This High-Yield Stock Is Down 19% in 2018. Is It a Buy?

Although most people might think of highly engineered jet engine components when they think of titanium, the largest market for the metal is actually titanium dioxide, a white pigment sold as a powder and used in paints, sunscreen, and even foods. However, the lack of glamour doesn't translate to a lack of opportunity: Selling prices for titanium dioxide increased more than 20% in the first half of 2018 compared with the year-ago period. 

Despite continued strength globally for the material, many titanium dioxide producers have seen their share prices drop by double digits since the beginning of the year. For instance, Kronos Worldwide (KRO 0.01%) stock has dropped by 19% in 2018 even though the business is cruising along right now. That has pushed its dividend yield to 3.4% -- much higher than most peers.

Perhaps the year-to-date slide among titanium stocks is simply a function of their triple-digit gains in the last three years, or maybe Wall Street has other causes for concern. What should investors make of the situation? Is this high-yield stock a buy?

Image source: Getty Images.

By the numbers

Kronos Worldwide is making the most of rising titanium dioxide demand and selling prices. Well, technically not, as the business could have seen even better results if scheduled maintenance and upgrades hadn't temporarily knocked production facilities offline in the first half of 2018. The production fleet output dropped 6% in the first six months of 2018 compared with the first half of 2017. Significantly higher selling prices in the most recent period mean the lost sales potential was greater than 6%, but routine maintenance is routine maintenance. 

The important thing for investors to consider is what happens when production facilities revert back to 100% utilization in the back half of the year. Given the strength in selling prices -- the company said it realized a 23% spike year over year -- there's potential for a significant upside. That's great news considering what Kronos Worldwide was able to do in the first two quarters of 2018 even as it juggled production downtime. 

Data Source: SEC filing.

As the table above shows, the only financial blemish was net income. But that was impacted by a $120 million tax benefit in the first six months of 2017, compared with paying $61 million in tax expense in the first half of this year.

So, given the momentum of the business and industry, how does Wall Street justify sending the shares of almost every major titanium dioxide producer lower in 2018? The simple answer: history.

That is, the titanium dioxide industry is historically cyclical -- and the last crash was uniquely painful. During the Great Recession in 2009, many inefficient producers idled facilities. That led to a supply shortage that eventually was met by an avalanche of new capacity from China in 2011, which crashed global selling prices for years. While the memory is still fresh for Wall Street analysts, things are different today.

Most Chinese production facilities rely on inefficient and outdated processes that result in lower-quality grades of titanium dioxide. The global industry generally hasn't been willing to lower its standards, which has forced China to take a significant amount of capacity offline -- permanently. The result: Demand currently outpaces supply by an estimated 200,000 metric tons per year. 

It won't be so easy to fill the supply gap quickly, which gives Kronos Worldwide confidence that the current strength will continue for the foreseeable future. From its outlook: 

Due to the constraints of high capital costs and extended lead time associated with adding significant new titanium dioxide production capacity, especially for premium grades of titanium dioxide products produced from the chloride process, we believe increased and sustained profit margins will be necessary to financially justify major expansions of western producers' titanium dioxide production capacity required to meet expected future growth in demand. Any such major expansion of titanium dioxide production capacity, if announced, would take a number of years before such production would become available to meet future growth in demand.

Furthermore, many titanium dioxide producers have begun signing customers to long-term contracts, which smooths out pricing volatility on both ends of the transaction. That will help to blunt the impact of the historical boom-bust cycle. In other words, many titanium dioxide producers think Wall Street will be proven wrong relatively soon. Considering Kronos Worldwide stock trades at just eight times future earnings, 1.3 times sales, and sports an EV-to-EBITDA value of 5, long-term investors may find good reasons to be attracted to the low valuations across the industry right now. 

Image source: Getty Images.

Long-term investors may see an opportunity here

Kronos Worldwide has done everything right in the first half of 2018, which has helped the business to deliver solid year-over-year growth in revenue, various profitability metrics, and operating cash flow. That makes its 3.4% dividend yield more than sustainable and bodes well for management's ability to send even higher levels of regular income to shareholders in future periods.

While analysts have turned sour on titanium dioxide producers out of fear that the historically cyclical industry is peaking, Wall Street may be overlooking why things are different this time around. Major producers have been careful to balance supply with demand in recent years, China isn't the wild card it used to be, and new long-term supply agreements should all combine to lower the risk of another bust. Given the low valuation of Kronos Worldwide stock, long-term investors may want to seriously consider giving this high-yield investment a closer look.