W. R. Grace & Co.
Q1 2020 Earnings Call Transcript

Published: 30 Apr 2020

[Operator:]

Ladies and gentlemen, thank you for standing by. And welcome to the Q1 2020 W.R. Grace & Co. Earnings Conference Call. [Operator Instructions]I would like to turn the call over Jeremy Rohen, Vice President, Investor Relations and Corporate Development. Please go ahead.

[Jeremy Rohen:]

Thank You Denise. Hello everyone and thank you for joining us today for Grace's first quarter 2020 earnings call. With me this morning are Hudson La Force; Grace's President and Chief Executive Officer, and Bill Dockman; Senior Vice President and Chief Financial Officer. Our earnings release and presentation are posted on our website under the Investor section at grace.com.Please note that some of our comments today will contain forward-looking statements based on our current view of our business 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'll 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 provide an update on Grace's response to the COVID-19 pandemic, review our second quarter demand assessments and planning assumptions.Bill will provide a brief summary of our first quarter results and discuss our strong financial position. We will then open the call for questions.So with that please turn to Slide 4 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 have three key messages this morning. First, our team acted early and effectively to fully implement our pandemic response including significant new safety protocols throughout our global operations. We formed our COVID-19 response team in January and we're already closely monitoring the outbreak at the time of our last earnings call on February 4. Then and now our first priority has been the health and safety of our employees. We have also focused on business continuity to ensure we continue delivering value to all of our customers.Our manufacturing operations and global supply chain have not been materially affected by the pandemic and all of our manufacturing sites are operating at this point. I want to publicly thank my leadership team and our 4,000 employees for their exceptional creativity, adaptability, commitment and discipline. You've made a significant difference to your fellow employees and to our customers and their customers around the world.Second, we've taken decisive actions to mitigate the economic effects of the pandemic and to ensure we generate strong free cash flow this year. As always we are using cash flow to guide our economic response decisions. We are lowering capital spending by $35 million to $40 million improving working capital by $35 million to $40 million in reducing operating costs by $25 million to $30 million.As Bill has said, we will remain nimble and take immediate additional actions if necessary. And third, we are carefully balancing the short term with the long term. So our pandemic response has required significant attention we have maintained our focus on our strategic growth initiatives. The pandemic does not change our strategy or the long term value of our growth plan. In fact, the investments we've made over the last several years gave us significant new capabilities to deliver value to our customers and strengthen our long-term relationships with them.Please turn to Slide 5 and I'll review how we're assessing demand for Q2. I know this is a busy slide but I wanted to be transparent in how we're assessing near-term demand in our three segments. Understanding demand is critically important to effectively managing our operations, working capital and costs. We are triangulating customer information, economic and industry data, inventory levels and our own experience in prior downturns to plan Q2. In refining technologies demand will be hit hard in this downturn especially while government stay-at-home orders are in effect.In April, refinery customers have reduced crude runs by about 20% so far and we expect further reductions in Q2 before demand for refined products stabilizes.Estimates from IHS and Wood Mackenzie indicate that the drop in refined product demand this year will be significantly more than it was in 2008-2009. Many of our refinery customers are also affected by the significant drop in crude oil prices. Historically, lower crude prices would lead to lower fuel prices and greater demand for transportation fuels. Given the pandemic and the stay-at-home orders that demand response is not occurring. This significant demand decline is temporary and does not change our long-term business strategy. We improved pricing in Q1 and our plans include improved pricing in Q2. We remain committed to maintaining our global market share and focused on delivering innovative products and technical services to our refining customers.In our ART joint venture we expect first-half results to be in line with our original plans for this year. ART's sales and earnings are weighted to the second half of the year due to order timing following the IMO 2020 implementation and the startup of our new hydro processing catalyst capacity.In specialty catalyst polyolefin catalysts will also be significantly lower in Q2. We see demand in non-durable applications like packaging and consumer items down and demand in durable induced applications down more significantly. We are carefully monitoring resin and catalyst inventory levels as good indicators of future demand changes. We have recently seen some increase in resin inventories indicating some customers will have to reduce production volumes to rebalance inventories.For catalysts, some customers are building inventories to improve security of supply while other customers are reducing inventories to improve their cash flow. Overall, we expect a net reduction in customer catalyst inventories in Q2.We signed two new UNIPOL polypropylene process licenses in Q1 and expect to announce them later this year. Our licensing pipeline remains strong and we expect another good licensing year. Customers are continuing to invest for their future growth. Materials technologies will also experience lower demand in the quarter. In Q2 we see significant demand increases in pharma applications in some non-durable consumer categories but this will be more than offset by a significant decrease in durable induce applications in coatings and chemical process.Overall, MT customer inventory levels are in line with end market demand. Accordingly we expect to see some inventory correction in Q2 but not at the same level as we saw in 2008-2009. As a highlight we're proud to be supplying specialty silicas that are used in COVID-19 diagnostic test kits and therapies. Although a small part of our overall business sales in these applications are expected to add about 400 basis points of growth to the consumer pharma segment this year.Please turn to Slide 6 and I'll summarize our response to lower demand and how we're managing uncertainty in the macro-environment. Based on our segment demand assessments, we are planning for Grace's Q2 sales to be down 20% to 25% from last year. We are using this assumption to set our production plans, sourcing plans and cost reduction plans. In response, we're lowering our capital spending $35 million to $40 million by deferring projects originally intended to add capacity or debottleneck operations that don't create near-term value given current demand levels. We are completing our three larger capacity additions and expect them all to safely start up by mid-year as planned. We have not reduced EHS or maintenance capital.For operations we are aggressively reducing production volumes and inventories to improve working capital by $35 million to $40 million. This is one of our best levers to maximize cash flow and ensure our costs stay aligned with demand. If demand is less than we've planned we will further reduce production volumes to ensure we achieve our inventory targets. In addition we're reducing costs in our commercial, functional and manufacturing operations by $25 million to $30 million this year. Some manufacturing positions will be affected by furloughs or other cost reduction actions beginning this quarter.Our gross margins will be affected by our response to the pandemic. While we continue to plan pricing and mix improvements this year they will be offset by the negative effects of lower production and inventory levels.In Q2 we expected 200 to 300 basis point decline from lower fixed cost absorption. This will continue while production volumes are at reduced levels. In addition we expect another 300 to 500 basis points decrease in gross margins in Q2 as we reduced inventory. With less inventory fixed costs that were previously included in inventory will now hit earnings. We expect gross margins to recover as demand increases and our inventory adjustment completes.Given the heightened uncertainty in the macro environment we're using three deliberate strategies to ensure we adjust quickly as conditions change. Most important is our discipline and using cash is our primary operating in financial metric. Cash especially inventory is always the surest decision-making metric especially in times like these. Second, we are tenaciously testing and retesting demand assumptions. We have been deliberate about triangulating our demand estimates with customers, industry data and our own experience.We're also carefully monitoring customer and end market inventory levels as an important signal of future demand changes. We've seen a 12% decrease in sales since the end of March and we are reducing production volumes even faster to achieve our inventory goals. We will remain nimble and take immediate additional actions if necessary.Last we've made 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 when the recovery begins.Please turn to Slide 7. As I commented last quarter we've made tremendous progress with our strategic growth initiatives, significantly strengthening our foundation for long-term profitable growth and extending our competitive advantages. The pandemic does not change our strategy or the long-term value of these initiatives. It may delay our payback in some cases but in other cases we're seeing a significant benefit from our investments.For example, our investments in commercial excellence have made us more effective selling remotely to customers. We invested $6 million and over 50,000 employee hours to upgrade our commercial capabilities in the last few years including a global salesforce.com implementation and intensive value selling and negotiations training.Using the tools and training we've deployed our materials technology sales team added almost 800 new sales opportunities in their sales pipeline in Q1. In specialty catalysts an account team completed a virtual two day technology ideation workshop with one of our biggest customers and our refining catalyst businesses are using remote technology to provide technical support to customers facing significant changes to their businesses. They've even worked with customers to remotely start up an FCC unit and a hydrocracking unit.In operations we are maintaining our startup schedules for our three new plants despite the disruption of the pandemic. Our teams are using creative new ways to safely work through startup procedures, qualify products with customers and ensure startup success. Clearly we're not letting the pandemic slow us down. In fact our intent is to sustain these investments to ensure we are well-positioned for the recovery. The disruption caused by the pandemic is temporary and does not change our strategic direction or my conviction about the earnings power of our businesses.With that I'll turn the call over to Bill.

[William Dockman:]

Thanks Hudson and good morning. Let's turn to Slide 9 for a summary of our first quarter results.To sum up Q1, our sales earning and cash flows were in line with the expectations we communicated to you in February which included our estimated impact related to COVID-19. Sales for the quarter were $422 million and down 10% including an estimated impact of 4% or $20 million from COVID-19. 170 basis points of improved price more than offset 100 basis points of unfavorable effects. Adjusted EPS of $0.71 for the quarter was down $0.22 per share. The estimated impact of the pandemic was $0.10 per share.Adjusted free cash flow was down $34 million due to lower earnings at $22 million, $19 million of higher capital expenditures as we work to complete several strategic growth investments including our new colloidal silica plant in Germany, specialty catalyst capacity expansions as well as the new hydro processing catalyst plant.Now let's go to slide 10 and briefly look at segment performance. Catalyst Technology sales were down 12%, the lower sales volumes partially offset by 210 basis points of improved price. Refining Technologies sales were down 7%. The decline in sales volumes was driven by higher refinery turnaround activity and the closure of a North American refinery customer last June. FCC Catalyst pricing was up over 200 basis points for the trailing 12-months period. And Specialty Catalyst sales were down 17% year-over-year including an estimated 10% impact related to COVID-19. Lower sales volumes in Chemical Catalysts for industrial applications were in line with expectations.Moving to Slide 11, materials technology sales were down 5% including a 200 basis point headwind from FX. Lower sales volumes included 2.5% impact related to COVID-19 that primarily affected coatings, chemical process applications.Now let's turn to Slide 12. We are confident that our strong financial position will enable us to successfully navigate the economic uncertainties presented by the pandemic. First, at the end of Q1, we had over $600 million of available liquidity including over $190 million of cash on hand.We continue to run various stress test models in our businesses and we are very comfortable with both our current cash position and our ability to generate cash under each scenario we analyzed. Second, we have resilient cash flows. We acted early to implement our response plans and took decisive actions to support cash flow.We expect to ultimately drive about $100 million of cash from CapEx, working capital and operating cost initiatives this year. As we look beyond Q2, we are ready to flex our business and cost structure. If the economy improves in the second half we will ramp up production quickly to meet increased customer demand. If demand does not improve we will keep our foot on the brake or brake harder if we have to.Same goes for capital spending. We have slowed down or postponed certain growth investments to preserve cash. We have the flexibility to restart these projects when we have clear signals of an improvement in underlying markets for further slow capital if that is warranted.Finally, we have a very solid balance sheet. Annual debt service, pension obligations and long-term debt maturity profile is very manageable. We have no long-term debt maturities until September 2021.Please turn to Slide 13, where we have provided a chart summarizing a few key points about our pensions. At the end of Q1, our net pension liability was $521 million. This includes both advanced funded and unfunded pay as you go to find benefit plans. The advanced funded plans are more typical plans where the company funds a trust to pay benefits to plan participants. These plans are well funded, will only require approximately $2 million per year funding for both U.S. and non-U.S. plans for each of the next three years.The remaining $445 million of the pension liability is for pay-as-you-go plans primarily related to our German operations. These plans do not require advanced funding. Under these plans, the 2020 pension costs of $16 million, cash contributions of $15 million are consistent with prior years and indicative each of the next three years. We thought it was important to address our pension liabilities, so everyone understands the dynamics because we've received some questions on this recently. It is important to recognize that the pension expense and cash contributions for all of these plans are included in our EBITDA, EPS and cash flow metrics, specifically some analysts may be double counting the financial effects by treating the pension liabilities as debt while also including the pension cost in their EBITDA calculation.Now let's turn to Slide 14 before I turn the call back to Hudson. The capital allocation framework doesn't change as a result of COVID-19 but we have deliberately shifted our near-term priorities to reflect today's economic uncertainties. We lowered our planned capital spending for 2020 from about $195 million, $155 million to $165 million as we've discussed. Acquisitions remain an important part of our long-term strategy but we are taking a conservative approach and slowing down these activities given the economic environment.In terms of return of cash to shareholders we are fully committed to maintaining our dividend but we have temporarily suspended our share repurchases. We will continue to evaluate our capital allocation priorities as economic conditions evolve.With that please turn to Slide 16 and I will turn the call back to Hudson for some final thoughts.

[Hudson La Force:]

Thank you Bill. Grace is well-positioned to safely and successfully navigate the operating and financial challenges of the pandemic. We have an experienced management team with a proven track record of effectively adapting to dynamic and challenging conditions. We are taking decisive actions to adjust to the economic effects of the pandemic. Our customer relationships are strong. Our workforce is healthy and highly committed and we have resilient cash flows and a strong balance sheet. Finally, I am highly confident in the essential elements of our value creation framework the Grace value model. We are well-positioned to capture growth, drive profitability and deliver significant cash flows for the long term. I look forward to your questions.

[Operator:]

[Operator Instructions] Your first question comes from John McNulty with BMO Capital Markets. Your line is open.

[John McNulty:]

Yes, good morning. Thanks for taking my questions. Glad everybody's doing well and is safe. So a question on the -- it looks like when we look at the gross margin hit that you're calling for 2Q the biggest portion of that is going to be tied to inventory reduction. I guess the questions is how long do you expect that inventory wind down to take and should we think about it as being different from the catalyst side to the materials tech side? How should we be thinking about that?

[Hudson La Force:]

John this is Hudson. Thanks for your question. I think the vast majority of the inventory reductions will be completed by the end of Q2. We have our targets in place at all of our plants. Our management system is tight and we expect to do this fairly quickly.

[John McNulty:]

Got it. And then I guess a follow-up on Slide 5, I mean first of all it was a helpful slide. There's a lot of information on it. When I look at the forecast for refinery utilization rates obviously there's a 20 to 25 point drop right now. If I'm looking at it right the levels return to kind of a 1Q-ish type level by June or July and then push higher throughout the year as we kind of look to the back half of the year. Is there any reason to think that you wouldn't see a similar snap back in your volumes for one reason or another?

[Hudson La Force:]

It's a good question John and as we're looking at this we're triangulating information that we have from our customers, information that we're getting from industry consultants like Wood Mack and IHS and others and other segments. And in our own experience in prior downturns and our intention is not really to call the direction of demand; is it going to come back at X pace or Y pace but really to stay flexible so that whatever pace it comes back to we'll be able to adjust our operations up or down. That said just as context we've got a pretty broad footprint in the refining industry and I would expect our experience to mirror the experience of the industry as a whole. And John I realized, I didn't answer the second part of your first question. You were asking about the inventory reductions in the different segments. It's roughly the same across the different segments.

[John McNulty:]

Got it. Thanks very much for the color.

[Operator:]

Your next question comes from Bob Koort with Goldman Sachs. Your line is open.

[Unidentified Analyst:]

Thanks. Good morning. This is Anthony Walker on for Bob. Guys, I was a surprised a little bit by the price performance in Catalysts and your ability to maintain pricing in light of the 20% to 25% anticipated step down in the second quarter. Do you think that is likely to continue or should we expect pricing to level out or even potentially decline into the back half of the year?

[Hudson La Force:]

Anthony, it's Hudson. Our strategy is the same. We're focused on product innovation in these businesses. We are focused on selling value to our customers and that strategy hasn't changed and you saw the benefits of it in Q1. And as I said, our intention is to continue to drive.

[Bob Koort:]

Great. And then on raw materials you highlighted that as potential offset to the headwinds that you're seeing on the gross margin line. Can you just help us think for how meaningful that potential relief could be and then just the timing of realization in the P&L; did you see any of the first quarter; do you expect to see any in the second quarter? Thanks.

[Hudson La Force:]

We did. We saw some improvement in rolls in Q1 relatively small and we're expecting additional improvements as the year goes on and we'll start to see that in Q2.

[Operator:]

Your next question comes from Mike Harrison with Seaport Global Securities. Your line is open.

[Mike Harrison:]

Hi, good morning.

[Hudson La Force:]

Hey, Mike.

[Mike Harrison:]

I was wondering if you can give us an update on the capacity edition for the ART joint venture. Did that end up getting completed and it's up and running or is that one of the projects that is being delayed or deferred in your CapEx outlook?

[Hudson La Force:]

Mike, it is proceeding as planned. It was mechanically complete in Q1 and we're working through commissioning activities right now and we expect it to start up in the middle of the year.We still feel good about demand in our ART business. Obviously it'll be affected by the downturn and refining but that market, the hydro processing catalysts market will continue to grow and we'll be happy to have that capacity online and started up.

[Mike Harrison:]

Alright. And then another question on one of the charts. So, one of the tiny little charts on Slide 5 there. One of them shows crude distillation unit utilization rates.And my question for you is are FCC units generally running at about the same rate as those CDU numbers that are shown on that chart or is it a case where if overall CDU utilization is down maybe the FCC unit is not down quite as much, the FCC units running harder.Can you help us understand what's going on there?

[Hudson La Force:]

Sure. Mike, we included it with the intention that it be a proxy for FCC utilization. And if you're a refiner and you have an FCC unit, you want to do everything that you can to run it and to run it as hard as you can. It is a source of significant profit for our refinery customers. And if they're running they want to be running their FCC unit.

[Mike Harrison:]

Alright. Thanks, very much.

[Operator:]

Your next question comes from John Roberts with UBS. Your line is open.

[John Roberts:]

Thank you. You had a large number of refinery customers down in the first quarter. Did they all restart by April or has some of them stayed down into the June quarter here?

[Hudson La Force:]

John, most of them did start up as they had planned but some did stay down for economic reasons. And that's reflected in our thinking about Q2.

[John Roberts:]

Okay. And then sometimes a crisis will provide a catalyst for industry structure change no pun intended. We've got a number of oil companies that participate in the catalyst industry and again China has been captive. Do you think this kind of crisis period here will provide any major changes to the industry structure?

[Hudson La Force:]

It's an interesting question, John. And as I've thought about it, I think I go back to the fundamentals of this industry and whether it's refining catalysts or polyolefin catalysts. At the end of the day, the catalysts have value to our customers because of what it allows them.What the catalysts allow them to do in terms of the productivity of their operations and the value of the products that they can create. And these really are technology purchases for our customers. It's reflected in the margins that we have and it's reflected in the close relationships that we have with our customers.And the formulation for all of this, the business model is technology development of products; strong collaboration and innovation skills; and strong technical service skills. These are the things that our customers value from us and they're the things that they're ultimately paying for.And these are capabilities that we've built up over decades. And they're not really disrupted by something like this. And quite to the contrary, I don't think disruptions like this create significant new opportunities for competitors because you can't develop these sorts of capabilities overnight.I go back to the 08/09 downturn; I go back to the big disruption that was caused by rare-earth a few years ago and those events didn't change the industry structure and I think the industry structure will survive this event as well.

[John Roberts:]

Thank you.

[Operator:]

Your next question comes from Mike Sison with Wells Fargo. Your line is open.

[Mike Sison:]

Hi, guys. Glad to hear you all are safe and sound. Hudson, historically you talked about driving miles being the key driver for us to see catalyst and you know we I think everybody understands why 2Q is so weak.As folks get back to work and that's maybe an area that could be more V-shaped. When do you think you would see that improvement in your numbers as the year unfolds?

[Hudson La Force:]

Well, Mike it's a great question. And we're not in a position today to really forecast when the recovery will begin. John asked a question and I wanted to give John McNulty when I was responding to him I wanted to make a broader point about.Our strategy here is not to try to predict a recovery or to make decisions that are dependent on a certain assumption about how things play out from here. We want to be balanced and nimble so that if the recovery happens quickly we can bounce back with it. If things take longer then we'll stay focused on reducing inventories and costs.That said, I think once it begins it will read through pretty quickly for us. And certainly on the refining side, supply chains are very short in that market and I would expect it to read through very quickly for us.

[Mike Sison:]

Understood. And then, I know it's difficult to sort of talk about your long-term plans these days but any help in maybe thinking about where maybe a normalized margin for the business could get back to and post this crisis whether it be next year or longer term maybe help rebuild some of the earnings power for us as things hopefully get better over time?

[Hudson La Force:]

Mike, it's a very important question and I'm appreciating you asking it. I fully expect for our margins to fully recover as demand recovers.We're taking cost actions to reduce our costs. The inventory correction is transitory and the productivity investments that we've made over the last couple years that haven't fully paid off yet will pay off fully as our demand recover.So, I think in a nutshell I fully expect our margins to recover as the recession passes by.

[Mike Sison:]

Great, thank you.

[Operator:]

Your next question comes from Ben Kallo with Baird. Your line is open.

[Ben Kallo:]

Hi. Thanks for taking my question. Hudson, could you just talk through your different customer bases and the strength of each of the customer bases?And then on refining, could you remind us just in the last downturn how refiners flexed replacing their catalysts on both the FCC side and the HPC sides? So, what kind of lag that takes your people are pressured financially if they can string out their catalyst changes? Thank you.

[Hudson La Force:]

Yes, thanks Ben. So, then I'll go segment-by-segment. In the refining segment, refiners are obviously pressured right now by reduced demand for fuels. In terms of how they respond to that from a catalyst perspective there is not a lot of inventory of catalysts.It's a -- and I'm speaking about FCC at this point. It's a product that is continuously added into the FCC unit on a day-to-day basis and we're shipping to customers on a daily and weekly basis to keep them supplied. It's a short supply chain in a single phrase.On the HPC side, the physical dynamic is different. HPC catalysts are used in a fixed-bed configuration and those catalysts are changed out periodically typically coinciding with a refinery turnaround. And so, what drives the specific demand for HPC catalysts is a refinery turnaround or a new unit startup when new equipment has started up.In the short term, that demand because it's tied to turnarounds is pretty resilient. Refiners are, they want to complete their turnarounds on the schedules that they've identified and planned for.In the long-term, refinery turnarounds maybe pushed out some. If they're running slower, then they can extend the cycle time between turnarounds and we may see that effect later in our hydro processing catalysts business.On the specialty catalyst business, our customers are going to experience some demand declines nothing like what the refinery customers will experience. And they have the ability to adjust their operations to match those demand declines just like the refiners do.From a catalyst perspective, it's more like FCC catalysts where the catalysts are added in a fixed proportion based on the amount of resin that our customers are producing. And so, if our customers are operating they're consuming catalysts, they order on a less frequent basis they tend to carry more inventory of catalysts than our refining customers do.And that's why we expect to see some inventory reduction of catalyst inventories in Q2 by some customers. And we are seeing a difference in philosophy. Some customers have been increasing their catalyst supplies, their catalyst inventories for security and supply reasons but other customers have been reducing their catalyst inventories for their own cash flow reasons.In Q2, the catalyst inventory reductions will outweigh the catalyst inventory increases. And then, for materials technologies, the material that we provide is usually a manufacturing process aid or an end product ingredient for our customers. And so, it's consumed continuously as our customers are either manufacturing their products or running their processes.And in terms of end markets for that business, Ben, it's a pretty wide diversity of end users. We try to summarize this simply on Page 5 by categorizing it into non-durables, then consumer Pharma end user applications and then more durable applications that would be driven more by construction activity and things like that.That was a broad overview but I want to check and make sure I addressed your question.

[Ben Kallo:]

No, that's it. I guess just as far as financial stability maybe just on the catalyst side. Could you just kind of remind us? I know that different catalyst providers have different mixes of integrated refineries versus kind of smaller refiners.And could you kind of give us some sense of that just thinking of your that some of the smaller refiners have to start closing down and how much of a risk that is?

[Hudson La Force:]

Okay. Given our market share, our customer base broadly reflects the market. We are tilted towards customers that value technology that the Grace catalyst technology and their operations as opposed to customers that are just focused on catalyst costs.That's probably the real defining characteristic of our customer base. As a broad statement, as we've talked to our customers, we're not seeing any slowdown in payments from them or anything like that if that's what you're getting at.

[Ben Kallo:]

Great. That's it, that's good. Thank you.

[Operator:]

Your next question comes from Chris Kapsch from Loop Capital Markets. Your line is open.

[Chris Kapsch:]

Yes, good morning. So, there's been a couple questions on the gross margin degradation and I did have a follow-up though. If you look at the inventory drawdown as transitory like you suggested Hudson, curious about the 200 to 300 bips of degradation which I guess is a function of just the end market weakness.Is that comparable across the two different segments or more pronounced in the catalyst segment. And then if you look back to the 2008/2009 great recession, I guess in 2009 and 2010 Grace's gross margin was up pretty substantially.So, I'm wondering if you could just compare and contrast like the differences in the industry structure or the mitigates that happened then that allowed you to increase margins whereas it looks like we’ll see subdued margins may just be a function of FCC pricing at the time. Thank you.

[Hudson La Force:]

Thanks, Chris. You're right, the 200 basis point or 300 basis point decline that component really is just driven by demand levels, production volume levels. Think of it as under absorbed fixed costs as we operate at a reduced manufacturing rate.The fixed variable cost mix between the two businesses, between catalysts and materials is roughly the same and so I think you can use those data points to look at both segments.And when you compare today to the 2008/2009 time period, from a margin perspective the biggest differences are around FCC catalyst pricing and raw material costs. Back in '08 and '09 we were going through a period where Grace as a company was significantly raising FCC prices.FCC catalyst prices. And those price increases started in 2008 before the recession began and they continued through the downturn and into 2009. But the other big component was a pretty dramatic decrease in raw material costs that occurred at that time.And you may recall, it was a period of very high inflation in commodity costs. We were affected by that. And commodity costs really collapsed in Q4 of '08 and the early part of '09 and that benefited us significantly. Today we are seeing some decrease in commodity costs but nothing on the scale that we saw back in '08 and '09, at least not at this point.

[Chris Kapsch:]

Fair enough, thank you.

[Hudson La Force:]

Yes.

[Operator:]

Your next question comes from Kevin McCarthy with Vertical Research. Your line is open.

[Kevin McCarthy:]

Yes, good morning. On Slide 4 you indicate an operating cost reduction range of $25 million to $30 million. Wondering if you could talk about how you would expect that level of savings to flow through the income statement in the second quarter and beyond?

[William Dockman:]

Hi, Kevin. Thanks for the question. I would take that number and spread it over the rest of the year. We began the cost reduction actions in Q3 -- excuse me, sorry -- in March month three of Q1 and so they'll start to benefit Q2 and most of these we can implement pretty quickly.

[Kevin McCarthy:]

Great. And then with regards to the reduction in the capital budget of $35 million to $40 million, can you talk about which projects you've canceled if any, which projects you still intend to execute you know on a postponed basis. What exactly is changing within the budget?

[William Dockman:]

Sure. So, first what we're keeping, EH&S investments, safety related, maintenance related those are continuing as planned. Those are important to me obviously.The big growth investments that are the ones we've talked about the hydro processing catalyst investment, the colloidal silica investment in MT and a couple smaller projects in the specialty catalyst business; we're completing all of those.They were 95% complete in Q1 anyhow and obviously it made sense to complete those and startup which we're doing now. In the demand, that we want to supply with those investments, is still there. These investments were made to coincide with customer investments and so the economic logic of those investments is still sound.There were other investments that were I'll call growth investments, sorry, there's one more category that we're continuing and these are cost productivity investments. So, think of investments in our manufacturing operations that are being made to lower costs or lower energy consumption. We're continuing with those.The ones where we've delayed, these are investments that were based on anticipating growth in '21 and '22 and '23, 2021 and '22 and '23 or we're debottlenecking investments where we wanted to improve throughput in a specific operation.Those investments have been delayed because the business reason for making them has shifted out. We'll still make those investments but we'll make them when it coincides with the recovery and increase in demand.

[Kevin McCarthy:]

Makes sense. Sir, I appreciate color and be well.

[William Dockman:]

Thank you Kevin, you too.

[Operator:]

Your next question comes from Laurence Alexander with Jefferies. Your line is open.

[Unidentified Analyst:]

Hi. This is Adam Bubes on for Laurence today. In terms of operating cost reduction, could you provide a little bit more clarity surrounding cost reductions and where exactly are they coming from or are they more employee headcount or productivity?And then, in a prolonged downturn I was wondering how much more flexibility do you have to cut cost without losing the ability to quickly adjust to a demand snap back?

[William Dockman:]

So, these cost reductions are broad-based, Adam. They're coming from our commercial parts of the company; the manufacturing organization; the functional organizations.And but your point about sort of staying nimble is important and we're making reductions that are designed to match the changes that we see in our end markets but also keeping a balance towards not changing our ability to grow when the recovery begins and also not changing our flexibility.One of the messages I want to be clear about today is this idea of us being flexible because we can't predict exactly what's going to happen and so we're making adjustments that reduce our cost without affecting our flexibility.

[Unidentified Analyst:]

Okay, thank you. And then my last question is on FCC pricing. I was just wondering how do you continue to maintain pricing for the balance of the year in its current environment.

[William Dockman:]

Well, our focus is on creating value for our customers and capturing that value and that really hasn't changed as a business strategy. And we had a good progress in Q1 and we're going to retain the focus on that strategy as we go through the end of the year.

[Unidentified Analyst:]

Okay. Thank you, very much.

[Operator:]

[Operator Instructions] Your next question comes from Paretosh Misra with Berenberg. Your line is open.

[Paretosh Misra:]

Great, thanks for taking my questions. So, firstly on raw materials. Can you talk about how you're currently buying alumina? Is that spot or contract and just trying to figure out given that prices have come down fairly sharply in the last several months. When do you start seeing benefits of that in your P&L?

[William Dockman:]

We do buy alumina under long-term contracts with negotiated pricing but there are repricing mechanisms in those contracts. And so, as prices come down, we would expect those to flow through to us over time.

[Paretosh Misra:]

Okay, fair enough. And then on your end market exposure, I believe in the past you have said that your automotive exposure is I think 7% to 8% of specialty catalysts. So, can you remind us where you're currently now perhaps across your portfolio?And is there a way to think of your exposure also to the aerospace or air traffic end market?

[Hudson La Force:]

Your memory is right. Our end market exposure in a specialty catalyst to automotive build is about 7% or 8%. On aerospace, we have an exposure to jet travel not to jet manufacturing but jet travel in our refining catalyst business.Obviously, with a miles flown down, a consumption of jet fuel is down. That would be our biggest exposure to aerospace.

[Paretosh Misra:]

Thanks, got it. And if I could just ask one last quick one. On the licensing business, I was hoping if you could provide some more color how that part of the business might be affected by this downturn?And I think you said you've signed two new licenses. Any kind of any more color on that and how big those are relative to your typical license?

[Hudson La Force:]

You bet. No, I -- we did sign two licenses in Q1, we have not announced the details of those yet but they're in line with typical license sizes for us. From a longer term perspective, really what drives demand in our licensing business is long-term demand growth for polypropylene.And as our customers look to build their capacity to supply the long-term growth in polypropylene, they look to us to be a technology partner in the process design. That's really the demand driver for that business. And customers make these decisions three, five, sometimes seven years in advance of their construction intentions.And so, things like an economic downturn, don't really slow their long-term planning. I'm sure that project timing changes for customers, obviously project timing changes for customers. But the long-term demand drivers are intact for polypropylene.

[Paretosh Misra:]

Thank you. Really appreciate that.

[Operator:]

There are no further questions coming up. At this time, I'll hand the call back over to Jeremy Rohen.

[Jeremy Rohen:]

Thank you, Denise. Thank you everyone for your time today and your interest in Grace. We look forward to speaking with you and hopefully seeing many of you on the road over the coming months. Thank you.

[Operator:]

This concludes today's conference call. You may now disconnect.