Stock Fundamentals

Tata Sponge Iron: Buy

Adarsh Gopalakrishnan | Updated on March 19, 2011 Published on March 19, 2011

Captive power, long-term arrangements for iron ore with parent Tata Steel and a 45 per cent stake in coal mines to be commissioned in 2013 are positives.



In a volatile pricing environment for steel, low leverage and high levels of integration provide a good margin of safety for profits. One such company, Tata Sponge Iron, appears to be an attractively priced bet at Rs 317 or 5.6 times trailing twelve month earnings. Captive power, long-term arrangements for iron ore with parent Tata Steel and a 45 per cent stake in coal mines that are to be commissioned in 2013 provide the company with room to manoeuvre and possibly bolster margins over the next two fiscals.

While the company's valuation is on a par with peers such as Prakash Industries and MSP Steel and Power, higher levels of capacity utilisation and tight operations with mines in close vicinity compared with peers make Tata Sponge Iron a preferred play in the sponge iron space.

BUSINESS

Tata Sponge Iron has the capacity to produce around 3.3 lakh tonnes of sponge iron at a facility in Orissa. Sponge iron is an intermediate in the production of steel and is utilised by secondary steel producers in arc furnaces as a complement to scrap.

Utilising sponge iron as an input for steel production has a host of advantages, including a more optimal composition of ‘furnace' input and lesser dependence on imported scrap whose supply and prices are more volatile. Just under 44 per cent of the company is controlled by Tata Steel and Tata Sons. The company operated at 92 per cent utilisation levels in the last fiscal, maintaining this in the current fiscal too.

Sales and net profits have grown at 37 and 14 per cent to Rs 485 crore and Rs 58 crore, respectively, over the first nine months of FY11 compared with the same period last fiscal.

The company has seen no capacity additions since 2007. Net sales have moved from Rs 455 crore in FY08 to Rs 520 crore in FY10.

Net profits have moved from Rs 96 crore to Rs 85 crore, thanks to a higher raw material bill which has outpaced sponge-iron realisations. Operating margins have hovered between 28 per cent (in the most recent fiscal) and 37 per cent.

However, favourable dynamics for sponge iron prices with increasing demand from steel alloy producers (who operate utilising arc furnaces) is likely to work in the company's favour, enabling it to enjoy operating margins of 15-20 per cent.

Working in favour of the company's net profit margins is the fact that there is no debt to service and stable depreciation expenses. This should also serve the company well in its effort to bring its coal mines on-stream.

Around 25 km from its Orissa plant are the iron ore mines the company has leased to parent Tata Steel. These mines supply the company with high-quality iron ore at rates considerably lower than those in the spot markets.

Similarly, the company has a 45 per cent stake in a venture that been allotted coal mines with reserves of around 120 million tonnes. Bringing these coal mines on-stream by FY13 will be a key move for margin expansion as the company's coal bill accounts for 60 per cent of raw material costs.

PRICE OUTLOOK

Sponge iron prices are up around 25 per cent over the last three months tracking steel prices, which are up as a result of the spike in input costs.

With several evolving supply side constraints for steel scrap, including curtailed exports from Russia (third largest exporter mulling a ban) and Japan (the second largest scrap exporter), there is the possibility of increased demand for sponge iron, driving up prices.

This is despite falling iron ore prices as secondary steel producers turn to an increasing proportion of sponge iron as a furnace input.

The major challenges for the company include the substantial hike in input costs as Coal India increased prices of high-grade coal by 30 per cent last month.

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