More Patience Required
• We consider the pullback in OLN shares to be an opportunity for patient capital. We exit Olin’s 4Q earnings call rather disappointed in recent trends and near-term prospects. As we discuss below, we now project lower operating earnings in 2018, with additional headwinds below the line for interest and book taxes vs. our prior model. In addition, elevated maintenance costs will persist through 1H18, resulting in a more back-end loaded quarterly cadence than we anticipated, although full-year maintenance expense could decline by $30mn absent any future unplanned outages. As evidenced by Wednesday’s stock reaction (-7.5% vs. -0.5% for the S&P500), none of this was particularly welcomed by investors, but we do see a few silver linings of note. First, Olin’s cash tax bill is expected to drop by ~$75mn beginning in 2019, thanks to US tax reform. Second, the earnings “bar” and investor expectations have now been reset lower. Third, with shares having pulled back, we consider valuation to be more appealing, especially in light of where Olin’s businesses are in the cycle. As we survey Olin’s portfolio, we note that ethylene dichloride (EDC), epoxy resins and Winchester are all at or near cyclical trough conditions presently, while chlorine likewise remains below mid-cycle profitability. We reckon that only caustic soda is trending above par in 2018. In this context, we consider OLN shares to be priced attractively, so we grit the teeth and remain constructive on the shares with a 12-month view.
• Top 10 takeaways: (1) Olin posted 4Q GAAP EPS of $2.89; ex our estimated after-tax effects of restructuring charges ($10.4mn), a gain on the sale of a manufacturing facility ($2.4mn) and one-time tax benefits ($437.9mn), we estimate adjusted EPS of $0.35, which compares to our $0.48E and consensus of $0.44; (2) Operating EBITDA of $278mn came in weaker than the $286mn that we had expected and consensus of $288mn; (3) all three segments missed our forecast, with the largest variance in Winchester, which suffered a substantial decline in profitability; (4) caustic soda volumes are expected to decline in 1Q as OLN entered 2018 will less inventory compared to last year; (5) Epoxy earnings will be hit by $45mn in 1H18 due to a 54-day T/A at Freeport, TX; 4Q was hit by $9mn from Harvey and $16mn from a T/A in Germany (in line); (6) Winchester earnings in 4Q were pressured by ongoing weakness in demand for ammunition among commercial customers; 2018 is expected to...
• We reduce our earnings estimates for this year and next. For 2018 we decrease our EPS estimate by $0.50 to $2.15 from $2.65. Our model revisions reflect slightly lower forecast profitability in chlor-alkali and a more substantial reduction at Winchester. In Epoxies, we are somewhat encouraged by improvement in underlying market conditions, aided by environmental-related supply constraints in China. However, our 2018 earnings cadence in Epoxies is now back-ended loaded in recognition of a major 54-day maintenance turnaround at Freeport, Texas in 1H18 that Olin had not previously disclosed. Maintenance expense looks modestly higher y-y in Chlor-Alkali as well with a turnaround scheduled at Plaquemine, LA in 1Q18. Below the line, we now model higher interest expense of $240mn in 2018 to reflect 20% of debt that is variable rate as well as the refinance of $550mn at 5.0% in January 2018. Finally, an updated book tax rate of 25.0% comes in higher than the 23.7% that we had previously penciled in.
• We maintain our Buy rating and price target of $40. Our target suggests shares offer upside potential of 23%, including a dividend yield of 2.4%. As a reminder, our OLN price target is based on an average of two valuation frameworks; a relative EV/EBITDA multiple and a relative normalized P/E multiple. Our relative EV/EBITDA multiple uses a 1.5x discount to the group average and suggests a warranted stock price of $40. We note that OLN shares now trade for 7.0x our estimate of 2018 EBITDA, a full turn below Westlake Chemical (WLK), Olin’s closest peer, and a discount of 2.9x vs. the average of the 18 stocks in our coverage universe. Our normalized P/E methodology also suggests a warranted value of $40, based on our normalized EPS estimate of $2.60 and a 12.5% discount to the group average multiple applied thereto.
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W.R. Grace and Co. (GRA: Buy, $88 PT)
4Q EPS in Line; 2018 EPS Range Looks Light Apples-Apples
• Grace posted 4Q17 EPS a penny ahead of the Street. Grace reported 4Q17 adjusted EPS of $0.98, in line with our $0.98E and a penny ahead of consensus of $0.97. Sales grew 4% in 4Q to $459mn, which surpassed our forecast of $452mn, but EBIT came in a touch light at $115mn vs. our $117mn and consensus of $118mn. On a segment basis, Grace posted upside to operating earnings in Catalyst Technologies while Material Technologies(MT) fell short. Equity income contributions from Grace’s ART joint venture with Chevron rebounded to $8.0mn from the $4.8mn in 3Q but came in shy of the $9mn that we had penciled in. Net debt trended flat q-q at $1.38bn or 2.6x trailing EBITDA.
• Grace guides 2018 EPS lower than we had expected. Prior 2018 EPS commentary from Grace signaled confidence that the company would achieve EPS growth of 7% at a minimum. In the 4Q release, Grace guided to higher EPS growth of 9-12%, or $3.72-3.82. However, we believe the comparison is not apples-apples for two reasons: (1) the updated guidance now assumes a March 31 closure of the pending acquisition of Albemarle’s polyolefin catalyst business that was announced in December; and (2) the new range incorporates a lower tax rate of 27-28% following passage of the US Tax Cuts and Jobs Act. As adjusted for these two events, we view the more comparable underlying EPS growth guidance as 3-5%, or ~300bps below Grace’s prior EPS growth guidance of 7%. Pending the conference call at 9:00AM ET we suspect that raw material cost pressure, MT segment earnings, and/or other fundamental issues are causing a more conservative outlook for operating earnings on an apples-apples basis. Adjusted EBIT of $440-450mn is in line with Street consensus of $444mn, yet well below our above-consensus $482mn, which includes the pending deal, whereas we suspect many analysts have not included it. We have estimated EBIT associated with the pending ALB deal of $15mn in 2018, followed by $22mn in 2019. Sales growth of 8-10% is a bit below our +11% (or 6% excluding the pending acquisition). Regarding the 2018 tax rate, management believes that Grace’s new book tax rate will be in the range of 27-28%, essentially in line with the 27.3% that we had modeled.
• Catalysts provided marginal upside to our estimate. In EPS terms, EBIT of $109mn provided a $0.01 tailwind vs. our estimate of $108mn. Segment earnings included an $8mn contribution from the ART JV, just below the $9mn we had penciled in. Hurricane Harvey was expected to be an additional $2mn drag on results during the quarter, though any impact was left unquantified in the release. Sales growth of 4.8% was double the rate that we had anticipated, and was the primary driver of the beat, as EBIT margins of 31.7% were just below the 32% expected. Despite the ongoing raw material inflation, gross margins were up again sequentially, in at 42.1% from the 41.4% realized in 3Q17 and the 1Q17 trough of 39.2%. Looking ahead we are optimistic on the outlook for the catalyst business in light of outstanding FCC price initiatives, though we are cognizant of the headwind faced by the business interruption insurance payment gap related to sales of FCC to customer Takreer (Abu Dhabi).
• Materials Technologies drags on results. EBIT of $25mn missed our $29mn estimate, and represents a disappointing setback after an encouraging 3Q performance. Sales were essentially inline, but margins eroded. Specifically, gross margin declined 140bps sequentially and 360bps y-y, noticeably worse than the 220bps of y-y decline in 3Q17. Higher raw material costs as well as an unfavorable mix were cited. Given the trajectory in oil-linked raw materials over the quarter, we would expect these headwinds to persist at least through the 1H18.
• We rate GRA shares Buy. Our target of $88 suggests total upside potential of 25%, including a dividend yield of 1.2%. GRA shares now trade at a 2018 P/E multiple of 17.0x, unadjusted for the $6/share in present value of tax assets, and 16x our 2018 EPS inclusive of NOLs. This NOL adjusted value represents a discount of 4.0x or 25% vs. the average specialty chemical company, and an inline multiple to our coverage average 2018 P/E multiple. 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 20% premium to the S&P500 multiple, we calculate warranted value of $87 per GRA share.
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