Grace Under Pressure

Few stocks are so toxic they can't be decimated by a federal criminal indictment. But insolvent polluter W.R. Grace (GRA) can now claim that dubious distinction.

Grace shares fell 8.3% to $10.50 Tuesday, the day after a federal grand jury charged the specialty chemicals supplier and seven current or former executives with conspiring to endanger residents in Libby, Mont., and concealing the health risks of a mine that produced vermiculite contaminated with asbestos.

The indictment charges the Columbia, Md., company with one count of conspiracy, three Clean Air Act violations, two counts of wire fraud and four counts of obstruction of justice. Investors shouldn't have been surprised. On Oct. 29, Grace announced it was the target of a federal grand jury probe.

"I'm perplexed why the stock didn't go down the first time the Libby probe mention was made," says Jim Barrett, an analyst at C.L. King & Associates, a brokerage in Albany, N.Y.

The stock actually closed up seven cents that day. In fact, Grace and other asbestos liability defendants such as USG (USG), Armstrong Holdings (ACKHQ) and Owens Corning (OWENQ) enjoyed a tremendous rally last year after President Bush won re-election.

The market expects the Republican-dominated Congress to set up a nationwide fund capping corporate liabilities for asbestos claims. It was reserves for such claims that drove Grace into bankruptcy court in the first place. The prospect of legislative relief has nursed hopes that the stock won't become worthless, as often happens in bankruptcy. The share price has more than quadrupled from May's lows.

"The reason the stock is worth anything is because there is a feeling that we will have asbestos reform," says C.L. King's Barrett. "Then the litigation overhanging Grace goes away and the company will pay a small percentage of sales into a trust fund for 27 years. The tendency to buy asbestos stocks was based on post-election thinking that there was a high possibility of asbestos legislation in 2005. The critical fact that Grace was under investigation seemed to be ignored by investors collectively."

But that will be hard to do in the wake of a federal indictment, which says Grace spread asbestos to businesses, schools and homes in a small town that hosted its mine for three decades. In a written statement, Grace categorically denied any criminal wrongdoing.

Grace operated the Libby mine from 1963 to 1992, with processing operations continuing until 1992. It filed for bankruptcy protection in April 2001.

Yet, asbestos liabilities aside, its core chemical business remains profitable. In 2004, Grace posted a net loss of $402.3 million, or $6.11 a share, as sales grew 14% to $2.26 billion. The loss included a $476.6 million provision for asbestos-related litigation. Pretax operating income from core operations came in at $179.3 million.

"Grace is a modestly healthy chemical company wrapped in an envelope of asbestos," says Peter Cohan, president of Peter S. Cohan & Associates, a management consulting firm in Marlborough, Mass. "If the current administration has its way — by capping asbestos damages as part of its tort reform program — Grace could be a value stock."

Cohan says the market is valuing the company based on two factors: the value of the assets if they were sold to a buyer with a strong balance sheet and the likely cash costs of the asbestos liability.

Incidentally, other asbestos stocks also lost ground Tuesday as investors began to wonder whether a national settlement will ever get through the increasingly divided Congress.

The indictment throws another unknown into the equation. Grace is no longer merely a company that hurt people, but, according to a federal grand jury, one that did so knowingly and criminally.

"It was a purpose of the conspiracy to increase profits and avoid liability by misleading the government and preventing the government from using its authorities to protect against risks to human health and the environment," the indictment alleges.

The conspiracy allegedly lasted from 1976 until 2002. According to the indictment, 1,200 of Libby's 8,000 residents have asbestos-related lung abnormalities. And 70% of those victims did not work in the mine. Asbestosis, a scarring of the lungs from asbestos, is 40 to 80 times more common in Libby than elsewhere in Montana and the U.S. The rate of lung cancer is 30% higher.

If found guilty of criminal conduct, Grace could be fined twice the $140 million in profits it allegedly extracted from the mine.

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"Unfortunately it is hard to tell whether it might be possible to take the chemical company out of the asbestos envelope and unlock the value," says Cohan. "With a market capitalization of $690 million — the market is concluding that there is something left over after all the asbestos payouts have been made." (Barrett doesn't own shares of Grace; C.L. King & Associates doesn't have an investment-banking relationship with the company. Cohan doesn't own shares of Grace nor does he do business with the company.)