Description

TROX - 145 Px – 2.2bn Mkt Cap

Structurally the TiO2 market is changing and TROX will be a beneficiary.  Historically , feedstock producers were locked into long term contracts (3-7 years); however, in a tightening market at both the feedstock and the Ti02 production level this historical contract trend is changing.  This change to shorter term contracts throughout the vertical.  This change is creating pricing power in a very tight market with limited substitutes (at most 25% through mixing with fillers).

This industry dynamic along with two TROX specific factors lead to TROX conservatively showing upside of 75% within a 12 month investment horizon. These core factors are 1) non-core business related bankruptcy (stuffed with environmental liabilities) and 2) non-listed, non-filing entity.

These factors will come to a head with minimal risk in late Q2 when an announced vertically integrating merger with Exxaro closes concurrent with a listing.  This merger and listing will create a more liquid and visible entity where the current proforma valuation of 2.8x fwd EBITDA should accrete to at least a 4 to 5x fwd EBITDA given to peak cycle cyclical /commodity names (though there is a sound argument for the Ti02 cycle being extended).

I recommend playing this trade through two illiquid warrants which typically even at the bid side have implied vols sub 25% or market levels.  Both the 62 strike and the 68 strike 2018 warrants will occasionally trade at intrinsic value (or 0% implied vols) due to the illiquidity.

Some detailed notes are below which highlight some key drivers of the industry and the company itself.

Thesis:
1) Changing industry structure as pricing power shifts higher in the chain
2) Structurally tight TiO2 feedstock and producer market which is likely to remain tight due to capacity expansion lead times
3) Minimal substitutes for high quality TiO2 with the max amount of possible filler products peaking at 25% and no true substitutes
4) Acquisition offers significant margin expansion opportunities as TROX able to source feedstocks at cost (market prices rising 70%+ per yr)
5) Global demand growth driven by emerging Asia construction/industrialization…but TROX's position in highest-quality, lowest cost products shelters company from global GDP slowdown
6) Significantly undervalued equity driven by technicals that will roll-off within 6 months;  (emergence from Ch. 11, OTC-listed, no big-name Street coverage, pending acquisition)

Catalysts:
1) Completed acquisition of Exxaro in late Q1 2012…subsequent listing on NYSE or other major stock exchange
2) Stable global GDP growth of 3.0%+ will out-pace supply growth…enabling higher pricing and expanding margins
3) Full roll-off of longer-term feedstock contracts (particularly for Exxaro) enables better pricing power going forward
4) Attractive M&A target…(shares sold off in late Sept when TROX announced Exxaro M&A, because large holder base expecting TROX to be the M&A target)

Risks:
1)  China hard-landing… Emerging Asia is a the marginal driver of demand and due to the increased level of new construction vs existing buildings the demand will be more volatile
2) Failed acquisition (TROX shareholder disapproval, regulatory blocks)
3) Unexpected development of Chloride processing capabilities in China (not expected for at least 7 years)
4) Emergence of unforeseen, meaningfully effective substitute products…given rapid pricing increases, end-users are looking harder than ever for replacements
5) Very illiquid before coverage, listing and merger

Industry Keys:
1) The Titanium feedstock market takes 3+ years to put new capacity in place and is currently expected to be in deficit ~16% of total global demand by ~2015
2) TiO2 processing capacity is expected to remain tight especially on the higher end choride process which has both quality and cost advantages (~15% cheaper) until China can develop the process in scale ~7 years
3) Asia Pacific has be 95.6% of the incremental TiO2 demand in the last 10 years.  This demand should continue to grow as the per capital usage adjusted for rural population in China is still only ~50% of the U.S.  In addition, China is expected to continue importing high quality product which accounts for 26% of demand while exporting lower quality product (sulphate process – 98% of production) which accounts for 17% of country wide production.  This mismatch in quality will continue to benefit the chloride process producers such as TROX.

Company Keys:
1) The Exxaro acquisition should add 13pts of upside to gross margins and provide the company with excess feedstock.
2) TROX chloride process plants are in the 1^st, 2^nd and low 3^rd quartile on the cost curve; thus, insulated from high cost Chinese and other sulphate process plants

Valuation Keys:
1) Upside to downside ratio very conservatively 3x with ~70% upside versus ~24% downside over the next 12 months
2) While competitors in the specialty chemical space trade at 6x+ EBITDA, I handicapped the downside multiple at 4x in the scenario where the merger does not happen.  I chose this multiple to highlight selling pressure and the disproportionate amount of tightness in the feedstock market.
3) The upside valuation assumes the merger goes through and managements guidance is hit at 1.4bn of EBITDA.  I used a conservative 4x multiple representing the peak in a cyclical business.
4) There is clearly much more upside on the table from M&A, ability to sell excess feedstock, and likely extension of the TiO2 cycle.

Catalyst