Sunday, June 21, 2009


A tightrope walk

The government will present the Union Budget in the Parliament for the balance months (August-March) of FY10 on July 6. The budget is set to be presented against a backdrop of the government grappling with conflicting objectives of supporting growth and containing fiscal deficit. Given the fiscal constraints the government faces at the moment, any significant tax concessions or large direct government stimulus expenditure seem unlikely. However, programmes targetting rural employment generation, low cost housing, weaker sections of the society are likely to continue. The budget’s focus is likely to be on inclulsive growth, infrastructure, small and medium enterprises (SMEs), and labour-intensive and export-oriented industries (textiles, leather, gems and jewellery, etc). Agriculture will continue to be favoured. The UPA, both in its manifesto and the interim budget, had emphasised on divestment. Hence, one can expect the same to be on for discussion in the current budget.

Apart from the duty and tax cuts on budget wish lists, companies expect the government to promote investment. Construction companies expect an increase in funding for roads, irrigation, and in both rural and urban infra schemes. FMCG companies expect the government to boost the rural economy by increasing allocation for various agriculture-centric and employment generating schemes. In the metals sector, companies expect the government to help PSU steel companies to increase capacity and grant of infrastructure status for steel sector. The 3G auction issue for telecos is also expected to be touched upon in the budget, as it may generate additional funds of INR 250-400 bn. The wish list of oil & gas companies includes deregulation of auto fuel prices making domestic auto fuel pricing linked to international crude oil prices up a level (e.g, below USD 75/bbl). However, it is uncertain to what extent this proposal will go through, since an alignment to international prices will imply significant fluctuations in gasoline and diesel retail prices.

However, in case of most reforms (including 3G auction and oil price deregulation), only general directions and broad guiding criteria are expected in the upcoming budget. Detailed announcements and quantitative specifications are likely to follow in a staggered manner, in consultation with the specific ministries.

Inclusive growth, infrastructure to be key focus areas
Supporting growth will be the foremost objective of the upcoming budget. The government has repeatedly emphasized that its focus is “the common man” and, hence, it prefers the growth process to be as “inclusive” as possible. Amidst subdued job scenario across the economy, the government is likely to demonstrate its commitment to generating employment. There are also talks of sector-specific stimulus measures, particularly labour-intensive, export-oriented industries and SMEs. The government has also stated that concerns raised in the interim budget, especially with regard to sectors hit badly by the global financial crisis—textiles, leather, and gems and jewellery—will be addressed in the budget. The measures may include interest rate subsidies and tax subsides. Representatives of the export sector are also seeking a market development fund to support the sector.

Agriculture will continue to be favoured. The government is likely to introduce new initiatives
in rural infrastructure, such as, widen the irrigation cover, apart from increasing the corpus of
the Rural Infrastructure Development Fund (RIDF) to ensure greater availability of funds.
Government initiatives are expected to ensure better credit disbursements to agriculture, and
increase agriculture input subsidies.

The budget may include some announcements on public sector-led infrastructure spending,
including new initiatives in power sector development, improvement of railway infrastructure,
upgradation of port infrastructure and capacity building in airlines and airports. The
reintroduction of infrastructure bonds and investment allowance is on the wish list of corporates.

High fiscal deficit a concern; but small scale projects to continue
The government has expressed the need to contain the fiscal deficit within reasonable limits. Certain government sources have indicated that they will attempt to contain the combined (Centre and States) fiscal deficits within 11% of GDP. However, given the sharp revenue slowdown the government is currently facing, this target appears ambitious unless there is a significant turnaround in the economy.

Accordingly, the government’s ability to provide any further dose of large and generalized stimulus for the economy will be limited in the current budget. However, the government will continue with small scale projects such as providing land at zero pricing for the economically weaker sections (EWS) and lower income groups (LIG) under the Model Real Estate Regulation Bill, increasing the minimum wages under the NREGA scheme to INR 100/day, and providing food security.

Can there be any significant tax reductions?
Given the difficult business environment, demands from industry have been strong to reduce corporate tax rates or remove the surcharge on corporate income tax. Wish lists also include maintaining the reduced indirect tax rate and increasing tax free thresholds on income tax so as to not depress consumption.

However, the government is currently facing sharp revenue slowdown and there is no immediate need to be populist. Hence, there is no realistic expectation of a significant reduction in taxes. Tax concessions, if any, will only be token and largely for uplifting sentiments.

There is a possibility of rationalisation of income tax slabs yielding benefits to tax payers particularly at the lower end of the pyramid. The existing limit of INR 0.10 mn of tax exemption under Section 80C could be revised upwards.

On the other hand, to help interest rates to soften further, the government may consider reducing administered interest rates for small saving schemes like postal deposits. This will help banks reduce deposit rates and, in turn, lending rates.

Goods and services tax (GST)
The government is keen on speeding up the streamlining of the tax system with the introduction of the Goods and Services Tax (GST). The finance minister has proposed to set April 1, 2010, as the date for introducing GST. Currently, there are parallel systems of indirect taxation at the central and state levels. Each of the systems needs to be reformed to eventually harmonize them.

Some of the steps the government needs to take with regard to GST are: (1) harmonize central excise and service tax rates; (2) eliminate end use/region based exemptions; (3) set up a body to recommend constitutional amendments, if any, needed to implement a uniform GST; and (4) give clarity on how import duties will be merged with GST. It remains to be seen how many of the above-mentioned issues will be addressed by the finance minister in the budget.

The GST rate may be pegged at 10-12% against the current 8-12% Cenvat rate, 10% service
tax rate, and 12.5% VAT rate. There is also a possibility of introducing GST with differential
rates for different goods and services with gradual unification of the rates over time.

Fringe Benefits Tax (FBT)
Another long-standing demand from corporates is the removal of the Fringe Benefits Tax (FBT). Corporates have been opposed to FBT, not just on account of the added tax burden, but also because of the huge additional paperwork and accounting complications involved. Given the miniscule FBT collections (~2% of the total direct tax collection), there is a view that FBT may be removed in the budget for certain sectors. However, removal of FBT does not gel with UPA’s focus on “the common man”.

Securities Transaction Tax (STT)
The wish list of the capital market includes abolishing Securities Transaction Tax (STT). Several market participants, however, feel that abolishing STT will be low in the priorities of the government as such a move will not offer any significant help for “the common man”. Another option for the government can be to reduce the STT (from the current 0.125%) instead of abolishing it altogether. There is also a possibility that if the STT is abolished, it will be replaced by another tax, such as long-term capital gains tax.

Expectations high on a roadmap for divestment …
With the economic slowdown impacting the government’s revenue receipts, divestment is one route to raise funds to improve the fiscal scenario. IPOs from unlisted government owned companies could help revive the primary capital market. Indian National Congress’ (INC) manifesto and the interim budget both emphasized the need for divestment.

PSUs in which government’s stake is significantly higher than 51% may be the ones where stake sales will be pushed through first. Thus far, a majority of the amounts raised from divestment have come in from sale of minority stakes in companies, rather than strategic sale and residual sale. This suggests that the government is likely to lean towards divestment of minority stakes in PSUs through the IPO route. However, strategic sales in loss-making companies too may be considered.

Given that government holding in many public sector banks (PSBs) is near 51% and statute prohibits further dilution. The government will have to resolve this issue to ensure that PSBs are able to raise funds by diluting their equity base. Divestment may not occur in PSBs or at the most it could be restricted to non-strategic banks. However, the government may relax the 51% statute, thereby keeping the control in its hands and at the same time garnering the much-needed capital. The governement is not likely to be aggressive on divestment in the infrastructure sector, as it will be sensitive to opposition from employees and other stakeholders.

Potential listing candidates include Oil India, NHPC, Coal India, RINL, Manganese Ore, Cochin
Shipyard, and Air India. The government may also look at follow-on public offers in BPCL, HPCL, IOC, and ONGC, and stake sales in BSNL and LIC.

… and for increasing FDI cap
The proposal for increasing the FDI cap in retail and insurance was raised by the United Progressive Alliance (UPA) government in the 2004-05 Budget. However, opposition from Left parties eluded consensus on the issue.

FDI is not currently allowed in multi-brand retail, thus curbing mega-international stores like Walmart, Tesco, and IKEA from entering Indian markets. Although allowing FDI in retail is on the wish list of the middle and upper classes, as it will boost the service quality, available choice as well as pricing, we doubt if such a proposal will find a berth in the forthcoming budget, as introduction of such norms will adversely affect employment generated by local

Currently, 26% foreign equity is allowed in insurance companies. Expectations are that over the next two-three years, this will be raised to 49%, as it will help bring in more resources and experience to Indian insurance companies. This may not happen in the forthcoming budget itself. However, the government may take an initial step in this direction and chart out a future roadmap for the same.


Still factoring too much potential upside

Revised PO implies 9% downside; cut to Underperform
The Mumbai High Court on June 15 ruled against Reliance Industries (RIL) in its litigation with RNRL, the consequent hit to PO being Rs173/share. A stronger rupee means hit of another Rs68/share. We have cut PO by 5% to Rs1,837/share even after factoring in upside of Rs137/share for upgrade in prospective resources in KG D9 and D3 blocks. After a 70% rally over 5 months RIL looks over-valued on our PO and on fair value in most other scenarios (Table 2). It is not cheap at 15.5x FY10E and 11.8x FY11E. Our earnings and PO do not factor all potential downsides (no tax holiday on gas output and weaker than assumed refining margins). We are therefore downgrading RIL to Underperform from Buy.

Share price factors lot of potential upside, not all downside
RIL has large reserve accretion potential. Our PO amply factors the reserve upside - 4bn boe valued at Rs427/share (US$13bn). We estimate RIL’s share price values reserve upside at Rs614/share (US$20bn) implying 6.2bn boe of future reserve accretion. It effectively values 10.9bn boe of reserves (PO values 9bn boe) vis-à-vis 4-5 year reserve target of 10bn boe set by RIL in October 2007. All potential downsides are not factored in. 7-year income tax holiday may be disallowed for gas production. We think the probability of it being disallowed is very low but downside to our PO if disallowed is significant at Rs300/share (16%).

Refining margins may be weaker for longer than assumed
Singapore refining margins are down to US$3/bbl in Jun’09 (US$5.1/bbl in Apr’09) and light-heavy crude spread has collapsed to below US$1/bbl. US refiner Valero warned of loss in 2Q. IEA forecasts 2.5m b/d decline in global oil demand in 2009E. This could keep refining margins weaker for longer than assumed by us.

To see full report: RIL


Optimism Overplayed; maintain 'Sell'

The recent rally in DLF's stock price suggests that markets are factoring in a 'V' shaped recovery. However, we expect the recovery to be 'U' shaped, given the weak margins in affordable housing and the continued slowdown in commercial and retail demand; this will maintain pressure on NAV. We maintain 'Sell' on DLF with a revised TP of Rs157 (earlier Rs 80), a 56% downside from current levels.

Mkts pricing in 45% rise in property price-unsustainable
As per our sensitivity analysis, DLF's CMP (Rs354) is factoring in a 45% rise in property prices in FY10E, which, in our view is unsustainable. Our recent visits to Delhi and Bangalore suggest that the buyer continues to be price conscious due to fear of job losses.

Higher sales not to be margin accretive
Focus on affordable housing is likely to generate higher sales for DLF,but compress its EBITDA margins, from 55% in FY09 to 36 in FY10E. Moreover, with a price conscious buyer at one end and an oversupply situation on the other, DLF would find it extremely difficult to increase prices.

Sensitivity analysis to property price.
Our sensitivity analysis indicates that if property prices were to be increased by 50%, the NAV is 378. If the prices were to be increased by 100%, the NAV would rise to Rs 600. If we assume a price rise in FY12 and FY13 of 30% each, then the NAV would stand at Rs258.

Two-pronged strategy - maintain sales & lower debt
To ensure sales, DLF is pricing its residential projects lower than the existing prices in the vicinity. This strategy has already ensured success for DLF in Delhi and Bangalore. DLF is also selling its non-core assets and land to lower debt.

We maintain 'Sell' on DLF with new TP of Rs 157 (earlier Rs80) that is based on 1x NAV. Our NAV factors in teh expected sale of non-core assets/land and reduction in debtor. We have also lowered the discount to NAV to nil due to the aggressive steps taken by DLF to improve its balance sheet. Currently, the stock trades at 42x FY10E earnings and 41x FY11E earnings

To see full report: DLF LIMITED


Sell: Life Valuations Not Assured

Capital markets have bounced, but so has the stock — RCap's businesses are highly levered to capital markets, and recent equity performance should result in higher growth/earnings of individual segments. We revise our target price to Rs821 but maintain Sell (3M) as we believe RCap's earnings/operating growth will lag the sharp increase in its stock price (+137% outperformance in last 3 months), thereby making the stock expensive at current levels.

...But the business will grow with a lag — While equity market performance has a strong correlation with RCaps' businesses, we expect growth in most businesses to lag the rebound in broader markets – in particular, we expect relatively moderate growth in life insurance, non-life insurance and consumer finance segments.

Implied valuations for life insurance appear to be at a significant premium RCap is seeking to sell up to a 26% stake in its life insurance business, including likelihood of inducting a strategic stakeholder. The transaction does not come under current FDI cap (100% owned) but requires other regulatory approvals. However, current stock price implies valuations of 20x 1Yr Fwd NBAP multiples, which is at 30-40% premiums to our benchmark values for peers.

Asset management, equity broking likely first to rebound — RCap's asset management and brokerage segments should be the first to rebound. While AUMs in the domestic business have grown 46% over Dec'08, retail equity inflows so far, have been modest. We expect brokerage revenues to grow but led by institutional segment as retail investors participate with a lag.

To see full report: RELIANCE CAPITAL



The global rally in stocks has seemingly stalled, and the euphoria of the election results seems to be in share prices. Several investors are arguing for a correction. The high volatility in share prices suggests that market participants are unsure of the market’s direction. We identify the following key drivers for the market in the coming months:

Politics and Capital Flows: The change in our view in the middle of May following the elections was not a move away
from our fundamental framework. Indeed, in the run up to the elections, we had argued that if a single party won in excess of 180 seats, Indian equities would likely beat emerging markets by more than 25% in the ensuing 12 months (see note dated 6 March 2009, entitled Dealing with Uncertainty - Part 1: The Forthcoming General Elections). This forecast was premised on our fundamental framework that India’s growth was being driven primarily by capital flows and strong election results would revive capital flows. However, our base case called for a fragmented verdict. We were wrong about our assumption on the election results and, hence, changed our view on both the economy as well as the market post the elections. In hindsight, we realize that we missed the growing maturity that the electorate had been displaying over the preceding 18 months in choosing its representatives for the country’s law-making bodies and that the general election results were only a continuation of this trend.

Budget on July 6: History does not favor a move up in the market in the month post the budget. However, we have to
make an assumption ahead of the budget as we did with the election result. Therefore, we expect the finance minister to deliver a solid reform-oriented budget that will incorporate tax cuts, fiscal consolidation, a divestment program, and infrastructure spending as well as announcements relating FDI and deregulation in the financial sector.

Reforms and the upside to growth forecasts: We raised our growth forecast following the election as we expect capital flows to improve. Since then, we think the government has struck all the right chords on reforms, and this encourages us to further raise our earnings growth forecast. The recent quarterly earnings, which have been ahead of expectations, also influences this change. We now think that earnings growth for the Sensex will be 5% and 17.5% in F2010 and F2011, respectively, in our base case. If the government executes on reforms, we believe there will be more upside to growth, especially in F2011. A notable concern would be that the social agenda takes over the economic agenda, hurting confidence and growth. Another is whether the government’s lack of majority in the Rajya Sabha hampers law making. A key point to note here is that our current growth forecast does not take us back to trend or anywhere close to the heady growth rates of the past five years.

To see full report: INDIA STRATEGY


Paper division acts as a drag...

Orient Paper has reported a YoY revenue growth of 23.1% to Rs 467 crore. The EBITDA margin has improved by 150 bps due to improvement in margin in the electrical consumer durables division. The adjusted net profit has grown by 24.6% YoY to Rs 66.7 crore.

Highlight of the quarter
Net sales grew 23.1% YoY to Rs 467 crore in Q4FY09 from Rs 379.3 crore in Q4FY08. This was due to increase in revenues from the cement, paper and electrical consumer durables divisions. The EBITDA margin improved by 150 bps YoY to 25.2% due to improvement in margins in the electrical consumer durables division. Other income grew 331% YoY to Rs14.6 crore due to income from carbon credit of Rs 8 crore. The reported net profit has increased by 14.1% YoY to Rs 54.9 crore. During the quarter, the company has written off dues from the Kenyan JV and made a provision for water tax for the earlier year. Thus, adjusted net profit has grown by 24.6% to Rs 66.7 crore. On a QoQ basis, net sales grew 35%. The EBIDTA margin has improved by 40 bps to 25.2%. The reported and adjusted net profit has grown by 7.2% and 30.1%, respectively.

At the CMP of Rs 57 per share, the stock is trading at 4.5x and 4.6x its FY10E and FY11E earnings, respectively. We are assigning a PERFORMER rating to the stock with a price target of Rs 66 per share.

Segmental results


The cement division has reported revenue growth of 20.9% YoY to Rs 233.5 crore. Cement dispatches grew 13.8% YoY to 7.5 lakh tonnes while realisation improved by 6.2% YoY to Rs 3132 per tonne. The EBIT margin has remained almost flat at 39.9%. Due to growth in revenue, the EBIT has reported growth of 20% YoY to Rs 93.1 crore.

The paper division has reported revenue growth of 51.4% YoY to Rs 91 crore. However, due to the disturbed pulp mill operations division, Paper division has reported a loss of Rs 0.2 crore in Q4FY09 as compared to profit of Rs 1.4 crore in Q4FY08.

Electrical consumer durables

The electrical consumer durables division has reported revenue growth of 13.7% to Rs 142.5 crore due to incremental revenue from the CFL business. The EBIT margin has improved by 600 bps on account of a decline in metal prices. Thus, EBIT has surged by 76.4% YoY to Rs 23.9 crore.

To see full report: ORIENT PAPER & INDUSTRIES



Bond yield back-up causing no macro panic
The June FMS shows no signs that investors are spooked by the recent rise in US bond yields and oil prices. The investor mood is pro-growth and fears of a growth "double-dip" or an imminent crash in U.S. Treasuries and the US$ are currently absent. On the contrary, the consensus is overweight assets that usually benefit from rising bond yields such as commodities and Emerging Markets.

Optimism is back in fashion
Global growth expectations continue to surge (+78%, a 6-year high); a net 7% of investors believe global recession is likely in the next year versus 70% just two months ago. Investor expectations have shifted decisively from recession to recovery: one-third of our panel believe corporate profit growth will exceed 10% in the next 12 months; cash balances fell to 4.2% (in-line with historical average); hedge fund net exposure surged from 25% to 35%.

Asset allocators finally back overweight equities
Expectations shifted from deflation to inflation in June: a net 19% of investors see higher inflation in 12 mths time versus -1% last month. Asset allocators reduced bond exposure (to -15% from -3% in May) and finally moved overweight equities (+9% from -6% in May). But optimism remains measured. Back in March the FMS showed extreme pessimism making us very constructive on equities. June levels of optimism on equities or risk cannot yet be described as dangerously high.

All bulls in the China shop
Global positioning remains pro-China. The survey shows the biggest OW of commodities as an asset class in the past 3 years. A net 49% of fund managers want to be OW Emerging Markets, versus just 8% who wish to be long European equities. Investors are OW technology, energy & materials, as the link to Chinese growth supersedes traditional notions of early cyclicals such as consumer discretionary. And investors are U/W every single defensive sector (pharma, staples, telecoms & utilities) for the first time since Nov 2003; a point at which the S&P had seen a similar 30% rally and presaged a further 10% run into year end.

There will be them
Markets and optimism may have rebounded so quickly that both need to pause for breath. But "buy the dip" is the equity message coming from the survey with Q2 reporting season set to be the next major hurdle for re-setting expectations. The contrarian trades are as follows: directional bulls would buy consumer discretionary, industrials, Europe and Japan. Directional bears would go short the relative euphoria on Emerging Markets, energy and materials. Note that panellist's feedback on oil price valuations implies the consensus thinks $65/b is fair value.

To see full report: SURVEY GLOBAL


Higher loan growth, lower NPL’s to sustain re-rating

Sector re-rating to sustain on growth, reforms
We expect the banking sector re-rating, already underway, to sustain owing to a) higher than estimated loan growth at 16.5% in FY10 and +20% in FY11 driven by our GDP upgrade (by Indranil Sen Gupta, our India economist) to 6.3%, greater focus on infra spend; b) easing rates and less likelihood of spike in bond yields as govt. pursues divestment (making it easier to fund the fiscal deficit); c) easing concerns on asset quality with NPL formation levels peaking at a lower level (though NPL’s will rise and remain the key challenge); and d) progress on reforms incl. insurance, with higher visibility on banks’ monetizing their stakes.

Raising PO’s on higher ROEs; Upgrading Axis, Fed to Neutral
We are raising our PO’s across banks to capture i) the sector re-rating due to the expected improvement in macro; ii) roll forward of our estimates to FY11; iii) capturing higher RoE’s due to higher growth and lower credit costs; and iv) rerating of equity related biz. like insurance and asset management for banks that have stakes in these biz. Re-rating accounts for 40-60% of the PO upgrade. We are also upgrading Axis and Federal Bank to Neutral owing to easing of NPL
concerns. But given the sharp run up, we refrain from taking them to a Buy.

ICICI Bank, HDFC – Preferred picks in large caps
ICICI Bank remains our top pick in the sector as it remains a key beneficiary of easing rates, less vulnerable to rising NPL’s (even though concerns are easing), benefits from re-rating of its equity related biz. (insurance and asset management) and positive risk return trade off. HDFC is the other stock we like (despite being expensive) as it is a key beneficiary of the likely uptick in mortgage lending, good asset quality and also offers a play on HDFC Bank and insurance and asset mgmt. SBI, while offering a positive risk return (1.2x FY11 book for subs; 17% ROE) is behind ICICI and HDFC owing to near term margin and NPL issues.

Govt. banks (like PNB, BOI) can provide +30% upside
The bigger upside, may, however, come from some of the govt. banks (ex-SBI) that could offer much better value, trading at 1.1-1.3x FY11 adj. book with RoE’s of +20%. The key triggers would be higher growth and rising comfort on asset quality. Key risks remain the rise in bond yields (that we hope will not spike). In particular, we like PNB and BOI (+30-35% upside) followed by UBI. Indian BK is our preferred small cap pick (+40% upside). These banks are also better placed
on asset quality, amongst govt. banks.

To see full report: BANKS-RETAIL


Rise in long-term interest rates: Some explanations are convincing, others are not

The rise in long-term interest rates (particularly in the United States) is very bad news, since a fall in longterm interest rates was the only policy left for central banks.

What accounts for this rise?
− inflationary risk due to the scale of monetary creation? But if expected inflation rises, there is no real inflation risk and, moreover, the US and European economies will remain very weak for a long time to come;

− crowding-out effects due to the size of the expected public debts? But private indebtedness
continues to fall and the savings rates keeps rising;

− contagion from higher returns that can now be obtained, for instance on emerging-country
equities, due to the economic recovery in Asia? This third argument (correlation of bond yields in
the United States and Europe with returns on other financial assets) seems the most reasonable in our view; it corresponds to a return of capital flows to emerging countries.

To see full report: SPECIAL REPORT