Saturday, November 14, 2009

>The cause of the dollar’s weakness is different, and less durable than before the crisis

Before the crisis, the dollar’s weakness was mainly caused by the US external deficit due to the shortfall in savings. It resulted in a continuous rise in the US external debt, and therefore a long-term trend depreciation of the dollar.

Since the second quarter of 2009, the dollar’s weakness has mainly been due to capital outflows from the United States, due to the very low level of interest rates. The potential for dollar weakening is greater than before the crisis, due to the magnitude of the capital outflows. However, if the US household savings rate remains higher, investment lower and the US trade deficit accordingly becomes smaller, this dollar weakness will be temporary and not permanent, as it will disappear when dollar interest rates rise again due to the future improvement in the economy. This will, nevertheless, take time: interest rates must rise again in the United States up to the point where capital stays in the United States.

1 - Dollar weakness until the Lehman bankruptcy
Until the summer of 2008, the dollar’s weakness (Chart 1) was mainly due to the widening of the US external deficit (Chart 2) due to the decline in household savings (Chart 3); or in an equivalent manner, the rise in their indebtedness (Charts 3 and 4).

2 - The dollar’s weakness since the beginning of the second quarter of 2009
The crisis caused an upturn in the US household savings rate (Chart 3 above) and a fall in investment (Chart 7), and hence a marked reduction in the US external deficit (Chart 2 above).

3 - A major difference impacting the duration of dollar weakness
When the dollar’s weakness was due to the US external deficit and the accumulation of external debt before the crisis, it had a structural, durable cause: the shortfall in savings. One could therefore anticipate a lasting depreciation of the dollar in the long term.

Since the second quarter of 2009, the dollar’s weakness has been accounted for by a different cause: the capital outflows due to the low dollar interest rates. The upturn in Americans’ savings and the fall in investment (productive and housing) have eliminated the US trade deficit as the main cause behind the dollar’s weakening. The difference from the pre-crisis situation is that there are cyclical reasons for the dollar’s weakness: the Federal Reserve’s low interest rates due to the weak US economy (Charts 11A, B and C), which explains the high unemployment and the very low inflation.

To read the charts and report: SPECIAL REPORT

>Thematic Strategy: A further upswing for tech (BNP PARIBAS)

We believe investors have overlooked the strong possibility of a corporate spending upswing in 2010. The drivers to rising corporate capex are falling into place: Improving economic growth (capex has a beta of 2.5x to GDP), significant increases in free cash flow, and thawing of capital markets for corporate funding. Several industries should benefit, including tech, media, airlines, hotels and capital goods.

Technology is our preferred play on the theme for four reasons. First, with a severe cut in corporate tech spending this year (-8% in the US and -5% globally), tech investment is set to rebound. Second, lead indicators point to a 5-15% rise in real tech spending and a sustained demand recovery. Third, the corporate PC repalcement cycle should take off, spurred by aging PC and the release of Windows 7. Lastly, investors have a large underweight position on tech, whereas our Investment Wheel highlights tech as a major outperformer in Phase 4.

We expect a strong upswing in corporate spending in 2010.

Tech is our preferred play on this theme, due to 1) positive lead indicators, 2) depressed base, 3) PC replacement cycle and 4) investors’ underweight position.

Recommend buying Taiwan hardware producers and select India IT services.

While Asia’s consumer tech demand should stay robust, we believe corporate tech spending will be an important determinant of tech performance next year. Taiwan hardware stands out as the major beneficiary of this theme, due to high operational leverage and attractive valuation. For Indian IT services, a less-pronounced recovery and rich valuation necessitate careful stock selection. Our analyst is also bullish on the Korean memory business. Within these areas, we recommend four stocks to buy.

Strong upside for corporate spending in 2010
We believe markets have overlooked the significant upside potential for corporate spending next year. This is understandable. In this cycle, investors have been focusing on beneficiaries of the strong policy stimulus and resilient Asian domestic demand that triggered this V-shaped rebound. While the global economy is expanding again, concerns on the sustainability of the recovery linger, leading to expectation of muted private-sector investment ahead.

However, three factors support our upbeat view on rising corporate capex. First, corporate spending is a leveraged play on growth. Historically, capital spending has a beta of 2.5x real
GDP growth, based on US quarterly data over the past 40 years (Exhibit 1). With a depressed base in 2009, a moderate global growth outlook still could drive a strong rebound in corporate spending. Our economists forecast US GDP to grow 1.6% next year, up from a 2.6% contraction this year, while Asia ex-Japan is expected to stage a strong 7.4% rebound in 2010, recovering from the 4.8% pace this year.

To read the report: THEMATIC STRATEGY

>EDUCOMP SOLUTIONS: Stressed and Streched

Educomp’s core business of Smart Class (50% of revenues and 60% of profits) is seeing deteriorating economics as growth shifts to smaller towns. Both per student realisation as well as number of classrooms wired per school will see a leg down. The new securitization arrangement, and associated upfront revenue and profit booking ensures that this does not show up in reported financials yet, but the trend is concerning, even as Educomp is stretched thin across a multitude of other businesses, most of which are making losses, and others such as ICT are seeing margins erode. EPS Cagr is set to head to the teens over FY10-13, putting downward pressure on PE multiples. We downgrade the stock to Underperform.

The battle comes home: Deteriorating economics in Smart Class
With a near monopoly in its multimedia content for private schools business (Smart Class), we had expected growth to continue unhindered till at least 8,000 schools (1/3rd of target market) were won. Instead, we notice that with just 2,200 schools implemented, Educomp is now shifting increasingly to smaller schools where per student fee will drop to Rs130 (from Rs150 earlier) and classrooms per school will now be 18 (from 25 earlier). This is a 40-45% swing in core assumptions for Smart Class, and even with an accelerated school addition estimate of 2,000 in FY11, the slide in Smart Class economics is clear.

How does the new securitization arrangement help reported financials?
We like the cash flow profile of the new securitization structure for Smart Class, but disagree with the front loaded recognition of revenues and profits. Notably, this accounting choice will likely mask underlying business deterioration in FY11. Profit estimates that would have been cut 20-25% otherwise per new Smart Class assumptions are instead getting a 15-18% boost thanks to the new accounting policy. In fact, with the new accounting policy, Educomp’s reported profits for FY11 would be higher by almost 80% c.f. older accounting method (refer Figure 9). We note that for the current fiscal, Educomp’s net profit guidance has already been effectively cut, if the one time stake sale proceeds from Pearson JV and the benefits from a mid year accounting change in Smart Class are adjusted.

Stretched thin elsewhere
Our March 2008 report on Indian Education argued that the education business opportunity, while large, is skewed towards just a few segments. While Educomp’s leadership position within the sector is laudable, we suspect there are too many businesses vying for attention, with some making losses. The efforts in vocational training, higher education, e-learning, pre-schools, K-12, Smart Class, and ICT are set to expand further with tutoring and public-private partnerships on horizon.

Growth expectations need tempering, and valuations to take a leg down
Even with a revised earnings model including front loaded revenue and profit recognition, Educomp trades at 19xMar11 earnings, even as EPS Cagr will rapidly reduce ahead, hitting the teens over FY10-13. Elevated growth expectations need tempering and valuation multiples are at risk. We rate the stock Underperform.

To read the full report: EDUCOMP SOLUTIONS


Key takeaways from Q2 FY10 results: Sales growth for our coverage universe was below estimates because of slow order execution, highlighting the impact of improving macro growth yet to percolate into the order book. EBITDA margins expanded 50-110bps y-o-y (except NCC) on better revenue mix and lower commodity prices.

Estimate changes:
On the back of trends visible in H1 FY10, we have revised sales for our coverage down by 3-7% and EBITDA margins up. This has resulted in our earnings estimates changing by -1% to 7% in FY10 and FY11 (IVRCL cut by 6% in FY10 and 12.5% in FY11).

Q2 results were a mixed bag, as high margins offset lower sales growth impact.
We continue to expect H2 FY10 recovery on improving macro growth.
NCC OW(V) and Simplex OW(V) are our top sector picks.

Outlook: We expect macro economic recovery in H2 FY10 to increase order inflows and drive earnings acceleration. While interest cost should also inch up, it should be more than offset by higher volumes.

We believe near-term valuation for the sector is rich and investors with a medium- to long-term horizon should “cherry pick” stocks with better revenue visibility and earnings growth. NCC and Simplex emerge as leaders on both counts and hence are our top picks. We expect IVRCL to underperform its peers on expectations of 12-15% lower than consensus earnings estimates over FY10-11.

Expecting H2 FY10 recovery

We look forward to recovery in sector top-line growth in H2 FY10 on the back of improving macro growth
Adjusting earnings for Q2 FY10 performance of weak sales growth, which was offset by operating margin expansion
Despite the recent correction, valuations remain rich in the near term. NCC OW(V) and Simplex OW(V) are our top picks

To read the full report: INDUSTRIALS CONSTRUCTION


Some of the key highlights of Q3CY09 Standalone results are as follows:
ACC reported 10% y-o-y growth and 5.4% degrowth q-o-q in net sales in Q3CY09 to Rs.1,969.4 cr on account of lower volume growth. Volumes climbed merely by 2.8% y-o-y (though q-o-q, they were down 6.8%) to 5.14 mn tons. Average realizations for Q3CY09 stood at Rs.3,892/ton, up by 6.1% y-o-y and 2.8% q-o-q. The marginal growth in realisations could be attributed to low exposure to the Southern region, where prices have declined the most.

Cement prices in ACC’s key market of Central and North have retraced to levels of May 2009 (All-India price of Rs244/bag in September 2009), having peaked in the month of July 2009 with All-India prices at Rs254/bag.

ACC’s has been carrying out cost control measures so as to improve/maintain its margins. Freight cost in absolute terms increased by 7.7% q-o-q and 0.1% y-o-y due to the increase in rail freight and increase in lead distance. Power and fuel cost per ton fell 16.6% y-o-y to Rs.710.4/ton on the back of decline in coal costs. However, the benefit of lower coal prices was partially offset by increase in cost of raw materials like gypsum, slag and fly ash coupled with an increase in diesel prices and in royalty on limestone. Other expenditure also fell by 19.9% to Rs.749.2/ton in Q3CY09 as last year other expenses included consulting fees relating to implementation of SAP and alternate fuel research, which was not incurred this year. All this helped boost EBIDTA/ton by 48.2% y-o-y to Rs.1,320/ton but sequentially fell by ~Rs.30/ton.

Interest charges for the quarter were Rs.13.5 cr, which grew at 16.5% on y-o-y basis while, depreciation also increased by 8.1% to Rs.79.6 cr for the quarter. Tax rate for the quarter was 30.4%. On the back of improved operating efficiencies, ACC reported a healthy Q3CY09 PAT at Rs.435.7 cr, up 53.7% y-o-y, but down 10.3% q-o-q.

A major portion of the Bargarh expansion project was commissioned in Q3CY09. The commercial production is yet to be started as the plant is undergoing the trial runs and the same is expected to be completed by Q4CY09. The expansion programme at Wadi is on and is likely to be commissioned in Q1CY10. The grinding plant at Thondebhavi near Bengaluru is undergoing trials and the second grinding plant at Kudithini in Bellary District would be commissioned in Q4CY09. These projects would add 3 mn tonnes p.a. of capacity.

The Chanda expansion project which comprises a new line of 3 mn tonnes p.a. of cement alongwith an additional 25 MW CPP is progressing well and is scheduled for completion in Q4CY10. At the end of these project expansions, ACC will have a total capacity of 30.3 mn tones from the current capacity of 22.6 mn tonnes.

ACC’s expansion plans are concentrated in the southern and western regions, as 6.8 mn tonnes p.a. of its total planned capacity addition of 8 mn tonnes p.a. will be in these two regions. ACC has a relatively smaller market share in the southern region and with capacity expansion in this region, ACC’s presence could increase. However, in the medium term ACC could face challenges in ensuring volume throughput given the fact that the South is currently facing slow demand growth and new capacities coming on stream. Moreover instability in the South is beginning to result in companies diverting supplies westward.

Going forward, the cement prices could decline in coming quarters due to oversupply. Fall in cement prices, could lead to lower realisations. The margins of cement companies are expected to be under pressure on the back of rising input costs and cement pricing pressures. ACC would have to bear higher freight and fuel cost due to upward revisions in prices of domestic fuel in the month of July and revision in domestic coal prices by an average 11% by Coal India Ltd w.e.f October 16, 2009.

To read the full report: ACC LTD.