W.R. Grace – Maybe The Most Valuable Bankrupt Company Going

By Stephen D. Simpson, CFA | June 18, 2013 AAA

While individual/personal bankruptcy is pretty straightforward, the same cannot be said for corporate bankruptcy. Airlines go through bankruptcy seemingly about as often as most people buy and sell cars, while in other cases bankruptcy is the end of the story – whatever assets are worth something are sold off and the company ceases to be.

Then there's the case of W.R. Grace (NYSE:GRA). Technically in bankruptcy, Grace did not go into bankruptcy because of any flaws in its core business, but rather the rapidly-accelerating and virtually uncontrollable costs of settling asbestos litigation. With a valuable catalyst business, a stable coatings business, and a construction products business leveraged to a recovery, Grace is most definitely a going concern. On the other hand, a better-than-60% jump in the stock over the past year and a nearly 20-fold increase from the 2009 lows seems to already recognize the ongoing value in this business.

A Very Good Business, Built Around Catalysts
Grace largely participates in specialty chemical markets effectively controlled by oligopolies. What's more, the company generates about two-thirds of revenue in markets where it has the #1 or #2 market position. That has long been a recipe for success for other specialty chemical companies (and Grace rivals) like Albemarle (NYSE:ALB) and BASF.

Catalysts are the biggest component of Grace's business, producing 40% of revenue and eye-popping operating margins above 30%. Grace's catalysts are used to produce fuels (diesel and gasoline) and plastics like polyethylene and polypropylene. Grace not only has the best global footprint in this industry, but its share of the fluid catalytic cracking (FCC) catalyst market is upwards of one-third (with Albemarle and BASF both holding close to 20% of the market each).

SEE: Analyzing Operating Margins

While the catalyst business is great, the other 60% of the Grace business isn't bad either. Construction products, including cement additives, admixtures, and waterproofing materials, contribute about one-third of revenue, and Grace holds strong share alongside companies like BASF, Sika, and RPM (NYSE: RPM).

Although the construction business is very sensitive to construction activity (cement production in particular), the material technologies business (nearly one-quarter of revenue) is more stable. Grace is the leading producer of can sealants and is also a specialist in various silica products (sodium silica, colloidal silica, and silica gels).

Engineering Pays Dividends
One of the key differences between specialty chemical businesses like Grace and more bulk/commodity-oriented chemical business is the crucial role of technology. The rare earth element lanthanum is an important ingredient in FCC catalysts, and Grace responded to the huge price increases in rare earth elements by uses new zeolite catalyst technologies and reducing the lanthanum content by as much as one-third. While that doesn't seem as important now that rare earth prices have round-tripped back to low levels, I think the ability to respond to input cost increases with technological alternatives is nevertheless valuable.

The Bankruptcy Saga Is Close To A Conclusion
It has taken about a dozen years, but Grace is close to emerging from its asbestos liability-induced bankruptcy. There are still appeals going through the legal system, but the consensus opinion is that Grace's proposed settlement will be accepted and the company will emerge in late 2013 or early 2014.

The details of the settlement are pretty convoluted, but the gist of it is that Grace will likely pay over $2 billion over up to 20 years to resolve its liabilities. There will be an initial cash payment of almost $500 million into a trust, followed by a cash settlement of warrants worth up to $490 million, and deferred payments of $110 million for four years (2019 to 2023) and $100 million from 2024 to 2033.

Not only are those settlement amounts not to onerous, but the company actually expects to return as much as $500 million to shareholders through dividends and/or buybacks after emerging from bankruptcy. The company will also look to increase its leverage (take on debt) and consider M&A – while management has talked about “bolt-on” deals, I have to think it will at least consider bidding for Dow Chemical's (NYSE:DOW) polypropylene catalyst business.

The Bottom Line
For all of its good points, I think it's hard to argue that Grace isn't fully valued at this time. While the construction products business should be due for a recovery, the catalyst business could see some near-term pressure as customers respond to price hikes from Grace and Albemarle by trialing competitors' catalysts. All told, I see about 3% to 4% annual revenue growth potential over the long term, with about 6% free cash flow potential.

Free cash flow is a tricky tool when it comes to chemical companies. Looking instead at EV/EBITDA, it also appears that Grace is richly valued. Even with a 10x multiple to 2014 EBITDA, it's hard to generate a target price above the mid-$70s. So while Grace is indeed a high-quality specialty chemicals company, it's hard to see a lot of intrinsic undervaluation at this time.

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