Friday, December 30, 2011

>INDIA'S ECONOMY: Doing business in Dharavi

We visited Mumbai’s Dharavi Slum on Boxing Day, gaining a peek into this city within a city. We were moved by the scenes of daily life that we encountered but were most surprised by the sophistication of Dharavi’s economy. As a single data point in India’s informal economy, the recycling, textiles and leather businesses that we saw were vibrant enterprises and had developed sophisticated links with the wider economy.

One of Mumbai’s largest slums
 Dharavi encompasses a 1.7km2 area and is home to an estimated one million residents
 Its residents face a daily challenge from their impoverished conditions

Sophisticated businesses
 Dharavi supports a strong economy, producing ~US$600 million of goods each year
 We visited local recycling, textiles and leather businesses and were surprised by their sophistication

Sophisticated consumers
 Even in the midst of poverty, we still saw evidence of growing consumerism
 We were struck by the number of smartphones in use, satellite TV dishes on the rooftops and motorcycles on the streets

Seeing is believing
 We recognise that Dharavi is just one slum of many and may not be representative
 Still, Dharavi provides a fascinating insight into India’s informal economy and refutes the idea that the informal economy must be stagnant and backward
 We recommend investors contact Reality Tours & Travel to see Dharavi with their own eyes (contact details provided inside)

To read the full report: India's Economy

>Recent developments in the road and highway space; NHAI (National Highways Authority of India)

Key takeaways from the meeting with Mr. Gajendra Haldea, Principal Adviser (Infrastructure) in the Planning Commission with a view to facilitate in-depth discussions on the roadmap in respect of US$1trn spending on infrastructure

The 11th Plan (FY07-12) infrastructure spending is estimated at US$460bn and the 12th Plan (FY12-17) infrastructure outlay would be US$1trn, on which a detailed document will be released within a month. Taking into account sector-wise problems like the power sector facing issues such as shortage of coal, losses suffered by state electricity boards (SEBs), delay in getting environmental clearance and also airport construction companies facing lack of clarity on airport guidelines, land acquisition and funding problems, Mr. Haldea said he expects a slippage of only around US$100bn in infrastructure spending, which still implies 100% higher infrastructure outlay (US$900bn) under the 12th Plan.

The methodology adopted by the Planning Commission in respect of capital expenditure in every Plan period for each infrastructure segment is based on historical trend and assumes a holistic approach to determine the infrastructure spending. Based on the analysis by the Planning Commission, the expenditure may show an increase or remain stagnant, but not decline, after factoring in structural and technical problems pertaining to the respective segment.

Despite lot of problems, Mr. Haldea expects the infrastructure sector to grow at a moderate rate. However, he has not given a clear roadmap to justify his point of view. The key sectors that would drive growth under the 12th Plan period are power (generation, transmission), roads, and ports. The power sector is expected to remain as a top investment option, but with a selective approach.

Mr. Haldea said the power distribution space needs much more than what the Shunglu Committee and the B.K. Chaturvedi Committee have proposed. He does not expect any state to revise the power tariff every year, as it is a politically sensitive issue. The road ahead is a blend of the committees’ recommendations and government support which includes partial bailout by every state, partial write-off of loans by banks and power tariff hike by some states to offset the losses of SEBs.

Mr. Haldea believes that India is an infrastructure deficit country, which will keep demand intact in the long term. Funding seems to be a problem area for policymakers, as most of the banks have reached their limits in terms of lending to infrastructure companies. However, the policymakers are currently outlining ways to meet this huge capex which includes increasing borrowings via the ECB route, infrastructure debt fund, insurance funds and household savings, with the private sector accounting for 50% of the share. He does not expect a dramatic structural shift in project implementation and expects moderate growth in the long run to continue.

Key takeaways from the meeting with Mr. Mr. N.R. Dash Chief General Manager (Finance) in National Highways Authority of India (NHAI) to track the recent developments in the road and highway space, which is the only infrastructure segment currently that drives robust growth.

■ NHAI has set a target of awarding 7,300km of highway projects during FY12, of which 4,300km has been already awarded during April–November 2011, 1,000km is in advanced stage of evaluation and the rest 2,300km (14 projects) are in different stages of the bidding process. NHAI is confident of achieving its FY12 target. Till date (i.e. April-November 2011), 33 projects were awarded, of which 22 projects were offered at a premium.

■ Out of the total ~50,000 km of national highways planned by the NHAI, work on 28,000 km of highway projects has been awarded (of which 15,000 km of projects have been completed and 13,000 km are in progress) and 22,000 km of projects are yet to be awarded. NHAI expects robust growth in the award of projects to continue, with 22,000km of projects to be awarded in the next three years, thereby translating into 7,300km every year.

■ NHAI believes the aggressive bidding scenario is cooling off, but still there is good demand for highway projects. It says the aggressive bidding is justified keeping in mind the opportunity of higher traffic growth, decline in interest rates and factoring in the project cash flow over the concession period.

■ NHAI is also carrying out a study on higher difference in project cost calculated by it and the project cost announced by developers. Out of 33 projects awarded, the cost of 18 projects is higher by ~0-25%, six projects’ cost is higher by 25%-50% and five projects’ cost is higher by 50%. NHAI normally takes two years for it to award a road project from the date of preparation of feasibility report and another three years to construct the project, for which it adjusts any escalation in input costs.

■ NHAI has outlined three major risks for the road sector: shortage of skilled labour, land acquisition issue and problems in project funding.

■ Land acquisition has seen an improvement since the past two years after the implementation of the state support agreement, creation of land acquisition units and an apex body for acquisition. During CY11, NHAI acquired 12,000 hectares as against 8,000 hectares acquired in CY10. It has not faced any major problem on the land acquisition front till date, but requires more clarity on the market price as stated in the Land Acquisition Bill (which is an issue due to improper maintenance of records in rural areas). Currently, NHAI is granting orders on the basis of 50% land aggregation as against the norm of 80% stated in the concession agreement, which would keep the project award momentum on track. During the 12th Plan period, estimated requirement of funds would be ~US$70bn of which US$35bn is
likely to be invested by private players, translating into equity investment of ~US$10bn. To ease project financing, NHAI has come out with guidelines that developers can exit from a project completely after two years of project COD (earlier, developers had to hold 26% stake during the entire concession period). This would increase churning by equity funds. Apart from this, NHAI is pushing for changing the status of loans for road projects availed from banks from unsecured to secured, for which it has given an assurance to increase the concession period by 1.5% for fall in traffic by 1%.

>DIVIDEND YEILD STOCKS: table of companies that offer dividend yield of 4.5%+

To read the table: DIVIDEND YIELD STOCKS


>MAHINDRA SATYAM (MSat; erstwhile Satyam Computer Services): Resolution of the major litigations has paved the way for the potential merger of MSat and Tech Mahindra

■ Business momentum continues: The MSat management has indicated business momentum has improved with increased client mining and new deal wins from existing clients. Besides, the company is seeing invitation for new requests for proposal (RFPs) gaining momentum. In the last five quarters, MSat’s revenues grew at a compounded quarterly growth rate (CQGR) of 4.3%.

  • Focus on client mining: MSat is increasingly focusing on deepening its relationship with its existing clients and getting new business from its existing pool of customers. Currently 98% of its revenues come from repeat business from the existing customers. The company plans to mine its existing clients and move up the value chain in terms of service offerings. This can be witnessed in the growth in the contribution from the top 20 clients—the same has increased from 54% in Q4FY2011 to 57% in Q2FY2012. Also, the number of $20-million clients has increased from 12 to 16 in the same period. Currently, of 228 total active clients about 65-70 clients are Fortune 500/Global 500 companies.
  • Finalisation of accounts aiding sales pitching and invitation for new RFPs: Till last year the company was facing difficulty in pitching for new business as its financials had not been finalised. However, the restatement of accounts for the last three years and better understanding of the company’s capabilities have led to MSat increasingly participating in the new RFPs.
  • Tech Mahindra—MSat joint go-to-market strategy a winwin for both: Tech Mahindra and MSat have initiated a joint go-to-market strategy, which has started showing traction and MSat has already won ten clients. Going forward, the management is optimistic of winning more business through strong domain expertise of both the companies - MSat (enterprise solutions practice) and Tech Mahindra (managed services practice).
  • Margin to range in 15-17%: MSat has seen a smart improvement in its EBITDA margin from 5.6% in Q2FY2011 to 15.3% in Q2FY2012. The margin improvement has been possible due to an improving volume growth (1.5% to 4% in the same period), cost rationalisation, increase in fixed price projects, higher offshoring and flattening of employee pyramid. The percentage of employees in the 0-3 years experience category has increased from 18% in Q2FY2011 to 27% in Q2FY2012. The management expects the margin to remain in the range of 15- 17% (ex currency impact) backed by the available levers like further flattening of the employee pyramid, higher offshoring and improvement in utilisation.

On a visible path to recovery

■ Business outlook remains soft on the back of macro uncertainties: The escalation of the sovereign debt crisis in the euro zone has kept the business outlook uncertain and affected the lead time for closure of deals (the lead time has gone up in the recent months).  Nevertheless, the management foresees a decent revenue growth in the coming quarters (ex currency impact). However, it expects lower discretionary spend owing to the macroeconomic uncertainties.

  • Cut in discretionary spends to have lower impact: On account of the current uncertain environment discretionary spends would be under pressure. MSat is a focused player in the enterprise solutions (ES) space contributing about 43% of the revenues of the company. Of the ES revenues, about 60% comes from the maintenance &; support services, which are largely annuity based.

  • Billing rates comparable to mid-tier players: As per the management, the current billing rates are comparable with that of the mid-tier Indian IT companies like Patni Computers but are much lower than that of the big IT companies like Infosys. However, as per the management MSat is getting higher rates on new deals.
  •  CY2012 budgets flat to down: In mid November 2011 the company did a survey of its top 30 clients. The survey pointed to a flat to marginally down IT budget for CY2012. However, offshoring is expected to increase. Also, there are no major worries regarding the budgeting cycle. There would be pressures on clients’ discretionary spends.

■ Q3FY2012 expectation: The management expects the revenues to grow at 2.0-2.5% in US dollar terms with a volume growth of about 3-4% whereas cross-currency movement would adversely affect by 1.5%. The EBITDA margins are expected to be lower by 20-30 basis points. The margins would be affected by a wage hike (an impact of 250-300 basis points) whereas the rupee’s depreciation would lower the adverse impact. The company expects a
net gain in its foreign exchange transactions in Q3FY2012; at the end of Q2FY2012 the company had total hedges of $221 million.

■ Manufacturing and TME remain the stronger verticals: For the company manufacturing and telecommunications, media and entertainment (TME) would remain the focus verticals. The company has strong offerings in the two verticals as well as proprietary solutions to cater to these verticals. Though the two verticals would be affected by the uncertain macro environment, the management expects the two verticals to be steady on an overall basis. The banking, financial services and insurance (BFSI) vertical would see volatility on a quarter-on-quarter basis due to lumpiness of business. The management is looking at acquisitions to grow in the BFSI vertical.

  Major litigations resolved paving way for merger with Tech Mahindra: MSat has seen the resolution of major litigations: both the class action suit and the Upaid litigation have been resolved. The company has not provided for the Aberdeen class action suit whereas for the IT demand the company has provided for about Rs400 crore. The resolution of the major litigations has paved the way for the potential merger of MSat and Tech Mahindra.
Tech Mahindra-MSat merger expected by December 2012: The merger process of the two companies has begun with MSat initiating the winding down of its American depository shares (ADS) which is expected to be completed by March 2012. The management had earlier indicated the merger would get complete by May 2012. However, the delay in resolving the other litigations would delay the merger process till December 2012.

MSat has come a long way from its tainted past with rechristened Mahindra Satyam, much improve financials and better business prospects. Going forward, to recapture the growth prospects MSat would be leveraging its own legacy in the enterprise part of the business and Tech Mahindra’s expertise in the area of managed services. We remain optimistic on the revival of MSat in the coming years. However, intermittent hurdles cannot be ruled out. On valuation parameters, MSat currently trades at 8.3x FY2013E consensus earnings estimate whereas relatively comparable companies like Patni Computer and Mphasis trade at 12.8x CY2012E and 7.6x FY2013E consensus earnings estimates.

Patni Computer’s superior valuation has more to do with the anticipation of a higher open offer price than with the fundamentals of the company whereas Mphasis finds it difficult to recover its lost ground owing to a series of lacklustre performance in recent quarters. Among these three mid-tier IT companies, we prefer MSat owing to its better growth visibility with earnings
compounded annual growth rate (CAGR) of 35% over FY2011-13E as compared to negative earnings CAGR of 13% in Patni Computer and flat earnings in Mphasis over the same period. Currently, we do not have any active rating on MSat but we remain positively biased.


>Commercial Engineers & Body Builders Company (CEBBCO): Largest player in outsourced body building fabrication of commercial vehicles (CVs) in India

■ Beneficiary of increasing demand for FBVs: Commercial Engineers & Body Builders Company (CEBBCO) is the largest player in outsourced body building fabrication of commercial vehicles (CVs) in India. The company stands to gain as fleet operators are increasingly in favour buying fully-built vehicles (FBVs), as against the earlier practice of buying a chassis and getting the body built by vendors in the unorganised market. The share of FBVs in total CVs has risen from 12% in FY10 to ~25% in the current fiscal. Our interaction with players in the industry leads us to believe that this would rise further, as in addition to better product quality, fleet operators can obtain complete financing for vehicles through the FBV route.

Organised body-building to spur growth

■ Railway segment to drive incremental growth: CEBBCO recently forayed into wagon manufacturing after a successful entry into the wagon refurbishing market, where it has garnered a market share of 20% over a two-year period. We expect the railways segment to contribute 20% of total revenues by FY14, up from 11% in FY12, post commencement of wagon production at its new plant in Deori, Jabalpur in Mar12. Moreover, given the higher margins in the segment, we expect blended EBITDA margins to improve by 40bps in FY13 and 30bps in FY14 to 13.7% and 14% respectively.

■ Outlook and valuation: CEBBCO’s operating performance post its IPO in late 2010 was adversely impacted as its largest client, Tata Motors’ (TTMT) realigned production to meet new, changed emission norms. However, we consider this an aberration; its fundamentals remain strong, as seen by its 1HFY12 results, wherein it posted a PAT of Rs164mn, against a PAT of Rs57mn for FY11. Going forward, we expect CEBBCO to grow revenues at CAGR of 32.2% over FY12-14, backed by the increased demand for FBVs (spurred by strong demand in the tipper segment) and higher revenues from railways segment. This robust growth in revenues, combined with better EBITDA margins should result in earnings CAGR of 31% over FY12-14. We value the company at a P/E of 10x FY13 EPS of Rs7, given the cyclical nature of the industry and lower entry barriers in the body fabrication business. We initiate coverage on CEBBCO with a Buy rating and a target price of Rs70.

To read the full report: CEBBCO

>JSW STEEL: Feedback from USA NDR (Non deal road show)

JSW Steel was on an NDR (non deal road show) with us last week to the USA. Investors seemed concerned about the outlook for commodities given concerns in Europe and, more importantly, the slowdown in China. For India, concerns are greater given policy inaction and high interest rates. Though the investors generally believe that the valuations are factoring in most of the concerns, they don’t see a trigger for the stocks to perform in the near term.

We highlight some of the key areas of discussion during the meetings.

■ Agree with valuation comfort but not sure the time is right
In general, investors have adopted a wait and watch policy given global growth concerns. While most agreed that stocks have corrected a lot and are now factoring in most of the issues, they are not convinced if it’s the right time to buy. They don’t see any near term triggers as, apart from global issues, Indian stocks have faced internal issues as well, which have little clarity even now.

European crisis a concern but Chinese slowdown a bigger threat for commodities
While the European debt crisis is a concern, investors think the slowdown in China would be a bigger threat for the steel industry. China has large surplus capacity and in general the fear is that it could start dumping excess production (despite at a loss) leading to a collapse in global steel prices. There is little clarity on the extent of Chinese demand slowdown and how it will pan out.

  •  Our house view on China recognises the above concerns and agrees that there is a threat to current production numbers. Our China Steel analyst expects flat production/demand in China going forward. However, we think the threat of cheaper exports would be limited, given raw material prices remain high and our belief that companies would rather go for production cuts than flood overseas markets with cheaper steel; overseas demand is weak anyway and lowering prices won’t lead to higher utilizations.

■ Indian steel sector is in worse shape – policy inaction/lower investments the key reasons
Apart from the global crisis, India as a country is in bad shape with almost all the fields seeing a slowdown in activities/growth. As a result of policy inactiveness and high interest rates, investments have been impacted. This has resulted in slower steel demand growth. The key
question is how companies see the demand outlook? If the same scenario continues India could turn into a steel surplus country, and along with a global surplus scenario, this could lead to a fall in capacity utilizations. Therefore Indian companies might see both margin pressure and lower volumes.

  •  Our view: While we agree that Indian steel demand has remained weak, we believe even the supply side has been weak with delay in SAIL (SAIL IN, BUY) expansion and even ESSAR Steel (Not listed) has been slow in the ramp up of production. Therefore we see limited steel capacity addition for the next 12-18 months. Even if Indian steel demand grows 5-6% YoY, India would remain a marginal importer of steel. We don’t believe overcapacity is a concern in India and hence don’t see volume pressure for Indian companies.

 Depreciating INR – has saved P&L of Indian steel companies, but what about balance sheet
Depreciating INR has helped Indian companies as domestic steel prices haven’t corrected much despite fall in global steel prices. However all the major companies have foreign currency debt and would see cash flow pressure. How would this affect the balance sheet stretch and cash outflows if any in next 6-12 months time?

  • Our view: We agree that the depreciating INR would have a negative impact on the balance sheet of the companies. However most of the companies have hedged the foreign currency loans and the problem is with the convertible loans which are not hedged and given current stock prices, these are unlikely to be converted. However, companies don’t have very significant FCCB and hence it shouldn’t be a major concern – though is certainly a negative.

 Government regulation over land acquisition/iron ore bans – when is clarity likely
Land acquisition and illegal iron ore mining have been two key issues affecting expansion plans in India. With new mining act even royalty would be doubled. Investor concern is that what other government intervention is likely and how would it affect the industry. Will doubling the royalty in the mining bill help the industry in any way (through better land acquisition policy)?

  •  Our view: While we agree that government policy has created an uncertain environment and there are no near term solutions to these issues, the stocks have been sufficiently penalized and we believe stock prices are discounting expansions (despite spending a significant sum on capex) altogether.

■ JSW Steel: is there an alternate to Karnataka iron ore?
Investors agree that while there is strong likelihood of Karnataka iron ore situation improving, they asked the company if it has any alternate strategy in place in case there is no solution in the next six months.

  • Company view: JSW Steel mentioned that if Karnataka ore is not available they can’t run the plant in the long run. Imported iron ore would not make sense as costs would be too high, while getting iron ore from Orissa is not likely due to high freight and logistics issues.

Some key points highlighted by the company during the road show:
■ Enough iron ore to run the plant at 80-85% utilization
JSW Steel has maintained its guidance of 7.5mtpa production in FY12 and has enough iron ore visibility to run the plant at 80% utilization for next six months. They expect some mines to start production in next 2-3 months time (they expect some decision by January 2012 and post that mines will gradually start production) and major production to start in six months’ time.

■ Expansion to slow: Bengal project delayed
The company has said that while 2mtpa expansion at Vijaynagar will continue (though at a slower pace), the Bengal project has been postponed by a year. They expect some clarity on the start of the project by next year (FY13).

■ Debt to remain high on working capital increase and FCCB payment
The company has indicated that working capital would increase due to iron ore price increase. At the same time there is FCCB payment of US$ 380mn in July 2012 which would be financed through new debt.Therefore debt should remain at higher levels.



Issue of tax-free secured redeemable non-convertible bonds in the nature of debentures

  • Issue period: Friday, December 30, 2011 to Monday, January 16, 2012
  • Basis of allotment: On a first-come-first-serve basis within each category
  • Issue size: Rs1,000 crore with an option to retain an oversubscription up to the shelf limit of Rs4,033.13 crore)

Interest rates are at peak level; best time to invest in fixed income tax free instruments.

■ Interest rate cycle has peaked out
Given the sharp slowdown in the industrial activity and softening of the food inflation, the interest rate cycle has peaked out. Reserve Bank of India has restrained from increasing the interest rates in the last policy review meet and is expected to begin reducing rates in March or April 2012. The bond yields which have increased close to 9% levels have corrected significantly and show easing of pressure on rates.

■ High post tax yield for triple A rated product
Tax free bond with yield of 8.2-8.3% is comparable with yields offered on government bonds and offer extremely attractive pre-tax yield close to 12% for a long period of time. The bond issue has got AAA (stable) rating from the rating agencies -- Crisil and CARE. The bonds would also be listed and tradable on NSE/BSE.

About Power Finance Corporation:
  • Power Finance Corporation-A Navratna Government of India undertaking (GoI; 73.72% equity stake held by GoI)
  • Set up in July 1986 as a specialised financial institution dedicated to power sector financing and committed to the integrated development of the power and associated sectors
  • Classified as infrastructure finance company in July 2010 by the Reserve Bank of India and as a public financial institution u/s 4A of the Companies Act ,1956

To see term sheet: PFC