Deciding how to balance short-term and long-term drivers is seldom easy, but in the case of Element Solutions (NYSE:ESI) it’s a little more challenging than usual.
On the negative side, markets like autos, construction, and short-cycle industrial aren’t that healthy today and likely will need a few quarters to turn around, and the valuation isn’t exactly obviously cheap. On the positive side, Element Solutions has solid share in its core markets, and it is attractively leveraged to long-term growth trends like vehicle electrification and lightweighting, increased electronic content in many markets, and ever-increasing complexity within that electronic content.
I wish I had done my due diligence on Element Solutions a little sooner, as the 10% move in the share price after a guidance boost doesn’t exactly help the valuation case. Although I can’t say I love the valuation, I do like the business and when I have to choose between the two, I tend to go with the good business, and particularly when there are attractive long-term drivers.
A Welcome Boost To The Outlook
Element Solutions announced on June 11 that it was boosting its guidance for Q2’24 and the full year, with a new quarterly EBITDA target of $135M (versus $125M previously) and a full-year target of $530M-$545M (from $515M-$530M).
Management tied the improved guidance to stronger conditions in its electronics business, and particularly wafer-level packaging and circuitry. These were the strongest businesses in a mixed Q1’24 report, with Electronics revenue up 4% overall but Circuitry up 8% and Semiconductor up 11%.
I believe both of these drivers could prove to be healthy tailwinds for some time to come. On the wafer-level packaging side, although overall chip demand is still shaky and there’s uncertainty as to the timing of a broad sector recovery, demand for chips produced on the most advanced nodes (driven in part by AI) has been strong and many of these chips require more elaborate and advanced packaging. I also expect improving demand for physical storage (helping the Circuitry segment) coming off of an inventory correction.
I also want to note that Veeco (VECO), a capital equipment supplier leveraged to both advanced packaging and physical storage media, has been discussing improving trends for both lines, so I don’t believe this is simply a byproduct of inventory restocking or other drivers specific to Element Solutions.
Challenges Remain In Other Parts Of The Business
As wafer-level packaging and physical media demand improves, challenges remain in many of ESI’s other businesses, and these challenges seem likely to persist at least through 2024.
Autos
The auto sector accounts for about a quarter of ESI’s business, and while auto production in the first half of the year has held up, there are signs of deceleration. I’m also concerned about the relatively weak pace for sales growth in EV space in Western countries, as many suppliers and OEMs have warned of weaker than expected demand and slower launch plans for new vehicles.
ESI’s leverage to autos has multiple layers. The electrification of EVs is an important driver here, as ESI’s potential vehicle content is almost twice as high on EVs, so the weakness in Western EV sales is disappointing, though partly offset by respectable exposure to China’s market.
ESI is also solidly leverage to lightweighting (replacing metal components with lighter metals or plastic components), including the company’s leading position in metal finishing that allows auto OEMs to replace metal parts with plastics that at least look like metal. In this case, though, I think the weakening global passenger vehicle volumes are a short-term headwind.
Construction & General Industrial
There’s nothing fundamentally wrong with core addressable markets like material cleaning, pre-treatment, or coatings to enhance corrosion/wear resistance and paint adhesion. These are volume-driven markets, though, and both construction and short-cycle industrial markets (as well as heavy machinery) have been weakening, with several companies tied to these markets recently lowering their guidance due to weaker underlying activity.
All told, it is plausible to me that ESI won’t see much growth in its Industrial & Specialties business between Q1’24 (when sales were down 3% in organic terms) and Q4’24, as I expect ongoing pressure in construction and industrial markets, and I’m not confident that the Graphics segment (which supplies photopolymer plates for flexographic printing that is used largely for consumer packaging) will continue to grow this year.
Attractive Long-Term Drivers
Notwithstanding the short-term pressures on the business, there are longer-term trends in play here that I like and push me towards a generally positive sentiment for the shares.
Within the Electronics business, the company remains attractively leveraged to the increasing complexity of semiconductor, circuit, and electronics design. Circuit boards are becoming increasingly dense and including more components with more complex interconnects, not to mention the ongoing growth of flexible circuitry.
That will continue to drive demand for ESI’s plating products, surface preparation and finishing chemicals, solders, stencils, and so on. Likewise, it also drives growing demand for new substrates that can accommodate a range of chips made at different nodes, as well as new bonding materials to connect circuits. Last and not least, higher power and thermal demands require more advanced interface materials (like nano-copper) to make it all work. All of this can drive a richer, higher-ASP, higher-margin mix for ESI; the company has the advantage that its products (even at higher prices) are a pretty small part of the final bill of materials but can be critically important in achieving performance standards.
I also expect ongoing growth in advanced wafer-level packaging. Advanced packaging is increasingly necessary to achieve higher performance and energy consumption standards in smaller form factors, and just as I expect circuit boards to get more crowded and complex, I expect the same with packaging.
All of this gives ESI good exposure to not only leading-edge chip production for applications like AI, but also large-volume applications like smartphones and emerging large-volume applications like autos (both EVs and ICE-powered vehicles with more onboard electronics) and industrial electrification. All told, I believe Electronics can grow at a mid-single-digit rate for some time to come, with some markets/applications growing at a double-digit rate.
The Outlook
I do see some risk to revenue expectations for FY’24 given the exposure to markets that I believe could weaken as the year goes on (autos, construction, general industrial, et al.). As seen with the recent guidance upgrade, though, it’s possible that growth and recovery markets in the electronics business can compensate for this, and particularly so on the margin/mix side.
Longer term, I’m expecting around 4% annualized revenue from ESI, with much of the growth driven by opportunities like new materials in circuitry and circuit board assembly, as well as semiconductor assembly and packaging. I see less growth on the Industrial & Specialties side (even with drivers like lightweighting), but the company has strong share in many markets that are functionally oligopolies.
I expect operating margins to move up through the low 20%’s over the coming years, and I likewise expect adjusted EBITDA margin to reach 25% over the next three to five years. That should drive free cash flow margins further through the low double-digits and toward the mid-teens over time, driving mid-to-high single-digit annualized free cash flow growth.
None of this drives an especially exciting fair value, though. Even factoring in ESI’s attractive market share, the shares are not cheap on a cash flow basis. I also use an EV/EBITDA approach with stocks like ESI, looking at what the market has paid for similar levels of growth, margins, and returns (ROIC, et al.) in the specialty chemicals sector in the past. On that basis, I can argue for a 15x-16x forward multiple, or a $27 to $29 fair value.
The Bottom Line
I would like a bigger spread between today’s price and my fair value estimates, and it’s worth noting that the SOX index is already up more than 50% over the last year, and both ESI and Entegris (ENTG) shares have done alright. I don’t think, then, that this is a “hidden gem.” That said, I do think there is room for further positive guidance revisions and/or beat-and-raise quarters that can, in turn, also drive richer multiples. I also think there’s room for the shares to head higher as more of these advanced materials opportunities convert to revenue and margins.
All in all, while I don’t think this is an especially cheap stock, I do think it still has a respectable risk/reward profile. I can’t rule out a more pronounced slowdown in the wider economy and the risk of nervous investors selling out of tech stocks, but I think this is a name worth further due diligence, even after the recent spike.
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