Just continuing with the second day of the Jefferies Industrials Conference, Laurence Alexander with the Jefferies Chemicals team. It's my pleasure to introduce Andrew Sandifer, who is the CFO at FMC Corporation. Without any further ado, let me pass it over to you, and then we'll get into the Q&A.
Thanks, Laurence. Good morning, everybody. Before we get into our planned just fireside chat with Laurence teeing up, which I'm sure will be a series of interesting and intriguing questions, as always, just wanted to acknowledge I'm aware that there was a short report issued early this morning by a short research firm. I don't even know who it is. I'm not prepared to comment on it in detail, but I will say simply, read the disclaimer. It's not an unbiased piece of research. We believe there's factual inaccuracies on the first page, and we you know, don't, don't believe there's anything there. That said, you know, understand that's obviously diamides are obviously an area of interest and a key area that the portfolio for the company.
But again, you know, having not reviewed in detail the report, I can say that, you know, some of the statements made in the early stages of it are, we believe, to be factually incorrect and misleading. So just leave it at that.
Just to, unfortunately, flog the dead horse a bit, can you just touch on whether diamides are kind of the majority of profits for FMC?
We've never disclosed the contribution of any product line to the overall profitability of the portfolio. Diamides were about $2.1 billion in revenue out of our $5.8 billion in revenue in 2022, so about 36% of sales. I think any assertion that they're 60% of EBITDA would take some very aggressive and unreasonable estimates to get to that.
And secondly, can you touch on... kind of, can you put in context your strategy for the patent rollover for Diamides, and maybe put that in context with what's happened with other chemicals that have gone-
Sure.
Off patent? And then just, you know, it's clearly there's an entire, you know, that seems to be the focus of the debate at this point.
Yeah, look, we, we've been talking about the diamides and how we've been managing that franchise since shortly after we bought them in 2017. And to be clear, we've been facing illegal competition from well-established illegal competition in China and India before we bought the molecules and have continued to face them. And our strategy is, it's certainly, we believe we have a very strong patent portfolio, a combination of manufacturing process patents, composition matter patents. We also have very strong protections, depending on which country you're in, and the protection of regulatory registration data. So in the Q2 2021 earnings call, we mapped out a timeline of how all those protections build up and carry through over the horizon.
Now, what that says is that, you know, essentially a combination of patents, both composition of matter and product, you know, the actual manufacturing process patents, along with registration data, provides protections, and depending on which diamide molecule and which country you're looking at, that would limit legal competition entry from into 2026, or later, depending, again, on the country or the molecule. That doesn't preclude people from entering into countries where, for example, China and India, where the composition of matter patents have expired. And we do have generic competition, and in most cases, we believe those competitors are producing with processes that infringe on our patents, and we've been actively litigating in that space.
Certainly you're welcome to check, you know, we've made very public statements both in our 10-Ks as well as in press releases around that litigation.
So let's then shift to the other kind of, you know, bit of turmoil: the inventory destock.
Mm-hmm.
That happened in Q2. Now that we've had a bit more time to sort of look at the dynamics there, can you frame just how unusual is it, how did it happen, and how do you work, and how much of the world has worked its way through, or how much is still-
Yeah.
-to go?
Look, I don't think our industry has ever seen a coordinated slowdown across all major geographies at the same time, right? When we look back in history, we've certainly seen corrections in the marketplace, you know, 2014 through 2016, a big correction in Brazil, for example, that have typically been tied to either specific economic events or weather activity or crop issues in a specific country. But a coordinated slowdown across all regions, across all product lines, and that impacted the entire industry. Let's be clear, when you look at, you know, the Q2 results of all of our peer companies, everybody ran into the same wall in Q2.
What I think we've—the world has experienced and what the agricultural input sector is, and certainly crop chemistry is, is run into, is a significant reset after a pendulum swing too far into the, I guess, in hindsight, into the just in case category of inventory management, following several years of disrupted production, and very rapid price increases, particularly for more commodity inputs like glyphosate, which to be very clear, is not a product in which FMC participates in, but certainly is a big portion of the overall crop protection market.
So it came to a head, you know, particularly in the latter part of Q2, this combination of an improved outlook and expectation of more security of supply, you know, a bit of easing or rapid easing in commodity inputs, fertilizers and glyphosate in particular, making people a little questioning about whether prices were gonna start turning on other inputs. And then I think the realities of a big year-on-year shock to the world of a return to more historically normal interest rates, particularly short-term rates, right? So much of our customers, much like us we do, use short-term financing to fund their working capital. And I can speak directly for FMC, we've gone from paying 50 basis points overnight for commercial paper a year ago to 605 today, right? It's a pretty dramatic year-on-year change.
Over a long-term run average, not that out of line with long-term historically. So I do think those factors combined led to what we saw in Q2, and we talked extensively about this in our August call. You know, those three factors really led to a very substantial reset hitting across the entire industry in Q2. That reset is not a one-quarter event. When we guided for the second half, we guided a very down 11% Q3. We did guide to an up Q4. We can talk a little more about why and what's driving that. But I think to Laurence, to your point, you know, what we have to do here is think about the growing season calendar around the world and working through this reset period.
So reset started at some point, and Q1 became very painfully evident in Q2. Where are we at in the growing seasons around the world? Well, Europe is a Q1, Q2 business. So we essentially, through the EU in particular, we're essentially through the season in, in Europe, so we've had a full season to adjust. Does that mean we're fully adjusted? Unclear, but a significant adjustment has occurred in inventory levels in the channel in Europe through that growing season. In the U.S., North America, more broadly, we're coming to the end of the current growing season. Is there been a significant reduction in channel inventory? Yes, there has. Are we still at whatever the new normal for channel inventory? Not clear yet. I mean, certainly we've seen a significant improvement in, in inventories.
I do think there are some differences depending on where in the value chain you are. There have been numerous reports from some of your peer sell-side analysts, as well as from some of our customers in public statements, where it appears U.S. inventory retail levels are very, very low. Our viewpoint at the distributor wholesaler level, we still think it's a bit elevated. So system-wide, where is the inventory? Still leveling out, but we've had a full growing season now that's been exposed to this reset for us. In Latin America, we're just entering the first growing season during this reset, right? Because as the reset really became clear, we're pretty much in the dead period. We're in the winter in Latin America.
So now as we're moving into the planting and growing season in large part in Latin America, particularly Brazil, Argentina, you know, we are just gonna see the digesting of this reset theme through those markets. So, you know, our expectations for Q3 are definitely impacted by that. I think our expectations for Q4 are impacted by the reset. They're countered a bit by our expectation for contribution from new product introduction. The situation in Asia is much more fragmented and much more nuanced. You know, the reset, these reset factors we've been talking about certainly apply, but we've not had the same magnitude of response that we've seen in the other three regions. You know, we do have channel inventory challenges in India.
You know, it's something we've been managing, and we've been very open about from the beginning of this year. We initially gave guides in February, and that is not something that will resolve in a single year. That's something we'll continue to work through in the coming year. But, you know, I do think what we've seen here really is a pendulum swing coming back from COVID.
So just be clear, the bridge for Q4, so the Latin American reset is already in Q4, and you have visibility on the products you're launching. So what's the potential swing factor, the magnitude of the swing factor for orders to slip from Q4 to Q1?
Good question. I can't give you a concrete answer. I can just say this, you know, I... The factors we're seeing with the reset generally, for products that are being, you know, current products in the marketplace, where you're restocking at the beginning of the season to make sure they're available as needed during the growing season, we are seeing slower purchases all the way up the chain. And to be absolutely clear, through the month of coming into September, Latin America has been slow. You know, Asia, Europe, North America have been tracking, you know, our admittedly low expectations for Q3, but they've been in line basically for where we thought we would be with Q3. Latin America has been slow.
Now, that said, September is always a huge month in Latin America, and generally speaking, we do the preponderance of the business in a quarter, in the last month of the quarter. So it's not surprising that we are, you know, looking at that pretty big hill to finish for the rest of the quarter. You know, the dynamic that is gonna be tricky with Brazil, both in Q3 and Q4, is the question of, all right, how close to the application timing are customers gonna buy, and how much channel inventory is gonna flow through the channel before that? So you know, it's the 17th of September. We've got the rest of the month to continue to push through, and we'll see how Q3 settles out.
When we get into Q4, we'll continue to be wrestling with some of those dynamics. Our expectations for Q4, which is, you know, year-on-year sales growth of about 6%, are really driven by new product introduction rather than sale of existing advice. There's certainly sales of new ex- existing product, but the growth is new product introduction. Those are new, you know, either new active ingredients, our fluindapyr fungicide, which we're introducing under the Onsuva brand in Brazil and Argentina, or new formulations of the diamides. High concentration Rynaxypyr in North America, particularly Canada, which has been a strong contributor to growth this year, or new combination formulations of Rynaxypyr and bifenthrin. It's gonna be sold under the Premio Star brand in Brazil. Very, very strong customer interest.
So as opposed to having a restock dynamic, what you're doing is building initial volumes out in the field. Could there be some timing slips between Q3, Q4, Q1, based on the purchases closer to the time of use? And certainly, insecticides, you know, are used throughout the growing cycle, not just at planting. Yeah, yeah, that's one of the variables, and I think we tried to point to that very clearly when we—you know, if you look in our investor presentation, our earnings presentation on the August call, you know, we talked very clearly about the timing of channel orders being a factor that could drive to either end of what is an admittedly pretty broad guidance range for the second half.
And so can you talk a little bit about, you know. You know, you've outgrown the market by 1.5x-2x for the last 20 years. A lot of that was when FMC had a very different strategy. You know, what's gives you the confidence that with the current pipeline, you can maintain that kind of delivery rate?
Yeah.
Particularly given the type of volatility you've seen this year.
Yep. Look, long term, crop protection industry has grown between 3%-4% compounded for decades. The industry grew high double digits, excuse me, low double digits in 2021 and 2022. So, you know, a reversion to mean happening, you know, with this reset, not entirely surprising. Throughout that, you know, we have the best history I have goes back about 25 years. You know, FMC has consistently outperformed the market over various time classes, differing amounts, but, you know, it's over a 20-year period, it's a 2x market outperformance.
Some of that's M&A, but a lot of that is, you know, at its core, FMC has always had a strength in developing value-added formulations from active ingredients, both patented and unpatented, and finding ways to create additional value for growers that bring them more yield that they're willing to pay for. And certainly, you're just starting to see the impact of that with the diamides. Because it does take several years to come up with a concept, develop it, test it, get it registered, and get it to market. You know, and particularly in certain markets like Brazil, it can take 5 years to get a new product, even a new formulation to market. So we're just now seeing the real impact of that FMC legacy strength in formulation and product development from an existing set of AIs, having benefit to the portfolio.
What we have now that we didn't have prior to the acquisition of the DuPont assets is a world-class active ingredient discovery engine. You know, FMC had, had for a long period in the aughts, moved away from investing in direct discovery of new molecules and relied on partnerships. Around 2012 to 2014, we started being a bit more aggressive in working in partnerships, you know, led to the development of fluindapyr, which we're, you know, we jointly developed with a small Italian company and then later bought the full rights, and are now commercializing and seeing very good response to. Now with the acquisition of the DuPont assets, when we acquired the DuPont R&D operation in 2017, all we got were the long-term projects. Anything that was near commercialization was retained by the merging companies.
So we will have the first product to come out of the DuPont pipeline, DuPont legacy pipeline, coming out in the end of twenty... early 2025, and that's what we recently announced, yet another god-awful, hard-to-pronounce active ingredient brand name, Dodhylex, which is a brand name for tetflupyrolimet. Another easy-to-announce chemical name. But it is a brand-new mode of action, herbicide for use in controlling grass, weeds, and rice. Right? And this is a, you know, a nice fit with FMC's long-term history in a lot of ways, in that, one, you know, we've always had a broader interest across a broad set of crops. We're not a corn and soy play. Soy, corn and soy collectively are about 30% of our mix.
They're important to us, but other crops like fruits and vegetables, rice, sugarcane, coffee, cereals, are a significant part of our portfolio. So, you know, we're excited that we're bringing, again, you know, a brand-new product with Dodhylex. The family of products that will be developed from that new active ingredient that bring a very different and new high-performing mode of action to help control some really difficult weeds and rice. And for, you know, the chemistry nerds out there, rice is a grass. Controlling grass weeds in a grass species is not a simple thing to do. So it's a pretty highly selective, and, you know, the field data has shown highly effective herbicide.
So that'll be the, the first time to show what the new pipeline can really deliver on top of what we've been introducing out of some of the legacy FMC activity. And I think you'll see the continued impact from what we're doing to develop value-add formulations with all of the active ingredients in our portfolio. I think it's an important point. You know, sulfentrazone is a long time FMC active ingredient, went off patent in 2009. We make more money on sulfentrazone today than we did in 2009, right? There are generic, significant generic competitors in that molecule and in straight formulations of, you know, no formulation technology added sulfentrazone, where we have a lot of competition, and quite honestly, we don't do very well in that business because it's not particularly attractive returns.
But we have value-added formulations of sulfentrazone that make very high profits and are very, very, and still growing and still contributing very significantly to the company's success. So I do think that legacy capability of FMC, combined with the new active molecule, active ingredient molecule development and discovery engine, it's gonna be a really powerful combination. And this is something I think... Look, we have an investor day coming up in November, November 16th in Philadelphia, and, you know, at that time, we intend to unveil a new strategic plan for the company.
You know, moving on from our first five-year plan as a, as a standalone focused ag company, where we will look, you know, to give some expectations for, the company over the three-year horizon in more detail, as well as share some aspirational targets for a longer horizon, more of a ten-year horizon. And that interplay of new active ingredient introduction, along with FMC's traditional strength and building out products off of existing active ingredients that provide additional benefit and value to farmers, be a big part of the story to talk about. A few other pieces there to talk about as well, but I don't want to steal the thunder from that day. So certainly stay tuned. November 16 , we'll look forward to sharing some more with you about that.
... And so one of the comments on the August call was the, you know, your confidence on underlying end market demand or real demand. I think a lot of the chemical industry sort of struggles to really tease out what real demand is. Can you just describe a little bit what gives you that confidence? Are there data sources or, you know, how do you get past just doing an anecdotal survey?
Yeah, it's a combination of data sources. Depending on the country, there are better third-party sources than not. What we see and what we've seen over many years, and certainly over the past year and past several years, is sustained steady use by the grower of products. And again, it depends on the country, what the level of sophistication of that data collection. But, you know, in our larger countries like Brazil and the U.S., we have pretty good data sources that show that we have had continued growth in the consumption of crop chemistry by farmers in the production of product. You know, and it also ties with increases of acreage and increases of output, so you can correlate that.
Certainly, though, you know, the outsized growth of the industry in 2021 and 2022 were ahead of those rates, and I think that's how you get to some of the imbalances that are being reset right now in the value chain.
So can you talk a little bit about your kind of, your free cash flow dynamics going into next year? You know, clearly, kind of free cash flow this year is way off, kind of the conversion ratio that you have as a longer-term target. Should we think of the target as... Well, that target is sort of reset as well, and it applies to 2024-2026, or should you over generate, you know, should your conversion ratio overshoot in 2024 or 2025 to bring you back in line with that historical target? Can you just walk through those dynamics?
Sure. All right. Certainly. Look, I think first, you know, when we look at free cash flow, you know, we're looking at the cash available to pay dividends, buy back shares, or make acquisitions. All right? CapEx, legacy expenses, all those fun things are included when we talk about free cash flow. We look at free cash flow relative to net income. You know, our target is to have, on a rolling three-year basis, free cash flow conversion as a percentage of net income of 70% or above. We've been above that. We've been, you know, over a three-year basis going to 2022, we were about 68, 67. Not quite to that level, but getting there. Midpoint of our free cash flow guidance for this year is $0, right?
So to be clear, you know, it's a 0% conversion in a single year, drops the three-year down to 50%. I don't think that changes our structural expectations for the cash generation of this business. What we have is when you have a sudden demand drop-off, like we experienced in Q2, which leads to a buildup of inventory on our level, which means we don't really need to make much right now, and in fact, we are not producing, manufacturing much new product at the moment, because we have pretty significant inventory on hand. We are not buying anything. So payables, which are much shorter than the combination of inventory days and collection receivable days, are dropping rapidly. With the, you know, the simple bridge, our initial guidance for free cash flow for 2023 was a midpoint of $625 million.
We lowered our EBITDA outlook by 580, and we're expecting payables at year-end to be at least $400 million lower than the prior year. It's a pretty straight, direct move from $625 million this year . Now, that said, I believe that as you return to more, as the- you return to more normal production cycle and you re-equilibrate with this inventory reset, you'll get back to that working capital cycle of, you know, 120, 130 days of payable, 130 days or so of receivables, and 2-2.1 inventory turns. When you do that, you get back to a model that generates over, you know, over a rolling period, 70%+ free cash flow conversion.
In 2024, should there be some buildback from rebuilding payables while you're collecting on the sales as you're burning off inventory? There should be. What's the timing of that ramp? I don't have a budget yet. We're not... I can't get that granular just yet. We're still working through that, but I would expect to see some return next year of rebuilding of payables. How pronounced that is in one year versus over two years, it's gonna depend a little bit on how the dynamics work with burning down inventory and with collections. Again, I don't think there's anything that's structurally changed. We just have to get through, you know, the reaction and the, the, of this sort of sudden deceleration of production and then spin back up and get payables back in the right place.
Can you tie that to how you're thinking about your balance sheet, covenants, covenant risk, and so on?
Yeah, absolutely. So, you know, we have always worked on the presumption of maintaining metrics consistent with a triple B, which, you know, we translate to being 2.5 or below gross debt to EBITDA. Perhaps a bit more, you know, we carry a bit more cash right now, so it could be a little higher than that, but not much, in that general ballpark. We have never allowed ourselves a lazy balance sheet, so within that target leverage, you know, we've grown borrowings and we've deployed cash to keep the balance sheet around that level. You know, the challenge is when you have a sudden deceleration in your earnings, that can stretch your leverage.
Certainly, you know, as we did in Q2 with that sudden drop off, it pushed us to a point where we were gonna be too high relative to our covenants. So we did work with our bank group, and we adjusted our covenants to move from a 3.5 covenant leverage to a 4.0 covenant leverage through Q1 of next year. You know, I think that was done proactively. It was negotiated and in place before the end of the quarter. You know, it was not something where we allowed ourselves to get close to a breach, but it is one of the trade-offs of running, you know, a very targeted balance sheet at close to your ratings.
So I think one of the discussions we're having internally, and we'll continue to have, and I should expect some further conversations as we get to the November Investor Day, is should we target so, a little bit lower long-term average leverage than the 2.5 to give a little more breathing room in times of volatility or within years where we have significant swings in interest rates like we've experienced this year? But I think that general idea of managing the balance sheet to the, you know, to an investment-grade rating, and making sure that we do utilize the cash generated by this business to reward shareholders, I think we're pretty well committed to.
To be very, very clear, you know, from the 2019 to 2022 period, of the cash we generated and the incremental borrowing capacity from growing EBITDA at that target leverage, we spent about 12% of it on our inorganic growth investments, some M&A and acquisition, yeah, venture investments. The rest of it, we split almost perfectly 50/50 between dividends and share repurchases. You know, with share repurchases not being a, you know, an ongoing commitment, there's a margin of safety there in your cash deployment to be able to adjust to year-to-year fluctuations. You know, to be very clear, our dividend policy is very mainstream. It's a payout ratio at the market median, which is between 25%-30%. We pay about 27%.
Mm-hmm. And then just lastly, just if we can very quickly touch on the rest of the... I'm gonna take advantage of you not having the budget. The bridge to 2024-
Yeah.
You know, the price versus, raws differential looks likely to widen, and you should have a productivity tailwind. You get an increasing tailwind from new product introductions. Can you just walk through kind of how that all fits together?
Yeah.
and what the offsets might be?
Sure. So let me, I'll talk top line and then bottom line. You know, on a top-line basis, you know, we're seeing a reset. We're not seeing a snapback. We believe that the industry will revert to long-term averages, you know, whether that's exactly in 2024, through 2024 and 2025, we'll see, but we don't necessarily see a massive restock coming in 2024. So top line, we would expect, you know, at, you know, the industry to be very similar to the long-term average of 3%-4%, and could it be a little bit lower? Possibly a little bit higher, but and that FMC would outperform that. On the bottom line, you know, I think you pointed to a number of positive factors, and I think they're all there, right? I think we have the mixed benefit of new product introduction.
We do expect to have a favorable price and cost relationship. While input costs are declining less and are in some cases flattening off, the year-on-year comparison is still favorable and will be favorable in 2024. The one counter, the one offsetting factor that I do wanna acknowledge, is because we are not producing at full capacity right now and don't anticipate going into the new year being operating at full capacity, there will be some absorbed, some unabsorbed fixed costs that will carry over into 2024 as a headwind. They do not offset the fully those benefits, but they will temper them a bit.
So I think, you know, the idea that we should have, you know, more historical trendline kind of top-line growth, and margin expansion, so therefore growth of the bottom line faster than that, I think that's kind of how we're thinking about the budget right now. But as you had your, your opening, your disclaimer in your question-
Mm-hmm.
We don't have a budget yet. We'll give that guidance in February.
Okay, wonderful. On that note, we're out of time, so thank you very much.
Thanks, Laurence.