Thursday, February 11, 2010

>GLOBAL DISEQUILIBRIA: Don’t expect lasting stability

Our basic view remains unchanged; we remain positive on equity markets, credit spreads and most commodities because liquidity flows are still very positive and key indicators discussed below are supportive. However, we still are very concerned about the artificial nature of the economic recovery and financial markets and when the relatively benign environment might change for the worse.

Past issues have pointed to the widespread and huge disequilibria in the U.S. economy and financial system. That is also true globally. No one knows what’s real and what is not when it comes to the economic recovery and market prices for assets and currencies. Market forecasts are always a big part of the game; in today’s context, we can’t attach much confidence to any of them. Rather, it makes more sense to think in terms of whether the environment is favorable for assets or not and to watch for benchmarks to gauge when that might change and how it would affect the different markets.

One thing we do know: markets eventually correct disequilibria and it is usually painful. However, time lags are variable and frequently longer than most people can imagine. But when the adjustment comes it is usually swift and substantial. This makes for an uncertain environment because the risks are not easily quantifiable.

Financing the U.S. Treasury Debt
As we have pointed out frequently in past letters, the explosion in the deficit and the government debt to GDP ratio is not a problem in the short run when the U.S. economy is in recession, inflation is low, private savings are rising, the dollar is firm and the existing debt ratios relatively moderate. But now that the economy is growing, possibly quite fast, financing the deficit may not be easy at existing interest rates as people are looking ahead to government debt ratios which will be anything but moderate.

Who has been buying the massive issues of U.S. government debt? In an interesting recent piece, “Is it all Just a Ponzi Scheme?,” Eric Sprott and David Franklin looked behind the published numbers to see who bought the $2 trillion of net new U.S. government debt last year to finance the budget deficit and other cash requirements. The Treasury data shows the “Other Investors” sector increased its holdings of government debt by 200% in 2008 and 2009 (Charts 1& 2). Similarly, flow of funds data shows that the ‘Household” sector was the largest net purchaser in late 2008 and 2009. These two categories - “Other” from Treasury statements and “Households” from FRB statements are residuals: if the figures don’t add up, they are used to “balance” the numbers.

Investment Conclusions
January was a month of correction. U.S. and international stock markets were virtually all down, some by negligible amounts, others such as the key Shanghai market, by as much as 10%. Shanghai was hit hard because the government ordered a clampdown on bank lending and increased reserve requirements to counter too rapid economic growth and strong asset price increases in some real estate markets. Commodities and precious metals also sold off in January.

U.S. 4th quarter GDP data indicate almost 6 % real growth and many are predicting a mini boom to last for some time. One of the main arguments used to project strong growth is based on past experience which shows deep recessions are followed by rapid recoveries. If this occurred, the expectations of continued easy money and ultra low interest rates would

To read the full report: GLOBAL DISEQUILIBRIA

>India Sugar Outlook 2010: Supply/Demand Mismatch to Benefit Sugar Mills

Summary: Fitch Ratings expects the liquidity position of sugar mills to improve significantly in the Indian sugar season 2010 (SS10, October 2009‐September 2010), mainly due to an increase in profitability and free cash flow (FCF). Enhanced liquidity should in turn be utilised for debt reduction, thereby resulting in an overall boost to credit profiles.

This trend should continue into SS11, with the sugar cycle continuing to remain positive. Thus, on the back of comfortable credit profiles due to lower leverage and financial costs, sugar companies should be in a much better situation to handle the downward pressures in the next down‐cycle.

However, Fitch notes that any improvement in credit profiles would be limited in the short‐ to medium‐term for companies incurring significant capex which would be partly funded by debt.

Bright Prospects for SS10
High sugar prices should be sustained — a result of a significant shortage in sugar cane production and, to a lesser extent, ongoing demand growth. During SS09, the poor monsoons, coupled with a reduction in the acreage of sugar under cultivation, resulted in insufficient sugarcane relative to overall sugarcanecrushing capacity. This led to India’s widest‐ever sugar deficit, which Fitch expects to be extended, although to a more moderate extent, during SS10 — and SS11 as well. During the first three months of SS10 (Q1SS10), sugar prices — factoring in the supply/demand situation — increased by 88%, to INR32 per kg from INR17 per kg in

Although rising sugarcane acreage will mean a higher cane supply during this timeframe, the growth is unlikely to fully meet the current deficit (as of February 2010). Market estimates indicate that cane supply will increase by around 3% in SS10, from around 155mt (million tonnes) in SS09, whilst growth in demand is likely to remain stable. The resulting deficit is likely to keep sugar prices high during much of SS10 and SS11. However, prices could ease towards H2SS11, with better visibility of cane output and a declining supply deficit, although Fitch does not expect the low prices of SS08 and H1SS09 to be repeated. The global price outlook for sugar also remains strong, with other major sugar‐producing regions such as Brazil also seeing a drop in production during SS09.

Fitch expects sugar mills’ profitability to continue to be strong during SS10 and SS11, as the higher prices would more than offset the lower output due to cane shortages. While margins could be trimmed due to the higher cane procurement costs, they will still improve liquidity and cash flow for most sugar companies. Fitch does not expect the industry to witness large‐scale increases in sugar‐crushing capacity, due to the excess capacity built up over the past two to three years. The ongoing capex plans mostly include investments in refined sugar capacities (either forward integration for existing capacities, or for imported raw sugar) and captive cogeneration or bio‐fuel power plants, which (once operational) would add incremental margin.

Indian Sugar: NearTerm Deficit

Continued Supply Shortage; Cane Prices to Remain High

Sugar production has typically been affected by shortfalls in sugarcane availability — an outcome of the relative sugarcane price paid to farmers, substantial disputed sugarcane arrears payable by the mills to the farmers, and better prices from other cash crops. Adverse weather conditions are clearly also a major factor in sugar supply — with a direct impact on sugar yields and recoveries. Fitch notes that the industry has traditionally followed a pattern whereby the cycle seems to turn every two years.

During SS09, a significant 17% drop in sugarcane acreage cultivation — in addition to a drop in sugar recoveries from over 10% in earlier years to 9.5% in SS09 — resulted in a 44% drop in total sugar production.

Fitch expects sugarcane acreage to partially increase in SS10, resulting in a continued shortage in cane supply. The shortfall will lead to further competition between sugar mills to obtain a share of the cane produced, which will put pressure on the capacity utilisation of most mills — as well as a sharp rise in cane procurement costs. During SS10, sugar mills have procured sugarcane at a price per quintal of INR200‐205, as against the announced State Advised Price of INR165‐175 per quintal — a difference of over 40%. Fitch expects these rates to further increase during SS10 and SS11, and a part of this increase will be to motivate farmers to increase cane acreage.

To read the full report: SUGAR OUTLOOK


Our FY10E estimates are at risk — Suzlon’s 3QFY10 Recurring PAT loss of Rs2.4bn was below CIRA expectations of loss of Rs722mn. Reported PAT at Rs141mn was higher on account of Rs2.5bn profit on sale of 35.22% stake in Hansen. 9mFY10 recurring losses of Rs10.5bn imply that our FY10E loss
expectation of Rs4.9bn has significant downside risks.

FY10E WTG MW sales guidance expected to be cut — WTG 3QFY10 MW sales at 404MW were down 41% YoY. In 9mFY10 Suzlon has done sales of 810MW. We expect Suzlon’s management to revise down sales guidance of 1900 - 2100MW as it is unlikely that the company can do more than 900MW in 4QFY10.

Domestic sales could be good and exports poor in FY11E — We believe there is a possibility that Suzlon could do more than our estimates of 800MW domestic sales in FY11E given the recent pickup in orders in India from public sector undertakings and large corporates like ACC, GACL, GAIL, ITC and RSMML. However, we are unsure if our FY11E exports estimates of 1300MW can be achieved at this point in time given tepid international order inflows.

Hansen/REpower disappoint due to sales decline — REpower's provisional 3QFY10 EBIT at €25mn was 15% below CIRA expectations of €29.6mn on YoY sales decline of 3% at €310.8mn (CIRA at €370.7mn). EBIT Margins at 8% were in line with CIRA expectations of 8%. Hansen's 3QFY10 sales at €137mn (vs. CIRA at €154mn) were down 12% YoY due to reduction in scheduled deliveries. EBITDA margins at 9.8% were in line with expectations.

WTG net debt down – but still too high — WTG had Rs125.8bn of gross debt at the end of 3QFY10 and cash balance of Rs10.4bn. Issue of GDRs for US$108mn, cash infusion of US$94mn through additional CBs, Rs17.2bn from Hansen stake sale and refinancing of acquisition loans has helped reduce net debt.

To read the full report: SUZLON ENERGY


Siemens reported a substantial surprise on margins leading to strong earnings growth in its 1Q10 results. We remain Underperform on the stock while our increasing price target to Rs438 from Rs318.

Substantial margin surprise in the quarter: Siemens reported an impressive 18.0% EBITDA margin in the quarter vs a 9-11% run rate in the past 16 quarters. We spoke to the management, which commented that it might be due to advance revenue bookings in few projects and should even out in the next few quarters. The power segment (which contributes 45% to revenues) margins were the key driver up to 22.2% vs 12.1% in 1Q09.

Revenue growth in line with estimates; margins should even out: Revenue growth came in at 13%, in line with estimates. We believe Siemens may have booked advanced revenues in few power projects and margins should even out going forward. Power sector revenues grew by 11% while automation & drives grew by 18% YoY.

Valuations rich despite better outlook

Building moderately strong growth: On the back of an improving outlook, we are now building 11% and 15% revenue growth, respectively, for 2010 and 2011 for Siemens with 10.5-10.7% margins in the domestic business.

Strong order inflows on the back of 1 large Rs30bn Qatar order: Order inflows came in at Rs51.7bn (+161% YoY) driven by a large Rs29.6bn order received from Qatar Electricity. This has taken the order book up to Rs136bn (+33% YoY), which had remained stagnant for about 9 quarters now.

Order inflow momentum could improve and boost growth: We expect transmission order inflows from PGCIL (PGCIL IN, Rs113, Not rated) to start flowing in CY10 in addition to improved activity in the industrial
segment, which would support growth into 2011.

Earnings and target price revision
We are increasing our earnings estimates by 12% and 9% each for the next two years assuming higher margins vs earlier. We have increased our target price to Rs438 from Rs318 on the back of our earnings upgrade and a higher 20x multiple to its March-11 earnings vs 18x earlier.

Price catalyst
12-month price target: Rs438.00 based on a PER methodology.
Catalyst: Maintaining 11-13% margins in next few quarters.

Action and recommendation
Stock remains expensive; Switch to Crompton: We are now building in higher margins for Siemens despite it selling off its high margin IT business to its parent last year. We are also building an improved growth outlook on the back of an expected increase in order inflows on the transmission side. Despite that, the stock is trading at 32x Sep-2010E earnings and 27x Sep- 2011E earnings, and at a substantial 30-35% premium to our preferred play Crompton Greaves (CRG IN, Rs434, OP, TP:Rs509).

To read the full report: SIEMENS

>BHEL: 14th India Investor Conference (MERRILL LYNCH)

Key takeaways were:
India’s #1 power equipment major with ~54% share:
BHEL plants light two out of the three Indian homes and have ~54% share, even in XI plan (FY08-12). Its competitive advantages are its efficient, rugged, indigenously produced power equipment and after sales services, which give clients consistent high PLF / availability – key to superior RoE. BHEL remains our top pick on improving visibility of 23% EPS CAGR over FY09-12E, led by multi-year capex cycle driving backlog at 4x FY10E sales, peaked costs and improved competitiveness.
BHEL strategy to retain its market leadership in world’s 2nd largest and the most exciting power market being keenly contested by global majors are detailed below:

Upgrade product suit: Super-critical, ACGT & Nuke turbines
BHEL has upgraded its technology and ratings across the product e.g. It acquired technology for super-critical boilers upto 1GW from Alstom, TG from Siemens, CFBC boiler from Lurgi, Germany and advance class gas turbines with up to 289MW (ISO) from GE, USA. It is in final stages of finalizing Nuke turbine technology of up to 1.6GW in JV with Nuke Power Corp. of India. It has also developed 300MW, and 600MW sub-critical sets on its own to fight Chinese competition.

Focus on Private IPPs to retain market share
Its focus on private IPPs has led to some big order wins - JP (2x250MW & 3x660MW), IndiaBulls (10x270MW), JSPL (4x600MW) and Hindalco (6x150MW).

Expanding capacity to meet burgeoning backlog (US$27bn): It is expanding capacity to 15GW v/s 10GW by FY10E and 20GW by FY12E.

New wage settlement = Improve cost competitiveness:
BHEL has signed a 10 year wage agreement, which will cut its labor costs ~250bps in 2 years and boost competitiveness / operating leverage. BHEL is likely to have 50K people for 15GW v/s 43K for 10GW.

JVs with customers to enter new products
BHEL has entered into JVs with its customers to secure market share in supercritical & Nuke technology - TNEB 2x800MW, Mahagenco 2x660MW / 800MW and 2x660 MW / 800MW with Karnataka and Nuke Power (NPCIL).

To read the full report: BHEL