Sunday, October 25, 2009


Mid-Cycle Valuations – Finding the “Value” in Global Cyclicals
Mid-Cycle Earnings: What Looks Cheap and Where

• The rally in global equity markets has seen the Global cyclical sectors (Discretionary, Industrials, Materials and Information Technology) rise 77% from the low set on March 9th, outperforming Global defensive sectors by 40%. The rally has been largely driven by multiple expansion, with the forward P/E of the MSCI World index up 40% for the cyclical sectors, in comparison to forecast earnings which are up 13% over the same period.

• We think the multiple expansion phase of the cycle is now largely over (see our report titled “Global Equity Strategy: A Rally, But One to Sell Into”). Consequently, our focus is now on how quickly earnings can ramp up to support further price performance and how stocks are priced on a return to more trend-like earnings. This is particularly important for Materials, Industrials and Consumer Discretionary, where arguably year-ahead earnings are likely to be below trend. Technology is different: current consensus forecasts expect the IT sector to reach a new earnings peak in 2010.

• We create estimates of trend earnings for the major regions: the US, Europe, Asia ex-Japan, and Japan. (This is based on work by Toby Walker, our Australian Equity Strategist. See his note “Who Continues to Look Cheap on Mid-cycle Value”, dated October 1, 2009). Based on the past four cycles (73-75, 80-83, 90-91, 00-02), earnings take an average of two years to recover to mid-cycle levels (see page 10). Consensus expects this cycle to be different. In the current cycle, consensus expects earnings to trough in 2009 and get back to the 2007 cycle peak in 2010. We believe this is highly optimistic, and history supports this view. Our base case calls for earnings to bottom in 2009, with a return to mid-cycle ROE’s by 2011.

• Our analysis suggests that Japanese cyclicals are trading at the largest discount to mid-cycle earnings, followed by Europe. The cyclical sectors in the US are the least attractive at only 9.4% below their trend earnings valuation despite having to wait until 2011/12 before reaching this earnings level.

• Among the sectors, Industrials and Materials are most attractive in Japan, Consumer Discretionary is most attractive in Asia Pacific ex-Japan, and Technology is the best value in
Europe. None of the US cyclical sectors show strongly on a trend earnings valuation basis, which fits with the relative performance of US over rest-of-world cyclicals since markets bottomed in early March.

To see the full report: GLOBAL STRATEGY



Identifying the leak

  • The shadow banking system
  • Bank sector leveraging
  • Corporate & consumer leveraging
  • Global regulatory mismatch
  • Liquidity risk
  • Global imbalances
Repairing the pipes
  • Supply and demand for credit
  • Bankers’ compensation
  • Liquidity constraints
  • More stable, but much less liquidity
  • Bank losses
Ready for a new shower?
  • The ‘new normal’
  • Where do bubbles form?
  • Where will the money go?
  • Is there a bubble yet?
To see all graphs and report: FINANCIAL SYSTEM

>Higher the rise, harder the fall (ICICI SECURITIES)

Based on the performance of BSE-100 stocks in the past five rallies and subsequent significant corrections (since May 1999), we conclude that a considerable proportion of stocks that lead a rally decline the most in the subsequent correction. However, the laggards of the rally are less likely to be the best performers in the subsequent correction. Since March ’09, the Sensex has doubled; in the past two months, it has become increasingly difficult to justify the rally on fundamentals and valuations. For the rally to continue or even the markets to sustain at current levels, we believe that Q2FY10 results need to be considerably higher than expectations and FY10/FY11 earnings revisions significantly positive. This report assumes relevance if this does not happen.

Conclusions. On an average, 46% of the rally leaders are the top underperformers in the subsequent correction. In two of the five time-periods considered, 60% of the leaders have given up their gains the most in the correction. The conclusion is less compelling for the laggards of a rally. On an average, less than one in three laggards feature among the top performers during the correction phase and in two of the five time-periods, the number was less than one in four.

Methodology. We have considered five time-periods since 1999, when the Sensex rallied at least 50% and subsequently corrected at least 15%. We have taken the BSE-100 constituents (at that particular time period) as our universe and define the top-25 performing stocks among them as ‘leaders’ and the worst 25 performers as ‘laggards’.

Top-25 leaders and laggards in the recent market rally
Current Bull Run from March 12, ’09 to October 15, ’09

To see the full report: MARKET STRATEGY

>India: risk of aggressive tightening (DBS)

Despite the recent surge in manufacturing sector growth, our assessment of India’s growth prospects remain largely unchanged. We continue to expect GDP growth of 5.7% in FY09 (ending Mar10) and 7.5% in FY10. Yet we believe price data, including food price data, betray a buildup in underlying inflationary pressure that is non-transient. We also believe the Reserve Bank of India (RBI) will not regard such pressures as transitory food price or supply-side blips. As a result, we continue to expect the first rate hike in Jan10, well ahead of consensus’ expectations. Moreover, we see rising upside risks to our forecast for 200bps of rate hikes in 2010.

At the quarterly policy meeting next Tuesday, we expect the prevailing hawkish tone to be raised another notch and expect clearer signals that rate hikes are imminent. To be sure, the central bank’s indicative inflation projection for Mar10 would have to be raised from the current 5% YoY rate to be credible (we expect inflation to cross 6% by Mar10). The forecast change itself would be a signal that rate action is imminent implying, as it would, inflation in excess of the RBI’s comfort level of 5%. Furthermore, the statutory liquidity ratio (SLR, the minimum share of bank deposits to be held in government bonds, cash, gold etc.) could be hiked as early as next week. We do not rule out a 1 percentage point hike in the SLR rate to 25% reversing the 1 point cut implemented in Nov08 (the rate had been held at 25% for 11 years before last year’s cut). Such a move could also point to imminent rate action.

Recent growth momentum - picking up, but, in part temporary
Industrial production recorded a double-digit rise in year-on-year terms in Aug09 (10.4%), drawing attention to the economy’s surprisingly strong growth momentum. To be sure, manufacturing sector growth is stronger than what was anticipated at the start of the year but this is already factored into our current GDP forecasts. Also, our reading of the current growth spurt is that it is in part temporary and a result of pent-up demand (steep rate hikes followed by the global financial crisis dragged down consumption), and that growth should moderate soon. This is also evident in the graph of industrial production levels (graph, previous page). Manufacturing sector GDP grew by 22% (QoQ, saar) in 2Q09 and we estimate 3Q09 manufacturing growth at 12%. We expect manufacturing growth to slow to around 7% in the quarters ahead. The expected slowdown is already evident in the monthly data for consumer durable goods (graph, previous page).

This correction should keep GDP growth in line with our 5.7% forecast for FY09 and 7.5% FY10 (the non-agriculture GDP growth forecast underlying this GDP forecast is about 7.2% and 7.9% respectively). Even though we do not foresee growth quickly returning to the 9% rate that prevailed in recent years, for purposes of monetary policy and inflation forecasting, it should be noted that the slower pick up in growth is in part due to supply constraints, especially in infrastructure and hence cannot be deemed as materially below-potential. Indeed, the RBI acknowledges that the economy is supply-constrained.

Rising inflation - is it supply-side?
Wholesale price (WPI) inflation has begun climbing rapidly in year-on-year terms in recent weeks and is also leading to worries about earlier rate hikes. In fact, prices have been rising rapidly since March. The month-on-month seasonally adjusted and annualized growth rate (MoM, saar) has been running at an average rate of 7.5% since Mar09 and it is now reflected in higher on-year rates. The latter has begun to climb since August and has printed 0.9% (YoY) as on Oct 3, from a low of -1.5%, hit on Aug 8. According to our calculations, WPI inflation should cross RBI tolerance level of 5% (YoY) by Dec09 and cross 6% by Mar10 (graphs, below). While on-year inflation might decline after Mar10, it should remain elevated at about 5%, with risks to the upside. At the same time, consumer price (CPI) inflation, which has been elevated since 2008, accelerated in recent months. In Aug09, CPI inflation recorded double-digit gains in both on-year and sequential annualized terms. In fact, CPI has exhibited a rising trend each year since 2006, driven especially by rising food prices.

As always, the question is whether inflation is supply-side and/or temporary in nature or whether it reflects persistent excess demand pressures. On the surface, there are reasons to believe that inflation is not demand-led. After all, growth is not at the scorching 8-9% rate now and food prices are one of the key drivers of inflation, at present. However, our reading of the price situation is that underlying inflationary pressures are building up and warrant early rate action. We believe that the underlying rate or core rate of inflation is around 5% already and risks rising further, especially in 2H 2010, as growth picks up further. In fact, there is a rising risk that 150bps of rate hikes in 1H09 is insufficient to cap inflation and further rate increases are needed in 2H10, beyond the 50bps we have pencilled in for 2H10. It is, therefore, important for interest rates to keep pace with growth and rising inflation risks, and hence vital that the RBI starts normalizing rates from Jan 2010.

Proxies of underlying or core inflation
Two simple proxies of the underlying or core rate of inflation are WPI exprimary articles and fuel (i.e.: manufacturing WPI) and CPI ex-food and fuel. CPI inflation has generally been viewed as the less preferred measure of the two by the government and the central bank. This partly owes to the lack of a single national measure of consumer prices and the narrower basket of goods in the latter. Both WPI and CPI measures of core inflation point to material underlying inflationary pressure. Core WPI has averaged 6% (MoM, saar) in Mar-Sep09 while core CPI (for industrial workers) has averaged 5.5% (MoM, saar) in Mar-Jun09 (latest available data). In year-on-year terms, core CPI is rising beyond 6% while core WPI is still depressed due to basis effects (graphs, below). The interpretations from these data though are only as good as the data themselves. CPI excluding food and fuel has the disadvantage of excluding nearly half of the consumption basket. WPI manufacturing, on the other hand, is influenced by commodity prices. For this reason, the government does not announce any official measure of core inflation, and the central bank considers WPI manufacturing as merely a proxy of core (and doesn’t discuss core CPI).



We raise our FY10E & FY11E EPS estimates for Sesa Goa 5% & 23%, accounting for: i) 2% & 13% increase respectively in iron-ore realisations, ii) increased royalty at 10% ad valorem, iii) lower railway freight (reduction of US$10/te since June), iv) lowered depreciation estimates owing to lower-than-expected rate followed by the company for newly acquired Dempo, and v) dilution on account of the recent FCCB issuance. Increased newsflow on steel-capacity rationing in China in a backdrop of domestic overcapacity weakens short-term price outlook for iron ore. Triggered by expectations of inorganic acquisitions, the stock trades at ~14% discount to global FY11E EV/EBITDA (historical high) leaving little headroom for upside. Downgrade to HOLD with revised target price of Rs 299/share (FY11E EV/EBITDA of 6.4x). Sesa Goa reported lower-than-expected Q2FY10 results with 51% YoY and 61% QoQ PAT dip to Rs1.7bn. While volumes grew 16% YoY to 1.61mnte, realisations disappointed yet again, at US$50.8/te (I-Sec: US$53.6/te). Lower-than-expected topline and operating income for the company’s metcoke division led to reported earnings being 22% below our estimates.

Iron ore disappoints for consecutive quarter. Q2FY10 blended realisations at
US$50.8/te surprised negatively as majority of the volume is shipped from high quality mines at Karnataka and Orissa during Q2 (seasonal). Also, for the first two months of Q2FY10, the Indian iron-ore export market share in China touched multiyear lows (at 11%) on account of the increased demand being met by Australia and Brazil, who utilised the spot market to their advantage. This led to subdued volume growth (16% YoY, including Dempo) despite delayed monsoons and strong July imports from China. Based on current 63.5Fe Indian ore at US$90/te, we marginally raise our FY10E realisation estimates 2%.

Metcoke ─ Major drag in Q2FY10. Sesa registered Rs32mn PBIT losses in its metcoke business. Subdued performance in metcoke division helped boost operating profit for the pig iron division, with PBIT margin of 28%. The company has undertaken capex of US$125mn to increase pig iron (and commensurately metcoke) capacity to 0.625mnte by Q2FY12.

Stretched valuations. Tax rate increased to 23% versus 17% QoQ, as no perceptible benefits flowed-in despite the company being granted EoU status in Karnataka and Amona (pig-iron plant). Sesa’s cash-on-books stands at ~Rs30bn. Short-term risks include inorganic acquisition (on the upside). With the imposition of 10% ad valorem royalty, we revise upward our FY11E target EV/EBITDA to 6.4x from 5x. Downgrade to HOLD with revised target price of Rs299/share.

To see the full report: SESA GOA



1 Financial markets after the crisis
2 Regulatory changes
3Global economy: Status quo
4 Global economy: Outlook by region
5 Exit strategies and inflation risks
6 Effects on long-term growth

To see the full report: ECONOMIC OUTLOOK