AKZA posted a 17.3% EBITDA margin in Q1 2021 (260bps y/y improvement) despite 100bps of gross margin pressure – we think the combination of management’s efficiency efforts, a strong H2 2021 / 2022 rebound in its highest margin segments and coordinated pricing increases across the industry will drive EBITDA margins closer to 19% in FY 2022 (in-line with PPG consensus, which we think may also be light).

2)      AKZA topline growth will beat expectations.

Context here is important. On the Q4 2020 results call, AKZA management stated their expectation that their underlying end markets will grow 2% vs. 2019 on a constant currency basis. This guidance has served as the basis for Street estimates. Prior to Q1, analysts took this comment and simply assumed AKZA would grow 2% CC vs. 2019. We felt this guidance was highly conservative at the time – the Q1 2021 results, which showed sales 10% higher than 2019, add to our conviction that the tailwinds in AKZA’s markets are both stronger and more durable than the market currently expects.

Our conviction is based in part on a review of how AKZA and other paint producers have performed coming out of previous recessions, as well as commentary from former industry executives describing important recent changes to the competitive dynamics in AKZA’s markets.

Field contacts noted that dominant global coatings suppliers like AKZA are ultimately beneficiaries of economic downturns as weaker, independent competitors reduce capacity or exit the market altogether, leading to improved competitive dynamics as end markets rebound. More importantly, in the context of a highly inflationary environment where key raw materials are in short supply, AKZA’s global scale carries substantial advantages with respect to sourcing these inputs and fully passing on price increases to its customers.

Contacts also highlighted that global competitors have become increasingly focused on margins, with volume growth / market share becoming a secondary consideration. AXTA (relevant for AKZA’s Performance Coatings business) best represents this recent shift. AXTA has spent the last 5+ years shopping itself in hopes of receiving an attractive bid. To maximize its strategic value, AXTA aggressively bid on low margin business to generate volume growth. Contacts suggested that AXTA no longer believes it will find a clean M&A solution, and that its 2020 restructuring announcement reflects a strategic shift to de-emphasize volume growth and focus on margins / free cash flow. In an industry with only a handful of scaled, global competitors, AXTA’s shift will facilitate even more pricing power for AKZA and PPG in particular.

We also think AKZA will be a modest beneficiary of high inflation. Our field research left us with the view that during inflationary environments, coatings producers can capture additional price increases as inflation provides an overall tailwind for pricing conversations with customers – inflation gets the ball rolling and creates room for additional value capture.

We see FY22 sales rising to €9.93bn vs. €9.66 bn consensus without factoring in any M&A.

3)      M&A could fuel additional upside.

While not incorporated into our model, we think AKZA could create considerable value through either meaningful bolt-on acquisitions or sales of pieces of its business.

AKZA is very well capitalized at 1.0x net debt / EBITDA - this gives management significant firepower for bolt-ons should attractive assets shake loose. Field contacts mentioned that management has carefully built out a pipeline of prospective bolt-on acquisitions and has intentionally kept its balance sheet underutilized to prepare for possible deals. Nippon Paint has also noted in earnings calls that major paint companies have recently restarted M&A discussions around pieces of their portfolios.

We also believe a sale of all or parts of AKZA is plausible. PPG has been far more aggressive on executing a meaningful M&A program, highlighted by its recent acquisition of Tikkurila (for which PPG outbid AKZA with an offer that valued the business at 17x EBITDA and 30x EPS). PPG’s aggressiveness in acquiring a sizable paint producer in a key European market is notable. It is well-publicized that PPG tried to acquire AKZA in 2017, and that AKZA’s then CEO and board was upset by PPG’s hostile approach. Elliott subsequently forced through several management changes and a refresh of the board. We think PPG may now be implicitly communicating to AKZA that it can either sell parts of itself (or the entire company to PPG) or deal with PPG outbidding it on key assets in its home market. While an outright sale is not a high probability event, we think AKZA is the most likely acquisition candidate among the global producers.  

Valuation

We see FY22 adj. EPS at ~€6.25 as AKZA grows 15% / 3% organic in FY21 / FY22, with EBITDA margins rising to 18.9% in FY22 on the back of continued volume growth (particularly in AKZA’s highest margin businesses), additional “self-help” in the form of footprint consolidation / ERP completion, and strong pricing growth. AKZA also has a new €1bn share buyback in place – we anticipate this will be reloaded in FY22 should AKZA not make any material acquisitions.

Our PT of ~€140 assumes AKZA trades at its pre-COVID NTM P/E of 22.5x, representing 40% upside over the next 6-12 months.

Catalyst

Earnings