New Position: Betting on a narrowing discount for NL Industries
Two weeks ago I took a position in NL Industries.
I don’t expect this position to be a long-term hold for me. There are a number of things not to like about the stock. Nevertheless the beaten up share price over the last couple of months presents a disconnect to the underlying assets that is historically large and I think has a reasonable chance of being corrected over the coming weeks and months.
NL Industries has 49 million shares outstanding. At $8 that gives it a market capitalization of $400 million. They have about $100 million of cash on the balance sheet. They have no debt, but do have a long-term liability for environmental remediation that is $115 million. These costs are associated with previously operated lead smelters and mining operations. They also have legal proceedings ongoing, which I will get to shortly.
NL Industries is a holding company that has ownership in two businesses. The first is Kronos. Kronos is a large, titanium dioxide pigment producer. NL Industries owns 30% of Kronos. Kronos used to be a wholly owned subsidiary but they have slowly divested that into the public market.
Titanium dioxide is used to create a white pigmentation in paints, plastics, and other coatings. Those that follow this blog might remember that I have previously held a position in another titanium dioxide producer, Tronox, and from that experience I learned that this is a tough business. Kronos has a 9% market share in the Titanium dioxide market worldwide.
The titanium dioxide market is quite cyclical. Kronos stock traded to as low as $3 at the trough of the last cycle, but we are now on an upswing as demand has been rising and little new production is on the horizon. The stock has risen from $12 to $18 since the beginning of the year.
The second business that NL Industries owns is CompX. Their ownership in CompX is 87%. CompX is a manufacturing company. They have a segment that manufactures locks and another that manufactures marine components. CompX has been consistently profitable and free cash flow positive for the last 3 years, but has not shown any growth over that time.
In addition NL Industries owns 14.4 million shares of Valhi, which is a related company that also owns a stake in Kronos. These shares are worth a little less than $50 million. The relationship with Valhi is complicated as Valhi in turn has 83% ownership of NL Industries. Valhi is 93% owned by the private company Contran, which is owned by the family of Harold Simmons. There are a number of interesting articles on the late Mr. Simmons and his controversial life (here and here for example).
While the ownership structure likely raises some questions about the long-term direction of the business, my thesis here is very short-term, so I am not going to dwell on it. By the time any strategic concerns are realized I should be long gone from the stock.
Getting back to the assets, neither Kronos or CompX are particularly bad businesses, but neither is either a particularly good business. Kronos is cyclical and requires large capital expenditures. CompX is in a low growth end market. I probably wouldn’t invest directly in either company.
What makes NL Industries interesting is that their stake in these businesses far exceeds the market capitalization of the stock. CompX has a market capitalization of $170 million. NL Industries has a 88% interest in them, so that is worth $150 million. Kronos has a market capitalization of $2.2 billion. The 30% ownership that NL Industries has is worth $660 million.
Thus, NL Industries has a market capitalization of about half of its underlying ownership in Kronos and CompX.
The story would be that simple, but it isn’t. There is one remaining caveat. The company has went through a number of lawsuits with respect to its production of lead based paints back in the 1980s. Almost all of these suits have been ruled in their favor. But there is one exception and that is the lawsuit brought about by the county of Santa Clara. Their suit, like all the others, alleges that NL Industries and other lead paint producers are responsible for compensation and abatement costs because they sold lead paint back before it was realized how dangerous it was. The suit is against NL Industries, Sherwin Williams and ConAgra. You can read about the details in their 10-K.
This suit has gone back and forth. The original verdict dismissed the claims, but an appeal overruled and ordered NL Industries and its counterparts to pay damages ($1.1 billion). But this ruling was not final and there is now a second appeal in process. This SeekingAlpha article outlined a few different legal opinions that expressed surprise at the second ruling and that expect it will be overturned on the next appeal. What is surprising is that at the time the lead paint was being sold, there were minimal concerns about its long-term environmental effects. It is unusual to hold a company accountable in such circumstances.
Its important to note that the lawsuit has been ongoing for some time and there hasn’t been any developments since January 2014 when the appeal overturned the original verdict. Also worth noting is that the stock did not react much at the time of the January 2014 appeal result. There is also nothing in the immediate future that will change the state of the trial. The timeline for the second appeal trial has yet to be set. My point here is that insofar that this risk should be reflected in a discount of NL Industries to its underlying assets, that discount shouldn’t be any different today than it was 3 years ago.
Keeping that in mind, when I look back at the stock price of NL Industries, Kronos, and CompX over that time, I notice that the current relative price is close to the bottom of the relative range of NL Industries. To throw out a few data points:
NL Industries trades in a range of 40-75% of the value of its underlying ownership in Kronos and CompX. Other than when the titanium dioxide industry was in the depths of a recession (in late 2015, early 2016) the stock tended to trade closer to the higher end of the range. Right now it trades at under 50%. Other times when the delta became that large, it eventually rebounded back to the 75% range. If I’m right, the stock should move back to $11 or $12, which would be a nice gain.
The risk of course is that A. the rebound does not occur this time or B. that Kronos, which is a very volatile stock, falls significantly from its current near-52-week highs. I am wary of both possibilities, and am not making this a large position for that reason. It’s a 3% position in my value portfolio. I am also not planning on holding this stock for too long – hopefully it rebounds back into the usual range and I sell for a nice profit. If it doesn’t rebound relatively quickly, I don’t plan to overstay my welcome.