Background & Industry: Kronos (KRO) is a specialty chemical producer, focused on titanium dioxide (TiO2.) TiO2 is a pigment that provides opacity to white chemical compositions. It is used primarily in coatings, plastic, paper and personal products. It is in everything from a white AAPL Mac keyboard to toothpaste to white paint. There are two production methods for TiO2, sulfate (older, more expense, inferior quality) and chloride (proprietary technology, much larger continuous production process, more efficient and higher quality end product.) KRO owns plants in the US and Europe and its capacity is roughly equally split between sulfate and chloride technology. The TiO2 industry is a global oligopoly, with five main players: DuPont (26% market share), Cristal (privately held Saudi company - 16%), KRO (10%), HUN (10%) and Tronox (currently in BK - 10%.) There has not been a world scale greenfield TiO2 plant built in the last 20 years anywhere on the planet.
The TiO2 industry was overbuilt in the late 1980s, and suffered from declining prices and margins for most of the next 15+ years. The price of TiO2 declined from ~$3,700/metric ton in 1987 to $2,200 in 2007. For much of this time, the average plant ran at close to breakeven; the ROAs were terrible, but there was a disincentive to shut them down b/c of high environmental and regulatory decommissioning costs (~$100MM per plant.) The Great Recession caused a massive build up of inventory in the channel as demand, which customarily has risen and fallen with GDP, dropped 25% as customers completely de-stocked. This provided the catalyst to remove capacity from the industry, and over the ensuing 12 months, approximately 7% of global supply was permantly shut.
Pricing Power: Demand began to increase in mid-2009 and has remained strong as the channel restocks. Interestingly, pricing did not move down much during the recession, but beginning in mid-2010, the industry was running at capacity, and suppliers began putting thru price increases. Prices have risen ~15% in 2010, with most of the increase coming in H2. While pricing differs by region (Asia and South America being the strongest, North America being okay, and Europe being weakest), it is a fair approximation to say the global weighted average price for TiO2 will be $3K/ton as of the end of 2010. New capacity in the industry takes 3-5 years to come on line, and currently there are no plans for expansion. China is an interesting player; they produce a several hundred thousand tons per year (of a ~5MM ton market), but they lack chloride technology, so it is all low cost, low quality sulfate based TiO2. Much like nitrogen based fertilizer, TiO2 is essentially a closed market, a little may get imported or exported, but for the most part, they make it there to use it there. DuPont has been trying to build a 200K metric ton chloride plant in China since 2005, but has yet to break ground b/c they can not agree with the government or regulatory issue, fees, and technology sharing.
Earnings Power and Valuation: As one of only two pure plays in the TiO2 space (the other is Tronox, which is in chapter 11, exiting early next year), KRO is well positioned to enjoy margin and earnings leverage to the nascent upswing in TiO2 pricing. While 2009 and 2010 comparisons are irrelevant b/c they lost money due to massive fixed cost de-leveraging, I believe they will earn ~$400MM EBITDA and $3.75 in EPS in 2011; these levels should reach (base case) levels of $550MM and nearly $6.00 by 2012. With PF 58MM shares outstanding at $42.00 ($2.4B mkt cap) and ~$240MM PF net debt ($2.6B EV), the company is trading for ~11x 2011 earnings and ~6.5x 2011 EBITDA, both of which could rise by more than 50% in 2012.
Valuation is reasonable (if not dirt cheap), which allows us to focus on the only thing that really matters: PRICING. My research calls to date include the former head of sales and marketing at Cristal, the leading titanium ore and TiO2 consultant in Australia, and a former executive at Tronox. All independently corroborate the pricing story, with the former Cristal executive saying "if you want to be conservative you can model in 5% price increase each quarter in 2011." (My model incorporates a 3 % quarterly change, for a 12.5% compounded annual increase next year; remember, they have already increased prices 16% in H210 alone.) Channel checks with customers at major coatings manufacturers confirm that the market remains very tight, end user inventories are low, and they expect their TiO2 suppliers to raise prices next year. As a procurement professional at Valspar told me "After 20 years of us taking them for granted, the tables have finally turned, they have the power to dictate prices, and I don't expect them to stop anytime soon." Sherwin Williams pubicly called out TiO2 prices in their Q3 earnings call, and went so far as to say they expected to see 20-30% price increases in 2011. My experience with high fixed cost businesses with pricing power, from aerospace forgings to rocks, is uniform - earnings rise dramatically, and often the multiples placed on those earnings follow suit. On my bull-case $600MM in 2012 EBITDA, with an 8x multiple (25% above a "more reasonable" 6x multiple), KRO would be an $80 stock.
On the downside, I believe the current (or even a higher) valuation is supported by the replacement value of KRO's assets. My discussions with multiple industry veterans indicates greenfielding a TiO2 plant would cost ~$6K per ton, while line extensions at current facilities would likely cost $4K per ton. Building a new plant would be a very long and involved process (environmentally, the NIMBY quotient would be huge) and would take 3 to 5 years. With 532K metric tons of capacity, valuing KRO at $6K/ton yields an EV of $3.2B, or $50 per share. KRO's facilities are not brand new, and most of their European assets are sulfate-based, so I won't give them full credit for this value. But, their plants already exist and they have scale, so certainly they are worth more than their fully depreciated value.
Recent Offering and Use of Proceeds: KRO completed a secondary offering earlier this month, which was really more akin to an IPO. While previously publicly traded, only 2MM shares (5%) were in the float, with the remaining 95% held by Texas billionare Harold Simmons. The 9MM share offering consisted entirely of primary shares. Management has not said precisely what they intend to do with the proceeds, but it is clear that opportunities are going to arise over the next year that will allow for further consolidation of the TiO2 industry. Specifically, Tronox is set to exit bankruptcy shortly, and their 225K metric ton plant in Mississippi would be a prize asset for either Huntsman or Kronos (DuPont can not realistically buy this due to anti-trust issues.) KRO currently owns a 50/50 JV on a 150K ton facility in Lake Charles, Louisiana with Huntsman. My hunch is that KRO buys out this JV (which would be incredibly accretive for KRO); this would give HUN the liquidity to go after Tronox's Mississippi facility. Post-bankruptcy, Tronox only owns one facility in the US, one in Europe, and a JV in Australia. The management team there has been described to me by industry contacts as "caretakers" and I think it is just a matter of time until we have more consolidation in the space. KRO management told me that if they can not find suitable acquisition targets, they will use the proceeds to pay down their modest debt facility and bide their time. They have no current plans for greenfield construction.
Other Points to Note:
- Demand for TiO2 is inelastic with respect to price. You simply can not make paint, coatings, plastics, etc. without titanium dioxide. And while there is no substitue for TiO2 in creating opacity in these applications, it still represents a fairly small amount of overall costs. For example, a can of paint that costs $30 at your local Home Depot contains about $1.50 worth of TiO2.
- Prior to the secondary offering, there was zero sell-side coverage of KRO. DB and Stephens have just initiated, and at least 3 more institutions (BB&T, Stern Agee, Wells Fargo) should do so soon.
- While KRO is still not the most liquid name in the world to trade, average daily volume since the October 28th offering has been ~270K shares (excluding the day of the offering, when nearly 3MM shares traded hands) vs. an average daily volume of less than 20K share in the year prior to the offering.
- As with any commodity business, one must be mindful of new entrants as prices rise. While I believe some minor debottlenecking and line extensions could add 100K to 200K of capacity over the next 3 years, prices have to get pretty out of hand before anyone would commit to greenfielding a major new facility. I have modelled out the returns on a greenfield plant, assuming $6K/ton in costs, 95% utliziation and constant EBITDA margins of 30% (peak EBITDA margins in the industry are about 35%; I've not taken them this far, but I've also not put in any cyclicality.) Under this scenario, a new entrant would need to realize prices of $10K/ton to get a 20% IRR on the project. For reference, at $10K/ton, KRO would earn about $40/share in earnings and $3.5B in EBITDA.
Risks and Concerns:
- China. China is a risk from both a supply and demand perspective. On the supply side, China is currently only capable of producing sulfate-based TiO2, which is lower quality and not up to western standards. They continue to add sulfate capacity, most of which is used internally. They do export some low quality TiO2 to markets like eastern Europe. While the Chinese obtaining chloride technology would be worrisome, labor is not a huge component of TiO2 costs. China also imports high quality TiO2 for higher end applications. DuPont's chloride based facility in Mississippi is currently exporting to China because the price is better there than in North America. If China decides to grow 2% instead of 8%, we may have a problem.
- Raw Materials. Prices for titanium ore are set to go up next year. An industry contact recently told me to expect to see 10% price increases across the board on January 1, 2011. KRO is somewhat insulated from this because they are vertically integrated in Europe, and their chloride plants in North America are more flexible (both from a production and regulatory standpoint) than other players. KRO management has guided to an 8% increase in raw materials (which are about 30% of total costs) for 2011.
- Double Dip. If the we have a global double dip, and the channel de-stocks again, all bets are off. On everything.
- Mid-to-high single digit price increase for TiO2 expected in late 2010 to take effect for the spring paint season.
- Tronox emergence from bankruptcy and potential further consolidation of space.
- Continued positive sell-side initiations.
- Strong Q4 2010 earnings