Element Solutions Inc (NYSE:ESI) Q3 2023 Earnings Call Transcript

Element Solutions Inc (NYSE:ESI) Q3 2023 Earnings Call Transcript October 26, 2023

Operator: Good morning, ladies and gentlemen, and welcome to the Element Solutions Q3 2023 Financial Results Conference Call. At this time, all lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] As a reminder, today’s call is being recorded. I will now turn the call over to Varun Gokarn, Senior Director of Strategy and Finance. Please go ahead.

Varun Gokarn: Good morning and thank you for participating in our third quarter 2023 earnings conference call. Joining me are Executive Chairman, Sir Martin Franklin; CEO, Ben Gliklich; and CFO, Carey Dorman. In accordance with Regulation FD, we are webcasting this conference call. A replay will be made available in the Investors section of the company’s website shortly after completion of the call. During today’s call, we will make certain forward-looking statements that reflect our current views about the company’s future performance and financial results. These statements are based on assumptions and expectations of future events that are subject to risks and uncertainties. Please refer to our earnings release, supplemental slides and most recent SEC filings for a discussion of material risk factors that could cause actual results to differ from our expectations.

These materials can be found on the company’s website in the Investors section under News & Events. Today’s materials also include financial information that has not been prepared in accordance with US GAAP. Please refer to the earnings release and supplemental slides for definitions and reconciliations of these non-GAAP measures to comparable GAAP financial measures. It is now my pleasure to introduce Element Solutions CEO, Ben Gliklich.

Ben Gliklich: Thank you, Varun, and good morning everybody. Thank you for joining. Element Solutions had a solid quarter as our Electronics end markets began to recover from their second quarter trough and easing raw material prices drove favorable margins. We continue to deliver against important strategic initiatives and generated strong free cash flow. The overall macro environment remains a challenge, declining economic activity in Central Europe, a slow post COVID recovery in China and the ongoing UAW strike are headwinds compounded by the once again strengthening dollar. On the other hand, the green shoots in the Electronics market are growing taller and we have reason for optimism as we prepare for 2024. Another source of that optimism is margins.

Gross margins improved nearly 500 basis points year-over-year on a constant currency basis despite lower volumes as we benefit from declining raw material inputs and logistics costs and continued synergy actions. These cost trends are encouraging setting us up nicely as demand rebounds. On our last call we talked about uncertainty around Q3 versus Q4 timing given the ongoing recovery in the Electronics market and what that might mean for phasing of earnings. The third quarter proved to be better than planned and we now expect to see a more normal seasonal pattern in the fourth quarter. This means a sequential slowdown in Electronics but we do not view this as end market softness just ordinary course to seasonality. Demand in our industrial portfolio is impacted by the macroeconomic factors mentioned earlier but improvement in both cost of goods and OpEx are offsetting that impact.

In the third quarter we recorded an impairment charge on our Graphic Solutions business. We’ve had a few years of challenging markets driven by CPG packaging trends, SKU rationalization and stubborn raw material inflation. We do not believe our demand experience in this business diverges from the competition and we have several work streams underway to improve its profitability in the years to come. This impairment is the primary driver of the difference between reported and adjusted EPS this quarter. We’re very pleased with our progress on the transactions we announced in June to enhance and grow our high-end Electronics portfolio. The ViaForm distribution rights we reacquired are already driving deeper commercial engagement and unlocking new sizable pipeline opportunities with the largest semiconductor manufacturers in the world.

We’re on track to complete the integration of customer service, quality support and inventory management for ViaForm later this quarter. We believe this front end of line offering is well positioned for growth beyond our initial expectations and have traction on both leading and legacy nodes. These products complement our back end of line advanced packaging solutions that enable the increasing complexity in triplet design, which should drive the next leg of computing performance improvement for data center, AI, IoT devices and industrial automation. We’re confident our semiconductor business is poised to deliver significantly above market growth even as the market rebounds in 2024. The customer response to the nano copper technology we acquired with Kuprion has been outstanding.

Many large electronic components and semiconductor manufacturers are eagerly working with us on applications development. The team is busy driving commercialization of the technology and progress on product qualification. We’re ahead of our expectations from the onset of this transaction and the business may begin to contribute to profits as early as the second half of 2024 and should drive growth in 2025. Taken together, our Electronics businesses will bring an increasingly differentiated set of solutions to market in 2024 with a powerful and unique breadth of enabling technologies for a global semiconductor industry that is rebounding from a deep cyclical trough is experiencing robust support and investment and has been reinvigorated by the promise of generative artificial intelligence.

Looking through any near-term noise, the next few years promised profound opportunities for Element Solutions. Carey will now take you through third quarter business results in more detail. Carey?

Carey Dorman: Thanks, Ben. Good morning, everyone. On slide four, you can see a summary of our third quarter financial results. Net sales declined 3% on an organic basis, primarily reflecting continued year-over-year Electronics softness throughout Asia, where most of the business resides. Reduced commodity costs and stable pricing drove significant gross margin improvement, leading to constant currency adjusted EBITDA growth of 2%. Excluding the impact of a sizable bonus accrual reduction in Q3 2022, adjusted EBITDA growth would have been 8%. Relative to the second quarter, our reported revenue improved 2%, while adjusted EBITDA improved 16%. Though there were pockets of improvement in the Electronics segment compared to the particularly weak end market in the first half.

Overall consumer electronics demand in Asia was still weak relative to the prior year. This drove a 5% year-on-year decline in organic sales. Our Industrial and Specialty business declined 1% organically, a soft Industrial demand in Asia and Europe offset double-digit growth in our offshore energy business. In constant currency terms, adjusted EBITDA margin improved 110 basis points year-over-year or over 250 basis points sequentially. Electronics segment adjusted EBITDA margin benefited from lower pass-through metal costs and mix within our circuitry business, driven by sales from the higher-margin smartphone supply chain. Industrial segment margin improved 70 basis points in constant currency, due to positive mix from Energy Solutions, as well as ongoing synergy realization, pricing benefits and input cost deflation.

Excluding the impact of the $94 million of pass-through metal sales in our Assembly Solutions business, our adjusted EBITDA margin would have been 27% in the third quarter. Adjusted EPS was flat year-over-year with the graphics impairment Ben mentioned, the primary driver of the year-over-year difference in the GAAP figures. On slide five, we share additional detail on organic net sales. Our Electronics segment results were driven primarily by mobile phone and consumer electronics markets in Asia. Consistent with the first half of the year, our automotive electronics business remained resilient, particularly for power electronics applications and electric vehicles. Assembly Solutions sales were flat organically, as new business growth and traction with new higher reliability alloys for use in automotive end markets was offset by soft consumer Electronics.

Semiconductor Solutions declined 6% organically, better than recent trends for semi MSI. Circuitry Solutions declined 12% organically, as China consumer electronics activity remains subdued and some commodity-related surcharges rolled off. The overall PCB market is improving sequentially, but remained soft in comparison to prior year activity levels. We believe our third quarter performance outpaced the broader PCB market and are heartened by supply chain commentary of much improved inventory levels. Our business with memory disk customers was notably weak and drove a significant portion of the organic sales decline. For the third quarter, organic net sales in Industrial & Specialty declined 1% year-over-year. Industrial Solutions declined 2% organically as demand in global construction and industrial markets remain soft and commodity-related surcharge revenue for palladium fell versus Q3 of last year.

Energy Solutions remains a bright spot with sales again growing 11% organically in the quarter despite difficult comps from Q3 of 2022. Production and drilling activity have sustained their rebound and price actions continued to benefit sales. We expect continued growth from this business throughout the year and into 2024. Slide six addresses cash flow and the balance sheet. We generated $75 million of free cash flow in the third quarter. Working capital was relatively flat sequentially, reflecting increased sales that were offset by modest inventory improvements. Net CapEx year-to-date was $35 million and we expect our fourth quarter investment to be approximately $20 million, a certain growth projects and integration initiatives progress.

We now expect to spend approximately $55 million on a full year basis. Turning to the balance sheet. Our net leverage ratio at the end of the quarter would have been 3.6 times with the estimated full year benefit of the ViaForm product line, for which we reacquired distribution rights in June. We continue to expect to be below our targeted ceiling of 3.5 times by year-end. As a reminder, the swap maturities on our term loans are split over the next three years and our capital structure is 100% fixed until 2024 and more than 80% fixed until 2025. We have no debt maturities until 2026 and our liquidity position remains strong. And with that, I will turn it back to Ben.

Ben Gliklich: Thank you, Carey. We’re pleased our results have inflected positively here in the second half. We’ve seen what we considered the trough and are beginning to recover from it. We didn’t know what to expect in terms of the slope of the recovery and the sequential seasonal slowdown we expect in Electronics in Q4 suggests that while we will not see a sharp immediate recovery, we will continue to improve from the cyclical trough. Against our last guidance, we’ve seen an incremental $5 million of FX headwind to adjusted EBITDA due to the strengthening dollar. Slightly less than half of that headwind was in the third quarter. That together with timing of sales associated with our ViaForm transition, lead to a modest reduction in our full year adjusted EBITDA guidance of approximately $485 million.

The ViaForm impact is timing related to idiosyncratic customer ordering and inventory management around the transition. Given this timing impact we now expect a greater contribution from this transaction in 2024 on a year-over-year basis. Gross margins for the company are back over 40% and cash flow conversion remains very strong. Even with the second half recovery we’re seeing in Electronics, semiconductor production and high-end electronics markets remain far below their long-term averages. Overall, we’ve seen soft volumes across nearly all of our businesses for over a year. This is not a reflection of share but of inventory destocking and economic malaise. The current situation suggests substantial room for margin accretive growth in the years to come.

However, we’re not waiting idly by for that broader recovery. We’ve identified an action $10 million of cost savings to impact next year and we’ve invested and gained real traction in the technologies and market niches that we expect will propel market growth; event packaging, new semiconductor node transitions, expanding vehicle electrification programs, and thermal management. We believe it’s reasonable to expect the business to deliver adjusted EBITDA growth north of 10% in 2024 and to continue to grow from there. As you can tell we’re enthusiastic about the future and have evidence that the growth we’ve come to expect from our business is returning. Our team is doing a terrific job navigating the complicated macro environment and continuing to deliver reliable high-quality solutions for our customers’ existing and newly emerging needs.

I’m very grateful for their energy and effort this quarter and going forward. With that operator please open the line for questions.

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Q&A Session

Operator: [Operator Instructions] Your first question is from the line of Bhavesh Lodaya with BMO Capital Markets.

Bhavesh Lodaya: Thanks for taking my question. So, in the third quarter, we saw a nice margin expansion across both your segments. There appears to be a case of you holding on to price as your input cost or logistics some of those have moved lower. So can you help us provide more color on what’s driving the success there? And how should we think about your EBITDA margins as you see volume growth come back in next year?

Ben Gliklich: Thanks for the question Bhavesh. A few things contributed to the margin expansion price relative to cost was a big one. We’ve always said that this is a business that has sticky pricing actions and that’s been made manifest in the quarter. We have not seen real price asks as our raw material prices have come down, which is what we would have expected. Another large contributor is just mix. So, last year at this time with high metal prices a decent portion of sales were coming from surcharges which are much lower margin than we’ll call it proprietary chemistry sales. And so those surcharge sales of metals have fallen away as metal prices have come down have been replaced by higher-value sales of proprietary chemistry.

So, that explains a chunk of the margin expansion that we experienced in the third quarter. As we look forward volumes are still low. Year-over-year volumes are down. And as we see volume growth we should get greater facility utilization and see incremental margin expansion. Our metal adjusted EBITDA margin in the quarter was 27%. It peaked at 30% in 2021. We see room for margin expansion from here.

Bhavesh Lodaya: Got it. And as a follow-up. So, I believe you mentioned EBITDA growth of 10% for 2024 it is possible next year 2024. Given what we saw in the third quarter and your implied guide for the fourth quarter would you say analyzing in the second half of this year is a good baseline for the business? Or are there some other puts and takes maybe around ViaForm?

Ben Gliklich: Yes. So, the simple rule of thumb, right? It’s early to give guidance. It’s a short-cycle business visibility especially into the second half of 2024 is limited. But historically we’ve said that the second half of the calendar year is a pretty good indicator for the first half of the subsequent calendar year. And that remains to be the case. The timing of the second half ramp is unpredictable as we saw this year. So, starting with annualizing the back half seems reasonable. We do get a contribution from ViaForm which is an incremental $10 million going into next year. There’s a little bit of an FX headwind. We’ve talked about some cost actions we’ve taken and those are the puts and takes as we start plotting 2024. But there’s a case to be made for 10%-plus EBITDA growth as we said in our prepared remarks.

Operator: Your next question is from the line of Jon Tanwanteng with CJS Securities.

Jon Tanwanteng: Hi, thank you for taking my question. First what’s driving the ViaForm Entegris inventory dynamic and the reduction this year? And how does that set up your positioning going into next year with pricing and service levels and just the demand recovery that you probably could expect to see in semiconductors?

Ben Gliklich: Yes. So, we reacquired the distribution rights for this product line and we reacquired them from Entegris and they were holding our inventory. We took the decision to stop selling during this transition period. It just simplified logistics. And so those sales basically stopped for several months and that’s not lost sales. It’s just delayed sales. The customers expect us to hold a certain level of inventory and we will and we are in the process of rebuilding that inventory, now that we’re in that transit now that we own it, we’re just not realizing the value for it in this calendar year. So that’s really what’s driving it. It’s a decision we took and it’s deferred revenue. It has no bearing on our expectations for this business frankly our expectations for the business for the product line are higher today than they were when we announced this transaction.