Baseline Growth Hits a Pothole; Reigning in Estimates, Target
• We will admit to having had higher hopes entering the 4Q17 earnings report. It had appeared as though a lot was going right Grace, notwithstanding a well-chronicled EPS “hole” of $25mn or $0.25 in 2018 related to the discontinuation of business interruption insurance recoveries and foregone sales of FCC catalysts to customer Takreer (Abu Dhabi), which suffered a fire in January 2017. Specifically, we thought that earnings growth could accelerate, based on a combination of recent catalyst price increases, numerous technology licensing wins, more favorable FX, and an accretive (pending) acquisition, not to mention a substantial decline in book tax rate. The latter two issues – M&A and tax – were of course not included in Grace’s prior EPS growth bogey of “at least 7%” for 2018, so stripping those out, the company’s updated “underlying” EPS growth expectation of 3-5% pales in comparison, which disappointed investors and sent shares reeling –8.0% vs. –3.8% for the S&P500 index. So, what gives? Unbeknownst to the Street, Grace’s prior EPS growth plan had incorporated theoretical benefits from two sources, share repurchases and tax planning, that are now not expected to materialize. Grace’s new EPS range does seem conservative to us in that it includes (unquantified) strengthening of the USD in 2H18. However, it is difficult to gauge risk to sales and also gross margin, given uncertainties related to raw material cost volatility and the pace of realized price increases. As a result, we trim our earnings view, albeit not quite to the midpoint of Grace’s range, since we model FX as flat from here.
• Top 10 takeaways: (1) 4Q17 EPS, ex items, of $0.98 was in line with our above consensus estimate; (2) in EPS terms, EBIT was a $0.02 headwind, driven by $0.03 of underperformance from Materials Technology; (3) Catalyst Technologies delivered solid results, despite a lower than expected contribution from the ART JV; (4) FCC price was positive excluding the effect of customer mix; (5) following the passage of the US Tax Cut and Jobs Act, Grace’s new book tax rate will be in the range of 27-28%, in line with the 27.3% we had modeled; (6) 2018 guidance includes $0.05 per share of accretion from the acquisition of Albemarle’s polyolefin catalyst business, $0.02 better than our prior estimate; (7) raw material inflation is expected to peak in 1H18, with price gains surpassing cost headwinds in 2H18; (8) current guidance implies a strengthening of...
• Changes to our model: We reduce our 2018 EPS estimate by $0.35 to $3.85, including $0.74E for 1Q18. Our revisions reflect lower expected sales of FCC catalyst, and greater cost pressure across the portfolio from various inputs, such as natural gas, caustic soda, aluminum derivatives and rare earth minerals. While we anticipate solid earnings from Grace’s ART JV with Chevron, we also anticipate a more back-end loaded pattern in HPC catalyst deliveries that could result in a similar pattern for EPS. We trim our Materials Technology segment earnings expectation slightly as well. Finally, we now model D&A of $113mn, which is up only slightly vs. $112mn in 2017. Despite the pending acquisition of Albemarle’s polyolefin catalyst business (click here), we now expect depreciation expense to decline due to an extension in the assumed useful lives of certain assets, effective 1 January 2018.
• We maintain our Buy rating on the pullback, yet reduce our target to $82. We reduce our price target by $6 from $88 to $82, which suggests total upside potential of 27%. This includes a dividend yield of 1.5%, which reflects a new dividend increase of 14% announced this morning. GRA shares now trade at a 2018 P/E multiple of 17.0x, unadjusted for an estimated $4 per share in net present value (NPV) of tax assets, and 16.0x our 2018 EPS as adjusted for the NPV of tax assets. This tax-adjusted multiple represents a discount of 2.8 turns or 15% vs. the average specialty chemical company, and a slight discount to the median 2018 P/E multiple of 16.1x for our entire coverage universe of chemical stocks. 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 $82, using a WACC of 7.9% and a terminal growth rate of 3.0%.Using our relative P/E framework wherein we apply a 20% premium to the S&P500 multiple, we calculate warranted value of $82 per GRA share.
(Please see full report for details)