>STRATEGY: Silver linings aplenty, but cloud lingers on

A small reversion in the P/E and stable earnings growth could lift the Nifty by 20% within four quarters. However, uncertain macroeconomic trends and government policies tend to hold down the valuation. Silver linings are held out by the resilience in FY12 earnings growth and, the yield‐gap to the Libor nearing the low end. Twice within three quarters, FII buying rose when the gap fell near its low. Another protective factor is the cyclical high in interest rates and inflation, and low in industrial growth. In the near term, sectors with strong earnings momentum during FY12 may extend their run. Over the next four quarters, a few more ‘non‐defensive’ sectors could outperform; we advise an overweight position on Construction, Telecom and Utilities, and select segments in Banks, Automobiles and Oil & Gas.

Triple deficits; policy measures hold key to next rebound in P/E
The large potential rebound in the Nifty depends upon the resolution of challenges posed by deficits in the budget, current account and monsoon rains as well as by inflation, interest rates and exchange rates. Earnings growth has lesser influence on the P/E than feared, as indicated by the lower contraction in the P/E, even as forecasts fell in the last six quarters.

Resilience in profits of vulnerable sectors is a positive
Three sectors with a strong link to industry and infrastructure, viz., Automobiles, Cement and Financials drove a late rebound in consensus forecasts for FY12 earnings growth of the Nifty to c9%. The pessimism on 1H2012 earnings growth coincided with the gloom cloaking most aspects of India. However, the diversity of businesses saw the weakness in a group of sectors, viz., Utilities, Telecom and Construction, being more than offset by the strength in the above three. This indicates that businesses and companies represented in the index are capable of protecting earnings during tough times.

Gap with USD Libor has set bottom of range, also precedes FII rebound
Relative to the Libor, the Nifty P/E is much closer to Feb09’s eight‐year low compared to local yields. The yield gap to the one‐year USD Libor indicates that the Nifty is barely 10% above a level that corresponds to this worst case. We also find a surge in the FII purchase of Indian equities soon after the yield gap nears this low. Over the medium term, this metric may point to a likely low point in the valuation as well as a likely revival in FII inflows.

Select ‘non‐defensives’ outperform; may expand over four quarters
Over a four quarter horizon, we advise an overweight position on stocks within Construction, Telecom, Utilities, and select segments within Banks, Automobiles and Oil & Gas. The 2012 year‐to‐date outperformance in Cement, PSU Banks, Construction, among others, indicates that a swing towards ‘nondefensive’ sectors is under way. Our top picks for the near term are ACC, Ambuja, UltraTech Cement, Torrent Pharma, Unichem, NTPC, Tata Power, HDFC Bank, LICHF and RECL. Over the next four quarters, our top picks are SBI, Axis Bank, Maruti, Tata Motors, BPCL, Cadila, L&T, Wipro, Bharti and Tata Steel.

To read report in detail: STRATEGY

RISH TRADER

>RELIANCE COMMUNICATIONS: Margins decline due to higher network operating costs

Wireless revenues were below our estimates, led by a sequential fall in the ARPU. However, overall revenues grew 5% owing to healthy growth in the Global Enterprise and Others segments. Higher network operating costs drove a 67% q‐o‐q fall in the PBT. Negative tax provisioning and minority interest, however, saved the day, helping the PAT rise 78% q‐o‐q to INR3.3bn. On the other hand, write‐offs due to bad debts and forex variations led to an INR32bn decline in the net worth. We lower our earnings forecasts up to 12% over FY13f–FY14f. Reduce TP to INR59, including the impact of likely refarming, license & spectrum renewal fees and free roaming. Upgrade the stock to Hold due to a c24% underperformance in the last three months. 


■ Wireless segment disappoints; consolidated revenues up 5% q‐o‐q The 1.3% sequential growth in wireless revenues was below expectations due to a q‐o‐q fall in the average revenue per minute (ARPM). The significant q‐o‐q drop in the ARPM after seven quarters has not led to strong growth in total minutes. Consolidated revenue grew by 5% q‐o‐q led by 4% revenue growth in Global Enterprise and 18% in Others. We expect a slower revenue growth of 9% during FY13f–FY15f. 


■ Margins decline due to higher network operating costs As a percentage of sales, the network operating costs rose 500‐bp q‐o‐q. This was partially offset by a 180‐bp q‐o‐q decline in SG&A costs, as a percentage of sales. Though the management attributed this increase to be a seasonal phenomenon, the network operating costs, as a percentage of sales, rose 600‐ bp y‐o‐y in FY12. We expect a 307‐bp improvement in the EBITDA margin over FY13f–FY15f. 


■ PAT higher on one‐offs; net worth fell by INR32bn PAT was up 78% q‐o‐q to INR3.3bn led by one‐offs. This includes a negative tax provision of INR1.2bn on the reversal of provisions, which are no longer required. Also, the provision for losses worth INR1.3bn towards minority interest on restructuring of a foreign subsidiary boosted the PAT. However, the consolidated net worth declined INR32bn during the quarter (INR16/share) owing to various write‐offs, including INR11bn worth of debts due from cancelled licensees. Other write‐offs are mainly due to forex variations. 


■ Downgrade earnings; include regulatory impact; upgrade to Hold We reduce our PAT estimates up to 12% over FY13f–FY14f to reflect a moderation in our growth assumptions for the wireless segment. Furthermore, we include a regulatory impact of INR7/share for refarming, INR2/share for license renewals and INR3/share for free roaming in the new proposed telecom policy. Thus, we arrive at a Jun13 TP of INR59. Due to a c24% underperformance over the last three months, we upgrade the stock to Hold. At our TP, the stock is likely to trade at one‐year forward EV/EBITDA and P/E multiples of 4.3x and 6.0x, respectively. The success of the planned IPO of the subsea telecommunications infrastructure business is a key upward risk to our call.


RISH TRADER

>STRATEGY: Avendus advise cuts in allocations to Two‐wheelers and Consumer, and increases in Commercial vehicles, Passenger vehicles, Cement, Pharmaceuticals, Telecom, Metals and IT Services

Amidst the pervasive gloom, a few signs are pointing to better times returning sooner rather than later. The rapid fall of the Nifty PEG has brought it to within 10% of the band where it stabilized in 2009, before the next rally began. A ‘time‐correction’ could pull down the PEG to
0.7x in 1Q2012. The yield‐gap is down to near its three‐year mean. In the real economy, two lead indicators – Electricity generation and LCVs – are pointing to a rebound in Manufacturing. The missing element – lower interest rates – may be back soon, as seen in the recent fall in
bond yields. Shifts in earnings momentum suggest that sectors with strong links to the recovery are more likely to outperform in 2012. We advise cuts in allocations to Two‐wheelers and Consumer, and increases in Commercial vehicles, Passenger vehicles, Cement, Pharmaceuticals, Telecom, Metals and IT Services.


Steep fall in valuation; Nifty within 10%, three months of stable level
After falling from 2.0x to 0.8x in nine months, the Nifty PEG is within 10% of the range where the Nifty stabilized in 2009, before the next rally began. If prices and FY13 earnings forecasts stay at end‐Dec11 levels, the ‘time‐correction’ could push down the PEG to that range within three months. The yield‐gap to the 1‐year government bond too has fallen close to its three‐year mean, partly due to the fall in the Nifty, but more due to the large fall in the bond yield itself.


Latent signs suggest manufacturing recovery may be impending
Previous cycles saw the Electricity segment of the IIP rebound about six months before Manufacturing. A strong rebound in Electricity has now been under way for 14 months. Another similar lead indicator has been growth in sales of LCVs. Despite the leading indicators being flashed, the rebound in Manufacturing has not commenced. We believe the missing element in this cycle, that was active in the previous economic cycle, is a low interest rate regime. The fall in food inflation in Dec11 is significant as the food segment contributed over half the rise in wholesale inflation during 2011. The fall in the one‐year government bond yield has been a strong indicator of the fall in the Repo.


Tilt away from defensives may have begun
Late 2011 saw sectoral performances begin to shift from previous trends. There is a tilt away from ‘defensive’ sectors and towards stocks with stronger linkages to the next rebound. These changes are linked to the shifts in earnings momentum and have signaled the revival of ‘normal’ sectors such as Cement and Commercial vehicles. For 2012, we advise cuts in allocations to Twowheelers and Consumer and increases in Commercial vehicles, Passenger vehicles, Cement, Pharmaceuticals, Telecom, Metals and IT Services. Our top 10 stocks for 2012 are Bharti Airtel (BHARTI IN, Buy), Hindalco Industries (HNDL IN, Buy), HCL Technologies (HCLT IN, Buy), ICICI Bank (ICICIBC IN, Buy), Larsen and Toubro (LT IN, Hold), LIC Housing Finance (LICHF IN, NR), Maruti Suzuki (MSIL IN, NR), State Bank of India (SBIN IN, Buy), Sun Pharmaceuticals (SUNP IN, Add) and UltraTech Cement (UTCEM IN, Add).


To read the full report: STRATEGY
RISH TRADER

>CONSTRUCTION SECTOR: Implementation of the Lokpal mechanism across states could make things even worse for the sector

Of all the current challenges faced by the construction sector, the  policy paralysis at the Centre seems to us to be the biggest concern.  We met the managements of some companies to seek any signs of  change, but come away largely disappointed. Implementation of the  Lokpal mechanism across states could make things even worse for the  sector as the fear psychosis may extend to state department officials.  The role of interest rate reversal as a catalyst may be muted in the  context of a sharper slowdown – any significant improvement in  fortunes may be at least 2 quarters away.



■ Government approvals slow; turnaround at least 2 quarters away
Our interactions with the managements of some construction companies in  Hyderabad indicate that there is no discernable pick up in the pace of  government approvals. Delays in documentation have impacted last‐mile  approval of several projects. Collections from irrigation projects executed in the  state of Andhra Pradesh have normalized, though companies continue to be  cautious and are going slow on execution. Receivables from central authorities  in some projects have been delayed due to setting in of extreme fear psychosis 

amongst government officials. We see a large risk that implementation of the  Lokpal mechanism across states may extend the paralysis to state machinery as  well and adversely impact the construction industry, which has large exposure  to orders from state government departments.

■ Bidding for NHAI projects is less intense, but IRRs still uneconomic
Managements have echoed the common view that bidding for NHAI projects have become less intense than the situation six months ago. However,  companies that have won projects recently have lowered their threshold IRR  expectations to 16% and below. We believe actual IRR may end up being lower,  if traffic disappoints. Companies that win projects are, thus, accruing negative  NPV projects; the poor relative stock performance of such companies reflects  the market’s concerns. Although bids aggregating to c950km were opened in  Nov11, it does not necessarily indicate a pick‐up in award activity since bid  awards are being bunched up by the NHAI – the next bunch of bids being  invited in Jan12. Large companies have shown interest in bidding for small ticket  OMT projects to get a sense of traffic patterns. The discord between the  NHAI and the Planning Commission seems to have increased, resulting in  resignation of several top officials of the NHAI. This is likely to further hamper  the organization’s working.



■ Interest rate reversal may not be enough of a catalyst
Interest rate reversal is a much‐anticipated catalyst for the sector. However, its  impact may not be significant in the context of overall slowdown in the sector.  The sector is not facing an acute funding crunch—as in 2008—hence, we  believe the competitive intensity continues to be high at the current stage. NCC  (NJCC IN, Buy) is our preferred sector pick as a potential stake sale in  development assets may drive a large re‐rating from current levels.


To read the full report: CONSTRUCTION SECTOR
RISH TRADER

>Banking Sector: Worsening NPL gap to prolong underperformance of PSBs

The large rise in net NPL/networth of PSBs in the Sep11 quarter

overshadows the expansion in their NIM. The NPL gap against PSBs is

now at a 12 quarter high and getting worse. At mid‐Nov, the valuation

gap between Nifty and CNXPSBK is at its highest in eight quarters. The

spurts of outperformance may stay short‐lived; we estimate the

underperformance could extend by up to six more months. The

surprise freeing of savings bank deposit rates in the Oct11 monetary

policy may pull down ROA for all, over the long term. Its medium term

impact may be less stark than implied by early reactions. Pricing is not

the sole influence on growth of savings deposits. The trend in NPLs

may be a stronger influence on valuation than the revisions in policy

rates. BOB and ALBK among PSBs, and HDFCB and IIB, among new

banks, are the preferred stocks over the near term.

Buoyant NPLs pull down Sep11 earnings and worsen the outlook

The gap in the net NPL/networth between PSBs and new banks is currently at

its widest in four years and is rising. PSBs saw a 3.3% sequential rise in the net

NPL/networth to 16.7%, while it remained stable for new banks at 2.9%. The

outstanding gross NPL of PSBs increased by 19% sequentially, against a 2%

increase for new banks. NIM expansion and pre‐provision profit growth of 16%

was offset by c44% rise in NPL provisions. During the past six weeks, consensus

net profit growth of PSBs for FY12 has been lowered by 7% to 15% y‐o‐y.

Underperformance of PSBs may extend for another six months

Oct11 was the worst month for PSBs after May11. The premium of the Nifty

P/E over the CNXPSBK increased by c16% in the past six weeks to c125% at the

end of 17 Nov11. It has stayed above the 12‐month moving average for close to

seven months. Historical precedence suggests the underperformance may

extend for another six months. The Bankex underperformed the Sensex by

2.4% in Oct11 and by 3.5% in Nov11. With a combined weight of c70%, new

banks contributed 91% of the rise in the Bankex in Oct11. The trend reversed in

Nov11, as new banks contributed c79% of the c11% fall in the Bankex.

Early reactions to SB deregulation reversed in the following weeks

In our report dated 25 Oct11, we had stated “we believe banks may follow

different strategies, with banks with a very small franchise in savings deposits

possibly adopting aggressive pricing.” Pricing is not the sole influencer of

savings deposits growth. Deregulation may lead to a fall of up to 25‐bp in the

ROA of all banks. The initial run up in banks with low CASA did not sustain.

Contribution of overseas sources of fund to the commercial sector rises

Loan growth declined by 5.4% in Oct11 to c18.0% y‐o‐y. Overseas sources of

funds offset the fall in the contribution of bank loans. The 11% decline in the

contribution of non‐food loans in the Sep11 quarter to c41% was offset by a

13% rise in the contribution from overseas sources such as ECBs/FCCBs and FDI.

Preferred stocks over the near‐term

BOB, ALBK, HDFCB and IIB are the preferred stocks over the near term.

To read the full report: BANKING SECTOR

>EDUCtATION SECTOR IN INDIA (AVENDUS)

To read the report: EDUCATION SECTOR

>TELECOM SECTOR (AVENDUS)

Incumbency may confer a strategic advantage in the 3G auctions because of the infrastructure, customers and cash flows of the large companies. All the winners in 3G may find reasons to observe price discipline and tone down the tariff war. Another force that may end the tariff war would be exhaustion of spectrum with new operators after Mar11. Number portability may act differently in India because the forces triggered by it in other parts of the world have existed here
for some time; portability may actually be good for incumbents. Underperformance of telecom stocks for five quarters suggests that 3G and the tariff war are priced in. However, a rebound may not be round the corner due to the risks to FY11f earnings. We initiate coverage on BHARTI (Hold), IDEA (Add) and RCOM (Hold).

■ Incumbents hold the edge in 3G auctions
The strategic advantage of large incumbents arises from their infrastructure, customer relationships and cash flows. Winners could quickly lift quality of service in 2G. Later, they could tap the high‐ARPU segments to identify customers for 3G offerings. A potential positive spin‐off from the 3G auctions is the return of pricing discipline. Incumbents with a superior quality would not need to resort to aggressive pricing. A new provider who wins a 3G license may only obtain funding with covenants that prescribe superior returns on capital.

■ Tariff war could end after Mar11
Aside from the influence of 3G a potential inflection point may emerge after Mar11 when new operators begin to exhaust their spectrum. Exhaustion of spectrum with large incumbents since 2007 had slowed the decline in tariffs. However, the tariff war resumed in 2009 because new entrants used the pricing tool to grab incremental market share. We believe the situation in FY11
would be similar to that in 2008 with a high probability of bottoming out of tariffs.

■ MNP may add little to the high ambient competition in India
Global precedents indicate that onset of portability leads to high churn rates, loss of market share by incumbents and a cut in ARPU. Much of these effects have been present in India for 5 quarters. Portability may be favorable to incumbents in India due to extensive network coverage, distribution reach, customer service and brand.

■ Near‐term downside risk to earnings may delay a re‐rating
Across the globe, winners in 3G auctions had seen consequent erosion in market value. In India this phase may be over. Underperformance of telecom stocks to the Nifty after Dec08 correlates with concerns over 3G and the tariff war. Yet, stocks may not rebound soon as net profits for FY11f face potential downside arising from the persistence of low tariffs and the possible rise in financing costs. FY12 may have more positives such as the likely return of price discipline and payback in some projects where investments were made till FY10. We initiate coverage on BHARTI (Hold), IDEA (Add) and RCOM (Hold).

To read the full report: TELECOM SECTOR

>STATE BANK OF INDIA (AVENDUS)

New norms that require all banks to reach 70% specific provision cover by Sep10 could catalyze merger activity within Indian public sector banks. In particular, SBI stands to gain if the amalgamation of its associate banks were to revive and accelerate. At end of Mar09 the provision cover of the standalone bank was 38.5%, 10.8% below that in the consolidated bank. The new norms would erode net profit for FY10f and FY11f by up to 18%. The erosion for the consolidated bank would be capped at 13%. Two associate banks have been merged with the parent and this experience could help to quicken the process for the other five. While these mergers may not have material impact on the numbers used in valuing the stock they could potentially re‐rate the P/E. We value the stock using a combination of P/E, P/B and DCF method. We maintain ‘Hold’ rating on the stock with Dec10 target price of INR2,123.

Provisioning norm may erode standalone pre‐provision profit by 18% The additional specific provisions required to raise the cover to 70% are estimated at INR72.5bn. If equally distributed over FY10 and FY11 they would erode our current forecasts for pre‐provision profit by 18% and 15%, respectively. Due to higher loan loss provisions, we had downgrade EPS forecast for FY10f and FY11f by 12% and 22%, respectively in our report dated 18th Nov09 “Rising concern on NPL provisions’’.

Accelerated NPL provisioning could catalyze mergers

Higher provision cover in consolidated book would cut burden by c5%: At the end of Mar09, the provision cover of standalone SBI, including writeoffs, was c57%. That for the consolidated bank, assuming the amount of writeoffs stays unchanged was 61%. So, the additional provisions required to reach the mandated 70% level would be INR69bn. Consequently, the potential erosion in pre‐provision profit would be capped at 13% and 10% for FY10f and FY11f, respectively. The erosion would be even lower if we consider the additional write‐offs made by the associate banks.

Merger with associate banks would cut the provisioning burden: Over the past two years two of the smaller associate banks were merged into SBI. The natural corollary of extending the mergers to the other five associates is taking a pause due to opposition from the bank unions. Now, the mandated surge in NPL provisioning adds to the argument for rapid progress of mergers with these banks. We value SBI using the consolidated numbers. So, the actual merger is likely to have little material impact on the valuation of the stock. However, these mergers have potential to re‐rate the P/E in the near term.

We value the stock using a combination of P/E, P/B and DCF method. We maintain ‘Hold’ rating on the stock with Dec10 target price of INR2,123.

To read the full report: SBI

>POWER SECTOR (AVENDUS)

Winds of change blowing across BOP bidding

The Central Electricity Authority has recently put out revised draft prequalification norms for Balance of Plant bidders. These indicate further dilution in pre‐qualification norms as it allows joint ventures to bid for turnkey BOP orders. By reducing bank guarantee requirements, it has
made consortium bidding financially competitive. Another significant change is the proposal to allow vendors from other industries, with similar experience, to bid for BOP packages in the power sector. We believe the proposed changes are likely to increase competition for turnkey BOP packages as bidding in consortiums and JVs becomes viable. Overall, the development may be adverse for established turnkey BOP contractors, while favoring material handling companies
and other BOP vendors.

Revised draft guidelines put out for BOP pre‐qualification norms
The Ministry of Power and the Central Electricity Authority on August 18‐19 hosted an international conclave on “Key Inputs for Accelerated Development of the Indian Power Sector for the XII Plan and Beyond.” The CEA has put out revised draft guidelines on qualifying requirements for bidders of BOP orders for coal/lignite‐based thermal power plants. The earlier guidelines were released in Jun08. These guidelines are not binding on State Electricity Boards; however, they have largely been following them while inviting bids.

Vendors from non‐power industries stand to gain
The CEA has changed several covenants in the Aug09 draft. The main change allows JVs to bid for BOP packages, from only consortium and individual companies earlier. The revised draft guidelines also mandate lower bank guarantees for JVs and consortiums. As per the earlier norms, higher financing costs were one of the key disadvantages for consortium bidders versus
individual bidders. The new norms allow vendors with relevant experience in other industries to participate in the power sector. This is likely to increase the vendor base and encourage bidding in consortium, while they were disqualified earlier on minor technicalities.

Dilution in norms to improve vendor base, increase competition
High entry barriers restricted the number of players capable and qualified to bid for turnkey BOP orders of 500MW and above from SEBs to five. We believe the number of vendors interested in entering the turnkey BOP space has increased. However, several companies at the conclave cited strict qualification norms that benefited existing players and were the key constraints for entering the space. The revised norms address several concerns and are likely to increase competition in turnkey BOP orders. The move to allow EPC contractors from other industries to participate in the power industry may not increase competition by much in individual packages as several domestic BOP package vendors (like those in material handling, civil construction and water treatment) operate in more than one industry.

To see full report: POWER SECTOR

>Wockhardt (AVENDUS)

Cut target price; near‐term events to determine value

Wockhardt’s 2008 results point to large uncertainty over the nearterm. While operational performance has been in‐line with expectations, excessive leverage and undisclosed hedging positions could continue to heavily influence net income. A claim of INR4.9bn on the company on forex contracts adds to the air of uncertainty. We paint two scenarios that could lay ahead for Wockhardt. Assuming the company stays unbroken and functions as a going concern, the strong visibility in operating margins would be rewarded by the market. In our assessment, this could draw a value of INR204/share, to which we assign a probability of 15%. In a second scenario analysis, an assets stripping sale of individual businesses indicates INR87/share, to which we assign a probability of 85%. Combined valuation for the company thus stands at INR104/share. Downgrade to HOLD. Near‐term movement in the stock would be driven by news flow on sale of assets by the company.

Uncertainty clouds thicken over net earnings
Wockhardt is saddled with debt, with 2008 closing at a D:E of over 3.8:1, by our estimates. The high degree of leverage would keep the company’s bottom‐line vulnerable to changes in interest outgo. In 2008, the company’s coverage ratio was a low 2.6x. We believe the number would slip further in 2009. Concern over MTM losses may persist until publication of unabridged annual accounts. A claim on the company for INR4.9bn pertaining to forex losses lies unaccounted. We assign a probability of 50%.

Scenario I: Significant upside if company stays unbroken
Assuming the company stays unbroken, the strong visibility in operating margins would be rewarded by the market. Over the last 16 months, the company has traded at an average 1‐year forward MCap/EBITDA of 2.7x. Doing away with the extreme ends of the valuation range we arrive at a steady‐state mean MCap/EBITDA of 2.5x. The company, in our view, is operationally sound with a steady growth in revenues and healthy operating margins. At 2010 EBITDA of INR9.1bn, we arrive at a per share value of INR204. Assigning a 15%
probability we draw a valuation of INR31/share.

Scenario II: Strip‐down asset valuation at near distress sale
Wockhardt has initiated the process of hiving off parts of its business in a bid to raise its cash coffers. We estimate the cumulative sale values of individual businesses would close at INR46.4bn, about 16% lower than the current EV of the company. Per share value from a strip‐down method thus stands at INR87. We assign an 85% probability, drawing a valuation of INR74/share. Weighted average value of INR104; news flow to drive momentum Our sum‐of‐scenarios valuation stands at INR104/share. Upside risks pertain to higher than estimated proceeds from asset sales and interest waiver benefits from the CDR. Above estimated losses on derivative contracts is the single biggest downside risk to our call. Downgrade to HOLD.

To see full report: WOCKHARDT