The recent vaccines-induced rally complicated the stock-picking process for dividend-focused investors, as the inflation in share prices led to the compression of dividend yields. Earlier this year, during the first months of the pandemic gloom, the market has encountered the great dividend reset caused by dwindling profits and restrained cash flows, which made companies across the globe to revisit their shareholder rewards patterns and put financial position first. As a result, the list of high-yield dividend opportunities shrank dramatically, but that certainly does not mean substantial and relatively safe yields have entirely evaporated from the investing landscape.
Today, I would like to discuss Kronos Worldwide (KRO), one of the major players in the global titania market, which I have been covering since January 2019. In June, I revisited the dividend thesis, which is still relevant now. Though the rally led to the yield compression, investors in KRO who will buy the stock for ~$14.1 can still enjoy an over 5% yield (assuming an $0.18 quarterly dividend; ex-dividend date is November 30) with a relatively safe risk-reward profile, given the woes of the recession are ultimately coming to an end thanks to the long-awaited COVID-19 vaccines. On the negative side, the DPS growth story is anything but certain: the previous time it increased the DPS was in 2018. So, for investors who seek income with the prospects of gradual growth, KRO might not be a top pick. Also, it is worth remembering that the dividend did not survive the Great Recession because back then, the company had a much weaker balance sheet and higher interest expenses, which I discussed in the previous note.
Anyway, the capital rotation is in full swing, as investors return to cyclical stocks abandoning the tech darlings that outshined the S&P 500 (SPY) thanks to the tailwinds spawned by the pandemic. The chart below illustrates this process quite clearly:
In this sense, in addition to dividends, investors might enjoy capital gains, as the market is pricing in revenue recovery prospects.
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Now, let us take a deeper look at the company and revisit the thesis once again.
Bleak Q3 results, but the titania market trajectory reinforces the dividend thesis
Though Kronos was not the most afflicted among the basic materials companies, the toll the pandemic took on it was anything but cosmetic. As the economic softness curbed the demand for titanium dioxide, in Q2, sales fell by over 20%. In Q3, the decline continued, but the magnitude was much less severe, only 4.7%. As revenues crept lower, profits extended a two-year-long decline, thus jeopardizing dividend coverage.
However, it seems the worst is far behind. For example, despite Q3 sales contraction YoY, Kronos reported an 8% sequential improvement. Unfortunately, the company itself did not share Q4 or 2020 guidance with investors (and, on a side note, it has not had an earnings call since 2012 and has not published related earnings presentations like other TiO2 players), but we can assess the overall health of the titania market by delving deeper into investor resources of its peers. For example, The Chemours Company (CC), the leading TiO2 market player responsible for 16% of the global production capacity (page 10 of the annual report), said in its Q3 presentation that it was “continuing to see early stages of market recovery across all regions and markets.” Tronox Holdings (TROX), another heavyweight in this industry, said that it noticed “strong sales trends” that “reflect favorable deviation from typical fourth quarter seasonality” (slide 9 of the presentation). Venator Materials (VNTR), #4 in terms of production capacity, is also quite optimistic about the pace of the recuperation, as it sees a “gradual recovery in textile demand benefitting specialty TiO2 volumes” in the near-term (see slide 5).
I also reckon it is worth taking a look at the upstream side (in other words, on results and outlook of rutile miners that supply feedstock, which is used in the chloride and sulfate production processes) to have more clues about the current state and the short-term prospects of the TiO2 industry. From the 2019 Form 10-K, we know that among Kronos’ essential suppliers are Sierra Leone-based Sierra Rutile Limited, a wholly-owned subsidiary of Australian mineral sands miner Iluka Resources (OTCPK:ILKAY), which supplies standard grade rutile to KRO under sales take-or-pay agreement (page 3 of Iluka’s 2019 results). By the way, the firm is also one of Chemours’ suppliers, but now, the companies have a contract dispute, as Iluka claims CC failed to pay for its scheduled shipments of synthetic rutile in May and July 2020 (page 1; during the Q3 earnings call, CC did not touch on that matter, but in the Form 10-Q, it said that “the lawsuit lacks merit”).
So, what analysts are expecting Iluka to deliver in 2021? The pundits are overall optimistic, predicting an over 25% rebound from the 2020 revenue nadir. This, in turn, means that the revenue growth will be bolstered by the demand from the TiO2 companies that will replenish their inventories, anticipating higher demand for the pigment, and, obviously, higher sales and cash flows going forward.
To conclude, it seems the overall industry is demonstrating signs of a nascent but quite robust rebound, and KRO’s fundamentals are due to improve going forward, which might serve as a catalyst for capital appreciation, and also clearly means the dividend is not in jeopardy.
YTD cash flow surplus despite lackluster sales
Surprisingly, Kronos’ net cash flow touched a nadir well before the coronavirus crisis, in mid-2019. Back then, net CFFO (trailing four quarters) was only $44.8 million (as I explained in the note, it was partly the consequence of a hefty increase in receivables and also a result of the gross margin compression, which, in turn, was precipitated by inflation in the feedstock prices).
In 2020, the market conditions were (surprisingly) a bit more favorable, and KRO’s gross profit did not fell in such a precipitous manner. Sure, its gross margin was not unscathed, as it declined to 19.3% from 20% in 3Q19 (and was still deeply below the 1H18 level of 38%), but KRO remained profitable.
Also, in response to the tepid demand, the firm scaled production down in order not to end up with a pile of excess inventory that does not match short-term demand. Reduction in inventory provided an over $7.7 million inflow vs. $52.1 million in 9M19. So, FCF left after covering capex was $17.8 million. Of course, $62.4 million in dividends were not fully covered by it, but I hope that the coverage will improve along with the macro conditions.
Financial position cemented by hefty cash pile
While analyzing dividend sustainability, we should make sure a company has no looming maturities that can make it eliminate the dividend in order not to fell short of cash. Equity investors must always remember that they are not the only stakeholders in a company, and a dividend they receive is not the single cash allocation priority management has. Kronos’ case is not different. The company is not borrowings-free. So, we cannot simply ignore the liabilities side of the balance sheet, especially considering that its total debt stands at ~$467 million, and the market cap is slightly north of $1.6 billion. However, the company is anything but cash-strapped. Its Net debt/Net CFFO ratio is only 1.3x (thanks to the massive cash pile), while it has no material principal repayments due until 2025 (page 35 of the annual report). So, its balance sheet risk is very low.
Since summer, Kronos’ stock price has been on a tear, which led to the dividend yield compression, but I reckon ~5% is still quite appealing.
Insider buying even after vertiginous rally points to the fact that Kronos’ executives reckon the market has not priced in the revenue recovery prospects yet. Also, I strongly believe there is no risk that TiO2 lose relevance in the 2020s or later due to structural changes in the global economy and increasing focus on greener technologies. As I discussed in my January 2019 article, titania is almost irreplaceable, as it is the essential ingredient for a plethora of “quality of life” products.
To sum up, the stock has an appealing yield, but I should reiterate that among strong arguments against investing in KRO are its volatile revenues and vulnerable gross margin. So, investors who shun unstable margins and rollercoaster sales dynamics should look for better options.
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.