Tata Sponge Iron Analysis

Current Price: 352.1 INR
Market Cap: 5.42 billion INR
Book Value: 5.071 billion INR
Exchange Rate: 45.17 INR to 1 USD
Ticker: TTSP.NS

Tata Sponge Iron (TSI) looks interesting. It’s got a P/E of 5.35, a yield of 2.28%, and P/B a bit over 1. It’s actually one of those companies that gives me the creeps: it’s cheap and I don’t see any reason for it to be such a bargain.

The company’s business is the manufacture of sponge iron, also called direct-reduced iron. It is partially owned (40% stake) by Tata Steel, one of the world’s larger steel companies. TSI has a relatively small share of the total Indian DRI market, about 1.5% as of 2009/2010. A total of 1.44B in sales went to Tata Steel in FY 2010, accounting for 27.6% of sales. Normally high customer concentration is off-putting to me, but the customer’s large ownership interest complicates the situation in this case. On one hand, the Tata Steel has a financial interest in continuing to do business with its affiliate (TSI), since moving its business elsewhere would knock down the value of their investments in TSI. On the other hand, Tata Steel would have a lot of power to push for deals that gave it preferential treatment at the expense of TSI and its shareholders. That doesn’t appear to have been a problem recently – margins and earnings look pretty strong – but that could change in the future.

TSI currently has a great financial position. The company currently has 1.8 billion INR in cash against zero debt and a market cap of 5.38 billion. The only threat to its financial stability would be the capital-intensive nature of its industry. Luckily it appears that the company is now producing enough free cash to fund its operations internally. Big capex years consume about 1B INR, but the company has produced operating cash flow in the billion-rupee range for several years now so that level of expenditure looks supportable. Shares outstanding have remained stable at 15M for many years and all long-term debt was paid down back in 2009.

Returns on invested capital have been fairly high for many years. Return on invested capital (using net income), cash return on invested capital (using free cash flow), and return on equity have typically been 20% or higher for the past five years. It looks like capital expenditures follow a three year cycle, where two years of modest capex are followed by a year with substantial expenditures of up to 1 billion INR. This causes CROIC to intermittently plunge, so a more accurate and less volatile figure might be a three year average. The average CROIC for 2008-2010 is 20.3%.

The company is small and not widely followed, so it’s difficult to know exactly which factors are spooking investors and keeping the valuation so low. My research leads me to think that potential areas of concern for TSI’s future would be the sponge iron market, the overall Indian economy, margin compression, competition, expenditure requirements, conflicts of interest between Tata Steel and other shareholders, and past valuation levels.

The health of the sponge/DRI market probably isn’t the cause. Figures here show that production had been increasing steadily for decades up until 2009, when it dipped from the global recession. It began rising again in 2010. India has provided more and more of the world’s production as the years went by. As of 2010 India accounted for 36.5% of world DRI production. As you can see, the growth curve leveled out in recent years (a comparison of annual growth rates is available in the spreadsheet at the bottom). Considering the size of its production share and the decelerating production, it feels fair to assume that production will rise long-term by a single-digit rate rather than the 25% CAGR of the past 30 years.

With that conservative assumption, TSI is undervalued based on its substantial ability to generate free cash flow. After all, if there is no need to expand capacity, there is no need for large expenditures and that cash could be put to profitable use for the shareholders. If, on the other hand, DRI production began increasing again in India, then its current valuation would be severely discounting its ability to serve the growing demand. Granted, it would need to at least maintain market share to participate in the DRI market’s overall growth but in that case the concentration of sales with a customer who (all else equal) has an incentive to buy with TSI would serve it well.

Tentative figures from the World Steel Association suggest that production is increasing once again. Total estimated Indian DRI production from the January – April period is 8.521 million metric tons. Annualizing that production level leads to a rough 2011 output of 34.084 million metric tons. Projecting that forward for the rest of the year seems reasonable given that monthly crude steel and iron output (2010 and 2009 for steel; 2008 for iron in Table 43) seems to vary little from month to month. Even if production falls off toward the end of the year, 2011 production is still on track to substantially exceed 2010’s 20.65 million ton output.

A bit of reverse-DCF might be useful to illustrate the kinds of assumptions that the market is pricing in. With a required rate of return (k) of .2,  net income of 1,013M, and market cap of 5.42B, this is the level of growth that the current valuation implies:

(in millions of INR)
5420 = 1013 / (.2 – g)
g = .0131 or 1.31%

That’s a pretty simplistic calculation, but it gives you an idea of the kind of implicit assumptions going on here.

The health of the overall Indian economy is a bit harder to judge. I don’t have any particular edge in judging where it’s going, so I’ll limit my analysis here to the possible impact of less-than-favorable economic outcomes. At its current price the company wouldn’t require runaway economic growth to provide a solid return to its shareholders. It produces a lot of cash and you’d be getting that cash flow dirt cheap. The main problem would be if the economy dipped into a recession. On that front, the massive growth of the Indian housing market is a red flag (gee, does that look familiar?). Steel consumption – and therefore iron consumption, since 98% of iron ore is used for steel-making purposes – in India is spread across a number of areas unrelated to the real estate market, but the economic effects of a major decline in real estate values would probably put a damper on overall steel consumption. Figure revenue dropping to something like FY2010 levels (fiscal year ends in March, so that’s primarily 2009 sales numbers) for a year or more in that case before steel consumption picks up again. TSI’s strong financial position makes this outcome a short-term nuisance rather than a solvency-threatening dilemma.

I think that margin compression might be less of an problem for investors, since they would be buying in when gross margin is approaching its 2007 low  rather than during a period of peak margins:

A bigger factor driving earnings – or rather, not driving them – would be that sales will probably be flat for the immediate future, since any expansion of existing capacity would take time.

Competition is definitely a concern since this is a commodity business with a small market share. Here again the self-interested customer/shareholder might be somewhat advantageous, since there is at least a modest incentive to make purchase from TSI. Management has also performed well by generating very strong returns on invested capital.

Expenditure requirements are probably the least of the company’s (and investors’) worries. Not only is DRI production a less capital-intensive process than blast furnace iron production – the process used to make pig iron – but the company currently produces enough cash (especially over a full multi-year cycle) to cover its expenditures.

To me, the company’s past valuation levels represent both the biggest puzzle and the biggest risk. Going by Reuters’ info, this outwardly healthy company has within the past five years traded for as little as 1.58x earnings. That period looks like it was in 2008/2009 when markets were bottoming out, but even still that’s unsettling to say the least.  It’s also worrisome to see that the peak valuation over the past five years has been 6.89x earnigns. As a result the single biggest risk to an investment in TSI appears to be valuation-based rather than business-based. Despite the fact that the company is cheap by virtually any metric, an investment here could be obliterated by these peculiar valuations or end up as dead money.

With that in mind I’d opt for a “safety first” approach. The fiscal years ends in March, so I figure the annual report ought to be up on their site within a month or so. A look at that might be a bit reassuring.

A few financial notes:
The “other expenses section” on the spreadsheets is the result of classifications by the Financial Times (the source of all the info). On the actual financial statements these expenses are all filed under the heading “Manufacturing and other expenses” and broken down in detail.

Since the financial statements use Indian-style numbering a quick explanation is in order. In Indian numbering, commas appear at the thousand, lac, and crore levels. A “lac” (commonly seen in the financial statements) is 100,000. http://en.wikipedia.org/wiki/Indian_numbering_system

Annual report
Financial Statements Breakdown and Iron Production

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