Monday, March 8, 2010

>Why are financial markets not worried about the US fiscal deficit?

The financial markets are not penalising the United States, whose public finances are in a very poor state, while they are penalising many European countries. Can this asymmetry in the way they are treated be explained?

− Are the financial markets confident about the capacity of the United States to quickly regain vigorous growth capable of reducing the fiscal deficits? This is unlikely, due to deleveraging and accelerated deindustrialisation. Moreover, the low level of asset prices is eliminating the tax revenues generated by capital gains.

− Are the financial markets confident about the US administration’s commitment to reducing the fiscal deficits? But the Obama administration’s plans do not suggest this is the case, and the drastic reductions in fiscal deficits in the past in the United States (under Clinton) were due to exceptional circumstances (military spending cuts, taxation of capital gains, etc.).

− Are the financial markets confident that it will remain easy to finance the US fiscal deficits? Admittedly, the household savings rate is rising, central banks in emerging and oil-exporting countries are investing massively in dollars and the dollar plays a safe-haven role when risk aversion increases. This explanation is probably the right one, but it cannot be valid in the medium term. We therefore believe that there is an anomaly in the way US public debt is valued in the financial markets.

To read the full report: FINANCIAL MARKETS

>Staying defensive despite a good budget (PRABHUDAS LILLADHER)

Against the global macro and market backdrop delineated below, our India equity strategy recommendations, both at the sector and recommended cash levels, remain unchanged for the forthcoming month, as shown in Table 1. In order to purely rebalance the portfolio in response to changes in weights due to market movement, we are adding 0.30% to FMCG, 0.20% to Technology and reducing 0.40% from Telecom and 0.1% from Real Estate.

Our recommended sector allocation has outperformed the BSE 500 by 0.36% since January 22, 2010. Our recommended stock portfolio has outperformed the Sensex by 9.38% since initiation on September 3, 2009.

We believe Indian market participants’ continued resilience in embracing the thesis of ‘full decoupling’ between the Indian and the Global macro outlook, at a time of burgeoning budget deficits globally and escalating credit concerns is most clearly reflected in the narrowing of valuation premium between small and large cap names (illustrated in Figure 1). Market cycle history has shown such valuation differentials to be justified only in macro environments characterized by low financial and overall macro volatility in addition to low liquidity premium. According to our global macro investment thesis, discussed at length in sections below, the current macro outlook does not meet such characteristics. As a result, we recommend clients to take a cautious stance towards smaller cap names and be overweight in higher quality large cap names.

Emerging Markets
In our view, the declines in risk assets since the beginning of the year are fuelled by a spike in risk premium triggered by (1) mounting sovereign credit concerns, more notably out of Greece, (2) a continued US dollar rally that has extended into the month of January and the earlier part of February, and (3) equities’ overbought condition with the turn of 2009 calendar year.

Our medium and long-term investment outlook towards emerging markets remains exceedingly constructive owing to emerging market countries’ strong balance sheets, underleveraged household sector, competitive currencies, and ample room for financial deepening dynamics to take hold. Moreover, the emerging markets’ growing share of world growth and world GDP, versus a mere 5 or 10 years ago comparison levels, has mitigated the macroeconomic contagion risks stemming from adverse economic growth and financial sector shocks emanating from the developed world.

To read the full report: EQUITY STRATEGY


Reliance Industries (RIL) has delivered consistently high sequential growth for the last three quarters. The stock has, however, underperformed the Sensex due to concerns around sustainability of GRMs, future cash flow utilization and overhang of Supreme Court ruling in the RIL-RNRL dispute. We believe the concerns are overblown. We see the trend turning for refining spreads, as the economic recovery gathers pace and OPEC brings heavy crude supply back, thereby reviving the premium for complex refiners. While the petchem business will increasingly face headwinds from capacity additions, strong volume growth in the domestic market should soften the blow. The upstream business remains on track with the ramp-up of KG D6 a matter of time. While the timing and size of Lyondell (LB) bid remains uncertain, we see substantial upside in LB in the long run even at US$14.5bn. RIL may also look at other acquisitions (e.g. VCI) in the upstream space. We expect a 23% PAT CAGR over FY09-12E for RIL. Reiterate Outperformer.

Refining cycle is turning: RIL reported GRMs of US$5.9/bbl in Q3FY10, against Singapore benchmark GRMs
of US$1.9/bbl. With Singapore benchmarks showing a marked improvement to ~US$3.9/bbl for January 2010, we expect significant improvement in RIL’s Q4FY10 margins as well. We see RIL’s GRM rebounding to double digits by H2FY11, led by improved availability of heavy crude and economic revival gathering steam.

Petchem – playing the domestic growth story: With consistently high double-digit growth for the last three quarters, the strength in the domestic petrochemicals market has caught everyone by surprise. We see the volume growth sustaining over the next 12-18 months, which should help offset the likely weakness in petchem business due to the huge capacity additions over FY11-12E.

Valuations attractive; Outperformer: With improvement in the key business of refining and marketing as also strong volume growth in petchem, downstream looks set to deliver on the growth front. We see upstream continuing to grow robustly with KG D6 on track to hit 80 mmscmd by H1FY11E, while other exploration assets (NEC 25, CBM and KG D9) are well on the way to reach appraisal status. Current valuations of 11.6 FY12E earnings and 7x EV/EBITDA, we believe, are undemanding. Our SOTP-based valuation of Rs1,233 per share offers 25% upside from CMP. Reiterate Outperformer.

To read the full report: RIL


Excise duty increased; new format of cigarettes allowed
Prima facia, the Budget is negative for the cigarette business, the excise duty has been raised by 11-18% for King Size and RSFT which is higher than we assumed. The Budget has introduced a new format for cigarettes at <60mm>

Positive for hotel business
ITC however, will gain from an investment-linked tax incentive of 100% deduction in respect of the whole of capex in the hotel business. ITC will be commissioning a 600-room hotel in FY11E, we believe the tax incentive on the capex should contribute to c.3% to PAT estimates.

Interim growth higher, EPS remains unchanged
We do not change ITC's estimates for FY11E but reduce price target from Rs325 to Rs300, given a worsening margin profile of the cigarette business in the near term. In our interim period, however, the estimated volume growth in the cigarette business improves from the 4.2% trend growth in volumes to 5.5%, as the microfilter segment should emerge as a volume driver in the cigarette business.

Valuation: ITC is our top pick, price target of Rs300
We derive our price target from a DCF-based methodology and explicitly forecast long-term drivers with UBS’s VCAM tool. Our price target of Rs300 assumes an interim growth rate of 12% and a WACC of 11.6%.

To read the full report: ITC


The live wire

Plans to raise power-generation capacity 10-fold in next three years.
We assume higher coal costs and lower merchant tariffs.
Revenue growth of 132% and EPS growth of 127% over FY11-13E.

Initiate with BUY and a DCF-based TP of INR135.00.
At an inflexion point, in our view We initiate coverage of Adani Power (APL), an independent power producer (IPP), with a BUY rating. The company plans to expand its power-generation capacity 10-fold to 6.6 GW over the next three years and by another 6.6 GW. APL has a good mix (75:25) of long-term agreements to sell power and exposure to the spot market where tariffs are higher. This mix provides earnings visibility and high returns. We project APL’s ROE will peak at 41.9% in FY12.

Vertical integration, strong execution
APL is part of the vertically integrated Adani Group, which has interests in coal mining, shipping, special economic zone (SEZ) development, commodities trading (including coal and power), city gas distribution and oil & gas exploration. Listed group companies, namely, Adani Enterprises (ADE IN, CP: INR486.4, Not rated) and Mundra Ports and SEZ (MSEZ IN, CP: INR673.85, Not rated) have a track record of executing large infrastructure projects.

Conservative assumptions but still find upside
We estimate APL’s coal cost for its Mundra plant would increase only 7% if there is an increase in imported coal costs (we expect a 17-18% hike) from a change in the Indonesian mining laws. This is as APL will partly source cheaper coal from Coal India. We also assume conservative merchant tariffs, at INR3.50/kWh in FY11 and FY12, after which we model in a 6% increase. Based on our conservative assumptions, we estimate APL’s revenue will grow an average of 129% pa and EBITDA 141% pa in FY11-13, on the back of the planned10-fold rise in power-generation capacity.

We value APL’s 6.6 GW of projects using a DCF model. We estimate project free cash flows for the next 15 years and then consolidate it to determine free cash flow to the firm. We assume a terminal growth rate of 3%. We use a WACC of 9.2%, a tax rate of 30%, a cost of equity of 15%, a cost of debt of 11% and a target D:E ratio of 80:20. APL trades at an FY12 EV/EBITDA of 6.4x versus the global peer group average of 6.6x on Bloomberg consensus estimates (Exhibit 10). At our TP, the stock would trade at an FY12E EV/EBITDA of 8.1x – a premium which we believe is justified given APL’s substantial growth prospects. Key risks stem from higher-than-expected coal costs, lower utilization, lower-than-expected merchant tariffs, non-allocation of captive coal blocks for Tiroda, protracted arbitration for reneging on its PPA with GUVNL, or a withdrawal of tax incentives.

To read the full report: ADANI POWER