Axalta Coating Systems Ltd.

Ladies and gentlemen, thank you for standing by and welcome to Exalta's second quarter 2019 earnings conference call. All participants will be in a listen-only mode. A question and answer session will follow the presentation by management. Today's call is being recorded and replays will be available through August 1st. 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 McRae. Please go ahead, sir.

Good morning. This is Chris McRae, VP of Investor Relations. Thank you for joining the call today to review our second quarter 2019 financial results and for your interest in Exalta. Joining me today are Robert Bryant, CEO, and Sean Lannan, CFO. We released our financial results this morning and posted a slide presentation to the Investor Relations section of our website at exalta.com, which we'll be referencing during this call. Both our prepared remarks and discussion today may contain forward-looking statements reflecting the company's current view of future events and their potential effect on Exalta'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. This presentation also contains various non-GAAP financial measures. In the appendix, 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'll now turn the call over to Robert.

Thanks, Chris. Good morning, and thanks for joining us to review Exalta's second quarter financial results. We're very happy to report a quarter with stable top-line sales growth, XFX, expanded consolidated margins, and strong operating profit and earnings performance, supplemented by excellent corresponding cash flow. Underlying drivers remain broadly consistent with our first quarter results, notably including acceleration and average price-cost gap closures, as well as ongoing progress with Exaltaway productivity savings, which remain on track for our 2019 targets. As you are aware, Exalta's Board of Directors announced in June that we are conducting a review of strategic alternatives. The board and management remain committed to maximizing value for our shareholders. As I'm sure you can appreciate, we're not prepared to share any incremental information regarding that review at this time, and we thank you for your patience until we can share any conclusions. Shifting to operating highlights for the quarter, as you can see on page three, consolidated constant currency net sales were stable in Q2. A reported 4.5% decline included a 3.5% negative foreign exchange impact as well as a 0.9% negative M&A impact driven by the sale of our interest in a previously consolidated joint venture in China, which we noted on our April earnings call and included in our updates to our four-year guidance. The flat organic net sales included lower volumes offset by equally strong price mix effects. Performance Coating's net sales were flat before currency effects and increased 1.2% before M&A related impacts. Transportation coatings net sales decreased 2.4%, XFX, driven by lower light vehicle global production volumes. Price mix in light vehicle showed solid and encouraging positive acceleration as we continue to work with customers to adequately compensate for the ongoing raw material inflation experience over the last two years. We reported second quarter consolidated EBIT of $197 million, a 9% increase compared to the $182 million in the same quarter a year ago, driven by strong price mix drop-through to earnings, as well as including benefit from productivity efforts across the business, which included year-over-year benefits from stock-based compensation in the quarter. Volume effects were a notable offset to profit growth, while ongoing variable cost inflation and FX also weighed on results, though to a lesser extent than Q1 is anticipated, given the overlapping sequential headwinds seen during 2018. Adjusted EPS for the quarter was $0.52 per share, which compared with $0.46 per share in the prior year quarter, with drivers consistent with those just mentioned at the operating level. Looking at our end markets briefly, Refinished net sales increased 3.6% XFX in the quarter. We grew net sales XFX in the mid-single digits across North America and EMEA, while other regions appeared to exhibit more tepid economic business conditions. We continue to efficiently offset variable inflation with appropriate price management to sustain the broader margins of this business. In volume terms, we continue to see moderate pressure from the North America region, which we attribute to ongoing distributor channel destocking and continued adoption of our more efficient premium paint systems. We remain on track for full year expectations for both net sales and profit bolstered by continued share gains and stable and market body shop demand. Our industrial coatings and market saw a net sales decline of 1.1% in the quarter XFX and before negative M&A related impacts from the China JV sale. Drivers of the slight pullback in net sales XFX include low single-digit net sales decreases in North America and EMEA, offset by solid growth in Asia Pacific, excluding our JV disposition impacts. Overall volumes were down mid-single digits, while average price mix increased low to mid-single digits. The contraction correlates broadly to global industrial production indicators, which remain slow and appear to accelerate negatively somewhat in the period. Looking ahead, we've somewhat reduced our volume assumption for the balance of the year, though offset largely by better than expected price mix outcomes and additional cost control across the company. We also continue to invest in business and introduce many new products as per our plan. Light vehicle net sales declined 4.3% XFX for the second quarter, reflecting lower production rates for our OEM customers in most regions. and more severe ongoing demand weakness persisting in China. IHS production forecasts for 2019 have been further reduced several times in recent months, now calling for a 3.7 global production decline versus a 1% lower assumption as of March end. The updated global production guidance now includes a 4.7% reduction from EMEA, a 2% decline in North America, and a 4.1% decrease for Asia-Pacific. including a negative 6.9% in China. Commercial vehicle net sales increased 4.5% XFX in Q2, including ongoing strong production of commercial trucks in the Americas, and continued solid demand for non-truck customers across our business. Price mix was down slightly in the period, but margins for commercial vehicle have seen continued improvements due to volume contribution. Regarding our balance sheet and cash flows, Second quarter free cash flow was solid, and we reconfirmed our full year free cash flow targets of $430 to $470 million. We finished the quarter at 3.5 times net leverage versus 3.6 times net leverage at March quarter end. We repurchased 1.6 million shares for a total consideration of $39.5 million in the second quarter at an average price of $24.90. In terms of innovation investment highlights, in Refinish, we continued the launch of several new products in EMEA, including a new ultra-high productivity primer sealer and a new waterborne base coat performance additive. We also launched our new premium Refinish STANDOX product line in China. In our industrial market, we have partnered with a robotics company to introduce a real-time, in-line monitoring solution to optimize a process related to coating electrical motors, which enhances customer quality and productivity. Finally, in transportation coatings, Exalta continued its focus on harmonized coating technologies with the first commercial launch of a direct-to-plastic low-bake base coat clear coat system, which significantly reduces overall cycle times for customers. Regarding our 2019 execution priorities, We remain firmly focused on meeting our objective of generating profitable growth. The back half of 2019 is expected to be moderately challenging, given ongoing lower automotive OEM production rates in key markets we serve, as well as somewhat subdued industrial coatings demand in North America and Europe. Further, we remain committed to actively managing our cost structure to ensure broad margin stability, regardless of the volume backdrop. and our Exalta Way planning remains highly engaged and an integral part of our goal achievement. I'll now turn the call over to Sean for further review of our financial results.

Thanks, Robert, and good morning. Starting with slide four, consolidated constant currency net sales decreased 1% year-over-year, including a flat result in performance codings and a decrease of 2.4% in transportation codings. Excluding M&A impacts, which incorporate the sale of the interest in the consolidated JV in China, Consolidated net sales would have been flat, with performance coatings posting a 1.2% increase. The top line result was driven principally by solid ongoing price mix outcomes, offset by volume pressure across most end markets and regions. On the pricing side, Exalta posted ongoing stronger capture within performance coatings and acceleration within transportation coatings driven by sequential uptick in light vehicle, which is our third sequential quarter with positive price recapture. FX translation was a 3.5% headwind for the period, and the drop-through impact of this was largely consistent with our overall corporate margins. Key sources of pressure included the euro, renminbi, and Brazilian real. Q2 adjusted EBIT of $197 million was a 9% increase from the prior year, and margins improved 210 basis points to 17.1%. This result was driven by strong price mix drop-through as well as continued productivity benefits, including a benefit from stock-based compensation forfeitures in the quarter. Our bottom-line growth was delivered despite volume headwinds across most end markets, the ongoing FX impact, and raw material inflation at mid-single-digit percent increases at the adjusted EBIT level, albeit at moderating rates against prior year comparisons as anticipated. Turning to slide five, performance coding second quarter net sales were flat year-over-year, excluding a 3.5% negative FX impact, and up 1.2%, excluding the JV SAL-related impacts previously noted. Organic growth drivers included a 4.7% increase in average price mix, offset partially by a 3.5% decrease in volume. Refinished produced second quarter constant currency net sales growth of 3.6%, versus the prior year quarter, which was slightly faster growth sequentially relative to the first quarter, driven by improved price-mix contribution. Net sales growth, XFX, was led by solid increases in North America and EMEA, while other regions were more subdued in the period. Volumes in the period included somewhat weaker Asia Pacific and Latin America results, along with a moderate impact from distributor channel inventory management in North America. Exalta channel checks within customer body shops continue to suggest steady demands, including steady purchase patterns from distribution. Total refinish net sales, XFX, also continued to grow positively, despite the volume-related headwinds, as the benefit of improved product mix and continued pricing benefits accrued a positive net sales growth. Industrial and market net sales, XFX, decreased 5.3% year-over-year in the second quarter, but decreased 1.1%, excluding the impact of the China JV sale. The modest decline was driven by volume pressure in most regions, offset by solid gains in average price mix from all regions. Volume pressure is fairly broad-based, and global industrial production in the period appeared to be the primary underlying factor. Performance coding second quarter adjusted EBIT of $128 million increased 17.2% year-over-year with strong continued price-mix traction and benefits from productivity initiatives partially offset by volume drop-through impact, continued variable cost inflation, and negative FX impacts. Adjusted EBIT margins of 16.9% increased 300 basis points year-over-year, including both price-mix tailwinds as well as cost reduction benefits against the prior year quarter. Turning to slide six, transportation coatings net sales decreased 2.4% year-over-year in the second quarter before FX headwinds of 3.6%. Segment volumes decreased 5.1%, slightly offset by favorable price impacts from light vehicle. Light vehicle second quarter net sales decreased 4.3%, excluding a 3.9% FX headwind. Volumes decreased mid-single digits overall, driven by lower production rates globally in light vehicle, and most notably from China. Average price mix accelerated sequentially from the first quarter, reflecting the realization of initiatives noted in our last quarterly call and ongoing discussions with customers regarding the need to offset persistent inflation across the business for the last several years. Commercial vehicle Q2 net sales increased 4.5% before FX headwinds of 2.6%. This growth reflects continued solid global vehicle markets, as well as non-truck submarkets such as bus, rail, and recreational vehicles. Global forecast updates for heavy-duty truck production remain steady for 2019, despite more moderate audit rates seen in North America heavy truck this past spring, as backlogs remain elevated in the region. Transportation codings generated a Q2 adjusted EBIT of $40 million versus $38 million in the second quarter of 2018. and associated margins of 10.1% in Q2 compared to 9% in the year-ago period. The margin uptick included the benefit of price mix drop-through, as well as the tailwind from moderate productivity benefits, offset in large part by volume declines and ongoing input cost inflation. Turning to slide seven, second quarter free cash flow totaled 104 million versus 107 million in the second quarter of 2018. The similar free cash flow outcome was driven by moderately greater working capital uses in the current period, offset by lower capital expenditures compared to the second quarter, 2018, which are largely timing-related. We ended the quarter with cash and cash equivalents of $577 million and a net debt balance of $3.3 billion versus $3.4 billion at March 31st end. Our net leverage ratio at quarter end was 3.5 times compared to 3.6 times at March 31st. primarily reflecting a $76 million higher cash balance due to sequentially improved working capital performance, and after deploying an additional $40 million for share repurchases in the quarter. Turning to slide eight, we're updating our financial guidance for 2019. For net sales XFX, we now assume no growth overall, which incorporates our updated view on volume development from the end markets, as we have noted, particularly impacted by lower light vehicle builds, but also reduced industrial costs global production demands. For reported net sales, we expect to be around 2% lower year-over-year, including an approximate 2% FX headwinds versus approximately 1% to 2% in our prior assumption. We have updated our original guidance range for adjusted EBITDA from $950 to $1 billion to a range of $950 million to $975 million, reflecting continued volume headwinds, particularly in light vehicle as well as FX headwinds of approximately 2% to net sales and around $20 million at the adjusted EBITDA level. For adjusted EBIT and adjusted EPS, we continue to assume low single-digit variable cost inflation at the cost of goods sold level and broadly similar sequential guidance constructs, but we anticipate some incremental cost reduction as well as price max benefits as well as incremental stock-based compensation forfeiture benefits. which collectively offset the lower top line assumptions. DNA is also about 10 million lower, principally due to FX translational impacts. Other line items remain consistent, as you can see, though the incorporation of lower share count from our buybacks in the first half contribute approximately two cents per share, which are reflected in the adjusted EPS guidance. For quarterly phasing of results, we expect third and fourth quarter profit based on the midpoint of our adjusted EBIT guidance range to approximate 25% and 26%, respectively, of the full year total. This concludes our prepared remarks. We will now be pleased to answer any questions. Operator, please open the lines for Q&A.

At this time, we'll be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment, please, while we poll for questions. Our first question comes from a line of Paritash Misra with Barenburg. Please proceed with your question.

Thank you. Can you elaborate on this 3.6% price mix contribution in the light vehicles business? I'm actually curious about the mix part. How big is the mix component within this 3.6, and what's driving that, and is that sustainable?

Good morning, Paritash, and thanks for your question. In terms of the price mix achievement of 3.6%, in the quarter, the majority of that is price and only a small amount of that is mixed.

Got it. And maybe just as a follow-up on the refinish business, can you elaborate a bit more about the volume trends that you're seeing? It sounds like you saw some weakness in North America and emerging market. Do you expect that to continue?

Well, I think as your question points out, when we think about refinish, we have to look at it as a global market. And actually, our largest market for refinish is actually in Europe. And as far as growth markets go, our emerging markets are our largest potential growth area as we move forward. Specifically, if we talk about North America, the volume trends that we've seen there as we've explained in prior calls, is predominantly driven by the shift from solvent-borne to water-borne coatings, as well as the growth that we see in the MSO segment of the North America refinish market. Those shops are just, on average, more efficient than average shops that are not owned by MSOs, and therefore they use slightly less paint from a volumetric perspective. So as we continue to innovate both in terms of the productivity of the product as well as the services that we provide, we capture what is given up there on a volumetric perspective and price mix. And then the third element has to do with behavior we see in the distribution channel. And as we've highlighted previously, distribution in terms of lowering their cost structure, both at an operating level as well as a working capital level, is a trend that we have seen continue in the industry, given consolidation as well as distributors' desire to increase their margins.

Got it.

Thanks, and good luck with everything. Thank you, Paritosh. Our next question comes from the line of Christopher Parkinson with Credit Suisse.

Please proceed with your question.

Thank you. This is Harris Fine. I'm for Chris. I'm just curious, how should we be thinking about the need for you to implement additional pricing, specifically in transportation coatings versus just letting this price increase that you had in Tukey roll through the next few quarters?

If we look at what's happened over the last couple years in terms of refinish, margins have been negatively impacted by fairly dramatic raw material inflation. at a period in time when prices did not go up very much in the overall market. We're now seeing traction in terms of having those conversations with our light vehicle customers in terms of price increases, and we had several of those discussions come to fruition and be realized actually in the first quarter, although it wasn't an impact of a full quarter. So you see a pickup in the first quarter of what's going on in the second quarter, and And in addition, what you also see in light vehicle is just the ongoing impact of several other changes that we've made in terms of moving more customers to be on an index, as well as other surcharge mechanisms. So the progress that we've seen there in the second quarter is not a one-time event. We would expect to see that on an ongoing basis, but perhaps not at exactly the same level. Specifically with regard to second quarter, it's approximately roughly half price and roughly half mix effect in the second quarter for light vehicle.

Got it. And just as a follow-up, in terms of the destocking that you saw in refinish during the quarter, could you just point us to any indicators that give you confidence that that doesn't represent any deceleration in demand from declining frequency and that it is just destocking? Thank you.

Given our close relationship with the end customers at the body shop level, we have a very good feel for what's going on in the repair shops. And what we can see there is the amount of activity at the repair shop level as well as just the size and growth of the car park and accident rates give us confidence that the end market is actually continuing to perform as we had originally expected. And what you're just really seeing is the continued push by distribution to become more efficient.

Got it. Thank you. Our next question comes from the line of Gansham Punjabi with Baird.

Please proceed with your question.

Hey, guys. Good morning. I guess first off, going back to auto-refinish and sort of looking back at the last couple of years, have volumes, Robert, for the industry played out the way you thought they would across your major regions, sort of separating out some of the unique destocking elements that you've been impacted with? And then going forward, what do you think is reasonable for industry volumes specific to refinish on an ongoing basis across your major regions?

Gontram, as we look at that, I think the important thing to remember is that when you look at the refinish business, you really need to look at it at a net sales level, just structurally as the business operates. And in your customer base, you're trying to push towards higher and higher productivity coding systems. So whether you're in Europe or whether you're in Southeast Asia or North America, everybody is under pressure to become more efficient. So if you look at just volume trends, I think we'll be missing a very important part of the story. You really have to look at overall sales. And I think compared to our expectations, we've actually seen at a net sales level the overall end market growth that we would have expected. And I think we'll continue to see that growth in particular in emerging markets as you see the car parks and increasing grow and increasing penetration of the middle class and growth of the middle class in those emerging markets.

Understood. And so as you disaggregate, you know, that comment on net sales, how much do you think price, how much do you think mixes impacted that component? As you kind of think about volume mix, you know, and so on, the evolution of higher productive coatings, et cetera, what do you think the mix component is if you disaggregate that?

Well, we've certainly seen an increase in waterborne coatings. Much of that in developed markets is really driven by just the natural evolution of the market. And then you have some markets where it's more regulatory driven, such as China. And then you're seeing other countries really push on the environmental regulatory side of the equation. So therefore, we think that there's going to continue to be a push towards waterborne. But waterborne isn't the right solution necessarily for every situation and every body shop. So we do have a high solids, low VOC solvent-borne product that's the leading product in that category in the industry that has also experienced strong growth. So I think overall, we would expect to see the refinish industry grow globally and each market. And then we also expect to see some of those shifts that we had talked about in terms of more solvent-borne or less solvent-borne to more water-borne, and then even in some jurisdictions that are predominantly solvent-borne, an increase in the use of high-solid, low-VOC solvent-borne.

Okay, and just one final one. Understanding you're very limited in what you can say on the strategic review, but during this period, how should we sort of think about capital allocation as it relates to your free cash flow generation for 2019? Thanks so much.

I think Nothing really changes as far as capital priorities. I think we remain focused on our M&A efforts. I think we're going to continue to drive the internal organic projects, those high return projects that we've continued to voice over. And we'll continue to look at opportunistic share buyback. And to the extent, you know, we're not looking at something from an M&A perspective, we'll continue to build cash on the balance sheet, you know, heading towards our net leverage target of two and a half times. So that's kind of how we think about Capital priorities today, regardless of the strategic review.

Thank you very much. Our next question comes from the line of Mike Tyson with KeyBank.

Please proceed with your question.

Hey, guys. Nice quarter. I think I heard you say that your guidance for the second half is 25% third quarter, 26% of the outlook. fourth quarter, so you'll have an acceleration into the fourth quarter. Can you maybe talk about some of the drivers of why the fourth quarter is going to be stronger than the third quarter?

We do see raw materials moderating as we get into the back half of the year, so that's one big contributor. And then from an FX perspective, we also see a little bit of strengthening in And last thing, and not as notable, but we do see our comps from an LB perspective improving slightly in the fourth quarter.

And the last component, Mike, would be the usual process of accumulating cost savings through the year, which usually are most impactful and helpful in the fourth quarter.

Got it. And then just a quick one on commercial vehicles. It sounds like it continues to see good growth for you guys. Anything In particular, driving that, the new products, market share gains, just kind of your thoughts on that segment.

Yeah, the big driver is just the America's heavy-duty truck market continues to do extremely well, and given our market penetration there, we're benefiting from that.

Great. Thank you.

Our next question comes from the line of David Begweter with Deutsche Bank. Please proceed with your question.

Hi, this is David calling here for David. I guess first, as raws deflate in the second half, where are you at risk for pricing pressure? And I guess, can light vehicles sustain pricing in an environment of weak and market demand and low raw materials?

Yeah, I think... Could you repeat your question?

I'm sorry, you came through quite softly. We got part of your question, but not all of it.

As you think about second half, roads are expected to deflate. Where are you at risk for pricing pressure? When you think about light vehicles, can light vehicles sustain price in an environment of weak macro demand and lower raw materials environment?

I think as we look at our markets, we do see raw material headwinds easing throughout the second half of the year based on purchases that we've made up till now. So barring a shock here and a big uptick in the third quarter in terms of what we're buying that would flow through in the fourth quarter, there still are headwinds. It's just that they're lower. So we still have year-over-year inflation. And as such, I think our customer base understands our need to recoup that inflation. And with regard to light vehicle, the gap in price capture to offset the raw material inflation that has occurred there over the last really two and a half years now, two years is quite substantial. And so while there's been good progress on price increase there to offset those costs, there still needs to be more to offset more of the margin decrement that's occurred over the last two years.

Thanks. And then, how do you think about your 2020 EBITDA relative to your 2019 expectation?

At this point, we haven't provided any guidance on 2020. Our regular cadence is to do that towards the end of the year. you can expect that towards the end of 2019.

Thanks.

Our next question comes from line of PJ Jubiker with Citi.

Please proceed with your question.

Hi, good morning. This is Eric Petrione for PJ. China auto sales were weak in the quarter, but do you buy the view that auto dealer inventories in China have declined and are now back to normal?

And then what is your order book looking like?

Yeah, so we don't typically carry an order book or certainly one that we discuss in automotive. That's a relative just-in-time delivery business. And automotive manufacturers will carry generally a couple of weeks inventory that we're consistently replenishing. So our visibility into that short term is about two weeks. We certainly discuss with our customers what their plans are longer term. We are aware that inventories in China are now quite low, which should be or at least could be helpful, the outlook for demand there. But we remain relatively cautious in terms of our guidance construct with regard to any acceleration of the China market at this point.

Thank you. And secondly, could you talk a little bit about the industrial and market demand and what you saw that did well or better in or worse in the regions, especially in the noted strength in Asia Pacific?

I think as others have seen in broader industrials as well as in coatings, in the second quarter, we did see a softening in demand. And for us, we've been experiencing an outsized growth in that end market for a while. We did see some market softening in the second quarter. As we go through our markets, not too dissimilar from perhaps what others have commented, in the wood business, residential starts and remodels in the market were down about 5%. Fortunately, we've been able, through new products, new customer gains, and price increases, to offset a large portion of that. In the coil business, we have been impacted by lower demand in construction, agriculture, and also lower steel imports have also dampened demands there somewhat. However, we do have a number of new products that have been launched in that market segment and more throughout the course of the years. I think we're also fairly optimistic about our position within the coil market. Our energy solutions business, what we see there is volumes down, kind of low single digits, but price mix up mid-single digits. We have strengthened China, given the growth in that market there, and that's been offsetting the softer demand that we see in Europe. And then in our powder business, volumes have been flatter through the second quarter, but we have had price mix up in that business. So the global price increases that we've had there and some of the new business gains have really enabled us to offset some of the slowness that we saw in North America and EMEA, and China is also you know, a market that in the second quarter performed well for us.

Great. Thank you.

Our next question comes from the line of Alexey Efimov with Nomura Internet. Please proceed with your question.

Good morning. This is Matt Skowronski on for Alexei. In refinish, last quarter you touched on how you saw some sales wins in the Americas. Were these fully implemented during 2Q? And if they weren't, how should we think about that cadence in the coming quarters?

So we've had very good commercial performance, including some new business that is in the process of being converted. The conversion of that business actually takes time. Because you go on a shop by shop basis and convert and convert each shop over to a new over to a new paint supplier So we expect to see that benefit Be relatively small this year, but have a much larger impact next year Thank you for that and then just touching on something that you commented on earlier in terms of raw materials you mentioned you're pretty far along closing the gap and

in light vehicle, or at least you made progress. Will that gap with raw materials and price be completely closed by the end of the year?

No. So we're still, I would say, early innings as it relates to light vehicle. And just to correct something that was said earlier, the pricing you're actually seeing come through this quarter, it's predominantly price versus mix. So I just wanted to correct that point. But we still have a fair amount of work to do on the pricing side. And You've seen the last three quarters, you know, we've gotten price with that accelerating this quarter, but there's still work to be done. And when you bridge over to performance, we are largely caught up on the performance side.

Thank you.

Our next question comes from the line of Laurent Fabry with Exane. Please proceed with your question.

Yes, good morning all. Two questions, please. The first one on the raw materials side, can you give us a bit of an indication on what kind of pressure or where are you seeing still pressure into the second half on HDIs and things like that. And then the second question on the strategic review, I appreciate that you don't want to speculate on the outcome, but I was wondering if you could share anything on the process itself. For instance, have you hired consultants and are you sharing info with them on your business and are you asking them to look at what you could improve on your business itself or are you mostly doing it yourselves and getting in bankers to think about the M&A outcomes? Thank you.

Laurent, on your second question, we won't be commenting on any of the details of the strategic review at this time. I think what we've said publicly is pretty much all we're going to say about that for now. On your first question, in looking at the raw material basket, just a little color by category, I think for Q3 at least, we see resin prices finally starting to be flat, which is an improvement over our earlier expectation of slight inflation. In isocyanates, we do continue to see price pressure there and expect them to be up year over year, third quarter to third quarter. Solvents we expect to be, for the most part, flat in the third quarter. Monomers is a category we do see due to some supply tightness there. We do continue to expect prices to be up. Pigments, as is usually the case, kind of up. And then on the additive side, we are seeing some relief there in the additive category with prices flattening out, at least for the moment. In particular, the entire basket and the overall category is just reflective of where oil price oil prices spend. So again, still headwind overall for us, but a lessening headwind compared to prior quarters.

And just to add two other notables that we've noted in prior quarters, we're still assuming about $13 million in headwinds as it relates to tariffs. And you recall with oil really spiking in October of last year before we started to see the change, we were sitting on some high dollar inventory at the end of 2018 that largely turned in the first quarter of 2019.

Great. Thank you.

Our next question comes from the line of Josh Spector with UBS.

Please proceed with your question.

Hey, guys. Within performance, I was wondering, could you break down the volume change year on year for the refinish versus industrial?

Yeah, Josh, we haven't typically provided a bridge at that level, so we've noted the 3.5% lower volume offset by a higher price mix for the segment. You know, we did have some decline in volume in refinish offset by improved mid-single-digit price mix, and likewise, some decline in volume and industrial offset very well by price mix as well.

Okay. And then on performance, I guess when I look at what you did from an EBIT standpoint in the quarter, and I look at prior years, typically quarter on quarter into the September quarter is around maybe a $10 million decline sequentially. If I look at the guide that you have today, there's maybe closer to a $15-20 million decline. And I guess I think with some of the mixed efforts and maybe a little bit of price benefits, that it might have been more like a normal decline into the quarter. Curious, you know, what would be potentially driving that higher sequential decline versus what we typically see?

You know, it's challenging to look at it on that basis in part because prior years had a lot of moving parts, notably including the distributed stocking that occurred in 17, and there was some correction for that in 18. and the development of price mix in the segment over the last couple of years. So, you know, doing that particular type of analysis is a little bit challenging, so I prefer you think about it in terms of the current year dynamics predominantly. But you are correct that it is normal and typically seasonal to see a little bit of a step down 2Q to 3Q.

Okay, thanks.

Our next question comes from the line of Lawrence Alexander with Jefferies. Please proceed with your question.

Hi, everyone. This is Dan Rizwan from Lawrence. How are you? Hey, Dan. Hey. If we think about how, you know, shifting refinish customers to the coding systems, to the higher margin coding systems, how does that process work? I mean, what's the length of it? Is it kind of involved or is it something that they accept or do you have to do a lot of, like, kind of teach-ins?

It varies. If someone is switching from waterborne to solvent-borne, there is an investment that's required in the paint booths. There's also training that's required of painters because the paint actually sprays differently. So if your question is kind of waterborne to solvent-borne, it's a fair amount of training And really, there's got to be a certain amount of throughput, or there's a break-even level where it makes sense for a shop to be solvent-borne or to be waterborne, just based on the overall economics and outlook of the shop. Now, if you're talking about switching from one competitor's paint system to another competitor's paint system, even if they're both waterborne or even if they're both solvent-borne, they spray differently. So there's also education and training that's required in that scenario.

So it takes a number of months to years to kind of do the switchover? How does it work?

A switchover of a body shop can be done in a weekend. The training and getting people up to an acceptable level of performance can take a few months. But again, it's largely a function of the quality of the painters. If you have painters that have been in the business for a while and highly skilled, the process moves quite quickly. If you're in a shop where you've had a lot of pain or turnover, the process may take longer.

Okay. And then just one other question. And then if we think about auto OEM trends and what we're seeing in light vehicle, do you have any initial thoughts on Q4, and is there any likelihood of an extended winter shutdown potentially for your customers?

As we think about our updated guidance, I'm kind of going back to the January guide. We started off the year expecting to be slightly up. At the end of the first quarter, IHS was showing down 0.9%, and now we're down at 3.7% based on what was recently published. So we're not expecting any sort of acceleration. I think as you look at our new top-line guidance, it's now reflecting further volume declines, following largely the IHS guidance.

Thank you very much, guys.

Our next question comes from the line of Jeff Zakowskis with JP Morgan. Please proceed with your question.

Good morning. This is Soke Cook for Jeff. How are you?

Good morning, Soke.

When you look at the restructuring announcement by the large auto OEM customers in terms of geographic trimming down of a footprint in manufacturing, How do you think that might touch your businesses? And is that something that will be something that you'll feel like in 2020 or something that's like a longer-term issue? Would you think that's something that you'll feel this year?

Okay, it's Chris. You know, there's actually been a series of announcements in different parts of the world. Probably the easiest way to answer that is that there is actually some impact in 2019 from announcements that were made last year, including in North America and a little bit in Europe. There's probably still some incremental impact that could occur in 2020 from announcements that have occurred this year. In some cases, we are not affected, so it really is plant by plant. When I looked at it in detail, I was relatively pleased at the direct impact to us relative to what I had essentially first feared when I read those announcements. So overall, while we can't completely duck the reality of some plant shutdowns globally, I would say that the impact to Exalta is moderate.

Okay. Secondly, I was wondering whether you can speak about your cash flows that is like the free cash flow sort of like 30 million for the first six months. How do you think you'll get to your target for your end and like what working capital changes do you expect to get to those numbers?

Yeah, I mean, we continue to drive working capital improvement. I mean, year to date, we're fairly happy on where we're tracking against the full year guide. But as you bridge June to December, you know, the big areas of opportunity that we're driving towards are accounts receivable and inventory. AR, just by a function of seasonality, you know, that typically comes in, but we expect that to tighten even more compared to the prior year. But we're on track to hit the guidance on why we're reconfirming the outlook that we provided last April.

So you think you'll go from like 30 to 475 by year end?

So we're reconfirming the range of 430 to 470 for our free cash flow.

Okay. And the last question I have is this. I was wondering whether you can talk about like the timing of the announcement of the strategic review. Like what prompted it and why now?

So, Silke, yeah, we've been asked quite a bit, as you can imagine, during the second quarter about that, and essentially all we can say is that the Board made that announcement June 19, and we haven't added anything specific to the context around that timing.

Okay. Thanks very much.

Thanks, Silke.

Our next question comes from the line of Vincent Andrews with Morgan Stanley. Please proceed with your question.

Hi, guys. This is actually Steve on for Vincent. I just had maybe a question on the macro level. It looks like you guys cut your IP assumption from like 2.1 to 1.5, but your sales guidance is coming down quite a bit more. So maybe if you could just bridge the delta in those two revisions, that would be helpful.

Can you clarify – The 2.1 referring to what?

Industrial production, your assumption there.

Oh, okay. Yeah, I mean, essentially you have an effect both on industrial and light vehicles from that reduced industrial production guidance, which is some of the underlying driver behind the outlook for those businesses. but maybe jump in if we miss anything in your question.

Yeah, I mean, the biggest change, so we did provide the macros in the deck, but the biggest change for the top-line guide is really volumes within light vehicle, you know, following IHS. We are seeing, you know, some headwinds as far as industrial, but the broad change relates to the light vehicle.

Okay.

That's helpful.

Thank you.

Our next question comes from the line of Steve Byrne with Bank of America Merrill Lynch. Please proceed with your question.

Hi guys. This is actually Luke Washer on for Steve. I wanted to touch back on the inventory, the stocking and your refinish business. Where do you think the distributors are in the stocking process? And do you expect us to continue in the back half of 2019 and then kind of into 2020?

It's difficult to say. I think the distributors overall are, as we said before, looking to become more efficient, both in their operating cost structure as well as in the amount of working capital. And where they are exactly on their process is something that I think you'd have to ask them. But I think at the end market level, again, we're seeing strong growth. And overall, globally, we had good overall growth at 3.6%. And I think, again, it's important that everybody not lose sight of the fact that we're in a global refinish market. And within that market, Europe is actually our largest market, and North America is our second largest market, the area of the most amount of growth over the next 5 to 10 years. will be Asia and emerging markets. So I think it's just important to keep that full picture in context.

Sure, that's helpful. And last question, you know, you guys did quite well on the margin for your performance codings, you know, 300 BIPs. Could you maybe break out a little bit more on how much of that was driven by the price mix versus actual price increases and maybe productivity enhancements?

Yeah, so on price mix, generally speaking, it was about 50-50 as far as actual price versus mix. We don't actually quantify productivity by end market, but we are continuing to see the benefits of Exaltaway, and you see that dropping through to margin.

Great. Thank you very much.

Ladies and gentlemen, we have reached the end of the question and answer session, and I would like to turn the call back to Robert Bryant for closing remarks.

Thank you. I just wanted to highlight that the second quarter was a very strong quarter for us. We executed extremely well. We achieved 4% price mix overall, and that includes price realization in both segments and across all four regions. And in particular, our efforts to offset raw material inflation with price increases in light vehicle showed through clearly in the quarter with price mix of a positive 3.6%. We're also seeing raw material inflation headwinds finally starting to ease somewhat. So the higher pricing, the lower raw material inflation, and the continued strong contribution from our Exaltaway cost reduction program is having a great impact on our profitability and our margins. Adjusted EBIT itself increased 9% year over year, and our adjusted EBIT margin expanded by 210 basis points. So if you flow that through to net income, net income also increased by 9% year over year, and our adjusted earnings per share increased 13%, which was further aided by our share buyback. Although industrial demand and light vehicle builds are expected to be lower in Q3 and Q4, we believe that the strong performance of our refinish and commercial vehicle businesses, our price increases, the easing of raw material inflation, and our cost reduction programs will position us well to hit our full-year profitability goals. So just wanted to provide that overall summary and perspective on the second quarter here. And thank you very much for joining us today, and we look forward to updating you again on our progress in October.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.