|Shares Out. (in M):||113||P/E||8.0x||6.7x|
|Market Cap (in $M):||2,638||P/FCF||3.8x||3.5x|
|Net Debt (in $M):||1,607||EBIT||598||668|
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Tronox Inc. (“Tronox”) represents a compelling long opportunity as a classically underperforming orphan equity during the growth cyclical sell-off of the past months. The stock is trading at a 26% FCF yield and is significantly below its YTD high on the market perception that the TiO2 cycle has peaked, when in actuality underlying demand is growing and has been masked by a destocking cycle, which is in its final stages. We expect the company to return up to $2bn in cash to shareholders (via buybacks and dividends) over the next 24 months from internal FCF generation and proceeds from a recent $900mm high yield offering, representing more than 60% of the current equity market cap. The company is currently purchasing shares in the open market under a $400mm repurchase authorization while awaiting regulatory approvals for a potential tender; additionally the company expects to pay a special dividend of roughly $300mm in 4Q12. As inventory levels normalize by year end and the market recognizes the structural transformation of the TiO2 industry, we expect meaningful upside to Tronox shares, given the consistent earnings power of its vertically integrated business model and significant valuation discount to its peers. At peer multiples, Tronox would trade between $44 and $76, a 70% - 190% return from the current share price. Further, Tronox deserves a premium valuation to its TiO2 peers due to vertical integration, $1.5bn of NOLs (resulting in a high teens cash tax rate for the foreseeable future) and minimal pension liabilities. As a restructured chemical company with high quality assets in a transformed industry, we cannot help but be reminded of LyondellBasell (LYB), which lost a third of its value upon its NYSE re-listing in summer 2010, only to triple from those levels in the subsequent 24 months.
Tronox is a global top five producer of titanium dioxide pigment (“TiO2”), a key input in paints and coatings. The company is in the midst of a strategic transformation as a result of a recent bankruptcy reorganization, vertical integration via strategic acquisition and tax advantaged re-domicile to Australia. Subsequent to closing the acquisition of the upstream titanium feedstock assets of its JV partner Exxaro Resources (“Exxaro”), Tronox has become a low cost, vertically integrated producer in an industry with historically stable end demand growth and minimal new capacity coming online in the forseeable future.
At the current price of $25.91, Tronox trades at a 26% FCF yield, 4.3x EBITDA and a 40%+ discount to relevant comps. Pending catalysts include a return of capital equal to 21% of the current market cap ($400mm share repurchase program and subsequent $300mm special dividend), resolution of environmental litigation (which can only represent upside to Tronox) and receipt of final approvals for a mine life extension project. We believe the pending return of capital is representative of management’s shareholder friendly posture and indicative of an ongoing focus on maximizing shareholder returns. Pro forma for the recent high yield offering, Tronox is levered 1.75x EBITDA and trading at a 26% ’12 FCF yield, leaving management with the flexibility to opportunistically return excess cash to shareholders on an ongoing basis.
Additionally imminent are other standard post-bankruptcy, re-listing catalysts such as additional financial disclosure, investor roadshows, sell-side coverage and increasing overall buy–side exposure to the company. We expect these events to close the valuation discount over time, resulting in significant share price appreciation for equity holders.
Tronox is trading at a 26% FCF yield and significantly below its YTD peak due to the market perception of TiO2 as a commodity chemical at a cyclical peak. In reality the current TiO2 destocking cycle has masked solid industry fundamentals for the past few quarters, the structural industry transformation that has taken place over the past few years and the robust pricing that the TiO2 industry is poised to sustain.
Due to an extremely tight TiO2 market in late 2009 through mid 2011, large TiO2 customers hoarded product to assure security of supply during a time of potential shortage. This phenomenon concluded in late 2011 as consumers had built sufficient inventories and end market demand, while still growing, decelerated slightly. In 2Q12, Tronox and other TiO2 producer equities sold off significantly as industry shipment volumes experienced mid-teens y-o-y declines. However, end demand for paints and coatings remained strong, as major publicly traded coatings companies reported volume trends ranging from up 10% to down 2% in 1H12. Historically, TiO2 end demand has grown consistently with coatings demand at GDP+ levels, experiencing only five years of shipment declines in the past 30, the largest decline being a 5% decline in 2008. Our diligence indicates that the current destocking cycle, now ongoing for 6 – 9 months is nearing its end, at which point TiO2 industry utilizations will rise back above 90% in 2H12 to meet ongoing end demand; a level at which the industry has historically had pricing power. Upon the conclusion of industry destocking we expect the market to begin appreciating the sustainability of current attractive TiO2 economics.
This sustainability is the result of a structural transformation that the TiO2 supply chain has experienced over the past few years. A number of factors have contributed to this transformation. First are the changes in the titanium feedstock industry. Two decades of underinvestment in exploration and production, a consolidated industry structure and new management at Iluka and Tronox have resulted in a feedstock industry focused on per unit profitability, re-investment level pricing and shorter term contracts. Supply discipline at the feedstock level argues for a protracted period of elevated feedstock prices, resulted in a step change price increase in ore costs for the TiO2 industry. This has transformed TiO2 production from a largely fixed to a largely variable cost structure. The 5 – 7 year lead time for bringing on new titanium feedstock capacity highly discourages TiO2 producers from bringing on new capacity without security of feedstock supply and higher feedstock costs prevent TiO2 producers from accepting lower prices during periods of soft demand. Further, company balance sheets across the supply chain are healthier than historically, resulting in significantly improved operational flexibility. This transformation has resulted in a TiO2 industry focused on per unit profitability rather than maximizing production to leveraged fixed costs and service interest payments. TiO2 producer supply discipline in both the ’08 – ’09 recession and the current destocking cycle as well as a lack of major new capacity expansion projects speak to the transformed nature of the industry.
Amidst this backdrop, Tronox is positioned to generate consistent FCF yields in the 20 – 30%+ range over the next few years and has committed to returning this cash to shareholders via dividend and buyback. Given the potential for shareholder return from FCF generation along with a potential doubling of valuation multiple to achieve parity with peers, we believe Tronox to be an exceptional long opportunity at the current share price.
|TROX pro forma financial summary (1) (2)|
|L+325bp (1% floor) TL due 2018||700|
|6.375% senior notes due 2020||900|
|Less: special dividend||(2.65)|
|Adjusted share price||23.26|
|Shares outstanding (buyback adjusted)||113|
|Plus: net debt||1,174|
|Plus: pension / other||134|
|Cash flow summary|
|FCF ex growth capex||686||747||844|
|EV / EBITDA||4.3||4.0||3.3|
|P / E||8.0||6.7||5.4|
|FCF yield (ex growth capex)||26%||28%||32%|
|1) Pro forma for Exxaro deal close, share repurchase program and special dividend|
|2) Assumes flat TiO2 pricing flat from current; earnings growth driven by repricing of legacy contracts|
In addition to a cheap absolute valuation, Tronox trades at a 40%+ discount to a sum-of-parts valuation derived from using current pure play feedstock (Iluka and Kenmare) and TiO2 (Kronos) market valuations. Tronox, at these comparable company valuation multiples would trade at $44 (pro forma for the $400mm buyback and $300mm special dividend), or 70% above the current share price of $25.91. There are also compelling arguments that Tronox deserves a premium multiple to these comps given its lower tax rate (including 10+ years of NOLs in the US), minimal environmental and pension liabilities and the scarcity value from its status as the only low cost, 100%+ vertically integrated TiO2 producer globally. We expect the valuation gap to compress over time as company specific catalysts, such as the special dividend and resolution of environmental litigation play out and the company benefits from increasing investment community exposure following its recent NYSE re-listing.
The TiO2 producers as a whole trade at a substantial discount to other chemical peers, which we believe is unwarranted given the industry’s recent structural transformation and ongoing market discipline across the titanium supply chain. Valued at the average FCF yield (7%) of commodity chemical comps, Tronox’s share price would be $76, nearly triple the current price.
|TROX price target analysis|
|Sum of parts methodology||FCF yield||FCF||FCF yield||Price target|
|TROX s-o-p target valuation||100.0%||13%||$44|
|Average commodity chemical valuation||7%||$76|
|Blended price target||$60|
|TROX current valuation||22%||$25.91|
|Note: calculated using midpoint of TROX 2012 guidance|
At Huntsman’s investor day earlier this year, Chairman Jon Huntsman expressed dissatisfaction around the company’s valuation and indicated he would be open to exploring strategic alternatives for all or part of the business, including a sale if shareholders received fair value. Subsequently on 4/2/12, Huntsman shares rose 7% on headlines that the company had retained Bank of America to explore a potential sale of the company. Kronos, as a pure play TiO2 producer and Huntsman’s existing joint venture partner at their Lake Charles facility, represents the most logical candidate for a strategic combination. A combination of Huntsman (or its TiO2 business only) with Kronos would be another positive development in further consolidating TiO2 production capacity.
Tronox produces and sells TiO2, an opacifier used in paints, coatings, plastic and paper. TiO2 has no substitutes and represents a small percentage of end product cost. As such, demand is largely inelastic and producers have significant pricing power during periods of supply constraint. The company is headquartered in Stamford, CT, incorporated in Australia for tax purposes and has operations in the US, Australia, South Africa and the Netherlands.
Tronox became an independent company in 2006 when Kerr-McGee spun off its non-core TiO2 assets. The combination of being saddled with significant legacy environmental liabilities and the 2008 global economic slowdown drove Tronox into bankruptcy in early 2009. Tronox emerged from bankruptcy in February 2011, having shed all of its environmental liabilities and all of its debt, save for a small exit term loan that was refinanced in January 2012.
The company emerged from bankruptcy with roughly $1.5bn of NOLs, will not be a US taxpayer for the next decade and thus will have a long term cash tax rate of 15 - 20%. Per management guidance, Tronox will pay cash taxes of 8 – 12% in 2012 and 2013. Additionally, under the terms of the bankruptcy, Tronox was relieved of all potential future environmental claims in exchange for its rights to any proceeds from its $25bn fraudulent conveyance lawsuit against Anadarko Petroleum (who acquired Kerr-McGee after the Tronox spin off). The suit remains ongoing, but to the extent Anadarko is held liable, represents upside to Tronox via additional tax shield. Under no circumstance is Tronox liable for these environmental claims.
In September 2011, Tronox announced a strategic transaction with Exxaro, in which Exxaro contributed its titanium feedstock assets to Tronox in exchange for a 38.5% stake in the pro forma business, thus 100%+ vertically integrating Tronox’s operations (titanium feedstocks are the key raw materials used to make TiO2). The combination results in a company with the unique position of being both a low cost producer and having the most strategic flexibility given an internal source of key feedstocks.
Per the terms of the deal, old Tronox shareholders received new Class A shares and a $2.50 per share special cash distribution. Exxaro received Class B shares with a three year lockup and restrictions on accumulating an additional ownership stake. Exxaro ownership above the proscribed limitations would require an offer for all Class A shares and approval from either the Tronox Board or a majority of Class A shareholders. Exxaro has spoken publicly about its desire to increase its ownership stake in Tronox (Exxaro will reach its 45% ownership threshold in Tronox as a function of the Tronox share buyback program currently ongoing). The deal closed in June 2012 and concurrently Tronox re-listed on the NYSE.
TiO2 industry overview
TiO2 is a critical input in the production of paints, coatings, plastics and paper to which it imparts opacity, brightness and whiteness. The industry is dominated by five global players that represent more than 60% of global capacity; Tronox, DuPont, Cristal Global, Huntsman and Kronos. Each of these producers has access to chloride production process technology, which is lower cost and higher quality than competitive processes. Access to the chloride production process provides a substantial barrier to entry. The majority of productive capacity away from these five players is in China, which utilizes the sulfate process, a higher cost process with a lower quality product that is not an adequate substitute in most applications. Paints and coatings are the largest end market for TiO2 at 56% followed by plastics (25%) and paper (9%). Demand for TiO2 has historically grown at global GDP+ rates. TiO2 is a quality of life product and demand growth continues to be driven by increasing penetration in emerging markets. A US housing recovery, while not factored into our projections, would also drive substantial TiO2 demand growth as North American demand remains 20% below 2005 levels and currently represents 39% of Tronox sales.
A TiO2 capacity overbuild in the early 1990s led to poor returns on capital for the past two decades with prices remaining effectively flat over this entire time period. Lack of industry reinvestment and steady global demand growth eventually soaked up overcapacity. The global financial crisis and subsequent sharp destocking caused TiO2 to experience a rare decline in demand of 9% during the ’08 - ’09 time period; the industry responded by permanently shuttering 7% of global capacity. The subsequent rebound in economic activity starting in 2H09 resulted in supply tightness and ten consecutive quarters of price increases continuing through 2Q12.
|Historical TiO2 industry data|
Extreme market tightness in 2010 and 2011 resulted in an inventory build at the TiO2 consumer level as customers purchased in advance to assure themselves of supply security. Beginning in 4Q11, this phenomenon reversed and for the past three quarters, TiO2 shipments have been down in the mid-teens y-o-y, despite steady paints, coatings and plastic end demand. TiO2 producers have responded rationally by reducing utilization 15 – 20% to match supply with demand. Our diligence indicates that destocking has slowed and we expect TiO2 demand to come in line with ultimate end demand in 2H12.
Absent a significant global contraction, fundamentals for the TiO2 industry are poised to remain strong. Demand should grow at GDP+ rates while significant visibility into new supply indicates that no capacity expansions will come online until 2015. According to industry projections, the 2015 expansion announcement by DuPont would at most fulfill demand growth between 2012 and 2015. Thus, what is now a healthy market is expected to tighten through 2015 barring a global demand shock.
Titanium feedstock industry overview
Titanium feedstocks are produced by mining and processing mineral sands. 90% of titanium feedstocks are used for TiO2 production, the remaining 10% for titanium metals and other applications. Zircon is a co-product in titanium feedstock production and the ratio of zircon to titanium varies by deposit. Zircon is used primarily as an opacifier in ceramics and is projected to generate 16% of Tronox’s pro forma revenues. Countries with significant titanium feedstock production include South Africa, Australia, Canada, Norway and the US. The largest titanium feedstock producers are Rio Tinto and Iluka Resources, followed by Tronox (pro forma for the Exxaro transaction).
The titanium feedstock industry experienced two decades of poor returns on capital preceding the downturn of 2008. During this time titanium feedstock producers were subject to long term cap and collar contracts with little ability to raise prices. This resulted in chronic underinvestment in both exploration and production across the industry. During and after the 2008 downturn the titanium feedstock industry experienced a transformation. First, global demand rebounded significantly faster than expected and for the first time in many years exceeded supply. Second, a number of mines reached the end of their useful lives further exacerbating the tight supply / demand dynamics. Third, Iluka Resources’ new CEO, David Robb, took an industry leadership role in prioritizing profit margins over market share. Iluka took additional capacity out of the market and replaced the long term cap and collar contracts with shorter term, market based pricing. Under Robb, Iluka raised prices 70% in 2H11 and an additional 80 – 90% in 1H12.
Two phenomena in 1H12 have eased the mineral sands bottlenecks that persisted for most of 2011. First, weakness in the Chinese property market has translated to weakness in zircon demand. Comparable to TiO2, the zircon market experienced an inventory build in 2011. Markedly weaker demand in 2012 combined with inventory destocking has resulted in zircon shipments down nearly 50% y-o-y in 1H12. Second, the TiO2 destocking discussed earlier has resulted in a shift in preference of TiO2 producers toward cheaper titanium feedstocks, such as ilmenite and chloride slag vs. higher priced feedstocks such as rutile and synthetic rutile. The downshift to lower quality feedstocks benefits TiO2 producers in two ways; first, lower titanium content feedstocks naturally reduce production yields, which help enable producers to match supply with demand and second, lower titanium content feedstocks trade at a discount, thus reducing input costs. Mineral sands producers have responded by cutting production and held firm on price for both titanium feedstocks and zircon. Nearly 75% of zircon and high grade titanium feedstock production is controlled by the top three producers (Tronox, Iluka and Rio Tinto), all of whom have indicated their prioritization of per unit price and profitability over volumes and market share.
Given varying product mix, these trends impact each of the major mineral sands producers differently. As a zircon, rutile and synthetic rutile producer, Iluka has been much more negatively impacted than Tronox and Rio Tinto, who are primarily chloride slag producers. Tronox in particular has unique operational flexibility given vertical integration to use rutile and synthetic rutile internally and external sales toward the much stronger slag market, thus optimizing earnings power.
Looking past the current period of de-stocking driven weakness, the mid-term outlook for titanium feedstocks remains strong. It takes 5 – 7 years to bring on new mineral sands supply. The projects are capital intensive with reserves often located in difficult political regimes where permitting and infrastructure development are challenging. The backlog of potential expansion projects is highly visible and will be largely used to offset resource depletion at existing mines. As with many global mining sub-sectors, the titanium feedstock industry cost curve has steepened over the past few years and new titanium feedstock resources tend to require far higher medium term prices to justify reinvestment. The dominant industry producers are focused on maximizing profitability evidenced by their own production discipline and price increases. Various junior miners are in the early stages of exploring and developing resource bases, a process that will take many years and multiple stages of capital. Meanwhile, one of the few late stage development projects, Kenmare’s Moma expansion has continued to be characterized by delays and cost overruns.
Supply chain dynamics
The current structure of the titanium supply chain is particularly favorable to a vertically integrated TiO2 producer.
The titanium supply chain consists (primarily) of titanium feedstock, TiO2 and paints and coatings. Titanium feedstocks represent roughly 35% of TiO2 production costs, which in turn represent roughly 10% of paint production costs. As such, a 100% increase in feedstock pricing corresponds to a 3 – 4% increase in the cost of paint. Further, when the cost of paint is put in the context of the home or automobile on which it is applied, it becomes negligible. Since TiO2 is essential to its end products, has no known substitutes, and represents a small proportion of the end cost, TiO2 producers are poised to enjoy sustained pricing and profitability.
Given the chronic underinvestment that has occurred in both the titanium feedstock and TiO2 markets, downstream coatings customers acknowledge that higher returns and profitability are required to justify necessary reinvestment in both areas. Typically, in cyclical industries, periods of high margins leads to a classic overbuild, where increasing demand and profitability spur too much capacity expansion and sow the seeds for the inevitable bust. However, current dynamics within the titanium industry, and particularly the long lead time required to add feedstock capacity, along with the more disciplined behavior of management teams and strong balance sheets, argue for an extended cycle. During periods of weak demand, major feedstock producers have balanced the market by cutting production levels or warehousing excess supply.
Similarly, TiO2 producers have exhibited production discipline in periods of weaker demand, including during the 2008 downturn when four of the top five global producers dismantled higher cost production and over the past few quarters when virtually all the major industry players prioritized margins over volumes by reducing capacity utilizations to match supply with current demand. This more disciplined behavior illustrates a transformed industry structure likely to drive higher and more sustainable industry profitability going forward. We believe the multi-year lack of visibility on feedstock availability presents a major obstacle to TiO2 capacity expansions. Further, the increase in feedstock pricing has transformed the pigment industry from a fixed cost to a variable cost business model. In the past, when feedstock prices were low, pigment producers were incented to maximize production to offset their fixed costs. Now that feedstock costs have risen substantially, fixed costs are a much smaller portion of the cost structure and pigment producers are focused on profitability per unit of production.
Tronox represents a compelling long opportunity as a classically underperforming orphan equity subsequent to its strategic transformation and NYSE re-listing. The company has become a low cost, vertically integrated producer in an industry with historically stable end demand growth and nearly no new capacity coming online in the forseeable future. At current levels, Tronox is exceptionally cheap on both an absolute and relative basis and given cash flow generation potential and shareholder friendly management, remains well positioned to continue returning cash to shareholders. At peer multiples Tronox would trade between $44 and $76, more than double the current share price of $25.91. We expect this valuation gap to narrow and Tronox shares to appreciate as the company continues to execute operationally, announce shareholder friendly initiatives and broaden its investor base.
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