AKZOF - Akzo Nobel: Earnings Momentum To Continue Debt Level Is Key To Watch

2023-05-04 06:03:07 ET

Summary

• The 1Q23 results of AKZOF were better than expected, with an increase in group sales and better volumes, indicating the company's underlying strength.
• Management's FY23 guidance seems conservative, given the company's better-than-expected 1Q23 results and strong momentum in China.
• The company's ability to reduce debt and improve its leverage ratio will be a key factor to watch going forward.

Thesis

Akzo Nobel N.V. ( AKZOF ) produces a wide variety of chemicals, including those used in the production of paints, coatings, surfactants, polymers, pulp and paper, and more. The results for AKZOF's 1Q23 were better than expected. The solid 1Q23 result and 2Q23 outlook , in my opinion, are an unmistakable indication of the firm's underlying strength. Management has not revised their FY23 forecast, which, in my opinion, is too conservative. This could lead to a beat and raise, which would be bullish for the stock. One major reason I feel this way is that the price of raw materials appears to be falling, which is great news for AKZOF's profit margins. This, along with management's forecast of price increases in the mid-single digits for 2Q23, suggests a continuation of the margin recovery trend. However, debt may be detrimental to the company and its stock. If AKZOF's leverage ratio doesn't return to normal this year, as expected, it could put downward pressure on valuation. Overall, I recommend a buy rating with the notion that earnings should continue to exceed expectations, driving a positive momentum to the stock price.

1Q23 results

The increase in group sales to €2.66 billion was slightly higher than consensus of €2.63 billion. The outperformance was driven by both pricing and volumes. Adjusted EBIT for the 1Q23 fell 5% to €218 million, which was still better than expected. Better volumes, with stronger recovery in China and milder decline in EU, are probably the main reason for the outperformance.

Guidance seems conservative

Management has reiterated their FY23 adjusted EBITDA guidance of €1.2 to €1.5 billion, which they say will be driven by a 1-5% drop in volume and pricing/cost effect. Management also anticipates that paint volumes in China will grow by double digits in FY23, while volumes in EMEA will decline by the mid-single digits. Given the better-than-expected 1Q23 results and the improved China volume outlook, I find the guidance to be too conservative. To put this in perspective, prior guidance for China's growth was in the high single digits, while the new projections are in the double digits. The end market commentary made by management is also in line with what PPG is saying as well. If we look at AKZOF recent quarter performance, they have also consistently beat consensus revenue estimates 11 out of 13 time since 1Q20.

China

Even though China's demand is expected to grow by double digits, I think it's important to note that in 1Q23, despite higher volumes, decorative paints in China saw lower price and product mix as a result of increased competitive intensity. I also note that cost of raw materials in China came down much faster than other regions since 2H22, and it would be interesting to see how much would pricing be a headwind for AKZOF. If it is just a matter of comparison, then we should start to see normalized pricing growth in 2H23. If we don’t, then it could be sign of worse than expect pricing competition, which could be a red flag.

Debt could be a problem

While this is not a big issue now, I highlight that AKZOF net debt to EBITDA ratio has reached 4.17x in 1Q23. I believe there are 2 way to look at this (I stand by the latter):

1. Leverage ratio could be pushed further higher, thereby pushing valuation down relatively to peers (like PPG who has a much lower debt level). This is not a distinct possibility. If we head into a recession and volumes decimate worse than expected, coupled with pricing deflation, AKZOF could face short periods of weak EBITDA. I believe this is a valid concern and should be considered when investing in the stock
2. This is just a 1x blip that pushed the ratio beyond 4x. Management has guided confidently that they will reduce the leverage ratio to less than 3.4x this year and 2x post FY23. Given the strong momentum in China and the price/cost positive impact, there should be no issue in AKZOF hitting consensus figures. Importantly, management has also guided for $1.35 billion in FY23 EBITDA, which implies a 3.15x ratio, on the back of improving end-market trends and low customer inventory levels

Valuation

Looking at valuation, the stock is currently trading at 18x forward PE, which I think is alright relative to its average. While I believe there is a chance for some form of short-term multiple re-rating upwards due to earnings momentum, I will assume the same 18x in my model. With consensus now expecting around $920 million in net income in FY25, this implies an upside of 30%. This 30%, coupled with 2 to 3% of dividend yield + share buybacks should equate to mid-30+% upside over 18 months.

Conclusion

In conclusion, AKZOF had a strong 1Q23 with sales and volumes exceeding expectations. Management's guidance for FY23 may be too conservative, especially considering the strong momentum in China and improving end-market trends. The company's ability to reduce debt and improve its leverage ratio will be a key factor to watch going forward. However, the positive impact of falling raw material prices and price/cost improvements should help drive continued earnings growth. Overall, I recommend a buy rating for AKZOF stock with the expectation of continued earnings growth and positive momentum for the stock price.

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