Trox Stox Rox in 2014

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Tronox Incorporated was spun off from Kerr-McGee in 2006 along with a high debt load and a lot of legacy environmental liabilities. The company was a producer of titanium dioxide (TiO2). Titanium dioxide is critical to paint and coatings and is the secret ingredient that allows paint to cover and hide surfaces.  In 2009, Tronox declared bankruptcy, unable to pay debt and environmental obligations and emerged in February 2011 sans debt and environmental expenses. Shortly after coming out of bankruptcy, Tronox acquired  Exxaro Mineral Sands mining in a cash and shares deal. The deal gave them vertical integration with access to the feedstocks that go into the making of titanium dioxide. In June 2012 they were listed on the NYSE as Tronox Limited (NYSE: TROX).

Supply and Demand

Before the merger, revenue was strictly from the sale of TiO2 (86% and 93% in the three and nine months ended September 30, 2011). With the Exxaro mineral sands acquisition, revenue has become more diversified and TiO2 sales decreased to 57% (3 mos) and 73% (9 mos) of total revenue. Thie diversification will  soften the effects of the intensely cyclical titanium dioxide business. After After a couple of decades of difficult operating conditions, titanium dioxide had a record  2011 with high volume and a series of price increases that restored profitability. The cycle is once again turning down and  TiO2 sales are slowing in 2012 due to continued customer destocking and declining demand  as a result of weaker residential and commercial construction in Europe and Asia.

 While TiO2 has no substitute there are threats to its historically reliable but slow-growing demand in the paint industry. Since paint/pigments make up 77% of TiO2 sales, any decreased end product use is going to negatively impact growth over the long-term. Dow Chemicals  (NYSE: DOW) brought its polymer Evoque to market in 2011 and will begin heavy promotion in 2012-2013. Evoque is a polymer that efficiently disperses TiO2 in paint so less TiO2 can be used for equal hiding capacity. Evoque polymers surround and attach to the surface of TiO2 particles. As the two materials come together, they form a composite that makes TiO2 better dispersed and more resistant to crowding. Dow believes up to a 20% reduction in titanium dioxide will be possible, while maintaining the paints ability to cover and hide the original surface.

Dow also makes Ropaque (introduced 30 years ago) and combining Ropaque with Evoque can decrease TiO2 by up to 50% and still keep paint’s ability to hide and cover equal to or better than the pure TiO2 containing product. PPG has already targeted a 4% decrease in TiO2 use discussed in the Q3 conference call. Sherwin Williams also mentions decreasing concentrations of TiO2 in paint. Broad adoption by the paint industry poses a threat to growth to TiO2 producers.

 Historical data

Tronox emerged from bankruptcy in February 2011 and  provides financial results back to 2008 but are unable give any further data claiming it's too costly to provide it.  The financial documents they do provide are complicated by various one-time charges for the reorganization and the acquisition, proforma and successor/predecessor differences and a switch from their January to December year-end. What can be consistently tracked is the disastrous, rock bottom 2008 and recovery in 2011pre-Exxaro. This is the pure titanium dioxide business. The high growth and expansive margins were short-lived and by the third quarter of 2012, Tronox was back to negative growth and negative margins effectively illustrating how fast the cycle turns and how severe the downturn can be. This decline was across the sector and took Tronox, DuPont and Kronos  by surprise. Tronox shares dropped 21% and Dupont was down 10% after disappointing Q3 earnings.

Gross margins improved more than 3-fold from 2008 to 2011 and the company went from operating at a loss to operating margins of 19.5%. The high cost of sales in 2008 are responsible for the worst gross margins and biggest net losses in 4 years.  Cash flow from operations was negative in both 2008 and 2009, recovering to $250 million in 2011.Exxaro does not appear in the consolidated results until June 15 2012. It adds two weeks of revenue to Q2 and is present for all of Q3 2012. 

In 2009, operating income went from negative operating earnings to over $67 million accounting for the outsized increase of 49-fold. Tronox continued to post positive growth numbers up through 2011 as volume, pricing and margins improved.  Business was good through the first quarter of 2012, but by Q3, was back to low margins and nogrowth

June 2012 is slightly distorted by two weeks of Exxaro revenue. That revenue was left in as cost of sales could not be be adjusted to account for Exxaro. The June quarter was also saw a tax benefit, altering net income and increasing net margin and net growth. In tow out of four years, the company has had tax benefits and has NOLs going forward that may be used. I left it in. Growth and margins were in an accelerating decline by the second quarter. 

 

By Q3, gross margins were worse than the annual 2008 figure and disappointing since supplying their own feedstock should relieve some of the pressure on gross margins.  Their margins should show highly competitive improvement over industry peers as the cycle moves up again. Unfortunately, anticipating upturns in the TiO2 cycles is not easy. 

Third quarter 2012

Pigment sales decreased by 30% as destocking by end users continued far beyond company predictions for destocking and the move into restocking. Exxaro revenue in Q3 was $207.1 million of the $487.3 million in total revenue for the quarter. The legacy business sales were $280 million and significantly worse than the Q3 2011 revenue of $465. The growth was only possible with the acquisition. Total revenue increased 5%.

 TiO2 sales made up 57% of Q3 revenue compared to 86% one year ago. The diversification obviously improved sales. During 2012, both the minerals and pigment businesses are seeing declining volumes on market weakness in China, Europe, and North America. This may never correct in China as China is expected to be able to supply almost all of its TiO2 from internal sources. China may still need to buy feedstock. Europe and North America will not provide much of a market until the GDPs of both return to higher growth.

 During 2012, they cut pigment production volume in response to decreased sales from ongoing customer destocking and global economic concerns. Reduced capacity utilization increased the cost per unit and negatively impacted margins.

Gross for the third quarter and the nine months declined due to lower sales volumes of TiO2 and zircon, and third party purchases of ore. Gross margin declined due to higher input costs for TiO2 but adding back the step up charge for Exxaro inventory improves it from 4% to 21%.

E.I. duPont (NYSE: DD) as the largest TiO2 producer is a good indication of how the sector is affected. They fell short of analysts’ expectations and are responding quickly by cutting 1,500 jobs in an effort to offset underutilization. dPont reported net income of $10 million (1¢ per share earnings) compared with $452 million, or 48¢ per share Q3 2011. Excluding one-time items, earnings were 44¢ compared to 69¢ in 2011. Revenue from continuing operations totaled about $7.4 billion, down 9% from $8.1 billion. Share dropped nearly 10% in response. The CEO cited weak demand resulting in a return to overcapacity much the same as Tronox reported. The sector was hoping that market demand was going to continue to absorb capacity and support price increases. From record sales and volumes in Q3 2011, dupont saw an 18% decline in volume and 19% drop in sales in 2012. The recovery of 2011 is not sustainable and end users are still in the process of winding down overstock.

 Cash flow, debt, share repurchases and dividend

Free cash flow for the first nine months of 2012 is ($23) million with $68 million in cash flow from operations (CFFO) and $91 million spent on capex. There was no free cash to pay the $31 million in dividends and issuing debt helped finance the dividends and the share repurchases.

 

Two one-time items occurring in January 2011 complicate the 2011 cash flow. Backed out, cash flow from operations for 2011 is approximately $250 million. That would not include any Exxaro numbers. Free cash flow for 2011 is around $110 million and an improvement over 2008-2010. That has not held into 2012.

Cash flow from operations for the first nine months (includes Exxaro for 3 1/2 months) is only $68 million. With the short history of the merger, it’s not possible to anticipate normal cash flow levels for the combined companies. Tronox Limited is not insulated or diversified away from these cycles entirely as titanium feedstock depends on titanium dioxide sales and both are at the mercy of paint sales. The combined company free cash flow for nine months is ($23.2) million with capex at $91.2 million.

 Tronox bought shares at $26 even though by September they must have known an unprofitable, low margin Q3 with muted guidance would bring share prices down –- questionable motives and judgment. If the current downward cycling of TiO2 continues, share repurchases will be stopped and the dividend may be suspended. The special dividend was cancelled.

Total debt is $1,638 million and there are covenants governing dividend payments and the issuing of new debt. The dividend will not  be paid from issuing new debt as it was this year. The debt to capital ratio is 37% and while not dangerously high, there is little headroom for increasing that under current economic conditions. For nine months the interest coverage ratio was 28X, but will decrease as the interest on the new notes is annualized.

Tronox had negative operating income for the third quarter and is predicting Q4 will be more of the same. A dividend that can be cut will not put much of a floor under the current price of $15 and ongoing negative earnings and eroding cash flow may continue to pressure share price. The dividend is now $1.00 per annum with a 6.6% yield.

Guidance

Tronox ix expecting market conditions for TiO2 pigment in Q4 to be similar to Q3. If that’s the case, they will have negative earnings (-0.14¢ in Q3) and may turn operating cash flow negative if the results are worse than Q3. During the third quarter, average selling prices of TiO2 were approximately 6% lower than Q2. Given the softening of sales volumes in the pigment segment, they expect further price declines in the fourth quarter.

 The company anticipates sales volumes of its mineral sands (excluding Zircon)will remain steady and prices will be higher in Q4 2012 compared to 2011. Ore contracts have been subject to low locked in pricing and those unfavorable contracts began to expire in June.

 Valuation

Valuing Tronox is difficult with too little information and no data in the filings over numerous business cycles. There is not a long history available—it goes back to 2008. We can’t appreciate more than one cycle from the bottom in 2008 to the top in 2011. That history is peppered with adjustments and one-time charges/credits, an acquisition, and a change in year-end. There are also changes in the world of paint and coatings that are altering historical demand and we have no idea how much impact that will have. Then there is the seemingly endless gloomy macro-environment that cannot be completely quantified and whose end can’t be predicted.

 What is the market pricing in now? TiO2 growth mirrors GDP. If we take the average GDP to be 3% then we get a rough framework to build a growth model on. China and Asia/Pacific often have higher growth than 3% and Europe/North America can be in negative numbers. In addition there is the looming threat of paint polymer additives that are going to decrease the use of TiO2 by some of the biggest paint manufacturers.

 If we give the company 1% growth for 10 years and 0% terminal growth at an 11% discount, the value is $16. A catalyst considered by the model was the probable expansion of margins as the company sees better sales seasonally and the Exxaro acquisition increases margins as a source of lower cost feedstock. The mining operation itself has better margins and as it becomes a bigger percentage of annual revenue, will improve on the existing TiO2 margins.

 Free cash flow is not predictable or consistent and the next 2-3 quarters are at risk for negative cash flow as sales remain sluggish. The dividend will be at risk and the stock price may not have seen the bottom yet. There is no hurry to buy Tronox --  waiting and watching for three to six months may help clarify what Exxaro brings to the company as a buffer when titanium dioxide markets disappear. 

Comments from Sherwin-Williams and PPG Industries

Sherwin-Williams (NYSE: SHW) and PPG Industries (NYSE: PPG) both warn of slower paint/coating sales in the last quarter of 2012 to at least the first half of 2013. This is consistent with Tronox guidance. Asia/Pacific will be especially weak according to Sherwin Williams. Conditions in 2012 going into 2013 will not be a repeat of 2011. End users are using up inventory and will be buyers again, but even with destocking ending, restocking may be slow until Q2 and Q3 2013 when painting season commences. There is mention of decreasing the TiO2 used in paint-- PPG says it plans to cut TiO2 consumption by 4%-6%. Both companies anticipate stabilization and even decreases in the price of TiO2.

 Sherwin Williams

 Robert J. Wells - SVP, Corporate Communications and Public Affairs:

 What we mean by stability is that pricing is no longer – does not appear to be rising. We do not believe that the price increase announced by the industry affected in July was very successful. So, it appears that TiO2 pricing is stabilized.

Translation: TiO2 has no pricing power in the current environment and expect revenue and margins for Tronox to reflect that.

Robert J. Wells - SVP, Corporate Communications and Public Affairs

 Just as a reminder, Bob, the North American market consumes less than 25% of global supply of TiO2. So, we’ve got 75% – more than 75% of the global TiO2 market that’s struggling for volume even if North America is relatively strong.

Translation: International markets are weaker than North American markets and make up the biggest percentage of consumption. With the macro picture internationally and overseas even weaker than NA, expect global sales to suffer.

PPG Industries

David Begleiter - Deutsche Bank

Chuck, you discussed your efforts to reduce your usage of TiO2; I believe you had a 4% to 6% target for this year?

Charles E. Bunch - Chairman and CEO

 Yes and we are still on track through the first three quarters of this quarter we were tracking at a little over 3%. So we feel that for the full year we will be into certainly the 4% to 6% range, probably as we roll up all the numbers it will be kind of on the low end of that range or a little over 4%, but certainly within our target and we feel we still have opportunities as we go into 2013 and beyond to continue the more productive use of TiO2 in our formulation.

Translation: OMG! Dow was right—TiO2 can be reduced in paints and coatings and the new product formulation is comparable. The economics of changing the formulas are good enough to convince a major end-user (PPG) to start reformulating their paint. Evoque (the Dow polymer) can be used to reduce TiO2 content and still maintain hiding capacity. It can be used with the same concentration of TiO2 to create superior hiding ability.

With 2012 almost done and 2013 not looking much better, 2014 may be the year that ushers in recovery of the titanium dioxide market. When the cycle finally turns, Tronox is well placed to take advantage of the opportunity. 

 


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