Tata Sponge - Favorable risk-reward ferrous midcap with attractive portfolio - Centrum

We view Tata sponge as an undervalued ferrous midcap stock with an attractive portfolio which mitigates risk in an otherwise volatile sponge iron industry. We note that the company has i) access to captive iron mines of its parent Tata Steel, ii) is currently developing a captive coal block having 120 MT reserves, iii) has captive power (26 MW) backed sponge iron capacity of 3.9 lakh tonne and iv) a strong operational track record. Despite this attractive mix of assets the stock is currently available at cheap valuations with cash at ~0.5x of market cap. We expect net sales and EBITDA CAGR of 11.3% and 21.9% during FY12-15E. We initiate coverage with a BUY rating and a target price of Rs520.

- Higher capacity utilization going ahead as iron ore sourcing issues resolved: We expect volume CAGR of 10.6% during FY12-15E as volumes have already recovered from the lows of FY12 (~70% capacity utilization) on account of improved iron ore availability from captive mines of Tata steel at Joda, Orissa.

- Key cost savings through waste heat captive power: Tata Sponge has 26 MW of waste heat recovery based captive power plants (CPP) which makes it self sufficient in power. It also has a surplus (~2x captive consumption) which is sold to the state electricity corporation.

- Domestic iron ore shortage keeps sponge iron price outlook strong: Shortage of iron ore in the domestic market in the wake of mining bans and clampdown on illegal mining activities has led to large scale capacity shutdowns in sponge iron industry lending support to sponge iron price outlook with stable demand from secondary long producers.

- Stake hike by Tata Steel and non de-allocation of coal block remain strategic positives: Tata Steel has recently completed its open offer of Rs375/share for Tata Sponge shares and hiked its stake to 51%, thus making it its subsidiary. Also, the company's coal block at Radhikapur (east) with 120 MT of reserves has not been de-allocated by the IMG and remains on track for starting coal production in a few years. We view these recent developments as strategic long term positives.

- Cash rich balance sheet to aid in coal block development: Tata Sponge had cash/share of Rs160 at the end of FY12. We expect investments of ~Rs2.5bn in coal block development during FY13-15E to be funded out of internal accruals and cash. For captive use we expect cost savings of ~65% in coal landed costs for sponge iron making as currently the company is dependent on imports and e-auctions.

- Valuations - attractive, initiate with a Buy: Tata Sponge currently trades at cheap valuations despite having sound fundamentals and scope of high cost savings and superior valuations from the developing coal block. We have valued the company using EV/EBITDA methodology for sponge iron business and EV/tonne of reserves for the coal block. We initiate coverage with a target price of Rs520 and recommend Buy.

Key Risks: Lower capacity utilization in sponge iron due to raw material shortage, price fall in sponge iron, delay in coal block and high mining tax from the new mining bill.

Source : Equity Bulls

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