Element Solutions Inc
Q2 2021 Earnings Call Transcript

Published: 31 Jul 2021

[Operator:]

Good morning, ladies and gentlemen, and welcome to the Element Solutions Q2 2021 Financial Results Conference Call. At this time all participants are in a listen-only mode. 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 second quarter 2021 earnings conference call. Joining me are Executive Chairman Sir Martin Franklin; CEO, Ben Gliklich; and CFO, Carey Dorman. In accordance with Regulation FD or Fair Disclosure, we are webcasting this conference call. Any redistribution, retransmission or rebroadcast of this call in any form without the expressed written consent of Element Solutions is strictly prohibited.

[Ben Gliklich:]

Thank you, Varun, and good morning, everyone. Thank you for joining. Element Solutions had an outstanding second quarter. We’re executing well against our strategy to capitalize on growth trends in our businesses, drive efficiency and deploy strong free cash flows prudently to compound earnings growth. The momentum in our markets remain strong. And the contrast between the second quarter of 2020 and the same period in 2021 is stark. Our sales grew 52% year-over-year, lapping the most COVID-impacted quarter of 2020, while adjusted earnings per share doubled. Despite supply chain-related constraint, the Electronics industry and the broader industrial economy continued to accelerate in the second quarter. Our core markets continue to see the benefits of the expanding secular megatrends of increasing electronics and automotive applications, rising adoption of electric vehicles and increasing content in 5G-enabled mobile devices. Our team continues to demonstrate its ability to position our business well within these attractive growth markets and to capture value above and beyond market growth. As expected, the increase in economic activity in the first half of 2021 stretched supply chains and created challenges that continued in the second quarter around raw material pricing, raw material scarcity and logistics. The team did an outstanding job of navigating the effect of these factors, which combined with negative mix impacts, weighed on gross profit margins relative to the first quarter. Many raw materials have seen meaningful price increases. Inclusive of metals, we saw our raw material cost basket increased almost 10% sequentially. Freight costs increased materially and lead times significantly. Demand for logistics is far outweighing supply across nearly all transportation modes and regions as the global economy recovers. We expect this imbalance to continue into 2022.

[Carey Dorman:]

Thanks, Ben. Good morning, everyone. On Slide 4, we share additional detail on the drivers of organic net sales growth in our two segments. Organic growth for electronics was 25% in the second quarter, with all three verticals, again growing at double-digit rates. Global consumer and automotive electronics market sustained their high levels of demand in the quarter, and we lapped the worst of the COVID-19-related production shutdowns in Q2, 2020. Strong demand from automotive and power electronics market drove 37% organic growth in Assembly Solutions in the second quarter, which was the most impacted in the same period last year from the temporary declines in automotive electronics demand. Our Circuitry Solutions vertical grew 13% organically, driven by strong demand in China and the Americas for both mobile and automotive electronics. Semi Solutions grew organically 18%, experiencing similar end market demand drivers for our wafer plating and advanced assembly products. Net sales in Industrial & Specialty increased 41% on an organic basis. Industrial Solutions grew 61% organically, lapping the most COVID-19-impacted quarter of 2020. On a sequential basis, our Industrial business saw demand hold up well from a strong first quarter, with strength in European construction and industrial manufacturing, offsetting softer automotive production from the back up chip shortages and other supply chain challenges. Graphic Solutions had a strong quarter. We’re turning to organic growth of a 11% year-over-year as the business on uptick in packaging sector demand in the Americas and Europe. Sequentially, the Graphics business improved sales 15%, which is greater than we would expect from typical seasonality. Energy Solutions grew net sales sequentially and was flat year-on-year as the business continues to be impacted by slow deepwater drilling activity. Across our businesses, we experienced raw material inflation in the second quarter from metals and other inputs. Metals prices increased significantly. In many cases, these are contractually passed on to customers, although they impact margins as net sales grow with no contribution to profit. This impacted gross margins by more than 200 basis points in the quarter year-on-year. Other input price inflation in the quarter was significant, but at a smaller dollar impact. We worked to offset price increases by passing them on to customers. Although there is typically a lag effect. Gross margins were impacted on a sequential basis due to this dynamic. While we expect pricing actions in the second half to help moderate this inflation, certain costs continue to rise, particularly in logistics, which means we expect to continue catching up for the next several months, at least. Overall, adjusted EBITDA margins still improved year-over-year in the second quarter.

[Ben Gliklich:]

Thank you, Carey. Slide 6 provides more detail on Coventya. This is an excellent business that aligns seamlessly with our acquisition criteria and a company that we’ve admired for decades. The business has projected revenues of roughly $190 million for its fiscal year ending September. Brings a global scale and capabilities with over 650 employees, 13 manufacturing facilities and eight R&D sites around the world, Coventya represents a meaningful expansion of our Industrial Solutions business. More than 75% of their sales align with current solutions in our Industrial business and their strength in protective and anti-corrosion technology is a nice complement to our leadership in decorative applications, particularly in key growth markets in Asia.

[Operator:]

We’ll take our first question today from Bob Koort with Goldman Sachs. Your line is open.

[Bob Koort:]

Thank you very much. Good morning. Ben and Carey, I wonder if you could talk a little bit about the step-up in cash flow for the second half. Does that presume that you’re able to draw down working capital and that some of the logistics cost ever, how do you get such a nice lift in the second half on cash flow?

[Ben Gliklich:]

Yes. I appreciate the question. So we’ve been investing significantly in working capital over the first half of the year. Some of that is driven by raw material scarcity, some of that is longer lead times. And we’ve seen sales grow significantly as well. As we look out to the back half of the year, that sales growth, that significant sales growth begins to abate. And so we should have stable working capital and even a release over the back half as opposed to the sizable investment we made in the first half, which accounts for the step-up in cash flow to get to the cash flow guidance we’re giving this year.

[Bob Koort:]

And Ben, I don’t know if you can give us help on Coventya, but I was just curious, they have more of an auto focus and maybe a little bit less Asian presence than maybe in your Electronics business. Is there an opportunity to leverage the Electronics side of the house to bring in those industrial sales? And/or do you do that already in the ESI industrial assets? Do we expect to see faster growth in Asia there? And then secondly, do they pass-through their zinc and other metal costs? Or is that something that has to be negotiated?

[Ben Gliklich:]

Yes. So across all of Element right now, there is a convergence in the automotive OEMs, where automotive OEMs are becoming increasingly large customers of the electronics business where their supply chains are and we’re trying to take advantage of the breadth of our touch points. The significant value we sell into that broader supply chain across all of our verticals and bringing Coventya into the fold should be helpful to Coventya sales and also to Element’s overall relationships with OEMs because we are going to have a bigger seat at the table. With regard to the question around Asia, that’s less of an opportunity around Electronics, but more an opportunity around having more scale in the market and having more complementary products in the market and driving growth across both of our portfolios. The Coventya presence in Asia and anti-corrosion is very strong relative to our presence in Asia, which is more on the decorative side. So by combining those two, we have a better offering to customers, which should translate into more opportunities for growth going forward. Finally, with regard to metal pass-through, the dynamic around metal pass-through in our company is more on the assembly materials side around things like tin and silver and less in our surface treatment businesses, whether that’s Electronics or Industrial. However, we do have surcharges and the ability to take price when our price has gone up, which is something we’ve been actively pursuing. And Coventya has been over the past couple of quarters.

[Bob Koort:]

Great. Thanks for the help.

[Ben Gliklich:]

Thanks, Bob.

[Operator:]

Our next question comes from Josh Spector with UBS. Your line is open.

[Josh Spector:]

Yes. Hey, guys. Thanks for taking my question. So I guess, first, if you indicate strong demand into third quarter, can I interpret that as sales ex metals sequentially as relatively stable in both segments? And if that is a fair assumption? Can you walk through the drivers of the sequential EBITDA decline? And specifically trying to consider how much of that might be temporary that you guys recover in time? Thanks.

[Ben Gliklich:]

Yes, I appreciate that question, Josh. Yes, I think that the good baseline is for a stable top line from the second quarter into the third quarter. And so you’re right to point out that there is a bit of margin pressure as we roll from the second quarter to the third quarter. And there are a couple of drivers of that. The first is logistics cost increases. And so we’ve seen significant rise in logistics cost on a percentage basis over the past couple of quarters, and we don’t see that abating. That’s a couple of million dollars of headwind in the third quarter. The second is OpEx as we begin to travel a bit more normally. So we’ve had to add some heads to support what is a significantly larger business today than it was entering the year. That’s offset by the pricing action that we’ve taken over the first half of the year and more in the second quarter. And so that’s how you get to a modest decline on the EBITDA line on flat sales. What’s transient or temporary in that framework, I’m not sure we’re ready to say that this is a permanent environment from a logistics cost perspective and these are record levels. And so I’m not sure how to extrapolate that for many years. And so we should have a bit of a tailwind from that over time. And similarly, raw material pricing actions is something – or pricing actions to offset raw material pricing increases, that’s something we continue to pursue and should be contributing to profitability in the quarters to come.

[Josh Spector:]

Okay. Thanks. And just a follow-up on the full year guidance update. So last quarter, you were at $500 million to $510 million, so a $10 million range. Now you’re at a $15 million range, and I understand I’m nitpicking here, but with only two quarters left to go and good visibility on 3Q. Just curious what creates the additional uncertainty here? And what perhaps are the bigger risks that you’re seeing that you’re accounting for?

[Ben Gliklich:]

Yes. It is a nitpicking question. So the increased variability is driven by a couple of factors. The first is the increase in logistics costs and whether that’s persisting or whether that abates, that gives us upside or a little bit of potential downside. The second is understanding the magnitude of the slowdown in the fourth quarter. Obviously, last year was an anomalous year. And we saw an acceleration into the fourth quarter, whereas in many prior years, you see the fourth quarter being down 10-ish percent relative to the third quarter. We’re expecting, as you heard in our prepared remarks, that there is a slowdown in the fourth quarter, just fewer selling days with the holidays and also product launches drive the volumes higher in the third quarter than the fourth quarter. But we’re not exactly sure what that order of magnitude is, hence, a slightly wider range and a bit more variability in fourth quarter expectations.

[Josh Spector:]

Okay. Thank you.

[Operator:]

We’ll go now to Steve Byrne with Bank of America. Your line is open.

[Steve Byrne:]

Yes. Good morning. So, Ben, you were talking about the sequential decline in gross margins, and you provide some specific numbers around inflation in metallic raws. And a real quick rough math here, if we back out that inflation in metallic raws, it looks like your gross margin was really kind of flattish, maybe even slightly up sequentially. I don’t know if the rough math is right or not, but that’s relatively resilient. And yet you said your non-metallic raws were up 10% sequentially. So is there something you were doing to offset it? Or is this a mix shift that helped to offset that? Any comments on that would be helpful.

[Ben Gliklich:]

Yes, I appreciate that question. And let me make a couple of comments around margins. So sequentially, margins were down, and about half of that is attributable to metal price inflation on pass-through metals really aren’t – that don’t impact – aren’t a reflection of underlying profitability of the products we’re selling because we’re passing through metal at cost. And about half of the sequential margin decline was driven by raw material price inflation and logistics cost inflation. We’ve taken significant pricing actions in the second quarter which will offset the raw material price inflation that we’ve seen. And so we’re really dealing with just logistics cost inflation as we look into the back half. As we reflect, and if you recall the conversations we’re having last year at this point, there was a significant concern about margin trajectory on the back of the crisis level cost containment, cost reductions we took in 2020 and particularly in the second quarter and what would happen with the snapback in that cost to profitability. And this was in advance of any concept of the raw material and logistics inflation that we’re seeing, which is an additional headwind as we think about year-on-year margins. And yet despite those dynamics and those significant headwinds, both on the OpEx line and on the raw materials line, on a year-over-year basis, our margins expanded in the quarter. The other way we’re looking at things is if you were to exclude the impact of metal on sales, what was the incremental EBITDA margin on a year-over-year basis? And on a year-over-year basis, incremental margins – EBITDA margins were in the 30s, which is where we would expect them to be if you exclude the impact of metal. So indeed, as you pointed out, Steve, the margin resilience in light of an inflationary cost environment is something we’re quite proud of and a testament to the quality of the business. And the price actions we’ve taken and other execution we delivered is responsible for that.

[Steve Byrne:]

And just wanted to ask a little bit about what you’re seeing in your electronics businesses, are you – which of those three buckets are you seeing the most capacity expansions at your customer? And any comment on win-loss ratio of those capacity expansions with respect to whether you’re getting the contract to supply that, that incremental chemical supply for the expansions?

[Ben Gliklich:]

Yes. So I think it’s well understood that semiconductor industry is running at full capacity right now and making substantial investments to grow capacity. And we’re a beneficiary of that, as you can see in our semiconductor segment results. But the chips that are going to be made – the additional chips that are going to be made as capacity comes online need to find circuit boards to go onto and need to be assembled into electronics hardware. And so that whole supply chain is seeing growth and first, high utilization; and second, significant investment in additional capacity. And we’re engaged at the high end of the technology curve with the largest market leaders in PCB fabs and also in electronics assembly companies to help support that capacity expansion at a time when smaller competitors are struggling to get raw materials. And so we do consider ourselves very well positioned to grow in excess of the market through share gain and are converting sales opportunities at a very high clip on an ongoing basis.

[Steve Byrne:]

Thank you.

[Operator:]

Our next question comes from Jon Tanwanteng with CJS Securities. Please go ahead.

[Pete Lucas:]

Hi, good morning. It’s Pete Lucas for Jon. You guys have covered a lot, so I’ll just keep it brief. Can you dive a little bit more into your implied expectations for Q4 as it relates to what you’re seeing in terms of the customer inventories? Seem to be low across a number of industries and just are you basing your assumptions that they catch up in Q3? Or do you think people are well-stocked already?

[Ben Gliklich:]

Thanks for the question, Pete. So our guidance for the fourth quarter implies a slowdown, order of magnitude, 10%, which is what we’ve seen – on a sequential basis, which is what we’ve seen in 2018 and 2019 and the years prior, driven by fewer selling days and the fact that in Q3 there’s typically a pickup. So what we’ve seen in the first half has been such buoyant demand that we’re not underwriting to that same level of pickup. There’s a bit of conservatism based into that. We’re not expecting a substantial recovery in the automotive industry, for example, which has been – which has seen muted growth driven by chip shortages. So we’re assuming normal seasonality and a continued tight environment around raw materials and logistics to get to that slowdown.

[Pete Lucas:]

Great. Thanks. And then just last one for me and a bigger-picture type question. Any update on the M&A pipeline beyond Coventya and if the capital structure is optimized currently for further acquisitions?

[Ben Gliklich:]

Yes, absolutely. So we’re always looking to bring great businesses into the fold that bring additional capabilities, technologies, customer reach to our universe of customers and to compound value and earnings for our shareholders. The balance sheet is very healthy right now. And even pro forma, taking into consideration the Coventya acquisition, we should be nicely inside of three times levered at the end of the year. So we have some capacity from a balance sheet standpoint to deploy additional capital. We would do so in a very measured way should we find something or be in a position to execute something between now and the end of the year, more like the tuck-ins that we’ve done prior to the Coventya acquisition in terms of size and structure.

[Pete Lucas:]

Very helpful. Thank you.

[Operator:]

We’ll take our next question from Josh Silverstein with Wolfe Research. Please go ahead.

[Josh Silverstein:]

Thanks. Good morning, guys. I know it was asked a little bit beforehand, just on some of the working capital items. Were you suggesting that within the back half of the year that you’re only going to get $20 million back of the roughly $60 million or $70 million of working capital that you built up? I just wanted to clarify that.

[Carey Dorman:]

Yes. Josh, its Carey...

[Ben Gliklich:]

Carey, you want to take that?

[Carey Dorman:]

Yes. So that is what is implied by our $285 million when you compare that to our updated EBITDA guidance. The business overall has grown significantly versus 2020 and so you would expect some amount of working capital investment. But yes, we’re expecting a moderation in a release that will probably come from inventory in the second half.

[Josh Silverstein:]

Got it. Okay. Just to add on that. If I’m thinking about looking at what potential free cash flow for next year could be, should I kind of think, at least at a minimum, it would be, let’s just say, the $285 million plus maybe the remaining working capital, let’s just call it, $50 million plus the Coventya acquisition on top of that to kind of get you over the 350 mark, potentially the 375 as kind of a base starting point? Or am I not thinking about that correctly?

[Ben Gliklich:]

I think it’s early for us to comment on 2022. And the biggest driver, obviously, other than Coventya contribution of free cash flow in any given year for us is going to be sales growth. So commenting specifically would take a view on sales growth. But I think in an environment where our business grows in line with our long-term expectations of 3% to 4%, or yes, hopefully, higher than that, the working capital investment should be more modest than it would be this year.

[Josh Silverstein:]

Okay. Yes. I mean, I wasn’t assuming any sort of growth in that, so that’s the minimum I was suggesting. And then the other thing you had mentioned on customer visibility or whatnot. It seemed like in the first quarter, you had some limited visibility. Now you’re talking about strong demand or at least have some greater visibility for the back half of this year. Where are you guys being more cautious in terms of your visibility? Is it on the auto side? Or is there something else you’re just being cautious on?

[Ben Gliklich:]

Yes. So I think we’ve always been clear that we have visibility into the production lines where our chemistries are being used but the key driver of revenue is the flow-through or the utilization of those production lines at our customer sites, and that’s hard for us to see. Where we get confidence as we look out at the back half of the year is based on general industry commentary and the trends that we’ve seen over the past couple of months and the order patterns that we’ve seen going forward. And so that’s how we get a level of confidence around the second half guidance. With regard to the fourth quarter, we’re relying on typical seasonality. That’s what we keep referring to. In a typical fourth quarter, things slow down materially in November and further in December as we get to a holiday season. And that accounts for the decline that we would see in a normal year. We’re counting on that this year. Obviously, if those slowdowns don’t happen, there’s upside. The other pocket of upside would be in the automotive industry, as we talked about, where chip shortages have been slowing growth within the automotive sector of our industrial surface treatment business. That’s been more than offset by very strong demand in industrial equipment and machinery and building products and other applications for our industrial surface treatment technologies. If auto were to pick up, we’d see significant upside relative to the guidance we’ve given for the fourth quarter.

[Josh Silverstein:]

Awesome. Thanks, guys.

[Operator:]

Our next question comes from Chris Shaw with Monness, Crespi. Your line is open.

[Chris Shaw:]

Yes. Good morning, everyone. I thought I jumped out of queue because Pete asked the question, but I actually have another one. On the Coventya acquisition, I was curious, is it more complementary than – I just – I guess I was trying to figure out maybe what the sort of status of the concentration in industrial surface treatment is in the sector itself. I mean, does this make you a major, major player? Or are you still sort of minor, less than 10% of the market kind of player? I’m not sure how concentrated that industry is.

[Ben Gliklich:]

Sure, Chris. So it really depends on how you define this market. We’ve always said we’re market leaders in the niche markets in which we participate. And where Coventya gives us additional strength is in decorative coating and anti-corrosion coatings. So think about that as rust resistance and other protective coatings put on plastic and metal and then decorative coatings that make plastic look like metal, for example, which have been hallmark markets and technologies that Element and its legacy companies have participated in. And the majority of what Coventya sells, about 75% overlaps quite nicely in that market. And so we are going from market leadership to market leadership in that end market but – or in those specific niche markets. But as we’ve said, this is a growth acquisition and it opens additional interesting adjacent markets for us, whether that’s from a geographical perspective, we were talking earlier in the Q&A about increased scale in Asia, which is an attractive market for us, where we’re underrepresented relative to our global market share, and also in light metal surface treatment. So it’s a market we haven’t been able to crack into. This is anodizing aluminum, which is increasingly important in electric vehicles for helping them become more lightweight. Coventya has a nice position in that market with great technology, and we can leverage our broader seat within automotive supply chains and at the OEM table to drive that business and drive growth. So this is both helping improve our market positions in some existing markets and opening doors in other very exciting markets for Element Solutions.

[Chris Shaw:]

I guess, and to that end, you wouldn’t anticipate any difficulty getting approval for the deal?

[Ben Gliklich:]

We communicated that we’re on track to close this transaction on the first of September at this point, which reflects a level of confidence in getting it closed in a relatively short period of time.

[Chris Shaw:]

Got it. Very helpful. Thanks.

[Operator:]

And we will take a follow-up from Josh Spector with UBS. Your line is open.

[Josh Spector:]

Hey, guys. I was actually going to ask about the aluminum in Coventya and you kind of just went to that. So I’ll leave it there. Thanks.

[Ben Gliklich:]

Thanks, Josh.

[Operator:]

We have no further questions in queue at this time. I would like to hand the call back over to Ben Gliklich for closing remarks.

[Ben Gliklich:]

Great. Thank you so much, Catherine, and thanks to everybody again for joining this morning. We look forward to seeing many of you in the weeks and months to come, and stay safe. Take care.

[Operator:]

This does conclude today’s program. Thank you for your participation. You may disconnect at any time.