Kronos (KRO)

Background:

A lot has been written about titanium dioxide (TiO2)and the run up in prices. High cost suppliers shut down production during the depths of the financial crisis and Tronox went bankrupt. Once the dust settled, prices skyrocketed and now it seems as though there are monthly TiO2 price increases. Dupont, Cristal, Kronos, Tronox, and Rockwood are enjoying massive profits on limited supply and typical demand.

I have reviewed several TiO2 companies and believe that Kronos represents the best opportunity right now. They are one of the few pure plays to TiO2 and have been unduly punished due to the European Crisis. On top of that management thinks like owners.

Business:

Kronos has six TiO2 plants and a total capacity of 533,000 tons/years split 75:25 between chloride and sulfate routes. Two of their plants are in North America and the others are in Europe. They also own and operate an ilemnite (raw material for sulfate TiO2 production) mine in Norway, supplying 10% of the worlds supply of ilmenite (and all of the their sulfate European production).

Management:

Harold Simmons is the Chairman of the Board. Mr. Simmons is a simple man, he loves TiO2 and hates President Obama.

Regardless of his political tendencies, he has been buying shares just about as quickly as he has been donating to conservative Super PACs. If that's not conviction I don't know what is. Directly and indirectly he owns about 95 million shares of Kronos.

Unlike his LBO days, he left Kronos relatively unleveraged ($481.5M in total debt). His conviction, track record in business, and insider buying are a moderately positive sign for the individual investor. There do seem to be multiple related party transactions. I can't say Simmons gets me excited as a leader but his influence hopefully is waning.  

CEO, Steven Watson, has been buying shares often in the open market and owns over 128,000 shares. Mr. Watson was made CEO in 2009 right around the time Tronox went bankrupt. He was with the company "during the last big upsurge" (Q4 2010 conference call) and seems to understand the perils of too much capacity. The scars from the 1990's have clearly impacted Mr. Watson.

Each swoon that beats the stock down results in another round of insider buying. While insider buys are not something to rely on, I think they are a positive sign.

Favorable Economics

Much has been written about TiO2 and how the prices will just keep going up. I have no idea if prices will keep going up. I can make a couple of reasonable assumptions that indicate Kronos will remain an attractive investment for several years.

1. There's almost no real TiO2 capacity coming online. No good ones anyways. Supposedly there are plants coming online in China, I put that in the "I'll believe it when I see it" category. Regardless, there is plenty of technical knowledge involved with TiO2 production, something the Chinese recognize. The incremental improvement by first tier firms will likely only keep up with the expected increase in demand and not surpass it.

There have been no green field announcements and these plants take about four years to build according to Kronos(Q4 2010 Conference Call). Those that choose to invest will need to be sure that they can get adequate returns. Kronos has stated multiple times that a new 150,000 tpa chloride plant will cost upwards of $1B. An investment that takes four years to build will need assurance that pricing will remain strong.

Some estimate that TiO2 demand will reach 6-7.5 million tons per year. The upper range will only occur if all plants come online(expected by 2015 at the earliest). I'd say those estimates are a little aggressive as current worldwide demand stands at roughly 5 million tons per year. I would imagine TiO2 demand would track global GDP growth. If all that capacity comes online and works as expected it may result in lower TiO2 prices.

The take home point here is: capacity will not just pop up overnight. The capacity that is coming is several years away, so I believe pricing for TiO2 will remain strong for at least a couple of years.

2. Feedstock capacity is easy to bring online. Kronos has said so themselves on multiple occasions and it makes sense. Titanium and iron are everywhere, you just need capital to mine it.

Steve Watson talked about feedstock constraints in 1H 2012. This was expected to ease in the second half of 2012. No matter what feedstock ends up costing it doesn't matter, there's no capacity leftover in pigment production and thus far pricing increases have been passed on with ease.

There is feedstock production coming online and a lot of capacity can be brought on quickly. Mines in Madagascar, Mozambique, and other countries are expected to start producing ilmenite in excess of pigment capacity, depending on demand projections. Ilmenite is used in the sulfate production method and thus lower quality and doesn't have the same pricing power as rutile.

As reference, if TiO2 demand hits 6.2 million tons per year feedstock demand will need to be around 7.3 million tonnes per year (Arkitol).

3. The last titanium dioxide cycle was long. Peaking in the early 1990's it destroyed pigment manufacturers until plants were closed permanently. The reason it's such a long cycle is simple, plants take time to build and only a few players have the technical knowledge. Most of the plants that are being built now, whether in China or elsewhere, will take several years to build.

In the late 1980's (the last cycle peak for TiO2) gross profit margins hit 50% and EBITDA margins were in the 45% range (Q4 2010 KRO Earnings Call). I think this is a good proxy for what levels would have to hit before new plant expansion happens. Currently KRO has gross margins of 61.4% (1,194M gross profit in 2011) and EBITDA margins of 30.8% (600M in 2011). 

What's it going to earn and why is it so cheap?

I lack the ability to know exactly what TiO2 pricing is going to be but let's take a base case scenario.

In Q1 2012 the company generated $561M in revenue COGS were $299.8. There have been two price increases that will raise prices by ~10%. If no other price increases occur revenue will be ($561*1.1) times 3 quarters plus $561 for Q1 2012 revenue. Revenue for 2012 will be $2.412B.

Per Kronos conference calls, COGS will rise by 50-60%. If that's the case then COGS will be ($299.8M*160%)* 3 quarters (9 months left in 2012) plus Q1 2012 COGS of $299.8M. COGS for 2012 will be around $1.738B.

Our base case gets us gross profit of $674M. This trickles down to roughly $317M in net income ($195M for SG&A and $25M for interest and $137M for taxes at 30% ). Let's call it $300M because it will take a couple of months for those price increases to hit and SG&A will probably go up. With 115.9 shares outstanding that's EPS of $2.58. With the share price hovering around $16, plus or minus a lot depending on Spain's weekly bond auction/bailout, that puts it 6.2X earnings.

I think that's a little pessimistic though. While a meteoric rise in prices like 2011 is unlikely (40% YoY increases) I feel confident that 1. feedstock costs will moderate and 2. TiO2 prices will increase. How much I don't know.

The central thesis for me here though is that if ore prices go through the roof and pigment pricing stays the same we're looking at a company that still has a good shareholder return. Even if prices decrease and feedstock prices stay elevated you still will get a good return.

For what it's worth, I think that Kronos will generate around $3-4/share in earnings for 2012.  I used 60% ore increases and TiO2 price increases of 10-20% (~11% has already occurred this year at Kronos, Cristal looks like their are leading the industry with more increases, there are some reports that Western European pricing is softening though). Finally I ramped up SG&A $5M and backed out $25M in interest expense.

So I believe I'm buying a business for 5-6X earnings. Some of these estimates are based on talks with contacts in the paint and chemical industry, some are just plain old estimates.

My final point for how cheap it is focuses on replacement cost. Steve Watson has said a couple of times that it would cost around $1B to build a 150,000 tpa chloride plant. Kronos has 400,000 tons of chloride production. The replacement costs of their chloride plants is $2.6B. This makes no allocation for their sulfate production or mine in Norway. All this for a company that can be bought for $1.8B plus some debt.

Depending on the scenario you believe will occur, Kronos is kinda cheap, or stupid cheap. The question is, why?

I think most investors are concerned with the recent bankruptcies, plant closures, and Europe. The bankruptcy concern is dumb because Tronox went bankrupt for legacy environmental issues (which were made impossible to overcome by crappy TiO2 economics). Baupost owns Tronox now so I feel their chance of going back into bankruptcy is slim.

Plant closures happened to the higher cost providers, Kronos has new plants and vertical integration that may help slightly. I didn't factor this is because mining revenues are only a couple of percent of their revenue at best. Also ilmenite pricing hasn't been as strong as rutile and probably will only get weaker as new capacity comes online.

It really seems to trade with Europe though. Oh no Spain needs a bailout?! Sell KRO!!

Yes, a significant amount of their plants are in Europe but they have two large plants in North America and their product could easily get shipped elsewhere. I believe that European fears are unfounded for a commodity like TiO2 and that demand may weaken slightly but will not crater. One cannot just stop using TiO2 (Everybody loves off-colored clear plastic). Short interest is pretty high for this name, at 5.05 days to cover. I wasn't able to find any solid short thesis on Kronos but I would love to see one. This will be an important discovery for the thesis.

I will admit I don't like some of their inter-party transactions. They are not large enough to worry me for now, but I will keep an eye on them. Hopefully Watson continues to plow ahead and run a profitable business leaving Simmons to attend Tea Party rallies.  

Conclusion:

I have spent quite a bit of time looking at this, I originally started researching the different TiO2 players around November. To me the thesis is simple: demand is going to remain relatively stable and there is almost no significant capacity coming online for the next 3+ years. In the meantime the earnings power of these businesses will keep rising. Is this a hold for 10 years? Probably not.

I doubt demand for TiO2 will fall off a cliff but the strength of Kronos' balance sheet and high quality plants lets me sleep at night. This thesis does depend on TiO2 pricing staying constant and perhaps increasing slightly.

Kronos offers a compelling risk/reward due to solid insider management, a supply/demand imbalance and powerful profit generator for several years. It will be crucial to monitor new plants and capital expansions. As with everything, if Europe really goes to hell in a hand basket this bet would probably tank as well. Long KRO

Update 7/10/2012

Iluka had a conference call yesterday saying they were revising down production targets.


"We think, for example, chloride pigment producers, who are clearly important  to us, have reduced their production by somewhere around 25% in the US and in Europe, and their forecast production
similarly, obviously.
Sulphate pigment production is also down, although we think by not as much as margins are
actually better in that segment versus chloride." David Robb Managing Director

So if Kronos lowered production by 25% in the 2nd half they should produce around 200,000 tons this year (I've ignored whether or not it's Cl2 or sulphate for simplicity). Iluka's conference call seemed to believe that it was more inventory control. So it could be a small cyclical downswing or a canary in the coal mine. We'll see.

Dupont and Tronox came out today swinging saying that Iluka's comments weren't indicative of their business and this is an over reaction. Dupont believes 2H 2012 pigment demand to be strong. So who knows, conflicting news in some ways but in other ways it supports my thesis. I believe the most prudent decision is to simply sit and wait for earnings.