Wednesday, November 23, 2011

>INDIA STRATEGY: India’s Future Large Caps

We have used a combination of quant and our analysts’ opinion to filter Morgan Stanley’s best mid-cap picks (market cap

Over the long term, stocks down the cap curve tend to outperform their larger brethren: Valuation and performance make the case in favor of these stocks.

A combination of analyst opinion and quant: Our quant technique combines institutional ownership, consensus ratings, price momentum, earnings growth, revisions, trading volumes, valuations and ROE to score stocks. We overlay our analysts’ opinion on these metrics to generate our best ideas.

In general, we prefer stocks that are:

• Unloved: Trading significantly below 200 DMA with depressed trading volumes vs. history

• Under-owned: Rated poorly by the consensus and not owned by institutions

• Undervalued: Valuations cheap in the context of ROE versus history

• But with improving price momentum… Poor 12M performance but rising 1M returns

• …and earnings estimate revisions not priced in: Earnings estimates rising – but not share prices

To read the full report: INDIA STRATEGY

>Recent correction offers opportunity to accumulate RIL stock

Weak Rupee versus weak cycles. We believe RIL stock offers a favorable reward-risk
balance post the 10% correction in its stock price in the past three weeks. The softness
likely reflects the market’s concerns about recent weakness in refining margins but
ignores the steep correction in the Rupee over the same period, which should partially
offset weaker margins. We have made a few changes to our earnings model but retain
our 12-month SOTP-based fair valuation of `1,000. We upgrade RIL stock to a BUY
rating from ADD noting 27% upside to our target price.

Recent correction offers opportunity to accumulate RIL stock
We see a favorable investment reward-risk balance at current levels. RIL stock has corrected by
10% in the past three weeks reflecting the market’s concerns on (1) sharp decline in global
refining margins (see Exhibit 1), (2) likely subdued chemical margins given a weak global macroenvironment and (3) continued decline in KG D-6 gas production. RIL stock is currently trading at 10.3X FY2012E EPS and 9.7X FY2013E EPS (adjusted for treasury shares).

Refining margins tumble led by contraction in gasoline cracks
Singapore margins have plunged in the recent weeks, led by sharp contraction in gasoline/naphtha cracks. We compute Singapore complex gross refining margins at -US$2.5/bbl in the latest week versus US$3.5/bbl in October 2011. We would not be unduly concerned about weekly movement in refining margins and expect a rebound from current very low levels. However, we maintain our subdued view on the refining cycle for the next 12 months due to (1) demand weakness and (2) refining capacity additions in CY2012E. We model RIL’s refining margins for FY2012-14E at US$9.8/bbl, US$10.1/bbl and US$10.4/bbl; US$10.2/bbl in 1HFY12. Exhibit 2 gives the sensitivity of RIL’s earnings to key variables—exchange rate assumption, refining margins and chemical prices.

Production from KG D-6 continues to decline; factored in our earnings estimates
We take cognizance of the continued disappointment in the gas production from RIL’s KG
D- block, which has declined to 41.7 mcm/d for the week ended October 30, 2011. (1) The
steady decline from the block and (2) lack of progress on other E&P blocks has resulted in
sharp contraction in the value being ascribed to RIL’s E&P business. Our reverse valuation
exercise reflects that the market is not ascribing any meaningful value to RIL’s prospective
E&P blocks.

>STRIDES ARCOLAB: Focus on specialty segment to drive 25% revenue CAGR

We met Mr Arun Kumar, Executive Vice Chariman and CEO of Strides Arcolab (STR), who shared his views on the company's long term strategy, growth prospects, and challenges among other things.

Specialty business to be the key long term growth driver
STR's business focus is on the specialty segment as its key long-term value creator and growth driver. STR has developed one of the most competitive sterile product franchises globally with eight manufacturing facilities.
The company is looking to divest the pharma business, (non-sterile business) if it gets the right price. The pharma business comprises institutional business related to antimalaria, anti-TB remedies and branded generic business in India, Australasia and Africa, contributing ~INR12b to STR's annual revenue.

Partnership with MNCs leverages strong product pipeline
We feels that STR's partnership with Pfizer in various regulated markets and with GSK for 95 emerging markets has enabled Strides to leverage strong and best in class distribution of these MNCs across the globe.
Partnership with Pfizer, particularly the US, gives it a strong competitive advantage. STR expects to corner 15-25% market share in the US, backed by Pfizer's strong marketing and distribution, and low competition.

STR slated to post revenue CAGR of 25% over the medium term
STR's has raised its CY11 revenue guidance to INR25b from INR22b and is slated to grow overall revenue by 25% CAGR in the medium term. The product portfolio of the company targets USD11b market opportunity.
Further, given the strong product pipeline which includes High Potency drugs, Penems, Cephalosporins, Ophthalmic and Peptides, the company is likely maintain robust licensing income of INR2.5b every year over the next few years.

Profitability to increase as capacity utilization ramps up
The management guidance is for significant improvement in profitability, led by a scale-up in manufacturing.
STR expects EBITDA margins, RoCE and RoE to improve substantially over the medium term and believes profitability was depressed in the past due to large investments in building the specialty business.

Valuation and view
STR is set to emerge as a specialty company with revenue contribution from the segment rising from 28% in CY09 to 51% in CY12. STR has an impressive product pipeline in the specialty segment.
We expect STR to post earnings CAGR of 36% over CY10-12. At CMP of INR406, the stock trades at 10.8x CY11E and 10.4x CY12E earnings. Maintain Buy with a target price of INR509 (13x CY12E EPS), an upside of 25%.

To read the full report: STRIDES ARCOLAB