Description

WR Grace (GRA or the Company) has been written up on VIC several times over the years, so I will not rehash the business in detail. The purpose of this write-up is to highlight the opportunity recently created by 40 North’s offer to acquire the 85% of the Company it doesn’t own for $60 a share in cash. 40 North is the investment arm of Standard Industries, a privately held industrial conglomerate that is the legacy of Samuel Heyman, the well-known corporate raider from the 1980s who died in 2009. Standard Industries has a historical focus in building materials and chemicals and is controlled by David Winter and David Millstone, Heyman’s sons-in-law. A 2019 FT article put Standard’s revenue at over $6 billion and EBITDA at $1.3 billion. As a 14.9% shareholder, 40 North had an employee on GRA’s board in Kathleen Reiland as well as an outside nominee in Henry Slack. These two were appointed in February 2019 as part of a letter agreement that included a standstill. On October 13, 2020, Reiland resigned from the board. This is the text of her letter to the board that was published in an 8K: “I am writing to inform you that I hereby resign as a director of W.R. Grace (Grace), and from each committee of the Grace board of directors, effective immediately. It has become clear during my time serving as a director that my views on how to address Grace’s performance are not shared by this Board, in particular my views with regard to the Company’s current strategic direction. I have no confidence that my continued service would result in the significant, meaningful change I have advocated for at Grace.” The stock rose from $40 to $47 on the news. On November 9, 2020, 40 North made public its offer to acquire the Company in a 13D. The offer included no financing contingency and allowed for a go-shop provision. The stock rose from $44 to $55 on the news. The Company followed up with a press release later that day saying that the board unanimously rejected the bid and that the board “remains open to all opportunities to maximize value for shareholders.” It is notable that a unanimous decision includes Slack, 40 North’s appointee.

This is not 40 North’s first foray into activism in the chemical industry. In July 2017 they partnered with Corvex to buy 25% of Clariant and scuttle Clariant’s planned merger with Huntsman. 40 North/Corvex believed Huntsman was overvalued and had a large, more commoditized and cyclical polyurethanes business that was at its peak and would devalue Clariant’s higher quality specialty chemicals business. They suggested instead that Clariant sell its lower growth, lower margin plastics and coatings business to bolster its balance sheet and focus on its three specialty chemicals platforms. They also believed Clariant had cost savings opportunities to bring their margins up to competitors’ levels. After the deal blew up, 40 North sold its stake in January 2018 to a strategic buyer in a Saudi state-owned entity called Sabic for $2.5 billion, netting a large profit. In addition, 40 North/Standard owns 24% of GCP, the building materials and construction chemicals business spun out of GRA in 2016. Starboard Value is a 9% active holder with board seats in GCP after a two-year campaign, indicating there is likely history between 40 North and Starboard as well.

We believe 40 North’s $60 bid significantly undervalues the Company, but it is not a bad consolation prize from a ~$55 purchase price if that’s where things end up. 40 North has effectively put GRA in play and there could well be strategic and/or private equity interest at prices well above $60. Honeywell is one possible suitor with ample liquidity that might want to combine GRA with their UOP business. UOP is a major player in licensing of refining equipment but has a weak catalyst business. Clariant, where 40 North has history, also could have strategic interest in parts of the business but may not be able to acquire the whole Company.

We suspect the GRA saga will play out in the near-term as 40 North will likely not be content to own 15% of a business where they have lost faith in Company leadership and where they have made an active bid for the Company. If the board chooses not to pursue a sale of the Company, we suspect 40 North could run a proxy contest or another activist could get involved (there is history with Corvex and Starboard and the situation also could attract others). It is notable that as long as 40 North remains under 15% of the stock, they only require a majority of shareholders to approve any transaction, including their own shares. This means they need 35% of other shareholders to go along. Had they gone above 15%, they would require a supermajority of shareholders to go along, excluding their own shares. On the flip side, they could go over 15% as part of a tender for the Company. Such a move would force the board’s hand.

We believe the downside is limited to around $40 in the absence of a bid and in real terms the floor is $60 given the 40 North proposal. Fair value for the business is around $70-$90, which is where we expect to see a deal concluded if there is interest among other buyers.

Business Overview

GRA operates in two segments: Catalysts Technologies (CT) and Materials Technologies (MT).

CT is the bigger segment at around 77% of LTM attributed total Company sales and 82% of segment EBITDA (the notion of attributed sales is discussed below). CT primarily sells two types of catalysts used by refineries. The bigger business for GRA is for fluid catalytic crackers (FCCs). FCCs are mainly used to crack hydrocarbon chains in distilled crude oil to produce transportation fuels like gasoline and diesel, and feeds for petrochemical production. By our math, FCC catalysts are around 43% of attributed CT sales in the LTM. The other refining catalyst business for GRA is called hydroprocessing catalysts (HPC). GRA sells HPC through a 50/50 JV with Chevron called ART. HPC are used in process reactors to upgrade heavy oils into lighter products, primarily to meet environmental regulations. HPC catalysts are around 16% of attributed CT sales. When we say attributed, we are including GRA’s 50% share of ART’s sales in the figure (ART is not consolidated for reporting purposes, so these sales do not appear on GRA’s GAAP statements).

The other major business within CT is polyolefin and chemical catalysts, which GRA built up largely through acquisition over the last decade or so. Polyolefin catalysts are used to produce polyethylene (PE) and polypropylene (PP), which are thermoplastic resins used in a variety of industrial and consumer applications. PP catalysts were around 20% of 2019 attributed CT sales while PE catalysts were around 14%. GRA also has a process licensing business for the manufacture of PP (which leads to follow-on catalyst sales) and a small chemical catalyst business. In total, polyolefin and chemical catalysts are around 41% of attributed CT sales. GRA’s other segment, MT, primarily sells silica-based products used for consumer/pharma, chemical process and coatings applications. MT is around 23% of LTM attributed sales for the whole Company and 18% of segment EBITDA.

GRA has a good business. The Company earns attractive ROIC (in the 20-25% range in recent years) and high margins (in the 27-32% range on an EBITDA basis). They have strong market positions, with 80% of sales coming from markets where they are #1 or #2. They are the market leader in FCC catalysts, HPC, PP and PE catalysts, PP process technology licensing, specialty silica gel and colloidal silica, among other categories. Many of GRA’s markets are effectively oligopolies, including FCC catalysts, HPC and polyolefin catalysts. In FCC catalysts they are mainly competing with Albemarle, in PP catalysts and process technologies they are mainly competing with LyondellBasell and in PE catalysts they are mainly competing with Dow. In HPC there are a handful of large competitors and MT primarily competes with manufacturers of alternative non-silica solutions as well as companies like PQ Group. Their markets overall appear rational.

GRA’s products tend to be technically differentiated and specialized with a high degree of tailoring for specific customer needs. This creates high switching costs for customers. Changing catalysts suppliers introduces operating risk and end-product risk and in the case of polyolefin catalysts, it can require spec changes all along the supply chain to the finished product. GRA’s products tend to be critical to customers’ performance but represent only a small portion of customers’ cost. This all makes GRA’s products fairly sticky.

Despite its positive attributes, GRA has not performed up to expectations even prior to Covid. ROIC, while attractive, has been declining as management has grown assets (mainly through acquisition) without growing profit at a similar rate. They have struggled in FCC catalysts due to some competitive missteps and various one-off events like refinery explosions. FCC catalyst pricing had been lackluster for many years but was picking up prior to the virus, with expectations and recent realizations of 1-2% annual growth in pricing. The other businesses have also had their share of “one-time” issues, like equipment outages and customer inventory adjustments.

The CEO, Hudson La Force III, replaced longtime CEO Fred Festa in May 2019. La Force had been COO for two years prior and CFO for the eight years prior to that. It is notable that his background is in finance, not operations or science.

Valuation

Prior to the pandemic, management had expected 4-6% annual organic sales growth in the medium-term. This is primarily driven by global demand for plastics, petrochemical feedstocks, cleaner fuels and heavy oil upgrading. Polyolefin catalysts and HPC are the main growth areas. On the negative side, they expect FCC catalyst demand to be up only slightly as the world transitions from transportation fuels to electric power. They expected this level of organic sales growth to lead to 6-8% EBITDA growth and over 10% EPS growth. Prior to the pandemic, we had seen the following growth CAGRs for the period 2015-2019 on an adjusted basis: sales of 4.7%, EBITDA of 8.2% and EPS of 17.3%.

Covid has had a negative impact on the business. Refiners have cut throughput to match reduced demand for transportation fuels, and plastic resin producers and users of MT silica products pulled back due to reduced end market demand. In Q2 and Q3, respectively, the Company saw RT sales down 28% and 24% year over year. Polyolefin and chemical catalysts sales were down 15% and 5%, respectively, while MT sales were down 7% and up 4%. MT sales have benefited from strong demand in consumer/pharma applications (up 24% in Q3) and recovery in coatings (up 5% in Q3). On an adjusted basis, EBITDA declined 22% in Q3 year over year and EBITDA is down 27% on a YTD basis vs. the prior year.

For calculating multiples, we adjust the market cap and enterprise value up for the environmental accruals, legacy product liability reserve and pension underfunding and down for the Federal NOLs. On an LTM basis, GRA is trading at 12.4x EBITDA, 14.8x EBITA and 17.8x earnings. The dividend yield is 2.2%. On 2019 numbers, GRA is trading at 10.0 EBITDA, 11.5x EBITA and 13.2x earnings. Using 2019 is a conservative proxy for what results should look like once the pandemic is in the rearview mirror as 2019 suffered from a handful of issues that held back profitability (FCC customer bankruptcy following refinery explosion, customer-specific inventory correction in polyolefins, equipment failure in silicas). There are no good comps for GRA. Prior to the virus, analysts had pegged value at $80-$90. A competitive M&A driven value should start around $70 and could easily work back up to the $80+ range if there are a few interested buyers. An $80 price tag would put the 2019 multiples at 12.9x EBITDA, 14.9x EBITA and 18.7x earnings before deal synergies. According to Bloomberg, this would compare to a median 14.0x forward EBITDA multiple and 20.3x forward earnings multiple for the S&P 500.

Disclosures

The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved.  All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis.  The user of the information assumes the entire risk of any use it may make or permit to be made of the information.

Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.

The adviser, through a partnership that it advises, holds an investment in the issuer's securities.

Catalyst

Potential for further actions by 40 North.

Potential for other activists to show up.

Recovery from pandemic-led slowdown.