Saturday, February 13, 2010

>U, V or W: What Kind of Recovery Can We Expect, and When? (WHARTON)

Delegates to the just-ended World Economic Forum in Davos, Switzerland, found plenty of positive economic signs -- but not enough to keep them from wringing their hands. The consensus at the five-day gathering called for strong growth in emerging markets like China, India and Brazil, and poor growth in Japan and much of Europe, with the United States somewhere in between. The Forum's official statement called the global recovery "fragile." (See Wharton management professor Michael Useem's op-ed article on the event.)

Nouriel Roubini, a New York University economics professor who had predicted the financial crisis at the Davos meeting three years ago, sent jitters through the meeting with his forecast for a slow recovery worldwide, "subpar growth" and risk of a double-dip, or second recession. Yet most speakers viewed the world as better off than it was a year ago. The question remains: What's next? Will the world's economic recovery -- assuming it has started -- follow the hoped-for V pattern, form a less desirable but acceptable U or turn into a much-feared W? There was little agreement on how the recovery will proceed. Threats, like panic sparked by a possible government-bond default in Greece or Spain, could roil the financial markets and world economy, many said.

At the start of February, economists and financial experts have mixed opinions as to the strength of the recovery, although Wharton finance professor Jeremy Siegel sounded a note of optimism. "We got some
very good news today," he said on Monday, citing the latest purchasing managers' report showing
manufacturing at its highest level since August 2004. Others are more cautious. "It all boils down to jobs
at this point," says Mark Zandi, chief economist and co-founder of Moody's, analyzing the
U.S. economy. "We're still losing them. There's widespread optimism that we will start creating them
soon. If we don't, then the recovery will be stillborn."

The Us, Vs and Ws refer to the shape of a graph plotting the ups and downs of economic gauges, like gross domestic product (GDP). Siegel expects a V -- with the upturn mirroring the downturn as the economy climbs to the old heights. Of course, he notes, there can be a distorted V, with the right-hand side -- the recovery -- taking longer than the decline, or progressing faster. Among the other patterns, U signifies a delay between the downturn and recovery, while W is a downturn and recovery followed by another downturn and another recovery -- a kind of bouncing on the bottom.

In the U.S., GDP grew at an annual rate of 5.7% in the fourth quarter of 2009, a surprising turnaround given the weak 0.4% growth in 2008 and falling GDP for much of last year. The GDP figure was cheering, even though much of the growth came from an inventory buildup that will end when supplies are restored to normal, Siegel says. "Exports and imports are growing very strongly. World trade is definitely bouncing back, no question about that."

Exports accounted for about 2 percentage points in the 5.7% GDP figure, says Wharton finance professor Richard Marston. He agrees with Siegel that "most of the rest was inventory buildup. Inventories are not a source of sustained growth, so many experts expect that U.S. growth this year will be considerably slower." Analysts at Morgan Stanley predict that U.S. GDP will grow 3.1% this year, while Citigroup puts the figure at 2.9%. Morgan Stanley forecast global growth at 4% and Citibank at 3.2%.

A number of speakers at Davos argued that emerging economies like China and India are the key to worldwide recovery. Siegel concurs. "They are already helping us. China's recovery is helping all of Asia, and Asia is experiencing a very nice recovery.... India and China are doing well." Morgan Stanley expects China's economy to power ahead by 10% this year, and India's by 8%. Citigroup puts the figures at 9.8% and 8.4%. The weak spots: Japan, the United Kingdom and the euro zone. Both firms expect growth of less than 2% in those areas. Morgan Stanley is especially pessimistic about Japan, forecasting growth of just 0.4% in 2010 and 1.5% in 2011. "The Davos discussion was correct that a lot of the prospects for world growth lie with the emerging markets, particularly China and India," Marston says. Most experts point out that the world economy is fragile and much could go wrong. "Oil prices could shoot up," Siegel warns. "We could have a very serious development in Greece that causes disruption to the euro zone." Spain looks even more worrisome to many observers.

Wharton Management Professor Marshall W. Meyer notes that China is prone to boom and bust cycles, with booms introducing damaging factors into the world economy, such as higher commodities prices. Currently, he says, China appears to be in a real estate bubble. "Real estate prices are way beyond the reach of ordinary Chinese, particularly in the cities." If the bubble continues to expand and then bursts, it could spark panic in world financial markets, he notes. "I think the psychological impact of a sudden drop in real estate prices in China would be far more important than any economic impact." Fortunately, he says, the Chinese government is aware of the problem and is tapping the economic brakes. Meyer thinks this will gradually slow the Chinese economy, but not enough to hurt the rest of the world.

In the U.S., the world's largest economy, many signs are positive, but not all. A Federal Reserve survey released February 1 found that none of the 50 banks questioned had tightened lending standards for large and medium companies, while only two had tightened lending for small firms. The findings showed the business-lending situation is no longer getting worse, but money remains tight. "Banks are not lending very much," says Wharton business and public policy professor Howard Pack. "There's still a huge amount of unemployment and no prospect that it will be reduced very rapidly. And there are still foreclosures."

The burst real estate bubble was a key factor to the recession in the U.S. Now there are signs of improvement. On February 2, the National Association of Realtors said its index of pending home sales was strengthening. The Standard & Poor's Case-Shiller Home Price Indices show home price declines are slowing substantially. "We appear to be forming a bottom in the housing market," says Wharton real estate professor Susan M. Wachter, noting that in some parts of the country, prices are actually rising. "We have stabilization of the housing market, which is very important to the banking system." Low interest rates, the $8,000 tax credit for home purchases and government support for the mortgage market via purchases of mortgage-backed securities are key factors, she says.

But, Wachter adds, high unemployment will dampen the housing recovery. "People who don't have jobs are not going to be purchasing homes." Also, she notes, home prices are not likely to rebound given that the market is flooded with foreclosed homes being sold at fire-sale prices. Various studies have found that between 4.5 and 5 million homes are worth less than their owners owe on their mortgages, a condition that leads many to stop making loan payments, spurring foreclosures. "The foreclosure problem is what will keep a V-shaped recovery from happening in the housing market," she says.

Even if the housing market improves, there are growing problems in commercial real estate, warns Pack. Rents are not rising as developers had projected, and there have been a number of high-profile failures. In New York City, investors recently defaulted on $4.4 billion in debt on a development called Stuyvesant Town and Peter Cooper Village. "The ongoing problem is huge," Pack says, noting that the health of the commercial real estate market is very difficult to gauge.

More Hiring and Spending
The big problem in the U.S. is jobs. The February 5 unemployment report "is probably going to be the most important report of the next few weeks," says Siegel, adding that employment figures have been improving for months. "We will get job creation this year, [probably] this quarter."

About a third of recent GDP growth was due to government stimulus programs over the past year or so, according to Zandi. Now prospects are getting better. Businesses have cut to the bone and are likely to begin hiring soon to increase production as the economy strengthens, he says, arguing that President Obama's proposed tax credits for businesses creating jobs could be enough to spark improved confidence among business owners. "All they need is a little bit of benefit to overcome their fear and start hiring again." Still, he warns that it will take a lot for the unemployment rate to drop from the current 10% to a normal level around 5%. "To get there, you need to create at least 10 million jobs," he says. "That's doable, but it feels like a reach" to expect it by 2013 or 2014. Marston notes that the U.S. economy is heavily dependent on domestic demand, including consumer consumption. He expects that to strengthen this year.

"How can consumption revive with 10% unemployment? I believe that a lot of the fall in consumption was in families who could have spent more but were unnerved by the financial crisis," Marston says. "These are families that have seen wealth -- houses, stocks -- decline, but still have maintained their income. Now they are in a position to resume their spending. With the revival of the stock market and the good news on third and fourth quarter GDP, we are seeing a modest revival of consumer demand.... We can't rule out a double dip, but I think it's very unlikely. Instead, we are likely to see growth this year, though at a modest rate."

Still, many experts debate whether the economy needs more help in the form of another government stimulus. Siegel argues against it, suggesting that an additional stimulus like government spending could overheat the economy, sparking inflation. "I do not see a major stall in the recovery," Siegel says, predicting GDP will grow at a 3% rate in the first quarter of 2010. Zandi believes another stimulus shot, such as Obama's proposed tax credit for job creation, would help insure against a double dip. "While the job market and economic recoveries are likely to gain traction even without substantially more fiscal stimulus, odds remain uncomfortably high -- about one in four -- that they won't," he writes in his Dismal Scientist newsletter.

"For the next year or so, most Americans will swear we are still in recession," Marston concludes. "I can't blame them because unemployment will respond only sluggishly to the upturn. But the fact is that the recession is over. I predict that the [National Bureau of Economic Research] will announce shortly that the recession ended last summer, or perhaps early last fall."


Q3FY10 was yet another tepid quarter for the telecom industry led by hyper competition and falling tariffs, which kept revenues flat QoQ. Bharti Airtel and state-owned players, BSNL and MTNL, were losers on all fronts, shedding both subscriber and revenue market share. Vodafone and Idea Cellular were amongst the major gainers in terms of revenue market share. The Tatas, despite strong subscriber traction and increased market share following the successful launch of DoCoMo, lost adjusted gross revenue (AGR) market share by 28bps QoQ. Aircel captured more of the subscriber and gross revenue pie, but its AGR market share remained relatively flat.

Wireless revenue down 3.3% QoQ: With fierce competition and declining tariffs, the telecom sector witnessed flat sequential revenues of Rs 291bn (AGR) in Q3FY10, as per data released by telecom regulator TRAI. Strong growth in the AGR for wireline (up 6.3%) and long distance services (NLD: up 11.5% and ILD: up 11.7%), was negated by a fall in the wireless segment (down 3.3% QoQ). Wireless gross revenue (GR), which is inclusive of inter-operator payments, registered a marginal increase of 0.7% QoQ to Rs 265.6bn in Q3FY10. However, adjusted for these payments, net revenue or AGR dipped 3.3% to Rs 197.8bn. This is despite the wireless industry adding 53mn subscribers in Q3FY10, up 11.3% QoQ.

Market share highlights – Wireless segment

Bharti Airtel: Bharti witnessed a decline of 79bps, 97bps and 65bps QoQ in subscriber, gross and net revenue market share respectively. The company saw the steepest revenue market share erosion in ‘C’ category circles, from 45.7% to 41.3%, down 434bps. Business was partly affected by the ban on prepaid operations in Jammu & Kashmir (since 1 November, 2009) and late adoption of low per-second billing plans (w.e.f 1 November) vis-à-vis competition. GR for the J&K circle declined 19% QoQ from Rs 2.8bn in Q2FY10 to Rs 2.3bn in Q3FY10.

BSNL/MTNL: Subscriber, gross and net revenue market share for BSNL/MTNL fell by 55bps, 57bps and 79bps respectively QoQ. Capacity constraints and bureaucratic operations, amongst others, hinder the operating performance of state-owned players.

Vodafone: Despite a 16bps fall in subscriber market share, Vodafone’s gross and net revenue share improved by 39bps and 80bps respectively.

Idea Cellular: With a 6bps increase in subscriber market share, Idea witnessed a growth of 61bps and 73bps in gross and net revenue share respectively. Early adoption of low per-second price plans helped Idea and Vodafone to stimulate traffic growth.

Tata Group: With the launch of GSM (DoCoMo brand) services in July ’09, the Tata group has witnessed 54% growth in subscriber base from 37.1mn in Q1FY10 to 57.3mn in Q3FY10. But despite a 100bps improvement in subscriber market share in Q3FY10, its AGR market share declined 28bps QoQ.

Aircel: In Q3FY10, Aircel registered an improvement in subscriber and gross revenue market share by 45bps and 35bps respectively. However, its corresponding AGR gain was restricted to just 3bps.

Reliance Communications: Revenue market share for Rcom improved marginally although it shed 40bps of the subscriber pie.

To read the full report; TELECOM SECTOR


Cautious optimism on refining recovery
Refining margin recovery seen in Jan 2010 (Singapore complex margins US$4.8/bbl vis-à-vis US$3/bbl in Apr-Dec 2009) may sustain. Two-thirds of the refining industry lost money in 2009. Consequent refinery closures and strong demand mainly from emerging markets would help the recovery. RIL, with its 2 complex refineries operating at high utilization rates, is well placed to benefit, in our opinion.

Update on KG D6 ramp-up and other key E&P issues
KG D6 gas may ramp up to peak in 2 quarters (our assumption), while KG D6 oil output may be 10-20k b/d in 2010E (22k b/d assumed in FY11E). The Supreme Court ruling in RNRL litigation may come in the next few weeks. Clarity on whether there will be a tax holiday on gas may take a long time, as it would to be decided by the courts.

Acquisition update
Canadian oil sand company Value Creations (VC) is unlikely to be acquired by RIL (recent press report of EoI), as the matter is closed now.

To read the full report: RIL


Pick-up in execution with 2 toll roads already commissioned in 2Q, cash-rich balance sheet (>Rs78bn), consol. P/BV of 1.6x FY09 and transformation of RELI into an Infra developer with project wins across domains.

Key takeaways were:
Rs190bn order book in EPC - gives visibility for 35% CAGR till 2012 in revenues.

RELI has 9 road projects, 2 of which are currently operational, 4 will be operational in next 12 months. Have received LOA for 2 projects in January 2010. Currently Rs73bn road portfolio is set to rise to Rs200bn by 2012. The company uses 20% as an internal hurdle rate for project evaluation. The biggest constraint in road development was land acquisition which has now been substantially taken care of with the new government policy. The new policy ensures at least 80% land acquisition before the project is awarded.

Metro rail:
Return from Metro projects lower than that in road projects but added benefits could come from real estate development. E.g: IRR of delhi metro substantially improved with over doubling of FSI at land-bank recently.

Entry into cement:
Planning to enter cement business in 3 years. The company can use ash and power from Reliance Power's power plants in the limestone-rich belt of Madhya Pradesh. The combination of abundance of cheap ash, power, and limestone will mean company may be the cheapest cement producer.

To read the full report: RELIANCE CAPITAL


Life insurance business moving towards profitability
R-Cap has outlined major initiatives, which we believe will lead to better core profitability going ahead. In its life ins. Biz., given that 70% of its biz. comes from tier 3&4 cities, NBAP margins will likely come down to 18.5% from (+20% now), but various cost saving initiatives like reducing agency manager (high fixed cost) base should enhance profitability of the life business. Also, co. is looking to increase its traditional biz. (7%) to enhance profitability. Co. looking to break even by FY11.

Cons. Fin. +16% RoEs target; AMC- Focus on PMS - offshore
R-Cap expects its home fin. and asset fin. biz. to yield 16-18% RoEs over medium term. On AMC, it plans to focus on the PMS and offshore biz. given the regulatory hurdles affecting the profitability of mutual fund biz. R-money (broking, the co. expects to move to variable fee structure) from flat fee) to increase yields (from 2.5bps to 3.5bps) and focus on fee based products (wealth mgmt etc). Finally, general insurance, the co. believes given the de-tariffing, RoEs have come down to 4-5%, hence non-core going ahead.

Stake sale in Ins. and AMC subject to regulatory approvals
Reliance Capital is looking to sell minority stakes in life insurance and asset management ventures to a strategic investor. R-Cap also likely to divest some stake in general insurance. Also, R-Cap is looking to list its life insurance venture. We believe these initiatives may lead to enhanced disclosure and also impact
valuations positively.

To read the full report: RELIANCE CAPITAL