Tuesday, August 31, 2010

>FX Alert – QE2 as USD end-game

A second round of QE will likely put sharp downward pressure on the USD, to some degree versus the euro and other G10 currencies, with potential for a broader USD sell-off. Foreign investors are likely to view the renewed direct intervention as indicating that the Fed’s balance sheet expansion and implicit monetization of fiscal expenditures are first line approaches to dealing with disappointing recovery prospects, rather than the exceptional measures they were meant to be initially. This could have severe implications for foreign perceptions of the quality of the US assets that they are accumulating in private and official portfolios, and
may lead them to draw the conclusion that USD weakness is less a by-product than a desired outcome of these measures.

It is hard to argue that the EUR and JPY do not share some of the same weaknesses. However, the euro zone is essentially self-financing, with private savings offsetting almost all public deficits, and fiscal deficits remaining considerable smaller than in the US. Moreover, the euro zone’s fiscal austerity provides a credible, if painful, signal of an underlying desire to reduce fiscal imbalances that so far is lacking in the US.

Even if the ECB maintains its ‘pragmatism’ on the collateral front, the reluctance to buy significant quantities of government debt signals a desire to return to orthodoxy. From a currency perspective the euro zone combination of external balance, fiscal austerity, ECB
pragmatism and reluctant sovereign buying is likely to be more attractive than the US mix of QE2, limited deficit reduction and the need to finance a growing external imbalance while offering increasingly low rates.

Buying a little government debt while austerity is put in place is ultimately more credible than buying a lot when austerity is not put in place.

We are more sympathetic to the view that the USD/JPY is close to its trough. The stronger yen is increasingly negative for growth and wealth (through the reaction of equity markets to yen strength). Japanese real interest rates are much higher than elsewhere in G3 because of deflation. This is not really a currency plus because it is impossible for investors to arb the Japanese and USD CPI against nominal interest rate differentials. It creates a headwind to growth that becomes more severe as deflation intensifies and the yen appreciates.

To be sure the major euro risk remains that the austerity and slowing global growth will slow euro zone growth to such a degree that a sovereign default occurs and has severe knock-on effects on other fiscally weak countries. That clearly remains the major euro zone risk. However, investors have tolerated prior ECB intervention well, and the ECB’s reluctant intervention to avoid the worst in sovereign debt markets has been euro positive.

Concern that monetary policy is ineffective
Recent downward surprises in housing and investment data suggest a deepening risk that the US is entering into a significant slump. Given the run of very weak data investors are now focused on the policy response, with comments by Fed and international officials at Jackson Hole the ‘payrolls’ event of this week. Central bankers are loath to admit that they may be pushing on a string, although the combination of balance sheet constraints at commercial banks, idle balances throughout the financial system and low loan demand by borrowers make this a possibility. Moreover unlike the first run at QE, neither the level of rates nor spreads point to an obvious problem that a new round of QE can solve (unless they decide to buy Greek and Irish debt). Our US Economists have stressed that “… monetary policy will need to err on the side of ease…. The [Fed] reinvestment plan likely will be enhanced by more active balance sheet expansion or perhaps new efforts to unblock credit.”

To read the full report: FOREX ALERT

>SOVEREIGN SUBJECTS: Ask Not Whether Governments Will Default, but How

This is the first issue of Sovereign Subjects, a new Morgan Stanley publication focusing on sovereign risk in advanced economies. In this first installment, we take a broad perspective on government balance sheets and raise several themes to which we will return in more depth in subsequent issues. We encourage clients to provide us with feedback on this new publication.
Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by advanced economies’ governments. On the basis of current policies, most governments are deep in negative equity.

This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take. So far during the Great Recession, sovereign (and bank) senior unsecured bond holders have been the only constituency fully protected from partaking in this loss.

It is overly optimistic to assume that this can continue forever. The conflict that opposes bond holders to other government stakeholders is more intense than ever, and their interests are no longer sufficiently well aligned with those of influential political constituencies.

There exists an alternative to outright default. ‘Financial oppression’ (imposing on creditors real rates of return that are either negative or artificially low) has been used repeatedly in history in similar circumstances.

Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection.

To read the full report: SOVEREIGN SUBJECTS


Focused mid-income housing player with an asset-light model: Godrej Properties (GPL) is a focused mid-income housing player, with a pan India presence and a differentiated business model. Almost ~77% of GPL's land bank of ~50msf comprises of joint development (JDA) projects. The JDA approach allows GPL to enjoy a low risk, low capital intensive business model. The advantages of GPL's model are reflected in its superior RoEs.

Ability to emerge as a leading pan India player: Several RE players have been trying to position themselves as pan-India players. Nonetheless, most RE companies have not been successful in their pan India expansion attempt because of the lack of brand recognition. Godrej group enjoys tremendous brand recall and trust across the country. Hence, we believe GPL has the potential to emerge as a leading pan India RE player, going forward.

Option value provides significant upside potential: GPL's parent, Godrej Industries Limited (GIL) and its group/ promoter companies have strategic land holdings across India. GPL has been identified by the Godrej group as the RE development vehicle for developing these key land holdings through the JDA model. It already has MoUs with Godrej group companies to develop ~185acres. We have attempted to capture this option value by valuing all the disclosed MoUs and assuming an incremental development on 100acres at Vikhroli (Mumbai). Based on our probability-weighted methodology, we arrive at an option value of Rs177/share. Our option value still does not capture possible upsides from (i) new MoUs with group companies for their existing land bank and (ii) the full developmental potential of the 500-acre Vikhroli land.

Expect valuation to remain at premium to NAV due to high growth visibility: We expect GPL to trade at premium to NAV due to its strong growth visibility, asset-light model and brand equity. We estimate GPL's FY12E core NAV at Rs538/share and probability-weighted option value NAV at Rs715/share, which is our price target (33% premium to core NAV). GPL currently trades at 46% premium to FY12E core NAV and 10% premium to option-adjusted NAV. It is richly valued at 4.6x FY12E BV of Rs167 and 24x FY12E EPS of Rs32. Going forward, the key catalysts which could further re-rate GPL are (i) traction on disclosed MoUs, (ii) visibility on development of other group land bank (particularly at Vikhroli) and (iii) continued momentum on new third party JDAs. We initiate coverage on GPL with a Neutral rating.

To read the full report: GODREJ INDUSTRIES

>CUMMINS INDIA: Exports to grow 3x by FY12, driving 37% EPS CAGR over FY10-12

Encouraging long-term outlook, as parent looks at sourcing more from India; domestic sales to grow at a steady pace

Strong demand to boost growth: Cummins India (CIL), the largest engine
manufacturer in India, is likely to post accelerated growth over the next two years,
led by improving demand in the domestic market and strong rebound in exports
on the back of increased outsourcing by its parent. Better product mix, healthy
pricing environment, stable commodity prices, and continuous cost-cutting
initiatives will keep margins strong.

Domestic business to grow at 26% CAGR over FY10-12: After sluggish demand
in FY09 and 1HFY10, the domestic engine market has shown impressive recovery.
With growing power shortage, diesel engine demand for power-generation
applications will continue to be strong. We expect robust demand pull from the
industry segment as well, particularly from construction and mining.

Exports to grow 3x by FY12; parent raises guidance: CIL is among Cummins
Inc's leading manufacturing bases, and meets its global requirement for several
key products and components. After reaching a high of Rs13b in FY09, exports
sharply declined to Rs4.8b in FY10, as US and European economies shrank.
However, buoyed by strong recovery in American and Asian markets, its exports
have grown sharply since 4QFY10. We expect exports to reach Rs15b by FY12.
Cummins Inc has also raised its sales guidance for CY10 to US$13b, which
augurs well for CIL.

Superior product mix, cost-cutting boost margins; more surprises likely:
CIL has surprised markets by sharp improvement in margins during the last two
years. In FY10, EBITDA margin expanded 410bp to 18.5%. The company has
maintained strong margin momentum, posting 21.3% (up 290bp YoY) in 1QFY11.
We believe that better product mix, healthy pricing environment, stable commodity
prices and continuous cost-cutting initiatives will keep margins strong, going

Powerful tailwind; aggressive capacity expansion: Given quality standards
and cost benchmarks that CIL has established, Cummins Inc will enhance the
product portfolio that it outsources from India. To meet domestic demand and
export requirements, CIL will spend around US$300m at its new mega-site near
Pune over the next five years, which will add capacity at 20% CAGR. This is a
significant positive for the company's growth.

Earnings CAGR at 37%; stock trades at 17x FY12E earnings; Buy: CIL has
exhibited strong 26% earnings CAGR over the last four years, despite uncertain
business environment globally. We expect the company to post a robust 37%
earnings CAGR over FY10-12. We believe that the stock will command higher
valuations due to long-term growth potential and possible upside to earnings
expectations in the medium-term. We upgrade the stock to Buy, with a target
price of Rs840 (20x FY12E earnings).

To read the full report: CUMMINS INDIA

>BHARTI AIRTEL LIMITED: Some positives, more unknowns

We assume coverage of Bharti Airtel with a Neutral rating and a Mar-11 price target of Rs357 (13% upside). We prefer Bharti over RCOM and Idea as we believe it is better placed to benefit from Phase 1 (minute growth, moderated price competition). However Phase 2 in the Indian telco sector (competition resurgence) could throw up some challenges and we also expect Bharti to face operational issues in Africa in the near term. We see regulation as a continued overhang and don’t expect consolidation in the market anytime soon. Improving performance in Africa, benign regulations, and evidence of high-end churn not increasing at Bharti would make us more positive.

Phase 1 opportunity: Bharti, helped by its leadership position and strong operational performance, will fully benefit from the moderating price competition coupled with minute growth at the GSM majors, in our view.

Phase 2 challenges: We expect to see increased competition in the postpaid wireless segment as a result of 3G rollouts and implementation of MNP. With 3G we expect to see higher capacity in the market, a need to defend 2G revenue base (70% coverage), and also an opportunity for
revenue consolidation. We estimate that a 0.5% increase in Bharti’s postpaid churn negatively impacts its margins by 1.5%.

Africa a near-term concern: Africa offers Bharti longer-term growth potential, in our view, especially if management is able to deliver on cost management. However, we expect Bharti to face operational and execution challenges. On our estimates, Africa is 8%/4% dilutive on EPS in
FY11/FY12 but 4% accretive in FY13.

Our Rs357 price target is based on our SOTP valuation. At current levels we don’t believe Bharti is inexpensive – it is trading at over 14x one-year forward P/E (up from 10-11x in May) back to the levels last seen in early 2008. Key risks to our rating and price target are rational competition post MNP and a better performance in Africa on the upside, while downside risks include higher-post paid churn at Bharti on account of competition, a less benign regulatory environment than is being priced-in currently.

To read the full report: BHARTI AIRTEL

>CAIRN INDIA: Disappointing deal

Vedanta to acquire 51-60% stake in Cairn India: Cairn Energy is expected to sell 40-51% of its stake in Cairn India (it currently has 62.4%) to Vedanta Resources for a consideration of US$6.65bn-US$8.48bn, implying per share value of Rs405. This includes Rs50/share of non-compete fee paid to Cairn Energy for not engaging in E&P operations in Bhutan, India, Sri Lanka and Pakistan for a period of three years. At the acquisition price of Rs405/share, Vedanta has valued Cairn India at ~US$24/boe (2P+2C). Post the open offer (additional 20% at Rs355/share) Vedanta would hold 51%-60% of Cairn India. Cairn Energy’s stake in Cairn India, on the other hand, would reduce to 21.6%-10.6% (fully diluted basis) depending upon the open offer

Open offer lower at Rs355/share; lower than our expectations: Given a non-compete fee of Rs50/share, the open offer price has been fixed at Rs355/share. We see limited rationale in paying a non-compete fee for a commoditised business and hence believe that the deal is unfavourable from minority shareholder’s point of view. This differential treatment, we reckon, has been the primary reason for the stock’s correction by over 6% in trade yesterday. While concerned, we expect company fundamentals to provide support at the current levels.

Fundamentals intact; management’s lack of sectoral experience a concern: We continue to remain excited about the exploration prospects in the Rajasthan basin, especially the Balmer Hill formation where we expect upgrade in recovery factor going forward. Additionally, prospective exploration resource base of 2.5bn boe (10% recovery) in the Rajasthan block would provide the necessary leg up to resources going forward. However, given the lack of experience of the new management (Vedanta) in running oil & gas operations, we believe that the stock could reflect the above concerns going forward.

Downgrade to HOLD: While maintaining our 12-month target price of Rs380, we downgrade the stock from BUY to HOLD, mainly on two counts a) the stock is likely to be range bound given deal closure by 1QCY11 b) concerns on the lack of experience of the new management in handling E&P operations is likely to impact valuation in the medium term. We would however highlight that Vedanta management has delivered superior operational performance in assets acquired historically (Sesa Goa, Hindustan Zinc).

To read the full report: CAIRN INDIA

>BANK NIFTY: Banking – End of road soon (IIFL)

Bank Nifty has rallied staggering 226% from its bottom of 3,330 touched in March 2009. The
outperformance to Nifty has been substantial at 113%. Improvement in market sentiment followed by robust earnings has driven a sharp upswing in banking stocks both PSU and private.

In the past one month, (from July 16th), CNX Bank Nifty index has delivered returns of ~9% with majority of PSU banks scaling to all-time peak. Nifty appears to be stalling around resistance levels of 5,450-5,550 and the Bank Nifty, which has ~22% weightage, could see some profit booking. We have conducted a study of 15 banking stocks (large and medium size banks) and Bank Nifty to arrive at our medium-term outlook.

Ideally, as per Technical analysis, whenever, a stock trades at its all time high, it is considered to a bullish signal. However, taking into consideration advanced technical parameters like fibonacci
extension, fibonacci retracement and RSI, our study found that 8 out of 15 stocks covered in this
report have entered into an overbought zone. Any unwinding pressure at these levels could lead to sharp corrections in them. All chart studies have been carried on a weekly and monthly
basis to get a better perspective of the medium-term outlook.

To read the full report: BANK NIFTY