Dear members,

Lloyds Metals & Energy (BSE Code 512455) is part of the Lloyds group of companies, which also includes Lloyds Steel (BSE Code 500254).

While the group has been around since 1974, it did run into trouble in the late 90s, with both the companies coming under the purview of the BIFR..

Promoted by the Gupta family, the group doesn't have a great history of creating value for stakeholders but recent years have been quite different. With Lloyds Metals already having scripted a sharp turnaround and out of the purview of the BIFR, post its CDR, Lloyds Steel is on the verge of doing the same.

If the grapevine and sources close to the group are to be believed, the next 3 months could be a defining moment in the group's history and put them back in the race for being a significant player in the metals and mining business. Nothing unprecedented being talked about here though, just induction of a strategic partner, followed by expansion at a time when everything seems to be falling into place.

Here's what is being talked about... Lloyds Steel is on the verge of finalizing its CDR package, post which its debt levels are expected to come down significantly.  Side by side, the Gupta family had been looking to finalize a strategic partner who can recapitalize the company immediately upon completion of the same and thereafter go in for a tripling of capacity to 3mn MTPA. This at a time when its group company Lloyds Metals' iron ore mine of 90mn MTPA is all set to commence mining begins to make a lot of sense.

The Lloyds Group also had a small steel pipes business vested in a company called Lloyds Line Pipes, which also had some stake from the Miglani family (Uttam Galva). The same was sold in November last year to Delhi-based APL Apollo Tubes. Besides this, the Miglani family's association with the Lloyds group goes back one generation and they have had business relationships for over 3 decades.

Obviously when the group was embarking on its next big move, the Miglani family becomes the best option to fall back upon for a strategic partnership. So, while others like the Bhushans also evinced interest in the opportunity (which on a closer look appears to be much more attractive than the recent Ispat-JSW deal), sources say that the deal with the Miglanis is all but done and over with. In fact, they have already completed their due diligence. Further, the Miglanis are understood to have no interest in the engineering business of Lloyds Steel.

Therefore, the same is likely to be demerged into a separate listed company
and Lloyds Steel shareholders are likely to get shares of the new company on a proportionate basis. Interestingly, this business is highly profitable and for the 9 months period ended December 31 2010, it reported a segmental EBIT of INR 50.14 crores. I would assume not much long-term debt is likely to get transferred to the engineering company. If one looks at the engineering business closely, then the margins and the return ratios both are much better than the commoditized steel business and have remained robust over the years. The engineering business operates across different sectors (steel, power, oil and gas etc) and the longer-term thought process of the Management I believe is to look at inducting strategic / technical partners in each of the areas, while looking to grow the overall engineering business to INR 1000 crores in 3 years, with limited external capital.

On an as-is-where-is basis, if I were to hazard a guess as to the value that the market could attribute to the engineering business, this could be around INR 350 crores, at 10x FY11E PAT.

The capital infusion in Lloyds Steel, sans the engineering business, is expected to happen at a mutually agreed fair value, which sources say is a little under INR 30 per share. This is likely to trigger an open offer at the same price for an additional 20% stake. Even at these valuations, on a replacement cost basis, the deal would be fairly attractive for the Miglanis, being almost 15-20% cheaper than the price JSW paid for the Ispat acquisition.

The Guptas would be banking on iron ore from group company Lloyds Metal, which has flexibility to sell iron ore on merchant basis but obviously would be first meeting the Group's own requirements.

At a rated annual output of 3mn MTPA, which I believe, the Guptas are hopeful of scaling up to 5mn MTPA too over the longer term, the iron ore will be used not just to meet Lloyds Metal's sponge iron plant requirements but also the requirements of Lloyds Steel, which currently has a capacity of 1mn MTPA.

Its fair to assume that the key to any expansion plans and the quantum of capital infusion in Lloyds Steel would depend on when the iron ore mine of Lloyds Metals commences output.

The link below gives some useful insights:

http://www.indiainfoline.com/Research/LeaderSpeak/Mr.-Rajesh-Gupta-Managing-Director-Lloyds-Steel-Industries-Ltd./25018609 

All in all, if things play out as per plans, then there seems to be fair upside on the table for investors in Lloyds Steel... the stock is likely to be re-rated once there is a strategic partner in place and if one does back of the envelope calculations, then investors can hope for a 80-100% capital appreciation in a year's time.

However, what takes the cake is Lloyds Metals. Here's what they have: a 2.7 lakh TPA sponge iron unit, a 30 MW waste heat recovery based power plant and a 90mn MTPA mine with all clearances in place and no ongoing litigation / renewal issues.

The power plant has been commissioned only in end October 2010 and the resultant profitability of the entire operation has started getting reflected already, if one looks at the numbers for Q3FY10.

The cost of generation is INR 1.10 per unit and selling price is INR 3.30 per unit and 90% PLF is expected in FY12. The company has already made bulk of the investments required for developing the mine and long-term debt on the books is hardly INR 30 crores.

At a market capitalization of INR 459 crores, it would be safe to say that the market is not attributing too much value to the mining part of the business.

The cost of mining is expected to be INR 700 per tonne and the royalty payment is expected to be INR 500 per tonne, thereby giving a total cost of INR 1200 per tonne. As against this, the realization per tonne is expected to be not less than INR 4000 per tonne. Even if one assumes that it takes 3 years from now to reach a peak annual output of 3mn MTPA, then in the 3rd year, the company will make a gross profit of INR 840 crores. On an NPV basis, even at a 15% discounting rate, the value of the mine could easily be INR 3000 crores.

It would be noteworthy to point out here that even the much talked about pure play on iron ore mining, OMDC, whose valuations have seen a surge in the last year or so, is not likely to do 3mn MTPA of iron ore production in 3 years. Its mines are embroiled in controversary and there is high degree of uncertainty surrounding the renewal of their leases. Despite this, the market has been valuing the company at well over INR 3000 crores, while it scaled to a peak valuation of over INR 5500 crores in November last year.

While all this sounds very rosy, the real risk to Lloyds Metals reaching its targeted mining output is trouble from the naxalites. This as we know is a problem that the mining industry in many parts of India has been plagued with. However, Lloyds has been lobbying with the Maharashtra State Government to help resolve the issue and also investing in creation of social infrastructure such as schools and colleges in the region, so as to appease the naxalites.

It is unclear as of now as to by when the problem will be resolved and full-scale mining operations can commence but for investors willing to stick their neck out and take a call that the matter will be eventually resolved could hit upon a goldmine of sorts.

The stock could be a multi-bagger over the coming couple of years.

My personal sense is that the mining operations should commence in the coming 6 months at least and the strategic partner in Lloyds Steel (which is likely to have a more financial and political muscle) than the Gupta family, would also be instrumental in driving the process. It would be in Lloyds Steel's own interest to enter into a longer term sourcing arrangement for iron ore from Lloyds Metals as currently they are paying much higher prices for their iron ore, which they also buy on 'spot' basis.

My hunch is that the end game for Lloyds Steel would be a complete sale maybe 3 years down the line, post expansion of capacity and if Miglanis are the ones who come in as strategic partners now, I wouldn't be surprised if the capacity is eventually sold to the Mittals, given their ongoing association with the Miglanis.

All said and done, both Lloyds Steel and Lloyds Metals deserve to be on the radar screen of investors looking for small-cap turnaround stories.