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 capacity by the end of 2014, primarily through additions to their Mexico plant. This addition is not anticipated to shake the current supply/demand imbalance. With current global demand over 5 million metric tons, minimal demand growth over the next three years should easily eclipse that capacity addition.
The industry has already added capacity through debottlenecking existing plants over the past decade, and the capacity gains from further debottlenecking are expected to be very minimal. The estimated timeline for a greenfield plant from planning to production is three to five years, basically ensuring that no significant capacity will come on in the Western world until 2015. And as will be discussed further below, there is currently not enough raw feedstock available to supply significant pigment capacity expansion. That will also most likely deter further investment in capacity expansion until raw materials output expands. Given the consolidation in the industry and the nascent rebound from a long period of depressed prices, I would expect the major players to be very cautious in committing capital to capacity expansions.
In theory, given that TiO2 is a commodity product it should not be priced above a level that would justify a greenfield capacity expansion. I don’t think that calculation is particularly relevant to the current investment thesis in KRO given the years it would take to build a new plant and the existing limitation on feedstock to supply any new plant. And as KRO management has said, coming out of a twenty year down period producers would need to be assured that margins are stable. They will not rush to invest in new builds right away as margins rise. But even if we do assume that metric is relevant, I am getting about $5,300/mt as a TiO2 selling price that would provide a 20% ROIC on a new plant for a major producer (see this spreadsheet for more detail). At $5,300/mt KRO would be generating over $1 billion in EBITDA versus $400 million in TTM. For what it is worth, Kronos management has stated that margins are still below a level that would justify investment in a new plant.
The major question on the supply side is China. Ti Insight estimates that there are currently between 60 and 80 TiO2 plants in China with about 1 million mt of capacity, which is virtually entirely sulfate capacity. Chinese producers have announced some significant capacity expansions, but there are doubts as to whether those plants will actually get built and whether they will actually run at stated capacity. (DuPont has had a Chinese plant project stuck in the early planning stages since 2005). Ti Insight estimates that China will add 770,000 mt of capacity by 2015. The consensus confirmed by both industry consultants and TiO2 buyers is that Chinese production is generally regarded as suitable only for lower end markets and is not a substantial threat to Western producers at the present time. The sulfate process produces a lower quality base pigment than chloride. While sulfate TiO2 can be finished in a way that makes it comparable in quality to chloride, the finishing process is proprietary to each producer and the Chinese are not up to Western standards in that area. Only the top five producers possess chlorine technology and it is assumed the Chinese producers will have tough time replicating it even if they attempt to do so. And even with the anticipated Chinese capacity expansions the total supply CAGR is only 3% out to 2015. That will probably just keep up with demand growth.
Industry wide plant utilization is currently well over 90%, which typically correlates with rising prices. The publicly traded TiO2 companies have stated they are running at full capacity and that large customers are on supply allocations. The supply tightness has been confirmed by public comments of major paint companies such as Sherwin Williams. With no relief for the supply tightness forecasted, prices are anticipated to keep rising through 2015 barring a global double dip in demand. Supply tightness might even get worse the next several years, as approximately 200 thousand mt of annual supply growth would be needed just to keep up with rising demand. Ti Insight forecasts prices rising to $6000/mt by 2015 from the current $3500-4000, and they acknowledge that we possibly could see that number by as early as 2013 if current pricing momentum persists.
Raw Materials Pricing
The potential fly in the ointment for the TiO2 bull story is the rising costs of TiO2 feedstock (ilmenite and rutile ore). Like the TiO2 producers, TiO2 feedstock miners have also suffered from two decades of poor returns and there has been very minimal recent investment in expanding output. As demand for feedstock has risen there is now a shortage and ore pricing has shot up over the past year. In June Iluka (the largest titanium miner) announced price increases of 70-75% for rutile feedstock for the second half of the year. There is plenty of potential supply available in the ground, but it will take several years of investment in mining expansion for the feedstock producers to substantially increase their output.
Pigment producers have thus far been able to pass along ore price increases given the current supply/demand dynamics, and they remain optimistic that they will continue to be able to do so. While ore represents the largest cost for pigment producers, it is still only 25-35% of the total cost of goods sold. Ti Insight thinks that means margins for pigment producers should continue to rise as the price increases to TiO2 end users outstrip the increase in COGS.
As Kronos management likes to point out, the fate of the TiO2 miners and Tio2 pigment producers are linked. The miners need the pigment producers to have stable margins in order to stabilize demand for feedstock and justify investment in expanding mine outputs. Thus they would be shooting themselves in the foot if they were to destroy pigment producer margins by raising prices beyond what the pigment producers can pass on. Iluka is clearly aware of this dynamic and they have spoken about maintaining pigment producer margins. They displayed a chart in their most recent investor presentation to confirm that the spread between feedstock and pigment pricing (i.e. pigment producer margin) has actually increased even as feedstock costs have gone up:
Kronos Worldwide (KRO) is headquartered in Dallas, and has TiO2 plants in Germany (two), Belgium, Norway, Canada, and a joint venture with Huntsman (HUN) in Louisiana. 2010 TiO2 production capacity was 532,000 mt. 75% of their capacity is chloride. They also own two ilmenite mines in Norway that provide all of the feedstock for their sulfate capacity in Europe. Kronos has about half of their sales in Europe, a third in North America, and 10% in Asia. In 2010 90% of their sales were from TiO2 pigment, and the other 10% were from sales of chemical byproducts of the TiO2 pigment production and sales of excess ilmenite.
The historical financials for Kronos are not particularly relevant given the rapidly changing pricing dynamics of their business. The major issues in determining the outlook for KRO are where pricing is headed for their raw inputs and finished product. While it is admittedly hard to forecast the next few years of earnings with any precision, given industry dynamics the upward trend is clear and there is a large margin of safety with the current stock price. I’ll walk through the assumptions in my base case scenario. (The model underlying this analysis can be downloaded here.)
(Figures in millions except for metric ton figures)
Volume and Sales Price
Kronos management has stated that capacity moving forward will not expand more than a few thousand metric tons beyond 2010 capacity of 532,000 mt. Like the other major producers, Kronos has already completed major debottlenecking projects, which have increased capacity 30% over the past decade. For the remainder of the year they expect to run at full capacity and sell all of the TiO2 they produce with both production and sales volumes up a few thousand metric tons from 2010 capacity. I have assumed sales of 534,000 mt per year in my model.
In the second quarter average selling price rose 39% YoY and 10% QoQ. Management anticipates further price increases for the remainder of the year. Although they have not given guidance on pricing for the company as a whole, Kronos has announced price increases by region for their customers. Those are subject to negotiation, but they have not had trouble implementing several sets of increases over the past year. Kronos announced two rounds of increases for July and September implementation. Price increases are announced in absolute dollar terms, so it is hard to know the percentage increase with precision. However, based on average prices in industry reports they appear to be raising prices by over 10% in each round.
About half of KRO’s customers have 90 day “price protection” from the implementation date of price increases. So the increases from the second quarter will be hitting those customers in the third quarter. My model assumes an 11% price increase in Q3 based on the announced price increases, and a 5% increase in Q4 (which they should get just from the roll forward of Q3 increases to price protected customers).
For pricing in 2012 and 2013, I assume $4,450/mt in 2012 and $5,150/mt in 2013- both slightly below Ti Insight estimates for major producer average pricing. That assumes 5% quarterly price increases in 2012 and 3% quarterly increases in 2013 and equates to a 26% annual increase in 2012 and 16% increase in 2013.
Cost of Goods Sold and SG&A
KRO is partially backwards integrated, which should help offset some of the rising ore costs. The two mines in Norway provide the feedstock for all of their European sulfate production, which is about 22% of total production. Additionally, KRO only uses a third of the ore from the mines and sells the rest to third parties. So KRO will benefit on these sales from rising ore prices, although ore sales are only 3% of revenues.
KRO has guided for total per metric ton COGS to be up 10-15% in FY11, which includes the impact of both rising feedstock costs and higher energy and freight costs. Based on the amount of feedstock they have effectively hedged with the vertical integration, the guidance implies about a 50% YoY increase in feedstock cost. KRO does not yet have visibility into feedstock pricing for 2012. I have also modeled 15% YoY increases in per metric ton COGS in 12 and 13, which assume a continued steep rise in ore cost comparable to the one seen this year, as well as continued high inflation on other costs such as energy. Given the interrelationship of the ore and pigment producers discussed above, I do not anticipate prices rising faster than the very large increases the producers experienced in 2011.
There should be large benefits to scale on the SG&A line as sales rise. However, Kronos runs commission costs through SG&A so there are some costs that rise with selling prices and I also assume some incremental profit sharing with employees. SG&A was $51 million in the last quarter and should rise moderately over the next few years to the $60-65 million a quarter range.
Putting these assumptions together yields EBITDA margins in the 37% range in 2012 and 2013. As a sanity check this is still below the 40% EBITDA margins the industry saw in the last big uptick in the early 90s.
Free cash flow in the coming years will probably come in modestly below net income due to increases in working capital and maintenance capex running higher than D&A. The use of cash will be partially be offset by NOLs that reduce cash taxes.
KRO’s working capital has been increasing as sales rise. I assume it continues to do so in line with the increases in COGS and revenues. They do have a $177.8 deferred tax asset, which appears to consist mainly of NOLs and should help reduce cash taxes. In the first half of 2011 KRO had $80 million of accounting income tax expense and paid only $40 million in cash taxes. Maintenance capex appears to be around $60 million, while depreciation has been running around $50 million a year. Management has guided for $70 million in capex in 2011, which also includes some equipment upgrades.
KRO had $511.7 million in debt as of June 30, but announced on the last conference call that they have since paid down their revolver, which leaves them with $462 million in total debt and $360 million in net debt (counting marketable securities under current assets as cash). This is reasonable even in light of trailing twelve month EBITDA of $402 million, and is certainly safe in light of estimated 2011 EBITDA of $600 million plus. The remaining debt is in the form of 6.5% senior notes secured by the European operations. They also have a currently untapped 80 million euro revolver also carried by the European operations at L+1.5-1.75%. Management has said they are comfortable with the current debt levels given the recent increases in EBITDA.
The senior debt is due in April 2013 and has a call option at slightly above par. KRO redeemed 80 million euros of notes in March, which they funded by borrowing on the revolver. The borrowing spread between the revolver and senior notes is over 400 basis points, so KRO has said they will consider calling back more of the senior notes.
KRO pays a .15 cent quarterly dividend ($70 million a year), which is currently a 3.2% yield. They also did a 50 cent special dividend in February. I would not be surprised if the dividend was raised in the next year barring an acquisition.
Kronos raised $360 million in a secondary offering in November 2010. The speculation has been that they were going to attempt to buy part of the assets of Tronox, the fifth-largest TiO2 producer that came out of bankruptcy earlier this year and was presumably putting itself up for sale. And on the last conference call KRO management expressed strong interest in Tronox’s assets. But a Tronox acquisition might be off of the table now that Tronox has announced they will be merging with Exarro’s titanium mining operation.
On a trailing twelve month basis KRO is trading at 9.3X earnings of $1.98 per share and 6.2X EBITDA of $402 million. As those are slightly below comp multiples there appears to be no growth in earnings anticipated in the current valuation. Comps for commodity chemical makers are generally in the 10-12X earnings and 6-8X EBITDA range. Here is the implied share price based on a range of multiples off of my 2012 base case estimate:
While multiple expansion is not needed at all for this investment to work out, often once a commodity producer starts generating earnings momentum their multiples expand as well.
The downside is protected by two simple facts: TiO2 is an irreplaceable component in a variety of building block goods and there is a structural limitation on TiO2 supply that cannot be substantially corrected for at least five years. So unless we get sustained negative global GDP growth it is hard to envision how Kronos does not have earnings power similar to the trailing twelve month numbers. In that case Kronos would still be modestly undervalued compared to comps. We might see a repeat of the 08/09 destocking/restocking cycle for a year or two but Kronos has the financial strength to weather another dip.
Variant View and Risks
I have not seen a fleshed out bear thesis on KRO, but I imagine it would consist of the following:
- TiO2 industry concerns- ore price inflation, Chinese supply flooding the market
- Macro concerns- fear of global double dip in demand, exposure to Eurozone
- Insider control
I addressed the micro concerns in the TiO2 industry section above. On the other issues:
- Demand shock- A macroeconomic crisis would presumably reduce demand and cause inventory destocking by their customers similar to the 08/09 period. But given the irreplaceable nature of TiO2 and the strong financial position of the company it is hard to see a temporary demand shock causing a permanent impairment of capital. Due to the supply tightness it also seems the industry is in much better position to handle a downturn than it was in 08/09.
- European exposure- Kronos has about half of their revenues from Europe, leaving them potentially exposed to a slowdown in the Eurozone economies. However, TiO2 is a product with global demand that can be shipped. KRO has said they can shift TiO2 sales to whatever region has the demand. On the Q2 conference call, they noted that they were seeing weaker demand in North America but pricing was still going up because supply is so tight and demand in other areas compensates to maintain global pricing. Aside from the direct business exposure in Europe there is also foreign exchange exposure to the Euro. This has gone for them and against them the last several years, but I don’t think it is significant enough to alter the thesis.
- Insider Control- Various entities owned by Texas billionaire Harold Simmons (publicly traded VHI and NL) control 80% of Kronos stock. There are some related party transactions such as Kronos holding $106 million worth of stock in related entities TIE and VHI and the possibility that Simmons will do something not in minority shareholders best interest. The flip side is that the company is run with an owner’s mentality. I think there is little risk of poor capital allocation such as overpaying for an acquisition. Both Simmons and the CEO Steve Watson have been buying stock in sizable amounts recently.
Another point worth noting is that KRO is underfollowed given its size. The share float was only 5% prior to the November 2010 secondary and even now is only at 20%. The company did not have any sell side coverage prior to the secondary and even now has only four analysts following it. The TiO2 pigment industry is underfollowed in general as the only other public pure play in the space, Tronox (TROX), is a post-reorg.
(On Monday Tronox announced their acquisition of the titanium mining assets of Exxaro. At current prices Tronox also appears to be a very compelling investment. I hope to be back with more on Tronox.)
Disclosure: I own shares of KRO and TROX.