Value Pick:A qualitative analysis of Tata Sponge

The guest post below is written by Krishnaraj Venkataraman, also known as Kimi.  Kimi has been an entrepreneur, and after selling his last business, now runs an investment partnerships that seeks to invest capital in undervalued securities in India.-Raoji

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Benjamin Graham begins his seminal book Security Analysis with a quote by Horace, “Many shall be restored that now are fallen, and many shall fall that now are in honor”. With Indian politicians rushing to demonstrate the latter; investors such as me search for the former. One such candidate is Tata Sponge.

The rush to sell

Tata Sponge is a small and relatively obscure firm run in an obscure place making an obscure product called Sponge Iron. Experts have prognosticated a poor outlook for steel industry – the end user of sponge iron; raw material inputs like iron ore & coal and power are either not available or shockingly priced; steel scrap, a sponge iron substitute is available cheaper. It could get worse, and the industry as such is reeling under heavy debt and low capacity utilization – the business equivalent of a gas chamber. Some will surely not survive, and many others will be hurt badly.

Shareholders are petrified and are crowding to exit; and in that they are indifferent to the value of the stock. Who would want to hold when business is sure to decline in the next quarter and foggy after that?

However, the very act of such unrestrained selling pushes price far below levels indicated by good sense.

Characteristics of the business of Tata Sponge

Tata Sponge sources iron ore fully from the mine of its parent (at a discount to NMDC rates) and imports a good part of its coal needs, eliminating uncertainty of availability. It also generates its own power eliminating another source of availability uncertainty. (Makes you wonder if India is the only large economy where availability of any economic resource is the first consideration, and its cost is a distant second)

Tata Sponge operates its plant at near full capacity; and runs it well. For instance it tries to continuously minimize the coal and power needed to make a unit of sponge iron. Further the quality of sponge iron produced is consistent in its Iron content and weight – important consideration for customers. Operating a plant at full capacity allows its fixed costs to be spread over the largest possible quantity minimizing per unit costs of sponge iron – not to mention time and costs saved from rampant start-ups and shut-downs.

The advantages above add to a few vital points in margins where the selling price is out of control. However the trump card lies in its profitable power business. Tata Sponge uses waste heat from the sponge iron making process to generate power, 2/3rds of which at full capacity is sold to the local state electricity board. The marginal cost involved is about 30 – 40% of the price at which power is sold to the grid. These profits are independent of the sponge iron prices allowing the bottom-line to escape to an extent the cyclical nature of the sponge iron business.

Further Tata Sponge has turned a profit every year in the past since 1992, even under worse economic conditions than exists today.  In other words, it is reasonable to assume that Tata Sponge operationally should do OK under trying circumstances and quite good otherwise.

There’s another vital difference that separates the best from the rest especially during periods of high interest rates, viz., capital structure. Tata Sponge is practically debt free and none of its peers seen is. A debt free capital structure allows all the operational excellence to flow through to the bottom-line. This has added qualitative advantages as well – no covenant breach, no loan restructuring and no short term measures taken to meet loan liabilities.

The outcome is an economic performance that is far superior to the average Indian company; a Return on Equity of about 30% averaged over the last 20 years!

Comparing value with price for Tata Sponge

After a reading of the above one may conclude that Tata Sponge is more valuable alive than dead but the market seems to think the exact opposite. Not only that, the market thinks that Tata Sponge is worth even much less than its value as a closed shop. There cannot be any other conclusion reached when we find that it is changing hands at 68% of its Book Value as of 11 May 2013. This, even as it uses as it uses only about 30% of its Book Value for its core business; 25% on advances for a coal block allocated to it and the remaining 45% as cash and liquid assets.

Clearly a case of fallen honor that should be restored!

Notes:

  1. Sources are Annual and Quarterly Reports and Industry numbers publicly available.
  2. Reasonable and practical assumptions have been made wherever necessary. Conclusions won’t be affected by minor changes in assumptions.
  3. We have long positions in the firm.
  4. Comments welcome at krishnarajv@gmail.com

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Is Emkay Global worth more dead than alive?

In 1932, the father of Security Analysis, Ben Graham wrote an article in Forbes called “Is American Business worth more dead than alive?” .He cited many instances where businesses where sold for a fraction of their net quick assets.

The wealth destruction in the Indian markets in small and mid cap stocks in the last six months has lead to many instances of good businesses being sold for less than their liquidation value

Take for instance Emkay Global..

Started in 1995,Emkay Global is one of the leading brokerages of India with around 350 retail outlets spread across the country.Its finances and stock price has taken a knocking in line with the markets.

For the year 2010-2011,its consolidated results show the following:

Long Term Debt:2.94 Crores

Net Current Assets: 114.15 Crores

Quick Liquidation Value = Net Current Assets- Long Term Debt i.e 111.21 Crores

Quick Liquidation Value/Share= Rs.45.57

Current Market Price of Emkay Global (as on 13 April, 2012) =Rs 29.3

Conclusion: As per the Indian markets, Emkay Global is worth more dead than alive

Value unlocking at Sundaram Clayton

Sundaram Clayton Limited (SCL) is part of the $5 billion TVS group, one of the largest auto components manufacturing and distribution group in India.

SCL is a leading supplier of aluminium die castings to automotive and non-automotive sector. (Rs.808 Crore sales in FY2011)

It has a fully owned subsidiary called Anusha Investments Ltd (AIL)

Now SCL owns 4.2 Crore shares (8.84%) of TVS Motors.AIL owns 23.06 Crore Shares (48.56%) shares of TVS Motors.

So effective ownership of SCL in TVS Motors is 27.26 Crore Shares (57.4%).

As of today 27 March, 2012 at a CMP of Rs.38.75,  this works out to a valuation of Rs.1056.3 Crores

Sundaram Clayton Ltd (SCL) has a current market cap valuation of Rs.580.24 Crores.

So effectively if you were to buy SCL today , you’ll get the SCL business for free as well as Rs. 476 Crores of TVS Motors for free.

Typically, the markets discount holding companies as the value unlocking doesn’t happen.

But in this case, the management seems intent to remove this anomaly.

They have proposed a scheme of arrangement wherein all the non-automotive related businesses of SCL will be transferred to a company called Sundaram Investments Ltd (SIL)

If the scheme gets the necessary approvals, a person holding two shares of existing SCL will get one share of the demerged SCL and one share of SIL.

The only catch is that the promoters don’t intend to list SIL.They intend to provide an “exit option” to public shareholders at a fair value based on a report by a valuer/merchant banker.

The TVS group is known for its integrity.Its unlikely they will screw the minority shareholders.

So , all in all, the scheme should unlock tremendous value.

 

 

Would Warren Buffett have invested in Concor?

There was an interesting article in Mint today on Concor (see link).

The article states that increase in haulage charges has taken business away from Concor towards private roadway operators.Hence the company is facing headwinds.

Lets look at this company from Warren Buffett’s eyes:

1.Does this company have a significant moat?

The answer is Yes.This company is more or less a monopoly.Private operators who tried to enter this business got their heads handed to them on account of govt. regulations.

2.Are the macro trends in favor?

India will grow its international business as it grows.So will its domestic haulage.Not only the volume of business will grow, but also the value due to persistent inflation

The clincher is diesel prices.While short term, diesel prices may not be increased due to political compulsions, long term the laws of economics will prevail.As per the Parikh report (section 4.9), railways consume 1/4th the diesel per net tonne kilometre as trucks.This is a huge huge advantage

3.Does the company need additional equity capital to grow?

The track record of this company is outstanding.It is sitting on 2600 Crores Rupees net cash.The dilution of equity is neither needed nor wanted

4.Is the management competent and ethical?

As the management is government owned,this question is a tricky one.

5.Is the company’s prices regulated?

The finances of this company depends on the haulage charges of the Railways.It is possible that political compulsions may wreak havoc with Concor’s finances but the possibility is remote

6.Are the valuations attractive?

At 11 times estimated fiscal 2013, they are fair.

Conclusion:Warren Buffett would probably buy this stock  and keep it forever !!