Paint Ball – But With Real Winners and Losers

gcopley
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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

November 27th, 2017

Paint Ball – But With Real Winners and Losers

  • We doubted the Akzo/Axalta deal – see research – but did not see the Nippon Paint (NP) move. This could force hands among the others and create an interesting six months.
    • Axalta wants either a fair control premium or a sale/merger where Axalta management retain control – clearly the middle ground with Akzo, but not something Akzo wanted.
    • With a possible NP deal, AXTA may get both – a proper cash premium and the ability to manage the US and possibly European business of Nippon Paint.
      • Air Liquide left Air Gas in charge of the US and this has worked well.
  • An AXTA/NP combination is a significant inconvenience for BASF, a problem for SHW and a major problem for PPG in our view. The combination creates a stronger auto OEM player in a business likely already peaking in revenue and margin, everywhere outside China.
    • NP and AXTA will have cost and revenue synergy opportunities if they can integrate the business and the technology – improving the competitive position versus BASF and PPG.
    • The combined business would have a small foothold in US architectural with the NP acquisition of Dunn-Edwards. NP has a significant architectural business in Asia and this deal may give the company more confidence to keep adding in the US.
  • This could be a game changer for many, leaving Akzo as the only major target for either PPG or SHW in a business that could se only a couple of further consolidations. In our view:
    • PPG must bid again for Akzo – soon.
    • SHW probably can’t afford to let this one get away – so may need to jump in also.
    • Akzo must take a deal – or suffer being squeezed out of the business slowly.
  • Akzo’s management suffers from every ailment that we outlined in our “what makes a good company” piece and we would only recommend owning the company today for the special dividend and both a bid and enough pressure on management to accept the bid.
    • If PPG can get Akzo amicably there is support for the current PPG share price and upside for Akzo. A bidding war with SHW would work out better for SHW than PPG and probably get Akzo a higher price.
    • If SHW buys Akzo, and AXTA and NP combine, PPG looks ex-growth and expensive.
    • Akzo probably sells for €100 if it sells – so 28% upside – more if PPG and SHW compete for it – no deal and back to €65 with no growth (9x EBITDA) – 16% downside.
    • Both Benjamin Moore and MAS are wild card, but US, options for PPG – Exhibit 1.

Exhibit 1

Overview

We go back to our year ago analogy of the coatings business today with the Industrial Gas business of 5 years ago. With coatings, we have a business where growth has slowed dramatically, in part because of peaking end-markets and in part because of cost actions of customers – as well as a raw material squeeze, that may not go away given tightness in many chemical intermediate sectors. The industrial gas slowdown was denied by the stock market for a while and then the group seriously underperformed for the better part of two years – Air Liquide’s acquisition of Airgas followed by the proposed PX/Linde deal has breathed life back into this sector – though it remains much cheaper than the coatings space.

The coatings industry has seen multiples expand meaningfully over the last few years – Exhibit 2 – despite a rising market multiple, as investors have maintained faith in the face of falling estimates. While most companies have seen falling estimates (on a same store sales basis – i.e. ex acquisitions for SHW) consistently in 2017 – Exhibit 3 (note also that Akzo 2017 and 2018 estimates have tumbled since May), estimates for 2018 look ambitious and suggest EPS growth that we have not seen in recent years. We think that estimates are too high for 2018 for all except possibly SHW where the VAL synergies will help – Exhibit 4.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Hence the wave of mergers (or attempted mergers) – looking for new areas of growth and synergies:

  • SHW for Comex – Failed
  • PPG for Comex – Succeeded
  • SHW for VAL – Succeeded
  • BASF for Chemetall – Succeeded
  • PPG for Akzo – Failed – so far
  • Akzo for AXTA – Failed – so far
  • NP for AXTA – we will see!
  • Multiple small bolt on deals for all – more for AXTA than others – another one from Akzo today in Thailand

Our investment thesis is driven by several key assumptions:

  1. Automotive OEM is likely to peak globally within the next few years (the only growth today being in Asia), with auto manufacturing and demand trends likely to result in lower and declining volumes of high end coatings as driving autonomy and TaaS increases (we would be surprised in Ubers purchase of 24,000 Volvos were not all the same color).
    1. Refinish peaking now – negative trend from here outside China.
  2. Aero paint demand is great, but hard to see how it grows, with aircraft demand strong and likely at peak rates already.
  3. Architectural – increasing trend towards contractors in the developed world because of demographics, but market share gains by big box retailers over paint stores because of cost savings.
    1. Ok in the US because PPG and SHW have strong positions in HD and LOW – but probably better at the margin for MAS.
    2. Bad for Akzo and PPG in Europe as the big box retailers do not sell their paints.
    3. Value of Benjamin Moore likely at peak today and Berkshire should sell – to PPG.
    4. MAS would fit well with Berkshire portfolio but not cheap if Berkshire determined to keep Benjamin Moore.
    5. Still small bolts-on deals possible (larger ones in Europe).
  4. The broad remaining industrial coatings space still has plenty of room for consolidation but pieces are small and as AXTA has shown, effective integration is challenging.

Risks to the thesis are that we are underestimating decorative paint pricing power and the resilience of the branded store versus the big box retailers – this is not a business that Amazon has found a way to disintermediate yet and it could not do so without a paint manufacturer as a partner – probably not a high priority.

A deal with AXTA and NP could be a small window of opportunity for PPG and BASF, if the deal process and the integration distracts both companies. A distracted competitor can often allow others to win business for a while and there are many examples of this in chemicals and other industries.

AXTA – For Sale

Whether Akzo approached AXTA or whether AXTA made it known that it was willing to talk – either directly or through shareholder pressure and recommendations, it does not matter now. AXTA is in play and for sale. The company is not in bad shape, with much better management, sales and margins than in its DuPont days. The bolt-on acquisition strategy has likely not been as successful as the company was hoping and earnings have disappointed in 2017. If the company sees the same auto OEM pressures that we are suggesting, a sale or a merger is the right strategy for shareholders.

The discussions with Akzo were likely an either/or of a full value cash bid – something Akzo shareholders would have rejected – for all the reasons we have written about, or alternatively AXTA and Akzo shareholders would probably have taken a low premium “merger” with AXTA management taking control. This deal would have made a great deal of sense and would likely have had support from shareholders on both sides – this idea was probably rejected by Akzo management – for all the reasons that we have discussed previously.

AXTA is expensive on current EBITDA and likely on 2018 EBITDA (where estimates look too high to us). So, a deal premium is already largely in the stock. This is a business already run quite leanly, so NP cannot afford to pay much more than the current price, or risk significant dilution – as shown in Exhibit 5 there is a huge gap between current and forward multiples for each company – there are not enough likely synergies to cover this gap. If NP goes ahead with a bid it will be for larger strategic reasons in an attempt to create a stronger global footprint – a 5-10-year view rather than a 1-2-year view.

Exhibit 5

Source: Capital IQ and SSR Analysis

PPG – Ex Growth – Competitive Landscape More Challenging – MUST buy Akzo – or Something Else – Risk of Overpaying Just to Get a Deal Done

Another year of disappointing earnings for PPG underscores the issues of limited growth and more competition in the two core business lines – automotive and architectural – raw materials cannot be an acceptable excuse alone because in stronger end-markets historically it was possible to pass through these increases. Revisions have been negative – Exhibit 6 and multiples have expanded – Exhibits 7 and 8. As we indicated in the overview, we think all estimates for 2018 look too high, including those for PPG.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

PPG has made no secret of its strategy to grow through acquisition and it faces two possible paths – one big deal – Akzo – or many smaller deals – slower growth – possibly higher and higher multiples for each deal because Akzo, SHW, and now possibly NP will be looking to do the same thing.

PPG should make another bid for Akzo in our view – getting this deal done sets the company on a much clearer path for the next 5-7 years for synergy and revenue growth and possibly the opportunity to carve up Akzo chemicals – selling the pieces to the highest value bidders.

PPG is not expensive today when taken in the context of the value of the broader market – Exhibit 9, but it is not cheap if earnings growth slows, as we have seen in 2017, where estimates now expect flat to a slight decline versus 2016, and 2018 estimates look very hopeful. PPG is a well-run lean company – like PX, when the company ran out of top line growth, there was not much fat to cut.

Exhibit 9

Source: Capital IQ and SSR Analysis

PPG should bid for – and get Akzo. Or go off-piste in another direction and buy Masco (possibly selling the non-coatings pieces to someone like SWK).

SHW – Still Absorbing VAL – But May Regret Not Getting in the Fight For Akzo

SHW is in a good spot already:

  • Expanding through the VAL acquisition
  • Still opening stores in the US
  • Ample cash flows to retire the VAL debt quickly
  • And with an Equity currency that creates significant competitive advantage – Exhibit 10

If SHW does nothing, someone else will buy AXTA and PPG may well buy Akzo. This will then limit some of SHW’s options in Europe and in Industrial Coatings. There will be no big deals left unless Benjamin Moore becomes available (SHW would likely be blocked on that one) or MAS becomes interesting.

SHW may be fine with the outcome, and we would certainly not recommend a bid for AXTA given our views of the auto OEM market. However, neither PPG nor Akzo have made much of an attempt to hide the level of animosity which grew between the two management teams over the spring, and while the senior Akzo management team is largely gone, it may still sit better with Akzo to sell to SHW rather than PPG. SHW may be invited to participate.

In a cash plus stock deal, SHW could outbid PPG because of its high equity value. The risk is that SHW is only just getting its hands around the VAL acquisition and may be talent constrained (unlikely that it can rely on Akzo to supply any).

Exhibit 10

Source: Capital IQ and SSR Analysis

Akzo – Doomed – Should Sell The Company Now – But Looks Very Reluctant

We do not believe that Akzo has a stand-alone future that is un-investable, and that current holders are there because of the special dividend, because of the possible sale/spin of the chemicals business AND because they expect to be taken out by either PPG or SHW.

Akzo’s past and current management team have shown excessive optimism and a complete lack of corporate “self-awareness” over the last 10 plus years. The bid for AXTA made sense only if the company was willing to admit its leadership shortcomings and hand the reigns over to a team that could drive efficiency and margins. This was not the case! Earnings estimates remain far too high for 2018 in our view and we would be surprised if there is any growth in the coatings business in 2018.

Selling the chemicals business for cash – to private equity – will result in a tax bill; will leave all of the cost cutting benefit in the hands of the buyers, and, while it will give Akzo more cash to return to shareholders it will also give the company cash for a likely “high priced” acquisition, to add to a coatings business that is already not run well. We have seen another small acquisition announced today in Thailand which suggests that the company is focused on a go-it-alone strategy.

Unless Akzo accepts a bid from either PPG or SHW we do not see how the stock can outperform in 2018.

Other thoughts

MAS (Masco) – If PPG was willing to take on chemicals to get Akzo, why not looks at MAS? There are likely buyers for the pieces that PPG would not want (SWK possibly). The questions would be whether the regulators would let it through and whether the big box retailers would react negatively as it would reduce their suppliers of paint – on the positive side, there would be synergies and these might be shared with the likes of Home Depot and others.

Benjamin Moore – While it is highly unlikely that Berkshire would sell, Mr. Buffet is a trader and there is a price for everything. Benjamin Moore could be a good fit with PPG, even if there were some store sales needed to keep the FTC happy. The overlap with SHW would be too great and we do not think a deal is possible.

Nippon Paint (NP) – Nippon Paint has been selling to auto OEMs in the US for years (mostly Japanese car manufacturers building in the US). The company made a foray into US architectural paint in 2017 with the acquisition of California based Dunn-Edwards (a 120-store chain). Architectural paint is NP’s largest Asia business – auto OEM second.

The logic behind the AXTA potential bid is likely a last opportunity to gain a major US and European foothold in auto coatings, as well as some refinish and industrial coatings assets. NP is in a net cash position, but AXTA represents an acquisition of a company essentially the same size as NP. The company would have to take on significant debt, but the underlying business cash flows are high.

©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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