NL

Business Context and Reporting Period

Company: NL Industries, Inc. (NYSE: NL)
Reporting Period: Fiscal year ended December 31, 2010
Structure: NL is primarily a holding company. Its operations are conducted through two primary subsidiaries:

• CompX International Inc. (87% owned): Manufactures component products including security products, furniture components (ball bearing slides, ergonomic systems), and marine components.
• Kronos Worldwide, Inc. (30% owned): A leading global producer of titanium dioxide (TiO2) pigments. NL accounts for this investment using the equity method.

Ownership: Valhi, Inc. owns approximately 83% of NL's outstanding common stock. Valhi is majority-owned by subsidiaries of Contran Corporation, which is controlled by Harold C. Simmons.

Key Financial Metrics (2010)

Material Changes vs. Prior Period

The Company reported a significant turnaround from a net loss in 2009 to a net income of $70.4 million in 2010. Key drivers included:

• Equity in Earnings of Kronos: Kronos reported net income of $130.6 million in 2010 compared to a loss of $34.7 million in 2009. This was driven by a 27% increase in net sales due to higher TiO2 volumes and prices.
• Gain on Reduction of Kronos Ownership: NL recognized a pre-tax gain of $78.9 million in Q4 2010 following Kronos' secondary public offering, which reduced NL's ownership from 36% to 30%.
• CompX Performance: CompX returned to profitability with $9.4 million in operating income, compared to a $4.0 million loss in 2009. Sales increased 17% to $135.3 million, driven by improved economic conditions in North America.
• Unusual Items:
  • Litigation Settlement Expense: A $32.2 million pre-tax expense was recorded in Q1 2010 related to a settlement of legal proceedings (partially offset by insurance recoveries).
  • Insurance Recoveries: Recoveries increased to $18.8 million in 2010 from $4.6 million in 2009.

Guidance, Outlook, and Risks

Outlook for 2011: Management expects net income in 2011 to be lower than 2010. This expectation is primarily due to the absence of the one-time $78.9 million gain on the reduction of Kronos ownership and lower expected insurance recoveries. However, this is expected to be partially offset by higher equity earnings from Kronos and higher operating income from CompX.

Management Commentary:

• Kronos: TiO2 industry conditions remain strong with low inventories. Kronos expects to operate at near full capacity in 2011 and anticipates further price increases. However, raw material and energy costs are expected to rise 6-10%.
• CompX: Demand continues to improve. The Company is focused on lean manufacturing and cost improvements. Currency fluctuations (weakening USD) are expected to have a negative impact on 2011 results.

Key Risks and Contingencies:

• Lead Pigment Litigation: NL faces numerous lawsuits regarding former lead pigment operations. No accrual has been made as liability is not considered probable or estimable, but a material adverse impact is possible if outcomes change.
• Environmental Matters: Accrued environmental costs were $40.4 million at year-end. The upper end of the reasonably possible range is approximately $73 million. Additional costs could be material.
• Raw Material Costs: CompX is exposed to commodity price fluctuations (steel, zinc, stainless steel). Kronos faces rising feedstock and energy costs.
• Liquidity: NL's ability to pay dividends and service debt depends on distributions from subsidiaries. NL expects to borrow from Valhi in 2011 to meet cash requirements.

Investor Verification Checklist

• Kronos Valuation: Verify the fair value of the 30% equity investment in Kronos, which increased significantly due to the secondary offering and improved earnings.
• Litigation Exposure: Review the status of lead pigment and environmental litigation (Note 19) to assess the potential for future accruals beyond the current $40.4 million environmental reserve.
• Recurring Earnings: Analyze earnings excluding the $78.9 million one-time gain on Kronos ownership reduction to understand the underlying operational performance.
• Debt Covenants: Confirm compliance with debt covenants for CompX and NL, particularly regarding the $37.5 million revolving credit facility and the $40 million note with Valhi.
• Dividend Sustainability: Assess the ability of subsidiaries (CompX and Kronos) to continue paying dividends, which are critical for NL's liquidity and ability to pay its own $0.50/share annual dividend.