Analysts and investors have gone hog wild over Huntsman's (NYSE: HUN ) latest announced buyout of Rockwood Holdings' (NYSE: ROC.DL ) titanium dioxide, or TiO2, pigments business. Huntsman's management is super excited, and the markets sent the stock soaring post the announcement. But I have a feeling that Huntsman may not have made its best decision ever.
The deal not only increases Huntsman's exposure to a struggling industry significantly, but may also eat into the competitive advantages that Huntsman has enjoyed so far. From what I see, things could get really tough for Huntsman moving forward, until the company actually separates its pigments business through a public issue. And that's at least two years away.
Why not the more practical option?
In an earlier article, I had mentioned how volatile and unpredictable the TiO2 business can be. To reiterate, between 2008 and 2012, the TiO2 industry cycle had one peak but two troughs. In fact, the uncertainties have compelled almost every TiO2 producer, including DuPont (NYSE: DD ) , the world's largest TiO2 maker, to rethink their strategies. Let's not forget that major TiO2 consumers, especially paint companies, are also increasingly looking at alternatives. For perspective, PPG Industries (NYSE: PPG ) reduced its TiO2 usage last year by roughly 4% and plans to continue doing so this year.
If you go back a year, Huntsman didn't appear too keen on TiO2 either. During the company's second quarter 2012 earnings call, CEO Peter Huntsman had said: "I expect that our other divisions' earnings will improve, over time, as we become less dependent on our TiO2 earnings as a percentage of our overall business."
Certainly, Huntsman's plans to spin off its pigments business in two years' time will eventually lead to less, or actually zero dependency on TiO2 earnings. But if Huntsman wanted to keep its pigments business while mitigating risks, wasn't integrating vertically a better option, especially when high feedstock costs continue to pose a major threat?
Not the best place to be
That's exactly what Tronox (NYSE: TROX ) did. It acquired titanium ore deposits from feedstock producer Exxaro Resources last year, and now sources most of its pigments business' feedstock requirements in-house. So Tronox has not only secured a permanent solution to the long-standing problem of costly input, but has become one of the few feedstock suppliers in the industry.
Consulting company, TZ Minerals International, forecasts higher titanium feedstock prices to put "significant" pressure on margins of TiO2 producers over the next couple of years. Rockwood's pigments business will add nearly 60% to Huntsman's current TiO2 capacity of 565,000 metric tonnes, making Huntsman the largest buyer of sulphate ores. Combine TZMI's projections with the fact that ore accounts for 55% of Huntsman's pigment division's costs, and I'm not too sure whether I can be happy about Huntsman taking over as the second-biggest TiO2 producer in the world after the deal.
Even if I want to give Huntsman the benefit of doubt, presuming that ore costs may stabilize, there are other bigger factors about the deal that perturb me.
What Huntsman didn't tell you
There are two methods to produce TiO2 pigment – the chloride and the sulphate methods. While Huntsman currently uses both methods, the Rockwood deal will make it, essentially, a sulphate-TiO2 producer. Huntsman argues that sulphate feedstock is much cheaper than chloride feedstock, which is true. But what the company didn't tell investors is that the sulphate process also comes with extra baggage – it consumes greater amounts of energy and generates larger amounts of waste as compared to the chloride process.
Here's a simple, yet very useful chart that I have picked from Australian-based mining company, Mineral Deposits' presentation:
See the waste/TiO2 ratio for the two processes? Naturally, Huntsman will need to pump a good amount of money into waste management to abide by environmental regulations. And higher energy consumption will only add to costs. So it may not really be as cost effective as Huntsman wants investors to believe.
Landed in hot water
My bigger concern is what Huntsman itself has mentioned in its Annual Report – the sulphate technology is less capital intensive and easier to set up than the chloride technology -- think lower barriers to entry. So new players can easily enter the market and eat into the profits of existing companies. In short, Huntsman may have just landed itself in a muddle by becoming a primary sulphate player.
Need evidence? Cheap TiO2 products from China have flooded the U.S. markets in recent months, and China is almost a 100% sulphate-based TiO2 technology nation. Ironically, this increased invasion of sulphate-based TiO2 may have also driven Huntsman's decision to acquire Rockwood's TiO2 business, but that can also have two implications.
Where Huntsman may lose out
For one, Huntsman will lose the privilege of being one of those few companies that primarily produce high-grade chloride-based TiO2. Currently, while DuPont and Tronox are entirely chloride-based TiO2 producers, Huntsman, Cristal and Kronos Worldwide incorporate both processes. Secondly, Huntsman's competition base will widen significantly to include Chinese producers.
In fact, even Chinese producers, attracted by the superiority of the chloride process, are trying to build chloride-process plants. Several are expected to come online over the next three to four years. PPG Industries also chose China-based Henan Billions last year to license its TiO2-chloride technology.
Does Huntsman's move into the cheaper-grade TiO2 then make sense? More importantly, chloride-based TiO2 is widely used for automotive coatings, which means Huntsman may lose out on an important market.
Going against the tide
I see another yellow flag here. After the acquisition, share of Huntsman's pigment revenue from the Asia-Pacific region will fall2 percentage points to 15%, while Europe's share in revenue will increase 6 percentage points to 51%.
Europe continues to remain sluggish even as demand from Asia-Pacific soars. According to TZMI's Global TiO2 Pigment Producers Comparative Cost & Profitability Study 2013, the Asia-Pacific region, including China and Japan, alone accounted for a whopping 60% of the total TiO2 demand last year. What exactly is Huntsman thinking?
Separation of the TiO2 business will undoubtedly unlock greater value for Huntsman and its shareholders, but it's not going to be a smooth ride until then. I have been enthusiastic about Huntsman's business profile so far, but for reasons mentioned above, this deal has just left me a little wary.
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