Axalta: Paint Me Pink

Axalta Coating Systems Ltd. (AXTA, Financial) got hit hard by the coronavirus selloff, but has since recovered quite a bit of lost ground. The company is currently selling not too far from its initial public offering price in 2014.

Axalta recently reported its second-quarter numbers. Covid-19 has hit its sales quite severely with revenue down around 40% compared to the same quarter last year. The company noted that sales have improved sequentially over the quarter, with June sales up 80% from April. The company has shored up its liquidity by issuing $500 million worth of senior notes in June. Total liquidity is now around $1.5 Billion. The company has withdrawn its guidance for the rest of the year, cut down capital expenditures by 50% from the earlier plan and has started a global restructuring, which includes cutting out $50 million in expenses.

Background

Axalta is a global manufacturer, marketer and distributor of coatings systems. With a market cap of $5.4 billion, it caters to a diverse customer base in the "refinish" market as well as to large original equipment manufacturers.

It was the former DuPont paints and coatings business. As DuPont's strategic focus shifted increasingly to agriculture and industrial biosciences beginning in the early 2000s, the coatings business was not a candidate for growth, although it was the worldwide leader in automotive refinish and a top-three player in transportation OEM and industrial coatings. It was sold to private equity firm Carlyle Investment Management for $4.9 billion in early 2013 in what was, at the time, the largest-ever carve-out of a chemical business from a diversified chemical conglomerate and remains among the biggest of such deals; Carlyle carried out an IPO of Axalta in November 2014.

The company's primary competitors in the refinish end-market include PPG (PPG, Financial), BASF (BASFY, Financial) and Akzo Nobel (AKZOF, Financial), but Axalta also competes against regional players in local markets. Similarly, in industrial coatings, the company competes against multinational suppliers such as Akzo Nobel, PPG, Valspar (VAL, Financial) and BASF, and regional players in local markets.

The following is a list of large global coating companies.

Two dynamics have been reshaping the paints and coatings sector over the past two decades. The lineup of leading players has shifted from predominantly coatings businesses owned by diversified chemical companies to mainly pure plays. At the same time, the largest coatings companies have been acquiring smaller rivals and consolidating the industry. Axalta itself has made a number of small acquisitions and has been subject to merger and acquisition interest as well.

Source: Investor Presentation

Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) owns about 10% of outstanding shares acquired at a higher price of $32.50 in 2015. Buffett already owns paint and coating company Benjamin Moore, so he is quite familiar with the industry.

Growth

Axalta's revenues have increased modestly since its IPO at a rate of 1.6% per year, but Ebitda has increased much more rapidly at 8.2% annually. These are good results in a mature industry.

The company has been generating copious amounts of cash flow since its debut but has hit a wall in the last two quarters.

Axalta does not pay a dividend, but the company has reduced the number of shares outstanding from 246 million to 236 million since 2017.

Balance sheet

Axalta's balance sheet appears to be in good shape, even though debt is on the higher side, which is a function of the company's IPO. Basically, Axalta, a new entity (backed by Carlyle) purchased the business from Dupont for approximately $4.9 billion prior to the IPO in 2013. That purchase was funded mainly with debt. Carlyle then listed Axalta and exited the investment in 2016, selling its stake at $28.25 a share.

The nearest debt maturities on both its term loans and unsecured notes are in 2024. It has no affirmative financial covenants on its currently outstanding debt and it ended the first quarter with an interest coverage ratio of 4.7. In January, it prepaid $300 million of its term loan, which lowered its full-year cash interest expense by over $10 million.

Conclusion

A discounted cash flow analysis using the Gurufocus DCF Calculator indicates that the company has a solid margin of safety of over 30%. The company was trading in the low $30s prior to the crisis and I am confident that when this recession is over, it will regain the high ground. I used a 6% growth rate for the first 10 years and 3% of the second. A cost of capital (discount rate) of 8% was used in the model.

Valuing the company by the five-year median price-to-operating cash flow ratio also indicates a value in the mid-$30s, suggesting undervaluation. Though it should be noted that operating cash flow will likely decline in the current recessionary economic environment.

A comparative analysis with other paint and coating companies shows that Axalta compares quite favorably with selected peers on a price-to-operating cash flow and enterprise value to Ebitda basis.

The company is a leading candidate for a buyout. In 2017, Axalta was in merger talks with AkzoNobel and Nippon Paints. More recently, it was rumored that PPG was interested in acquiring the company, but nothing has come of it. Consolidation is very much the name of the game in this industry, so I expect Axalta to be prominent pick on any list of targets. Given Berkshire already owns over 10% of the outstanding shares, I am sure it could be interested in getting the rest of the company at a decent price. In an merger and acquisition transaction, Axalta should be valued in the low $30s or around a 40% premium from the current level. I believe it is currently a good time to go long Axalta.

Disclosure: The author owns Axalta stock via options.

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