>Indian Companies Likely to Reassert ROE Superiority

• Key Debate: India has always enjoyed a superior ROE relative to the rest of the world as well as emerging markets. Hitherto, this advantage has been driven by a combination of superior asset turn, a degree of overestimation of the life of assets driving down depreciation expense, inferior quality of earnings (i.e., book adjustments to shore up profits) and strong financial leverage effect despite low debt-equity. Strong cost cutting in the early part of this decade also helped the ROE cause. However, in the recent down cycle, India has lost most of its ROE edge. The key question is whether Indian companies will regain their ROE superiority which is critical to the premium valuations of their shares relative to the world?

• ROE drivers go through cyclical correction in 2008: The downturn in the previous growth cycle has taken India’s ROE gap with the rest of the world to a 13-year low (since our data series starts) of 2.6%. India’s key ROE drivers have gone through a sharp cyclical correction notably asset turn but profit margins as well. This analyses is based on the respective MSCI indices.

• Seven out of 10 sectors witness sharp fall in ROE: The ROE fall in 2008 is pretty pervasive across sectors with healthcare, industrials and materials leading the fall and technology, utility and telecoms holding up pretty well.

• Indian companies more geared than before: During the previous cycle Indian companies have increased net financial gearing which is now higher than its peer group in the emerging world as well as the Asian region. This has caused financial leverage effect to stay at high levels relative to the world and also cause a sharp upswing in interest expenses by the end of 2008 relative to EM and AXJ.

• Capex cycle strains balance sheet and return ratios: India’s margin superiority (an outcome of low costs) is intact though the gap has narrowed a tad in 2008. Indian companies’ EBITDA margin was 3.2ppt higher than the AXJ average in 2008. The biggest drop across the ROE drivers has been in the utilization of assets. Clearly, India’s big capex cycle in 2006 and 2007 has hurt asset turn. The capex cycle has also strained the balance sheet causing capital costs to rise and hurt return ratios.

• Earnings quality improves a tad: At the end of 2008, earnings quality seemed to have improved a bit as it had for the rest of the world. The gap in depreciation expense with the rest has also narrowed and, to that extent, some of the bad factors that drove India’s ROE superiority in the past have lost their influence. Pertinently, return on assets has dropped to a low point in history which shows how bad 2008 was for Corporate India.

• ROE superiority likely to return in 2010: As growth accelerates we expect India companies to reassert their ROE superiority versus AXJ and EM. The bulk of the relative performance should come from improving asset turn which should also set us up for a new capex cycle in 2011. Margin performance should also improve due to the cost cutting that Indian companies have undertaken in 2008 combined with the conducive macro environment. On that basis, India’s relative multiples to EM can sustain at the current 20%-odd levels in 2010.

To read the full report: INDIA STRATEGY