Global commodity play

Tata Chemicals has three businesses: chemicals which accounts for 50 per cent of its revenue; crop nutrition and agri-business includes the fertiliser business; this too contributes about 50 per cent of revenue; and new business initiatives which doesnt contribute much at present.

State of chemicals business. Demand for soda ash comes primarily from the detergent industry 60 per cent and the glass industry 40 per cent. Within the detergent industry there is no slowdown,so demand remains intact. Within the glass segment,two types of glass are produced container glass and flat glass. While the demand for container glass remains intact,the demand for flat glass,which is used by the real estate and the automobile industry,is down. Overall soda ash demand is expected to be down around 10-15 per cent this year. Contract prices have also declined,especially in Asia.

State of fertiliser business. Tata Chemicals produces both urea and phosphatic fertilisers. The urea business is expected to do well this year. The fertiliser business in India is controlled by the government,which reimburses fertiliser companies according to the following formula: cost12 per cent return of net worth. The government has changed its policy to allow fertiliser companies to expand their capacity this is called de-bottlenecking. Tata Chemicals has completed the de-bottlenecking of its urea plant at Babrala. Now it will be allowed to sell the additional capacity which has gone up from 8.64 lakh to 11.55 lakh tonnes per annum at import parity price IPP,which could range from US250 to US425 per tonne. Even at US250,Tata Chemicals realisation will be much higher than what the government pays it. This is expected to expand its margins in the urea business significantly this year.

The availability of gas from Reliance is expected to improve the margins of the urea business further the company earlier depended on naphtha whose prices was prone to fluctuation,while that of Reliances gas will remain fixed.

In case of phosphates,in FY09 the price of DAP a phosphatic fertiliser had risen very high,but raw material prices that of rock phosphate and sulphuric acid had escalated even more. The company had to temporarily stop production of phosphatic fertiliser. Now raw material prices have stabilised,so it has resumed DAP production. This year while sales value is likely to decline because of the fall in DAP price,margins will remain intact and the business is likely to be profitable.

Strengths

In soda ash,Tata Chemicals has the advantage of size: the acquisition of US-based General Chemicals Industrial Products GCIP in 2008 made it the worlds second-largest producer of soda ash with about 20 per cent of global natural soda ash capacity. It is also the lowest-cost producer of soda ash,which means that it is much better placed to weather price declines than,say,Chinese companies that have higher cost of production.

Tata Chemicals diversified geographic presence on four continents is also a source of strength. Explaining how geographical spread can be an advantage,Ashish Kapur,chief executive officer of Delhi-based Invest Shoppe India says: In case of soda ash,forward contracts in the US and Europe got locked at higher prices. Price erosion occurred mainly in Asia.

Tata Chemicals is also the most efficient producer of urea in the country i.e.,it consumes less energy per tonne of urea produced than others.

The company is also the worlds fourth-largest producer of sodium bicarbonate. Its salt brand,Tata Salt,is the market leader in India while its other brand,I-Shakti,is number two.

Weaknesses

Debt a cause for concern. To fund its global acquisitions,Tata Chemicals has taken on debt: at present its net debt to equity ratio is 1:1. Commenting on whether this level of debt is a cause for concern,Tarun Surana,analyst at SPA Securities says: In FY10 and FY11,Tata Chemicals is expected to generate sufficient cash to take care of both principal and interest repayment. So debt repayment is not a cause for concern. Moreover,bulk of the debt is scheduled for repayment only after 2012. But the interest cost will definitely put pressure on the bottom line.

To conserve cash,the company has put its non-essential capex plans on hold.

Commodity nature of business. Most of Tata Chemicals businesses chemicals,fertilisers,etc are commodity businesses. Cost alone determines who garners maximum market share. In a downturn,since no player wants to keep production capacity idle,everyone opts for price cuts,which in turn affects margins see table on quarterly results to see how margins have shrunk.

Government control over fertiliser business. Though Tata Chemicals is the most efficient producer of fertilisers in India,it does not get the benefit of its efficiency because of the cost-plus pricing mechanism. If it could have sold its produce at free market rates,the benefits would have accrued to the company being the lowest cost producer,it would have earned the highest margins. Instead today the benefits of its efficiency accrue to the government.

Government control over the fertiliser sector is also a cause for worry regarding the future course of this business. An adverse change in policy could affect it negatively. Take for instance what happened last year. The government for the first time decided to pay subsidy to fertiliser companies in bonds instead of cash. Says Surana: If a fertiliser company wanted money to meet its working capital requirements,it had to sell these bonds to raise cash. But these bonds were trading at a discount. A company that sold them straight away made a loss.

Quality of management

The managements policy of growing through acquisitions has enabled it to secure crucial raw material supplies at low costs an enduring source of competitive advantage. The takeover of GCIP in the US has enabled Tata Chemicals to acquire captive supply of low-cost natural soda ash. Its 33 per cent stake in IMACID Morocco has enabled it to secure the supply of phosphoric acid,a key input in producing phosphatic fertilisers.

The management has also initiated several new businesses whose contribution to revenue and profits is likely to grow in future. It has set up a small 30 KL per day ethanol plant and is also planning a 5 KL per day bio-diesel pilot plant.

The company has entered into the business of supply and distribution of fresh farm produce in joint venture with Total Produce of Italy.

Through Tata Kisan Sansar,a network of 600-plus outlets,it not only sells fertilisers and other Tata group products in rural areas but also offers advice to farmers regarding crop rotation and fertiliser usage. This network has enabled the company to penetrate the rural hinterland in north and east India 8211; an advantage that could be leveraged in several ways in future.

Tata Chemicals has also set up a laboratory that will focus on research in bio- and nano-technology.

Should you buy?

Opinions differ among analysts. According to Surana,at the current price of Rs 175,the expected earning for FY10 is fully priced in. With an expected EPS of Rs 25,the stock is trading at a PE multiple of seven. That is a good enough multiple for a commodity business. Commodity businesses generally trade at a PE multiple of five to six. But since Tata Chemicals has a urea business as well that will have an upside due to the government decision to allow new capacity to be sold at import parity price,the PE can expand up to seven. He suggests buying the stock when the price corrects from its current levels.

Kapur is more optimistic about the stocks prospects. At the current price of Rs 175,the forward PE for FY10 and FY11 is 6x and 5.5x respectively. The PEG ratio for FY11E earnings would be as low as 0.5, he says.

The bottomline: here is a chance to buy a global player with quality management,which is the lowest-cost producer in one business soda ash and the most efficient producer in another urea. Though the commodity nature of the business,high debt and government control of the fertiliser business are definite negatives,the single-digit valuation is attractive. Besides,the company pays high dividends see table and carries on its books investments worth Rs 20 per share. To enhance your margin of safety,buy on price declines and hold the stock for at least three years. As the global economy recovers and the demand for commodities increases,you should be well compensated.

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