Tata Sponge, which has access to captive raw material, excess land, technical knowhow and huge cash in books, is now looking at forward integration.
Tata Sponge, which has access to captive raw material, excess land, technical knowhow and huge cash in books, is now looking at forward integration. This could create good value in the long run considering that the excess cash will be used for a useful purpose allowing it to earn higher return on capital.
Strong return ratio on core operations
The company has Rs 877 crore of capital employed in business. After removing cash of Rs 570 crore and claims (of about Rs 180 crore relating to cancellation of coal blocks) the effective capital employed in the business is only Rs 127 crore. On this capital, in FY17 it generated core EBIT of about Rs 36 crore, which translates to close to 30 percent return on capital.
Forward integration into steel
Tata Sponge has taken board approval for building a 1.5-million tonne long steel manufacturing plant. The capex will be funded through the cash in books and by recourse to minimal debt. This will not only improve its return ratios, but will also bring in growth. To put the numbers in perspective, even a 1-million tonne long steel production (first phase to be completed in the next three years), at current market prices of around Rs 35000 a tonne, can fetch an annual sales turnover of Rs 3500 crore as against the company’s current sales turnover of Rs 615 crore.
Tata Sponge currently produces 4 lakh tonnes of sponge iron annually which is used in making final steel-like long products. For manufacturing one million tonnes of steel it requires a little higher amount of sponge iron. And as Tata Sponge will be using its captive sponge, it will be in a position to leverage its capabilities.
Huge operating and financial strength
Tata Sponge, which is operating in the iron ore belt, has greater advantage than its peers owing to its own captive power plants and assured iron ore supply from Tata Steel's mines. In India, it is one of the most efficient players.
"The production plant of Tata Sponge Iron is located in the close vicinity (30Km) of high grade iron ore mines. As a result, the company enjoys huge savings on logistic costs. Captive railway siding facility for inbound raw materials and despatch of finished products in bulk enhances its competitive edge. The company has also integrated power generating plants to reduce the cost of manufacturing and sells surplus power," said Kamal Kant Sahoo, who is tracking the company at IndiaNivesh Securities.
Lean Balance Sheet
The other big advantage for Tata Sponge is its debt-free balance sheet, which allows it to remain profitable in a down-cycle and make strong profits in an up-cycle. This is already visible. With the recovery in steel demand and prices, realisations that had dipped to a low of Rs 11,000 per tonne in Q4FY16, has now recovered to 16000 per tonne in Q1FY18. Sponge iron prices are currently hovering around Rs 15,500 per tonne, which is still better compared to the realisation of Rs 13,700 per tonne in FY17.
Higher realisations have a huge impact on earnings. For instance, in Q1FY18, because of higher realisations, the company's profit jumped three-fold to Rs 30.57 crore from Rs 10.55 crore in the corresponding quarter last year.
While in FY18, volumes and realisations may not increase drastically (volumes 407,000 tonnes), even at the current market price of Rs 15,500 per tonne, the company will be making close Rs 102 crore of net profit in FY18 (see table), which is a growth of over 73 percent compared to last year’s profit of Rs 59 crore.
The company is sitting on a cash and cash equivalent of Rs 570 crore, which is equal to 370 per share or about 44 percent of its current market price of Rs 850. If one includes the Rs 180 crore claim (due with the government post the cancellation of coal block earlier), the value of cash per share comes to Rs 487, which is close to 60 percent of its current market price.
If one removes the cash, on a sales turnover of Rs 630 crore, the company is available at market capitalisation of Rs 730 crore. The stock is trading at 10 times core estimated earnings for FY18, which is quite reasonable considering that it has a strong balance sheet, good management and has one of the most efficient plants. That apart, since the company is now putting the excess cash in books to create new capacity in steel, the market will be gradually attributing a higher valuation as the growth visibility improves.
Part of Tata consolidation?
Apart from valuations, the Tata Group consolidation could be good news for companies like Tata Sponge which is a subsidiary of Tata Steel. Considering the product profile and similarity of the business, in the long term, it might make sense for the Tata Steel to merge Tata Sponge. Tata Sponge can fill the product gaps of Tata Steel, which is largely into flat steel products whereas Tata Sponge is building long product capacity. Such a reverse merger would perhaps give due cognizance to the interest of Tata Sponge’s minority shareholders.Follow @jitendra1929The Great Diwali Discount!
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