Published on the Value Lab 26/8/22
We are learning more about Tronox (NYSE:TROX) and it appears very cheap at the moment. There are reinvestment economics to the business. There are tax assets that create a margin of safety around price. They are reducing cyclicality by offering contracts with margin stabilization to customers. Finally, their markets have offsets in an environment of general commodity decline and are highly advantaged where capacity in their industry has been underinvested. Their scale will grow with their new mine coming online and providing more high grade zircon especially, which has seen meaningful volume decline, and despite substantial APAC exposure, we are still not seeing meaningful hits from end-markets on their results. Also, they are a bet on continued geopolitical tensions due to their access to titanium feedstocks.
Before we discuss the points to the thesis, a primer on what Tronox does. They are vertically integrated and own mines of mineral sands that produce zircon (typically considered a byproduct but with value in ceramics and tiles important for APAC exposure but also gets used in specialty chemicals) and also all the elements that form feedstock for titanium. These are acquired from a separation process of elements mined from mineral sands deposits. Ilmenite is a well known one, and these titanium feedstocks are put through slaggers and through other processes to get titanium dioxide for paints and coatings. They happen to have an option on a slagger operation in Saudi Arabia as well as capacity already owned by them. These feedstocks can also be used to make titanium sponge which are used in defense and aerospace but this is not Tronox's business.
TiO2 and zircon have a pretty decent exposure in the housing market. 35% of Tronox's exposure of zircon in China is for ceramics which is driven primarily by housing markets. But coatings and paints in general have plenty of housing exposure, but also industrial and chemical industry applications.
There are so many moving parts that investors should take into account from the Q2 that we will do a list of all the things supporting the business in contrast to their EV/EBITDA multiple of about 3.5x, indicating a very late-cycle situation:
Below is the valuation also including the tax asset. We have assumed no incremental cost savings despite all our arguments above. Therefore we annualize current EBITDAs despite mid single-digit growth being guided for.
The multiple is 3.5x which is very low considering the advantages that TROX has and the continued resilience in its markets so far, despite getting about 33% of its revenue from a presumably beleaguered market, and volumes being decimated in zircon. Below that is a target multiple analysis which uses DCF logic to impute a reasonable multiple to a business that has the inputs we showed. Highlighted in orange is the ROIC figure, which we averaged up based on the 50% IRR on the project expected over the next 5 years, where the payback period is only 3 years or so. Using 10% of the asset base for the new mine as a weight we get a 13% ROIC which is really high. A fair multiple for a business with the reinvestment economics above could be around 15x, which is about a fivefold increase in the current multiple, and a much bigger increase in equity values because of the leverage effect. 5 years was the growth appreciation period on the basis that competing mines would take several years to develop from scratch, and the industry is underinvested.
The upside here is pretty substantial in our opinion. The assets are strategic and advantaged where competitors' aren't, and therefore prices must stay high to the benefit of TROX which controls its main inputs. The resilience so far evident despite broader slowdowns in commodities. The tax assets provide a meaningful non-operating margin of safety. The debt level is low relative to EBITDA. They also benefit fundamentally on the back of the geopolitical conditions based on the Ukraine war, which is only worsening as the conflict escalates with assassinations of Russian high-ranking officials. That war won't end anytime soon and Putin still holds the very powerful energy card.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in TROX over the next 72 hours. 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.