Friday, June 25, 2010

>Yuan Revaluation: Not Necessarily Bad for China

It’s diffi cult, these days, arguing that the yuan is not
undervalued. The widely publicized large current account
surpluses and bulging foreign exchange reserves in China
suggest otherwise and continue to provide fodder to
critics of Beijing’s exchange rate policy. While today’s
revaluation of the yuan was inevitable, given the necessity
to rebalance the global economy, the change in Beijing’s
currency policy need not be detrimental to China.

Why Rebalancing Growth is Important
In fact, a revaluation of the yuan could get China to a more
sustainable growth model faster. While China’s rise to
export prominence was made possible by relatively cheap
labour, the latter won’t last forever, given the rising domestic
wages and the ascent of other low-cost centres (such as
Bangladesh and Vietnam). Note also that consumers are
still a small part of the economy relative to traditional
powerhouses like the US, Japan and Germany (Chart 1).
Strengthening its economic base by stimulating domestic
consumption further, while not relying too much on exports,
is a plus for sustainability of growth. An appreciation of the
yuan goes in that direction, with resources being shifted
from exporters to consumers who will be benefiting from
lower import prices and more choice.

Implications for Trade
The potential harm to exporters, wouldn’t be as dramatic
as feared. Any appreciation of the yuan will result in a
less-than-proportionate increase in the dollar price of
a Chinese product in the US. That’s because only the
domestic component of the product will be impacted
(e.g. the value-added by the producer, refl ecting factors of
production in China). The foreign component of the price,
namely the input prices (such as imports from suppliers),
and US costs (like shipping, retailing, and advertising) will
be unaffected. Of course, that’s assuming that supplier
countries like Japan and other Asian nations do not let
their currencies appreciate as steeply as the yuan against
the US$, a reasonable assumption given policies during
the last yuan revaluation.

Numerous studies1 have noted that the domestic content
of Chinese exports is between 35-55%. Even assuming
the upper-bound of that range, a yuan revaluation of
similar magnitude to the one seen from July 2005 to
July 2008 (i.e. 17% appreciation) would, at worst, raise
the price of imports from China by 9%, not signifi cant
enough to cripple China’s overall exports, especially
considering that any appreciation will be spread out over
several years.

That might explain why China coped well the last time
the yuan was revalued. Trade remained relatively healthy
during the 2005-2008 unpegged period, with exports to
Asia nearly doubling and sales to North America soaring
70%, while exports to other regions were even more
impressive, helped by the yuan’s competitiveness (Chart
2). If history is any guide, a small appreciation is unlikely
to have major detrimental impacts on China’s export
market share.

To read the full report: YUAN REVALUATION

>Direct Tax Code version 2.0… (ICICI DIRECT)

The government of India has come out with a revised draft of the Direct
Taxes Code (DTC) that proposes several changes over the first draft to deal
with some of the major concerns raised in the first draft. It is open for
public comments till June 30,,2010. The proposed changes in the revised
draft, its impact and our views are mentioned herein below.

􀂃 MAT to be calculated on book profits as compared to gross assets
The revised draft suggests that book profits rather than gross assets,
as proposed in the first draft, should be used to calculate the minimum
alternate tax (MAT). However, the tax rate as a percentage of the book
profits has not been specified. Under the previous draft, it had been
proposed to calculate the MAT on gross assets (0.25% for banks and
2% for all other companies). However, the revised draft also does not
allow for carry forward of MAT paid.

Our view: The revised provision is positive for companies that are
eligible for MAT, as the calculation of MAT on gross assets, as
provided in the first draft, could have led loss-making companies,
newly set up infrastructure companies and companies undergoing
major expansions to pay very high taxes.

􀂃 Tax exemption on withdrawal for select saving schemes
Under the first draft, it was proposed that withdrawals towards saving
schemes would be subject to taxation at the applicable marginal rate
of tax (EET taxation). The revised draft now proposes complete tax
exemption for government provident funds (GPF), public provident
funds (PPF), recognised provident funds (RPF), pension schemes
administered by Pension Fund Regulatory and Development Authority,
approved pure life insurance and annuity schemes.

Our view: The provisions are marginally positive for individual
taxpayers. However, the tax exemption on withdrawals applicable
only on pure life insurance schemes is negative as unit linked
insurance plans (ULIPS) would be subjected to tax on withdrawal.
Also, it will be negative for mutual funds as withdrawal from equity
linked savings schemes would be subject to tax post implementation
of DTC. The new pension scheme will, thus, have an edge over the
other market related savings instruments as it will be the only
instrument providing equity exposure (50%) and have the
withdrawals exempted.

To read the full report: DIRECT TAX

>METALS: Early recovery in steel prices unlikely, cost increases more certain

􀂄 Mounting inventories at the producers’ end have dashed all hopes of an early recovery
in steel prices. Steel producers, who held on to prices in April and May in the hope
that prices would recover on the back of rising costs, have lost market share to traders,
who cut prices in line with the changing market reality. With diminishing hope of an
early recovery in prices, given continued production growth in China, steel producers
around the world have also begun cutting prices since the beginning of June. However
cost increases are more certain due to recently negotiated quarterly prices of iron ore
and coking coal.

􀂄 Squeezed by price cuts and cost pressure, steel producers are likely to witness
margin contraction. In 1QFY11, margins would be hit the hardest for SAIL, followed by
JSW Steel and Tata Steel India. There would be a bigger drop in margins in 2QFY11.
Though Corus’ management sounded very confident about 1HFY11 earnings when
Tata Steel reported 4QFY10 results, we are less confident about 2QFY11 due to the
change in market conditions post the analyst meet. However, we believe that margins
will rebound in 2HFY11, as market forces adjust steel prices and raw material costs.

􀂄 We are cutting our FY11 EPS estimates by 19% for Tata Steel, by 24% for JSW
Steel, and by 26% for SAIL to factor in the margin shrinkage in 1HFY11. Based on our
revised FY11 estimates, the three steel companies appear expensive. JSW Steel,
however, appears attractive based on FY12 estimates due to expected addition of
new capacities by March 2011. Volume growth will elude SAIL and Tata Steel in FY12.

To read the full report: METALS


The BFSI space, which has ~25% weightage in the Nifty, lifted the index
in the recent rally from the lows of 4700. Within the banking space, we
saw midcap banks taking the cream of the rally on takeover and
recapitalisation buzz. The credit growth in the system has started to
pick up pace. It grew by 19.1% while deposit growth moderated to
14.3% for the fortnight ended June 4th. Banking sector stocks have
outperformed the market over the past 12-15 months. PSU banks are
now trading between 1.2x and 1.8x FY12E ABV while private banks are
trading at 1.8-3.5x. Both private and public banks have led the rally in
our markets from the lows of March 2009.

􀂃 What next?
In our view, banking stocks are likely to move in line with markets in
the coming quarter as the first quarter is a lull season for bank
credit. We prefer banks that have sustainable NIM (high CASA, low
bulk deposits), higher RoE and growth potential in addition to low
volatility to profitability (i.e. less dependency on treasury gains).
For FY10, credit growth in the system is expected at 20% and
deposit at 18% with an upward bias. We expect the NIM for banks to
stabilise. Base rate implementation is unlikely to impact the
bottomline substantially. Asset quality will remain a concern for a
couple of quarters more on account of slippages from restructured
assets. Most of the banks have already seen a slippage of 6-10%
from the restructured portfolio so far and this is likely to inch up
further in the coming quarter.

On the basis of the following parameters we prefer Oriental Bank of
Commerce, Union Bank of India, Punjab National Bank from the
public sector space and HDFC Bank from the private space. We also
recommend IDBI Bank as our contrarian pick from the coverage

Bearing in mind the current liquidity scenario where banks are borrowing
under the LAF window from RBI and with inflation at 10.2% in May 2010,
we expect rates to have an upward bias from here on. The RBI may raise
both repo rate and reverse repo rates by 25 bps each to 5.5% and 4.0%,
respectively, in the July monetary policy meet though monsoon will be a
key monitorable.

To read the full report: BANKING INDUSTRY

>INFORMATION TECHNOLOGY SECTOR: Indian IT vendors: New growth opportunities

Indian Tier 1 IT vendors appear to be poised for the next wave of growth, driven by the return of stable IT budgets, improved decision making at clients and higher thrust on offshoring and global delivery model. We expect multiple growth drivers over FY10-FY13E which predominantly includes underpenetrated service lines like Infrastructure managed services, BPO, Package implementation, Engineering and R&D services, as well as increasing focus on new markets like Latin America, Middle east , India and China.

Service line wise growth opportunities:
a) While Remote Infrastructure management services (IMS) is a USD100bn opportunity, Indian exports from this service line stood at USD4bn for FY09, which represents just 4% penetration.

b) BPO services have already been witnessing robust traction for Indian Offshore vendors but can still count a USD130Bn opportunity as on FY09, of which Indian vendors derive just USD12.8bn as on FY09 which represents 9.8% penetration.

c) Consulting and Package implementation, which has been the key growth arenas during the 2003–2008 upcycle for Indian Tier 1 vendors still has a huge market opportunity. The ERP services market which includes ERP, SCM, CRM etc, is a USD71bn opportunity as on CY10 and the top four IT vendors derive just USD3.46bn in revenues from package implementation and consulting as on FY10.

d) Finally Engineering design and R&D services is touted as another growth arena by the Nasscom with a potential for Indian vendors to derive over USD35bn-USD40bn by 2020 as compared to USD8bn (Approx) as on FY09.  Vertical wise growth opportunities: Governments across the world spend around USD154bn on IT services and Indian IT vendors currently have a very minimal penetration in this segment. We expect Government and Healthcare verticals as strong growth opportunities over the coming period. Geographical growth opportunities: Indian vendors are fast expanding the addressable market by ramping up client base in emerging markets like Latin America, Australia, NZ, Middle East, and China. Vendors like TCS have reached critical mass in emerging geographies and are poised for further scalability.

Indian IT vendors: New growth opportunities
Infosys Tech: Infosys appears to be banking on non linear growth initiatives as its new growth drivers. Some of the initiatives include platform BPO, Pay per use services, and Application platforms (Mobile Flypp, Shopping trip 360, Itransform).

TCS: We believe that TCS key growth drivers would be its strong geographical mix with 20% of the revenues derived from the emerging markets like Latin America, India, Australia, NZ, Middle East etc. Platform BPO also appears to be a key forte.
Wipro: Wipro has strong competency in the IMS and BPO service lines, which contribute to 21% and 10.5% of the total revenues respectively for FY10. We expect these two service lines along with testing to be growth drivers for Wipro.

HCL tech: HCL Tech has well diversified service line mix with Enterprise application services, IMS, and Engineering design services, which account to 21.4%, 22%, and 19% of the total revenues and could be strong growth drivers.

To read the full report: IT SECTOR

>INDIAN INFRASTRUCTURE: Accelerating investments... ....…unprecedented opportunities

12th plan spend of Rs 27tn driven by power, roads, railways

We expect India to see an investment of Rs 27tn in infrastructure development
over the 12th plan period (FY13-FY17); 65% of this investment is estimated to
be in sectors like power, roads, and railways. This development will offer
~Rs 12tn of EPC opportunity to construction companies. The Private sector is
likely to account for 39% of the total spend. Overall debt funding of Rs 14tn
may not be a constraint if the proportion of infrastructure credit to total bank
credit continues to rise moderately each year. Key risks include delays in coal
availability (power capex) and road project award activity by NHAI, and slow
execution of railway projects. Within our coverage universe, we prefer L&T,
IVRCL, NCC, Patel Engineering and Ahluwalia Contracts and recommend
buying these stocks for long-term value creation.

Expect infrastructure investments of Rs 27tn over 12th plan period: We estimate
an infrastructure investment of Rs 27tn, up 32% over government’s revised
estimate of Rs 20tn spend for the 11th plan. We expect the government (centre
and state) to account for Rs 16.5tn of the spend (61% of total). We are factoring
in Rs 7.1tn of budgetary support, which is ~1.6% of GDP in that period. In terms
of debt funding, we estimate requirement of Rs 14tn across the private sector,
centre, and state (54:34:12).

Debt funding may not be a constraint: Bank credit to infrastructure, as a
percentage of total bank credit (non-food), has increased from 8% in FY07 to
12.7% in FY10. Even if the share of credit to infrastructure increases by 50bps
every year over FY10-FY17, bank credit itself can meet 47% of the total debt
funding requirement. The remaining requirement will be met through other debt
sources like NBFCs, pension funds, and ECBs.

Private sector share to rise to 39% in 12th plan from 36% in 11th plan: Private
sector share will rise in roads (to 44% in 12th plan from 17% in 11th plan), power
(to 51% from 44%) and railways (to 14% from 4%). However, lower spend in
telecom (large private sector share but capex peaked out) and lower private
sector share in airports will limit the rise in overall share to 39% in the 12th plan.
65% of total spend in power, roads, railways: Power sector will continue to
account for highest share in the 12th plan spend at 32%. The road segment is
likely to see an investment of Rs 4.5tn, 17% of total. Rise in project award
activity by NHAI will lead to higher investment in national highways. Railways
will see an investment of Rs 4.5tn over the 12th plan period.

EPC opportunity of ~Rs 12tn: We estimate an EPC opportunity of ~Rs 12tn from
12th plan, primarily in sectors such as roads, railways, power, irrigation, and
water supply. This will necessitate ramping up of business by existing players.
Key risks: a) Delay in coal availability for power plants; b) delay in road project
awards by NHAI (due to land acquisition, environmental clearances); c) slow
execution by the railway ministry.

Prefer L&T, IVRCL, NCC, Patel Engineering and Ahluwalia Contracts: We expect
companies within our coverage universe to deliver revenue/earnings CAGR of
20%/25% over FY10-FY12E. These companies are set to tap the upcoming EPC
and asset development opportunities. We prefer companies with strong cash
generation, a good execution track record, and reasonable valuations.

To read the full report: INDIAN INFRASTRUCTURE