11.30.17
W.R. Grace and Co. (GRA: Buy, $87 PT)
License to Grow; Raising 2018 EPS and Target
• Licensing is an internal growth story, not just an external growth opportunity. Over the past four months, there has been considerable investor and analyst focus, including by yours truly, on process technology licensing as a potentially strategic, attractive, and accretive source of external earnings growth available to Grace. Indeed, we have written extensively on the subject, including analysis of one specific opportunity: assets to be divested by CBI (click here and here). For the record, we continue to see potential here. What some may have overlooked however is the internal growth opportunity at Unipol, Grace’s existing polypropylene (PP) resin technology licensing business. Herein we take a fresh look at recent licensing activity and what it could mean for Grace’s earnings profile and stock in 2018. Our conclusion: licensing activity has accelerated markedly and will help Grace to offset most of the earnings pressure from foregone sales of FCC catalyst to Takreer in 2018+. We are raising numbers accordingly.
• Grace’s licensing deal “frequency” has picked up quite a bit... Exiting 3Q results we commented that we had “gained conviction that Grace’s high-margin licensing business will continue to rebound from a cyclical trough in 2016”. However, we didn’t expect three substantial deals to be announced in the space of two days, which is what has transpired this week. It’s hard to overstate how unusual that is. For context, Grace won two such deals in all of 2015 and another two in all of 2016. As shown in Figure 1, activity has accelerated in 2017 with an additional...
• …and so has the “amplitude”, i.e. recent licensing deals are larger too. We generally like technology licensing businesses because they tend to feature oligopolistic market structures, defensible technology moats, and sustainably high margins supported by low marginal costs. However, licensing deal economics can be rather opaque to the Street due to complexities such as project size, specific services offered, and software that may or may not be included in each deal. While we don’t have perfect visibility into the latter two factors (services and software), we do have a better idea of project size, which tends to...
• We are adding a nickel to our 2018 EPS estimate on strength in licensing. Notwithstanding the aforementioned sources of uncertainty in modeling a licensing business, we have given it a shot. Our analysis suggests that 2018 could be a strong “rebound” year for licensing. As outlined in Figure 3, we project an incremental sales contribution of...
• We rate GRA shares Buy and raise our price target by $1 to $87. Our target suggests total upside potential of 19%, including a dividend yield of 1.1%. GRA shares now trade at a 2018 P/E multiple of 19.7x, unadjusted for $6 per share in present value of tax assets, and 18.1x our 2018 EPS inclusive of tax assets. This tax-adjusted value represents a discount of 4.6x or 20% vs. the average specialty chemical company. Likewise, it is in line with the chemicals sector median 2018 P/E multiple of 18.1x, whereas we would argue that the quality of Grace’s assets and the best-in-class level of its margins should warrant a premium valuation vs. the sector average. 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 $89. Using our relative P/E framework wherein we apply a 15% premium to the S&P500 multiple, we calculate warranted value of $85 per GRA share inclusive of tax asset value.
(Please see full report for details)
License to Grow; Raising 2018 EPS and Target
• Licensing is an internal growth story, not just an external growth opportunity. Over the past four months, there has been considerable investor and analyst focus, including by yours truly, on process technology licensing as a potentially strategic, attractive, and accretive source of external earnings growth available to Grace. Indeed, we have written extensively on the subject, including analysis of one specific opportunity: assets to be divested by CBI (click here and here). For the record, we continue to see potential here. What some may have overlooked however is the internal growth opportunity at Unipol, Grace’s existing polypropylene (PP) resin technology licensing business. Herein we take a fresh look at recent licensing activity and what it could mean for Grace’s earnings profile and stock in 2018. Our conclusion: licensing activity has accelerated markedly and will help Grace to offset most of the earnings pressure from foregone sales of FCC catalyst to Takreer in 2018+. We are raising numbers accordingly.
• Grace’s licensing deal “frequency” has picked up quite a bit... Exiting 3Q results we commented that we had “gained conviction that Grace’s high-margin licensing business will continue to rebound from a cyclical trough in 2016”. However, we didn’t expect three substantial deals to be announced in the space of two days, which is what has transpired this week. It’s hard to overstate how unusual that is. For context, Grace won two such deals in all of 2015 and another two in all of 2016. As shown in Figure 1, activity has accelerated in 2017 with an additional...
• …and so has the “amplitude”, i.e. recent licensing deals are larger too. We generally like technology licensing businesses because they tend to feature oligopolistic market structures, defensible technology moats, and sustainably high margins supported by low marginal costs. However, licensing deal economics can be rather opaque to the Street due to complexities such as project size, specific services offered, and software that may or may not be included in each deal. While we don’t have perfect visibility into the latter two factors (services and software), we do have a better idea of project size, which tends to...
• We are adding a nickel to our 2018 EPS estimate on strength in licensing. Notwithstanding the aforementioned sources of uncertainty in modeling a licensing business, we have given it a shot. Our analysis suggests that 2018 could be a strong “rebound” year for licensing. As outlined in Figure 3, we project an incremental sales contribution of...
• We rate GRA shares Buy and raise our price target by $1 to $87. Our target suggests total upside potential of 19%, including a dividend yield of 1.1%. GRA shares now trade at a 2018 P/E multiple of 19.7x, unadjusted for $6 per share in present value of tax assets, and 18.1x our 2018 EPS inclusive of tax assets. This tax-adjusted value represents a discount of 4.6x or 20% vs. the average specialty chemical company. Likewise, it is in line with the chemicals sector median 2018 P/E multiple of 18.1x, whereas we would argue that the quality of Grace’s assets and the best-in-class level of its margins should warrant a premium valuation vs. the sector average. 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 $89. Using our relative P/E framework wherein we apply a 15% premium to the S&P500 multiple, we calculate warranted value of $85 per GRA share inclusive of tax asset value.
(Please see full report for details)