At the end of January 2017, Huntsman announced that one of its most important manufacturing facilities had experienced a fire. No one was hurt and the fire was quickly extinguished, but the Pori, Finland, facility had been badly damaged. The timing couldn't have been worse.
That's because Huntsman was in the process of spinning off its titanium dioxide business as Venator Materials (VNTR 47.06%). The Finland facility fell under the new company's umbrella -- and now it was the new company's problem. Worse, it was knocked offline just as the global titanium dioxide market was entering an epic rebound.
While Venator Materials is strategically rebuilding the facility in two stages, the cost to do so will exceed the amount it received from an insurance policy -- and the price tag continues to climb higher. That admission from management has Wall Street worried that the rebuild could threaten cash flow through 2020. The stock now trades at some of the lowest valuation metrics among titanium dioxide producers, while shares have grossly underperformed those of peers in their short time on the market, losing 12.5%.
Will the next 12 months really be that bad for Venator Materials? The Finland facility is very important to the company and shareholders, so here's what investors need to know about the rebuilding efforts.
Why is the Finland facility so important?
Venator Materials' Finland facility is one of the largest titanium dioxide manufacturing plants in the world. It had an annual production capacity of 130,000 metric tons (MT), which represented approximately 15% of the company's total output and 10% of European demand for the pigment.
Additionally, Venator Materials was and is still weeding out operational inefficiencies that didn't exist or weren't as obvious when it was part of Huntsman. Those issues created internal operating friction and weighed on margins, which partially explains why the company didn't fare quite as well as its titanium dioxide peers for much of 2017. The good news is those efforts are nearly wrapped up and are expected to deliver up to $90 million in annual adjusted EBITDA benefits by the first quarter of 2019. The bad news is the Finland facility has weighed on performance, rather than helping it.
How is Venator Materials approaching the rebuild?
Management has proceeded with a strategic rebuild of the Finland facility. The primary focus is getting the specialty products capacity back online. While that portion only comprised 60% of the site's total production capacity, it generated about 75% of the plant's EBITDA.
Approximately 40% of the total plant capacity, or two-thirds of the specialty portion, will come back online by the end of June 2018. The specialty portion will operate at full tilt by the end of 2018. However, because of the strong market fundamentals for titanium dioxide, Venator Materials is racing to rebuild this portion and claims to be paying a "fast-track premium" as a result.
The remaining 40% of the plant's total production capacity sells into commodity markets and is therefore not a priority at this time. Venator Materials doesn't plan to bring this portion of the facility online until 2020 at the earliest.
How much will the Finland facility rebuild cost?
Cost has become a central issue for Wall Street and shareholders. The good news is the Finland facility is covered by an insurance policy for property damage and business interruption for up to $500 million total. The bad news is the rebuilding costs were always expected to exceed that amount. The worse news is that costs have been revised upwards.
At the end of the third quarter of 2017, Venator Materials estimated that reconstruction expenses would exceed the insurance limits by as much as $150 million. By the end of the fourth quarter of 2017, management revised its estimates much higher, expecting the costs to outpace the insurance policy by $325 million to $375 million.
Why the giant increase? Well, the price tag of the rebuild with respect to the insurance policy has soared in large part due to the strong fundamentals of the titanium dioxide market, not entirely because rebuilding costs have increased. In other words, rising selling prices of titanium dioxide increases the calculated paper loss associated with "business interruption," but the "property damage" estimates haven't risen. Of course, since the insurance policy covers $500 million of these combined expenses, the result is the same: Venator Materials has to cover the excess.
Should investors be concerned?
The Finland facility's reconstruction costs have soared well above what management originally prepared shareholders to expect, which has pushed many investors and Wall Street analysts toward the exits in early 2018. That's hardly surprising.
Although Venator Materials is finally piecing together respectable operations as a stand-alone business, it was expecting to apply most of its excess cash flow in the next few years to cleaning up the balance sheet. Management's long-term goal is to reduce net debt to $350 million, compared to $519 million at the end of 2017. Swelling costs at the Finland facility aren't going to make that any easier.
But some nuance is needed here. The company has received $315 million from its insurance policy to date. It's possible that the full $500 million limit will be collected by the end of 2018 as the specialty materials portion of the Finland facility is fully rebuilt. In other words, most of the $325 million to $375 million in excess costs won't be incurred until Venator Materials decides to bring the commodity materials portion of the site back online.
Since that's not expected to occur until 2020 at the earliest, it should be entirely possible for the company to meets internal debt reduction goals before it swallows the out-of-pocket reconstruction costs. Management may even choose to not rebuild that part of the site if the opportunity cost is less than $325 million in a reasonable period of time, which would mean the cash costs would never be incurred at all.
That's not an insignificant detail to consider. Among titanium dioxide stocks, Venator Materials trades at a relatively high EV to EBITDA ratio of 11.8 times. Peers Kronos and Chemours Company trade at just 7.5 times and 8.5 times, respectively. But the newcomer also offers a healthy PEG ratio of just 0.27, a price-to-sales ratio of just 0.87 times, and a price-to-book ratio of 1.75 times. Kronos and Chemours Company are twice as expensive on the basis of revenue and trade at 3.5 times and 10.4 times book value, respectively.
If cost efficiency measures pan out as management expects, then Venator Materials will deliver significantly higher EBITDA beginning in 2019. If cash flow can be devoted to reducing debt, then the company's leverage will drop closer to peers. At that point, the stock would either be significantly undervalued relative to peers or on the road to redemption.
Therefore, while Mr. Market is treating this issue as a giant red flag for Venator Materials stock, the excess costs of the rebuild with respect to the insurance policy are a largely voluntary expense. Investing in the company today isn't risk-free, and this stock needs to be monitored closely if it's in your portfolio, but it may be substantially less risky than Wall Street seems to think.