Friday, June 27, 2014

Part II: Changes Afoot 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.  This is the second in a two part series offering investors two ways to play the innovation.

The Paint Producer

Paint and coatings are big business for companies like PPG Industries (PPG:  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 in 2016.  Raw materials, principally titanium dioxide, represent between 70% and 80% of the cost of paint. 

A proliferation of uses has put pressure on demand and selling price of titanium dioxide (TiO2).  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.  Suppliers and their customers are meeting both challenges head-on.
PPG Industries has entered into a supply and 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) plans to produce high purity TiO2 pigment from ilmenite ore using a highly proprietary process the company has been developing with PPG’s support.

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.  The process is 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, but it 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.         

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 security 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.  (See Part I of this two part series published on June 24, 2014 for more details on capital requirements.)   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 risk adverse investors to take advantage of changes in the titanium pigement market.  However, Argex is the innovator.   Thus Argex is the company 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.  Investors with the time to wait for results could be well rewarded for their patience with a position in Argex.

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.


No comments: