Sunday, January 22, 2012

>The Financial System is a Farce: SPROTT ASSET MANAGEMENT

2011 was a merry-go-round of more bailouts, more deferrals and more denial. Everyone is tired of the Eurozone. It’s not fixable. There’s too much debt. The politicians don’t know what’s going on. Nothing has structurally changed. We’re still on the wrong path. There’s more global debt than there was a year ago, and it’s the same old song: extend and pretend, extend and pretend,… around and around we go,… and it isn’t fun anymore.

Just as we wrote back in October 2007, and again in September 2008, we feel compelled to state the obvious: that the financial system is a farce. It’s a complete, cyclical farce that defies all efforts to right itself. This past year continued the farcical tradition with some notable scandals, deferrals and interventions that underscored the system’s continuing addiction to government interference. With the glaring exception of US Treasuries and the US dollar (which are admittedly two of our least favourite asset classes), it was not a year that rewarded stock picking or safe-haven assets. Many developments during the year bordered on the ridiculous, and despite some positive news out of the US, we saw little to test our bearish view. If anything, our view was continually re-affirmed.

Let’s start with MF Global. With more than two months passed since the scandal broke, federal officials are still unable to find the estimated US$1.2 billion of missing customer funds.1 The whole episode has been a disaster 

for the CME, the self-regulatory body in charge of making sure the futures brokers play by the rules. Normally in instances of broker bankruptcy, the CME is supposed to backstop client accounts and keep them liquid – i.e., allow them to continue trading while the bankruptcy gets settled. It never happened in this case. Client accounts were frozen for weeks. Funds have remained missing for months – an eternity for clients who were caught short. The great shock was watching how inept and incapable the CME was in 1) preventing the fraud in the first place and 
2) recovering client assets during the aftermath. The CME essentially copped out of their responsibility, offering little more than some perfunctory press releases along the way. They were also surprisingly quick to offer excuses for their non-action. According to CME, it really wasn’t their fault, since CME had “no control over the disposition of customer segregated funds that are held by MF Global and not by CME Clearing”.2 Their on-site review of MF Global’s operations the week before its bankruptcy suggested that the brokerage firm was in full compliance of all the rules, so it wasn’t really the CME’s problem. But of course it was their problem. That’s what the CME is there 
for – to protect clients in cases of fraud or bankruptcy. To protect the “integrity of the exchange”.

In the weeks that have passed, a curious web of transactions have surfaced between MF Global, JP Morgan and Goldman Sachs. Before its bankruptcy, MF Global had been drawing down a $1.2 billion revolving line of credit with JP Morgan. In bankruptcy court, JP Morgan was able to negotiate a lien on some of MF Global’s assets in exchange for paying $8 million towards bankruptcy costs. According to Reuters, “The lien puts JPMorgan’s interests ahead of MF Global customers who have not yet received an estimated $900 million worth of money from their accounts, which remain frozen as regulators search for missing funds.”3 It is also alleged that JP Morgan accepted a roughly $200 million transfer from MF Global the day before its bankruptcy to cover an overdraft in MF Global’s trading account held with them (it still isn’t clear if JP Morgan has the cash).4 MF Global also appears to have sold hundreds of millions worth of securities to Goldman Sachs in the days leading up to its collapse, but did not immediately receive payment for them from the MF Global’s clearing firm, none other than JP Morgan.

To be fair, on November 22nd, the CME did offer to pledge $550 million as a guarantee to the SIPC Trustee in the event that they did not recover all of the missing client funds, but we cynically wonder if that pledge was made after they finally figured out where all the money had gone. The CME seems to have had a good idea by early December, based on comments made by Commodity Futures Trading Commission (CFTC) member, Jill Sommers.5 The bottom line is that MF Global’s client interests and security appear to have been side-stepped to buy time for bigger, more important players to cover their losses (asses), and that is not the way the regulatory system is supposed to function. We’re not naïve – we know the government will always protect the interests of the big banks over paltry retail investors, but do they have to be so brazen about it? The MF Global episode is basically shameless.

Then there’s Dodd-Frank. Remember Dodd-Frank? It’s the massive financial regulatory reform act that was signed into law by President Obama back in 2010. We are certainly not fans of cumbersome overregulation, but in its essence, Dodd-Frank was supposed to provide a new framework to address the potential failure of a too-big-to-fail bank. There’s nothing wrong with that. Given the sheer size of the off-balance sheet derivatives market, we don’t see a problem with at least attempting to prepare for another large scale banking failure in the US. But almost two years later, we have to laugh at how little of the Dodd-Frank framework has actually been implemented. According to law firm Davis Polk, a mere 21% of the act’s 400 rulemaking requirements have become finalized since the law passed in July 2010. Of the 200 Dodd-Frank rulemaking requirement deadlines that have already passed, 74.5% of them have been missed to date.6 The lawyers must be having a field day with all the paperwork.

One part of the Dodd-Frank story that interests us is the CFTC positions limits rule set to go into effect on January 17, 2012. The new position limits are aimed at preventing excessive speculation in the commodity markets which are believed by many, including ourselves, to have driven wild fluctuations in the gold and silver spot price over the past decade. Position limits are an obvious threat to large futures speculators like the big banks, so it was no surprise when two Wall Street lobby groups, the Securities Industry and Financial Markets Association (SIFMA) and the International Swaps and Derivatives Association (ISDA) launched a lawsuit against the CFTC demanding that the new rules on commodity trading be thrown out, or at the very least, delayed. The CFTC voted on the request to delay implementation and officially rebuffed it on January 4th, which is a heartening development in an otherwise cynical saga.7 Back in December, however, the CFTC had already quietly waived the position limit filing requirements on all CME participants until May 31, 2012.8 So even if the new rules go into effect this month, banks won’t have to report their position levels until May 31st either way. Given the lobby groups’ outstanding lawsuit against the new rules, combined with the CFTC’s apparent tendency to grant temporary reprieves, we don’t expect the new position

limit rules to be enforced any time soon. Once summer approaches, there will probably be more delays and more deferrals, granting the big players plenty of time to protect themselves. Extend and pretend. Delay and defer. That’s the song we sing on the merry-go-round. Then there’s Europe and the European Central Bank (ECB). Back in December, the mighty ECB had to step in with yet another massive liquidity injection to avert a total meltdown in the EU banking system. On December 21st, they flooded 523 separate EU banks with a “Long Term Refinancing Operation” (LTRO) program totaling €489.1 billion ($626 billion).9 The program consists of loans that are due in three years and will charge an accommodating 1% interest rate. The liquidity injection will allow the EU banks to participate in a delightfully convenient carry-trade whereby they can take the borrowed money at 1% interest and invest it in various sovereign debt auctions that will likely pay them 3% or higher. The banks will keep the difference in profit, and the EU PIIGS countries get to breathe easier knowing they’ll be able to sell their garbage paper to the EU banks at suppressed rates as long as the LTRO loan money lasts. And the best part? It doesn’t involve any money printing, so there’s really no risk of inflation, you see?

So just so we’re on the same page, if everything goes according to plan this year, European sovereign governments will fund their debt auctions with borrowed money lent to them by over 500 European banks who have themselves borrowed hundreds of billions of euros from the European Central Bank,… who as far as we can tell, borrowed those euros from the various EU sovereign states (or simply printed them). Do you get it? Do you see the circularity? Do you see the can being kicked down the road? And guess what? Since €489.1 billion is clearly not enough to avert disaster this year (most EU banks are so undercapitalized they’ve simply parked the borrowed LTRO money back with the ECB at 0.25% interest), the ECB has promised to launch another LTRO injection this coming February!

No wonder gold was down in December. They completely solved the European debt crisis! Last but not least, we must mention an alarming component of this year’s National Defense Authorization Act (NDAA) that was quietly signed into law by President Obama on December 31st, 2011. This year’s defense bill, officially known as Senate Bill 1867, includes a specific provision that seems to grant the US government the power to detain accused terrorists, including US citizens, indefinitely, without trial.11,12 There has been much uproar and confusion over the language used in the sections of the Bill related to the subject, and it’s still not clear how the Bill will change the existing laws related to terrorism detention in the US, but it doesn’t bode well for constitutional freedom within the country. There’s obviously no direct market impact to the legislation, but we mention it only to remind investors how quickly the rules can change when governments feel vulnerable. ‘Political risk’ should no longer only be applied to mining investments in third world countries. In 2012, it may apply to us all.

It’s very difficult to predict what lies in store for the stock market this year. Anything could happen. Government intervention in the financial system has never been more extreme. We hope the examples above have shed some light on that. As we enter 2012, there are significant debt-related financial risks festering within the three great economic theatres of the world: the US, Europe and China. The market may rally, it could crash, it could tread water, we just don’t know. A lot will depend on how the central banks react. But we are eager to maintain the positioning that we held in 2011. We will maintain our exposure to precious metals equities and bullion. We will maintain our large gross short weightings in our hedge funds. We are confident that they will protect us on this farcical merry-go-round that seems to spin faster and faster with every passing day.


>HERO MOTO CORP: “Margins weak, maintain Neutral”

Volume expansion and price hikes leads to strong revenue growth
Hero MotoCorp has reported 11% yoy volume growth in Q3 FY12 and had taken a price hike of ~Rs700-1000 per vehicle in October resulting into 17% yoy and 4% qoq growth to Rs60.3 bn. The company has been consistently putting up a strong show by selling ~5.3-5.4 lakh units per month and has won ~2% market share in the quarter. Going forward, with domestic motorcycle industry showing signs of weakening, we expect Hero to feel the heat in the wake of strong competition from Honda, which is aggressively expanding its capacities. With three new launches expected this year from Hero in the form of 110cc Passion XPro, Ignitor 125cc and a scooter Maestro, and the recent launch of Impulse, we slightly increase our FY12E/FY13E volume expectations at 15%/10% respectively from 14%/9%. We do not see a significant scope for realizations to grow in wake of competition as market share retention will be the main aim.

Margins below our expectations as staff cost rise & rupee depreciates 
In spite of commodity prices going down, Hero was unable to fetch the benefits of the same in this quarter, as rupee has depreciated significantly vis-à-vis Japanese yen. Since Hero imports ~17% of RM from Japan, this impact was felt a bit too much. Also, employee costs increased 11% qoq, due to wage hike taken in August getting reflected in this quarter. Excluding royalty, margins came in at 15.6%. However, we consider royalty in other expenses, due to which our EBITDA margins came in at 11.9% considering royalty outgo of Rs2280 mn which has increased over the previous quarters due to yen appreciation. Margins have come below our expectations. Going forward, we expect HMCL to post improving margins of 12.1%/13.2% in FY12E/13E as commodity prices start showing their impact as rupee has started showing some strength vis-à-vis foreign currencies.

Outlook and valuation
In view of good show in the domestic markets and increasing the market share, we have slightly increased our volume estimates. We believe new launches also will support the domestic growth of Hero. However, rapid expansion of Honda and overall slowdown in the 2wheeler market will arrest a strong growth in market share, due to which we believe the volumes will not grow above 10% in FY13E. On margin front, we are maintaining our margin estimates as we believe FY 13 will show margin improvement of up to 100bps as raw material prices are slowing down, but at the same time, low price new launches will lead to an adverse product mix, thus capping realization growth. We value the stock at 14x times FY 13E EPS of Rs142.5, due to its market leadership position and domestic strength. Due to expectations of slightly better domestic volume performance, we are increasing our target price to Rs 1996. At CMP of Rs1945 we see a very limited upside of 3%, due to which we reiterate our Neutral rating on the stock.


>SUZLON ENERGY- World’s 3rd largest wind turbine manufacturer : Indian Operations (Suzlon Wind) & REpower (Europe Operations)

Suzlon Energy Ltd (SEL), with manufacturing capacity of 6GW in India, China, Germany and USA is the world’s 3rd largest wind turbine manufacturer. The company enjoys10% market share globally and more than 50% market share in India.

• SEL is the one of the low cost producer of wind turbine in the world, with cost of production of per MW of 1.32mn euro as compared to world average of 1.8mn euro in FY11.

• Due to the ongoing volatile growth in developed economics, the company has diverted its focus on emerging markets like BRICS countries. As on Q2FY12, the Suzlon Wind order book comprised of 96% of domestic order as compared to 80% in the same quarter last year. SEL through its fully owned subsidiary REpower, supplies wind turbine to Euro zone. As on Q2FY12, the subsidiary has an order book of USD 4.1bn, giving an earning visibility for the next two years.

• The management is confident of turning around the operating performance of the group by taking initiatives like focusing on high revenue and margin markets, reduction in COGS and lower CAPEX. For FY12, the management has given top line guidance of Rs. 240 – 260bn with EBIT margin of 7-8%.

• In Q2FY12, the company has fully acquired its German subsidiary REpower, which has cash and cash equivalent balance of Rs. 11bn as on FY11. This huge cash reserve will help in reducing the group leverage position in future.

• The concern for the company could be the highly leveraged balance sheet, lower order book from USA & Euro Zone, depreciating rupee against USD/ Euro and competition threat from Chinese manufactures.


Leveraged balance sheet: The company is planning to deleverage its balance sheet by using cash from the 26% stake sale in Hansen Transmissions and also by using the cash from its wholly owned subsidiary REpower. As of H1FY12, the company had total debt of Rs. 134bn as compared to debt of Rs. 121bn in H1FY11. Due to high leverage, the company may find difficulties in raising funds.

Lower new order: Due to ongoing volatile economic position of developed world especially USA and Euro Zone, the company may find difficulties in getting new order. In Q2FY12, Suzlon Wind, the international orders fell by 65% Y-o-Y to 25MW. Thus the sustained economic downturn in developed countries can adversely affect the company’s performance.

Increase in international competition: China has added wind energy capacity aggressively for the last three years. Because of better outlook of wind energy, various international players have ventured resulting into competition. SEL may be affected both in domestic and in international markets by losing its market share.

Lower wind turbine realization: Due to increase in number of players in wind turbine manufacturing, the  capital cost for per MW of wind energy has declined drastically from 1.2mn euro to less than 1mn euro in FY11. This may affect SEL in getting international orders as in most countries the orders are placed through competitive bidding process. SEL’s domestic market is not expected to be much affected because of various import duties.

Foreign exchange risk: A significant part of SEL’s revenue, costs, assets and liabilities are denominated in foreign currency. Unhedged trade and financial exposure can adversely impact the company’s overall profitability. SEL’s presence across geographies helps in providing natural hedging by offsetting purchase and sales transactions amongst various currencies. Also the company is expected to repay FCCB worth USD 389mn by FY13 as the stock is trading at 70% discount to the conversion price.

To read the full report: SUZLON ENERGY

>Stock Market 2011 v/s 2008 Many similarities, but a few differences too and its impact

2011 witnessed the second biggest fall in Indian markets (25%) after 2008, when markets fell 52%. We draw several interesting observations from a comparison of the years, 2008 and 2011. There are several similarities and also a few differences in key elements related to both, stock markets and the macro economy.

2011 v/s 2008 for economy: Slower downturn; sharp recovery unlikely
We compare 2011 macroeconomic situation with that of 2008 on 5 elements: Growth, Inflation & rates, Credit & liquidity, Fiscal scene and External situation. Essentially, 2008 was a period of a sharp economic downturn followed by an equally sharp recovery. In contrast, 2011 has been a slower downhill but signs of firm recovery yet to emerge. Interestingly, in 2008, we had both fiscal and monetary tools available to stimulate revival. Currently, however, we have only one – monetary tool to stimulate growth.

Element #1 Growth slowdown: Sharp then, more gradual now
Real sector indicators including GDP and IIP growth was on a downhill on both the occasions although the fall was sharper in the post-Lehman period.

Element #2 Inflation & rates: Yet to ease, unlike then

  • In 2008, inflation had risen quickly in the pre-Lehman period followed by a collapse towards the year-end. In 2011, inflation stayed higher through out the year and is showing some signs of easing only in Nov-Dec.
  • Repo rate saw a cycle in 2008, while in 2011, they have on risen so far. Yield curve is very flat in 2011 unlike 2008.

Element #3 Credit & liquidity: Still tight, unlike then
  • Bank credit growth was on an upswing pre-Lehman and collapsed subsequently. In 2011, bank credit gradually and continually slowed down.
  • Liquidity was moderately stressful followed by significant easing in CY08. In contrast, through out CY11 liquidity has been under severe stress with no signs of easing so far.

Element #4 Fiscal scene: No headroom for stimulus this time
  • Fiscal consolidation in 2008 left significant headroom for fiscal stimulus to counter slowdown impact of global crisis. But, unlike in 2008, there is no fiscal flexibility now.
  • While G-Sec yields were rising in both 2008 and 2011, higher deficit and stressed liquidity ensured that yields are currently at much higher levels than 2008.

Element #5 External sector: Trade worse, reserves better
  • In both CY08 and CY11 exports slowed down. However, deficit came down in the later half of CY08 as trade itself shrank and rupee depreciation helped restore trade balance.
  • Current account deficit worsened and forex reserves depleted in CY08. Early signs of the same are visible in CY11 too.
  •  Indian rupee depreciated by 19% vs USD in 2011; in 2008, the depreciation was 24%.

To read full report: INVESTMENT STRATEGY