Monday, November 16, 2009

>>The Worst Is Behind Us. Now What? (WELLS FARGO)

The global economy plunged into its deepest recession in decades last autumn as financial markets seized up in the wake of Lehman Brothers’ failure. By early this year industrial production in the 30 countries that comprise the Organisation for Economic Cooperation and Development was down more than 15 percent from year-earlier levels (Figure 1).

It could have been far worse, however. The governments of the world’s major countries averted catastrophe last year by taking steps to prevent a wholesale collapse of their financial systems via recapitalization, loan guarantees and increased deposit insurance. In addition, governments responded to the crisis with stimulative economic policies. Major central banks slashed policy rates to unprecedented levels, and governments in most major countries opened the fiscal taps.

There are signs that the medicine is having its desired effects and that growth is returning to most economies. The global recovery is being led by Asia where growth turned positive again earlier this year. The financial systems of most Asian economies were not nearly as levered as their western counterparts, so banks in the region were able to ramp up lending again. In addition, most Asian governments responded to the crisis with expansionary fiscal policy. The year-over-year GDP growth rate in China rebounded to a strong 9 percent in the third quarter of 2009, but the expansion is not confined to only China. Many other countries in the region, including the large economies of Japan, Korea and Taiwan, are posting positive growth rates again.

On a purchasing power parity basis, we forecast global GDP will decline about one percent in 2009. Although our projection may not sound “bad,” global GDP has never contracted, at least not since the International Monetary Fund began calculating the series in 1970. We project that the global economy will grow close to its long-run average of 3.6 percent in 2010 before accelerating to roughly 4 percent in 2011. Relative to 2004-2007, however, when global GDP grew nearly 5 percent per annum, the global recovery that we project over the next few years may seem a bit sluggish. Indeed, we project that growth in the United States and in some western European economies will be held back by slow growth in consumer spending as individuals attempt to delever and repair battered balance sheets.

Inflation rates in most countries shot higher in the first half of 2008 and commodity prices went through the roof. On a global basis, CPI inflation rose to 6 percent in 2008, the highest rate in about 10 years. However, the global downturn caused commodity prices to collapse, and global inflation has receded significantly this year. Despite unprecedented amounts of monetary stimulus, inflation should not really be an issue until the global economy truly strengthens. Due to the slow recovery that we project, we believe that inflation in most countries will largely remain benign over the next few years.

The Dollar Should Appreciate Modestly versus Major Currencies
The dollar strengthened significantly last autumn as risk aversion spiked. U.S. Treasury securities are considered to be the safest assets in the world, and massive buying of U.S. government bonds by foreign investors contributed to the dollar’s strength. However, the greenback has given up most of its gains over the past few months as investors have turned less risk averse. With stock markets rising in most countries and corporate bonds rallying, the safety of low-yielding U.S. Treasury securities is not as compelling as it was only a few months ago when worst-case scenarios did not seem farfetched.

Looking ahead, the currency strategy team of Wells Fargo projects that the dollar will trend modestly higher against most major currencies. Investors expect that most major central banks, including the Federal Reserve, the European Central Bank and the Bank of England, will be on hold until well into next year. Therefore, expected changes in short-term interest rates will not have as much of an influence on exchange rates as in the past. As the U.S. recovery gathers steam, foreign investment flows into long-term securities (e.g., corporate bonds and equities) and direct investment inflows should resume, helping to lift the greenback. In addition, the decline in the U.S. current account deficit will exert less headwinds on the greenback than it did earlier this decade when the dollar was trending lower.

However, most “commodity” and emerging market currencies should continue to trend higher versus the greenback in the quarters ahead. The global recovery should cause most commodity prices to drift higher, which should help to support “commodity” currencies (e.g., the Aussie dollar). In addition, rising levels of risk tolerance should cause capital to flow to “risky” developing countries, which should put upward pressure on many of those currencies.

The global economy fell into its deepest recession in decades as capital markets locked up in the wake of the Lehman Brothers bankruptcy. Fortunately, the central banks and governments of the major economies of the world averted disaster by slashing interest rates, undertaking fiscal stimulus and taking steps to support the global financial system.

There are clear indications that the global economy is starting to recover, although levels of activity remain well below year-earlier levels in many countries. Commodity prices are off their cyclical lows and the rise in the Baltic Dry index, which measures international shipping prices of dry bulk cargoes, suggests that global trade is starting to pick up again. Moreover, “hard” data show that industrial production is beginning to expand in most economies.

Asia, which did not have overly leveraged financial systems heading into the crisis, is leading the world out of recession. However, both the United States and the euro area appear to be turning the corner as well.

The United States recently endured its deepest recession in decades. Between Q2 2008 and Q2 2009, the economy contracted about 4 percent. However, real GDP rebounded in the third quarter, rising at an annualized rate of 3.5 percent.

Some of the lift in the third quarter reflects the temporary effects of government stimulus. “Cash for Clunkers” contributed to the 22 percent jump in durable goods purchases, and home building was stimulated by the first-time home buyer tax credit. However, growth in other areas of private spending, such as consumer purchases of non-durable goods and services and business spending on machinery and software, shows there was more to overall GDP growth in the third quarter than simply government stimulus.

Despite the rise in real GDP in the third quarter, a self-sustaining recovery has not yet truly taken hold. Unemployment has shot up to the highest rate since the early 1980s, and it will likely climb a bit further in the months ahead.

Since peaking in the first quarter of 2008, real GDP in the Euro-zone has contracted more than 5 percent, making the current downturn the worst in decades. Not only did exports take a sizable hit, but domestic demand weakened as well as credit markets ground to a halt in the wake of the Lehman Brothers bankruptcy.

Official GDP data have not been released yet, but there are indications that growth turned positive again in the third quarter. The purchasing managers’ indices for the manufacturing and service sectors moved into expansion territory during the quarter, and “hard” data show that industrial production grew at a solid rate in the first two months of the third quarter.

Although the worst may be over, we believe that the recovery in the Euro-zone will prove to be frustratingly slow. There are a few important economies in which consumers became highly geared. In our view, sluggish growth in consumer spending in these economies will restrain the overall GDP growth rate in the Euro area. In addition, economic weakness in eastern Europe should constrain growth in exports from the Euro-zone.

Japan’s economy started growing again in the second quarter, and growth continued into the third quarter. The most visible sign of expansion is the rebound in Japan’s industrial production. Industrial production rose another 1.4 percent month-over-month in September, extending the rebound to seven consecutive months. Japan’s industrial production has already retraced about half of the amount that was lost over the prior five months. September inventories were the lowest in five years, suggesting that production gains are sustainable.

The strong yen may be denting Japan’s export performance, however. Japan’s export growth has struggled to advance at the same pace as its Asian neighbors such as China, South Korea, and Taiwan. On a seasonally adjusted basis, Japan’s exports have slipped for three consecutive months, back down to April levels.

Deflation is still firmly entrenched in Japan. The national core CPI edged up 0.1 percent in September relative to the previous month, but the overall CPI is down -2.3 percent from a year ago.

Real GDP in the United Kingdom has declined for six consecutive quarters. Since peaking in the first quarter of 2008 British real GDP has plunged 6 percent, making the current slump as deep as the horrendous downturn in the late 1970s/early 1980s. N0t only have exports tanked, but domestic demand has taken a sizable hit as well.

There are some signs that the worst may be over. The purchasing managers’ indices for the manufacturing and service sectors have moved into expansion territory, although “hard” data on industrial production have yet to confirm the upturn in manufacturing activity. Most indices of house prices have risen from their lows of earlier this year.

As with their counterparts in the United States, British consumers have built up their leverage over the past decade or so, and it seems likely that a period of consumer retrenchment is in store. Therefore, we project that the upturn will prove to be very slow due, at least in part, to sluggish growth in consumer spending.

Despite a global recession, Australia managed to avert a deep contraction in its economy. After a mild decline in real GDP of 2.2 percent in Q4 2008 , growth returned to positive territory in the first and second quarters.

The Royal Bank of Australia (RBA) is among the first foreign central banks to begin tightening monetary policy in this cycle. It lifted the cash rate by 25 bps to 3.25 percent in October, and then another 25 bps to 3.50 percent in November. In the RBA’s accompanying statement, it noted that the “considerable downside risks” present when the bank decided to take the cash rate from 7.25 percent to 3.00 percent had abated and that the Australian economy now seems well on the way to recovery.

Whether or not the RBA will continue to hike rates will depend on the inflation outlook and the pace of economic growth in Australia. Since the run-up in oil and other commodity prices in the summer of 2008, CPI inflation has come down in Australia, giving the RBA cover to continue to tighten if the bank sees fit.

To read the full report: GLOBAL CHARTBOOK

>Indian Companies Likely to Reassert ROE Superiority

Key Debate: India has always enjoyed a superior ROE relative to the rest of the world as well as emerging markets. Hitherto, this advantage has been driven by a combination of superior asset turn, a degree of overestimation of the life of assets driving down depreciation expense, inferior quality of earnings (i.e., book adjustments to shore up profits) and strong financial leverage effect despite low debt-equity. Strong cost cutting in the early part of this decade also helped the ROE cause. However, in the recent down cycle, India has lost most of its ROE edge. The key question is whether Indian companies will regain their ROE superiority which is critical to the premium valuations of their shares relative to the world?

ROE drivers go through cyclical correction in 2008: The downturn in the previous growth cycle has taken India’s ROE gap with the rest of the world to a 13-year low (since our data series starts) of 2.6%. India’s key ROE drivers have gone through a sharp cyclical correction notably asset turn but profit margins as well. This analyses is based on the respective MSCI indices.

Seven out of 10 sectors witness sharp fall in ROE: The ROE fall in 2008 is pretty pervasive across sectors with healthcare, industrials and materials leading the fall and technology, utility and telecoms holding up pretty well.

Indian companies more geared than before: During the previous cycle Indian companies have increased net financial gearing which is now higher than its peer group in the emerging world as well as the Asian region. This has caused financial leverage effect to stay at high levels relative to the world and also cause a sharp upswing in interest expenses by the end of 2008 relative to EM and AXJ.

Capex cycle strains balance sheet and return ratios: India’s margin superiority (an outcome of low costs) is intact though the gap has narrowed a tad in 2008. Indian companies’ EBITDA margin was 3.2ppt higher than the AXJ average in 2008. The biggest drop across the ROE drivers has been in the utilization of assets. Clearly, India’s big capex cycle in 2006 and 2007 has hurt asset turn. The capex cycle has also strained the balance sheet causing capital costs to rise and hurt return ratios.

Earnings quality improves a tad: At the end of 2008, earnings quality seemed to have improved a bit as it had for the rest of the world. The gap in depreciation expense with the rest has also narrowed and, to that extent, some of the bad factors that drove India’s ROE superiority in the past have lost their influence. Pertinently, return on assets has dropped to a low point in history which shows how bad 2008 was for Corporate India.

ROE superiority likely to return in 2010: As growth accelerates we expect India companies to reassert their ROE superiority versus AXJ and EM. The bulk of the relative performance should come from improving asset turn which should also set us up for a new capex cycle in 2011. Margin performance should also improve due to the cost cutting that Indian companies have undertaken in 2008 combined with the conducive macro environment. On that basis, India’s relative multiples to EM can sustain at the current 20%-odd levels in 2010.

To read the full report: INDIA STRATEGY


We met the management of Exide Industries. Following are the key highlights: New opportunities offers visibility of ~15-18% growth till FY11E Exide expects the battery industry in India to more than double over the next five years. The company aims to grow at a faster rate than industry by eating into the market-share from the unorganized sector. The company has undertaken a host of new initiatives to gain market share. This includes:

Expansion of its existing sales network
Introduction of new products
Acquisition of two smelters to recycle lead from old batteries.

Exide could gain from stronger demand for inverters
We expect Exide to be a key beneficiary of stronger demand for inverters in near term due to rise in power deficit. Exide has over 40% share in the inverter market and derives about 15% of its total revenue from inverters at a higher margin.

Market Leader in OEM Segment
Exide Industries (EIL) is the largest player in the Indian auto battery industry with a market share of almost 77%.

EIL is also the biggest supplier to almost all OEMs in the Indian Auto Industry and thus the biggest beneficiary of the strong demand being witnessed by the auto majors in all segments.

The company supplies brands like EXIDE, SF, SONIC and Standard Furukawa in the domestic market. It exports brands like DYNEX, INDEX and SONIC.

Market Leader in Organised Battery Replacement Market
Around 50% of the battery replacement market is organised. In this market, EIL is yet again a market leader with 65% market share. With a higher margin in the replacement segment compared to margins earned in OEM segment, EIL continues to maintain higher margins compared to most of its peers.

Recommendation and Valuation
We have revised upwards our estimates driven by likely upside to volumes owing to strong demand in the auto sector and inverters and likely increase in market share owing to new products and sales network expansion.

Accordingly our EPS stands revised for FY11 from 7.4 to Rs8.0. The stock is currently trading at a P/E of 13.7xFY11E. We maintain accumulate on the stock.

To read the full report: EXIDE INDUSTRIES


While the outlook has improved in recent times, we feel stocks are trading at the upper end of their valuation bands and are unlikely to rerate further. Hence, we are Neutral on the sector. Stock picking is a judicious balance of long-term outlook and low risk in meeting near-term numbers. Thus, Buy BHEL and CGL.

Sector trading at the upper end of its valuation band; initiate coverage at Neutral

The capital goods and engineering space has seen a fundamental shift over the past six months, with a new government promising more on infrastructure, improved liquidity conditions and softer commodity prices. However, this structural shift is already reflected in share prices, in our view, and the sector is trading at the upper end of its valuation band, capping near-term upside potential. Stocks appear to be pricing in medium-term valuations, on a two- to three-year horizon. Hence, we initiate coverage at Neutral on a 12-month view.

Stocks unlikely to touch past valuation peaks, in our opinion

The bull argument for the sector, from a valuation standpoint, is that stocks are still trading well below historical highs seen in 2007, at which time valuations were explained by PEGs. While stocks may yet see some liquidity-driven PE expansion, we believe they are unlikely to repeat 2007 PEs when viewed from the PEG angle. If one compares the growth exhibited by these companies over FY05-08 with that in FY09-12F, one finds that sales, EBIDTA and PAT growth is much slower now. Similarly, the operating leverage story that played out in the earlier period will now be much more muted. Finally, the delta we saw in RoE and RoCE earlier is unlikely to be repeated because capital goods companies are themselves in capex mode. Slowing order books and stretching working capital cycles also means free cash flow generation is much lower than in the past. What is different this time around is the global cost of capital. At an all-time low, this variable is driving up the valuations of many sound companies. Could this be the dark horse in the valuation game?

Relative stock picking is the order of the day; Buy BHEL, Crompton Greaves
In the current scenario, we believe stock picking has become relative instead of absolute. Of the core bellwether stocks, BHEL and Larsen & Toubro, we prefer BHEL on a 12-month perspective. This is based on our view that downside risk is greater than upside, thus we advocate stocks with lower beta. While Larsen has multiple drivers to fire when the going is good, it is precisely this that increases its beta. Among the T&D stocks, we pick Crompton Greaves, because we believe the traditional valuation gap between Crompton and its MNC peers should shrink within the next year. The other key reason for choosing BHEL and Crompton is that we believe they are the least likely to disappoint in terms of FY11 numbers.

To read the full report: CAPITAL GOODS SECTOR


OVERVIEW: Food shelf life is a primary concern for both food manufacturers and marketers. A food product’s ability to uphold standards of safety and quality for prolonged periods directly affects sales and customer satisfaction. Antioxidants are designed to reduce the development of oxidative rancidity which limits the shelf life of oils, margarine, snacks, dressings, meat products and other products. Apart from extending shelf life, antioxidants also ensure a consistent quality from batch to batch providing a minimum of variation in taste, odour, color and texture of the product. Consumer’s interest in and awareness of the health properties of antioxidants has been rising in recent years. Not only has this increased global sales of antioxidants (whether used as a food preservative or to provide a health enhancing or functional benefit), but demand for foods recognized as being naturally rich in antioxidants are also growing. One company which intensively understands the complex processes and interactions resulting from lipid oxidation in foodstuffs is Mumbai based Camlin Fine Chemicals Ltd (CFC) as it is engaged in manufacture of food antioxidants. Apart from manufacturing food antioxidants this company is also involved in manufacture of Industrial Antiocidram (used in industries like paints, polymers, resins and plastics), artificial sweetener (Sucralose), bio diesel additives, natural shelf life enhancers (used for fruits, flowers and vegetables).

INVESTMENT RATIONALE: In order to give an idea of the company’s plans going forward in the food antioxidants segment it shall be prudent to quote what the management has said in the annual report - “This business unit is the biggest contributor to the company in terms of volume and growth and the company is also the world’s largest manufacturer of Food grade antioxidants, TBHQ and BHA with market share of about 35% world wide and 70% in India. The company has laid out an aggressive plan for increasing world wide market share above 50% by making an entry into growing food processing markets like Asia, Middle East and South America”. Under the industrial antioocidarm, CFC has plans to launch three products which have already gone through trial runs and technology transfer at plant levels. Seeing the huge market potential for these products the company has already created adequate capacity for these products. The artificial sweetener business of the company also has a bright future because of the growing health awareness. Sucralose, the new age sweetener has begun business in South America, Europe, India and Central America. CFC has filed a process patent for this product.

The company is also involved in manufacture of products under bio diesel additives segment which enables stabilizing of the fuel from oxidation. The world wide demands for these products are in excess of 70 million metric tones. The natural products preservation has been the focus worldwide. CFC has also ventured into this segment and has developed products, though under initial trials. This product shall help in maintaining color, freshness, aroma and prevents spoilage when in transportation and storage. The company expects to file patents for this and many more new products also. Through its subsidiary the company is also engaged in Nutraceuticals like gluosamine and its salts which are used as a supplement in bone management in conditions like osteoarthritis. The company has in the last three years grown at an average growth of 23% and this was primarily due to enhancing its product basket in the food antioxidants product range. One can expect this growth to be maintained in the near future as CFC has ambitious products in the pipeline to be launched soon.

INVESTMENT CONCERNS: Delay in product development could affect future growth and Competition from China could be a major cause of concern.

VALUATION: At the current market price of Rs.65 CFC’s projected FY 10E EPS of Rs. 9.1 is
discounted 7x. Long term investors can add this to their portfolio.

To read the full report: CAMLIN FINE CHEMICALS