Description

W.R. Grace & Co. (ticker: GRA)

Conclusion:

GRA is a collection of very good businesses that is embarking upon a split into two different publicly traded companies; New Grace and Grace Construction Products.  Fundamentals are strong and improving at both businesses, both business have compounder characteristics (high returns on capital, and good capital deployment opportunities), and both businesses will be better appreciated by investors on a standalone basis, particularly the Grace Construction Products business.

Business Description:

GRA currently reports as three divisions, but given the impending split/spin, I will describe it as the two different public companies that it is set to become; New Grace and Grace Construction Products.  Whether they be in New Grace or Grace Construction Products, GRA’s products can typically be thought of as highly technical, critical to customer’s performance, but a small portion of a customer’s operating expense or finished product cost.  GRA is also #1 or #2 market position in the majority of their businesses / products.  As a little bit of history, Grace entered bankruptcy protection in 2001 to resolve pending asbestos claims.  The company exited bankruptcy in 2014 and has no remaining asbestos liabilities after settling the deferred payment obligation to the Asbestos Trust in August of 2014 and settling the 10m warrants paid to the Asbestos Trust for cash in February 2015.

New Grace

Catalysts Technologies

Refining Technologies

• Produces FCC catalysts and additives for petroleum refiners - #1 position in FCC catalysts with ~33% market share

• The top 3 players in the market (GRA, Albermarle, and BASF in that order) make up ~75% of industry supply

• FCC catalysts are used by refiners to improve product yields and quality as well as reduce emissions, and FCC additives are used to reduce sulfur content in gasoline and maximize propylene production

• FCC units keep catalyst moving constantly and have to continuously introduce fresh catalyst.  Scheduled maintenance shutdowns occur every few years

Advanced Refining Technologies

• Produces hydroprocessing catalysts - #1 position in resid hydroprocessing catalysts (#3 position overall with ~20% market share, but expect to become #1 with new positioning in distillate hydrotreating and hydrocracking)

• The top 5 players (Albermarle, Criterion/Shell, ART, Axens and Haldor Topsoe in that order) make up +90% of industry supply

• Hydroprocessing catalysts are used to remove impurities (nitrogen, sulfur, heavy metals, etc.) from heavy oil and upgrade it into lighter products

• HPC catalysts run 2-3 years before needing to be replaced, so sales are lumpier than FCC

• ART has traditionally had a strong market position in fixed bed resid hydrotreating catalysts, but has recently improved it’s positioning in distillate hydrotreating and hydrockracking in recent years through the realignment of the ART JV to 50/50 between GRA and Chevron, as well as the recent alliance with the Chevron Lummus JV

• ART is a 50/50 JV with Chevron and thus the financials are not consolidated in GRA’s statements

Specialty Catalysts

• Licenses technologies and produces catalysts for polyolefins - #1 position in independent (non-captive) polyethylene catalysts, and #2 in polypropylene catalysts and licensing technology

• Support The production of polyethylene and polypropylene which are used to produce a wider range of plastics

Materials Technologies

Engineered Materials

• Produces specialized silica-based materials used as process aids, additives and adsorbents - #1 in specialty silica gel

• Adsorption capacity of these products is used to enhance the product characteristics of a number of consumer and industrial applications from toothpaste to tires

Discovery Sciences

• Produces pharmaceutical and life science products including silica-based separation media and excipients

Grace Construction Products

Construction Products

Specialty Construction Chemicals

• Produces cement additives and concrete admixtures - #1 position in cement additives and #2 position in concrete admixtures

• In cement additives GRA has ~18% share followed by SIKA and BASF each with ~5%, and a fragmented market making up the remaining ~70%.  In concrete admixtures BASF has ~15% market share followed by GRA and Sika each with ~8%, and a fragmented market making up the remaining ~70%

• Cement additives are used to improve the energy efficiency of the plant and enhance the performance of the finished product, and concrete admixtures are used to reduce the production costs of concrete as well as increase the performance and life cycle of the product

Specialty Building Materials

• Produces waterproofing and fire protection materials - #1 in pre-applied waterproofing

• Waterproofing membranes and grouts used in commercial and residential buildings, as well as spray-applied fire protection barriers

Darex Packaging

• Produces formulated coatings and sealants for metal cans and closures - #1 position

• Used to seal and enhance the shelf life of can and bottle contents

GRA expects to lever New Grace at 2-2.5x EBITDA, and expects that the company will have a 10-15% cash tax rate through 2021 given that it will keep GRA’s NOLs.  GRA expects to lever Grace Construction Products at 3-3.5x given the low (~2% of sales) capital intensity, and expects the company to have a cash tax rate of 25-30%.

It’s also worth noting that GRA has a very good history of capital allocation.  Since they entered bankruptcy in the early part of the last decade, they’ve grown the business substantially at attractive returns by doing 22 acquisitions, 6 divestitures, +$500m of share repurchases (now on second authorization), and a $490m warrant settlement at attractive prices.  I believe the current plan to spin Grace Construction Products is a continuation of that effective capital allocation policy, as it will help uncover the value in that business and allow it to capitalize on attractive capital opportunities of its own.

Why GRA is Cheap / Misunderstood:

While all the businesses within GRA generally share the attractive attributes of #1 or #2 market positions, low percentage of final product/system cost, and high value / critical performance, they also generally split into two different buckets around how they generate their high returns.  New Grace, which will encompass the company’s catalyst and materials technologies businesses is a very high margin business that is a result of relatively substantial capital requirements.  Meanwhile, Grace Construction Products is a lower margin business with higher SG&A/opex than New Grace, but also with substantially lower capital requirements.  Both are great businesses with high returns on capital, but they are difficult to fully appreciate when combined.  Additionally, while Grace’s catalyst markets are highly oligopolistic, the construction markets are more fragmented and full of local monopolies (top 4 players only make up ~35% of the concrete admixture market and ~30% of the cement additive market).  This latter characteristic makes for a very attractive M&A runway, but the company has been hesitant to capitalize on this given the dilutive margin profile as compared to the catalyst business.

As a standalone business I think New Grace will be thought of similar to other high fixed investment / high visibility / high return materials businesses like Praxair and Air Products.  As a standalone business I think that Grace Construction Products will be thought of similar to other industrial / materials businesses with good returns and robust M&A programs; like Assa Abloy or Mohawk Industries.  I think the latter part of this story is the most misunderstood (both the quality of Grace Construction Products, and the capital deployment opportunities) piece of the investment thesis, as investors have mainly coveted the FCC franchise.  Despite the historical focus on the FCC business (which is certainly an excellent business), I think that Grace Construction Products is also a great business, with perhaps a longer runway for both organic growth and M&A, and thus deserves to trade with peers with similar characteristics like ALLE, MHK, ASSAB SS, etc.  Management has stated that they have passed on attractive construction-related M&A due to the fact that margins would be lower than the Catalysts Technologies and Materials Technologies business.  To get a sense for the M&A opportunity, one can either look at the fragmented market share in Grace’s construction markets (mentioned earlier in this write-up), or the consistent M&A track record of competitor Sika (note that I do not mention Sika as a valuation comp simply because I don’t see where their stock is trading as relevant given that Saint Gobain is trying to take control of the company by paying a premium for the controlling position).  Supporting the idea that management expects Grace Construction Products will reflect greater value as a standalone entity is the fact that separating it results in GRA’s NOL being amortized over a smaller profit pool at New Grace, thus lowering the NPV.  A few quotes supporting quotes from management with regards to the opportunity at Grace Construction Products:

CEO Fred Festa at a May ’15 conference: “We want it (GCP) to be able to do a lot of acquisitions.  We think it’s got opportunities to consolidate some of the industry, some of the smaller players around that space.”

CFO Hudson LaForce at a September ’15 conference: “we were convinced, remain convinced that the construction products business is undervalued within the existing Grace portfolio…….so when you look at GCP, compared to construction industry peers, it is a top quartile performer on margins, it’s a top quartile performer in terms of the cash flow that it throws off, it’s got great strategic position within the markets that it serves and in the context of the construction industry, is in a strong position to grow, to acquire, to build out its portfolio.”

The fundamentals at both business are also on the cusp of improving substantially as well.  At New Grace, the FCC business is poised to accelerate with volume from new customer contracts and tighter industry capacity that should bolster pricing power.  This is in stark contrast to the last few years that saw some industry turbulence as customers adjusted their crude slates and GRA had to deal with skyrocketing rare earth prices.  On the most recent conference call GRA talked about how they will be sold out of FCC capacity going into next year.  With capacity utilization in the mid to low 90s in 2015, one can see that this is a meaningful volume boost.  Additionally there should be a price benefit.  The last time capacity utilization was really tight in FCC catalysts was in the middle to end of last decade, and as a result prices rose substantially for a few years.  At Grace Construction Products, industry fundamentals remain strong, and the business should experience a larger margin benefit from lower crude prices than the Street is currently expecting.  Raw materials represent ~70% of COGS in the construction business and management has stated that ~1/3 of COGS are oil based like solvents and ethylene derivatives.  Additionally, Grace Construction Products should be able to lever its SG&A nicely as volumes rebound (N.A. commercial building starts are still ~40% below the prior peak on a square footage basis).  A few quotes supporting quotes from management (the first two re: the FCC business, the third re: raw materials in the construction businesses):

CEO Fred Festa at a May ’15 conference: “I think industry utilization, capacity utilization, is getting to the point where it’s fairly high and it’s getting even higher, when Takreer comes on fully, and I think if you look out from end of ’15 and out through the end of ’18, that’s a long time before any capacity is going to come on.  That tends to you know, you get pricing through the belly of new products, you get that all the time.  But you get a big sustainability when that utilization is that high, and it’s either there or getting close to that.  And so I think the next three years following that will be good, will be a good period for the FCC catalyst side of it.”

CEO Fred Festa on the Q2’15 conference call:  “We secured and positioned our FCC business for the next three to five years….I think the FCC business is going to be in a good place from a commercial standpoint the end of this year going into next year.”

CFO Hudson LaForce from a September ’15 conference: “I think we said early in the year that we thought deflation benefit across the whole company would be order of magnitude $25 million or so.  That’s consistent with what we’ve seen throughout the year.  We’re probably, we’ve gotten probably half of that roughly in the first half P&L.  That opportunity started to moderate.  If we were having this conversation 60 days ago, I might have said, it looks like it’s starting to moderate.  Crude has taken a leg down and we’ve seen a further leg down in some of the products we buy as well.  And so, I think we’re going to get a little extra deflation in the second half of this year and into next year that we didn’t see 60 days ago.”

I also think that there is greater potential for a takeout (for both New Grace and Grace Construction Products) when the businesses are separated.  For example, with respect to New Grace, Honeywell (who just acquired Elster for ~$5b at a ~12.5 EBITDA multiple, with lower margins and growth prospects than New Grace) could be interested in New Grace to further bolster their PMT division and complement their UOP business.  With respect to Grace Construction Products, the business could be attractive to the likes of a Sika or Saint Gobain, particularly if the contentious deal between those two parties falls apart.  Lastly, the fact that Grace Construction Products is being spun instead of sold outright, should not be taken as a sign of its attractiveness to an acquirer, but more to do with the fact that these assets have a very low cost basis.

Earnings Power:

I expect the top line at New Grace to grow mid to high single digits in 2016, and mid-single digits thereafter.  This is based mainly on the FCC business where I expect them to add another mid-single digits of growth in volume based on their comments that their new agreements have them sold out in 2016, vs mid to low 90s utilization in 2015.  The growth rate is also underpinned by expected pricing gains, although I am modeling a much more conservative scenario than we saw last cycle.  I also expect the ART JV income to grow double-digits, in line with management comments, as they benefit from new HPC units globally, as well as the share gains that should arise from the previously mentioned structural change to the JV, as well as the partnership with Chevron Lummus.  I am also modeling some continued modest margin opportunity from the pricing power and scale on fixed costs, as well as all available cash going towards share repurchases that keep leverage at 2x.

I expect the top line at Grace Construction Products to grow steadily in the mid-single digits as we progress from mid cycle in the N.A. commercial construction market.  I am also modeling raw materials related margin expansion this year and next, as well as some additional margin expansion as they leverage their SG&A.  While I think that M&A is highly likely, I instead model share repurchases that keep leverage at 3x.

Valuation:

I believe you can underwrite a +20% IRR on GRA using the above fundamentals, as well as exit multiples of 12x for New Grace and 14x for Grace Construction Products.  For New Grace I use high quality but relatively asset-heavy industrial and materials companies like the industrial gas companies and ECL as comps.  For Grace Construction Products I use high quality but asset-light industrial and materials companies like ALLE, ASSAB SS, AWI, MHK, SHW and VAL, with an emphasis on those with consistent M&A programs.

Balance Sheet & Liquidity:

Grace is conservatively levered at just over 2x net debt to EBITDA (including the pension and the NOL).  New Grace will be levered at 2-2.5x, and Grace Construction Products will be levered 3-3.5x.  I am modelling the low end of both of those ranges to be conservative, and with the cash that GRA will generate in 2H’15, the consolidated balance sheet is roughly the same as those standalone targets put together.

Catalysts:

• Split/spin – expected 1Q’16

• Acceleration in FCC business as new contracts ramp – should begin in Q4’15

• Raw material deflation in the Specialty Building Products and Specialty Building Chemicals businesses of Grace Construction Products

• M&A – variety of options here; bolt-ons at either business, or a takeout of either business

Risks:

• Economic weakness – mainly consumer spending for New Grace (FCC catalyst main driver is miles driven), and N.A. commercial construction for Grace Construction Products

Catalyst

Catalysts:

• Split/spin – expected 1Q’16

• Acceleration in FCC business as new contracts ramp – should begin in Q4’15

• Raw material deflation in the Specialty Building Products and Specialty Building Chemicals businesses of Grace Construction Products

• M&A – variety of options here; bolt-ons at either business, or a takeout of either business