An investment in the B shares of Tronox Incorporated (TRX.B) provides an exceptional risk/reward opportunity at current prices.  We believe that TRX.B is trading well below any reasonable downside case, and we present a range of scenarios that suggest shares could be worth $19-$38 over the next one to two years.  Indeed, our extremely conservative case for a year out yields a price that is 60% above today’s price and a reasonable base case valuation a year out is $20/share.  The primary catalysts for unlocking this value will be: 1) continued rounds of price increases in the titanium dioxide industry; 2) continued fundamental improvement for TRX.B specifically, driven by those price increases and significant operating cost and working capital reductions; and 3) further industry consolidation, in which either Tronox will be acquired, or a competitor will, at a price that establishes a new, higher valuation for TRX.B.

 

Tronox Incorporated is the world’s third largest manufacturer of titanium dioxide (TiO2), a whitening pigment primarily used in coatings, plastics and paper, with other applications in ink, cosmetics and food.  Tronox operates five plants, two in the US (Hamilton, MS and Savannah, GA), one in the Netherlands (Botlek), one in Germany (Uerdingen), and one in Australia (Kwinana).  TiO2 represents 93% of TRX.B’s business, with the balance being electrolytic chemicals.  The titanium dioxide industry is an oligopoly, with the top five players controlling 70% of the market.  TRX.B is the only pure play in this market, as the other four players are a division of DuPont, a Saudi company (Cristal), a division of Huntsman (Huntsman is in the process of being acquired by Hexion) and Kronos, which is a public operating subsidiary of Valhi, Inc. 

 

Tronox is drastically undervalued, as demonstrated by the following valuation scenarios:

1)      Reasonably achievable EBITDA at conservative multiple yields price 185% above current price: As will be described later, we believe a reasonably achievable EBITDA level for Tronox to achieve in the next 18 months is $240MM.  At 5x EBITDA, which we’ll show is a significant discount to comparables, and assuming an incremental $40MM of debt pay down, which we’ll show is quite reasonable, Tronox would have an equity value of $20.00/share, 185% above today’s price.  Even without further debt pay down, which is frankly unrealistic, TRX.B would be worth $19.00, or 170% above today’s price.  This EBITDA assumption is based on flat revenue; pricing power and volume gains could take the EBITDA to $300MM in two to three years; this would yield an equity value closer to $26.00/share without any additional debt pay down.

2)      Comparable Transaction on EBITDA multiple yields price 240-300% above current price: In February 2006, Saudi-based Cristal purchased Millennium Inorganic Chemicals, the titanium dioxide business of Lyondell, for $1.2B.  This price equated to 13x trailing EBITDA and 8x forward EBITDA.  Applying those same multiples to Tronox today would yield prices of $24-28/share, or 240-300% above today’s price.

3)      Comparable Transaction on capacity basis yields price 190% above current price: Cristal’s valuation for Millennium implies $2,000/metric ton of capacity.  Putting that same valuation on Tronox’s footprint yields a value of $1.28B; less current net debt yields an equity value of $20.40/share, 190% above today’s price.  As Tronox has a slightly higher proportion of its footprint comprised of chloride production facilities than did Millennium, (Tronox is 83% chloride production, which is a lower cost, cleaner production method, and thus is more valuable than the alternative sulfate production method), it is reasonable to assume that a capacity valuation for the Tronox footprint would be at least as high as the Millennium valuation.  We believe it’s appropriate to look at capacity valuations in an industry with high share concentration, high utilization rates and no new capacity expected online until 2011.  Indeed, we will likely see continued capacity reduction in the near-term as evidenced by: a) the recent closure of a Millennium facility in Le Havre, France, the first of several expected, b) increased environmental restrictions leading to plant closure in China, and c) further capacity rationalization as Hexion decides what to do with the TiO2 assets to be acquired in the Huntsman deal.

4)      Replacement Value of capacity yields price 440% above current price: Industry participants and experts estimate that it would cost at least $3,000/metric ton to build a new titanium dioxide plant.  In fact, Cristal announced earlier this month a plan to invest $250MM to expand chloride production at a facility in Saudi Arabia by 80,000 metric tons.  This investment works out to $3,125/metric ton just to expand a facility; it is reasonable to assume that a greenfield site would cost more.  Put this $3,125 on Tronox’s footprint and you get a plant value of $2.0B; less current net debt yields an equity value of $37.85/share, 440% above today’s price.  Even if you put this $3,125 on just the 83% of Tronox’s footprint that is chloride and put ZERO on the sulfate asset, you’d get an equity value per share of $29.60/share, 320% above today’s price.  Note that this incremental capacity will not add much to industry capacity, as the recently announced Le Havre closing had 75,000 metric tons of capacity.  Participants are simply investing more in the more efficient chloride process as a substitute for sulfate production.

5)      Free Cash Flow Valuation yields a price 105-240% above current price: Tronox is currently trading at 3.75x trailing FCF/share.  Comparable companies are trading at 16-20x FCF/share.  At half the low-end, TRX.B would be worth $14.40, or 105% above today’s price.  On a forward basis, TRX.B should generate $3.00/share of FCF in the next 12-18 months, with considerable room for growth beyond that based on pricing and further cost improvements.  At 8x FCF TRX.B would be worth $24.00/share, 240% above today’s price.  Even if the irrationally low multiple today holds on those future flows, you’d have a value of $10.30, almost 50% above today’s price.

6)      IPO/Spin-off Valuation yields a price 120-210% above current price: It is important to note that prior to the IPO in 2005, the Board of Kerr-McGee was considering two options: selling the company or spinning it off.  The Board chose to spin-off Tronox at an enterprise value that was equivalent to the tax-adjusted value it would have received in a sale.  The IPO was done at $14/share, suggesting an enterprise value at IPO of approximately $1.1B.  While Kerr-McGee had a very low tax basis in these assets, having owned them for many years (some since 1929), let’s assume that the basis was $300MM.  Assuming a 35% tax rate, that would suggest a potential sale price of $1.35B.  As the IPO was done at the low end of a revised filing range (original range was $4.50-6.50 higher), one can argue that the real tax-adjusted equivalent price is higher.  Today, a $1.35B enterprise value would equate to a $22.00 share price, more than triple today’s price.  Even the IPO enterprise value would equate to a value of $15.50/share (higher than the IPO price/share because of the debt paid down since), more than double today’s price.

7)      Downside Case Still Above Today’s Price: If Tronox were to see a 10% revenue decline in 2008, which as we’ll show is not realistic, and achieves no further cost savings, they should still do $180MM in EBITDA in 2008.  If they cannot pay down any more debt, again unlikely, then at 5x, you’d have an equity value of $11.10/share, almost 60% above today’s price.  In fact today’s price is effectively pricing in a 10% revenue decline, no further cost savings, no further debt pay down and a 4x EBITDA multiple.  It is simply not realistic to justify any of those scenarios, let alone all four.

Tronox was spun-off from Kerr-McGee (now part of Anadarko Petroleum) in an IPO in November 2005, when the Tronox A shares (TRX) began trading.  In March 2006 Kerr-McGee spun-off its remaining holdings in the form of Tronox B shares (TRX.B).  The dual-class structure remains in place today, with approximately 18MM A shares outstanding and 23MM B shares outstanding.  The B’s have six votes per share and the A’s have one vote per share, and both classes receive the $0.05 quarterly dividend.  Despite having super-voting rights, equivalent economics and more shares outstanding, the B’s actually trade at a discount to the A’s (currently about 1%, but has been as high as 4% in recent months).  The A’s generally trade more stock in a given day than the B’s, but not uniformly, and the average volume for the A’s over the past three months is less than 50% higher than that of the B’s.  In short, there’s no good reason for the B’s to trade at a discount to the A’s, and we are recommending TRX.B given its superior voting characteristics.

 

The titanium dioxide industry, and Tronox in particular, are operating at historic trough margins.  Four of the top five firms are currently unprofitable on an earnings basis, and five of the top five are not earning their costs of capital.  The primary reasons for this are an irrational pricing environment, exacerbated by input cost escalation.  Though both of these factors are turning the industry’s favor, it is important to see how we got here.

 

When Hurricane Katrina struck the Gulf Coast in late August 2005, DuPont’s industry-leading titanium dioxide plant in DeLisle, Mississippi was forced to close, and did not reopen until late January 2006.  This world-class plant produces 10% of the world’s TiO2, so its closure was a significant swing factor in the world’s supply/demand balance, particularly given that global manufacturing utilization rates were well north of 90%.  This capacity shrink, in a consolidated industry and in the face of a strong demand environment, should have allowed other players to raise prices.  Rather than raise price, however, some industry participants cut price to try to steal share.  DuPont responded in kind with a price cut to maintain share, and soon the entire industry had re-priced its product at a lower base.

 

These lowered prices became even more of a drag on industry margins as input cost began escalating in 2006 and continued through 2007.  Prices for key inputs such as chlorine and petroleum coke, in-bound freight costs and natural gas prices have all had significant spikes during this time (though there has been some moderation in the fourth quarter of 2007).  These cost increases, coupled with artificially low prices, has eroded gross margins industry-wide.

 

DuPont began the process of re-rationalizing the pricing environment by announcing the first of a series of regional price increases in June 2007, which was effective July 1.  The other four major participants followed with similar increases shortly thereafter, and did so again after DuPont announced another round effective October 1.  In general, titanium dioxide is purchasing on a 90-day forward basis, so the July price increase started impacting price received in October, and the October increase will be realized in January.  The industry tends to price different regions separately, so if you look back at the individual company press releases, you’ll see separate announcements/pricing for the US, Europe, the Middle East and Africa and Asia.  DuPont has told its customers to expect multiple rounds of subsequent increases; it is reasonable to expect the industry to follow these as well.  Further, there is no acceptable functional substitute for TiO2, which should further support price increases in a time of increasing demand and likely decreasing capacity.

 

To see how impactful price increases are, consider the first round announced in the US of $0.05 per pound (in different regions, titanium dioxide is priced either per pound or per metric ton).  On Tronox’s footprint of 642,000 metric tons of capacity, a nickel increase would yield an incremental $70MM of revenue (approximately 5% increase).  On a constant cost basis, this would generate an incremental $70MM in EBITDA and using a 40% tax rate, this would generate just over an incremental $1.00 of earnings/share (free cash flow should be similar). 

 

In reality, Tronox won’t get all of that nickel increase in the first round.  Historical price increases have generally seen 1-2 cents of the first increase go through, with increasing percentages in subsequent rounds.  So with a third round likely in January, it’s reasonable that we’ll soon see an incremental 1.5 cents, 2.25 cents and 3 cents of price increases, if not more.  Later rounds should be closer to the full 5 cents per pound, on average.  Using the same logic as above would yield an incremental $95MM of EBITDA and $1.40 of earnings/share on just 6.75 cents per pound of price increase.  As a reference point, trailing FCF was $1.80/share, so just these pricing gains could bring FCF/share to $3.20, before further operating cost efficiencies and working capital improvements.

 

As an example of historic increases, the industry began a round of price increases in October 2003, and announced seven increases in total by October 2005.  The total announced increases were $0.30 per pound, and realized increases were $0.20/lb.  If this current round of price increases plays out like the ’03-’05 period, Tronox’s EBITDA and free cash flow growth could be explosive…a 20 cent increase, all else equal would generate an incremental $280MM of EBITDA and $4.10 of FCF/share.

 

The final flow-through of price increases may be partially offset by further input cost increases, but there several mitigating factors to these offsets: 1) recent moderation should allow early price increases to drop more fully to the bottom line; 2) DuPont intends to lead further rounds, and can adjust future price increases accordingly based on these input costs (downstream customers we have spoken with are all expecting to pay further increases for TiO2); and 3) companies like Tronox are in the early stages of negotiating more favorable relationships with companies like PPG that are both suppliers of raw materials (chlorine) as well as purchasers of finished TiO2 for paint manufacture.  Further, Tronox, through its joint venture in Australia, has a fully integrated production facility, including a mine with titanium ore, giving it a relative cost advantage in the Asia-Pacific region.

 

In addition to the gross margin benefits that Tronox should see from the price increases, the company is in the midst of realizing considerable operating expense and SG&A savings.  When the company was spun-off from Kerr-McGee it inherited an inefficient manufacturing footprint and a bloated G&A structure.  The company-wide effort to reduce these costs, Project Cornerstone, originally targeted $60MM in cost savings when it was initiated in 2006, with $50MM of that coming from operating cost improvements.  Since the program began, management has identified an incremental $33MM in savings, bringing the total expected savings to $93MM.  These are true cash cost reductions.  Management expects to have achieved just over $80MM of these costs savings in 2008, with the balance during 2009.  On an after-tax basis, those savings will yield an incremental $1.35 in earnings/share and FCF/share.  As the company has consistently increased its target for savings over the past year, there is reason to believe that further reductions can be achieved.  These are not heroic cost savings, as achieving them would simply bring Tronox in-line with Kronos’ EBITDA margins, which has a smaller revenue base, and would still be a few hundred basis points behind industry leader DuPont.

 

There is also a working capital reduction program in Project Cornerstone, with a targeted reduction of $100MM by 2010.  The company has already taken over $35MM of working capital out, and is targeting roughly that same amount again in 2008.  The benefits of this increased cash generation will continue to be used to pay down debt.  Further, in September 2007, the company entered into a receivables securitization program, the proceeds of which it is also using to pay down debt.   

 

The third quarter of 2007 should serve as an inflection point.  Not only was it the first quarter of sequential pigment operating profit and EBITDA growth in over a year, but subsequent quarters should benefit from pricing improvement and continued cost reductions.

 

TRX.B often trades down on negative housing news, and in general, the stock has been hurt by the assumption that TiO2 is used to make paint, and nobody’s painting houses if the new and existing housing market in the US is weak.  But if you pull apart the market exposures, you can see that the impact is much less than anticipated.  See the following averages:

 

·        Percentage of TRX.B revenue from Ti02: 93%

·        Percentage of Ti02 revenue from North America: 43% (which is more than just the US)

·        Percentage of Ti02 revenue from coatings applications: 60%

·        Percentage of coatings applications that are paint: 67%

·        Percentage of paint that is for residential applications: 75%

·        Percentage of residential applications that are new homes: 20%

 

So if you call North America a proxy for the US, then 2.5% of Tronox revenue is tied to new US housing starts.  As for existing home sales, painting has historically been counter-cyclical.  While the market assumes that if people are moving less, then they are painting less, the opposite has generally been true: one of the cheapest ways to spruce up your house whether you’re staying or preparing for a future sale is to paint it.  Moreover, this 2.5% drag in the US is in stark contrast to the high single digit growth in Europe and high teens growth in Asia-Pacific.  As pricing firms, therefore, Tronox should enjoy the double boost of price increases and volume increases.  But again, as we show in this report, even if you assume that price and volume simply offset each other, you still come out with a value considerably in excess of today’s price.

 

1)      Land Sales: Tronox owns land that it received as part of the Kerr-McGee spin-off that is not core to its operations.  In fact, Tronox does not operate any facilities on these properties and is in the process of seeking buyers for various parcels.  The company estimates that this land is worth $250MM based on 2004 assessments.  This land is in Nevada, and is a mix of potential light industrial and residential property.  While the residential real estate market has softened considerably over the past 18 months, they are still at or above 2004 levels, while the light industrial segment remains strong.  Therefore, it is reasonable to assume that $250MM is still a good estimate of this land’s value.  On an after-tax basis, the real estate sales should generate $160MM, which the company intends to use to further pay down debt.

2)      Environmental Exposure: Pursuant to its spin-off from Kerr-McGee, Tronox is responsible for environmental remediation at multiple sites on which it never had operations as a titanium dioxide manufacturer.  Tronox currently has a reserve of $214MM against future claims, and a receivable for $60MM for reimbursement, for net exposure of $154MM, or roughly the amount of after-tax proceeds expected from the land sales.  Tronox’s environmental exposure is mitigated by government reimbursements (for work done on behalf of government agencies such as the Departments of Energy and Defense), insurance policies and a 7-year Kerr-McGee (now Anadarko) reimbursement program.  Under the latter, Kerr-McGee must reimburse Tronox for 50% of remediation costs in excess of the reserves at the IPO, up to $100MM.  Tronox spends $35-40MM towards remediation annually.  What has scared off some investors is the concern that the true environmental exposure is considerably greater than what the company discloses.  While this may be the case, one can gain some comfort by estimating what additional exposure there might be, and netting it against the valuations from our scenarios above.  So if Tronox’s net environmental exposure is understated by $300MM, which is an extremely high number (140% above current reserve) given the reimbursement mitigants listed above, that would be $7.25 of value/share.  If such an extreme case were really accurate, only in our unrealistically conservative scenario above would you actually lose money from today’s price.  Taking the average of the scenarios (including the down case) yields an average equity value of $21.40.  If you took that full $7.25 off the $21.40, you’d still be at $14.15, 100% above today’s price.  Now that the two-year period has passed since the IPO, and Tronox is free to sell the company without tax consequences to Kerr-McGee, it is reasonable to assume that the company will pursue methods to further mitigate this risk.

3)      Insider Purchases: In mid-November 2007, multiple members of senior management made open market purchases of Tronox stock.  While there have been occasional small purchases by management over time, this was the first “group” purchase since the IPO.  While the total amounts (no one bought more than 10,000 shares) were not staggering, it is particularly interesting that the largest purchase was by John Romano, Vice President, Sales.  Romano led the efforts to raise prices with customers on Tronox’s behalf in October, and we believe it is a bullish sign of their response that he then bought 10,000 shares in mid-November.

4)      Further Industry Consolidation: Bolstered by Upstream/Downstream: There is considerable industrial logic to another round of consolidation in the titanium dioxide industry.  With the pricing wind finally at their backs, the industry participants can further strengthen their hands by further consolidation.  By taking less efficient sulfate capacity off-line, reducing significant amounts of duplicative G&A (Tronox’s G&A is almost 25% of its current enterprise value, and almost 60% of its current market cap) and creating a more favorable supply/demand balance across a more efficient footprint will yield considerable margin benefits.  We believe that Tronox will be a participant in such consolidation, as it is a significantly undervalue pure-play asset.  At the very least, a deal amongst other participants, similar to the Cristal/Millennium deal, will establish a value for TiO2 assets that will allow Tronox’s true intrinsic value to be recognized by the marketplace.  There has also been considerable consolidation downstream, as evidenced by PPG Industries’ recent acquisition of Sigma-Kalon, Akzo Nobel’s recent acquisition of ICI, and Sherwin Williams’ many deals over the past two years.  Consolidation by the TiO2 players will help the industry maintain pricing power over these consolidating customers.  Further, potential upstream deals, such as a BHP Billiton/Rio Tinto deal would consolidate mine owners of titanium ore, a key input, making consolidation in TiO2 even more important.

5)      Uerdingen Sale Pulled: In September, Tronox announced that it was retaining the sulfate plant in Uerdingen because it did not receive bids that the Board thought were commensurate with the cost improvement opportunity and the revenue generating opportunity from the sale of specialty chemicals at the plant (made possible by an investment in a new feed line).  Rather, buyers were focused on trailing EBITDA, which was depressed.  Rockwood Holding is known to have offered upwards of $250MM for that plant in the past, and at a recent roadshow for a secondary offering, Rockwood’s CEO said that the only way to solve Rockwood’s capacity issues in Germany is to acquire Uerdingen.  In the near term, Tronox will generate incremental profit from operating the plant in a more efficient manner and selling higher margin specialty chemicals.  Eventually, a sale to Rockwood is inevitable.

1)      EBITDA LEVEL: We believe $240MM is a reasonably achievable EBITDA expectation for 12-18 months out because of the following: a) Tronox’s average EBITDA margin for the three years prior to the introduction of cost savings initiatives was 11.2%; b) if you assume no pricing improvement and 3% volume growth (below industry estimates of 4-5%), you’d have $1.442B in  revenue.  Apply that pre-cost savings EBITDA margin and add in the $80MM of cost savings that will be achieved cumulatively through 2008, and you get an EBITDA level just over $240MM (note: by the third quarter of ’07, $39MM of costs were already out of the business; by year-end ’07, that will be over $40MM).

2)      DEBT PAY DOWN: We believe at least $40MM of incremental debt pay down is reasonable over the next 12-18 months because the company has lowered net debt by $52MM through three quarter of 2007 during a difficult operating environment with weaker free cash flow than its likely to have going forward. 

3)      MULTIPLE: In addition to the comparable transaction EBITDA multiples, lightly traded KRO trades at over 6x forward EBITDA.