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Sid Choraria January 13, 2014

My Take on Tata Sponge

Tata Sponge (BSE: 513010), with a market capitalizat ion o f approximately $65 million and an enterprisevalue of just $8 million, is a s ignif icantly undervalued deep value stock trading at mouth-watering multiples

that initially invokes an “ick” reaction o n the part o f most investo rs to delve further.

At t he current price o f INR270 (US$4.15), Mr. Market is of f ering a consistently prof itable business (net

profit positive every year for 20 years), returns on tangible capital employed in excess of 50%, prodigious

f ree cash f low generator (FCF greater than company’s enterprise value) and value-o riented shareholders

f or a ridiculously low 0.4x FCF, 0.36x EBITDA and 0.6x P/E excluding cash (company has 86.9% of current

market cap in net cash). The company has been had a debt- f ree balance sheet f or o ver f ive years with no

dilution in the last 20 years.

Several factors have led to the market to all but ignore the company: under-researched, obscure “ick” name

and product (sponge iron), misinformed selling at any price and cyclical industry with dif f icult economics.

The company has s ignif icant brand power given the “Tata” brand and is run by disciplined management with

excellent corpo rate governance and capital allocation with no dilution in the last 20 years. We not e the

positive presence of notable value investors, Ruane Cunniff & Goldfarb (Sequoia) who recently increased

their stake to 5.45% that will serve to shine greater att ention on Tata Sponge. At current levels, we think the

stock of f ers a high margin of saf ety with upside potential of 50% – 150% valued conservatively.

Why is Tata Sponge Worth Your Attent ion?

Consistently profitable over several economic cycles: Tata Sponge f eatures excellent businesseconomics with high returns on t angible capital employed in excess o f 50% and unlevered return on

tangible equity over 20%. Impressively, Tata Sponge has grown revenue 15 out of the last 20 years

and had pos itive net income every year f or 20 years with median net margins in excess of 10%

despite operat ing in a cyclical industry. The company has genuine competitive advantages benef itt ing

from the “Tata” brand and as a low cost producer sourcing key raw materials like iron ore from

captive mines f rom its parent, Tata Steel at a signif icant 15% discount to market prices.

Free cash f low generative business with cash rich balance shee t : The business is a s ignif icant

cash f low generator and has been f ree cash f low positive f or 8 out o f the last 10 years. As of March

2013, Tata Sponge had $55.6mm in net cash ($3.6 net cash per share) with zero debt (the company

has been debt f ree for the last f ive years). The company has low predictable capex requirements as

f urnaces f or manufacturing sponge iron – an intermediate product f or steel is signif icantly smaller in

size to other alternatives where furnaces are larger.

Mr. Market currently valuing business for practically free: At current prices , Tata Sponge t rades

at absurdly low multiples – 0.4x FCF, .07x Sales, 0.36x EBITDA and 0.6x P/E ex cash. The bus iness

trades at a material discount to historical multiples o ver the last 10 years (refer t o valuation section

f or historical multiples t able). Simply, reverting to historical median EV/EBITDA multiple of 2.7x would

result in over 85% upside. Based on our DCF downside case of 5% revenue decline each year (this

has not happened in the last 20 years) for the next five years and operating margins reduction by

400 bps to 12% (this has no t happened in the last 10 years; March 2013 EBIT margin: 16.2%), weest imate a per share value of $8.5 or +105% upside. Additionally, while we typically do not rely on

sell-s ide research targets, we pay note if there is a big disparity between current share price

(INR270) and target price. In the case of Tata Sponge, the lates t sell-side report f rom Centrum has a

price target of INR513 or +90%.

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Shares trading at a material discount to Tata voluntary offer last year: In August 2012, Tata

Steel, the parent acquired 1,734,040 shares, represent ing an additional 11.26% of out standing

shares in Tata Sponge through a voluntary open offer from public shareholders at INR 375 per

share, taking its ownership stake to 51% as of August 28, 2012. We not e the parent o f f ered a

premium of 22.5% at then prices on INR 306 at a P/E of around 5.9x. Mr. Market has ignored this

event and is now of f ering an larger discount with shares trading at a 28% discount to the voluntary

of f er price.

Notable dee p value investors, Ruane Cunniff & Goldfarb stake increase is positive: As o f July 31, 2013, Ruane Cunnif f & Go ldfarb increased their stake in Tata Sponge to 5.45%. As value

investors, we think the stake increase by them will undoubtedly attract the attention of other value

oriented investors and potentially serve to unlock value.

Multiple Catalysts to unlock deep value : We think there are multiple catalysts that can serve to

unlock the material undervaluation of Tata Sponge. Catalysts include (i) a f urther increase in stake by

Tata Steel, (ii) greater visibility on coal block st atutory clearances (management expects approvals in

the next year and development in 24-36 months ) which will lead to margin expansion, (iii) greater

attention f rom other value oriented investo rs (we think Ruane Cunnif f & Goldfarb’s recent increased

stake will help to att ract others), (iv) increased dividend payout or share repurchases given cash pileand (v) government f ocus on infrast ructure growth should see a sustained demand for sponge iron.

Business Model with Compet itive Advantages: Low Cost Producer and Quality “Tata” Brand

Tata Sponge traces its roots back to its founding in 1982 in India by Tata Steel, part of the Tata Group,

among the top respected brands and conglomerates in India. The company has an annual manufacturing

capacity of 390,000 tonnes of sponge iron, which is an intermediate semi-finished product in the value

chain used f or pro ducing steel. To unders tand the sponge iron making process , refer to Appendix C (or

http://www.tatasponge.com/products/iron-making-animation.asp). The company also o perates two power

plants with a combined generation capacity of 26 MW that generate power from waste heat.

Over the last 20 years, Tata Sponge has never had a los ing year – it has cons istent ly been operat ing and

net pro f it positive. How is the company able to remain prof itable in a cyclical business?

The answer lies in that t he company has genuine competitive advantages due to being a low cost producer

and the premium “Tata” brand. As the cost of iron ore and coal const itute a majority o f the cost of

production, prof itability directly depends on market price o f these raw materials vis-à-vis price of sponge

iron. The only way to be the low cost producer is to have full ownership of these raw materials. Tata

Sponge so urces iron ore f ully f rom captive mines o f its parent, Tata Steel at a signif icant 15% discount to

market prices through the Orissa Mineral Corporat ion. Additionally, the company is developing a capt ive coal

block with 120 MT reserves, which will meet a s ignif icant part of its coal requirements. The company applied

f or t he block paying US$31mm (this has already been paid f or) but due to government statutory clearance

delays, management expects the coal block to be operat ional in the next 24 months. The company has

made significant progress with respect to land acquisition related to the coal block. Once operational, this

is expected to lead to f urther margin expansion, as in the last f ew years rising coal prices have led to

margin pressure.

Tata Sponge’s operational efficiency enables the company to consistently sustain over 90% capacity

utilization. In FY ending March 2012, the company had lower ut ilizat ion rate due to unrest by truckers

around Tata Steel’s mines leading to supply disruption. Operating a plant at near f ull capacity allows it t o

spread its fixed costs and achieve economies of scale. Below is the historical capacity utilization of Tata

Sponge over the last f ive years.



The business is run by a well-respected management team who is acutely focused on value oriented

metrics like return on invested capital and economic value added (EVA). The company tremendously

benef its due to its premium “Tata” brand leading to s tro ng customer captivity. As a result, Tata Sponge has

a business model that generates high returns on invested capital relative to its cos t o f capital. Thecompany has not had any dilution over the last 20 years.

Tata Sponge Ret urn on Invested Capital Drivers Tree – March 2013

With Tata Sponge having a captive iron ore source

and its bid to build a captive resource base of

thermal coal, we believe the company is set to be

among the mos t stable sponge iron players in the

industry.

Why is Tata Sponge Mispriced?

Investors have thrown in the towel due to

coal block delay: Many investors have thrown

in the towel due to external factors such as thedelay in the development o f Radhikapur coal

block due to statuto ry clearances by the

government. Tata Sponge had applied f or a

coal block with 120 MT reserves, which will

meet a significant part of its coal raw material

requirements (see attached supporting pdf

detailing coal block development). Due to

statuto ry approval delays, this is now expected

to be operat ional in the next 24 months . The company has made signif icant progress in private land

acquisition and already spent INR 2,040mm (US$31mm) ent irely paid f or through internal cash f low.We think investors have thrown the baby out with the bath water without merit to the business

prof itability and valuation. Once the coal block is operational, margins are expected to only f urther

expand, providing current prices as an att ractive entry point to long term value investo rs.



Obscure company with pract ically no coverage from major analysts: Tata Sponge is a relatively

obscure f irm with a bo ring name and does something ridiculous (sponge iron manuf acturing). Indeed,

the f irst reaction is “ick” accompanied by a wrinkle of the nose on t he part o f mos t investors to delve

any further (unrelated to the valuation merit). Practically, no “major” brokerage houses cover the

name in India. The analysts t hat cover the name in India are small cap houses that are interested in

undervalued stock picking. While we do no t pay heed to sell-s ide research price targets , as analysts

f requently have an inherently “bullish” bias and change price targets every f ew mont hs, we note in

Tata Sponge case, that the latest sell side report as o f Sept 2013 f rom Mumbai-based Centrum

Broking has a price target of INR513 or 90% ups ide. We note the wide gap between current share

price and target price is rare by sell-s ide analysts (part icularly given the lack of corpo rate f inance

business with Tata Sponge which is a small f irm).

It’s not in a “hot” industry with few pure play comparables: The growth in sponge iron demand

has correlation with steel demand. Investors are looking for the next growth industry and are happy

selling the “good with the bad”. While the indust ry is cyclical with most players reeling with heavy debt

and low capacity utilization, Tata Sponge has been net profit positive for 20 years in a row with no

debt and over 90% capacity utilization. We think investors are rushing out the door and happy to

throw out the baby with the bath water, with no regard to valuation or business profitability.

Furthermore, there are very f ew publicly listed pure play sponge iron directly comparable.

Institutions not rushing to buy due t o small-cap stock (unrelated to the valuation merit): Tata

Sponge is a small market capitalization st ock (US$64.0mm) and larger f unds cannot move t heir

performance due to capitalization hurdles. We think the stock is ideal for long-term oriented value

investors and small cap focused f unds, given the ridiculously low valuation. We note the presence of

f ew notable investo rs, Ruane Cunniff & Go ldfarb (Sequoia) who recently increased their stake to

5.45%, which will undoubtedly attract the attention of other value oriented investors and potentially

serve to unlock value.

Valuation

At INR270, Tata Sponge has a market capitalizat ion of $64mm. To calculate ent erprise value (TEV), we

subt ract $55.6mm in cash and add $0mm in interest bearing debt, leading to a TEV of $8.4mm.

As o f March 31, 2013, t he company had sales of $127.3mm, operat ing income of $20.6mm, EBITDA of

$23.3mm, net income of $13.1mm and unlevered f ree cash f low of $19.9mm. This t ranslates to absurdly low

multiples of .07x sales, .4x EBIT, .36x EBITDA, 0.6x P/E excluding cash and 0.4x FCF.

The business trades at a material discount to

historical multiples over the last 10 years. Simply,

reverting to histo rical median multiples of

EV/EBITDA of 2.7x and EV/Sales 0.79x implies a85% and 144% ups ide respectively.



Discounted Cash Flow

As value inves tors, we typically don’t “f orecas t” part icularly with rosy management or sell-side project ions.

We make highly conservative assumptions for back of the envelope math to understand the margin of

saf ety in Tata Sponge. Thus, we decline revenue 5% revenue each year (this has not happened in the last20 years) for the next five years and operating margins reduction by 400 bps to 12% (the company has not

had EBIT margins as low as 12% in the last 10 years with March 2013 EBIT of margin: 16.2%), we est imate

a per share value of $8.5 or +105% upside.

The sensit ivity tables below show a range of equity upside for sensit izing WACC and operating margin

while keeping revenue decline YoY f or the next f ive years at -5%. The high and low ranges based on this

downside case are 69.3% and 137% ups ide.

The sensitivity tables below show a range of equity upside for sensitizing revenue decline and operating

margin. The high and low ranges based on this downside case are 72% and 144% upside.



Based on any of the above metrics, we think the sto ck of f ers a signif icant margin of saf ety with upsidepotential of 50% – 150% under highly conservative basis.

How would Valuation and Margins Change if Tata Sponge Loses its 15% Discount on Iron Ore?

Even when we assume that the 15% discount on iron ore f rom Tata Steel is taken away (this has never

happened in the last 20 years), Tata Sponge still of f ers a signif icant margin of saf ety

Key Risks to Investment The sis

Large Investment in coal block post approval: Investors worry that there is always the possibility

that companies engage in value destroying activities and investing in low return projects. We think

this is unlikely in Tata Sponge case as management as had a histo ry of delivering high returns on

equity and invested capital. The upf ront payment o n the coal block has already been made, and any

f urther investment can be adequately made f rom internal cash f low.



Disruption of iron ore sourcing agreement f rom Tata Ste el – Tata Sponge benef its f rom being a

low cost producer due to sourcing iron o re at 15% discount to market prices f rom its parent.

Disruption o f this is unlikely as we note this has not happened in 20 years, and with the increase in

stake by Tata Steel to 51%, the parent is more likely to cont inue to be a captive source of key raw

materials.

Volatile sponge iron prices: With a cyclical industry, inefficient producers are often debt-ridden

with no pricing power. Tata Sponge has never posted a loss in 20 years, managing through variouscycles. The company benef its f rom the Tata brand with strong custo mer captivity. Sponge iron prices

are expected to remain relatively stable based on analysts’ fo recasts (ref er to Appendix D)

External factors like coal block delay and transportation : The business could be impacted by

external f actors not in its contro l, like f urther coal block delay by the government and transportation

of raw materials. The company has already made signif icant progress in private land acquisition and

spent INR 2,040mm (US$31mm) f or the coal block paid for through internal cash f low. Management

expects the development to be ready in 24-36 months, and are in final stages of land acquisition and

received f irst s tage clearance on f orest . Once operational, the coal block is expected to only f urther

increase margins. If the pro ject is derailed, the company can be refunded cash or the land by the

government, so we do not see this as a huge risk, particularly at the current valuation.

Appendix A: Financial Summary



Appendix B: Historical Free Cash Flow Calculation



Appendix C: Sponge Iron Making Process

Appendix D: Historical and Projecte d Industry Average Prices

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