Friday, April 30, 2010

>The Economy vs The Stock Market

The global financial market rally is now in its 13th month. As we have pointed out repeatedly, it has occurred against an unsettling, uncertain and unbalanced macroeconomic backdrop. There is an array of structural problems that could derail the recovery once momentum from fiscal and monetary stimulus ends. However, slower than expected growth isn’t necessarily a big negative for investment returns. Sustainability, liquidity flows, interest rates and long‐term profit expectations are crucial variables. In this letter we offer a brief review of what we believe will be the weak link in the U.S. recovery and explain how investors should position themselves for it.

Forecasts for the durability of this bull market are wildly divergent, and with good reason. Most signs of recovery are clouded by the influence of government stimulus and reflation efforts. Moreover, year on year comparisons are misleading. Almost anything would look better than the abyss we were in a year ago. However, a common mistake many of the more bearish analysts are guilty of, is the assumption that investment returns are predicated on their near‐term assumptions of the GDP growth rate.

In terms of the negatives, runaway public‐sector deficits and debt growth are the greatest threats, which we will discuss in detail in a coming letter. However, there is likely at least a year or two before this weighs heavily on markets. The reason is that a massive fiscal drag is likely to hit the U.S. and other economies in 2011, in good part from tax increases. While extremely negative from a supply side perspective, it should help cool the angst coming from debt projections at least temporarily. However, the political process is always a wild card when unemployment is high, and it remains to be seen whether the structural deficit will actually shrink on a sustainable basis.

In the U.S., the more immediate threat to the recovery is consumer deleveraging. Housing prices and unemployment have stabilized, but a quick rebound is not in the cards. Years of credit‐fuelled consumption, which was taken to its ultimate stage of excess during the housing bubble, will be a slow and painful process to unwind. There are no shortcuts, and given that domestic consumption is responsible for 70% of economic activity in the U.S., sluggish growth seems inevitable.

Personal consumption expenditures are growing, although only at a 2% rate from last year. Retail sales are up substantially, but must be adjusted for government incentives which have been successful in causing a bulge in current spending, likely at the expense of future consumption. Worryingly, consumer confidence remains low, which is a reflection of weak income growth, high structural unemployment and excessive household debt levels. This is a grim picture particularly if income growth remains anaemic. It is important to keep in mind that the wealthiest 20% of Americans are responsible for 65% of consumption, and that their buying power is more closely correlated with stock market performance than with income.

Recent stock market gains have given this source of consumption a boost, while the lower middle class has had to be more frugal. However, asset‐driven spending is a two‐way street. A sharp break in the stock market and further weakness in housing prices could cause household spending to dry up again. Below, we present some charts that highlight the unbalanced and artificial nature of the recovery.

The case for a weak recovery.....

To read the full report: ECONOMY & STOCK MARKET


Siemens reported 2Q10 earnings of Rs1.8bn, which were largely in line with our estimate of Rs1.9bn. Margins significantly surprised on the upside, which was offset by lower-than-expected revenues. We have increased our target price to Rs542 from Rs440, as we have rolled over to the average of FY11/12E; however, we still maintain an Underperform rating, as we believe the stock has already built in a sharp turnaround in growth.

Margins surprise, however unsustainable at these levels: EBITDA margin stood at 12.9% in 2Q10, and if we adjust for the forex loss of Rs700m, margin stood at 16%. However, this high margin is mainly due to high-yield historical projects, which are likely to be over soon. We expect the margin to stabilise at 11.5% in FY11 and FY12.

Pricing pressure in projects business, product margins holding on:
Management said that there are pricing pressures in the projects business due to intense competition. However, product margins are stable at the moment.

Clear signs in industrial capex pick-up, order inflow growth back in +ve trajectory: Order inflow in 2Q10 stood at Rs22.4bn (+20% YoY), and the order book stood at Rs134.5bn (+40% YoY). Management said that though there was a good repeat demand in the industry automation and drives business, industry solution remains soft currently.

HVDC/800kV PGCIL order could aid growth: If Siemens were to win the Rs60bn HVDC/800kV order from Power grid (PGCIL IN, Rs110, Not rated), it could lead to significant revenue inflows for the company. Siemens is competing with ABB for this order, which is likely to be given out in CY10.

Earnings and target price revision
We have increased our 9/12 FY10E and 9/12 FY11E EPS forecasts by 13% and 12%, respectively, to factor in higher EBITDA margins. We also are rolling over our valuation to the average of FY11E and FY12E 20x EPS from the average of FY10E and FY11E EPS earlier.

Price catalyst
12-month price target: Rs542.00 based on a PER methodology.
Catalyst: Margins settling around 11–11.5%.

Action and recommendation
Earning growth does not justify historical multiples: The stock is trading at 27x Sep’11 and 26x Sep’12 earnings. Even after building in an upturn in order inflow, earnings growth should remain at a 15% CAGR over the FY10– 12 period, as the company faces competition from new entrants and takes longer gestation-period contracts. Earnings growth should not go back to 30% levels to justify historical multiples of 30x. We maintain an Underperform rating on the stock.

To read the full report: SIEMENS INDIA

>GLOBAL INVESTMENT TRENDS MONITOR : Fourth Quarter of 2009 and First Quarter of 2010 (UNCTAD)

• Foreign direct investment (FDI) flows remained relatively stable during the fourth quarter of 2009, though at a level much lower than that of 2007 and 2008. UNCTAD’s FDI Global Quarterly Index was practically unchanged at 117 over the previous quarter, and half the level in the first quarter of 2008

• During the last quarter of 2009 only a handful of economies – including China, Hong Kong (China) and Ireland – received more FDI inflows than those in the quarterly average of 2007.

• Among the three components of FDI flows, equity flows – the most closely linked to real investment operations abroad – compared to reinvested earnings and other capital (intra-company loans) remained at a very low level. Transnational corporations (TNCs) thus apparently remained cautious regarding their international investment expenditures during the
last quarter of 2009, as also illustrated by the low value of cross-border mergers and acquisitions (M&As) and number of greenfield projects.

• Prospects for the first quarter of 2010 are better as indicated by improvements of the global business environment and a growing optimism of TNC executives regarding their own company’s prospects and a pick-up in the value of cross-border M&As.

• In general, growth of FDI inflows trails economic growth. The current trend of gross domestic product (GDP) turned positive in mid-2009. Government policies regarding the current crisis have double-edged effects. While the majority of these policies may promote and facilitate FDI, some policies such as increased screening requirements and new limitations of foreign equity may work against renewed flows.

• With the slight drop in the number of greenfield projects in the first quarter of 2010, it is premature to say that FDI is now on a strong rebound. TNCs still remain very cautious in their international investment programmes.


>YES BANK : Another Strong Quarter; Maintain OW

Yes Bank reported a PAT of Rs1.4 bn (+11% QoQ, +75% YoY): This compares with our expectation of Rs1.35 bn. On a per share basis (given equity issuance), earnings were up 57% YoY and 1% QoQ.

NII growth driven by volumes: NII was up 16% QoQ, driven by loan growth, which was up 19% QoQ. Margins expanded by 10 bps QoQ to 3.2% as the bank benefited from the free funds effect of the equity issuance. Adjusted for this, NII grew at about 10% QoQ and
margins were flat to slightly down sequentially.

Non-interest income (ex-capital gains) grew 26% QoQ and 72% YoY: YoY strength was broad-based with all segments growing well. In this quarter, the key driver was financial markets, which saw a sharp uptick, owing to some chunky deal-related revenues.

Weak liability franchise means margins will compress in F2011, but will still deliver 18% ROE: We expect Yes Bank’s margins to come off from current levels in the coming year as rising short rates (given low CASA/assets), impact of free funds effect fading, and CRR hikes filter through. Despite this, we expect the bank to deliver 18% ROE in F2011.

Well positioned for growth cycle in terms of capital and asset quality: With a Tier I ratio of 12.9% and an impaired loans ratio of 0.5%, we think Yes Bank is well positioned entering the new credit growth cycle, especially given its small size. We agree that margin progression will be challenging near term, but believe that this has already been factored into expectations.
Yes Bank trades at 15.7x F2011 earnings and 2.6x BV – we believe that the risk-reward is still favourable and hence maintain our Overweight rating.

To read the full report: YES BANK


Polaris Software (Polaris) is an end-to-end global financial technology company with a
comprehensive suite of products and services for the BFSI sector.

Improved outlook for the IT sector
The outlook for global IT spend has improved since the latter part of 2009, after a brief phase of
weak demand outlook. Consequently, the outlook for Indian IT vendors has also improved which
has prompted them to set a high recruitment target for FY11. The BFSI (banking, financial
services and insurance) sector is globally the largest spender on IT. Demand improvement in
the US – largest target market – bodes well for financial technology vendors like Polaris.

Polaris has evolved as an end-to-end global financial technology company
Through the acquisition of Orbitech, a Citibank subsidiary, in 2002 Polaris got access to 56
software modules for the banking industry. Polaris has transformed these modules into serviceoriented- architecture (SOA). Aided by acquisitions in the insurance and India-focused banking products space, Polaris has evolved as an end-to-end global financial technology company.

IT products business at an inflection point
Over the past few years, Polaris has been in the process of transforming banking products into
SOA, broadening its products portfolio and building customer references. It is now at an
inflection point in its products business wherein it can capitalise from its investments made in
software development. In FY10 Polaris won 54 deals in products business as against 21 deals
each in FY08 and FY09. We forecast a CAGR of 25% in US dollar terms (21% in rupee terms)
over FY10-13 for the IT products segment and expect its revenue contribution to increase to
25% in FY13 from 20% in FY10.

Increasing contribution from IT products to drive margin expansion
We forecast total revenues to grow to Rs 19.3 bn in FY13 from Rs 13.5 bn in FY10 at a CAGR
of 12.4% (16.2% in US dollar terms). We expect Polaris’ EBITDA margin to increase to 19.3% in
FY13 from 16.5% in FY10 on account of: (a) increasing revenue contribution from IT products;
(b) IT products’ margins expansion to 29% from 23% currently on account of increasing
operating leverage; and (c) broadening of the employee pyramid.

Net profit to grow at a CAGR of 22.2% over FY10-13
After considering the impact of higher tax rates and forex gains from hedges ($170mn hedges at
Rs 48), we forecast net profit to increase from Rs 1.5 bn in FY10 to Rs 2.8 bn in FY13. We also
expect the RoE to increase to 20.2% in FY13 from 18.6% in FY10. The company has a strong
cash balance which we expect will touch Rs 10 bn in FY13, which could be used for acquisitions
aimed at client acquisition and access to intellectual property rights.

We assign 4/5 on fundamentals and 5/5 on valuations
Polaris’ fundamental grade of 4/5 indicates that its fundamentals are superior relative to other
listed securities in India. The grading factors in experienced management, a strong IT products
portfolio, balance sheet strength and improved outlook for the IT sector. The grading has been
tempered by dependence on the BFSI sector and high client concentration. The valuation grade
of 5/5 indicates that the current market price has strong upside to our fundamental value per
share of Rs 247.

Key stock statistics

  • Fundamental value : (Rs) 247
  • Current market price : (Rs, as on April 21) 186
  • Shares outstanding (mn, face value : Rs 5) 99
  • Market cap (Rs mn) : 18,407
  • Enterprise value (Rs mn) : 13,319
  • 52-week range (Rs)(H/L) : 204/60
  • PE on EPS estimate (FY11E)(x) : 7.7
  • Beta : 1.16
  • Free float (%) : 41.1%
  • Average daily volumes (last 12 months) : 1,998,306

To read the full report: POLARIS

>Bombay Rayon Fashions (PRABHUDAS LILLADHER)

Increasing utilization levels on massive capacity expansion: Bombay Rayon Fashions (BRFL) has enhanced the overall fabric and garment (FY09) processing capacity by 1.9x and 1.2x, respectively (~5x of its FY07 capacity in both segments) during FY10. We believe that the increasing asset turnover ratio from 0.9x in FY10 to 1.6x in FY12 will drive the growth, going forward. BRFL has currently completed its expansion plan. Hence, we believe that there is no risk of raising equity or debt further in the future. We have visited BRFL‟s Tarapur fabric processing plant (constitute ~80% of company‟s total fabric capacity) recently and came back convinced that it has the potential to propel BRFL into new growth trajectory.

Expect robust PAT CAGR of ~50% over FY09-12E: BRFL has a strong client list, including DKNY, Guess, Gap, Wal-mart. This, coupled with strong business positioning, convince us to factor in robust sales and PAT growth CAGR of ~36% and ~50%, respectively during FY09-12E. We believe that BRFL‟s operating cash flow would turn positive from FY10 and it would help to reduce the debt/equity ratio from 1.5x in FY09 to 0.6x in FY12E.

India’s largest integrated Garment & Fabric player: BRFL has embarked on an aggressive growth path from post quota opportunities and in-house design capabilities via its integrated manufacturing facilities. It would add value and sustain competitiveness, with considerable advantage over peers such as fast-track delivery model of 30-60 days vis-a-vis industry average of 60-90 days. It enhances BRFL‟s ability to quote premium for its products. We believe that rupee appreciation has had a limited impact on BRFL on account of better pricing power, premium to its peers and presence in the fashion garment business.

Attractive valuation, initiate with ‘BUY’: We believe that BRFL is well positioned as against its domestic peers, given its in-house designing capabilities, better margin and strong earnings growth along with visibility. BRFL is trading either at par or at discount to peers. Hence, we strongly believe that it should trade at a premium than peers, considering that it‟s well-positioned. Further, stock is trading at near-to-lower end of its historical forward P/E, EV/E and P/B band. We recommend ‘BUY’ the stock on the basis of 11x of FY11E earnings.

To read the full report: BRFL