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Executives

Mark Sutherland - VP, IR

Hudson La Force - SVP and CFO

Fred Festa - Chairman and CEO

Analysts

Mike Ritzenthaler - Piper Jaffray

Laurence Alexander - Jefferies

Mike Sison - KeyBanc

Jim Barrett - C.L. King & Associates

W.R. Grace & Co. (GRA) Q4 2012 Earnings Call February 6, 2013 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 W.R. Grace & Co. Earnings Conference Call. My name is Jessenia and I’ll be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to host for today, Mr. Mark Sutherland, Vice President of Investor Relations. Please proceed, sir.

Mark Sutherland

Thank you Jessenia, well everyone, and thank you for joining us today, February 6th, 2013 for a discussion of Grace’s fourth quarter 2012 results that were released this morning. Joining me on today’s call are Fred Festa, Grace’s Chairman and Chief Executive Officer, and Hudson La Force, our Senior Vice President and Chief Financial Officer.

Our earnings release and the corresponding presentation are available on our website. To download copies, go to grace.com and click on Investor Information. Links are available in the upper right corner of the page.

As you know, some of our comments today will be forward-looking and are made under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected or implied due to a variety of factors. Please see our recent SEC filings for more details on the risks that could impact Grace’s future operating results and financial conditions.

We will also discuss certain non-GAAP financial measures which are described in more detail in this morning’s release and on our website. Reconciliations to the most directly comparable GAAP financial measures and other associated disclosures are contained in our earnings release and on our website.

Our comments on forward-looking statements and non-GAAP financial measures apply both to the prepared remarks and to the Q&A. We wanted to remind everyone that this webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission or reproduction of this call without company consent is prohibited.

With that, I’ll turn the call over to Fred.

Fred Festa

Thanks Mark and good morning to everyone. I am pleased with our results for the fourth quarter and our strong finish to the year. Our year-over-year and sequential quarterly performance was good and positions us very well for 2013. Hudson will discuss the fourth quarter in more detail. My comments will focus on 2012 in general.

Organic sales increased 7% in a tough macroeconomic environment and adjusted EBITDA margin increased 160 basis points to 20.2% confirming the strength of Grace’s earnings potential. We made great progress towards our vision of being the premier specialty chemical company.

In January, we introduced a new operating structure, three business segments each run by proven leaders reporting to a Chief Operating Officer who might have great confidence in. by leveraging this one grace platform we were able to reduce cost, grow productivity through the use of common management system business processes. Our structure is an important enabler for driving growth for each business.

In 2012, we took additional action to expand the company’s presence in emerging regions. We announced a joint venture in Abu Dhabi to manufacture refining catalyst. We acquired catalyst manufacturing assets in China which gives us a foothold to better supply refining catalyst in China and East Asia.

We’ve also acquired a concrete add mixture supplier in Brazil that expanded our presence and capabilities and in of the fastest growing construction markets in the world. We’ve invested capital to strengthen our technology base and to improve manufacturing productivity.

We completed several key capital projects at manufacturing facilities in North America and Europe that will support growth in our faster growing polyolefin and catalyst business. These projects include capacity for growth as well as new product technology.

2012 was also a challenging year in many ways. It was a year marked by volatility and uncertainty as manufacturers faced a recession in Europe, lower growth in emerging regions, and uncertainty in the U.S.

We saw significant volatility in currency and rare earth cost. This environment pressure tested our management systems and processes as each segment faced its own challenges. Catalyst technologies managed through refinery closures, rare earth volatility, lower polyethylene demand post a year of almost 10% organic growth.

Materials technology overcame a week first quarter improved throughout the year and exited the year at its target margins for 2013 and construction products delivered its best performance since 2008 as strong growth in emerging region offset that we construction markets in North America and Western Europe.

Our 2012 financial performance is a clear testament to the focus and execution of our employees globally and the strong positioning of our product technologies

In looking ahead 2013, our outlook for adjusted EBIT is $560 million to $580 million, an increase of 8% to 12% compared with 2012. We expect our businesses to manage well in a global economy that may have slowed or uneven growth. We remain confident in our 2014 goal of $850 million of adjusted EBITDA. We are tempering our top line goal to $3.8 billion from the $4 billion.

Macro environment has not been as strong as we have expected, but we have the business levers to keep earnings growing. We’re also confident in our three year adjusted free cash flow goal of more than $1.2 billion.

I’ll turn it over to Hudson, who’ll provide more specifics on the quarter and our 2013 outlook.

Hudson La Force

Thank you, Fred. Please turn to pages 5 and 6 and we’ll start with a quick review of Grace’s overall results for the quarter. Sales were $798 million, down 3% from last year. Solid organic growth of 8% was offset by lower rare earth surcharges of 9% and unfavorable currency translation of 2%. For the full year, organic growth was 7% consistent with our recent growth track record. Emerging region sales grew 16% for the quarter and 15% for the year.

Adjusted EBIT was $133 million, up 23% from last year. Adjusted EBIT margin increased 360 basis points to 16.7% and adjusted EBITDA margin increased 370 basis to 20.5%. Improved pricing, productivity, operating leverage and expense control all contributed to the growth in margins.

Adjusted free cash flow was $421 million for the year, up 51% from last year driven by reduced working capital requirements and lower required pension contributions. Adjusted EBIT return on invested capital increased to 36% from 35% last year. Adjusted EPS was $1.11 based on diluted shares of $76.8 million.

Let’s turn to Catalysts Technologies on page 7. Fourth quarter sales for Catalysts Technologies were $328 million, down 11% from last year. Sales volumes and base pricing increased 12% but were more than offset by lower rare earth charges and favorable currency translation, totaling $82 million of 23% of sales. Sales volumes and base pricing of FCC catalysts increased 12% year-on-year and 2% sequentially largely due to strong growth in emerging regions. Sales of refinery catalyst in emerging regions increased 29% year-over-year. Polypropylene catalyst sales grew strong double digits however polypropylene catalyst sales decreased due to continuing weakness from Polypropylene plastics in Europe. Chemical catalyst sales primarily for PDO production were also strong contributors to segment growth. Catalyst technologies gross margin was 41% for the quarter, an increase of 300 basis points, primarily due to improved based pricing and lower manufacturing costs.

Segment operating margin increased 490 basis points to 31.3% to the higher gross margin, lower operating expenses and higher earnings from ART's joint venture. Our share of ART's net income was $5 million up approximately $3 million from last year. With the year, our state income was up more than 20% in lined with our 2012 plan.

Looking ahead, we expect FCC catalyst sales volumes to continue to grow in line with the historical growth of transportation fuels of 2 to 3%. Sales headwinds from rare earth were totaled almost $120 million in 2013, mostly in the first half. Polypropylene catalyst volumes are projected to grow in the mid to high single digits as our customers with favored feedstock positions in North America and the Middle East continue to gain share with their customers. Let's move to materials technologies on page 8.

Fourth quarter sales from materials technologies were $210 million an increase of 3% from last year, organic growth totaled 6% partially offset by unfavorable currency translation. Sales in emerging regions increased 7% in the quarter to 43% of segment sales. We saw strong demand for engineered materials in China, in Latin America, an increase demand for packaging technologies in developing Asian countries and Eastern Europe. Gross margin was 34.3% up 240 basis points, due to improving operating leverage and lower manufacturing costs. Segment operating margin was 18.9% up 280 basis points due to higher gross margin and lower operating expenses. The Materials Technologies leadership team has made good progress improving the fundamentals of this business, and it is well positioned to deliver good sales and earnings growth in 2013.

Please turn to page nine for construction products. Fourth quarter sales for construction products were $259 million, an increase of 2%. Sales in North America declined 4%, in total, with a 9% sales increase in specialty construction chemicals, offset by a decrease in specialty building materials.

Sales volumes in Western Europe were down more than 10% due to continued market weakness and our earlier decisions to exit low margin businesses in that region. Our restructuring actions over the past several years have reduced sales in Western Europe to less than 14% of total segment sales in improved gross margins and earnings in the region. We expect 2013 to be another down sales year in Western Europe and continue to focus on reducing costs in this business. Emerging region sales grew a strong 20% year over year and now total 37% of segment sales. Latin America, the Middle East and emerging Asia all posted double digit sales growth in the quarter. In addition the emerging regions in total are now accretive to segment operating margin.

Segment gross margin improved 340 basis points to 36.1% due to success recovering raw material cost increases as well as benefits from volume leverage and productivity gains. Segment operating income was up 53% year over year and operating margin improved 410 basis points to 12.5% due to gross margin improvement and strong expense control. 2012 was construction products' best year for segment operating income since 2008, despite the slow recovery for North American construction spending and chronic weakness in Europe. We have improved operating margins to their 10 year average although our U.S. sales are still 29% below their peak. With continued improvement in North American construction spending and further penetration in the emerging regions, we believe this segment is well positioned for new levels of earnings.

Let’s turn to our outlook on page 10. Our outlook for 2013 adjusted EBIT is $560 million to $580 million, an increase of 8% to 12% over 2012. We expect adjusted EBITDA to be $685 to $705 million. We think this is a balanced outlook. Our intent is to incorporate our best judgment about the opportunities and risks we have and to provide an outlook that is neither aggressive nor conservative.

Here are some of our assumptions. We expect full year sales to be $3.2 billion to $3.3 billion with organic growth of 6% to 8% and $120 million of sales headwinds primarily from lower rare earth.

Volume is expected to be a bigger component of organic growth in 2013 than pricing. We may see a tougher pricing environment in 2013 and are focused on productivity and supply chain actions and continue to improve margins.

We expect gross margin to be in the range of 36% to 38%, this is a 100 basis point increase in our target range driven by good results from our productivity initiatives. Similarly, we expect adjusted EBIT margin to improve about 100 basis points this year.

We have planned for an average euro exchange rate of $1.29 for 2013, flat with our 2012 average. Currency may be less of a headwind in 2013. The currency volatility will still impact our results. The yen and riyal have weakened which reduces the value of our sales and earnings in those currencies and we have exposure to the Venezuelan Bolivar. If the Bolivar devalues in Q1 or Q2 as markets expect, we could have an impact of $2 million to $3 million to adjusted EBIT in that quarter. Obviously, we are trying to mitigate this but options are limited.

Turning to taxes, we expect our 2013 effective tax rate [audio gap] with the cash tax rate of 14%. As you know, we have been working to maximize the present value of the U.S. Federal NOL will generate at emergence. We have also been able to increase the realizable value of our state NOLs based on growth in our U.S. taxable income.

In Q4, we released $44 million of a previously accrued valuation allowance against our state NOLs. This benefitted GAAP earnings in the quarter but will increase our ETR going forward. The release of the valuation allowance had no material effect on Q4 adjusted EPS and no effect on adjusted free cash flow. Based on assumed share price appreciation we estimate about 78 million diluted shares outstanding for the full year. As you know we are not able to offset the dilutive effects of our equity compensation programs until we emerge from bankruptcy.

Adjusted free cash flow should be over $400 million again, in line with our three year target of over $1.2 billion. We expect full year capital expenditures of $180 million to $200 million. We are investing more in our manufacturing operations. But the timing and size of those investments will be determined by our ongoing assessment of our growth opportunities. It's implied by our sales outlook. We are modestly more cautious about the strength of the global macro-environment and have adjusted our capital allocation in line with that.

Finally we intend to make another accelerated contribution to our U.S. pension plans. As you recall from prior discussions, this is a tax and earnings opportunity created by the timing of our emergence and is the best use of excess cash for now.

As we discussed on earlier calls, 2012 had an unusual quarterly earnings pattern due to the effects of rare earth inventory accounting. Catalyst Technologies earnings in Q1 were significantly greater than normal and its earnings in Q3 were significantly lower than normal. 2013 will be closer to our normal quarterly pattern. As a result Catalyst Technologies Q1 earnings will be down single digits from last year. For Grace, this means our first half, second earnings but should be about 46%, 54% compared with about 50-50 in 2012.

Those are the details, but I want to give you a bigger picture too. As Fred said earlier, we intend to achieve our earnings goals. Although the macro-environment has been weaker than we expected a year ago, we have gross margin and operating margin opportunities that should keep earnings growing nicely. Our business fundamentals are solid. We are focused on our growth programs and we are focused on our margins and cash flow.

With that, we’ll open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And the first question comes from the line of Mike Ritzenthaler from Piper Jaffray. Please proceed.

Mike Ritzenthaler - Piper Jaffray

Could you provide a bit more context around the decline in roofing materials? Was there some pull forward from 4Q into 3Q sort of fiscal cliff related or was it related to Sandy or something else?

Fred Festa

It was really related to the past year and half of mild winters. So the inventory that was stocked at our distributors was heavy. So as they went into this cycle they just didn’t buy. Now, we will see what happens coming out or going into 2013 with the super storm Sandy and some of the ice storms that have happened but it was really just that mild winter, distributors not buying as heavy.

Mike Ritzenthaler - Piper Jaffray

I see okay and then in construction products, continuing to improve profitability outpacing volumes of phenomenon we’ve seen for few quarters now specifically in Europe. How much more runway does the lower margin pruning have? Is it something that continues to unfold through ’13?

Fred Festa

Yes, I feel very good about the construction business prospects going forward both on a margins basis as well. We tend to lag residential recovery in North America by nine months maybe 12 months. As we’re starting to see the residential recovery I think that’s going bode well for 2013. We positioned the underlying business to continue to lever both in North America.

Europe, we’re not planning a bounce back in European volume at all in 2013. if there is a bounce back, we’re positioned for that and then if you look around the globe in the emerging regions, what we’ve done in Brazil, what we’ve done in China on the cement side, what we’ve done in the rest of Asia were very well positioned there. So I feel very good and as Hudson said in the opening remarks on construction chemicals, we believe it's positioned to achieve new earning type levels.

Mike Ritzenthaler - Piper Jaffray

And then just one last one from me on the polyolefin catalyst. Would geographic exposure be mitigated through these new products that you talked about in you prepared comments?

Fred Festa

Yes, if you look at our polypropylene side, those polypropylene sales were up significantly’12 over ’11. As we go into ’13 they become a bigger part of the overall portfolio. I also think in the polypropylene side, we saw that the phenomena as China weakened that polypropylene demand slowed down and there’s been a rebalancing too more advantage to feedstock regions which is North America which were very well positioned in on the polypropylene side as well as the Middle East. So, we weathered 2012 well on that side of it and we feel pretty good that going into ’13.

Operator

Your next question comes from the line of (inaudible). Please proceed.

Unidentified Analyst

Just want to follow up on Mike’s last question there. Can you remind us how large polypropylene is today relative to the polyethylene? And then your guidance early into next year is pretty favorable for polyethylene catalyst. So, is that going to be largely polypropylene growth or do you maybe have some more visibility into inventory levels of your polyethylene customers?

Fred Festa

It’s going to be both, we feel better that the polyethylene destocking has almost run its course and so the polyethylene catalyst will come back to normal type levels as well as the acceleration on the polypropylene side. So, overall as we look into 2013, I mean we think our polypropylene to polyethylene catalyst; specialty catalyst will be in the range of 7% to 8% volume growth.

Unidentified Analyst

You kept 2014 EBITDA target the same and you took down revenues a little bit and you mentioned there are some more opportunities maybe on the operating margin and gross margin side. Can you just give us quick overview of some of the things you’re looking out for ’13, some new initiatives to cost even further?

Fred Festa

Yes, some of the key projects, we spent a significant amount of our capital improving manufacturing operations in 2012. It paid even larger benefits than we thought, as referenced in that we’re expanding our gross profit margin another 100 basis points from there. So, as we go forward, we have a number of productivity projects on the manufacturing side that we’ll fund again this year and we see from where we ended 2012 that we should be able to increase our adjusted EBIT margin another 200 basis point over that period of time. I also believe, as we look out to 2014 it should be a stronger year on the top line than we're forecasting 2013 just based on general economic conditions as well as construction recovery in North America.

Operator

The next question comes from the line of Lawrence Alexander from Jefferies, please proceed.

Laurence Alexander - Jefferies

Two questions, first your CapEx for 2013 looks a little bit light and you've also done a good job bringing down SG&A and R&D expense. To what expense are costs being pushed into 2014 or 2015? I mean should we see a bump in any of those line items?

Fred Festa

So, for the capital in 2013 Laurence, I mean we're up significantly over '12 but a lot of it is the timing of projects. I mean we're right now forecasted to break ground on the Abu Dhabi facility in the first quarter, we're doing the engineering now. That won't come online until mid-2015 or later on that side of it. So you've got a little bit capital flowing from that side as well.

Hudson La Force

Our construction cycle just a (inaudible) our construction cycles are shorter than our customers construction cycles. So we want to make sure that we're building our capacity at the right time and not too early.

Laurence Alexander - Jefferies

On your construction business, are you still comfortable that you got some incremental margin expansion as we get any recovery in US housing?

Hudson La Force

Yes, we are, I mean as we've said before, we're at the historical margin levels with volume especially in North America being down significantly. We would like this business to be in the 18% EBIT type range and we don't see any reason why it should not be.

Laurence Alexander - Jefferies

Okay and then finally on your 2014 targets, you had some M&A included in that target. To what extent is that already accounted for, or is that still to come?

Hudson La Force

Yes, there is about in our earnings about $15 million of deals we've done already that are in the earnings so far, so the rest is on account.

Operator

(Operator Instructions) and the next question comes from the line of Mike Sison from KeyBanc, please proceed.

Mike Sison - KeyBanc

Just wanted to get a little bit of color on your outlook for Catalyst, sort of the split between first half and second half, is it largely due to the rare earth sort of impact in the first half or there may be some customer maintenance stuff and the extra costs you have to do in terms of capacity expansion, just a little bit of color there.

Fred Festa

You know Mike, it really is, it's the inventory accounting related to rare earth on the earnings side, I mean if you look at our FCC volume for 2012, at the end of the year, as the year shook out, we ended up just under 4% overall volume increase on FCC. As you know we started the year a little bit slower because of the shutdowns. As we go into 2013 we think our overall volume will be in the 5-6% range, which will track transportation fuels up 2-3%, so we're still right in that range but what you're seeing on the earnings side it's not turnarounds, it's really the impact of the rare earth accounting, how it's fallen out in these quarters.

Hudson La Force

I'll add to Fred's comment if I may, it's how the inventory flowed through in 2012, so for example if you go back to Q1 of 2011, I think Catalyst's earnings were I want to say $73 million, Q1 last year they were 99. And so, as I said in my remarks Mike, the Q1 was significantly higher than normal, Q3 was significantly lower, that's how the inventory accounting was flowing through, so when you get to Q1 of this year, or normal quarter but compared to a very high quarter last year.

Mike Sison - KeyBanc

Okay, great, and then your outlook on ART, what degree of gulf can we see in '13.

Fred Festa

Yes, we feel good about it; our volumes were up significantly for the year in '12 and with income anywhere from 7-10% in the hydro processing area.

Mike Sison - KeyBanc

Okay, great, and then in Materials Technologies continues to show pretty good improvement there in terms of profitability, looks like you've gotten that business well back on track. What type growth do you think we can see over the next couple of years as may be some of the end market starts to recover?

Fred Festa

We have been generally a two times global GDP grower and over a long period of time, that’s what it averages. I mean last year we fell behind in Asia as you know, we got our position back in Asia as well as we had some operational issues that we corrected but over the long cycle, we are (inaudible) on a global GDP grower.

Operator

The next question comes from the line of Jim Barrett from C.L. King & Associates. Please proceed.

Jim Barrett - C.L. King & Associates

Fred, could you talk about your specialty chemical business for a moment in North America? Have your North American customers accepted your January price increase?

Fred Festa

You are talking on the construction specialty chemicals?

Jim Barrett - C.L. King & Associates

Yes, I am sorry. Yes.

Fred Festa

We are working very hard on that right now. As you know, the cement pricing has not settled out yet. Our customers went out with almost a 10%. That is not settled out. We think we’ll see that come to fruiting by the end of the first quarter. As I said, we are working very hard on that.

Jim Barrett - C.L. King & Associates

Has your competition within North America followed your lead on that price increase?

Fred Festa

Jim, I really don’t know where they are at.

Jim Barrett - C.L. King & Associates

And then sort of a related but broader question, you mentioned pricing appears to be getting more challenging in 2013, is that confined to you, or could you elaborate where you see at least directional pricing pressure in your core businesses?

Fred Festa

Your instincts are correct. Europe is definitely more challenging on the pricing side as well as South East Asia. as you are seeing some of the recovery come back, we are seeing some fundamental capacity come back on line on the underlying raw materials which have the effect of dampening some of the effects of the pricing. So, that’s the balance we're seeing. In North America, we think we are fairly well positioned.

Operator

Ladies and gentlemen, I would now turn the call over to Mr. Mark Sutherland for closing remarks.

Mark Sutherland

Thank you, Jessenia. I thank to all of you, who are listening this morning to our remarks. I’d like to leave you my personal number for any follow-up questions or clarifications. That number is 410-531-4590. And again we thank you for your time this morning. Goodbye.

Operator

Ladies and gentlemen thank you for your participation in today’s conference. You may now disconnect. Have a great day.

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