Description

Overview

NL Industries is a holding company, majority owned through a convoluted mesh of public companies by the Contran Corporation, a family trust investment vehicle for the late Harold Simmons. The public float is small, there are no conference calls or analysts pounding the table, and for the most part no one has really cared about the stock in a really long time. The last time NL was written up on VIC (and Seeking Alpha) in late 2013/early 2014, it traded above $11/share. Today it trades below $10, despite the value of its underlying assets increasing by over 18% and, as of last week, a substantial reduction in its potential liabilities. Conservatively, I think a very easily estimable net asset value is $16.40/share (>70% upside).

Background - Assets

NL stands for National Lead, at one point a top three manufacturer of lead-based paint in the US primarily sold under the Dutch Boy brand name. The company eventually sold the brand to Sherwin Williams in 1980 after the CPSC banned lead-based household paint and was left with a hodge-podge of chemical/industrial businesses, one of which was Kronos, a manufacturer of titanium dioxide (TiO2) pigments, the primary component that makes paint white. Simmons saw a mismanaged, undervalued business and won a corporate battle to acquire majority ownership via tender offer in 1986. After a series of other divestitures and spin-offs, NL eventually spun-off Kronos (KRO) in 2003. Today the ownership of 35.2 million shares of KRO (~30% of the outstanding) represents NL’s largest asset, which it accounts for using the equity method. It’s second largest asset, CompX National (CIX), evolved from another Simmons/Valhi target in the 1980s, Keystone Consolidated Industries, whose primary business line was manufacturing cabinet locks under the National Cabinet Lock brand. Valhi spun-off CIX in 1998, and today NL owns 10.8 million shares (~87% of the outstanding). Together these two public companies have a market value of $1.02 billion.

NL’s third primary asset is in the form of Valhi (VHI) shares, of which it owns 14.4 million shares (~4% of the outstanding). Valhi, also a holding company, owns 50% of KRO outright.  Although it has a market value, we can sort of look through as most of value of the VHI shares is ascribable to holdings in KRO and NL itself. VHI has about 339.2 million shares outstanding, and it owns about 40.4 million NL shares (~83% of the outstanding), so, in effect, each VHI share holds .12 NL shares, so NL’s 14.4 million share Valhi holdings in effect reduce NL’s outstanding share count by 1.72 million to 47 million outstanding. In the same manner, NL’s 14.4 million shares of VHI represent an additional 2.46 million shares of KRO, or $61 million worth.

When isolating the NL value, it doesn’t make sense short out the VHI exposure unless it is demonstrably overvalued compared to its holdings since a decent chunk of that value would be in the NL stock being purchased anyway. I’d rather aggregate the total KRO exposure and structure a primary hedge that way. To value the rest of Valhi’s assets, then back out the public NL and KRO values which results in $1.88/VHI share or $27 million of value back to NL.

In addition to its public holdings, as of 3/31/2018, NL has $76 million in cash on the balance sheet. All told, this adds up to $1.18 billion in assets.

Background - Liabilities

Moving to the liability side of the balance sheet, the same hodge-podge of businesses has left the company with an equally messy list of liabilities. The largest of which, until last week, was the pending Santa Clara litigation (County of Santa Clara v. Atlantic Richfield Company, et al), a lead-pigment public nuisance lawsuit where, in December 2013, the trial court ruled against NL, ConAgra, and Sherwin Williams, ordering the three companies to fund a $1.15 billion abatement fund in the State of California. According to the company this was just the second such adverse ruling, and the first one was ultimately overturned on appeal. The company appealed the decision to the state appellate court where it was upheld with the exception that the calculation of the abatement funding include only pre-1952 homes instead of all homes built before 1978 (when the US CPSC banned lead paint). By my calculation, this reduced the total burden to between $400-$500 million for the three companies, bringing down the tail-risk for an investment in the company, but certainly still a large overhang, especially since it remained unclear how the liability would be shared between the companies. After a denied appeal to the State Supreme Court in February and a shrewd but shady attempt to pass a ballot measure in this year’s election that would have taxpayers fund the remediation instead, NL agreed to a $60 million settlement on May 16th, which promptly sent the stock up 20%+.

The only other lead pigment case that the company has disclosed is in Cook County, Illinois filed in 2000 (Lewis, et al. v. Lead Industries Association) where the plaintiff is seeking reimbursement for a class of children who were required to get blood tests for lead toxicity. The case is still ongoing, but even in a worst-case scenario, the settlement would be much lower than the Santa Clara case given the scope of the damages sought. The company hasn’t disclosed any other specific lead pigment proceedings, but there is a chance that the Santa Clara sets a stricter precedent going forward and that the probability of further settlements/judgements has increased. This is pretty difficult to quantify, but I will ascribe an arbitrary $25 million liability to future lead pigment cases.

In addition to lead pigment remediation, the company is a potentially responsible party (PRP) liable for environmental remediation at 38 different locations consisting of decommissioned lead smelting plants and former mining locations. As of March, this liability was estimated to be $116 million, but the company also indicates the future costs could be up to $146 million as a high-end estimate. They also have five locations that are in the pre-assessment phase (and have been so for over a decade), that they have not provided an estimate for. There is a chance that they will not be found responsible for these locations; just to be on the safe side, I’ll accrue an average per site clean-up bill of $4 million, totaling $20 million for the five sites. This amounts to a total liability of $166 million.

The company does carry insurance to defray these costs, and the cumulative recovery over the past five years has been about $24 million. Going forward, I haven’t estimated any future recoveries, but there is a definite possibility that the total liability is reduced by insurance coverage.

Other than the environmental/litigation liabilities, the company has a small pension obligation of $14 million. In total, I estimate NL’s liabilities at $265 million.

In 2017, the company spent $11.5 million on corporate expense (ex-environmental), $4 million of which was related to litigation-related expenses, which is about on par with the average for the last several years. 2018 is expected to be a higher expense litigation year, but I would expect that over time, these expenses will go down with the Santa Clara case settled. I think it’s fair to estimate a $6-8 million run rate of corporate overhead as long as the holding company structure is intact. At a 5% discount rate in perpetuity, that amounts to up to $160 million reduction in net assets. Another way to account for the corporate structure is to ascribe a “holding company discount,” and I think it’s reasonable to slap a 15% discount which comes out to approximately $130 million. Splitting the difference, I’ll take a $145 reduction from net assets to arrive at a fair value, which comes out to $770 million. Divide that by the adjusted share count of 47 million, and you get a fair value of $16.40/share, or 74% upside from the close on May 18th.

Sum of the parts

Position Structure

Since its KRO holdings represent over 100% of the equity value of NL, an outright long position in NL would have to be comfortable with an investment in Kronos. KRO trades at forward earnings yield of about 12%, but as VIC author jyu pointed out in his bearish January post, the company has been operating at full capacity since 2014, and TiOz pricing is at a cycle high. Historically a price taker with 15-20% market share in North America and Europe, KRO has benefitted from the rising prices, which may or may not continue. Personally, I’m not excited about betting on a commodity producer this late in the cycle, so I’ve chosen to hedge a lot of that risk out. Fortunately, the shares are relatively easy to borrow.

CIX, unlike KRO, has historically had consistently predictable margins, with gross margin ranging between 29% and 32% and net margins between 13% and 18% for the past 6 years, since the divestiture of their Furniture Components segment. Today it sells products under two segments, Security Products, which includes cabinet locks for which they have the number one North American market share, and Marine Components, which includes specialty manufactured mechanical components for performance boats. The company has done roughly $10 million in free cash flow for the past 3 years and trades at an Enterprise Value of $150 million. Not something I’d rush to go out and buy, but definitely something I’m willing to hold at a significant discount.

In addition to its NL and KRO holdings (about $2.3 billion), VHI’s other primary assets include a real estate development business (BMI and Landwell). In late 2013, Valhi purchased a 32% interest in BMI (which holds equity in Landwell) for $32 million. I’ll be aggressive and assume that investment has done well and has compounded at 10% beginning in 2014 from its implied $100 million valuation, so it’s worth about $140 million to VHI today. VHI also borrowed $250 million from Snake River Sugar at a 9.4% interest rate. With the proceeds, they acquired a preferential interest to dividend income from Snake River’s operations in an amount that has averaged close to $25 million/year (roughly equal to the interest it’s paying). It also has the ability to put the preferential interest back to Snake River for $250 million. My understanding is that the interest and income have historically offset and therefore no substantial value should be allocated to VHI’s agreement with Snake River.

I did a back of the envelope valuation for VHI, adding to the $2.4 billion market cap to $667 in preferred equity and $320 million in corporate debt to come up with an Enterprise value of $3.4 billion, and I think the equity is worth about 2/3 of what it’s trading for.

In 2014, the Harold Simmons Foundation liquidated over $16 million worth of stock between $5-6.50/share (which could very well have been for tax purposes), so the insiders probably don’t think is a bargain above $7.

Even without the same holdco discount as NL, I think VHI is overvalued, so I am short for a portion of my long NL position as a hedge to the whole Contran complex.  

Catalyst

Santa Clara Settlement – The risk of a solvency-testing adverse outcome has been substantially reduced with the announcement of the $60 million settlement. The stock spent plenty of time trading at a premium to today’s valuation even when it had a $1.15 billion penalty overhang.

Resumption of dividend – Pre-2014, before the Santa Clara decision, NL had maintained a $0.50 dividend for eight straight years. After my discussions with the company, I am confident that they will begin paying one again with the Santa Clara case behind them. Only their direct share of the recently increased KRO dividend amounts to $24 million per year, or $0.50/share (5.2% yield). CIX, KRO, and VHI all pay dividends.

Simmons estate liquidation – Harold Simmons died in late 2013, and while there has not been a rush to liquidate assets, Valhi did finally complete the sale of their waste management business after shopping it around for years for a price much lower than they’d been offered originally (it failed to pass anti-trust consideration the first go-around). Simmons’ daughters, who now run the family foundation full-time, have a reputation for being much more left-leaning than their father, so who knows how long they will want to own a portfolio of dirty, boring, old industrial businesses.