The demerger process of ICI's Paints segment is nearing completion and in this regard, trading in the new paints company (Akzo Nobel Pakistan) will commence from next month. In today's note, we have briefly described the fundamentals of the paints industry in Pakistan as well as Akzo Nobel's value proposition. Furthermore, we have also provided our initial earnings estimates for the 'Paints' business and have arrived at a target price of PkR110/share using a blend of DCF and relative valuations. .
The demerger process in brief: The 'Paints' unit is being split from ICI Pakistan to form a new entity 'Akzo Nobel Pakistan'. Share capital will be distributed in a 33.5%/66.5% ratio i.e. 33.5% for Akzo Nobel Pakistan and the remaining for ICI Pakistan, which in turn will translate into a paid up capital of PkR465mn (46.5mn shares) for the Paints business and PkR923mn (92.3mn shares) for ICI Pakistan. Akzo Nobel is the parent company of ICI holding 76% shareholding (105mn shares) in ICI via ICI OMICRON B.V, where post demerger, Akzo will continue to hold the same proportion of share in the two entities. Furthermore, AKZO will sell its stake in ICI Pakistan (92.4mn shares) for which we have already seen three potential bidders (LUCK, NML, and a consortium of ICOR and Fajr Capital) come forward with their intention to purchase Akzo's stake.
Akzo's value proposition: Akzo is a global leader in the paints industry, enjoying market leader ship in a number of categories. Some of its leading brands include 'Dulux – Decorative Paints', 'International – Performance Coatings' and 'eka – Specialty Chemicals'. The company is targeting to expand its footprint in high growth markets which include the Middle East and South Asia region, where profitability is also above average, with huge growth potential. Akzo has 3 major business areas namely Performance Coatings, Decorative Paints and Specialty Chemicals, where margins for the Specialty Chemicals are the highest, while that of Decorative Paints is the lowest. Furthermore, raw materials for Akzo account for 72% of the total variable costs while the remaining 28% is represented by Energy & other variable costs. The global paints industry is estimated at around EUR70bn of which the 'Decorative' category accounts for 44% of the market.
Where does Pakistan fit in? The Pakistani paints industry is passing through a difficult phase as slow pace of growth in the construction and industrial sector has softened demand for paints. Furthermore, the discontinuation of token schemes in the decorative paints category, which was viewed by CCP as market distorting as well as requirement of CNIC on invoices from Apr'12 onwards are likely to further dent demand. However, long term fundamentals of the Pakistan remain alluring given the huge population base, one of the lowest per capita paints consumption (taking paints production as proxy for consumption, per capita consumption is just at 0.15ltr/annum) and potential for revival in the construction sector given the huge housing backlog. Furthermore, penetration in the industrial segment paints business will hold the key for profitability given the high margins in the category. Going forward, AKZO can also utilize Pakistan as a manufacturing hub for exports to the region (Middle East and India).
ICI paints segment performance review: The ICI paints segment has struggled since the takeover by Akzo in CY08 as the high margin auto OEM paints contracts were terminated post Akzo takeover. Operating margins have subsequently reduced from a high level of 23% in CY07, down to just 3% in CY11, while sales volumes are still to match the pre-Akzo levels. However post demerger, we could see Akzo aggressively expanding into the paints market and expanding its product palette, particularly towards high margin segments.
One-off cash dividend in the offing: According to the latest 1QCY12 accounts, the net assets of the paints segment amounted to PkR5.8bn, which includes a PkR3.7bn inter-unit account receivable, where post demerger, all inter-unit receivables/payables will be settled, which could potentially result in a one off cash inflow of PkR3.7bn (PkR80/share), which could also be distributed as an extra-ordinary cash dividend. .
Paints valuation: We arrive at a blended average Dec'12 end target price for Akzo at PkR110, where our target price based on various methodologies range between PkR44-PkR137. For CY12, we estimate the Paints division to post an NPAT of PkR210mn (EPS: PkR4.52), while the 5-yr earnings CAGR is forecast at 19%, where we see earnings accretion coming from steady increase in margins (higher contribution of specialty chemicals) and steady growth in volumes (8%pa). Our DCF based Dec'12 end TP for Akzo Nobel is calculated at PkR127/share, where we have assumed a WACC of 18%, terminal growth rate of 3% and cash balances of PkR3.8bn. Amongst the listed companies, only Berger (BERG) is a comparable peer for Akzo, however the company has been incurring losses over the last three years, therefore making PS the most appropriate measure for relative valuation. BERG's PS ratio over the last 5 years has averaged at 1.07x and taking our CY12 sales/share of PkR128 for Akzo, we arrive at a TP of PkR137 for the company. Akzo's target price based on AKD chemical sector peer group (LOTPTA and EPCL) comparison is PkR126 based on EV/EBITDA, PkR44 based on PE and PkR115 based on PBV.
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