Michael Boyd Nov 2, 2016

Tronox (NYSE:TROX) is a leader in the production and sale of titanium-bearing mineral sands and titanium dioxide pigment, along with being the world’s largest producer of soda ash. From a broad high-level view, titanium oxide is used in the production of a variety of everyday applications to bring brightness and additional durability (paints, coatings, etc.).

Natural soda ash is produced from a mineral called trona, a mineral that is the number one export of Wyoming interestingly enough. Soda ash is used to produce specialty products (baking soda, sodium sesquicarbonate), along with being sold raw to the glass and detergent industries as a chemical input.

Tronox flirted with bankruptcy after facing years of sequential pricing erosion in titanium oxide. As a diversification move in 2015, the company bought the Alkali business, but rather than assuage investor concerns, it only increased fears due to the high implied leverage within the business model.

The company has missed bottom line expectations for two straight years, and even after tripling off recent lows of $2.75/share, the equity value is a far cry from the $22/share the company traded for at the start of 2015. Despite the rally in the stock price, things may not be as healthy as they seem.

Alkali Business

I’ll start with the rosier side of Tronox. The soda ash business is organized under the Alkali segment. This business was acquired from FMC Corporation for an aggregate purchase price of $1.65B in April of 2015. As mentioned earlier on, this made Tronox the world’s largest natural soda ash producer.

Trona is a highly sought after raw material, principally used in the manufacture of glass due to lowering the melting point of silica. However, the product is often used by chemical detergent manufacturers due to its absorptive and water softening properties.

Soda ash is produced in two ways: mining (the good old fashioned way as Tronox produces it) and synthetically. Due to lack of supply, three quarters of worldwide production is produced synthetically. There are various methods, but principally, synthetic soda ash is made via the solvay process, which uses salt, limestone, ammonia, and hydrocarbon (coke/natural gas).

Synthetic producers react ammonia with carbon dioxide and water to form ammonium bicarbonate. The ammonium bicarbonate is then exposed to salt to form sodium bicarbonate, which is then calcinated to produce the end product. Chloride is produced as a byproduct, and is often neutralized with lime to produce calcium chloride (sold primarily for road de-icing). The ammonia is recovered and recycled.

Even in ideal situations, synthetic production is difficult and cash costs for Tronox are more than 30% less than the most economic synthetic producers. Demand is massive for the product, and the business is perpetually operating in “sold-out mode” per management; everything they can produce, they sell. Given current expected demand and barring any breakthroughs in synthetic production, this will likely continue.

Most of the mined product is sold domestically, but Latin American and Asian exports represent roughly one third of sales. Capacity continues to go offline (Chinese plant shutdowns) and input costs for the synthetic process continue to rise, which means higher prices. Tronox is positioned to meet demand; the company holds hundreds of millions of tons in reserves of the mineral within its properties. At current mining rates, this is more than one hundred years’ worth of assets.

Current run-rate of 2016 EBITDA in the segment is $126M (pre-corporate overhead). However, this included some one-off costs, including a move off of longwall mining and some legacy IT issues. Management guided 20% adjusted EBITDA margins as long-run sustainable, which puts EBITDA in the $160M range, GAAP around $150M. Depending on how you slice it, the business as it sits today was bought for 8-10x EV/EBITDA, and throws off excellent cash flow.

I wouldn’t necessarily view it as highly complementary to the titanium businesses, but it is an excellent diversifier and produces cash flow that the company can count on to help reduce earnings cyclicality that is present in the other businesses.

Titanium Dioxide Business

Titanium dioxide is generally a fairly ubiquitous product. If you looked around yourself right now, chances are you would see a product that contained it. It is the opposite of carbon black, and is used as the white pigment of choice, which gives it a wide variety of applications. However, supply and demand have decoupled incredibly over the past several years. Low feedstock prices and massive capacity expansion have destroyed any semblance of pricing stability in the market.

For context, China went from a net importer of the product to a massive producer in just a few short years, a decision driven by supply shortages in 2010 and 2011. This drove continuous quarterly pricing declines starting in 2012, which continued until Q1 2016 unabated. Since then, we’ve seen marginal pricing expansion.

The bottom is apparently in, and major producers like Huntsman (NYSE:HUN) have announced further pricing increases into 2017. This follows price increases by all three major publicly-traded plays (Tronox, Huntsman, and Chemours (NYSE:CC)) in May.

Tronox sales volumes increased 7% y/y over the past two quarters, as the company wins back market share as capacity goes offline. Still, the company remains cautious. Tronox has reduced pigment inventory to below normal levels, in order to free up working capital and generate cash. Tronox has a so-called “TiO2 Operational Excellence Program,” where it aims to generate $600M in aggregate cash flow from 2015-2017.

 The company executed on this plan in 2015, generating $188M in cash flow from operating cash cost reductions and working capital cuts. 2016 brings the meat of guided cash generation – $315M – which should help bolster the company.

Remember that despite pricing improvements, the company still has generated net negative operating income for 2016 (-17M), and this is before factoring in the company’s massive interest expense (nearly $200M annual run-rate). Despite cash flow initiatives, the company has also not generated positive free cash flow.

The Numbers Don’t Add Up

My problem with Tronox is the company has never been meaningfully profitable; there has not been a year of positive operating income since 2012. Company presentations on EBITDA generally focus on segment level EBITDA (exclude corporate costs), which vastly overstate the consolidated profitability of Tronox.

While debt maturities have been pushed out to 2020 ($2.3B worth) so short-term bankruptcy remains out of the picture, the company remains highly levered. Even if we see pricing improve within titanium dioxide, there is no real route to retiring this debt. The company requires $350M in cash annually, split fairly evenly, to handle interest payments (pre-tax) and capital expenditures (post-tax) to keep the business running. There is simply not much left over to retire debt. Depreciation and working capital tailwinds can only go so far.

The $900M worth of 2020 bonds (Cusip 897050AB6) currently trades at a 9.8% yield, despite the original coupon of 6.375%. If the company had to refinance today, it would likely bear another $30-40M in interest costs given current market sentiment on company health. This is within a corporate bond market hungry for yield, so that picture might become even more negative with time.

Assuming $280M in 2016 GAAP EBITDA (which prices in significant earnings improvement in Q3/Q4), the company trades at 14x EV/EBITDA currently. At current equity prices, the company would need to generate $450M in mid-cycle GAAP EBITDA (assuming 8.5x multiple average across the cycle as fair value). Even with the inherent leverage in the business, Tronox is a long way from $450M in GAAP EBITDA.

With $150M in GAAP EBITDA in the Alkali business closer to peak than trough (given no production increases despite strong sell-through), the company needs $380M in GAAP EBITDA from its titanium dioxide segment (assuming $80M in corporate costs). That did not occur in 2012/2013 despite strong pricing tailwinds, and it is unlikely to happen here as the titanium dioxide market moderates.

The upside picture here seems fractured, and the company certainly looks like it’s closer to fair value at $6-7/share at best, even considering potential pricing tailwinds in titanium dioxide. The company simply has a tough time competing with larger operations from global chemical companies (DuPont (NYSE:DD), Huntsman, Chemours) with less leverage present on the balance sheet. As it stands, the company is wholly uncompetitive in a product which has very little differentiation among producers. This is a strong avoid, or an outright short, in my opinion.