Description

Long W.R. Grace at $73/sh for 25%+ upside from here and favorable asymmetric risk/reward.  GRA's simplified operating structure of faster-growing, higher-margin and capital-intensive catalyst and silica materials businesses will lead to better capital allocation and productivity. Higher prices and volume for its catalysts, and the acquisition of Albemarle's single-site catalyst unit, as well as an improved mix for silica products, will continue driving sales and EPS growth in 2019. Spending on R&D will also boost product-mix expansion in catalysts. A flexible balance sheet leaves room for additional M&A and investment. Shares of GRA are undervalued by ~25% as investors have only recently begun to warm-up to the story after underperformance from 2015-2017.  The company has shown four consecutive quarters of improving catalyst price/mix, closed an earnings accretive acquisition (ALB single-site catalyst platform), and should see its largest (and highest margin) customer come back online in 2H19.

 General background:  GRA is a global specialty chemical company that generates >$2B in revenues with ~75% from its Catalyst Technologies Segment and ~25% from its Materials Technology segment.  Catalyst Tech is GRA’s highest margin (~30% EBIT) and fastest growing (5-7%/y) segment serving the refining and petrochemical industry with products to improve output, meet impending emission standards, and supplying growing polyethylene (PE) and polypropylene (PP) capacity (global capacity growing 25% by 2022). Materials Tech is growing at 3-4%/y with 23-25% EBIT margins producing functional additives and processing materials to serve the coatings, consumer pharma, and chemical processing industries.

Why go Long:  1) GRA could see strong catalysts demand this year, 2) materials business is focused on higher-valued applications, 3) refining, petchem capacity additions should boost cash flow, 4) Asian demand, Middle East goals will continue to drive refiner capex, and 5) shale to fuel refinery will expand raise shale oil production and demand.   Most importantly, acquisitions and organic growth in GRA's Catalysts Technologies segment are driving sales and earnings gains. The company generates 80% of sales in markets where it's ranked No. 1 or 2, and management expects sales growth of 1.5x global GDP. Catalysts Technologies' revenue drivers include the worldwide increase in consumption of transportation fuels and plastics and the commercialization of new products. Materials Technologies sales come from specialty applications of silica in coatings, chemical processes and pharmaceuticals.  Catalysts Technologies' margin is underpinned by technology, with complex manufacturing operations and high barriers to entry. The company partners closely with customers and technology providers. Materials Technologies' margin reflects silica used in niche specialty applications. 

In the next five years, GRA aims for minimum 3-4% compound annual revenue growth across its segments, with specialty catalysts primed for 6-8% gains based on improving capacity utilization and licensing opportunities from its polyolefin business. Cash taxes remain low at 12-15%, and management has the ability to deploy $1-$1.5 billion for bolt-on deals.

GRA is beginning to gain traction after shares traded flat from 2015-2017 following the loss of its largest customer’s refining facility to fire.  Mgmt. spent two years right-sizing its output and finding new outlets for refining catalysts, which impacted both margins and top-line performance.  GRA has now put together four consecutive quarters of EPS beats, largely driven by positive price traction, bringing its multiple back by a turn to ~11X EBITDA (vs. historical ~12x).  Against the backdrop of its largest customer coming back online, a stronger platform to serve the growing PE and PP industries from the ALB acquisition, and growing fuel emission standards, the company should easily meet its targets of 10-15% annual earnings growth over the next 3-5 years (which the market has not fully priced-in).

GRA tailors its catalyst offerings, using the company's technical expertise and global direct sales force to target large refining and plastics customers. The company's long history and close partnerships with customers create high barriers to entry. Catalysts reflect less than 1% of costs to Grace's customers. About one-third of Grace's contracts with catalyst customers turn over every year, which may allow the company to raise prices. Specialty catalysts are becoming a larger part of the product mix.  Grace completed the purchase of BASF's polyolefin catalysts business in mid-2016. The deal added polypropylene and polyethylene catalyst products as well as additional capacity.

Earnings: After several years of modest/no growth across Catalyst and Materials tech (for a host of reasons), the company delivered 20+% earnings growth in 2018, and should continue to deliver annual EPS growth of 10-15% y/y over the next 3-5 years.  The company is guiding 2019 earnings in the $4.45-$4.65 range, up from $4.13 in 2018, driven largely by strong top-line and margin performance in the Catalyst Segment. 

·       Catalyst Tech: Should see ~10% top-line growth as well as margin expansion over the next several years. Top-line should benefit from strong end-market demand across all catalyst segments, price capture of 100-200bps, and continued benefits from the Albemarle acquisition (which alone adds 6-8 points of growth).  Margins should continue to expand by about 50-100bps/yr from 2018’s 30% from price capture (offsetting prior inflation), plant optimization, and synergy capture from ALB. 

·         Materials Tech: Should see more steady/stable growth in the mid-single-digit range as WR Grace benefits from general demand from the coatings, pharma and personal care industries (cosmetics, dental, etc.) as well as modest pricing. Additionally, the new division president has been tasked with accelerating the growth with share gains (particularly in the healthcare industry, where she has a background).  Margins have trended upwards after falling off in 2016 (food patent expiration) and should conservatively push 20-40bps higher each year as pricing initiatives and optimization improve profitability.

Cash Flows: Based on the earnings ramp as well as WR Grace's large NOL, the company should generate pre-dividend FCF of $400-$450M (post dividend ~$300M) from 2019-2020, despite an uptick in capital investment to help drive future growth. Cash flow priorities are as follows:

·         Growth capex: One of GRA’s top priorities is building a $150M facility in the Middle East (10-15% spent), which should see mid-teens returns while supplying its highest margin business.

·         M&A: A dominant position in the FCC catalyst space precludes additional M&A, but specialty catalyst (for additional chemical platforms) is another potential avenue of growth as are opportunities in the fragment Materials Tech arena.

·         Debt reduction: GRA’s net debt currently sits at ~3.5x.  The goal is 2-3x over the next few years, which should see steady debt reduction allowing for balanced capital allocation.

·         Return cash to shareholders: GRA repurchase of $80M of shares in 2018 shows that even at these leverage levels, returning cash to shareholders is a priority. This level of buybacks should continue with $80M/y representing a floor, alongside continued dividend increases.  There is likely 30-50% upside here should the M&A path prove fruitless.

Valuation: Over the next 12-24 months, GRA should reach ~$95/share based on a 12x EV/EBITDA multiple, offering returns of ~25% including the dividend yield.  While the company had traded in the 10-11x range in 2015-2017 as earnings hit a speed bump (construction products weakness, operational issues, Takreer downtime), the multiple should firm back up to the 12x range as investors rewards consistent earnings growth, shareholder-friendly capital allocation, and returns on capital improving from ~15% to ~20%.  The downside risk is ~$65/share based upon 2008-2010 recession-level margin contraction (200-300bps) and top-line growth stalling out.

Key Risks:

·         Timing of Takreer Ramp: The refinery’s start has been delayed by a quarter, but since it’s not a major factor in 2019 earnings (~$0.20-$0.30 in EPS on a full-year basis) this shouldn’t affect the multi-year story that much.

·         EV Concerns: There is little doubt about the future of electric vehicles, but the demand for transportation fuels is expected to grow through at least 2035.  

Valuation Summary:

GRA Valuation mm

2020 EBITDA $648

Target EBITDA Multiple 12.0x

Implied EV $7,772

2020 YE Debt + other - NOL $1,825

Implied Mkt Cap $5,946

YE Share Count 64

Implied 12-Month Tgt Price $95

Catalyst

1.  ALB Acquisition:  The deal provides GRA with a strong, established platform in one of the highest-value segments of the PE market, with a full suite of products for the polyolefins arena (which is seeing major capacity growth). The acquisition also removed the potential $50-$70M in capital spend to compete in this market, which when factored in along with synergies drops the deal multiple.

2. IMO2020 Benefit:  GRA is likely to benefit from the International Maritime Organization’s emission regulation beginning in 2020, where sulfur content from marine fuel emissions are required to drop to 0.5% from 3.5% at present. GRA already has several customers accelerating investment in hydroprocessing facilities in order to meet the pending step-down.

3. Catalyst Price on the Rise:  GRA announced 3-9% price hikes that began in 2018 and should continue through 2021 owing to a “tight” catalyst market as its largest customer comes back online against the backdrop of growing fuel emission standards, and growing PE/PP demand.

4. Catalyst Volume Growth: GRA should see 3-5% volume growth for its catalyst business over the next 3-5 years driven by significant new business wins in the PP licensing business (that could bring in catalyst business in the longer term), solid growth in global polyethylene capacity that should drive catalyst demand, and the eventual ramp of the Takreer Refinery in 2H19.