Element Solutions Inc (ESI) Earnings Call Transcript & Summary

Thank you all for joining us, again, hello and welcome to the 2022 Global Chemicals, Agriculture and Packaging Conference. With me today we have Ben Gliklich, CEO of Element Solutions. Before we get started, I do want to read a quick disclaimer. So, 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 and, again, just a reminder, as we're going through the conversation, we want to make this interactive. So, if you have any questions, please raise your hand and we'll make sure to get a mic to you. So, with that, why don't we get started. Ben, thank you so much for joining us. Appreciate you coming out.

So, I think one of the great things about ESI so far has just been despite all of the macro, despite all the difficulty, you have a lot of exposure to autos but yet you've been able to deliver great results driven by execution on pricing, execution on costs, execution on new winning, or I guess, customer wins. So, as you think about -- reflect on this past year and you start to plan for 2023, can you talk to us about maybe what the secret sauce is or what are the benefits or drivers to both the execution on the cost side and the pricing side as well as the new wins and how you see that kind of evolving into 2023?

Yes, thanks for the question, I appreciate that observation. We are leaders in the markets in which we participate but there's a lot of white space around us for us to pursue. And as a company we're very focused on outperforming our end market. So, there is some level of cyclicality in units and we're going to do better on the way down and on the way up and we've demonstrated an ability to do so. The way we do that is by investing in innovation, right? So, the technologies that our customers need to deliver high quality products to their end-customers and service, great people, supporting our customers manufacturing processes. And we are regularly investing in that, increasing our investment in that, in all market environments. So, you did call out our ability to manage costs and this is a business with a high level of variable operating costs. So, when times get tough, we can pull levers to preserve profits, which we've demonstrated an ability to do, but we do that without damaging the long-term growth trajectory of the business, consistently investing behind our people to drive growth. We have had really interesting incremental breakthrough innovation and that has been supporting market outperformance over the past several years and we expect it to continue to.

Maybe could you give us a little bit of a sense for some of that innovation and maybe where you're excited about, what are those products, what are those markets where you maybe see more whitespace and you're investing behind?

Yes, so we operate in 6 verticals and in each of those verticals we have compelling growth opportunities, organic growth opportunities, so areas where we can drive organic growth through innovation, through market expansion. Some of the more exciting, specific, call it capabilities and solutions that we're investing in are around power electronics. So, this is material that's used in the power semis that are used primarily, at the moment, being driven by electric vehicle proliferation. We've made entrees into interesting markets around [Die Attach] as more -- as Moore's Law is beginning to break down and breakthroughs in computing power require new structures in the semiconductor industry away from the homogeneous package, more towards a heterogeneous package. So, in chiplet. Multiple [die] on an IC substrate, which is a very high-end printed circuit board, we're incredibly well positioned to enable those types of breakthroughs from the technology we have plating silicon to chip assembly and to the circuit board market. And we've been really partnering with the major OSAT, the major printed circuit board fabs at the high end and the major fabricators to allow for innovation in that market as well. But if you were to look in each of our distinct businesses, there's a small handful of really compelling organic growth opportunities. We're investing behind and executing against.

And how do you see the competitive environment, particularly in those areas. There's been some shifts in kind of the broader, I would say, electronic chemical space. But as you kind of -- you're a leader in this space, and it's also very fragmented, right? So, just how are you seeing that competitive environment evolve in this market?

So, there's been significant consolidation in the broader electronics materials space. But it really hasn't impacted us. Over the past several years, we've been the consolidator. And M&A around us doesn't have an impact on our internal strategy, despite not being a huge company, we are a leader in each of the niches in which we participate. And so, the M&A around us hasn't changed our strategy. It hasn't changed our competitive position, and it's created opportunities. Because we've been very focused on the customer for the past several years. We have not seen any -- we've not had any distractions associated with M&A, and that's accrued to our benefit.

And maybe, I guess, switching to the other side of kind of the organic sales equation. So, volumes just from a broader macro have been more challenging. We talked about automotive production, maybe not ramping up as much as was kind of anticipated. So, maybe as you think about fourth quarter in 2023, maybe initially in the fourth quarter, thinking about in electronics, what does your guidance assume in terms of volume? And then how are you seeing that unfold here as you've gone kind of 1.5 months or so behind you?

Yes. So, this is a secular growth business. Let's start there. It is a secular growth business. Now mobile phone units aren't necessarily a secular growth end market, right? Autos are going to have some level of cyclicality. The reason our business is growing secularly over the long term is because of content, right? 5G phones have more content. Computing power is proliferating. The density, the value to our company, the necessity for our materials is increasing every year, and that will continue over time. That having been said, in the short and medium term, the business is driven by units, right? So, we're getting more content per unit, but when units are declining, we're going to feel that pressure. That's really what happened in the third quarter in our electronics business, and it's something we've been dealing with and living with in the auto exposed end market -- in our auto exposed business for the past 2 years, right? Units have been soft. Electronics were weaker in Q3 than in Q2, which is unprecedented in our business, right? Typically, there's a big ramp in the third quarter in anticipation of new mobile platform launches. That didn't happen this year. And Q3 is a pretty good harbinger for what to expect in Q4, right? Q4 demand in electronics is driven by pull-through of those new platforms that are being launched. So, when that pull-through isn't there, which we wouldn't expect it to be, given what happened in Q3, you're going to see a continuation of that trend. And So, our expectation is that we will see volume softness on a year-over-year basis, offset by price because we've been taking price to offset cost inflation in Q4, similar to what we saw in the third quarter.

And how much price do you think -- I guess, as you're thinking about that into 2023, is there more price that you'll continue to pursue? And in particular, can you also talk about maybe some of your efforts around recovering costs, whether it was freight or others that you're maybe going out through surcharges or others?

Yes. So, we have had consistent pricing action to reflect the inflation in our supply chain, right? That's the way we think about taking price. It's not annual, it's based on inflation in our supply chain. We sell value to our customers. They rely on us. And as our costs go up, we are typically able to pass that through. And over the course of this year, we have passed through price. We're getting the benefit of it. It's the reason that we had sales growth in the third quarter, offsetting softer volumes and it has preserved margin in the business as well. And it's the reason why the margins have been healthier than they otherwise would have been in a heavily high inflation environment. As we get into 2023, we'll be lapping some of that cost impact, So, we'll continue to have that benefit, right, from a timing perspective. And insofar as there is ongoing inflation, we will continue to pursue price. Hard to predict the inflationary environment in a dynamic economic environment, such as the one we're in today. Historically, we haven't had logistics pass-throughs. We do have some level of surcharge. Logistics has been a challenge from a cost perspective. We do a lot of trucking and that was quite expensive over the past 18 months. In a weaker economic environment, there's a reason to believe that should get better, if that's your base case.

Got it. And you talked about how short term or near term, maybe the business is a little bit more unit driven rather than kind of the secular stories. But going back to maybe some of this secular or some of the customer wins that you've indicated that you've had, how is that kind of playing out in terms of the volume? Or maybe how much -- help us understand maybe how much of an offset that is to kind of the underlying unit dynamics that we see.

Yes. So, we have a very rigorous and robust selling process, which we track thoroughly and review monthly. And the good side of the story is that that selling process is translating into a stronger pipeline and more wins. So, when we think about Element Solutions, it's operational excellence and prudent capital allocation, a big part of that operational excellence is the sales process and commercial excellence. And our pipeline is as big as it's been, and our new wins this year are bigger than they've ever been. So, through 3 quarters, we had more wins. Through 3 quarters of 2022, we had more wins than in all of 2021, all of 2020. And the other side of that coin, though, is the contribution from those wins in the year is well off of what it typically is, right? So, there's a period of customer ramp that we normally expect we'll get somewhere between 50% and 75% of the expected value in the year of that commercial win. This year, it's trending at 25%. Why is that? One, our solutions often go into equipment and there's backlogs in equipment because of supply chains. There's a slow ramp because of underlying economic conditions. Our customers' volumes might be trending down. And So, you're not getting that full value. The wins are real, right? So, over time, those wins will accrete to their full value, but they're not contributing as expected this year. That's a good thing because over time, that's a book of business, a sticky, high-margin sales that we're going to benefit from as end markets recover.

So, basically, is the right way to think about that is kind of pent-up demand that once the macro recovers, you would see that actually accelerate beyond kind of the underlying demand and really drive kind of outsized growth.

Yes. I think that that's right. As units recover, our participation from that should be greater.

Got it. And maybe switching a little bit to automotive, which is another big end market. You kind of alluded to it. But as we were talking about electronics, maybe on the automotive side, which also entails your industrial business, things haven't really played out and haven't really improved as much as anyone kind of anticipated. And as we go into 2023, there's kind of a debate as to what that's ultimately going to be. But can you just remind us about maybe some of the nuances about -- of Element Solutions? portfolio and maybe where you play within the automotive suppliers and how maybe some of the underlying trends that we're seeing right now in EVs might actually impact you versus what we actually…

Sure. So, we have a great deal of value in the automotive supply chain in our Industrial and Specialty segment, which is about 40% of the business. We have an Industrial Solutions business, which is 70% of that 40%. So, think about it as 30% of the company, and about half of that is surface treatment that goes into automotive applications, whether that's decorative or functional. So, that's chrome plating, nickel plating, corrosion resistance for nuts, bolts, fasteners, brake calipers. And then in our electronics business, we sell a great deal of value into automotive supply chain as well. Printed circuit boards as cars become computers, power electronics, I talked about that before, which is the power semi and other assembly materials that are used in automotive applications. We get 1.5 to 2x the value on an electric vehicle versus a comparable internal combustion car. So, as EVs grow their share of the automotive fleet, again, we talked about secular growth, we're going to see a significant content uplift, right? In the conventional car market in the ICE market, we're also seeing a content uplift because there is more driver assist systems and sensors. There is more corrosion resistance as reliability requirements increase. There's more decorative content as the wealth effect drives the average quality car in emerging markets to a higher level of finish. And So, again, there's a content over unit driver that we're participating in. As it relates to 2022, we have seen unit production increase in the back half. We have not seen that same uplift in our business because there's a bit of inventory that's built up as OEM production rates or production forecasts haven't been delivered upon. The supply chain has been building for that. And So, we're working our way through some of that inventory, which explains the difference in our industrial business growth in Q3 from unit growth year-over-year. We expect that to normalize, assuming a steady production level going into next year.

Got it. And I think as you think about the inventory destock, I think has been a pressure that we've heard from every company this quarter, you mentioned that, that may be as production improves. I guess what are the checkpoints you're looking for? And do you have a sense of maybe how much inventory has been built in the supply chain and maybe how long it typically takes for that kind of work [itself] through?

Yes, it's a really tricky question because the supply chains are as long as they are. But what we saw was pretty significant outperformance in our business versus underlying units compared year-over-year through about July of this year and then a divergence. And so, it's been a couple of months that we've been working through this inventory on the IS side of the business. And it's reasonable to expect as we turn into 2023 that we should be through it. But there's not a great deal of visibility at the moment.

Got it. And maybe going back to your comment about the content lift even within ICE vehicles. Could you give us a sense, I think you said 1.5 to 2x within EVs. What's the content lift within an ICE vehicle just from more electronics proliferation in the vehicle and other factors?

So, if the long-term forecast for auto unit growth over time, not from today's level, but over time, is 2% to 3%, we expect 2% to 3% additional growth in value to us.

Got it. And then I just want to remind everybody, if you have any questions, by all means, raise your hand and happy to include. So, maybe to that point, I think at the Investor Day, you talked about 5% to 7% annually as kind of the company's CAGR or the growth outlook that you talked about. Can you give us maybe a little bit more sense of how you're thinking about that within the sub-vertical or your subsegments: assembly, circuitry and other pieces within industrial?

Yes, absolutely. So, what Angel is referring to is at our Investor Day in February of this year, we outlined the go-forward growth algorithm for our business, right? And the weighted average market growth rate is 4-ish and we said we could grow a point or 2 faster converting that to EBITDA at 1.5x, compounding EPS through that EBITDA growth and prudent capital allocation, the business will generate $2 billion of free cash flow over the next 5 years in the teens. And So, we set a target of $2.50 of adjusted EPS in 5 years. The top line portion of that is somewhat as you'd expect. The electronics business is going to grow faster than the industrial and specialty businesses through the cycle. In our electronics business, we've got a really nice semiconductor business. It's going to grow faster than our printed circuit board business. The assembly business has 2 components. Some of it is more circuit board oriented. Some of it is more semiconductor oriented. And so, you can sort of split it along those lines as well. The Industrial and Specialty business will grow a little bit slower than that.

Got it. And I guess, as you think about that 1% to 2% outperformance, I think we've kind of gone into it a little bit with the innovation, but -- or some of the other factors that are driving growth above and beyond the markets. Do you need to see continued, I guess, customer wins or pricing cost? I guess what are the other incremental factors other than what we've discussed that you need to see in order to deliver on that 1% to 2%?

Yes. As we're talking about before, in each of our businesses, there are a small handful of high-value, high-growth opportunities. And they look different. Some of them require incremental innovation in the existing core product lines. Some of them require entering an adjacent market.. Some of them require strong commercial execution in a new region where we're underrepresented. And we're very, very focused on identifying the deepest profit pools available, understanding what it requires to capture them and investing behind those at the expense of other things. And we've proven an ability to do that. We have the resources to bring to bear to win, and that's been demonstrated. And that's why we have this confidence that we can get one to 2 points better than the market. It's not one thing we need to do, but it's not a hundred. And that's how we run the business through a strategy process that's focused on those specific opportunities, high-impact opportunities.

And to that point, I think one factor we maybe haven't talked about that's really interesting is just how does that sustainability and ESG play into this? What are the products that ESI is working on that you're excited about? And how does it fit into this broader kind of ESG and sustainability in [theme] and is that included then in the 1% to 2%? Or would that be kind of incremental?

Sustainability is a value driver for our company. It's -- the trend towards our supply chains being more invested and caring more about their environmental footprints, brings value to our company in addition to doing good and how so, innovation to eliminate certain hazardous materials, electric vehicle value accretion. If customers care about the environment, they prefer to do business with us. We have seen that over and over again. And so, it does factor into that 1% to 2% because it's an organic growth driver for our business. But again, it looks different in different businesses. One really interesting area that we made a small acquisition in and it has been driving a lot of value is in wastewater and I call it waste treatment equipment, right? So, all of our customers have long equipment lines plating and then they have waste plants. And we're very well positioned to help them treat that waste. So, we understand what's in those waste streams. We have equipment offerings that help them reclaim metal. So, we're plating nickel or copper. We can pull copper out of the equipment that's unused and recycle it. So, we're providing value to the customer because they can sell that copper, and we're taking that copper out of the waste stream. And we sell that equipment in exchange for chemistry business, long-term contracts. So, it's a value driver for us and for our customer. It's a win-win. In each of our businesses, there are sustainability link opportunities that are driving outperformance.

Got it. And as you think about, I guess, some of the maybe businesses like, I guess, oil and gas or the energy side of maybe more of the industrial specialty business, how are the products there, I guess, playing into this theme? And then what are the opportunity sets there?

So, the energy business is a great example. We provide materials that are used to help operate equipment that's drilling and producing deep offshore minerals. And we just introduced in the past 18 months, the #1 most environmentally friendly fluid for these purposes, right? It's got the highest ratings with all of the regulators. None of our competitors have a rating equal to ours and it's going to win us business because environmental attributes are the primary attribute that customers are solving for because this is material that's used in the ocean. So, that's an example of our investment in sustainability translating into value for us and improving our customers' environmental impacts. Similarly, in the industrial solution surface treatment business, where we've worked to eliminate certain hazardous materials from our chemistries and from our customers' processes to allow for them to comply with tightening regulation. It's a value driver for our customers because it allows for them to continue to operate the value driver for us because we get paid for that innovation. In all of our businesses, as I was saying before, there are opportunities linked to sustainability. We're investing behind them, and we're enabling our customer sustainability.

And the customer receptiveness to these innovations and willingness to pay premiums or just differentiated value for products. How are you seeing that unfold?

It can't just be this is more sustainable, so pay us more. There has to be a value proposition to the customer, right? So, again, with that equipment, the customers are able to resell that copper or that nickel. So, they make money, while at the same time, their waste treatment costs go down because there's less copper and nickel in their waste. So, that's why I say it's a driver of our business. This isn't for the intangible idea of sustainability. It has a payback. It's sustainability that reduces operating costs for our customers. And in that case, we are able to earn more because we're providing more value.

And that's a good segue. I guess in terms of inflation has been a topic that's -- we've talked about it quarter after quarter over the last year. But can you tell us your business is very variable cost driven. So, how are you seeing the different cost buckets in the current environment as we kind of go through the fourth quarter and it's 2023, what are your expectations?

So, our costs can really be broken into 2 buckets. There's metal, a significant portion of which is passed through at our cost. And then there's -- or at spot prices. And then there's other, right? And other is the raw material we're buying, logistics and so forth within cost of goods, so excluding freight and logistics. That basket was up in the teens year-over-year in Q3, but it was only up a point or so sequentially. So, we are seeing some level of stabilization. We haven't seen a decline other than in metals, which are passed through. Logistics continue to be increasing in cost to the tune of -- we paid more than twice -- in Q3 of 2022, we paid more than twice what we paid in Q3 of 2021 on logistics. And as we roll into Q4, our expectation is sort of a continuation of Q3 dynamics. And for 2023, it's early to call it.

And we talked about the surcharges that you've been kind of implementing for maybe some of those outsized headwinds in terms of freight or just logistics. How are you seeing the customer receptiveness to that pass-through and the kind of structure around that?

So, the way we've taken prices in 3 buckets, right? So, 2 buckets of cost of goods and 3 buckets of price. The first is the pass-through, which is just the way the business is done. Customers are buying a lot of tin for assembly materials, they're used to paying the spot price. And we haven't had any issue with that. The second bucket is surcharges. So, products like nickel and palladium, where there hasn't been a direct pass-through historically, we would have a surcharge mechanism. It was trailing 30 days average or drilling 2 weeks average. When nickel and palladium skyrocketed earlier this year, we had to modernize that methodology because of the volatility. And we were able to change that structure such that we weren't losing value. Of course, those prices have come down recently. And then the third bucket is a negotiated price increase, where a significant portion of our raw buys are niche molecules that aren't on commodity exchanges. And there, there's a negotiation. Our prices have gone up by this, and we bring evidence and data to support it. And over time, that price increase is implemented. It has gotten more challenging given unit and energy prices to take price in this environment. The first 2 buckets are pretty clear, that third bucket, it's not quite that environment but fortunately, as we said, we've seen a stabilization for the most part. And we had hard conversations on an ongoing basis over the past 6 quarters and have put us in a position to preserve a significant amount of margin.

Yes. And maybe I want to unpack that a little bit more. I guess one of the factors that, again, has allowed the company to deliver strong execution has been the cost management, right, and being able to kind of be focused on that and proactive on it. So, as you look at 2023, what are kind of the levers that you're looking at as potential opportunities for you to help manage some of that cost and offset that one?

So, it goes back to what we were talking about before. We will continue to invest in the value drivers for this business. We are not going to manage costs in a way that damages the long-term growth trajectory of this business because we believe deeply that these markets will recover and our people are required to be there to capture more than our -- more than our proportionate value from that recovery. So, you're not going to hear us talk about restructurings. People are the critical asset in this business. It's an asset-light business, right? So, this isn't about plant optimization, right? It's about the people and the business servicing and providing solutions to the customers. That having been said, the fact that it's an asset-light business and a people-based business gives us a significant variable operating cost that we can harvest. When demand isn't strong, we don't need to travel as much. We don't need to market as much. If you miss a trade show once every 3 years is -- are you damaging the long-term growth trajectory of the business? We would say no. Variable compensation is a significant portion of our cost. And if we're not growing, if we're not hitting our plan, that cost falls away and protects margins. And So, as we enter a new year, we have at our disposal, many levers of, I'd call it, discretionary spend that you can tweak, that we tweak, to make sure we're preserving profit while also positioning the business well for long-term growth.

Maybe just from a higher-level business or portfolio perspective, as you think about I&S and the electronics business, kind of operating under the ESI umbrella, do these make sense together longer term, how are you thinking about the portfolio? Is there opportunities to do anything kind of portfolio restructuring basis?

Yes. Look, we've got great businesses. They're all high margin. They all fit the attributes that we just went through, right, asset-light, variable operating costs, strong, strong cash flow, sticky customers and leading market positions. And so, we like all of our business. Some of the businesses -- the 2 smaller business, the offshore and the graphics business don't, frankly -- they don't have a lot of revenue synergy with the other business but they're really nice businesses, and they continue to contribute strong cash flow. The rest of the business, there is some real overlap. When you think about electronics and into the Industrial Solutions side, when automotive is a huge growth market for electronics, we've got deep relationships with OEMs and the tiers through our Industrial Solutions business. There's quite a bit of collaboration across electronics and industrial solutions, less so in the other I&S businesses, but we're not going to put a for sale sign on any assets. But I think it's understood, we're also not an entrenched emotional management team. So, I wouldn't say no.

Yes. And maybe on the flip side of that, I think bolt-on M&A was something that was talked about. And so, you just did Coventya and you've done a couple of other kind of smaller bolt-on M&A. In this current environment, how are you thinking about maybe those opportunities in the pipeline you see there versus kind of the use of capital as buybacks or dividend?

We're very focused on -- our vision as a company is to be the best in our industry in 3 areas: the value we add to our customers, the opportunities we create for our people and the value we create for our shareholders. Insofar as there is M&A that fits within our existing businesses that improves our customer value propositions, we will look at that in our markets. The hurdles associated with that M&A change based on our cost of capital and based on the opportunity cost of that capital. So, when our shares are dislocated from intrinsic value, the bar for M&A goes up. And we're in an environment where the cost of capital is reasonably high, shares are trading at what we would believe is a dislocated value relative to intrinsic value. And so, the hurdle for M&A is higher right now. It doesn't mean we wouldn't do anything, but it would have to be a real screamer. What you've seen from a capital allocation perspective over the past few years, we've been retiring shares, not very aggressively, but regularly, and that should be the base case in this environment.

And maybe as to kind of round it all out, as we think about 203, obviously, there's some real headwinds, just macro and FX alone. But as you think about maybe the CAGR, the 13% CAGR that you're kind of looking at through 2026, is there -- do you see, I guess, any leverage like buybacks that you could continue to pull to try to get to that 13%? Or do you see that as maybe more kind of still longer term? And maybe next year, how are you thinking about that EPS growth?

Yes. So, it's really early to talk about 2023. Clearly, our expectation is the first half is going to be a difficult, a continuation of what we're seeing in the back half of this year. The nice thing about slower periods of economic -- of macros and weak demand is that we generate excess free cash flow, more than in a growth period. And So, we will have capacity from cash flow to deploy should there be an interesting opportunity in our shares or otherwise. That 13% -- that teens percent EPS CAGR isn't something you can count on in a linear fashion. We always say, secular growth isn't linear. They're air pocket. There's volatility along that trend. And we're clearly in one of those air pockets. But the nice thing about this business is, especially in electronics, you see a big snapback. So, you have a tough year for smartphone platforms. Typically, the year after, you see a very strong year. And so, you think about 2023, the opportunity is that the back half sees a strong smartphone platform launch. We see continued automotive production growth and even if the broader macros are poor, we can outperform. And if that doesn't materialize, that just is pent-up demand for a subsequent period and we can get back and outperform that 13% trend to get back on track to our longer-term objective over time.

And to your -- maybe to your point on cash flow, strong cash flow generation, you indicated earlier, you want to continue to invest in your business organically. There's still a lot of opportunities here. So, how are you thinking about that CapEx over the next couple of years, particularly as you see the pipeline of projects and innovation.

Yes. It's an asset-light business. And so, it's not a business that has significant capital requirements or lumpy capital requirements. This year, we had intended to spend up to $60 million in CapEx, which is way more than we've ever spent before. We're not going to be able to spend that much, not because of a lack of willingness, but because of supply chain difficulties. And so, normalized CapEx should be less than 2% of sales. And I wouldn't expect it to exceed that next year, and I wouldn't expect it to exceed that going forward.

Okay. I don't know if there's any other questions from the audience. Otherwise, Ben, thank you so much for attending and appreciate all your comments and everything.

Yes, of course. Thank you for your time.

Thank you.