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My Take on Tata Sponge

Sid Cho raria January 13, 2014

Tata Sponge (BSE: 513010), with a market capitalization of approximately $65 million and an enterprise value of just $8 million, is a signif icantly undervalued deep value stock trading at mouth-watering multiples that initially invokes an ick reaction on the part of most investors to delve f urther. At the current price of INR270 (US$4.15), Mr. Market is of f ering a consistently prof itable business (net prof it positive every year f or 20 years), returns on tangible capital employed in excess of 50%, prodigious f ree cash f low generator (FCF greater than companys enterprise value) and value-oriented shareholders f or a ridiculously low 0.4x FCF, 0.36x EBIT DA and 0.6x P/E excluding cash (company has 86.9% of current market cap in net cash). T he company has been had a debt-f ree balance sheet f or over f ive years with no dilution in the last 20 years. Several f actors have led to the market to all but ignore the company: under-researched, obscure ick name and product (sponge iron), misinf ormed selling at any price and cyclical industry with dif f icult economics. T he company has signif icant brand power given the Tata brand and is run by disciplined management with excellent corporate governance and capital allocation with no dilution in the last 20 years. We note the positive presence of notable value investors, Ruane Cunnif f & Goldf arb (Sequoia) who recently increased their stake to 5.45% that will serve to shine greater attention on Tata Sponge. At current levels, we think the stock of f ers a high margin of saf ety with upside potential of 50% 150% valued conservatively. Why is Tata Sponge Worth Your Attention? Consistently profitable over several economic cycles: Tata Sponge f eatures excellent business economics with high returns on tangible capital employed in excess of 50% and unlevered return on tangible equity over 20%. Impressively, Tata Sponge has grown revenue 15 out of the last 20 years and had positive net income every year f or 20 years with median net margins in excess of 10% despite operating in a cyclical industry. T he company has genuine competitive advantages benef itting f rom the Tata brand and as a low cost producer sourcing key raw materials like iron ore f rom captive mines f rom its parent, Tata Steel at a signif icant 15% discount to market prices. Free cash flow generative business with cash rich balance sheet : T he business is a signif icant cash f low generator and has been f ree cash f low positive f or 8 out of the last 10 years. As of March 2013, Tata Sponge had $55.6mm in net cash ($3.6 net cash per share) with zero debt (the company has been debt f ree f or the last f ive years). T he company has low predictable capex requirements as f urnaces f or manuf acturing sponge iron an intermediate product f or steel is signif icantly smaller in size to other alternatives where f urnaces are larger. Mr. Market currently valuing business for practically free: At current prices, Tata Sponge trades at absurdly low multiples 0.4x FCF, .07x Sales, 0.36x EBIT DA and 0.6x P/E ex cash. T he business trades at a material discount to historical multiples over the last 10 years (ref er to valuation section f or historical multiples table). Simply, reverting to historical median EV/EBIT DA multiple of 2.7x would result in over 85% upside. Based on our DCF downside case of 5% revenue decline each year (this has not happened in the last 20 years) f or the next f ive years and operating margins reduction by 400 bps to 12% (this has not happened in the last 10 years; March 2013 EBIT margin: 16.2%), we estimate a per share value of $8.5 or +105% upside. Additionally, while we typically do not rely on sell-side research targets, we pay note if there is a big disparity between current share price (INR270) and target price. In the case of Tata Sponge, the latest sell-side report f rom Centrum has a price target of INR513 or +90%.

Shares trading at a material discount to Tata voluntary offer last year: In August 2012, Tata Steel, the parent acquired 1,734,040 shares, representing an additional 11.26% of outstanding shares in Tata Sponge through a voluntary open of f er f rom public shareholders at INR 375 per share, taking its ownership stake to 51% as of August 28, 2012. We note the parent of f ered a premium of 22.5% at then prices on INR 306 at a P/E of around 5.9x. Mr. Market has ignored this event and is now of f ering an larger discount with shares trading at a 28% discount to the voluntary of f er price. Notable deep value investors, Ruane Cunniff & Goldfarb stake increase is positive: As of July 31, 2013, Ruane Cunnif f & Goldf arb increased their stake in Tata Sponge to 5.45%. As value investors, we think the stake increase by them will undoubtedly attract the attention of other value oriented investors and potentially serve to unlock value. Multiple Catalysts to unlock deep value : We think there are multiple catalysts that can serve to unlock the material undervaluation of Tata Sponge. Catalysts include (i) a f urther increase in stake by Tata Steel, (ii) greater visibility on coal block statutory clearances (management expects approvals in the next year and development in 24-36 months) which will lead to margin expansion, (iii) greater attention f rom other value oriented investors (we think Ruane Cunnif f & Goldf arbs recent increased stake will help to attract others), (iv) increased dividend payout or share repurchases given cash pile and (v) government f ocus on inf rastructure growth should see a sustained demand f or sponge iron. Business Model with Competitive Advantages: Low Cost Producer and Quality Tata Brand Tata Sponge traces its roots back to its f ounding in 1982 in India by Tata Steel, part of the Tata Group, among the top respected brands and conglomerates in India. T he company has an annual manuf acturing capacity of 390,000 tonnes of sponge iron, which is an intermediate semi-f inished product in the value chain used f or producing steel. To understand the sponge iron making process, ref er to Appendix C (or http://www.tatasponge.com/products/iron-making-animation.asp). T he company also operates two power plants with a combined generation capacity of 26 MW that generate power f rom waste heat. Over the last 20 years, Tata Sponge has never had a losing year it has consistently been operating and net prof it positive. How is the company able to remain prof itable in a cyclical business? T he answer lies in that the company has genuine competitive advantages due to being a low cost producer and the premium Tata brand. As the cost of iron ore and coal constitute a majority of the cost of production, prof itability directly depends on market price of these raw materials vis--vis price of sponge iron. T he only way to be the low cost producer is to have f ull ownership of these raw materials. Tata Sponge sources iron ore f ully f rom captive mines of its parent, Tata Steel at a signif icant 15% discount to market prices through the Orissa Mineral Corporation. Additionally, the company is developing a captive coal block with 120 MT reserves, which will meet a signif icant part of its coal requirements. T he company applied f or the block paying US$31mm (this has already been paid f or) but due to government statutory clearance delays, management expects the coal block to be operational in the next 24 months. T he company has made signif icant progress with respect to land acquisition related to the coal block. Once operational, this is expected to lead to f urther margin expansion, as in the last f ew years rising coal prices have led to margin pressure. Tata Sponges operational ef f iciency enables the company to consistently sustain over 90% capacity utilization. In FY ending March 2012, the company had lower utilization rate due to unrest by truckers around Tata Steels mines leading to supply disruption. Operating a plant at near f ull capacity allows it to spread its f ixed costs and achieve economies of scale. Below is the historical capacity utilization of Tata Sponge over the last f ive years.

T he business is run by a well-respected management team who is acutely f ocused on value oriented metrics like return on invested capital and economic value added (EVA). T he company tremendously benef its due to its premium Tata brand leading to strong customer captivity. As a result, Tata Sponge has a business model that generates high returns on invested capital relative to its cost of capital. T he company has not had any dilution over the last 20 years.

Tata Sponge Return on Invested Capital Drivers Tree March 2013 With Tata Sponge having a captive iron ore source and its bid to build a captive resource base of thermal coal, we believe the company is set to be among the most stable sponge iron players in the industry. Why is Tata Sponge Mispriced? Investors have thrown in the towel due to coal block delay: Many investors have thrown in the towel due to external f actors such as the delay in the development of Radhikapur coal block due to statutory clearances by the government. Tata Sponge had applied f or a coal block with 120 MT reserves, which will meet a signif icant part of its coal raw material requirements (see attached supporting pdf detailing coal block development). Due to statutory approval delays, this is now expected to be operational in the next 24 months. T he company has made signif icant progress in private land acquisition and already spent INR 2,040mm (US$31mm) entirely paid f or through internal cash f low. We think investors have thrown the baby out with the bath water without merit to the business prof itability and valuation. Once the coal block is operational, margins are expected to only f urther expand, providing current prices as an attractive entry point to long term value investors.

Obscure company with practically no coverage from major analysts: Tata Sponge is a relatively obscure f irm with a boring name and does something ridiculous (sponge iron manuf acturing). Indeed, the f irst reaction is ick accompanied by a wrinkle of the nose on the part of most investors to delve any f urther (unrelated to the valuation merit). Practically, no major brokerage houses cover the name in India. T he analysts that cover the name in India are small cap houses that are interested in undervalued stock picking. While we do not pay heed to sell-side research price targets, as analysts f requently have an inherently bullish bias and change price targets every f ew months, we note in Tata Sponge case, that the latest sell side report as of Sept 2013 f rom Mumbai-based Centrum Broking has a price target of INR513 or 90% upside. We note the wide gap between current share price and target price is rare by sell-side analysts (particularly given the lack of corporate f inance business with Tata Sponge which is a small f irm). Its not in a hot industry with few pure play comparables: T he growth in sponge iron demand has correlation with steel demand. Investors are looking f or the next growth industry and are happy selling the good with the bad. While the industry is cyclical with most players reeling with heavy debt and low capacity utilization, Tata Sponge has been net prof it positive f or 20 years in a row with no debt and over 90% capacity utilization. We think investors are rushing out the door and happy to throw out the baby with the bath water, with no regard to valuation or business prof itability. Furthermore, there are very f ew publicly listed pure play sponge iron directly comparable. Institutions not rushing to buy due to small-cap stock (unrelated to the valuation merit): Tata Sponge is a small market capitalization stock (US$64.0mm) and larger f unds cannot move their perf ormance due to capitalization hurdles. We think the stock is ideal f or long-term oriented value investors and small cap f ocused f unds, given the ridiculously low valuation. We note the presence of f ew notable investors, Ruane Cunnif f & Goldf arb (Sequoia) who recently increased their stake to 5.45%, which will undoubtedly attract the attention of other value oriented investors and potentially serve to unlock value. Valuation At INR270, Tata Sponge has a market capitalization of $64mm. To calculate enterprise value (T EV), we subtract $55.6mm in cash and add $0mm in interest bearing debt, leading to a T EV of $8.4mm. As of March 31, 2013, the company had sales of $127.3mm, operating income of $20.6mm, EBIT DA of $23.3mm, net income of $13.1mm and unlevered f ree cash f low of $19.9mm. T his translates to absurdly low multiples of .07x sales, .4x EBIT, .36x EBIT DA, 0.6x P/E excluding cash and 0.4x FCF. T he business trades at a material discount to historical multiples over the last 10 years. Simply, reverting to historical median multiples of EV/EBIT DA of 2.7x and EV/Sales 0.79x implies a 85% and 144% upside respectively.

Discounted Cash Flow As value investors, we typically dont f orecast particularly with rosy management or sell-side projections. We make highly conservative assumptions f or back of the envelope math to understand the margin of saf ety in Tata Sponge. T hus, we decline revenue 5% revenue each year (this has not happened in the last 20 years) f or the next f ive years and operating margins reduction by 400 bps to 12% (the company has not had EBIT margins as low as 12% in the last 10 years with March 2013 EBIT of margin: 16.2%), we estimate a per share value of $8.5 or +105% upside. T he sensitivity tables below show a range of equity upside f or sensitizing WACC and operating margin while keeping revenue decline YoY f or the next f ive years at -5%. T he high and low ranges based on this downside case are 69.3% and 137% upside.

T he sensitivity tables below show a range of equity upside f or sensitizing revenue decline and operating margin. T he high and low ranges based on this downside case are 72% and 144% upside.

Based on any of the above metrics, we think the stock of f ers a signif icant margin of saf ety with upside potential of 50% 150% under highly conservative basis. How would Valuation and Margins Change if Tata Sponge Loses its 15% Discount on Iron Ore? Even when we assume that the 15% discount on iron ore f rom Tata Steel is taken away (this has never happened in the last 20 years), Tata Sponge still of f ers a signif icant margin of saf ety

Key Risks to Investment T hesis Large Investment in coal block post approval: Investors worry that there is always the possibility that companies engage in value destroying activities and investing in low return projects. We think this is unlikely in Tata Sponge case as management as had a history of delivering high returns on equity and invested capital. T he upf ront payment on the coal block has already been made, and any f urther investment can be adequately made f rom internal cash f low.

Disruption of iron ore sourcing agreement from Tata Steel Tata Sponge benef its f rom being a low cost producer due to sourcing iron ore at 15% discount to market prices f rom its parent. Disruption of this is unlikely as we note this has not happened in 20 years, and with the increase in stake by Tata Steel to 51%, the parent is more likely to continue to be a captive source of key raw materials. Volatile sponge iron prices: With a cyclical industry, inef f icient producers are of ten debt-ridden with no pricing power. Tata Sponge has never posted a loss in 20 years, managing through various cycles. T he company benef its f rom the Tata brand with strong customer captivity. Sponge iron prices are expected to remain relatively stable based on analysts f orecasts (ref er to Appendix D) External factors like coal block delay and transportation : T he business could be impacted by external f actors not in its control, like f urther coal block delay by the government and transportation of raw materials. T he company has already made signif icant progress in private land acquisition and spent INR 2,040mm (US$31mm) f or the coal block paid f or through internal cash f low. Management expects the development to be ready in 24-36 months, and are in f inal stages of land acquisition and received f irst stage clearance on f orest. Once operational, the coal block is expected to only f urther increase margins. If the project is derailed, the company can be ref unded cash or the land by the government, so we do not see this as a huge risk, particularly at the current valuation. Appendix A: Financial Summary

Appendix B: Historical Free Cash Flow Calculation

Appendix C: Sponge Iron Making Process

Appendix D: Historical and Projected Industry Average Prices

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