NL - NL Industries: Will The Past Ever Go Away?

2023-04-04 18:02:02 ET

Summary

• Value investors may be drawn to NL as it is a holding company selling at a discount to the market value of its positions in KRO and CIX.
• Unfortunately, it's not that simple, as NL has numerous pending litigations due to its discontinued operations in the lead industry.
• I believe investors are not adequately compensated for the uncertainty, with shares trading near my estimate of fair value at time of writing.

Executive Thesis

NL Industries ( NL ) was one of the first companies included in the DJIA and was originally a lead smelter and miner. Those days are (almost) behind it now, as it is now primarily a holding company. Despite this, the company is still haunted with numerous multi-year lawsuits related to the toxicity and environmental impact of lead requiring constant litigation expenses and settlements.

The company owns 87% of CompX ( CIX ), a US boat parts and security products manufacturer, as well as 31% of Kronos Worldwide ( KRO ) a titanium dioxide manufacturer. Of note, all these companies are controlled by Valhi ( VHI ) and Valhi has an 83% stake in NL. As NL is trading at a 40% discount to its combined holdings in KRO and CIX based on market cap at the time of writing, a closer look is warranted to see what accounts for this. I recently wrote about CompX and Kronos and believe they are both trading near value at time of writing.

CompX Overview

CompX manufactures boat parts and security products in its US manufacturing plants for the mid to high tier markets. It has a strong balance sheet with $130 million in equity and no debt, and has recently been returning more capital to shareholders, with an extra $1.75 in special dividends declared in 2022 on top of its $0.25 quarterly dividend. Indeed, this special dividend coincided with the 2022 special dividend of NL. I estimated the company is worth approximately $180 million based on DCF models with a premium likely paid due to the strong balance sheet. This puts NL's stake at approximately $150 million.

Kronos Overview

Kronos competes in a mature industry with high barriers to entry, manufacturing Titanium dioxide TiO2 in both Europe and the US. This industry is cyclical and tends to increase sales as global GDP increases, and TiO2 is important as a whitening agent for many products. The company has an estimated 7% market share in the industry and has no plans for future growth. I estimated the company to be worth about $1.1 billion on a DCF basis, putting NL's stake at approximately $340 million.

Valuation

If we try to value the company based on historic GAAP cash flow, the results are mediocre. What accounts for this? Alarm bells start ringing that maybe at the corporate level, litigation fees are so high that it's not worth it at all to own this company. In reality, a large part of this difference can be attributed to how the company accounts for its interest in KRO. Though KRO earnings are accounted for via proportional ownership in consolidated income or "equity in earnings," operating cash flow subtracts out this amount and adds back the dividends, as can be seen below.

In order to get a more accurate estimate of free cash flow attributed to the parent, we need to subtract out dividends and add back the equity in earnings from KRO. As KRO's capex has not differentiated materially from depreciation and amortization expense over the years, this method will give us a rough estimate of free cash flow from the segment. This modification over the last 5 years is demonstrated below.

Using this method, we get a more realistic estimate for FCF, which includes both KRO and litigation expenses. 2023 is projected to be a poor year, due to declining demand and legal expenses, so I reduced FCF by $5 million in my model. After than I assumed the company's earnings would slowly normalize, and FCF would climb back to $28 million per year on average. Considering that KRO has not demonstrated its ability to grow over the years and has no plans to expand production I assume no growth in this segment. CIX likely will be able to grow due to the mid to high tier markets it operates in, so all together for NL I assumed a 2% growth rate in fcf on average into perpetuity. This can be visualized below, putting fair value around $300 million for NL.

Conclusion

Although upon initial examination some investors might be attracted to NL as it trades at a discount to its equity holdings, the company has other litigation related expenses, which detract from the margin of safety. There is $140 million in cash and marketable securities on the balance sheet, but that is almost completely mitigated by the $130 million in litigation and environment remediation costs.

The company does not know how much of these expenses there will be in the future, except that there will be more next year than this year. Therefore, the cash on the balance sheet is not really cash that can be counted on by investors in the common. The holding company will continue to be dependent on dividends received from KRO and CIX to pay its uncertain legal fees and returns to shareholders will plausibly have to be muted.

Therefore, despite having an appearance of a discount from an equity ownership perspective, I do not consider NL stock to be an attractive investment vehicle at this time. The inherent litigation uncertainty requires a much larger margin of safety than near fair value on a discounted cash flow basis, with our models suggesting the company to be worth around $300 million.

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