Last month, the U.S. Bankruptcy Court for the Southern District of New York issued an unfavorable ruling against Anadarko Petroleum Corporation (APC) regarding Tronox Inc (TROX) litigation (United States Bankruptcy Court, Southern District of New York Case No. 09-10156). The lawsuit is an attempt to extract money from Anadarko to pay for tort and environmental cleanup claims, and most of the analysis on this decision pertains to how it impacts Anadarko. But for Tronox, it was a favorable ruling which has received very little, if any, analysis. So let's look at how this ruling affects Tronox.
On December 12, the bankruptcy judge, Judge Allan A. Gropper, issued a 166 page "Memorandum of Opinion, After Trial" in which he suggested that Anadarko (by virtue of its acquisition of Kerr-McGee) is liable for between $5 billion and $14.459 billion for its fraudulent transfer in the 2006 transaction in which it acquired Kerr-McGee. The parties are still arguing and will continue to do so for a while. We cannot opine on where things will be when the dust settles but we wanted to provide some insight into what any amount of settlement means to Tronox.
To put some flesh on the bones, let's look at the current numbers involved in this dispute. The initial settlement/judgment range was established by the US Government (as Plaintiff-Intervenor, who originally sought about $25 billion) and Anadarko (as Defendant, who initially maintained its' innocence and said the correct number was $0). We believe that Judge Gropper mentioned a range of $5 billion to $14.459 billion as a way of telling the parties to evacuate their respective extremes and meet somewhere in the "middle", which he suggested as $5 billion to $14.459 billion. On January 13, 2014, Anadarko came off their "entirely innocent" position and countered with a range of $850 million to $1.75 billion - still a far cry from what the US Government was seeking and below the $5 billion "low end" mentioned by Judge Gropper. The ending figure may well be $0 but for our hypothetical purposes, let's assume a $5 billion settlement/judgment.
Tronox investors need to know that the beneficiaries of any $5 billion settlement/judgment are six grantor trusts (Tronox Tort Trust, Cimarron Trust, Multistate Trust, Nevada Trust, Savannah Trust, and West Chicago Trust), and that Tronox is the grantor of each trust. Tronox created these grantor trusts while still in bankruptcy and transferred the legacy environmental liabilities (which sent it to bankruptcy in the first place) into those grantor trusts. This is critically important because, as grantor, Tronox gets to consolidate its US tax returns with the tax returns of its grantor trusts.
Per Tronox, the receipt of any settlement/judgment money by the grantor trusts is not considered income to Tronox. However, as the grantor trusts expend the settlement/judgment money, Tronox will consolidate its tax returns with the grantor trusts' tax returns. So a hypothetical $5 billion settlement/judgment results in no income at the Tronox accounting level but as it is expended by the grantor trusts, it creates a hypothetical $5 billion in collective losses at the grantor trust level, which, when consolidated with Tronox's US tax return, offsets $5 billion in Tronox's taxable US income. Assuming a 35% corporate tax rate for Tronox, the hypothetical $5 billion settlement/judgment shields $1.75 billion in US taxes for Tronox.
Now the six grantor trusts' losses are not incurred all in one year or at one time, but are spread over a number of years so the net present value of a hypothetical $5 billion settlement/judgment today is something less than $1.75 billion mentioned above. To figure out the net present value, we have made the following assumptions:
- 12% of any settlement/judgment is expended in year one. This is the amount of the settlement/judgment which goes to the Tronox Tort Trust. So we assume that these monies are paid out as soon as administratively possible and results in a loss to offset some or all of Tronox's taxable US income in year 1.
- 88% of any settlement/judgment goes to the other five grantor trusts and is expended over a 14-year period in years 2 through 15.
- 35% corporate tax rate
- 10% discount rate for the cash flow stream, given the certainty of the presence of the money (due to the settlement) and the certainty of the expenditure (given the environmental cleanup required).
Using these assumptions, the net present value (NYSE:NPV) of a hypothetical $5 billion settlement/judgment is $1.05 billion (or $9.30/share assuming 113 million Tronox shares).
Because the legal fight between Tronox and Anadarko has been public information for a number of years, it is entirely reasonable, and most probable, that some of that hypothetical $9.30/share NPV was already baked into Tronox's stock price before Judge Gropper's December 12 Memorandum of Opinion. How much? We don't know, but let's assume $1 for sake of showing the math. If so, the 12/12/13 closing price was $21.17 which represented $20.17 for the core Tronox business and $1 for the tax assets we are discussing. But if the hypothetical tax asset has a $9.30 NPV then Tronox's stock should trade closer to $29.47/share so that the core business ($20.17/share) and the tax assets ($9.30/share) are properly reflected in Tronox's stock price.
Reasonable persons can disagree on how much of the settlement was already baked into the 12/12/13 price, what the actual amount of the settlement will be, and how those monies will be expended over time. But using various ranges of assumptions on each of these variable results in a range of NPVs of the tax assets between $1.86 and $27.89 per share. Combined with the 12/12/13 TROX closing price, the math reveals various possible target prices using various assumptions. Take your pick of assumptions.
One final way that any settlement/judgment could affect Tronox is that a hypothetical $5 billion settlement/judgment could put Tronox into play. For instance, a hypothetical $5 billion settlement/judgment using the grantor trust mechanics is the equivalent of a $5 billion planned NOL - an NOL that has yet to be created. A potential suitor/acquirer with considerable taxable US income (especially a private buyer whose shareholder base is stable) could, by acquiring Tronox, replace Tronox as the grantor of the trusts, sell off any operating assets it would rather not own, consolidate taxes with the grantor trusts as the losses are incurred, and get the benefits of the hypothetical $5 billion tax shield over time without the change of control limitations imposed by Section 382 of the tax code - a perfect tax shield.
In conclusion, there are many moving pieces to this Anadarko/Tronox puzzle. We do not know where or when it will shake out but our bet is that it will get settled within 2014, as it creates an enormous overhang on Anadarko's stock until settled. The final settlement/judgment figure may be $0, but if the settlement/judgment is anywhere near the range mentioned by the bankruptcy judge, Tronox shareholders need to understand how Tronox and its shareholders will be the indirect beneficiary via the grantor trust mechanics.
Disclosure: I am long TROX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have no plans to sell the position within the next 72 hours.