Description

Investment Thesis

Tronox has been written up before, but this is a recommendation to invest in the 9.5% senior notes at 112 and to participate in the $105 MM rights offering. At current bond prices, the company is being created for 6.5x 2010E EBITDA ($150 MM) and 13x FCF. Based on strong January and February monthly numbers, these estimates are likely conservative.

The company is the third-largest producer of titanium dioxide (TiO2), a pigment used to impart whiteness, brightness and opacity (i.e. hiding power) for products such as coatings, plastics, paper, fibers, food, ceramics and cosmetics. Tronox was originally owned by Kerr-McGee prior to its partial IPO in May 2005 and subsequent spin-off to Kerr-McGee shareholders in March 2006. On January 12, 2009, Tronox filed for bankruptcy due to - 1) legacy environmental, tort and retiree obligations, 2) macroeconomic conditions, specifically weak housing markets (coatings = 69% of sales volume) and 3) volatile raw materials.

Pursuant to a "Plan Support Agreement" with the Official Committee of Unsecured Creditors, the United States, tort claimants and others, Tronox should emerge in 3Q-4Q with a balance sheet free of legacy environmental claims and tort liabilities. Additionally, money-losing plants (Savannah and Uerdingen) will be shuttered and new operations will start up. Both should enhance earnings.

Upon emergence, I believe Tronox will be an acquisition candidate for an existing TiO2 company (huge potential synergies - nearly all SG&A can be removed), LBO player or larger chemical company looking to expand into a non-petrochemical-based business. On a standalone basis, significant cost reductions over the past several years plus volume increases, pricing power and new business/capacity ramp-ups should result in strong growth over the near and medium term.

Company Overview

As mentioned above, Tronox is the third-largest producer of TiO2. Pro forma for expected shutdowns, Tronox should be the fifth-largest producer. The remaining plants rank on the lower half of the industry cost curve (lower = good). Approximately 76% of Tronox's capacity uses the chloride process, the newer of the two technologies used to produce TiO2 pigment. Compared to the older sulfate process, the chloride technology generates less waste, uses less energy and labor and allows for the recycling of chemicals back into the production process. Most new capacity added since the late 1980s uses the chloride technology. The complexity of this process and the limited number of companies with the technology (Chinese do not have it) make it difficult for others to enter the industry with any meaningful scale.

The primary raw materials used in the chloride process are titanium-containing feedstocks (natural rutile ore or purchased slag), chlorine, caustic soda, petroleum coke and natural gas.

Hamilton, Mississippi (Chloride)                       225,000 tons

Kwinana, Western Australia (Chloride)*            55,000

Botlek, Netherlands (Sulfate)                          90,000

Total                                                          370,000 tons

*Represents 50% share of the Tiwest JV. Tronox markets the other 50% for a fee. Currently expanding production by 40K tons (20K net).

Tronox's TiO2 products are sold to several industries - coatings (69%), plastics (23%) and paper and specialty (8%). Within coatings, the main application is paint (residential/commercial). Other coatings markets include industrial, automotive and specialty. The applications in plastics are broad-based including food packaging, plastic films, engineering plastics and uses in vinyl windows and siding. In the paper and specialty market, the main uses are paper and laminate (packaging) in addition to inks and rubber, food and pharmaceuticals.

Tronox also operates in several non-TiO2 markets, but these businesses are fairly small. This segment includes battery materials (electrolytic manganese dioxide), sodium chlorate (bleach pulp) and boron (pharma, semiconductors, etc.). In total, these non-core businesses account for sub-10% of EBITDA.

Brief Industry Background

The major players in this industry include DuPont, Cristal (Saudi Arabian company who purchased Millennium from Lyondell), Kronos and Huntsman*. The industry has not operated like an oligopoly and historical price increases have not kept up with inflation, but a demand recovery, recent capacity shutdowns and consolidation should help the sector gain some pricing momentum.

*In late August, Huntsman bid $415 MM (stalking horse) for Tronox's assets, but this was rejected in favor of a standalone reorganization.

With estimated global sales of 4.8 MM tons, the total market size is approximately $11 BN. Over the past decade, TiO2 consumption has grown at a CAGR of 1.3%. Going forward, this rate is expected to increase due to a gradual housing and commercial construction recovery in the US and Europe and as emerging markets become a larger portion of the pie. For example, developed country TiO2 per capita consumption ranges from >5 lbs to 8.5 lbs annually compared to ~1 lb in emerging markets.

Capital Structure/Claims Pool

Here's the breakdown of my general unsecured claims (GUCs) pool:

9.5% Bond Outstanding                     $350 MM

Pre-Petition Accrued                          $20

CERCLA Claims                                $100

Other GUCs                                     $66

Total GUCs                                     $536 MM

Post-emergence capital structure:

Tranche B-1 Term Loan*                    $335

Tranche B-2 Term Loan*                    $90

Total Debt                                       $425

Remaining Environmental                  $20

Estimated Cash @ Emergence            $(75)

Total Net Debt                                 $370

*Rate is L+700 bps with a 2% LIBOR floor.

As part of the Plan Support Agreement, a $105 MM rights offering (fully backstopped) will fund the establishment of trusts used to satisfy various environmental and tort claims. It is through this mechanism that non-TiO2 specific environmental/tort claims will be disposed of and bondholders and other accredited investors will receive a substantial share of the restructured equity (70%). The other 30% of the equity will be carved up based on the general unsecured claims pool above. Assuming 100% participation by bondholders in the rights offering and partial participation (50%) from the "other GUCs" category, I calculate bondholders will own 84% of the pro forma equity (after accounting for backstop dilution). At a 112 bond price plus a small recovery for equity holders (based on current trading values) and adding in the rights offering, I calculate the company is being created for ~$975 MM.

In the event a GGP situation develops and an emboldened equity committee sells the company or raises enough funds to take out the bonds, a holder would still receive a 122 to 125% recovery (based on accrued interest and depending on when the transaction closes), or an IRR of 15% to 20%.

Financials                              2007                        2008                        2009E                      2010E                      2011E

Revenues                             $1,426                     $1,485                     $1,041                     $1,148                     $1,203

Gross Profit                          $116                        $65                          $130                        $146                        $176

EBITDAR*                            $140                        $84                          $126                        $130                        $162

Capex                                 $71                          $38                          $22                          $96                          $53

*Note the company's EBITDAR calculation is aggressive as it adds back stock compensation and non-cash pension and OPEB costs.

Tronox released the above projections in October 2009. The Uerdingen (German) sulfate plant is excluded from these numbers, but the cash-burning Savannah facility is included. The industry has improved since October and monthly debtor numbers have been trending far better, so these figures are likely conservative. For 2010, I expect a at least $150 MM of EBITDA. In January and February, the US operations alone generated ~$22 MM of EBITDA, which implies $130 MM+ for the year. The other plants should do in the $40-$50 MM area for a total of ~$175 MM.  

In 2H 2009 and 2010, the industry announced several price increases. Strong buyer power results in difficult negotiations and lagged pricing, but prices should continue to increase in 2010 and beyond due to plant shutdowns and high capacity utilization (Kronos expects 90-95%). Additionally, re-stocking should provide a boost as current inventory levels are reportedly in the 30-40 day range compared to the 50-day average usually seen at this time of the year.

Further growth should come from two sources: 1) RTI International Metals (RTI) and 2) Kwinana (JV) plant expansion. Per a definitive agreement, RTI will purchase titanium tetrachloride (TiCl4) from Tronox's Hamilton plant starting in 2011 when the RTI plant is expected to come online. Sales of TiCl4 and incremental cost savings are expected to result in additional operating profits of $12-$15 MM once full production is reached. The Kwinana plant expansion should be completed in 2010. This will add 20K tons (40K @ 50%) to Tronox's capacity and should result in $10-$15 MM higher EBITDA. Net, net, 2011 EBITDA could approach $200 MM or higher.

Valuation

At $150 MM, $175 MM and $200 MM EBITDA levels, Tronox trades at 6.5x, 5.6x and 4.9x EBITDA. This compares to commodity chemical trading levels in the 7x+ area. In 2007, Cristal paid 9.2x '07 EBITDA for Millennium, or 7.2x "run-rate" EBITDA. On an unlevered FCF basis assuming $50 MM on ongoing capex needs, the multiples are 9.8x, 7.8x and 6.5x. Finally, if I use FCF, the multiples are 13.1x, 9.5x and 7.5x. Potentially boosting FCF is a refinancing of the current exit facility as L+700 bps with a 2% floor seems steep.

On a per ton basis (excluding Savannah and Uerdingen and pro forma for the Kwinana expansion), Tronox trades for ~$2,400. Brownfield costs are ~$2,300+ (see Kwinana expansion) with greenfield costs in the $4,000 range.

Another source of value is excess land in Henderson, Nevada. Originally Tronox targeted $250 MM over four years, but that was in a different market, so I assume only $25 MM of value. This is more of a placeholder. US NOLs of ~$100 MM could also enhance returns, although US taxable income should be fairly low. 

Net, net if I apply a 7x EBITDA multiple (10x UFCF) on $175 MM of 2010E EBITDA, I calculate upside of >40%. At $200 MM of EBITDA, the potential upside is over 70%.   

Conclusion

In a picked over distressed market, the Tronox bonds remain a source of value. The company has several positives - 1) reasonable valuation, 2) clean post-emergence balance sheet, 3) bankruptcy dynamics 4) potential take-out play and 5) improving industry outlook. While this recommendation is for the bonds, I also believe the equity is attractive. At the very least, it provides a hedge against value escaping from bondholders.

 Risks

1. Value escaping to equity holders. A committee was appointed in March 2009. If a GGP situation develops we are capped at 122-125. Discussions with the equity committee are currently ongoing.
2. At the end of the day, this is only one step above (via chloride technology) a commodity chemical player.
3. Price increases not sticking. This industry has a history of getting pricing increases below inflation because customers are powerful (Sherwin-Williams, Akzo Nobel, Valspar, PPG, etc.) and DuPont does not always play ball. DuPont has a cost advantage in this business. They can disrupt the market by lowering price to a point where only they make money.
4. Higher raw material costs.
5. The Plan Support Agreement still needs state approvals.
6. New capacity additions.
7. Macroeconomic weakness. Pullback in already weak housing.
8. Pension contributions. We do not have color on this yet.
9. Both bonds and stock are not all that liquid.

Catalyst

Further progress on plan of reorganization and disclosure statement

Emergence from bankruptcy

Takeout