UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

 

Commission file number 1-32669

 

TRONOX INCORPORATED

(Exact Name of Registrant as Specified in its Charter)

 

 

One Leadership Square, Suite 300

211 N. Robinson Ave, Oklahoma City, Oklahoma 73102

(Address of principal executive offices)

 

Registrant’s telephone number, including area code: (405) 775-5000

 

Securities Registered Pursuant to Section 12(b) of the Act:

 

 

No Securities are Registered Pursuant to Section 12(g) of the Act.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (see definition of “accelerated filer” in Rule 12b-2 under the Exchange Act). (Check one):

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market values of the registrant’s Class A and Class B common stock held by non-affiliates of the registrant, computed by reference to the prices at which the classes of common stock were last sold on the New York Stock Exchange on June 30, 2006, were $238.3 million and $301.5 million, respectively.

 

As of February 28, 2007, 18,539,014 shares of the company’s Class A common stock and 22,889,431 shares of the company’s Class B common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III incorporates certain information by reference from the registrant’s definitive proxy statement to be filed within 120 days of the year end with respect to its Annual Meeting of Shareholders to be held on May 8, 2007.

 

 

Tronox Incorporated

 

Form 10-K

 

Table of Contents

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

Statements in this report regarding Tronox Incorporated’s or management’s intentions, beliefs or expectations, or that otherwise speak to future events, are “forward-looking statements” within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. These forward-looking statements include those statements preceded by, followed by or that otherwise include the words “believes,” “will,” “expects,” “anticipates,” “intends,” “estimates,” “projects,” “target,” “budget,” “goal,” “plans,” “objective,” “outlook,” “should,” or similar words. Future results and developments discussed in these statements may be affected by numerous factors and risks, such as the accuracy of the assumptions that underlie the statements, the market value of Tronox Incorporated’s products, demand for consumer products for which Tronox Incorporated’s businesses supply raw materials, the financial resources of competitors, changes in laws and regulations, the ability to respond to challenges in international markets, including changes in currency exchange rates, political or economic conditions in areas where Tronox Incorporated operates, trade and regulatory matters, general economic conditions, and other factors and risks identified in Tronox Incorporated’s U.S. Securities and Exchange Commission filings. Actual results and developments may differ materially from those expressed or implied in this annual report on Form 10-K. Tronox Incorporated does not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statement was made. Investors are urged to consider closely the disclosures and risk factors in this annual report on Form 10-K.

TRONOX INCORPORATED

 

PART I

previously stated 72,000 tonne capacity. The Uerdingen, Germany, plant is our only sulfate process TiO₂ plant and produces a very high-quality pigment demanded by many specialty markets, with a current capacity of 107,000 tonnes.

 

In the past, we have operated or held businesses or properties, or currently hold properties, that do not relate to the current chemical business, including businesses involving the treatment of forest products, the production of ammonium perchlorate, the refining and marketing of petroleum products, offshore contract drilling, coal mining and the mining, milling and processing of nuclear materials.

 

Company Background

 

Tronox Incorporated, a Delaware corporation, was formed on May 17, 2005, in preparation for the contribution and transfer by Kerr-McGee Corporation (“Kerr-McGee”), of certain entities including those comprising substantially all of its chemical business (the “Contribution”). The Contribution was completed in November 2005 along with our recapitalization, whereby our common stock held by Kerr-McGee converted into approximately 22.9 million shares of Class B common stock. An initial public offering (“IPO”) of our Class A common stock was subsequently completed on November 28, 2005. Prior to the IPO, we were a wholly-owned subsidiary of Kerr-McGee. Pursuant to the IPO registration statement on Form S-1, we sold approximately 17.5 million shares of our Class A common stock at a price of $14.00 per share. Pursuant to the terms of the Master Separation Agreement dated November 28, 2005, among Kerr-McGee, Kerr-McGee Worldwide Corporation and us (the “MSA”), the net proceeds from the IPO of approximately $224.7 million were distributed to Kerr-McGee.

 

Concurrent with the IPO, we, through our wholly-owned subsidiaries, issued $350.0 million in aggregate principal amount of 9.5% senior unsecured notes due 2012 and borrowed $200.0 million under a six-year senior secured credit facility. Pursuant to the terms of the MSA, we distributed the net proceeds from the borrowings of approximately $537.1 million to Kerr-McGee.

 

Following the IPO, approximately 43.3% of our total outstanding common stock was held by the general public and 56.7% was held by Kerr-McGee. The holders of Class A common stock and Class B common stock have identical rights, except that holders of Class A common stock are entitled to one vote per share while holders of Class B common stock are entitled to six votes per share on all matters to be voted on by stockholders. On March 30, 2006, Kerr-McGee distributed all of our Class B common stock as dividends to its shareholders (the “Distribution”), resulting in Kerr-McGee having no ownership or voting interest in Tronox.

 

Competitive Strengths

 

We benefit from a number of competitive strengths, including the following:

 

Leading Market Positions

 

We are the world’s third-largest producer and marketer of TiO₂ products based on reported industry capacity by the leading TiO₂ producers and the world’s second-largest producer and supplier of TiO₂ manufactured via proprietary chloride technology, which we believe is preferred for many of the largest end-use applications. We estimate that we have a 14% share of the $5.5 billion global market for the use of TiO₂ in coatings, which industry sources consider the largest end-use market. We believe our leading market positions provide us with a competitive advantage in retaining existing customers and obtaining new business.

 

Global Presence

 

We are one of the few TiO₂ manufacturers with global operations. We have production facilities and a sales and marketing presence in the Americas, Europe and the Asia-Pacific region. In 2006, sales into the Americas accounted for approximately 46% of our total TiO₂ net sales, followed by approximately 30% into Europe and approximately 24% into the Asia-Pacific region. Our global presence enables us to provide customers in approximately 100 countries with a reliable source of multiple grades of TiO₂. The diversity of the geographic markets we serve also mitigates our exposure to regional economic downturns.

 

Well-Established Relationships with a Diverse Customer Base

 

We sell our products to a diverse portfolio of customers with whom we have well-established relationships. Our customer base consists of approximately 1,100 customers in approximately 100 countries and includes market leaders in each of the major end-use markets for TiO₂. We have supplied each of our top ten customers with TiO₂ for more than ten years. We work closely with our customers to optimize their formulations, thereby enhancing the use of TiO₂ in their production processes. This has enabled us to develop and maintain strong relationships with our customers, resulting in a high customer retention rate.

 

Innovative, High-Performance Products

 

We offer innovative, high-performance products for nearly every major TiO₂ end-use application, including seven grades of TiO₂ for specialty applications such as inks, catalysts and electro-ceramics. We are dedicated to continually developing our TiO₂ products to better serve our customers and responding to the increasingly stringent demands of their end-use markets. We have new and improved products for nearly every major application, and these grades are in various stages of development and preliminary plant trials.

 

Proprietary Production Technology

 

We are one of a limited number of producers in the TiO₂ industry to hold the rights to a proprietary chloride process for the production of TiO₂. Approximately 83% of our gross production capacity uses this process technology, which is the subject of numerous patents worldwide and is utilized by our highly skilled and technologically sophisticated work force. TiO₂ produced using chloride process technology is preferred for many of the largest end-use applications. The chloride production process generates less waste, uses less energy and is less labor intensive than the sulfate process. The complexity of developing and operating the chloride process technology makes it difficult for others to enter and successfully compete in the chloride process TiO₂ industry.

 

Experienced Management Team

 

Our management team has an average of 24 years of business experience. The diversity of their business experience provides a broad array of skills that contributes to the successful execution of our business strategy. Our operations team and plant managers, who have an average of 22 years of manufacturing experience, participate in the development and execution of strategies that have resulted in production volume growth, production efficiency improvements and cost reductions. The experience, stability and leadership of our sales organization have been instrumental in growing sales, developing and maintaining customer relationships and increasing our market share.

 

Business Strategy

 

We use specific and individualized operating measures throughout our organization to track and evaluate key metrics. This approach serves as a scorecard to ensure alignment with, and accountability for, the execution of our strategy, which includes the following components:

 

Strong Customer Focus

 

We target our key markets with innovative, high-performance products that provide enhanced value to our customers at competitive prices. A key component of our business strategy is to continually enhance our product portfolio with high-quality, market-driven product development. We design our TiO₂ products to satisfy our customers’ specific requirements for their end-use applications and align our business to respond quickly and efficiently to changes in market demands. New and enhanced grades for coatings, plastic and specialty applications are being developed for introduction in 2007 and 2008.

 

Technological Innovation

 

We employ customer and end-use market feedback, technological expertise and fundamental research to create next-generation products and processes. Our technology development efforts include building value-added properties into our TiO₂ to enhance its performance in our customers’ end-use applications. Our research and

development teams support our future business strategies, and we manage those teams using disciplined project management tools and a team approach to technological development.

 

Cornerstone Performance Improvement Program

 

In mid-2006, we implemented Project Cornerstone in an effort to achieve top quartile financial performance. Formal teams and a structured project approach were utilized during the year to execute agreed upon work plans and timelines over a five-year period. The program is designed to achieve targeted levels of performance in a number of key operational and financial areas such as:

 

 

Operational Excellence

 

In 2006, we continued to improve in the areas of energy efficiency and operating efficiencies. We also continued to use a broad spectrum of TiO₂ ores, while maintaining the TiO₂ yield through more tightly controlled plant operations. In addition, increased plant uptime contributed to record production in 2006. This increased production capability coupled with additional organic growth opportunities positions us to meet near term market growth.

 

Maximize Asset Efficiency

 

We optimize our production plan through strategic use of our global facilities to save on both transportation and warehousing costs. Our production process is designed with multiple production lines. As a result, we can remedy issues with an individual line without shutting down other lines and idling an entire facility. We also actively manage production capability across all facilities. For instance, if one plant’s finishing lines are already at full capacity, that plant’s unfinished TiO₂ can be transferred to another plant for finishing.

 

Supply Chain Optimization

 

We improve our supply chain efficiency by focusing on reducing both operating costs and working capital needs. Our supply chain efforts to lower operating costs consist of reducing procurement spending, lowering transportation and warehouse costs and optimizing production scheduling. We actively manage our working capital by increasing inventory turnover and reducing finished goods and raw materials inventory without affecting our ability to deliver TiO₂ to our customers.

 

Organizational Alignment

 

Aligning the efforts of our employees with our business strategies is critical to our success. To achieve that alignment, we evaluate the performance of our employees using a balanced scorecard approach. We also invest in training initiatives that link our employees’ activities directly to our business strategies. For instance, we continue to utilize training from the well-regarded supply chain management training program at Michigan State University’s Broad Executive School of Management along with Six Sigma methodology training to support our operational excellence and asset efficiency strategic objectives.

 

Industry Background

 

We are one of the leading global producers and marketers of TiO₂. We also produce a variety of electrolytic and other specialty chemical products.

 

Titanium Dioxide

 

Titanium dioxide, or TiO₂, is a white pigment used in a wide range of products for its exceptional ability to impart whiteness, brightness and opacity. TiO₂ is a critical component of everyday applications, such as coatings, plastics and paper, as well as many specialty products such as inks, food and cosmetics. TiO₂ is widely considered to be superior to alternative white pigments in large part due to its hiding power, which is the ability to cover or mask other materials effectively and efficiently. For example, TiO₂’s hiding power helps prevent show-through on printed paper materials (making the materials easier to read) and a high concentration of TiO₂ within paints reduces the number of coats needed to cover a surface effectively. TiO₂ is designed, marketed and sold based on specific end-use applications.

 

The global TiO₂ market is characterized by a small number of large global producers. In addition to our company, there are four other major producers: E.I. du Pont de Nemours and Company, Millennium Chemicals Inc., Huntsman Corporation and Kronos Worldwide, Inc. These five major producers accounted for approximately 65% of the global market in 2006, according to reports by these producers.

 

Based on reported industry sales by the leading TiO₂ producers, we estimate that global sales of TiO₂ in 2006 exceeded 4.9 million tonnes, generating approximately $10 billion in industry-wide revenues. Because TiO₂ is a “quality of life” product, its consumption growth is closely tied to a given region’s economic health and correlates over time to the growth in its average gross domestic product (“GDP”). According to industry estimates, TiO₂ consumption has been growing at a compounded annual growth rate of approximately 2.8% over the past decade.

 

Although there are other white pigments on the market, we believe that TiO₂ has no effective substitute because no other white pigment has the physical properties for achieving comparable opacity and brightness or can be incorporated in as cost-effective a manner. In an effort to optimize TiO₂’s cost-to-performance ratio in certain applications, some customers also use pigment “extenders,” such as synthetic pigments, kaolin clays and calcium carbonate. We estimate that the impact on our total sales from the use of such extenders is minimal.

 

Titanium Dioxide Outlook

 

The world economy has experienced a prolonged period of GDP growth over the past several years and throughout 2006. In Europe, we observed some of the strongest growth since 2000, with Germany being a strong contributor and continued growth in China and India. The overall trend is expected to end in 2007 as the world economic growth decelerates. Due to the slowdown in the housing sector and its effects, the United States (“U.S.”) economy is expected to remain soft for the first half of 2007 but may begin to turn around in the second half of 2007. While growth in China, Europe and Japan are expected to remain close to last year, the growth in these areas is not expected to totally compensate for a weak U.S. on the global economy. Outlook for emerging economies remains positive overall, but some moderation in growth is also expected.

 

Following the moderation in growth in 2007, the long-term outlook for TiO₂ remains positive with increasing demands in the rapidly growing Asia-Pacific region, which is projected to be the world’s largest pigment consuming region by 2010. This coupled with the fact that new plant construction projects are not expected to be completed until at least 2010 should contribute to strong long-term demand.

 

Manufacturing Titanium Dioxide

 

Production Process.  TiO₂ is produced using a combination of processes involving the manufacture of base pigment particles followed by surface treatment, drying and milling (collectively known as finishing). There are two commercial production processes in use: the chloride process and the sulfate process. The chloride process is a newer technology and has several advantages over the sulfate process: it generates less waste, uses less energy, is less labor intensive and permits the direct recycle of a major process chemical, chlorine, back into the production process. In addition, as described below under “Types of Titanium Dioxide,” TiO₂ produced using the chloride process is preferred for many of the largest end-use applications. As a result, the chloride process currently accounts for substantially all of the TiO₂ production capacity in North America and approximately 55% of worldwide capacity. Since the late 1980s, the vast majority of TiO₂ production capacity that has been built uses the chloride process.

 

In the chloride process, feedstock ores (titanium slag, synthetic rutile, natural rutile or ilmenite ores) are reacted with chlorine (the chlorination step) and carbon to form titanium tetrachloride (“TiCl₄”) in a continuous fluid bed reactor. Purification of TiCl₄ to remove other chlorinated products is accomplished using a distillation process. The purified TiCl₄ is then oxidized in a vapor phase form to produce base pigment particles and chlorine gas. The latter is recycled back to the chlorination step for reuse. Base pigment is then typically slurried with water and dispersants prior to entering the finishing step.

 

In the sulfate process, batch digestion of ilmenite ore or titanium slag is carried out with concentrated sulfuric acid to form soluble titanyl sulfate. After treatment to remove soluble and insoluble impurities and concentration of the titanyl sulfate, hydrolysis of the liquor forms an insoluble hydrous titanium oxide. This precipitate is filtered, bleached, washed and calcined to produce a base pigment that is then forwarded to the finishing step.

 

Types of Titanium Dioxide.  Commercial production of TiO₂ results in one of two different crystal forms, either rutile or anatase. Rutile TiO₂ is preferred over anatase TiO₂ for many of the largest end-use applications, such as coatings and plastics, because its higher refractive index imparts better hiding power at lower quantities than the anatase crystal form. Although rutile TiO₂ can be produced using either the chloride process or the sulfate process, customers often prefer rutile produced using the chloride process because it typically has a bluer undertone and greater durability.

 

Anatase TiO₂ can only be produced using the sulfate process and has applications in paper, rubber, fibers, ceramics, food and cosmetics. It is not recommended for outdoor applications because it is less durable than rutile TiO₂.

 

Raw Materials.  The primary raw materials that we use to produce TiO₂ are various types of titanium-bearing ores, including ilmenite, natural rutile, synthetic rutile, titanium-bearing slag and leucoxene. We generally purchase ores under multi-year agreements from a variety of suppliers in Australia, Canada, India, Norway, South Africa, Ukraine and the U.S. We purchase approximately 40% of the titanium-bearing ores we require from two suppliers under long-term supply contracts that expire in 2007 through 2010. Approximately 78% of the synthetic and natural rutile used by our facilities is obtained from the operations under the Tiwest joint venture arrangement. See “The Tiwest Joint Venture” in Item 2. We do not anticipate difficulties obtaining long-term extensions to our existing supply contracts prior to their expiration. Other significant raw materials include chlorine and petroleum coke for the chloride process, which we obtain from many suppliers worldwide, and sulfuric acid for the sulfate process, which we produce ourselves.

 

Electrolytic and Other Chemical Products

 

Battery Materials

 

The battery industry uses electrolytic manganese dioxide (“EMD”) as the active cathode material for primary (non-rechargeable) batteries and lithium manganese oxide and lithium vanadium oxide in rechargeable lithium batteries. Battery applications account for nearly all of the consumption of these chemicals.

 

The primary battery market is composed of alkaline and zinc carbon battery technologies to address the various power delivery requirements of a multitude of consumer battery-powered devices. Approximately 81% of market demand in the U.S. is for alkaline batteries, which are higher performing and more costly than batteries using the older zinc carbon technology. We are a key supplier of EMD for the alkaline battery market.

 

EMD quality requirements for alkaline technology are much more demanding than for zinc carbon technology and, as a result, alkaline-grade EMD commands a higher price than zinc carbon-grade EMD. The older zinc carbon technology remains dominant in developing countries such as China and India. As the economies of China and India continue to mature, and the need for more efficient energy sources develops, we anticipate that the demand for alkaline-grade EMD will increase.

 

The market application for rechargeable lithium batteries is consumer electronics, in particular cell phones, computers, camcorders and, most recently, power tools. A combination of improved power delivery performance and lighter weight has allowed rechargeable lithium technology to displace older lead acid and nickel cadmium technologies.

 

The primary raw material that we use to produce battery materials is manganese ore, which is purchased under multi-year agreements and spot contracts.

 

Sodium Chlorate

 

The pulp and paper industry accounts for more than 95% of the market demand for sodium chlorate, which uses it to bleach pulp. Although there are other methods for bleaching pulp, the chlorine dioxide process is preferred for environmental reasons. Approximately 62% of North American sodium chlorate production capacity is located in Canada due to the availability of lower cost hydroelectric power, which reduces manufacturing costs and ultimately, product prices. However, we believe that the proximity of domestic sodium chlorate producers to the major domestic pulp and paper producers helps offset the lower-cost power advantage enjoyed by Canadian sodium chlorate producers, through lower transportation costs.

 

The primary raw material that we use to produce sodium chlorate is sodium chloride, which we purchase under multi-year agreements and spot contracts.

 

Boron

 

We produce two types of boron specialty chemicals: boron trichloride and elemental boron. Boron trichloride is a specialty chemical that is used in many products, including pharmaceuticals, semiconductors, high-performance fibers, specialty ceramics and epoxies. Elemental boron is a specialty chemical that is used in igniter formulations for the defense, pyrotechnic and automotive air bag industries.

 

End-Use Markets and Applications

 

Titanium Dioxide

 

The major end-use markets for TiO₂ products, which we sell in the Americas, Europe and the Asia-Pacific region, are coatings, plastics and paper and specialty products. The tables below summarize our approximate 2006 net sales by geography and our approximate 2006 sales volume by end-use market:

 

 

Coatings End-Use Market.  The coatings end-use market represents the largest end-use market for TiO₂ products and accounts for approximately 60% of overall industry demand, based on reported industry sales volumes, and 66% of our 2006 sales volume. Customers in the coatings end-use market demand exceptionally high quality standards for TiO₂, especially with regard to opacity, durability, tinting strength and brightness. We recognize four sub-markets within the coatings end-use market based on application, each of which requires different TiO₂ formulations. The table below summarizes the sub-markets within coatings, as well as their applications and primary growth factors:

 

Plastics End-Use Market.  The plastics end-use market accounts for approximately 24% of overall industry demand for TiO₂, based on reported industry sales volumes, and 23% of our 2006 sales volume. Plastics producers focus on TiO₂’s opacity, durability, color stability and thermal stability. We recognize four sub-markets within the plastics market based on application, each of which requires different TiO₂ formulations. The table below summarizes the sub-markets within plastics, as well as their applications and primary growth factors:

 

 

Paper and Specialty End-Use Market.  The paper and specialty end-use market accounts for approximately 16% of overall industry demand for TiO₂, based on reported industry sales volumes, and 11% of our 2006 sales volume. We recognize four sub-markets within paper and specialty end-use market based on application, each of which requires different TiO₂ formulations. The table below summarizes the sub-markets within paper and specialty, as well as their applications and primary growth factors:

 

Electrolytic and Other Chemical Products

 

Our other product lines include chemicals for battery materials, sodium chlorate for pulp bleaching and boron-based specialty chemicals. The sub-markets for those products, together with their applications and growth factors, are as follows:

 

 

Sales and Marketing

 

We supply TiO₂ to a diverse customer base that includes market leaders in each of the major end-use markets for TiO₂. In 2006, our ten largest customers represented approximately 36% of our total sales volume and no single customer accounted for more than 10% of our total sales volume.

 

In addition to price and product quality, we compete on the basis of technical support and customer service. Our direct sales and technical service organizations carry out our sales strategy and work together to provide quality customer service. Our direct sales staff is trained in all of our products and applications. Because of the technical requirements of TiO₂ applications, our technical service organization and direct sales offices are supported by a regional customer service staff located in each of our major geographic markets.

 

Our sales and marketing strategy focuses on effective customer management through the development of strong relationships throughout our company with our customers. We develop customer relationships and manage customer contact through our sales team, technical service organization, research and development team, customer service team, plant operations personnel, supply chain specialists and senior management. We believe that multiple points of customer contact facilitate efficient problem-solving, supply chain support, formula optimization and product co-development. By developing close relationships with our customers and providing well-designed products and services, we are a value-added business partner.

 

Competitive Conditions

 

Titanium Dioxide

 

The global market in which our TiO₂ business operates is highly competitive. Worldwide, we believe that we and the four other major producers are the only companies that use proprietary chloride process technology for production of TiO₂. We estimate that, based on gross sales volumes, these companies accounted for approximately 65% of the global market share in 2006. We believe that cost efficiency and product quality, as well as technical and customer service, are key competitive factors for TiO₂ producers.

 

TiO₂ produced using chloride process technology is preferred for many of the largest TiO₂ end-use applications; however, TiO₂ produced using sulfate process technology is preferred for certain specialty applications. The following table summarizes the estimated market share and production process mix for the five leading TiO₂ producers for fiscal year 2006:

 

 

As of December 31, 2006, including the total production capacity of our Tiwest Joint Venture (see “The Tiwest Joint Venture” in Item 2), we had global production capacity of 642,000 tonnes per year and an approximate 12% global market share. In addition to the major competitors discussed above, we compete with numerous smaller, regional producers, as well as producers in China that have expanded their sulfate production capacity during the previous five years.

 

Electrolytic and Other Chemical Products

 

Electrolytic Manganese Dioxide.  The U.S. market accounts for approximately one-third of global demand for EMD, and is based on alkaline grade EMD. We are a key supplier to this market and have an estimated 8% share of total global capacity. Other significant producers and their estimated global capacity shares include Erachem (7%) in the U.S., as well as international producers Delta (17%), Tosoh (15%), Xiangtan (11%) and Mitsui (7%). The remainder of global capacity is represented by various Chinese producers.

 

Sodium Chlorate.  We have an estimated 8% share of North American sodium chlorate capacity. Our significant competitors and their estimated share of North American capacity are ERCO (27%), Eka Chemicals (27%), Canexus (19%) and Kemira-Finnish Chemicals (11%).

 

Other Specialties.  For boron products, we believe that we have the majority of the installed global capacity for boron trichloride. Other boron production capacity is located in Ireland, Japan and Russia.

 

Research and Development

 

Research and development is an integral component of our business strategy. Enhancing our product portfolio with high-quality, market-focused product development is key in driving our business from the customer perspective.

 

We have approximately 90 scientists, chemists, engineers and skilled technicians to provide the technology (products and processes) for our business. Our product development personnel have a high level of expertise in the plastics industry and polymer additives, the coatings industry and formulations, surface chemistry, material science, analytical chemistry and particle physics. Among the process technology development group’s highly developed skills are computational fluid dynamics, process modeling, particle growth physics, extractive metallurgy, corrosion engineering and thermodynamics. The majority of scientists supporting our research and development efforts are located in Oklahoma City, Oklahoma. Our expenditures for research and development were approximately $9.4 million in 2006, $8.4 million in 2005 and $6.3 million in 2004.

 

New process developments are focused on increased through-put, control of particle physical properties and general processing equipment-related issues. Ongoing development of process technology contributes to cost reduction, enhanced production flexibility, increased capacity and improved consistency of product quality.

 

In 2006, we commercialized two new pigment grades for architectural paints and specialty applications and continue to work closely with customers for market implementation. Additionally, several existing products were

enhanced either in performance, manufacturing capability or cost reduction. New products for coatings, plastic, paper laminate and specialty applications are in the pipeline for introduction in 2007 and 2008.

 

Patents and Other Intellectual Property

 

Patents held for our products and production processes are important to our long-term success. We seek patent protection for our technology where competitive advantage may be obtained by patenting, and file for broad geographic protection given the global nature of our business. Our proprietary TiO₂ technology is the subject of numerous patents worldwide, the substantial majority of which relate to our chloride products and production technology.

 

We also rely upon and have taken steps to secure our unpatented proprietary technology, know-how and other trade secrets. Our proprietary chloride production technology is an important part of our overall technology position. We are committed to pursuing technological innovations in order to maintain our competitive position.

 

Employees

 

We have approximately 2,130 employees, with approximately 1,230 in the U.S., 860 in Europe, 30 in Australia and 10 in other international locations. Approximately 16% of our employees in the United States are represented by collective bargaining agreements, and approximately 99% of our employees in Europe are represented by works’ councils. We consider relations with our employees to be good.

 

Government Regulations and Environmental Matters

 

General

 

We are subject to extensive regulation by federal, state, local and foreign governments. Governmental authorities regulate the generation and treatment of waste and air emissions at our operations and facilities. At many of our operations, we also comply with worldwide, voluntary standards such as International Organization for Standardization (“ISO”) 9002 for quality management and ISO 14001 for environmental management. ISO 9000 and 14000 are standards developed by the ISO, a nongovernmental organization that promotes the development of standards and serves as a bridging organization for quality and environmental standards.

 

Environmental Matters

 

A variety of laws and regulations relating to environmental protection affect almost all of our operations. Under these laws, we are or may be required to obtain or maintain permits or licenses in connection with our operations. In addition, these laws require us to remove or mitigate the effects on the environment of the disposal or release of chemical, petroleum, low-level radioactive and other substances at various sites. Operation of pollution-control equipment usually entails additional expense. Some expenditures to reduce the occurrence of releases into the environment may result in increased efficiency; however, most of these expenditures produce no significant increase in production capacity, efficiency or revenue.

 

The table below presents environmental related expenditures we incurred for the year ended December 31, 2006, and projections of expenditures for the next two years. While it is difficult to estimate the total direct and indirect costs of government environmental regulations, the table below includes our current estimate of expenditures for 2007 and 2008.

 

 

 

 

Recurring operating expenses are expenditures related to the maintenance and operation of environmental equipment such as incinerators, waste treatment systems and pollution control equipment, as well as the cost of materials, energy and outside services needed to neutralize, process, handle and dispose of current waste streams at our operating facilities. These operating and capital expenditures are necessary to ensure that ongoing operations are handled in an environmentally safe and effective manner.

 

We are party to a number of legal and administrative proceedings involving environmental matters or other matters pending in various courts or agencies. These include proceedings associated with businesses and facilities currently or previously owned, operated or used by our affiliates or their predecessors, and include claims for personal injuries, property damages, breach of contract, injury to the environment, including natural resource damages, and non-compliance with, or lack of properly updated or renewed, permits. Our current and former operations also involve management of regulated materials and are subject to various environmental laws and regulations. These laws and regulations obligate us to clean up various sites at which petroleum and other hydrocarbons, chemicals, low-level radioactive substances or other materials have been contained, disposed of and/or released. Some of these sites have been designated Superfund sites by the U.S. Environmental Protection Agency (“EPA”) pursuant to the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (“CERCLA”) and are listed on the National Priority List.

 

We provide for costs related to environmental contingencies when a loss is probable and the amount is reasonably estimable. It is not possible for us to reliably estimate the amount and timing of all future expenditures related to environmental matters because, among other reasons:

 

 

We believe that we have reserved adequately for the reasonably estimable costs of known contingencies. However, additions to the reserves may be required as additional information is obtained that enables us to better estimate our liabilities, including any liabilities at sites now under review. We cannot reliably estimate the amount of future additions to the reserves at this time. Additionally, there may be other sites where we have potential liability for environmental-related matters for which we do not have sufficient information to determine that the liability is probable and/or reasonably estimable. We have not established reserves for such sites.

 

For additional discussion of environmental matters, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K.

 

Availability of Reports and Governance Documents

 

We make available at no cost on our website, www.tronox.com, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports as soon as reasonably practicable after we file or furnish such reports to the SEC. Interested parties should refer to the Investor Relations link on our website. In addition, our Code of Business Conduct and Ethics, Code of Ethics for The Chief Executive Officer and Principal Financial Officers and Corporate Governance Guidelines, all of which were adopted by our Board of Directors, can be found on our website under the Corporate Governance link. We will provide these governance documents in print to any stockholder who requests them. Any amendment to, or waiver of, any provision of the Code of Ethics for the Chief Executive Officer and Principal Financial Officers and any waiver of the Code of Business Conduct and Ethics for directors or executive officers will be disclosed on our website under the Corporate Governance link.

 

We confirm, as required by NYSE Rule 303A.12, that we are filing the certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 as exhibits to this annual report on Form 10-K.

 

We are subject to significant liabilities and claims that are in addition to those associated with our primary business. These liabilities and claims could adversely affect our financial condition and results of operations and we could suffer losses as a result of these liabilities and claims even if our primary business performs well.

 

We currently operate our chemical business through our subsidiary, Tronox Worldwide LLC, and its subsidiaries. Tronox Worldwide LLC, its subsidiaries and their predecessors have operated a number of businesses in addition to the current chemical business, including businesses involving the treatment of forest products, the production of ammonium perchlorate and other chemicals, the refining and marketing of petroleum products, offshore contract drilling, coal mining and the mining, milling and processing of nuclear materials. As a result, we are subject to significant liabilities and claims that are in addition to those associated with our primary business, including legal, regulatory and environmental liabilities and claims. For example, we have liabilities and claims relating to the remediation of various sites at which chemicals such as creosote, perchlorate, low-level radioactive substances, asbestos and other materials have been used or disposed. Our financial condition and results of operations could be adversely affected by these liabilities and claims. We also could suffer losses as a result of these liabilities and claims even if our primary business performs well. See Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K for a discussion of contingencies.

 

The costs of compliance with the extensive environmental, health and safety laws and regulations to which we are subject or the inability to obtain, update or renew permits required for the operation of our business could reduce our profitability or otherwise adversely affect us.

 

Our current and former operations involve the generation and management of regulated materials that are subject to various environmental laws and regulations and are dependent on the periodic renewal of permits from various governmental agencies. The inability to obtain, update or renew permits related to the operation of our businesses, or the costs required in order to comply with permit standards, could have a material adverse affect on us. For example, we are currently updating potential permit modification language with the EPA related to air emissions for our facility in Savannah, Georgia, and with the Clark County Department of Air Quality Management for our facility in Henderson, Nevada. Although we do not anticipate any significant difficulties in obtaining such modifications, the failure to obtain updated permit language could have a material adverse effect on our ability to produce our products and on our results of operations.

 

In addition, changes in the laws and regulations to which we are subject, or their interpretation, or the enactment of new laws and regulations, could result in materially increased and unanticipated capital expenditures

and compliance costs. For example, the proposed Registration, Evaluation and Authorization of Chemicals (“REACH”) regulatory scheme in the European Union (“EU”), if implemented beginning in June 2007, as currently proposed, could adversely affect our European operations by imposing on us a testing, evaluation and registration program for some of the chemicals that we use or produce. At the present time, we are not able to predict the ultimate cost of compliance with these requirements or their effect on our business.

 

Environmental laws and regulations obligate us to remediate various sites at which chemicals such as creosote, perchlorate, low-level radioactive substances, asbestos and other materials have been disposed of or released. Some of these sites have been designated Superfund sites by EPA under the CERCLA. See Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K for a discussion of these matters. The discovery of contamination arising from historical industrial operations at some of our properties has exposed us, and in the future may continue to expose us, to significant remediation obligations and other damages.

 

The actual costs of environmental remediation and restoration could exceed estimates.

 

As of December 31, 2006, we had reserves in the amount of $223.9 million for environmental remediation and restoration. We reserve for costs related to environmental remediation and restoration only when a loss is probable and the amount is reasonably estimable. In estimating our environmental liabilities, including the cost of investigation and remediation at a particular site, we consider a variety of matters, including, but not limited to, the stage of the investigation at the site, the stage of remedial design for the site, the availability of existing remediation technologies, presently-enacted laws and regulations and the state of any related legal or administrative investigation or proceedings. For example, at certain sites we are in the preliminary stages of our environmental investigation and therefore have reserved for such sites amounts equal only to the cost of our environmental investigation. The findings of these site investigations could result in an increase in our reserves for environmental remediation. While we believe we have established appropriate reserves for environmental remediation based on the information we currently know, additions to the reserves may be required as we obtain additional information that enables us to better estimate our liabilities.

 

Our estimates of environmental liabilities at a particular site could increase significantly as a result of, among other things, changes in laws and regulations or relevant clean-up levels, revisions to the site’s remedial design, unanticipated construction problems, identification of additional areas or volumes of contamination, increases in labor, equipment and technology costs, changes in the financial condition of other potentially responsible parties and the outcome of any related legal and administrative proceedings or alternative dispute resolution proceedings (including mediation) to which we are or may become a party. For example, in 2006, the commercial disposal facility that receives soil excavated from the West Chicago, Illinois, Kress Creek site notified us that the unit disposal rates were increasing. Currently, this is the only site licensed to accept the soil for permanent disposal. As a result of this notification, we increased reserves for environmental remediation for the Kress Creek site by $12.0 million, which was part of a total increase in our 2006 environmental reserves of $56.4 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Environmental Matters — Environmental Costs” and Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K.

 

In addition to the sites for which we have established reserves, there may be other sites where we have potential liability for environmental matters but for which we do not have sufficient information to determine that a liability is probable and reasonably estimable. As we obtain additional information about those sites, we may determine that reserves for such sites should be established. New environmental claims also may arise as a result of changes in environmental laws and regulations or standards or for other reasons. If new claims arise and losses associated with those claims become probable and reasonably estimable, we will need to increase our reserves to reflect those new claims.

 

As a result of the factors described above, it is not possible for us to reliably estimate the amount and timing of all future expenditures related to environmental or other contingent matters, and our actual costs related to such matters could exceed our current reserves at December 31, 2006. See “Business — Government Regulations and Environmental Matters” and “Legal Proceedings.”

 

Hazards associated with chemical manufacturing could adversely affect our results of operations.

 

Due to the nature of our business, we are exposed to the hazards associated with chemical manufacturing and the related storage and transportation of raw materials, products and wastes. These hazards could lead to an interruption or suspension of operations and have an adverse effect on the productivity and profitability of a particular manufacturing facility or on us as a whole. Potential hazards include the following:

 

 

There is also a risk that one or more of our key raw materials or one or more of our products may be found to have currently unrecognized toxicological or health-related impact on the environment or on our customers or employees. Such hazards may cause personal injury and loss of life, damage to property and contamination of the environment, which could lead to government fines or work stoppage injunctions and lawsuits by injured persons. If such actions are determined to be adverse to us, we may have inadequate insurance to cover such claims, or we may have insufficient cash flow to pay for such claims. Such outcomes could adversely affect our financial condition and results of operations.

 

Violations or noncompliance with the extensive environmental, health and safety laws and regulations to which we are subject could result in unanticipated loss or liability.

 

Our operations and production facilities are subject to extensive environmental and health and safety laws and regulations at national, international and local levels in numerous jurisdictions relating to pollution, protection of the environment, transporting and storing raw materials and finished products and storing and disposing of hazardous wastes. We may incur substantial costs, including fines, damages, criminal or civil sanctions and remediation costs, or experience interruptions in our operations, for violations arising under these laws and regulations. In the event of a catastrophic incident involving any of the raw materials we use or chemicals we produce, we could incur material costs as a result of addressing the consequences of such event.

 

We are party to a number of legal and administrative proceedings involving environmental and other matters pending in various courts and before various agencies. These include proceedings associated with facilities currently or previously owned, operated or used by us or our predecessors, and include claims for personal injuries, property damages, injury to the environment, including natural resource damages, and non-compliance with permits. Any determination that one or more of our key raw materials or products, or the materials or products associated with facilities previously owned, operated or used by us or our predecessors, has, or is characterized as having, a toxicological or health-related impact on our environment, customers or employees could subject us to additional legal claims. These proceedings and any such additional claims may be costly and may require a substantial amount of management attention, which may have an adverse affect on our financial condition and results of operations. See “Business — Government Regulations and Environmental Matters” and “Legal Proceedings”.

 

The amount of our debt could adversely affect our financial condition, limit our ability to pursue business opportunities, reduce our operating flexibility or put us at a competitive disadvantage.

 

As of December 31, 2006, we had $534.1 million of long-term debt and $437.3 million of stockholders’ equity. Our debt could have important consequences for us. For instance, it could:

 

 

 

The senior secured credit facility and the indenture governing the unsecured notes limit, but do not prohibit, us from incurring additional debt, and we may incur additional debt in the future. If we incur additional debt, our ability to satisfy our debt obligations may become more limited.

 

The terms of our senior secured credit facility and our indenture governing the unsecured notes contain a number of restrictive and financial covenants that could limit our ability to pay dividends or to operate effectively in the future. If we are unable to comply with these covenants, our lenders could accelerate the repayment of our indebtedness.

 

The terms of our senior secured credit facility and our indenture governing the unsecured notes subject us to a number of covenants that impose significant operating restrictions on us, including on our ability to incur indebtedness and liens, make loans and investments, make capital expenditures, sell assets, engage in mergers, consolidations and acquisitions, enter into transactions with affiliates, enter into sale and leaseback transactions, make optional payments or modifications of the unsecured notes or other material debt, change our lines of business and pay dividends on our common stock. We are also required by the terms of the senior secured credit facility to comply with financial covenant ratios. These restrictions could limit our ability to plan for or react to market conditions or meet capital needs.

 

A breach of any of the covenants imposed on us by the terms of our indebtedness, including the financial covenants in the senior secured credit facility, could result in a default under such indebtedness. In the event of a default, the lenders under the revolving credit facility could terminate their commitments to us, and they and the lenders of our other indebtedness could accelerate the repayment of all of our indebtedness. In such case, we may not have sufficient funds to pay the total amount of accelerated obligations, and our lenders under the senior secured credit facility could proceed against the collateral securing the facility. Any acceleration in the repayment of our indebtedness or related foreclosure could adversely affect our business.

 

Market conditions and cyclical factors that adversely affect the demand for the end-use products that contain our titanium dioxide could adversely affect our results.

 

Historically, regional and world events that negatively affect discretionary spending or economic conditions generally, such as terrorist attacks, the incidence or spread of contagious diseases or other economic, political, or public health or safety conditions, have adversely affected demand for the finished products that contain TiO₂ and from which we derive substantially all of our revenue. Events such as these are likely to contribute to a general reluctance by the public to purchase “quality of life” products, which could cause a decrease in demand for our chemicals and, as a result, may have an adverse effect on our results of operations and financial condition.

 

Additionally, the demand for TiO₂ during a given year is subject to seasonal fluctuations. TiO₂ sales are generally higher in the second and third quarters of the year than in the other quarters due in part to the increase in paint production in the spring to meet demand resulting from the spring and summer painting season in North America and Europe. We may be adversely affected by existing or future cyclical changes, and such conditions may be sustained or further aggravated by anticipated or unanticipated changes in regional weather conditions. For example, poor weather conditions in a region can lead to an abbreviated painting season, which can depress consumer sales of paint products that use TiO₂.

 

Our business, financial condition and results of operations could be adversely affected by global and regional economic downturns and other conditions.

 

We have significant production, sales and marketing operations throughout the U.S., Europe and the Asia-Pacific region, with approximately 1,100 customers in approximately 100 countries. We also purchase many of the raw materials used in the production of our products in foreign jurisdictions. In 2006, approximately 47% of our

total revenues were generated from production outside of the U.S. Due to these factors, our performance, particularly the performance of our pigment segment, is cyclical and tied closely to general economic conditions, including global GDP. As a result, our business, financial condition and results of operations are vulnerable to political and economic conditions affecting global gross domestic product and the countries in which we operate. For example, from 2000 through 2003, our business was affected when the TiO₂ industry experienced a period of unusually weak business conditions as a result of a variety of factors, including the global economic recession and exceptionally rainy weather conditions in Europe and the Americas, and the outbreak of SARS in Asia. Based on these factors, global and regional economic downturns and other conditions, such as downturns in the housing or construction industries, may have an adverse effect on our financial condition and results of operations.

 

Our results of operations may be adversely affected by fluctuations in currency exchange rates.

 

The financial condition and results of operations of our operating entities in the European Union, among other jurisdictions, are reported in various foreign currencies and then translated into U.S. dollars at the applicable exchange rate for inclusion in the financial statements. As a result, any appreciation of the U.S. dollar against these foreign currencies will have a negative impact on our reported sales and operating margin (and conversely, the depreciation of the dollar against these foreign currencies will have a positive impact). In addition, our operating entities often need to convert currencies they receive for our products into currencies in which they purchase raw materials or pay for services, which could result in a gain or loss depending on fluctuations in exchange rates. Because we have significant operations in Europe and Australia, we are exposed primarily to fluctuations in the euro and the Australian dollar.

 

In the past, we have sought to minimize our foreign currency translation risk by engaging in hedging transactions. We may be unable to effectively manage our foreign currency translation risk, and any volatility in foreign currency exchange rates may have an adverse effect on our financial condition or results of operations. For a further discussion of how we manage our foreign currency risk, see “Quantitative and Qualitative Disclosure about Market Risk — Foreign Currency Exchange Rate Risk.”

 

Our industry and the end-use markets in which we compete are highly competitive. This competition may adversely affect our results of operations and operating cash flows.

 

Each of the markets in which we compete is highly competitive. Competition is based on a number of factors such as price, product quality and service. We face significant competition from major international producers, including the four other major producers, as well as smaller regional competitors. Our most significant competitors include major chemicals and materials manufacturers and diversified companies, a number of which have substantially larger financial resources, staffs and facilities than we do. The additional resources and larger staffs and facilities of such competitors may give them a competitive advantage when responding to market conditions and capitalizing on operating efficiencies. Increased competition could result in reduced sales, which could adversely affect our profitability and operating cash flows. See “Business — Competitive Conditions.”

 

In addition, within the end-use markets in which we compete, competition between products is intense. We face substantial risk that certain events, such as new product development by our competitors, changing customer needs, production advances for competing products or price changes in raw materials, could cause our customers to switch to our competitor’s products. If we are unable to develop and produce or market our products to compete effectively against our competitors following such events, our results of operations and operating cash flows may suffer.

 

Fluctuations in costs of our raw materials or our access to supplies of our raw materials could have an adverse effect on our results of operations.

 

In 2006, raw materials used in the production of TiO₂ constituted approximately 32% of our operating expenses. Titanium-bearing ores, in particular, represented more than 20% of our operating expenses in 2006.

 

Costs of many of the raw materials we use may fluctuate widely for a variety of reasons, including changes in availability, major capacity additions or reductions or significant facility operating problems. These fluctuations could negatively affect our operating margins and our profitability. As these costs rise, our operating expenses likely

will increase and could adversely affect our business, especially if we are unable to pass price increases in raw materials through to our customers.

 

Should our vendors not be able to meet their contractual obligations or should we be otherwise unable to obtain necessary raw materials, we may incur higher costs for raw materials or may be required to reduce production levels, which may have an adverse effect on our financial position, results of operations or liquidity. For a further discussion, see “Business — Industry Background — Titanium Dioxide — Raw Materials.”

 

The labor and employment laws in many jurisdictions in which we operate are more restrictive than in the U.S. Our relationship with our employees could deteriorate, which could adversely affect our operations.

 

In the U.S., approximately 200 employees at our Savannah, Georgia, facility are members of a union and are subject to a collective bargaining arrangement that is scheduled to expire in April 2007. Approximately 42% of our employees are employed outside the U.S. In certain of those countries, such as Australia and the member states of the European Union, labor and employment laws are more restrictive than in the U.S. and, in many cases, grant significant job protection to employees, including rights on termination of employment. For example, in Germany and the Netherlands, by law some of our employees are represented by a works’ council, which subjects us to employment arrangements very similar to collective bargaining agreements.

 

We are required to consult with and seek the consent or advice of the unions or works’ councils that represent our employees for certain of our activities. This requirement could have a significant impact on our flexibility in managing costs and responding to market changes. Furthermore, there can be no assurance that we will be able to negotiate labor agreements with our unionized employees in the future on satisfactory terms. If those employees were to engage in a strike, work stoppage or other slowdown, or if any of our other employees were to become unionized, we could experience a significant disruption of our operations or higher ongoing labor costs, which could adversely affect our financial condition and results of operations.

 

Third parties may develop new intellectual property rights for new processes and/or products that we would want to use, but would be unable to do so; or, third parties may claim that the products we make or the processes we use infringe their intellectual property rights, which may cause us to pay unexpected litigation costs or damages or prevent us from making, using or selling the products we make or require us to alter the processes we use.

 

Although currently there are no pending or threatened proceedings or claims relating to alleged infringement, misappropriation, or violation of the intellectual property rights of others, we may be subject to legal proceedings and claims in the future in which third parties allege that their patents or other intellectual property rights are infringed, misappropriated or otherwise violated by us or by our products or processes. In the event that any such infringement, misappropriation or violation of the intellectual property rights of others is found, we may need to obtain licenses from those parties or substantially re-engineer our products or processes in order to avoid such infringement, misappropriation or violation. We might not be able to obtain the necessary licenses on acceptable terms or be able to re-engineer our products or processes successfully. Moreover, if we are found by a court of law to infringe, misappropriate or otherwise violate the intellectual property rights of others, we could be required to pay substantial damages or be enjoined from making, using or selling the infringing products or technology. We also could be enjoined from making, using or selling the allegedly infringing products or technology pending the final outcome of the suit. Any of the foregoing could adversely affect our financial condition and results of operations.

 

Results of our operations may also be negatively impacted if a competitor develops or has the right to use intellectual property rights for new processes or products and we cannot obtain similar rights on favorable terms and are unable to independently develop non-infringing competitive alternatives.

 

If we are not able to continue our technological innovation and successful commercial introduction of new products, our profitability could be adversely affected.

 

Our industries and the end-use markets into which we sell our products experience periodic technological change and product improvement. Our future growth will depend on our ability to gauge the direction of

commercial and technological progress in key end-use markets and on our ability to fund and successfully develop, manufacture and market products in such changing end-use markets. We must continue to identify, develop and market innovative products or enhance existing products on a timely basis in order to maintain our profit margins and our competitive position. We may not be able to develop new products or technology, either alone or with third parties, or license intellectual property rights from third parties on a commercially competitive basis. If we fail to keep pace with the evolving technological innovations in our end-use markets on a competitive basis, our financial condition and results of operations could be adversely affected.

 

If our intellectual property were compromised or copied by competitors, or if competitors were to develop similar intellectual property independently, our results of operations could be negatively affected.

 

Our success depends to a significant degree upon our ability to protect and preserve our intellectual property rights. Although we own and have applied for numerous patents and trademarks throughout the world, we may have to rely on judicial enforcement of our patents and other proprietary rights. Our patents and other intellectual property rights may be challenged, invalidated, circumvented, rendered unenforceable or otherwise compromised. A failure to protect, defend or enforce our intellectual property could have an adverse effect on our financial condition and results of operations.

 

We also rely upon unpatented proprietary technology, know-how and other trade secrets to maintain our competitive position. While it is our policy to enter into confidentiality agreements with our employees and third parties to protect our proprietary expertise and other trade secrets, these agreements may not be enforceable or, even if legally enforceable, we may not have adequate remedies for breaches of such agreements. We also may not be able to readily detect breaches of such agreements. The failure of our patents or confidentiality agreements to protect our proprietary technology, know-how or trade secrets could result in significantly lower revenues, reduced profit margins or loss of market share.

 

We may be unable to determine when third parties are using our intellectual property rights without our authorization. We also have licensed certain of our intellectual property rights to third parties, and we cannot be certain that our licensees are using our intellectual property only as authorized by the applicable license agreement. The undetected or unremedied, unauthorized use of our intellectual property rights or the legitimate development or acquisition of intellectual property related to our industry by third parties could reduce or eliminate any competitive advantage we have as a result of our intellectual property, adversely affecting our financial condition and results of operations. If we must take legal action to protect, defend or enforce our intellectual property rights, any suits or proceedings could result in significant costs and diversion of our resources and our management’s attention, and we may not prevail in any such suits or proceedings. A failure to protect, defend or enforce our intellectual property rights could have an adverse effect on our financial condition and results of operations.

 

We may need additional capital in the future and may not be able to obtain it on favorable terms, if at all.

 

Our industry is highly capital intensive and our success depends to a significant degree on our ability to develop and market innovative products and to update our facilities and process technology. We may require additional capital in the future to finance our future growth and development, implement further marketing and sales activities, fund our ongoing research and development activities and meet our general working capital needs. Our capital requirements will depend on many factors, including acceptance of and demand for our products, the extent to which we invest in new technology and research and development projects, and the status and timing of competitive developments. Additional financing may not be available when needed on terms favorable to us or at all. Further, the terms of the senior secured credit facility and the indenture governing the unsecured notes may limit our ability to incur additional indebtedness or issue additional shares of our common stock. If we are unable to obtain adequate funds on acceptable terms, we may be unable to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures, which could harm our business.

 

None.

 

Titanium Dioxide

 

We produce TiO₂ using either the chloride process or the sulfate process at five production facilities located in four countries. We believe our facilities are well situated to serve our global customer base.

 

Two of our facilities are located in the U.S., and we have one facility in each of Australia, Germany and the Netherlands. We own our facilities in Germany and the Netherlands, and the land under these facilities is held pursuant to long-term leases. We own our facilities in the U.S. and hold a 50% undivided interest in our Australian facility. We market and sell all of the TiO₂ produced by our Australian facility and share in the profits equally with our joint venture partner. See “The Tiwest Joint Venture.”

 

The following table summarizes our production capacity as of December 31, 2006, by location and process:

 

Titanium Dioxide Production Capacity
As of December 31, 2006
(Gross tonnes per year)

 

 

 

 

Including the TiO₂ produced by our Australian facility, we produced 598,196 tonnes of TiO₂ in 2006. Our average production rates, as a percentage of capacity, were 95%, 94% and 91%, in 2006, 2005 and 2004, respectively. Excluding the Savannah sulfate facility we closed in September 2004, over the past five years, production at our current facilities increased by approximately 16%, primarily due to low-cost process improvements, improved uptime and debottlenecking. Our global manufacturing presence, coupled with our ability to increase capacity incrementally, makes us a stable supplier to many of the largest TiO₂ consumers.

 

The Tiwest Joint Venture

 

Our subsidiary, Tronox Western Australia Pty. Ltd. (“TWA”), has a 50% undivided interest in all of the assets that comprise the operations conducted in Australia under the Tiwest joint venture arrangement and is severally liable for 50% of associated liabilities. The remaining 50% undivided interest is held by a subsidiary of our joint venture partner, Exxaro Australia Sands Pty Ltd (“Exxaro”), which is a subsidiary of Exxaro Resources Limited. The joint venture partners operate a chloride process TiO₂ plant located in Kwinana, Western Australia (the “Kwinana Facility”), as well as a mining venture in Cooljarloo, Western Australia, and a synthetic rutile processing facility in Chandala, Western Australia. Under separate marketing agreements, we have the right to market our partner’s share of the TiO₂ produced by the Kwinana Facility.

 

We have begun work to expand our 50% owned pigment production facility in Kwinana, Australia, increasing the plant’s total annual capacity by 40,000 to 50,000 tonnes. This new capacity is expected to come on line in 2009 and allow us to capture growth opportunities in the Asia-Pacific market, while meeting the needs of existing customers in this region. For more information regarding the Kwinana Facility, see “Titanium Dioxide” above. For more information regarding the mining venture, see “Heavy Minerals” below.

 

Management.  The operations associated with the Tiwest joint venture arrangement are governed by two committees: a management committee and an operating committee. The operating committee meets at least

monthly and supervises the joint venture’s routine operations, and the management committee meets at least quarterly and has the authority to make fundamental corporate decisions and to overrule the operating committee’s decisions. The committees’ decisions are made by simple majority approval. If there are an equal number of votes cast for and against a matter at an operating committee meeting, the matter is referred to a subsequent meeting. If at the subsequent meeting, the matter still receives an equal number of votes cast on each side, the matter is referred to the management committee. TWA and Exxaro each have the right to appoint half of each committee’s members.

 

Heavy Minerals.  The joint venture partners mine heavy minerals from 29,164 acres under long-term mineral leases from the State of Western Australia, for which each joint venture partner holds a 50% undivided interest. Our 50% undivided interest in the properties’ remaining in-place proven and probable reserves is 5.3 million tonnes of heavy minerals contained in 148 million tonnes of sand averaging 3.6% heavy minerals. The valuable heavy minerals are composed on average of 60% ilmenite, 10% zircon, 5% natural rutile and 3% leucoxene, with the remaining 22% of heavy minerals having no significant value. The reserves include approximately 1.0 million tonnes of heavy minerals contained in 10 million tonnes of sand averaging 10.2% heavy minerals from additional mineral leases acquired in 2006. Continued evaluation of the new leases during 2007 by Tiwest may result in further increase our reserves.

 

Heavy-mineral concentrate from the mine is processed at a 750,000-tonne per year dry separation plant, for which each joint venture partner holds a 50% undivided interest. Some of the recovered ilmenite is upgraded at the nearby synthetic rutile facility in Chandala, which has a capacity of 225,000 tonnes per year. Synthetic rutile is a high-grade TiO₂ feedstock. All of the synthetic rutile feedstock for the 110,000-tonne per year TiO₂ plant located at Kwinana is provided by the Chandala processing facility. Production of feedstock in excess of the plant’s requirements is sold to third parties, as well as to us, for the portion not already owned, as part of the feedstock requirement for TiO₂ at our other facilities.

 

Information regarding our 50% interest in heavy-mineral reserves, production and average prices for the three years ended December 31, 2006, is presented in the following table. Mineral reserves in this table represent the estimated quantities of proven and probable ore that, under anticipated conditions, may be profitably recovered and processed for the extraction of their mineral content. Future production of these resources depends on many factors, including market conditions and government regulations. See “Risk Factors — Fluctuations in costs of our raw materials or our access to supplies of our raw materials could have an adverse effect on our results of operations.”

 

Heavy-Mineral Reserves, Production and Prices
(Reserves and production in tonnes)

 

 

Electrolytic and Other Chemical Products

 

We produce electrolytic and other chemical products at three domestic facilities, each of which we own. The following table summarizes our production capacity as of December 31, 2006, by location and product.

 

Electrolytic and Other Chemical Capacity
As of December 31, 2006
(Gross tonnes per year)

 

 

Savannah Plant

 

On September 8, 2003, the Environmental Protection Division of the Georgia Department of Natural Resources (“EPD”) issued a unilateral Administrative Order to our subsidiary, Tronox Pigments (Savannah) Inc., claiming that the Savannah plant exceeded emission allowances provided for in the facility’s Title V air permit. On September 19, 2005, the EPD rescinded the Administrative Order and filed a Withdrawal of Petition for Hearing on Civil Penalties. Accordingly, the proceeding on administrative penalties has been dismissed, without prejudice. After dismissal of the Administrative Order, representatives of EPD, the EPA and Tronox continued with their discussions regarding a resolution of the alleged violations, with EPA taking the lead role in these discussions. On December 6, 2006, EPA informed Tronox Pigments (Savannah) Inc. that it had submitted a civil referral to the U.S. Department of Justice (“DOJ”) with respect to the air quality bypass issue and for matters stemming from the EPA led Resource Conservation and Recovery Act (“RCRA”) Compliance Evaluation Inspection (“CEI”) that occurred in January 2006. Prior to the filing of any formal action, DOJ had agreed to a series of settlement negotiations to determine if the matter could be resolved. Though imposition of a penalty is probable, we believe that any penalties related to this matter are not likely to have a material adverse effect on us.

 

New Jersey Wood-Treatment Site

 

Tronox LLC was named in 1999 as a potential responsible party (“PRP”) under CERCLA at a former wood-treatment site in New Jersey at which the EPA is conducting a cleanup. On April 15, 2005, Tronox LLC received a letter from the EPA asserting it is liable under CERCLA as a former owner or operator of the site and demanding reimbursement of costs expended by the EPA at the site. The letter made demand for payment of past costs in the amount of approximately $179 million, plus interest, though the EPA has informed Tronox LLC that as of December 5, 2006, project costs are approximately $244 million, plus other future costs and interest. Tronox LLC did not operate the site, which had been sold to a third party before Tronox LLC succeeded to the interests of a predecessor in the 1960s. The predecessor also did not operate the site, which had been closed down before it was acquired by the predecessor. Based on historical records, there are substantial uncertainties about whether or under what terms the predecessor assumed any liabilities for the site. In addition, although it appears there may be other PRPs to whom notice has been given, we do not know whether the other PRPs have any valid defenses to liability for the site or whether the other PRPs have the financial resources necessary to meet their obligations, if proven. Tronox LLC and EPA have submitted the matter to nonbinding mediation that could lead to a settlement or resolution of EPA’s demand. In the event the mediation process does not lead to an acceptable solution, Tronox LLC intends to vigorously defend against the EPA’s demand.

 

Forest Products

 

We are defending a number of lawsuits related to three former wood-treatment plants in Columbus, Mississippi, Avoca, Pennsylvania, and Texarkana, Texas. All these lawsuits seek recoveries under a variety of common law and statutory legal theories for personal injuries and/or release of chemicals used in the wood-treatment process, primarily creosote. We currently believe that claims asserted in these lawsuits are without substantial merit and are vigorously defending them.

 

At Columbus, Mississippi, the Maranatha Faith Center filed a state court property damage lawsuit in 2000. The church filed bankruptcy in 2003 but continues to prosecute its lawsuit. Tronox LLC moved for change of venue due to adverse publicity in the Columbus community stemming from prior litigation and settlements. In September 2006, the judge agreed with Tronox LLC and ordered the transfer of venue. After the new trial venue is determined, a trial date will be set. Also pending in Mississippi state courts are a case with 26 plaintiffs alleging personal injury and a case with two local businesses alleging property damage. Pending in Mississippi federal court are 238 cases filed from 2002 to 2005 that have been consolidated for pretrial and discovery purposes. While many plaintiffs have been dismissed on motions filed by Tronox LLC, over 2,000 plaintiffs remain in the consolidated action. In January 2007, the judge granted the Tronox LLC severance motion, requiring each individual plaintiff’s case to be tried separately. However, the judge excepted from his severance order two plaintiffs (one with personal injuries and the other with property damage) who are set to be tried jointly later in 2007.

 

At Avoca, Pennsylvania, 35 state court lawsuits were filed in 2005 by over 4,000 plaintiffs. The plaintiffs have classified their claims into various alleged disease categories. In September 2005, the judge ordered that discovery and the first trial will focus on plaintiffs who allege precancerous skin lesions. Of these plaintiffs, ten will be selected (five by plaintiffs’ counsel and five by Tronox LLC) for the trial.

 

At Texarkana, Texas, three federal lawsuits filed from 2004 to 2006 are pending with 27 plaintiffs in the first case, five plaintiffs in a second case and 12 plaintiffs in a third case. In the first case, the judge ruled that five plaintiffs who resided at the same house near our plant will have their claims tried at the first trial. Our insurer has acknowledged a defense duty in this case. In addition, the insurer is engaged in settlement negotiations with plaintiffs’ counsel in all three Texarkana cases.

 

For a discussion of other legal proceedings and contingencies, including proceedings related to our environmental liabilities, see Note 17 to the Consolidated and Combined Financial Statements included in item 15 (a) of this annual report on Form 10-K.

 

None.

 

Our common stock is traded on the New York Stock Exchange (“NYSE”). As of February 28, 2007, we had 10 holders of record of our Class A (NYSE: TRX) common stock and 13,652 holders of record for our Class B (NYSE: TRX.B) common stock.

 

We declared four dividends in 2006 and one dividend in 2005 of five cents per share for Class A and Class B common stock. There were no dividends declared prior to December 19, 2005.

 

 

Because our common stock began trading on November 22, 2005, full quarterly market prices were not available for any quarter in 2005.

 

We did not purchase any of our equity securities during the fourth quarter of 2006.

 

The following graph presents the cumulative total return for the company’s common stock since initial trading started on November 22, 2005, compared with the cumulative total return to shareholders of the S&P 500 Stock Index and the S&P Chemicals Index.

COMPARISON OF 13 MONTH CUMULATIVE TOTAL RETURN*
Among Tronox Incorporated, The S & P 500 Index
And The S & P Chemicals Index

 

 

 

 

 

The following table sets forth selected financial data as of the dates and for the periods indicated. The statement of operations data for each of the five years ended December 31, 2006 and the balance sheet data as of December 31, 2006, 2005, 2004 and 2003 have been derived from our audited consolidated and combined financial statements. The balance sheet data as of December 31, 2002 was derived from our accounting records and is unaudited. The information should be read in conjunction with the company’s consolidated financial statements (including the notes thereto) and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this report.

 

 

The following table reconciles net income (loss) to EBITDA and adjusted EBITDA for the periods presented:

 

 

 

 

The following discussion should be read in conjunction with the selected financial data and the consolidated and combined financial statements and the related notes included elsewhere in this annual report on Form 10-K.

 

Overview

 

We are the world’s third-largest producer and marketer of titanium dioxide pigment (“TiO₂”) based on reported industry capacity by the leading TiO₂ producers, and we have an estimated 12% market share of the $10 billion global market in 2006 based on reported industry sales. We also produce and market electrolytic manganese dioxide (“EMD”) and sodium chlorate, as well as boron-based and other specialty chemicals. We operate seven production facilities and have direct sales and technical service organizations in the United States (“U.S.”), Europe and the Asia-Pacific region. We have approximately 2,130 employees worldwide and approximately 1,100 customers located in approximately 100 countries. In 2006, we had net sales of $1.4 billion, a net loss of $0.2 million and adjusted EBITDA of $191.9 million. For a reconciliation of adjusted EBITDA to net loss, see “Selected Financial Data” in Item 6 of this annual report on Form 10-K.

 

Our business has one reportable segment, pigment. Our other businesses include electrolytic and other chemical products. Our pigment segment, which accounted for approximately 93% of our net sales in 2006, primarily produces and markets TiO₂, a white pigment used in a wide range of products for its exceptional ability to impart whiteness, brightness and opacity. Performance of our pigment segment is cyclical and tied closely to general economic conditions, including global gross domestic product (“GDP”). Events that negatively affect discretionary spending also may negatively affect demand for finished products that contain TiO₂. Our pigment segment also is affected by seasonal fluctuations in the demand for coatings, the largest end-use market for TiO₂.

 

From 2000 through 2003, the TiO₂ industry experienced a period of unusually weak business conditions as a result of a variety of factors, including the global economic recession, exceptionally rainy weather conditions in Europe and the Americas and the outbreak of SARS in Asia. However, global economic conditions generally improved in late 2004, driving increased demand, and, in the last half of 2004 continuing through early 2006, increased prices. In the last half of 2006, demand continued to increase while prices increased only moderately in certain regions.

 

In February 2007, we announced a global TiO₂ production strategy that focuses on capturing opportunities presented by our chloride technology expertise, strong customer base and the rapid growth of the Asia-Pacific market. Consistent with this strategy, we have made the following recent announcements:

 

 

Engineering studies have commenced at our Western Australia plant, and the regulatory approval process is currently under way. This expansion is expected to increase the plant’s annual capacity by 40,000 to 50,000 tonnes (or approximately 40%). We anticipate that the expansion will cost approximately $35 million to $45 million (to be shared proportionately between us and our partner) and will be completed in 2009. The Botlek, the Netherlands, plant has demonstrated the ability to consistently run at rates of up to 90,000 tonnes, an increase above the previously stated 72,000 tonne capacity. The Uerdingen, Germany, plant is our only sulfate process TiO₂ plant and produces a very high-quality pigment demanded by many specialty markets, with a current capacity of 107,000 tonnes.

 

Our electrolytic and other chemical products businesses produce chemicals for both rechargeable and non-rechargeable batteries, sodium chlorate for pulp bleaching used in the paper industry and boron-based specialty chemicals used in pharmaceuticals, high-performance fibers and other specialty products. We are a key supplier and have leading market positions in each of these products.

Due to the nature of our current and former operations, we have significant environmental remediation obligations and are subject to legal and regulatory liabilities. Former operations include, among others, operations involving the production of ammonium perchlorate, treatment of forest products, the refining and marketing of petroleum products, offshore contract drilling, coal mining and the mining, milling and processing of nuclear materials. For example, we have liabilities relating to the remediation of various sites at which chemicals such as creosote, perchlorate, low-level radioactive substances, asbestos and other materials have been used or disposed. As of December 31, 2006, we had reserves in the amount of $223.9 million for environmental matters and receivables for reimbursement for such matters of $71.4 million. For the year ended December 31, 2006, we provided a net environmental remediation reimbursement of $20.4 million as part of continuing operations and a net provision of $23.7 million for environmental remediation and restoration costs related to discontinued operations. We had $56.2 million of expenditures associated with our environmental remediation projects, and received $38.4 million in third-party reimbursements in 2006.

 

Pursuant to the Master Separation Agreement dated November 28, 2005, among Kerr-McGee Corporation (“Kerr-McGee”), Kerr-McGee Worldwide Corporation and the company (the “MSA”), Kerr-McGee has agreed to reimburse us for a portion of the environmental remediation costs we incur and pay during the seven-year period following our initial public offering (“IPO”). The reimbursement obligation extends to costs incurred at any site associated with any of our former businesses or operations. With respect to any site for which a reserve has been established as of the effective date of the MSA, 50% of the remediation costs we incur and pay in excess of the reserve amount (after meeting a $200,000 minimum threshold amount) will be reimbursable by Kerr-McGee, net of any amounts recovered or, in our reasonable and good faith estimate, that will be recovered from third parties. With respect to any site for which a reserve has not been established as of the effective date of the MSA, 50% of the amount of the remediation costs we incur and pay (after meeting a $200,000 minimum threshold amount) will be reimbursable by Kerr-McGee, net of any amounts recovered or, in our reasonable and good faith estimate, that will be recovered from third parties. Kerr-McGee is only required to reimburse us for costs we actually incur and pay during the seven-year period following the IPO, up to a maximum aggregate amount of $100 million. Kerr-McGee’s reimbursement obligation is subject to various other limitations and restrictions.

 

Contribution of Entities and Distribution of Tronox Class B shares.  In November 2005, Kerr-McGee contributed its equity in certain entities, including those comprising substantially all of its chemical business to us (the “Contribution”). The Contribution was completed along with our recapitalization, whereby our common stock held by Kerr-McGee converted into approximately 22.9 million shares of Class B common stock. On March 30, 2006, Kerr-McGee distributed our Class B shares to its stockholders as a dividend (the “Distribution”). Concurrently, as provided in the employee benefits agreement between us and Kerr-McGee, certain of our employees received Tronox stock-based awards as a result of a conversion of unvested Kerr-McGee stock options, restricted stock, stock opportunity grants and performance units. Approximately 920,000 stock options and 625,000 restricted stock-based awards resulted from the conversion based on the closing stock prices of Kerr-McGee and Tronox on March 30, 2006.

 

Also concurrent with the Distribution, we established certain tax-qualified and nonqualified pension and postretirement plans for qualifying current and former U.S. employees previously covered under the U.S. benefit plans of Kerr-McGee. As a result, we assumed certain obligations and received associated trust assets in accordance with the employee benefits agreement between the two companies.

 

We adopted SFAS No. 123 (revised 2004), “Share-Based Payment” effective January 1, 2006, using the modified prospective method of transition. Including the effects of adopting the new accounting standard and the effects of the conversion of Kerr-McGee stock-based awards, stock-based compensation expense in 2006 totaled $8.5 million ($6.2 million on an after tax basis). The total unamortized compensation cost as of December 31, 2006, was $7.5 million. Compensation cost ultimately recognized may differ from this amount due to new awards and changes in the estimate of forfeitures, if any.

 

Asset Impairment.  We have been working on the development of a raw materials feed project to improve efficiencies and reduce costs at our Savannah, Georgia, pigment facility. The initial trials of the project indicated that modifications would be required to achieve a satisfactory economic benefit. During 2006, additional studies were performed to determine the technical requirements needed to achieve operations and the additional cost to

complete the project. We are planning a trial to evaluate the effectiveness of the project. The trial will be scheduled when permitting and installation issues are confirmed, which is expected to occur by mid-2007. If it is determined that this is not a viable project, the assets will be written down approximately $4.0 million to their net realizable value.

 

Basis of Presentation

 

Consolidated and Combined Financial Statements

 

Our combined financial statements prior to the Contribution (November 28, 2005) were derived from the accounting records of Kerr-McGee, principally representing the Chemical — Pigment and Chemical — Other segments of Kerr-McGee, using the historical results of operations, and historical basis of assets and liabilities of the subsidiaries that the company did not own but currently owns and the chemical business the company operates.

 

Our Consolidated and Combined Statement of Operations included in Item 15 (a) of this annual report on Form 10-K includes allocations of costs for corporate functions historically provided to us by Kerr-McGee prior to the IPO (November 28, 2005), including:

 

General Corporate Expenses.  Represents costs related to corporate functions such as accounting, tax, treasury, human resources, legal and information management and technology. These costs have historically been allocated primarily based on estimated use of services as compared to Kerr-McGee’s other businesses. These costs are included in selling, general and administrative expenses in the Consolidated and Combined Statement of Operations. This allocation ceased at the IPO date and any services rendered subsequent to that date and the resulting costs are being billed under the terms of the transition services agreement.

 

Employee Benefits and Incentives.  Represents fringe benefit costs and other incentives, including group health and welfare benefits, U.S. pension plans, U.S. postretirement health and life plans and employee stock-based compensation plans. These costs have historically been allocated on an active headcount basis for health and welfare benefits, including U.S. postretirement plans, on the basis of salary for U.S. pension plans and on a specific identification basis for employee stock-based employee compensation plans. These costs are included in costs of goods sold, selling, general and administrative expenses, restructuring charges and loss from discontinued operations in the Consolidated and Combined Statement of Operations.

 

Interest Expense.  Prior to the IPO, Kerr-McGee provided financing to us through cash flows from its other operations and debt incurred. Although the incurred debt was not allocated to us, a portion of the interest expense was allocated based on specifically-identified borrowings at Kerr-McGee’s average borrowing rates. These costs are included in other income (expense) in the Consolidated and Combined Statement of Operations, net of interest income that was allocated to Kerr-McGee on certain monies we loaned to Kerr-McGee. This allocation ceased at the IPO date because Kerr-McGee no longer provides financing to us.

 

Prior to the IPO, Kerr-McGee allocated certain expenses that were considered to be reasonable reflections of the historical utilization levels of various corporate services. Expense allocations from Kerr-McGee reflected in our consolidated and combined financial statements were as follows for the years ended December 31, 2005 and 2004:

 

 

 

 

Subsequent to the IPO, the expense allocations for certain corporate services previously provided by Kerr-McGee ceased, and we began purchasing such services from Kerr-McGee under the terms of the transition services agreement. Under the terms of this agreement, which ended in November 2006, we also received compensation for services provided to Kerr-McGee. The net expense charged to us in 2006 was $3.0 million for the period prior to the

expiration of the transition services agreement. Under the provisions of the employee benefits agreement between Kerr-McGee and us, our qualifying current and former U.S. employees continued to participate in certain benefit plans sponsored by Kerr-McGee through the Distribution. As such, in the first quarter of 2006, Kerr-McGee billed us $8.3 million in costs related to these benefits.

 

Kerr-McGee utilized a worldwide centralized approach to cash management and the financing of its operations, with all related activity between Kerr-McGee and us reflected as net transfers from Kerr-McGee in our Consolidated and Combined Statement of Comprehensive Income (Loss) and Business/ Stockholders’ Equity prior to the IPO. In connection with the IPO, the net amount due from us to Kerr-McGee at the closing date of the IPO was contributed by Kerr-McGee to us as equity, forming a part of our continuing equity. Subsequent to the closing of the IPO, amounts due from or to Kerr-McGee arising from transactions subsequent to that date are being settled in cash.

 

We believe the assumptions underlying our consolidated and combined financial statements are reasonable. However, the consolidated and combined financial statements may not necessarily reflect our future results of operations, financial position and cash flows or what our results of operations, financial position and cash flows would have been had we been a stand-alone company during the periods presented.

 

Segment Evaluation

 

Our management evaluates segment performance based on segment operating profit (loss), which represents the results of segment operations before unallocated costs, such as general corporate expenses not identified to a specific segment and environmental provisions related to sites no longer in operation, income tax expense or benefit and other income (expense). Total operating profit (loss) of our segment and other businesses is a non-GAAP financial measure of the company’s performance, as it excludes general expenses and environmental provisions related to sites no longer in operation which are a component of income (loss) from continuing operations, the most comparable GAAP measure.

 

Our management considers total operating profit (loss) of our segment to be an important supplemental measure of our operating performance by presenting trends in our core businesses and facilities currently in operation. This measure is used by us for planning and budgeting purposes and to facilitate period-to-period comparisons in operating performance of our reportable segments in the aggregate by eliminating items that affect comparability between periods. We believe that total operating profit (loss) is useful to investors because it provides a means to evaluate the operating performance of our segment and our company on an ongoing basis using criteria that are used by our internal decision makers. Additionally, it highlights operating trends and aids analytical comparisons. However, total operating profit (loss) of our segments has limitations and should not be used as an alternative to income (loss) from continuing operations, a performance measure determined in accordance with GAAP, as it excludes certain costs that may affect our operating performance in future periods.

The following table summarizes segment operating profit (loss), with a reconciliation to consolidated and combined net income (loss) for each of the last three years:

 

 

 

 

Results of Operations

 

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005

 

Net Sales.  Total net sales were $1,411.6 million in 2006, an increase of 3.5% compared to the 2005 period. The year-to-year change is presented in the table below, followed by segment discussion.

 

 

Pigment Segment — Net sales increased $43.1 million, or 3.4%, to $1,310.1 million during 2006 from $1,267.0 million during 2005. Approximately $28.0 million was due to an improved volume and mix of sales and approximately $15.1 million was due to increased average unit selling prices. Total volume increased 2.0%. Volume increased primarily in the Asia-Pacific region due to the overall strength of that market in 2006 and the impact, in 2005, of a temporary two-week shutdown of our Australian pigment plant in the fourth quarter of 2005. The unplanned shutdown was necessitated by a shutdown of our third-party process gas supplier. Volumes in Europe were relatively flat from year to year as the European economy started the year slowly and improved as the year progressed. Volumes in the U.S. were down from the prior year, in part due to 2005 volumes in the fourth quarter being unusually high as a result of the hurricanes and the shutdown of a competitor’s plant which followed. The increase in average unit selling price resulted from price increases in the early part of the year, following the hurricanes and plant shutdown. The overall average impact of foreign currency exchange rate changes was approximately $0.8 million when comparing the twelve month periods ending December 31, 2006 and 2005, respectively.

 

Electrolytic and Other Chemical Products Businesses — Net sales increased $4.5 million, or 4.6%, to $101.5 million during 2006 from $97.0 million during 2005. The increase was primarily due to increased sales of sodium chlorate, partially offset by lower sales of manganese dioxide. Sodium chlorate sales volumes increased 10.6% in addition to an increase in sales price. During 2006, we aggressively sought additional market share and increased prices to offset higher costs. We were able to increase sales prices and volumes by utilizing latent capacity at a restructured competitive cost structure. Manganese dioxide sales declined primarily due to a decrease in volumes of 17.4%, which is the result of record volumes in 2005 brought about by hurricane Katrina.

 

Gross Margin.  Gross margin decreased $53.3 million, or 24.2%, to $166.9 million during 2006 from $220.2 million during 2005. Gross margin percentage decreased to 11.8% in 2006 from 16.2% in 2005 primarily due to higher costs of production offset slightly by the improved pricing mentioned above. Increased production costs in our U.S. and European operations were primarily due to higher energy and process chemical costs. In our Australian operations, difficult mining conditions and a temporary shutdown of the Chandala kiln increased costs and reduced production, both of which increased per unit costs. The kiln had to be shut down to perform maintenance that had been scheduled for 2007, but had to be accelerated due to deterioration in the kiln.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased $3.5 million, or 3.0%, to $118.7 million during 2006 from $115.2 million during 2005. The increase was mainly due to increased compensation and benefit costs, including costs related to stock-based awards, certain retention award programs, and increased retirement and other postretirement benefits expense. Partially offsetting the increase was a decrease in variable cash compensation, primarily the result of lower overall profits.

 

Restructuring Charges.  Restructuring charges in 2006 resulted from updating our estimates of closure costs (including timing) related to our former Mobile, Alabama, synthetic rutile facility and Savannah, Georgia, sulfate facility.

 

Arbitration Award Received.  The award in 2006 was related to an arbitration claim in the London Court of International Arbitration (“LCIA”) against Kemira, alleging breach of representations and warranties related to the acquisition of the TiO₂ production facility in Savannah, Georgia. On November 15, 2006, we were notified that the

LCIA awarded us approximately $8.9 million in damages and interest. Legal expenses of $2.7 million in 2006 and $1.1 million in 2005 related to this lawsuit are included in Selling, General and Administrative Expenses.

 

Provision for Environmental Remediation and Restoration, net of Reimbursements.  The provision for environmental remediation and restoration, net of reimbursements, reflected income of $20.4 million in 2006 compared to an expense of $17.1 million in 2005. The income recognized in 2006 consisted of a $20.5 million reimbursement settlement of our claim against the U.S. for contribution of past costs for ammonium perchlorate remediation at our Henderson, Nevada, facility. During 2005, we recorded $11.4 million related to the remediation of ammonium perchlorate contamination at the Henderson, Nevada, facility and $5.6 million related to remediation of the Jacksonville, Florida, former agricultural chemical site, for soil removal and excavation. For further discussion see Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K.

 

Operating Profit (Loss).  The table below presents the change in operating profit (loss) from 2005 to 2006 of $3.3 million, or 3.7%, and is followed by a detailed segment discussion.

 

 

Pigment Segment — Operating profit for the year ended December 31, 2006, was $77.9 million a decrease of $23.6 million, from $101.5 million, in the same period of 2006. The decline in operating profit was primarily due to the higher costs of production, offset slightly by the improved pricing mentioned above. Increased production costs in our U.S. and European operations were primarily due to higher raw material, process chemical and energy costs at our manufacturing facilities around the world. Higher costs were primarily attributable to higher energy and process chemical costs. In our Australian operations, difficult mining conditions, and a temporary shutdown of the Chandala kiln increased costs and reduced production which increased per unit costs of sale. The kiln had to be shut down to perform maintenance that had been scheduled for 2007, but had to be accelerated due to increased deterioration in the kiln.

 

These higher costs were partially offset by lower selling, general and administrative expenses which decreased $21.6 million primarily due to a decrease in employee incentive compensation related to cash bonuses as a result of lower overall company profits, partially offset by increased other compensation and benefit costs, including costs related to stock-based awards, certain retention award programs, and increased retirement and other postretirement benefits expense.

 

Electrolytic and Other Chemical Products Businesses — Operating profit increased $31.2 million to a profit of $25.3 million during 2006 from a loss of $5.9 million during 2005. The change was primarily due to the $20.5 million recovery of past environmental remediation costs from the U.S. in 2006, compared to a net environmental provision of $11.4 million in 2005 related to ammonium perchlorate remediation associated with our Henderson, Nevada, facility. For the year, increased manufacturing costs more than offset the sales gains discussed above, and lower selling, general and administrative expenses. Higher costs are primarily related to higher feedstock, maintenance and energy costs.

 

Interest and Debt Expense.  Interest and debt expense increased $45.9 million to $50.4 million during 2006 from $4.5 million during 2005. The increase was due to interest on our unsecured notes and term loan facility that were entered into concurrent with the IPO in November 2005.

 

Other Income (Expense).  Other income increased $29.1 million to income of $13.9 million during 2006 from expense of $15.2 million during 2005. The change is mainly due to a $4.3 million increase in income from equity affiliates, the elimination of $14.7 million of interest expense allocated from affiliates during 2005 and foreign exchange gains during 2006 of $8.8 million compared to losses during 2005 of $3.0 million. Partially offsetting these favorable effects was a provision for litigation settlements of $3.7 million, in 2006, related to the Western Fertilizer case (see Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K).

 

Income Tax Provision.  The effective income tax rate was 48% for 2006 compared to 32% for 2005. The fiscal 2006 effective income tax rate was higher primarily due to the taxation of foreign operations, in particular, non-deductible differences and losses in certain foreign jurisdictions in which our actual tax rate is below the U.S. statutory rate. The foreign losses in relation to U.S. income are proportionately greater for 2006, contributing to the higher effective tax rate. The treatment of stock-based compensation as required under our Tax Sharing Agreement entered into in connection with our separation from Kerr-McGee also contributed to the higher effective rate.

 

Loss from Discontinued Operations.  Loss from discontinued operations decreased $2.4 million, or 8.7% to $25.2 million during 2006 from $27.6 million during 2005. In 2006, the loss from discontinued operations included $16.6 million, net of taxes, for legal fees and environmental costs associated with the company’s former forest products operations, additional environmental costs of $3.8 million, net of taxes, for groundwater remediation at a former nuclear fuels plant in Crescent, Oklahoma, and additional costs of $0.8 million, net of taxes, for erosion and vegetation studies related to former uranium mines at Riley Pass, South Dakota. The 2005 loss includes $17.7 million loss, net of taxes, on our former forest products operations, including legal costs of $4.8 million, net of taxes, and an environmental provision of $7.2 million, net of taxes, for additional soil volumes related to the Sauget, Illinois wood-treatment plant. The 2005 loss also includes a $5.2 million environmental provision, net of taxes, for pond closure, rock placement and surface water channels at the Ambrosia Lake, New Mexico, site associated with our formerly conducted uranium mining and milling operations (see Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K).

 

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

 

Net Sales.  Total net sales were $1,364.0 million in 2005, compared to $1,301.8 million in 2004, which represents a 4.8% increase. This increase is detailed in the table below, followed by segment discussion.

 

 

Pigment Segment — Net sales increased $58.6 million, or 4.8%, in 2005 compared to 2004. Approximately $136.4 million of this increase was due to an increase in average selling prices of approximately 12%, partially offset by a decrease in volumes sold of $77.8 million. Stronger market conditions contributed to the improvement in pricing while the decline in volume was primarily attributable to the shutdown of our sulfate production facility in Savannah, Georgia, in 2004 and due to reduced volumes in the Asia-Pacific region resulting from increased volumes in the latter part of 2004 in advance of announced price increases and an unplanned temporary two-week shutdown of our Australian pigment plant in the fourth quarter of 2005 necessitated by a shutdown of our third-party process gas supplier. Approximately $4.0 million of the increase in average sales prices in 2005 was due to the effect of foreign currency exchange rates.

 

Electrolytic and Other Chemical Products Businesses — Net sales in 2005 were $97.0 million, an increase of $3.6 million compared to 2004, primarily due to increased sales of electrolytic manganese dioxide and lithium manganese oxide. Sales of manganese dioxide increased due to improvement in both volumes and price, while sales of lithium manganese increased due to improved volumes.

 

Gross Margin.  Gross margin in 2005 was $220.2 million compared to $132.9 million in 2004. As a percent of sales, gross margin increased to 16.1% in 2005 from 10.2% in 2004. The improved margin was primarily due to improved pricing in the pigment segment realized in 2005 and due to an inventory revaluation charge of $15.6 million recognized in 2004 in connection with the shutdown of our TiO₂ sulfate production at our Savannah, Georgia, facility. (See further discussion under “Restructuring Charges” below.)

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased $5.1 million in 2005 compared to 2004. Selling, general and administrative costs were higher in 2005 compared to 2004, primarily due to an increase in employee incentive compensation (including stock-based compensation), largely as a result of improved operating performance for the year.

 

Restructuring Charges.  In 2005, we had no restructuring charges. In 2004, we shut down our TiO₂ sulfate production at our Savannah, Georgia, facility. Demand and prices for sulfate anatase pigments, particularly in the paper market, had declined in North America consistently during the previous several years. The decreasing volumes, along with unanticipated environmental and infrastructure issues discovered after we acquired the facility in 2000, created unacceptable financial returns for the facility and contributed to the decision to shut it down.

 

Included in the restructuring charges in 2004 related to the shutdown of the Savannah facility was $86.6 million of asset write-downs taken in the form of accelerated depreciation for plant assets, $7.4 million for impairment of intangible assets, $6.7 million for severance and benefit plan curtailment costs and $6.7 million for other closure costs. We also recognized an additional $5.6 million of costs in 2004 in connection with the closure of the synthetic rutile plant in Mobile, Alabama.

 

Provision for Environmental Remediation and Restoration, net of Reimbursements.  Provision for environmental remediation and restoration, net of reimbursements, was $17.1 million in 2005 compared to $4.6 million in the same period of 2004. The net provision in 2005 included $11.3 million related to remediation of ammonium perchlorate contamination associated with the Henderson, Nevada, facility. It was determined in 2005 that the groundwater remediation system at the Henderson facility would need to be operated and maintained over an extended time period and a provision was added for the closure of an ammonium perchlorate pond. The provision for environmental remediation and restoration also included a charge of $5.6 million in 2005 related to remediation of the former agricultural chemical Jacksonville, Florida, site for soil remediation and excavation (see “Environmental Matters — Environmental Costs” and Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K).

 

Operating Profit (Loss).  The table below presents the change in operating profit (loss) from 2004 to 2005 of $182.7 million and is followed by a detailed segment discussion below.

 

 

Pigment Segment — Operating profit in 2005 was $101.5 million, an increase of $188.0 million over the operating loss of $86.5 million in 2004. In addition to the $58.6 million increase in net sales discussed above, the improvement in operating results in 2005 was primarily attributable to the shutdown provisions incurred in 2004 of $123.0 million for the sulfate-process TiO₂ production at the Savannah, Georgia, facility and $6.8 million of costs incurred in connection with the continued efforts to close the synthetic rutile plant in Mobile, Alabama. These improvements were partially offset by an increase in selling, general and administrative expenses of $5.0 million over 2004, primarily due to an increase in employee incentive compensation (including stock-based compensation), largely as a result of improved operating performance for the year.

 

Electrolytic and Other Chemical Products Businesses — Operating loss in 2005 was $5.9 million compared with an operating loss of $0.6 million in 2004. Operating performance declined primarily due to higher environmental costs of $9.1 million in 2005, related primarily to ammonium perchlorate remediation associated with our Henderson, Nevada, operations. Operating results were also impacted by higher selling, general and administrative expenses of $2.0 million attributable to increased litigation expenses and an increase in employee incentive compensation (including stock-based compensation), largely as a result of improved operating performance for the year. These higher costs were partially offset by $2.1 million lower operating costs in 2005 at our Henderson, Nevada, EMD manufacturing facility which incurred higher costs in 2004 when production recommenced after being temporarily curtailed in late 2003.

 

Interest and Debt Expense.  Interest and debt expense to outside parties increased to $4.5 million in 2005 from $0.1 million in 2004. The increase was due to interest on our unsecured notes and term loan facility that were entered into concurrent with the IPO in November 2005.

 

Other Income (Expense).  Other expenses, net, decreased $10.0 million from $25.2 million in 2004 to $15.2 million in 2005, primarily due to lower net fees incurred in connection with the accounts receivable securitization program that was terminated in April 2005, including a return of estimated fees previously paid in excess of actual costs incurred. Other expenses were also lower due to a decrease in losses attributable to changes in the exchange rates for both the euro and the Australian dollar.

 

Income Tax Benefit (Provision).  Our effective tax rate related to continuing operations for 2005 was 32.0% compared to 31.9% for 2004. During 2005, we repatriated $131.0 million in extraordinary dividends under the American Jobs Creation Act of 2004, resulting in recognition of income tax expense of $4.7 million. Our effective tax rate was reduced in 2005 by tax benefits and reductions in statutory rates recognized in foreign jurisdictions. On a stand-alone basis, our pro forma provision for income taxes related to continuing operations in 2005 would have been $19.1 million less than that determined under our allocation policy with Kerr-McGee. This decrease in income taxes was due primarily to income in the United States that would have been eliminated by our theoretical stand-alone net operating loss carry-forward, which we would not have previously recognized as a deferred tax asset.

 

Loss from Discontinued Operations.  Loss from discontinued operations, net of taxes, in 2005 was $27.6 million compared to $45.8 million in 2004. The loss in 2005 includes $17.7 million loss, net of taxes, on our former forest products operations, including an environmental provision of $3.2 million, net of taxes, for additional soil volumes related to the Sauget, Illinois, wood-treatment plant and $4.8 million, net of taxes, for litigation expenses. Also included is a $5.2 million environmental provision, net of taxes, for pond closure, rock placement and surface water channels at the former Ambrosia Lake, New Mexico, site associated with our formerly conducted uranium mining and milling operation (see “Environmental Matters — Environmental Costs” and Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K).

Financial Condition and Liquidity

 

The following table provides information for the analysis of our historical financial condition and liquidity:

 

 

 

 

Overview

 

Our primary cash needs are for working capital, capital expenditures, environmental cash expenditures and debt service under the senior secured credit facility, the unsecured notes and the note payable due July 2014 (See “Liquidity and Capital Resources” below). We believe that our cash flows from operations together with borrowings under our revolving credit facility, will be sufficient to meet these cash needs for the foreseeable future. However, our ability to generate cash is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. If our cash flows from operations are less than we expect, we may need to raise additional capital. We may also require additional capital to finance our future growth and development, implement additional marketing and sales activities, and fund our ongoing research and development activities.

 

Additional debt or equity financing may not be available when needed on terms favorable to us or even available to us at all. We are restricted by the terms of the senior secured credit facility and the indenture governing the unsecured notes from incurring additional indebtedness. Under our tax sharing agreement with Kerr-McGee, if we enter into transactions during the two-year period following the Distribution which results in the issuance or acquisition of our shares, and the Internal Revenue Service subsequently determines that Section 355(e) of the Internal Revenue Code is applicable to the Distribution, we will be required to indemnify Kerr-McGee for any resulting tax liability.

 

We have an interest in The LandWell Company LP (“LandWell”), a limited partnership formed to market or develop land in the Henderson, Nevada, area. LandWell entered into an agreement in late 2004 to sell to Centex Homes approximately 2,200 contiguous acres of land in Henderson for eventual use as a new, mixed-use master planned community. We were notified that the general partner of LandWell received from Centex Homes on January 9, 2007, a letter giving notice of termination of the agreement, effective immediately. Since that time, LandWell has commenced negotiations with a number of parties who have interest in the development of either part or all of the 2,200 continguous acres; however, we do not currently anticipate any cash flows associated with this in 2007. LandWell continues to pursue zoning approval for the development plan, with the City of Henderson currently scheduled to approve zoning on June 12, 2007. This large parcel, in addition to other parcels available for sale by LandWell or under contract, is in the vicinity of our Henderson facility. Cash flows resulting from the sale of the 2,200 continguous acres area of land in the Henderson, Nevada, area must be used to pay down outstanding debt under our senior secured credit facility.

 

We are making progress in negotiations with interested parties for the sale of parcels of land which are 100% Tronox owned, including surplus land in the Henderson area, as well as other parcels across the U.S. In 2006, we were successful in selling a number of smaller parcels, including former gas station properties in the midwestern U.S. and we currently anticipate realizing cash flows associated with these parcels in 2007.

 

Liquidity and Capital Resources

 

Prior to November 28, 2005 (the IPO date), we participated in Kerr-McGee’s centralized cash management system and relied on Kerr-McGee to provide necessary cash financing. The related cash activity between us and Kerr-McGee has been reflected as net transfers with affiliates within financing activities in our consolidated and combined statement of cash flows. Additionally, as discussed below under “Cash Flows from Operating Activities,” prior to the IPO date, certain expenditures related to our operations were paid by Kerr-McGee on our behalf and, therefore, did not affect cash flows from operating, investing and financing activities reported in our consolidated and combined statement of cash flows. As such, the amounts of cash and cash equivalents, as well as cash flows from operating, investing and financing activities presented in our consolidated and combined financial statements, for the period prior to November 28, 2005, are not representative of the amounts that would have been required or generated by us as a stand-alone company.

 

In connection with our separation from Kerr-McGee, the net amount due from us to Kerr-McGee as of the IPO date was contributed by Kerr-McGee, forming a part of our continuing equity. Such net amounts due to Kerr-McGee that were outstanding at the balance sheet dates prior to our separation have been reflected in our consolidated and combined financial statements as a component of owner’s net investment in equity. Amounts due to or from Kerr-McGee arising from transactions subsequent to our separation through the expiration of the transition services agreement with Kerr-McGee have been settled in cash.

 

Of cash and cash equivalents at December 31, 2006, $51.3 million was held in the U.S. and $25.3 million was held in other countries. In 2005, $131 million of unremitted foreign earnings in Australia were repatriated as extraordinary dividends, as defined in the American Jobs Creation Act of 2004, and subsequently transferred to Kerr-McGee as part of its centralized cash management system. Until April 2005, we had an accounts receivable monetization program, which served as a source of liquidity up to a maximum of $165.0 million.

 

A significant portion of the company’s liquidity is concentrated in trade accounts receivable that arise from sales of TiO₂ to customers in the paint and coatings industry. The industry concentration has the potential to impact the company’s overall exposure to credit risk, either positively or negatively, in that its customers may be similarly affected by changes in economic, industry or other conditions. The company performs ongoing credit evaluations of its customers, and uses credit risk insurance policies from time to time as deemed appropriate to mitigate credit risk but generally does not require collateral. The company maintains reserves for potential credit losses based on historical experience and such losses have been within expectations.

 

Credit Agreement.  In November 2005, our wholly-owned subsidiary, Tronox Worldwide LLC, entered into a senior secured credit facility. This facility consists of a $200 million six-year term loan facility and a five-year multicurrency revolving credit facility of $250 million. This facility is unconditionally and irrevocably guaranteed by us and Tronox Worldwide LLC’s direct and indirect material domestic subsidiaries. The facility is secured by a first priority security interest in certain domestic assets, including certain property and equipment, inventory and receivables of Tronox Worldwide LLC and the guarantors of the senior secured credit facility. The facility is also secured by pledges of the equity interest in Tronox Worldwide LLC and Tronox Worldwide LLC’s direct and indirect domestic subsidiaries and up to 65% of the voting and 100% of the non-voting equity interests in Tronox Worldwide LLC’s direct foreign subsidiaries and the direct foreign subsidiaries of the guarantors of the senior secured credit facility.

 

Interest on amounts borrowed under the senior secured credit facility is payable, at the company’s election, at a base rate or a LIBOR rate, in each case as defined in the agreement. The current margin applicable to LIBOR borrowings is 150 basis points and may range between 100 to 200 basis points depending on our credit rating. (See “Contractual Obligations and Commercial Commitments” below).

The terms of the credit agreement provide for customary representations and warranties, affirmative and negative covenants, and events of default. We were required to maintain compliance with the following financial covenants effective beginning in 2006 (in each case, as defined in the agreement):

 

 

We were in compliance with these financial covenants at December 31, 2006. In March 2007, we requested and obtained approval for an amendment to the financial covenants in the credit agreement. The amendment maintains the original Total Leverage Ratio and the Interest Coverage Ratio at 3.75:1 and 2:1, respectively, through December 31, 2007. For fiscal year 2008, the Total Leverage Ratio must be no more than 3.50:1 and the Interest Coverage Ratio must be at least 2.5:1 in the first two quarters and 3.00:1 in the last two quarters. The amendment did not modify the limit on capital expenditures, which is $130 million in 2007 and 2008.

 

We are required, under the terms of the credit agreement, to remit a certain percentage of excess cash flow (“ECF Percentage,” as defined in the credit agreement) as a prepayment of the principal. As a result, we expect to prepay term loan principal of approximately $11.1 million in April 2007. This is in addition to the normal quarterly installments. Installment payments will total approximately $2 million in 2007.

 

Senior Unsecured Notes.  Also concurrently with the IPO, Tronox Worldwide LLC and Tronox Finance Corp. issued $350 million in aggregate principal amount of 91/2% senior unsecured notes due 2012 in a private offering. Interest on the notes is payable on June 1 and December 1 of each year. During the second quarter of 2006, we registered these notes with the Securities and Exchange Commission (the “SEC”) and subsequently completed an exchange of all notes and guarantees for publicly tradable notes and guarantees having substantially identical terms, on July 14, 2006. These notes are guaranteed by our material direct and indirect wholly-owned domestic subsidiaries.

 

Both the credit facility and the senior unsecured notes have limitations on the amount of cash dividends that we can pay to our stockholders. These limitations restrict cash payments of dividends to $5.0 million in the aggregate in any fiscal quarter and to $13.5 million in the aggregate in any fiscal year.

 

Note Payable due July 2014.  In July 2006, Tronox Western Australia Pty Ltd, our wholly-owned subsidiary, completed the purchase of a 50% undivided interest in additional mining tenements and related mining assets. We acquired the mine tenements by entering into an eight-year note payable agreement. As a result, we recorded noncash capital additions of approximately $9.4 million and have additional debt outstanding of $8.8 million, following a principal payment during the third quarter of 2006. The debt requires scheduled payments through 2014, with an early payment option at the end of 2007. Interest is currently accrued at the rate of 13.26% per annum on the outstanding balance as of the first day of January of each calendar year and is calculated through December 31, with payments made on July 28 of each year in which an installment is due.

 

Cash Flows

 

Net Cash Flows from Operating Activities.  Cash flows from operating activities in our consolidated and combined statement of cash flows for the period prior to the IPO date exclude certain expenditures incurred by Kerr-McGee on our behalf, such as income taxes, general corporate expenses, employee benefits and incentives, and net interest costs. Therefore, reported amounts are not representative of our cash flows from operating activities as a stand-alone company. For example, cash flows from operating activities for 2005 and 2004 exclude $27.2 million and $37.0 million, respectively, paid by Kerr-McGee for income taxes on our behalf. Additionally, 2005 and 2004 cash flows from operating activities exclude $48.0 million and $55.1 million, respectively, of general corporate expenses, employee benefits and incentives, and net interest costs associated with our continuing and discontinued operations. While such costs are reflected in our consolidated and combined statement of operations because they were allocated to us by Kerr-McGee, they did not result in cash outlays by us. As a stand-alone company, costs and expenses of this nature require the use of our cash and other sources of liquidity.

 

Cash flows from operating activities for 2006 were $111.6 million compared to $61.5 million for 2005. The $50.1 million increase in cash flows from operating activities for 2006, was due primarily to the impact of the termination of the accounts receivable monetization program in 2005 and a lower amount of net cash used from relative changes in our inventories in 2006 compared to 2005. This was partially offset by interest payments on long-term debt arrangements, timing of income tax payments, a decrease in environmental reimbursement receipts and cash bonus program payments in 2006. Termination of our accounts receivable monetization program resulted in an extension of the collection period for accounts receivable arising from pigment sales compared to the collection period of receivables prior to program termination. This had a one-time impact, in the 2005 period, of reducing our cash flows from operating activities related to the increase in our accounts receivable.

 

This one time impact from termination of our accounts receivable monetization program referenced above was the primary reason for the 2005 versus 2004 variance in cash flows from operating activities. Cash flows from operating activities also decreased in 2005 due to an increase in inventories at year-end 2005 compared to year-end 2004. The decrease in cash flows from operating activities caused by termination of our accounts receivables monetization program and increase in inventories was partially offset by decreased environmental expenditures of $24.1 million and an increase in environmental cost reimbursements of $20.9 million.

 

Net Cash Flows from Investing Activities.  Net cash used in investing activities for 2006, was $75.0 million, a decrease of $158.3 million compared to 2005. The decrease is due primarily to the collection of repurchased accounts receivable of $165.0 million contributed to us by Kerr-McGee in the 2005 period.

 

Capital expenditures in 2006 were $79.5 million, a decrease of $8.1 million compared to 2005. Significant projects in 2006 and 2005 included changes to the Uerdingen, Germany, pigment facility to convert waste to a saleable product and reduce raw material costs, upgrading the oxidation line at the Botlek, Netherlands, facility and process improvements at the Hamilton, Mississippi, facility for the purpose of producing a new grade of pigment for use in architectural paints.

 

Net cash provided by investing activities in 2005 was $83.3 million, an increase of $174.7 million from $91.4 million used in investing activities for 2004. The collection of repurchased accounts receivable that were contributed to us by Kerr-McGee resulted in an increase of $165.0 million in cash from investing activities in 2005.

 

Capital expenditures in 2007 are expected to be approximately $81 million, which includes capital for the planned expansion at our Kwinana, Western Australia, pigment plant and waste treatment upgrades at our Botlek, Netherlands, facility.

 

Net Cash Flows from Financing Activities.  Net cash used in financing activities was $19.6 million in 2006 and $103.3 million in 2005. The decrease in use of funds primarily resulted from becoming a stand-alone and self-supported company. The cash used in 2006 consisted primarily of principal payments related to our long-term debt of $11.1 million and the payment of $6.2 million in dividends. Of the total principal payment of $11.1 million, $8.0 million was paid under the optional prepayment provision of our credit agreement.

 

In 2005, we completed our IPO by issuing 17.5 million shares of Class A common stock which provided proceeds, net of issuance costs, of $226.0 million. Concurrent with the IPO, we issued $350.0 million in aggregate principal amount of 91/2% senior unsecured notes and entered into a senior secured credit facility consisting of a $200.0 million six-year term loan facility. Proceeds from the unsecured notes and the term loan facility provided $539.1 million in cash flow from financing activities in 2005, net of debt issuance costs. The net proceeds from our Class A common stock offering, unsecured notes and term loan facility were distributed to Kerr-McGee in the amount of $761.8 million. Net transfers to Kerr-McGee were $106.6 million in 2005 and $131.1 million in 2004.

 

Off-Balance Sheet Arrangements

 

We have entered into agreements that require us to indemnify third parties for losses related to environmental matters, litigation and other claims. We have recorded no material obligations in connection with such indemnification obligations as none are currently evaluated as probable of loss. In addition, pursuant to the MSA, we will be required to indemnify Kerr-McGee for all costs and expenses incurred by it arising out of or due to our environmental and other liabilities other than such costs and expenses reimbursable by Kerr-McGee pursuant to the MSA. At December 31, 2006, we had outstanding letters of credit in the amount of approximately $67.8 million.

These letters of credit have been granted to us by financial institutions to support our environmental clean-up costs and miscellaneous operational and severance requirements in international locations. As of February 28, 2007, we had outstanding letters of credit in the amount of $67.9 million.

 

Outlook

 

Given the recent moderate economic growth worldwide, the company’s outlook for 2007 is continuing to evolve. Due to the slowdown in the housing sector and its effects, the U.S. economy is expected to remain soft for the first half of 2007 but may begin to turn around in the second half of 2007. Western Europe and Japan ended 2006 on a strong note but are expected to soften to more trend-like levels over the course of 2007 due to weaker external demands and appreciating currencies. Emerging markets, led by China and India, are expected to continue experiencing strong growth during 2007 but will likely also see a slight softening from their 2006 levels.

 

Contractual Obligations and Commercial Commitments

 

In the normal course of business, we enter into operating leases, purchase obligations and borrowing arrangements. Operating leases primarily consist of the rental of railcars, office space and production equipment. Purchase obligations are agreements to purchase goods or services that are enforceable, legally binding and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions, and the approximate timing of the transaction. We are also obligated under an employee benefits agreement with Kerr-McGee to maintain the Material Features (as defined in the employee benefits agreement) of the U.S. postretirement plan without change for a period of three years following the effective date of the Distribution. Based on the actuarially determined obligations under that plan, we expect contributions to be approximately $11 million for each of the next five years.

 

The aggregate future payments under these borrowings, contracts and other arrangements (including all U.S. nonqualified and foreign pension and postretirement obligations) as of December 31, 2006, are summarized in the following table:

 

 

 

 

Environmental Matters

 

Current Businesses

 

We are subject to a broad array of international, federal, state and local laws and regulations relating to environmental protection. Under these laws, we are or may be required to obtain or maintain permits or licenses in connection with our operations. In addition, under these laws, we are or may be required to remove or mitigate the

effects on the environment of the disposal or release of chemical, petroleum, low-level radioactive and other substances at various sites. Environmental laws and regulations are becoming increasingly stringent, and compliance costs are significant and will continue to be significant in the foreseeable future. There can be no assurance that such laws and regulations or any environmental law or regulation enacted in the future is not likely to have a material effect on us.

 

Sites at which we have environmental responsibilities include sites that have been designated as Superfund sites by the U.S. EPA pursuant to CERCLA and that are included on the National Priority List (“NPL”). As of December 31, 2006, we had received notices that we had been named a PRP with respect to 12 existing EPA Superfund sites on the NPL that require remediation. We do not consider the number of sites for which we have been named a PRP to be the determining factor when considering our overall environmental liability.

 

Decommissioning and remediation obligations, and the attendant costs, vary substantially from site to site and depend on unique site characteristics, available technology and the regulatory requirements applicable to each site. Additionally, we may share liability at some sites with numerous other PRPs, and U.S. law currently imposes joint and several liability on all PRPs under CERCLA. We are also obligated to perform or have performed remediation or remedial investigations and feasibility studies at sites that have not been designated as Superfund sites by EPA. Such work frequently is undertaken pursuant to consent orders or other agreements.

 

Legacy Businesses

 

Historically, we have engaged in businesses unrelated to our current primary business, such as the treatment of forest products, the production of ammonium perchlorate, the refining and marketing of petroleum products, offshore contract drilling, coal mining and the mining, milling and processing of nuclear materials. Although we are no longer engaged in such businesses, residual obligations with respect to certain of these businesses still exist, including obligations related to compliance with environmental laws and regulations, including the Clean Water Act, the Clean Air Act, the Atomic Energy Act, CERCLA and the Resource Conservation and Recovery Act. These laws and regulations require us to undertake remedial measures at sites of current and former operations or at sites where waste was disposed. For example, we are required to conduct decommissioning and environmental remediation at certain refineries, production and distribution facilities and service stations previously owned or operated before exiting the refining and marketing business in 1995. We also are required to conduct decommissioning and remediation activities at sites where we were involved in the exploration, production, processing or sale of minerals, including uranium and thorium compounds and at sites where we were involved in the production and sale of ammonium perchlorate. Additionally, we are decommissioning and remediating our former wood-treatment facilities as part of our exit from the forest products business. For a description of the decommissioning and remediation activities in which we currently are engaged, see “Environmental Costs” below and Notes 5 and 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K.

 

Environmental Costs

 

Expenditures for environmental protection and cleanup for each of the last three years and for the three-year period ended December 31, 2006, are as follows:

 

 

Recurring operating expenses are expenditures related to the maintenance and operation of environmental equipment such as incinerators, waste treatment systems and pollution control equipment, as well as the cost of materials, energy and outside services needed to neutralize, process, handle and dispose of current waste streams at our operating facilities. These operating and capital expenditures are necessary to ensure that ongoing operations are handled in an environmentally safe and effective manner.

 

In addition to past expenditures, reserves have been established for the remediation and restoration of active and inactive sites where liability is probable and future costs to be incurred are reasonably estimable. For environmental sites, we consider a variety of matters when setting reserves, including the stage of investigation; whether EPA or another relevant agency has ordered action or quantified cost; whether we have received an order to conduct work; whether we participate as a PRP in the Remedial Investigation/Feasibility Study (“RI/FS”) process and, if so, how far the RI/FS has progressed; the status of the record of decision by the relevant agency; the status of site characterization; the stage of the remedial design; evaluation of existing remediation technologies; the number and financial condition of other potentially responsible parties (“PRPs”); and whether we can reasonably evaluate costs based on a remedial design or engineering plan.

 

After the remediation work has begun, additional accruals or adjustments to costs may be made based on any number of developments, including revisions to the remedial design; unanticipated construction problems; identification of additional areas or volumes of contamination; inability to implement a planned engineering design or to use planned technologies and excavation methods; changes in costs of labor, equipment or technology; any additional or updated engineering and other studies; and weather conditions. Additional reserves of $56.4 million, $69.0 million and $81.4 million were added in 2006, 2005 and 2004, respectively, for active and inactive sites.

 

As of December 31, 2006, our financial reserves for all active and inactive sites totaled $223.9 million. In the Consolidated Balance Sheet at December 31, 2006, included in Item 15 (a) of this annual report on Form 10-K, $128.6 million of the total reserve is classified as Noncurrent Liabilities-Environmental remediation or restoration, and the remaining $95.3 million is included in accrued liabilities. We believe we have reserved adequately for the reasonably estimable costs of known environmental contingencies. However, additional reserves may be required in the future due to the previously noted uncertainties.

 

Pursuant to the MSA, Kerr-McGee has agreed to reimburse us for a portion of the environmental remediation costs we incur and pay after the IPO (net of any cost reimbursements we expect to recover from insurers, governmental authorities or other parties). The reimbursement obligation extends to costs incurred at any site associated with any of our former businesses or operations.

 

With respect to any site for which we have established a reserve as of the effective date of the MSA, 50% of the remediation costs we incur and pay in excess of the reserve amount (after meeting a $200,000 minimum threshold amount) will be reimbursable by Kerr-McGee, net of any amounts recovered or, in our reasonable and good faith estimate, that will be recovered from third parties. With respect to any site for which we have not established a reserve as of the effective date of the MSA, 50% of the amount of the remediation costs we incur and pay (after meeting a $200,000 minimum threshold amount) will be reimbursable by Kerr-McGee, net of any amounts recovered or, in our reasonable and good faith estimate, that will be recovered from third parties.

 

Kerr-McGee’s aggregate reimbursement obligation to us cannot exceed $100 million and is subject to various other limitations and restrictions. For example, Kerr-McGee is not obligated to reimburse us for amounts we pay to third parties in connection with tort claims or personal injury lawsuits, or for administrative fines or civil penalties that we are required to pay. Kerr-McGee’s reimbursement obligation also is limited to costs that we actually incur and pay within seven years following the IPO.

The following table reflects our portion of the known estimated costs of investigation, remediation or claims that are probable and estimable. The table summarizes EPA Superfund NPL sites where we have been notified we are a PRP under CERCLA and other sites for which we had financial reserves recorded at year-end 2006. In the table, aggregated information is presented for other sites (each of which has a remaining reserve balance of less than $3 million). Sites specifically identified in the table below are discussed in Note 17 to the Consolidated and Combined Financial Statements included in Item 15 (a) of this annual report on Form 10-K.