Description

Investment Thesis:
W.R. Grace (Grace) filed for bankruptcy in April 2001 in response to an increasing number of asbestos-related lawsuits. An investment in the common stock is predicated on the contraction of liability per congressional action or the bankruptcy process (524(g)). The current market value overstates the company’s asbestos and environmental liabilities relative to the growing value of its assets and options at its disposal. Due to the uncertainty inherent in the bankruptcy process and the Fairness in Asbestos Injury Resolution Act (FAIR Act) currently being contemplated by Congress, the stock is underappreciated by investors and Wall Street. I will explain why the stock is cheap and the near-term catalysts, which in my opinion will lead to substantial share appreciation.

Business Overview:
Grace breaks its operations into two segments: Davison Chemicals and Performance Chemicals. Davison Chemicals generates approximately 54% of Grace’s sales and 56% of its EBITDA versus Performance Chemicals 46% and 44%, respectively. On a consolidated basis, sales by region are broken out as follows: North America – 42%, Europe – 36%, Asia-Pacific 16% and Latin America – 6%.

The Davison business is split into two parts, namely Refining Technologies (58% of Davison) and Specialty Materials (42%). Refining Technologies consists of fluid cracking and hydroprocessing catalysts and additives used to remove impurities when refining crude oil into transportation fuels. This unit continues to benefit from high capacity utilization at refineries and should benefit from more stringent environmental emission requirements and the growing use of heavy oil containing greater amounts of sulfur. The Specialty Materials unit consists of other catalysts and silica-based products used to manufacture polyolefin resins and engineered materials applied in various industrial, consumer and pharmaceutical applications. This segment is dependent on general economic conditions and targeted end-market growth.

The Performance Chemicals business is divided into three segments: Construction Chemicals (51% of Performance Chemicals), Building Materials (24%) and Sealants and Coatings (25%). The Construction Chemicals unit includes concrete admixtures, cement and masonry additives, while the Specialty Building Materials segment consists of fireproofing and waterproofing materials. These businesses are affected by construction activity – mostly non-residential construction and should benefit from the rebuilding of the Gulf Coast along with the expected pickup in commercial construction and infrastructure activity (Highway Bill). The Sealants and Coatings unit helps to protect food and beverages from bacteria and other contaminants, extends shelf-life and preserves flavor. Demand is fairly stable.

Description of Asbestos Liabilities:
Understanding Grace’s asbestos liability is one of the keys to this investment. The asbestos liability includes personal injury, property damage and Zonolite (ZAI) claimants. Unlike some of the other companies with asbestos liabilities, Grace mined and processed vermiculite, which contained a form of asbestos. The company stopped manufacturing products containing asbestos in 1973, but did not close its Libby, Montana mine until 1990. Here is a quick description of Grace’s asbestos-related activities and claimants.

In 1963, Grace purchased the Zonolite Company (now part of Performance Chemicals), which incorporated asbestos into various construction products, mainly spray-on fireproofing (Monokote-3), acoustical plasters and textured ceiling finishes (gypsum, cement, clay, vermiculite). One of Grace’s products, Zonolite Attic Insulation was used in homes and other buildings and contained asbestos. These products were handled by workers and put into homes and buildings, which is where the litigation comes into play.

Personal injury claimants allege adverse health effects from asbestos-exposure to Grace’s products. Upon filing, Grace reported personal injury claims of almost 130,000. Some of these claims are for claimants who are symptomatic for asbestos-related illnesses (asbestosis, mesothelioma and other cancers), while others are for asymptomatic patients claiming exposure.

Property damage (PD) claimants seek payment for the removal of asbestos contained in buildings, whereas ZAI claimants want the removal of attic insulation containing asbestos. Upon filing, Grace reported eight PD lawsuits, but many more were filed before and after the Bar Date. There are ten proofs of claim for ZAI.

I will go through Grace’s options in settling these liabilities and my estimates in the asbestos resolution section. I would like to also note here that the property damage and ZAI claims have been truncated throughout the bankruptcy (many thrown out). Like USG, Grace could conceivably settle with the asbestos personal injury claimants and litigate the remaining PD and ZAI claims.

Plan of Reorganization:
Grace filed a Plan of Reorganization (POR) and Disclosure Statement in November 2004 and amended these documents in January 2005. These filings attempted to set the value of the asbestos liability around $1.7 BN and calculated a stock price midpoint estimate of $17.01 ($12.37 under certain conditions leading to greater dilution). After recent discussions with management and other parties to the POR, I conclude that the structure of the reorganized entity and payments contemplated by the POR could be vastly different from that proposed by the current POR. Rather than explain the shortcomings of the POR, I will compute the value myself based on my estimations of assets and liabilities.

Asset Value (See Summary Breakup Analysis):
To quote a chemicals analyst I speak with, Grace and its competitors are currently on steroids right now in terms of profits and growth. One of the best comparables to Grace’s catalyst business is Engelhard. BASF is pursuing a hostile takeover of Engelhard for 11-12x 2006E EBITDA and many expect the takeover price to be increased. Another data point is Albemarle’s April 2004 acquisition of Akzo Nobel’s refinery catalyst business for 8.9x EBITDA. Grace maintains the #1 market share position in the refinery catalyst business. Excluding the aforementioned companies, specialty chemical companies trade at around 8-9x 2005E EBITDA and ~8x 2006 EBITDA, respectively.

Comparables (ElkCorp, Valspar, HB Fuller, Vulcan Materials, RPM International, etc.) to Grace’s Performance Chemicals business trade around 9x 2005 EBITDA and 8x 2006 EBITDA. Degussa recently sold its construction chemicals business to BASF for 10.4x 2005E EBITDA.

Given these data points, I think it is appropriate to use an 8-9x EBITDA multiple for Grace’s consolidated enterprise. As a value investor, I generally do not look to purchase companies at over 8x EBITDA (unless there is a value-enhancing catalyst at play – like here), but I think it is important to understand the market’s demand and valuation for these assets based on trading and M&A multiples.

On an LTM basis, I calculate adjusted EBITDA for Grace of close to $375 MM (Rita and Katrina affected 3Q performance). The November 2004 Plan of Reorganization (POR) projected 2005 and 2006 EBITDA of $386 MM and $415 MM. Given these data points, I used an 8.0x multiple on $415 MM of 2006E EBITDA for a value of $3.3 BN. Each 0.5x multiple increase generates $207.5 MM of additional value or $3.10 on 66.9 MM shares outstanding ($2.77 including management options).

At year-end, Grace’s cash balance approximates $475 MM and the cash value of life insurance policies on its balance sheet sums to $85 MM. Grace’s insurance for asbestos varies depending on the total liability. At a $1.7 BN asbestos number, the insurance is estimated at $500 MM. I assume the number is closer to $700 MM based on a $3 BN figure. Upon emergence, the company should also have significant tax assets based on asbestos, pension, OPEB and environmental payments. To be conservative, I use pre-tax amounts for many liabilities, which are tax-deductible. Depending on the form of the resolution of the asbestos liability (I’ll explain later), Grace’s NOL could exceed $1 BN. The remaining assets consist of contributions from Fresenius and Sealed Air per litigation settlements.

Pursuant to concerns about potential fraudulent transfer litigation, both Fresenius and Sealed Air, which purchased Grace assets in 1996 and 1998, reached agreements in principle to settle asbestos and fraudulent conveyance claims. Fresenius will pay $115 MM to the Debtors’ estates as directed by the Bankruptcy Court upon confirmation of a plan. Sealed Air will contribute $512.5 MM plus accrued interest and 9 million shares of Sealed Air common stock. Based on Sealed Air’s March 3rd closing price, the total value of the Sealed Air contribution is approximately $1.1 BN. As I will explain later, these assets should provide the backbone of a settlement with the asbestos attorneys.

The sum of Grace’s assets is ~$6.4 BN (see summary breakup). Again, this does not factor in much of the value to Grace’s enormous tax assets, with the exception of certain recoveries expected per a 524g plan (akin to USG–10 year carry back).

Non-Asbestos Liabilities (See Summary Breakup Analysis):
Grace non-asbestos liabilities include: debt, pension and other post-retirement benefits, environmental (vermiculate and non-vermiculate), payables and other accrued liabilities.

I used the total value of the pension and OPEB liabilities, despite the fact that payments are made in pre-tax dollars. Lastly, I did not subtract the entire amount of Grace’s environmental liabilities. A portion of these liabilities should be paid over time and would be much less on a NPV basis. Additionally, most chemical companies have environment liabilities and these costs were not factored into the aforementioned EBITDA multiples.

Libby, Montana Grand Jury Indictment (per 10Q):
On February 7, 2005, the Department of Justice announced a 10-count grand jury indictment against Grace and seven current or former employees. The indictment relates to Grace’s former vermiculate and mining and processing activities in Libby, Montana. Grace is accused of (1) conspiracy to violate environmental laws and obstruct federal agency proceedings; (2) violations of the federal Clean Air Act; (3) wire fraud in connection with the sale of allegedly contaminated properties; and (4) obstruction of justice. The U.S. District Court for the District of Montana has entered a scheduling order setting a trial date of September 11, 2006. Grace “categorically denies any criminal wrongdoing.”

If convicted, the company could be subject to fines of twice any profits made from the mine or twice the alleged loss suffered by Libby victims, plus additional amounts for restitution. The maximum penalty is difficult to compute. The indictment indicated $140 MM in after-tax profits. A starting point is twice those profits or $280 MM. One thing to keep in mind is that many of the victims have already filed personal injury claims against Grace and would be part of a settlement discussed below. The general consensus among the people I have spoken with is that the DOJ would participate in the settlement (i.e. not hold up the case and potentially delay distributions to claimants). In my recovery analysis, I estimated $150 MM in my base case.

New Jersey Lawsuit:
In September, New Jersey entered the fray seeking $75,000 per day for every day from June 1995 to the present that Grace failed to correct allegedly false reports involving asbestos contamination. Presumably (I hope), the automatic stay would kick in upon filing and potentially limit additional penalties beyond April 2001. From June 1995 to April 2001, a daily penalty of $75,000 amounts $150 MM. Again, I would imagine Grace could settle this for less (model assumes $50 MM). Settlement discussions are currently ongoing. Discussions with attorneys suggest these types of claims are often settled for significantly less than the maximum amount.

Asbestos Resolution (Truncation of Liability):
There are a three ways Grace can resolve its asbestos liabilities. Let’s call them scenarios.

1. Wait and see if Congress passes the FAIR Act, which would take care of asbestos personal injury liabilities and then settle or litigate the remaining PD and ZAI claims.

2. Settle with the various asbestos claimants and use the 524(g) provision of the Bankruptcy Code, which creates a channeling injunction that would be the sole recourse of asbestos claimants going forward. This would allow Grace to emerge free and clear of asbestos liabilities.

3. Allow the Bankruptcy Court judge, Judith Fitzgerald to estimate the asbestos liabilities based on information from Grace and the asbestos claimants.

The most favorable scenario is Congressional action. However, the current bill has stalled in Congress due to a parliamentary tactic from the bill’s opponents (budget point of order requiring 60 votes to continue floor debate). The tally was 59-40 in favor of continuing discussion with one member absent (and apparently in favor of continuing debate) until Frist changed his vote in order to allow for re-introduction of the bill at a later time.

The “no fault” bill has a lot of history. Senator Orrin Hatch (R-Utah) introduced an asbestos bill (S. 1125) in May 2003 with a proposed $108 BN contribution from business and insurers. This bill passed out of the Senate Judiciary Committee with one Democrat on board, but stalled in the Senate. Senator Arlen Specter’s bill (S. 852) replaced the prior bill and called for a $140 BN asbestos trust fund. This bipartisan bill emerged from the Senate Judiciary Committee in May 2005, but recently failed due to the aforementioned budget point of order.

While the bill generated some Democratic support, many Conservative Republicans opposed the bill due to the deficit projected in the early years of the fund (payments to claimants > defendant contributions) and the potential for a future Congress to voluntarily accept liability for potential underfunding rather than allowing claimants to revert to the tort system as the bill contemplates. Republicans are also concerned with what they perceive to be weak medical criteria. These Senators essentially “killed” the bill per the budget point of order.

One positive is Senator Spector’s reluctance to give up on this bill. Many people consider the bill to be on “life-support” right now, but we have heard that many times before, only for Spector to bring it back to life. Additionally, the President has repeatedly urged Congress to pass an asbestos bill as has the Supreme Court.

Senator Frist has stated, “60 members must signify their commitment” to end a budget point of order and any potential filibuster, before he would bring the bill back to the floor. With this in mind, Spector and Leahy are trying to gather 60 senators’ signatures on a letter requesting a re-vote on the bill. One consultant I spoke with indicated the letter had 58 signatures. Regardless, I think the probability of FAIR Act passage is low or ~10%. Under the bill, Grace would contribute its personal injury insurance assets and pay 1.67% of 2002 revenues annually into the fund or $30 MM for an NPV of ~$375 MM (pre-tax).

The second most favorable scenario is a settlement with the plaintiff attorneys. It is my view this has the greatest likelihood of happening. Plaintiff attorneys take a large share of asbestos settlements (30-40%) compared to a small percentage (5%) under the FAIR Act. Would a lawyer want to take a chance on the FAIR Act or an estimation hearing (whereby questionnaires would have to be sent out to each claimant and the process would continue on for quite some time), or just settle and collect a ton of cash immediately? For a company like Grace, where most of the proceeds could be funded upfront, the lawyers would collect their fees quickly.

Compared to other companies with asbestos liabilities, it makes more sense for Grace to cut a deal. Unlike other companies, Grace has access to over $1.2 BN of other companies’ money. Plus, Grace could contribute insurance valued at $500 MM or more. By adding some of the cash on hand, Grace is at $2 BN without breaking a sweat. Halliburton, Crane, Johns Manville, ABB, McDermott and USG have used or are using the 524(g) process to eliminate asbestos liabilities. While Halliburton, Crane and ABB settled asbestos claims for $6,500-$10,000 apiece, the McDermott (Babcock & Wilcox is its subsidiary with asbestos liabilities) and USG settlements are the most intriguing, especially considering that in many of these cases, the debtor and personal injury attorneys are often the same.

McDermott and USG hedged the passage of the FAIR Act by entering into a settlement, whereby the amount contributed to a 524(g) plan is contingent upon whether or not the FAIR Act becomes law. Under the FAIR Act, McDermott estimated the NPV of its obligations at $335 MM. Under the settlement, if the FAIR passes before November 2006 and is not subject to a Constitutional challenge as of January 31, 2007, McDermott pays $375 MM and contributes its insurance assets of $535 MM (akin to the FAIR Act). In the event the FAIR Act is not passed, the company contributes $350 MM in cash plus insurance ($535 MM) and a contingent note and right of $250 MM and $355 MM (interest rate of 7% on both) for a total cash payment of $955 MM. The note would be secured by Babcock & Wilcox stock, which satisfies the 524(g) requirement that over 50% of its stock be “at-risk.” This is a key point because a similar deal would allow Grace to limit the dilution to its stock. USG entered into a similar settlement arrangement, whereby USG owes $900 MM if the FAIR Act is passed and $3.95 BN (pre-tax recoveries) if it does not pass. I see no reason why Grace would not craft a similar deal.

Here is some other anectdotal information. Joe Rice (asbestos honcho) indicated at a Mealey’s asbestos conference that the paperwork (questionnaires) required by Judge Fitzgerald for asbestos claims is overly burdensome. For personal injury claims, each claimant must complete a detailed questionnaire providing information about their medical condition, including diagnostic support, exposure to Grace and non-Grace asbestos-containing products, employment history and pending lawsuits against other companies.

In order to further settlement discussions, Judge Fitzgerald granted the various parties (the DOJ may join) involved in Grace’s settlement negotiations 60 additional days from February 21st until April 17th to work on an agreement. Per the Court docket, it appears that a mediator has been found. It looks like the parties have consensually decided on Samuel Pointer, a former federal judge, who was involved in the Dow Corning breast implant settlement. Negotiations should begin shortly. Per these revelations, I estimate a 50% (or higher – I think it’s higher) chance a settlement is achieved. Last I heard the Grace asbestos liability bid-ask was in the $2-$3 BN range. For the purposes of this analysis, I assumed $3 BN.

The last scenario is by far the worst case. In the event the judge estimates the asbestos liability, the number could be quite a bit higher than $1.7 BN, or even $3.0 BN. In the Owens Corning estimation hearing, the debtors’ estimated a liability of $2 BN versus the asbestos claimants at $16 BN. It appears like the judge used a near-midpoint estimate of ~$10 BN. That case was different that Grace’s, but in the event the asbestos liabilities are estimated, the plaintiff attorneys are going to look for a complete wipeout of Grace’s existing shareholders. An estimation hearing is currently set for September 2006, but a final ruling on a shareholder recovery in a contentious bankruptcy would be far in the future as appeals are exhausted. Regardless, I do not expect Grace’s stock to head to zero if there is no settlement (40% chance or lower) and the FAIR Act is delayed further or killed. Over the last three years, the stock has ranged from a low of $2.51 and a high of $14.95. As the business has improved over this timeframe and multiples have expanded, I think $7.00 is the lowest the stock would go over the next year, and it probably would not even head that low. Even if the FAIR Act dies or settlement discussions break down, there is always the option of new legislation (Medical Criteria Bill in the House) or additional settlement talks down the road.

Summary Breakup Value:
EBITDA $415
Multiple 8.0x
Enterprise Value $3,320

Cash $475
Cash Value of Life Insurance Policies $85
Asbestos-Related Insurance $700
Sealed Air Cash (@ 3/3/06) $609
Sealed Air Stock $520
Fresenius Contribution $115
Total Distributable Value $5,823

Sources of Cash from Working Capital $200
NOLs - Asbestos Payments $400
NOLs - Pension + OPEB + Environmental ???

Asbestos $3,000
Libby, Montana DOJ Criminal Indictment $150
New Jersey Civil Lawsuit $50
Total Debt $685
Pension $448
Underfunded Special Pension $75
OPEB $113
Environmental Remediation $250
Income Taxes $135
Other Obligations $106
Total Obligations $5,011

Remaining Equity Value $1,413

Total Shares Outstanding (Incl. Mgmt Options) 75 MM shares

Implied Share Price $19

Other Assumptions:
1. As asbestos liability grows from $1.7 BN to $3.0 BN, I assume the insurance asset increases from $500 MM to $700 MM.
2. Cash conversion cycle reverts to historical days.

*If the FAIR Act is passed, the asbestos liability approximates $375 MM and the asbestos insurance, Sealed Air cash and stock and the Fresenius funds are eliminated and the tax asset is reduced. When the model is adjusted for these changes, the share price approximates $23/share.

Summary of Valuation under the Three Scenarios:
Under the first scenario (FAIR Act), Grace contributes ~$30 MM annually and some of its insurance would be lost (insurers for Grace’s personal injury liability would pay monies into the trust fund created by the FAIR Act). The PD and ZAI lawsuits would remain (many of these lawsuits have been truncated). After speaking with a lawyer involved in the case, the Sealed Air and Fresenius money could be used for a 524(g) to diffuse the remaining PD and ZAI liabilities. These funds should be more than enough. Using the asset values and liabilities discussed above and assuming an NPV of $375 MM, I compute a stock price (diluted for management options) of close to $23. This excludes the tax assets. Including these tax assets and increasing the EBITDA multiple to 9x, it is not hard to envision a stock price close to $30.

Under the second scenario, I use a $3.0 BN estimate for the entire asbestos liability (personal injury, property damage and ZAI). This is where the guessing (educated) game comes into play. I have spoken with Grace’s general counsel, the CFO, investor relations and many other lawyers and consultants. I have been able to piece together that the bid-ask is somewhere between $2 and $3 BN, and I used the high-end. Using this number along with the other estimates, I calculate a near $19 stock price.

As mentioned above, I view $7 as the downside given the option of favorable asbestos resolution, the improvement in the business and the expansion of multiples.

I assign probabilities to each scenario.

Scenario 1: 10% = $23
Scenario 2: 50% = $19
Scenario 3: 40% = $7

The weighted average price is $14.60 or 39% above current prices. Including additional NOLs, the recovery would be even greater. Again, a 0.5x increase in EBITDA yields $2.76 more per diluted share.

Risks:
1. Settlement discussions cease
2. FAIR Act is terminated
3. Economic downturn
4. Specialty chemical multiples decline
5. Libby, Montana and New Jersey liabilities are higher than expected

Summary:
When Grace emerges, it will have tremendous earning power and significant tax assets. It is not hard to see a case in which the stock is worth in excess of $20 a share.

Catalyst

1. Settlement with asbestos claimants (like USG and McDermott).
2. FAIR Act is back in the news.