Akzo Nobel: Caution Warranted Following A Disappointing Quarter
Summary
- Akzo Nobel missed consensus estimates across the top and bottom lines.
- The magnitude of the raw materials cost inflation remains a concern going forward as well, likely driving downside risk to near term projections.
- While M&A potential presents upside, I am cautious at the current valuation.
Following a quarterly miss and ongoing raw material inflation, Akzo Nobel (OTCQX:AKZOY), a leading global producer of paints and coatings, could struggle to deliver its targeted c. 50bps EBIT margin improvement/year. Similarly, its fiscal 2023 EBITDA target of c. €2 billion is also looking ambitious if the company were to solely rely on organic growth and further efficiency improvements. At current levels, Akzo Nobel trades at a premium P/E multiple relative to its peers Axalta (AXTA), and PPG Industries (PPG). Considering the headwinds that Akzo faces in the upcoming year, it seems challenging to justify the existing premium to peers, and against this backdrop, I would be cautious at this juncture.
Targeted ROS Improvement Could Prove Challenging This Year
Disappointingly, Akzo missed consensus estimates that had tracked down heading into the quarter, with raw material inflation (a c. €128 million EBIT headwind) offsetting pricing benefits (a c. €89 million tailwind) to the bottom-line. Meanwhile, a lack of raw material availability also impacted volumes, especially across EMEA decorative paints and powder coatings – a trend PPG had noted in its results as well. Divisionally, the adj EBIT for Decorative Paints came in well short of consensus at c. €191 million (+9.1% Y/Y), with margins decreasing by c. 190bps to 17.6% on the back of a sub-par +3% pricing gain, which was not enough to offset the unfavorable mix related to EMEA and raw material headwinds.
Source: Akzo Nobel FQ2 ’21 Earnings Presentation Slides
In aggregate, ROS (“return on sales”) for the group came in at 14.7% - this was not only well short of consensus but also the 2021-2023 target for an average ROS improvement of 50 bps/year and EBITDA of c. EUR 2 billion. With the profitability continuing to lag, it seems unlikely that this year’s ROS will be on track for the targeted c. 50 bps improvement amid the ongoing raw materials inflation. In FQ2 ’21 alone, the gross margin declined by c. 300 bps Y/Y to 41.2%, and Akzo believes that it will take until FQ4 ‘21 for the raw materials inflation to be offset by an increase in selling prices. Nonetheless, the company did deliver a +4.5% price increase for the quarter and remains committed to fully offsetting the full amount of 2021 inflation by year-end, implying an ambitious second-half catch-up ahead.
Guidance Indicates Raw Material Cost Inflation Remains the Key Issue
Looking ahead to the upcoming quarters, management has guided to limited or negative overall margin progress depending on the speed of price hikes in the system. In particular, the company is confident it will grow earnings in both Decorative Paints and Coatings, with volumes to grow next year at least in line with end markets. My key concern, however, remains the magnitude of the raw materials cost inflation, which has been much more robust than many had expected. Early this year, for instance, the general view was that these costs would only go up in the mid-single-digit % range, yet by FQ1 ‘21, this had already increased to a high single-digit % increase. And in the latest quarter, Akzo and its peer PPG have signaled toward raw materials cost inflation at c. 20% for the near term. This highlights the limited visibility into raw materials pricing trends, and as such, I am skeptical that FQ3 ’21 is the peak (as guided by management). Should prices continue to rise in the consecutive quarters and going into fiscal 2022, I see material downside risk ahead.
Source: Akzo Nobel FQ2 ’21 Earnings Presentation Slides
Grupo Orbis Acquisition Adds to Longer-Term Outlook
With an active presence across South/Central America and the Antilles, along with a leading market share of c. 10% in the Central and South American market, the proposed Grupo Orbis acquisition is promising. From a strategic perspective, the deal is a clear win, adding complementary assets in terms of expanding Akzo’s presence in the region. Based on an enterprise value of c. €550 million, this implies an EV/EBITDA multiple of c. 16x for the transaction, which seems a tad expensive.
Source: Akzo Nobel FQ2 ’21 Earnings Presentation Slides
Nonetheless, current projections suggest the deal will prove modestly accretive to fiscal 2022 EPS on a pro-forma basis. Assuming some synergies, however, the multiple likely comes down to a more palatable 12-13x post-synergies, which is closer to Akzo’s current EV/EBITDA multiple. Still, I would note that the pre-tax ROIC (“return on invested capital”) pre-synergies from the deal is low and should result in a net dilution to Akzo’s current c. 15% ROIC. All in all, funding should not be an issue - the net debt position remained solid as of quarter-end at c. €1.9 billion (equivalent to 1.2x net debt/EBITDA), leaving plenty of room for further M&A and capital return (both share buybacks and dividends).
Final Take
Overall, I view Akzo as an ongoing self-help story – longer-term, the business is well-positioned for fundamental improvements and a structural reshaping of the earnings profile, which should narrow the margin gap relative to key peers further. The balance sheet flexibility is a bonus, as is management’s track record in executing bolt-on M&A. However, the key concern remains the pace of raw material inflation and the extent to which the group can offset these headwinds in the upcoming quarters. Considering the limited near-term earnings visibility and the premium P/E valuation, I would be cautious at these levels.
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