2023-07-06 10:30:00 ET
Summary
- Tronox Holdings is one of the world's largest producers of titanium dioxide, used as a pigment in paint, coatings, plastic and paper.
- Tronox experienced tough times towards the end of last year, but is slowly increasing its EBITDA again.
- The underlying free cash flow (excluding working capital investments) will likely exceed $1.40/share this year, increasing to $1.8+ next year.
- I will continue to write put options on Tronox, and I am considering the 2029 bonds as an income idea.
Introduction
I have been covering Tronox Holdings ( TROX ) for several years here on Seeking Alpha and back in August last year, I mentioned the stock was trading at a free cash flow yield of in excess of 20% . Unfortunately, the company was also hit by the slowdown of the world economy so the FY 2022 free cash flow result was lower than I had anticipated but it looks like the worst is behind us. The Q1 EBITDA handsomely beat the company's own guidance and Tronox is expecting a double-digit EBITDA growth on a QoQ basis which will also boost the underlying free cash flow of the stock. Based on the current projections, I think Tronox is still trading at a double-digit free cash flow yield and
Q1 wasn't great but better than expected
This article is meant as a follow-up to previous articles. To get a better understanding of Tronox's business model, I'd like to invite you to re-read my older articles which you can find here . Long story short, Tronox is a vertically integrated player in the TiO2 (titanium dioxide) sector. Titanium dioxide is used in the paper, plastic and paint industry as it has excellent whitening characteristics . The demand for TiO2 is closely correlated to the world economy so one should look at Tronox as a cyclical company.
When Tronox announced its full-year results for 2022, it also provided an outlook for the first quarter of the current financial year. According to Tronox, it was expecting an adjusted EBITDA of $120-130M . Needless to say, the expectations were pretty low considering the full-year 2022 adjusted EBITDA came in at $875M and the Q4 2022 EBITDA was just $113M on an adjusted basis. This means the second half of last year was much weaker than anticipated as Tronox had previously guided for a $1.1B EBITDA .
Tronox was actually able to surprise the market as the company reported a total adjusted EBITDA of $146M which is approximately 15% higher than the midpoint of the guidance.
The total sales volume increased by approximately 14% while the average realized price increased by approximately 1% on a QoQ basis. Additionally, the company was able to take advantage of the FX changes which provided a tailwind to the reported results. During the first quarter, Tronox reported a total revenue of $708M which resulted in a gross profit of $133M which was a 43% decrease compared to the first quarter of last year. Additionally, the SG&A expenses decreased by approximately 10% resulting in an operating income of $62M. While this optically appeared to be pretty decent compared to the $69M operating income generated in Q1 2022, keep in mind last year's Q1 results was negatively impacted by a $85M settlement and the underlying operating profit in Q1 2022 was $154M which means the operating profit fell by about 60%.
Not great at all but fortunately Tronox hasn't been hit yet by increasing interest rates which meant the net interest expenses remained relatively unchanged. And the bottom line clearly shows Tronox remained profitable as the net income came in at $23M or $0.15 per share. Definitely not as disastrous as originally anticipated and the $21M EBITDA beat most definitely helped the bottom line, that's for sure.
In my previous articles, I looked at Tronox from a cash flow perspective. And while the company was free cash flow negative on a reported basis in the first quarter of the current financial year, this was completely caused by the investment in the working capital elements . As you can see below, the reported operating cash flow was a negative $79M but this included a net investment of $198M in the working capital position.
Excluding these WC changes, the adjusted operating cash flow was approximately $119M and the free cash flow was roughly $26M (keep in mind the $93M in capital expenditures included in excess of $50M in growth investments). That's still not great, but keep in mind the first quarter will likely be the weakest quarter of the year on a cash flow basis, while the capex was disproportionally high.
A look at the Q2 guidance and the full-year potential
That's not just a gut feeling, but based on the company's official guidance. After publishing stronger than expected results in the first quarter of this year, the guidance for the second quarter also sounded pretty upbeat. The company now expects a Q2 EBITDA of $160-170M on an adjusted basis; using the midpoint of that guidance ($165M), the QoQ EBITDA increase would be around $19M of which $10-14M would likely directly flow to the bottom line.
The Q2 EBITDA increase will be caused by higher titanium dioxide volumes and prices, partially offset by higher operating expenses (power prices in Africa and transportation costs in Australia).
But what's perhaps more important is the company's full-year guidance. As you can see below, the total capex is expected to come in below $275M. That's less than $70M per quarter while we know the company already spent $93M on capex in the first quarter of this year. This means the residual capex will be around $60M on a quarterly basis in the three remaining quarters of this year. This means we will see increasing operating cash flows in combination with lower capital expenditures for the rest of this year.
The guidance above now also allows us to calculate the full-year free cash flow. We know the Q1 EBITDA was $146M and using the midpoint of the Q2 EBITDA guidance, the H1 2023 EBITDA will likely come in at around $310M. If I would now assume a full-year EBITDA of $675M (which would be a 25% decrease from FY 2022), we can now calculate the full year free cash flow.
We know the EBITDA ($675M) while we also know the total capex, interest expenses and cash taxes will come in at around $455M. This results in a free cash flow result of $220M or in excess of $1.4/share. And that includes the weaker first quarter.
The consensus estimates for the 2024 EBITDA is $886M . Let's use a 10% lower result at $800M in EBITDA and let's hike the cash taxes to $100M. This would result in a free cash flow result of $290M or $1.85 per share. Note: the consensus estimate for this year is $706M in EBITDA, which is about 5% higher than the $675M I used for my 2023 assumptions.
Investment thesis
Tronox Holdings will for sure remain cash flow positive on an underlying basis but the ongoing investment in working capital elements will very likely result in a lower reported free cash flow result. That's fine as long as Tronox gets a grip on the situation but the market may be unimpressed. I'm not expecting too much from this year but excluding the changes in the working capital position, I expect the free cash flow result to come in at $1.4/share, increasing by 30% to in excess of $1.80/share next year (based on the current situation). This is based on a $270-280M in annual capital expenditures but I expect the full-year capex to start trending down in the next few years as the newTRON project reaches completion and as the sustaining capex in 2022 was just $125M .
The incoming cash flow will be useful to further reduce the net debt which remained relatively high at $2.55B. The net debt level likely explains why the market is a bit worried about Tronox Holdings but if we indeed see a reduction towards $2.3-2.4B by the end of next year while the EBITDA simultaneously increases to $800M the debt ratio of 3 times EBITDA should be fine. Let's also not forget the current market capitalization of Tronox is just $4.5B which represents about 7 times this year's EBITDA but potentially less than 5 times next year's EBITDA. And keep in mind Tronox's original plan was to generate $1.3-1.5B in EBITDA in 2025 . Even if it misses the lower end of that guidance by 20%, it still implies an EBITDA of north of $1B in 2025 which should result in a free cash flow result of $2.5-2.75 per share.
I will continue to write put options on Tronox in the near future but just like in the previous article I'd like to highlight the 4.625% bond maturing in March 2029 which is currently trading at just 83 cents on the dollar for a yield to maturity of just over 8.4%. While the net debt should definitely be reduced, I think the 8%+ bond yield offers a very fair risk/reward ratio.
For further details see:
Tronox Holdings: Still Trading At A Double-Digit Free Cash Flow Yield