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Ugly Yet Undervalued

|Includes: APC, Tronox Inc. (TROX)

Tronox (NYSE:TROX) produces titanium ore and titanium dioxide (TiO2). Following their acquisition of Exxaro Mineral Sands in 2012, they are the largest fully integrated producer of TiO2. This allows them to produce all of their own feedstock, theoretically providing a cost advantage for the company. The Exxaro Mineral Sands assets also make them the third largest titanium feedstock producer, and the second largest producer of Zircon. Tronox specifically focuses on chloride TiO2, which is a higher quality form, to produce a white pigment mainly used for paints and plastics. Currently, there are no exact substitutes for chloride TiO2.

Tronox was owned by Kerr-McGee prior to their IPO in 2005. The IPO was set up as an A share to generate proceeds for Kerr-McGee, and they later distributed the B shares in a spin off. Kerr-McGee was later acquired by Anadarko (NYSE:APC) in 2006. Kerr-McGee saddled Tronox with massive debts and environmental liabilities, which forced Tronox's price to decline significantly, and in 2008, the stock was moved from the NYSE to OTC. Then in 2009, Tronox filed for Chapter 11 bankruptcy. Tronox was able to settle all of these environmental liabilities through bankruptcy to start with a clean slate, and they emerged in 2011. Following the acquisition of Exxaro Mineral Sands in 2012, they once again had two classes of stock, A and B, as Exxaro Resources owns the B shares. Tronox then listed their A shares on the NYSE in June of 2012. As you can imagine, this whirlwind of instability has made Tronox an incredibly complex business to analyze. And currently there's no way around it, Tronox looks ugly. There's very little financial statement history, the stock has had negative earnings and cash flow, its in an incredibly cyclical and commoditized industry, and very few sell-side analysts follow it. But those are the exact reasons the stock seems to remain undervalued.

First and foremost, owner-operators are key for me. Great owner-operators are the ultimate risk-mitigator, as they allow for more leniency in mistakes when estimating the intrinsic value. Great owner-operators also make moves that unexpectedly enhance the intrinsic value of a company ex-post original analysis. With that in mind, Tom Casey (the CEO since 2012 and Chairman of the Board since 2011), in my opinion, has been fantastic. He has initiated a dividend that equates to a current yield on the stock of about 5%, he bought back shares below book value, the acquisition of Exxaro Mineral Sands thus far looks brilliant, and he has been incredibly forthcoming with information for the future of the company. Casey has been impressive thus far, as he seems to have a keen eye toward creating shareholder value.

The past cash flows of the company are not a good representation of the future cash flows. After fully working out past litigation issues, acquisition costs, and legacy contracts, the company's operating leverage should be a fantastic asset. To be sure, I expect the company to generate negative cash flow through 2014 and continue losing GAAP earnings through 2015. However, as past costs work themselves out and future pricing simply increases at incremental historical rates, that leverage should begin to generate great cash flow margins.

In my model, I don't expect a price increase until 2015, and I simply assume an increase of 2% at that time. Historically, TiO2 pricing has tracked inflation almost perfectly (over long stretches, it is fairly volatile over short periods of time). Indeed, the price of TiO2 in real terms is virtually the exact same today as it was in 1950. So a 2-3% pricing increase over the long term seems realistic. Further, I assume zero extra demand until 2016. From there, I estimate production (i.e. demand) to increase at a 1.81% per year clip, which is also what the TiO2 market has experienced since 1950. I also expect costs to increase beyond what management has eluded to.

I don't expect any further shareholder enhancing moves, e.g. share buybacks or dividend increases. These conservative estimates should leave plenty of room for error and hopefully net upside surprises.

I forecasted operating cash flows stagnating around $200 million until 2016, when I then forecast a jump to about $450 million, largely due to seeing their first positive year of earnings, which in turn is due to the finishing of development costs going into their Fairbreeze mine. Then there's simply incremental increases in revenues (less than 5%) up until they reach full capacity in 2021. However, income and operating cash flows do increase much faster due to the absorption of fixed costs. Further, post the development of Fairbreeze, capital expenditures are assumed to only be about 9% of sales, which will help generate the first healthy year of free cash flow in 2016 (~ 11% free cash margin). Then using discounted cash flows, with a 12% cost of equity, we get to a valuation of about $30. If we give this a "10% window" for the value, the shares would have an intrinsic value of somewhere between $27 and $33.

However, the risks abound with Tronox. Although I have been impressed with Tom Casey, he is still unproven and has no observable track record. If he pursues destructive growth at the expense of higher capital expenditures, intrinsic value could quickly diminish. There is also no real track record of success at the corporate level for Tronox; the company was under duress almost immediately after its IPO, and then its been in bankruptcy. So any estimates about costs are difficult to be firmly confident in. Third, Tronox is in an incredibly cyclical and commoditized industry, and TiO2 could remain under pressure for longer, and/or deeper, than expected. Finally, there is no true substitute for chloride TiO2 today, but if one is developed or demand for chloride TiO2 changes dramatically, this would be detrimental to the long term value of Tronox. But with an improving housing and autos market, a work-down of inventory, and great management, there seems to be a lot of hidden value.

The forecasts can be found here.

Disclosure: I am long TROX.