Description

Tronox is a cyclical stock that is extremely cheap on 2q-20 TROUGH earnings run-rate at 6.5x 2Q annualized EBITDA and 15% LFCF yield.  The company is on the verge of a marked improvement in earnings as the global economy recovers and it executes on synergies that could add an additional $208mm to the $600mm run-rate.  If you include 2/3 of the additional future synergies (ahead of schedule) and add those to the 2Q run-rate – the valuation is 5.2x EBITDA with a 31% LFCF yield.  If you include synergies and mid-cycle earnings, EBITDA growth has stratospheric potential.  This sets up one of the most remarkably asymmetric stocks I have seen in a while.  Your short-term risk is mark-to-market and should not be permanent unless we have a nuclear winter.  I estimate downside to $6/share.  At $6/share, the stock would be roughly 20% of TEV which I would consider an option floor.  Your upside can be 600-700%.

What does Tronox do?

Tronox is a fully integrated manufacturer of titanium dioxide (“Tio2”).  Titanium dioxide makes things white.  Key end markets are paints, plastic bags, toothpaste and dyes.  There are two manufacturing processes sulfate and chloride.  The two processes have their pros and cons.  Chloride produces a pure product that is favored in the US as paints are mixed on a local basis.  Sulfate is less pure but is less abrasive and can be used in more specialty applications as a result.  Sulfate is more common in Europe.  Sulfate based paints must be blended at the plant.  Tronox supplies the raw materials for both processes but its Tio2 plants are weighted to the Chloride process. 

Industry Composition/Cost Curve:

The industry can be divided into Western and China.  China is a fragmented high cost supplier primarily for internal consumption.   The inefficiency relates to lack of sophistication in manufacturing a fairly complex product, sub-scale plants and a lack of domestic raw materials.

Western Tio2 supply is dominated by Chemours, Tronox, Venator and Kronos.  The make-up of this group has changed dramatically over the last 10 years.  Formerly fragmented with an irrational market leader DuPont/Chemours, today the consolidated industry is led by the newly independent & rational Chemours.  DuPont ran the unit for volumes.  Chemours rationalizes capacity to hold price.  This task is made easier as the limited number of competitors have curtailed supply to match the market – much like the U.S. containerboard market.  This has reduced the volatility of pricing on the upside and this trough. This consistency would argue for higher multiples.

China is a very large supplier of lower quality sulfate capacity.  The majority of its exports go to other Emerging Markets and some higher quality product from the best Chinese producer (Lomon Billions) does make it into the European market. 

Chemours is the most efficient manufacturer owing to its unique manufacturing process which allows considerable flexibility.  Tronox is next most efficient partly driven by vertical integration.  Venator after that.  Kronos is the marginal supplier.  Chinese producers are higher on the cost curve due to sub-scale plants and the need to import raw materials.  Today 90% of Chinese producers are reportedly under-water.  Producers are pushing for price increases as the Chinese industrial economy is ramping up.

Where are we in the cycle?

On the Ti02 manufacturing side, the industry was on the verge of a sharp recovery in 1q-20 as the industrial economy was responding to stimulus and an 8 quarter de-stock process had left inventories depleted.  However, covid crushed the recovery as demand imploded.  As we emerge from the 2q lock-down, inventories are favorable.  Over the past 5 years, material capacity has been eliminated from the West via shut-downs and Venator had a plant explode.  China has not been adding material capacity.  As a general rule, emerging market middle class expansion creates material demand creation.  Due to limited capacity expansion in recent years and nothing material slated for construction as margins are well below new-build, the outlook for capacity is clear for the next 4-6 years.

On the raw material side, the industry had pricing power in 1q-20 and TROX reported today that this continued into 2q.  the raw material mining side to the industry has 3 main suppliers and limited new mine capacity has been announced.  Pricing power during 2q-20 where demand declined 10-15% speaks to the supply/demand picture in this segment.

The following factors could drive a faster recovery for market conditions than currently expected on the Ti02 manufacturing side.

1)      Western supply has been in decline for the last 5 years

2)      Chinese capacity has not materially expanded during this period.  China stopped providing inefficient capital to this industry many years ago.

3)      Emerging market middle class continues to expand rapidly.  As they resume their daily lives, demand is likely to bounce back quickly.

4)      Chinese capacity may have rationalized during 2q-20

TROX highlighted EBITDA potential of $1.5bn.  When this market tightens next, that bogey is likely to be surpassed.  At 6x peak, the stock would be worth $45/share before including any fcf generated between now and the peak.  Given the lack of any plans for new supply, peak conditions would likely hold for 3-5 years.

In conclusion, this stock should trade at a higher multiple on 2Q-20 run-rate to reflect

1)      the extremely high likelihood that earnings should improve substantially in the coming quarters based on self-help and higher market volumes. 

2)      The tremendous upside optionality that exists here in an industry with the most favorable supply-demand backdrops in the chemical sector

 

Catalyst

Continued re-opening of global economy and synergy execution.
Small chance that raw material mines are disrupted due to Covid which would materially tighten both the mining segment and the ti02 mfr segments.