Analysis - Tata sponge ltd

About
Tata sponge ltd is a 676 cr sponge iron manufacturer with an annual capacity of 3.42 Lac MT. The company uses iron ore and coal as the raw material, which is used to produce sponge iron. Sponge iron is an important raw material for the manufacture of steel and the price for sponge iron in turn depends on steel demand and pricing.

The company is a part of the Tata group, which holds a 40% stake in the company through Tata steel. Tata steel also supports the company, by supplying iron ore. In addition the company has purchased and is developing coal mines for captive use and to control input costs.

Financials
The company has revenue of 676 crs and has recorded an average growth of 15%+ in the last 10 years. The bottom line is around 105 Crs with a growth of 20%+ in the last 5 years. The key point to note in the performance is that quite a bit of growth in the topline and bottomline has happened in the last 5 years.
The net margin of the company is currently at 17%. However the net margin has fluctuated between 4% and 17% in the last 10 years. These fluctuation are closely linked to the steel demand and pricing and has generally fallen when the overall economy has slowed down.
The company has now become a debt free company and has a cash holding of around 115 crs on its balance sheet.

Positives
The company has a strong balance sheet with excess cash which can be used to fund additional capacity without taking on debt. In addition the company is a part of the Tata group which is known for good corporate governance.
The company also has access to ore supplied by Tata steel which provides some stability to raw material costs. In addition the company has acquired a coal mine and is in process of developing it. This would help the company to control its key inputs costs which is iron ore and coal.
The company has demonstrated good topline and bottom line performance and has a high ROE (15% or higher) at low to moderate levels of debt. Finally the company has always operated at a low or negative working capital.

Risks
The key risk for the company is the nature of the industry in which it operates. The industry is cyclical, with low barriers to entry. In addition, the product is a commodity and hence the profitability of the company is tied to steel prices and the demand supply situation of the same.
The industry and the company are also characterized by large swings in performance depending on the demand and pricing for its product.

Competitive analysis
The industry is characterized by low entry barriers and the only competitive edge a company can have in this industry would be from economies of scale. Companies do not have much control on raw material (coal and iron ore mainly) pricing and the pricing of the final product (sponge iron) is also driven by steel prices. Scrap steel is a substitute for sponge iron and hence the price and availability of scrap steel also has an impact on the price of sponge iron.
Finally the industry faces price based competition, atleast at the local level and most of the companies are price takers. I don’t think any company can demand a premium for their sponge iron.

Management quality checklist

- Management compensation: Management compensation is fairly low with the MD drawing a compensation in the region of 50-60 lacs
- Capital allocation record: The management has demonstrated a good capital allocation record. The company has maintained an ROE in excess of 15% even during downturns. The company has also demonstrated an ROE of around 25% on the incremental capital invested in the last 5 years. The only negative has been the low level of dividend payout. The low dividend payout is however understandable due to the lower levels of free cash flows (atleast 20-30% of the earnings is required as maintenance capex).
- Shareholder communication – Shareholder communication has been good and the management has been transparent about the performance.
- Accounting practice – looks conservative
- Conflict of interest - none
- Performance track record – good in comparison to the industry economics

Valuation
The intrinsic value of the company can be taken between 350-400 for a net profit margin of around 11-13% over a business cycle and for a topline growth of around 13-15%. The current margins of around 17% cannot be taken as a base line as the margins have fluctuated between 4 to 24% with an average of 11% for the last 10 yrs. The topline assumption is a bit conservative, but a higher rate of growth will not increase the intrinsic value as much, as a higher growth would require a higher level of re-investment and result in a lower free cash flow.

Scenario analysis
The current price discounts a net margin of 11% and topline growth of 9%. A topline growth of 15% would give an intrinsic value of around 360-400.

Conclusion
The company seems to be undervalued by around 30-35% at best. The company may look undervalued based on the PE, but the correct approach to value a company is to compute its intrinsic value based on a DCF (discounted cash flow) formulae using the free cash flow generated by the company.
A company such as Tata sponge is in a commodity business which requires a higher level of maintenance capex (for understanding maintenance capex, see here). As a result the earnings of such a business consistently overstates the free cash flow. In case of tata sponge, the free cash is around 70-80% of the earnings. Based on the above free cash flow, margin and growth estimates, I would conservatively put the intrinsic value between 350-400.
Finally, the industry and the company is in a commodity industry with low to non-existent competitive advantages. As a result, it would be sensible to take the intrinsic value on the conservative side

Disclosure: I don’t hold the stock as it is not cheap enough for me. However I may not disclose it on my blog, when I decide to initiate a position in the stock. As always, please read the disclaimer