- Venator is bullish on the long-term outlook for titanium dioxide (TiO2) fundamentals as supply-side additions are expected to lag the normal annual demand growth.
- TiO2 pricing is already at elevated levels, and a change in pricing strategy could result in limited incremental margin improvement this year.
- The company delays the rebuild of the Pori plant (in Finland) by a year on a disciplined approach on capex spending plan.
Image credit: Company presentation
Titanium dioxide (or TiO2) fundamentals are becoming better than expected. Investor fears that feedstocks will continue to increase seem to be unreasonable. Inventory build-up that occurred in 2017 overstated the demand. Subsequently, the reverse is occurring as TiO2 inventory destocking is happening now. The decline in average selling prices was due to a consolidation of higher European selling prices towards North American prices and fragile business conditions in the Asia Pacific, partially offset by strong pricing for specialty TiO2 products globally. Can Venator Materials Plc (NYSE:VNTR) rise from the challenge unscathed?
Recent export data from China have fallen significantly from January to April’s high levels. As TiO2 suppliers experience declining volumes (with VNTR falling 18% year on year in the third quarter), why VNTR would not lead to destocking? Let’s try to dig deeper.
Weak TiO2 Demand Volume
Demand for TiO2 remains weak in the first quarter of 2019. Volume growth is estimated to be below mid to high teens. Just the same, it was in the second half of 2018 that demand volume also fell below mid-teens.
The consumption volume of TiO2 is approaching its long-term average of 2.5% as end-markets (paints and plastics) are climbing by 3% to 5% in volume demand. Analyzing further, it only means that the market has already depleted a significant level of inventory since the summer of 2018. At the maximum, destocking can last for another 2 to 3 months prior to a possible demand that moves in line with consumption levels.
Margins are somewhat squeezed for VNTR and its industry peers. Although the outlook for the second half of 2019 and 2020 appears to be favorable. For Tronox Holdings Plc (TROX), their backward integration into ore should help them. But they want to see excess inventory worked down and don’t want to sell into discounting programs. So, they will probably see a volume hit of similar size to Chemours Company (CC).
On the other hand, Kronos Worldwide (NYSE:KRO) is building substantial inventories relative to industry peers, so it has more products to sell. So, investors will need to keep in their radar screens KRO’s price volume numbers to see if it is holding for price or monetizing some of the inventories.
The first quarter of 2019 rendered $60 million EBITDA for VNTR (versus a consensus estimate of $56 million). Revenue fell 7% year on year on lower dollar prices (10% lower), offset by demand volumes (up 3%) due to weather-related weak construction activities in North America, customer destocking, and plant shutdown.
Despite the revenue decline, the 3% increase in sales volume showed that the prolonged destocking that happened in 2018 may have run its course. The company anticipated increased purchases in Europe, modest growth in North America, and strong demand for its specialty TiO2 (estimated to increase by 11%). There is still weakness in the Asia Pacific, although VNTR is confident that the destocking cycle is approaching the end tail. Thus, demand would eventually pick up in the succeeding quarters.
CC is also experiencing some EBITDA pressures on the base refrigerant business in Europe. Some illegal products seem to be coming through Eastern Europe thus putting pressure on prices. Ramp-up costs for its new HFO plant are also significantly higher. The company experienced a continued decline in TiO2 prices, driven by a further increase in Chinese net exports.
TiO2 Cycle: Prices Stabilizing
Prices of TiO2 fell by 6% year on year due to weak pricing in functional TiO2 products and larger geographical exposure to Europe. VNTR has noted increasing purchases in Europe, while there is only mild growth in North America. The company is positive that destocking is nearing its end.
We have witnessed a number of cycles since 1990 where the usual duration and price inﬂation was shorter and lower than we are observing today. TiO2 prices have recovered to more sound levels, and the duration of the cycle is now directed towards the high end of historical averages following a strong run since TiO2 bottomed in the first quarter of 2016.
The upcycle is getting moderate, which is driven by CC. This company is aiming for multiyear pricing contracts despite the supportive industry conditions, which could sustain more pricing gains. The year-on-year gains in TiO2 pricing seem to decelerate in the near term, and the inflection in the second derivative is seen by the market as an important period in the cycle. This period is also correlated to the peaking equity prices of KRO during the prior cycle.
VNTR stressed that they will not slash prices to hike volumes. Specialty TiO2 prices rose on higher demand (up 11% year-on-year) globally. Thus, the market can well expect a stronger pricing outlook for the functional TiO2 as well as for the specialty TiO2.
The company incurred a net loss of $163 million in 2018, which also included a restructuring charge of $628 million. And because of it, VNTR’s management has recently launched its 2019 cost management program. It contributed $3 million savings in the first quarter of this year. Before 2019 ends, the program is expected to accumulate $10 million savings and estimated to climb to $35 million by next year.
U.S. pricing is holding in well, given the apparent volume hit. Prices of TiO2 have held in quite strong due to chloride technology differentiation and CC’s value stabilization strategy. There is no price discounting so to speak.
Asian pricing has been falling since this time last year. But just recently, it seems to have moved off the bottom. It is too early to tell if it is due to a sustainable better supply/demand dynamic. It may also be a temporary bounce off the bottom. A key reason has been that the net Chinese exports do not appear to balloon as it did in March, April, and May last year.
Overall, I believe that VNTR promotes a “trajectory of change” for its price stabilization efforts, so that it could drive less volatility for TiO2 prices. However, they did not mention about engaging in flat pricing, noting they can only accommodate a narrower price range if stabilization efforts proved to be successful.
How Cost Inflation Impacts VNTR?
Major TiO2 suppliers are experiencing cost inflation due to three industry factors:
- higher fixed costs per unit (on lower units produced)
- increased ore costs, and
- higher carrying costs on the slight build-up of inventories.
The first industry factor mentioned is more possible to happen (for a while) but should not worsen, while the second and third factors mentioned are transitory.
The most prominent risk in the investment case of VNTR is the volatility in the TiO2 price cycle. There could be a significant pricing gap on how VNTR deals with cost inflation if TiO2 market prices are stronger, driven by a reduced supply out of China, further industry outages, stronger-than-expected demand, and a persisting benign raw material price environment.
Compelling Free Cash Trajectory Despite Struggling EBITDA
I can see that free cash flow (FCF) trajectory appears to be compelling. The company generated $29 million in net cash used in operating activities. Free cash flow was a use of $82 million in the first quarter of 2019.
VNTR is trading at a cheap FCF yield of 11% compared to its peers. An analysis of its FCF forecast revealed a promising outlook consisting of a combination of returning cash to shareholders, reducing gross debt, and bolt-on M&A. Its accretive capital allocation represents the most positive catalyst for its equity shares. However, the company has not yet laid out a speciﬁc deployment strategy other than deleveraging.
The company guided that capital expenditures (capex) for 2019 will be at $130 million. Around $25 million is allocated to the Pori specialty capacity transfer program. The total program capex is now lowered from $150 million to $90 million. Expenses incurred related to the closing down of the plant are estimated at $65 million to $70 million in 2019.
Last year, the company decided to shut down the Pori site while boasting a $15 million EBITDA expected by the year 2020. They guided that they have already relocated their assets. The specialty plant is still running at very low levels of production. The production plan is to hold on to two-thirds of the specialty TiO2 volumes. However, the out-of-pocket cost has significantly risen.
At the very least, I believe that VNTR will delay ramping up the Pori plant by a year. This facility has an equivalent 10% of European production capacity. But what is more feasible is that VNTR might opt NOT to rebuild Pori anymore due to escalating costs.
Cost of rebuilding is expected to be $325 million to $375 million (up from previous cost guidance of $100 million to $150 million). Hike in cost estimate is driven by the rebuild cost inflation and higher business interruption reimbursement utilizing more of the $500 million cap of the insurance policy. Barclays estimates cash outlay to be at $175 million in 2018, $150 million in 2019, and $25 million in 2020. Thus, the outlay will weigh down on free cash flow over the next two years.
The company is prioritizing on cash management. It aims to optimize capex spending in order for them to deliver $60 million from working capital in 2019, as they evaluate more feasible options to reduce cash costs associated with the Pori plant wind-down.
But Can EBITDA Levels Sustain?
At current levels of EBITDA, VNTR struggles to produce sound free cash, thus making the company unable to justify its inventories. Cash flow is still considered negative due to weak EBITDA generation, huge cash cost for Pori closure, while its working capital is depleting more funds than expected this year.
Source: Company data
VNTR has not piled up on huge amounts of inventory in the last quarter of 2018. They had around 70 days of pigment inventories. This level compares to more than 100 days during periods of demand weakness. It only shows that VNTR is disciplined in managing its operating assets.
Unlike its peer CC, VNTR did not lose or gain market share in the pigment category during destocking. The pigment destock has loosened the ilmenite feedstock markets slightly. They believe its costs will be nearly ﬂat year on year in 2019.
I believe that this is a favorable dynamic as the market can expect ore price hikes across all grades (ilmenite represents 50% of its volume requirements). However, I noted that the company is still expecting a signiﬁcant price inﬂation in slags and for rutile.
Source: Company data
Mr. Simon Turner, President and CEO of Venator, commented:
“… In response to the current economic environment and a reduced TiO2 manufacturing footprint, we have commenced a new comprehensive cost and operational improvement program. These actions are designed to improve profitability, starting with the rationalization of senior leadership and simplification of organizational structure.
As we aggressively manage costs under the 2019 Business Improvement Program, we remain focused on transferring our specialty TiO2 technology from Pori to other sites within our network which, combined with other cost actions, should strengthen our cash flow generation throughout the cycle. We continue to explore measures within our portfolio to unlock shareholder value. Notwithstanding global economic uncertainty, longer-term industry fundamentals remain positive and we believe these actions will better position Venator for the future.”
Healthy Balance Sheet
VNTR still has a sound balance sheet. The company booked $165 million of cash and cash equivalents in the full year 2018, as compared to the $251 million in September 2018 and $238 million in December 2017. The company has in place an undrawn asset-based revolving credit facility with an available borrowing base of $259 million in 2018. Net debt was $583 million as at end-2018 compared to $497 million as of September 2018 and $519 million as of December 2017.
VNTR saw its stock price fall by a hefty 46% for the first nine months of 2018 due to an industry-wide fall in stock prices. It weighed on the business’s financial risk posed by the delayed ramp-up of its specialty titanium plant in Finland.
Trading at EV/EBITDA of 4.6X with lowered price target from $7 to $6 a share, I can see that cash flows are still depressed, given current low levels of EBITDA due to the required capital spending to shut down the specialty plant.
I recommend a buy on VNTR stock as near-term risks associated with the stock like inventory levels will be offset by near-term recovery in TiO2 prices. I also believe that VNTR has a satisfactory FCF yield (11%) relative to industry peers.
To recap, the selling prices for specialty TiO2 remain robust, and VNTR is progressing the transfer of its specialty technology from the Pori plant to other sites. The company is encouraged by the industry pricing discipline during destocking. They believe that, in the past, the level of demand volume weakness for TiO2 would have resulted in much-pronounced pricing declines.
The company is also concerned by the less substantial price hikes and reduced scope for upward earnings revisions. But VNTR could offset this issue either through success in fostering longer-term stability in TiO2 or through the deployment of its excess cash. VNTR also stressed its focus on restructuring, earnings growth, and generating positive free cash flow in the long term.
I noted that price inflation is essentially good for chemicals like TiO2. However, price swings, which can be significant and challenging to predict, create earnings volatility. Thus, it leads to adverse boom-bust cycles for VNTR stock. I believe that the current TiO2 pricing cycle can become another prominent cycle, given the low global inventory levels and tight industry utilization rates.
I believe that a modest improvement in the positive margins will be rewarded with enhanced stock valuations. A shift to contracted pricing could result in a positive rerating as well. Margin volatility leads to low stock valuations with VNTR trading at a substantial discount to those peers with more stable margin performance.
At this point, it is tough to conclude if there is enough discipline for VNTR to control capex spending and to translate it into long-term contracts. However, I believe that the consolidation in the TiO2 industry with most of the global capacity owned by pure-play companies like VNTR has a good incentive to stabilize its earnings and avoid deep cyclicality.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.