Elie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of Value Slant
Kronos Worldwide (KRO) offers a timely investment opportunity in an oligopoly industry experiencing extremely favorable pricing dynamics for the foreseeable future. A structural supply/demand imbalance in the industry should lead to quickly growing margins, earnings, and cash flow for at least the next several years. KRO currently trades at just 3.9X my estimate of 2011 EBITDA, while comps in the chemicals space trade between 6-8X. In my 2012 base scenario EBITDA and earnings will rise another ~50%. At the current share price KRO offers over 100% upside potential in the next 18 months.
|Price as of 9/27/2011||18.50|
|52 Week Range||15.92-34.50|
|Shares Out (MMs)||115.9|
|Market Cap (MMs)||2,144.2|
|Net Debt (MMs)||359.9|
|Enterprise Value (MMs)||2,504.1|
TiO2 Industry Overview
Kronos is a producer of titanium dioxide (TiO2) pigment. TiO2 is the world’s most widely used white pigment with a variety of end uses, although it is predominately used in paints (50%+ of global production), plastics (30%), and papers (5%) to whiten and provide opacity. TiO2 possesses unique opacity and brightness characteristics with no cost effective known replacement. While “extenders” like calcium carbonate can help lower the amount of TiO2 required, they are not true replacements.
The raw materials for TiO2 consist of either rutile or ilmenite, which are predominately mined in Australia, South Africa, Canada, and Norway. Intermediate chemical processes are also used to produce synthetic rutile or titanium slag that help boost the TiO2 content of the feedstock. TiO2 producers extract the pigment from the raw feedstock with either sulfuric acid or chlorine. The chlorine process is the more advanced technology and is generally regarded as having a lower cost structure than the sulfate process. While the chlorine process has a higher raw ore cost due to using purer feedstock, the sulfate process has higher labor, waste, and environmental liability costs. The chloride process is generally preferred for the major end uses in paint and plastics, and about two thirds of global capacity utilizes chloride.
After the base TiO2 pigment is formed it undergoes a finishing process depending on the specific end use. TiO2 is a commodity product in the sense that pricing is typically determined solely by supply/demand dynamics for the commodity as a whole. But the end product differs chemically between providers. The finishing process of the base TiO2 pigment provides differentiation based on the intended end use and producer quality.
TiO2 demand generally tracks global GDP growth. Demand for TiO2 is global, although the developed world has a much higher per capita consumption. As the standard of living rises in the developing world, TiO2 demand is anticipated to increase dramatically.
Total TiO2 industry capacity is currently around 5 million metric tons. Ti02 is an oligopoly market that continues to undergo intense consolidation, with the top five producers operating 63% of the production capacity in 2010:
The industry had been plagued with overcapacity since the 1990s. TiO2 pricing in real terms fell close to 50% from 1990 to 2009. Due to the high fixed cost structure of the business, in periods of overcapacity producers cut prices in desperate attempts to fill up excess capacity.
The last two decades have been marginally profitable at best for TiO2 producers, with plants often running at breakeven. However, overcapacity persisted in part due to the large environmental liabilities associated with decommissioning a TiO2 plant.
TiO2 demand underwent a rare sequential decline in 08 and 09, coming down 8% globally and 16% in Western markets over those two years. Several producers responded by permanently shuttering higher cost plants constituting 7% of worldwide capacity. Additionally, many producers temporarily idled plants due to demand weakness. These shutdowns, coupled with a rise in demand due to inventory restocking in the global recovery, led to supply tightness and sharply rising prices starting in the back half of 2009. Prices have risen consistently since then, with price increases for the third and fourth quarters of 2011 already announced by the major producers. While there is no uniformly agreed upon price index for the industry, based on industry data and public company reports prices have risen about 40% in the past year.
The current investment thesis in the TiO2 industry and KRO is predicated on the persistence of the present structural supply/demand imbalance for at least the next several years, sending selling prices even higher and boosting the cash flows of the major producers.
Global Supply/Demand Outlook
In developed countries, high TiO2 penetration and low GDP growth rates lead to a subdued demand growth outlook. In developing countries we find the opposite with a higher GDP growth outlook and the potential for rapid growth in per capita TiO2 consumption as the standard of living increases. Leading industry consultant Ti Insight (founded by Gary Cianfinchi, former VP at Cristal) sees an aggregate CAGR of 3-4% for TiO2 demand growth through 2015 based on muddle-through GDP growth in the developed world and continued above average GDP growth in emerging markets.
It is widely agreed upon among industry participants at all levels of the supply chain that there is no substitute with properties comparable to TiO2, and that pricing momentum will not be halted by customers increasing their use of TiO2 replacements. Extenders such as calcium carbonate can help reduce the TiO2 required, but these extenders have been around for many years and end users have already maxed out on the amount of extenders they can employ.
TiO2 producers have not seen demand destruction from their price increases thus far as their customers have been able to pass along price increases to the consumer. TiO2 makes up a small percentage of the cost of the end paint or plastic product- in the range of 5-15% of paint cost and 5-10% of plastic cost. In the last quarter there have been reports in industry trade journals that some customers are having trouble passing on the continuous price hikes to the consumer. But it is hard to tell if that is serious or just posturing on the part of customers to avoid further price hikes, and so far this year the producers have implemented all of the planned price increases. The stance expressed by Kronos and other producers is that they need to realize higher margins for an extended period in order to justify investment in capacity expansion that will alleviate the supply shortage customers are currently experiencing. They are expecting that their customers will have to give up some of the margin they have enjoyed for the last two decades at the expense of the pigment producers.
On the supply side, the plants closed in 08 and 09 are not coming back on line and DuPont is the only Western producer that has announced a capacity expansion. They plan to add 350,000 metric tons of