Description

I recommend purchasing shares in Osaka Titanium Technologies, the only listed pure play titanium sponge producer. The stock is almost 300% YTD, but I believe it could easily double or more from here as the industry enters what should be a multi-year upcycle.

Background. Titanium is an indispensable material used in aerospace and defense applications due to its strength at a relative low density (~60% of stainless steel) and corrosion resistant characteristics. It is the 4^th most abundant metallic element and occurs primarily in minable form as ilmenite and rutile. Ilmenite is much more abundant, accounting for ~95% of minable titanium. Roughly 90% of titanium raw material is used in the chemical industry to produce titanium powder (TiO2). The rest is primarily used to make titanium sponge, which is what we care about. For the titanium sponge production process natural rutile can be used directly as the raw material, but ilmenite must go through a chlorination process. The full production process is a difficult and energy intensive process called the Kroll Process, which involves numerous steps including chlorination, electrolysis, deoxidization, and vacuum separation.

There are not many countries that have been able to produce quality titanium sponge profitably and at scale. Currently, global sponge production capacity is roughly 342k tons. China accounts for roughly half (173k tons), while former Eastern Bloc countries account for another ~25% (88k) - Russia (49k), Kazakhstan (27k), and Ukraine (12k). Most of the remaining capacity exists in Japan between two companies - Osaka (40k) and Toho (25k + a Saudi JV with 15k). There are also a couple of companies in the US that have idled facilities - ATI with ~20k tons between its facilities in Utah and Oregon, and TIMET (part of BRK) with ~12k tons at its Ohio facility.

The major caveat here is that not all titanium sponge is qualified for aerospace applications by the FAA and EASA.  Chinese titanium is not high enough quality to be qualified, meaning half the global capacity is unable to serve the largest end markets - aerospace and defense. Of the global qualified production, ~75% is used in the aerospace industry and another ~10% in the defense industry. The remainder is split between various industrial, medical, and consumer applications. It is also important to note that the aerospace qualification process is lengthy at ~3 years for non-engine parts and ~5 years for engine parts.

Business Overview. Osaka Titanium is the second largest titanium sponge producer globally (behind VSMPO in Russia) and the only publicly traded pure player producer. Toho Titanium, the other major Japanese producer, is also interesting but generates a third of its revenue from its chemicals business where it manufactures TiO2 and ultra-fine nickel powder for use in electronic components. Osaka used to have a polysilicon business, but it exited in 2018.

Over 90% of Osaka’s business comes from the sale of titanium sponge and ingots, and historically 5-10% of sales have come from the High-Performance Materials segment which produces various titanium specialty products such as TILOP. About 40% of production is sold domestically while the rest is exported, mostly to the US and China.

The major inputs costs here are the raw material (~2 tons of rutile per ton of sponge), electricity, and procured materials (mainly magnesium, coke, chloride), plus labor and transportation. Additionally, titanium slag can be used for low-to-medium grade titanium sponge and sometimes “upgraded” for use in high grade. About 70% of Osaka’s production is high-grade requiring rutile or “synthetic rutile”.

Last time around. This is a cyclical industry. The last cycle was 2005-2011 during the commodity super cycle and the macro set up then was eerily similar to today’s. The industry was coming out of an extended down cycle that limited capacity while the demand outlook was robust, driven by growing backlogs in the aerospace industry as well as increasing titanium content per plane. Unsurprisingly, the upcycle was killed by significant capacity expansion from almost every player in the market just as demand was peaking. The high-cost US producers ended up idling their facilities while the low-cost Russian producers (cheaper energy + labor, government sponsored) captured market share. Meanwhile the Japanese managed to survive through other operations and significant cost optimization in what has been a difficult decade for both the companies and their shareholders.

Why now? While titanium is yet to be sanctioned, the Russia-Ukraine War has led most aerospace and defense customers to seek alternative sources of titanium sponge supply. Effectively, a third of the qualified market is at risk. Boeing has already suspended its purchasing of titanium from Russia and its suppliers and partners across the supply chain have followed suit. Airbus, on the other hand, hasn’t yet as it depends heavily on Russian titanium and the process involved in recertifying new supply as well as rearranging the supply chain will be lengthy. I believe it is only a matter of time until Airbus follows suit. If it publicly announces its intention, it runs the risk of losing its current supply before a replacement is found. I also believe it is important to note that VSMPO is part-owned by Rostec, a Russian defense manufacturer led by a close associate of Putin, Sergey Chemezov. Rostec is already subject to sanctions, and it seems likely that sanctions against VSMPO could be used as a further tool in the future.

There is simply not enough current capacity in the rest of the market to replace Russian sponge. The Japanese have already announced price increases for domestic customers (15% at Toho and 30% at Osaka) with similar or greater increases likely coming for foreign customers during end of the year negotiations (maybe sooner?). However, these increases are not enough to cover the increased costs that Osaka and Toho have experienced over the past two years as the price of ore, electricity, and other inputs have soared. By my estimate, Japanese titanium sponge prices will need to rise by 40% just to get back to pre-COVID margins. Furthermore, sponge prices likely need to show a sustained increase above that for US producers to commit to ramping their idled capacity.

Demand drivers. The demand side of the narrative is driven by two long term tailwinds. First and foremost is a recovery in the aerospace industry. Consensus seems to be that the aerospace industry will recover to pre-covid levels by 2024 and maintain a mid-single digit growth rate through 2030. I don’t have a strong variant view here and am comfortable with those assumptions. Adding to this, however, is that newer aircrafts contain more titanium. By weight Boeing’s new 787 contains nearly triple the amount of titanium as the 767 and almost double that of the 777. The trend is set to continue as the plane manufacturers seek to reduce weight and increase fuel efficiency. This is because manufacturers are increasingly using more carbon fiber reinforced plastic (CFRP) in their aircrafts to attain these goals. Titanium is better suited for use in tandem with CFRP than aluminum since aluminum rusts when in contact with CFRP.

The second key driver is increased global military spend due to the geopolitical state of the world. A number of NATO members have announced increases to their defense budgets following the Russian invasion (link). Japan has proposed to double its defense budget (link). Not to mention the US’s ever increasing defense budget (link).

What numbers could look like. Last cycle saw four consecutive years of 24%+ top line growth as gross margins expanded from ~19% to ~48% and EBIT margins expanded from 4% to 39%. If a similar scenario plays out this cycle, we could see Osaka’s realized titanium sponge pricing double over the next 3-4 years and gross margins reach 45%+ as utilization ramps from 50% last year to ~95%. If input costs remain at elevated levels and SG&A grows at a mid-single digit rate, I estimate Osaka could earn over ¥750 per share.

In a more conservative scenario, if prices only rise the ~40% required to bring margins back to pre-Covid levels and utilization reaches only 85%, Osaka could generate around ¥280 per share.

Valuation. Admittedly, it is difficult to value cyclical businesses like this. The two scenarios above imply P/Es of 4x and 11x, respectively.

While Osaka had no coverage during the last cycle, Toho traded on a 50x P/E at its peak (2006) and 12x at its trough (late 2008) before turning unprofitable. From 2015 through March 2020 the stock traded between 14x and 35x. I think the high end of these ranges are obviously unrealistic, but a low to mid-teens multiple on normalized earnings seems reasonable for a business like this. A 10x multiple on the above peak cycle earnings, gets you ¥7,500 per share (140% upside), while a 15x P/E on the above pre-COVID scenario, which I believe represents normalized earnings, gets you ¥4,200 per share (35% upside).

Regarding capital allocation, the company very well could pay out more through the cycle, but at its historical 30% payout ratio we are looking at about 7% and 2.5% dividend yields, respectively.

Key Risks:

- China gets qualified. As mentioned earlier China accounts for half the global titanium sponge capacity but is not qualified for aerospace applications. While the qualification process is lengthy (3-5 years depending on the part), could this be narrowed in response to today’s environment? I have no idea, but I lean towards likely not, given current China relations.

- Everyone is friends again. If the Russia- Ukraine War ends tomorrow and governments are willing to look past the invasion and happily go back to purchasing Russian titanium than the shortage likely dissipates. I believe this to be unrealistic, and I would expect impacted aerospace companies to be seeking alternative sources going forward regardless as it is a risk they must now account for.

- Air travel slows. The risk remains that demand from aerospace does not return to previous levels as expected, which would ease the demand side of the equation.

Catalyst

Airbus fully abandoning Russian titanium.

Export price increases during end of year negotiations