Friday, January 8, 2010

>The new world regulation: between words and reality (CITICS SECURITIES)

OVERVIEW: The S&P 500 and Eurostoxx continued their rally toward the year end of 2009. Since they reached their trough at the end of February 2009, the two indices have rebounded by more than 60%. This dynamism results from a quicker than expected recovery of the US labor market, and from the resilience of households’ expenditure. Despite very high level of unemployment rates, industrialized economies seem to be on track to exit the recession and distance themselves from a deflationist scenario. Banks continue to repay the
financial help of governments. The Dollar is stabilizing. Finally, everything seems to indicate a reversal to the pre-crisis world, casting doubt on the utility of the promised new world regulation.

Focus: The new world regulation: between words and reality
The devastating effects of the crisis in terms of jobs and wealth destruction had prompted global leaders to coordinate their responses. This coordinated response emerged from a consensus on three necessities:

  • To quickly bail-out the banking system
  • To conduct expansionary monetary and fiscal policies to support the demand in the short term
  • To fundamentally reform the global financial system, in order to avoid repeating the mistakes of the past

The first two instruments of economic policy have produced good results as banks are not in danger any more and economies have generally come out of the recession in 3Q09. Nevertheless, the third lever of the post-crisis global policy, the reform of financial system at global level, takes a lot of time, and the incentives to reform will become weaker and weaker as time passes and economies stabilize. We illustrate this stalemate of the new world regulation in four points. First, we assess the progress made in relation to the G20 proposals for reforming the global financial system. The first observable results, notably in terms of prudential ratios, leverage and liquidity policy of banks could appear only from the end of 2012. The Financial Stability Board still considers that the risk management of banks leaders remains poor.

Second, we explain why the implementation of the equivalent of a Tobin tax seems to be impossible despite the support of several European countries. Then, we analyze the small success accomplished during the Copenhagen summit as another example of the difficulties of the new world regulation. In a post-crisis context, the lack of long-term vision of governments and national priorities limit initiatives on global redistributive policies. At last, we believe that the real issues at global level, i.e. excess liquidity, Dollar predominance, and public debt sustainability, are not covered by any initiative, which should in fact lie at the heart of the new world regulation.

The end of this year has seen UK’s and France’s decision to tax up to 50% of the highest bonuses of the banking industry. The Copenhagen summit was also at the center of the spotlight in December. These two events, which do not seem to be related to each other, may nevertheless precede what could emerge as a new world regulation in the years to come, i.e. more socially-oriented economies, more ecologically-responsible models of growth. The
impact of the last crisis and the strength with which governments intervened to stabilize their economies suggest that a new world regulation will emerge rapidly.

Nevertheless, the most optimist reformers have quickly come to recognize that profound changes of the financial system and curbs of carbon emissions will be difficult and will take a long time. The UK’s and France’s example has not been followed by other major countries. The Copenhagen summit has resulted in a minimal agreement only. The reality of economics has one more time eclipsed the importance of social and ecological agendas. The
urgency of the situation, in terms of growth, employment, and financial stability, has prompted governments to favor short-term issues to the detriment of forming a long-term vision. Moreover, the growing complexity of economic relations at the global level makes reform increasingly more difficult to coordinate. At last, the emergence of a bipolar
world where the US and China predominate, makes the harmonization of rules hazier than a recent past characterized by a uni-polar world.

We will see that the difficulties of reforming the financial system are paradoxically related to the growing strength and continuing weakness of the banking sectors. The most important actors have come to depend less on support from their governments, and have paradoxically more market power as a result of consolidation of the banking industry. It is therefore increasingly more difficult for governments to impose a new system of regulations and remuneration. At the same time, the difficulties of the smallest banks, namely the regional banks in Europe and in the US, make the highly capital-consuming new standards hard to implement. The growing competition between Asian and Western financial centers only heightens the difficulties of harmonizing rules.

The resurface of the Tobin tax debate from time to time casts doubt on the possibility to organize a more sustainable and egalitarian model of growth. Such a tax has been envisaged to solve the problem of financing climate change, for taking control of international capital flows, and for organizing an insurance system in case of shock on banking institutions. We will see in the second part that it will be difficult for these ideas to materialize.

The growing market share of Asian financial markets, existence of potential free riders like fiscal paradises, and growing needs of governments in terms of fiscal revenues for domestic purposes, make the coordination for such a global question quite impossible.

Mirroring the stalemate of new world regulation, Copenhagen has exhibited a typical dilemma, i.e. a universal recognition of the needs to curb global warming against national interests in the aftermath of the crisis. The decoupling of macroeconomic conditions, bipolarization of the world, lack of political vision, and fragility of governments, make the global environment less conducive to forging any kind of agreement. Moreover, the real issues of the world regulation, e.g. the path to be taken by the Dollar, control of excess liquidity, and reduction of public debts, have not yet received serious attention that they deserve.

Difficulties concerning the implementation of new financial regulation
The G20 summit of Pittsburgh in September 2009 has paved the way for an ambitious overhaul of world regulation. In the aftermath of the crisis, the ambitions of political leaders were clear: to give more weight to emerging countries in international negotiations, to strengthen the capital basis of banks globally, to initiate a better monitoring of complex financial activities (improvement in transparency), to implement reasonable compensation practices and better coordination of monetary and fiscal policies.

As of now, the only real decisions taken after the wave of recapitalizations in industrialized economies is in compensation practices. The British government has decided to tax 50% of discretionary bonuses above GBP 25K. The French government shortly followed the British example. Such decisions are indicative of sound progress in terms of risk control, as overly generous wage compensation policies can lead to excessively risk-taking behaviors. But we will identify several limitations of this approach.

First, even if other governments regard the British and French initiatives positively, as in case of Germany, chancellor Angela Merkel did not decide to take further action. In the US, Congress has already rejected the idea. Moreover, the decision to tax bonuses may not curtail overly high compensation. The UK and French banks may decide to absorb the tax hike and not pass the pain to their employees.

To read the full report: NEW WORLD REGULATION


On account of global recessionary trends, India witnessed slowdown in its economy which resulted in all time high 16 – year high fiscal deficit of 6.8% which by any standard is unsustainable. The government in order to overcome economic slowdown and ensure that the economic growth process is not derailed growth during it introduced three stimulus packages which resulted in fiscal deficit of 6.8% of GDP.

Economy has started improving on account of government’s stimulus package. We expect, stimulus package would be withdrawn in a phased manner in tune with the gradual improvement of Indian economy.

It is encouraging to note that the government made its intentions clear to roll back the fiscal deficit to 5.5% from 6.8% of GDP in FY 11 and further down to 4% in FY 12. However government needs revenues to overcome these fiscal slippages and increasing the rates of indirect and direct taxes prematurely would defeat the very purpose of stimulus package. Government was left with the onerous task of maintaining a delicate balance between maintaining the growth momentum and ensuring rigorous fiscal discipline to bridge the fiscal deficit at acceptable levels within the shortest possible time span. Under the circumstances divestment of PSU’s was the only panacea to the abovementioned dilemma.

PSU Disinvestment inevitable…

The Cabinet Committee on Economic Affairs decided that the government will lower its stake in all listed public sector enterprises (PSEs) to atleast 90%. Government has already initiated this process by divesting 5% stake in companies like NHPC, Oil India which fetched ~Rs.42,600 mn. There are ~13 companies in which government stake is in excess of 90%. Disinvestment in these companies could fetch ~Rs. 280,000 mn which are shown in report

Further, disinvestment by the government would lead to significant re – rating of PSU companies. Local indices and MSCI India are on free float basis, where PSUs score poorly- e.g. PSU weightage in Nifty by Market Capitalisation is ~29%while actual weightage is only 14.7% due to low free float. As a result global fund managers may have to increase their weightage in PSUs. In general, India may have a poor perception of PSU companies but these stock’s have outperformed the Sensex over the last 1,3 and 10 years.

2010 can expect huge issuances from Government of India. As India is transiting from US$1 trn economy to US$ 2 trn, it has a digestable appetite to absorb these massive investments mainly due to its 38 % savings rate.

Companies in the PSU basket have huge cashable, monetizable assets like for eg. a land bank. Government is increasingly consenting to monetize these land banks.

PSU’s a wealth generating story in the past…
PSUs disinvestment has created value for investors in the long run. If we recall the 1st time that PSUs got listed in 1993 – 94, it was amazing to see the bargains that one got in companies like CMC, BHEL etc.

To read the full report: PSU DISINVESTMENT


Right time, right place. Market leader IRB offers a focused play on India’s road sector at a time when highway construction is a top government priority. The company, which builds and operates toll roads, has the largest portfolio of build-operate-transfer (BOT) toll assets (1,154km across 16 projects). We estimate that IRB will record a FY09-12 earnings CAGR of c47%, driven by four contracts that the company has won in the last six months, new projects we expect IRB to be awarded over the next year, and revenue from two new toll roads.

Strong sector growth prospects. Given the government’s renewed focus on the building of highways, we estimate India’s road sector will generate cINR3trn (USD65bn) worth of business over the next 7-10 years. In the near term (FY09-13), this should amount to INR1.8trn (USD40bn), and we estimate IRB will capture a c6.5% share (USD2.6bn) of this highly fragmented market during this period. IRB will need to raise fresh capital to fund this growth. Its historical capital utilization record has been positive; we estimate the value of existing projects at 1.9x invested equity. Our current estimates do not factor in any dilution.

Attractive valuation. Our sum-of-the-parts value consists of INR138 for existing projects (DCF based), INR113 for its construction business (18x FY11e EPS), INR10 for other businesses and INR37 for future growth. IRB’s 62% earnings CAGR during FY09-11e and FY11e ROE of 20% are superior to its Chinese peers (earnings CAGR 13%, CY10e ROE 13%). Superior fundamentals justify IRB’s higher PB of 3.3x and PE of 17.8x against its Chinese peers (2.0x PB, PE 14.5x). If we factor in IRB’s impending INR12bn fund-raising, it would trade at an implied FY11e PB of 2.5x. Key risks: A sharp drop in traffic growth and an increase in interest rates.

To read the full report: IRB INFRASTRUCTURE


BRICS auto universe registered 69% yoy growth and 4% mom decline in vehicle sales in December 2009- commercial vehicles (up 146% yoy, 21% mom), two wheelers (up 69% yoy, down 4% mom) and passenger cars (up 58% yoy but down 6% mom). Key highlights: (1) CV sales of Tata Motors and Ashok Leyland improved 143% yoy and 165% yoy respectively, (2) Maruti’s exports rose 21% mom, (3) TVS’ motorcycle sales grew 24% yoy (first positive growth in FY10), and (4) M&M’s automotive sales grew 125 % yoy mainly on low base effect along with better performance of Scorpio and UVs.

BRICS auto universe registered 69% yoy growth and 4% mom decline in vehicle sales in December 2009. Two wheelers saw 69% yoy growth led by Bajaj Auto. While commercial vehicles grew 146% yoy led by Tata Motors (143% yoy growth), passenger car companies grew 58% yoy (6% mom decline).

Two Wheelers: The industry continued to report impressive performance and reported 69% yoy growth despite the end of festive season in October (usually November-December is lean period as most purchases are made during festive season). Bajaj Auto’s total sales was down 9% mom mainly due to lower sales in motorcycles (Pulsar sales volume at 44,518 units was lower than average 50,000 units and Discover 89,769 units v/s average 92,000 units). TVS Motor reported 24% yoy growth in motorcycle, 44% in scooters and 41% in mopeds. Industry leader Hero Honda maintained momentum and reported 74% yoy growth. We expect growth traction in two-wheelers to continue for rest of FY10.

Passenger Cars: Sales volume for Maruti Suzuki was up 51% yoy and down 3% mom, while for M&M it was up 120% yoy and 12% mom. Domestic volume for Maruti was up 37% yoy at 71,000 units, while exports were up 223% yoy and 21% mom at 13,804 units. The company said it would achieve export target of 140,000 units in FY10 (YTD 105,535 units). Tata Motors posted growth of 48% yoy in volumes but down 30% mom at 15,239 units.

Commercial Vehicles: Commercial vehicle sales volume reported 146% yoy and 14% mom growth. Ashok Leyland (165% yoy growth) outpaced Tata Motors (143% yoy growth). We expect CV sales growth to remain robust in Q4FY10, led by improving industrial production.

M&M and Bajaj Auto preferred bets
We expect auto sales to continue to grow over FY09-11 driven by rising income, easy access to financing, and higher industrial production. We prefer exposure in M&M and Bajaj Auto in the auto space as they are likely to be biggest beneficiaries of growth in India's consumption. M&M is our preferred bet - we value M&M's core business at Rs910/share and subsidiaries and other investments at Rs443/share (after applying 20% holding company discount) and expect RoCE of 20% in FY10 and 19% in FY11. We have a BUY on Bajaj Auto - expect 22% CAGR in sales volume (likely to regain some domestic market share lost in FY08 and FY09), 12% revenue CAGR and 64% earnings CAGR over FY09-11, and RoCE at 35% in FY11 v/s 31% in FY09. The stock trades at 17x FY10E and 15x FY11E, which is attractive. We expect Bajaj Auto to trade at premium to Hero Honda (15x FY11E) as it is expected to deliver higher earnings growth.

To read the full report: AUTOMOBILE SECTOR


To read the full report: MANGALAM CEMENT