Top Ex-US Case: Tata Sponge--Heads I Win, Tails I Don't Lose Much

The FactSet Top Idea Tournament, a SumZero research contest for buyside professionals, is now open for submissions. Contest #1 is: Best International (Ex-US) and members are encouraged to submit their best ideas on companies with at least USD$500mm in market cap, are domiciled outside the USA, and that generate greater than 50% of revenues outside the USA. The last day for new submissions in this contest is June 23rd.

We have assembled a phenomenal panel of judges including fund managers like Scott Ferguson (Sachem Head), James Montier (GMO), Guy Spier (Aquamarine), as well as large investors like the Notre Dame Endowment, the Virginia Tech Foundation, the UCLA Endowment, and Cook Children's Health Care. Prizes include $160k in cash (up to $56k to one pitch), a full speaking slot at the 10th Annual NY Value Investing Congress, products from FactSet, and more. Those who wish to enter the Tournament (and meet our membership criteria) need to join SumZero here: https://sumzero.com/pro/user_applications/new.

In honor of the upcoming contest and to provide the necessary inspiration, we thought we would highlight three of the finest internationally-focused pitches that have been published within the SumZero community over the years. Here's the last in this series: Tata Sponge by Sid Choraria of Marwar Capital.

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Tata Sponge ($64.0mm, EV $8.4mm) is a significantly undervalued deep value stock trading at mouth-watering multiples that initially invokes an "ick" reaction on the part of most investors to delve further. At current price of INR270 (US$4.15), Mr. Market is offering a consistently profitable business (net profit positive every year for 20 years), returns on tangible capital employed in excess of 50%, prodigious free cash flow generator (FCF greater than company's enterprise value) and value-oriented shareholders for 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-free balance sheet for over five years with no dilution in the last 20 years.

Several factors have led to the market to all but ignore the company: misinformed selling at any price, under-researched, obscure "ick" name and product (sponge iron) and cyclical industry with difficult economics. The company has significant brand power given the "Tata" brand and is run by disciplined management with excellent corporate governance and capital allocation with no dilution in the last 20 years. We note 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 attention on Tata Sponge. At current levels, we think the stock offers a high margin of safety with upside potential of 50% - 150% valued conservatively.

Why is Tata Sponge Worth Your Attention?

• Consistently profitable over several economic cycles: Tata Sponge features excellent business economics with high returns on tangible capital employed in excess of 50% and unlevered return on tangible equity over 20%. Impressively, Tata Sponge has grown revenue 15 out of the last 20 years and had positive net income every year for 20 years with median net margins in excess of 10% despite operating in a cyclical industry. The company has genuine competitive advantages benefitting from the "Tata" brand and as a low cost producer sourcing key raw materials like iron ore from captive mines from its parent, Tata Steel at a significant 15% discount to market prices.

• Free cash flow generative business with cash rich balance sheet: The business is a significant cash flow generator and has been free cash flow positive for 8 out of 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 free for the last five years). The company has low predictable capex requirements as furnaces for manufacturing sponge iron - an intermediate product for steel is significantly smaller in size to other alternatives where furnaces are larger.

• Mr. Market currently valuing business for practically free: At current prices, Tata Sponge trades at absurdly low multiples - 0.4x FCF, .07x Sales, 0.36x EBITDA and 0.6x P/E ex cash. The business trades at a material discount to historical multiples over the last 10 years (refer to valuation section for historical multiples table). 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 not happened in the last 10 years; March 2013 EBIT margin: 16.2%), we estimate a per share value of $8.5 or +105% upside. Additionally, while we typically do not rely on sell-side 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 latest sell-side report from Centrum has a price target of INR513 or +90%.

• Shares trading at a material discount to Tata voluntary offer last year: In August 2012, Tata Steel, the parent acquired 1,734,040 shares, representing an additional 11.26% of outstanding 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 note the parent offered 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 offering an larger discount with shares trading at a 28% discount to the voluntary offer price.

• Notable value investors, Ruane Cunniff & Goldfarb stake increase is positive: As of July 31, 2013, Ruane Cunniff & Goldfarb increased their stake in Tata Sponge to 5.45%. As value investors, we think the stake increase by Sequoia 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 further increase in stake by Tata Steel, (ii) greater visibility on coal block statutory clearances (management expects approvals in the next year and development in 24-36 months) which will lead to margin expansion, (iii) greater attention from other value oriented investors (we think Sequoia's recent increased stake will help to attract others), (iv) increased dividend payout or share repurchases given cash pile and (v) government focus on infrastructure growth should see a sustained demand for sponge iron.

Download the Full Pitch on Tata Sponge