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When Dirt-Cheap Valuations Do Not Mean a Buy

Neha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If anyone tells you about a stock that’s trading at a paltry 5 times earnings and is within 20% of its 52-week low, you’d probably jump at the opportunity. I would have done the same, if the industry in which Kronos Worldwide (NYSE: KRO) operates wasn’t so unpredictable.

I think it’s prudent for an investor to get a grip on what’s going on around a company before getting swayed by cheap valuations. I am not tagging Kronos a loser. Only, present situations don’t excite me, and peers seem to be better positioned anyway.

Here’s a quick lowdown on Kronos’ third quarter-

  • Sales slipped 14% and gross and net profits tanked 59% each from the year-ago period.
  • Titanium dioxide (TiO2) volumes were down 15% from last year. Production was down 27%. Facilities operated at only 71% capacity.
  • TiO2 prices were 7% lower sequentially.

That’s about it -- key takeaways that present a truly dismal picture of the company. I frankly can’t be a buyer with such numbers, but no, it isn’t just this quarter that’s making me wary of Kronos.  There are a string of factors at play.

Detangling the Mess

2011 was a dream year for TiO2 producers as rapid price hikes helped them offset costs and boost top lines and margins. In its latest industry report, consulting company TZ Minerals International crowned 2011 as the strongest year for the TiO2 pigment industry ‘in two decades.’

Fast forward to 2012, and things are different. As troubles surfaced in Europe and China put the lid on the housing boom late last year, customers who bought large stocks of TiO2 in advance suddenly found themselves stuck with full warehouses but no takers. Destocking followed, which hasn’t stopped since.

No Respite

None of the pigment producers thought it would last so long. Ironically, the world’s largest TiO2 producer DuPont (NYSE: DD) was more optimistic than anyone else when it predicted the destocking phase to have already ended by the second quarter this year. The forecast fell on its face.

Ask pigment producers what their outlook is, and all they can do is take cues from what customers (paint companies) say, who I feel aren’t too sure about where it’s all headed to either. Top paint retailer Sherwin-Williams (NYSE: SHW) thinks a 10% year-to-date drop in TiO2 spot prices isn’t enough, and sluggish demand coupled with high inventory should pull down pigment prices further. This factor had a part to play in the company’s improved full-year earnings guidance.

Uncertainty is justified considering that sales for paint companies hang on the vagaries of consumer buying behavior and the shape of housing and construction markets. As the U.S. housing markets recover, emerging economies need to show strength as well. End markets won’t be at their best so soon. Worse, there’s a bigger tension brewing underneath.

Looming Concerns

Following months of cost pressures, paint makers have started a silent war against high-grade TiO2 by switching to substitute products. Valspar has trimmed its TiO2 usage this year by ‘mid-single-digit’ percentages, opting for cheaper from-China sulphate-based TiO2. Sherwin is weighing similar options, having already introduced sulphide-grade TiO2 in its factories in Latin America. PPG is one notch higher, not just targeting 4% to 6% lower TiO2 usage this year but even considering manufacturing the pigment. If that sounds whimsical, PPG ran its own TiO2 manufacturing facility till 1971, when, according to a Chemical & Engineering News archive, it was wound up because of unfavorable market conditions. 

TZMI considers China, the largest producer and exporter of the pigment, to be a major threat going forward. What works is that at least 10 of the top 20 ‘lowest-cost’ TiO2 plants are located in China according to the TZMI report, which explains the flurry of cheap products. TZMI projections don’t leave much for U.S. producers to cheer about. Demand from China could gain 10% to hit 35% by the end of the decade, while that from developed economies fall by 7 percentage points to 33%. And China should be able to meet domestic demand on its own.

Interestingly, competition’s building up at home as well. Not many know how Dow Chemical is spending money on developing TiO2 alternatives. Its EVOQUE polymer technology launched last year reduces the amount of TiO2 needed for paints by 20% while improving resistance. Dow says ‘customers are lining up’ for EVOQUE, encouraging it to plan a world-wide roll out of the premium paint. Like it or not, threats are big.

It Hurts…

The core problem of TiO2 companies -- feedstock costs – is murky. With a handful of companies ruling the feedstock world, short supply is a perennial fear. TiO2 producers got a taste of it last year when costs zoomed. But even as demand for TiO2 softened over the past few quarters, input prices remained firm. Kronos’ TiO2 division profits slumped to $42 million in its third quarter from $159.2 million a year ago, while Tronox’s (NYSE: TROX) pigment division swung to a loss of $13.2 million in this past quarter from a profit of $111.6 million last year. DuPont’s performance chemicals segment reported a 37% decline in operating profits, and Huntsman’s (NYSE: HUN) pigment segment sales and operating profits slipped 30% and 50%, respectively, in its third quarter.

Each company hopes the market will bottom out in the first half of 2013. Add these clauses: If Europe bounces back, U.S. housing takes off full speed, and China boosts infrastructure spending. And when eventually demand gathers steam, do you think feedstock prices will soften? I don’t see why they should. Further, new feedstock suppliers, even if small, won’t be up and running before mid-decade, which means supply of high-grade feedstock will be limited. In short, Kronos and others won’t have peace so soon.

Trailing Behind

Only, Kronos might be the biggest victim of the wild swings in TiO2 prices and demand, simply because that’s the only product it thrives on. DuPont is a highly diversified company generating one-third revenue from a lucrative businesse like agriculture. Huntsman has a profitable-even-during-downturn polyurethanes business to hang on to, and its CEO’s recent words still ring loud in my ears – “I expect that our other divisions' earnings will improve, over time, as we become less dependent on our TiO2 earnings as a percentage of our overall business.”

As for Tronox, its product portfolio is one of the most interesting ones – Tronox makes TiO2 as well as its feedstock, both high grade and low grade. Very soon, the company will start generating 100% of required titanium feedstock internally, and even have surplus to sell. As the world’s third-largest titanium feedstock producer, Tronox is certainly the advantaged one in the industry.

Foolish Takeaway

TZMI feels the 2011 euphoria will never return. I won’t expect starry numbers from Kronos at least for the next couple of quarters, which is why its low stock prices don’t excite me. A forward P/E double its trailing further indicates the massive fall in earnings markets are expecting in the near future.

Only one reason could encourage me to have Kronos Worldwide in my portfolio – solid dividend yield of 4.2%. If that satisfies you, go for Kronos and add it to your stock watchlist by clicking here. I am going to give peers a second look. 

Neha Chamaria has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Sherwin-Williams. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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