With Grace (GRA) down about 4% today (apparently analyst expectations were too high), I thought it would be a good time to do a short post on why I think Grace will provide shareholder returns in the 10-13% range for the long-term. The short answer is the company's absolute focus on returns on invested capital. I will borrow a lot from Grace's investor day presentation this past March.
But before we get to the specific financials and past performance, let's take a quick look at what Grace does.
Grace is a specialty chemicals company with three segments spread fairly evenly across the world: catalysts, construction products, and materials technologies. A very high 70% of sales come from products with #1 or #2 in market positions.
Now for some amazing historical figures!
The company grew sales from $1.8bn to nearly $3.1bn. Gross margins improved from 30% to 37%. ROIC went from 14.6% to 37.4% if you exclude their recent UNIPOL acquisition. The share price went from about $1.50 to yesterday's $101 per share. All this is even more impressive given the fact they were under the protection of bankruptcy during this entire period as they dealt with some enormous asbestos liabilities.
So how were they able to achieve such results? It's all about ROIC. They got out of businesses that were becoming commoditized and devoted capital to higher margin, higher return businesses and products. Grace instituted lean and Six Sigma business practices. They eliminated a lot of bureaucracy and created what I think is a somewhat decentralized organization structure of three business segments, each one supported by the corporate office.
The nice thing about the focus on higher margin businesses is it usually means Grace has to partner with or work closely with their customers on creating highly specific solutions to their needs, which turns into long-term relationships and greater stability in sales growth and higher switching costs for the customer. It's a nice virtuous circle.
So Grace has done exceptionally well in the past five and ten years, but what is likely to happen in the future?
Over the next five years, Grace expects sales growth at 1.5x global GDP, slightly higher gross margins, >$400 million in free cash flow per year, pret-tax ROIC of >30%, and continual share repurchases. I think it's also important to note Grace does not factor in any potential future acquisitions.
In terms of capital allocation, Grace currently feels their greatest opportunity is reinvesting in the company, but they will still have excess capital which they will be returning to shareholders assuming they have no other capital investment or acquisition opportunity that meets their return threshold.
As you can see in the above slides, Grace expects to return >$2 billion to shareholders over the next five years. I think they are giving a conservative estimate here and the more likely figure could be $2.5 billion, or about 1/3 of their current market cap.
In summary, and despite today's slide in share price, Grace has a lot of the qualities that will produce above average returns for shareholders:
- Experienced management team focused on capital allocation and ROIC;
- Lean culture and processes;
- High margin products with sticky customer relationships;
- Dominant positions in the vast majority of their products (70% of sales come from products with #1 or #2 market positions);
- Strong balance sheet with net debt to ebitda of 2.6x and fully-funded pension plans;
- Opportunities for further margin improvement; and
- Returning excess capital to shareholders via regular share repurchases.
If I haven't convinced you yet that Grace is worth looking at in more detail, consider that Grace was Ted Weschler's largest position when he was running Peninsula Capital before being hired by Buffett. As Weschler wrapped up his partnership, Grace shares were distributed in-kind to the limited partners and to himself. He received 3.74 million shares of Grace, which right now is about 4.8% of current fully diluted shares. I doubt he's sold any of this position.
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