Element Solutions Inc.

Moat: 2/5

Understandability: 4/5

Balance Sheet Health: 3/5

Element Solutions is a global specialty chemicals company that provides performance-enhancing solutions used in various applications across different industries.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Element Solutions Inc. (ESI), formed in January 2019, is a global specialty chemical company providing products for a diverse set of industries, including electronics, industrial, and specialty sectors. They operate in a fragmented industry that has many players, but the company aims to differentiate itself with a focus on specific industries.

Revenue Distribution

ESI’s revenue is divided into three reportable segments:

  • Electronics: This segment is the largest, representing approximately 52% of 2022 revenue, and focuses on materials for circuit boards, semiconductors, advanced packaging, and other electronics applications.
  • Industrial & Specialty: This segment contributes approximately 38% to total revenues, offering specialty chemicals and material for a wide range of industrial surface finishing processes, including decorative, functional, and performance coatings.
  • Energy Solutions: This segment generates about 10% of revenue and is specialized in chemicals and specialty materials used in oil and gas production and exploration.
  • Electronics: The demand for electronic solutions is driven by trends in automation, data storage, connectivity, and electric vehicles. This is leading to increased demand for their products related to microchips, packaging, and plating chemistries.
  • Industrial & Specialty: This sector benefits from the demand for corrosion-resistant and high-performance coatings in manufacturing, transportation, and construction. Trends around sustainability and the move towards alternative coatings are also driving the business.
  • Energy Solutions: This sector benefits from oil prices and a sustained higher production demand in the oil and gas industry. Their revenue correlates strongly with activity in that sector.

Margins

  • Net margins fluctuate, but as of 2022 were around 5%.
  • Their operating margins have been stable with adjusted EBITA being around 18% of revenue.

Competitive Landscape

  • The markets they operate are generally competitive and their competition in each segment depends on a variety of factors.
  • In the electronics sector they compete with major companies such as Dupont, Dow, and BASF along with regional players.
  • The industrial & specialty segment has large competition from both global and local companies.
  • The energy solutions space is dominated by players like Halliburton, Schlumberger, and Baker Hughes

Moat Assessment

ESI’s competitive advantage is not extremely strong or difficult to replicate, but it does have some components which earn it a narrow moat rating.

Moat Rating: 2 / 5

  • Intangible Assets (Brands & Patents): ESI has a number of recognizable brands and patents in specific areas, especially in the Electronics and Industrial and Specialty segments. However, most of their products could be considered commodity chemicals with some added benefits. These advantages help it retain customers but not very aggressively.
  • Switching Costs: There are switching costs in the electronics and industrial applications, because companies need to have a reliable supply of materials to ensure their operations run smoothly. For example, in the semiconductor area, customers would want consistent materials to ensure no disruptions in their production. Therefore, companies are often reluctant to change suppliers unless another company provides substantial cost savings. However, these types of savings are easy to replicate, making this advantage weaker. * Cost Advantages: While they have manufacturing capabilities in low cost countries they mostly operate in industries where location isn’t a crucial advantage. These are not extremely durable sources of advantage, even when paired with operational excellence.
  • Network Effects: None of the segments they operate benefit from network effects

Risks to the Moat & Resilience

  • Technological Disruption: In the electronics sector, fast-changing technology and the entrance of new materials can disrupt demand.
  • Economic Conditions: The demand for their products, particularly those used for manufacturing, depends on macroeconomic conditions and industry trends. Therefore, a global recession or local market weakness might affect their sales and profitability negatively.
  • Competition: They operate in highly competitive industries, where many similar products are offered by other firms. The presence of a multitude of competitors can reduce their ability to pass higher prices on to customers.
  • Commoditization: They are in industries that are subject to commodification of products, where companies mostly compete on price, and profits will only gravitate to lower-cost producers. This will lead to low barriers to entry and easy competition in the long-run.
  • Geopolitical Instability: Several regions in which they operate or sell into have various geopolitical issues, which might affect their sales, ability to access markets, or other things.
  • Supplier concentration: Their operations are heavily dependent on the availability of materials and components, with any supply disruption having huge financial consequences.

Financial Deep Dive

Overview

  • Their financial performance reflects the underlying trends of their end markets. Overall, they’ve been improving performance during the past few years, but are still not stable and are subjected to risks.
  • Their margins are moderate, but should increase with their focus on higher quality materials.
  • Their cash flow is steady, but not exceptional, and a good percentage of it is spent on acquisitions, making share repurchases less important for the management.
  • In the latest quarter, ending September 30, 2023, ESI’s revenues decreased by 3% to $550.8 million, which showed a slight decline.
  • However, adjusted EBITDA improved by 3%, indicating an improved efficiency in the operating business.
  • Their net income attributable to common stockholders for the quarter was $10.4 million, or 4 cents per diluted share. This is a massive improvement from last quarter’s -$17.1 million, or -7 cents per diluted share, and shows improving performance.

  • The adjusted EPS rose to 44 cents for the quarter from 42 cents in the same period of the last year, signaling higher operating profitability.

  • Their organic growth was 1% in this quarter. They have been acquiring a lot to grow revenues, indicating M&A might be a major source of growth for the company.

Balance Sheet

Balance Sheet Health: 3/5

  • ESI has a moderate level of debt, with their debt-to-equity ratio ranging between 2-3 in recent quarters. Although this is not very high, the debt levels could be a risk in the long run.
  • Their liquidity is good, with a current ratio consistently higher than one. However, cash has been decreasing due to their focus on acquisitions.
  • They also have significant intangible assets, most of which stem from goodwill.

Capital Allocation

  • The company has used a significant part of its cash in acquisitions, thereby reducing the cash flow available to shareholders.
  • They have not been very active in buying back shares, but occasionally repurchase shares when prices are low, signaling opportunistic capital allocation.
  • They offer a consistent dividend, indicating commitment to returning capital to shareholders.

Concerns

  • Customer Concentration: Their electronics segment is reliant on few large customers. A decline in demand from those customers could seriously affect ESI’s revenues.
  • Acquisition Risk: The company has been using M&A to boost revenue and as such their growth depends on acquisition success. Their ability to integrate the companies and generate synergies is critical to them and can act as a risk if the acquisitions do not perform as expected.
  • Inflation and Increased Input Costs: ESI has been reporting increasing input costs and inflation for the past few quarters, which can affect the margins in the near term.

Understandability

Understandability: 4/5

  • While the chemical and material sciences aspects are complicated, the business operations of ESI are pretty straightforward to grasp.
  • They operate by making and selling their products in diverse industries and focus on providing support and guidance to their customers as a value add.
  • Understanding the financial statements and the value created by the company is somewhat difficult for a lay investor due to certain accounting rules, particularly with acquisitions.
  • Their reliance on acquisitions may make the underlying business less clear to the everyday investor.

Conclusion

Element Solutions is a business that operates in various sectors, providing specialty chemicals and material. It has a moat, but not a wide one. Its strengths lie in some niche markets and product quality, but that does not imply complete protection against competition. The company has also a decent balance sheet, but a significant amount of it is tied to intangible assets, goodwill, and debt. The company’s reliance on acquisitions for growth carries risks that need to be monitored carefully. Overall, the company can be understandable to a trained investor with some effort.