When a Low P/E Shouldn’t be the Only Reason to Bet on a Stock
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Kronos Worldwide (NYSE: KRO) presents an interesting situation right now. Its stock is trading at a low single-digit P/E, but the situation in its key pigment market, titanium dioxide, isn’t really bright. And how Kronos fares operationally depends entirely on the TiO2 market. Its net income for the second quarter was around 28% down from the comparable period last year. The softness could continue for the rest of 2012. Here’s why…
- The impact of high ore (input) costs could be more pronounced in the second half of the year. That’s because most of the pigment sold during the first two quarters was made out of low-cost input bought last year. With the exhaustion of these, raw material supply contracts that are getting renewed now are high-priced ones, which will naturally hurt margins.
- Till some time back, TiO2 producers could easily get out of the high-cost-low-profit tangle by passing the buck to consumers – a trend that was at its peak last year. But tables turned after the fourth quarter when destocking slammed the brakes on the run. Volumes fell for all three major U.S. TiO2 producers, DuPont (NYSE: DD), Kronos, and Huntsman (NYSE: HUN), leaving prices alone for support. Obviously, such a situation where prices hold up revenue while volumes falter is unsustainable.
Though DuPont feels the destocking phase has already ended, I somehow agree with Huntsman on this point; management there feels the phase will continue for another quarter before it ends. Industry TiO2 inventory is still at high levels. The situation now is that although raw material suppliers will continue to charge more, TiO2 producers will have to think twice before increasing prices further as demand remains subdued and buyers resist price hikes. The last major price increase announced by producers was effective from April, and things have been quiet after that.
Kronos expects prices to be up in the next two quarters, but it might not be much. DuPont forecasts TiO2 prices to remain ‘flattish’ in the second half of the year, and Huntsman expects low prices and high costs to dent margins by around $350 per ton. Kronos sees its total cost per metric ton (for full 2012 TiO2 production) to be 50 to 60% higher from last year, which is big. Clearly, suppliers are at an advantage now, with pigment producers at the receiving end. Until demand truly picks up, margins will remain under pressure for Kronos and others.
- If rising costs weren’t enough, cheaper substitutes from China pose another challenge. Huntsman feels aggressive and competitive pricing by Chinese producers has cut into its market share. This concern looms large as chances of markets like Europe shifting preference to Chinese products going forward are high. In fact, China has also been most aggressive when it comes to expanding TiO2 production. TiO2 is still in oversupply in the Chinese market, and it might take some time for inventories to reach levels that support increased production. To top the threat from China, players like Dow Chemical (NYSE: DOW) are also researching and developing TiO2 alternatives. An example is its EVOQUE polymer technology launched last year that can reduce the amount of TiO2 used to make paints by 20%, while improving performance by providing more resistance to stains and corrosion. The polymer is reportedly gaining popularity among customers.
The biggest challenge for Kronos currently is how to strike a balance between costs and prices without hurting volumes. A P/E of 5.7 looks compelling, but a higher forward P/E (7.4) suggests the market is not expecting earnings to grow much in the next few quarters. My reasoning above explains why. A low P/E valuation is no guarantee that the stock cannot suffer anymore. So if an investor is expecting great top or bottom line growth in Kronos in the forthcoming quarters, it might be a little too early to do so. Not until volumes pick up and ore prices stabilize.
Yet, things will turn for the better some time, which makes Kronos the kind of stock you might want to keep on your watchlist to stay updated. Meanwhile, you can enjoy its handsome dividend yield (currently at 3.3%). Click here to add Kronos to your personalized stock watchlist.
Neha Chamaria has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.