W. R. Grace & Co. (NYSE:GRA) Q2 2020 Earnings Conference Call July 30, 2020 9:00 AM ET
Jeremy Rohen – Vice President, Investor Relations
Hudson La Force – President and Chief Executive Officer
Bill Dockman – Senior Vice President and Chief Financial Officer
Conference Call Participants
Kevin McCarthy – Vertical Research
John McNulty – BMO Capital Markets
Kieran de Brun – Credit Suisse
Anthony Walker – Goldman Sachs
Mike Harrison – Seaport Global Securities
David Silver – CL King
John Roberts – UBS
Mike Sison – Wells Fargo
Dan Rizzo – Jefferies
Paretosh Misra – Berenberg
Ladies and gentlemen, thank you for standing by, and welcome to the W.R. Grace Second Quarter 2020 Earnings Conference Call [Operator Instructions].
I would now like to hand the conference over to your speaker today, Jeremy Rohen, Vice President, Investor Relations. Thank you. Please go ahead, sir.
Thank you, Raquel. Good morning, everyone, and thank you for joining us today for Grace’s Second Quarter 2020 Earnings Call. With me this morning is Hudson La Force, our President and Chief Executive Officer and Bill Dockman, our Senior Vice President and Chief Financial Officer. Our earnings release and presentation are posted on our Web site under the Investors section at grace.com.
Please note that some of our comments today will contain forward-looking statements based on our current view of our businesses and actual future results may differ materially. Please see our recent SEC filings, which identify the principal risks and uncertainties that could affect future performance.
We will discuss certain non-GAAP financial measures, which are described in more detail in this morning’s earnings materials. Reconciliations of non-GAAP financial measures and other associated disclosures are contained in our earnings materials and posted on our website. This morning, Hudson will discuss Q2 highlights and our views on Q3 and the underlying long-term strength of our businesses. Bill will provide an overview of our financial results and our Q3 planning assumptions. We’ll then open the call for questions.
So, with that, please turn to slide four in our earnings presentation, and I’ll turn the call over to Hudson.
Hudson La Force
Thank you, Jeremy. Good morning, everyone. I hope you and your families are all safe and healthy. We’re proud that our technology plays a role in the pandemic response, and I want to acknowledge the contributions our teams are making during this challenging time. Grace’s specialty silicas provide critical functionality in COVID-19 diagnostic test kits, and we expect to supply material for tens of millions of tests this year. Customers using our UNIPOL polypropylene process technologies and catalysts, our manufacturing materials for medical supplies, including masks and ventilator valves, and our employees and foundation have given generously to those in need. We’re grateful to be able to help our communities at this time.
Please turn to slide five. I’m very pleased with how our teams are managing the unique challenges of the pandemic and recession. They acted early and effectively to fully implement our pandemic response, including significant new safety protocols throughout our global operations. Our workforce remains safe and healthy, and we have experienced no business continuity issues in our global operations or supply chain.
Q2 sales and earnings were better than we expected. Although end demand was down significantly in almost all our markets, our customers did not adjust their inventories as quickly as we anticipated. Our value selling and commercial excellence efforts continue to be robust, and our technical teams continue to work closely with customers to deliver the full value of our technologies. In April, we outlined our plans to mitigate the economic effects of the pandemic by lowering capital spending, improving working capital and reducing operating costs. We’ve taken these actions and identified additional opportunities to improve cash flow this year. We are raising our estimate for the full year benefit of these cash flow improvements from $100 million to $125 million. These actions are starting to pay off.
In Q2, we delivered over $100 million in adjusted free cash flow, including a $60 million reduction in net working capital. Year-to-date adjusted free cash flow is 60% higher than last year, even though adjusted EBIT is almost 40% lower. This cash performance is exceptional and shows the resiliency of our operating model. We reduced inventory $52 million in Q2, beating our original inventory target by more than $25 million. Because this reduction was higher than we expected, the effect on adjusted gross margin was more than we planned. This effect is temporary and lasts only while we’re reducing inventory levels.
For Q3, we expect a strong sequential improvement in gross margins to 37% to 38%, and we fully expect gross margins to return to normal levels of 40% to 42% when volumes return to normal levels. Reducing inventory is obviously great for cash flow, but it also positions us very well as our end markets recover. Lower inventory levels give us valuable flexibility in our plants to capture growth opportunities because such a high percentage of our products are custom formulated and made to order.
Our integrated supply chain team has done an extraordinary job quickly adjusting our manufacturing operations to reduce production rates, inventory levels and operating costs. They also improved product quality, set a new record for on-time delivery and safely completed construction and start-up of our new manufacturing plants. All three plants have turned over to operations and are producing commercial products. We’ve started invoicing customers and expect these plants to add to earnings this year even though short-term demand is, obviously, down from originally expected levels. They provide needed growth capacity, and I’m very pleased to be at this point. Please turn to slide six. I expect you’re all working to assess the long-term impact of the pandemic on our business.
While the pandemic has significantly disrupted our markets in the short term, it has not changed the value of our technology to our customers, our long-term growth potential or the strategic value of our specialty chemicals franchise. Simply put, our long-term strategic framework is fully intact. We have strong leadership positions in end markets that are critical to consumers and the global economy, with more than 80% of our sales in segments where we are number one or two. We’ve made significant investments in capacity, capability and talent to strengthen our businesses, accelerate our growth and extend our competitive advantages. We are continuing these targeted investments during the recession and maintaining our R&D spending.
The investments are producing measurable results. For example, our Grace Manufacturing System investments added 75 basis points to our margins last year, and we fully expect that value to increase when demand returns to normal levels. I’d like to give you three examples of how we’re positioned for growth and how much customers value our technology, even during a severe recession. In Specialty Catalysts, we look to new process technology licenses and new product trials as important leading indicators of the demand for our technology. We’ve already signed four UNIPOL PP process technology license deals this year that will provide more than 2.2 billion metric tons of capacity.
We’re also seeing strong demand for trials for our polypropylene and polyethylene catalysts. Although the total number of trials will be well below this year’s original plan, customers are eager to conduct trials when travel restrictions permit and we’re already scheduling trials for next year, too. Customers want the performance, flexibility and value our polyolefin catalyst delivered to their operations. In Refining Technologies, we’ve had hundreds of conversations with customers about their refinery operating strategies during the pandemic and what catalyst technology is best for them. It’s an important reminder that we deliver a lot more than just a physical product.
Our advice and insights into our customers, markets and operations are highly valued. A very high percentage of our customers continue to use the high-performing, high-value catalyst technology they were using before the pandemic. In Materials Technologies, our strategy is to drive our technology into the highest value specialty silica and pharma end users. We’ve shifted our R&D and selling focus to higher growth, higher value uses, added sales and technical service people and invested in new technology to accomplish this.
We’ve seen significant progress as growth in high-value coatings, consumer and pharma-end uses has accelerated even as demand in our traditional end markets has declined since the pandemic started. This strategic mix shift helped MT outperform many of its end markets in Q2, including 15% growth in consumer pharma. Once the recession subsides, I am fully confident we’ll be back on track to deliver mid-single-digit sales growth, adjusted EBIT margins above 30% and strong cash flows and returns on invested capital. Now please turn to slide seven for an overview of what we saw in Q2 and what we are anticipating for Q3.
Refining Technologies sales were down 28% year-over-year versus a 30% decrease in gasoline demand. We plan for customers to reduce refined product inventories in the quarter, but instead, refined product inventories grew in Q2. This inventory build will have to be worked down through reduced operating rates in the coming months. We also expect catalyst inventories to be trimmed as refiners reduce rates and operating costs. Refinery utilization bottomed in April and started to improve in May and June, but rates are still 10% to 15% below typical levels. Gasoline demand was improving in the U.S. into about two weeks ago, when demand started to level off. FCC catalyst pricing improved in Q2 and remains more than 200 basis points higher on a rolling 12-month basis. For the year, we expect FCC catalyst prices to improve about 1%.
Our long-term view of the FCC catalyst market hasn’t changed. We continue to expect low single-digit annual sales growth, including one to two points of improved pricing. We remain committed to maintaining our global market share and are focused on delivering innovative products and technical services to our refining customers. Specialty Catalysts sales were down 15%, reflecting weaker end market demand in resin and catalyst inventory reductions. SC sales were better than we expected, as we saw some inventory correction, but not as much as we were planning for. As a result, we’re anticipating about $10 million to $20 million of customer inventory reductions in the second half.
We’ve signed four UNIPOL polypropylene process license agreements this year, including two in Q2. Our licensing pipeline remains strong, and we expect another good year, though not as good as last year. Despite the current economic conditions, customers continue to invest in our technology to support their future growth. Materials Technologies sales were down 7% in Q2, with significant declines in coatings and industrial end uses, partially offset by very strong growth in consumer pharma. MT outperformed its end markets in coatings and consumer pharma and was in line with industrial end markets. Consumer pharma growth was led by significant demand for specialty silicas that provide critical functionality in COVID-19 diagnostic test kits. We expect to supply material for tens of millions of diagnostic tests this year.
For Q3, we are planning for FCC catalyst demand to improve sequentially, reflecting stronger end market demand, partially offset by restrained refinery utilization as customers reduced refined product inventories. We’re planning for Specialty Catalysts sales to be about flat sequentially, reflecting weaker end market demand but less impact from customer inventory corrections that occurred in Q2. And for Materials Technologies, we are planning sales to be down versus Q2 due to order timing in consumer pharma and mild seasonality in Europe. We expect continued growth in consumer pharma in Q3, but not to the extent we saw in Q2.
With that, I’ll turn the call over to Bill.
Thanks, Hudson, and good morning. Let’s turn to Slide 9 to discuss our second quarter performance. Our results reflect the impact of the COVID-19 pandemic, but also highlight the strong execution of our mitigation plans and ability to deliver strong cash flow. For the second quarter, sales were down more than 18%, adjusted gross margin of 34.1%, was down 800 basis points from the prior year. The impact of lower production volumes and inventory reductions were offset by lower raw material and energy costs, improved pricing and lower manufacturing costs.
As Hudson discussed, we effectively implemented our plans to drive cash and adjust our production to match demand. For the full year 2020, we increased the cash flow benefit targets we communicated on our first quarter conference call in April from $100 million to $125 million. We have largely completed our working capital initiatives and increased our full year targets by $10 million to $15 million to $45 million to $50 million. Savings targets and manufacturing costs and operating expenses also increased by $10 million to $15 million and are expected to be $35 million to $40 million. We were very targeted and strategic in reducing operating costs and are confident that we are well positioned to act quickly to capture demand as the recovery occurs.
Turning to our consolidated performance on Slide 10. For the quarter, adjusted EBIT was down 50%, and EPS was down 58%, on significantly lower sales volumes due to COVID-19 and the effect of the lower production volumes and inventory reduction. Adjusted free cash flow was $100 million for the quarter, up over 60% year-over-year, highlighting the execution of the mitigation plan. In addition to inventory reductions, we continue to see strong results from our credit collection efforts.
Now let’s turn to Slide 11, to discuss our segment results. Catalysts Technologies sales were down 22% in the quarter. Refining Technologies sales were down 28%, as refinery operating rates were significantly impacted by government shutdowns and lower economic activity as a result of the pandemic. Specialty Catalysts sales were down 15%. We saw increased demand in certain nondurable end market applications such as hygiene, medical and food packaging, but that was not enough to offset declines in durable end market applications.
Operating income for the quarter was $72 million, down 43%, primarily due to lower gross profit, partially offset by improved pricing and $8 million business interruption insurance recoveries. This now closes out our claim related to the FCC catalyst customer fire that occurred in June 2019. Overall, we received $24 million in recoveries, which reflects approximately eight quarters of impacts from this event.
Turning to Slide 12. In Materials Technologies, sales were down 7%, primarily due to weakness in coatings and industrial end markets. Consumer pharma sales were up 15% and above our expectations entering Q2, driven by strong demand for customers’ COVID-19 diagnostic tests. Operating income of $12.6 million for the quarter was down primarily due to lower gross profit.
Now let’s turn to Slide 13. During the quarter, we implemented changes to our Refining Technologies, manufacturing operations global footprint to support long-term global growth as well as drive operating and capital efficiencies. First, we accelerated a Grace Manufacturing System implementation in our three hydroprocessing catalyst manufacturing sites.
The project included key organizational changes and optimization by processes. These actions will support the long-term global growth in hydroprocessing catalysts, as the plants improve operating rates and capacity driving operating leverage. We expect the benefit to operating margins in ART joint venture to be in the range of 150 to 200 basis points, with the benefits beginning to be realized in Q3. Grace will recognize the margin benefits through its equity and earnings in the joint venture. As a result of these changes, Grace has taken a pre-tax charge of $20 million in Q2 to write-off inventory now deemed obsolete based on process and footprint changes.
Cash cost to implement this change is expected to be approximately $1 million. Second, in agreement with our local partner, we have discontinued the project to build a full-scale FCC plant in the Middle East. The decision was influenced by the rapid advance of FCC catalyst technology, the value of flexibility inherent in our existing global manufacturing network to meet the dynamic needs of our customers in a cost- and capital-efficient way.
As Hudson stated, this in no way changes our commitment to our customers and partners in the Middle East. We have made significant we have a significant presence in the region today, including state-of-the-art catalyst characterization lab, local technical resources, and strategically located logistics hubs. With three world-class FCC plants in the U.S. and Germany, we have the flexibility and capability to produce today’s most advanced catalyst platforms. Based on the decision to discontinue the project, we recorded a pre-tax charge of $17 million to write-off engineering and site cost related to costs that were incurred largely before the second half of 2018. The expected cash cost to discontinue this project is approximately $1 million.
Now let’s turn to Slide 14. As we’ve discussed, we remain focused on generating cash flow and maintaining our strong financial position to fund our priorities. In June, we announced the intent to issue $750 million of senior unsecured notes to refinance all of our notes due in September 2021. We completed the redemption in July. As a result, we have now addressed all of our near-term maturities. At the end of the quarter, our net leverage was three and half times. This is outside our target range of two to three times adjusted EBITDA, which is a result of the decline in earnings due to the pandemic.
We expect our balance sheet to delever as markets recover. As we discussed in April, our capital allocation framework doesn’t change as a result of COVID-19. However, we have shifted our near-term priorities to address today’s economic uncertainties and continue to focus on cash generation. Our top priority is still funding our organic growth opportunities. While it’s true we have reduced our capital spending this year, we are making targeted strategic investments to maintain our leadership positions to drive growth. In terms of return to shareholders, we are fully committed to our dividend. While we didn’t repurchase any shares in Q2, we don’t plan to repurchase shares in Q3, we expect to reinstate our program at the appropriate time. Finally, let’s turn to slide 16 to discuss our third quarter planning assumptions. As Hudson has mentioned, our end markets have stabilized, but we continue to operate with a prudent mindset given the ongoing uncertainty.
We expect third quarter sales to be down 10% to 13% from last year, with the largest decline in Refining Technologies. We expect adjusted gross margins to improve sequentially from Q2 to Q3 by 300 to 400 basis points to 37% to 38%. While production remains below prior year levels, we do not expect further inventory reductions in the third quarter. We expect our gross margins to continue to improve and are confident they will return to pre-pandemic levels as demand recovers. Regardless to the timing of the recovery, we are fully prepared to capture the growth as the economies recover, but we also remain focused on executing our mitigation actions, generating cash and closely managing discretionary costs.
Now I’ll turn it back to Hudson.
Hudson La Force
Thank you, Bill. When I assess where we are overall, three key points come to mind. First, April appears to have been the weakest month from an aggregate demand perspective. Demand has improved since then, and more importantly, customer response to the pandemic and recession has clarified. This gives us much better information to plan our operations. Second, uncertainty remains high.
Active COVID-19 cases continue to grow in the U.S. and other countries and some governments are reassessing their policy responses to the pandemic. The EU has agreed on a significant stimulus package, but stimulus in the U.S. may decline. The shape of the recovery is still unclear, but it is clear that a full recovery will not occur in 2020. And third, we will continue to manage the pandemic in recession well with a focus on the recovery. After more than four months of actively engaging customers and analyzing our markets, we remain fully confident in the long-term growth and profitability of our businesses.
We are continuing the investments needed to support our growth and extend our strong competitive advantages. And we continue to make flexibility a high priority. While we’ve reduced costs, we’ve been careful not to jeopardize our ability to respond to changes in demand. We want to be able to quickly slow production further if demand is lower than we planned and we want to be able to quickly respond to capture growth opportunities as the recovery strengthens. This balanced approach will serve us well as we manage the significant uncertainty created by the pandemic.
I look forward to your questions.
[Operator Instructions] Your first question comes from the line of Kevin McCarthy with Vertical Research.
Hudson, I was wondering if you could update us on where you see inventory levels among your catalyst grades at Grace? And where you think inventory levels are downstream in your Specialty Catalysts business and elsewhere?
Hudson La Force
Kevin, thank you for your question. Inside Grace, inventory levels both in Catalysts and in Materials Technologies are in good shape. Now, we made significant progress in Q2, as you saw in our report this morning.
Now we made significant progress in Q2, as you saw in our report this morning. And we expect inventory levels to be roughly flat as we go through the balance of this year. The team really did a super job executing this very quickly. When I look outside of Grace, if I look at Refinery catalyst inventory levels, I think they’re in line. As we highlighted on our chart, we’ve got them colored green. They’ll move within a small level, but catalyst inventories in refining are usually pretty lean. There’s not a lot of storage space within a refinery and things like that.
When I look at Specialty Catalysts, inventory levels, catalyst inventories were high coming into Q2. And we expected customers to reduce inventory levels during the second quarter, and they did, but not as much as we had thought 90 days ago. And so some of that reduction will have to occur in the future. It’s why we still have that yellow on the analysis we included in our presentation. And then in Materials Technologies, our product levels our product inventory levels at our customers, we’re good going into this year, and they were pretty healthy, right about where they should be as the pandemic started. I don’t have a concern about customer inventory levels in MT.
And then secondly, it appears as though you’ve increased your cost savings objective by about $25 million, is that correct? And if so, would you discuss the source of those incremental savings? And how they might flow through your financials over the next few quarters?
Hudson La Force
Kevin, I’m going to ask Bill to respond to your question, please.
Kevin, I think the increases are in the working capital area and the operating expense area relative to what we had put out back in April. From an expense standpoint, we have identified additional opportunities of $10 million to $15 million. So we got some of that in Q2, and that will continue through the rest of the year. In terms of working capital, we’ve largely achieved that piece already in the second quarter. So we would expect to hold the working capital gains through the rest of the year. And then on the capital spending, we’ve held the number consistent with where we were at $40 million, and that will be realized ratably throughout the year as well as we continue on.
So yes, we’ve got the $125 million of benefits. And that’s not our past number for the year. We started the year with a forecast of $260 million to $280 million. That obviously came down due to the pandemic, but it didn’t go to 0. And so now we have $125 million on top of that lower number, which we’re not trying to give a full year range, we just want to make sure it’s clear that $125 million is not our full year cash flow target.
Your next question comes from the line of John McNulty with BMO Capital Markets.
Yes, thanks for taking my question. So, I guess, maybe two of them. On the CapEx front, and I guess, on the cash flow side, when we think about OK, you’ve pulled the Middle East expansion out and so it seems like and you’ve put a lot of CapEx into some of the other growth opportunities. So it seems like you’re getting closer to a point where you’re going to be yielding more cash once we get out of the pandemic than maybe you have in the past. I guess how should we think about the capital allocations? Like historically, about one third, it looks like went to the shareholder, one third to CapEx and one third to acquisitions. I guess, if you’re looking out over the next couple of years, how should we be thinking about how that mix plays out going forward?
Hudson La Force
John, this is Hudson. And let me touch on the first part of your question. I think you analyzed it well. I think with the completion of the three big plants that are coming online now, you will see our capital spending start to moderate. That will obviously translate into higher cash flow as we work into 2021 and ’22 and the recovery is complete. Bill will point out that we also expect cash flows to resume or, dividends, I should say, to resume from the ART joint venture this year. And continue into next year.
And that will help us from a cash flow perspective as well. From a capital allocation perspective, our framework is the same. We prioritize organic investments like the plants that we’ve recently built, that will continue to be our first priority, including maintenance and environmental spending and things like that.
Next, we look at bolt-on opportunities. And while we’ve slowed that activity right now because of the pandemic really, it still is an important part of our growth strategy. I don’t know how to quantify it for you ratably in terms of that pie chart. But I want you to know that it is still an important part of our growth strategy when the opportunities are right and when the timing is right. As Bill said, we do intend to continue our dividend. We’re well committed to that. And while we’re not doing share repurchase now, it is part of our return of capital strategy, and we would expect that to resume when the time is right. Bill, anything I’ve missed?
No, I think that’s right. I mean the big capital spending, though, those projects are complete now. So I think as you think about CapEx spending over the long term, it will generally be 7% of sales most years, and we’ll make more incremental growth investments in the next couple of years. We’ve got things that we were thinking of doing later this year before the pandemic, and we have projects on the shelf that will be ready to start as the recovery occurs.
And then I guess, maybe just two quick ones. Can you speak to the pricing dynamic in FCC catalysts? It sounds like you do expect it to decelerate. Do you is that something that could actually go negative as we look at the end of the year? And I guess, maybe tied to that, look, there’s raw material deflation as well. So is it pricing just kind of mirroring that? Or is it maybe something where the given the condition of the market, it’s just tougher to hold price right now?
Hudson La Force
Pricing doesn’t really follow raws. As you can imagine, given the specialty nature of the products that we’re manufacturing. But we do expect our progress on pricing to moderate in the second half. We said at the beginning of this year that we thought our pricing would be at the low end of our 1% to 2% range. That’s still our view as we sit here in July. We continue to improve pricing in Q2. We’ve had great conversations with customers over the last 90 days as they’ve thought about how to reposition their operations. And time and time again, they come back to the value of our technology and helping them operate their refineries well. We continue to sell that value to our customers. And I think we’ll finish the year at about 1% up.
So it sounds like this current environment isn’t necessarily having an incremental impact on pricing, and it should be at least stable, if not positive going forward. Is that fair?
Hudson La Force
Our yes, our view is that in the long term, we’ll still be in that 1% to 2% range. And as I said, we think we’ll be up about 1% for the year.
Your next question comes from the line of Christopher Parkinson with Credit Suisse.
Kieran de Brun
This is Kieran on for Chris. I was just wondering, obviously, the implementation of the Grace Manufacturing System and cost measures have provided support in this weaker environment. Can you give us a little bit of an idea of what the cadence of those benefits might look like, especially kind of in the HPC side of the business throughout the back half of this year and into 2021? And then I guess, looking longer term, any additional opportunities that you see that you can implement the Grace Manufacturing System or cut additional costs? That would be helpful.
Hudson La Force
And specifically, with the work that we’ve done this past quarter in ART those benefits will start in the third quarter, but they will start slow and build over time. The benefits are driven by volume levels. And so we’ll need volumes to fully get back to normal to fully realize the value of the 450 to 200 basis points that we talked about. And then more broadly, your question about the Grace Manufacturing System, I’m really pleased with the work that our team has done on that over the last couple of years. We added about 75 basis points to margin last year.
Our plants were running hard, and we got really a strong benefit from the changes we had made. We won’t get all of those benefits this year, of course, with volumes lower. But as our volumes return to normal levels, I would expect all of the work that we did last year to still pay off at the same level, plus we’ll get additional benefits based on the work that we’re continuing to do this year and we’ll continue to do in the future. We’re not fully implemented on GMS. It’s a journey. It’s not a destination. But we’ve done a great deal of work over the last two or three years. And we’re well, well, well down the road on that.
Kieran de Brun
And I guess, just quickly, when we think about organic and inorganic investments going forward, whether it’s in 2021 or further out, does I guess, have your strategic priorities shifted at all in terms of how strong some of the end markets, whether it’s pharma and consumer within Materials Tech or Specialty Catalysts has been? Or is the focus still relatively in line with how it’s been in the past?
Hudson La Force
I appreciate that question, Kieran. I don’t think our framework hasn’t changed. Our focus and priorities are consistent we’ve made a lot of investments in our catalyst businesses over the years, and we still look for opportunities there. Materials Technologies has been a significant focus for us over the last year, maybe closer to two years now. But I think the one thing that has changed is timing. It’s more difficult to do a transaction in this environment, not just because of the recession, but because of the complications that the pandemic creates around diligence and integration and things like that. So timing may move out, but the strategic importance of this to us doesn’t change.
Your next question comes from the line of Bob Koort. Mr. Koort, please state your company name and proceed with your question.
It’s Anthony Walker on for Bob from Goldman Sachs. Guys, could you just provide some color on your expectation for slightly weaker demand for the Specialty Catalysts sequentially? I guess I’m somewhat surprised that it’s not showing some improvement, with sequentially higher industrial production and durable good demand.
Hudson La Force
I think the big thing there is weaker demand in some of the excuse me, nondurable end uses. Q2 was pretty strong in those areas, as you can imagine. We don’t see that strength continuing into Q3. The bigger question mark for us in Specialty Catalysts is the pace at which customers will reduce inventories. That’s part of what has us yellow on that circle on page seven.
And then you noted strength in the pharma segment due to COVID diagnostic testing. Does the expectation of sequentially lower sales anticipate some slowdown in this business? Or what’s driving that sequentially weaker expectation?
Hudson La Force
It’s not really a slowdown in that business. We continue to expect that to be strong, but those orders were front loaded as you can imagine, given the speed with which our customers are trying to respond to the pandemic, a lot of those orders were front-loaded. Operator, let’s prompt for the next question please.
Next question comes from the line of Mike Harrison with Seaport Global Securities.
Hudson, I was wondering if you could talk a little bit about what maybe has changed in your long-term plans that it no longer makes sense to have the plant in the Middle East? And do you feel like shifting back to your other manufacturing locations, does that impact your competitive position in the Middle East at all?
Hudson La Force
What we’ve experienced in the last few years is a very rapid advance in our Catalysts Technologies. And the technology that we’re focused on today and focused on in the future requires a certain manufacturing configuration and certain manufacturing assets. And we realize that that’s going to continue to be the case as we move into the future. Our customers are demanding high-performing catalysts that’s given us the opportunity to continue to invest strongly in R&D, in our product technology, and we see the next few years as continuing to be a period of strong advance in Catalysts Technologies.
And for that reason, we don’t want to have a plant that doesn’t have the right equipment, that doesn’t have the right process configuration. We have that equipment. We have those process configurations in our existing plants. And as they’ve improved their fungibility, as they’ve improved their flexibility, the need for that fourth plant diminished. And as we look at our footprint today, I feel very good about the flexibility and the capability of those plants in our network. And frankly, their ability to continue to debottleneck and drive productivity to supply demand growth in the future.
And then also, if I could ask on FCC, what steps are you needing to take in order to help your customers? I think you mentioned that many of them are having to reposition their operations. What are some of the key obstacles that they’re dealing with? I’m guessing that one of those is jet fuel demand being depressed and maybe impacting how they’re looking at refined product streams. Any thoughts on some of the key changes you’re helping your customers work through?
Hudson La Force
It’s operating a refinery is a challenging undertaking. And our customers even in a normal environment have a lot of options about how they operate their refinery, the optimization for them that gives them the most margin and most profitability. And then you throw in the dynamic of the pandemic, and it just it complicates things. You mentioned weaker demand for jet fuel. That’s certainly part of it. We’ve seen mix shifts in relative demand between gasoline and diesel. And we’ve seen mix shifts in refined product inventory levels between gasoline and diesel.
All of these things have occurred in the last few months. And in some cases, the relative positions have flipped within a matter of weeks. And so it’s been a particularly dynamic time period for our refinery customers. They get some optionality in the way they configure their operations, but they get a lot of optionality from the catalysts that we provide them as well. And today, most of our customers opt for a high-performing catalyst that gives them the maximum optionality and gives them the maximum results. We’ve had lots of customer conversations over the last few weeks last few months really.
And time and time again, they come back to, we want the high-performing catalysts because it gives us the optionality we need in our operations to achieve our results. Those conversations have been intense in the last few months. Intense maybe is the wrong word, more frequent. More frequent is really the point I’m trying to make because of the dynamic environment. And as I said in the prepared remarks, it just it’s a good reminder to us of the fact that we’re selling a lot more than just a catalyst. We’re selling information and knowledge about how customers can optimize what they’re doing.
Your next question comes from the line of David Silver with CL King.
I had a couple of maybe accounting-type questions and then maybe a more strategic one. But first, I just wanted to ask a couple of things. So with your top line revenue decrease of 18% or 19%, how much of that might be related to cost pass-throughs or things like that as opposed to strictly price and volume? And then secondly, I did have a question about the big kind of inventory draw down and its significant effect on your cost of sales line. And I’m just wondering about, going forward, whether the when your demand rebounds and you rebuild inventories, is there going to be kind of a cost of goods sold benefit? In other words, does the poor absorption in the second quarter reverse? Or is it really more based on your accounting choices and whatnot, is it really more just a return to historical cost of goods sold trends?
I think first off, on the impact of cost pass-throughs, there’s really 0 impact at the Grace consolidated sales level. Our ART joint venture does have their prices will vary with pass-through of certain metals like molybdenum, but that’s not consolidated into our business. So you don’t see that on our financial statement. So really zero effect on our sales line from the effect of pass-throughs.
On your gross margin question, we did see, obviously, a big decline this quarter, right? We had the effects of the fact we’re making and selling less product and that has a negative effect on margins in terms of fixed costs and overhead absorption. But then secondly, that was compounded by the fact that we were reducing inventories at the same time, which means we’re making even less than what was needed to supply the demand which creates further negative absorption and did compound the gross margin decrease.
As we see the recovery occur in the third quarter, we don’t expect for inventory reductions. So we will see a nice bounce back on margins, the 300 to 400 basis points to really take out that inventory reduction factor. So we’ll see third quarter come back to 37% to 38%. Longer term, we expect we’ll get back into the 40% to 42% range over time. And I think that’s the best way to think about it is over time. Yes, you may see fluctuations quarter-to-quarter periodically with inventory movements. But this was a very sharp movement this quarter. In terms of the inventory declines, you wouldn’t typically see our inventories move this dramatically in any given quarter. So I think long term, think about the 40% to 42% and Q3, think about the 37% to 38%.
And then I did have kind of a more strategic question. So your company was extremely proactive in issuing debt and kind of clearing out the near-term maturity profile. And I guess in a more subdued business environment, I always think management’s thinking strategically kind of look at maybe other ways to add value other than pure operations. And I’m just wondering, I mean, in my impression, and maybe you can correct me, but I kind of view the catalyst business is one that’s still quite fragmented globally where there’s a lot of companies that have kind of 1s and 2s, kind of in particular areas, maybe in chemicals or refining.
And I’m sure you have kind of an acquisition funnel internally, but has the landscape changed significantly for identifying targets and maybe finding more willing partners? You did mention the due diligence was going to be extended. But I’m just wondering if this is the environment where some of the smaller players was maybe an attractive adjacency or something to your existing base of catalyst products and services, whether the opportunities the opportunity has increased in the current environment?
Hudson La Force
David, this is Hudson. Thank you for the questions. In the catalyst space, we’re the natural owner of a lot of different catalyst businesses. The Refining business, obviously, is has been a long part of our portfolio. And Specialty Catalysts, we’ve made a number of acquisitions in the last few years and helps consolidate that industry, as you know. And when we look at other opportunities in catalysts, what we see most obviously is in chemical catalysts.
We have a very, very small position in chemical catalysts today, and that’s a natural area for us to invest in. I think if there are opportunities in that space, we would absolutely want to be involved with that. I’m not going to try to predict or comment on timing. But I’d also comment on the Materials Technologies space. There are lots of opportunities for adjacencies, bolt-on type opportunities in MT, and we’re looking at those sorts of investments as well when the timing is right.
Your next question comes from the line of John Roberts with UBS.
The changes at ART resulted in some raw material work in process inventory becoming obsolete. Could you talk about the different raws or the different processes that would cause that?
Hudson La Force
John, I’m not going to comment too specifically for competitive reasons, but we’ve made some changes in the way we’re manufacturing. And so that resulted in the adjustments that you saw this morning.
How are you doing in replacing the lost PES volumes? I assume it’s relatively hard to try to gain share at other refiners to offset that in this environment?
Hudson La Force
We had made a lot of progress. The it was something we started doing on June 22 last year, the day after the refinery had its incident. But to your point, it is much harder to do that in this environment. It doesn’t change our intention to recover that share and maintain our market share. But we want to do that in a way that’s balanced and in a way that allows us to continue to focus on selling high-value technology to our customers. It’s the exact same strategy we articulated a year ago about this.
Your next question comes from the line of Mike Sison with Wells Fargo.
I know the investors I guess have been talking a lot about hydrogen and green hydrogen and their plans to expand. I would imagine you would need a hydrogen catalyst to support some of those needs. Is that an opportunity for you guys longer term? I know it’s sort of 2025, 2030 type of event, but just wondering how the hydroprocessing catalyst sort of fits in there?
Hudson La Force
The need for hydrogen in refineries, an important part of that is in their hydroprocessing operations, where our hydroprocessing catalysts fit in. It’s been a significant destination for investment for our refining customers. And I continue to expect it to be a significant source of investment for them in the coming years. When you look at the big refineries that are being built in the Middle East, in China, a significant part of that capital is being invested in hydroprocessing equipment. And we’ll see that demand flow through to us. We see ART growing high single digits in the future. We’ve talked about that being partly driven by regulatory requirements for low sulfur. But a big part of it is driven by the use of hydrogen in refineries.
And then Materials Technologies, it looks like inventories are in a good shape, and that business seems to be holding up a lot better. When you look at the second half of the year, what do you think would need to happen to see that one turn positive?
Hudson La Force
You mean positive from a year-over-year growth perspective?
Hudson La Force
We’d need a strong economic recovery, something stronger than what forecasters are calling for right now. We’re working very hard to drive the technology we have into higher-growing segments. But outside pharma and a few consumer segments, demand is still down. Coatings and industrials, hard to see that turning positive before the year is over.
Your next question comes from the line of Laurence Alexander with Jefferies.
This is Dan Rizzo on for Laurence. How are you? Are we seeing any customers permanently change their production capacity, particularly in Specialty Catalysts, whether they’re just shutting down some of the longer term plans?
Hudson La Force
Dan, we’ve seen some temporary shutdowns. I have not I’m not aware of any permanent plant shutdowns, but we did see some temporary shutdowns in the Q2 time frame as customers were working to control inventory levels.
And then you mentioned the $125 million in savings. I was wondering how much of that would be considered more temporary? And how much potentially would be will come back to just to support a rebound of volume recovery?
I think as you think about the operating expense and cost reductions, it’s for the most part, it’s temporary in nature. I mean these are headcount deferrals. It’s less spending on discretionary items like travel, entertainment, consultants, contractors. So a lot of things are being deferred or just not being spent at this time as well some of the lower cost at the manufacturing plants, we’ve been able to take down fixed cost.
So this is I look at it as short-term in nature. But these are things we can continue to keep down as long as this slowdown continues. But when the recovery occurs, we can reinstate the hiring and start to spend on some of these areas where we’ve deferred it to date. So it shouldn’t affect our ability to recover quickly as the recovery occurs. So we’re being fastest here to manage it in the short-term without affecting our long-term ability to capture the rebound.
And then finally, you mentioned, I think capex is generally kind of 7% to 8% of sales with some bigger projects being deferred. I was just wondering of that 7% to 8%, how much of that would be considered like maintenance versus like growth projects that are still ongoing or continuous?
Yes, I think the 7% to 8% would cover maintenance capital, EH&S spend that we need to make in our plants to keep things safe and compliant as well as some IT capital for necessary IT investments. Of the 7% to 8%, the majority of that would be on the maintenance capital side.
Your final question comes from the line of Paretosh Misra with Berenberg.
Jeremy, Just given the optimization plans that you described in the hydroprocessing catalyst business. Just wondering, with regard to the new plant, has there been any change in you’re thinking about the ramp-up schedule for that plant also? Or is that pretty much stays the same versus, say, three to six months ago?
Hudson La Force
That new plant has started up, we’re making commercial product now. And the demand that we need to supply is reduced, of course, because of the pandemic but we expect to ramp that plant up pretty fast. The plant having the plant online actually gave us some flexibility that allowed us to accelerate. It was part of the reason why we were able to accelerate the GMS implementation. So there is that connection. But the plant itself will ramp up. It is selling making commercial product now, but it will be a little slower than we had thought given the pandemic.
And then on the FCC catalyst side, I was just wondering if you could talk about the demand side of the equation, not so much the mix and capacity utilization, but more in terms of the new FCC capacity additions plan over the next one, two years, how what are you hearing from your customers? How are those plans progressing just given the volatile environment?
Hudson La Force
These are extremely important investments for our customers. They remain very focused on these investments and certainly well committed to these investments. And I’ll have to let them tell you about their timing plans. It wouldn’t be appropriate for me to comment. But I will say that they remain strongly focused on these investments.
This concludes the Q&A session for today. I would now like to turn the call back to Jeremy Rohen for any closing remarks.
Thank you, Raquel. Thank you, everyone, for your time today and your interest in Grace. We look forward to engaging with you over the coming months. Thank you.
Thank you ladies and gentlemen. This concludes today’s conference call. Thank you for participating. You may now disconnect.