Tronox (TROX) – Merger Arbitrage – 16%+ Upside

Current Price: $23.24

Offer Price: $27.00

Upside: 16%+

Expiration Date: TBD

This idea was shared by Alan.

 

Short note on the rumored takeover by Apollo.

Last week, rumors appeared that titanium dioxide producer Tronox received a $27/share offer from Apollo. The alleged offer is opportunistic and comes at the beginning of the TiO2 producers’ industry upcycle. The offer prices the company around the 6.7x 2021 adj. EBITDA and 13% FCF yield, which doesn’t seem expensive relative to peers. The situation offers 16% upside with what seems to be a fair chance of an improved bid. The downside is capped at around 10%.

Tronox is the largest global vertically integrated TiO2 pigment producer. TiO2 pigment is also called titanium white and is used in paints, coatings, plastics, paper, and many other applications to add opacity, brightness, and consistency of color. TiO2 accounts for 80% of TROX revenues, while the other 20% is attributed to zircon (used in ceramic glazes) and pig iron products (used in foundries for ductile iron castings). The company is 85% vertically integrated and owns 9 pigment facilities across the globe. The remaining 15% of materials are acquired from third parties. More background on TROX can be found here.

I am far from an expert on the pigment industry, however, there are some interesting angles to this situation.

Caveat emptor: this is a mid-cap ($4bn) merger arbitrage and the spread most likely reflects the risks of this rumored transaction failing.

 

Industry upcycle

TiO2 industry was strongly affected by the COVID downturn but is now swiftly recovering – as alleged by TROX and its peers the industry has recently entered into an upcycle which is expected to continue into 2022. The momentum has been created by the stimulus-induced economic rebound and booming housing, automotive, and other industries, which significantly ramped up the demand for TiO2 white pigment. Industry’s capacity is apparently constrained due to limited investments into feedstock supply side over the recent years. Global shipping issues add to these supply constraints. All in all, this has created a tight market with pigment prices going up and industry participants (TROX, CC, and others) reporting very strong near-record/record quarters this year.

TROX and its peers are talking non-stop about very strong demand into 2022 and hint the beginning of an upcycle. Tronox has recently been beating or landing close to the top of its the earnings guidance and is now very close to reaching its previous $1bn EBITDA goal. Company’s peer Chemours (CC) has increased 2021 EBITDA guidance by 10% in Q1 and in Q2 updated it to be closer to the upper limit. TROX has also increased its dividends by 25% in Q2 (to $0.40/share annually). A number quotes are highlighted below.

TROX Q2:

We believe we are still in the early stages of the cycle.
[…]
Demand remains very strong throughout the supply chain, driven by the recovery across all of our end markets
[…]
Given the continued strength in our cash generation capabilities, our confidence in our business model and our view on the cycle, we are increasing our quarterly dividend by $0.02 per share to $0.10, bringing our annualized dividend to $0.40 per share.

TROX Q1:

Achieving our highest TiO2 sales volume quarter in the company’s history is an incredible accomplishment and is evidence of continuation of the recovery of the TiO2 cycle.
[…]
Taking into consideration the pricing momentum in the market and the expected incremental synergy and cost saving from newTRON, even after accounting for headwinds from exchange rate and cost inflation-based on our current assumptions, the $1 billion adjusted EBITDA target set at Investor Day is shown to be very achievable in the short to midterm.

CC Q2:

So yeah, looking out today, we certainly see very strong second-half demand.

VNTR Q2:

We are encouraged by the strong demand environment and expect this to continue into 2022
[…]
We’re not prepared to put a number on 2022 except to say we expect to see the cycle extend and continue
[…]
and we can see — continue to believe that we’re in the earlier part of the cycle, and we’re going to see further development of that in next year.

 

Fairness of the Offer Price

TROX has recently reported its record Q2 results with $927m revenues, $237m adj. EBITDA (close to the upper limit guidance of $240m) and $150m in FCF. The company expects to generate $245-$260m EBITDA in Q3. So the company is likely to reach $1bn in EBITDA this year and then should top that during 2022 if the upcycle continues. FCFE is likely to be around $540m before working capital adjustments.

Apollo’s rumored offer comes at around 6.7x 2021 EBITDA and a 12% FCF yield. The company is currently undergoing various cost cutting/operational efficiency initiatives (project newTRON), which are expected to add $140m-$180m EBITDA by 2023 (full effect) and results in even lower acquisition multiples. In comparison, CC trades at 6.2x E2021 EBITDA, however, it is a lower margin, not vertically integrated operator with significant PFAS liability overhang. KRO trades at 8.3x H1 run-rate EBITDA, while it is also a much smaller/lower margin/not vertically integrated operator with a Holdco/Simmons family discount.

Taking into account the expected continuation of the upcycle, ongoing cost-efficiency improvement and lack of premium relative to peer valuations, the $27/share seems more like a starting bid and rather than the final price.

25% of TROX is owned by Cristal Global – Saudi-based second-largest TiO2 producer in the world. This stake was received as consideration for TROX acquisition of one of Crystal’s businesses back in Apr’19 when TROX shares were in low double digits. There is a chance Saudi’s would push for a higher offer. Cristal Global also has 2 directors on board, so if the offer gets approved by the board, the spread will likely collapse immediately as shareholder approval will be almost guaranteed.

 

Risks

• As already noted above this is a mid-cap ($4bn) merger arbitrage case and the spread most likely reflects the risks of this rumored transaction failing.
• This is a rumored offer. So far both companies have declined to comment, but if the report appears to be fake, the price is likely to return to pre-announcement price levels ($21/share) or lower.
• Worsening logistics headwinds. TROX is facing industry-wide feedstock supply as well as finished product shipping constraints and expects the volumes to go slightly down 5%-10% QoQ in Q3. Nevertheless, this impact will be more than offset by the pigment price increases.
• TiO2 prices currently (at c. $3,000/ton) sit somewhat above the long-term average of $2,000/ton and the trend could revert back. In the near-term such pricing is likely to be sustained as there should be no new supply coming to the market and it will take time for the new feedstock mines to open/ramp up the production. The risk of China flooding the market is also limited as stated by TROX CEO (Q2):

But we see that as positive for the industry because in the coming year, I think that what will limit pigment production is not building new pigment plant, it’s going to be opening new mines to feed those pigment plants. And I think that’s where when people panic about China overflooding the market, China cannot do that, because they don’t have the mine to feed their chloride expansion. So that’s where the vertical integration of product will really play in our favor.