Axalta Gaining Share, But Still Seeing Punishing Cost Pressure (NYSE:AXTA)

My bullish call on Axalta (NYSE:AXTA) back in April of 2021 was the wrong call, as the shares have dropped about 20% since then – slotting in between PPG (PPG) (worse) and Sherwin-Williams (SHW). While my thesis of leveraging recovering volumes wasn’t entirely off-base, the reality is that passenger vehicle volumes were hit harder than I expected by semiconductor shortages. On top of that, Axalta saw a punishing level of cost pressure that it couldn’t fully offset with price.

I may be a glutton for punishment here, but I still think there’s a buy argument for Axalta. The company has been gaining share in most of its major categories (refinish, light vehicle and commercial vehicle), and while there’s a long way to go to recoup cost inflation, any meaningful easing of input costs (more likely in a slowing economy) would have a very positive effect on margins. Between low-single-digit revenue growth, high-teens EBITDA margins, and mid single-digit FCF growth, I think Axalta is undervalued now.

Mixed Results In Q3, With A Weak Guide

Axalta reported better-than-expected financial results for the third quarter – revenue was 3% above the sell-side, while EBITDA was 1% better – that has to be viewed in the context of repeated lowerings of guidance throughout the year, including another significant cut to operating income guidance for the fourth quarter of this year.

Revenue rose 14% as reported, but closer to 19% in organic terms, with price up 10% and volume up close 9%. Gross margin weakened again year-over-year, down 230bp to 29.2%, but did improve 100bp sequentially, and management believes that cost inflation peaked in Q3’22 (though the track record here of predicting cost peaks isn’t great). EBITDA rose about 5% yoy, with margin down 150bp to 17%, while operating income rose 1%, with margin down 150bp to 11.9%.

The Performance segment saw almost 8% reported growth (and 14% constant-currency growth) on 12% price improvement, with Refinish up 16% organically (price up 12%, volume up 4%), and Industrial up about 7% organically (price up almost 12%, volume down close to 5%). Profits here fell 1%, with margin down 130bp to 14.5%.

In the Transportation business, revenue rose about 35% organically, with price up close to 5% and volume up 30%. Light vehicle revenue rose about 35%, with price up 3% and volume up 32%, exceeding global passenger vehicle production growth of 27%. Commercial vehicle revenue rose 35% on 24% volume growth. Profits reversed a year-ago loss, with a margin of 0.9%, up from 0.5% in the prior quarter.

For the quarter ahead, management guided adjusted EBIT to a range of $120M to $145M; at the midpoint, that is about 19% below prior sell-side expectations. I’d note that PPG also guided lower, and the entire sector continues to suffer from the overhang of high input costs.

Will Cost Headwinds Turn Into Tailwinds?

Management had previously predicted (back in Q4’21) that cost inflation would peak in Q1 of this year, but that wasn’t the case, and the company has seen a cumulative $650M hit from cost inflation versus an initial expectation of $400M.

Pricing could continue to recoup some of this. Pricing in this industry almost always lags cost input trends, and PPG has managed to achieve more on pricing than Axalta – seeing 14% pricing improvement in its industrial business this third quarter. How much of that is due to stronger brand value, as opposed to more proactive management, is hard to say, but I would expect Axalta to continue to look for pricing opportunities.

There could also be some macro drivers working in the company’s favor next year and in 2024. Chemical producer prices have started to fall, as have railcar loadings (down about 1% on a trailing three-month average). Multiple industrial companies have pointed to signs of weakening (or at least normalizing) demand, and both residential and non-residential construction activity has started to weaken. Given debottlenecking efforts that came into play this year (and in some cases are still underway), there could be enough of a gap between supply and demand next year that basic chemical costs start falling more meaningfully for Axalta, allowing the company to shore up its margins.

Underappreciated Execution Through A Challenging Stretch

Relative to end-market conditions, I believe Axalta has executed fairly well since my last update. The worse hit from input costs shouldn’t be ignored, but underlying volumes have been solid – Axalta has seen better volumes in its light vehicle business than global production rates would otherwise suggest, and the company has likewise outperformed several North American industrial markets, while weaker demand from Europe (energy prices and the Russian war) and China (COVID lockdowns) has undermined those volumes; even there, though, I believe Axalta has gained some share.

The Outlook

Axalta’s board needs to find a new leader to take the company through the next phase of the cycle. The now-former CEO unexpectedly announced his departure with second quarter earnings, and there has been no commentary as to why he chose to leave (and I don’t believe he’s taken a new position since then). With the interim CEO praising the performance of the Mobility business, it’s possible the new permanent CEO could come from there, but that’s just idle speculation on my part. It’s also worth noting that Axalta has been in play before as a buyout candidate, and this is a point in time when the board may be receptive to an overture.

Since my last update, Axalta has actually been outperforming on revenue – 2021 revenue was about 2% better than I’d modeled and 2022 has trended about 5% higher. Of course, that’s offset by far weaker margins; 2021 EBITDA margin was three points lower than I expected, and my expectations for FY22-FY24 are about three to six points lower than before.

I’m still looking for long-term revenue growth in the neighborhood of 2.5% to 3.5%, but I now believe the company may not get to 20%-plus EBITDA margins until 2024 or 2025. Long term, I think mid-teens FCF margins are still possible, but it will take longer; I’m looking for long-term FCF growth of around 5% relative to pre-pandemic levels and execution on margins is a key to-do for whoever becomes the next CEO of this company.

The Bottom Line

Discounted cash flow suggests high single-digit long-term annualized return potential, while a margin and return-based EV/EBITDA approach suggests upside into the high-$20s. It’s not uncommon for DCF approaches to undervalue cyclical companies near their troughs. That said, there are a lot of high-quality companies trading at meaningful discounts to fair value now, so investors should shop around. I do think Axalta is a “better than it seems” type of story today, with perhaps a stronger contrarian story if raw material prices ease more significantly in 2023-2024 on a weaker macro.