Element Solutions Inc (ESI) Earnings Call Transcript & Summary

Very happy to have with us today the CEO of Element Solutions, Ben Gliklich. Ben was appointed CEO in January of 2019, after having served as the leader of ESI's operations and corporate development functions, really, since about 2014. And prior to that, Ben has spent some time in both private equity and i-banking. ESI itself is a leader in Electronic and Industrial chemicals, where they sell chemicals, materials for electroplating, metalization and chrome plating markets. Ben's going to open up with a few slides here. And so I'll let you take it away.

Yes. Thanks, Matt. Thanks to Bank of America for hosting. Thanks to everybody for joining. Really glad to be here. On the back of yesterday's earnings, we released Q4 and full year earnings. It was a good strong end to the year, and we're really happy with what we've accomplished last year. As we think about how we think about the company coming into 2020, we feel like by laying the foundation last year, we focused a lot on what we do on our products, on our customers. And we spent a lot of time in the trees and maybe didn't talk enough about the forest, about what that all translates to from a business model perspective and from a growth driver perspective and from an operating metrics perspective. And so we'll just spend a quick minute on a few slides capturing them. So just tops the way for those of you who are new to Element Solutions, it's about a $2 billion specialty chemicals company, focused on electronic and industrial end markets, about 50 countries, $417 million of EBITDA we reported yesterday. Importantly, $238 million worth of free cash flow, so some of the best free cash flow conversion in the industry. About 4,400 people around the world. We go to market in 2 segments, the Electronics segment is about 60% of the business, and 40% of the business is what we call Industrial & Specialty. Truly global business, 40% of sales are in Asia, and 1/3 are in each of Europe and the Americas. Now our business is exposed to very compelling secular growth stories, and those look like electrification of vehicles, where we're sitting really at the juncture of our industrial surface treating -- treatment business, which goes into automotive; and our circuitry and semiconductor and assembly materials business that go into electronics. And as electric vehicles, as cars become computers, we're in a very differentiated position to benefit from that and to grow our share in those markets. Those are markets that are growing really quickly of a relatively low basis and we're primed to benefit from that growth. Similarly, we're sitting at the onset of a new generation of mobile device technology in 5G, and we've got great capability in those markets. Our circuit board chemistries skew towards higher-end, more complex electronics hardware, and that's where 5G plays, not just in cellphones, but in the infrastructure itself. And we're seeing significant ramps of investment in that market this year, and that's going to be a multiyear story. As 5G penetrates, there'll be more autonomous activity around the world, which will require more complex, more reliable, greater durability electronics hardware, which translates into growth and margin for our company. More than just a growth company, it's a people-based company. And so all of our people around the world, we have 4,500 people around the world, it's a customer-focused company. So whether you're in sales, you're one of our -- 50% of our sales -- of our employee base is sales and service-oriented, visiting customers every day or you're in R&D, which is customer-led innovation. This isn't a blank sheet of paper research projects, this is incremental improvements on existing technologies on the basis of having worked with customers and OEMs to solve their next-generation problems for many, many years. Or you're in our OEM effort. So some of our sales force is oriented towards the applicators, the circuit board manufacturers, the assemblers. But a large portion, an increasing effort is working with OEMs to solve their problems, to help them design specifications and qualifications, such that their end products meet the increasingly demanding needs of markets and of technology. So it's a people-based business, not a plant-based business, which is to say we've got about 40 facilities around the world, but our manufacturing is formulation-driven, it's not chemical synthesis. So they're relatively inexpensive plants. They're more like warehouses with blending tech. So across the world, to support this $2 billion of sales, we have 40 facilities and net PP&E of about $265 million. It's an asset-light business. And so it's people intensive and capital light, right? So CapEx as a percentage of sales is less than 2%, but gross margins are very robust. How do we support those margins? What are the moats? There are people and our innovation capability, and that translates into very strong EBITDA margins, and ultimately, very strong cash flow characteristics. So EBITDA less CapEx is north of 20% and 93% free cash flow conversion. Now taking a step back and putting that in the context of the broader specialty chemicals industry, right, that CapEx as a percentage of sales is far and away the best out of our peer set. And that EBITDA margin is above average for our peer set. So unsurprisingly, EBITDA less CapEx is top quartile. And our return on tangible assets, right, the return that's generated from the assets we have on the ground is industry best. We reported 2019 last -- yesterday, yesterday morning. It was a tough market environment and the business fared quite well. So our top line was up 4% organically, and our markets were off mid-single digits. Importantly, we grew EBITDA despite that. We were able to manage cost. Unsurprisingly, with such a people-intensive business, there's a lot of variable cost. And when the market is weak, we can curtail spending. And so that translated to over 100 basis points of margin expansion despite the top line having been off last year. And $238 million of free cash flow, which we talked about earlier, that was 20% year-over-year free cash flow growth despite the top line being off. EPS grew 29%. And lastly, what you can expect from this company, and again, taking a step back and thinking about the forest. What is this business model, this very sticky high cash flow business model translate to outperformance relative to our growth markets, and we'll talk a little bit about how we're going to do that. But our leading-edge technology allows us to gain more of the growth than our competitors. Stable margins and cash flow. We're going to be thoughtful about capital allocation. I'm sure I'll get questions about that, and we'll talk about that in Q&A. Keeping leverage below 3.5x and returning capital to shareholders, recently in the form of buybacks. Our goal is to double EPS from 2018, which was the base year for the launch of Element Solutions, at $0.68 to $1.36 by 2023. So an EPS double in 5 years. And despite a challenging market backdrop, we're on track as we demonstrated by 30% EPS growth in 2019. So with those opening remarks and just a couple of slides, I'll...

Yes. Come join me over here.

I'll come join Matt over here, and look forward to your questions.

Sure. So perhaps we can start with earnings a bit and the 2020 outlook. You interestingly made some comments that you saw some encouraging signs of growth actually in January, and you're not alone, we've been on the road, both in Houston and with the conference past few days, and we've seen from a number of companies now that there were some green shoots developing December, January time frame. Obviously, with coronavirus that all kind of came to a halt. But can you expand on what you're seeing, what was encouraging to you as you came out of the gate in 2020?

Yes, absolutely. Happy to do so. So obviously, 2019 was a tough year, and there was a sequential weakness quarter after quarter in our end markets. And it really started at the back of 2018. So at the beginning of 2018 was strong, and we saw things sort of deteriorating over the course of the year. And they stabilized, and we had a strong Q3, really driven by a recovery in the Asian electronics market. And things continued to show stabilization in that market in Asia through Q4, which allowed for us to deliver a strong result last year, certainly, better than what we had guided to for the year coming into Q4. And that persisted in January. When we were thinking about our guidance coming into the year, we built a budget that was cautiously optimistic, I would say, about Electronics and more conservative about our Industrial business. In January, we were ahead of plan. So 5G investment was happening. We saw it. That's our sense of what was driving that resurgence in Electronics. And obviously, things hit the skids a bit when we came into February, but we feel good about underlying demand, notwithstanding the impact of coronavirus.

Yes. And so you mentioned 5G buildout. The Wall Street Journal published an article the other week, talking about maybe how that's happening slower than initial expectations. But it seems to have been a growth driver for you towards the back end of this year into 2020. What is the -- I guess can you just discuss what you're seeing with 5G, perhaps what the time line looks like? And maybe reiterate how large of an opportunity this represents for ESI?

Yes, absolutely. So the time line for 5G rollout has been -- 1 year ahead of us rolling for a while now, right, starting back in 2018. But we did start seeing investment in infrastructure. There's a little bit of a chicken and an egg issue in that having a 5G-capable phone without 5G infrastructure available is not going to be able to deliver 5G service. And so the infrastructure needs to be in place for that new smartphone replacement cycle to arrive in, and we saw investment in that infrastructure. We've got a big opportunity from that infrastructure. If you think about, in our business, where there's a lot of value, it's in complex small circuit boards. So circuitry that is powerful and in small spaces because that requires very complex circuit board design and that requires more technical chemistry. So more margin and more value and more market share for us. And 5G base stations are a case study for that. Lower latency, you need a lot more density of base stations. So that means a lot more volume as well. And so we started seeing that investment in 2019 in the back half, and we saw a bit of that in the beginning of 2020. One month doesn't make a trend, but there was reason to be optimistic about it. And we're reading about stimulus in China to support further 5G infrastructure investment. So it's only a matter of time for that to translate into our P&L. Once that infrastructure is in place, a replacement cycle around smartphones will be driven because once the infrastructure is there, people are going to want the phones that are capable of that higher-speed service. And one of the headwinds we were facing, as you think about '17 and into '18, was that the penetration story for smartphones had played out and replacement cycles were extending. The iPhone 9 wasn't that much superior to the iPhone 8, so people weren't going to go replace the phone. Well, with 5G, we expect there will be an increased replacement cycle, which will again translate into value for us. And it's not a 1-year story, right? The infrastructure is such that this is going to persist for several years and be a tailwind for us.

I'm not a telecommunications analyst, so I might be going off a little bit over my skis here. But -- so domestically, we had T-Mobile, Sprint kind of in the throes of the potential acquisition and all the legal battling that went on there. I mean with that may be clearing up, are we seeing grounds for -- like was that a headwind to the build-out domestically? Or would you expect that to maybe unlock new spending and new growth initiatives as far as that is concerned?

I think it's more of a global story than just in the domestic United States. I mean you're hearing from watching television ads about 5G networks and the best 5G networks. There's still a lot of investment required in the U.S. for the quality of coverage that one would expect. Where we're seeing big picks up are in Asia -- pickups are in Asia, which has always been a leader in these types of investments. And so in China, for instance, that's a -- there's a lot of infrastructure that's going to go in there, and that's something that we will participate in.

Kind of conversely. So coronavirus is obviously taking its toll on the business a little bit here. I believe you highlighted $15 million in revenues for February and additional headwind in March, but perhaps smaller. So what exactly are you seeing on the ground in China as it relates to coronavirus? And how are you positioned may be in the market versus your peer set?

Yes. So coronavirus is obviously an unexpected negative surprise. And it's been very difficult for people, right? And our first priority is health and safety of our people and making sure that we're doing everything we can to ensure that they're okay and that, insofar as we're operating, we're operating in a way that's compliant and protecting them. We're fortunate in that all of our facilities are open, right? We had several facilities that had delayed openings after the new year, but we had several facilities that opened immediately after the new year. Our last facility reopened on the 14th of February. They've been running -- this is in China, they've been running at mixed levels of production between 30% and 80%, and we're seeing that increased as we've gotten further into February, and we think we'll be continuing on that trend into March. Our customers have -- some of them are still closed, some of them didn't even close for the new year, right? So there's been real continuity of demand. And the 2 sort of impediments to demand are whether the factory could be opened because where it is geographically or because they had availability of people, right, to run the facilities. In our business, because it's asset-light as I talked about, it's not a people-intensive manufacturing process. But the circuit board shops have tens of thousands of people. And so they are seeing more of an impact because of the inability for the free flow of people to support their manufacturing processes. China is about 20% of our sales, right? And our business is off 30-ish percent in the month, which is at $15 million. Most of that is in China, some of it's in other parts of Asia as there are follow-on impacts. And that's an estimate, right? The month's not over, but that's our best read. And we see March being less than that. That's not taking into consideration any potential future impacts in South Korea and Italy or elsewhere, right? We're not in a position to speculate about the impact of coronavirus on our business because there are so many unknowable variables. That having been said, we're in a better position than our competitors. And our goal is always to outperform our markets. Why are we in a better position than our competitors? Because we've got a more global footprint, so we've been able to supply into China from our facilities in Singapore and in Taiwan. And we're calling on customers or on competitors' customers, we're open. And our competitors, many of them don't have that diversity of supply chain because they're not in a position to continue to supply when the customers are open and they want to be manufacturing.

That's helpful. And so you had mentioned this in your presentation as well, but you have fairly impressive control over your SG&A. And cost being down $50 million on the SG&A line despite what most companies have talked about as ongoing inflation in labor force. And so what steps is the company taking to manage its costs? How much of this represents cost removal versus cost avoidance? And then how does this flow through to 2020 results run rates, things like that?

Yes. So it's a highly variable operating cost model. It's one of the beauties of the business, right? It's people-based. When you look at our manufacturing, 10% of COGS are fixed. So if we're not making things, we're not spending a lot. And if the market is down and we're not in a position to grow and we don't have the earnings growth to support travel, T&E and trade shows and variable compensation, right, bonuses are a big portion of that SG&A, and if we're not growing, we're not hitting growth numbers, we're not paying bonuses, then cost just comes out of the business. We were in an advantage position last year because we were transitioning from Platform to Element. The Platform had a holding company structure that had some, we call it, stranded corporate costs, and we took about $25 million out of that. So out of the $50 million on a year-over-year basis, about $25 million was cost avoided. But I'd say we only really throttled down on cost around the middle of last year. So if you think about in the context of what this year is going to look like, we will have some carryover impact benefit in the beginning of this year from a cost perspective to support earnings growth if the top line is flat. And there's -- we're hopeful that we can drive organic growth and continue to -- and release some of that spend because that spend does support the long-term growth trajectory of the business. You can skip a trade show 1 out of 4 years, and it's not really going to have an impact. But if you skip it for 3 years running, well, then you're going to stop building some relationships, and that will translate to a weaker top line. So we're hopeful that some modest organic growth comes into this year, and so we're spending a little bit more that we can support that spend because the top line is there.

Well, I'm happy you found some room in the budget to come down to Fort Lauderdale. So we really appreciate that.

Short drive.

You recently closed the acquisition of Kester. Can you talk a little bit about what Kester brings to your portfolio? How this deal fits in with your growth and your capital deployment strategy as you kind of get on briefly?

Yes. We're thrilled, and I think Kester acquisition was a great, great deal for us. It fits each of the criteria we think about when we're looking at M&A. The business, we deeply understood. Really strong brand, overlaps of what we do, but also bring some interesting new capabilities that we can bring to our customers and run through our bigger sales force and good innovation capability, available at a reasonable value. And that's before synergies, and there will be synergies. It's better as a part of our business than outside of it. Kester is an assembly materials business. So if you think about our Electronics business, which is about 60% of sales, about half of that is assembly materials. These are materials that are used to put components on to circuit boards. At its most basic, it's melted metal, but of course, it's gotten far more technologically sophisticated as we have smaller components and more demanding requirements for reliability and durability. You drop your cell phone, the pieces can't fall off of it. And we are the -- effectively the adhesive for those pieces that current runs through. Kester brought capability in interesting end markets. So our assembly business is #1 assembly business in the world. It's more weighted towards consumer electronics. So Kester business has a nice presence in medical devices, in aerospace and defense. Those are nice niche businesses, good margin opportunities and good growth. It brought some semiconductor capabilities in the form of thermal interface materials. Those are basically heat management materials. And there's a robust synergy opportunity from integration. We were surprised by how -- by the size of the top line relative to the power of the brand. So this was a business that we had always seen as a big, viable competitor to our company. And when we saw the top line, we kind of scratched our heads, we thought it would have been bigger. And so that speaks to the power of the Kester brand, which is something we're going to retain in terms of how we go-to-market with those products.

So you had mentioned it taps into a few different markets, niche end markets like health care. I mean as you think about your capital deployment strategy going forward, you've been, for those of you who don't know, it's a lot of bolt-on driven deals. Can you talk about avenues for growth, whether it will be targeted to businesses and end markets where you don't have as much exposure? Or how do you think about where to deploy capital?

Yes. So business generates a lot of cash. Last year, we deployed north of $500 million because we had an underlevered balance sheet after we sold Arysta. Most of that went into share buyback, right? We like buying our shares at dislocated values. If you listened on the call yesterday, our Executive Chairman, Martin, talked about being buyers of our stock at these levels, but we're not afraid and then we're excited by growing the company through M&A in more modest ways. And so what does that mean? We're going to buy businesses we deeply understand that overlap with what we do, that are better as a part of our company than outside of it. That means synergies. And that are available at reasonable values. We're not going to chase transactions. The Kester acquisition was a case study in -- where we were a good buyer of that business, and we were able to buy it at a good price for a handful of specific reasons. The nice thing about our portfolio is that there's a lot of surface area around it. So we've got an Electronics business, but it circuitries assembly -- semiconductor on the Industrial side. A lot of different surface treatments and a lot of different end markets there. We've got an offshore business, that's a strong business that has some adjacencies available. And our Graphics business that has further consolidation and adjacencies around that. There's a lot of surface area where we can allocate capital that fit those criteria. And so investors should expect us to continue to deploy capital in a measured way, always staying within our leverage threshold of 3.5x to grow the business and compound value for shareholders.

Yes. And so Kester takes you above 3, not quite 3.5, I think 3.2, 3.1. And you have a solid cash flow profile, so perhaps this level of debt isn't concerning to you. I know you spoke a little bit about this on the call yesterday. But with the market tension around leverage, as it relates right now, in the optics and a volatile tape of a perhaps over 3-turn leverage balance sheet, how do you juxtapose taking shots when you need to with managing the balance sheet and paying down debt as you need to as well?

Yes. It's a good question. This is a business that generates a great amount of cash in all markets, as we've demonstrated last year, in 2019, right? So the top line, in actual dollars, right, ignoring the impact of currency -- or including the impact of currency, was down 7%. We grew free cash flow by 20%, right? That was because when the top line is off, we release working capital, right? The capital requirements of this business is less than 2% of sales, that's steady. There are no lumps. There's no big facility we need to build. Our facilities are running at 50% utilization. We're running 1 shift. So there's no big impending capital requirement to build a new plant to support growth. The business doesn't require material CapEx to grow or to sustain its margin. So there's always going to be cash coming in the door. And so we believe that 3.5x is a reasonable ceiling. That doesn't mean we should live with 3.5x all the time. We fully cash funded the Kester acquisition, right? So we deployed $75 million of capital in Q4 and leverage was flat quarter-over-quarter. So we don't think that leverage poses a risk whatsoever to this business. All of these businesses have been run with significantly more leverage on them than they have at the moment. But we do hear from shareholders from time to time that leverages will tick high, and we listen to that and we integrate that into how we think about the right balance sheet. We feel like as we put up more runs, put up more innings of executing in good markets and bad and generating cash and demonstrating prudent capital allocation that this issue will become less front and center, we've already seen that over the balance of 2019. But if it persists, we're not afraid of taking that leverage threshold down. And by the way, because of the cash flow characteristics of the business, it takes 2 quarters to delever half a turn. So we're within your shot. It's a short put to 3x.

Yes. No, I hear you. You touched on this briefly, but I did want to circle back. So I mean you've been with ESI and really Platform since 2014. The launch of ESI was maybe a more recent occurrence. Can you just go through the history of how Platform became ESI? And any real key learnings that you've had coming through the experience where it was rocky at times as they do emerge?