Coatings – Developed Markets Peaking – China and M&A Can Keep Select Momentum

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 15th, 2016

Coatings – Developed Markets Peaking – China and M&A Can Keep Select Momentum

  • The dynamics of the Coatings market today have key drivers in the developing world likely peaking (autos, housing, and aircraft) while developing China sees strong growth in the consumer space – especially autos and food packaging.
    • Industrial Coatings are more mixed, with the true industrial component weak everywhere and food packaging Coatings strong because of growth in the emerging world and better product quality everywhere.
    • Auto refinish is improving generally but we do not believe that will be a long-term trend with smarter and smarter cars eventually overwhelming/outsmarting the careless texting and phone use trend that has increased the developed world accident rate in recent years.
  • The lower cost tailwind that the industry has enjoyed – first with pigments starting in 2013 and then will most other materials following oil from mid-2014 – is likely behind us, with difficult compares going forward.
    • We do not expect steep increases in raw materials but we do suspect that post 2016 there is greater risk to the upside than downside.
  • Faced with slower underlying growth and likely more limited cost gains, M&A has picked up materially in the last 24 months. This trend should continue, though there is not much more that can be done in the Auto OEM space in the US and Europe.
    • PPG/Comex – major architectural move into Mexico.
    • Sherwin Williams/Valspar – consolidation in the US but diversification into other geographies and industrial Coatings.
    • BASF/Chemetall – significant complementary Auto OEM business – high price.
    • AXTA – multiple industrial, OEM and auto refinish businesses.
  • With only the US end markets quite consolidated, the big guys appear to be all about global consolidation and some diversification. We are seeing some horse trading (smaller businesses moving to better owners). At the same time everyone is trying to grow in Asia (China).
    • Axalta (AXTA) is now one of very few large purer plays – only really autos.
      • We think Axalta has upside from focused share gain and further cost initiatives.
    • BASF’s Coatings portfolio is dominated by autos and the Chemetall deal was all about autos. We are not as convinced as BASF’s that the engineering plastics and catalyst/battery division gives BASF an edge in everything (including Coatings) – but BASF should maintain share.
      • We are neutral to marginally negative on BASF but not because of this business.
    • PPG probably most at risk in Autos from a developed market share perspective, but the aggressive expansion of architectural paints and all paints in China should provide enough of an offset – we expect more large deals – $1 billion plus.
      • PPG remains our favored name, as we also believe that there are more costs to go.
    • Sherwin Williams (SHW) has slowing US fundamentals and a large and diverse acquisition to digest – we think that this combination is more likely to create negative rather than positive surprises over the next few years.
      • The very high stock value is a risk in our view and we would be underweight.
    • Akzo appears to have upside based on return on tangible capital and sum of the parts analysis.
      • If the company can find a clever way to split off its Chemical business in a non-dilutive manner, we see meaningful upside.

Contents:

Overview

1. Executive Summary 

2. Focus on M&A 

Company Summaries

3. PPG 

4. SHW 

5. RPM 

6. Akzo 

7. AXTA 

8. BASF

Major End Market Overviews

9. Auto 

10. Housing 

11. Industrial 

12. Aerospace 

Risks & Valuation

13. Risks 

14. Valuation Summaries 

We would like to acknowledge and thank Lucas Laria for his contributions to this report as a summer intern at SSR. Lucas is entering his senior year at the University of Maryland, where he is pursuing a major in Mechanical Engineering.

  1. Executive Summary

Coatings has been the clear winner in the Chemical Sector for the last six to seven years with the “discount from normal value” chart in Exhibit 1 showing the strong move from cheap to expensive over the period relative to the S&P 500. No other chemical sub-sector has shown the same performance. This has been the place to invest in the group and surprisingly the right “pairs trade”, with the benefit of hindsight, would have been to short the industrial gas group – Exhibit 2. What of course is most interesting is that Industrial Gases were the place to be from 2000 to 2010! They peaked in valuation just shy of 2 standard deviations expensive – where the Coatings guys are now!

Exhibit 1

Source: Capital IQ, SSR Analysis

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

We think we can draw comparisons, and they lead us to some interesting and perhaps cautious conclusions with regard to Coatings today.

  • The Industrial Gas gains were driven in our view by three things.
    • A focused drive towards much greater productivity and efficiency than the industry had seen historically – lead by Praxair.
    • Consolidation in the packaged gas business in the US – lead by Praxair and Airgas – consolidation geographically and into end uses such as CO2 and healthcare – all players, and some bigger moves by Air Liquide and Linde to reduce the number of major players.
    • Innovations leading to demand growth – steel; food preservation and packaging, healthcare, electronics etc.
  • While APD was a bit late to the game with the first driver, the industry has essentially captured all of the low hanging fruit in all of these areas today and is much more dependent on underlying economic growth to move its bottom line – as earnings growth has slowed multiples have come down and the Praxair chart is much more illustrative than the industry average, which is offset by the recent catch-up game APD has been playing – Exhibit 4. Note that in our view PX has done nothing wrong in the period from 2012 to today – growth drivers have slowed and the general economic/industrial production growth has been anemic, while Brazil has been a bit of a basket case.

Exhibit 4

Source: Capital IQ, SSR Analysis

So is it appropriate to think about Coatings the same way?

  • The industry has benefitted from innovation – new technology in industrial and automotive markets – new formulations in architectural technology – this may be slowing.
  • The industry is also benefitting from consolidation, particularly in architectural and general industrial – with PPG, BASF and SHW taking the lead – there is more that can be done here and this may be a key difference versus Industrial Gases.
    • There are still some bigger deals to be done in Coatings while what is left in Industrial Gases is generally too small to move the needle for the major players.
  • There have been some unusual demand growth drivers in the form of lower and lower interest rates – helping both housing – new builds and resale – and autos, where we now have the risk of a bubble in the US. This tail wind is probably done.

While there are some interesting correlations between the two stories, we can make a case that things are not that bad for Coatings – that said – everyone made a case that things were not that bad for Industrial Gases in 2010 and it was absolutely the WRONG call from an investment perspective.

The positives and negatives for Coatings line up as follows in our analysis:

Positives:

  • Further consolidation (of a meaningful nature) is possible in architectural and industrial – though for the most part outside the US, unless Berkshire is willing to part with Benjamin Moore. We would expect this to be core to PPG’s strategy, but would expect SHW to pause and digest Valspar before doing anything else.
    • Who buys Axalta? Akzo to diversify; Dow to compete with BASF; no-one?
    • Is there a BASF/Akzo opportunity or is BASF focused on integration into automotive rather than diversification in Coatings?
    • Does a differently configured DowDuPont split set up an obvious combination with PPG?
  • China remains an interesting growth market in both housing and autos and the capital barriers to entry and project risks are lower than they are/were for the Industrial Gas companies. This is a significant opportunity for Axalta, BASF and PPG in auto Coatings.

Negatives:

  • Slower growth in the developed world in housing and autos and a possible bubble in US autos because of loan defaults that could cause a 12-24 month correction in new production.
    • Changing demographics are also an issue in the US with preferences growing for shared car travel and condos versus houses.
  • A more focused auto competitor in Axalta – good for Axalta but probably bad for PPG and BASF.
  • Limited consolidation opportunities in the US – only small deals left – not enough to move the needle for PPG and SHW.
  • Europe – possible weaker economic growth – consumer sentiment falling – weaker currencies possible – negative for PPG.
  • Aircraft sales are peaking – order flow is slowing – marginal negative for PPG.
  • China – great growth, but developing local competitors.
  • Valuations are high – even for RPM, which otherwise might end up being a take-out target.

Conclusions

While the sector is expensive, PPG appears to have the most to do from a self-help perspective, as returns are much lower than SHW and the business mix has changed dramatically away from commodities and now entirely focused in Coatings. PPG is likely to outperform the sector in our view, even with an auto slowdown as an auto slowdown will likely trigger a concern about the consumer in general and indirectly impact SHW. SHW has the added headache of integration risk associated with VAL. This is the biggest deal that SHW has done and is further off-piste than normal.

There is a greater than zero chance that Axalta gets taken out – not this year – but possibly once the growth runs out and management is more open to creative offers – given the cost cutting that remains on the table and the moves the company is making in the refinish business, we think we can see further growth through 2017 and we would be overweight.

Akzo likely has value to unlock in its portfolio, as its Specialty Chemicals business has a minimal degree of integration into Coatings and could conceivably be valued higher on its own or in someone else’s business. Finding a buyer could be an issue – a Reverse Morris Trust with OLN might make sense but there are debt impediments on OLN’s side. Akzo also (like PPG) appears to have upside based on return on tangible capital – Exhibit 5. SHW is an outlier here, partly because of improved returns driven by price gains combined with flat to deflationary inputs over the past several years, but also due to an accounting treatment whereby many of the company’s stores are leased rather than owned outright. The trend line is influenced to some extent by this end point but ex-SHW the trend is only marginally less steep, and the conclusions remain the same – Exhibit 6. We would expect AXTA’s return on capital to trend higher as the company takes advantage of cost opportunities and potential share gains.

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

2. Focus on M&A

With a muddled global macroeconomic picture and recent growth drivers (auto, aerospace) running out of steam, M&A has come into focus in the Coatings space recently.

Prior work on M&A in the Chemicals space has shown the historical performance record for companies pursuing large (>$1B) acquisitions is decidedly mixed with significant variability in results – Exhibit 7. The averages are generally positive, but are influenced by significant outliers (i.e. DOW bouncing +200% in 2009, lining up with Rohm & Haas deal) and at the mid-point, performance is generally positive versus the sector but negative versus the broader market.

Exhibit 7

Source: Capital IQ, SSR Analysis

Within the Coatings segment, we have only seen a handful of deals of this size, most of them executed by PPG, summarized in Exhibit 8. Timing again plays a part – SigmaKalon kept PPG roughly flat to the market and sector in the troubles of 2008; Akzo’s North American Architectural Coatings business provided a boost at a time when the Coatings space began to benefit from positive sentiment; Comex has mostly benefitted PPG, though the stock underperformed the market in the 12 months following deal completion.

Exhibit 8

Source: Capital IQ, SSR Analysis

The only other major Coatings acquisition (none from RPM, VAL, or, until recently, SHW) was Akzo’s purchase of Imperial Chemical Industries in 2007, and timing was again a factor, with the stock significantly underperforming both the Chemicals sector and the market from deal announcement and completion.

In the case of SHW-VAL, compounding this issue of historical performance volatility post-acquisition is the unprecedented scale of the deal from SHW’s perspective – Exhibit 9. Strategically, the deal is logical, offering diversification at the geographic and market segment level – Exhibit 10. This plot also suggests that game changing moves will be harder to come by, as further deals from either PPG or Akzo will only provide incremental adjustments to business mix and regional exposures.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Company Reports, SSR Analysis

3. PPG – M&A Versus Returning Cash

Investment Conclusion: PPG has been a favorite of ours in 2016. Even as auto growth slows, bolt-on M&A should continue to provide a boost, and the SHW-VAL merger leaves two main competitors for assets on the sidelines. Leverage remains to any European recovery, though the Brexit complicates this.

M&A has been PPG’s stated strategic focus, and the company has made a flurry of smaller deals over the past several years – Exhibit 11 – in addition to the major Comex acquisition. Comex itself is to a certain extent a follow on move from the previous acquisition of Akzo Nobel’s North American Architectural Coatings business – PPG has moved strongly into this space, creating a potential diversifying strength out of a former weak spot in its portfolio. We still see the potential for mid-sized deals up to $1 billion, and the path here appears to have been cleared for PPG with the SHW-VAL tie up that likely eliminates those players as M&A competition for a while.

Exhibit 11

Source: Capital IQ, SSR Analysis

M&A will be needed to offset a slowdown in auto growth. From 2012 through 2015 PPG enjoyed outsized growth in automotive Coatings relative to OEM production – Exhibit 12 – though this appears to have ended in the first half of ’16.

Exhibit 12

Source: Company Reports, SSR Analysis

Regionally there is significant operating leverage to a recovery in European volumes (30% of sales), though the Brexit has clouded the outlook. China is pivotal – if Chinese growth can provide enough of an offset to the lost auto tailwind and potential further disruptions in Europe, the stock could still work. PPG has supplier relationships in China through JVs (Henan Billions notably) that meet some of the company’s TiO2 requirements. While Asia remains a focus, it is currently only 16% of PPG sales.

Volume growth was fairly strong in 2015 against difficult prior year comparable figures, but has continued to taper off in 2016 – Exhibit 13 – given the auto slowdown and a generally weak macro environment.

Exhibit 13

Source: Company Reports, SSR Analysis

PPG is among the least expensive Coatings stocks on normal earnings – Exhibit 14. The risk of diluting returns by expanding the capital base is generally lower for the types of acquisitions PPG is likely to explore, but the company’s most direct and immediate path to improved share performance may come not from M&A, but from an increased dividend payout. PPG was one of the highlighted companies in our analysis of potential unconventional bond proxies in the Industrials & Materials space – the relative stability of returns and ample cash flow combined with a higher yield could attract investor interest in a low growth, low yield world.

Exhibit 14


Source: Capital IQ, SSR Analysis

4. SHW – Is Growth More Important Than Returns?

Investment Conclusion: SHW’s acquisition of VAL suggests the company is reaching the limits of its high-density, new store based strategy. VAL provides diversification in geographic and business mix but there could be integration challenges, as the deal dwarfs any of SHW’s previous acquisition. The stock is the most significantly expensive in the Coatings space and we see more downside risk than upside potential.

The SHW-VAL combination creates the largest paint/Coatings company by sales – Exhibit 15.

Exhibit 15

Source: Company Reports, SSR Analysis

While margins are expected to expand (providing the targeted synergies can be achieved) the acquisition only moderately expands SHW’s geographic reach beyond the United States, which will still account for 76% of sales – Exhibit 16.

Exhibit 16

Source: Company Reports, SSR Analysis

SHW believes it can drive $280 million in synergies by 2018 and $320 potentially over a longer time frame. We are somewhat concerned that 45% of the identified synergies are related to raw materials – this is less tangible than SG&A and creates risk to the achievement of the target, as the combined SHW-VAL buying power may not be as influential as currently believed. Additionally, while the company points to its 21 acquisitions over the past 10 years, the scale of the VAL deal dwarfs prior experience – before the $11.4 billion VAL purchase, SHW’s largest acquisition was for $216 million (a Swedish Coatings company) in 2010.

Exhibit 17

Source: Company Reports, SSR Analysis

The VAL acquisition will reduce SHW’s reliance on its paint stores. With the assumed $280 million in synergies margins are expected to expand by roughly a percentage point – the expanded consumer segment will see margins diluted by the addition of Valspar Paints, but Global Finishes will mostly make up the gap with increased margins from Valspar Coatings.

Exhibit 18

Source: Company Reports, SSR Analysis

Exhibit 19

Source: Company Reports, SSR Analysis

The VAL deal marks a break and diversification from SHW’s existing strategy, focused on expanding company owned paint stores – Exhibit 20. SHW still plans to open 90-100 new stores (net) in 2016 (45 new stores opened and 14 redundant locations closed in 1H ’16, for a net gain of 31). There is plenty of runway to the company’s target of 6,000 stores (current count as of Q2 ’16 is 4,117) but the VAL deal suggests the company believes it is reaching density limits. Same store sales growth for SHW has remained strong in 2016 to date, but the trend is generally toward less robust figures than those seen earlier in the decade – Exhibit 21.

Exhibit 20

Source: Company Reports, SSR Analysis

Exhibit 21

Source: Company Reports, SSR Analysis

SHW’s return on capital has greatly expanded over the past five years, and its above trend returns offer some justification for the move in the stock price and the premium reflected in Exhibit 22. Part of the improvement can be attributed to an extended period of stable input costs – note the rise in return on capital has come as raw materials (measured by a Producer Price Index) have been flat to deflationary for US architectural Coatings – Exhibit 23.

Exhibit 22


Source: Capital IQ, SSR Analysis

Exhibit 23

Source: Bloomberg, SSR Analysis

5. RPM – The Next Consolidation Target?

Investment Conclusion: RPM’s diverse brand portfolio and exposure mainly to less-cyclical maintenance & repair markets (versus new construction) have driven the stock to multi-year highs. While the company could be an intriguing takeout option in a time of consolidation in the industry, the elevated valuation works against this, and the flipside of its brand diversification is the significant complexity entailed. Tough to chase here but no obvious downside catalyst.

RPM is not a competitor in the traditional paint and Coatings markets that PPG, AXTA, and SHW operate in. The company’s most notable product is Rust-oleum – this and related varnishes/revitalizing oils makes up the bulk of its Consumer segment that accounts for 32% of sales. The other major business within the Consumer segment is DAP Products, a company offering caulks, sealants, and adhesives. Also included here is the smaller Kirker business, which manufacturers enamels and Coatings for nails in the Personal Care industry. The majority of RPM’s sales (53%) come from industrial applications, divided along three business lines: Tremco, Tremco Illbruck, and Performance Coatings. Tremco is a US based manufacturer of sealants and waterproofing products; Illbruck is the European division, cross-branded, and based in Germany. Performance Coatings is composed of a number of businesses and brands in applications ranging from fireproofing to flooring. The smaller Specialty segment (15% of sales) is also a portfolio of brands, which include fluorescent and anti-fouling paints among others.

RPM is mostly a repair and maintenance story (60% of sales), though construction (33%) is a driver as well, mostly on the commercial side. Geographically, this is a North America play, with minimal emerging market exposure – more than 70% of sales are generated in the US and Canada, with an additional 20% in Europe.

Exhibit 24

Source: Company Presentations, Capital IQ, SSR Analysis

RPM’s extensive brand portfolio creates a great deal of complexity which could hinder a potential purchase of the company as a whole. RPM has continued to acquire – over $1 billion in primarily piecemeal acquisitions since 2010 – while making no divestitures of note.

Additionally, RPM’s somewhat elevated valuation could preclude a takeout. On normal earnings (Exhibit 25) RPM is currently as expensive as VAL is inclusive of the SHW buyout premium; on EV/trailing EBITDA (Exhibit 26) RPM is more than a full multiple point above where VAL was trading before the SHW bid.

Exhibit 25


Source: Capital IQ, SSR Analysis

Exhibit 26

Source: Capital IQ, SSR Analysis

6. Akzo – Not a Pure Play – Hybrid Valuation – Can/Should Akzo Exit Chemicals?

Investment Conclusion: Akzo trades at a discount to its Coatings peers, both currently and historically. Sum of the parts indicates the Specialty Chemicals business is trading at a very low multiple or that the Coatings businesses are being excessively discounted. In aggregate the Coatings portfolio is balanced with considerable presence in higher growth geographies, and there appears to be upside to the stock based on a sum of the parts analysis.

Akzo has historically traded at a discount relative to others in the Coatings space, and currently the difference is even more pronounced – Exhibit 27.

Exhibit 27


Source: Capital IQ, SSR Analysis

The company’s Specialty Chemicals segment (~33% of sales) has its highest margins, and should not be a weight on the multiple. Haircutting the current Coatings multiples and applying even 9x to Akzo’s Coatings businesses, the Specialty Chemicals segment is only valued at 6x currently. Granting Specialty a conservative 8x multiple implies more than 10% upside on 2015 actual/’16-’17 estimated EBITDA. A 9x multiple for Specialty suggests 20% upside; a 10x multiple suggests 25-30%. All of this assumes that the Coatings business continues to be undervalued relative to peers by a full multiple point.

Exhibit 28

Source: Capital IQ, SSR Analysis

Akzo’s Specialty Chemicals business is based on five business platforms – Exhibit 29. The company claims integration into Coatings, but only the polymer and surfactant segments would appear to qualify, suggesting that pieces of the business could be divested, if not the entire segment.

Exhibit 29

Source: Company Presentations, Capital IQ, SSR Analysis

Exhibit 30

Source: Company Presentations, Capital IQ, SSR Analysis

Akzo does not have a presence in the auto OEM market, and is a laggard in the refinish market. Markets where the company has leading positions have mixed growth prospects: packaging and protective/marine show sub-2% growth through 2018, wood finishes and coil are expected to grow modestly at 2-3%, and the powder and specialty plastics markets should exceed 3% growth. Akzo is also one of the top two competitors in the smaller aerospace segment, and expects greater than 3% growth here as well.

Exhibit 31

Source: Company Presentations, Capital IQ, SSR Analysis

Exhibit 32

Source: Company Presentations, Capital IQ, SSR Analysis

Exhibit 33

Source: Company Presentations, Capital IQ, SSR Analysis

Exhibit 34


Source: Capital IQ, SSR Analysis

7. Axalta – Pure Play With Focus – Should Win Share

Investment Conclusion: AXTA should benefit from continued cost opportunities over the next few years, as well as from its smaller, more-focused organizational structure which should enable share gains. The smaller size and focus also make AXTA a plausible takeout candidate. A general economic slowdown in North America and/or Europe (together 70% of sales) poses downside risk.

AXTA emerged from the hands of private equity with a reasonable set of opportunities still available. Margins expanded and are now best in class – Exhibit 35. The cost structure is predictably lean – Exhibit 36 – given its size and its PE history, but the company has room for further cost moves over the next few years.

Exhibit 35

Source: Capital IQ, SSR Analysis

Exhibit 36

Source: Capital IQ, SSR Analysis

Volume growth has surpassed PPG’s – Exhibit 37. Broken down at the segment level – Exhibit 38 – Performance consists of refinish (70%) and industrial (30%) while Transportation is broken into light (80%) and commercial (20%) vehicles.

Exhibit 37

Source: Capital IQ, SSR Analysis

Exhibit 38

Source: Capital IQ, SSR Analysis

The company is driving plenty of cash from this volume – Exhibit 39 – but debt is an obstacle to implementing a dividend – Exhibits 40-41.

Exhibit 39

Source: Capital IQ, SSR Analysis

Exhibit 40

Source: Capital IQ, SSR Analysis

Exhibit 41

Source: Capital IQ, SSR Analysis

AXTA generates roughly 70% of its sales in the US and Europe, making the threat of a slowdown a significant risk to continued share gains.

Exhibit 42

Source: Capital IQ, SSR Analysis

AXTA has made several bolt on M&A deals over the summer:

  • Duracoat – niches in North American commercial construction and general industrial – “core Coatings”)
  • High Performance Coating – SE Asia supplier of refinish Coatings
  • United Paint Chemical Corp’s Auto Interior – weighted thermoplastics Coatings business

8. BASF – Can One of Many Tails on a Big Dog Get the Attention it Needs

Investment Conclusion: We have previously been concerned about BASF, particularly with respect to the company’s competitive positioning in the changing Ag space. From a Coatings perspective, the company’s auto presence is bolstered by high levels of chemicals/plastic content per vehicle – scale and relationships should maintain share even as more focused competitors have emerged (AXTA). A combined DowDuPont poses a broader problem for BASF. The bull case for the stock would materialize in a world of rising oil prices.

Coatings makes up roughly 5% of BASF’s consolidated net sales – Exhibit 43. The company is backward integrated via its Pigments business (within Performance Products), and this plus the benefits of leveraged technology platforms in an enterprise that dwarfs its smaller, more focused competitors, may be enough to offset what on paper is a lower innovation spend per dollar of sales – Exhibit 45.

Exhibit 43

Source: Company Reports, SSR Analysis

Exhibit 44

Source: Company Reports, SSR Analysis

Exhibit 45

Source: Capital IQ, Company Reports, SSR Analysis

BASF attempts to gain advantage from its positions with auto manufacturers, not just in Coatings but in catalysts, plastics, and other chemical content, generating $10 billion of revenue from auto customers (~15% of sales). The company’s content per car has been growing, and market share wins have enabled above-market growth similar to PPG. Unlike PPG, BASF’s auto growth is likely to continue, as the Chemetall acquisition provides a missing link in BASF’s offering (the first coating on the metal frame). The company has been in the process of fine-tuning its Coatings exposure, adding Chemetall in addition to selling its Industrial Coatings unit to Akzo earlier in the year.

Exhibit 46

Source: Capital IQ, Company Reports, SSR Analysis

9. Automotive Coatings – Can China Offset Peaking Markets Elsewhere

Auto has been a key source of growth for the past several years, and many companies are signaling the auto space as a strategic priority. There appears to be plenty of runway for growth in the auto markets of developing nations such as Brazil and China based on vehicle per capita data. India is further behind, and progress remains too slow to move the needle.

Exhibit 47

Source: NationMaster, SSR Analysis

In the near-term, growth in US auto sales has slowed. Incentives and credit extension are expected to keep sales flat in 2017, but the strong gains of recent years appears to be over and there is likely more downside risk than upside potential in the US auto market. Growth in 2016 has been bolstered by sales to fleet customers rather than at the retail level. Europe auto sales have been trending higher recently, at increasing growth rates. Brexit has brought the specter of recession to a region that has yet to fully recover from the previous downturn, posing a potential headwind for auto sales that may possibly be offset by continued low rates and availability of credit.

Exhibit 48

Source: Bloomberg and SSR Analysis

Exhibit 49


Source: Bloomberg and SSR Analysis

Capital spending intentions for the major auto manufacturers reflects a general slowdown after an extended period of elevated spending emerging out of the depths of the crisis in ’08-’09 – Exhibit 50.

Exhibit 50

Source: Capital IQ, SSR Analysis

Hidden beneath the record US auto sales of recent years are a series of (perhaps structural) trends that do not appear encouraging for the future. US youth appear to be shying away from driving. 91.8% of 20-24 year olds had a license in 1983, but thirty years later, this figure fell to 76.7% – Exhibit 51. Looking at the growth rates of licensed drivers of all ages in the US – Exhibit 52 – there is a broader trend of slowing growth of US drivers.

Exhibit 51

Source: University of Michigan

Exhibit 52

Source: Bloomberg

At the same time we are seeing drivers hold onto their vehicles for longer – the average age of light vehicles on the road in the US climbed steadily from 2003 to 2013 when it plateaued at around 11.5 years – Exhibit 53. The trend of older vehicles on the road suggests drivers are maintaining their vehicles and perhaps implies a marginal preference to repair their existing car rather than buy a new one. This trend also suggests that the bulk of auto sales we have seen in recent years can be attributed to people buying second (and third, and fourth) cars rather than swapping out their older model for a newer one (which would work more to drive down the average age if it was being done).

Exhibit 53

Source: IHS Automotive

The notion of consumers buying second (and third) cars recalls the proliferation of second (and third) mortgages in the mid-2000s, and there are some who are concerned that this is indeed a similar story with a predictably painful ending. Currently the percent of US auto loans that are at least 90 days delinquent is off the highs from earlier in the decade, and has held around 3.5% since the middle of 2013. The total debt balance for US auto loans has increased meaningfully since 2010, however, and the value of new delinquent balances in Q2 ’16 reached a level not seen since 2009.

Exhibit 54

Source: Federal Reserve Bank of New York

Exhibit 55

Source: Federal Reserve Bank of New York

Exhibit 56

Source: Federal Reserve Bank of New York

PPG, AXTA, and BASF all claim to be gaining share in the OEM market! BASF can leverage its existing auto customer relationships outside of Coatings, as well as its broader organizational technology engine, but we think AXTA’s focused approach puts the company in the best position to gain share. However, BASF’s acquisition of Chemetall should lead to additional wins. PPG appears most likely to hold steady or be left behind, evidenced in the first half of 2016 as auto Coatings growth rates have reverted to industry averages.

Exhibit 57

Source: Company Reports, SSR Analysis

Exhibit 58

Source: Bloomberg, SSR Analysis

10. Housing – Consolidated but Still Competitive

Housing markets have shown a slow but steady recovery out of the mortgage crisis. Single family units started are only about halfway back to the long term “normal” average around one million units from the lows of early 2010. Construction spending toward single family units has been marginally displaced by multi-family units which have been growing at consistently higher rates coming out of the crisis.

Exhibit 59

Source: US Census Bureau

Exhibit 60

Source: US Census Bureau

Exhibit 61

Source: US Census Bureau

As with vehicle ownership, there are questions about structural changes to homeownership. The overall US rate of homeownership is at its lowest level in more than 50 years and the trends in key demographics continue downward.

Exhibit 62

Source: US Census Bureau

Exhibit 63

Source: US Census Bureau

Not everyone in the younger demographic is eschewing houses for apartments – some have simply never left home. Unless living with parents can be considered a structural lifestyle change, it could be argued that there is simply pent up housing demand given the elevated rates of 25-34 year olds living with parents.

Exhibit 64

Source: US Census Bureau

From a distribution perspective, the architectural Coatings market can be grouped into three major channels: home centers (Home Depot, Lowe’s), company stores (i.e. SHW branded paint stores) and independent dealers (Mom-and-Pop shops). Regional differences are most significant in the company branded and independent channels – North America tends toward company stores, highlighted by SHW’s recent proliferation in the US and PPG’s expansion plans for Comex stores in Mexico, while globally there remains ample opportunities for consolidation given the significant share commanded by independent dealers.

Exhibit 65

Source: Company Reports, SSR Analysis

Latin America

While Home Depot and Lowe’s are common in North America, home centers are a small component in aggregate for the Latin America region. PPG has noted the density opportunities for Comex in Mexico, and Central America is an even more fragmented market. Mexico accounts for 50% of architectural Coatings industry revenues. Comex dominates the Mexican landscape with over 4,000 stores across the nation. Competition Prisa, Sherwin Willaims, Sayer, et al have less than 2,000 stores combined.

Exhibit 66

Source: Company Reports, SSR Analysis

Asia-Pacific

China represents slightly less than half the $17 billion architectural Coatings market in the Asia-Pacific region. PPG has little influence in the market excluding Australia/New Zealand, as the industry remains highly fragmented and competition is widespread, notably in China. Sherwin Williams with the acquisition of Valspar will obtain a significant amount of business in Asia. The Chinese market for architectural Coatings does not have the DIY component that is seen elsewhere. Australia’s market structure more closely resembles what is seen in the West, with growing penetration of home centers.

Exhibit 67

Source: Company Reports, SSR Analysis

Europe

Europe has a reasonably well developed home center market (35% of industry revenue, same as in North America), though unlike in North America, this space is dominated by private label brands. Company stores have a foothold, accounting for about 25% of sales of architectural Coatings (half of the similar figure in North America). There is still significant opportunity for consolidation given the 40% share independent distributors currently enjoy. Regional differences are evident at a broad level between Western and Eastern Europe (lower consumption per capita in the still developing East), and pronounced even from country to country where brands and distribution models vary.

Exhibit 69

Source: Company Reports, SSR Analysis

U.S. and Canada

With the acquisition of VAL, SHW will control nearly half of the North American market. PPG retains a leading position in Canada. Opportunities for further consolidation are likely limited for competitive reasons. Benjamin Moore, owned by Berkshire, has a strong brand and could be an attractive target, as the company’s strategy has left it somewhat out in the cold amidst the proliferation of branded stores and brand penetration in home centers.

Exhibit 69

Source: Company Reports, SSR Analysis

11. Other Industrial – High Tech and High Margin but Growing with a Slow Economy

Industrial Coatings tends to be a catch-all for various manufacturing applications, but definitions vary by company. PPG for instance, puts its auto OEM business in its Industrial Coatings segment, which also includes packaging end markets.

Exhibit 70

Source: Bloomberg, SSR Analysis

While packaging and auto end markets have been strong, global manufacturing activity has been subdued over the past year. The emerging markets of China and Brazil have been notably troubled, while the US and Europe show only modest levels of expansion. All things considered the outlook is tepid at best – Brexit creates uncertainty in the Eurozone, the US election cycle, marked by protectionist rhetoric on trade, similarly clouds the regional manufacturing picture, and China is likely to track the neutral 50 line as its government works on shifting resources from industrial production to consumer development. The lack of an industrial impetus is likely to encourage further exploration of M&A as a means of gaining momentum.

Exhibit 71

Source: Bloomberg, SSR Analysis

12. Aerospace – Niche and High Margin but Small and Slowing

Aerospace Coatings accounts for a small share (~1%) of the $130 billion global Coatings market.

Exhibit 72

Source: Company Reports, SSR Analysis

Increased maintenance requirements in the aerospace industry are driving the importance of Coatings, though aero remains among the most niche applications. As in the auto market, light-weighting and efficiency are key trends and differentiators. Growing middle class populations in emerging economies offer potential for sustained long term growth in air travel and the global aerospace fleet.

Akzo, PPG, and Sherwin have dedicated digital platforms for their aerospace Coatings businesses. Other players include Hentzen Coatings, a privately owned US company, and Aerospace Coatings International, also privately owned (by the Wencor Group).

Akzo claims to have the first or second position in the aerospace Coatings market, and expects growth of greater than 3% from 2016 to 2018. PPG similarly claims to have the leading global position, and depicts SHW as a minor player. Several of PPG’s recent acquisitions have been aerospace related including Le Joint Francais, Cuming Microwave.

The short term outlook is mixed, with delayed builds and growth from ramp ups masking a declining order book. Current backlogs extend several years out at present, but the situation here is similar to that in the auto market, where it is tough to see conditions improving materially from current levels.

13. Risks
Our overall call is that we are fairly neutral to negative with respect to Coatings relative to Chemicals and relative to Industrials and Materials. In Chemicals the sector is expensive but has good fundamentals – we prefer Ag given valuation. In Industrials we would prefer the Packaging space over Chemicals – we do not like much else.

Risks to the sector call:

  • Coatings will outperform under very few circumstances from here in our view as most of the macro upside surprises that would drive Coatings up would likely drive cheaper sectors up further. All chemical sectors have more economic leverage as do many Industrial and Material sectors
    • More aggressive M&A could be a trigger – BASF changing strategy, Dow/DuPont changing strategy – China looking for technology, but valuations are already high.
  • Coatings could easily underperform as aggregate valuation is high
    • Raw material spike – oil price rise, natural gas price rise, pigment price rise
    • Severe correction in auto demand caused by credit default in the US.
    • Housing slowdown as rates increase

Risks to the company calls:

  • PPG – all of the macro issues plus
    • Poor integration of Comex – cost over-runs.
    • Larger and dilutive acquisitions.
    • BASF develops technology gain through internal R&D and Chemetall integration and steals OEM share.
  • SHW – upside would come from:
    • Perfect execution and integration of Valspar – beating all cost cutting and other synergy projections.
    • Better US housing numbers – especially resale – though this would help PPG also.
    • Declining raw materials – again PPG probably has more upside.
  • AXTA
    • Place too big a bet on refinish and market stops growing.
    • BASF develops technology gain through internal R&D and Chemetall integration and steals OEM share.
    • Cost opportunity overstated.
    • A legacy DuPont liability comes to the surface!
  • BASF
    • Rising oil would have the most positive impact on BASF’s share price.
    • Quick recovery in Europe.
    • Decline in the Euro.
  • Akzo
    • Failure to find a transaction which exposes the “sum of the parts” opportunity.
    • European recession.
  • RPM
    • Discounting a take out in our view – slow relative decline without a take-out – step change of no more than 20% in our view in any deal given current high value.

14. Valuation Summaries

Exhibit 73

Source: Capital IQ, SSR Analysis

Exhibit 74

Source: Capital IQ, SSR Analysis

Exhibit 75

Source: Capital IQ, SSR Analysis

Exhibit 76

Source: Capital IQ, SSR Analysis

Exhibit 77

Source: Capital IQ, SSR Analysis

Exhibit 78

Source: Capital IQ, SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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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