Sunday, November 1, 2009


Corporate Valuations Shifting to Growth
In the aftermath of the Lehman bankruptcy last September, firms around the world embarked on drastic steps to preserve liquidity. Companies undertook deep cuts in capex and operating expenditures, a near halt of share buyback programs and the fastest increase in dividend cuts in fifty years. During this period of extreme volatility in capital markets and uncertainty in the global economy, investors rewarded firms that demonstrated strong financial flexibility — valuations of companies with higher on-balance sheet liquidity than their industry peers outperformed those with below-industry liquidity by 15.7% (Figure 1). Similarly, firms with a stronger ability to fund capex with internal cash flow and less risk of refinancing outstanding liabilities compared to industry peers also outperformed. Thus, enhancing corporate liquidity and preserving financial flexibility was the optimal financial strategy for most firms.

With prospects for the global economy stabilizing and a sharp resurgence in capital markets, extreme risk aversion is abating. As a consequence, there are signs of increased investor risk appetite and growth has returned as a key driver of equity valuation. Figure 1 shows a decomposition of P/E multiples for non-financial companies that belong to the MSCI Global Index (as of December 2005). It displays the PE multiple as the sum of two parts — the base component that reflects the value of the existing earnings stream, and a growth component that captures the value of the expected future earnings growth. Prior to the crisis, MSCI constituent companies typically derived two-thirds of their value from their current earnings stream and one-third from expected growth prospects. Since October 2008 and continuing into the spring of 2009, the expected value of growth essentially disappeared as investors focused primarily on survival. As valuations and market confidence have rebounded over the past few months, the importance of growth has returned sharply. In fact, given the relatively low current earnings of many companies, the growth premium is a bigger component of the P/E multiple than ever before, accounting for 40% of overall value. These valuation dynamics imply that it is now time to adjust corporate financial strategies to focus on future growth once liquidity and balance sheet risks have been addressed.

Widening Gap Between Strong and Weak
The past year has been challenging for companies across all industries and geographies and the economic and financial stabilization is welcome news universally. But the past year has had a very asymmetric impact on firms – in most sectors the gap between strong and weak players has widened considerably. This in turn is creating strategic opportunities for industry leaders.

To illustrate this widening gap, we analyzed the financial metrics of companies in the MSCI Global Index on an industry-adjusted basis. For each industry, we calculated the 25th percentile, median, and 75th percentile of various financial metrics. These numbers were then aggregated across industries to reflect economy-wide patterns

Capital Deployment Lessons From Past Cycles
As companies begin to re-focus on growth strategies, they will have to carefully allocate financial resources in a way that capitalizes on strategic opportunities created by the crisis without undermining their financial flexibility. Clearly, a large part of this question will be company and industry specific. Yet a review of capital allocation decisions over the past few cycles provides interesting insights for today’s decision, even if the optimal path to earnings growth will look very different today compared to the past.

Consider how US companies have pursued capital deployment over the past two decades. For much of the 1990’s and through 2004, US companies deployed about twice as much of their cash flow towards capex and M&A as they did for capital distribution (Figure 5). After 2005, however, US companies spent as much on dividends and share buybacks as they did on capex and M&A. As a result, US companies have spent a lower fraction of their cash flows on investing in growing the business in the past 5 years than at any other point in the last 20 years. The increase in share buybacks has been particularly pronounced for large firms — between 2003 and 2008, share buybacks accounted for one-third of EPS growth for the largest 100 US firms.

European and Asian firms followed a somewhat similar investment pattern although they deployed more capital towards capex and M&A than for capital distributions compared to their US peers (Figure 7). Since European and Asian firms generally do not report quarterly results, any pullback in capital deployment would only be apparent once full year 2009 financials are released next year.

Implications for Corporate Finance Strategy
The current economic and capital markets environment suggests that it is time to reconsider many of the financial policies that companies across the globe have adopted over the last twelve months. As economic indicators have improved and capital market conditions have resumed normalcy, strategies centered on preserving or improving liquidity may no longer be optimal for some companies. At the same time, it would be premature to dismiss the possibility of downside economic risks. Hence, companies need to balance the investor focus on growth with the prudence of maintaining a strong financial flexibility and profile.

To read the full report: FINANCIAL STRATEGY


Our marketing trip suggested many investors remain bears
…but have been buying against their better judgement
That probably explains the sharp sell-off in the past few days

Since our Quarterly was published on October 6, we have been around Asia and Europe exchanging views with clients. In three weeks, we have seen almost 70 institutions in six countries (and next week we will be in the US). The mood among investors varies greatly from one location to another. We found most CIOs in London shared our view that the current environment is positive for equities, with growth likely to surprise on the upside but interest rates to remain low. In Hong Kong and Singapore, views were split 50:50 between those who agreed with us and those who believe the global economy will double dip. But in much of Europe – particularly Switzerland, Scotland and Paris – we found deep bearishness and focus on the structural problems in the world economy. But even the bears recognised the strength of the recent momentum and have become reluctant buyers.

That goes a long way to explain the sell-off of the past few days. After global equities rose 70% in six months (and emerging equities 106%), as shown in Chart 1, many fund managers who had bought into equities against their better instincts were itching to find an excuse to take profits. A few weaker data points in the US, the first stirrings of central bank tightening and the end of the Q3 earnings season were enough to give them that.

We are happy to stick with our view that the upgrade cycle is likely to continue. Even after the much better than expected earnings season, analysts’ expectations for next year remain too cautious. Valuations are not stretched (see Chart 2). Cash levels are still high, and retail investors continue to buy bonds rather than equities. The easiest part of the rally is over, but we still see upside over the next six to nine months.

To read the full report: EQUITY INSIGHTS

>INDIAN BANKS : RBI’s 2Q policy – provisioning shock? not really

By far the biggest surprise of the RBI’s 2Q policy was the 70% NPL coverage requirement by Sep-2010; we do not believe it is all that negative – the devil is in the detail

While rates and CRR were left untouched, RBI’s tone was clearly hawkish; we expect rate hikes next year

Other measures are marginally negative – higher provisioning on real estate loans, CRR on CBLO

The eye-catcher: RBI’s credit policy announced the 70% provisioning coverage required on NPLs (non-performing loans) to be met by Sep-2010. As a consequence, bank stocks fell up to 8% post announcement given the potentially large impact on earnings and book values (see Table 1). While the measure is clearly aimed at prudency, given the risk of rising NPLs as well as potential slippages in banks’ restructured portfolios, it came as a negative surprise to the banks as well as to the market. Subsequently, at an IBA-sponsored press meeting, bank chiefs suggested that in the coming days the RBI may throw more light on the mechanics of implementation as well as possibly extending the implementation period (e.g. to Sep-2011).

What’s our take? we believe that the RBI is likely to issue clarifications shortly allowing provisions made on technically written-off loans to be included in the computation of the 70% coverage ratio (ie. those NPLs which have been fully provided for but continue to be monitored by the banks – a.k.a. ‘technical write-offs’ – as opposed to written off NPLs that have been abandoned). If this is the case, most banks are adequately protected as their coverage ratios would be at or above 70% based on our estimates of written off assets (see Table 2)

Scenario analysis: however, the question is really whether this buffer is adequate to absorb further slippages, particularly on the restructured loan book. On running a simulation of the resultant shortfall, (assuming 70% coverage required on 50% of the restructured portfolio assumed to turn into NPLs), the impact varies between 1% and 11% of FY11e book value (see Table 3)

Conclusion: RBI has clearly turned to a hawkish stance on monetary policy and we are almost certainly likely to see policy rates and the CRR (cash reserve ratio) going up next calendar year. While the RBI has turned cautious on asset quality, we believe this caution is a little overdone given the expected economic recovery starting next year.

To read the full report: INDIAN BANKS


What surprised us: Reliance Industries (RIL) reported 2QFY10 PAT of Rs38.5bn, down 6% yoy, in line with our expectation of Rs.38.6bn and Bloomberg consensus of Rs38.1bn. RIL’s EBITDA at Rs72.2bn, up 11% yoy, came in above our estimate of Rs65bn, as higher-than-expected recouped costs from D-6 (based on 1P reserves) depressed net profit. RIL’s 2Q cash profit was up 12.5% yoy. While refining margin at US$6/bbl came below our estimate of US$6.3/bbl, owing to stabilization losses in new refinery, petchem did better than expected. We note that RIL’s earnings appear to have bottomed out in 1Q and are likely to show strong growth going forward from stabilization/ramp-up of the new projects.

With refining cycle passing through trough, D-6 gas ramp-up on track and a likely petchem trough in FY11E, we see multiple growth drivers in the medium term for RIL. Moreover, we believe RIL has the room to pursue inorganic growth in its businesses, as we see no major projects lined up to consume more than US$20bn of excess cash flow for FY11E-14E after its committed capex. In addition to scope for future reserve accretion in E&P, we find that RIL’s refining valuations do not reflect the trough and its petchem segment is also at a discount to the regional multiples.

In line with expectations: Low GRM, high recouped costs surprise

What to do with the stock: We reiterate our Buy on RIL (on Conviction list) and SOTP-based 12-m TP of Rs2,620, implying upside of 31%. Key risks: 1) Delay in D-6 ramp-up; 2) court case overhang; 3) petchem weakness; 4) lack of exploration success.

To read the full report: RIL


Revenue disappoints: EMCO reported revenue de-growth of 12.7% YoY to Rs2bn, out of which 68% sales was from transformers, 28% from projects and 4% from meters. The management has reduced its revenue guidance to 10% growth for FY10. EBITDA margin decreased only by 38bps to 12.9% despite employees growing by 41% to Rs149m (due to an interim bonus of Rs40m given to employees because of the Emco Energy sale). Adjusting for the bonus, EBITDA margin has actually increased by 159bps to 14.9%. This was ahead of our expectation and was due to lower raw material cost.

PAT for the quarter de-grew by 17% to Rs94m. The company realised Rs985m (net
of taxes of Rs288m) as profit from the EMCO energy sale which was recorded below the line as an extra-ordinary item.

EMCO Energy sold for ~Rs1.7bn: EMCO had sold off its fully owned subsidiary, EMCO Energy, for Rs1.7bn to GMR Energy. EMCO had spent Rs430m on this power generation venture and had already obtained several approvals as well as coal linkage for 300MW and expandable to 600MW. The cash from this sale has been partly used to retire debt and partly for working capital, which will in turn help keep a check on interest cost, going forward.

Order inflow improves: EMCO’s order book grew by 23% YoY to Rs16bn, out of which 34% is towards transformers, 64% towards projects and 2% towards meters. The order inflow during the quarter stood at Rs3bn (growth of 43% YoY), the management expects the order inflow to continue at a brisk pace in H2FY10.

Valuation: At CMP of Rs92, the stock currently trades at 10.4x FY10E and 8.8x FY11E earnings of Rs8.8 and Rs10.5, respectively. Given the expectation of improved order inflow, reduced working capital pressures on the back of cash inflow from Emco Energy sale and relatively cheap valuation, we maintain our ‘Accumulate’ rating on the stock.

To read the full report: EMCO