Tronox Has Reducing Cyclicality, Pricing Backstops, Reinvestment Economics And Tax Assets

Summary

• Margin stability agreements coming further into force helping reduce cyclicality, and competitors are getting hamstrung by higher input costs as less ilmenite enters the market from iron ore.
• Moreover, prices continue to rise for zircon and titanium oxide in their markets, indicating that their use cases in things like housing are not slowing down yet.
• The APAC exposures seem to not be forming a problem, and the company is guiding for improved pricing in Q3 to drive continued sequential net income growth.
• Investments in lower-cost replacement mineral sand mines look very promising and show an important reinvestment sink for the company that should justify higher multiples.
• Zircon volume recovery should create more scale and reduce costs on top of newTRON.
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RHJ

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.

Quick Primer

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.

All the Mitigating Factors to Softening Macro

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:

• They have lost scale temporarily because they liquidated spare zircon inventories in 2021 to keep up sales. Volumes declined 38% YoY because of the extraordinary contribution of those inventories to sales last year. Price also went up 47% which did offset revenue declines to being only 8% YoY, and 5% decline sequentially. New major mines are coming online towards the end of the year that will restore zircon volumes and therefore fixed cost absorption. Unit margins will improve at that point.

Timelines on Mines (Q2 2022 Pres)

• The new mining project will take about $175 million in CAPEX in 2022 and be replacing waning capacity in the Snapper and Gingko mines. The grade of zircon will be higher in this new mine, and its costs should be lower. As this mine takes over (in late 2022) for the older ones and frictions in passing the baton disappear, we should see operational improvements that lead to margin expansion. The CAPEX burden imposed here is more than half of the typical annual CAPEX. It will be about 7% of the company's PPE after one year of investment. There shouldn't be any extraordinary CAPEX beyond this for the Atlas Campaspe mine for at least a while where it guarantees the feedstock need for at least 10 more years. With the company operating at maintenance CAPEX prior to this, around 10% of the fixed assets can be said to be of this latest project, and the IRR's are expected to be about 50% over a 5 year period of active development. Their mining assets that assure their procurement are evidently an excellent sink for reinvested income.
• NewTRON continues to be a CAPEX sink to provide $200 or so in per unit cost increases, which is about a 20-25% in per unit cost declines. Currently the contribution annually was $20 million in procurement savings Which is about 2% of EBITDA annually, but these are expected to grow about tenfold. They make incremental improvement yearly, so this will protect margins.
• The slowdown in commodities has some benefits to TROX's market. Ilmenite is a byproduct of iron ore mining. With a current gully in iron and steel markets, ilmenite from that avenue is not entering the market. As a key feedstock, this is raising industry TiO2 prices. Since TROX is vertically integrated for 85% of its feedstock, it lets them reap the benefits of increased pricing that competitors need to do to stay profitable, where their own costs are meaningfully controlled. Moreover, the mineral sands deposits are underinvested in terms of mining, and giants like Rio Tinto (RIO) have spoken to that. So the commodity decline has some mitigating factors for them.
• The current evolution in costs is being driven by a concert of input inflation growth. Things like sulfur dioxide and other chemicals are already coming down in price as the macro environment softens. The only thing that is still very expensive is energy prices including utilities, natural gas and oil. These together account for about 10% of the company's OPEX, and this part is going to be evidently more durable, and we estimate it at about a $300 million annual additional headwind, so about 75% of the overall headwind in production costs. These could come down as well if run-cuts at refineries due to lower product spreads, where product spreads are already lowering in the chemical space, also lead to declines in crude and natural gas. However, the geopolitical situation and speculation also plays a large role in the levels of those commodities.

Cost Developments (Quarter) (Q2 2022 Pres)

• Q4 is historically weak, but the company is actually guiding to sequential increases in EBITDA. EBITDA has a delta of 15% YoY as of Q2, and this is from cost savings but also pricing increases. Volumes declined (mix actually didn't deteriorate). The EBITDA forecast is around $285 million. There is the expectation that in 2023 there will be some more declines, but inventories are low and TROX is not able to fill orders, especially on zircon. Pricing also remains favorable, thanks also to competitors inability to compete with TROX's low cost assets.
• Titanium is probably one of the most strategically important resources right now due to its use in aerospace and the existence of quite large reserves in Russia which produces 20% of global supply. Defense companies are already having trouble procuring it, and it was a hoarded object closely following the invasion of Ukraine. TROX is 85% vertically integrated to it while competitors aren't. Imagine the advantage there. Prices for TiO2 could stay high just on the basis of competitors cost-plussing despite the state of their end-markets like housing.
• Housing is a bit of a weak spot in terms of end-markets, but there hasn't been much softening except for in China, where they are also exporting excess product now due to the situation in their own housing markets. Moreover, paints are used in the finishing stages of inventory. There was massive bloat of incomplete housing inventory only 4 months ago, and this provides a demand sink for things like ceramics and paints which support the 2:7 zircon:TiO2 split in the TROX revenue. Moreover, the company confirms that pricing has already improved into the Q3.
• Analysts noted that the TROX pricing has been behind the industry, but this is because TROX is making use of margin stabilization contracts with customers to create more long-term certainty for their customers and to reduce their own cyclicality. The lagging in pricing is the cost of lessened cyclicality.
• Finally, the company benefits from tax assets. $70 million in cash benefits were received in 2021, and $120 million are expected in 2022. The total benefit is around $1.2 billion over the next 15-20 years. Supposing the 2023 $120 million benefit is the run-rate, it will exhaust the total benefit in 10 years. Discounting that at a standard 5.5% discount rate gives a pretty substantial tax asset that we will show in the valuation.
• They have the option to buy the slagger in Jazan that take their input and produce what is needed for TiO2. For now it is a useful task asset that provides the company optionality and the ability to offer a sink for working capital investments and keep up with as much demand as possible, even though there's an excess of it. The facility is also still in ramp-up, operating about at halfway capacity. It's great that they have this lever to pull as well as part of their sink for reinvestment, but here in working capital that can be quickly liquidated into a very strong market.

Valuation

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.

Valuation (VTS)

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.

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.