Tata Chemicals

A global de-rating of commodity stocks and worries over a sharp contraction in demand for commodities have bludgeoned Tata Chemicals’ valuation. The stock now trades at a P-E multiple of just 3.8 times its trailing 12-month earnings, down from 8 in August and 14 in March 2008. At the current market price of Rs163, the stock trades at a steep discount to global peers such as Solvay and FMC (9-10 times).

Tata Chemicals is an attractive ‘buy’ for conservative investors with a two-year perspective. A diversified global presence, a relatively strong soda ash cycle and the prospect of higher margins on the fertiliser business, suggest that the company may easily exceed the growth expectations reflected in its current stock price.

The low valuation and high dividend yield (5.5 per cent) provide protection against protracted downside.
Changing mix

Of its two leading business segments (fertilisers and chemicals), the fertiliser business has been the key revenue and profit driver for Tata Chemicals in recent times. It accounted for 60 per cent of revenues and 56 per cent of profits before interest and taxes in the first half of 2008-09.

Selling prices for both urea and complex fertilisers are fixed by the government with the difference between normative import prices or costs and the price reimbursed as subsidy to producers.

In this scenario, a spike in international prices of both fertilisers (urea and phosphates) and spiralling input costs resulted in a significant increase in fertiliser revenues for Tata Chemicals so far this fiscal.
Fertiliser margins to improve

Global urea prices have since fallen by 70 per cent from their peak levels in July, while DAP (di-amonium phosphate) prices have declined 35 per cent.

Revenues from this business are hence likely to decline significantly in the coming quarters. But this may not have significant margin or profit implications, as lower realisations are likely to be offset by a steeper fall in input costs (phosphoric acid prices are half of last year’s levels, while ammonia is at one-third).

In fact, the commodity meltdown may actually improve Tata Chemicals’ cash flows, as lower input costs may lighten working-capital requirements and lead to prompt receipt of subsidies.

The urea business is also likely to see an expansion in volumes and margins as the company’s de-bottlenecking project is commissioned in the first quarter of 2009.

Under the new urea policy, the output from this project will receive realisations linked to import parity prices of urea, which will mean a much higher margin profile.
Soda ash: Still firm prices

If the fertiliser business can look forward to volume growth and stable profit margins, Tata Chemicals’ soda ash business remains in a position of strength, despite the reversal in the global commodity cycle. A relatively tight-demand supply balance has kept global soda ash prices relatively firm, amid precipitous falls in most other commodities.

Global soda ash prices in non-US geographies now hover at $270-310 per tonne levels, 8-10 per cent higher than prices at the same time last year. Further increases are expected in the contracts for 2009.

Tata Chemicals, which markets the lion’s share of its soda ash output through long-term contracts, has already locked into higher prices for two of its facilities when contracts were renewed in August 2008. The remaining contracts are unlikely to see significant slippages. Higher exports from China do have the potential to moderate prices in the Asian region to some extent.

But for Tata Chemicals, a sharp correction in realisations compared to last year appears unlikely. Significant contributions from the Indian market, where prices are likely to remain stable (the depreciating rupee may offset any correction in dollar prices), may also help the company maintain margins in this business.

Easing trends in input prices are also likely to aid margins in the coming quarters.

An edge on costs

From a strategic perspective, Tata Chemicals’ aggressive inorganic growth strategy has also helped lower its cost structure and diversify, to benefit from price and demand trends across the world.

The acquisition of UK’s Brunner Mond in 2007 and the US-based General Chemicals in 2008 have taken the company’s overall soda ash capacities to 5.5 million tonnes, making it the second largest global producer of soda ash after Solvay.

The acquisitions have also endowed Tata Chemicals with manufacturing facilities spread across Northwich (UK), the Netherlands, Lake Magadi (Kenya), Wyoming (US) and Mithapur in India, enabling it to diversify currency and price risks across regions.

With over half the current capacities based on natural soda ash, which is much cheaper to produce than synthetic soda ash, the company has acquired a significant hedge against commodity cycles.
Future payoffs

With some of the facilities experiencing teething troubles earlier this year, contributions from the above buyouts are yet to fully reflect in Tata Chemicals’ numbers. Brunner Mond’s Kenyan facility for instance, reported a loss in FY08, due to high fuel costs, which impacted margins. Prospects for the facility have since improved on the back of the sharp fall in energy prices and better capacity utilisation levels.

Profit margins at the Wyoming facility may also show expansion on the back of cost savings and better realisations, from a higher contract price negotiated for the current year.

A better show from acquired facilities has helped Tata Chemicals report a 33 per cent profit growth (after charging off huge notional losses on foreign currency loans), on the back of a near two-fold expansion in sales in the September quarter, with margins improving sequentially.

The acquisition spree has hiked up the leverage on Tata Chemicals’ books, its debt equity rising from 0.7:1 to about 1.4:1 currently. Though refinancing of bridge loans contracted for the General Chemicals buy may peg up interest costs, the overall interest cover (at over 6 in the first half of this year) offers sufficient comfort to absorb a hike.

Notional forex losses arising from any further depreciation in the rupee could also depress reported earnings in the coming quarters; but the prospect of higher revenues and margins in the coming quarters appear likely to offset this impact.

Given its healthy cash flows and strong balance-sheet, the company may also be able to refinance loans at lower rates over the next couple of years.

On a consolidated basis, Tata Chemicals reported a per share earnings of Rs 41.7 over the trailing 12 months ended September 2008.