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