Monday, July 5, 2010

>EQUITY STRATEGY: The 100 Billion Dollar Club.

The 100 Billion Dollar Club. We analyze Indian companies and their attributes such as (1) IPR (brand and technology), (2) financial and industrial assets and (3) natural resources that can propel them to US$100 bn market capitalization over a period of time. We also look at global experience to draw conclusions for India; every decade throws up new and interesting names. Finally, we assess operating factors that are required to achieve and sustain US$100 bn market capitalization.

Asset-based companies: A few banks can and will get there Other than financial services companies, we are skeptical of any other asset-based company entering the US$100 bn league from India. Asset-based companies require constant reinvestment to grow and return on invested capital is not high enough in ‘mature’ businesses to create meaningful value. Most will trade at and around book value.

IPR-based companies: A rarity in India and will likely remain so Infosys and TCS can make it to the US$100 bn league on a 15-16% CAGR in earnings up to FY2021E and 14-15X P/E multiple. However, their headcount-led services business could face issues of (1) scalability, (2) manpower and (3) margin pressure. We don’t see circumstances changing meaningfully in India for creation of large IPR-based companies.

Resource-based companies: Few candidates but right policies critical RIL and ONGC are obvious candidates to get to US$100 bn market capitalization fairly quickly. For RIL, the migration to a resource-based company from an asset-based cyclical play would be critical. RIL’s ROIC has not been very high historically and has been supported by favorable fiscal incentives. For ONGC, a combination of (1) favorable government policies on pricing and (2) volume growth from domestic fields (its R/P and RRR are quite high and lend credibility) and judicious overseas acquisitions could drive its market capitalization to the coveted mark.

Global experience: Banks, IPR, natural resource plays dominate the league BFSI companies (23), IPR companies (16) and natural resources companies (23) dominate the top-100 global market capitalization companies currently. This list has changed dramatically in every decade. Not only have the companies in the top-100 list changed over the past three decades with (1) new companies from previously closed economies getting listed and (2) assetbacked industrial companies losing prominence, even sectors in the top-100 list have changed over the past few decades with the emergence of the IT/media era.

To read the full report: EQUITY STRATEGY


To read the report: EDUCATION SECTOR

>OIL MARKETING COMPANIES:Fueling fiscal prudence

Moving Towards Market Driven Price Regime:
Over the years the Indian Government has followed the policy of Administered Price to shield
the consumers from severe fluctuations in the international oil prices. This protective policy has
not only added to burgeoning fiscal deficit, but also resulted in huge under recoveries on the part
of Oil Marketing Companies (OMC’s). Sowing the seeds for moving from a controlled regime to
decontrolled regime, the administered price mechanism (APM) governing prices of auto fuels
was completely dismantled in April 2002. However, given the sharp increase in crude oil and
petroleum product prices over the past 5-6 years, the government continued to play a significant
role in the determination of auto fuel prices. However, now the Government has a target to
reduce fiscal deficit to 4% of GDP by FY12 from the current levels of 6.8% of GDP. In this
context, the move to deregulate petrol prices and allowing it to be determined by the market is

Impact on OMC’s:
Market driven price regime is expected to ease the pressures on OMC’s by reducing their under
recoveries. The pre-price revision, total estimated under-recovery on cooking and auto fuels is
estimated at Rs 801 bn. Out of this, the total under recovery for petrol would have been to the
tune of Rs 70 bn and for diesel Rs 230 bn for the whole year, if the prices would not have been
decontrolled. Under-recovery in auto fuels is expected to reduce from Rs 3.8 per litre (before
price revision) to Rs 1.9 per litre (after price revision) in 2010-11. Similarly, the estimated under- recovery on cooking fuels is likely to fall from Rs 465 bn to Rs 398 bn in 2010-11. The total under-recovery is estimated to fall to Rs 565 bn post price rise.

Impact on Consumers:
From now onwards, the fluctuations in international markets would get directly reflected in the
domestic market. However, the price hike will be done in a phased manner. Further, the
Government is expected to intervene, in case of very volatile increase in international fuel prices.
As of now, the government has approved the increase in the price of petrol, diesel and LPG. The
Empowered Group of Ministers (EGoM) has decided to permit Oil Marketing Companies
(OMCs) to raise the retail-selling price of petrol by Rs 3.5 per litre, diesel by Rs 2 per litre. For
an average car user the increase in petrol price would add a burden of Rs.150 per month while
for a motorcycle user the burden would be Rs.30-35 per month.

To read the full report: OMC

>LIFE INSURANCE: IRDA’s final guidelines: Near-term pain, long-term gain

Continuing its focus on bringing uniformity in product features and improving disclosures, the Insurance Regulatory and Development Authority (IRDA), today, came out with final guidelines on ULIPs, encompassing the entire spectrum of product features and charge structure. These guidelines will be applicable from September 2010 (against the earlier deadline of July 2010).

• Lock-in period and premium payment term raised to five years. Further, life/health cover is made compulsory for all products (excluding pensions and annuities), strengthening long-term protection feature of the instrument.

• All pension products to guarantee return of 4.5% to protect the lifetime savings from adverse fluctuations at the time of maturity.

• So far, capping of charges applied only on door-to-door basis at 3% for 10- year policy and 2.25% for 15-year policy; this is now fixed at 4% in the sixth year, dropping to limits prescribed earlier as the policy tends to maturity. Distribution charges to be spread evenly over the lock-in period to eliminate front loading.

• With the perspective of ensuring that only acquisition expenses are recovered in the event of discontinuance of the policy, surrender charges have been capped. Surrender charge will be much lower than the current levels.

• Directionally, IRDA has attempted to make ULIP a long-term protection contract covering risks related to mortality, longevity and health, and at the same time offering a fair deal to the policyholder, doing away with the excesses in the system.

• Clarity on charge structure facilitates pricing and setting up reasonable longterm assumptions.

• In line with expectations, capping of charges will impact margins adversely. However, capping of surrender charges is a bigger blow compared with capping the difference between gross and net yield, as it would not only restrict the ability to generate revenue, but also raise the persistency risk borne by the insurers.

• With limited product differentiation, having low and variable cost business model will be critical. This, in turn, will lead to cost cutting across the sector, impacting distributor commissions adversely.

• Stringent capping of charges will make products cheaper and more attractive, a big positive for volumes in the long run.

• However, in the near future, some negative impact on volumes is possible as:
a) insurers will not be able to cater to market for short duration products and
b) lowering of distributor commissions will make selling ULIPs uneconomical for marginal distributors

• Insurers will try to push as many ULIPs as possible before new norms set in.

• With all pension plans carrying guarantees, there will be a shift towards fixed income
securities in life insurers’ AUM.

To read the full report: LIFE INSURANCE

>BANKING: Base rate set to roll (EDELWEISS)

Today, State Bank of India (SBI) announced its base rate at 7.5%, in line with its guidance of below 8%. Banks in India will move to a new lending rate regime of base rate from July 1, 2010. The new regime will replace the common Benchmark Prime Lending Rate (BPLR) that largely proved ineffective, given wide disparities between banks and proliferation of sub-PLR lending. Following SBI’s announcement, other PSU banks (BoB, PNB etc) have also announced base rate of 8%. Over the next few days, we believe other PSU banks will mirror SBI and fix base rate at ~7.5-8.5% depending on their cost of deposits and proportion of CASA. Private sector banks, on the other hand, are expected to announce rates closer to 6.5-7.0%, marginally higher than the earlier expectation of 6.0-6.5%, given the recent rise in short-term rates.

Our view

  • We see the following impact of a new base rate regime: Marginal swing in market share in favour of private banks Having set a rate lower than PSU banks, we expect private banks to witness shift in business from top-rated corporates specifically for short-term needs. However, limits on borrower-wise exposure could restrict the swing in favour of private sector banks.

  • Partial increase in disintermediation: Disintermediation is set to increase as the top rated corporates are likely to opt more for commercial papers (CP). However, we expect limited migration as CP rates over the past one month have picked up by 150-200bps gyrating to the liquidity tightness and are currently hovering at ~6.5-7.0%- paring down the differential significantly. Also, given that the CP market is not very deep (limited appetite below P1/P2+ rated corporate), we believe the midsize corporates will continue to depend on the banking system.

  • Cost of funds may rise for large corporates: Though there is no prudential limit set by RBI for banks’ investment in CPs, banks are expected to set internal limit on exposure via CP. Hence, we believe large corporates will not be able to fully meet their short-term needs via the CP route. Therefore, there could be marginal rise in cost of funds.

Structurally, we see new base rate regime as positive for banking industry

  • Volatility in margins to reduce: In the current cycle, we saw banks sharply increasing and reducing their lending rates. Impact of margins was strongly positive in the initial phase, while it was negative in the downcycle. Moral suasion was leading to strong volatility in NIMs, especially for PSU banks. This move could reduce artificial changes to yields. However, effective yields could still be managed given that other components like tenor premium and credit risk premium are within banks’ control.
To read the full report: BANKING

>SHALE GAS: Small footprint …big impression!

1. What is shale gas?
2. Shale gas in the US: Long forays g g ys in a short time
3. Shale gas reserves in other parts of the world
4. Major Implications
5. Foray of RIL in this space: Opportunities and implications
6. Annexure

1.a. What is shale gas?
Shale are fine-grained sedimentary rocks comprising of mud (mix of clay mineral flakes) and small fragments of other minerals

Shale gas is produced from shale formations, which act as both reservoir as well as source rocks.

Shale tends to have lower recovery than conventional plays e.g., shale plays in Marcellus are estimated to yield only 3-12% of total organic carbon.

Every shale is different so each shale has its own learning curve in terms of extraction technology and corresponding operational and break-even costs.

Shale gas production was considered uneconomic earlier because of low permeability and gas content.

Emergence of a new drilling technology in the 1990s and higher natural gas prices made shale gas viable

To read the full report: SHALE GAS