Description

Situation Summary

We believe Tronox Limited (TROX) represents a very compelling investment opportunity. We see 150-200% upside according to our research over the next two years and forecast 2019 EBITDA ~30-50% above Street estimates in a like-for-like comparison (i.e. absent asset divestitures).

Our investment thesis is predicated upon the following:

1. Risk of deal not closing is extremely low due to how FTC defines the end market (easily remedied with an asset sale)
2. Earnings estimates are too low and are likely to go materially higher
   1. Industry profitability has historically been very cyclical but should be more stable going forward
   2. Variant view of Cristal earnings power leading to upward earnings revisions for the combined PF entity (upon closure)
   3. TiO2 and feedstock/co-product price increases yet to roll-through
3. Newly-installed, best-in-class, incentivized CEO who knows the asset well and has a history of creating value for shareholders
4. Compelling valuation, with PF TROX trading at a ~30% FCF yield on our numbers two years out even in a full U.S. divestiture scenario. The assets are trading below mid-cycle valuation and well below industry estimates of replacement cost

Background

TROX’s primary operations relate to the production of titanium dioxide (TiO2). The company mines and markets titanium-bearing mineral sands, the majority of which it uses internally to produce TiO2 pigment (the company is vertically integrated). Mining and oil giant Kerr-McGee spun off Tronox in 2005 and, following an industry downturn and burdened by onerous environmental liabilities, the company filed for bankruptcy in 2009. Tronox subsequently exited bankruptcy in 2011.

In February 2017, TROX signed a merger agreement with Cristal (majority-owned by Saudi petrochemical colossus Tasnee). Given continued strength in the TiO2 market, the ~$2.35 billion purchase price looks very attractive, as outlined below. The deal is currently being challenged by the FTC on antitrust grounds, and has also received a Statement of Objections from the European Commission, both of which have been a driver of recent weakness in the stock.

We believe that the transaction presents compelling financial and strategic rationale:

• Financial: We currently estimate that TROX is paying a purchase price of $2,700/tonne (subject to changes in the share portion of the purchase consideration), ~4x 2H’17 run-rate adj. EBITDA and ~3x 2H’17 run-rate adj. EBITDA PF for announced TiO2 price hikes. This compares favorably to industry-estimated replacement cost economics of ~$6,667/tonne for chloride assets and the ~$3,200/tonne that pure-play TiO2 peer Kronos was trading for at the time of the merger announcement
• Strategic: We believe that TROX is uniquely positioned to unlock ~75k tonnes of incremental capacity from two of Cristal’s chloride plants in Stallingborough, UK (~30k tonnes) and Yanbu, Saudi Arabia (~45k tonnes). Cristal’s Yanbu plant is an effective “sister plant” to TROX’s own chloride plant in Hamilton, Mississippi, given both plants have technology licensed from Kerr-McGee. The company will be sending the operating team from the Hamilton plant to run the Yanbu plant and remains confident that they can ramp Yanbu to full capacity within 12 months post-merger
  • Pre-merger, Tronox was ~220k tonnes net long feedstock (i.e. a merchant seller of high-grade feedstock), in that the supply of high-grade feedstock from their own mines exceeded the demand from their downstream pigment plants. In acquiring Cristal, the company’s feedstock balance shifts to being ~180k tonnes short, reducing the earnings volatility associated with being a merchant seller of high-grade feedstock, while also allowing the company to run their mineral sands assets at full utilization across the cycle (absent divestitures, pigment demand would need to fall >~15% in order for their feedstock balance to shift back to being net short)

Basic Primer on TiO2 Market

Titanium dioxide (TiO2) is the standard white pigment that is used principally in paint, paper and plastics. It’s the most consumed pigment in the world, accounting for about 70% of the total volume. The main consuming industries for titanium dioxide pigments are paints, which includes all surface coatings, plastic and paper and board. We expect that demand should grow at GDP levels, driven primarily by paint. We note that IHS calls for 3.4%/year demand growth over the next five years.

TiO2 historical demand vs. GDP:

1. Production – China accounts for ~40% of global production; majority of ROW production by 4 players (PF for TROX/Cristal transaction)
   1. Regional Demand Breakdown - ~6mm tonnes globally 
      1. China (~1.5mm tonnes demand, ~800k tonnes of exports)
      2. Asia Pacific ex-China (~1.2mm tonnes)
      3. North America (~1mm tonnes)
      4. Europe (~1.5mm tonnes)
      5. Middle East & Africa, Central & South America (750k tonnes) 
   2. Global Production Method Breakdown
      1. Sulfate (~3.1mm tonnes)
      2. Chloride (~2.9mm tonnes)
   3. Companies Worth Mentioning - Global capacity share 
      1. Tronox + Cristal (18.5%)
      2. Chemours (17.5%)
      3. Venator (11%)
      4. Lomon Billions (8.5%)
      5. Kronos (8%)
2. Demand grows at global GDP – TiO2 global demand by segment
   1. Architectural coatings (38%)
   2. Plastics (24%)
   3. Industrial coatings (22%)
   4. Paper (7%)
   5. All other (9%)
3. Historical cycles and noteworthy changes:
1. Titanium dioxide cycle >>> boom and bust
   1. In the past, the titanium dioxide market has experienced periods of high profitability followed by supply growth and subsequent weak pricing and low margins. This is most easily observed in pure-play Kronos’ metrics. 
2. Why we think past will not be prologue: supply constraints and increased industry focus should translate to more resilient earnings power this time 
   1. Supply is harder to expand – The Chinese government is no longer permitting greenfield sulfate pigment plants due to environmental concerns and may be starting to shutter existing facilities. New supply in China will need to be chloride-based, a production method that Chinese producers have historically struggled to master (it has taken China’s best operator three years to introduce 60k tonnes of chloride to the market)
      1. Two production methods: sulfate and chloride
         1. Chloride today accounts for ~49% of production (2.9m tonnes) while sulfate accounts for the remainder (3.1m tonnes)
         2. Sulfate is much easier to add and can be added in smaller sizes – historically has meant that supply creep could keep pace with (or outgrow) demand
            1. Between 2005 and 2015, China added approximately 1.7mm-1.8mm metric tonnes of nameplate sulfate TiO2 capacity. We estimate that Chinese sulfate capacity accounts for roughly 33% of total world nameplate capacity now
            2. The Chinese government is no longer permitting greenfield sulfate pigment plants due to environmental concerns and may be starting to shutter existing facilities
               1. Iluka (Australian high-grade feedstock mineral sands producer) estimates 250k – 300k tonnes of “mainly smaller sulfate production facilities” have been permanently removed as a result of China’s recent environmental crackdowns (November 10th, 2017 Investor Day)
               2. Lomon Billions (China’s #1 TiO2 producer), believes that “new greenfield sulfate pigment plants are unlikely,” and that there are limited expansion opportunities for well-managed and compliant sites
   2. In China, new supply will largely have to be chloride-based
      1. Chloride manufacturing method is more complex and chlorine transport is challenging. We do not believe Chinese supply additions will be in excess of 16% of existing Chinese nameplate capacity over the next 3 years (what it would take to disrupt global supply/demand balance)
   3. Announced supply growth has been minimal; will likely come from China
      1. China remains the key driver of supply growth globally; ROW has not announced any meaningful production growth since DuPont (now Chemours) announced in 2011 that it was adding 200kt of new production at their Altamira, Mexico plant (which was largely offset by a 130k tonne shutdown of their Edge Moor plant in 2015 as the company ramped the new Altamira line through ’16/’17)
      2. Lomon Billions announced that it will provide additional annual chloride supply of ~200k tonnes. Actual supply growth may be smaller and/or take longer to hit global TiO2 markets. Lomon Billions has historically struggled to master chloride production. They have a 100k tonne chloride plant that has taken the company three years to ramp up to 60k tonnes of production. They have aspirations to introduce an incremental 210k tonnes of chloride to the global markets by end of year 2020
   4. Supply growth is very manageable; market should remain balanced through 2020+
      1. We believe that there are very few sources of incremental supply in the Western world, particularly in light of the Western world currently running at full utilization:
         1. VNTR Q3’17 and Q4’17 earnings call: “we are manufacturing at full capacity”
         2. CC Q3’17 earnings presentation: “manufacturing facilities utilized at full capacity”
         3. TROX disclosed a 1H’17 operating rate of “95-100%”
         4. KRO has reported a utilization rate of “100%” for each of the past 5 quarters
      2. Incremental supply in ROW will come from three announced sources:
         1. VNTR’s rebuild of its Pori facility in Europe (+50k tonnes in 2018)
         2. CC’s de-bottlenecking initiatives (+31k tonnes/year through 2021)
         3. TROX unlocking incremental tonnes from Cristal’s plants (+75k tonnes)
      3. On a global market that grows ~200k tonnes/year, we believe there is room for China to expand their production base by ~150k tonnes/year through 2020 and not disrupt the global supply/demand balance (in fact, Chinese supply growth is needed to balance global markets). Under the lens that Chinese supply growth will largely need to be chloride-based (something they have struggled with historically), we believe global TiO2 markets will remain tight through 2020.
   5. Industry’s new focus matters – Used to be low-margin and highly-cyclical, however, recent events remind us of what happened in styrenics (asset ownership shifted from chemical conglomerates to focused independents, resulting in improved industry discipline and profitability). Trinseo IPO’d in ’14 and is up 4x, driven by strong earnings power as a core producer in a focused industry.
      1. Change is meaningful >>> There will be four major Western players in TiO2 that are all relatively pure-play: Tronox, Chemours, Venator Materials and Kronos Worldwide. That’s a big difference compared to the sector many years ago when Chemours was part of DuPont, Tronox part of oil and gas company Kerr-McGee, and Venator was being operated inside Laporte. 
      2. Recent key events timeline:
         1. 2014: Huntsman acquires the pigment business of Rockwood Holdings (TiO2 and colored pigments)
         2. 2015: DuPont spins off Chemours (TiO2 and Fluorochemicals); creates focused player
         3. 2017: Huntsman IPOs Venator Materials; creates focused player
         4. Pending: Tronox and Cristal – Creates largest pigment producer globally

The key takeaways when looking at global TiO2 supply/demand are:

1. Minimal supply growth in world ex-China
2. Little/no new sulfate capacity is being permitted in China (and permanent shutdowns may be occurring)
3. Chinese chloride-based production will be needed to balance global markets (a production method they have historically struggled with)

 Source: TZMI, company data, author estimates

The Cristal Acquisition

In February 2017, TROX signed a merger agreement with Cristal (majority-owned by Saudi petrochemical colossus Tasnee). Given continued strength in the TiO2 market, the ~$2.35 billion purchase price looks very attractive, as outlined below. The deal is currently being challenged by the FTC on antitrust grounds, and has also received a Statement of Objections from the European Commission, both of which have been a driver of recent weakness in the stock.

We believe that the transaction presents compelling financial and strategic rationale:

• Financial: We currently estimate that TROX is paying a purchase price of $2,700/tonne (subject to changes in the share portion of the purchase consideration), ~4x 2H’17 run-rate adj. EBITDA and ~3x 2H’17 run-rate adj. EBITDA PF for announced TiO2 price hikes. This compares favorably to industry-estimated replacement cost economics of ~$6,667/tonne for chloride assets and the ~$3,200/tonne that pure-play TiO2 peer Kronos was trading for at the time of the merger announcement
• Strategic: We believe that TROX is uniquely positioned to unlock ~75k tonnes of incremental capacity from two of Cristal’s chloride plants in Stallingborough, UK (~30k tonnes) and Yanbu, Saudi Arabia (~45k tonnes). Cristal’s Yanbu plant is an effective “sister plant” to TROX’s own chloride plant in Hamilton, Mississippi, given both plants have technology licensed from Kerr-McGee. The company will be sending the operating team from the Hamilton plant to run the Yanbu plant and remains confident that they can ramp Yanbu to full capacity within 12 months post-merger
  • Pre-merger, Tronox was ~220k tonnes net long feedstock (i.e. a merchant seller of high-grade feedstock), in that the supply of high-grade feedstock from their own mines exceeded the demand from their downstream pigment plants. In acquiring Cristal, the company’s feedstock balance shifts to being ~180k tonnes short, reducing the earnings volatility associated with being a merchant seller of high-grade feedstock, while also allowing the company to run their mineral sands assets at full utilization across the cycle (absent divestitures, pigment demand would need to fall >~15% in order for their feedstock balance to shift back to being net short)

The FTC hiccup and what happens next

On December 5th, 2017, the FTC issued a press release challenging the proposed merger of Tronox and Cristal, asserting that the acquisition would violate antitrust laws by significantly reducing competition in the North American market for chloride process titanium dioxide. We believe a transaction will be consummated, as U.S. regulator objections around market consolidation have a straightforward remedy (divestiture of Cristal’s U.S. assets). TROX has so far elected to fight the FTC given the agency’s unconventional initial approach of seeking to block the deal by deploying a time-consuming legal process that would cause the merger agreement to expire before the judge could reach a decision. Tronox and Cristal have subsequently announced an extension to the merger agreement, so now the FTC should require a favorable ruling if the deal is to be blocked. While we do not have a unique view into whether or not the deal will be approved as contemplated, we do note that there exists a simple structural remedy that should make a deal in modified form likely to occur. In their statement of objection, the FTC defined the relevant geographic market as “North America” and the relevant production process as “chloride.” Given this clear market definition, a sale of both of Cristal’s Ashtabula plants in Ohio would present a viable remedy. We estimate that a sale to TiO2 peers Kronos, Venator or private equity would remain under the HHI hurdle when examining a transaction in a highly-concentrated market under the Horizontal Merger Guidelines issued by the Department of Justice and the Federal Trade Commission.

Further, at a Goldman Sachs conference on March 21st, 2018, Kronos was quoted as saying that they would be a “very interested buyer of divested assets” should they become available. At that same conference, KRO cited greenfield capital requirements of ~$1bn for a world-scale chloride facility (150k tonnes), implying replacement cost economics of ~$6,667/tonne (vs. what TROX bought Cristal assets for at $2,700/tonne). The general industry perception is that Cristal’s U.S. plants are world-class, and thus, one could assume that KRO would be indifferent between building a new plant and purchasing world-class (and already cash-flowing) assets for ~$6,667/tonne. Assuming an EBITDA/tonne of $900, and that both Ashtabula 1 (160k tonnes) and Ashtabula 2 (80k tonnes) are divested, decremental EBITDA from divesting all of Cristal’s U.S. operations would be ~$215mm, while potentially netting TROX $1bn-$1.5bn of gross proceeds (assuming an EV/tonne of $4,000 – $6,500, or 4.5-7x EBITDA).

Given the clear market definition provided by the FTC, clear remedy options, and willing buyers of divested assets, we view the risk of the deal not going through in the U.S. as being extremely low.

The EC’s Statement of Objections

On March 20th, 2018, Tronox received a Statement of Objections from the European Commission regarding its purchase of Cristal. While not made publically available, we believe that the Statement of Objections provides TROX with a clearly-defined framework to move forward in Europe and that this is part of the merger process. After speaking with the company, we understand that the EC objection is said to be much narrower, much more specific and ultimately more manageable compared to the FTC’s objection. While PF Tronox will have two plants that can be divested in Europe (Thann, France [40k tonnes of sulfate, Cristal-owned] and Botlek, Netherlands [90k tonnes of chloride, Tronox-owned]), language from the company might suggest that a product line rather than a full plant would need to be divested in order to satisfy EC concerns, similar to the EC’s demand in the Rockwood/Huntsman (now Venator) tie-up. We would note that on the chloride side, Chemours has no presence in Europe and would therefore have a net zero effect on the industry’s HHI/market concentration threshold.

In both the U.S. and Europe, we believe that Tronox management is aware of what they would need to do to in order to close the deal tomorrow.

Earnings Estimates: The Variant View (30-50% Above Street in a Like-for-Like Comparison)

We believe PF TROX will do run-rate EBITDA of $1.4-$1.5bn and FCF/share of $5-$6 post deal (assuming close by end-of-year 2018 and no asset divestitures). This compares to Street estimates of ~$1-$1.1bn and ~$3/share in 2019 on an estimated like-for-like basis (absent divestitures). It is worth noting that we believe Street figures that do model the deal closing meaningfully underestimate Cristal’s earnings contribution.

Variant view of Cristal earnings power leading to upward earnings revisions for the combined PF entity (upon closure)

The biggest source of our variant view regarding PF numbers is that we believe Cristal is doing far better than what is being modelled, particularly on a run-rate basis.

• In their September 7th, 2017 Lender Meeting/Conference Call presentation, TROX disclosed Q1’17 and Q2’17 adj. EBITDA for Cristal of $67mm and $79mm, respectively, implying a 1H adj. EBITDA of $146mm, or $292mm on a run-rate basis
• In their March 27th, 2018 8-K, TROX disclosed full year 2017 adj. EBITDA for Cristal of $442mm, implying 2H adj. EBITDA of $296mm, or $592mm on a run-rate basis.
  • We think there is scope to believe that the Q4 run-rate could be even higher given the publicly disclosed Q3 EBITDA number of the Chemical segment of Cristal’s parent, Tasnee (which houses the Cristal business). Cristal run-rate could be as much as $650mm of adj. EBITDA in a bull case, particularly when considering that Q4 is typically a seasonally weaker period for pigment demand. In an attempt to capture a more stable earnings period, we note that between 2002 and 2006, Q4 EBITDA as a % of full year EBITDA averaged ~23.5% for TiO2 pure-play Kronos, suggesting potential seasonally-adjusted upside to the $650mm bull case run-rate

Source: Company data

Our estimate of $600-$650mm of run-rate adj. EBITDA from Cristal compares favorably to the Street estimates of those who do model Cristal as a separate entity (thus far, only BMO and UBS drop in Cristal’s earnings contribution as a separate entity):

• UBS 2018E of Cristal adj. EBITDA: $411mm in a no-divestiture scenario
• BMO 2019E of Cristal adj. EBITDA: $625mm in a no-divestiture scenario

In both cases of explicitly modelled Cristal estimates, we believe the figures are too low given Cristal may already be run-rating at a number that is higher than estimates two years out (while not giving benefit for reportedly announced Q1’18 and Q2’18 TiO2 price hikes that could add as much as $150mm of EBITDA to run-rate Cristal). All in, we estimate that Cristal could do as much as $750-$800mm of pre-synergy EBITDA in 2019 (implying TROX might end up paying <3x EBITDA for Cristal pre-divestitures).

Source: Capital IQ

Newly-Installed, Best-in-Class, Inventivized CEO who Knows the Asset Well and has a History of Creating Value for Shareholders

Newly installed, best-in-class CEO

Jeff Quinn, the newly installed CEO, has been on the board of TROX since 2011. He has spent substantial time in the chemicals sector, and we believe his track record is both impressive and highly relevant. He is probably best known for orchestrating the turnaround at Solutia Inc. He initially joined Solutia in 2003 as its Chief Restructuring Officer (ahead of what looked to be a likely bankruptcy) and was named President and CEO a year later. Solutia emerged from bankruptcy in 2008, and Quinn sold the company to Eastman Chemical for $4.7bn in July 2012. Quinn architectured Solutia’s emergence from bankruptcy through multiple non-core asset divestitures, cost-cutting initiatives and efforts to improve employee morale.

From the low point of its share price in March 2009, Solutia, led by Jeff Quinn, outperformed the S&P 500 Specialty Chemicals Index by a factor of 13x en route to being bought out by Eastman.

It is further worth mentioning that Quinn, along with a group of shareholders, was instrumental in effecting change at specialty materials/chemicals business Ferro Corporation (FOE). Quinn sat on the company’s board from 2013 to 2016. From the time that Quinn and a group of shareholders began their activist campaign, to the time that Quinn exited his position on FOE’s board, the stock increased in value by nearly 3x.

Incentivized to hit synergy numbers

As part of his hiring, Jeff Quinn was granted 115k performance-based restricted share units under the terms of TROX’s Integration Incentive Award program. Under this program, if the company hits 80% of the publicly announced synergies two years after close date, 50% of the RSUs will vest. If the company hits 100% of synergies, 100% of the RSUs will vest.

On Tronox’s most recent lender call, the company detailed that 80-90% of the $230mm synergy number would be retained in a divestiture scenario, and that as they move forward with the merger, they have grown increasingly confident that they could make up the synergy shortfall through a number of initiatives should the company have to pursue divestitures.

With a history of creating a tremendous amount of value for shareholders and knowing the Tronox assets well, we have confidence in Jeff Quinn.

Compelling Valuation, with PF TROX Trading at a ~30% FCF Yield Two Years Out Even in a Full U.S Divestiture Scenario

We would make the following notes regarding our valuation buildup:

• We are assuming two reportedly announced TiO2 price hikes of $150/tonne each are pushed through in Q1’18 and Q2’18 (with various utilization and yield assumptions)
• In the ‘w/o Ashtabula’ scenario, we are assuming both Ashtabula plants (totaling ~$215mm of EBITDA or $900/tonne), are sold for $5,000/tonne (5.6x EBITDA), netting TROX gross proceeds of $1.2bn, and assuming TROX uses the proceeds to pay down debt
• We do not have a unique view on whether or not Tronox will experience an “ownership change” as defined under Section 382 of the U.S. tax code and use the full value of TROX’s tax assets in our valuation
• We then deplete our estimate of the NPV of TROX’s NOLs by the associated taxable capital gains on the sale (on a crude estimate of the tax cost basis of the Ashtabula assets)
• We also remove our estimate of the capex associated with the Ashtabula assets
• At a 10% FCF yield, PF TROX is worth 2.5x-3x higher than the current share price
• We would note that in our Simple TiO2 Comp Table, after stripping out our estimate of the valuation of TROX’s mineral sands assets (using peer Iluka [ILU] as a comp), TROX’s pigment business appears to be trading at a material discount to TiO2 peers VNTR and KRO, and a material discount to our estimated mid-cycle EV/tonne of ~$4,500
• It is worth mentioning that in a full U.S. divestiture scenario, Jeff Quinn would have a ~$500mm-$2bn re-leveraging opportunity (target leverage of 2x-3x) and have the capacity to retire 15%-70% of TROX’s share count at current prices

Source: Company data, author estimates

Source: Capital IQ consensus estimates, company data, author estimates

Significant unpriced optionality: we believe we are getting the Cristal acquisition for free

In the event that the deal falls apart completely (a scenario to which we ascribe a very low probability), we believe we have a significant margin of safety as we value standalone Tronox at $18.5/share on already announced TiO2 and zircon price hikes.

Source: Company data, author estimates

Key Risks

Timing: Timing of deal closure is uncertain

Recession: TiO2 demand is sensitive to global GDP growth

Chinese Environmental Policy: Environmental policy reverses course and material capacity additions come to market

I do not hold a position with the issuer such as employment, directorship, or consultancy

I and/or others I advise hold a material investment in the issuer's securities

Catalyst

Deal updates

Market does the math