Element Solutions Inc (ESI) Earnings Call Transcript & Summary

Hi, everybody. Thank you all for joining. Next up we have Elements Solutions with us. And with us from the company is Ben Gliklich, CEO. So we'll start off with some Q&A and we'll see if the audience has any questions. [Operator Instructions] So before we begin, I just need to read a disclaimer. For important disclosures, please see the Morgan Stanley recent disclosure website at www.morganstanley.com/disclosure. If you have any questions, please reach out to Morgan Stanley [indiscernible]. Ben, do you want to kick it off with some opening comments?

Yes, absolutely. Thank you, Neel. Thank you, Morgan Stanley for hosting. Happy to be here and just spend some time with you. For those who are new to the company, Element Solutions is a global diversified company that provides chemical technology to enable performance. Sales are about $1.8 billion. We're split 30% in each of the Americas and Europe and 40% in Asia, and our 4,500 people are spread similarly around the world. Our workforce is heavily weighted towards sales and innovation as our business relies heavily on on-premise solution selling and technical service. I specified earlier and we specified that we provide chemical technologies. This is not a materials company, we are a solutions provider, and our solutions enable breakthrough technologies in electronics, in automotive and in other end markets. The materials that we do provide are made in relatively simple manufacturing processes, and so our business has light capital requirements. And all of this together translates to sticky, high-margin sales and stable, strong cash flows, return on tangible assets, which is something we measure ourselves on in industry leading. We are a market leader in attractive niche markets. They are attractive because the profit pools are attractive, the barriers to entry are high and they're growth markets. These are markets that are being supported by compelling long-term secular trends like 5G, vehicle electrification, proliferation of advanced computing power into a myriad of new markets. And we're just beginning to see the impact of these trends on our P&L, and we're enthusiastic about the growth that these trends will bring in the years to come. I'll end my summary there. I'm sure Neel will ask plenty of questions about all of what I just said. So let me turn it to him, and I'm looking forward to your questions.

Okay. Sound good. So maybe to start off, I mean, despite the challenging organic growth environment this year, you've been able to largely maintain your margins year-to-date. Can you just talk about how you've been able to accomplish this? Is this because of the variable cost base with the business model, and what specific cost actions have you taken? And how should we think about the cost base?

Yes. So the 2 hallmarks of our business are the sustainability of our margins and the sustainability of our cash flows. This is a business, as I went through, has a highly technical and sales and innovation-oriented workforce. So the operating cost in this business are very, very variable. The gross margins are sticky and high. They're not determined to the extent that many chemical companies, margins are determined by utilization of the plant. The gross margins are high. The fixed assets are low. And so operating -- the variable operating costs are really people costs. And so when we're in a challenging market environment, we're able to significantly flex down our OpEx. We're not paying the same level of incentive compensation when the business isn't growing for salespeople or for innovation people or functional people that support our footprint around the world. We're not traveling. This year is an exceptional case of reduction in travel. But as I said earlier, on-premise solution selling requires a significant amount of travel. We've been able to overcome that and continue to sell products and close new deals in this more remote and virtual world this year, but travel is down very dramatically. With some government subsidies, we took some salary actions and some furloughs in instances. Importantly, we have not cut headcount. This is a people-based business. There is a huge amount of technical capability learned on the job and workforce, and we've preserved employment. We don't cut to the extent that it damages the long-term growth trajectory of the business. So in the second quarter, OpEx was down 16% year-over-year without firing people. Some of us took salary cuts, but we've actually rolled those all back by now and same with furloughs. So we've really demonstrated our ability to flex down OpEx without damaging the long-term trajectory of the business. R&D spend has been flat on a dollar basis for 7 quarters.

Okay. And then when you think about going into next year, how many of those temporary cost savings in reverse? How do you think about the cost savings?

Yes. So since we became Element Solutions, we talked about operational excellence and prudent capital allocation. Operational excellence is running these excellent businesses better. We've got a great portfolio of businesses, and we have an opportunity to run them more efficiently. So we took out $25 million of cost in 2019. We've taken out another $8 million, $10 million of cost this year. There will be some build back in OpEx. We saw that in the third quarter to an exaggerated extent, and the reason I say to an exaggerated extent is because the pace of the recovery certainly was greater than our expectations. And so we had some compensation accruals that took our OpEx up by, I call it, an extraordinary amount of $10 million. Extraordinary because that wasn't cost that normally would have been incurred in the quarter. It was an accrual cash up, which cost will be taken out earlier in the year that ran in the P&L this quarter. So our run rate in the third quarter was above what it should be entering next year. So there will be a modest OpEx build back, but we shouldn't see that erode our ability to grow EBITDA. We may not have the same level of operating leverage that we expect 1.5 to 2.0x sales, but we shouldn't be growing EBITDA any more slowly than we're growing the topline as we look into next year as a baseline.

That's helpful. And you mentioned earlier, another kind of key component of your business model here is free cash flow generation. And your free cash flow is expected to grow year-over-year. Based on your guidance, I believe you are targeting free cash flow conversion in terms of EBITDA of about 55% this year. Is that a reasonable level of EBITDA going forward? Or is there an opportunity because that ratio is higher?

Yes. So rightly -- as you're rightly pointing out, the second hallmark is very strong cash flow generation. This is a business that doesn't require significant CapEx to sustain margin or to grow. We've got 35 facilities around the world, all running one shift. There is significant capacity to support growth -- volume growth without incremental material CapEx. And our facilities are not expensive facilities in so far as the context of the chemicals industry. We struggle to spend the $30 million of CapEx we guide to every year. And this year, we've had exceptional cash flow conversion because we freed up working capital, right? So while we've had a macro headwind that's impacted the topline, it's been offset by working capital release, and so cash flow has been exceptional. But it will remain strong in good times and more challenging times. We have done things that are built in that will support cash flow growth into next year. So from a balance sheet perspective, we've improved our cost of debt by $16 million. We'll get about a $10 million benefit next year because of the timing to free cash flow. Similarly, from a tax perspective, we've done some incremental tax rate improvement activities, and so we'll see better conversion of pretax profit to net income, and that will also support cash flow growth as well. Using a percentage of EBITDA is a little tricky because it depends on the direction of EBITDA, and how much of our growth is going to go into working capital. There is -- it's a business that runs low 20 percentage points of sales and working capital. So as we grow and we fully expect to grow next year coming off of the cyclical trough and driven by the secular trends supporting the business, we will invest in working capital. But we've got line of sight to material cash flow improvement next year as well.

Okay. And then maybe just drilling into the segments now. In Electronics, can you just break down how the business is organized? How growth trends have evolved throughout the year for your subsegment?

Yes, absolutely. So our Electronics business is about 60% of sales. And within Electronics, we've got 3 vertical. We've got the Assembly Solutions business, our Circuitry Solutions business and our Semiconductor Solutions business. The Assembly Solutions business is about 15% of sales, but a large portion of those sales are metal pass-through at low to no margins. So from a sort of contribution perspective, Assembly and Circuitry are about equal size and Semiconductor is a little bit smaller. We characterize the Circuitry business and the Semiconductor business as our high-end Electronics businesses because they're really focused on leading edge. So from a Circuitry standpoint, that's mobile phones, next-generation internet infrastructure, data storage and the semiconductor industry clearly is on the high end of the electronics spectrum. Those businesses define economic gravity this year. We had clearly a massive macroeconomic dislocation in the second quarter in these businesses. We're incredibly resilient and have grown year-over-year. The Semiconductor business has grown 20% year-to-date, and that supports our conviction in the secular growth driving those portions of the business. And we're just in the early innings of those demand drivers, 5G internet infrastructure or 5G wireless infrastructure and new generations of smartphones. The smartphone market is going to be down this year, yet our Circuitry business is going to grow. And then the Assembly business is more broad within its exposure across electronics. It has a high-end -- very high-end applications in electric vehicles and in smartphones, but it also has more consumer electronics exposure. And so it saw a big let down associated with COVID in the second quarter when automotive OEMs were shut down and other manufacturing facilities were shut down. And it recovered very robustly into the third quarter and that momentum has persisted into the fourth.

And then just in terms of 5G, when you think about your Electronics growth this year, is there a way to quantify how does that has been driven by 5G related benefit? And then just going forward, how much an uplift you expect 5G?

Yes. So it's a difficult exercise because line of sight to where every printed circuit board fab is sending their boards to is a challenge, right? And so you've got certain fabs that are making boards for not just multiple OEMs, but multiple end markets. So I can't give you a precise number as the contribution from 5G, but I think that it's material, particularly from a base station perspective. And as I said before, mobile phone units are forecast to be down 10% to 15% this year. 5G penetration of those mobile phone units is still pretty modest. And our content on a 5G phone is 15-or-so percent greater than in the normal phone. So I think that you can see an offset there, right, but only a modest offset relative to the percentage of phones that are 5G. The business has been sustained this year also because of data storage and demand for greater connectivity associated with work from home. So it's an uncertain answer, but clearly, the results demonstrate the significant investment we're seeing in higher-end electronics.

And then another secular driver for the business is electrical vehicles. Can you just shed some light, why the company is well positioned to benefit from growth there? Can you just quantify also how much more electric content goes into electric vehicles versus the [indiscernible] vehicle?

Yes. So in the opening, I talked about our business, providing enabling technologies, right? We provide technology that enables performance, and we have some technologies that are really critical to enabling the performance of high-end electric vehicles. In particular, we've got products that go into power electronics associated with the inversion, power from the battery to the car. And these are benchmark performing products that are in every high-end EV on the road. And so that's one example of high-value, high-margin technology that we're providing, that's enabling the reliability and performance of electric vehicles. Similarly, electric vehicles have far more electronic content, and that electronic content comes with very rigorous technical requirements and performance standards. We're in a great position to win more than our fair share of that business. We're known to the OEMs. We're well-known to the OEMs from our presence in the industrial side of the business. And our capabilities from circuit board formation or circuit formation through to electronics hardware assembly are unique in that no one else brings to bear with those 2 capabilities, and so our ability to generate collateral that shows the performance when you're talking about life or death applications with increasing advanced driver versus systems. We should win more than our fair share of that high-value content. As a rule of thumb, we think we have 1.5 to 2.0x the value in an EV as we do in an internal combustion car. Another driver of that is simply weight goes from being a convenience to existential when you get to EPS, right? Heavier cars have less endurance, right? They've got less performance. They can go fewer miles. And so taking weight out is increasingly critical in EVs and power plating on plastic technology is one way that EVs have tried to do so. And so more decorative plating is something that you would expect in electric vehicles. Similarly, taking weight out for cabling and glass and moving that into films where you may have circuitry on those films is an application that we've been developing to support OEMs' desire to take away out of cars, and there is a lot of value in that for us and potential.

And then recently, you made an acquisition of Kester. So I'm just curious how's that performed relative to activations? And what has the business been growing at organic environment?