Summary: This is a situation where investor fatigue has set in and no one is paying attention to the subtle signs of inflection rising in the business where earnings 2 years from now will be much higher than investors expect. Our field research indicates both demand and supply are inflecting positively, which is just beginning to drive the highly-expected-but-not-achieved pricing power within the oligopolistic Refinery Catalysts business. We project 2020E EBITDA of $690 MM (consensus $643 MM) and EPS of $5.15 (consensus $4.65); as sentiment reverts to optimism about the quality of the core Refinery Catalysts business, we apply GRA’s historical multiples of 12x EBITDA and 20x EPS for fair value of ~$102/share, upside of ~40%.
Setup: VIC is very familiar with W.R. Grace (“GRA”, “Grace” or the “Company”). GRA produces catalyst agents for refineries (Refinery or FCC Catalysts) and chemical companies (Specialty Catalysts) in the core Catalysts business along with specialty silicas sold through the Materials Technologies business. Grace has been a hedge fund favorite for years and when the Company spun off its Construction Products business in 2016 there was a belief GRA would be acquired. Since then, no buyer has emerged and results have been weak in both the Catalysts and Materials Technologies businesses, causing the heavy hedge fund ownership to give up and the stock to lag.
We don’t have a view GRA will be acquired, but we do believe the business is hitting an inflection point unappreciated by investors. Refinery Catalysts drive the bulk of Grace’s earnings and pricing has proved elusive since the 2014 bankruptcy exit, disappointing investors who viewed the 3-player industry structure (BASF & Albemarle the peers) as disciplined with pricing power as evidenced in the years leading up to 2014. It was then that GRA became greedy and attempted a 5-10% pricing increase while Albemarle had excess capacity and happily took disgruntled customers away from GRA at lower prices. Grace quickly received religion and stopped taking price increases altogether and the industry followed.
Now the supply/demand balance is inflecting in Refinery Catalysts with Albemarle at full capacity after taking business from GRA and diverting all of its capital into lithium. Meanwhile, incremental demand from new refinery (i.e., customer) capacity coming online has absorbed the catalyst industry’s residual capacity. There are no new catalyst plants coming online and our field research indicates the big-3 are at full capacity while the multi-year pipeline of new refinery openings in the Middle East and APAC is extensive. This will cause a supply shortage over the coming years.
This inflection is just starting and our field checks indicate pricing is already growing 3% y/y and possibly heading towards 4-5% in the near future, above management’s stated 2%. This pricing inflection makes a big difference, especially when factoring in the volume growth that occurs with new refineries coming online while catalyst capacity remains constant. However, investors think 2% is the maximum pricing threshold and a one-time occurrence as a cost pass-through from higher alumina and caustic soda costs in 2017. Management’s messaging is also intentionally conservative after the last pricing fiasco in 2014.
Key Assumptions: We assume by Q119 GRA can generate 3 points of pricing growth plus 3.5 points of volume growth while the Materials Technologies business generates 1-2 points of volume growth (note in 2018 volumes are growing 2.8% as of Q1 / accelerating from 2 new contract wins kicking in) and 50 bps of pricing. Catalyst margins are positively inflecting with (1) pricing and (2) recent new product / customer launches re-pricing to market after their 2017 trial periods expire while Materials Technologies margins are bottoming in 2018 from (1) lost contracts in 2017 of high-margin pharma business and (2) raw material cost increases that pass through pricing starting in 2018. This translates to 2019 EBITDA margins of 32.2% on revenue of $2,145 MM and run-rate capex of $120 MM.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.