Wednesday, December 21, 2011

>SECTOR STRATEGY: A mix of defensives and rate sensitives

Given our view that the economy will continue to be sluggish, we still do not find value in underperforming stocks yet. However, we are playing some rate sensitives and believe that will be a key theme for the market in 2012. We expect to gradually increase weighting to the rate sensitives and cut weighting to the defensive sectors in 2012.

Pharma is our top defensive play
Defensive sectors have done very well, led by consumer staple companies. Given our view of a slow domestic growth, we believe defensives will continue to do well over the next few months. However, the consumer staple companies are extremely expensive. We, therefore, play the defensives through the pharma sector, which is relatively cheaper. Secondly, the pharma sector should benefit from the rupee’s depreciation over the past few months.

Prefer consumer rate-sensitive plays: overweight autos
We prefer consumer-oriented rate sensitives rather than investment plays currently. Autos are our current way to play the pause and subsequent cut in the rate cycle. The auto sector also benefits from a possible fall in commodity prices.

Banks is the other rate-sensitive overweight
We are also marginally overweight the banking sector. However, our preference currently is for the defensive names like HDFC Bank and ICICI Bank rather than the Government banks. We expect to get more aggressive on the PSU banks later in 2012 after the NPA cycle has played out.

Underweight utilities and industrials: Prefer capital goods players
We are underweight the investment space as the capex cycle is likely to slow down. However, within this space we prefer the capital goods players to the infra/utility companies where we have a zero weight.

Model portfolio: Adding Sun Pharma
Given the changes in the MSCI index, we have correspondingly tweaked our model portfolio to reflect those changes. There is no change to our overweight and underweight sectors. We have added weight to telecom and reduced weight from banks in line with index changes, while keeping our overweight and underweight points largely unchanged. Similarly, we have made small tweaks to our pharma, industrials and software weights.

The one change we have made is to add Sun Pharma to our model portfolio by reallocating some weight from Lupin. We now have two pharma stocks (Lupin and Sun Pharma) in our model portfolio.

Pharma (overweight)
Following the estimated 23% profit growth this year, we expect sector earnings to grow 21% in FY13, on the back of sustained strength in the Indian market and US businesses’ benefit from patent expirations. Demand in US generics market (about 28% of industry sales) will be driven by: (1) new launches in niche segments, (2) patent expirations worth US$45bn over the next two years. Domestic formulations’ growth will be dictated by increased penetration in Tier 2/3 cities and improved field-force productivity.

Autos (overweight)
We expect auto volume to bounce back in CY12/FY13 on pent-up demand and reversal of the interest-rate/inflation cycle. Despite the current slowdown, structural uptrend in the industry is intact, driven by the improving demographic profile, rising disposable income and new launches.

Financials (overweight)
We expect loan growth to moderate to 15% by FY13. There is minimal fresh capex activity, which could see its impact on FY13 growth. Moreover, infrastructure lending was mostly impacted due to issues in the power sector. But retail is still likely to be ‘OK’. Among the banks, we believe private banks may trade closer to their average multiples of the past 5-7 year cycles as their overall risk profile is better, and earnings growth too could be better hedged in the emerging environment.

Software (equalweight)
Given an uncertain macro climate and likely quarterly review of IT budgets in 2012, discretionary spends (e.g., application development & package implementation) may see slower growth. However, unlike 2008, discretionary IT demand has not dried up and is being driven by spends on regulation, business optimization including adoption of technologies like cloud and analytics and business transformation to address an increasingly digital consumer and employee, globalization and growing ‘mobility’.

Telecom (underweight)
The RoE of Indian telecom companies is much below the GEM average, and 3G data uptake will be the key to RoE improvement. We expect strong YoY growth in data uptake but worry that data contribution to revenue and profit will remain small unless data prices drop sharply and spur usage elasticity. LTE launches may add to competitive pressures by end-CY12. Varying exposure to rural growth and the imminent launch of LTE services by new and existing players may aggravate competition.

Real Estate (underweight)
We expect volume recovery in the residential segment from 2HCY12 as developers correct prices over the next six months to clear off rising unsold inventory. We believe stock-price performance is closely linked to recovery in volume as it will improve cash flow and earnings visibility. Leverage across our real estate coverage universe remains a key concern as volume shrinks while interest costs are at its peak.

Energy (underweight)
Global oil demand has weakened since 2Q 2011. We believe weakness in the developed world to be the key risk to 2012 demand growth. We expect a strong refining capacity addition in 2012. Coupled with the expected weak growth or decline in oil demand, GRM can decline steeply from high levels in FY12. Also, if the rupee remains weak throughout most of FY13, it would hurt oil PSUs as it increases the subsidy burden.

Metals & Mining (underweight)
We remain cautious on base metals as global growth is expected to slow due to structural (sovereign debt issues) and cyclical headwinds (low confidence). Also, we expect China’s metal demand growth to moderate from the peak levels over the past few years. For steel companies, pricing power for steel firms globally should remain tough in CY12 due to slowing global demand and rising supply.

Consumer staples (underweight)
Volume growth for organized players is expected to remain robust despite price hikes led by rural demand as well as growth in modern trade. Raw material costs are expected to stabilize. A strong correction in raw material costs can provide an upside to margins. Also, while competitive intensity will remain high, margin destructive competition will likely be limited as per channel checks. We are however worried on valuations in the sector.

Infrastructure (underweight)
We are overall underweight on the infrastructure space but prefer capital goods to utilities where we have zero weight. Implementation delays will likely lead to disappointment's

(a) We see an extended cycle in which the Government of India has planned total infrastructure spends of Rs41tn (US$890bn) over FY13-17E – an about 2x rise compared with the FY08-12E spend at 14% CAGR. This is likely help the capital goods companies more. In the near term, we expect the soft material prices as the key driver of margins and to cushion weak-demand led pricing pressure

(b) We expect weakness in utility stocks on account of (a) lack of fuel and business case certainty, (b) the relatively expensive valuations of large IPPs such as NTPC, \

(c) increase in competition (regulated utilities) post the closure of MoU window (in Jan 2011) for winning projects as India moves to a competitive bidding regime and

(d) limited near-term growth catalysts. Competition for new generation capacity could make returns volatile and we believe that merchant power is a new ‘hype’ and potentially a ‘fad’.

To read the full report: SECTOR STRATEGY

>TATA GLOBAL BEVERAGES: Poised to perform

Tata Global Beverages Limited (TGBL) is an emerging player in the global beverage market. The company has made a strategic shift from being a local tea company to a global beverage company through various acquisitions and strategic partnerships with global beverage giants like PepsiCo and Starbucks. As a result, the company has made an entry into the top 10 global companies list in the hot drinks category, posing a challenge to global players like NestlĂ©, Unilever and Kraft Foods. The company’s product portfolio comprises leading global brands like Tetley, Eight O’ Clock and local brands like Tata Tea.

Bottomed-out margins; expect a positive surprise: We model in TGBL’s OPM to improve by ~150bp over FY2011-13E from 8.6% in FY2011 to ~10.1% in FY2013E, driven by a shift in the company’s focus from the plantation business to branded products and rationalization in the operating cost structure. While TGBL’s focus on volume growth remains intact, selective price increases and stable ad spends will further aid in margin improvement. Also, with the Tea Board of India estimating higher tea production in 2011 as compared to 2010 (~5% higher production), we expect auction prices of tea to soften, thereby providing a relief to the company from heightened input cost pressure.

Estimate ~40% plus adjusted EPS CAGR over FY2011-13E: We model a ~40% EPS CAGR over FY2011-13, led by (1) 9% revenue growth and (2) a ~150bp margin improvement. We believe the company is set to outperform the industry’s growth, with the help of selective price increases and strong brands like Tata Tea Premium, Tata Tea Gold, Agni Dust and Kanan Devan.

Key valuation trigger: Despite its leadership position in the Indian packaged tea market, No. 2 position in the global tea market and generating ~90% of its total revenue from branded products, TGBL is trading at 12.2x FY2013E EPS (which is at a discount to its FMCG peers, trading at 20x–35x FY2013E EPS). Also, on EV/Sales basis, the stock is trading at 0.6x FY2013E EV/Sales (historical average of 1x EV/ Sales). Hence, we initiate coverage on the stock with a Buy recommendation and a target price of `97, based on 14x FY2013E EPS of
`6.9(0.8x FY2013 EV/Sales).

To read the full report: TGBL

>INFORMATION TECHNOLOGY: Operating leverage at play

We recently met the managements of TCS, Infosys, Wipro and MindTree, respectively, to gauge their earnings risk. The commentary was consistent across companies. There are no warning signs from the clients’ IT budget as yet. The currency depreciation is going to result in operating margin tailwinds, but crosscurrency movement could be a spoil-sport for revenue growth in USD terms. However, in the quarter where the revenue performance is likely to be bunched-up, we expect the companies with better operating leverage to deliver stronger growth at the bottom-line. We expect stronger‐than‐peer performance for Infosys and HCL Tech as we enter Q3FY12. Hence, we reiterate Infosys and HCLT as our top‐picks.

 Volume growth likely to be bunched up: Based on our recent discussion with the management, we expect Tier-1 Indian IT companies to deliver low-to-midsingle digit volume growth. The growth pack is likely to be led by Infosys and HCL Tech, whereas we expect Wipro to continue lagging behind its peers. However, cross-currency exposure would differentiate USD performance for the companies. We see Wipro and TCS as the worst affected due to high rupee and GBP exposure.

 Operating leverage would drive positive surprise: This quarter has witnessed the strongest tailwind from the currency depreciation ever (excl Q3FY09). We expect Indian IT companies to see tailwind of ~300bps in Q3FY12. However, due to higher hedge, book positions of TCS (US$2.6bn) and Wipro (US$1.7bn) would be a drag at the bottom-line. Moreover, stretched margin levers of Wipro and TCS would result in margin erosion at constant currency terms. We expect Infosys and HCL Tech to deliver stronger quarter as these two are better placed in terms of operating leverages. However, aggressive pricing by HCL Tech to gain market share could yield negative surprise on operating margins.

 Infosys and HCL Tech – remain our top‐pick in the sector: Our recent discussion with the companies’ management indicates no signs of cut in the IT budget. The companies maintained a cautious tone due to uncertainties in Europe, but highlighted no early signs of any cut in IT budget for CY12. We expect the
current quarter performance to be differentiated based on the operating leverage. We see that Infosys and HCL Tech are advantageous as compared to TCS and Wipro in terms of exploiting these leverages. We reiterate Infosys and HCL Tech as our top‐picks in the sector.

To read the full report: INFORMATION TECHNOLOGY

>FOOD SECURITY BILL: Socially appealing, economically unpalatable

The Union Cabinet has approved the National Food Security Bill (bill), 2011 which provides legal entitlement to food grains at a cheaper price to ~63% of the country’s population. The bill, to be passed by parliament to become law, seeks to cover a much larger proportion of population, leading to a positive social impact. However, besides increasing the burden on the fisc, the bill can potentially lead to higher inflation and pilferages. In sum, the introduction of this bill at the time when economy is facing headwinds from all corners would further worsen already weak sentiments as the negative impact outweighs positives from the social angle.

The Cabinet has given its nod to the National Food Security Bill (bill), 2011 which provides legal entitlement to food grains at a cheaper price to ~63% of India’s population. As per media reports, the Govt is expected to table the bill in the ongoing winter session. Once the law is enacted, as per the Cabinet note, food grain
requirement would go up to 61mn tonnes as compared to present need of 55mn tones which would translate into a subsidy bill of ~INR950bn, much higher than this year’s budgeted ~INR606bn (Edel Estimates at ~INR700bn).

In terms of coverage, the bill deals with ~63% of the country’s population with 75% in rural India (of which 46% is priority) and 50% in urban centres (of which 28% is priority). The bill aims at an entitlement of 7kg of food grains per person per month to priority households at a cost of INR3/kg for wheat, INR2/kg for rice and INR1/kg for coarse grain. For population other than priority category (termed general category), the bill seeks to provide 3kg food grain per person per month at not more than 50% of Minimum Support Price (MSP). The priority households can be defined as those falling below the official poverty line plus additional population equal to 10% of BPL households. As per this definition, 46% of rural and 28% of urban population come under priority households.

Importantly, the bill covers less than 75% of the population, as recommended by the National Advisory Council (NAC). However, the coverage is much larger than the one proposed by an Expert Committee (EC) appointed by the PM. According to EC, the coverage should be restricted to priority households, leaving out the general category. At a time when the domestic economy is facing heavy headwinds, external economy remaining in a fragile state and the fiscal deficit is expected to be way higher than the budgeted, introduction of the food security bill would further worsen the macroeconomic situation in the country. While it would provide food and nutritional security to a large swathe of population, the timing and implementation remain questionable.

To read the full report: FOOD SECURITY BILL