Element Solutions Inc (ESI) Earnings Call Transcript & Summary

All right. Hello, everyone, and thank you for joining us. Before we get started, I just have to read a quick disclaimer. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. [Operator Instructions] But with that, again, thank you, everyone, for joining us for this last fireside chat of our Global Chemicals, Agriculture and Packaging Conference. My name is Angel Castillo, and I'm the packaging and SMID-cap chemicals analyst here at Morden Stanley. And today, we're pleased to have with us Ben Gliklich from -- our President and CEO of Element Solutions. And with that, Ben, why don't I turn it over to you?

Great. Thank you, Angel, and thanks, everybody, for joining. I'm really glad to be here and thankful to Angel for hosting. Looking forward to this discussion and answering your questions. Quickly before we get into the fireside chat and take some questions, let me add that I'm particularly happy to be here, given that Angel has just recently taken over coverage of Element Solutions. And in doing so, he's brought some new analytics to assessing our performance and our outlook, and this forum here is a great opportunity to address some of his conclusions. The main thrust of his assessment is that Element's organic growth has historically been tied to units and, therefore, so will our future growth. which is a fair point and aligns very nicely actually with what we've said in the past. Our performance is tied not only to units but also to content per unit. The subsequent conclusions, though, in the reports and the analysis seem inconsistent with the macro picture that we're seeing in our end markets. Surely, our growth rate will slow from greater than 20%, which we saw as we lapped COVID this year, but that was self-evident. To assume that we're going to revert to the historical low single-digit growth rates in this current backdrop, I think, fails to appreciate the changing world we're living in. Put another way, what do you have to believe to get comfortable that underlying growth in our markets is accelerating? You have to believe that people will continue to buy more 5G phones than 4G phones, that mobile carriers will continue to invest in building 5G mobile infrastructure. You have to believe that electric vehicles will grow as a percentage of the automotive market from the low single-digit penetration they have today. You have to believe that our devices, the devices we use every day, will require more computing power to deliver increased functionality, whether that's in a car or in a handset or in other areas of the industrial economy. The units in our end markets are growing, and the content per unit is growing rapidly as well at the same time. So we get 15% more content on a 5G phone than on a legacy technology phone. We get 1.5 to 2x the content value on an electric vehicle than on an internal combustion car. So what you have to believe is that these units are going to grow. And with that, we'll see an incremental benefit from content per unit. And in a recent note, Angel wrote that growth in our businesses this year has been due to COVID and chip shortages. And yes, certainly, year-over-year growth in 2021 has been due to lapping the impact of COVID. But the reality is that our absolute performance in 2021 has actually been hindered by COVID and chip shortages. Put another way, we would have higher sales were it not for the inability of our customers to meet demand. We would have higher profits were it not for chip shortages and the lingering impact of COVID. And then, at the same time, and this is empirical, our organic sales in the third quarter over the same period in 2019, so this is not lapping COVID, this is just like for like, we're up 11%. So we are growing organically, and we would be growing faster organically were it not for COVID, which is to say that these businesses are growing and have a strong tailwind behind them. So we're growing despite headwinds not because of them. What's a bit ironic is the analyst [ who's more ] bearish on our ability to grow has the highest numbers of all of our analysts for 2022, which is a mismatch that we would love to understand. And so maybe to wrap up before questions, I don't want to be an impolite guest to a gracious host, and I do hope today will be the catalyst to shift Morgan Stanley's assessment of Element Solutions, which is an assessment that, historically, has been wrong, as evidenced by the value we've created for shareholders in the past couple of years. We see a clear line of sight to continuing the relative overperformance, and we're thrilled to see that investors are beginning to appreciate the unique attribute to strengthen Element Solutions and the quality of the market it serves. And so I'm happy to have the opportunity to dig in on these points, and let me turn it to you to fire away.

Absolutely. No, and I appreciate that intro and looking forward to continuing to learn the company and continue to understand, like you said, every aspect of, kind of content growth and then how that's going to be driven in the future, as you mentioned, as we kind of transition from maybe a little bit more production geared to really these kind of secular trends. So why don't we dive into that a little bit? Maybe starting with the third quarter, as you noted, despite the challenges, you reported very strong growth. So could you help us just, I guess, understand a little bit maybe how much of a headwind was kind of autos, the production there for your business in the third quarter? And how are you seeing that kind of progress in the fourth quarter in terms of the headwind?

Yes, absolutely. So we started to see a headwind from the automotive market slowing down in the second part of the third quarter. It was a bit later for us and for many of our, let's call it, other chemical input companies into the automotive space. Sequentially, we were down a couple of points in our automotive business from the second quarter into the third quarter. And we don't expect that dynamic -- that weakness in the auto market will continue into the fourth quarter. That was offset by really strong performance, particularly the exposure in the Industrial Solutions piece of our business was offset by really strong performance in general industrial, whether that's building product, heavy machinery, decorative or functional products in homes. And so we're still seeing growth in industrial, with the auto piece of the business slowing down. All that is not to say that we're not seeing significant contribution from the content side of the business, where the products that we sell are going to electric vehicles, for instance, which are captured in the Electronics side of our business, continue to be performing exceptionally well.

That's helpful. And then, I think one of the things that really stood out as we think about the meetings that we've been having with investors throughout these last few days is just kind of the diverging opinions as to what auto is going to do into the coming year, in terms of auto production recovery. So to your point, you're benefiting -- you get some benefit from kind of the content growth, EVs and every kind of that secular side of the story. So help us understand, I guess, as we think -- if we think about that range of opinions, maybe -- if you take maybe on the more bearish side, auto is perhaps being a little bit flattish in 2022 to, on the more optimistic side, maybe being kind of up in the teens year-over-year growth for production. How would kind of Element Solutions -- should it be kind of on the flatter side or the other side? Where would your organic growth kind of come out in those scenarios?

Yes. So we outperform units on the way down and on the way up, and we've proven that through COVID and the period prior and subsequent. That outperformance is driven by a couple of factors. The first is, just in an average car, there's more content per unit every year, a couple of points, call it 1 or 2 points of content growth in excess of unit growth, driven by more decorative finishes, more corrosion-resistance products. Once you've got a lane departure warning in your car, the next generation of that car isn't not going to have a lane departure warning. It might have automatic cruise control. There's just increasing electronics content, also industrial solutions content. And then, of course, there's a kicker as EVs gain share of the automotive fleet. So we believe our auto business will grow in a flat unit environment, right, which is your bear case. Of course, if units recover dramatically, we'll have incremental growth on top of that. Even in that flat unit growth environment, Element Solutions is going to grow organically next year because auto is 25% of the business thereabouts. And the electronics piece of the business has very strong secular tailwinds behind it, whether that's from mobile infrastructure, handset unit growth, and again, this EV theme that's propelling the business. So we feel great about next year, with the big variable being auto units, but there should still be substantial organic growth next year, absent an auto recovery.

Got it. That's helpful. And maybe it's a good kind of time to just dive in a little bit more into the Electronics business. And as we think about that content, I guess, differential for EVs, you noted 1.5 to 2x. How do you see that evolving over time? Is that kind of the right level to think about? Or is there ability to creep that higher, whether it's through innovation or other products?

Yes. So we're getting 1.5 to 2x the content on an EV versus an ICE from more circuit board requirements and also from the power of Electronics. We lose a little bit of content in some of our industrial business because we provide corrosion-resistance products for things that go into the engines. Engines go away. We don't have that value. But that's more than offset by more plastic, which requires plating and more electronics intensity. The way that we grow our value per vehicle is through adjacencies. So we made an acquisition earlier this year of a business called H.K Wentworth. It has a unit inside of it called Electrolube, which provides some really interesting polymer-based technologies, thermal interface materials, conformal coatings, encapsulation resins. These are products that are used in high-performance electronics to dissipate heat or protect the circuit board from water, vibration, temperature. And it's a small business, and we believe our customers will want to buy their products from us. And so organic growth execution there bringing to bear our relationships with their technology could really drive more value in the EV space for us, but we're in the early innings of that.

Got it. That's helpful. And I guess one area that we get a lot of questions on is, there's been a lot of M&A deals in the space. And as we think about -- I think you mentioned on the fourth -- or on the third quarter call, some market share gains or some product and contract wins. If we focus, at least, just on the Electronics piece for now, with all that M&A, what kind of opportunities are you seeing in terms of areas where you might compete with some of the players that are involved in these kind of M&A deals? And what are you seeing in terms of, again, [ trends in ] market share gains, product opportunities or ability to get kind of new wins?

Yes. We're [ very ] focused on commercial execution in our businesses, and we have no distractions taking away our attention from solving our customers' needs. And we're executing very well. Market share in the circuit board industry is migrating towards the higher-end vendors, the higher technology providers because more of the growth in the industry is at that higher end than at the lower end. So just naturally, using the diverging growth rates between high-end circuit board technology and low-end circuit board technology, the high-end providers are gaining share, and we're one of them. At the same time, we're continuing to invest significantly in improving our technology and customer intimacy. We have the benefit of more touch points in our customer supply chains than our competitors, and we're leveraging that to our advantage to win more share. And yes, some of our competitors have been involved in transactions. Atotech was acquired recently. That transaction, from our perspective, doesn't change the competitive dynamics. So the acquirer of Atotech is not someone we compete with. It doesn't consolidate market share. We don't believe it provides more leverage at the customer side for them versus where they're coming from. Rogers Corporation was acquired recently or has announced that they were being acquired. Rogers isn't a competitor to Element Solutions. They've got great technology for laminates, I think sealants, but that's not what we do. And so we're a market leader in the markets in which we participate, and the M&A around us doesn't change anything for us, and we're laser-focused on the customer need at a time when clearly, there are competing priorities for attention in some of our peers.

And so I guess if we focus in on the areas where you are winning, perhaps against these more kind of incumbents or where you can compete against some of these players, and maybe it's not in existing business but in new business, how are you -- how is Element Solutions winning? What is kind of the secret to kind of displacing an incumbent that might already had prior business with some of the new facilities?

Yes. So I would just clarify one word, which is incumbency. I mean we are an incumbent in this market. We are a market leader in the market, and there's not a lot of business that's getting done away from us that we don't see. And so how do we drive market share? The business is incredibly sticky. The switching costs for our customers -- once a product is in a production line and they're running a lot of value through that production line, to requalify or to change suppliers, you have to stop producing something that's very valuable. You have to requalify the new process. In some cases, you have to change the equipment involving the process. You're going after very small amount of savings. The chemistry is a tiny fraction of the cost of the end product. So the switching costs are very high. So market share is primarily won and lost in new builds, and we're in the middle of a period of significant new capacity addition because of these secular tailwinds that we were just talking about. Our customers' printed circuit board fabricators are investing a lot in new production capacity. And so we just need to make sure that we're winning more than our fair share, more than 20%, 25% of the new lines that come on. And we do that by technology road map exchanges, by being close with OEMs and ensuring our products are qualified or even specified and by providing evidence that we are the lowest total cost of ownership, which is different than being the lowest price and the best service organization in our industry. And we've been doing that. Our book of business and our new wins this year is bigger than it's ever been. We elapsed the 2020 total win value of sales opportunities by the end of the third quarter of 2021, just to give you a sense for what our commercial progress has been.

And are you seeing any reaction or change in kind of the competitiveness of the environment in terms of as there -- as some of the players that maybe -- where you are winning a little bit in excess of your kind of 20%, 25% share? Are you seeing anyone getting more aggressive in how they're kind of coming to new builds or new, I guess, business, how they're coming to the table to these?

Yes, the industry structure has been pretty consistent going back many years. We've been the consolidator. And as I said before, business at the high end is not won on price. It's won on cost of ownership and service. And as noted, we're converting a lot of opportunities right now.

Got it. And maybe then just switching a little bit to the smartphones and 5G, digging in a little bit on that. I think -- so there's the 5G, the smartphones themselves, but then on the infrastructure side, if you could just give us a sense for where do you think we are kind of in innings in terms of the growth opportunity for this across these kind of areas of the 5G infrastructure? And how do you see that kind of benefiting on the solutions in the next year or 2, et cetera?

Yes. So we're in the middle of a handset replacement cycle and disruptive change in that technology, right? So 5G phones are gaining share, but they're still less than 50% of the phones that are sold. So units of smartphones are forecast to grow around 6% for the next couple of years. But the 5G phones, within that, doubled this year in 2021 and are expected to grow 50% next year. And so you see growth in content, in addition to growth in units. The base stations to support those phones, right -- the infrastructure to support a 5G phone is different than the infrastructure that's required to support a legacy technology phone. And so as these phones proliferate, the base station infrastructure needs to be there or else you don't have the 5G capability on the phone. And the infrastructure builds have lagged what people expected in the first 2 years of real 5G availability in 2020 and 2021. So we're optimistic. We're bullish that there will be more investment in base stations for the next several years in order to provide the capacity that 5G phones require. The carriers need to make those investments. This is a many-year cycle. I mean we are in the second or third inning of this investment cycle, and we expect it to be around for another several years.

And I guess in the fourth -- or in the last quarter, you kind of talked about the circuitry maybe having some delayed production schedule in some product areas. So I was wondering if you could give us a little bit more color as to what exactly that was referencing and just what you're seeing.

Sure. So chip shortages are not just impacting the automotive industry. We've seen some contagion from chip shortages into the electronics market. We're seeing it more in the local Chinese smartphone manufacturers, but we also [ soften that ], right? And that's not just chip shortages, that's also a supply chain disruption. But Apple reduced its iPhone forecast of several million units in the past couple of months. We saw that in the third quarter. And so it has been a headwind, coming back to this comment that the chip shortages have been a headwind to the business. It hasn't been a tailwind to the business. And these OEMs are manufacturing to demand, not to stock. And so it indicates that there's some real opportunity because the unit demand is there. And so it will be delivered at some point in the next year.

And I guess maybe just to -- just in going backward a little bit on that. Just so -- as we think about that demand and then as you mentioned, maybe it's been more of a headwind. But are you seeing any inventory build across the chain in any particular areas, whether it's -- or any end markets, where people are just -- we hear it, I guess, across most companies in our space where everyone is so concerned about supply of product that there is a little bit of operating with a different mentality to make sure that you don't risk going into a strong 2022 year without the right amount of availability of supply. So how are you seeing that play out across your supply chain and your customers?

Yes, it's a great question because, first, we've built safety stocks of our raw materials. We put more than $20 million of additional investment into working capital this year to ensure we can meet customer demand. And fortunately, we've been able to meet customer demand this year. And our outperformance relative to units begs the question in the automotive space, are customers and our supply chains building inventory that we're going to have to work through when the markets recover? And we don't see that in a material way. Our customers don't stock excess chemistry, right? It's a big tank of hazardous material. It's not going to sit on the shelf in the warehouse. And so -- and we deliver in very short lead times inside of a week, so there's just not a lot of our products sitting in inventory. And the plating shops that we're selling to in automotive supply chain are not building extra grills for cars and hood ornaments, right? They're used to a just-in-time environment, and they're feeling a bit strapped because it's been a couple of tough years for them from a cash flow perspective. They're not just building actual inventory. They're also used to just-in-time framework. So are there some cars sitting on lots waiting for a final piece, such that they can be sellable? Yes, I believe that. But I don't think that, that's millions of units from where we sit. And so a recovery in demand should very quickly absorb whatever there is in inventory in the automotive supply chain.

Got it. That's very helpful. And then as you think about maybe your own, as you mentioned, the metal pass-through and maybe some of the challenges in terms of your raw materials, how do you kind of see that throughout the fourth quarter? What are you seeing, thus far, in the last month or 1.5 months in metals and then how do you see that kind of progressing for fourth quarter, first quarter?

Yes. So raw materials and logistics have been a headwind this year both in terms of pricing and in terms of availability. We've been fortunate. And really, it's a credit to our team around the world that we haven't had a material impact on our sales due to an inability to produce and inability to get product because -- but it feels like every week, we're struggling to get enough of something, and then we find a way to get it. So scarcity is -- has been an issue that we've been able to manage. Inflation is another issue that we've been working very hard to manage. Metal prices is easy for us. It's direct pass-through for most of the metals that we're buying. So it has an optical impact on our margins because the price of tin has doubled. You see sales without a margin drop-through. But there's a big basket of raw materials that have inflated and sort of our nonmetals-oriented basket of raws are up about 4%. We've taken a couple of points to that back, but we haven't taken it all back. And so that's something that we're working through right now. Despite that -- despite not having caught up yet to cost through price and despite logistics prices being much higher, we expanded our EBITDA margin in the third quarter by 170 basis points, if you exclude the impact of metal price inflation. That's through operating leverage and mix. So the business is performing and expanding margins in the face of these headwinds, which is something we're quite proud of.

Understood. That's helpful. And then we have a question here from the audience, I guess. So GM recently said production has returned to normal. Has your company experienced increased activity and/or orders from the auto industry here in the fourth quarter? And what percent of sales go to China, Taiwan and Japan?

All right. So a bunch of questions there. Our auto business was where we thought it would be in October. So we didn't see that sequential recovery that you would think associated with GM, having all their sites up. Anecdotally, we have heard that there is more assembly activity in November than there was in October, which is a positive sign. But I don't have anything empirical, right? The data hasn't rolled in yet. We're just sitting here in the first third of November. But should auto be better in the fourth quarter in terms of units than it was in the second half of the third quarter, that's upside for us. I can't point to anything concrete in that regard sitting here today other than some anecdotes, if you will. What percentage of the business is in -- was it Taiwan, China and Japan?

Yes.

So across all of Element Solutions, about 40% of our business is in Asia. China is the biggest country in Asia for us. It's 25% or so. And then we have a nice presence in Taiwan and a reasonable presence in Japan. Japan's a market that has a lot of very high-tech providers that are local, that have not been as successful going internationally. But it's a competitive market. To be precise, I would say we're in and around high-20s percentages, including -- of sales, including China, Taiwan and Japan.

Got it. That's helpful. And then maybe, I guess, switching gears to Industrial & Specialty, honing on that a little bit, how should we think about kind of margins for this business in 2022 and as we progress here?

Yes. So the big variable for the Industrial & Specialty side of our business is going to be auto units. And we're not putting a line in the sand, making a forecast. As Angel correctly noted, the dispersion in expectation is incredibly wide, right? You've got some folks saying they're going to be -- units are going to be flat. Some folks pointing to the mid-teens. It's early for us to make a call. And we've got a few months before we have to give guidance, and we're going to learn what we can in that period of time to be a bit more precise in that regard. But that will be the big determinant for that business' performance on the top line next year. And we'll also have to speak to margins. If the auto business which is slightly higher margin inside of the Industrial Solutions vertical within the Industrial & Specialty segment is robust, we'll see some positive mix effects from that. If it's weaker, you'll see more contribution in that segment from the Graphics in the offshore businesses, which are relatively small businesses but quite high-margin businesses. So it's hard for me to put a stake in the ground, around what that margin progression would look like in 2022, and those are the variables that I will be looking at in modeling it out.

Understood. And I think on the third quarter, you talked about maybe a big contract win in Graphics, and that business was -- had some good growth. I guess, as we think about kind of the environment in that particular business, in Graphics, what are you seeing there in terms of market share, again, similar to the conversation we had with Electronics? What is kind of driving maybe some of that market share win or some of those contract wins? And as you think about kind of making investments in that -- into that going forward, how should we kind of...

Yes. I think this is a great story for us. That's a market where we're not #1 or #2. We're #3 or #4 in that market. We've been investing behind the business. It's a good market that's had a nice recovery as consumer packaged goods companies have been investing in new designs and new package rollouts, and that's been supporting the market overall. And we have a relatively new leader in that business, who's been driving real good commercial execution. And so we're winning big pieces of business. We're investing behind it to add a new line to build more capacity because we have a single site -- single source there in one site. And we're going to add another site because we see a path to volume to fill it. And we're very excited about the top line opportunity in the Graphics business.

Got it. And maybe just on the Coventya, I think you noted in the third quarter call about maybe seeing more opportunities there to have better synergies and better results than what we've kind of expected going into that being closed. So if you could just give us a little bit more color, what exactly are you seeing? And where should we kind of expect, if you could quantify that, that would be helpful as well.

Absolutely. So it's still early days on the Coventya acquisition, but signs are pointing very positively. For starters, we bought the business off of a forecast for EUR 28 million of EBITDA in their fiscal year, which ended September 2021. They overdelivered. They delivered EUR 31 million. We communicated about EUR 13 million of synergies. And here we are, 2 months in, we see in excess of that. So the multiple that we purchased this business against is well inside of where we thought it was going in. So that's always great. And then from a sort of intangibles associated with the integration, it's been very positive. We're seeing good customer engagement. We're seeing great commercial engagement across our organizations. And so we see not just the cost side but a growth aspect here that we're building more conviction around by being the leader in this market, some of the complementarity of the product portfolio, some of the new markets that they bring to bear. There's a lot to be excited about, and we're thrilled at this early stage.

Understood. And then maybe switching gears a little bit to capital allocation. I think this is probably the next kind of big topic that people tend to ask about. How should we think about your priorities in terms of dividends, buybacks and M&A?

Sure. There's a lot to be excited about from a capital allocation perspective because of the cash flow characteristics of this business. 2021 is a great case study for the power of the Element Solutions model, which is to say we bought a $500 million business. Borrowed to fund it, yet leverage at the end of 2021 is lower than it was going into the year, right? So growing EBITDA because of the secular growth and the execution, generating really strong cash flow in a year or even overinvested in working capital because of what's happening in supply chains, still generating close to $300 million of free cash flow. And so we've got capacity to continue to allocate capital to compound earnings per share. We are nimble in terms of how we deploy that capital. So in the first 2 years as Element Solutions, we bought back 20% of the company. We were trading at a high single digit, at some point double-digit free cash flow yield. It's a really attractive opportunity to buy at a price that was dislocated from the fundamentals, and so we did so aggressively. As that free cash flow yield has come in a bit, M&A has become more attractive from a relative value perspective in some of the [indiscernible] businesses. We're digesting those businesses. We have the capacity to do more bolt-on acquisitions. There's an almost indefinite list of smaller tuck-ins that add value that fit our criteria. They're better inside of our company with synergy potential and still buy back shares because we're still trading outside of a 5% free cash flow yield, which, to us, doesn't make a lot of sense. All of that balanced by 2 things. One, a dividend that we announced and launched last year and have incrementally grown modestly and keeping leverage well inside of our ceiling of 3.5x. So you should expect to see sort of all of the above, if you will, over the next several years from a capital allocation perspective.

Got it. And then I guess within the bolt-ons, any particular business that -- you mentioned you still have capability to continue to do more bolt-ons. But given that Industrial is kind of doing the Coventya acquisition or integration, is -- should we expect that it's perhaps a little bit more in the Electronics side of the business that you're seeing opportunities as more near term?

I wouldn't rule out any specific vertical. We're working on several things at any given time, and only a couple of them come through. And so we've got a wide aperture. We wouldn't do anything large in the Industrial space right now because we're busy with the Coventya integration, but smaller things, I wouldn't rule out.

Got it. And then I guess time line, in the past, I think -- so you've done a couple a year. Should we think about it as kind of 2 to 3 per year of small acquisitions, the kind of the right level in terms of bolt-ons going forward? Or is it perhaps a little bit more heavy on buybacks kind of near term?

Once again, we'll see what the market serves up to us both in terms of opportunities from a tuck-in perspective and in terms of relative value from a buyback perspective. So I wouldn't be prescriptive either way, but I would note that we have capacity in the near term and expect to deploy capital consistently in the coming quarters.

Okay. All right. Well, I think that brings us here to the end of our time. So Ben, thank you so much for the time, and I really appreciate the conversation. So thank you.

Thanks very much, Angel.

Bye.