Axalta Coating Systems Ltd. Q2 FY2023 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to Axalta's Second Quarter 2023 Earnings Conference Call. A question-and-answer session will follow the presentation by the management. Today's call is being recorded, and a replay will be available through August 9. Those listening after today's call should please note that the information provided in the recording will not be updated, and therefore, may no longer be current. I will now turn the call over to Chris Evans. Please go ahead, sir.

Thank you, and good morning. This is Chris Evans, VP of Investor Relations. We appreciate your continued interest in Axalta and welcome you to our second quarter 2023 financial results conference call. Joining me today are Chris Villavarayan, CEO and President; and Sean Lannon, CFO. Yesterday afternoon, we released our quarterly financial results and posted a slide presentation to the Investor Relations section of our website at axalta.com, which we will be referencing during this call. Our prepared remarks, the slide presentation and our discussion today may contain forward-looking statements, reflecting the company's current view of future events and their potential effect on Axalta's operating and financial performance. These statements involve uncertainties and risks, and actual results may differ materially from those forward-looking statements. Please note that the company is under no obligation to provide updates to these forward-looking statements. Our remarks and the slide presentation also contain various non-GAAP financial measures. In the appendix of the slide presentation, we've included reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures. For additional information regarding forward-looking statements and non-GAAP financial measures, please refer to our filings with the SEC. I will now turn the call over to Chris.

Thank you, Chris. I would like to welcome everyone to our second quarter 2023 earnings call. Let me begin by thanking Sean for his decade of service to Axalta. As you're aware, we recently announced that he is leaving the company to pursue another opportunity. Sean has had many notable accomplishments during his time with the company and was instrumental in building the foundation of an exceptional finance organization. I'm especially grateful for his partnership during my first seven months as CEO of Axalta. On behalf of the entire board, thank you, Sean. We wish you well in the future. Effective August 14, Carl Anderson will be joining Axalta as our new Senior Vice President and Chief Financial Officer. Carl was most recently CFO at XPO, one of North America's largest freight transportation providers. Prior to that, he and I worked closely together at Meritor, where he also served as the CFO for more than three years following other key leadership roles in finance, treasury, tax, and investor relations during his 16 years with the company. Carl has decades of corporate strategy and financial leadership experience in the global industrial and automotive sectors. As we strive to grow shareholder value at Axalta, Carl's background leading a finance organization through a strategic transformation and his track record as a true partner to the business leaders will be invaluable. We look forward to him joining us mid-August and appreciate that Sean will be staying a few weeks to ensure a seamless transition. In addition, we're delighted to welcome Kevin Stein to the Axalta Board effective September 1. Kevin has served as the CEO of TransDigm Group, a leading global designer, producer and supplier of highly engineered aircraft components since 2018. He brings a wealth of experience leading global industrial businesses and holds a PhD in inorganic chemistry. His track record in growing and creating value at companies will be a true asset to Axalta. Let's move to Slide 4, where I will cover the highlights of the quarter. Our second quarter adjusted EBIT was $155 million and adjusted diluted EPS of $0.35. Earnings were within our guidance range despite ERP-related operational issues in North America, a modestly softer industrial market environment, and exchange losses from hyperinflationary impacts in Turkey and Argentina. Given these items and the costs associated with our productivity investments, we have demonstrated considerable underlying earnings and profitability improvement year-over-year as well as sequentially. Net sales improved 5%, driven by strong pricing across all end markets and substantial growth in our Mobility Coatings business. Our focus on price-mix was evident again this quarter with a 7% increase year-over-year. As a result, we are seeing steady margin improvement. It is essential that we continue to prioritize more attractive returns in every end market and product category. Therefore, pricing will remain an active area for us even as we start to see the initial benefits of modest raw material deflation. Free cash flow of $99 million was a good result and much improved versus the prior year. This is an area where our productivity efforts are generating early wins as we right-size the inventory balances from historically high year-end levels. This improvement in cash flow is strengthening our balance sheet, one of our highest priorities, and for the second consecutive quarter we have voluntarily paid down an additional $75 million in principal of our term loan. Given improved visibility heading into the second half of the year, we have provided a 2023 guidance framework. This guide reflects an expected improvement in second half earnings versus the first half and puts us on a full run rate to exceed pre-COVID earnings levels. My main focus since joining Axalta has been to drive improved efficiency and performance across the portfolio of businesses. This past quarter, we kicked off the launch of a significant upgrade to our ERP system, which sets us up for supply chain and pricing intelligence, among other attributes. Second, the further acceleration of a purchasing optimization program meant to address recent cost inflation, derisk the supply base, and reduce variable cost volatility. We expect this to provide substantial benefits, which will start to be realized in the fourth quarter. Third, a supply chain enhancement program to improve planning, throughput, and working capital utilization. This work enabled us to drive down inventory and increase our free cash flow for this quarter. And finally, we also have a group looking at areas where we can optimize the structure of the company to enable us to be more responsive, resilient, and profitable. We will begin to give you more detail about these programs as we execute our plans and begin to see tangible benefits later this year. As we indicated last quarter, these programs require considerable investment. The ERP-related costs will step down in the third quarter. Others, like the consulting spend, will continue through the year-end but much muted compared to the second quarter as initial fixed cost investments begin to be offset with the realization of the benefits. This dynamic is reflected in our Q3 and 2023 guidance frameworks. I believe these initiatives are attractive investments in that they have short-term payback and accelerate our strategic goals. Please turn to Slide 5 for more detail on our ERP implementation. An ERP upgrade was needed to replace an inefficient 25-year-old legacy system. This implementation has been planned for years. Globally, we have been evolving from six ERP systems to one, and in doing so, we will be eliminating hundreds of applications, improving data redundancy and minimizing the need for costly manual interventions. We believe this system will significantly reduce our complexity and provide real-time insights into supply chain and pricing management. We went live in May with a North America launch that included 11 plants and several distribution centers. Despite comprehensive preparation, the scope and complexity of this launch led to some operational issues, primarily centered in our large Refinish manufacturing site. Yet we ended the quarter on a very strong note operationally and commercially. June was one of the strongest sales months in history for North America. As such, we believe the operational issues are now substantially behind us. Despite the near-record month we had in June, the operational issues limited our ability to fully deliver on customer demand in May, which resulted in a sales shortfall for the quarter. We're now working to normalize the elevated backlog in the second half of the year. Given the magnitude, I consider the implementation a success. We needed to launch the system and begin operationalizing the tool. In doing so, we gained valuable learnings, including insight into effective change management that gives me greater confidence for our remaining global implementations. I want to thank the team for their tireless work to stand up the system and manage the myriad of new processes to deliver a solid quarterly result. Moving back to the results on Slide 6. Let me elaborate on our second quarter volume performance. Globally, volumes declined by 4% year-over-year as growth in Mobility Coatings was offset by declines in Performance Coatings. We estimate that the operational issues we encountered had an estimated 2% to 3% negative impact on consolidated volumes, predominantly impacting our Performance Coatings segment. Mobility Coatings volume increased 13%, supported by improved light vehicle and commercial vehicle production rates as well as previously discussed customer wins. Performance Coating volume declined by 11% due to weak industrial markets and a lower Refinish volume primarily related to our ERP launch. China was the bright spot in the quarter as volumes increased 26%, driven by light vehicle and the reopening of the local economy. Let's move to Slide 7 for more detail on our Refinish end market. Refinish net sales improved by 6% in the quarter. Price-mix was very strong and improved by 10% year-over-year, supported by a blend of carryover and new pricing. Refinish volumes declined by 8% year-over-year, largely due to operational delays in North America as we saw stable underlying demand. Refinish market activity was largely consistent with the prior period. We see opportunities to grow market share and expand into adjacent markets. In the premium customer segment, we have over 850 new premium body shop wins year-to-date. In mainstream and economy, growth has been solid with over 200 new distribution points. This quarter, we launched Irus Mix, a fast, efficient, fully automated, and completely hands-free mixing machine for the automotive refinish industry. Irus Mix is a great addition to our productive single-visit base coat and industry-leading digital color management process. It is built on decades of innovation from award-winning spectrophotometers and AI-based color match software. With Irus Mix, customers benefit from high-speed mixing and enhanced body shop productivity that completely eliminates the need for manual mixing, accurate color matching every time, simple to use automated operation, which frees up painters to do other jobs while paint is being mixed, and finally, an environmentally thoughtful design that utilizes 50% recycled plastic and reduces waste by delivering every last drop of paint. In June, we launched Irus Mix commercially in Europe, and we expect to serve the rest of the world beginning in 2024. Early customer feedback has been incredibly encouraging. The order book is exceeding our projections with first deliveries beginning in August. Our success is predicated on remaining the most innovative solution provider in the industry. Irus Mix expands our competitive differentiation and deepens our customer-centric ecosystem. When Axalta Irus is paired with our single-visit application system, no one has a faster, more productive end-to-end process. This is why we believe we will continue to win and grow in Refinish. Moving to Slide 8, I will now cover the Industrial business. Constant currency net sales decreased modestly in the quarter as very strong price-mix growth of 7% year-over-year was more than offset by a 15% volume decline. Volumes were better in Asia Pacific, but this was more than offset by double-digit declines in EMEA and North America, due largely to the construction market slowdown. Yet, there are encouraging signs of stabilization as bookings in the second half appear modestly stronger than the first half rate. In our building products category, we're seeing big investments from customers as they anticipate favorable long-term market growth beyond 2023. Several markets appear to be bouncing off historic lows, such as architectural extrusion and coil, which are forecasting improving into 2024. The industrial team executed very well again on price and cost management, which helped to offset the volume decline. Moving to Slide 9. We continue to build momentum in Mobility Coatings. Volume improved 13%, reflecting a step-up in global auto and truck production versus the prior year as well as previously discussed new business wins. Growth was broad-based but especially strong in China and EMEA light vehicle. Price-mix contributed 3%, which included a 2% customer mix headwind. In light vehicle, 2023 auto production forecasts have modestly but steadily improved year-to-date. Industry forecasters now project 86.7 million global builds, representing more than 5% growth over 2022. This incremental volume growth is driving improved fixed cost performance in our business. Given the elevated age of the global auto fleet, we expect to see sustained global production in the near and medium term. In commercial vehicles, our customers remain bullish, and the production outlook is strong for 2023. For Class 8 OEMs, backlogs remain elevated, especially in North America. We are monitoring demand into 2024 as some forecasters believe there could be a soft pocket, but as of yet we see limited signs of a slowdown. With that, let me turn the call over to Sean for a review of our financial performance.

Thank you, Chris, and good morning. Second quarter constant currency net sales increased 5% year-over-year to $1.3 billion. Adjusted EBIT improved to $155 million from $151 million in the prior year period, inclusive of $15 million in headwinds associated with consulting and ERP-related costs in the quarter. Underlying earnings growth was driven by better price-mix in addition to the lower raw material, energy, and transportation unit rates. This quarter marks the first deflationary benefit we have recognized since incurring nearly $650 million of variable cost inflation through 2021 and 2022, representing an approximate 40% increase over this period. Variable costs declined 5% year-over-year in the second quarter with epoxies and isocyanates being the largest categories of drivers of the improvement. Market prices for most import categories are now trending favorably from historically high levels at year-end. We are also encouraged by early success in accelerating our cost recovery efforts due to the launch of our purchasing optimization program earlier this year, which we are clearly now seeing in what we are procuring today. The better variable cost environment in the quarter was offset by $9 million in realized foreign exchange losses in the quarter as well as higher compensation expenses driven by variable incentive compensation, labor inflation, and stock-based compensation expenses due to the expected profit improvements in 2023. We are thoughtfully managing these increased costs and expect to largely offset their impacts over time through our ongoing productivity enhancement programs. The cost of our productivity programs and the expenses related to the North American ERP implementation, as noted earlier, also drove $15 million of temporary spending in the period, in line with our second quarter guidance provided back in May. I will now cover Performance Coatings results on Slide 11. Performance Coatings second quarter net sales were flat year-over-year at $856 million. 9% better price-mix and a 2% benefit from the absence of a customer contract restructuring charge impacting net sales in the second quarter of 2022 was offset by lower volume. As Chris told you, operational constraints in the quarter drove a sales shortfall in North America, which disproportionately impacted Refinish volumes and the associated profitability. Performance Coatings second quarter adjusted EBIT was $118 million versus $125 million in the same period last year. Improved price-cost dynamics drove a significant benefit to segment earnings in this quarter, but the impact of lower volumes and the allocation of roughly $10 million in costs associated with the enterprise projects led to the year-over-year decline. Industrial earnings were relatively stable year-over-year as proactive cost management and favorable price-cost mostly offset lower volumes. Moving to Q2 Mobility Coatings results on Slide 12. Mobility Coatings net sales increased 16% year-over-year to $438 million. Mobility Coatings adjusted EBIT improved to $24 million from $2 million in the second quarter of 2022 despite the allocation of $5 million in costs associated with enterprise projects in the quarter. Growth was supported by strong volumes and a favorable year-over-year price-cost benefit. Notably, our China business made considerable contributions to year-over-year improvement given an attractive mix of high-growth customers at healthy contribution margins. There is a clear improvement in the underlying earnings power of this segment. Momentum is building into the second half of the year, where I expect us to show further earnings and margin improvement in addition to volume growth. Now turning to our debt and liquidity summary on Slide 13. Axalta's balance sheet continues to improve and our liquidity profile remains strong. We ended the quarter with just over $1 billion in total liquidity, including a cash balance of $518 million. Free cash flow in the quarter totaled $99 million compared to a cash use of $14 million in the second quarter of 2022. This is an excellent result that we expect to continue as we prioritize working capital and realized profitability improvements. For the second consecutive quarter, we voluntarily paid down $75 million in principal on our term loan, which now brings the year-to-date voluntary paydowns to $150 million. Gross debt reduction remains a high priority as we look to offset the impact of higher interest rates and strengthen our balance sheet. Note that we are also well positioned to explore other opportunities to reduce our interest expense given the recent expiration of the soft call penalty on our term loan and following a favorable turn in capital markets over the last few weeks. Our net leverage ratio was 3.6x, reflecting a slight improvement from 3.7x at March 31. And we expect operating performance improvements to drive meaningful deleveraging on both a net and gross basis throughout the remainder of the year. Before concluding, I would like to extend my gratitude to the exceptional Axalta team and the Board of Directors with whom I've had the pleasure of working for the past decade. Being part of this journey over the last 10 years and being part of such a talented organization has been an immense privilege. My best wishes go out to each one of you, including our analysts and shareholders. Your partnership, trust, and support have been greatly appreciated during my tenure here at Axalta. Now I'll hand the call back to Chris for an update on guidance and concluding remarks.

Thanks again, Sean, for a decade of commitment to Axalta. Moving to Slide 14 to review our Q3 and 2023 guidance. Third quarter adjusted EBIT is expected to be between $160 million to $175 million or $230 million to $245 million in adjusted EBITDA. For the full year 2023, we expect adjusted EBIT to be approximately $630 million to $650 million, corresponding to adjusted EBITDA of $910 million to $930 million, inclusive of $15 million in consulting costs incurred in Q2, which will amount to a 13% increase over 2022 at the midpoint. This reflects an EBITDA level we have not seen since 2019 and an improved earnings run rate entering 2024. Our full year guidance framework assumes a mid-single-digit price-mix benefit for the full year, which implies a low single-digit exit rate in Q4. Typical seasonal demand patterns are expected in the second half but volume for the year is fairly flat with mobility recovery offsetting industrial softness. This view does not currently contemplate fully addressing elevated backlogs and raw material procurement is trending favorably. We expect to realize a mid- to high single-digit percent benefit in our variable costs for the second half of the year, which should provide a boost to margins and help mitigate elevated operating expenses. We are increasing our full year 2023 free cash flow guide to $385 million to $425 million from $350 million, following a stronger pace of working capital release than was previously expected as well as a slightly lower CapEx forecast as we focus on capital allocation prioritization. I'm encouraged on how 2023 is shaping up. We are well on our way to returning to pre-pandemic levels with a path to unlock even more earnings power in the quarters to come. I'm proud of our global team for their focused execution and commitment they have demonstrated through the first half. Axalta's potential is robust, given our market leadership positions, growth platform, talent, and technology, all of which, I believe, will not only support but drive long-term growth and profitability. Sean and I will be pleased to answer your questions.

Our first question comes from Christopher Parkinson with Mizuho Securities.

Just given everything that's going on in the 3Q guide and with FX, some carryover pricing trends in the marketplace, it obviously implies a fairly decent hit on volumes. And can you help us just kind of think about what we should be seeing on a segment level in the third quarter, what actually flows into that? Presumably some of that's the ERP. And probably just as importantly, how to bridge that with your 4Q expectations, just given the annual guide? Any color on that would be very helpful.

Chris, it's Sean. Maybe I'll start here. So from a volume perspective, we're actually expecting third quarter to be somewhat similar to the second quarter. We're not baking in any sort of broader recovery as far as bringing the backlogs down. We're not expecting them to get any worse, and certainly, that could provide a little bit of upside if we're able to close that gap. But when you think about volume and pricing, it should look relatively stable opposite the second quarter. We'll certainly start to see a little bit more benefit from a cost of goods sold perspective, again we’re probably a little bit conservative just given some of the priorities around bringing down working capital. We're certainly not procuring as much from a raw material perspective as we have historically given the prioritization there. And then just the lower dollar inventory actually working its way through the balance sheet, that's part of the reason why you're not seeing a bigger margin uptick in the third quarter. And then it's a similar cadence into the fourth quarter. Again, there's probably a little bit of upside if we're able to close the gap. Internally, we're certainly focused on closing that backlog gap. And again, that would probably get us to the higher end of the range that we provided on the guidance slide.

Maybe just picking up from Sean, and I'll break it down into each of the individual three businesses. So obviously, Mobility with the seasonality of the Europe and North American shutdowns, the two weeks in July, plus the standard July-August shutdowns in mobility. So you do see a little bit of that softness that we have baked into the forecast. Industrial, we, as Sean put, we have actually looked at it being flat with what we have in Q2. And again, the real story here is in Refinish. And what we do have is we have the backlog being resolved by Q4, and we're giving ourselves time, obviously, with the impact that we had with our plant on the Refinish side. But any work that we do in improving that does provide us upside into Q4.

Just if we could just dig in very, very quickly on just the refinish trend. I mean, if we kind of do the very quick back-of-envelope math on the ERP hit of what you publicized in your press release and look at that versus the volume decline in the second quarter, is there anything else going on there? Because I think obviously, presumably, it seems like everything is going very well. It seems like you're gaining changes with the SMOs, top 10s as well as a lot of the tail. Is there anything else that you think investors should be paying attention to? I mean, it seems things are going pretty well with Irus and the launch there in Europe. But just anything else we should be monitoring into 2024 would be very, very helpful.

Sure, Chris. The story is very strong. If you look at it purely from a volume perspective and consider the 8% increase, part of that is due to comparing last year when we exited some low-margin business in Latin America. The remainder is tied to our ERP launch impacting North America. Any progress we make in the next two quarters should indicate stable growth in that business. Regarding Irus, it will undoubtedly help us enhance and grow the business moving forward. So, aside from our decision to exit some low-margin business in Latin America in Q2 and Q3, everything else is attributed to the ERP launch.

And Chris, just to add on, I mean, we're still expecting record profitability in 2023 for Refinish. We still have a lot of the underlying tailwinds as we think about market recovery both in North America as well as Europe. You still see work in progress at the body shop level at all-time highs as well as occupancy rates essentially stalled at roughly 50% in North America. So we continue to see upside. But we're going to bring down this backlog over time. And I think what we saw in the second quarter was stability around demand. So we're really happy with how that business is performing, and the expectations are extremely high as we move forward.

Our next question comes from John McNulty with BMO Capital Markets.

Sean, I appreciate all your help over the years. Chris, I want to delve a bit deeper into the comments you made during the last quarter's call regarding price recovery, raw materials productivity, and supply chain optimization. Now that you've been with us for about six or seven months, could you share your perspective on potential upside or margin opportunities? Additionally, how do you view the improvements we might see over the next 12 months, particularly concerning 2024?

Yes, that's a great question. In looking at our Q2 performance, we faced some challenges due to our ERP launches impacting one plant. However, if we exclude that, our guidance indicates we are on track for record earnings levels, even with our investments in enterprise programs and increased compensation compared to last year. Furthermore, our price-mix is up 7%, and our price-cost improvements are progressing positively. Moving into Q3 and Q4, we anticipate pricing to be somewhat more subdued. At the start of the year, we had a $120 million cumulative price-cost gap across two of our businesses, with about 60% of that resolved in the Mobility and Industrial sectors, and we expect to fully address that over the year. Additionally, aside from specialty raw materials like TiO2, the raw material benefits, as Sean mentioned, are looking good for the second half and should provide a positive tailwind into Q4. Considering all these factors, our Q4 guidance suggests a midpoint of 243, which would represent the second-best quarter in Axalta's 10-year history for Q4 performance. Typically, Q4 sees a decline, but at the upper end of our guidance, it indicates the strongest performance for Axalta, aside from 2020 when we had to take specific actions. This reflects the strong underlying performance of the company, and I am confident that we will resolve these operational issues in the next two quarters.

I understand. That's helpful information. I have another question. You mentioned some mix challenges in the automotive OEM sector and acknowledged that the price-mix was somewhat lower than expected. It appears that the pricing itself is quite strong, and the issue is primarily related to the mix. Could you provide us with some more details on this?

Yes, John, I wouldn't characterize it as an issue. It just happened that we sold a little bit more volume in a particular layer that has a lower price point. It's not anything structural as far as changes from a mix perspective, but it was about a 2% headwind when you think about price-mix. But nothing to be worried about on that front.

Our next question comes from Josh Spector with UBS.

This is Lucas filling in for Josh. I wanted to revisit the sequential assumptions in your third-quarter earnings guidance and the reasoning behind it. We are benefiting from lower raw material costs, the effects of ERP and consultant investments fading out, and the recovery of lost volumes. Each of these three factors could contribute approximately $15 million, leading to an overall sequential improvement of about $45 million. Typically, seasonal adjustments create a reduction of around $15 million to $20 million, which translates to a sequential advantage of roughly $25 million to $30 million. However, your guidance indicates only an increase of about $10 million to $15 million. I'm curious about what other factors might be impacting this estimate that I'm not seeing.

Yes, Lucas, we are not currently considering bringing that backlog in the third quarter. This is what I mentioned earlier. That represents potential upside, but it is not included in our guidance right now. When you think about pricing, it will remain stable from the second quarter to the third quarter. In terms of volume, we anticipate stability across all end markets, with light vehicles being a notable exception, which will be reflected in some of the industry forecasts. Europe is generally down, and we expect China, which had an excellent June, to see a slight seasonal pullback according to industry forecasters. Additionally, there will be a benefit from the consulting costs; while they won't completely disappear, most of them will. We will also see a slight increase in costs of goods sold, which serves as a bridge. Yes. We provided an overview of our remarks. However, there was approximately a $5 million decrease in consulting and ERP spending from an enterprise perspective that was allocated to Mobility. Therefore, the $24 million in EBIT increases to $29 million. Additionally, year-over-year, we are experiencing some variable incentive compensation pressures along with stock-based compensation, which are affecting margins compared to the previous year.

Lucas, I want to focus on Mobility for a moment. I believe this is a compelling story as we approach 2024. Referring to Sean's comments, with a $24 million EBIT for the quarter and an additional $5 million, we essentially have a run rate that allows us to annualize it, resulting in over $100 million for the complete year of 2022. In comparison, during a strong year like 2019, our EBIT was around $140 million with $89 million in builds, meaning we are about $3 million lower in builds this time. Considering the robust auto market driven by demand forecasts from both our customers and IHS, there is solid potential for continued growth as we head into 2024. On the heavy side, we're currently experiencing around seven months of backlog. Clearly, the business is well-positioned to achieve double-digit EBITDA, and the teams are performing exceptionally, outperforming the market and our peers.

Our next question is from Aleksey Yefremov with KeyBanc Capital Markets.

So your implied fourth quarter EBITDA guidance was about $242 million. How should we think about this as a base for 2024? So does this four quarter include the majority of your price-cost benefit? And where do you think there's additional margin opportunity in 2024? And also, is there a volume opportunity next year?

Yes, Aleksey, I mean, at the high end, it would imply about $252 million EBITDA contribution in the fourth quarter. When you think about the price-cost dynamics, regardless of inflation or deflationary environment, we'll continue to push price within Refinish. I mean, that's an area where we continue to innovate and provide value to customers, and we look to push through price. Some of the other businesses, as Chris mentioned, we are largely catching up and expect to be caught up by the end of the year. There could be some marginal pricing. It just depends on the pace of deflation. The bigger benefit really is expected from a run rate perspective around deflation. So today, where we're procuring inventories, we're probably down low double digits. As far as the back half of the year, we're expecting mid- to high single digits as far as the benefit in the P&L. So that will continue to unwind and provide potential margin upside as we round the corner into 2024.

We have discussed consulting, which includes three key aspects of our consulting expenditures. One aspect was directly related to the ERP project and the support it provided to our IT team. Additionally, we have efficiency projects in place, one of which targets inventory reduction. This initiative has enabled us to increase our working capital guidance for the year and achieve approximately $90 million in decreased inventory. Furthermore, there is a purchasing initiative that is expected to positively influence our material performance beyond what we have already seen. We anticipate the impact of this initiative to become evident in the P&L in the fourth quarter as we position ourselves for 2024.

Our next question comes from Duffy Fisher with Goldman Sachs.

I'm looking at your margins this year, and I've noted that you achieved an EBITDA margin of 16.6% in Q1 and 17.5% in Q2. The midpoint of your guidance for Q3 is 18.4%, indicating an increase of nearly 1% each quarter. However, the guidance for Q4 suggests a 17.8% EBITDA margin. Given that raw material costs have been declining throughout the year and continue to trend downwards, why do you expect Q4, which will have increased revenue compared to Q3, to not continue the trend of improving margins?

Duffy, you're seeing the dynamic in the fourth quarter just seasonally with some of our end markets dropping off with the holiday month in December.

But I guess I'd push back on that because your sales are up $100 million at the midpoint from Q3 to Q4. So some things may be falling off. But what you're saying is actually the company is still growing nicely, 5% sequentially. So something in there doesn't triangulate.

There's certainly an opportunity for margin improvement, particularly in procurement and addressing the backlog. If we consider the upper end of the fourth quarter with EBITDA at $252 million, there's potential for increased margins if other factors align.

Our next question comes from Vincent Andrews with Morgan Stanley.

Just wondering, with the issues with the ERP implementation in the second quarter, do you have to provide any terms or make holes or anything for customers in order to maintain that backlog in the North American market? And/or are you baking in any conservatism into the back half of the year for any further ERP implementation issues?

Yes, I will take that. Good morning, and thank you for the call, Vincent. We do have some cushion. Let me explain. The main impact of our ERP launch was on our Refinish business. We launched on May 1, and May was challenging for our Refinish business due to issues at our plant in Virginia. However, the teams around the world came together in June. To put this in perspective, Axalta has been operating for just over 10 years. In 123 months, June was our second-best month ever in terms of sales, EBITDA, and margin performance. This highlights the strong foundation we have and what the teams achieved after the difficulties in May. As we prepared our forecast for Q3 and Q4, we did have a backlog. There is typically an increase in Q3 for Refinish, so combined with our backlog, we forecast a way to reduce that backlog over the next two quarters, although the benefits won’t be reflected in our forecast. Regarding customer retention, this pertains to the Refinish business, and we are confident in our ability to retain these customers. We are not facing a destocking issue like what you may have heard from others. We have reduced inventory levels at our distributors and are replenishing them while ensuring we deliver what our customers need. This is our primary focus for the upcoming two quarters.

And just as a follow-up. SG&A is up $30 million. Can you just help me understand the components of that are? Is the consultant spending in there? Is some of that investment spending? Or just sort of what's the bridge there? And how should it play out over the balance of the year?

Yes. The vast majority of the increase relates to incentive compensation. Last year, we tracked well below our target from a budget perspective. Global incentive comp ranged around 70% of the payoff. We're tracking above the incentive comps this year. So that's really the vast majority of the headwind from an SG&A perspective.

Our next question comes from Anthony Mercandetti with Deutsche Bank.

Just back on the ERP. Can you quantify the benefits that you're expecting to realize by Q4 and then how we should think about this flowing through the P&L in 2024?

Yes. So we'll be providing the benefits with the ERP launch as part of the 2024 guide. We expect limited benefit other than the absence of the cost that we incurred in the second quarter as it relates to third quarter and fourth quarter. Right now, it's the focus on continued stability at our plants. But then we'll quickly turn to value realization. As part of this ERP implementation, we redid our integrated business planning. We put in new pricing tools. And obviously, we get a lot more visibility into transactions and working capital that we expect to benefit in 2024. But again, we'll provide more guidance when we're out with the 2024 guidance I am sure.

Understood. And then as other geographies roll out, their own ERP implementations, do you expect similar, I guess, operational hurdles and costs that we saw in North America? Or is this process more streamlined since it's been done already?

Well, that's a great question. One of the things that we are doing is going to take a bit of a pause for about a year and get launched with other regions such as Asia and Latin America and then start with Europe, which would be the next launch, a large region. So we're going to probably take this over the next two to three years. And obviously, big lessons learned that we have from here as well for us. But again, as I said, when you consider the scope, scale, and magnitude of the project, I am pleased with the implementation. And so there are some lessons learned on warehouse management and shipping management that we will take and apply as we go forward in future launches.

Our next question comes from Matthew Krueger with Baird.

So given the major shift in pricing over the last couple of years now, transitioning to a more favorable raw material sourcing environment, can you talk a bit about what you're seeing from a competitive backdrop perspective? Maybe highlighting any key gains by end market or region as well as where you may be facing some comparatively stiffer competition?

Sure. I'll begin and then hand it over to Sean. Reflecting on our price-mix, the company achieved a 7% increase as mentioned in our prepared remarks. The teams have performed exceptionally well, with a 10% increase in Refinish, and 7% in Industrial, despite a 15% decrease in volumes. In Mobility, even with a 2% challenge, we managed a 3% increase. Overall, we reached 7% as a company, demonstrating our commitment to driving both price and cost. However, the impact is becoming less pronounced in the latter half of the year. At the beginning of the year, we faced about $120 million in cumulative price-cost challenges, mainly in the light vehicle and industrial markets. The teams have successfully addressed more than half of this, and I anticipate that by the end of the year, going into 2024, most of it will be resolved. We expect pricing to become more subdued as we stabilize, and we are starting to see the positive effects of raw material deflation. Although we have encountered some resistance from customers, the overall business performance shows that our strategies are being effective.

Great. That's very helpful. And then your earnings release and presentation is fairly unique in that it doesn't reference destocking at all. It may be the first release that I've seen like this throughout the reporting period. Can you provide some details on any potential impact from supply chain destocking across the business during the quarter? And if there wasn't an impact, why is Axalta's business so uniquely immune at this point?

So Matt, I mean, we just don't go through distribution, and most of our customers are just not holding as much Refinish, keeping that aside. We actually destocked in North America within distribution just because of the ERP element. So that certainly provides some upside for us. Where we saw some marginal destocking was really within building products in North America, and so you saw the 15% pullback within Industrial. Building products were really a core driver to that. Certainly, building products market weakness, but there was some element of destocking. Again, it's just not as pervasive of an issue for us and why we're not calling it out.

Our next question comes from John Roberts with Credit Suisse.

Best wishes, Sean, and welcome, Carl and Kevin, if you're listening in. I believe Axalta sells coatings for auto OEM parts that are painted off-line and then shipped to OEMs. Does that part of the business serve as a leading indicator for the OEM business? And what are you seeing in the parts business?

Overall, John, we are experiencing very strong demand in the light vehicle sector, exceeding our initial forecasts. IHS has been gradually increasing their projections, and we are currently looking at 86.7 million builds. Additionally, our preliminary checks with customers indicate a robust underlying demand. The aging auto fleet and four years of underbuilding are contributing to what I consider a short- to mid-term favorable outlook. Regarding heavy trucks, backlogs are exceptionally strong. Our customer feedback shows that even with record production levels, they are facing nearly seven months of backlog. Both segments appear to be in good shape, although there are some concerns about potential softness in 2024, but we haven't experienced that yet.

Our next question comes from Kevin McCarthy with Vertical Research Partners.

In your Mobility segment, you've talked in the past about commercial courage and an effort to restore margins. So my question would be at this juncture of the cycle where we have raw material costs coming down sharply, in some cases, do you think you can continue to move price higher on a sequential basis in Mobility exclusive of mix? Or does that become impractical based on your recent customer experiences?

What we're observing right now is that pricing in the Mobility segment, particularly for light vehicles, began quite slowly. Looking back a year or a year and a half ago, the most significant cumulative price-cost issue was within our Mobility business. Today, we still have the largest price-cost gap in Mobility. Our teams are effectively working with customers to address this. As I consider the second half of the year, we anticipate this gap becoming less pronounced. As costs decrease, the price-cost gap is starting to stabilize. We believe it will continue to become less significant. Our customers recognize the need for us to invest in this business, especially in light vehicle mobility, to meet ongoing product requirements. While it has been a lengthy discussion, I think we're on the right track. With prices declining, we are starting to lessen these discussions going forward.

Yes. To add, approximately 40% of those contracts are indexed. Therefore, some price adjustments are expected, but you should continue to see improvements in variable margin due to the benefits from deflation. The team is highly focused. We are still 40 to 50 behind at the end of Q2 regarding the price-cost gap. The team is driving efforts but is becoming more selective, assessing each OEM and region individually. I believe there are ongoing opportunities as the team works on margin recovery.

Okay. And secondly, how would you compare Irus to your existing Daisy Wheel product and also your competitor's Moonwalk product? Is it essentially Daisy Wheel 2.0 or something that's more of a step function change? And are there financial implications we should be thinking about as you ramp up in Europe and elsewhere in terms of providing the equipment and those sorts of considerations on margins, for example?

I truly appreciate that question. Whether it’s 2.0 or 3.0, I see it as a significant breakthrough. Irus represents advanced technology; it is a fully automated match-and-mix system that I believe gives us a competitive edge. In the Refinish sector, this is essential and a basic requirement. I believe this advancement in our process really sets apart our Refinish business and the exceptional team we have. It’s remarkable because it's the only fully automated machine that I think outpaces anything else available. To provide some insights regarding the advantages for our customers, this product offers less than a year payback for our existing customers. Regarding sustainability, it utilizes Axalta's own bottles made from 50% recycled plastic. In terms of our customers, we’ve cut down about 400 tons of plastic waste entering landfills within a year. Additionally, since our launch in Europe, the feedback from customers has been overwhelmingly positive. During my first seven months engaging with the team and listening to customers in Europe, the feedback has been excellent, and I view this as a vital evolution for our business as we move into next year.

Thank you. There are no further questions at this time. Thank you so much for your participation. This concludes today's teleconference. You may disconnect your lines at this time.