[This thesis was written up retrospectively on the date below and refers to prices earlier that month.]
Date: Jul. 24, 2023
This is a holding company that has majority ownership in a number of businesses through a fairly involved corporate structure. Kronos Worldwide, a producer of titanium dioxide pigments, is the largest of these businesses, with a market cap of $1.1B.
Valhi, Inc. holds approximately 50% of the common stock in KRO, and additionally owns 83% of stock in a company called NL Industries (NL), which itself holds 31% of KRO common stock. This effectively puts VHI's ownership of KRO at 75%. However, the family-controlled Contran Corporation holds 92% of Valhi's outstanding common stock, leaving only a fraction of shares in circulation.
According to management, titanium dioxide (TiO2) is “the largest commercially used whitening pigment” and has “no effective substitutes” (10-K, 2022), which if true, leads me to believe that demand for the product is likely to remain high over the years to come, and that the recent drop in demand is temporary.
Kronos is the largest producer of TiO2 in Europe. Last year, titanium dioxide was banned in the EU as a food additive, and phased out in August. This may be a factor in why the price of KRO shares has plummeted over the previous year, as some investors fearfully sell on news of this kind. However, the company does not sell TiO2 as a food additive, meaning it's not affected by the ban. It lists its largest end-uses to be industrial coatings, plastics, paper, and other things like printing ink and textiles.
Management attributes the recent fall in revenues simply to decreased demand, which they must judge to be transient as they are ramping up production to full capacity by the end of 2023, after significantly curtailing it at the end of 2022. All this start-and-stop has undoubtedly produced lots of fixed costs, and temporarily eliminated profits, but these appear to me as normal fluctuations in the business cycle. KRO's competitors have experienced similar relative falls in revenue.
KRO's balance sheet appears to be in good shape as it carries manageable debt ($370M in 3.75% notes due 2025), the business has a history of strong demand, and has had cash flows of at least $100M in 8 of the last 10 years, and often much more. There's been very few bad years despite formidable competition from The Chemours Company (CC) and Tronox Holdings plc (TROX).
One could assume that Kronos Worldwide is not egregiously overvalued at its current market cap of $1.1B and a book value of $900M. From the perspective of the price-to-book ratio, markets have valued it much more optimistically in the past, with an average price-to-book ratio between 1.5 and 2 over the last 10 years, which is currently at 1.2. Perhaps the intrinsic value of KRO lies in the range between $750M and $1.5B. Whether the business is close to or near the bottom of its business cycle is hard to know.
The competition carries more debt than KRO, especially in the case of CC which holds $3.6B of various obligations, a considerable portion of which are variable rate. At the bottom of the business cycle, with demand likely to improve, this would not be a big deal. But if things are closer to the middle or the top with tougher times to follow, CC and TROX might find the obligations harder to service, and the relative strength of KRO's balance sheet might begin to shine with investors during such a period.
Now to the crux of the undervaluation, which in my mind lies with the holding company VHI: there is a sizable discrepancy between the market value of KRO shares owned by VHI, and the market value of VHI itself. As of last Friday, VHI is priced at $434M, and KRO is priced at $1.1B, putting the market value of the KRO shares VHI holds at roughly $820M, which is quite a discount.
All else being equal, I believe VHI should be worth at least the intrinsic value of its KRO shares, plus the intrinsic value of everything else it owns, which includes public companies NL (National Lead) Industries (NL), CompX International (CIX) and two other private businesses (Basic Management and The LandWell Company). However, there are factors that could cause the undervaluation to persist. For one, the family trust of the Simmons family in Dallas, Texas has not shown any interest to increase or decrease its ownership in VHI and has issued no new shares over the last decade.
The question of why the price of VHI has diverged from its ownership stake in KRO is well covered by a report from East 72 Holdings, an investment firm based in Sydney, Australia. They point out VHI's insignificant free float, a joint venture with a competitor, and environmental remediation and litigation liabilities within National Lead as some of the reasons for the divergence and persistent undervaluation.
A lack of free float alone does not strike me as a reason for persistent undervaluation. I believe that illiquidity is not a concern for a long-term business owner. However, a joint venture with a competitor (Venator Investments) does seem peculiar. The environmental remediation liabilities under National Lead are roughly $22M which is a sizable, but not back-breaking sum given the scale of the operation.
The lead litigation liabilities reaching back to 2019 have largely been paid, but there is a possibility that new litigation will take place at some unknowable point in the future. These costs are hard to quantify and could be one reason VHI remains undervalued indefinitely.
On August 10, 2020, Contran voluntarily contributed $667M of 6% Series A Preferred Stock it owned in VHI back to VHI itself, thus increasing VHI's equity at no cost to the shareholders.
Despite the risk that the undervaluation of VHI may persist indefinitely, this still appears to be an idea with little downside and significant upside.