Late last year, Axalta Coating Systems (NYSE:AXTA), a leading producer of performance coating systems (paints and industrial coating materials), became a public company. The 150-year old company is highly undervalued as its largest input cost continues to fall in price, which we do not believe that market has embedded into the current share price.
Axalta is a sturdy business that operates within a growing and increasingly insulated industry. The industry itself continues to consolidate and, with the company being a market leader, Axalta is intensifying its moat. The company has a long history dating back to the 1800s, but the name is relatively new.
We believe several catalysts will eventually make this a $40-$50 stock including the: 1) reduction in oil prices, its chief COGS input; 2) a de-leveraging process left from the Carlyle Group’s ownership; 3) long-term geographic expansion with free cash flow inflection; and 4) discount to its peer group. The new management team, hand-picked by Carlyle in early 2013, is highly incentivized to grow the company and share price.
Business Overview
Axalta was DuPont’s former OEM and industrial coatings business that it divested in early 2013. It operates two segments: performance coatings and transportation coatings. It is the number one supplier of commercial vehicle coatings along with holding the number two position in the light vehicle coatings end-market. Axalta has a number one or number two market position in all of its primary business lines.
(Source: Investor Presentation)
Within the performance coatings business, the key business is the Refinish segment which is driven by the automotive repair market. Although the refinish coatings are a small fraction of a vehicles total repair cost, they are a critical aspect in terms of appearance. The company has industry-leading color-matching technology that enables them to match original paint including aged looks, without regard to the supplier or vehicle brand.
The industrial business produces liquid and powder coatings used in a wide variety of applications and products. These include appliances, electrical components, coatings on copper wiring, commercial structure exteriors, automotive components like chassis and wheels, as well as oil and gas products to coat tanks, pipelines, valves to protect against corrosion.
The transportation coatings business primarily consists of light and commercial vehicle end markets. The performance is driven by OEM vehicle production and sales. US SAAR auto production recently eclipsed a 17 million run-rate, the highest since the mid-2000s. However, much of this segment’s growth is occurring in Asia, where vehicle ownership is exploding.
Market Size, Opportunity, And End-Markets
The global paints and coatings market will reach $176 billion in total revenue by 2020 according to Persistence Market Research. Demographics and middle-class growth are urbanizing the globe faster than ever, with growing palettes of sophistication increasing the need for greater comfort. The coatings market is benefiting from this trend at a greater than global GDP growth rate as the demand for vehicles and homes along with commercial growth needs to satisfy the growing populations and wealth around the planet.
Of the $176 billion in potential market opportunity for 2020, the refinish coating sub-category is worth about $77 billion of that with the industrial coatings market slightly larger at approximately $98 billion. Axalta only competes in a small portion of the large industrial coatings market worth about one-quarter of that $98 billion market opportunity. The current opportunity within the industrial coatings market is detailed below from its S-1.
(Source: S1- Registration Filing)
Overall, the company’s total market opportunity currently is approximately $37 billion and growing at a mid-single digit rate per year. The industry is highly consolidated with the top four companies controlling two-thirds of the market in the refinish business and nearly three-quarters of the market on the transportation side.
The market opportunity is growing rapidly within emerging markets with the company realizing a nearly 10% CAGR over the last three years. Today, the EMEA geographic segment is its largest at 39% of last year’s sales. Asia Pacific is the fastest growing geographic segment at 16% of consolidated sales.
Within the performance coatings business, the primary competition in the refinish business is PPG (NYSE:PPG), BASF, and Akzo Nobel, on a global scale, but the company also competes against regional players in local markets. On the industrial side, the company competes against the same players, but also Valspar (NYSE:VAL) and other paint suppliers.
Lower Oil Prices Not Priced In
The largest input material into the company’s products are derived from crude oil production. Propylene, a key material in the production of polymers, is used to bond the paint. The company has noted in its S-1 that a 10% decline in oil prices would improve its gross margin by 1%. Raw materials account for over 50% of its cost of goods sold and 70% of that is based on the price of crude. However, given that the company purchases product in advance, there is a several quarter lead time adjustment- in other words, lower oil prices take several quarters to filter down to benefit the company.
With a large reduction in oil prices of over 50%, we think the impact to EBITDA will be felt over the next two quarters. If raw materials account for 50% of COGS, and 70% of that is oil-based, then oil-related COGS is approximately 35%. Propylene spot prices have been in free fall since late last year but tends to lag the price of crude by a few months. Even before the precipitous decline in crude prices began last September, propylene looked oversupplied in North America and China. Production of propylene was on tap to increase to 165 million tons per year by 2030, up from the current 109 million tons per year level. The $120 billion market had largely been in a shortage situation causing higher pricing over the last four years. As a result of the shortage, substantial investments have been made to boost global propylene supplies.
This has created a near-term oversupply situation. The imbalance has yet to correct despite the fall in the price of propylene boosting overall demand for the product. Spot prices have plunged by more than 50% over the last year. The recent sell-off in the shares of Axalta belies the fact that the price of propylene continues to fall and accelerate lower. Shares of Axalta are down 16.5% since June 22.
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There is also a second derivative effect from the lower crude oil prices. This includes the lower gasoline prices derived from the lower crude prices, increasing the amount of miles driven. The 12-month moving average for miles traveled on all roads hit a new high in July of this year, and only eclipsed the November 2007 high a few months prior. As people drive for longer durations and longer mileage, they tend to get into more accidents, driving up the need for repair and refinish work.
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(Source: DShort.com)
We believe that Axalta and the refinish business in particular, is unique within the sector. Most of the sub-sectors of the chemicals industry sell to larger OEMs, who then use the oil-based input as a raw material for some finished product. These OEMs will seek significant price reductions when they know the price of the underlying (crude in this case) has declined. The company have associates within its procurement departments exclusively focused on achieving price concessions, detailing its rationale for such lower prices through complex analytical tools. This will typically prevent the supplier from realizing the cost savings from the lower raw material pricing. In the refinish business, this is typically not the case owing to the diverse customer base, consolidation in the space and market power of Axalta.
Deleverage Opportunity
The company came out of the LBO with significant leverage of 5.6x net debt to EBITDA, but as of the most recent quarter-end, it had already reduced that leverage to 4.1x. We think this is an overhang to the shares and is preventing the initiation of any share buyback program, nor dividend payment, and any MA transactions.
Interest expense totaled just 5% of revenue and 31% of fiscal 2014 EBITDA and management has committed to deleveraging the balance sheet further. However, simply through the robust EBITDA growth, net leverage should continue to decline fairly rapidly at 0.5x – 0.8x turns per year based on the current trends.
(Source: 10-K)
One of the overhangs is the nature of the debt, most of which is floating bank debt. The largest piece of its outstanding debt is its dollar term loans worth approximately $2.15 billion with a structure of 3-month LIBOR plus 275 bps. Given that the bulk of the debt is floating rate, we believe investors perceive interest rate risk as being sizeable. However, the floating rate component includes a 1% floor which, given that current 3-month LIBOR rate is just 0.31%, leaves a sizeable gap that would need to close to be pierced. In other words, they are paying 3.75% and that rate won’t move until 90-day LIBOR reaches 1%. Even with interest rates slated to rise later this year, we do not foresee LIBOR rising above the floor rate over the next two years- at a minimum.
As the firm deleverages, it will put them more in the realm with its peers, as PPG Industries trades at just 1.2x net debt to EBITDA and Valspar just over 2x. We believe this is a primary reason why the shares of Axalta trade at such a discount to its two main competitors. Over the next two years, we think the firm will be able to de-lever down to below 3.0x leverage, putting them into much safer territory- though we think the robust EBITDA generation and low interest rates all but eliminate a chance of default.
When leverage gets below 3.0x, and even below 2.5x, we think the shares will close the EV/EBITDA discount they trade compared to its main comps. For one, we see this as reducing the perceived interest rate risk. Second, it will allow them start paying a dividend, which both of its competitors currently do. Third, it will allow them to engage in other activities like accretive acquisitions, a key growth driver within the industry over the last decade. Management noted at a recent conference that deleveraging remains a top priority for the firm in the near-term.
Growth Opportunities And Overhead Reduction
The company is in the process of restructuring its business to reduce its cost footprint while implementing initiatives to increase revenues and take share. Cost reductions have helped drive EBITDA margin expansion by 300 bps since 2012 and has helped to drive down its net leverage level.
The company initiated the Fit for Growth program in Europe at the end of last year. The essence of the initiative was to right-size the cost structure and automate its European business for the current environment. This was to be accomplished through wage and benefit reductions, rationalizing manufacturing and logistics while investing in automation, and right-sizing staffing levels. Management projects that the savings will amount to $100 million in annual run rate by the end of 2017. $37 million of that goal was achieved by the end of 2014 through personnel adjustments.
Based on the success of the European expense right-sizing, the company has launched a similar initiative in the U.S. called the Axalta way. The Axalta Way program is a broader initiative that is more globally based on improving efficiency through technology and better communications along with automation on the production side. Much of the reduction will be done on the SGA side, similar to Europe but also on the production side through Lean tools. Management is targeting another $100 million in run-rate savings by 2017 on top of the $100 million from the European program.
On the revenue growth side, the company is supporting its growth through client wins, with 32 OEM plant vehicle wins in the last two years alone. There is a large amount of business ramp which is driving the revenue growth within the light vehicle OEM this year. On the OEM side, its share of the MSO market, which previous to the new management team only had a small market presence, has led to them achieving a leading market share position in the US.
A focus on emerging market growth is a key aspect of its strategy with increased vehicle demographics driving penetration. Orr Boss estimates that the coatings market within emerging markets will grow at a 9% CAGR through 2018 and reach $20.1 billion. On the refinish side, China represents a very large opportunity as the population are mostly recent drivers. Two decades ago, most of the people hadn’t ever driven a car and today, there are over 100 million vehicles on the road. That figure is up from just 35 million in 2008. China has just 61 vehicles per 1,000 people, compared to 743 for the U.S. More importantly for Axalta, given the nascent driving abilities of the Chinese driver, China has the highest incidences of damaged vehicles per 1M km driven.
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(Source: Company Presentation)
We believe a key source of the growth will come from the heavy-truck market. Axalta has an industry-leading share of between 70% and 75% in the U.S. in the heavy-duty truck market. But when the new management team took over in February 2013, the company sold very little, if any, within the heavy-duty truck industry in China. But that is where the majority of the world’s heavy-duty trucks are not only manufactured, but also consumed. The company has recently entered into several joint ventures to capture some of that market with Daimler Foton and Kinlite of China. Much of the new business wins over the last two years have come from China and we expect that to continue to be the case.
Valuation
The refinish business is the most attractive segment and Axalta has a higher percentage derived from this business than the competition. As we noted above, 42% of its sales are derived from this segment of the business compared to an estimated mid-teens level for PPG and BASF. We believe the combination of strong revenue drivers, lower oil prices and expense control will accelerate EBITDA growth through margin expansion.
We think costs will grow much slower than revenue over the next several years as non-recurring costs associated with becoming a standalone public company recede and the results of its two cost reduction initiatives take hold. The 300 bps of improvement in EBITDA margin over the last three years could be doubled in our estimation over the subsequent three years. We believe this is already playing out as the company saw a 380 bps improvement in EBITDA margin in the recently reported second quarter.
The combination of the above factors will also inflect free cash flow generation as investments into its automation and new plants in China begin to bear fruit and initial costs roll-down. Management estimates that growth and productivity capex represent 60% of total capex, which is expected to be $150 million in fiscal 2015. Net working capital is another 13% to 15% of net sales, excluding the non-recurring items.
We do not believe the market is fully accepting the lower oil price story and think that fiscal 2016 estimates are far too low. As such, we forecast the business realizing much stronger EBITDA generation next year as those lower oil prices – crude hit a fresh 6-year low on Friday, August 14 – filter through the supply chain. Again, there is a lag basis to that effect which we think will be revealed in the third and fourth quarters of this year (and likely is responsible for some of the second quarter’s large margin improvement as well).
We think the shares are currently worth around $38 and could rise to over $46 next year as lower oil prices filter down through the income statement. The only downside we see is from a global macro downturn that to us appears unlikely or a rebound in oil prices. Our bear case is predicated on that theory but the refinish market tends to be fairly insulated from cyclical downturns and is instead levered to miles driven and not vehicle sales. Thus, we think the upside case is significantly stronger than the downside case, creating an asymmetric opportunity.
We think the overhang of low float from financial sponsorship has been recently mitigated as the company priced a secondary offering for 30 million shares at $29.75. The shares are part of the Carlyle Group holdings which amounted to over 170 million of the 235 million shares. This large holding we believe is partially holding back the shares but as Carlyle continues to sell off its position, the shares will become more investible for large funds and indexes.
Finally, as the company further de-levers over the next year, we think there is a distinct possibility of the initiation of a dividend and even share buyback program. Free cash flow last year totaled just $84 million but with the investments in new plants rolling off, the cost savings programs, and the EBITDA growth, free cash flow should total over $300 million this year rising to $450 million in 2016, equating to over a 6% free cash flow yield. This should allow them the ability to return some cash to shareholders.
Catalysts
Lower oil prices have a lagged effect to the company. We think the late fall and early winter decline in crude is just starting to be realized in the supply chain.
The second derivative effect of lower oil prices is more miles driven, increasing collision rates.
The deleveraging of the company should help re-rate the shares as its debt load becomes more in line with the peer group. It should also allow the initiation of a dividend and share buyback over the next year, propelling the share price.
Financial sponsorship is on the decline with Carlyle Group selling off 30 million shares of its 170 million stake (74% of the share count). Greater float should allow larger financial investors the opportunity to invest.
Risks
Rising raw material prices are the key risk – as we noted above it is a primary component of its COGS. If prices jump back to the prior range ($80 WTI), then the cost savings are unlikely to materialize.
Large Carlyle sponsorship creates a low-float share base which we think gets mitigated over the next year through secondary offerings. As this occurs, we think the shares become more investable.
Leverage is a key risk and one of our bull thesis as the company de-levers and lowers its firm-risk profile. As its debt load becomes more in line with the competition, we think the discount the shares trade to them will close.
Conclusion
We feel that Axalta is currently mispriced as lower oil prices have yet to fully filter through the supply chain of the company. The firm only went public late last year and investors have yet to appreciate the pricing power and how crude oil prices affect its COGS line. The company is levered to emerging market vehicle growth, which the current management team has keenly focused on growing sharply in China over the last two years. We think there are several upside catalysts to the share price, which has backed off lately, despite new lows on oil prices. Should the price of oil be sustained or fall from these 6-year lows, we think the shares are worth between $38 and $45 a piece, for upside of at least 25%.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…)I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from ). I have no business relationship with any company whose stock is mentioned in this article.
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