>INDIA STRATEGY: Rural steroid is ebbing - Underweight rural exhilarants

■ Supply glut inducing broad-based decline in farm sector realized prices
Of the 82 primary agricultural produce items, 72 items (or 88%) have shown decline in prices from their respective peaks since Dec’2009. Even APMC-level data suggests that prices of base and higher grade crops (weighted average) have declined by 13.4% in Dec’2011 over Dec’2009 and by 10.4% over Jan’2011. The gap between average market price (all grades) and average minimum support prices (MSP) of base grade grains has fallen from 52% in Dec’2009 to 16% in Dec’2011 due to oversupply and government’s restraint in buying (due to overstocking).


■ Cost of cultivation remains elevated
Cost of cultivation has gone up by 68% during FY08-FY12E, a 14% CAGR. Elevated labor costs and increase in costs of several inputs, including fertilizers, fuel and electricity have had substantial impact on agri sector economics. 


■ Farm sector P&L to witness stress: Profitability could decline below FY05 levels
With the terms of trade (ToT) turning adverse from FY10 and the recent price decline accelerating the downtrend, we estimate that the cash margins may have declined by 1,150bps in FY12E to 39%. Assuming 10% YoY drop in average realised price and inelastic cost structure, cash margins could decline to 32% in FY13E, i.e, lower than the FY05 level of 37%. This sharp drop in profitability would imply that farmer’s cash profits could decline by as much as 29% CAGR over FY11-13E with cash profit declining to Rs9225/hectare in FY13E as compared to Rs18180/hectare in FY11. We note that over the past five years farmer’s cash profit had grown at a CAGR of 26% from Rs5691/hectare in FY2006 to Rs18180/hectare in FY11.


■ Agri sector NPA can spike up sharply
Significant rise in Agri sector indebtedness (institutional credit/GDP at 90% and around 130% inclusive of informal lending) and weakening repayment culture pose structural credit risk for PSU banks. Decline in farm sector cash flows will trigger significant spike up in Agri NPA and prompt banks to focus more on recovery than on lending.


■ Economic returns for agri sector are eroding
The broad base impact of decline in value of produce against the total cost of cultivation (cash+imputed) suggests that in FY12E, the economic returns (value of produce/overall cost of cultivation) may have already declined to 101% from the FY08 peak of 134%. A further 10% fall in realized price in FY13E could imply economic returns declining to 90% (implying negative returns).


■ Policy support hitting multiple constraints
Apart from storage capacity issues, limiting constraints are also emerging on the financial side. With seasonally adjusted buffer stock of around 60MT of foodgrain with FCI (close to the 61MT target of food security bill), it is likely that incremental build up of buffer, net of offtake will be low. Rising food subsidy and exponential rise in bank food credit to an all time high of Rs 800bn, against the backdrop of difficult government fiscal conditions imply that policy support behind rural growth theme has hit multiple constraints. Hence, in our view, consensus expectations that government’s support to the theme will remain strong may prove to be misplaced optimism.


■ Steroids behind the rural theme are fading
In our view, the confluence of adverse developments like (1) adverse economics for farm sector, (2) limited policy support and (3) rising default risk on agri credit will reinforce the expected cash flow problem for the farm sector. Hence, steroids fueling rural growth for the last 5 years seem to be ebbing.


■ FY01-03 like scenario relapsing
Historical comparison indicates a relapse of conditions prevailing during 2000-2003, when buffer with FCI rose to 60mt, food subsidy & food credit spiraled and subsequently, led to oversupply conditions. The similarity between the two episodes provides the basis for expecting similar outcomes in the current phase, ie further erosion in prices, decline in farm sector ToT, volatility in farm income and increase in debt default. In our view, given the steep rise in agri sector credit over the past 5-6 years, the default risk on farm credit is significantly higher than the 2002-04 and 2006-07 episodes.


■ What does the relapse mean for sectors?
The relapse of FY01-03 like scenario can reverse the substantial gains enjoyed by various sectors during FY09-11. The sectors that significantly outperformed on the rural steroid theme over the past 18 months are FMCG, autos (particularly two wheelers and tractors) and agri input stocks. Hence, given our macro view of moderating rural exuberance, we believe that the significant out performance of these sectors itself will weigh on their future performance.


■ Themes to play - Underweight rural exhilarants
The adverse impact of cash flows on rural consumption theme is likely to overweigh the positive effect from decline in food prices. Hence, stress for durables and passenger vehicles will accentuate and spill over to two wheeler sales as well. The expected slowdown in agri credit growth in response to credit concerns can impact demand for these sectors. Auto sector could be exposed to a period of growth moderation for two wheelers, passenger cars and tractors. FMCG companies dependent on agri inputs should benefit from the cost side. Agri sector indebtedness poses credit risk concerns for PSU banks in the medium term. Latest data shows that for high risk prone banks, the NPA ratio has already spiked up to over 7%. Our theme is likely to play out on Agri input sectors-seeds, fertilizers and agro chemicals in the form of top line growth moderation and decline in pricing power.




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