|Shares Out. (in M):||67||P/E||0||0|
|Market Cap (in $M):||4,301||P/FCF||0||0|
|Net Debt (in $M):||1,398||EBIT||0||0|
|TEV (in $M):||5,699||TEV/EBIT||0||0|
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W.R. Grace (GRA) is a high quality, defensive business that has been left for dead as multiple transitory headwinds and misplaced investor worries have caused the shares to stagnate for four years. More recently, despite three quarters of accelerating organic growth and earnings outperformance, GRA has fallen victim to the broad-based sell-off in global equities, misguided read-across from non-comparable chemicals companies (PPG guiding down on rising input costs), and investor fatigue after multiple years of issues in the core refining catalysts business that are finally in the rearview mirror.
Following the spin of the lower-margin, more cyclical construction products operations (trades as GCP) in early 2016, the business quality of the remaining W.R Grace portfolio improved dramatically. This is a business with very little discernible correlation to crude oil prices, crack spreads or other macroeconomic sensitivity:
· Catalysts Technologies segment gross margins have risen consistently for at least 10 years, even expanding in 2009.
· Today’s Grace portfolio (excluding GCP) reported organic declines of only 2.5% in 2009, offsetting much of the MSD volume decline with pricing, and was back with +8% organic in 2010. Moreover, the fastest-growing portions of the portfolio are even higher-margin and more recurring than the historical core business.
Today, at $64, the stock languishes at the lowest forward P/E ratio since the spinoff of GCP, for a business that we expect to compound EPS and adjusted free cash flow per share at high-teens rates over the next three years, yielding 2020E EPS of $5.60, EBITDA of $675mm, and adjusted FCF of $425mm. Our base case valuation of 17x 2020E EPS is well below historical P/E ratios for Grace, despite the fact that the business is quickly mixing towards higher-growth, higher-margin and more-recurring revenue streams which would support a higher multiple. Combined with a 1.5% dividend yield and our modest valuation assumption, GRA is worth $97, or +51% upside from current (45% IRR through 12/31/2019):
In fact, holding the share price constant, the stock will be under 9x forward expected EBITDA by the end of next year and at 8x by the year after (safe to say it won’t stay at this level):
W.R. Grace is a global specialty chemicals company deriving roughly 80% of earnings from its leading portfolio of fluid catalytic cracking (“FCC”), hydroprocessing (“HPC”) and polyolefin catalysts (“specialty catalysts” or “SC”). The company generates best-in-class EBITDA margins near 30%, and has a medium-term plan targeting 5% organic sales growth and an EPS CAGR > 10% through 2021 (excluding the impact of recently-closed Albemarle specialty catalysts business which is accretive to 2018 EPS pre-synergies).
Grace’s growth algorithm implies that not only is the medium-term framework achievable, but there is also significant upside to the plan over the next three years, driven by:
· Earnings mix shift towards attractive specialty catalysts business, where Grace is a share-gainer over time
· Clean fuels regulations benefitting both HPC and FCC catalysts demand growth and shifting refinery feedstock composition towards more catalyst-intensive crudes/resids
· Tightening global capacity of FCC catalysts supporting pricing
· Upside from incremental M&A in specialty catalysts, which is highly synergistic and accretive to margin, free cash flow and group organic growth
Here is Grace’s pro forma revenue by product group:
The company reports two segments, Catalysts Technologies (outlined in black above, includes refining/PE/PP/licensing/chemical catalysts + ART HPC business + newly acquired Albemarle PCS business) and Materials Technologies (end-markets are coatings, consumer/pharma, chemical process). The ART JV with Chevron is not consolidated into revenues but is reported proportionately in adjusted EBIT and EBITDA for the Catalysts Technologies segment.
Grace has roughly 40% gross margins, with 40-45% of COGS spent on raw materials. Key inputs are aluminum (hedged 18-24 months), caustic soda, sodium silicate, rare earths, nickel, molybdenum, some precious metals on the HPC side, and natural gas to power the plants (hedged). Less than 3% of spend is on oil or oil-derived inputs. We highlight this only because the shares have been pressured by broader chemical-sector input cost inflation worries, which are misplaced in the case of W.R. Grace. The company has ongoing productivity savings programs and has successfully used pricing to offset inflation thus far in 2018.
· Grace stock has been flat for five years as idiosyncratic growth headwinds have caused momentum to slow in the ~$750mm FCC catalysts business:
o In 2013, a failed price increase in FCC catalysts caused Grace to lose significant market share and led to the company effectively rolling back pricing over the following 1-2 years to regain lost volumes. The impact called out by the company was $65mm of annualized FCC catalysts revenues, or -5% impact to 2012 Catalysts Technologies segment revenues. The impacts of these events on Grace’s catalysts business lingered, and can be traced to the shutdown of 10,000 tons of FCC catalyst capacity at the Curtis Bay facility in early 2016, nearly three years after the price increase.
o In 2015, the company began shifting FCC catalyst volumes away from lower-margin customers in preparation for the startup of the Ruwais refinery’s FCC unit operated by Abu Dhabi National Oil Company refining arm Takreer. The refinery is the largest in the Middle East by capacity and represented a significant margin opportunity for Grace. However, after only a few months in operation, a fire in January of 2017 caused the refinery to cease FCC operations, and the unit has remained offline since. In the wake of the incident, Grace was forced to quickly backfill the lost volumes at a lower margin. Based on the resulting business interruption insurance recoveries reported by Grace, the expected contribution margin of the Ruwais refinery was $25mm in 2017.
· Now, however, with tight industry capacity in FCC catalysts and Takreer due back online in early 2019, the historical headwinds have abated, and strong multiyear growth trends have emerged:
· The company is a leading player in the global market for polyolefin catalysts, a higher margin, higher growth and more-recurring market than the legacy refining catalysts businesses. Grace has consolidated much of the industry over the past decade, carving out strong market share positions in polyethylene catalysts, polypropylene catalysts and technology licensing for polypropylene reactors.
o Industry participants claim that contract retention rates are 90%, since high switching costs mostly preclude customer churn, while cost-in-use of catalysts is extremely low (1kg of gas-phase polypropylene catalyst, which would cost $250-500, produces 40 metric tons of polypropylene, which has a market value of $70,000). Based on conversations with industry participants, we believe the following:
§ Grace supplies 85% of catalyst material to ChevronPhillip’s chromium-on-silica loop technology for high density PE, a $150mm market
§ Grace controls the majority of the global metallocene market for linear low density PE, growing at double the ~4% end-use demand rate as the technology takes share from Ziegler-Natta catalysts
· Polyethylene capacity growth has accelerated in the Gulf Coast as a delayed byproduct of the US shale boom, with multiple large projects coming online in 2018 and 2019 in which Grace should participate
§ Grace also has #2 market share in polypropylene technology licensing, and is taking share from sluggish global leader LyondellBasell in a ~$800mm market with demand growing 5%
· This is an attractive razor-razor blade-style business model, in which Grace catalyst is spec’d into the PP reactor technology that it licenses (and in which Grace enjoys an exclusivity period for catalyst supply)
· At the 2018 Investor Day, Grace showed the following estimates for industry annual catalyst wealth opportunity from polypropylene growth:
· The slide notes that the expected catalyst sales for a new plant are $5-7mm, and 6-8 plants are coming online each year. However, Grace alone press-released 7 new polypropylene licensing wins in 2017 and 4 more so far in 2018, suggesting that they are winning far more than their fair share of the attractive industry growth in this specialty catalyst. Below I estimate that Grace won $6mm of incremental recurring revenues in 2016, $42mm in 2017 and $24mm in 2018 YTD (2017 base is $233mm). The segment thus appears to be growing in the healthy double digits, and management is confident in the pipeline from here.
o Pro forma for the Albemarle acquisition, specialty catalysts already account for ~40% of Grace consolidated earnings, and the consolidated company will mix towards the 40%+ EBITDA margin specialty business as growth outpaces the other segments
· Grace is exposed to two attractive growth drivers in the proportionately-consolidated JV with Chevron, which produces hydroprocessing catalysts (HPCs)
o HPCs are used either to a) upgrade heavy, sour feed into higher-value, lower-sulfur refinery product (a process known as hydrotreating) or b) produce middle distillates like diesel in a hydrocracking unit. The implementation of regulations such as IMO 2020, which limits the acceptable level of sulfur contained in marine fuel oil, will encourage refiners to add more upgrading capacity to supply compliant fuels, which will boost the demand for hydrotreating catalysts
§ A key means of compliance with IMO 2020 is by blending diesel into fuel oil, which spurs demand for hydrocracking catalysts (since hydrocracking units are the prevalent way of producing diesel fuel)
§ Industry participants like container shipper Maersk expect only a small fraction of the industry to adopt onboard scrubbers in time to be compliant with the regulation, making increased demand for refinery solutions highly likely
o The falling price of resid (the heavy, sour “bottoms” left over after other refinery processes), partially driven by the reduction in high sulfur fuel oil demand, represents an opportunity for complex refiners to capture more margin by purchasing low-cost resid and upgrading to high value products like gasoline, diesel, kerosene and jet fuel – this in turn suggests more hydrotreating capacity and more demand for HPCs
o Outside of a couple of smaller resid upgrading catalyst plants in China, Grace is the only global player adding HPC capacity. We believe the Lake Charles plant expansion, due online in 4Q19, represents at least 25mm lbs per year of catalyst supply, into a global HPC market of 500-600mm lbs (+5% global supply growth, coinciding with the implementation of IMO 2020). Based on Grace’s high teens dollar share of the market, they have maybe 90-100mm lbs of HPC capacity, which will expand ~30% when the Lake Charles expansion comes online:
· Because ART is not consolidated at the top line, not only is consensus failing to account for the massive volume bump when Lake Charles comes online, but brokers also fail to accurately model the operating leverage achieved by the JV as organic volumes grow at a mid-to-high single digit rate over the next four years (ex-Lake Charles)
o On my estimates, EPS from the ART JV could nearly triple by 2021:
· Grace targets 20% IRR hurdle for new investments, and projects $1bn of dry powder for acquisitions over the next 4 years
o The company also expects to add $250mm in sales from growth capex, where typical IRRs are 20-30%
o Even modeling M&A that is severely dilutive to company ROIC, Grace’s EPS accretion from acquisitions would be material, and is pure upside to management’s targeted earnings algorithm
o Acquisitions will likely be focused in the specialty catalyst portion of the portfolio, which should be accretive both to organic growth and margin given the favorable market structure and product complexity; the real cost and revenue synergies from integrating independent businesses into Grace’s already best-in-class polyolefin catalyst offerings translate to buyer multiples below consolidated Grace level
§ Grace has managed to average less than 10x EV/synergy-adjusted EBITDA for recent acquisitions, even while buying companies with EBITDA margins in excess of Grace’s own (UNIPOL polypropylene licensing business from Dow—38% EBITDA margin before synergies, single-site catalyst business from Albemarle—31% EBITDA margin before synergies):
· Within FCC catalysts, the market is entering a phase of tight capacity with very limited projected supply growth
o Over the first half of 2018, pricing has inflected positively after several years of alternating market share losses and price-downs for Grace
o Although the demand for gasoline—the primary final output from the FCC process—is modest in developed markets, demand is growing in developing markets, and catalyst intensity should be rising due to feedstock composition (highlighted in discussion of ART JV above). A newer, emerging source of demand is related to a secondary product of the FCC process, propylene, which is processed into polypropylene through chain-growth polymerization. The polypropylene market has grown around 5% predictably, with end-market demand levered to rising global incomes and substrate substitution from glass/paper/metal. Within a complex refinery, the FCC unit is the highest-yield source of propylene.
o Apart from an addition in the Middle East from Grace (for which volumes are matched to specific customer demand requirements), the reinvestment economics for FCC catalysts are still too poor to merit supply growth from the major international competitors (Albemarle and BASF), and the industry appears to be moving into a healthier balance for the foreseeable future
§ Key competitor Albemarle is focused on funneling cash flow into its lithium business, and will not grow FCC catalyst capacity
§ Grace has now posted three quarters of 2% pricing growth in FCC catalysts, and management is clearly bullish on the opportunity over the foreseeable future
· Based on the above drivers, we conservatively expect Grace will grow +4-5% per year organically in the Catalysts Technologies segment (+HSD in specialty and +2-3% in FCC catalysts), and for the Materials Technologies segment we assume recent strength evaporates and the segment normalizes to +3% organic in 2019-21 (has done +7% and +6% in the last two quarters and company guides to +MSD, but track record is worse). Group organic will thus average ~4.5%, with plenty of upside risk from better Materials Technologies growth and better underlying refining catalyst volumes.
· On the margin side, we assume input cost inflation is fully offset by cost saves and operating leverage, with significant upside from Albemarle synergies (+$6mm), ART JV operating leverage (+$27mm), ramp up of Takreer FCC unit in 1H19 (+$19mm underwritten, but could be up to +$25mm based on 2017 business interruption insurance recoveries), with modest FX drag in 2019 of -$6mm. This bridges us to EBIT margin of 27% in 2020 vs. 24% today, with no net benefit from pricing or productivity savings.
· Assuming the company’s tax rate guidance, declining capital intensity and 2.5x steady state net leverage, Grace will generate nearly $350mm of free cash flow in 2019 and >$400mm p.a. after that, allowing management to purchase well over $500mm in shares between 2018 and 2020 (reducing share count by 8%). The resulting EPS is ~$5.60 in 2020 and ~$6.30 in 2021, vs. $3.40 in 2017. In reality, some cash will probably go towards accretive bolt-on M&A which would benefit earnings growth even more. The business has historically traded at a forward P/E of 20x+, and based on the increasingly recurring revenue mix, expanding margins and robust organic growth profile, such a valuation is probably justified. However, we choose to conservatively capitalize the business at recent average of 17x, plus $1.60 of dividends, for a target valuation of $97 (year-end 2019) and $110 (year-end 2020).
· Grace has offset the impact of raw materials on margins historically, even during the spike in rare earths in 2010-2011, when key inputs were up 1000%+. To the extent they are unable to do so in the future and pricing growth cannot keep pace with inflation, there is risk to margins
· The competitive balance of the refining catalyst industry may shift, as it has in the past, and competitors may act irrationally or prioritize market share over margin—unlikely in a capacity-constrained three-player market. For years investors have fretted about a threat from Sinopec, but so far they have failed to gain a significant foothold outside of China.
· The Lake Charles facility may negatively impact pricing for HPCs and may not ramp in the timeframe outlined.
· Tariffs have had no impact to date, and the company is confident that its minor revenue exposure to China imports (~4% of sales) is not at risk for the time being. Some risk is present if the scope and depth of tariffs increases, pressuring customer profitability or global demand for refined petroleum product/petrochemicals.
· Regulatory risks from delay of IMO 2020 implementation (unlikely) or significantly more usage of ethanol-heavy transportation fuels (also unlikely).
· Major customer outages or shut-downs, failure of Takreer to ramp on time.
Charts and thesis details:
Figure I. Grace’s estimated specialty catalysts historical organic growth:
Figure II. FCC catalyst demand framework. Based on announced (discounted) refinery capacity plans, estimated global refinery utilization rates, and estimated catalyst pricing per ton. Albemarle noted on the 2Q18 earnings call that “FCC utilization rates are fairly high right now. For the major players, it's very high. In China, utilization is lowered by Chinese FCC producers. But overall, it's a good market for FCC, given where utilization is. That's been favorable for pricing. We've seen pricing trending upward in most of our established markets.”
Figure III. Specialty chemicals public comps (FactSet consensus numbers). Grace leverage temporarily elevated following Albemarle PCS acquisition this year.
· Takreer benefit to margins and earnings beginning 2Q19
· ART JV contribution to Catalysts Technologies segment earnings
· Implementation of IMO 2020 regulation, more clarity expected throughout 2019
· Price increase announcements/execution in FCC catalysts expected late 2018
· Continued quarterly beats and raises, emphasizing the dramatic differences in industry structure, cyclicality and end-market exposure vs. other specialty chemicals companies
· Someone buys it – at various points in the past, speculation has abounded, but is subdued today. We believe CEO Hudson La Force will act if public markets continue to misprice the company
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