Akzo – Every Village Needs One!

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 30th, 2017

Akzo – Every Village Needs One!

  • Akzo is already having a “special” year.
    • A successful defense of a largely cash bid that would likely have given shareholders in excess of €100 per share!
    • An overly aggressive business plan to defend that bid – resulting in the exit of the CEO, the CFO and the Chairman – and a subsequent retraction of the goals/targets!
      • Akzo has either missed or guided down three times since July!
    • The announcement of a plan to exit their chemicals business, which looks like a gift for potential private equity buyers given high costs and the likely opportunity to make the business much more profitable and then either sell it or take public – with the value accruing to the buyer not Akzo holders.
  • Before Friday, shareholders had every right to question the credibility of the old and new management teams – but if there is any truth to the Axalta rumor things are likely going to get worse.
    • Axalta will want cash and a reasonable premium. With Axalta currently at 11.7x forward EBITDA, versus Akzo’s 9.8x, the deal will be dilutive even with significant synergies.
    • Synergies limited because of limited overlap – Akzo is mostly decorative and Axalta mostly Auto – there is no similarity between the business model for decorative and Auto OEM.
    • Plus…we believe the auto business is on the cusp of secular decline – refinish and OEM
      • Not surprising if Axalta willing to entertain an offer and probably why management won’t risk losing the deal by pushing for too high a premium, again in our view.
  • Likely a heaven-sent opportunity for Axalta – the acquisition strategy has not delivered the growth expected and the OEM business is likely to turn into a knife fight over the next few years even though there are only three players of size.
    • If this deal is confirmed – all hope of Akzo being acquired by PPG or SHW (at least for now) goes away and we think that the stock has meaningful downside just based on that.
    • As investors come to terms with the overall likely value destruction of the Chemicals sale and an Axalta acquisition, we think the stock could revisit its early year lows – Exhibit 1.

Exhibit 1

Source: Capital IQ and SSR Analysis

Details

Akzo is, in our view, both strategically inept and lacking the critical self-awareness needed to run a competitive business effectively today. While this has been demonstrated time and time again over just the last 6 months, the business has been run poorly for years – and a short better stretch under Ton Buchner resulted in the improving trends that attracted PPG in the first place. What Ton achieved gave PPG the confidence that there were things that could still be done to improve the business in addition to the synergies that could be gained by bringing together two large European decorative paint businesses and some smaller industrial product lines.

Akzo’s claim that it could do better on its own was pure hubris – as clearly demonstrated by the promises made by management that have already – within only a few months – been de-bunked. Our fear at the time was that in its attempts to fend off PPG, Akzo would go down the acquisition route – most likely for Axalta – as the combination would be untouchable for PPG – though maybe not for SHW, eventually.

Akzo would be selling a business that is bloated on the cost side – giving all the cost opportunity to the buyer, while potentially buying a business that has already been picked clean by both private equity and new management

Equally troubling: since June we have become increasingly concerned about the automotive side of coatings.

  1. We have always believed that the renaissance in Auto Refinish was a flash in the pan, with auto and now phone makers innovating to reduce the surge in texting based “fender-benders” which had given the refinish market some life. Ultimately, we would expect advances in driving autonomy to kill the refinish market completely, with the trend starting soon and then accelerating.
  2. OEM has a couple of problems near-term and a major problem longer-term
    1. Near-term we have an acceleration of model turn-over in the US as manufacturers push to meet 2020 CAFE standards. Competition to be the paint supplier on each platform is more intense than it was; with Axalta more focused than when lost in DuPont (and lower cost so more competitive), and BASF integrated with the Chemetall platform now with a more complete product offering. Axalta, PPG and BASF all need to win their share of these new platforms – we think price (and margin) concessions are likely.
    2. Also, near-term we have design changes – more plastic and more aluminum (for light-weighting) – neither of which rust and we are assuming require less coating as a consequence. This is accelerated with hybrid and electric vehicles as weight is critical in improving range on battery systems.
    3. The category killer in our view is the driverless taxi, and whether this adoption appears in 5 or 10 years, its likely emergence is going to impact consumer decisions earlier “do we need a second or third car or should we just use Uber/Lyft etc. for those days when we need two/three – especially if the cost is coming down”
      1. A driverless taxi fleet is unlikely to be made of steel and aluminum and designed to look sexy! It will be basic – easily cleaned – modular, and in our view mostly plastic. Plus; every “Uber” or “Lyft” or “Google” or “VW” autonomous vehicle will be the same color – from a branding perspective.

Electric and Autonomous vehicles are going to change a number of industries significantly – Honeywell is looking to separate a turbocharger business while it is still growing (a result of the CAFE rules), but with countries beginning to mandate the phase out of petrol and diesel cars within 15 years, turbochargers could be museum pieces by the time my kid’s children reach driving age. It is very hard to spin a growth story for sophisticated auto paint in this environment. While Axalta has had some issues with integration of the many acquisitions it has made recently, leading to some caution over earnings, it is interesting to note the negative revision trend that the company has seen since July – Exhibit 2. PPG’s revisions trends have been similar and PPG now trades at a very high multiple of both current and forward earnings. If PPG’s valuation has been based on the idea of another possible run at Akzo – any confirmation of an Akzo/Axalta tie up might be seen negatively for PPG, at least initially.

Exhibit 2

Source: Capital IQ and SSR Analysis

Regardless – Akzo Is Avoiding The Hard Task Of Getting Its Own House in Order By Distracting with M&A

PPG saw two opportunities with Akzo – straight overlap synergies AND the ability to run Akzo’s businesses more efficiently. As shown in Exhibits 3 and 4. Akzo lags both from a margin perspective and on earnings stability. The convenient answer for any management team either not able or not willing to manage its business aggressively and on a more granular basis is “mix” “we are different”. We do not believe this to be the case at Akzo.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

The opportunity with the chemical business is to make it much more efficient – possibly through merger or acquisition and then probably separate it later. We believe that this is what PPG had planned for it. Akzo is choosing to sell it because it is the easy thing to do now. All of the benefit from turning into something better will accrue to the buyer.

Axalta is a great example here – the company should post almost $0.9bn of recurring EBITDA this year. In 2009, it has $190 million of EBITDA after the financial crisis (mostly D&A), and DuPont sold the business to Carlyle for $5.15 billion in 2013, at which time it had EBITDA of around $650 million. When Carlyle took the company public in November of 2014, less than 2 years after purchase, the company had taken more than $100 million of costs out and Axalta went public at an enterprise value of more than $8bn – DuPont gave all the ($3bn) upside to Carlyle and faced significant criticism at the time for doing so.

If Akzo sells its Chemicals business today it will likely be making the same mistake.

If Akzo then turns around and buys Axalta, it is buying a business where both Carlyle and subsequent management have extracted most of the value by improving the business and current recurring EBITDA margins are in the 21-23% range, versus 16% when Carlyle bought it. This is before all of the fundamental concerns that we raise earlier.

Akzo will need to pay close to $40 per share to get it – with assumption of debt this will be an enterprise value of more than $13bn – Exhibit 5. Even with an aggressive view on synergies this will be dilutive to Akzo’s current EV/EBITDA ratio, and we suspect that the hope is that Akzo’s multiple rises with the exit of the chemical business.

Exhibit 5

Source: Capital IQ and SSR Analysis

Nothing Here Solves Akzo’s Core Coatings Issue – Density in European Decorative Coatings

The core issue facing PPG and Akzo is that European decorative coatings are less profitable than US decorative coatings. There are two reasons for this:

  • The manufacturing and distribution regional density is missing in most European countries – with too many independents
  • The big box retailers in continental Europe have taken a “white label” approach to in-store paint rather than collaborating with established paint manufacturers as in the US. The paint tends to be much lower quality and much cheaper – for now these markets are essentially closed to PPG, AKZO and others.

An Akzo/Axalta deal does nothing to help the decorative coatings business. Akzo would likely be better off offering PPG a significant premium for its European business – or swapping decorative for industrial with PPG (and some cash).

In the charts below – Exhibits 6 and 7 – the performance and results of Tikkurila are probably more illustrative of poor decisions and poor management than they are of a weak European market, but the company talks about the competition from the big box retailers as does Jotun. Note that both Akzo and PPG have outperformed their fundamentals this year – suggesting some sense of hope that the deal might still be on.

Selling Chemicals and buying Axalta are distractions from dealing with the most pressing issue at the company in our view.

SELLING TO PPG WOULD HAVE BEEN THE RIGHT MOVE.

As we have covered in recent research – we see no reason to be overweight the coatings industry today and see far better options in the commodity and the diversified/specialty space and in PX/Linde.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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