Solstice Advanced Materials

Solstice Advanced Materials announced a deal to acquire Element Solutions then canceled the transaction.

Why it matters: Solstice shares trade over 20% below the pre-deal announcement price. We think the market interprets management's desire for the acquisition plan as a sign that Solstice will see slowing growth in the coming years and the company will need to make acquisitions to accelerate growth. With no acquisition, exposure to the fast-growing semiconductor end market will remain a smaller business for Solstice, but the company should also see growth from refrigerants, nuclear, and defense, which combine to generate around half of companywide revenue.

The bottom line: We see value in narrow-moat Solstice shares, which trade in 4-star territory and roughly 25% below our $85 fair value estimate. We point to strong revenue growth over the coming quarters as catalysts for share. We think the market is reacting to management's pursuit of growth through acquisitions, which deviates from the company's investor day strategy of organic growth investment combined with maintaining a strong balance sheet. However, we credit management with listening to shareholder feedback and being willing to walk away from the deal. As a result, we think organic growth and maintaining a strong balance sheet will once again be top priorities in Solstice's capital allocation strategy.

We added Solstice Advanced Materials to our Best Ideas list in September. The company is one of our top picks in the basic materials sector.

We raise our Solstice Advanced Materials fair value estimate to $85 from $80 following the termination of the Element Solutions acquisition. The increase is due to our outlook that the deal was slightly value destructive and management's announcement of a share repurchase plan, which we view as value-accretive as the stock trades below our fair value estimate. We assume a weighted average cost of capital of a little below 8%.

In refrigerants and applied solutions, we forecast mid-single-digit revenue growth and modest margin expansion over our five-year explicit forecast, driven by growing global demand for higher-value low global warming potential refrigerants. We also see revenue growth coming from building materials as construction rebounds from current cyclically low levels and from uranium refining as US nuclear power generation grows over time.

In electronic and specialty materials, Solstice should see sales grow at a similar pace to global semiconductor production volume growth, which we forecast to rise at a mid-single-digit annual rate. We also see modest growth in the safety and defense solutions segment as US defense spending grows.

To develop new products, we expect Solstice to reinvest around 2.5% of sales in research and development, which is in line with the US chemicals industry. We forecast near-term capital expenditures will average 10% of sales over the next couple of years as Solstice is investing in new capacity for growth. Over time, we see capital expenditures falling back to the mid- to high-single-digit percent of sales as investment growth slows.

In a downside scenario, we forecast Solstice would see slower revenue growth and little margin expansion as the company would see prolonged declines in its more cyclical end markets, including building materials and semiconductors. In this scenario, our fair value estimate would fall to $45.

In an upside scenario, we forecast Solstice would see faster revenue growth and greater margin expansion as the company benefits from faster growth in its cyclical end markets and accelerated growth in refrigerants and semiconductors. In this scenario, our fair value estimate would rise to $115.

We award Solstice Advanced Materials a narrow economic moat rating from intangible assets based on the company’s patented portfolio of specialty products. While Solstice was a part of Honeywell, it successfully developed innovative materials and created a group of patented products that enjoy a premium position in the market. As a stand-alone firm, we expect the same level of innovation will continue to create differentiated products that command pricing power.

Solstice’s largest product category is refrigerants, which are sold under the Solstice brand. The company is a market leader in new hydrofluoroolefins, or HFOs. HFO refrigerants are replacing hydrofluorocarbons, or HFCs, as HFOs have far lower global warming potential than HFCs. This is because the carbon atoms in HFOs are double-bonded, which is a weaker link and can more easily be broken down by naturally occurring hydroxyl radicals in the Earth’s atmosphere. As a result, HFO refrigerants last days or weeks in the air, while HFCs can last for years, creating a greater risk for global warming. In response, many governments around the world, including the US and EU, where Solstice generates most of its sales, created regulations to phase out HFCs in favor of HFOs.

For Solstice, this creates a growing base of heating, air conditioning, and ventilation units, refrigerators, coolers, and autos that will require HFOs to be used for cooling. Roughly half of Solstice’s refrigerants are sold to original equipment manufacturers, with the remainder sold to the aftermarket. Cooling machines cannot change back and forth between different kinds of refrigerants, so the switch to HFOs will create a growing base that will require HFOs. Though switching to a different brand is possible, Solstice generally retains its customers as its HFOs are generally patent-protected for most end markets and in most regions for much of the next decade.

Building materials are another key end market for Solstice, where the company produces blowing agents used to make insulation foams with low global warming potential. Here, Solstice’s products allow buildings to use less energy and reduce carbon intensity. Due to stricter building regulations in key markets, including the US and EU, Solstice’s differentiated products should enable the company to sell at a premium.

Solstice also operates the only US uranium conversion plant. While uranium is a commodity, we see intangible assets coming from a regulatory license for uranium conversion with the US Nuclear Regulatory Commission, which runs until 2060. US nuclear power generation is set to grow as at least two plants are set to reopen in the next several years. As a result, Solstice’s Metropolis plant has been able to sign long-term sales agreements with lower price volatility. This should ensure Solstice generates economic profits over at least the next decade.

Semiconductor materials is another key business for Solstice, where the company’s moat comes from its ability to help its customers make smaller, more-powerful chips, with new materials and the ability to provide greater levels of purity for materials and the fab environment. As semiconductors get smaller, these newer, advanced chips have more intricate circuitry, or a denser arrangement, which requires more production steps and leads to the need for more advanced chemicals. Solstice makes chemicals and materials used in key, high-value manufacturing steps throughout the fab process, including deposition, etching, patterning, and packaging.

Solstice’s products allow smaller, more powerful chips to be manufactured at targeted yields of at least mid-90%, which is the percentage of semiconductors that successfully pass inspection. Semiconductor fabricators prepare to manufacture smaller, more powerful chips years in advance. Solstice will work closely with semiconductor fabricators to develop proprietary, customized solutions that remain the intellectual property of Solstice. This establishes valuable intangible assets that allow Solstice to generate economic profit over the lifecycle of the products in which its proprietary formulations are used. Intangible assets are also supported by Solstice’s status as a preferred supplier. Semiconductor fabricators use preferred suppliers for their chemicals and will typically choose from just two to four companies to bid on a chemical for a new node. Suppliers not on the preferred list usually do not have the opportunity to bid for the business.

Due to Solstice's differentiated product portfolio that commands pricing power, we are confident the company will generate excess returns on invested capital over at least the next decade.

Solstice will see long-term profit growth from the transition to low global warming potential refrigerants.

Solstice will benefit from growing demand for semiconductors as more semiconductors are needed in electronics, transportation, and to enable artificial intelligence.

Solstice owns the only uranium conversion operation in the US, which will see higher sales from growing nuclear power generation in the coming years.

Over time, new entrants will develop similar advanced refrigerants, eroding Solstice’s growth and pricing power.

Quantum computing may disrupt the semiconductor industry, which would hurt Solstice and its main customers.

Solstice is underinvesting in R&D relative to peers, which could limit its ability to create new products and gain market share over the long term or increase its reliance on acquisitions for growth.