Description

Element Solution “ESI” is a specialty chemical company, providing consumable solutions to the electronics, automotive, industrial and energy markets. Many of ESI’s end market are sustainably growing well above GDP levels, driving high-single digit organic growth, high-single/low double digit EBITDA growth and even higher free cash flow growth.  

With a reasonably levered balance sheet, strong capital allocation and significant insider “skin in the game” we believe ESI has a great recipe for creating shareholder value. By mid-next year we estimate ESI shares could trade above $25/share or close to 40% above the current share price driven by above consensus earnings growth and multiple expansion.

Before discussing the ESI business model, it is worth highlighting its history. ESI was founded as Platform Acquisition Corp (“PAH”), a SPAC created in 2013 by Martin Franklin and Nicolas Berggruen. Its first acquisition was MacDermid Incorporated, run by Dan Leever who then became the CEO of PAH. PAH continued its rollup of specialty and agricultural chemical businesses. Within a few years it became clear this strategy was not working and in early 2019, PAH sold its ag businesses and rebranded as ESI. We have found that some investors are focused on ESI’s past and not its current and future business. 

Business Description: 

The company operates two segments: Electronics and Industrial & Specialty.  

The electronics segment was 63% of total sales and had 23.7% Adjusted EBITDA margins. Adjusted EBITDA margins have improved significantly from 20.8% in 2017 and believe there is room for further expansion. This segment has three divisions: 

1.      Assembly solutions (40% of the segments 2020 net sales). End markets include consumer electronics, automotive, telecommunications, memory chips, medical, aerospace, among other markets. 40% of COGS are metal based and fluctuate in price but are passed through to end customers. The division supplies solder technologies, fluxes, cleaners, and other attachment materials as well as materials that join electronic circuits during high volume manufacturing.  

2.      Circuitry solutions (34% of the segments 2020 sale). The division designs, manufactures  and supplies liquid chemical processes used in manufacturing  printed circuity boards. We expect long-term growth to be driven by increased demand for internet infrastructure, consumer electronics, and connected vehicles.

3.      Semiconductor solutions (17% of segment 2020 sales). The division is driven by the need for high performance computing, semiconductor supply/demand cycle. This division provides advanced copper interconnects, die attachment, wafer bump processes and photomask technologies for IC and Semi fabrication and packaging. This division had 17% organic growth in 2020 and management expects similar trends to continue into the next few years.

In general, ESI electronic chemicals are less than 1% of total value of end products yet are relatively critical for circuitry or toward miniaturization. Once built into a PCB or semiconductor process, ESI products tend to be very sticky and gives the company a head start toward next generation products. ESI tends to work closely with customers to supply consistent formulations and innovative solutions to enhance end products. Our research suggests competitive dynamics within the industry are stable, with just 3 players making up the majority of the market. It is very difficult for new entrants and even regional players to gain shares as supply chains look toward global suppliers and consistency.

The Industrial & Specialty segment was 37% of total 2020 sales and had 21.3% Adjusted EBITDA margins for the year but was on track for 23% or more margins prior to the impact of COVID. The segment declined 9.1% in 2020, however was recovering toward the end of 2020 and generated 5.8% growth in Q4. The segment is comprised by three divisions with underlying exposure to a variety of end markets and geographies. At a high level, the segment manufactures chemical systems and coatings that protect surfaces against wear and tear and fluid solutions for energy extraction. These are generally specialized consumables: 

1.      Industrial Solutions (69% of segment sales). Industrial solution primarily manufactures coatings that protect wear and tear on surfaces, such as electroless nickel, metal plating, and clearing products. They also have a sustainable solutions platform where they provide turnkey solutions to wastewater treatment and recycling plants.

2.      Graphic Solutions (21% of segment sales). The division started the year strong with 8% growth but declined due to slowdown from covid starting in Q2. The primary products are manufacture are used in the transfer of graphical print images onto various end products such as packaging and commercial printing.  

3.      Energy solutions (10% of segment sales). The division specializes in manufacturing fluids for offshore energy extraction such as water-based hydraulic control fluids. 

ESI has significant exposure to the 5G rollout, which should be a multi-year tailwind. Additionally, content in EV vehicles is expected to grow rapidly in the coming years - as the CEO said on the Q4 call a few weeks ago, “…it’s a market that’s poised to explode for us”. Different industry sources point to general PCB end market growth of mid-high single digits for the next few years. Specifically, we’ve seen estimates of worldwide PCB growth of 5.3% in 2021, 8.6% in 2022 before falling to 7.3% in 2023. These estimates, coupled with ESI’s rapidly growing semiconductor business points us to high single digit organic growth rates over the next few years. 

The company has guided investors to EBITDA growth of 1.5-2x revenue % growth. Our checks tend to agree that this kind of contribution margin is possible. However, for 2021, ESI has guided to 7% topline and 7% EBITDA growth. This is due to some 1x Covid cost cuts coming back in 2021. However, we believe the 7% growth is conservative (both on revenue and EBITDA) for 2021 as end market growth should exceed the 7%. Our estimates suggest the company achieving ~$500m of EBITDA in 2022, decently ahead of consensus at $483m. Likewise, our free cash flow estimate for 2022 is $328m ahead of consensus at $283m (if we assume no working capital growth, FCF would be $368m in 2022).  As most ESI products are formulations vs. heavy chemicals, capex needs are sustainably low, less than 1% of revenue.

ESI has cash of $292m and debt of $1515m for a net debt position of $1223m or 2.9x adjusted EBITDA. Importantly, as EBITDA has a high conversion rate to FCF, we assume 2021 debt to FCF to be ~4x. Capital allocation since repositioning as ESI has been excellent. In 2019 the company repurchased ~44.8m shares (average price $11.33) and another 5.7m shares in 2020 (average price $9.74). Acquisition spend has been modest at ~$70m and the company recently initiated a small dividend. Despite wariness from investors, we believe ESI capital allocation has been excellent and will create value for investors in the future.

Valuation: 

We arrive at our $25 price target by applying a 17.5x multiple on 2022 FCF of $1.43/sh or about $360m excluding changes in working capital as we feel this is a normalized representation of their FCF. We believe is appropriate in the context of current interest rates, future growth and for the quality of this business. Newly listed competitor Atotech (ATC) trades at more than 20x 2022 FCF. A few years ago, Cabot purchased KMG at more than 20x FCF. Using the current Cabot multiple (we acknowledge this isn’t a perfect comp) ESI would be trading at $27.50.

We believe management of ESI is aligned with shareholders. The CEO and CFO are young but off to excellent starts as senior executives. Performance metrics are dependent upon FCF, adj. EBITDA and adj EPS objectives at the start of the year and execution of those objectives determines the majority of their total compensation. Executive Chairman Martin Franklin owns more than 12.5m shares, giving him significant skin in the game and aligns him with shareholders (despite his compensation). Operational and capital allocation execution has been excellent since the rebranding.

Conclusion: 

ESI is an excellent, under-appreciated and growing business characterized by low capital expenditures and high returns on invested capital. We believe their end-markets are set up to experience significant growth over the next few years as the demand for PCB’s, semiconductors, and IoT/5G devices should continue to increase globally, which are not being fully reflected in sell-side models. With superior free cash flows, aligned management and a good balance sheet, we believe this strategic asset is an attractive takeout candidate.

Risks:

General economic headwinds

End market technology slowdowns (5G, EV vehicles, mobile technology)

Multiple compression due to higher interest rates

Catalyst

Earnings above expectations

Capital allocation above expectations