Wednesday, December 23, 2009


The use of credit default swaps (CDSs) has become increasingly popular over time. Between 2002 and 2007, gross notional amounts outstanding grew from below USD 2 trillion to nearly USD 60 trillion.

The recent crisis has revealed several shortcomings in CDS market practices and structure. Lack of information on the whereabouts of open positions as well as on the extent of economic risk borne by the financial sector are partly to blame for the heavy reactions observed during the crisis. In addition, management of counterparty risk has proved insufficient, as has in some instances the settlement of contracts following a credit event.

Heading towards a more stable system

Past problems should not distract from the potential benefits of these instruments. In particular, CDSs help complete markets, as they provide an effective means to hedge and trade credit risk. CDSs allow financial institutions to better manage their exposures, and investors benefit from an enhanced investment universe. In addition, CDS spreads provide a valuable market-based assessment of credit conditions.

Currently, the CDS market is transforming into a more stable system. Various private-led measures are being put in place that help enhance market transparency and mitigate operational and systemic risk. In particular, central counterparties have started to operate, which will eventually lead to an improved management of individual as well as system-wide risks.

Meanwhile, regulation should be designed with caution and be restricted to averting clear market failures. Regulators should avoid choking the market for bespoke credit derivatives, as many end-users are highly dependent on tailormade solutions. From an analytical point of view, it has yet to be established under which conditions CDS trading – as opposed to hedging – does more harm than good, and whether central trading – in addition to central clearing – is required to achieve systemic stability.

To read the full report: CREDIT DEFAULT


The day has finally arrived that we can confidently say the Global Great Recession has ended. There were inklings that this transition was getting underway in the second quarter, when a number of the large emerging economies started to shoot out of the gate – particularly the Asian newly industrialized countries, India, China and Brazil. However, this was not all together surprising given that the financial systems of these countries were largely insulated from the mortgage subprime trap that had snared the banking systems of the advanced economies in Europe and North America. Hence the greater signal that the global recession was ending really materialized when France, Germany and Japan stepped out of the recession shadows in the second quarter and were able to extend growth into the following quarter. The global recovery was finally clinched when the North American economies jumped into the mix in the third quarter. Currently, the only G-7 country still stuck in a recession is the U.K., but that economy looks poised to make its lagged exit in the fourth quarter.

So the world economy is gaining traction and is expected to expand at a rate of 3.8% in 2010. Behind the recovery lies a well-synchronized dance. Financial markets are on the mend, as witnessed by sharp rebounds in global equity markets and declines in credit spreads. Housing markets are in repair, as witnessed by falling inventory levels and rising prices, particularly in the US and UK – the epicenter of the problem. Industrial production is on the rebound, as witnessed by replenished inventory levels and a pick-up in global trade. And lastly, but most importantly, consumers are more engaged, hence spurring the improvements in everything above.

The recovery is underway, but for the advanced economies that were deeply snared in the financial crisis, the recovery is not going to have the typical head of steam of past recoveries. For instance, the above graph demonstrates that the 1957-1958 U.S. recession reflected a contraction of similar magnitude to the 2008-2009 recession, but the pace of recovery then was more than three times stronger in the first year. As a rule of thumb, growth in real economic output during the first year of a recovery for an economy is typically 2-3 times larger than the decline over the course of the recession. But, we don’t believe this will be the case this time, as studies of past banking crises show that output for an economy grows more slowly relative to the pre-crisis trend for a number of years after the recovery has taken hold. There are many reasons why this occurs, including employment suffering enduring losses relative to the trend, credit flow destruction, risk aversion among financial institutions, and deep losses in household wealth. We have incorporated this view in our forecast by lowering the potential GDP growth forecast for the U.S. and Canadian economies to an average of just 2% (about half to a full percentage point below pre-crisis levels).

To read the full report: ECONOMIC FORECAST


With tea prices soaring due to torpid production over the past five years and sustainable consumption in the country, the fundamentals of the tea industry have improved significantly. Simultaneously, unfavourable weather conditions in major tea exporting countries have resulted in a considerable decline in global production in 2009. This has led to a surge in global tea prices. Given the negligible area addition under tea during the 2000-07 period, production would stagnate, going forward. This, in turn, would keep tea prices firm. We are initiating coverage on tea sector with a positive view on McLeod Russel, Jayshree Tea and Harrison Malayalam.

Domestic demand-supply gap to tighten further
The precipitous decline in tea auction prices during 2001-2005 had adversely affected tea plantation activity in India. As a result, tea production in India has been lagging behind consumption in the past few years resulting in a depletion of carry-over stocks. Conversely, demand for tea has been steadily growing at 2.9% per annum. In light of the relatively lengthy gestation period of a tea plant, which is typically around five years and the lack of area under plantation, the country is unlikely to register any significant growth in the near term, thereby tightening the deficit even further.

Tea prices on the boil…

Favourable global demand-supply dynamics
Led by a protracted dry season, Kenya, the world’s biggest exporter of black tea, has witnessed a 12.1% decline in production to around 209.5 kg in January-September 2009. Likewise, Sri Lankan tea output has also fallen by 16.8% to around 208.1 million kg in January-September 2009 as against 250.1 million kg in the corresponding period last year. This, coupled with negligible area additions under black tea, has exacerbated the deficit situation causing global tea prices to surge.

Tea prices expected to remain firm
Domestic tea prices have risen by almost 22% to Rs 135 per kg in 2009 due to the decline in tea production in India. Currently, domestic tea prices are the highest since the last nine years. Poor weather conditions in India have taken a toll on tea production and has resulted in a decline to 830.4 million kg in January-October 2009. This, coupled with high consumption levels, has led to the emergence of a tight demand-supply scenario. Moreover, a decline in the production of tea in key exporting countries has resulted in a surge in global tea prices. Kenyan tea prices hit a record high with the Broken Pekoe Ones (BP1s) average price touching $5.2 per kg. We believe global and domestic tea prices would remain firm on the back of negligible area addition under tea over the last four to five years.

The Indian tea sector is going through a positive pricing scenario as production has remained stagnant over the past five years and consumption is growing steadily. We believe tea prices will remain firm due to lower production because of negligible area additions under tea. Given the fixed cost structure of the companies, high prices would result in a concomitant rise in the EBITDA margin. Our rating rationale is based on P/E and price to book value (BV).We prefer McLeod Russel (MRIL), Jayshree Tea (JST) and Harrison Malayalam (HML) in this order purely on the back of the large capacities of these companies. We believe MRL, with the largest capacity, would benefit from the rise in volumes and price realisations. We value MRIL, JST and HML at 13x, 12x and 11x its FY12E EPS respectively, which are 2.0x, 1.9x and 0.87x of their respective FY12E book values.

To read the full report: TEA SECTOR


• CIL is India’s leading manufacturer of diesel engines with a range from 205 hp to 2365 hp and value packages serving the Power Generation, Industrial and Automotive Markets. CIL also caters to the growing market for gas and dual fuel engines.

• During the quarter the domestic business, power generation continues to remain the dominant
business vertical with 50% contribution to revenues while the industrial segment contributed
15-20% and auto business 10%.

• Revenues were lower by INR 700 mn in the quarter due to an illegal strike at one of the production facilities.

• The capital expenditure plan for FY09 is Rs.2000mn for all the Cummins group companies.

• Phaltan facility will be operational by CY10 and is expected to produce mid range of products.

• Net sales and PAT of the Company are expected to grow at a CAGR of 11% & 17% over FY08 to FY11E.

To read the full report: CUMMINS INDIA


Investment Rationale

Strong order flows after a pause in FY09
TCL started FY10 on a strong note with order inflows of INR 2.8 billion in1HFY10. We expect order book to reach INR 18.5 billion (up 8.8% YoY) and INR 19.6 billion (up 5.8% YoY) in FY10E and FY11E respectively, due to strong L1 profile (INR 1.0 billion) and fresh bidding of INR 63.0 billion in FY10. This is in sharp contrast to FY09 where the company saw a mere 2.1% YoY growth in its year end order book.

Increase in ticket-size of project
Over the years TCL's average ticket size of projects on hand has increased from INR 200 million to about INR 600 million currently. We expect this to touch INR 1000 million in next 3 years. We believe this will impart more scalability to the topline as the company will be able to derive higher revenue with limited number of projects to handle. This along with huge order book (4.4x FY09 sales) will result in a sales CAGR of 32.9% during FY09-FY11E.

Margins to remain healthy
TCL has progressively invested in captive equipments & machinery, resulting in a fall in contract
operating expenses as a percentage to sales from 58.3% in FY07 to 47.6% in FY09. As the company continues to invest in machinery as a policy to reduce dependence on sub-contractors,
we expect the contract operating expenses to fall further in FY10E and FY11E. The company
also has a Price-Variation-Clause in all its projects, cushioning its margins. We expect the
company's EBITDA margins to remain at current levels (~13%) in FY10E and FY11E.

Investing in equipment and machinery
The company commissioned a milling factory engaged in environment friendly bitumen recycling near Kolkata for optimised cost of road building using a state-of-art Writgen machine. The company is currently executing a pilot road project using this technology. Any similar orders received by the company will lead to material decline in the contract operating expenses, thus enhancing its margins. We have not accounted for additional fall in contracting expenses due to this.

Entering new business - Industrial Fabrication
TCL has started making railway wagons since March 2009 to cash on the opportunities thrown open by the Indian Railways' thrust on improving goods transport infrastructure. The company has supplied about 100 wagons to public sector company Braithwaite & Co and currently has orders of 50 wagons a month. According to the management, it enjoys a healthy ~15% operating margins in this business. However, we do not expect any significant contribution from this vertical till FY11E.

In view of the company's diversified portfolio, increased investments in infrastructure and its strong order book, we expect TCL to report an EPS of INR 15.7 and INR 22.6 for FY10E and FY11E respectively. It is currently trading at 4.9x its FY11E EPS. Given revenue growth visibility for next two years and healthy margins we believe the valuations are attractive. We initiate coverage with a BUY rating on the stock with a target price of INR 158 (FY11E PE multiple 7x).

To read the full report: TANTIA CONSTRUCTIONS


• We initiated Coverage of Astra Microwave Products Ltd and set a target Price of Rs.76.00.

• Company is engaged in designing and manufacturing of radio frequency (RF) and microwave super components and sub-systems that are used in areas of defence, space and civil communication systems.

• The company has been awarded an order of Rs 25.5 cr. from Indian meteorological department to supply, install and commission remote unmanned automatic weather stations in 550 locations.

• Astra Microwave has been granted 100% Export Oriented Unit (EOU) licence by Government of India (GoI) to one of its units.

• Astra Microwave Products has received an order for Rs. 81.28 cr. from a DRDO entity.

To read the full report: ASTRA MICROWAVE