Axalta (AXTA: Buy, $37 PT) 
Akzalta? Upgrade to Buy on M&A Optionality
• We upgrade AXTA shares to Buy from Hold with a target of $37. It seems there is never a dull moment in the rapidly consolidating coatings industry. Following a Reuters story on Friday that sent AXTA shares up 17.0%, the companies confirmed on Monday that they are engaged in “constructive discussions” regarding a merger of equals (MOE) transaction. It is not often that we would contemplate an upgrade in the wake of such a spike, but our analysis suggests that the prospective risk-reward profile is quite favorably asymmetric in light of a Akzo-Axalta deal, and AXTA shares did pull back 2.2% on Monday’s session. For reasons discussed below, we are not surprised by this potential combination and believe it can create substantial value for AXTA shareholders, particularly if Axalta’s management were lead the combined company with a free hand to extract synergies in relatively unfettered fashion. If a deal is struck, “Akzalta” would become the second-largest coatings company in the world as depicted in Figure 1. It would also mark the fourth trans-Atlantic MOE to be announced in the chemicals sector in recent memory, following Bayer-Monsanto, Praxair-Linde, and Huntsman-Clariant, although the latter deal was nixed by mutual consent last Friday.
• We are not at all surprised by talks between Akzo and Axalta. We can think of six good reasons why these two companies would be at the table: (1) Axalta management has addressed potential for a transformational deal, first at our conference in June 2017 (click here) and again on the company’s 2Q17 earnings call on 3 August 2017; (2) the global coatings industry is consolidating rapidly with the latest large example being Sherwin Williams’ acquisition of Valspar for $11.3bn on 1 June 2017; (3) having spurned PPG’s final  offer of a 50% premium, Akzo arguably needs a...
• How much value might be created? In our view, the answer to this question depends greatly on which management would run the combined company as well as the negotiated ownership levels in the combined entity. In the section that follows, we analyze two scenarios for an all stock MOE deal with different assumptions for management, synergy extraction, and value sharing…
• We see three key risks: PPG, Elliott and anti-trust considerations. Even if a deal is reached, we see several barriers to closing: (A) PPG regains the flexibility to re-engage with Akzo and could put forth a new bid for the company at that time, although recent rhetoric emanating from PPG leadership  suggests that is perhaps unlikely; (B) Elliott reportedly controls in excess of 9% of Akzo shares and is the subject of a standstill agreement that is set to expire on... 
• Our top 10 takeaways from 3Q: (1) adjusted EPS of $0.26 came in below our $0.28E but in line with consensus of $0.26; (2) adjusted EBITDA declined 10% y-y to $210mn; (3) total company sales increased 7.0% on acquisitions (+9.7%) and FX (+1.9%), while volume declined 3.9% and price eroded 0.7%; (4) Performance Coatings segment volumes sank 6.6% y-y, which we attribute to...
• We remain somewhat below consensus for 2018. Our 2017 EBITDA forecast dips to $837mn including stock-based compensation or $875mn on apples-apples basis with Axalta’s new range of $870-900mn. For 2018 we model EBITDA growth of 7.8% vs. management’s goal of a double-digit pace, which we consider possible with the benefit of ongoing bolt-on acquisitions as has been the case recently (we do not incorporate hypothetical deals). On an EPS basis we now model $0.32E for 4Q17, followed by $1.30E in 2018, which is below consensus.   
• We upgrade shares to Buy and raise our target to $37 on rising propensity for M&A. Our price target implies total return potential of 14% from current levels (AXTA shares do not currently pay a dividend). Given Axalta’s elevated exposure to autos, pockets of price and volume pressure across the portfolio, and somewhat diminished balance sheet flexibility, we feel that valuation is fair at $29 per share absent M&A-related optionality and at $37 per share given our probability-weighted value creation potential of nearly $8 per share as outlined in Figure x. As a reminder, our base-case valuation of AXTA is predicated upon on an average of two methodologies: DCF analysis and a relative P/E framework. Our DCF analysis suggests a warranted stock price of $30. Using our relative P/E framework wherein we apply a 15% premium to the S&P500 multiple, we calculate warranted value of $27 per AXTA share.   
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LyondellBasell Industries (LYB: Buy, $108 PT) 
The Boys from Brazil
• A possible takeout of Braskem looks quite attractive. According to the Wall Street Journal, LyondellBasell is in “early stage” talks regarding potential takeover of Braskem SA. The transaction would be Lyondell’s largest since emerging from bankruptcy in April 2010 and the second-largest M&A deal in Brazil, according to Dealogic. Our preliminary view is that a Lyondell-Braskem combination would be sensible, both strategically and financially, and perhaps timely in that it strikes us as counter-cyclical with respect to the ethylene cycle and the Brazilian industrial economy. Such a move would also be consistent with Lyondell’s growing appetite for M&A, as articulated at the company’s most recent investor day in NY on 5 April (click here). LYB shares responded favorably, rising 7.1% on Monday’s session vs. -0.3% for the S&P500 index.
• We have considered polyolefins to be one of three areas of interest to Lyondell. We have long viewed olefins and polyolefins (plastics) as a logical source of external growth for Lyondell, along with urethanes and acetyls. In contrast, we consider M&A potential in chlor-alkali and styrenics to be far less likely. In this context, a potential tie-up with Braskem, a US leader in polypropylene (PP) resin, makes sense to us. Given Lyondell’s...
• Braskem’s low multiple could facilitate a highly accretive cash deal. Braskem could be a $20.1-23.3bn deal taking into account Braskem’s undisturbed equity value of US$11.5bn (at BRL47.56 per share) and adding a hypothetical equity takeout premium of 35%, net debt of $4.8bn or $7.9bn including obligations related to BraskemIdesa’s $5.2bn petrochemical complex in Mexico, which appears to be out of compliance on covenants and therefore consolidated into Braskem’s balance sheet as of 30 June 2017. This would translate to a range of 6.2-7.0x Braskem’s 2018 consensus EBITDA of US$3.3bn. Based on these economics and assuming all cash financing, we estimate year one EPS accretion of $2.31 and ROIC of 11.4% in year one.
• Key risks: PP resin market scrutiny and key shareholder support. As shown in Figure 3, Lyondell and Braskem are essentially co-leaders in the North American market for PP resin, each with estimated share of 18%. While we consider PP resin to be a global market, it is not clear to us that pro forma regional market share of 36% would pass muster with US anti-trust authorities. While Braskem is a Brazilian company, we note that two of the company’s PP resin plants in... 
• We rate shares of LYB Buy with a price target of $108. Excluding any incremental value to be created (or destroyed) from M&A, our existing price target suggests total return potential of 6%, including a dividend yield of 3.6%. As a reminder, our LYB price target is based on an average of two valuation frameworks; a relative EV/EBITDA multiple and a relative normalized P/E multiple. Our relative EV/EBITDA multiple uses a 2.75x discount to the group average multiple and reflects a stock price of $113, while our normalized P/E methodology reflects a warranted stock price of $102 based on our normalized EPS estimate and a multiple equal to a 30% discount to the sector average multiple.
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