Axalta Coating Systems Ltd.

Ladies and gentlemen, thank you for standing by. Welcome to Exalta's third quarter 2022 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 a replay will be available through November 2nd. 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 Exalta and welcome you to our third quarter 2022 financial results conference call. Joining me today is Rakesh Sachdev, Interim CEO and President, and Sean Lannan, CFO. Yesterday afternoon, we released our quarterly financial results and posted a slide presentation along with commentary to the investor relations section of our website at exalta.com, which we will 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. Our remarks and this slide presentation also contain various non-GAAP financial measures. In the appendix to 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 Rakesh.

Thank you, Chris. I'd like to welcome everyone to our third quarter 2022 earnings call, and we'll start by discussing the key highlights on slide three. I'm very proud of our team and what we were able to accomplish this quarter. We delivered adjusted EBIT of 148 million and adjusted EPS of 39 cents, both within our third quarter guidance range. despite acute currency and inflationary headwinds, plus pockets of softening regional demand within our industrial business. Constant currency net sales growth of 20% was extremely strong, driven by both volume and price almost in equal parts. Volume increased 9% year-over-year as we benefited from market recovery in refinish, light vehicle, and commercial vehicle. Normalization of market demand in most of our businesses are being bolstered with new customer wins across our business portfolio. We again delivered strong year-over-year price mix growth of 10% in Q3, which more than offset inflation from raw materials and logistics inflation costs in the period. This represents an important inflection point toward our goal of recovering lost profitability during this two year period of unprecedented inflation. Before I review the quarter in more depth, I wanted to take a moment to comment on our strategic prioritization, organization, and my focus as interim CEO, which is summarized on slide four. Let me begin by reiterating that it has been an honor to work alongside this accomplished leadership team. After spending the last two months with the team, I believe more than ever that there is a great future for this company, and I share the team's strategic vision to unlock value for shareholders. Exalta's strategic priorities remain unchanged and focus on strengthening our industry-leading positions. We are the number one or number two player in the majority of our end markets. We are investing to support our differentiated capabilities and the needs of our customers, which is driving growth. Exalta's above-market growth accomplishments have been masked by challenging post-COVID dynamics, which has been inclusive of constrained auto production, hybrid work environments temporarily reducing body shop activity, unprecedented cost inflation, geopolitical headwinds and China's zero-COVID policy, and headwinds from currency translation given strengthening of the US dollar. Nonetheless, we are expanding the reach of our technologies and deep customer relationships into adjacencies, while also establishing platforms in new verticals to diversify our portfolio. We continue to explore bolt-on acquisitions largely within our industrial coatings business, where we have had success deploying capital and where there remains compelling opportunities. However, the pace of M&A clearly has and will remain slow for the time being, as we focus on our balance sheet. Rest assured that we are building a quality book of business which positions us to capitalize on post-COVID market normalization. Now on to my primary focus as interim CEO, which is centered on successful near-term execution. Of utmost importance today is price-cost recovery. We have made great strides with pricing in most key areas, but select products, customers, and regions need continued focus. Next, our single largest cost category is raw materials, where we now spend over $2 billion per year. Small productivity enhancements can deliver significant savings, while we also look to take advantage of any market dynamics. And lastly, operational and supply chain excellence is an area of emphasis and opportunity. Through more efficient planning and execution, We believe we can release capacity, improve operating costs, and reduce working capital needs. This requires a high degree of focused effort by many members of the organization across many sites, but I anticipate that we can transition to a more efficient environment over time. Altogether, we are focusing on controlling our own destiny to enhance profitability, no matter the near-term external environment. Before moving back to discuss the quarterly results, I wanted to touch on the board's search for a new CEO. There are no updates to provide today on timing, but I can pass along that the board and myself are working expeditiously. We are seeking a proven leader, someone who has the relevant industrial experiences and the tools to unlock value for shareholders. I'm pleased with the search committee's progress and increasingly optimistic that we will be able to onboard a real difference maker. Moving back to the results and slide five, where I'll give you more color on our third quarter volume performance. Globally, volumes improved 9% year over year, driven by end market recovery trends and share gains across the portfolio. This is a remarkable result given the global macro environment and speaks to Exalta's unique positioning today in the markets we serve. Volume growth was positive across all regions, but uneven driven by different macroeconomic end market and regional dynamics. It is also notable that three or four of our businesses increased volumes in the quarter. The Americas region was strong again this quarter with year-over-year improvements and contribution across all end markets. China led all regions with more than 20% volume growth year-over-year, as strong auto OEM production offset a somewhat weaker China industrial demand environment. In EMEA, the demand environment is again challenging as weakening macroeconomic conditions are becoming more evident, coupled with the continued geopolitical headwinds from the Russia-Ukraine conflict. For Exalta, the brunt of the impact was felt in industrial coatings, which is more economically sensitive than our other end markets and also lacks the sizable market normalization benefits we see today in refinish and mobility coatings. Altogether, volume in EMEA increased 1% year-over-year. Pockets of softness emerged in general industrial markets where volume dropped modestly. Moving to slide six. We are cautiously monitoring trends, and at the moment there are some early signs of softening in some of our industrial coatings exposure outside of EMEA. However, we believe that the risk of further macro headwinds to Exalta is mostly contained within select pockets of our industrial exposures. Elsewhere, we see bright spots heading into 2023 and expect to grow in most end markets. Market volumes have yet to recover to pre-COVID levels in most of the markets we serve. At year-end 2022, market volumes are estimated to be below 2019 levels, 8% for the refinish markets, 11% for light vehicles, and 5% lower for commercial vehicles, in particular within the heavy-duty truck space. Years of supply constraints have created deferred demand, evident in the aging auto fleets and also in low channel inventory levels, which continue to operate below normal. When taken together, we see significant upside opportunity for Exalta upon market normalization, which also represents an offset to near-term recessionary headwinds. Lastly, it is worth noting that our volume growth outperformed market performance since 2019. Exalta's differentiated technologies and superior service remain a powerful driver of our above-market volume performance. Given our pipeline of new customer wins, we expect to continue this trend going forward. Nowhere is this more evident than in our industry-leading refinish end market, which we will cover on slide 7. In refinish, our industry-leading aftermarket auto coatings business, we had a strong quarter with volumes up 4%. and price mix 12% better year-over-year. The team continues to gain market share in the mainstream and economy segments. Year-to-date, we added over 1,200 net body shops globally and 600-plus new stock points through distribution customers. Our leadership position with large multi-shop operators expanded during the quarter with the addition of several large UK-based MSOs. Our partners continue to recognize that we have a better way of doing business centered around what we believe to be the most productive paint system and technical teams in the industry. Meanwhile, we are seeing favorable trends in return to work leading to increased congestion rates and improved body shop activity in both North America and EMEA. Industry volumes are recovering but remain below 2019 levels in EMEA and North America. Normalization continues to represent an impactful demand tailwind and earnings driver over the medium term. Moving to industrial on slide eight. Industrial constant currency net sales increased 7% year over year, driven by 12% increase in average price mix, partially offset by 5% lower volume. The business teams are doing an excellent job prioritizing pricing to offset variable cost inflation. Even still, the business is under-earning today, and so the team is actively pursuing more actions to recover our cumulative price-cost deficits. The industrial portfolio is our most economically sensitive end market, and therefore our lower year-over-year volume is a result of macroeconomic cooling in EMEA and a slow recovery in China. Partially offsetting these challenges is robust demand for building products in North America. Our current capacity is essentially sold out for the remainder of the year, and we should continue to benefit from advantageous consumer trends going forward. Also, new product offerings like our R&D 100 winning Abisite 2060, which is a sustainable single-layer powder coating, are expected to support above-market growth. Moving to mobility coatings on slide nine. In mobility coatings, An industry leader in light vehicle and commercial vehicle exterior OEM coatings. Volume growth of 30% outpaced relevant industry production rates again as we continue to drive share gains. Trends for commercial vehicle are very favorable within North America in the second half of this year and is looking likely to exceed expectations. September Class 8 orders were a market record, and we expect a good end to the year for our business. The teams are doing a fantastic job, as evidenced by a leading industry position and external recognition from our customers. Exalta was the sole recipient of the Daimler Truck Supplier Award for Quality, a prestigious honor, and we have held the title of Master of Quality for 15 consecutive years as well. I'm very proud of the team's accomplishment and their tremendous performance. In light vehicle, new business wins made over the past year are increasing our exposure in China and should support continued market outperformance in 2023 and 2024. The contracts are attractive for the business and are coming in at variable contribution margins comparable to 2019 levels as evidenced by the current profitability of light vehicle in Asia Pacific. Yet at the segment level, we have much more to do to return to historic levels of profitability. Below normal, auto production is still a drag on earnings. But price cost remains a core challenge for the segment and worsened marginally in the quarter. We will cover this in more detail on the following slide. It is our intent to fully offset the impact of raw material, energy, and logistics inflation on our businesses. This quarter represented an inflection point in our price-cost trajectory, as we more than offset year-over-year variable cost inflation for the first time since the current unprecedented inflationary environment began mid-2021. Inflation has proven to be more persistent than we initially expected at the beginning of the year. We now forecast a 2021 and 2022 combined impact of approximately $650 million. versus a $400 million initial projection earlier this year. However, the raw material market has become more favorable in recent months. We are now seeing greater availability of bulk commodities, enabled by softening in adjacent markets and improved global arbitrage given normalized global shipping and logistics. Pockets of pressure do remain, however, with EMEA energy inflation becoming more significant. Elsewhere, inflation is mostly isolated to specialties like additives and certain pigments. Therefore, we believe that Q3 represents peak inflation and we see an opportunity for flat to modestly lower unit rates in the fourth quarter. The anticipated raw material benefits will come through on slight lag as we turn over higher cost inventory on our balance sheet during Q4. Pricing remains a focal point for the teams given incremental pressures like higher energy costs in EMEA and the need to offset the remaining $100 million price-cost gap impacting our margins. Now I'll turn the call over to Sean to discuss our financial results, beginning with slide 11. Sean?

Thanks, Rakesh, and good morning, everyone. Net sales were $1.2 billion, an increase of 14% year-over-year for the third quarter, while constant currency net sales increased 20%, driven by pricing actions, Demand strength across most of our businesses and benefits from our UPOL acquisition we completed in mid-September of 2021. Constant currency net sales growth included a 14% increase in performance codings and an impressive 35% growth from mobility codings. Both light vehicle and commercial vehicles showed strong year-over-year performance. Third quarter volume improved 9% year-over-year with positive contribution from three of four end markets. offset by mid-single-digit percent decline in industrial volumes due to supply chain constraints, as well as the macroeconomical and geopolitical headwinds within our European and China regions. Backlog remained a challenge, as we were again unable to fully meet demand in the quarter for both our industrial and refinished businesses. Price mix increased 10% year-over-year, or 14% better on a two-year stacked basis. Every end market contributed positive price mix, and three of our four end markets showed an impressive low double-digit growth. The drop-through of better pricing more than offset the 20% year-over-year increase in variable cost inflation, which is an important milestone in our efforts to reverse the price-cost gap. Sequentially, price mix improved by 3%, highlighting continued momentum and our prioritization of price-cost recovery. FX translation was a headwind of 6% on net sales for the third quarter, driven by a weaker euro, Turkish lira, British pound, and the Chinese renminbi. Third quarter adjusted EBIT was 148 million versus 146 million in the prior year quarter. The year-over-year comparison included approximately 16 million of EBIT headwinds associated with the impacts from the Russia-Ukraine conflict, China lockdowns, and FX translation. implying a more favorable earnings growth comparison when excluding these effects. In the quarter and throughout 2022, we have incurred higher selling and general administration expenses by design to support growth and from labor and general fixed cost inflation, which drove a step up in fixed operating expenses versus the prior year. Turning to slide 12, Performance Coating's third quarter net sales increased 8% year-over-year and 14% XFX, driven by a 12% increase in average price mix and a 2% increase from the UPOL acquisition. Volumes remained largely flat as refinish growth was offset by industrial headwinds in EMEA and China. Refinish reported a 13% net sales increase, or 20% XFX, driven by a low teens percent improvement in price mix, 4% growth in volumes, and a 4% contribution from our UPOL acquisition. Demand for our products and services was strong and exceeded our ability to supply, given constraints in our supply chain. Q3 marked the one-year anniversary of our UPOL acquisition. We are excited about the revenue synergies we've seen so far, along with the overall value creation in North America and Europe, as this team and the product offerings have integrated as we had expected. Industrial Q3 net sales increased 1%, or 7% XFX, driven largely by a low teens percent improvement in average price mix, partially offset by modest volume declines in Europe and China. Performance codings reported Q3 adjusted EBIT of $122 million versus $123 million in the third quarter of 2021, as benefits from price mix and modest volume contribution were more than offset by headwinds from FX, Russia-Ukraine, China COVID-19 lockdowns, and higher variable and fixed costs. Nonetheless, refinish is on pace for another strong year of profitability in 2022, continuing momentum seen in 2021 as our team continues to execute extremely well. Moving to slide 13, mobility coatings, constant currency net sales increased 35% in the third quarter as volumes increased by 30%, which outpaced bill rates across light vehicle and commercial vehicle. Pricing momentum continued in both businesses. which in aggregate grew 5% versus the third quarter of 2021, inclusive of negative mix. FX was a 5% headwind in the quarter, coming mostly from the euro, Turkish lira, and Chinese renminbi. Light vehicle net sales increased 35% ex-FX in the quarter, including a 32% volume increase, which outpaced global auto production by roughly 400 basis points. Commercial vehicle third quarter net sales increased 35% ex-FX, driven by customer wins and recovery from constrained production rates in the prior year. On a percentage basis, volume grew in the mid-20s year over year, while price mix had a low double-digit percent improvement. Mobility Coatings reported Q3 adjusted EBIT of $4 million versus negative $3 million adjusted EBIT in the prior year quarter, as volume and price mix growth were partially offset by raw material inflation and incremental fixed costs and FX. While we're excited that the volumes continue to outpace market trends, growing EBIT margins and closing the price-cost gap continue to be an area of focus and priority for the business. Moving to our debt and liquidity slide on slide 14. Exalta's third quarter balance sheet and liquidity profile remain solid. We ended the quarter with slightly over $1 billion in total liquidity. Our net leverage ratio ended the quarter at 4.1 times. reflecting a slight decrease from 4.2 times the June 30th. Net leverage remains elevated due to the phasing of free cash flow, as well as incremental pressures on working capital balances associated with pricing and buying growth impacting accounts receivable, as well as higher levels of inventory, which are elevated, partly due to inflation. On capital allocation, we made no additional purchases of shares in the quarter, and so the year-to-date total remains unchanged at $200 million. I would expect the pace of share buybacks to largely remain somewhat muted as we focus on net leverage and the balance sheet. As interest rates step up, the relative attractiveness of gross debt reduction has increased, and if trends continue, is likely to become a larger emphasis for future capital allocation in the near term. Meanwhile, we are closely monitoring the debt markets for a window of opportunity to execute the refinancing of our $2 billion term loan. which matures in June of 2024. On slide 15, we will review our fourth quarter guidance framework and commentary. For Q4 net sales, we expect between approximately 6% and 8% year-over-year growth, inclusive of an approximate 7% FX headwind. This framework assumes nearly double-digit price mix growth and reflects our continued prioritization of price cost recovery. Volumes are expected to grow in the mid-single digits largely centered within mobility. Elsewhere, pockets of softening demand, notably in Europe, are expected to drive volume declines for industrial. We expect to generate adjusted EBIT of $120 to $145 million in the fourth quarter, which correlates to approximately $200 million in adjusted EBITDA at the midpoint. Sequentially, we expect a small drop in profitability at the midpoint from the third quarter primarily from softening within industrial. Additionally, we expect further foreign currency translation and higher operating expenses will add some marginal pressure from our third quarter result. For adjusted EPS, we anticipate a range of 31 to 39 cents for the fourth quarter, inclusive of headwinds on a per share basis from FX and Russia-Ukraine totaling approximately four pennies. Within our fourth quarter forecast, we further assume raw material inflation will be a high teens percent headwind year over year, but flat to modestly lower sequentially. Lastly, we expect fourth quarter free cash flow to be between 175 and 225 million, which includes higher than normal working capital balances. As we move into 2023, we will be focused on returning working capital towards lower historical levels as a percentage of net sales, which we believe will represent a meaningful source of cash in 2023. I will end with a few additional comments on the outlook into 2023. The macroeconomic situation remains unclear and difficult to forecast. However, as Rakesh discussed earlier, we believe Exalta is uniquely positioned to benefit from cow wins as demand normalizes in core markets like refinish, light vehicle, and commercial vehicle, stabilization in global supply chains with likely deflationary benefits and our variable cost of goods sold, And lastly, from a heightened focus on execution, where our teams are focused on actions to enhance operational and supply chain excellence. We strongly believe in the earnings power of this company and the value creation opportunity that lies ahead. With that, we will be pleased to answer any questions. Operator, please open the lines for Q&A.

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate that your line is in the question queue. You may press star two 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 Mike Cezanne with Wells Fargo. Please proceed with your question.

Hey, guys. How you doing? Nice quarter. I guess my first question, in terms of mobility codings, and I look back historically, you've done several quarters of $400 million, and just the EBIT tends to be in the $30 to $40 million range. So why wasn't there more improvement, I guess, sequentially, given volumes were really good?

Hey, Mike. Good morning. This is Rakesh.

So, listen, I'd start off by saying none of us are happy with the lack of profitability in the mobility business. But having said that, you know, we know there are a few things we have to do to get this back to where the profitability used to be. You know, just to give you an idea, just to help you bridge what happened in Q3 versus Q3 of last year, you know, we had about $90 million in higher revenues volume sales. Well, if you include price and mix, we had a little more than $100 million. We got about $45 million to the bottom line.

Good guy from that.

Now we lost about $35 million from inflation of variable cost and freight. So we were down to about 10. We also reduced some costs in our plants. And then we had OPEX increases. So You know, we negated a lot of what we got from the new business. And by the way, the new business is quite profitable. The business that we are running in China has pretty good margins. What we have to do going forward is clearly we have to get more price. And I think the teams are fully committed. You're going to see some of that in Q4. We are going to try and get the benefit of the devaluation in the raw materials. I think that's beginning to happen. You know, we have As Sean said, $2 billion of our buy is in raw materials. Half of that, if you look at, is additives, it's solvents, it's monomers, and that's already coming down. So to the extent that we can take out even a few percent of the raws, it's going to help quite significantly. Now, obviously, we have to hold on to the price, not only hold on, but we have to get extra pricing in the mobility business, which we will. But that's where we are. It's going to take some time. I think there's a strong commitment in the company, within the teams, that we have to bring this back to, like the numbers you just said, $30 million a quarter is what we used to do. And you will see some improvement in Q4 in this business.

Got it. And as a quick follow-up, when you think about 23, I know it's a little bit early and certainly uncertain times. But if you think about a lot of your end markets, refinish, auto AM and commercial, it does seem like there's momentum there to grow next year, even if the economic environment continues to weaken. So if you think about growth in 23, given your wins and volumes trends recently, how do you think about the potential for EBIT growth, particularly with raw materials coming down?

Yeah, so Mike, there's still a lot of uncertainty about what's going to happen in 23, right, with the global recession discussion that's happening. You know, we're going to be cautious as we put our plans together in the overall auto production. You know, clearly, as you know, there is pent-up demand for automotive builds, but And we are also winning, as you said, you know, we have conquest business, mostly in Asia, that business is locked down. We are going to see that benefit next year. So this should be a growth business for us on a top line next year. And then, as I said, in terms of the EBITDA, our EBIT should grow much faster than our sales growth next year because of the things that I just mentioned.

Great. Thank you.

You're welcome.

Our next question comes from Mike Harris with Seaport Research Partners. Please proceed with your question.

Hi, good morning. Good morning, Mike. I was just hoping that you could talk through a little bit more detail on slide 10 and that cumulative price-cost gap. Was the progress that you made this quarter about what you expected when you gave guidance, or were there some surprises, I guess, either on the pricing side or on the cost side? And I guess maybe specifically to mobility, did you expect to lose a little bit of ground there, or was that kind of a key surprise in the quarter?

Sean, you want to take that first, and I can respond? Sure.

Yeah, I mean, certainly the dynamic shifted in the sense that, you know, the price-cost gap actually went down this quarter, which is clearly the dynamic we're heading for. But we saw a little bit more inflation. And in particular, on the mobility side, we saw a little bit more. On the performance coding side, you know, we're now in the positive. Industrial is still lagging, but refinish is overperforming. But mobility essentially jumped up to $115 million gap. And, you know, that was the big impact that Rakesh just walked through on. the challenge as far as the profitability on the volume growth on the mobility side.

All right. And then I was also hoping that you could talk a little bit more about this higher fixed operating cost issue. I think of Exalta as a company that over the years has really focused on reducing fixed operating costs. I understand that there are inflationary dynamics at play here, but can you give a little bit more detail on what's driving these costs higher and kind of why we're seeing it now and as we get into Q4?

So maybe I'll take a first shot and then Sean, you can. So really, if you break down the operating expense, about half of the increase was in the refinish business. And a lot of that was because of sales commissions. You know, the refinish guys are doing a phenomenal job of growing the business. Some of the OPEX increases, obviously, inflation. And the rest was where we had, you know, by design, as Sean said, had, you know, added people to help us in the growth around the world. Now, you know, given what could happen next year, you know, this is an area that we'll be looking at very carefully because, as you know, Exalta is very nimble in the sense of if we have to take out operating expense in the face of

a slowing environment, you know, we can absolutely do that and do that very quickly.

Yeah, just to add on, I mean, top line organic sales are going to grow 15% in 2022 and take it back all the way to 2020. You know, we did a lot on temporary savings and not backfill on attrition, but quite frankly, we needed to backfill some of those positions in order to grow. And you're seeing that and certainly merit, you know, has, you know, upticked quite a bit. You know, labor historically has run around 3%. This year it's, you know, much closer to 5%. So that's adding incremental pressure.

All right. Thank you very much.

Our next question comes from Steve Byrne with Bank of America. Please proceed with your question.

Hi, Rakesh. You just said that Exalta can take out operating expenses quickly and easily. From your fresh look at Exalta, would you say that the mobility business has done that? I'm asking about what fraction of cogs in mobility is fixed versus variable, and clearly you have challenges on the variable side, but is that fixed cost structure of mobility fairly significant and stuck? And is there anything that you concede to do to cut that to drive, you know, an improvement in earnings and mobility?

Yeah, so, Steve, you know, the fixed costs in this business, and let's take mobility, you've got obviously the fixed costs in the manufacturing plants. Some of our manufacturing plants are shared between the businesses. But then there's also SG&A, right? So if you look at the total fixed costs in the plants and the SG&A, just a high-level estimate, you're talking about half a billion dollars of expense in the mobility business. So it's a big number. And I'm not going to tell you what we're going to do because we're working through our plans, but obviously that's an avenue for us to look at very carefully. But it's a fairly significant number and we have the opportunity to address it and become more efficient.

Okay. And then on refinish, it does seem like there are several players in refinish that all seem to be gaining market share. Just wanted to ask about the structure of refinish. Is this something that, you know, is just ripe for more consolidation if the big players are all gaining share? Is there more to go on this consolidation? And where would you see the most opportunity for you? Is it by region or is it by segments between premium and economy and mainstream?

So clearly there's a consolidation that's been taking place in the U.S. where the multiple shop operators have been consolidating. And that has been helping Exalta in a big way because I think with what we offer to the MSOs and the kind of productivity that we can provide to them, you know, we've been signing up more and more of them. So we've been getting share here. In Europe, the MSO concept is just beginning to take hold. We just won some significant MSO business in the UK. That is not yet existent in Asia, but in Asia we are focused mostly on the premium segment. But if you look at overall globally, there's no question that we are benefiting from the consolidation and we're benefiting from share gains. And not only that, I think this is a business where we are able to outstrip the cost increases that we have seen by higher prices. So it's a great business. We are also adding content in the refinish business. We've got into adjacencies. So we are selling more than just paints and coatings. And that's going to continue because once we have the pipe into the shop operators, we are able to supply additional content and that's going to continue in the years to come.

Thank you. Welcome.

Our next question Question comes from Josh Spector with UBS. Please proceed with your question.

Yeah, hi. Thanks for taking my question. I guess just coming back to price cost and the cumulative gap closure, I mean, I think Exalt in the past used to give some type of timeline on when you expect to kind of get over the hump there. Do you have any estimate on visibility to when you actually may be closing this gap? And as you think about pricing and mobility, I mean, you talked about from lower raw as you talk about going after additional pricing. What's the mindset in terms of how much price needs to be captured? Are you capturing pricing kind of regardless of raw material decline to close that gap? Or are you thinking of being a blend of kind of both playing into that?

Yeah, listen, we know we've got about a $100 million gap, plus or minus. And we're going to get part of that through pricing. And you're going to get part of that through deflation, no question about it. And part of it has to come from operating efficiencies. You know, the one thing that I have found since in the time that I've been here, in the short time that I've been here, is I think we have a lot, and we haven't talked about this, but we have a lot more opportunities in just the way we run a manufacturing operation and the amount of cost we can take out and increase the capacity. And, you know, that's more to be discussed perhaps in the coming – call, but clearly we have several levels. I don't know, Sean, if you want to add any color to this.

I guess the other note is, you know, our price is typically pretty sticky. We're expecting the cycle to be no different. You know, if we see the pace of deflation, you know, as we think about next year, you know, we'll certainly be pushing price on the refinish side. And that's a question mark on how much deflation we see on how much incremental price we get. But you think about that $100 million gap, you know, that represents, you know, 2% price. So it certainly feels like we're on track, you know, to cover that as part of 2023, just given the pricing today.

So I guess what if we're wrong on Roth's deflation? Oil moves up, inflation starts to pick up again. I mean, is there anything that's being done so if that cycle picks up, changes direction, that you can act differently or react differently to that environment?

Well, I mean, if we go back into an inflationary environment, we have to just be more aggressive on price and more aggressive on our costs. But, you know, that's a commitment that we all have. And we're certainly seeing signs. Sean, I was going to say one wild card. I think we feel pretty good about that we're entering into a deflationary environment on the commodities. The one wild card that we're all watching is the cost of energy in Europe. Now, having said that, in the last few days, I've been pretty encouraged to see what's happened in cost of natural gas and energy in Europe. The spot market prices are down quite significantly. That doesn't mean it's going to continue to stay down, but, you know, that's something that we're going to continue to watch.

Okay, thank you.

Our next question comes from Christopher Parkinson with Mizzou. Please proceed with your question.

Right. You have a helpful slide seven and just kind of overlaying, you know, where we stand in the marketplace versus 19 on refinish. Could you just further kind of, you know, broadly speak about your conviction in the specifically in the U.S. refinishes business, its ability to grow next year, just given what you're hearing from body shops, you know, labor shortages, you know, kind of easing collision rates up, you know, totals down. You know, it seems like a lot of things are moving in the right direction. Low inventories, you know, Just given the macro environment we're in, it seems like a pretty big question. So can you just hit on kind of your outlook over, let's say, the next six to nine months and what you're currently seeing in the marketplace? Thank you.

Sean, you want to take the start and I'll give him a call up?

Yeah, I mean, we're feeling really good on the trending, Chris, you know, thus far through the year. Office occupancy rates, and I wouldn't say it's the hardest data point, but, you know, it certainly ticked up post the summer. You know, we hit 46% in September. You know, October, month-to-date, it's up to 48%. So, you know, as folks are getting back in the office, I'm expecting congestion to pick up, which should hopefully correlate to body shop activity. But, you know, the U.S. market's still down 10% to 11%. So, I do expect recovery next year, even if there are some recession fears out there. When you think about WIP at the body shop level, it continues to be fairly high. So I think as the labor shortages get filled, that's also a potential tailwind for us. And then just the MSOs continue to do very well as far as picking up market share. And I think we're really well positioned on that front. Our refinish team is doing a fantastic job just as far as the productivity of our paint systems. Yeah, the technicians that we bring and the overall service requirements there, I think that business is doing really well, which sets us up really good for 2023.

I mean, just to add to what Sean said, I think labor issues in the body shops actually helps us because of our technology and our paint. We have a single application versus our competitors who have to have multiple applications, so We definitely add productivity in the body shops, and that helps us.

Understood. And just very quickly, just on the mobility side of it, when you take a step back and, you know, look out into 2023, there's clearly a lot of, let's say, longer-term pensive demand. You see, you know, the market seeing some growth in China. At the same time, there's some, let's say, teetering in the Western world. know just going back to uh previous analyst question just how quickly can you actually react you know on the cost front um if and when you you know start hearing from your customers of incremental shutdowns or uh production rates being slightly lower than expected is that a case of you know weeks um or is that a case of let's say you know a month or two well we've had a precedent when the pandemic hit and you know i know i wasn't in the seat but sean you were and maybe

you might want to say what we did and uh but i can tell you is that we would react as fast as as you know as anybody can and we'd be you know very meticulous about it but sean you want to just give a recap a little bit of what we did yeah and i chris it feels like we're we're close to a bottom i mean we've been in that recession on the mobility side for

two and a half years. So it's hard to foresee that we'd be below 81, 82 million builds for 2023. But we're somewhere probably between weeks and months if we see a clear sign that there's demand destruction. And just as a reminder, we took $130 million out back in 2020. And we acted pretty quickly once we actually knew that the demand destruction was going to be there. I think we have the playbook. And we showed that we can execute against it. And I think in another hypothetical scenario, we could do the same.

Helpful caller as always, Sean. Thank you so much.

Our next question comes from Gancham Panjabi with Barrick. Please proceed with your question.

Yes. Good morning, everybody. Good morning. I just want to go back to the mobility segment and the questions on the widening of the price-cost gap in 3Q. Was that biased to a specific region, you know, Europe, or some sort of impact from mix because China was up so significantly? I'm just asking because, you know, inflation has been pretty visible in terms of what's been happening, and your pricing initiatives have been pretty substantial over the last few quarters. So what specifically changed in 3Q?

I don't think anything.

Sorry, go ahead, Sean.

Yeah, it was really across the board. Asia was actually a bright spot for us, just given all the volume improvement. That region now, it's the bright spot of the light vehicle business, just given all the incremental wins coming in and improved variable margins. But we saw the inflation really across the board. It's a global issue on the mobility side that we need to get more price contributions.

Got it. And the $100 million price-cost gap on a cumulative basis, what sort of buckets would you have us think about in terms of price recovery, volume, maybe some level of deflation? And then separately, Sean, maybe you can give us some indication in terms of what the high-level variances would be for 2023 EBITDA, especially on FX.

Yeah, we're going to steer away from giving any guidance on 2023 at this point, gotcha. But mobility, you know, earlier in the year, you know, when we think about back to 2019 profitability, you know, we had a roughly $140 million gap. You know, we've couched that, you know, it's 50-50 between, you know, volume and price cost. The price cost has gotten worse as we've progressed through the year. So it's probably more on the 75% on the price cost versus the volume. But certainly as we see stability on the inflationary aspect, you know, our pricing, you know, will start to catch up. And I mean, it's notable in the third quarter, we would have expected a lot more drop through from a profitability perspective. But we did see that inflation. And that's where fourth quarter and Rakesh alluded to this. You know, we are fully expecting to see a nice step up in profitability in the fourth quarter as we see stability and pricing starting to catch up. And then also the volume impacts as far as the incrementals on that.

Okay, very good. Thank you.

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

Yes, good morning. With regard to your mobility segment, you've spoken in the past about certain customers with whom you have formulaic contractual relationships. And so I guess my questions would be, are you observing a meaningful difference in profitability between those customers and customers who aren't on a formulaic relationship? And as it relates to these formulas, do you feel as though you're capturing all of inflation or are the formulas capturing mostly just the raw material aspect of it? I'd be curious to hear your thoughts on you know, basically how you think underlying price will flow through for those two buckets over the next few quarters?

Well, you know, what I would say is that clearly we have contracts with a number of our OEM customers. And, you know, we have taken the initiative of having discussion even before normally the contracts would open up for price discussion, as you can imagine. I think everybody's doing that. And yes, so, you know, we have indices that are tied to inflation that drive pricing up or down. Now, as you know, that what actually happened in the supply chain is different than what happened with the broad indices. So essentially, because there were significant supply chain constraints, you know, many companies, including us, paid more for raw material than what the indices would have suggested. Now, as they go down, we are going to benefit more because we will not have to give the same pricing back to the OEMs because we didn't get it on the way up. And that should bode well for us as we look in the face of a deflation. But yeah, I think we have different situations. I won't name customer names, but we have some customers that... we're getting pretty aggressive with, and we're going to see some of that benefit flow even in Q4.

Okay. And then as a follow-up, in your prepared remarks, I think you made a comment that you're sold out through the remainder of the year for certain industrial coatings. And I guess my question would be, in which product lines are you sold out? And given that circumstance, do you think you'll need to

invest in new capacity or or might it be the case that you know growth is cooling and we're fine on capacity no i listen i i think we have work to do to remove the bottlenecks and increase capacity in our existing plants i don't see us having a need to add more capacity by way of equipment and facilities um yeah you know we've got a great new team that's working on this now uh I think, as Sean said, we've not been able to deliver all our demand through the end of last quarter, but I think we're making good progress.

Kevin, just to add on, I know you asked specifics. We ended the quarter with roughly $50 million in backlogs, all performance coatings. 10 to 15 of that's coming through industrial, and it's specific to building products. Building products is really where we're essentially sold out through the rest of the year. And so sort of that backlog on remod and new home builds, you know, continues to benefit, you know, that part of the business, at least through the end of the year.

Great. Thank you both.

Our next question comes from David Bagleiter with Deutsche Bank. Please proceed with your question.

Thank you. Good morning. Rakesh and Sean, how much did the immobility coatings, how much did the raw material price-cost gap widen? in Q3 versus Q2?

It was about $20 million, Dave.

Very good. And, Sean, in Q4, you mentioned improvement in mobility versus Q3. How much are you thinking about in that segment?

Yeah, we're not going to call out that specifically, but, I mean, it's going to be a nice uptick. It's not going to be quite back to 2019 levels, but somewhere in between where we are today and 2019 levels as far as the quarterly contributions.

Very good. Thank you.

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

Yeah, good morning. Thanks for taking my question. Maybe just another one on the light vehicle side. I guess, you know, admittedly, Rakesh, we were surprised on the lack of operating leverage, and it sounds like some of it was tied to the raw materials for sure. But I guess maybe two questions around it. One is, On the new business that you're bringing in, since it was kind of one last year, have you had an ability to actually raise the price on that business yet because inflation has been so extreme? I guess, how should we be thinking about that? And then also, it sounds like you've been really kind of digging into the business pretty hard. are there any business or contracts where you go, you know what, this just doesn't make sense. We shouldn't be doing this business. Like, is there anything that we should be thinking about where you might be walking away going forward from low margin, no margin type business? How should we think about that?

Yeah, let me answer your last question first. So clearly, we do have some customers where the margins are below our threshold. And I think it's We have to prove to ourselves that we can get these margins up to where they need to be. Or, yeah, we will trade volume for profit, for sure. I mean, listen, it's not like we're going to try and get every business at any margin. We're not going to do that anymore. So having said that, I think the teams are really working through trying to address it. You know, this is an interesting space. You know, you only have two or three large players in this business. And hopefully our OEM customers will give us the appropriate prices that I think all of us need. It's not just us. And we will see where we go. But just to make sure you understand, we are not trying to get volumes at any cost. I forget your first part of the question.

Can you repeat that again? Just around the new business that you won, because I think you won it last year, and yet inflation's been so strong. Have you been able to reprice that?

You know, I can't answer that question if we've been able to reprice it. I know the margins we got on the new business in the quarter, and they were very good, but let's get back to you on that. Got it. Fair enough.

And then just as a follow-up, so, Sean, it sounds like you're looking to unlock a decent amount of working capital As you look to 2023 and at least by our numbers, it looks like you, you know, there could easily be a couple hundred million of a tailwind if things kind of play out right. I guess, how should we think about the uses for that going forward? I know historically Exalt is very comfortable with reasonable amounts of debt. Is that changing, Rakesh, under your watch? And also maybe can you give us thoughts on the potential for a dividend at some point for Exalta, if that might be in the cards or that might be a change in terms of how you're thinking about things?

Maybe I'll start, and Rakesh, you want to add on. So working capital absolutely will be a benefit as we circle into 2023. We ended the quarter with working capital as a percentage of sales, close to 14%. you know, we expect to be closer to 12% by the end of the year. And, you know, back 2019, 2020, you know, we've been running at about 8%. So clearly we're seeing the inflationary pressures in inventory as well as, you know, we've just seen a buildup in RALs given sort of the instability of supply chain and us building safety stock levels. So that's going to be a core part of our focus and getting that out, you know, certainly starting in the fourth quarter and continuing in 2023. But, Dave, on capital allocation, near-term, We're going to be building cash and looking to potentially paying down gross debt. I covered in my remarks, we are very focused on refinancing the term loan. Interest rates continue up. It's going to be a little bit more attractive to actually pay down some of that gross debt. But over time, it's going to be share buybacks and M&A and getting back to sort of the old playbook once we get past this high inflation time.

Got it. Thanks very much for the call, Eric.

Our next question is from Mike Lighthead from Barclays. Please proceed with your question.

Great. Thanks. Good morning. First question, maybe a little bit more higher level. Rakesh, you've been in the seat now for a few months. Any initial impressions with the business or just discoveries that might be different from when you were only on the board and not in the interim CEO role?

Listen, yeah, I have several observations. You know, when I think about the business and I look at our ability to get top-line growth, I think we're in a great place. You know, we are gaining share in several businesses. We haven't talked about some of our new product launches. Our pipeline for new business and industrial business is very healthy. So I feel good about the top-line growth and the ability to get top-line growth. Obviously the three or four things where I see significant opportunities and we've had this discussion on this call, you know, the price cost gap has to be closed and you know, it comes in the form of pricing with customers, which I've talked previously about having commercial courage to go after the pricing. The raw material has to be, you know, we have taken $650 million in raw material increases and we need, given that the environment is changing, We need to get our fair share back. And the other one that I think I've become acutely aware is just the opportunity in our operations and supply chain. I think we have a significant opportunity, both in terms of improving deliveries, clearing backlogs, lowering our cost, the fixed cost in the plants. And I think when you take all that in total, I think the business can be at a different place a year from now.

Great. That's it for me. Thank you.

Our next question comes from Alex Yefermo with KeyBank Capital Markets. Please proceed with your question.

Thanks, and good morning, everyone. I just wanted to come back to mobility. You know, quite stark contrast between 5% price and 20% cost inflation, and perhaps there was some surprise in inflation, but I thought you typically have a couple of quarters worth of inventory. So there is some visibility into that inflation. I guess with that in mind, are you disappointed with the pricing efforts that the team has been able, the pricing that the team has been able to achieve? And if so, what is changing in terms of improving the pricing execution?

Yeah, obviously we're disappointed that we have this gap and the gap grew in the quarter. Having said that, I think the teams who are running this business fully understand what we must do. Now, having said that, we're not trying to close the entire gap by just pricing with customers because we know there are things that we can do internally that we control that will also help offset that. And you're going to see some of that benefit in Q4. And I think, you know, as we march into 2023, I think you'll see fairly big chunks of improvement there.

Thanks, Ritesh. In EMEA, refinish volumes were pretty stable in the third quarter. This business is generally less cyclical, but still is subject to weaker consumer demand. demand, could this weaken in the fourth quarter or next year, or do you expect continued stability here?

We are expecting a little slowdown in the fourth quarter in refinish in EMEA. Some of that is seasonality in December, but we're still pretty bullish about where this business is going. Other than seasonality, we don't see any fundamentally

things changing that should reduce this business. Thanks a lot.

Ladies and gentlemen, we have reached the end of our question and answer session, and I would now let this conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.