The (hopefully) Hidden Earnings of Tronox

I was going to write up a short piece on Tronox as part of my monthly portfolio update but as I started to write it the length became significant.  I think it justifies its own post, so here you go.

Basically what you’ve got with Tronox is a housing/economy play whose earnings are being obscured by a trough in the price of their commodity and the fresh start accounting associated with an acquisition.

What they do

Tronox produces titanium dioxide, which is used as a whitening agent in paints, plastics, and paper but of the three its application in paints are the primary end use (made up 77% of consumption in 2012).   Tronox produces titanium dioxide from manufacturing facilities in The US, the Netherlands and Australia (called their pigment business).  The company is the third largest producer of titanium dioxide in the world, and they sell their product to major paint suppliers like Benjamin Moore and Sherwin Williams.

Tronox was spun out of Kerr-Mcgee in 2005 with a boatload of debt.  The company filed for bankruptcy after the recession in 2009 and emerged from bankruptcy in 2011.  There is about one clean year of financial statements (2011) but then things start to get messy again as the company took over a miner of TiO2 feedstock, Exxaro, in the middle of 2012 in order to become a vertically integrated titanium dioxide producer.

The Thesis

The story here revolves around a couple of different premises.  First, we are amidst an (albeit slow) housing and economic recovery in the United States and as the economy recovers people are going to do more painting.  Second, earnings at Tronox are being artificially depressed by fresh start accounting associated with the purchase of Exxaro, and this has been exacerbated by a fall in the price of TiO2.

Fresh start accounting associated with the merger with Exxaro forced Tronox to revalue the feedstock inventory held at Exxaro at market prices on the day of the acquisition.  This led to a huge one time gain at the time of the transaction but have subsequently depressed earnings as the company has had to amortize the inventory as they produce and sell TiO2.  This has been made doubly bad by the cyclical trough in prices that TiO2 is experiencing.  The end result is that the company has been producing negative EBITDA from the pigment business for the last few quarters. From the first quarter conference call it sounded like they would be mostly worked through this effect by the end of the second quarter.

While I profess only some minor, recently gained expertise in the supply/demand dynamics of the titanium dioxide market, it does appear the market is bottoming.  The drop in prices was brought on by slower global economic activity and a shift by some of the paint makers to lower concentrations of TiO2 in their product (PPG Industries is one that talks about it on their conference calls).   Most of these effects have worked their way through into prices and in the first quarter some of Tronox’s competitors tried to initiate an increase in price.  From what I read this was unsuccessful.  An increase was attempted again in the second quarter so maybe this time it will stick.  I’m not too worried about when the price increase does begin to take hold.  Inventories of titanium dioxide are declining at the major paint suppliers and so as long as the economy doesn’t go in the tank this will eventually feed through into prices. Whether it happens in July or later in the second half of this year is irrelevant to me; the trend is clearly in my favor.

What it means to the Bottom-line

When the combined effects of fresh start accounting and price increases begin to take effect, Tronox should begin to make decent money again.  Looking at the pro-forma results of the combined Tronox-Exxaro entity in 2011 (which is available in the prospectus of the proposed merger), the company would have had EBITDA of $843 million.  And while the 2012 numbers are obscured by the fresh start accounting, some insight is achieved by looking at the segment results of mineral sands (old Exxaro) alone.

Annualizing the results of the last few quarters leads to the conclusion that the mineral sands business alone can generate around $600 million in EBITDA annually.  This result was echoed by one of the analysts (Alembic Global) on the first quarter conference call.  Right now that number is being eaten into by the pigment business, which as I mentioned is producing negative EBITDA.  Presumably the major TiO2 producers will not always sell their pigment for a loss, and Tronox will see additional benefit once the raw material costs of its production come down as the high priced inventory is worked down.  Once this happens, a return to the $800 plus million EBITDA seems reasonable.

At that level of EBITDA the company is trading at about 4x enterprise value to EBITDA.  The business is not highly capital intensive once the manufacturing facilities and mines are built, as Tronox has noted maintenance capital requirements in the $100 million to $120 million range.  Therefore the potential exists for substantial free cash flow generation.

Finally, I do like to be involved in a commodity that is priced at the bottom of the cycle.  Too many times have I seen things play out whereby an unforeseen event (a supply disruption, an unexpected surge in demand) causes a market just on the cusp of a turn to turn far more rapidly than anyone would expect.  While no certainty, its a nice wildcard to have in your pocket.

Risks and Conclusions

The risks here are mostly related to end demand.  Sherwin-Williams came out with weaker than expected quarterly results last week but the forward guidance looked pretty good to me, as they said they expected a 6-9% year over year increase in sales in the third quarter.  PPG Industries noted that end demand was pretty good except in Europe, where it remains tough sledding.   PPG also has said that they are continuing to try to reduce the use of TiO2 in their product, though to a lessor degree than they have been able to do so far.

The other risk worth mentioning is that the company has talked about further acquisitions.  I don’t know the probability of this, but it does worry me some and it could impact the share price in the near term.

To conclude, I kind of look at Tronox at these levels as a company with minimal downside if the economy only improves slowly, and with significant upside if it does pick up to any degree.  Hopefully home construction and automotive manufacturing continue to rise in North America and if that’s the case we should see rising demand for titanium oxide and eventual price increases for Tronox.  If Europe and/or China can re-establish themselves economically (something I am much more willing to take as a possibility for the latter than I am for the former, but hey, you never know) we could see a scenario unfold that leads to significant cyclical profitability for the company.

This is a 2% position for me right now, so it isn’t a really big bet and I don’t want to spend too much time working through the minutia.  The way I’m looking at it is that improvements to the business should come gradually enough that I can add to the position as the thesis plays out.  If I’m right I suspect I will be adding every few dollars all the way up to the upper $20’s.

But for the moment I will let this ride. I won’t go too far into details of each specific outcome (gradual economic pick-up, strong economic pick-up, etc) and what it would mean to earnings, instead I will just note on a more qualitative basis that the range of possibilities that bounds the investment idea are sufficient to justify a position.   I will now sit back and watch how it plays out.