Tata Sponge Iron: Boost from steel

Growth in volumes and demand for steel are positives for the company

A supplier of sponge iron to steel producers, Tata Sponge Iron appears well-placed to benefit from favourable market conditions for steel and its raw materials. The company’s operating performance has been improving steadily over the past few years. Encouraging trends in volume growth and realisations, focus on costs and favourable market conditions are positives for the company.

At the current market price of ₹805, the stock is attractively valued at about eight times its trailing 12-month earnings, lower than the average that it traded at over the past three years (16 times). The stock has fallen about 25 per cent in the last nine months. At this level, it is a good buying opportunity for high-risk investors with a two-year horizon.

Tata Sponge’s dividend yield has been reasonable, at about 1.25-2.5 per cent over the past few years.

Demand visibility

The company derives about 90 per cent of its revenue from the sale of sponge iron. There are over 400 sponge iron units in India and, currently, Tata Sponge is one of the largest with a market share of about 5 per cent. While the capacity utilisation of the industry is at around 65 per cent, the company operates at about 110 per cent due to the increasing demand for its product.

 

 

The demand for sponge iron is directly linked to the performance of the steel sector. As per the earning’s call of the company, about 35 per cent of the country’s steel capacity uses sponge iron.

Indian steel demand is expected to accelerate gradually, driven by public investment and growth in the automobile and construction sectors. The overall growth in steel consumption in India for FY18 stood at a healthy 7.8 per cent. According to the World Steel Association, India produced 79.6 million tonnes of crude steel in the first nine months of 2018, which is a 6.1 per cent growth compared with the same period a year ago.

 

 

 

 

Also, as per the National Steel Policy formulated during FY 2017-18, the target for crude steel production capacity is 300 million tonnes by 2030. The share of sponge iron in steel-making is expected to be 80 million tonnes, which will create huge opportunity for domestic sponge iron industry, which is now at around 25-30 million tonnes.

With capacity expansion plans in place, Tata Sponge is now well-placed to cater to the increasing demand for sponge iron.

Resilient enough

The company managed to remain profitable even when the steel industry was going through a bad patch in FY16.

From FY 2016, while the sales volumes of sponge iron grew at a compounded annual growth rate (CAGR) of 3.3 per cent, revenues grew at a CAGR of almost 20 per cent till FY18 (₹816 crore). This can be attributed to the increase in realisations from about ₹13,500 a tonne in FY16 to around ₹18,500 per tonne in FY18. The operating margin too went up from just 4 per cent in FY16 to a healthy 23 per cent in FY18.

Going forward, average realisations are expected to hover between ₹22,000 and ₹23,000 while operating margins are projected to be around 20 per cent.

The company’s current production capacity is 4,25,000 tonnes, but it got environment clearance to produce 4,65,000 tonnes, which is 110 per cent of the capacity available.

The cost of raw material (iron ore, coal) constitutes about 80 per cent of the total cost of production. While iron ore is completely procured from Tata Steel, a significant portion of coal is obtained from South Africa.

For the nine months period in FY19, revenue, operating and net profit grew by 40 per cent (₹477 crore), 23 per cent (₹90 crore) and 26 per cent (₹73 crore) respectively compared to a year ago.

A healthy addition

The recent acquisition of Usha Martin’s steel business is expected to be value-accretive in the long run.

Usha Martin, which has an integrated operation for making one million tonne of specialised alloy-based long products with captive iron ore, coal and power plants, will be bought for nearly ₹4,500 core.

The amount, which seems huge compared to the size of Tata Sponge, will be funded by equity and debt.

This will dilute the earnings per share (EPS) in the near term and the company will no longer be debt-free.

However, the deal aligns with Tata Sponge’s intention to enter the steel-making business.

The valuation (EV/EBITDA at 10) looks reasonable and Usha Martin has the potential to add up to ₹500 crore to the company’s operating profits in the near term.

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