INTRODUCTION

I believe that Kronos Worldwide (KRO) is a short. The thesis is that a fair cycle average EBIT for KRO should be 40% - 50% below what the market is implying today, and there will be multiple potential catalysts over the next 1 - 2 years that can help the market realize this.

As of Jan 29, 2018, KRO has a market cap of $3.3bn, a TEV of $3.4bn, and is majority controlled by the Simmons family. 18.8% of shares outstanding are public float (i.e. $613mm). Average daily trading volume is 2.2% of public float (i.e. $13mm), and 12% of the public float is sold short. On a LTM basis, the Company generated revenue of $1.6bn, EBIT of $258mm, and FCF of $200mm.

KRO was formerly written up as a long idea by yarak775 in November 2010.

COMPANY BACKGROUND

KRO is one of six major global producers of titanium dioxide (“TiO2”), a white inorganic pigment that provides whiteness, brightness, and opacity (i.e. ability to mask something) to everything from paints, plastics (white bottle caps, white yogurt containers), coatings (cars, washing machines), paper, personal care products (toothpaste, face cream), and food products (mayonnaise or frosting). TiO2 pigment accounts for 70% of global pigment sales, and is considered a “quality of life” product for its ubiquitousness in everyday life.

INDUSTRY BACKGROUND

Because TiO2 is ubiquitous in daily life, demand for the pigment is strongly correlated to general macroeconomic conditions. The long-term compounded growth rate of TiO2 consumption is around 3%, in-line with the long-term growth rate of GDP in developed countries.

There are three main groups of players along the supply chain: feedstock ore providers, TiO2 pigment producers, and end consumers. Both the feedstock ore and TiO2 pigment segments of the supply chain are highly consolidated with a handful of players controlling a majority of market share. End consumers are fragmented, numbering in the thousands. 

TiO2 is manufactured using either a chloride-based process or a sulphate-based process. The feedstocks for each manufacturing process are generally not interchangeable. Chloride-based TiO2 pigments account for 80% of global demand, and sulphate-based TiO2 pigments account for the remaining 20%. 

WHAT THE BULLS ARE SAYING

TiO2 prices have risen by 25% over the past year, buoyed by a strong economy and tight TiO2 pigment supply. As a result, market optimism has soared, and KRO’s TEV and market cap have doubled during this period. The bull thesis is anchored by a single belief, that today’s higher TiO2 prices will be the new norm. To give a sense of the market’s optimism, please see the below table, which illustrates that KRO's current valuation implies a belief that cycle average EBIT is 87% greater than the Company's average EBIT over the past 10 years.

 

 

However, for KRO, a company with no vertical integration for the majority of its production capacity, price is not the sole indicator of profitability. Feedstock ore costs are an equally important piece of the puzzle. Currently, KRO’s gross margins are the highest they have been since the last cyclical peak in 2011, yet no one seems to be talking about why these margins are sustainable over the long-term. 

Research, not just on KRO, but across the industry uniformly hones in on price and demand, with little to no mention of raw material costs. Based on historical precedent, coupled with comments made on earnings calls by KRO’s feedstock suppliers, there are good reasons to believe that KRO’s gross margins will erode as their suppliers also look to benefit from higher TiO2 pigment prices.

WHY WILL GROSS MARGINS REVERT?

75% of KRO’s manufacturing capacity is chloride-based and is not vertically integrated. As a result, KRO relies on Rio Tinto and Iluka, two large global mining companies, for the majority of their supply. This dependence is likely to get even stronger if Tronox, a vertically integrated TiO2 pigment producer and one of the few remaining chloride feedstock providers of scale, successfully merges with Cristal (another TiO2 pigment producer with some feedstock assets). Pro forma for the merger, Tronox will cease to sell feedstock on the open market, and will instead be using all of it internally to produce TiO2 pigment. With a limited pool of viable global suppliers (Rio Tinto, Iluka, and PF Tronox would control 72% of the market), KRO is a price-taker with little bargaining power.

See above chart for reference on the following commentary. Prior to 2012, the feedstock industry was stuck in long-term price contracts that provided artificial stability and terrible economics. As a result, KRO, and other TiO2 pigment manufacturers, were able to capture significant margin improvement when pigment prices rose. Post-2012, the feedstock industry moved off legacy long-term contracts, with KRO now negotiating prices quarterly for the majority of their feedstock supply. The gross margin difference between these two periods has been stark. For the 5-year period leading up to 2012, KRO's average gross margins were 24%. Even in the middle of the recession, with revenues down 13% and average capacity utilization at 75%, the Company was able to maintain gross margins of 11%. Since 2012, KRO has had an average gross margin of 19%, with gross margins dropping to an average of 7% during FY 2013 (86% average utilization) because the Company got squeezed by falling TiO2 prices and rising feedstock costs.

Over the past three quarters, KRO's gross margin has expanded to over 30%, well above their post-2012 average of ~19%. It is my view that these gross margin levels are unlikely to be sustainable. It has taken time for tightness in the TiO2 pigment industry to trickle into the feedstock industry. At the same time, despite the favorable environment, KRO's feedstock suppliers have deliberately moderated the pace of feedstock price increases, because they believe it is a more sustainable strategy than spiking prices for short-term gains. The reality is that there is tightness in the TiO2 feedstock markets, KRO has little bargaining power, and if increases in TiO2 pigment prices prove to be sustainable, I see no rationale for why KRO's suppliers won't also look to benefit by raising their own prices. In fact, both Iluka and Tronox have alluded to not just the possibility, but the need for higher feedstock prices on their recent earnings calls.

Another bullish scenario is that KRO is able to raise prices at or above the rate of any raw material price increase, thereby preserving their gross margins at current elevated levels. I also view this as a highly unlikely outcome. Large paints and coatings manufacturers have already started voicing concerns regarding higher TiO2 pigment prices. Sherwin-Williams on their Q3 2017 earnings call voiced their skepticism that further price increases sought by TiO2 pigment manufacturers would be successful. PPG on their Q3 2017 earnings call went the farthest by warning that further price increases could cause demand destruction similar to what happened in 2011. As a refresher, in 2011, with TiO2 pigment prices rising by nearly 50%, many end customers resorted to thrifting (reformulating products to incorporate less TiO2) or substitution (reformulating products to incorporate cheaper grades of sulphate TiO2, a non-core product for KRO), causing temporary if not permanent demand destruction for the industry. As of Q3 2017, TiO2 pigment prices are only 20% below peak levels in 2011, suggesting that a price ceiling is likely within view if overall industry health is to be maintained.

Over the next 12 - 24 months, I believe slowing growth / stagnation in TiO2 pigment prices, coupled with decreasing gross margins as feedstock suppliers begin increasing prices, will be the catalysts needed for the market to realize that KRO's operational performance in 2017 is not the new cycle average.

WHAT ABOUT OTHER UPSIDE DRIVERS?

If I'm right on gross margins, I don't see threats to my short thesis emerging from other areas. KRO’s manufacturing capacity has maxed out at 555,000 tons since 2014. The Company has publicly stated that small incremental capacity might be unlocked through de-bottlenecking projects, but no meaningful capacity increases can happen without a greenfield / brownfield investment. For reference, the Company has grown capacity by 8% over the last decade, an average of 4,000 tons a year all from debottlenecking. KRO has also been operating at 100% capacity utilization since Q3 2016. Limited room for additional capacity coupled with 100% utilization means that volume growth is not a credible growth driver.

New greenfield / brownfield investments aren’t happening anytime soon either. Facilities take 3 - 5 years to construct, are very costly (~$1.0bn for a reasonably-sized facility), and KRO has publicly stated for multiple years now that until they see less volatility around pricing, and sustainable / high gross margins (my guess is high-20%), they won’t consider doing any expansions. In fact, a new greenfield expansion, by KRO or anyone else in the industry, will decrease TiO2 pigment supply tightness, sending prices lower such that it potentially offsets any gain in volumes.

Operating costs have remained relatively steady over the last decade. Taking into account that KRO recently completed a headcount restructuring in 2015, wringing additional cost efficiencies from OpEx seems unlikely. CapEx, which is comprised of regular maintenance and environmental compliance costs, is a similar story, also offering no obvious room for trimming. 

All this taken together means that there aren't any obvious growth drivers that could offset a price / gross margin decline.

VALUATION & SENSITIVITY ANALYSIS

 

If history is any guide, operating expenses should be relatively flat over time. CapEx should also be flat, as management has made it clear for a number of years now that they are not interested in new greenfield / brownfield developments. As a result, I’m flexing pricing and gross margins, KRO's two main historical drivers of profitability, to see the range of potential outcomes.

I am using a cycle-average EBIT valuation multiple of 12.6x, the median of the TiO2 peer set since 2009, defined as KRO, TROX, HUN, VNTR, and CC. I’m choosing EBIT over EBITDA because KRO has near-mandatory capex they need to do each year, and D&A should closely approximate capex. As a sanity check, the median TEV / EBIT multiple of publicly traded inorganic chemical companies, a sample set of over 100, is 12.1x. Narrowing down to just U.S. and European publicly traded inorganic chemical companies gives a valuation multiple of 10.3x. The average multiple of the last 5 years for these two sets doesn’t deviate significantly from today. As a result, I think 12.6x is fair, and seems to bake in the premium TiO2 companies should get for operating in an oligopolistic structure. At 12.6x, using cycle-average EBIT of $146mm (see above table for reference), I believe KRO’s fair value TEV is $1.8bn, and fair value market cap is $1.6bn, 48% lower than today’s market cap of $3.3bn.

To sensitize how cycle-average price and gross margins will affect fair value, please see the following chart, which shows KRO's fair value as a premium or discount to current market cap under various pricing and gross margin assumptions:

 

Base Case: Cycle average pricing and gross margins settle at long-term averages. To be conservative average gross margins includes pre-2012, when suppliers were locked into long-term, low-priced contracts

Upside Case: Cycle average pricing settles at long-term average. Gross margin settles at post-2012 averages of 18% - 19%

Downside Case: Cycle average pricing settles near 2011 peaks, and cycle average gross margin ends up significantly higher than historical

The following table lays out an expected value calculation based on the scenarios outlined above:

 

In conclusion, I arrive at an expected fair value for KRO that is 34% below current market cap.

OTHER CATALYSTS

Besides pricing pressure and rising feedstock costs, I believe there are additional events that could act as downward pressure on KRO's market cap:

1) Probably the most important unknown is how the economy will trend over the next two years. KRO is levered to U.S. and Europe, generating over 80% of sales to those two regions. A downturn in either region could negatively impact demand, causing volume and TiO2 pigment price declines. Conversely, for the reasons discussed above, a continuance of current strong economic conditions is unlikely to result in additional price gains or gross margin increases 

2) New chloride-based TiO2 pigment capacity builds are announced by a major Western producer. This new capacity could potentially reverse a favorable supply-demand dynamic for pigment producers

3) China reverses course on environmental policy, allowing low-cost, low-quality TiO2 plants to operate. Such action would offer end customers a significantly cheaper, albeit low-quality, substitute than is currently available in the market, and one which they have turned to before in 2011, amidst sky-rocketing TiO2 pigment prices

4) China brings on more high-quality TiO2 pigment manufacturing facilities in the next few years than anticipated. This new capacity further strains high-quality feedstock supply, sending feedstock prices higher while lowering TiO2 pigment prices

5) End customers, who have already voiced concern regarding current TiO2 prices, find ways to either materially lower their use of TiO2, or substitute cheaper products, potentially causing permanent demand destruction

RISKS

1) Due to low inventories and an inability to implement additional thrifting / substitution methods, end customers are forced to accept ever increasing prices from TiO2 pigment manufacturers. This allows TiO2 pigment manufacturers to increase prices at or above the rate of feedstock cost increases 

2) Significant new chloride-based feedstock ores are discovered and commercialized. This action creates a large feedstock supply surplus, keeping feedstock prices low over the mid-term

3) Feedstock suppliers move back to long-term pricing contracts, preferring to forgo margin on the upside for margin stability on the downside 

WHY THIS OPPORTUNITY EXISTS

To conclude, I have two hypotheses for why this opportunity exists:

1. KRO is a covered by only three research analysts. The Company hasn’t done an earnings call since Q2 2012, and doesn’t do investor presentations. TROX is probably KRO’s closest comp as it is the only other relatively pure-play name in the space. Both TROX and KRO have doubled their stock price over the past year, leading me to believe investors may be assuming that tailwinds benefitting TROX are also applicable to KRO. This would be a false assumption. TROX can supply 100% of its feedstock internally, so higher TiO2 pigment prices for TROX will translate into higher gross margins. 

2. Generally, the same set of wall street research analysts cover both TiO2 pigment producers and their end customers, whereas feedstock suppliers are covered by a different set of research analysts. As a result, research analysts for TiO2 pigment producers are more likely to focus on the demand / price side of the equation because that’s where they have the greatest insight / expertise.