Tronox

Buy Tronox (ticker: TROX) stock.   Currently at around $140.  Market cap of $2.2bn.  EV of $2.6bn.

The thesis is

1) Titanium dioxide pricing is very firm and is headed higher.  Could/should eventually go to where new build makes sense (i.e. from ~$2,500 / metric ton in 2010 towards $5,000 / ton perhaps in the next 2 years or so), which falls to the bottom line and would more than double EBITDA

2)  Company still trades cheap on a relative basis (trades at 6.75x 2011 EBITDA, while Kronos is at 7.5x 2011 EBITDA and Rockwood at 8.25x EBITDA).  ~7x isn't unreasonable given they're going to be generating specialty chemical, 25%+ EBITDA margins with solid pricing power for the next 4+ years.  

3)  Very favorable supply / demand dynamics,  pure play

4)  Potential M&A: Kronos seems eager, and Huntsman has bid for Tronox before

5)  Standard post-reorg catalyst (improving liquidity, cleaned up balance sheet and environmental liabilities which had been a large overhang before, upcoming research coverage, increased investor familiarity, etc.)

This could go to $225 (more conservatively in the medium term) or $310 in a few years.

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 Contents

1) Business

2) Supply / Demand

3) Financials

4) Valuation

5) M&A

6) Catalysts / Risks

Business

Tronox is a titanium dioxide manufacturer.   Titanium dioxide (or TiO2) is a pigment used to impart whiteness, brightness, and opacity.  You can find TiO2 in almost anything: paint, plastics, paper, food, medicine, toothpaste, milk, sunscreen, etc.

Coatings is about 71% of their sales volume

Plastics 23%

Paper 6%     

Geographic exposure:

57% Americas

17% Europe

26% Asia Pacific

Tronox has 7% share of the market.  DuPont has 20%, Cristal 11%, Huntsman 9%,  Kronos 9%.

Tronox utilizes the chloride process to make TiO2 (as opposed to the sulfate process).  The chloride process is cheaper (about a $300-350/ton cheaper or about 10% cheaper at the moment) and it produces higher quality, more pure TiO2 because the TiO2 particles are more consistent in size and hence reflect light more evenly (hence providing better color and consistency). 

HUN, KRO, Eastern European and Chinese operators use the sulfate process.

Tronox, DuPont, and Cristal use the chloride process.  

90% of Tronox's biz is TiO2.  10% is electrolytic and other chemical products. 

Tronox recently emerged from bankruptcy and cleaned up its $5 billion of environmental liabilities.   It is uncertain when they'll list on an exchange,  but they are working towards that (I've heard potentially May / June 2011).

Supply / Demand - TiO2

The TiO2 business has been a bad one to be in for the past 20 years.  However due to numerous capacity closures in the past few years (recession induced), the industry now has pricing power.  5%-6% of capacity has been shut since the peak.    At the moment all plants are running at effectively full capacity and customers (e.g. paint producers like SHW and VAL) are worried about not having enough supply. 

To go back to the last time the industry had pricing power, we have to look at the late 1980s.  Back then pricing went from ~1,400 / ton to ~$2,200 / ton (i.e. where new build capacity made sense at the time).  Afterwards, due to new capacity, TiO2 pricing was about flat for 20 years as new build capacity came online and depressed profits.    These days, new build capacity makes sense at $5,000 / ton (a new 150k ton plant costs about $800mm-$1bn).  Assuming it can put up 30% EBITDA margins, you'd get 22% cash on cash returns at that pricing. 

There is currently no supply coming online for the next 3+ years (outside of China, and even in Chinese capacity growth is slowing due to the lack of raw materials).  DuPont is supposed to announce a new plant, but that won't come online till 2014/2015 or later.   Hence, it's not unreasonable to project that pricing gets to $5,000 (where new build capacity makes sense) at some point in the near future.  On a somewhat related note, I don't think Valspar or Sherwin Williams are shorts.   Paint producers (e.g. VAL, SHW), have historically had very good pricing power and have been able to raise prices to offset input cost increases rather easily.  TiO2 is only about 15% of their raw material costs and raw materials are about 80% of their COGS. SHW also has its own retail distribution, which makes it easier for them to raise prices.  TiO2 is about $2-3 of cost in a $30-40 can of paint.  

In TiO2's other applications (plastic, paper),  it's also a small amount of the total end product cost, making pricing pass through relatively easy. 

Industry experts, TiO2 producer management teams, and paint management teams all agree that we should see quarterly pricing increases that eventually raise TiO2 prices up 20-30% in 2011, and a continued increase in 2012. Kronos has said publicly that they could double pricing from here (though they're rather promotional).

Thus far, there is no substitute product and customers have done all they can with extenders.  Also limiting supply is lack of raw materials to make TiO2 in the first place.

A large Japanese TiO2 plant was recently taken offline which further tightened supply.  One plant in Japan - Sakai Chem's (1% of global capacity) - suffered severe damage. Japanese rebuilding will also fuel demand as well.   This plant was about 20% of Japan's TiO2 supply

Global demand is currently already back to 2007 peak levels.   Inventory levels are low as well (35 days).   Demand growth is expected to increase at 3-4% a year for the next few years (driven by EM countries of course),  while supply growth will at best be 1-2% a year in the next few years (all without factoring much improvement in US and European construction).  So Tronox has some nice late cycle exposure as well (although volumes won't rise much given everyone's already operating near full capacity).

Financials

In 2009, they put up 13.5% EBITDA margins

For 2010 most of the industry generated high teens EBITDA margins

For 2011 most are projecting low/mid 20%s EBITDA margins.

Back in the late 1980s (the last time demand outstripped supply, EBITDA margins were around 45%;  also back then there was more projected capacity coming online on the horizon;  at the moment, there's no near term capacity additions). 

If pricing goes to $5,000/ton, and COGS/ton goes up 20% from 2010 levels, that would get you to 45% EBITDA margins (pretty reasonable)

Current cost breakdown:

titanium ore                  ~30%  

caustic/chlorine/etc        50%

energy                          15%    

SG&A                          5%      

Tronox sources 80% of its titanium ore needs from its Tiwest JV in Australia (which has plenty of ore still left).  Kronos is also vertically integrated and sources about 50% of its titanium ore internally.  Titanium ore is also in limited supply and is further limiting supply and new build prospects. 

Recent KRO call on costs:

"Looking into 2011, we expect to have increases in raw material, energy, and freight costs, including more than normal inflationary increases in the costs of our feed stock ore and petroleum Coke. Overall, on a per metric ton cost basis, we're currently anticipating to see a cost increase ranging from 6% to 10% compared to 2011."   So pricing is moving up 25-30% in 2011,  whilst COGS is going up 6-10%.

Tronox has 390k ton of capacity. Also, it's projecting $75mm of SG&A (much less than competitor KRO)

Valuation

16mm shares (diluted) = 15mm of regular shares, 0.77mm shares from the warrants, 0.18mm shares from management incentive plan

Trades at $140

$2.2bn mkt cap

$55mm cash

$425mm debt - senior secured term loan (also a very quite attractive, money good piece of paper trading around 101 especially if you can lever this up)  L+5% interest, with 2% LIBOR floor on a $425mm facility with only ~1x leverage.

I get to $385mm 2011 EBITDA pretty conservatively  (that's using $3,200 / ton in TiO2 pricing which is where prices are currently and a ~20% increase YoY;  and using $2,150 cost per ton which is a ~7.5% increase YoY).   Consensus out there is more like $400-425mm of EBITDA.

Multiples

TROX trades at 6.75x EV/ EBITDA, which is somewhat cheap. 

12.3x P/E  ($11.4 in earnings)

8x EV / EBIT.  Capex is $50mm a year

$30mm interest

13% FCF yield - don't mind waiting if I can build up plenty of cash.  They really don't have much to spend their cash on at the moment.  Will likely go to paydown debt or buyback stock.

All reasonable or attractive multiples on an absolute and relative basis.  And not factoring any benefit from future increases in pricing.

The only pure comp is Kronos which trades around 7.5x 2011 EBITDA,  so some more room up from here on a relative basis.   Arguably Tronox should trade richer than KRO given that it sources more of its own titanium ore (80% vs. 50%), and it uses the chloride process while Kronos uses the sulfate process.  

Others who have some exposure to TiO2 are Dupont and Rockwood, which trade around 8.25x-9x 2011 EBITDA

Also, as mentioned before, Tronox gets 80% of their titanium ore from their own operations.  So the impact of titanium cost increases is more muted for them.  KRO, which gets 50% of their own ore,  only projects COGS to be up 6-10% for 2011.  So cost increases will be a bit more mild for Tronox. 

Again, the last time the industry had this sort of supply demand imbalance was in the late 80s,  TiO2 prices went to where new build pricing made sense and stayed there but were rangebound.  Again, that implies a doubling of pricing to $5000 per ton from 2010's $2,500 levels.

Target

By the end of the 2011, you can expect people to factor in higher potential 2011 and 2012 EBITDA (perhaps $550mm for 2012) after a few more price increases go through.  Then factor in some cash build, TROX can go to $225 assuming it trades at 7.25x  $550mm of EBITDA.  +60% upside.

Peak upside

Let's say pricing does get to $5,000/ton and COGS go up 40% in that time (translates into 40% EBITDA margins, still below the 45% the industry was able to do before).  They'd generate $850mm of EBITDA and $34 in EPS,  hence this is currently trading at ~4.5x peak EPS (not giving credit potential NOL benefits and cash build).   Assuming this takes 3 years to get to peak, and using 9x peak EPS, this can be a $310 stock (+122%)

You can get a 30% IRR assuming if takes 3 years to get there

Assuming 2 years to get there, you get 50% IRRs.

Replacement value is about $6,600 ton at the moment, or about $2.6bn in value for Tronox's 390k in capacity (vs. the current $2.6bn in EV).   

New plant economics:

It costs $800mm-$1bn to make a plant that produces 150k a day.  At $5,000/ton  that's where you get a decent 20%-25% cash on cash return

Back in the 1980s, EBITDA margins for TiO2 producers were double what they are now (45% ish) vs. high teens for Q1 and probably low/mid 20%s EBITDA margins for 2011 for the industry.    But also, back then there was much more determinable capacity coming online on the horizon; currently, there are no new plans for plants at the moment (for the next 2-3 years).   And new build is much costlier than it was before due to raw material cost increases, environmental permitting issues, limited feedstock availability, and of course the high cost and long lead time.  

Unfortunately, TROX only trades ~125k shares a day.   KRO doesn't trade much either

M&A

Huntsman tried to buy Tronox when TROX was in bankruptcy in November 2009 for $415mm (that was about 3-3.5x 2010 EBITDA).

Kronos has all but said (publicly) that they want to buy Tronox.  That's partly why they raised all that money.  Listen to their last conference call,  it's pretty bullish and overt

Catalysts / Risks

Catalysts

- As long as pricing continues to go up,  which is much more likely than not,  every $200 / ton increase in pricing is worth about $80mm of EBITDA (assuming no incremental cost increases), because they have 390k tons of capacity, currently running near full capacity.  Price increases pretty much fall directly to the bottom line.  At the moment, the stocks aren't priced for continued price increases.   Given that producers are looking to implement another $200-400 increase in pricing this year perhaps quarterly (and thus far it's all been sticking), that could increase EBITDA by 22-44% on a run rate basis.   These stocks get a little bump every time they annouce a price increase.

- Longer term, if we get to prices where new build makes sense.  $5000 a ton,  clearly EBITDA here could more than double and get to $800-900mm of EBITDA. 

- I think upcoming earnings will show a lot more of the industries earnings power as pricing really started increasing last year and early this year.   There's a 90 day lag before pricing gets fully implemented.  Also, sell side has been catching up and raising earnings.

- KRO has been publicly adamant about buying more TiO2 capacity.  Huntsman threw in a lowball bid for TROX when TROX was in bankruptcy.  KRO on their last call all but said they'd want to buy Tronox and are ready to do so. 

- Some stereotypical post reorg catalysts like exchange listing, more coverage, starting to issue financials again, management talking to the street, increased familiarity, fading bankruptcy taint, etc. etc.

- Potential rebound in developed market construction

- KRO and ROC have had great moves recently,  while TROX has been relatively stagnant (probably just some bondholders taking some profits as many have had gains of hundreds of %).  Plenty of people are waiting on the sidelines hoping for a pullback and "don't want to chase",  but the pullback never really comes.

Risks

Negatives clearly are pricing weakness, cost inflation, and capacity increases (however this is not too concerning given there is no foreseeable serious capacity for the next 4+ years), customers pushing back, etc.  All of these risks aren't very concerning at the moment. 

- As long as pricing continues to go up,  which is much more likely than not,  every $200 / ton increase in pricing is worth about $80mm of EBITDA (assuming no incremental cost increases), because they have 390k tons of capacity, currently running near full capacity.  Price increases pretty much fall directly to the bottom line.  At the moment, the stocks aren't priced for continued price increases.   Given that producers are looking to implement another $200-400 increase in pricing this year perhaps quarterly (and thus far it's all been sticking), that could increase EBITDA by 22-44% on a run rate basis.   These stocks get a little bump every time they annouce a price increase.

- Longer term, if we get to prices where new build makes sense.  $5000 a ton,  clearly EBITDA here could more than double and get to $800-900mm of EBITDA. 

- I think upcoming earnings will show a lot more of the industries earnings power as pricing really started increasing last year and early this year.   There's a 90 day lag before pricing gets fully implemented.  Also, sell side has been catching up and raising earnings.

- KRO has been publicly adamant about buying more TiO2 capacity.  Huntsman threw in a lowball bid for TROX when TROX was in bankruptcy.  KRO on their last call all but said they'd want to buy Tronox and are ready to do so. 

- Some stereotypical post reorg catalysts like exchange listing, more coverage, starting to issue financials again, management talking to the street, increased familiarity, fading bankruptcy taint, etc. etc.

- Potential rebound in developed market construction