Fundamentals Humming; Is M&A Next?
• We exit 3Q feeling even better about risk-reward. We’d characterize 3Q as a good, solid quarter all around. While our estimate of Harvey-related headwinds was close to the mark ($7mn in 2017 vs. Grace’s expectation of $6mn), it turns out that underlying operations were tracking better than anticipated in FCC, polymerization catalysts and Materials Technologies. This may explain why Grace did not issue a pre-release as several other chemical companies have done. Through today’s news are also encouraged by pricing efforts in FCC and have gained conviction that Grace’s high-margin licensing business will continue to rebound from a cyclical trough in 2016. In this context, we continue to view GRA shares as inexpensive vs. peers in the chemicals sector and would expect shares to outperform in the coming year, irrespective of the well-chronicled, Takreer-related headwind in FCC of $25mn or $0.25 per share. What is more, we continue to see potential to create value via strategic actions as a buyer, or a seller, or perhaps both in succession. Indeed, management described the company’s M&A pipeline as “very active” and signaled comfort with a hypothetical increase in financial leverage to 4x EBITDA, which is the “ceiling” we used in our recent note entitled The ART of the Deal (click here). As a result, we continue to believe that Grace will pursue assets to be divested by CB&I, either independently or through ART, Grace’s hydroprocessing catalyst (HPC) JV with Chevron (please see appendix for our updated accretion analysis).
• Our top 10 takeaways: (1) adjusted EPS of $0.90 exceeded our $0.81E and consensus of $0.83E; in light of Hurricane Harvey, we had trimmed by $0.07, whereas Grace quantified the actual earnings hit at $0.04 in 3Q plus another $0.02 in 4Q; all Harvey-related hits are in Catalysts; (2) sales grew 6% in 3Q to $430mn, which likewise exceeded our forecast; (3) Grace posted operating upside in both Catalysts and Materials Technologies, while equity earnings (ART JV) came in ~$2mn less than we anticipated; (4) insurance proceeds of $12mn make $25mn YTD, so insurance has been “maxed out” entering 4Q17; (5) Grace announced a new FCC catalyst price increase of +3-9% effective...
• Changes to our model: We raise our 2017 and 2018 EPS estimates by $0.10 to $3.40 and $3.70, respectively. Changes reflect higher projected operating earnings in Catalyst Technologies and Materials Technologies as well as a slightly lower tax rate and share count, partially offset by higher corporate costs and somewhat weaker than expected 3Q results at Grace’s ART JV with Chevron. We have also reduced our 2017 capex forecast to $140mn from $155mn.
• We rate GRA shares Buy and raise our price target by $4 to $86. Our revised target suggests total upside potential of 16%, including a dividend yield of 1.1%. GRA shares now trade at a 2018 P/E multiple of 20.3x, unadjusted for the $6/share in present value of tax assets, and 18.7x our 2018 EPS inclusive of tax assets. This tax-adjusted value represents a discount of 3.2x or 14% vs. the average specialty chemical company, and only a 1.3 or 7% premium to the sector median 2018 P/E multiple of 17.4x. Our valuation of GRA is based on an average of two methodologies: DCF analysis and a relative P/E framework. Our DCF analysis suggests a warranted stock price of $87. Using our relative P/E framework wherein we apply a 15% premium to the S&P500 multiple, we calculate warranted value of $84 per GRA share inclusive of tax asset value.
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DowDuPont Inc. (DWDP: Buy, $79 PT)
3Q Flash: EPS and Sales Beat Street
• DWDP pre-released 3Q earnings upside. In somewhat unexpected fashion, DWDP pre-released earnings concurrent with this morning’s unscheduled filing of pro forma deal-related financials. 3Q EPS came in at $0.47A on an apples-apples basis with our $0.40E and consensus of the same. Going forward, we understand that DWDP intends to report EPS on a cash basis, i.e. adding back the full effect of deal-related amortization expense. On this basis, DWDP would have reported $0.55 per share. Likewise, sales of $18.3bn exceeded our forecast of $17.4bn and the Street’s $17.6bn. We look forward to learning additional details when DWDP reports earnings on 2 November.
• Three drivers propelled upside despite three headwinds. Upside drivers include (1) robust consumer-led demand; (2) pricing gains; and (3) higher equity earnings, which more than offset headwinds in the form of (A) higher feedstock costs; (B) lower corn area and a delayed start to the summer season in Brazil; and (C) and the unfavorable impact of the hurricanes.
• DWDP remains our top pick with a price target of $79. Our target suggests total upside potential of 14%, inclusive of the dividend which is yet to be determined by the company’s new board of directors (Dow’s old dividend was $1.84 per annum, which would imply a yield of 2.6%). Given a pending break-up into three separate companies, we continue to assess the value of DWDP shares using a sum-of-the parts (SOTP) framework for the combined entity, DowDuPont, including synergies and underfunded pension liabilities. DWDP now trades at a 2018 P/E multiple of 17.8x, in line with the average of our 16 chemical companies under coverage. Likewise, DWDP trades for 9.8x our 2018 EBITDA vs. an average of 10.4x for the sector. We continue to believe these multiples are too low for a catalyst-rich stock with a forward looking 3-year EPS CAGR of 11%+, or a premium of 400bps vs. the average for the US chemicals sector.
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