Element Solutions Inc (ESI) Earnings Call Transcript & Summary

Good afternoon, everybody. Welcome back. This is Bob Koort. I do the chemical equity research effort here at Goldman Sachs. Joined by my teammate today, Tom Glinski, who helps me cover ESI. And excited to have Ben Gliklich, who's the CEO of ESI, along with Varun Gokarn, who is the Senior Director of Strategy and Finance and helps run the IR effort. As is usual for this conference, we're going to have 30 to 35 minutes of Q&A. Tom and I will lead that. But if you have questions, there is a submission box on the webcast or you could e-mail them to us, and we'd be happy to ask them on your behalf and would love to prioritize your questions first. But in the absence of your questions, we definitely have a long list we'd like to get through today.

So why don't we start off then? I think one challenge we have with folks learning the ESI story is understanding exactly what the heck you guys do. So maybe you can just give us a little history of the evolution of how you got here. And then what the major businesses are and then maybe some actual tangible products that you sell into those markets.

Absolutely. Happy to do so, and great to be here. Bob and Tom, thanks for hosting. Element Solutions is a relatively new company. We were founded and launched in February 2019. But the businesses inside of our company have really rich histories and legacies going back several hundred years. To answer the first part of your question, how do we get here? What have we done since we became Element Solutions? In 2019, we spent most of the year building our identity, rightsizing our corporate structure relative to the predecessor company we came from. We took out $130 million of cost. And establishing our objectives and beginning to get the ball rolling in that direction. Last year was more of a focus on the commercial side of the organization and driving focus and building the strategy to deliver above-market growth for each of those businesses. And this year, more of the same and keeping those -- the momentum that we've built over the first 2 years as Element Solutions is going and going strong. What do we do in Element Solutions? We've got a portfolio of excellent businesses that are market leaders in attractive niche markets. As Bob really points out, what do we do? It's not a simple one thing, and the markets we participate in are niche markets. They're very attractive for that -- from that perspective, but they're not huge markets with large public competitors. By and large, the shared attributes of our portfolio are businesses that are incredibly sticky by virtue of the technical service and innovation resident in our products and solutions, right? So we sell blended chemistries that are formulated in asset-light manufacturing processes and where our customers rely on the deep technical expertise of our teams. So we get paid by customers for the materials that we send them, but the real value is in the innovation in the materials and the service we provide to them. And that runs the gamut from our Industrial & Specialty segment, which focuses on industrial applications in automotive, building products, printing applications and our larger Electronics segment, which sell materials into the broader electronics industry with a focus on high-end applications. These are businesses that are being driven and propelled by very compelling secular growth trends, whether that's next-generation mobile communications technology, electrification of vehicles, lightweighting, the proliferation of computing power and sustainability. And we're participating and leading the way in these very exciting trends, and they're driving the business to record results month-on-month.

And I was wondering then before we get into the business segments, you guys have had a pretty spectacular start to the year, certainly far more exciting than originally laid out in terms of margin progression. So you come into the year, obviously puts and takes out of the pandemic issues, but you talked about maybe keeping margins flat as some of the cost layer back in that creeped out during COVID. Your latest update was far more ambitious. So can you talk about what's changed in the market over that short time period?

Yes. So one of the attributes of this company, that's notable, one of the key characteristics, is an ability, a highly variable operating cost model and an ability to generate strong cash flow, preserve margins in difficult times. And that was something that was made evident through the COVID pandemic in 2020 when we saw a significant impact to the top line, particularly in the second quarter in our more industrial exposed businesses. And we were able to preserve margin, and we actually, through the year, grew EBITDA, grew the top line, grew EPS, grew cash flow. As we transitioned into 2021, there were a lot of question marks about the demand environment, about the sustainability of some of what we saw in the back half of last year in the electronics industry. And we took out a lot of cost last year. So as we were looking forward into 2021, took a conservative perspective with regard to the demand environment and had to take into consideration layering in some of the OpEx that we had taken out of the business last year. That translated to an initial guidance for the year of 7% EBITDA growth with an implied guidance effectively of 7% top line. Last year was a funny year, and the resilience we saw in our electronics business and the phasing we saw was idiosyncratic. In a typical year, Q3 is our biggest quarter, and we see things slow down materially in Q4. Last year, because of the cyclical recovery we saw as we were moving sequentially through the year and the continued traction in the mobile phone industry and around 5G infrastructure investment, November was the best month of the year until December. Both November and December were records from a top line perspective for this company in its history, very anomalous from a phasing perspective. What we saw into the beginning of 2021 was no slowdown from that exit velocity. And as we sit here in April, it's -- we're still seeing performance and a demand environment supportive of that. That's in spite of the auto production slowdown, where auto is a large end market for us, driven by supply constraints from semiconductor manufacturing. So the revised guidance we gave coming out of our first quarter was for 20% EBITDA growth. We're seeing operating leverage through the business driven by the level of volumes we're seeing. The return of OpEx has been a bit more slow than we expected. Delays in travel picking back up, persisted. So our estimate for the top line that is implied by that 20% EBITDA growth is a little bit less. There is operating leverage despite some of this cost coming back and despite some of the inflation we're seeing from a raw material perspective and a logistics perspective. The end markets are really healthy and the business is benefiting from that. And the strategy that we're deploying is allowing for us to continue to drive outsized growth.

And can you talk about -- maybe start going into the product segments. In the electronics business, as with your whole company, there's a very low capital intensity, but you have very good -- very high margins. So can you talk about what it is exactly that you do for your customers, maybe in the assembly business as an example, that helps drive that stickiness, but doesn't require a lot of capital investment?

Yes, absolutely. I'll start with the Circuitry business. I'll go to the Assembly business in a second. The Circuitry business -- to make a printed circuit board, you need a laminate, which is a piece of plastic, labor and our chemistry, our solutions. That piece of plastic is run through equipment that has our chemistry in it, that metallizes the circuit board, that puts the circuitry onto that piece of plastic. It's -- these processes are multi-step, very complex. The equipment is typically customized to our process or our competitors' process. And when you think about the cost in that ecosystem, the chemistry is a tiny portion of it compared to the plastics and the labor. So we represent a tiny portion of the overall cost to our customers and even less to their customers, but were critical to the functionality and performance of the end device. Our chemistry doesn't work, the smartphone doesn't work. So that gives us an incredible stickiness. We're built into manufacturing processes, very hard to change out and the value to get from changing us out is modest. And the Assembly business is very similar, where our products, in many cases, in the Assembly business, but also in the Circuitry business are specified or qualified by the end user. So if the smartphone is being made by Apple or Samsung or a local Chinese company, they will either qualify a certain characteristics of the products that their supply chain must use or specify the vendor, which gives us an even broader moat. And so what we're selling isn't manufactured in a complex capital-intensive way. But the margins that we're able to command look like some of our competitors in the electronic space that have much more capital-intensive processes.

And can you talk a little bit about your ability within those end markets to tap those sort of mega trends that you talked about a minute ago? Obviously, you've got IT infrastructure. You've got 5G. You've got the EV intensification. Talk to us a little bit about what you're seeing in those growth rates? And how your products are helping to enable that growth?

Yes. So in 2020, we saw inflection in some of these secular growth tailwinds that were promised but hadn't really manifested themselves prior to 2020. What are those tailwinds? 5G infrastructure investment, the mobile phone replacement cycle driven by that, vehicle electrification. These are things that we know are coming. They will come regardless of the economic environment. They're multiyear durable trends. In 2020, smartphone units were down 10%, but there was real traction in 5G phones as a percentage of the overall unit base. 2021, we're going to see growth in units, and we're going to see a doubling of the number of those units that are 5G. But that will still only represent 1/3 of the mobile phones sold in 2021. So there's a lot of growth left from 5G technology penetrating the mobile phone industry. And we get about 15% more content on a 5G phone than on a 4G phone, so you're seeing both growth in units and growth in content. And that's the story of EVs as well. It's -- electric vehicles are a tiny portion of the automotive fleet. We have enabling content for EVs. We all know that in the next 10 years, that percentage of the fleet is going to grow very significantly. We have 1.5 to 2x the value on an electric vehicle relative to an internal combustion car. So again, units are going to grow for us, and content is going to grow for us. So -- does that answer the question, Bob? Or is there a bit more?

Yes. No, that's good. And I'm curious. I thought it was somewhat admirable when you guys came public a couple of years ago, your first stab at a waterfall, if you will, down the income statement, revenue, EBIT, EPS. A lot of companies like to assume everything is going to be a blue sky and have very aggressive targets. I actually thought your's were quite achievable and weren't sensational. Well, now it seems like we're really getting a lot of extra growth, as you mentioned, penetration, the content for next-generation technology is higher for you. So just curious if you have any thoughts on how you'd assess now your electronics platform? What sort of growth algorithm and earnings algorithm should we expect maybe over a mid- or long term, not necessarily coming out of a pandemic year?

Yes, absolutely. So as I said in one of the opening remarks, in 2019, we were building identity. And our identity is a company that delivers on its commitments. That is part and parcel of who we are. In the context of launching the company, we've looked at every dollar of sales. We tried to tie it to a market driver and developed a weighted average market growth rate for our portfolio, which was around 3%, and we committed that we can grow that -- we can grow 1 point or 2 faster, which we've proven out over the past 2 years. You look at automotive units, mobile units and our growth relative to them. We've outperformed on the way down and on the way up. We said we could grow EBITDA at 1.5x the top line. We've demonstrated an ability to do that or more and that we could compound EPS through from capital allocation strategy being operational excellence -- through capital allocation in the teens with the goal of doubling EPS in 5 years from $0.68 to $1.36. At the time line, people scratched their heads. How does an industrial chemicals company double EPS in 5 years? Our guidance for this year is to deliver more than $1.30 of EPS. So that's in 3 years. So we feel great about that. We haven't gone through the exercise again of tying every dollar of sales to a market growth rate. What's clear though is that our faster-growing businesses have grown faster and are a bigger portion of the mix in this company. And so the underlying growth algorithm should be greater as we roll this forward. And the secular trends that we're seeing are not flash in the pans -- flashes in the pan. This is year 1 in a 5-year infrastructure investment boom for 5G. As I said before, only 1/3 of the smartphones sold this year are going to be 5G enabled. Less than a single-digit percentage of the automotive market is electrified right now. And there will be something that comes after that, which is as 5G penetration increases and capabilities increase and the infrastructure is there, there will be more technology leveraging that connectivity that will drive more technically demanding rigorous applications for circuitry technology, assembly technology, which will continue to drive growth. And so there are long legs to the trends that are supporting this business here.

A client question asking about why you don't suffer price downs serving the electronics industry where cost is so paramount to these companies?

For the same reason that I was explaining our stickiness before. Our customers are reliant upon not just the material that we're providing, but the service. They don't have a great deal of choice, particularly not over the short-term, of vendors. So once a line is in, where we are providing chemistry to a line that's making printed circuit boards, if they want to change us out to stop producing, tweak the equipment, requalify with a new vendor, all to save pennies. In fact, the opposite is true, which is we are able to take price, not inordinately but when our raw material prices increase. And so we're in the midst of those negotiations right now in this inflationary environment. It's never been a better time to take price given how scarce -- how high demand is and how scarce supply is. And so you can see that in our figures. You can look at the predecessor companies to Element Solutions and see their gross margins have been steadily above 40% going back decades through various commodity cycles, which suggests not only that we don't see price downs, but that we're able to pass price on to the supply chain.

And do you -- you mentioned the service intensity. Do you actually embed ESI employees at these manufacturing facilities? Or is it -- they're called in when there's a problem? Talk to us a little bit about that aspect.

It runs a gamut. In many instances, we have people on-site every day at customer locations. We also have a hub-and-spoke model. The business is close to the customer. So our manufacturing and sales are all spread around the world aligned with the manufacturing base for our end markets. And so we have a great deal of customer intimacy from a technical service and selling perspective. We have applications development labs to help customers trial their next-generation products on our equipment and with our technology all over the world. It's a very interactive model where we call ourselves chemical technology, enabling performance and innovation where our customers rely on us for their innovation and their products performance.

So one challenge we see is there's nobody like ESI. When you compete against pieces of bigger companies, you compete against a -- it's not hard to pronounce companies we've not heard of before. But more recently, compete against a company that was IPO-ed. And so there's naturally a compare and contrast there. And obviously, I wouldn't expect you to talk about where they might have shortcomings. But can you talk about where you're different than that company? And I'm talking about Atotech, which I think a lot of investors have now been introduced to the market and what you do by reference to that public listing of a competitor?

So Atotech went public earlier this year, had this business for thrills that they went public. And if you listen to what they say about their business and what we say about our business, there's more in common than there's different. These are terrific niche markets with deep profit pools and great growth. We do have differences. Our business is more diversified. They don't have an assembly materials business, for example. Those are products that are sold to electronics hardware assemblers to put chips onto circuit boards and help putting together electronic hardware. They focus on circuitry like our business, so metalization of circuit boards and industrial service treatment, likely the Industrial Solutions business inside of our Industrial & Specialty segment. They sell equipment. We don't. We had an equipment business in the past. We got out of that business due to the capital intensity and the cyclicality associated with it. We're able to provide built-to-suit solutions, including equipment, to our customers working with third parties, and that insulates us from some of the volatility that an equipment business has or our business is almost exclusively consumable. We see a lot of value on the breadth of our portfolio for the electronics industry. There's a huge risk of failure where the chip and the circuit board meet when you think about vibration and temperature volatility in automotive applications or smartphone applications. And we can speak to that interface intimately because we can provide both sets of solutions and show collateral that shows how our products work together. The margin structure of our business versus Atotech, something that's talked about quite a lot. They have a higher EBITDA margin than we show in our statements. And there are a few explanatory variables for that. One is, we have this Assembly business which sells quite a bit of metal on a pass-through basis at no margin. And when we -- the example of that is we sell a lot of assembly material and on the bill to the customers the price for the metal that they're buying and the price for the value adds. So we really don't get any margin on those dollars, but they show up in the top line. And we disclosed in the first quarter what our EBITDA margin would be, excluding the pass-through metals, and it's about 30%. So that's more of an apples-to-apples comparison to our margin profile. They also report under IFRS and we report under GAAP. And so there are certain things that they can capitalize as opposed to expense or they can consider financing cost as opposed to expense. And so between those few things, the margin is actually quite comparable. They're a viable competitor. We've been rooting for them in the capital markets, but pursuing business aggressively in the commercial markets. I would say they would say the same thing about us.

Got you. Can we move just briefly to the Industrial & Specialty side? I think the electronics side, obviously, is humming quite nicely. It has a lot of secular growth. The industrial side has some of that as well, but also a cyclical component that may be as the world reopens, as commodity inflation affects some of the end markets that you might serve, there's going to be a lot more health in that business. So can you talk about maybe where it was? What happened through the pandemic? And then what we see going forward? And again, maybe some illustrative examples.

Yes. As you rightly called out, the electronics business has been humming. And all of 2020, we were waiting for a shoe to drop, waiting for the electronics business to reflect what was happening in the broader macro economy and it didn't. It didn't because these secular trends gained traction and demand remained very, very strong. The industrially oriented businesses had a tough go in 2020, starting in Asia with our auto business or our Industrial Solutions business in Q1, but in a more pronounced way in Q2. The bottom was in May, where these businesses were off 30%, 40%. And we saw a pretty steady recovery across the portfolio from May through the end of the year. By the end of 2020, we were growing year-over-year in our Industrial Solutions & Specialty segment. The trajectory of that recovery was different by region and by business. But there was real momentum exiting 2020 and entering 2021, which has persisted despite the semiconductor shortages that are impacting the automotive industry. So our automotive industry business, we were expecting to grow nicely in the first quarter, and it had more muted performance because units were down, but that was more than offset by strength in the other subsectors in that Industrial Solutions business, industrial equipment and machinery and building products. Our -- we have business that goes into faucets and sanitary applications. That all came back really, really strong. So that business has continued momentum and growth. We are lapping the worst quarter, but we'll continue to lap a Q3 that was impacted. And so we should have pretty substantial growth in the third quarter in that business as well.

And can you talk about what's happened in the printing -- the graphics business you have? Maybe explain what you do there, and what prospects are for recovery there?

Yes. So our Industrial & Specialty segment is about 40% of sales. 70% of that is our industrial Solutions, our industrial surface driven business. 2 smaller businesses, one in offshore exploration and production for deep offshore energy; and another one about $150 million of sales in flexible printing substrates. So the flexographic printing technology is a huge process. It's used to print flexible packaging. So you've got a flexible substrate, whether that's the label on your bottle of water or a bag of chips, and we provide a polymer where that's used to actually print the images on those potato chip bags. That business had a very strong first quarter of 2020. As you'll recall, supermarket shelfs were empty. There's a huge surge of demand for flexible packaging. And then as the CPG companies delayed rolling out new marketing campaigns because of COVID, that business tailed off in the back half of the year and saw some sequential declines. Unsurprisingly, there was a year-over-year decline in the graphics business because of that surge in Q1 of 2020, but we're seeing some nice growth sequentially in that business. That's a business where our market share is lower than in our other businesses. Our market share there is 10%, 15%. And there's a lot of opportunity, big customer wins that we're pursuing that can really move the needle in that business. We've got great technology, great people. And we see a lot of reason to be excited about investing line.

And I know it's a tiny one, but maybe some cyclical power when the world heels or when the energy worlds heel. Tell us about your energy business.

Yes. So we've got a business that provides hydraulic fluids, small business, less than $100 million, but incredibly high margins. And they provide hydraulic fluids from drilling and production of deep offshore energy. And as the drilling market slows down, that business declines. We've got very, very large market share in that business. And so we really don't have an opportunity to outperform the market substantially there, given our market position. So we do swing with the cycles a bit there. And last year was a tough year with the low energy price. There's a bit of a lag before drilling activity picks up after the energy prices recovered. And so as we look out at the balance of this year, with the recovery in energy prices and breakevens becoming more attractive for offshore energy production, we see a bit of a tailwind there as well. So we should see sequential improvement in the offshore business and in the graphics business.

But I know your background has a little bit of banking in it. And I'd be curious. We talked about how you guys are a bit of an unusual company in terms of comparables. But I would suspect you do a decent amount of benchmarking internally there. Right now, at least quoting a Bloomberg, your forward multiple is about 13x EBITDA. You think that's the right multiple for your collection of businesses? And when you do your benchmarking, what might it suggest about where your returns come out or where your cash flow comes out? And also maybe if you've looked at it where your valuation comes out.

Yes. No, I appreciate that question, Bob. It's a great one. And we do, do a lot of benchmarking. Not all EBITDA dollars are created equal. EBITDA is used as a proxy for cash flow. But in our case, in our industry, our capital intensity is far less than the average. It's best-in-class, less than 2% of sales and CapEx. So EBITDA less CapEx, margins are leading. And EBITDA less CapEx is a multiple. If you think about valuation, we're in the lower quartile. And that's a proxy for cash flow in a business that has stable margins, steady cash flow, its proven ability to maintain and, in fact, grow cash flow in downturns. We think about ourselves on a free cash flow yield perspective. We think that at this point, we've proven an ability, as I stated, to sustain high cash flow, generate strong cash flow through the cycle, with 2020 as the most recent example. And now we're seeing this inflection towards growth that we believe to be sustainable. So when you marry the cash flow characteristics with this and the growth potential, it becomes pretty interesting. And the valuation seems dislocated from intrinsic value. And not to the extent it was last year, but still buying back shares isn't an unattractive use of capital in a modest way from here.

I have to say it was quite remarkable last year as the pandemic hit and everybody had to clamp down capital spending and try and find some liquidity, and then things started to relieve themselves as we went through the year. Your company was one of a few that we cover at least that had the ability and willingness to go out there and reduce the capital base. And obviously, with very, very good timing on your part. As you look forward, you've done a few small bolt-on deals, and the predecessor company had a legacy of lots and lots of transformational deals. So can you talk about at ESI, what is the inorganic growth strategy? What is the capital deployment plan? And what should we expect as we go into this growth phase that you just talked about?

Yes. So we reduced the capital base. We would have liked to have done more. But from a values perspective, which I think is appropriate when we are managing cost aggressively and have people on salary cuts to buy back stocks. So we weren't able to do it to the extent I would have liked. We also initiated a dividend, which may have been -- which was certainly different than what most companies were doing in light of the environment. Yes. This is -- you referred to the predecessor company and its approach to M&A. Our approach is very, very balanced. And it's all predicated on operational excellence and then improving capital allocation. We've got great businesses. We're running them better every year, more efficiently with investments in growth. And the more we are operationally excellent, the more attractive our ability to deploy capital becomes because when we tuck-in acquisitions, we can make them better. And we've built conviction over the past couple of years in our ability to integrate, in our ability to realize synergies and in backing our leaders. There's a long pipeline of attractive bolt-ons where we can invest behind our businesses, behind our people, in companies that we deeply understand that are better inside of our portfolios to get synergy potential, and that make our business better. They allow for us to provide a broader suite of solutions to our customers. And so that's been our MO and will continue to be our MO. There are just a handful of larger acquisitions out there that fit that criteria. Again, we are in largely consolidated rational markets. And so there aren't big slugs of market share available to be acquired. But there are a couple of opportunities where we can write a bigger check behind our businesses. Those are never high probability because there are just a few and action ability varies. But we are in a position right now, and we could pursue that because the balance sheet is healthy. It's healthy it's ever been and our conviction in our ability to integrate is strong. So there's no need for transformative M&A or in leadership positions in our businesses. We're only going to buy businesses we deeply understand, but there is an opportunity to do slightly larger transactions from here going forward.

And maybe we have time for one more. I wanted to ask you -- and hopefully, this doesn't sound insulting. But I still think there's a lot of discovery value to ESI. I find that there's still a large portion of my customer base, client base that just still doesn't seem to be fully aware of your company. I know you've been -- pandemic challenges notwithstanding, you guys have tried to get out there more on the road. You've now delivered some spectacular earnings growth and the stock price has really started to rally. You're above that $5 billion market cap. So I'm just curious from your vantage point and maybe Varun is more in the weeds for this answer. But are you starting to see a broadening of investor interest? Are you starting to meet new people? I mean, for your existing shareholders that are pleased, are they going to be happy to know that the addressable investor universe has been growing recently?

Yes. So for sure, we are gaining traction with a broader investor base. Part of the reason for the dividend was that, right? One, showing conviction and commitment to our leverage feeling; and two, introducing some income to attract a new slug of investors. And that has worked. And our shareholder base is very different, radically different than it was a couple of years ago. You get the shareholder base you deserve is something I've heard quite frequently, and we're focused on running these businesses better every day, and the story takes care of itself in that case. Our focus is on creating value for customers, creating opportunities for our people. We do those 2 things. The shareholder piece takes care of itself. The share price piece takes share of itself. And so that's where we spend most of our time. That having been said, we see new faces at each of these conferences that we've attended virtually, and that's encouraging. And the turnover in the shareholder base and some of the new investments we have, who are attracted to what we're doing, is also very encouraging.

That's great to hear. Unfortunately, that puts us out of time. Ben, I really appreciate your time. I really enjoy watching you guys deliver, and we'll look forward to more of that in 2021. Thanks so much.

Thank you. Thanks, guys.