Wednesday, July 8, 2009

>Crude drifts below USD64/bbl on economy, demand

Singapore - Crude oil futures drifted below USD64 a barrel in Asia Tuesday, as the market continued to be plagued by economy and demand worries.

On the New York Mercantile Exchange, light, sweet crude futures for delivery in August traded at USD63.94 a barrel at 0654 GMT, down 11 cents in the Globex electronic session. August Brent crude on London's ICE Futures exchange fell 9 cents to USD63.96 a barrel.

There is "no news pushing it (oil) will probably drift or move lower," before the latest U.S. inventories data are out, said David Moore, a commodities strategist with Commonwealth Bank of Australia.

Analysts polled by Dow Jones Newswires said they expect the forthcoming Energy Information Administration data will show crude stockpiles likely fell by 1.9 million barrels last week, while gasoline stockpiles climbed by 800,000 barrels and distillates rose by 1.7 million barrels.

A series of bearish U.S. consumer and labor data recently released has renewed demand worries for oil products, pushing Nymex crude futures to close at $64.05 in the previous session, the lowest settlement since May 27.

The U.S. Labor Department said unemployment in June hit a 26-year high of 9.5%, which some analysts said may signal weak gasoline demand in summer. Fewer people in employment means less commuting and less money to spend on vacations and trips to stores.

"The momentum has really turned around...the market is trying to go back to fundamentals," said Christoffer Moltke-Leth, head of sales trading of Saxo Capital Markets.

Oil prices might move lower before finding some support around USD60 a barrel, he added.

Technical charts also suggest further falls to USD62.00 in coming days if prices stay below USD68.90. On oil's daily continuation chart, the technical picture is negative-biased as the slow stochastic and Moving Average Convergence/Divergence, or MACD, indicators are bearish.

Meanwhile, the five- and 15-day moving averages are falling, suggesting a downward move is under way.

Nymex reformulated gasoline blend stock for August, the benchmark contract, rose 11 points to 174.15 cents a gallon, while August heating oil traded at 163.00 cents, 34 points higher.

ICE gasoil for July changed hands at USD514.00 a metric ton, down USD3.25 from Monday's settlement.



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Power Merger Increases Probability of Our Bull Case

Quick Comment: The board of directors of Jaiprakash Hydro Power Ltd. (Jaiprakash’s listed power subsidiary) at its meeting on July 3, 2009, approved the amalgamation of Jaiprakash Power Ventures Ltd (JPVL) with Jaiprakash Hydro Power Ltd (JHPL), with effect from April 1, 2009. The board also authorized, subject to approval at the ensuing Annual General Meeting, the raising of up to Rs15 billion by way of QIP / FCCBs / ADRs / GDRs / Follow-on Public Offer (FPO).

Implications on Fund Raising: We have in the past pointed out that we believed that a funding gap of around Rs30 billion existed for Jaiprakash centered on the power business. The announced fund raising coupled with the securitization of the cash flows from the existing plants (Baspa II and Vishnu Prayag) would in our opinion cover these funding needs.

Implications on Jaiprakash Stock Price: In our opinion, this merger of Jaiprakash’s listed (JHPL) and unlisted (JPVL) power subsidiaries should result in significant value unlocking for Jaiprakash’s shareholders. Based on the merger ratio (issue of three shares of JHPL for one share of JPVL), Jaiprakash’s shareholding in the merged entity would be 76.3%. Using the last close of JHPL, that indicates a value of Rs126/share for Jaiprakash’s holding in the merged entity, close to the Rs143/share value we use in our bull case (Exhibit 3), in which we price the business of listed peers (Exhibit 2).

Remains Top Pick in our Coverage Universe: Over the next two to three years, we expect Jaiprakash to emerge as a top-5 player in India in each of its main businesses: cement, construction, power, and real estate. We believe the company has sustainable advantages in each of its businesses, and it remains the top pick in our coverage.



A new interest rate conundrum?
Sentiment on bond markets has turned in recent months. Since the lows at the end of 2008 bond yields have climbed up more than 100 basis points for 10-year US Treasuries and 50 basis points for German bonds. We are almost back to “pre- Lehman levels”. At first sight, this seems to be quite at odds with the real economy and inflation. After all, since the fall of 2008, the world economy has seen the steepest slide in production for decades and inflation has been declining rapidly. So why this strong rise in yields, unexpected by so many forecasters? Here are some
possible explanations:

Mean reversion? First of all, it is important to note that by all statistical standards interest rates had fallen to unusually low levels after Lehman. In December 2008 rates in the US had fallen about 250 basis points or three standard deviations (one percent of all cases) below their ten year average (Chart). The “flight to quality”had bloated the demand for government bonds and pushed up their prices. As risk aversion slowly faded, so did the demand for government bonds. Their yields may just be returning to normal. There is no natural downward trend of interest rates,
especially if central banks anchor inflation expectations around 2%.

Expectations matter. In the midst of the very weak economic environment, market participants slowly seem to be embracing the story of the green shoots signaling a recovery. In doing so, they are quite a bit ahead of very downbeat official forecasts like those from the IMF, the OECD or central banks. Also, inflationary expectations have edged up (to around 1.8% in the US) in recent weeks. This is partly due to the mutterings about the “inevitable” inflationary consequences of aggressive central bank liquidity generation and Keynesian fiscal stimulus packages. While it is true, as Paul Krugman rightly observes, that the banks are still sitting on their extra reserves and in effect sending the money right back to the Fed, it would be na├»ve to assume that the concern about higher medium-term inflation will just disappear in the near future. Inflation expectations are likely to persist, at least on a moderate level.

Flood of government bonds. Even without high inflation expectations, the rise in yields can be explained by heavy government borrowing on capital markets. So far, large issues have been absorbed quite easily, as government paper was the safe haven for investors worldwide. But there is much more in the pipeline and, with investors’ risk appetite slowly rising, government bonds are starting to look less attractive. Of course, risk aversion could suddenly return due to some kind of shock that ends the recovery. But even if it does, it will not be a permanent effect and it will not prevent a repricing of government bonds indefinitely. A counter-argument could be that prematurely rising bond yields could kill off the economic recovery and thereby trigger a self-correction towards low levels again. For two reasons, this does not seem very plausible. First of all, despite the recent rise, long-term bond yields are still at a very low level, even taking only moderate inflation expectations into account. Secondly, the yield curve is already fairly steep – with money market rates, e.g. the EURIBOR at around 1% and 10-year government bond yields at around 3.5%. Such a steep yield curve is quite typical for economic recovery phases and has proven to be quite a good forward-looking indicator signaling expansion.

The conclusion is quite clear. If nothing derails the recovery, longer-term interest rates will be going up in the coming months, maybe not in the very near future but over the next six or twelve months. This would be magnified by an early re-appearance of inflation, a scenario that does not seem very likely at present, but which cannot be ruled out completely. On the other hand, there is the somewhat higher risk that the recovery falters and the economies get ensnared by deflation. After all, in a still very fragile situation with excess capacity, further deleveraging needs and rising
unemployment, even small shocks could end the recovery and lead into a doubledip recession. Many things – even big ones – are conceivable: military conflicts, pandemics or renewed oil price shocks or banking crises. While these shocks are possible, they are in a certain sense unpredictable exogenous events – and therefore should not dominate a yield forecast.

To see full report: MARKET OUTLOOK


5-year Government Agenda vs. 1-year Market Expectations?

Budget was expected to translate new government upsides into policy — But the market's 6% drop yesterday reflects a possible mix of: a) Expectations (and stocks) running well ahead of reality, b) A real problem on the fiscal deficit, c) Questions on the government's will to address head-on market friendly issues – divestment, FDI, broad-based reform, and d) Some sector policy and tax pain. In sum, the build-up was belied.

The real pain is the fiscal deficit – scale, scope and implications — This had always been an overhang. However, the government now expects it to rise to 6.8% (5.5% in Feb 2009); there is no roadmap to pull it back; it is driven by slack revenues rather than physical asset investments; and fundamentally stresses have already strained finances. This risks crowding out investments, higher interest rates and currency pressure, which do not bode well for investments, economic
growth or the equity markets.

And disappointment in text and tone — Market buzz words – divestment, FDI, deregulation, policy initiatives and reform roadmaps – were conspicuously absent. This does not mean that they are off the table. There is scope for policy action outside the budget (and near term), but near-silence on possibly contentious issues suggests caution and is disappointing.

Real gain too – rationalisation, direction and a clear agenda — The budget does have a clear and distinct agenda (consistent with its manifesto): sustain growth (continues stimuli) and make it equitable; simplify, rationalise and lower taxes (GST introduction); increase social investments; generate inclusive growth; and provide fiscal flexibility at least in the short term. This is probably the right (though risky) way to go with the government's five-year agenda. The market’s horizon looks clearly shorter than the government's. Should it risk looking farther

Real economy should drive the market, stay defensive — We believe the Indian market will trade at a premium to its long-term average (15-16x 1yr fwd P/E) or 13500-14000 levels by December 2009. Sustainable growth provides downside support. Upsides lie in meaningful earnings (EPS growth should moderate 1-3% on budget) or macro upgrades, which we do not see in the near term. We would remain defensively positioned.

To see full report: INDIA BUDGET



Positive subscriber growth outlook; competitive intensity manageable
The pace of net additions is expected to remain strong, though the management acknowledged that multiple SIMs may be prevalent. Free minute schemes being offered by competition are not sustainable and BHARTI has not attempted to match such offers. Tariffs are already competitive and lowering them is no longer a differentiator to attract customers. However, BHARTI continues to closely monitor new innovative tariff schemes and may evaluate the same based on customer uptake.

Rural expansion not margin dilutive so far; profitability sustainable
Rural expansion has not been margin dilutive so far. While network costs are higher in rural areas, rural channels (marketing & distribution costs, dealer commissions) are not expensive. This has helped in keeping costs low and maintaining margins. Management is confident of maintaining operating margins through continued focus on managing costs.

3G: Entry price is key
Management does not expect the incremental capex for 3G to be substantial, given that it will be an overlay on the existing 2G infrastructure. We understand, the auction price will, therefore, be the key to determining returns. 3G rollout is expected to be phased; metro/tier 1 locations are likely to be the initial potential markets for 3G.

MNP impact: expected to be neutral to marginally positive
Introduction of MNP is expected to be neutral to marginally positive; management is confident of maintaining/improving market share post-MNP. Post-paid customer retention will be key (~6% of subscriber base generating ~20% of revenues). Impact of MNP may not be as significant for the prepaid segment given the existing low switching costs and already high churn rate in this segment.

Outlook and valuations: Healthy earnings growth; maintain ‘BUY’
BHARTI remains our top pick in the Indian telecom space. The company’s healthy earnings growth (at ~14% CAGR in FY10-11E), strong return ratios and robust balance sheet support our positive outlook on the stock. Regulatory changes on spectrum allocation/charges remain a key concern. At INR 818, the stock is trading at an EV/EBITDA of 9.5x FY10E and 8.2x FY11E, and P/E of 15.6x FY10E and 14.1x FY11E. We maintain our ‘BUY’ recommendation on the stock.

To see full report: BHARTI AIRTEL


A black hole: It goes without saying that an investor would do well to steer clear of a bad business. A business that sacrifices profitability for growth, over leverages its balance sheet for making acquisitions, whose customers are constantly complaining about product quality, comes within striking distance of breaching its debt covenants and has an extremely volatile record of earnings. All characteristics that have become closely associated with Suzlon, the wind turbine major that until recently seemed to be growing at an astonishing rate.

We last recommended the stock in November 2006, when the company held a lot of promise by virtue of its good track record prior to that and the fact that it was present in a sunrise industry with great potential for growth. And we have been maintaining caution after the stock hit our target price subsequently. Now, a series of decisions made by its management has completely ruined not only the company’s business reputation and its balance sheet, but also out faith in the management's competencies and intentions.

It has now left us with a situation where many of the factors surrounding the company, as discussed in more detail though the rest of the report, make it an extremely tough and unreliable job to project any kind of earnings going forward. A big lack of clarity on what decisions the management will take going forward makes it even more difficult to estimate its performance. And its past track record on this front makes us only further queasy to say the least. As such, while the stock might appear cheap on some valuation standards, we do not see Suzlon being a part of any long term investors’ core portfolio. Thereby, we recommend a ‘Sell’ on the same.

Embroiled in several controversies: The past few years has seen Suzlon getting embroiled in a number of controversies relating to the performance and quality of its wind turbines. In India, Essel Mining, a Birla company, filed a lawsuit on the company seeking damages over technical problems experienced by the wind mills set up by it for the company. They are presently trying to settle out of court. Essel is seeking damages over under performance of the wind mill set up by Suzlon in Maharashtra.

In the US too, the company has faced a number of problems when the blades of wind turbines supplied by it developed cracks. This led to the company announcing a recall and retrofit program that is still in not completed. Further, other problems relating to the equipment not producing enough power to meet Suzlon’s sales contracts, and delays in providing technical support and service have kept cropping up for the company. All this has led to the company making a lot of unexpected provisions and heft extraordinary costs, bring in major instability and volatility as far as its earnings are concerned. To the extent that Suzlon, in one of our meetings with the company, had clearly indicated that all such charges and provisions have been made in FY08 itself, and there would be no impact on its FY09 numbers. That did not turn out to be the case, and the problems on this front continue to haunt the company

Sacrificing stability and profitability for growth: In a bid to grow aggressively, Suzlon has made two large acquisitions in the past few years. The first one was Hansen Transmission, a Belgium based gearbox manufacturing company. And the second was Repower Systems, a Germany based WTG maker who is mainly into the assembly of large capacity wind turbines.

Over reliance on regulatory climate: Apart from the inherent potential, one of the major factors aiding the growth of wind power industry in India and globally is the legislations and government policies that support the expansion of renewable energy sources like wind power. Support for investments in this sector is typically provided through fiscal incentive schemes or public grants to the owners of wind power systems. An example of incentives is preferential tariffs and tax breaks on power generated through the use of wind.

Globally, one of the best examples of such incentives is the Production Tax Credit (PTC), which is extended to wind power producers in the US. As per the PTC, wind power generators are granted tax credit at a base rate of 1.5 cents (US$ 0.015) per unit (kWh, of kilowatt hour) of electricity produced. Such has been the effect of the PTC scheme in the US that the country has witnessed a boom and bust cycle in the wind power sector in line with the extension and expiry of the scheme.

To see full report: SUZLON ENERGY


Better outlook for Novelis; standalone disappoints

Indian operations hit, Novelis surprises. Standalone operating profit for 4Q, at Rs3.14bn, was 60% lower q-o-q. Novelis results were much better with improved outlook going forward, and we thus raise FY10 estimates. We also raise target price to Rs73.

Novelis surprises positively. At US$1.94bn, Novelis’ 4QFY09 sales were slightly below our estimate. Novelis surprised positively on operating profit, which came at US$74m.

Margin squeeze in standalone business. The standalone operating margin was squeezed to 8.3% vs our expected around 11%, mainly due to lower by-product realizations. This is evident in sharply higher raw material costs, which were up 68% qoq.

Capacity expansions on track. Hindalco is going ahead with its greenfield and brownfield expansions, which would triple its smelting and refining capacities. The benefits of these projects, however, are expected to fully show from FY13 on.

Estimates raised. We raise FY10e revenues 17%, EBITDA 10% and PAT 35%. This is consequent on the good figures by Novelis and encouraging “guidance”.

Valuation. We raise our target price to Rs73 (earlier Rs68). Novelis EV/EBITDA multiple is raised to 5x (earlier 4x) while keeping standalone operations’ multiple unchanged. To see full report: HINDALCO.

To see full report: HINDALCO


Auto fuel price hikes: a bold step
The government increased auto fuel prices by 6-10%. While this is a bold step, such an ad-hoc increase also signals that pricing deregulation is unlikely near term. Higher prices translate into lower subsidies for ONGC; we upgrade EPS by 12-20%. The impact for the R&Ms would depend on the subsidy sharing equation; the upcoming budget could provide clarity. HPCL is the best relative pick; we maintain Upfs on ONGC, IOC and BPCL. We rate Cairn India a BUY where we expect a re-rating beyond DCF fair values as earnings multiples come into focus as production starts.

Auto fuel prices hiked by 6-10%

The price hike of Rs4/liter for petrol (10%), Rs2/liter for diesel (6%) will reduce overall retail under-recoveries in FY10 by Rs131bn (23%) to Rs450bn.

All R&Ms should gain but BPCL’s larger share of auto fuels means it will gain a disproportionate share (Rs34bn) as compared to HPCL (29bn) and IOC (Rs68bn).

While the breakeven for overall gross under-recoveries has now risen to $54/bbl Brent from $50/bbl, this is still lower than current prices and the R&Ms continue to lose money on all four fuels (Rs3.5/liter on petrol, Re1/liter on diesel).

A bold step but also mixed signals

The 6-10% price hike at this juncture took us by surprise, we had expected a decision after the key Maharashtra state elections were over (expected in Oct-09)

It is a bold step indicating that the government is willing to tackle higher oil prices.

The ad-hoc nature of the increase, however, also signals that pricing deregulation (including any price band formula) is unlikely near term. This could disappoint.

The subsidy sharing equation is uncertain

The earnings impact for the companies depends on the subsidy sharing equation.

We understand that the Ministry of Petroleum wishes to have direct budgetary support (or oil
bonds) for all cooking fuel under-recoveries (Rs307bn for FY10)
while residual auto fuel losses (Rs142bn) would be shared among the companies.

This could reduce earnings pressures significantly for all companies (including Gail) but the
contours remain uncertain; the upcoming budget could provide clarity.

In the interim, we keep our framework unchanged (one-third share for upstream, Rs100bn in aggregate share for R&Ms, residual losses via oil bonds).

We keep earnings estimates for IOC, BPCL and HPCL unchanged. We also keep estimates for Gail intact; it only shares cooking fuel under-recoveries.

Upgrading ONGC EPS by 12-20%, maintain U-PF

Lower under-recoveries (Rs131bn) imply lower subsidies for ONGC (-Rs39bn to Rs123bn) and higher net realisations (+$4.9/bbl to $50) leading to a 12% (Rs11) EPS upgrade for FY10. We upgrade FY11-12CL EPS by 18-20% (full year impact).

On our upgraded estimates (~Rs99-104/sh), ONGC trades at par with global peers on earnings based valuation multiples but we continue to see fundamental challenges ahead (higher costs, struggling production, falling return ratios).

Our upgraded target price (Rs950/sh) indicates 10% downside. Maintain U-PF. Crude prices remain the dominant variable

Crude prices remain the dominant variable for the R&Ms.
In this context, we continue to view them as crude-price and not deregulation plays and see earnings risks returning as crude rises. We forecast US$80/bbl long term Brent.

For example, every $10/bbl rise in crude increases gross under-recoveries by US$7.3bn – this is 1.25x the aggregate core FY10 Ebitda of the R&Ms (US$5.8bn).

Further, weak refining margins (Singapore Complex trading $3.9/bbl over the last four months) are an additional headwind with ever $ impacting EPS by 24-42%.

We maintain U-PF recs on IOC and BPCL. Investors who do not concur with our views on (rising) crude or the policy direction could choose HPCL given its lower valuations (0.8x PB) and higher upside in a low crude and deregulation scenario.

Cairn India is the only BUY rated stock in our coverage; we expect a re-rating beyond DCF fair values as earnings multiples come into focus as production starts. To see full report: INDIA OIL & GAS.

To see full report: INDIA OIL & GAS


Roads sector – Walking the talk

Activity in the road sector is gathering momentum after a 2-year lull. National Highway Authority of India (NHAI) has stepped up project awards under the new government. NHAI has opened tenders on six projects of 644km worth Rs69bn (US$1.4bn) awarded in the last 30 days.

Project awarding at full speed by the new government: After lacklustre activity over the last two years due to unfavourable policies and an economic slowdown, NHAI has shifted gears with a new minister in charge.

⇒ Six projects worth Rs69bn decided in last 30 days: In contrast to only nine project awards in FY09 vs a target of 56 projects, six projects have already been decided on in last 30 days. The actual award of the projects is now a formality. Four of these were bagged by IRB Infra – one each by the GMR-Punj Lloyd consortium and HCC-Laing-Sadbhav consortium.

⇒ Pipeline of road projects is very healthy: There are another 41 projects worth Rs410bn (US$8.5bn) at various stages of bidding, just waiting to be awarded. On top of this, there are another 9,000km of road projects where ground work has been done and they are awaiting project bidding.

Government moving to improve viability of projects: In order to revive developer interest and speed up project awards, several measures have been introduced and some are more likely to be taken up (refer to page 2 for details). ⇒ Plan to set up separate finance vehicle for highways
⇒ Project to be put up for bid on annuity basis directly if not viable on toll basis
⇒ Estimated project costs increased
⇒ Increase in Viability Gap Funding (VGF) and payment norms
⇒ Concession period increased for several projects
⇒ Beneficial land acquisition norms

Developers to benefit with better returns on the projects: Developers will gain as the competitive intensity for taking BOT projects has eased. Our channel checks suggest that new projects are being taken at an 18–20% equity IRR with conservative assumptions vs 14–16% IRRs last time around.

Construction contractors to gain, with a lag: Construction companies will gain, with a lag, as these projects will take around six months for financial closure before construction can start on the projects.

Road activity to also have a multiplier effect: Road projects worth US$10bn will directly benefit industries like steel, cement and construction equipment, while also generating large-scale employment opportunities.

To see full report: ROADS SECTOR


No light (yet) at the end of the tunnel

The monthly life insurance sales numbers for May, released by IRDA, show industry sales continuing to contract YoY.

Sales continue to contract. Sales for all major players continue to contract on a year-on-year basis. Private player new business sales declined 29% YoY for May versus -26% YoY for April and -16% YoY for March. A small positive was the strong MoM growth of 52%, but this could have been partly seasonal in nature given that May is a longer month and April has traditionally been weak.

Overall industry sales declined by -10% YoY for May compared to 14% YoY for April and -11% YoY for March. This was primarily due to the strong performance of state owned Life insurance Corporation (LIC, unlisted), which grew 17% YoY in the month (see Figure 7 on page 3 for more details in report).

Major players continue to see stress. Sales for ICICI Prudential declined 58% YoY in May. However, month-on-month there was a sharp fluctuation, with growth of 107% MoM in May, up from an 83% MoM drop in April. The latter is typically a lean month for the company with the annual sales reorganisation taking place, and so May could be called a more ‘normal’ month in that context.

Reliance Capital clocked negative sales for the second consecutive month, down 13% YoY (-11% YoY in April, 41% YoY in March). One of the reasons for the sluggish past two months was some internal restructuring at the firm, which is now over. Management continues to maintain its goal to outgrow the private sector market by a factor of 2−2.5x while continuing to focus on profitability. It also believes that the industry should return to positive growth by end of FY3/10E.

Average ticket size up MoM but trend is downwards. Average ticket size was up on a MoM basis for both the private players and the LIC. Ticket size has, however, been trending down for the private players, and is down ~20% from a year ago. The ticket size for LIC is half that of the private players (even after the decline) and has remained more or less stable (+3% YoY).


While the revival of the capital markets is good news for the insurers, its impact on insurance sales, we believe, would be felt only deeper into the cycle. Hence we expect sales growth to be more back-ended and pick up only in the second half of FY3/10E. At this stage, the buoyancy in the capital markets should benefit the brokers and asset managers more. However, the recent SEBI directive abolishing front-end loads on MF schemes could see third-party distributors concentrating more on insurance products, thus speeding up the revival. The best play on insurance remains Reliance Capital.

To see full report: INDIA INSURANCE