Opportunity in the Coatings Industry
Concerns about the direction of the Chinese economy and its implications for global growth dominate daily headlines and have weighed on global equity performance over the last few months. At Diamond Hill, while we are cognizant of macroeconomic developments, our research team’s focus is on fundamental business analysis and valuation. We believe this approach, coupled with our long-term investment horizon, enables us to 1) home in on the key value drivers of a business that determine long-term earnings power and intrinsic value; and 2) take advantage of dislocations between market price and intrinsic value when Mr. Market (referencing Benjamin Graham’s famous allegory) forgets about number 1 and is gripped by fear or greed.
The focus of this piece is on the favorable characteristics of the coatings industry and why we believe the recent market selloff has created a long-term investment opportunity in Axalta Coating Systems Ltd. (AXTA).
Returns on Invested Capital and Free Cash Flow
One approach I use to source investment ideas is to begin with a list of very good businesses I’d like to own at the right price. These businesses generate high returns on invested capital (ROIC) and are consistent positive generators of free cash flow. Why is this important? First, businesses that generate above-average ROIC (greater than 10%) over a long period of time generally possess more enduring competitive advantages than those that do not. ROIC is one of Warren Buffett’s favorite “yardsticks” for measuring business quality, since it not only measures the level of earnings generated by a business, but also takes into account the capital spent to generate those earnings. Taking it one step further, businesses that are able to reinvest their earnings at high incremental returns tend to compound earnings and cash flows faster than their peers, and Buffett has excelled at buying these “compounders” at reasonable or cheap prices throughout his lifetime. Second, companies that consistently generate positive free cash flow over business cycles are better able to return cash to shareholders and/or make acquisitions through good times and, perhaps more importantly, when times get tough.
The Coatings Industry
Over the past decade, the top U.S. publicly-traded coatings companies all made my list since they have generated above-average ROIC, consistently produced positive free cash flow, and produced strong returns for shareholders (see table below).
How were they able to achieve these results? I believe the key driver of these excess returns is the pricing power and enduring competitive advantages inherent in these businesses, which results from:
- Generating value for customers: Paint companies are relied upon by customers to help improve their businesses. Whether it’s fewer coats, faster dry times, lower drying temperatures, or more environmentally friendly paint, the technology embedded in the paint helps customers improve their products and save money, which generally leads to greater customer loyalty. In automotive manufacturing paints, for example, the paint booth can be among the highest uses of energy in the entire production process, so paint companies can really help their customers save money by taking steps out of that process.
- Paint critical to performance, but small percentage of end-product cost: The performance and appearance of coatings are critical to end-product performance, while only representing around 1% (automotive manufacturing) to 15% (architectural) of the cost of the end-product. This allows coatings companies to compete more on service, brand, and product performance—and less on price.
- Consolidated industries with rational competitors: Paint quality and consistency matter on a global basis, and only a few of these competitors have the scale and technology to compete globally, which has enabled larger coatings companies to take market share at the expense of smaller, less sophisticated competitors over time. Additionally, many coatings companies have consolidated their respective industries over time through acquisitions. As a result, coatings companies generally operate within consolidated industries where competitors have historically acted rationally from a pricing standpoint.
These critical factors have provided coatings companies with enduring competitive advantages and pricing power, enabling them to expand margins and improve ROIC through business cycles. In addition, coatings manufacturing facilities are relatively inexpensive to build, allowing these companies to reinvest growth capital at high incremental rates of return and further compound earnings, free cash flow, and strong returns for shareholders over the long term.
Why We Own Axalta
We believe the recent market pullback has provided us an opportunity to invest in Axalta Coatings Systems at a meaningful discount to our estimate of intrinsic value of the business.
The largest driver of earnings and value for Axalta is the company’s automotive refinish coatings business. It accounts for 42% of company sales and its primary customers are body shops. Axalta is the largest producer of automotive refinish coatings in the world. The refinish business benefits from all the favorable characteristics mentioned in the industry analysis above, but also has among the highest pricing power of all coatings companies, driven by the fragmented nature of its customer base. Operating margins in this business lead the industry, which is a key driver of strong and stable earnings, ROIC (north of 20% when measured on tangible capital1), and free cash flow for the company.
Axalta’s remaining business includes automotive light vehicle (32% of sales), commercial vehicle (10% of sales), and industrial (16% of sales) coatings. The company’s geographic sales mix is roughly 40% Europe, 30% North America, 15% Asia Pacific, and 15% Latin America.
Axalta has only been a standalone public company since November 2014. The business was formerly owned by DuPont and sold to Carlyle (private equity), which then took the business public in less than two years. Management firmly believes that the business was both undermanaged and underinvested while under the DuPont umbrella. During the company’s investor day in December 2015, management emphasized that it is in the early innings of both running the business more efficiently (and improving margins) and investing in high-ROIC growth projects in areas of the business previously underinvested by Axalta. For example, Axalta has invested in growing its sales force in industrial coatings over the past few years, a segment that was previously not managed as a standalone business under the DuPont umbrella.
As mentioned above, concerns about deceleration of the Chinese economy have led the current market selloff and, along with concerns about the sustainability of global automotive sales, have driven short-term pressure on shares of Axalta. However, Axalta’s Chinese exposure is relatively small (13% of total sales) and likely to grow over the next five years as the company invests in its business from a small base. Axalta’s refinish business in China has been growing at a double-digit rate, in line with growth in the Chinese car parc (total number of vehicles on the road). Additionally, we believe the market is underappreciating the resiliency and quality of the company’s global automotive refinish coatings business, which is the key value driver of Axalta.
Over the next five years, Axalta should continue to grow earnings, free cash flow, and returns on invested capital. We believe at today’s market prices, this will lead to strong returns to shareholders. Given Berkshire Hathaway’s history of buying great businesses at reasonable or great prices, we don’t think it’s a coincidence that it is a significant owner of the company (Berkshire owns nearly 10% of Axalta’s shares outstanding).
|2014 revenues ($B)||$15.4||$11.1||$4.6||$4.4|
|Average 10-year ROIC||13%||24%||10%||N/A|
|10-year annualized TSR||14%||18%||12%||N/A|
|10 years of positive free
cash flow generation?
|Primary coatings markets||Architectural,
* IPO November 2014
TSR – Total Shareholder Return
OEM – Original Equipment Manufacturer
1 Tangible capital includes net property, plant, and equipment, cash, and net working capital, but excludes goodwill and other intangible assets.
Originally published on February 17, 2016
The views expressed are those of the research analyst as of February 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.