>Analysis of royalty payments in view of Maruti’s margin surprise

Meaningful overhang on margins and valuations for foreign equity companies

Maruti delivered a big negative surprise this weekend as Suzuki raised royalty payments by 150 bps from 3.6% to 5.1%. While the impact on Maruti is already discounted (stock down 10% today), we have looked at the other companies in BSE-500 to ascertain the impact on broader Indian market. We find that that 75 (32 of them to foreign entities) companies in BSE500 pay
royalties largely dominated by automotive, capital goods, pharmaceuticals and FMCG sectors.

With the recent government regulation allowing for higher royalties, we could see the Maruti case being played out in several of these players. While the exact impact is difficult to quantify (as it will be case specific), we note that increasein royalties could hurt margins substantially by 370 bps if implemented across the board. We would closely watch out for more such announcements/changes over the next few months.

■ Govt. allows companies to pay royalty under automatic route: The Govt. recently allowed companies to remit royalty payments (upto 8% on exports, and 5% on domestic sales) on foreign technology collaboration under the automatic route (With retrospective effect from Dec 2009, notes attached). Companies have since raised royalty payments to foreign collaborators: Maruti raised royalty payments to parent Suzuki Motor Corp by 150bps to 5.1% of sales this quarter.

■ 15% of the BSE500 pays royalties, 32/500 to foreign equity holders: Royalty payments are made by 75 companies in the BSE500 universe, and comprised~19% of the overall SG&A costs in FY09, accounting for ~130bps on EBITDA margins. The new notification affects companies (32/500) that have technical collaborations with foreign (non-portfolio) equity-holders, and thus excludes domestic companies that have no restrictions on royalty payments. Whollyowned
foreign subsidiaries have no restrictions either.

■ Sector/stock focus: Royalty payments are generally made by companies in the auto and capital goods (technical know-how and collaboration), pharma (marketing rights) and FMCG companies (brand equity). Margin Impact: Royalties for these 32 cos. constituted 11% of their SG&A, accounting for 100bps at the EBITDA margin level (FY09 margin at 16%; FY10 figures available for 8 companies thus far). A quick sensitivity analysis shows that a rise in payments to a blended 5% of sales would hurt margins by a further 390bps, i.e. margins would fall to 11.8%.

■ Royalty payments vs. dividends: Royalties paid amounted to more than 40% of the total dividends declared in FY09. With little information on the actual value of the technical expertise, or by way of equity of certain brands, a potential rise in payments could raise questions on fair distribution of earnings to common stockholders.

To read the full report: INDIA STRATEGY

>Kotak - Lending biz improves, but all others in a weak spot

Kotak Mahindra Bank - Lending biz improves sharply, but all others in a weakspot [Dipankar Choudhury, Manish Shukla] Q1FY11 results, which were in line with our estimates on a headline basis, continue to reflect the trends visible for the last few quarters and could sustain for some time. The bank reported consolidated loan growth of 42% YoY driven bysecured retail and corporate lending, and a NIM of 5.7% that was down 40bps QoQ. The bank in their earnings call guided for a 30-35% loan growth for FY11E, which they had earlier estimated at mid-twenties, but also indicated that margins could correct to 5-5.5% despite the capital infusion expected soon.

HDFC Bank – Signs of strength in growth, costs stabilising [Dipankar Choudhury, Manish Shukla] We maintain Buy on HDFC Bank after increasing the target price to INR 2,090 from INR 2,050. The bank with its high share of low cost deposits and largely floating rate assets is the best play in a rising interest rate environment. Loan growth from both retail and short-term wholesale loans remains strong. We believe that operating cost ratios could improve further due to productivity improvement from the erstwhile Centurion network.

Yes Bank -Strong asset growth, but CASA remains low [Manish Shukla, Dipankar Choudhury] We maintain Hold on YES Bank with a target price of INR285. The bank continuesto gain good traction in corporate loans, and core fee income growth is also strong. Operating expenses are likely to rise, and the low share of CASA remains aconcern. Trading at 2.8x FY11E P/B, the stock appears fairly priced.

Sector & Company News
** RBI may up capital ratio for banks
** HDFC, Kotak to rework profit forecast for insurance arms
** Yes Bank to raise Rs 15bn tier II capital

To read the full report: INDIAN BANKS

>RELIANCE INDUSTRIES LIMITED: Result Update Q1 FY11

■ Revenues at Rs582bn, higher by 81.7% yoy and 1.1% qoq; much in line with our estimates

■ OPM falls 243bps yoy driven by fall in petrochemical EBIT margins yoy

■ PAT at Rs48.5bn v/s our estimate of Rs49bn

■ Gas production from KG-D6 field continues to be at 60mmscmd;management guidance as reported by media for not being able to sustain production higher than current levels a cause of concern

■ We maintain our Market Performer rating as key business segments of refining and petrochemicals will continue to see muted environment

To read the full report: RIL

>IPO NOTE: SKS MICROFINANCE LIMITED (IIFL)

SKS Microfinance (SKSMF) is the largest microfinance company in India with loan portfolio of ~US$1bn, 2,000+ branches spread across 19 states and 6.8mn members. Its strengths include pan-India presence, scalable operating model, diversified product revenues and access to various
sources of capital. Lending primarily to poor women, the business model involves village centered group lending, thereby ensuring a check on asset quality. The hugedemand-supply credit gap and inability of banks to penetrate into unbanked areas have driven the growth of microfinance industry. While valuations appear expensive, the scalable business model, market leadership position and high earnings growth provide comfort. Recommend

Rural centric business model
The success of SKSMF has evolved around five key elements: a) village selection, b) focus towards women, c) member training, d) group lending and e) village level lending and collection. With lending primarily to poor women, the company has expanded its reach to 2,029 branches spread across 19 states and over 6.8mn members. The pan-India presence has further helped mitigate the risk towards local economic slowdowns and disruption. Through systems and solutions in place, it has developed a scalable 3C’s model – Capital, capacity and cost reduction, which in turn has helped reach rural masses in large.

Diversified sources of revenue and capital
In addition to core business towards providing traditional loan products, the company has started offering productivity loans directly linked to business. This involves strategic alliances with Nokia, Airtel, Bajaj Allianz, HDFC, METRO and FAL. Despite being NBFC-ND, the company has benefited from benign interest rate regime and enhanced sovereign ratings. Historically, it has raised funds via alternate channels including – equity and debt issuance, loans with various maturities raised from domestic and international banks, and the securitization of components of loan portfolio.

Limited concerns over asset quality
The village centered, group lending model has ensured SKSMF an adequate check on asset quality. Innovative product structuring, focus on income generating loans and primary focus at women have enabled the company to maintain its GNPA and NNPA at low 0.33% and 0.16% respectively. In case of default by an existing member, the group is required to typically make the payment on behalf of a defaulting member. Any negligence towards payment bars the group from further borrowing.

To read the full report: SKS MICROFINANCE

>MONETARY POLICY: Hawkish stance; more hikes in the offing

The RBI hiked policy rates today – repo by 25bps and reverse repo by 50bps, in
line with our expectations. The central bank also increased its FY11 GDP growth
projection to 8.5% from 8% and fiscal-end headline inflation (March ’11)
forecast to 6% from 5.5% in the last review. The overall stance was hawkish and
the RBI appears to be gearing for a full-blown war against inflation. In our view,
today’s rate hike is effectively 50bps as liquidity is expected to return into the
system in 3–4 weeks, making reverse-repo the effective policy rate. However, we
believe that the RBI is still behind the curve, and that inflation will remain
elevated this fiscal and a risk to growth.

RBI’s hawkish monetary stance; liquidity to ease shortly: The RBI hiked repo by
25bps and reverse repo by 50bps today. We had anticipated either a 50bps hike in
both policy rates or a 25/50bps hike in repo/reverse repo respectively, as against
the consensus expectation of a 25bps hike in both rates. The RBI in its statement
said “With growth taking firm hold, the balance of policy stance has to shift
decisively to containing inflation and anchoring inflationary expectations”. The rate
hikes tell us that the RBI is confident liquidity will return to the comfort zone in 3–4
weeks, when the effective policy rate will be reverse repo, and not repo as is the
case now.

FY11 GDP and inflation projections hiked: The central bank appeared rather
convinced about the strength of India’s economic recovery. However, the concerns
over inflation have become more intense now. The central bank has acknowledged
that inflation has decisively become generalised, citing evidence from sectoral
price inflation as well as other measures (CPI-IW). The RBI raised its FY11 GDP
growth projection to 8.5% from 8% earlier and fiscal-end headline inflation
(March ’11) projection to 6% from 5.5% earlier.

Rate corridor narrowing a positive step: The rate corridor – the difference between
repo (rate at which banks borrow from the RBI) and reverse repo (rate at which
banks lend to the RBI) – has diminished to 1.25 percentage points now from 1.50
earlier. This will result in reduced interest-rate volatility in the money market.
Our GDP and headline inflation numbers remain unchanged: Our FY11 GDP
estimate stands at 7.9%, with some downward bias, while inflation is likely to
average at 8.5%, peaking at ~14% in August before declining and closing the fiscal
(March) at ~6.5%. We continue to believe that the persistently high inflation is
likely to hurt private consumption and investment demand, and poses a significant
risk to economic growth.

More rate hikes this fiscal (at least 75bps): With Delhi’s diminishing reservations
against an aggressive monetary policy stance (due to political-economic realities:
eight states go into elections in the coming 10 months and an opposition devoid of
any credible election agenda), we believe the RBI will try to get back on the curve.
We expect a further 75bps rate hike at least in the current fiscal, while the rate
corridor may narrow further by 25bps. Further, we do not rule out another rate hike
before the next scheduled policy meet on 16 September. The benchmark 10-year
bond yield fell below previous day’s closing (7.67%) just before the policy
announcement. It then rose to peak at 7.72%.

To read the full report: MONETARY POLICY