Description

Long Axalta (AXTA Equity)                                                                                                                               

Axalta is an industrial coating company that is underearning today due to auto weakness and raw material inflation. We believe earnings can double from $1.67/share in 2021 to $3/share in 2025 as auto OEM volumes recover and they put through price increases to offset elevated raw material costs. Axalta could be a $48 stock at YE 2024 (+20% IRR from $28/share today), based on 2025 EPS of $3.00 x 16x.

Axalta has been written up many, many times before on VIC, most recently by hawkeye901 in July 2021. I would refer you to AtlanticD’s initial writeup from March 2015 for a history of the company, and why it is a good business. My contribution to the literature is updating for the latest auto and coatings price-raws cycles, making the case for why AXTA could finally be an interesting long after 7 long and frustrating years as a public company.

Thesis

(1)   Auto recovery

·         Auto OEM industry volumes are currently -12% below pre-covid levels, but IHS forecasts industry volumes to grow +5% in 2022 and +9% in 2023.

·         Axalta’s Auto OEM coatings business (35% of sales) is running at breakeven margins. Returning to pre-covid profitability would add +50c to earnings.

(2)   Pricing power

·         The coatings industry takes oil-based inputs and processes them into paint. Axalta and the industry fell behind on price-cost in 2021 (+4% price, +16% cost increases), which caused EBIT margins to fall from 15% to 10%.

·         Axalta has responded with large price increases (+9% in Q1 2022, +14% for 2H 2022), which will fully recover the price-cost gap by Q4. We expect margins will recover to 15% in Q4.

Axalta overview

Axalta is an industrial coatings company.

·         $6bn market cap, $9bn enterprise value, $65mm ADV.

·         Axalta is DuPont’s former Performance Coatings segment, with a 100+ year history. DuPont sold Axalta to Carlyle in 2013, which took the company public in 2014.

·         $5bn revenue company in the ~$140 billion global coatings industry (~3% market share, #6 largest coatings company). Axalta is the leader in refinish and light vehicle, but does not have architectural coatings.

Axalta sells paint to car manufacturers (“Mobility Coatings”) and autobody shops (“Performance Coatings”).

·         Mobility Coatings (35% of sales).

o    Light Vehicle, 15% market share. #2 share in 5 player global industry: PPG, Axalta, BASF, Nippon and Kansai. Axalta’s geographic mix is 40% North America, 30% Europe, 15% China, 15% Latin America.

o    Commercial Vehicle, 10% market share. #1 share.

·         Performance Coatings (65% of sales).

o    Refinish, 25% market share. #1 share in 5 player global industry. Axalta’s best business, with high margins and pricing power.

o    Industrial. $0.9bn general industrial (appliances, machinery), $0.3bn building products (doors, furniture) and $0.1bn energy solutions (electric vehicles and wind turbines). Energy solutions is their electric vehicle content story, with ICE coatings content of $100/car potentially expanding to EV content of $400/car by adding coatings for battery cells and packs.

Source: Axalta investor day; May 5, 2021

Source: Axalta investor day; May 5, 2021

Source: PPG presentation; August 2021

Auto recovery

Auto production has been impacted by covid shutdowns and subsequent chip shortages.

·         Global auto sales peaked at 94mm cars in 2018. Sales fell to 78mm in 2020 and 81mm in 2021, -14% below pre-covid. Sales in YTD March 2022 are still -12% below pre-covid levels.

·         The cumulative underbuild, the area under the curve between 94mm car potential and ~80mm actual sales for 2 years, has been 28mm global units. It will take 4-5 years of building 100mm cars per year to balance the market.

Global Auto Sales, rolling 12M

Source: LMC Automotive

IHS forecasts global production will increase +5% in 2022 and +9% in 2023.

·         IHS forecasts production will inflect in 2H 2022, with volume growth improving from -1% Y/Y 1H to +12% Y/Y 2H. Growth in 2023 is forecast to be broad based: Europe +11%, China +10%, North America +12%.

·         IHS forecasts had generally been too optimistic on global production recovery, but it appears the latest estimates are more realistic. On their Q1 conference call, Axalta said: “Global auto build rates have been revised lower month after month by industry consultants and have settled close to our current 80 million production rate assumption, which is slightly above the 79 million we last forecasted”.

Global Auto Production Forecast

Source: IHS

Pricing power

The coatings industry takes oil-based inputs and processes them into paint.

·         Coatings raw material inputs are resins (acrylic, epoxy), pigments (titanium dioxide) and solvents, which are combined in batch processes to create paint.

·         Raw materials are ~40% of sales. In 2021, Axalta purchased $1.8 billion of raw materials relative to $4.4 billion sales.

·         Axalta, like the entire coatings industry, fell behind price-cost in 2021 (+4% price, +16% raw material cost increases), which led EBIT margins to fall from 15% to 10%.

Axalta has responded with large price increases (+9% in Q1 2022, +14% for 2H 2022), which will fully recover the price-cost gap by Q4.

·         Pricing takes 6-12 months to run through the P&L. Performance Coatings reprices quickly (+11% in Q1 2022), while Mobility Coatings takes longer (+5% in Q1 2022). Mobility Coatings has 3-4 year contracts (= 25-33% of contracts reprice each year), with 35-40% of contracts being indexed with 6 month escalators (= July price increase based on cost from January to June).

·         Cost inflation has plateaued. We calculate spot inflation was up +63% Y/Y in Q4 2021, +23% in Q1 2022 and +13% in March 2022. (Contracted inflation realized by Axalta tends to be lower than spot inflation). At the current levels of spot costs, cost inflation will flip negative year-over-year by July due to the base effect. It takes 6-9 months for costs to run through Axalta’s P&L (4-6 months for chemicals supply chain, 2-3 months for inventory cost accounting).

·         The coatings industry historically has strong pricing power. The industry tends to get pricing on a lag during periods of inflation (pricing averaged +3% from 2011-2019), and most importantly, does not give back pricing during periods of deflation. In 2014-2015, with raw materials down -22%, industry pricing was flat, and EBIT margins expanded +400bps.

Source: Axalta presentation; Q1 2022

Source: PPG presentation; August 2021

Source: Axalta investor day; May 5, 2021

Coating input costs index: 29% TiO2, 16% ethylene, 12.5% vinyl acetate monomer, 10% acrylic acid, 10% epoxy resin, 7.5% tin, 7.5% propylene, 3.8% polyethylene, 3.8% polypropylene

TiO2 = RLCNRTPJ Index; Ethylene = FINSETFD Index; VAM = TCPMCQMF Index; Acrylic Acid = TCPMCQAO Index

Valuation

Axalta trades at 9x earnings on our 2025 EPS estimate of $3/share.

·         On consensus 2023 estimates, Axalta trades at 12x P/E, 8% FCF yield, 8.5x EBITDA, 1.7x sales. On our +10% above consensus estimates, Axalta trades at 11x P/E, 10% FCF yield.

·         Axalta has historically traded at 19x P/E. The stock traded 20-25x P/E from 2014-2018, before de-rating to 15-20x P/E in 2019-2021 as the M&A premium came out of the stock. The current 12x P/E multiple is an all-time low.

·         Coatings peers trade at 20x 2023 P/E: AKZA NA 14x, PPG 15x, SHW 25x. AXTA used to trade at a premium to peers because of an M&A premium, but now trades at a record discount (-20% discount to PPG, -50% discount to SHW). Pre-covid, AXTA had the highest EBIT margin among peers (AXTA 15.7%, SHW 15.7%, PPG 13.7%, AKZA NA 10.7%) and second fastest organic growth from 2014-2019 (SHW +6%, AXTA +3%, PPG +2%, AKZA NA +0%), so we believe the valuation discount is unwarranted.

Axalta is discounting that Mobility Coatings margins never recover.

·         Base case target price of $48/share in YE 2024 (+20% IRR from $28/share today), based on $3/share EPS x 16x.

·         Bear case target price of $29/share in YE 2024 (+0% IRR), based on $1.80/share x 16x. Mobility Coatings margins never recover, EPS does not grow for next 3 years. Discounted back to today, bear case target price of $25/share (-12% downside).

·         Bull case target price of $62/share in YE 2024 (+30% IRR), based on $3.25/share EPS x 19x. AXTA’s multiple recovers to historical 19x average.

Coatings comparables

Coating’s NTM P/E multiples

Yellow = AXTA; Red= PPG; Blue = SHW

AXTA NTM P/E discount to PPG and SHW

Red = PPG; Blue = SHW

Risk factors

·         Oil prices. Axalta is just an oil processor. With Brent at $100/bbl, oil costs are going up.

o    Mitigant: While 20-30% of Axalta’s inputs are closely driven by oil (primarily solvents), the other raw materials are correlated to oil but at the end of complex petrochemical chains.

o    Mitigant: The driver of Coatings raw material inflation has primarily been supply chain distributions, mostly arising from the February 2021 Texas freeze, as opposed to higher oil prices. In February 2021, Brent oil was up +13% Y/Y, but coatings input costs were up +69% Y/Y, driven by ethylene +187%, propylene +218% and polypropylene +128%. By March 2022, Brent oil is up +77% Y/Y, but coatings inputs are up only +13% Y/Y, with ethylene -42% Y/Y, propylene +10% Y/Y and polypropylene -25% Y/Y.

o    Mitigant: Axalta is now pricing to $110-115/bbl Brent. From the Q1 conference call: “Given current baseline expectations and assuming Brent crude between $110 and $115 per barrel, we expect to largely cover the existing price-cost gap and incremental headwinds this year, with some lag in Mobility Coatings being offset by strength in Performance Coatings”.

·         Europe. EMEA is 35% of sales. The weak European consumer will impact Axalta.

o    Mitigant: Even if the consumer economy is weak, there is a pent up demand for cars. IHS forecasts European auto builds will be up +7% in 2022 and +11% in 2023.

·         China. China is 10% of sales. The covid lockdowns will impact Axalta.

o    Mitigant: Axalta quantified the Q2 impact of Chinese lockdowns are only -3c EPS. They averted supply chain disruptions by having their employees live in their customers factories (!).

·         Autonomous vehicles. Autonomous vehicles get into accidents less often than human drivers. Axalta’s Refinish business will see volumes decline as ADAS adoption increases.

Appendix A: Coatings industry

Disclaimer: The author of this memorandum presently has a long position in securities of this issuer and may trade in and out of these positions without notice.  This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation.  This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

Earnings, auto cycle, Coatings pricing