Thursday, December 31, 2009


There have been five overriding themes for our investment letters during the past year.
Below we list and review them.

1) Expanding liquidity drives financial markets, particularly when it occurs in the face of a sub-par but recovering economy and weak price inflation. This is the sweet spot in the cycle we so often talk about, and it is the best of all times for stock and corporate bond prices when perception of risk abates.

2) The Great Reflation underway since late 2008 has done its first job - aborted what surely would have been a full scale depression at least on the scale of the 1930s. That was Act I.

3) No one should believe that the huge reflation underway will make the economy and financial system whole again. The private sector debt excesses were far greater by 2008 than they were in 1929. A good part of the reflation effort is to transform private debt into public debt, and this will surely create another, different debt monster. As the year draws to a close, credit rating agencies are starting to downgrade sovereign debt and credit default swaps (CDSs) and are showing increased concern that some major developed countries are going to have problems servicing their debt (e.g. Japan, U.S., etc.). The markets are starting to tell us that Governments with brittle, over-extended fiscal positions will soon have to put in place credible fiscal consolidation -- tax increases, expenditure cuts, decline in services, etc. This means more deflation, more uncertainty.

4) Zero interest rates in the U.S. together with Federal Reserve asset purchases, much of it low quality, has done its job of inflating asset prices which improves balance sheets. Better financial markets greatly help capital raising ability, further strengthening balance sheets. As a result, they are much improved. The question is over sustainability. Fears of renewed asset bubbles have surfaced, complicating Fed and other central bank decision making. Do they risk tightening too soon or too late? Does a middle ground exist? Zero interest rates are an extreme anomaly and cannot last unless the U.S. economy remains permanently depressed and in deflation like Japan has been for 20 years. This seems unlikely but cannot be ruled out.

5) The great flaw in the international monetary system has allowed the U.S. - the key reserve currency country in the world - to run up a $4 trillion tab with foreign central banks and has created excess liquidity and asset bubbles in countries buying those dollars. It has also contributed mightily to the destruction of savings and investment in the U.S., and has created massive disequilibria in the global economy and financial system. Economics 101 tells us clearly that all disequilibria eventually get corrected. The interesting questions are how and when? That will be the story for Act II of the drama and it hasn’t been written yet.

As the year 2009 draws to a close, there is clearly an aura of unreality. We barely survived a near-death experience nine months ago. However, the pain and the fear for most people were brief. It was not like the 10-year depression in the 1930s that changed attitudes
for two generations.

To read the full report: RISK & UNCERTAINTY

>Top 10 Questions for 2010 (ECONOMIC RESEARCH)

1. Will the recovery become self-sustaining? Viewed from the depths of despair earlier this year, even the mild turnaround in the global economy in recent months is nothing short of remarkable. But while the economies of the U.S. and Canada may have stopped falling around the middle of 2009, the recovery has been tepid so far, and that’s even with a heavy assist from government spending. Conditions are gradually falling into place for a firmer and self-sustaining recovery next year, especially with employment finally stabilizing and business confidence perking up. Even so, the conventional wisdom that the upturn will remain subdued by past standards looks quite compelling. The main reason: the U.S. consumer simply is not going to ride to the rescue for global growth as it has so often in the past. Accordingly, we look for GDP growth of around 2½% in both countries next year (Chart 1); that’s not bad under normal circumstances, but it’s disappointing in the wake of the worst single year for U.S. growth since the 1940s.

2. Has the jobless rate peaked? The unemployment rates in both Canada and the U.S. ticked down last month, and recent hiring intention surveys have picked up, sending a tantalizing hint that the worst may be over on the job market front. However, it may be a tad premature to sound the all-clear note just yet, especially in the U.S., where the recovery will still be too modest to generate solid job gains for some time yet (Chart 2). The employment outlook is generally more positive in Canada, due to the relative strength in job-rich domestic spending areas such as housing and consumer spending. However, in both countries, we look for the unemployment rate to be lower a year from now.

3. Will China’s growth remain strong enough to drive commodities higher? To paraphrase our Global Commodity Strategist, Bart Melek, “Commodity markets have performed much better than anyone would have dared to predict at the beginning of 2009, when global depression chatter was rife and massive deleveraging and panic selling were the order of the day. Depression was averted thanks to massive government spending in China, the U.S., Europe and elsewhere totalling some $2.2 trillion, zero interest rates and various central bank liquidity measures.

4. After a powerful rebound, are stocks due for a correction? We have long maintained that the real distortion in equity markets this year was not the massive 65% bounce from the March lows, but the depth of those March lows. Much of the rebound in stocks occurred in the first two months after the lows were hit, driven by the realization that the global economy and credit markets were stabilizing, with a helping hand from extremely accommodative monetary policies globally. While the annual gains in many major equity markets in 2009 are certainly impressive—the TSX is currently just shy of a 28% rise this year, vying for the best performance in 30 years—they are by no means highly unusual, especially in a recovery phase.

5. Is the Canadian housing market set to pop? It seems many are falling over themselves to pronounce that the Canadian housing market is in a bubble, partly because it has been able to fully recoup all of its (fleeting) recession losses in a matter of months (Chart 4). If anything, we believe the risk is that the market will get even hotter in the first half of 2010, ahead of impending interest rate hikes and the Harmonized Sales Tax in B.C. and Ontario at mid-year. There is bound to be at least some modest correction in the second half of next year, almost certainly in sales, and possibly in prices.

To read the full report: TOP 10 QUESTIONS


Steel – The Worldsteel Association estimated November global steel production at 107.4 mln tonnes (-2.1% MoM, +22.4% YoY) and 75.0% utilization. Sequentially, US production held at 6.0 mln tonnes (-0.5% MoM, +26.9% YoY) as the ongoing cyclical recovery offset seasonality while China production declined to 47.3 mln tonnes (-8.7% MoM, +37.4% YoY). Spot iron ore fines imports into China rose by 9% to $115/ton delivered, lifting spot prices 66% above contract after adjusting for freight. This compares to consensus expectations of roughly 25%. Amongst our coverage, CLF and X own iron ore mines. US mill utilization rates declined 2.9% points to 62.0% for the week ending 12/18.

China Spot Iron Ore Prices Move Higher, Midwest Weather to Impact Appalachia Coal Supply

Coal – Platts reported that weather related power failures hampered production at many facilities in Central Appalachia and rail deliveries were delayed by as much as 4 days in many regions. Color from rail operators suggest that delayed shipments will be deferred and not cancelled under force majeure. Weekly coal shipments rose 0.4 mln tons from the prior week to 20.5 mln tons (-5.8% YoY) and power generation rose 0.7% YoY to 80.2 GWH as heating degree days came in at 141,1 above last year. In an abbreviated week with thin volumes, OTC CAPP coal for 1Q10 delivery eased $0.65/ ton to $51.50 while PRB fell $0.50 to $8.90/ton. Spot natural gas settled down $0.32/MMBtu on the week to $5.55/MMBtu after three weeks of strong gains.

Specialty Metals – In a media interview, Osaka Titanium (largest sponge producer in Japan) said they would keep capacity utilization at 45% to cope with excess inventories and aero related demand that is unlikely to recover until 2011. LME nickel surged $0.72/lb this week to $8.45/lb, a positive for stainless steel prices. Titanium scrap turnings rose $0.05/lb to $1.15/lb, well above the March bottom of $0.35/lb.

Non Ferrous – LME aluminum remained at $1.00/lb while global inventories rose 1% to 4,938k tonnes. LME copper rose 4% to $3.21/lb and global exchange inventories rose 1.6% to 678k tonnes. In November, Global aluminum production declined 8.4% YoY to 1.9 mln tonnes, while daily production gained 6% MoM to 44k tonnes

To read the full report: METALS & MONITOR

>Pondy Oxides & Chemicals Ltd (HDFC SECURITIES)

Company Background: Pondy Oxides & Chemicals Ltd (POCL) incorporated in 1995, is one of the India's leading metals, metallic oxides and plastic additives producers. POCL has broad based operations, manufacturing of Lead, Litharge Red lead, Zinc oxide, Lead sub Oxide, and solid and liquid stabilizers of PVC.

POCL has two subsidiary companies - M/s Baschem Pharma Ltd (100% subsidiary) at Maraimalai Nagar in Tamilnadu to manufacture liquid stabilizers, Epoxy oil and paint driers (manufacturing facilities since closed) and M/s Lohia Metals Pvt Ltd (51% subsidiary), which has an annual capacity of 12,000 tonnes of metal refining. Baschem Pharma Ltd is currently, solely engaged in trading activities and hence does not contribute any significant revenues/profits to the consolidated financials of POCL.

POCL has four different product divisions:

  • Metallic Oxides Division
  • PVC Stabilizers Division
  • Smelter Division
  • Zinc Division

POCL also had a battery-producing unit, which was sold off in 2007, as it did see scope in that segment of business.

POCL has its manufacturing facilities in Pondicherry and Tamilnadu. The factories for Metallic Oxides Division and Plastic Additives Division are situated in Pondicherry while the factories for Smelter Division and Zinc Refining Division are located in Tamil Nadu. It has a capacity of 12,000 Tonnes p.a. for Metallic Oxides, 6,000 Tonnes p.a. for PVC stabilizers, 5,000 Tonnes p.a. for oxides & refining and 14,400 Tonnes p.a. for Smelter division. A part of the production of lead oxide is used captively by plastic additives unit. Similarly Zinc and Lead are used captively for manufacture of oxides and alloys.

POCL earns ~ 60% from metals division, 20% from the oxides division and another 20% from the plastic additives division out of its overall sales. In the metals division lead metal forms ~80% of the sales while zinc forms the remaining 20%.

The products of the company are consumed by various industries namely, Tyres & Ceramics (Zinc Oxide), Cable sheeting (Lead oxides), Galvanizing units (Zinc).

POCL has large clientele which includes big names like Amara Raja Batteries, Exide Industries, J K Tyres, Supreme Inds, Kisan, Shriram EPC, Chemplast and MRF Ltd to name a few.

POCL is a recognized export house and mainly exports lead metal. Even though plastic additives are also exported, they form a small part of the total exports of the company. The export margins of the company are higher and stabler than the domestic margins.

Stability in the metal prices (especially lead) could lead to better volumes and consistent profits.
The business of POCL to a large extent is dependent on the metal prices especially lead as huge fluctuations in the metal prices create pressure on the margins of the company. Lead is a very corrosion-resistant, dense, ductile, and malleable bluegray metal. The metal prices have been quite unfavorable for POCL during FY09 and therefore led to fall in its overall margins during the period. The metal prices have stabilized since the start of this fiscal and hence has led to high volumes. POCL is also dependent on Zinc to some extent though lead is its main product.

Higher focus on exports could lead to better margins and efficient working capital management
POCL is also into export sales, mainly of lead metal. The exports have not been very high till now, for instance the first half of FY10 saw export sales of ~Rs 10 crores. The company is in H2FY10 focusing on improving on this front and increasing its exports sharply. POCL expects exports to form 50% of the total revenues in H2FY10. Exports form a key to the overall business structure of POCL. The robust export situation in H2FY10 could lead to better topline and bottomline for FY10. Export realizations are based on LME prices, while domestic prices at times quote lower than LME prices. Further export sales are made against sight L/C and receivables are realized faster.

Higher utilization of capacities to lead to economies of scale and spread of fixed costs
Till H1FY10, POCL did not utilize its plants to its full capacity. At the end of FY09, POCL had installed capacity of 33,460 MT of Metals and Metallic Oxides and 6,000 MT for Plastic Additives. It manufactured 10,104 tonnes of metals & metallic oxides and 4105 tonnes of plastic additives in FY09. Post H1FY10, it has started to utilize almost 100% capacity in the metals and metallic oxides segment. This will enable the company to reduce its per unit cost and also lead to a spread of fixed costs which could eventually lead to better margins for the company.

Shift to LME based pricing for sales and purchases to help POCL earn stable profits
Earlier, POCL used to make its sales and purchases on a spot market basis and hence there was no assurance of maintainable profits, as the raw material price fluctuation could not always be passed on to its customers. In FY09, POCL took a hit on its profits because of this reason, as, the huge volatility in the raw material prices especially lead metal could not be passed on to its customers leading to a fall in its profits.

To read the full report: POCL


Robust Cash Flow To Help Strengthen Balance Sheet
We are in the up-cycle of the sugar sector with acute shortage of sugarcane and there by acute shortage of sugar. Higher cash flows and negligible capex would help Balchini to improve its balance sheet and strengthen it further.

Lower Debt = Lower Interest Cost = Better Profitability
The higher free cash generation by Balchini will enable it to reduce its debt, thereby reducing the interest cost. Lower interest cost would result in better profitability, despite pressures on the operating profitability due to high sugarcane cost.

New Power Policy - "Santa's Gift
The new UP govt power policy has two key positives for the co-gen segment. Firstly, UPPCL has increased the power tariff by approximately 30% to around Rs 4 per unit effective from 1st October 2009. The state has also proposed a policy where they will facilitate sale of 10% bagasse based power through open access. This is during the season. UPPCL has further allowed 50% of off-season power through open access, which is from alternate fuel like Coal, etc. The balance 50%, would be bought by the grid at their own discretion for which they will have to fix up a tariff based on coal as feedstock. This would give a boost to the co-gen revenue not only during the up cycle but also during the down cycle mainly due to rising power deficit situation in the state of UP.

Moderate Sugar Volumes coupled With Higher Sugar Prices To Boost Revenue & Shoot Up Profitability.
The revenue from the sugar segment has been growing at a CAGR of 36% for the period between FY08-FY10E. The co-gen division has also performed moderately with 10% CAGR for the same period, however distillery division performance has been disappointing. The total revenue has been growing at 32% CAGR for the period between FY08- FY10E. We expect the profit to grow at 117% CAGR between FY08-FY10E on the back of rising sugar prices.

To read the full report: BALRAMPUR CHINI