AKZOY - Axalta Gaining Share And Catching Up On Margins

Summary

• Axalta reported good fourth quarter results, with strong double-digit price growth and share gains in the light vehicle OEM business, as well as margin improvements.
• The company has seen some relief on input costs, but many inputs are still stubbornly high; pricing has started to cut more meaningfully into the price/cost deficit.
• Auto and commercial vehicle demand should be healthy in 2023, but industrial is likely to be softer; share gains are a potential driver across the board.
• With a fair value in the low-to-mid-$30's I consider Axalta a more borderline buy now, but the company is executing well and has more margin upside.

Axalta ( AXTA ) continues to execute well in somewhat challenging circumstances, pushing through robust pricing to recoup some of the margin lost to higher input costs, while also leveraging technology and product differentiation to gain share in important markets. Up about 25% since my last update , Axalta has done about all I could ask or hope from it, including outperforming peers like Akzo Nobel ( AKZOY ) and PPG ( PPG ).

I expect that 2023 will be a more challenging year on the industrial side of the business, and there was already evidence of that in the fourth quarter. Still, pricing should help and I see more opportunities to gain share in what should be a healthy refinish and OEM auto/heavy vehicle business. I'm more ambivalent about valuation now, but I can stretch fair value to about $35, so I don't think this story is completely played out yet, and particularly not if the company can deliver some beat-and-raise performances.

A Better Q4 Than The Street Expected

Axalta's fourth quarter was a pretty clean beat across most lines. The Performance segment was a bit soft, but not to any surprising extent and there was evident progress on margin improvement.

Revenue rose about 9% as reported and a little more than 14% in constant currency, good for a small beat versus the Street, with close to 12% growth coming from pricing. Gross margin improved about 80bp year over year and quarter over quarter to 30%, with the company roughly halving the price/cost gap sequentially as higher prices play out. Adjusted EBITDA rose almost 28%, beating by almost 6%, while operating income rose 22% (with margin up 130bp to 11.9%), beating by almost 7%.

Looking further, the Performance segment posted a little under 8% year-over-year growth, a bit light of expectations, with pricing up almost 12% and volume down a little more than 4%. Refinish revenue rose more than 10% on a slight decline in volume, while Industrial rose 3% on a 9% decline in volume. Segment profits rose 7%, with margin up 60bp to 13%, beating by about 1%.

In Transportation, revenue rose 30%, with very strong volumes (up 19%) and beat expectations by more than 6%. Light vehicle revenue rose almost 31% on 20% volume growth, far ahead of underlying auto build growth of 2% (pointing to meaningful share growth). Commercial vehicle revenue rose more than 28%, with a more balanced mix of pricing and volume. Segment profits reversed a year-ago loss (with a 4.2% margin) and more than doubled the Street estimate.

PPG , arguably Axalta's best comp, reported 5% constant currency growth for the quarter, beating by about 2%, with Performance up over 5% and Industrial up close 8%. EBIT rose 24%, with margin up almost two points to 9%, beating expectations by about 5%.

Not Much Relief On Costs Yet

One of my concerns about Axalta, and the specialty chemical group in general, is how durable pricing actions taken in 2022 will prove to be. On a basic level, I think a lot of the inflation seen since the pandemic will ease, and I think it will be challenging for many of these companies to maintain pricing, as sooner or later somebody will use price to gain share (assuming underlying input costs ease).

That's not happening yet, though. Axalta saw pricing actions catch up more with cost inflation this quarter, roughly halving the deficit (from $108M to $52M) that the company had been carrying for a few quarters. While petrochemical-based input prices (resins and so forth) have improved, and indeed I think resin prices may bottom out this year, there hasn't been much improvement in inputs like pigments or energy.

Macro Trends Could Be More Challenging, But Share Growth Can Help

I'm not particularly bullish on Axalta's Industrial end-markets for 2023. I expect "general industrial" markets to slow through the fall of the year, and I likewise expect weakness in areas like construction (residential and non-residential). Given the breadth of the slowdown I expect, I don't think there will be much that Axalta can do to offset this, though legacy price hikes should be a meaningful offset to weaker volumes (as seen in Q4'22). I would also note, though, that volume comps are not really all that challenging this year, and Axalta could benefit from a pickup in activity in China.

Refinish should be fine in 2023. I don't think the slowdown in 2023 is going to be characterized by meaningful job loss, so I don't really expect meaningful changes to traffic congestion or accident rates. I also believe that the company can continue to gain share in this important market through product innovation. The company hosted an Analyst Day back in December for this business and laid out a series of recent innovations meant to reduce time and labor inputs for body shops, a key issue as skilled labor is still difficult to find (and this is a business where turnaround times matter).

I'm relatively bullish on autos for 2023, as I think mid-single-digit underlying unit growth is a plausible goal for the year as OEMs rebuild their channel/dealer inventories. I also expect good momentum in commercial vehicles to start the year, though I expect some weakness later in the year.

The Outlook

I've raised my revenue expectations for Axalta largely on the back of better-than-expected share growth in the auto and refinish businesses. I'm now a little ahead of the Street in FY'23 and FY'24 (by about 2%), and while I do see more opportunities for share gains in the auto and refinish business, my long-term revenue growth expectations are on the order of 3%.

I think it's going to take a little longer for Axalta to regain pre-pandemic profit margins, and while I expect meaningful improvement over the next three years (from an adjusted EBITDA margin of 16.6% in FY'22 to 19.5% in FY'25), that still won't quite get the company back to even. Of course, easing of underlying input cost inflation could drive a faster ramp, but then I think pricing would be harder to maintain at that point.

In terms of free cash flow, I'm expecting an improvement from FY'22 this year, but I expect FY'23 FCF margin will be below-trend before improving again in FY'24 and progressing into the low-to-mid-teens over the next decade, driving around 5% to 6% normalized long-term growth.

Discounting those cash flows back gives me a fair value in the low $30's and an anticipated long-term annualized total return in the high single-digits. I also use a margin/return-driven EV/EBITDA approach, and while I think a multiple of 11.35x is fair (on the high end of the company's 9x - 12x range over the last several years), I could argue for as much as 12x and further improvements in margins down the line can drive even more rerating.

The Bottom Line

I think a fair value of $32 is about right for now, but I can get to the mid-$30's without too much strain. At that high end, Axalta is still a borderline buy, though I think of this as more of a quality hold or buy-the-dip candidate at this point. I really have no complaints with how Axalta is operating now, and I'm curious to see what the new CEO will bring to the table in terms of strategy, but I don't quite see the same bargain that I used to before the 25% move.

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