Element Solutions Inc (ESI) Earnings Call Transcript & Summary

I'm delighted to host Element Solutions for the next fireside chat. I have Ben Gliklich with me, who's been with Element Solutions since 2014, serving as CEO since 2019. Pleased to have you here with me.

Yes. Great to be here. Thanks for having us.

Awesome. Yes. So I guess my first question is, going into things, how would you characterize ESI's growth compared to kind of market growth, whether it be autos, smartphone shipments or MSIs in each of the subsegments? And what would you say is driving the difference between those 2?

Yes, sure. So we have a diversified company exposed to multiple different end markets. Our commitment is to outgrow those end markets on the way down because there is some cyclicality from a units perspective and also on the way up. We've done that in the past couple of years in what have been tricky end markets, particularly on the electronics side. And as things are improving, we expect to continue to see that in 2024 here.

Sure. Would you be able to provide any examples of some of the emerging technologies that you guys have called out contributing to market share growth in both electronics and industrial?

Sure. So every single one of our businesses, we have 6 businesses, has an opportunity to expand its participation in the fastest-growing deepest profit pools available to us. Some of that is by sort of customer touch and listening, identifying incremental innovation that will allow for us to solve a customer need. Some of it is by using our balance sheet and providing equipment financing to help our customers grow. And some of it is really with breakthrough materials. Great case study of that is Argomax, which is a product used in power electronics, where we brought to market really new material science that improves the reliability and the range, the thermal management, the thermal qualities, in power semiconductors. It's been a great product for us that's got a -- it's really a category killer in its field for power electronics. The other thing we've recently introduced or we're in the process of introducing is our acquisition of Kuprion, which has a product called ActiveCopper, which is also new material science enabling the leading edge in the IC substrate market in the die attach market. A lot of momentum there, a lot of customer excitement. But we're not limited -- this isn't a blockbuster product company. We're not limited to one product that's changing one specific niche. Again, in every single one of our markets, we have investment in new capabilities to support what our customers need.

Just going back to Kuprion and some of your recent transactions, wondering if you could just discuss the impact of both ViaForm and Kuprion and kind of any specific synergies you could elaborate on?

Sure. So in 2023, we deployed capital into these 2 very compelling inorganic opportunities. And they were both idiosyncratic-type transactions. This wasn't market consolidation or conventional market expansion. The ViaForm transaction was our -- terminating a distribution agreement with a long-time distributor partner of ours for this specific product, which is used in front-end semiconductor manufacturing. It's a business with a strong market share, a capability with strong market share, in an attractive growth market. And the arrangement wasn't ideal for any of our -- for any of us, frankly, right? We owned the R&D, we owned the manufacturing. Our partner owned the distribution last-mile logistics. Our customers weren't particularly happy with it because they couldn't see through and they had multiple counterparties to deal with. So we made a payment to Entegris to terminate that agreement. We now own that product line soup to nuts. We timed it well. So this agreement was signed in the middle of 2023, basically at the bottom from the semiconductor industry standpoint. And we've seen great traction at the customer side. Our customers are happy that we own all of this capability. We are seeing great engagement with regard to the new semiconductor fabs that are coming online. And we're actually getting some traction with customers looking at backwards integrating onto legacy nodes. So that is looking like a real win. The integration is largely complete. And so we're off and running. Kuprion is a different -- a very different situation. This was an emerging technology where some outstanding scientists developed a new application for nanocopper. Nanocopper has been something that many companies in the industry have been trying to develop and it's been very challenging. And we believe that the folks at Kuprion solved that. And we made a modest payment upfront for access to the technology to own that technology. And we structured the transaction with milestone payments based on achievement of customer qualifications and eventually revenue. It's a win-win for us and for the sellers. It was modestly venture-backed because we enable them to monetize that technology. We've got deep relationships with customers. We've got deep applications know-how. So we've done the things that need to be done to turn this science into revenue. The customer engagement with the material has been outstanding, up and down the supply chain. But it's not a meaningful revenue contributor in 2024. The applications work and the qualification cycles are long. But it should be contributing to earnings in 2025.

Understood. Just given some reports of a weaker consumer market in China by some of your competitors, just wondering if you could provide some color on a rough segment split for ESI's 18% China sales exposure and how would you characterize China's market growth as well as ESI's for both automotive and smartphones.

So China is a large market for us, both in the Industrial side and the Electronics side. It's much more weighted towards Electronics. And a lot of that Electronics is export-driven. So we had a tough year in China last year because the Chinese economy was slower and also because the electronics market was slower, and that had a big bearing on our sales into China for that export market. As we look at 2024, our expectation for the Industrial side of the business is to be roughly flat. We're not expecting a big rebound in the Chinese construction market, for example, but for that Electronics business to recover. And the reason we have some confidence in that is because it's an export-driven market, because the electronics market has been soft -- softer than anyone, frankly, expected in 2023, and we're seeing a rebound there, inventory channel clearance. And even the domestic Chinese smartphone market is showing signs of life. There was a lot of inventory build by domestic Chinese OEMs coming out of COVID and their lockdowns, which were later than those in the West. And that demand or that production wasn't absorbed by the market until the first half, second half of last year. So there's reasons for optimism in the overall electronics market, and that's bringing China along with it.

I see. So I guess just to clarify, would you say that, I guess, the spread between the low and the high end of your EBITDA guidance is largely Electronics driven based on the recovery in that -- it's kind of more expected that Industrial will remain flat?

So as we -- there are many levers, and one thing that's for sure is that expectations for our end markets, sitting here in February, won't be accurate when we're sitting here a year from now, just as they haven't been for the past several years. But a basic rough walk to our guide is, at the low end, the demand environment we're seeing here in the first half carries over into the second half. And so we just have normal seasonality and that accounts for an uplift in half-on-half earnings that's standard in the business when you look back over time. The high end assumes the acceleration that is expected, maybe a little bit less than the most bullish electronics market forecast. But the acceleration is expected half-on-half in 2024.

I see. So I guess, seasonally, 2H is generally stronger than 1H. But I know you guys also typically have a drop in 4Q relative to 3Q just driven by the electronics market. Wondering, with the 2H recovery, would it be possible to see 4Q be sequentially higher?

We've seen that happen in the past. That's not typical for several reasons. In the third quarter, you see the big restock for the new smartphone handset launches. And the fourth quarter doesn't necessarily have that dynamic. There are also fewer operating days in the fourth quarter. When you think about the holidays in the West, Thanksgiving and year-end, and so there are fewer days to sell. And that typically accounts for some of that drop down. You never say never. Seasonality has been a bit skewed over the past couple of years. But if this is a normal year, you should see a big uplift in Q3 and then a smaller -- a small drop down into Q4.

I guess, given what seems like a growing margin disparity between your higher-margin Electronics business and lower -- relatively lower margin Industrials and Solutions business, do you have any views on what might drive a longer-term margin outlook and at least where to expect this margin spread to move?

Yes. So in 2023, we held our EBITDA margin across the whole business despite an 8% volume decline across the company. And more of that decline coming from our higher-margin Electronics businesses, semiconductor and circuitry. On a metals-adjusted basis, which is the way to look at our EBITDA margin because the metals' price fluctuations do impact the percentage but don't impact profit dollars, we were around 24%. Our peak was in the high 20s. There's no reason we can't get back towards that peak as markets recover. We've still lost about 1 point to logistics inflation, raw materials prices, we're lapping high raw material prices in the first half of '24 that we saw in the first half of '23. Facility utilization is low or was low in 2023. So we've got a margin expansion opportunity across the whole portfolio, not just in 2024, but going forward. There is a divergent growth rate, so it's not just divergent margin, but divergent growth rate, in our Electronics business versus our Industrial & Specialty businesses. And so over time, barring further capital allocation, M&A in the Industrials business, our Electronics business will be a larger portion of our overall portfolio. And with that, we'll have a higher blended margin in our portfolio. So there's room for margin to expand, not just here, but for several years to come. And in light of expectations for the leading edge in electronics and as the leading edge becomes more mainstream, there's a window for an acceleration in growth in our Electronics business that will make those dynamics happen faster than maybe the base case.

I see. Would you say that, I guess, there's value then in the future to kind of keeping your Industrials business or any synergies that come with having both businesses?

We've got a great portfolio of businesses, and none of the businesses are noncore. We're clear about that. There are some businesses that you could consider less core because there isn't supply chain overlap or commercial overlap or offshore business or graphics business. We're not dealing with the same customers as in our Electronics businesses. They have discrete supply chains. We're not emotional about any of our businesses. But they're good businesses. They have growth opportunities as we open to this, right? Every one of our businesses has a profit pool, at least one profit pool where we're underpenetrated and where we can grow share and drive compelling profit growth. But we're not -- separating these businesses for the sake of separating them doesn't make sense to us. If someone wants to own one of our businesses and pay us what it's worth or more, we're not emotional about it.

Sure. Makes sense. Just wondering if you can kind of give me some insight into what the level of share buybacks you may expect in 2024 as well as a broader capital allocation plan?

So the 2 hallmarks of the business, one is the ability to preserve profit. We talked about EBITDA margin having been flat year-on-year despite this volume decline. And the second is strong and stable cash flow generation in all markets. And we proved that last year with 11% free cash flow growth despite a decline in EBITDA. We stretched the balance sheet a little bit in 2023 for the ViaForm transaction. We ended the year with under 3.5 turns of leverage, which is our targeted ceiling. We see a path through cash flow generation and earnings growth to be inside of 3 by the end of the year, barring further capital allocation. We are very opportunistic with regard to capital allocation. And so we don't know what the market will serve us up in 2024. We will have capacity to deploy capital, both financial capacity and, call it, operational capacity as our integrations are largely behind us. But again, it's hard to say today what will be most attractive over the next 9 months.

I see. Just moving over to raw material inflation. Just wondering if you could provide some color on where it was in 2023. And what are ESI's expectations, at least in 1H '24 on both metals and non-metals basis?

So we had raw material inflation coming through the P&L in the first half of 2023. It eased a bit in the back half of '23, and so we saw a margin tailwind there. We should continue to see that through the first half of 2024. Logistics inflation, as I mentioned, sort of ordinary course prior to COVID, we were spending a little less than 3% of sales on logistics. At peak, we were spending more than 4% of sales on logistics. Now we're around 4%. So there's a point there that's stuck, and we haven't recaptured that in price. We've recaptured a lot of the raw materials inflation in price, but not that point in logistics. With regard to metals' price, that's very much commodity driven. So when you think about our -- the way that we offset cost increases, there are 3 mechanisms across the business. There's negotiated price increases, which we do for niche raws that we're buying that aren't traded on a commodity market. There are certain commodities where we have a surcharge, when the price goes above a certain level, that surcharge comes into effect. And then there's pass-through metals where we are charging our customers what we pay. We saw those price increases that first bucket hold in 2023. That was a big question we were getting all through 2022 because we were talking about the price we were taking, would we be able to hold it? And indeed, as we had in prior years, in prior periods of inflation, we have been able to hold the price we took. Those surcharges fell away in the back half of 2023, which makes the volume growth or the volume performance actually better than it shows, because we were losing volume from -- or we were losing some value from these things like nickel, and that was being replaced by proprietary chemistry. And then the metals pass-throughs are really market driven. I don't have a metals forecast. So I can't tell you what the metals' price impact will be this year. But we won't lose profit dollars because of metal price fluctuation. That's the sort of intrinsic, inherent in the business.

Understood. I have a few questions just regarding your product mix in each segment. First of all, just within the Assembly segment, just wondering what your approximate exposure is to both power electronics versus consumer and kind of a broader outlook for both.

Sure. So the Assembly business is the most diversified within our Electronics portfolio. So the semi business is front end of line, back end of line semiconductor, and roughly aligned with where those chips go with a skew towards logic. Our circuit board business really skews towards high-end applications, think smartphones and infrastructure, a little bit of data center. And the Assembly business is much broader. And the reason the Assembly business outperformed the circuitry and semiconductor businesses last year is because it's got a big auto exposure in there, both power electronics and electronics that are in automobiles. And so that business was down modestly in the -- over the year where the overall market was down significantly. The power electronics business is a discrete business that sits in electronics, both in assembly and a little bit in semiconductor. And this is that Argomax product I was talking about. But also other derivations from nanosilver, where we're providing materials that are used in power semis and power inverters that have much better reliability characteristics than legacy materials, and also better thermal management. So there's less heat that's lost. That heat that's lost, or rather, retained, could be, and is, in this case, used to power the motor. So it actually delivers more range for high-performance electric vehicles. And that's a business that's been growing double digits for 5 years, and it's now a reasonably sizable piece of business. But I wouldn't think about the Assembly business as just power electronics and consumer. It's got a much broader exposure than that.

Sure. Then just more broadly, wondering if you could kind of assess your relative exposure to kind of 5G smartphones versus maybe not 5G smartphones, the more feature phones? And how do you anticipate any changes in this product mix going forward?

Try to stay off my soapbox about 5G and the rollout of 5G in the West. But our business in the circuit board -- our circuitry business skews towards high-end applications. So smartphones are high-end applications, feature phones less so. 5G has 10% to 15% more content than a legacy phone. 5G actually enabled phones are an increasing percentage of the overall phone base. The replacement cycle has been really extended. And so last year, we sold 1.1 billion, 1.2 billion phones around the world. Peak was 1.7, median is around 1.5. So that extended replacement cycle, channel inventory dynamics have really driven that smartphone market down, and we're way below trend. And so as we look at the outlook for 2024, expectations are for a 3% to 5% unit growth on the smartphone side, we're still going to be below trend at that point. There's an incremental upside as we think about 2024 as we're lapping that period of inventory destock. We can't really tell how much less than that 1.1, 1.2 our volumes represented and that's upside as we think about the year. But the smartphone market will be a driver of growth in the foreseeable future. It's not necessarily a long-term driver of growth because the penetration of smartphones within the global population is sort of there. The big next driver of growth and call it TAM expansion is driven by AI and industrial automation. And as we sit here today, clearly, those technologies are taking root and our ability to speak with confidence that that's the next big thing and will be meaningful for our company over the medium to long term is much higher.

I see. Then just moving to autos. Wondering if you kind of do the same assessment between EVs versus internal combustion engine vehicles? And what are you doing in terms of the contracts you're winning to kind of drive, I'd assume, more share towards that EVs?

Yes. So we have 1.5 to 2x the value in an electric vehicle versus a comparable internal combustion car. Some of that is coming from power electronics. Interestingly enough, you would have thought all of the plating that we do on nuts, bolts and fasteners would go away when you move from an internal combustion car to an electric vehicle. Turns out an electric vehicle has more fasteners than an internal combustion car. So our Industrial Solutions business has a value uplift opportunity in electric vehicles as well, plating with electroless nickel on battery cases, for example, is another application, not present in internal combustion cars. So across our business, we see a value uplift from electric vehicles. And we're seeing that through the P&L. We're outperforming units in our auto exposed categories. There's also a share opportunity. So our leading-edge technology for electric vehicles and power electronics is not equally distributed amongst all electric vehicles. We're really concentrated in higher performance electric vehicles and in certain OEMs. And so there's a market share opportunity as other OEMs embrace this technology as the Chinese electric vehicle market increases its performance standards, which will drive greater adoption of our technology and significant value uplift in the medium term. And we're seeing that. So we won pretty big commercial opportunities last year and into this year with new OEMs, I would say.

Happy to open up to the audience more broadly.

Anything in the pipeline, Ben, that you want to highlight that's in development, either maybe a new product or a new application, new equipment development, something that has you excited?

I'm really excited, Steve. Thank you for the question. Each of our businesses has an opportunity to increase its penetration and position in deep fast growing profit pools. We do that by staying close to customers and understanding their needs and solving them. As I look at -- we talked about Kuprion, ViaForm and Kuprion together are giving this company a halo effect at the leading edge of technology. We're investing at the leading edge. We're bringing to bear new capabilities. And that's increasing, let's call it, our number of [ at bats ], which is just great for the business. An example where we're not actually going out and buying something new is a tool we've introduced called the Reliance tool. And this is looking at our solutions for assembly materials, not just on the metal-based assembly materials, but also the polymer-based market where we're underpenetrated. And we've combined multiple different materials for chip attached. So there's the solder joint and then there's the polymer around it. Sort of think about it as a very high-end glue. And we've done loads of testing, many different types of scenarios and conditions, and we can go to a customer and say, if you use this material and this material, you get this performance and this is what it costs. And so we can provide data on performance across a broader set of capabilities, all of which we can provide that they can't generate on their own, and that's driving really great levels of engagement in the electronics assembly supply chain. Our Assembly business has a very good share position, but our polymers based electronics adhesives business doesn't. And it's going to -- that -- this tool is going to pull that business along with it. And again, that's a deep profit pool where we're underpenetrated, and we can provide additional value by understanding customer pain points and bringing to bear our set of solutions. Just one example, but one that's pretty interesting. And there's a long list of others if we had more time I'd talk about.

The other one I wanted to ask you about is you've always chartered your segment level and your business unit leaders, your regional leaders with strategic objectives, perhaps to drive share gains and cross-selling and so forth. Just curious whether that has been beneficial to you in the last year?

Absolutely. Absolutely. I mean we've implemented a very rigorous operating system that's sort of borne out of our vision for the company and our strategy process. And all we have in our -- it's a people-based business, right? It's asset-light. This is not about sweating our plants. It's not about factory utilization. The way we win is to get the 5,500 people here spending their calories on things that matter to the customer and to the business, rolling in the same direction. And so we are really diligent about having a rigorous process and system to ensure people are spending their time on the right things and rewarded for that. And you don't see that from one day to the next, but you see the benefit accruing at the customer level and in the P&L, frankly. And there are daily breakthroughs, daily wins that I would attribute to our processes.

Ben, is there anything else you would say that maybe the market isn't appreciating about ESI and ESI story?

Look, we've been working through a very interesting several years. And I believe that the company has demonstrated what the hallmarks of the business are and delivered on its commitments in that difficult time. And now we're flipping to what should be a better time. And I wholly expect our company to continue to deliver on those commitments, outgrowing our markets, generating strong cash flow, call it operational excellence. And then prudent capital allocation, taking those strong cash flows and investing them in smart ways behind our businesses to compound per share value.

Okay. Looks like we're pretty much out of time here. So just join me in thanking Ben.