Axalta Coating Systems: Focus on free cash flow rather than earnings (NYSE: AXTA)
In October last year, I was not too happy when Axalta Coating Systems (AXTA) withdrew its full year 2021 guidance as inflation had a significant negative impact on operating margins. In September, Axalta announced that it expected third-quarter revenue to fall by around $40 million, while EBIT would fall by $130 million to $140 million. Despite the withdrawal of guidance, Axalta’s share price rose about 15% before starting to fall to just under $27, where it currently trades.
I won’t go into too much detail about Axalta’s business model, as discussed in previous articles, but the main takeaway is that Axalta is a leader in the coatings industry with multiple applications. While the automotive industry represents a significant portion of revenue, let’s not forget that industrial coatings also account for nearly 30% of fiscal 2021 revenue, providing useful diversification.
The writing was on the wall when Axalta withdrew its 2021 guidance in October
When a company pulls its full-year forecast, you kind of know that you shouldn’t expect too much. That being said, I feel like Axalta has done a good job of relatively limiting the damage. In fact, operating profit was only a few percent lower than the 2019 result (pre-COVID), while the reduction in interest charges over the past few years has actually led to an increase in pre-tax profit. .
As you can see below, revenue of $4.4 billion generated operating profit of $462 million and pre-tax profit of $341 million. After tax, net income attributable to Axalta shareholders was just under $264 million or $1.14/share. This means that the H2 result was not as bad as feared, as Axalta generated revenue of $122 million in the second half. And that’s higher than H2 2020 net income.
Although I totally agree that it seems rather expensive to buy a stock at 20 times earnings, but as I have explained in all my previous articles, the focus for an investor in Axalta should be on cash flow.
Reported operating cash flow in 2021 was just under $559 million and that includes a net working capital investment of approximately $45 million. On an adjusted basis, cash flow from operations was $603 million (compared to $450 million in fiscal 2020 and $659 million in fiscal 2019). Total investments in 2021 were just under $122 million, resulting in free cash flow of approximately $481 million.
Spread over the current stock count of 227 million shares, free cash flow per share was just over $2.11. This is indeed almost twice as much as EPS and the simplest explanation is to refer to the difference between depreciation and amortization expense of over $325 million while total capital expenditure are slightly lower at $122 million. The difference between the two elements explains the significant difference between the net result and the free cash flow result.
A large portion of the free cash flow (excluding the $649 million spent on acquisitions) was devoted to a major share buyback program to the tune of nearly $244 million. This allowed Axalta to repurchase 8.2 million shares, or more than 3% of the number of shares. The net decrease in the number of shares outstanding was 7.4 million shares, with an additional 0.8 million shares issued as part of stock-based compensation.
What are the implications for this year?
Axalta has not provided detailed guidance for the year 2022. While disappointing, it is likely the right course of action given the inflationary environment in which it currently operates. During the fourth quarter conference call, Axalta management confirmed that it plans to offset expected inflation “within the year”, but obviously it takes some time to complete the price increases.
Forecasts for the first quarter are however encouraging, as Axalta forecasts an adjusted EBIT of 100 to 120 million dollars. We also know interest expense ($32 million), which means the midpoint of the forecast implies pre-tax income of about $80 million. Applying a tax rate of 24%, net income for the first quarter will likely be around $60 million.
While that’s not great, keep in mind that free cash flow tends to be much higher because capital expenditures are much lower than D&A expenditures. For fiscal year 2022, we can assume a quarterly capex of $35-40 million, which is less than half of planned D&A spending in the first quarter. This means that even if Axalta implies a net income of $60 million, it will likely show a normalized free cash flow of $100 million or more. And that’s why the net debt of just under $3 billion doesn’t worry me too much. Free cash flow remains strong and is expected to strengthen throughout the year as Axalta is able to pass on an increasing share of the impact of inflation to end users.
Investors who only look at EPS will immediately dismiss Axalta as a valid investment idea. After all, why would anyone pay more than 20 times the net income for a coating and painting business? The answer lies in the cash flow statement. While the income statement is impacted by non-cash expenses, cash flow remains robust and despite 2022 shaping up to be another challenging year, Axalta will still generate a strong free cash flow result. If he does not make any acquisitions and if he does not repurchase shares, net debt will fall to around $ 2.5 billion by the end of this year, which would drop the debt ratio below. of 3.
I remain confident in Axalta’s longer term outlook and, as a free cash flow focused investor, I like the current opportunity to go long Axalta again. I haven’t made up my mind yet, but I could sell put options out of the money to at least profit from the volatility (and high option premiums).