Tuesday, January 24, 2012

>ACCOUNTING THEMATIC: Accounting quality drives investment returns

Along with everything else, accounting quality in India seems to have stagnated at a low level. Our analysis of the last four years of consolidated accounts of the BSE500 (excl Financials) points to continuing divergence in accounting quality within the stock market. The silver lining is that the relationship between good accounting and positive investment performance seems to be tightening over time.

As one would expect, accounting quality varies by sector (see table on the right) with the usual suspects like Realty, Conglomerates and Construction bringing up the rear. More importantly, the change in a sector’s accounting scores over time seem to have a bearing on investment returns (see exhibit 6 on page 5). Ironically, this puts Realty companies in a nice position as, inspite of being the bottom of the class on a blended basis over FY08-11, Realty is one of the most improved sectors when it comes to change in accounting score across FY08-11. Media companies are also in a similar position.

Similarly, accounting scores vary across market cap buckets (see table below right & Section 3). Whilst the “top 50” stocks have the best blended scores across FY08-11, the improvement in accounting scores over FY08-11 has been the greatest in the midcap bucket (bucket 3: the 100 stocks with mkt cap between $0.2-0.6bn).

Most importantly, from an investors’ perspective accounting scores have a clear impact on stock level returns. Whilst this is not apparent when you look at the BSE500 as a whole, when you drill down to the sector level the relationship is clear (see Exhibits below and Section 5). In fact, if you drill down further into a specific market cap segment in a sector (see Exhibit on the right), the link between good accounting and positive investment performance becomes even clearer.

Whilst our analysis uses on an array of accounting ratios to detect financial manipulation by listed companies, the most powerful ratios are:

  • CFO/EBITDA or the “cash conversion ratio” fluctuates widely across time and across companies. It appears that whenever promoters want to boost profits (and do a QIP), working capital deteriorates and cash conversion suffers.
  • “Other Loans & Advances as a % of Networth” seems to be the most widely favoured route when it comes to pulling cash out of the company (to fund whatever else has caught the promoters’ fancy outside the listed entity).
  • “Provisioning for doubtful debtors as a % of gross debtors” also fluctuates significantly across time and widely across sectors and companies. A low score on this metric combined with poor cash conversion is arguably the defining signature of a dodgy set of accounts.
To read the full report: ACCOUNTING THEMATIC

>BASEL III: Global regulatory standard on bank capital adequacy, stress testing and market liquidity risk

Highlights of Basel III:

  • Core equity tier-1 of 5.5% as against 4.5% for international banks
  • Capital conservation buffer of 2.5% by way of common equity
  • Leverage ratio introduced at a minimum 5% (without risk weighting) as against 3% for international banks
  • Early transition by March 2017, as compared to January 2019 as per international norms
  • Core equity fulcrum of CAR
  • Charges to core equity tier -1 as against total CAR
  • Dividend payout ratios relaxed, allowed upto 100%

For most private sector banks Basel III transition is likely to be smooth. High core-equity tier-1 capital along with room for increase in capital conservation ratios augur well for private sector banks. Select public sector banks are likely to face hiccups. Lesser room for capital conservation as PSU already operate on low dividend payout and low core equity are amongst the concerns for these PSU banks. For every 1% increase in core equity, RoEs are likely to moderate by about 200 bps on an average for the Indian banking industry.

■ Indian Private Sector banks well placed
Indian Private Sector banks are comfortably positioned to move towards Basel III guidelines. Banks would need to keep 11.5% as overall CAR with tier-1 capital at 9.5% (including capital conservation buffer of 2.5%). Core equity tier- 1 capital is the fulcrum of Basel III, and its impact extends into dividend payouts and computation of additional tier-1 capital and tier-2 capital. Leverage ratio has been introduced with core-equity as the capital base. Higher core-equity and CAR requirements are likely to moderate banks’ RoEs from current levels.

■ Select public sector banks, however, are on a sticky wicket
This list includes Bank of India, Central Bank of India, IDBI Bank, UCO Bank, United Bank of India and Vijaya Bank. Conversion of perpetual non-cumulative preference shares, however, may see UCO Bank, United Bank of India and Vijaya Bank sail through. With the Government of India holds bulk of the preference shares of these banks, such a conversion could be on the cards. Others in the list are likely to relook at their growth strategy, resort to dividend cuts or tap equity funding sources.

■ Higher core equity likely to moderate ROEs
Higher core equity are likely to curtail ROEs. Banks on average deliver about 15% ROE, and our estimates indicate that for every additional 100 bps of increase in core equity, ROEs are likely to dip ~200bps. An increase of 1% in tier-1 ratio would need an additional capital of ~Rs 470 bn (~US$10 bn) with the total RWA in the banking system at ~Rs 47 trillion. We believe private banks are well placed to strengthen their core equity through internal accruals.

To read the full report: BASEL III

>RELIANCE INDUSTRIES LIMITED: Comparison of RIL’s 3QFY12 results with 2QFY12 and 3QFY11 results

Financial highlights
 EBITDA and net income. RIL’s 3QFY12 EBITDA declined 26% qoq and 23.7% yoy to `72.9 bn led by (1) lower refining margins, (2) lower production from KG D-6 block and (3) weaker performance of the chemical segment. 3QFY12 net income declined 22.1% qoq and 13.6% yoy to `44.4 bn.

 Other income. Other income increased 55.8% qoq to `17.2 bn reflecting higher cash balance in 3QFY12. RIL had cash and cash equivalents of `754 bn at end- December 2011 versus `615 bn at end-September 2011.

 Interest expense. 3QFY12 interest expense increased to `6.9 bn compared to `6.6 bn in 2QFY12; gross interest expense including interest capitalized of `1.1 bn was `8.1 bn. RIL’s implied interest rate was 4.3% in 9MFY12 and 4.3% in FY2011.

 DD&A charges. 3QFY12 DD&A declined 13.4% qoq and 23.5% yoy to `25.7 bn reflecting (1) the first full-quarter impact on depreciation from reduction in gross block by the amount received from BP and (2) lower depletion due to lower production from KG D-6 block. RIL has not provided breakdown of depreciation and depletion separately.

 Taxation. RIL’s 3QFY12 effective tax rate was 22.6% compared to 22.1% in 2QFY12 and 19.5% in 3QFY11. We note that RIL continues to provide for tax at the MAT rate of 20% for gas produced from its KG D-6 block.

 Net debt. RIL’s end-3QFY12 net debt stood at –`0.4 bn against `99 bn at end- 2QFY12 reflecting `72 bn of gross cash flow generation (net profit + DDA + deferred taxation) and receipt of `147 bn of cash received from BP in October 2011. Net capex (adjusted for foreign currency gains or losses on foreign currency loans) was `58 bn in the quarter. We note that net capex includes (1) actual cash capex (not disclosed for 3QFY12) and (2) increase in gross block due to capitalization of increase in foreign currency loans due to depreciation in the value of the Indian Rupee against the US Dollar. The company has disclosed cash capex of `48.4 bn for 9MFY12, significantly lower than reported net capex of `124.6 bn. However, we would note that the net debt figure would capture the movement in foreign currency loans also due to movement in currencies of foreign currency loans relative to the reporting currency. Exhibit 3 gives details of movement in net debt over the past few quarters and years.

To read the full report: RIL

>Impact: Third Quarter Review of the Monetary Policy(January 2012): Impact on Liquidity

The Reserve Bank of India in its Q3 Monetary Policy Review retained key interest rates at the existing levels and reduced Cash Reserve Ratio (CRR) by 50 bps in order to ease the prolonged tight liquidity conditions in the banking system.

CRR, the proportion of the net demand and time liabilities (NDTL) that banks have to hold with the RBI, has been reduced by 50 bps to 5.5% effective from 28th January 2012. The 50 bps cut in the CRR would infuse approximately Rs. 320 bn into the banking system. With this change the RBI intends to permanently address the structural liquidity shortage in the banking system caused mainly due to the infusion of Dollar by the RBI since November.

On account of the increased government borrowings and the slowdown in private credit demand, the RBI has retained M3 growth projection for 2011-12 at 15.5%, while non-food credit growth has been scaled down to 16.0%.

Key Take-away:
1. Cut in Cash Reserve Ratio
In reducing the CRR by 50 bps the RBI wishes to address the liquidity pressure prevalent in the banking system since early November 2011.

Table 3 illustrates very clearly that the banks have been borrowing over the Rs. 600 bn comfort level of the RBI. Further, a CRR cut will end up giving money to even those banks that have surplus liquidity. Therefore, an infusion of Rs. 320 bn as induced by the 50 bps CRR cut would benefit the liquidity conditions to some extent. However to the extent that the liquidity crunch is due to bank investments in GSecs, these CRR released funds could flow mainly into government paper and support borrowing programme of government as commercial credit growth is sluggish due to demand and interest rate conditions.

2. Impact on Liquidity
Based on the RBI’s projections for growth in deposits (16% = Rs. 8,328 bn) and credit (16% = Rs. 6,301 bn) for FY12 along with the enlarged borrowing programme of the government (Rs. 5,099 bn), the following is the pattern of liquidity flows in the system.

Taking a closer look at the growth achieved so far in the financial year (Apr-Dec 2011-12), Table 3 shows that based on the RBI’s assumptions, there will be a net gap of Rs 1,324 bn in the system, of which Rs 320 bn would be addressed through the present CRR cut. Assuming that there are another Rs 200 bn of OMOs, there would be a gap of Rs 800 bn which will have to financed by other subscribers like PFs, Insurance companies, PDs, repos or CRR cut.

The mitigating factors would be:
- Deposits grow at a faster rate
- Credit growth slows down further

3. Inflation
Headline inflation, which averaged 9.7% for the Apr-Oct period of 2011-12 moderated to 9.1% in November and further to 7.5% in December. However, it is critical to note that the slowdown in inflation has been driven by the moderation in the prices of primary articles, especially vegetables while inflation continues to be high for the core sector. Further, the decline in food inflation is likely to reverse ahead with the base effect waning and seasonality factors sneaking in. Fuel inflation has also remained elevated at 14.9% in December 2011-12 on account of high Global crude prices and rupee depreciation.

RBI has maintained that the inflation target of 7% by the end of March would be attainable despite the slow improvement in core sector inflation and uncertainties in the global economies. This target appears to be reasonable. More importantly, core inflation should move down for any RBI action on this front.

4. Rate reduction
Further, speculation that CRR cut is guidance for interest reduction in the future, it is more likely that the RBI would be more cautious before reducing interest rates as it would be premature to begin reducing policy rates before a substantial and sustainable dip in overall inflation. We do not expect this before early FY13.


>ULTRATECH CEMENT: Expansion at Chhattisgarh and Karnataka for 9.2mt cement capacity are on track

Recommendation: Hold

Price target: Rs1,275
Current market price: Rs1,209

Price target revised to Rs1,275

Result highlights
  • Operating profit in line with estimate; PAT ahead of estimate: In Q3FY2012 UltraTech Cement (UltraTech) posted an operating profit of Rs964.9 crore (up 36.3%), which is in line with our estimate. However, on account of a surge in the other income and a decline in the interest cost (due to the subsidies received in the earlier years under the State Investment Promotion Scheme) the net profit of the company grew by 93.4% year on year (YoY) to Rs616.9 crore, which is ahead of our estimate. 
  • Revenue growth largely driven by realisation growth: The revenue growth of 23.1% was supported by an increase of 16.2% in the average blended realisation YoY to Rs4,509 per tonne. On the volume front, the overall sales volume (including cement, clinker, export and white cement volumes) grew by 5.9% on a year-on-year (Y-o-Y) basis to 10.14 million tonne. On a sequential basis, the volume has witnessed sign of post monsoon recovery and grew by 7%. The blended realisation was higher by 9.3% on a quarter-on-quarter (Q-o-Q) basis. Going ahead in Q4FY2012 we believe cement prices will remain strong with a likely increase in the cement offtake. 
  • Expansion in the OPM due to higher realisation: On the margin front, the operating profit margin (OPM) expanded by 205 basis points YoY to 21.1% on account of a 21.2% increase in the realisation. However, on the cost front the key cost elements like the raw material cost, the power & fuel cost and the freight charges continued their upward trend. This increased the overall cost of production by 18.1% to Rs3,618 per tonne. The operating profit increased by 36.3% YoY to Rs964.9 crore and the EBITDA per tonne increased by 28.7% YoY to Rs952. 
  • Surge in other income and decline in interest cost: The other income increased by 156.4% to Rs155.4 crore (which included Rs66.6 crore for the subsidies related to the earlier years availed of under the State Investment Promotion Scheme). Further, the net interest cost declined by 63.9% YoY to Rs29.5 crore on account of the net subsidies of Rs38.4 crore received. Hence, the reported net profit of the company grew by 93.4% YoY to Rs616.9 crore. 
  • Expansion at Chhattisgarh and Karnataka for 9.2mt cement capacity are on track: The company is setting up additional cement clinkerisation plants at Chhattisgarh and Karnataka. Work on both the plants is on track. The company has already placed the orders for the major equipment. The expansion will increase the total cement capacity by 9.2 million tonne and the additional capacities are expected to come on stream by Q1FY2014. After the commissioning of the aforesaid capacities the cement capacity of the company will enhance to 59 million tonne per annum (mtpa).
  • Oversupply to continue for three years, cost inflation to pressurise margin: As per the management, the oversupply scenario in the domestic cement industry is likely to continue in the coming three years which will have an adverse impact on the cement prices. Further, the sharp increase in the domestic and imported coal prices coupled with a likely increase in the freight cost will keep the margins under pressure. 
  • Upgrading earnings estimates for FY2012 and FY2013: We are upgrading our earnings estimates for FY2012 and FY2013 mainly to factor in the higher than expected blended realisation in Q3FY2012. We are also factoring in some pressure on the power & fuel cost with the change in the pricing mechanism for domestic coal. The revised earnings per share (EPS) estimates work out to Rs72.8 for FY2012 and Rs82.3 for FY2013. 
  • Maintain Hold with a revised price target of Rs1,275: We like UltraTech due to its diversified pan-India presence and strong balance sheet. Further, the company's footprint in the growing markets like Bangladesh, Dubai, Sudan and Bahrain augurs well for its business. However, on account of the pressure expected on the cement prices in the coming one year and the cost inflation in terms of the rising prices of coal (imported as well as domestic) we maintain our Hold recommendation on the stock with a revised price target of Rs1,275 (valued at enterprise value [EV]/tonne of $120). At the current market price the stock trades at a price/earnings (PE) of 14.7x, discounting the FY2013 estimates. On an EV/EBITDA basis, the stock trades at 7x FY2013E.

>MARUTI SUZUKI INDIA: Expect a Swift recovery

Recommendation: Hold
Price target: Rs1,138
Current market price: Rs1,163

Realisation expansion a positive surprise in Q3FY2012
During Q3FY2012, Maruti Suzuki (Maruti) reported a 7.1% quarter on quarter (QoQ) increase in net realisations. Lower discounts, price hikes and an improved product mix took the realisation to an all time high. The contribution/vehicle also surprised and reached to its highest level in the last six quarters.
Worst for margins behind; expect gradual improvement from Q4FY2012 
The company is expected to see a 100-150 basis points (bps) margin savings on account of favourable operating leverage as production ramps up in Q4FY2012. However, some hit is expected as vendors are compensated for higher costs with a lag. Vendor compensation is expected to have a positive effect of 100bps.
Foreign exchange (forex) related marked to market (MTM) losses in commodities and direct and indirect imports were to the tune of Rs75 crore, thereby impacting margins by 100bps. 
In case the currency remains stable, the company may see a 100-250bps margin expansion from Q4FY2012 onwards. FY2013 may see further improvement once the benefit of vendor hedges comes through. 
Open positions may cause margin volatility; 100bps Q-o-Q impact felt in Q3FY2012 Maruti saw a 100bps impact on margins on account of adverse forex movement. The company hedged its dollar/ yen as well as dollar/euro exposure for Q4FY2012 while FY2013 exposure is completely open. During Q3FY2012 the dollar appreciated 0.7% against the yen while it appreciated 4.5% against the euro. 
While the company hedged stable currencies, it has kept the most volatile dollar/rupee exposure open. An adverse currency movement in the rupee can have a direct bearing on the margins. During Q3FY2012, the pure currency impact on royalty is to the tune of Rs75 crore which includes reinstatement of liabilities of Rs20 crore and Rs19 crore of royalty hit related to H1FY2012.
ValuationWe are marginally cutting our earnings per share (EPS) estimates for the company as we incorporate the management's expectations of the future. Since our last Buy recommendation, the stock has achieved our target price. Our revised target price of Rs1,138 discounts FY2013 expected EPS of Rs81.3 by 14x. We believe that the current price is factoring in the positives. We recommend a Hold on the stock.


Recommendation: Buy
Price target: Rs497
Current market price: Rs418

Price target revised to Rs497

Key points
  • Q3FY2012 results-a blockbuster performance: For Q3FY2012 Godrej Consumer Products Ltd (GCPL) has reported a blockbuster performance with a sequential improvement of 214 basis points in the operating profit margins (OPMs) and a 50% growth in the bottom line for the quarter. The consolidated net sales grew by 36% year on year (YoY) to Rs1,344.1 crore (which was ahead of our estimate of Rs1,235.4 crore) during the quarter. This growth was driven by a 20.0% year-on-year (Y-o-Y) increase in the domestic business and a 68.2% Y-o-Y growth in the international business. Though the gross profit margin (GPM) remained almost flat but the OPM improved by 292 basis points YoY to 20.2%, largely on account of a 284-basis-point Y-o-Y decline in the advertisement and promotional spend during the quarter. The operating profit grew by 58.9% YoY to Rs272.1 crore and the adjusted profit after tax (PAT; before minority interest) grew by 54.3% YoY to Rs183.1 crore (which was ahead of our expectation of Rs143.2 crore). The foreign exchange (forex) loss due to the rupee's depreciation stood at Rs5.5 crore (in line with our expectation of Rs5 crore).
  • Raising Rs685 crore through preferential allotment: GCPL is planning to raise Rs685 crore by issuing around 1.67 crore equity shares of Re1 each of the company to Baytree Investments (Mauritius) Pte Ltd (an arm of Singapore-based investment firm Temasek) at a premium of Rs409 per equity share. With this preferential allotment the share capital of the company will go up to 34.0 crore from 32.4 crore currently. The funds thus raised will be utilised largely to reduce the debt on books and to fund acquisitions. The management expects the debt/equity ratio to come down to 0.7x by FY2013 from 1.1x at present. 
  • To acquire 60% stake in Latin American Cosmetica: GCPL has entered into an agreement to acquire a 60% stake in Cosmetica Nacional (Cosmetica), a leading player in Chile's hair colorant and cosmetic markets. The acquisition is in line with GCPL's 3x3 strategy of enhancing presence in the emerging markets. GCPL is likely to pay close to Rs195 crore for its 60% stake in Cosmetica. The acquisition is valued at 9x its enterprise value (EV)/EBIDTA and 1.8x its sales, which is in line with some of the acquisitions done by GCPL recently. The acquisition will be funded through the mix of low cost foreign currency debt and the money raised from the preferential allotment to Temasek. The management of GCPL expects the acquisition to be earnings accretive from the first year of its consolidation. GCPL is planning to buy the remaining 40% stake in the company over a period of the next three to five years.
  • Revision in earnings estimates: We have factored in the higher than expected operating performance of Q3FY2012 in our estimates for FY2012 and FY2013 and this has resulted in an upward revision of 2.8% and 1.3% in the adjusted PAT estimates for the respective fiscals. However, the equity dilution to result from the preferential allotment to Temasek has caused us to reduce the earnings per share (EPS) estimates for FY2012 and FY2013 by 5% each. We have also not incorporated Cosmetica's numbers in our estimates due to the non-availability of the figures of the key balance sheet items. Nevertheless, a back-of-the-envelope calculation shows that the consolidation of Cosmetica would result in an increase of 5-6% in the FY2013 earnings estimate. However, we will wait for the balance sheet details of Cosmetica before revising our earning estimates.
  • Outlook and valuation: The integration of the recent acquisitions and the cross pollination strategy would help GCPL to achieve a strong growth in long run. We believe the company is comfortably positioned to achieve a growth of around 20% YoY in the bottom line in the coming years. In addition, the company is focusing on reducing the debt on books to improve the balance sheet at the consolidated level. Hence, we like GCPL in the mid-cap space and maintain our Buy recommendation on the stock. In line with the reduction in the earnings estimates due to the impending equity dilution, our price target for GCPL now stands reduced to Rs497. At the current market price the stock trades at 24.6x its FY2012E EPS of Rs17.0 and 19.4x its FY2013E EPS of Rs21.6.

>FEDERAL BANK: Q3FY2012 results: First-cut analysis

Recommendation: Buy
Price target: Rs460
Current market price: Rs383

Result highlights
  • Federal Bank's Q3FY2012 results were ahead of our estimates as the net profit expanded by 41% year on year (YoY) to Rs202 crore on account of a strong growth in the net interest income (NII). However, the asset quality disappointed as the gross and the net non-performing assets (NPAs) increased on a sequential basis after showing some improvement in Q2FY2012.
  • The NII showed a strong growth of 18.1% YoY and that of 11% quarter on quarter (QoQ); the same was higher than our estimate. A growth of around 21% in the advances coupled with an expansion in the margins (calculated) supported the growth in the NII during the quarter.
  • In Q3FY2012 the non-interest income showed a growth of 13.3% YoY. On a sequential basis the non-interest income expanded by 18% QoQ.
  • The operating profit (pre-provisional profit [PPP]) increased by 17.4% YoY to Rs419 crore. The operating expenses increased by 16.5% YoY while the cost/income ratio was at 37% compared with 38.9% in Q2FY2012.
  • The asset quality of the bank deteriorated significantly as its gross and net NPAs increased to 3.97% and 0.74% from 3.61% and 0.58% respectively in Q2FY2012. In absolute terms, the gross NPAs increased 9.1% on a sequential basis.
Outlook: Though in Q3FY2012 the bank showed strength in the core income growth, the deterioration in its asset quality is a cause for concern. The management has shifted focus from growth in advances to improvement in risk management, efficiency and portfolio mix, which is positive for the bank in the medium term. Currently, the stock trades at 1.1x FY2013 book value and we have a Buy recommendation on it. We will come out with a detailed note after attending the bank's conference call scheduled on January 24, 2012.