Thursday, January 21, 2010

>COMMODITIES: Negative growth feedback to constrain oil prices in 2010

The interdependency of our growth and oil-price forecasts
In light of our relatively optimistic outlook for global growth, see Global Scenarios, it is natural to ask why our forecasts leave little in the way of further upside in oil? While our economists look for the US economy to grow 3.2% y/y in 2010, we expect oil prices to average USD83 this year (see charts).

There are three main reasons for this view. First of all, the significant stock overhang currently in place will take time to be worked off, notwithstanding the expected pick-up in demand. Secondly, during the past year, commodity prices appear to have risen largely on the back of expectations of a recovery in demand, which remains yet to be fully confirmed. Thus, the commodity sector seems to have risen rather early in the cycle this time around, contrasting with its late-cycle performance historically. Finally, a negative feedback loop with economic growth should constrain oil prices to some degree this year. We consider the latter effect in depth below.

Simulating feedback effects between oil and growth
As economic activity improves, demand for commodities – not least for energy – usually increases as well, driving e.g. oil prices higher. However, a rising oil price would in itself dampen growth to some degree, at least for an oil-importing country such as the US.

A Fed paper, see Aggregate Disturbances, Monetary Policy, and the Macroeconomy (1999), estimates that a permanent increase in the oil price in the US relative to the rest of the world cumulating to USD10 per barrel over four quarters leads to a decline in real GDP of 0.2% in the first year after the shock relative to the situation where no shock occurs and a decline of 0.4% in the second year. Consumer-price inflation is found to end 0.5% higher in year one and then come down to end a mere 0.2% higher in the second year after the shock has hit. The Fed would in turn react to the changing inflation-growth outlook by adjusting the short-term interest rate.

To illustrate these feedback mechanisms, we provide here some simulation results from a simplified model of the US economy. Our quarterly model based on data for the period 1986 to 2006, that is, leaving out the crisis period, allows for simultaneous modelling of US real GDP, PCE inflation, the three-month USD Libor rate, a ten-year government benchmark bond rate, the real effective USD exchange rate and the nominal WTI oil price.

To read the full report: COMMODITIES


What's changed:We visited (1) the 2x600MW Rajiv Gandhi thermal power project Hisar; Reliance Infra (RELI) is an EPC contractor; and (2) the Delhi airport metro link project, operated by RELI for a period of 30 years. Key takeaways: (1) Civil works for the power plant are almost complete and the project may become commercial during 2Q2010. Unit 1 was synchronized in Dec. 2009, 33 months from the main plant order vs. the CEA prescribed timeline of 41 months; (2) 65%-70% of the 23km (16km underground, 7km elevated) Delhi airport metro link project is complete and is on track to become operational by the scheduled timeline of Oct. 2010; (3) the development of property at Dwarka (120,000sq mt) may be delayed to 2011, but lease properties at New Delhi station and Shivaji stadium station (6000 sqm each) will be complete, along with airport metro link.

Site visit gives more visibility on execution; reiterate Buy

Implications: The site visits give us more confidence in RELI's ability to execute on (1) the US$9 bn EPC order book (primarily power); and (2) US$4 bn of infra projects in the pipeline. The EPC work has started on the US$3 bn super critical Sasan power project, which is the key driver of RELI’s near term earnings going forward, in our view. Also, our analysis of FY09 results of Delhi Metro Rail Corporation gives us more visibility on the potential EBITDA margin profile of RELI's Delhi metro project. We believe EBITDA margins for the RELI metro project would be in the range of 80% (vs. 61% for DMRC for FY09) primarily due to a higher lease income component.

Valuation: We believe news flows on execution of RELI’s infra and EPC order book will be a key re-rating trigger for the stock. We reiterate our Buy rating (12- m SOTP-based target price Rs1,370) with potential upside of 21%.

Key risks: Investment in unprofitable infra projects; adverse ruling in case with RIL.

To read the full report: RELIANCE INFRA


Company follows so loose working capital management policy that it is almost acting like a financial services firm which fund logistics operation of customers. In fact, more than half of PBIT (~14 cr. out of 21.86 cr) can be attribute to income which is “in effect” interest income rather than income from logistics operations.

Despite of such loose credit policies company claims that it didn’t had any bad or doubtful debt for last 5 years (Refer “Annexure 8”). If this is true, it’s a miracle. We haven’t come across any 3PL or for that matter any transportation company in our global coverage universe which doesn’t have allowances for doubtful debt. There is a good chance that some of the doubtful debts are not mentioned and others are artificially made good just to spike EPS & get higher valuations.

Employee costs have been artificially kept low by paying them via issuing equity at discounted price. Excluding promoters and related parties, employees were paid ~8 cr via issuing equity at discounted rate (in Dec. 2008) which even if spread over 2 years and taken out along with “in effect” interest income would make company loss making.

Seems like this discounted equity issuance was not enough and a lot of employees were not even mentioned on company books. They were just paid separately. DRHP of company filed with SEBI support this. For eg., Although the company has mentioned that their “key managers” Mr. Prasanna R. Yedkar and Mr. Narendran Kochat have joined them in March 2009 and February 2009, our checks indicate that they were working for the company even before that. DRHP of the company validates that they were made significant payments via these discounted equity routes in Dec. 2008 along with other “on book” employees. And it’s not just limited to top management. It’s quite widespread. Although, the company’s co-promoter and CEO married his ex-assistant (who is almost half his age), even her salary is nowhere mentioned in related party transactions in Annexure 18. [SEBI requires disclosing all related party transactions for last 5 years].

Promoters are raising cash like there is no tomorrow. Think about any possible reason and that’s there in promoters list. On the one hand they say they are asset light and on the other plan to use significant part of issue proceeds to buy transportation equipments. Then they are just thinking of buying some company (which they have not “thought” about) and are raising money just based on that thought (reminds us of dot com days!). India, China, Hong Kong, Dubai… castles in the air!

To read the full report: AQUA LOGISTICS

>Tata Consultancy Services (MACQUARIE RESEARCH)

TCS delivered strong 3Q results that exceeded our and street expectations on all financial parameters. EPS of Rs9.2 (up 10.7% QoQ and 32.9% YoY) was 15% higher than our and consensus expectation of Rs8. We maintain our positive view on the sector and are comfortable with our above consensus US$ top-line growth of 27% for the sector leaders in FY11E. Maintain TCS as our top pick in the sector.

Management comments point to broad-based recovery. Our positive thesis on the sector is based on demand recovery playing out for the Indian IT vendors in CY 2010. Sequential improvement across major verticals and management expectations of having turned the corner in Manufacturing, Telecom and Hi-Tech verticals strengthen our argument of revenue resurgence in FY11E. (Please see Figure 3 and Figure 4.)

TCS expects aggressive FY11E hiring, lateral hiring picks up in 3Q. Similar to the trend we have seen at Infosys, TCS management indicated their intent to hire aggressively in FY11E to meet the pick-up in demand. The company added 8,239 trainees in 3Q, ahead of its guidance of 8K given in 2Q. Importantly, lateral hiring picked up significantly in the quarter (3K in 3Q vs. 2K in 2Q). TCS expects to add another 3K lateral employees in 4Q FY10. Aggressive plans for a FY11E employee addition and significant uptick in lateral hiring signals a robust revenue growth outlook for the sector.

Good 3Q results. TCS delivered stellar results with US$ revenue growth of 6.3% QoQ (vs. Infosys at 6.7%), INR revenue growth of 2.9% (vs. 2.8% for Infosys) and QoQ EBITDA margin expansion of 100bp (vs. 90bp for Infosys).

Strong volume growth helps offset exchange headwinds. TCS delivered 6.6% QoQ volume growth in the quarter (vs. 6.1% for Infosys). This helped the company to deliver 2.9% QoQ INR revenue growth despite a 1% negative impact on revenues due to INR appreciation. Pricing for the quarter remained flat (vs. +0.2% QoQ pricing improvement for Infosys).

Improved productivity (+220bp), offshore leverage (+17bp), SG&A gains (+36bp), and currency (-167bp) resulted in a ~100bp margin expansion in 3Q.

Earnings and target price revision
No change.

Price catalyst
12-month price target: Rs830.00 based on a DCF methodology.
Catalyst: Finalisation of client IT budgets in February 2010.

Action and recommendation
TCS is our top pick, margin surprise poses upside risks to our estimates. Favourable FX movement (current INR/US$ expectation of 42 by Mar’11), would imply upside to our margin forecasts for Indian IT vendors.

To read the full report: TCS


Bharti enjoys significant first mover & scale advantages:
Bharti, thanks to its management’s vision has been a big believer in the potential of the Indian mobile market that led the company to invest earlier than its rivals in a nationwide network. This has led to Bharti having a much superior scale vs. its competitors. There is significant operating leverage as we believe 52% of the operating costs in the mobile business are fixed (please refer to table 1).

Positioned to emerge stronger

Bharti’s cost focus implies that it is likely to emerge stronger
We believe Bharti management is currently taking appropriate steps to optimize the cost structure further with a view to protect margins in a low pricing power environment. We think consolidation is inevitable in the Indian mobile sector over the next 2-3 years and some pricing power is likely to return. Bharti should emerge as the major beneficiary of any consolidation in the Indian mobile sector.

Quarterly results are likely to be uninspiring
Given the price war in the Indian mobile sector the quarterly performance of Bharti is likely to be adversely impacted over the next 4-8 quarters. For Q3FY10, we expect consolidated revenues to grow 0.8% qoq to Rs99.2bn, EBITDA to decline 5.8% to Rs39.0bn. Mobile revenue to decline 2.5% qoq to Rs78.9bn, and mobile EBITDA to decline 8.4% qoq to Rs23.7bn. We expect voice rev/min to decline from Rs0.51 to Rs0.47/min.

Maintain Buy rating and SoTP based PT of Rs450
3G licensing related developments may act as a dampener for Bharti stock price. We believe this could create attractive buying opportunities in Bharti stock on this potential weakness.

To read the full report: BHARTI AIRTEL