Two Ways to Play Changes in Titanium Pigment Industry

A Canadian company has developed new low-cost, environmentally friendly process to create titanium pigment. The process has already got the attention of one major buyer in the paint and coatings industry, and that could present a big challenge for incumbent titanium pigment producers. Investors have two ways to play the innovation. Rising Cost of Paint Early summer, with its not too cold and not too hot temperatures, is high season for home improvement. A bit of grass seed here and some paint there, leaves the ol' homestead looking like new. During the entire year 2014 over 1.2 billion gallons of paint will get applied to U.S. structures. Globally, homeowners, business owners, and others coat dwellings and buildings with three billion gallons of paint a year - a very large market. That is big business for the likes of Sherwin-Williams (SHW: NYSE), PPG Industries (PPG: NYSE) and Valspar (VAL: NYSE). Industry analysts at Timetric expect the global market size of paints and coatings to increase at a compound annual rate of of 7.1%, reaching US$69.4 billion in 2016. This year some of us may have fallen victim to ‘sticker shock' when buying paint. Many of the major paint suppliers implemented single-digit price increases in 2014, to cover increases in raw materials costs. Raw materials, principally titanium dioxide, represent between 70% and 80% of the cost of paint. Titanium dioxide is an opaque substance that gives paint its high gloss and rich depth of color. Indeed, it is the whitest substance known to man. TiO2 for short, titanium dioxide replaced lead in paint after lead's toxicity was fully understood. The rising cost of TiO2 is due in part to the growing popularity of this metal for a wide array of uses. Many of us probably think first of golf clubs and space vehicle coatings. However, TiO2 is also used in coloring for food, cosmetics and crayons as well as ultra-violet protection in sunscreens. Innovators in Japan are using TiO2 for its disinfecting qualities and European manufacturers are coating ceramic tile with TiO2. The food industry is eyeing the photocatalytic properties of TiO2 to remove ethylene gas from the air around fruits and vegetables so as to stave off ripening and prevent spoilage. Global TiO2 consumption is estimated at around 5.2 million tons per year, representing a value of US$16 billion per year according to the industry research firm TZ Minerals International Pty. The proliferation of uses has put pressure on demand and selling price. Suppliers and their customers are meeting both challenges head-on. For example, after a public spinoff failed to gain traction, Dupont Chemicals is now considering a spinoff of its TiO2 operation to current Dupont shareholders followed by a merger with Tronox Ltd. (TROX: NYSE), another smaller TiO2 producer. Dow Chemical (DOW: NYSE) received recognition from the Department of Environmental Protection for its Evoque branded paint ingredient, which is formulated to reduce the carbon footprint of latex paints. More importantly, it is expected to reduce the required amount of TiO2 materials by about 15%. New Supplier Enters Market Still latex paints represent only a portion of total paint demand, so Dow's Evoque is not likely to make much of a dent in the overall demand or price situation for TiO2. That is why an investment by another paint industry competitor is so interesting. Keeping with its corporate motto “bringing innovation to the surface,” PPG Industries has been in a development relationship with an enterprising Canadian company that could upset the proverbial cart in the supply of TiO2. Argex Titanium, Inc. (RGX: Toronto, ARGEF: OTC) has a history in the mining industry and management knows its rocks. Argex plans to produce high purity TiO2 pigment from ilmenite ore using a highly proprietary process the company has been developing with PPG's support. A demonstration plant in Salaberry-de-Valleyfield, Quebec has proven highly successful. Apparently PPG has been sufficiently impressed with Argex's progress that last year PPG entered into a new technology sharing and supply agreement with Argex. With one off-take agreement under its belt, Argex management hit the road to line up more customers. In October 2013, the company signed an agreement with a yet-unnamed distributor that has pledged to take at least 25,000 tons of Argex TiO2 each year. Roy Bonnell, Argex's chief executive officer, has more distribution discussions underway. Building Production Capacity Argex still needs to build its first commercial production facility. The company has located a suitable building at an industrial park near its headquarters in Quebec, Canada and has completed an engineering study of its process. Next step is to secure an environmental certificate and get construction permits. The design of Argex's production facility calls for standard equipment, some of which has already been put on order. It will take at least one full year after construction is completed to reach full production. In the meantime, Argex is working hard on sourcing ilmenite for its Canada plant. The ore can be found in abundance in a number of other continents, including North America and South Asia. Currently Australia is the largest ilmenite source, with South Africa running a close second. While Canada is fourth in terms of total ilmenite production, Rio Tinto's (RIO: NYSE) Lac Tio mine in Quebec is the largest with three million tons per year in annual production capacity. Eventually, Argex expects to open additional production plants in other locations. It might seem logical to locate production near ilmenite sources in order to minimize the cost of transporting heavy feedstock ores. However, Argex's chief financial officer Glen Kayll has put a sharp pencil to all production costs. The availability of low-cost natural gas supplies might ultimately sway the location decision. First New TiO2 Production Process in Decades Argex does much more than just bring a few extra thousand tons of TiO2 to the market. The company's patented production process relies on solvent extraction technologies that have been used successfully by uranium and rare earth producers. However, Argex has taken the process a few steps further, potentially changing both the economics and environmental profile of TiO2 production. The established TiO2 producers have had a few choices both in terms of type of process and ore feedstock. Usually titanium feedstock - ores called ilmenite and rutile - is mixed with sulfuric acid to separate the iron oxide group from the ore. The sulfate process was first used in Norway in 1915 and it is largely unchanged since. It is a messy process and highly exothermic – a fancy word engineers use to describe a system that releases large amounts of heat to the atmosphere. What is worse, the process emits hydrogen sulfide and sulfur dioxide as pollutants that must be neutralized before disposal. The industry has an alternative. Processing of titanium feedstock using chlorine gas and coke was first commercialized in the late 1950s. It too involves extreme heat, but is somewhat less harmful from an environmental standpoint. The metal chloride impurities that are left over are typically neutralized with lime and limestone and then sent for disposal at a landfill. Accordingly, the chlorine process is preferred over processing with sulfuric acid. Approximately, 60% of titanium ores are processed using the chlorination process. Feedstock quality matters. Generally, higher grade feedstocks must be used for the chloride process than for the sulfate process. Even though ilmenites are low in cost, this titanium feedstock is used by only one producer using the chloride process. Because the TiO2 content in ilmenite is typically low - only 45% to 60% purity - there are high chlorine losses and large volumes of waste products. Likewise ilmenites used in the sulfate process generate a high volume of co-products and wastes. Rutile ores, another source of TiO2, cannot be digested in sulfuric acid so they must be used for the chloride process. Slag based feedstocks arising from other ore mining operations have a higher TiO2 content and have lower by-product and waste volumes, but they cost more. The friction between feedstock grade and cost, not to mention production processes that are far from benign from an environmental standpoint, leave TiO2 producers between a rock and a hard place (no pun intended). The Argex process sidesteps both problems. Low-cost and Environmentally Friendly First, Argex has developed a closed loop process that emits no pollutants. There are by-products, but those are expected to be secondary sources of revenue rather than environmental headaches. Second, the Argex process is most accommodating of lower grade feedstocks, making it possible for the company to turn out even high purity TiO2 using lower-cost ilmenite feedstock that others cannot use. What is more, the Argex process requires low pressures and low temperatures, both of which yield cost savings in the front end of Argex's TiO2 production process. It is understandable why PPG Industries is so keen on supporting Argex. Argex is passing some of its savings on raw materials and operating costs to PPG through a very attractive sales price. Argex management admits its sales price to PPG is below market averages, but has not disclosed the exact amount. Compelling prices are likely to be central in gaining a big share of the TiO2 market. CEO Bonnell expects buyers of TiO2 pigments will be anxious to replace their expensive sources with Argex. Earnings Potential Despite competitive pricing, Argex management believes that with its low-cost process it will be possible to achieve gross margins in a range of 60% to 65%. The company will need to pay a 2% royalty to Canadian Titanium Ltd (CTL), which is the owner of the patented technology. The royalty will be paid as a dividend on certain classes of common stock owned by the minority owners of CTL. Argex already owns 50.1% of CTL and it seems plausible that Argex might at least consider purchasing the remaining shares. Argex gross margin predictions are certainly more promising for earnings generation than the gross margin of PPG Industries, which tends to the low teens. Historically, based on the two incumbent production processes for TiO2, margin performance by producers has swung widely through the industry's up and down cycles. Most in the industry last experienced peak margins in 2011, but then saw profits plummet to the bottom of the trough a year and a half later. The industry continues to experience significant cost pressures. End users like PPG that use TiO2 intensively are highly dependent upon supply and pricing conditions. The initial deliveries of Argex TiO2 pigments are not likely to make much difference in PPG's financial results whether the industry is in an up or a down cycle. However, increases in supply volume at lower than usual cost may even be discerned in PPG's total profit profile. Approximately, 80% of PPG's revenue is from sales of coatings and paint, making TiO2 one of PPG's most significant raw materials costs. Of Balance Sheets and Capital Needs The price tag for Argex's first TiO2 production plant in Canada is near CDN$300 million. At the end of December 2013, Argex held CDN$5.1 million in cash and short term investments. Argex management expects to raise all the required capital yet in 2014 and begin construction of its first plant next year. Most likely the financing will take the form of both debt and equity as the anticipated profit margins would certainly support servicing some debt. I would not look for a public offering, but qualified investors might have a chance to take part in a private placement. A private placement of CDN$7.5 million of 8% convertible debentures is already underway. The proceeds will be used as working capital while the company prepares for the construction phase. The debentures will present an element of potential dilution as the debentures convert into 6.6 million new shares of Argex common stock at the rate of CDN$1.14 per share. The company already has 113.2 million shares outstanding and another 19.9 million in options and 1.1 million warrants have been issued. With all derivatives exercised and debentures converted, the company would have 140.8 million shares outstanding - an increase of 24%. For some investors the shortage of capital and the potential for double digit dilution are less than appealing. Thus the play on Argex's innovative TiO2 production process might be better made through its principal customer, PPG Industries. Indeed, the paint supplier has no trouble meeting its capital investment requirements. PPG's operations are strong cash generators, turning an average of 12% of sales into operating cash flow over the past three years. PPG's capital spending budget averages approximately US$400 million annually. As of March 2014, the company had built up a fairly impressive nest egg on its balance sheet composed of US$1.7 billion in cash and short term investments. There was another US$393 million on long-term financial investments. An Option on Execution Argex shares trade on the Toronto Stock Exchange under the symbol RGX and are quoted in the U.S. on the Over-the-Counter Dealer Network. The stock has been near US$0.80 per share, making it more or less an option on Argex management's ability to execute on the company's strategic plan. The stock trades under low volumes making it a very illiquid position for all but those investors with long-term horizons. Investors with little tolerance for risk could tap into the anticipated changed in the titanium industry with a position in PPG. The stock is well seasoned and trades with significant volumes. However, it will be necessary to pay for safety as PPG is currently trading at 14 times trailing earnings. What might be more important to consider than liquidity and relative value, is which company will be able to capture most of the value in Argex's disruptive production process. I think it will be Argex and not PPG. True enough Argex is capital intensive and the company has a big job ahead to raise $300 million in capital for its first plant. However, Argex could also realize profits on its technology by selling an intermediate product to other TiO2 processors much like Coca Cola sells the syrup for its namesake beverage to independent bottlers. Considerable value would be captured without the capital expense of production facilities or the global marketing program to reach pigment customers. PPG Industries might be the better vehicle for some investors to take advantage of changes in the titanium pigment market. However, it is Argex we have added to the Materials Group of our Mothers of Invention Index of innovators in alternative energy. Argex has strong talent on its team with experience and past successes in metallurgy, construction, manufacturing and finance. The company has more to offer than just new TiO2 production. The Argex TiO2 process presents real change in the cost of TiO2 production in terms of cost an environmental profile. Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.