Tuesday, June 24, 2014

Part I: Changes Afoot in Titanium Pigment Industry

A Canadian company has developed a 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.  This is the first in a two part series offering investors 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, home and business owners coat dwellings and buildings with three billion gallons of paint a year.  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 7.1%, reaching US$69.4 billion by 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 private spinoff of its TiO2 operation to current Dupont shareholders followed by a merger with Tronox Ltd. (TROX:  Nasdaq), 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 expensive 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 entered into 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 has 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.     

Of Balance Sheets and Capital Needs

The price tag for Argex’s first TiO2 production plant in Canada is near CDN$300 million.  However, at the end of December 2013, Argex held CDN$5.1 million in cash and short term investments, just enough for working capital.  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 first 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 $393 million on long-term financial investments.         

PPG Industries might be the better vehicle for some investors to take advantage of changes in the titanium pigement market.  However, we have added Argex to the Materials Group of our Mothers of Invention Index of innovators in alternative energy.  The company has more to offer than just new TiO2 production.  The Argex TiO2 process presents real change in TiO2 production in terms of cost and environmental profile.  In the next post we will look more closely at how Argex’s technology has the potential to turn the TiO2 pigment industry on its head.

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. 


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