Friday, March 2, 2012

>INDIA STRATEGY: Budget 2012 impact on sectors at a glance

Now for the hard work. The recent sharp rally in the Indian stock market largely factors expectations of improved governance (fiscal consolidation, structural reforms) but there is little concrete evidence so far. The FY2013 Union Budget will be the first test of the Government’s willingness and ability to meet the market’s lofty expectations. We expect the Government to set the FY2013 GFD/GDP target at 4.7% with underprovisioning for fuel subsidies; we estimate 5.4% under more realistic assumptions. We have increased the concentration of high-quality names in our Model Portfolio; we have very little exposure to high-beta names now.

■ Model Portfolio: High concentration of high-quality stocks notwithstanding global liquidity
We find most high quality large-cap stocks offering 8-15% potential upside to, or trading at, our
FY2013E fair valuations. We expect moderate improvement in India’s macro-environment over the next 12 months but higher-than-expected crude prices may derail the recovery. Very high global liquidity has already pushed crude oil prices beyond India’s comfort zone. High crude oil prices will result in (1) high subsidies and fiscal deficit, (2) large CAD and (3) high inflation, which may limit the RBI’s ability to reduce policy (interest) rates.

■ Fiscal consolidation, though positive, is unlikely to be painless
The rally in the Indian stock market derives its strength from expectations of improvement in governance, including fiscal consolidation. Fiscal consolidation would be positive indeed, but is also likely to be painful. Fiscal consolidation can take place either through (1) higher revenues (increase in excise and service tax rates) and/or (2) lower expenditure, primarily reduction in fuel subsidies (increase in fuel prices). The ongoing global liquidity-driven rally in commodities, notably crude oil, will further weaken India’s fiscal and BOP positions.

■ We expect the Government to target 4.7% GFD/GDP in FY2013
We expect the Government to target an ambitious 4.7% GFD/GDP in FY2013, backed by nominal GDP growth of 13% (real GDP growth of 7.5% and WPI inflation of 5.5%). However, as has been the case historically, expenditure is likely to be depressed with under-provisioning for subsidies (fertilizer, food and fuel). We believe 5.4% GFD/GDP may be more realistic. Robust tax collections (negative service tax list, economic buoyancy) and 2G spectrum and coal block auctions may surprise positively but higher subsidies on food and fuel may disappoint.

■ Painful or not, the Government may have to bite the fiscal prudence bullet
In our view, India needs to tackle the problems of weak governance, high fiscal deficit and a vulnerable BOP position. Specific to the FY2013 Union Budget, we believe the Government can send the right signals through (1) taxation reforms to improve the low tax-to-GDP ratio (negative service tax list in FY2013E; commitment to implement GST and DTC by FY2014E) and (2) subsidy reforms with an increase in fuel prices and a commitment to reduce subsidies in the medium term through better targeting and distribution of subsidies.

To read full report: MARKET STRATEGY

>INDIA MARKET STRATEGY MARCH 2012: March: An “Eventful” Month but oil as important

Focus on the 3 events ….
Over the next couple of weeks, 3 events will be important for markets. Given the sharp rally in markets, expectations are high and the market could be vulnerable to a correction on any disappointment. However, price of oil may be as important as these events in determining the market direction (and of course will affect two of these events).

1. March 6 - Assembly election results: A Congress strong performance with a kingmaker role in Uttar Pradesh positive for markets. 
2. March 15th - Credit Policy: Consensus and our expectations are for a rate cut but high oil prices persist, RBI may do a CRR cut only.
3. March 16th – Budget: The key to watch is the fiscal deficit estimate.

… but oil prices as important
While an increase in crude oil is clearly negative for India’s macro-economy, the co-relation of Indian stock market and oil is strongly positive ie a rising crude oil prices lead to a rise in equity markets (co-relation is strong at 89%). However, this relationship turns negative at a tipping point (and we may be close to it) ie Indian markets fall even as crude continues to rally.

Sharp crude rallies break this co-relation: On 10 occasions over past 10 years we have seen a rally in crude prices by over 30% in 3 months. On 6 of these 10 occasions, markets gave a negative return over the next quarter. Similarly, India under-performed EMs on 8 of these occasions

Rising crude oil hurts the economy in 3 ways…
1. Inflation: A 5% increase in domestic oil prices increases inflation directly by app 75 bps (see Table 3)
2. Current account deficit: Oil accounts for 30% of total imports. A $10/bbl increase in oil prices will increase current account deficit by $8bn (0.4% of GDP).
3. Fiscal Deficit: Every $15/bbl increase in oil price can lead to an increase in fiscal deficit by roughly 0.3% of GDP assuming a 10% increase in domestic oil prices (see table 5).

.. but the positive is that the tipping point has gone up
In a macro sense, oil, at US$110/bbl today, is like oil at US$70/bbl in 2007. For example, net oil imports remain around 4% of GDP and the oil subsidy around 0.8% of GDP similar to 2007 although oil prices are over 50% higher.

To read full report: MARKET STRATEGY

>HAVELLS: Upbeat Outlook

■ Raising PO on higher EPS and re-rating
Our management meeting left us increasingly confident about margin expansion and 20%+ revenue growth. We have raised PO by 15% to Rs625 driven by (1) increase in our EPS for FY13 and FY14 by 5% and 8% respectively, and (2) increase in valuation basis of India entity by 10% to PE of 16.5x FY13E earnings owing to higher profitability. Our FY13 and FY14 EPS estimates are higher than consensus by 10% and 13% respectively. Stock at PE of 12.7x FY13E is attractive. Buy.

■ Margin improvement to continue
Havells has completed it’s investment in land and buildings for the next three years and is focusing on the expansion of margins and cash flow. The company is aiming to achieve 14%+ EBITDA margin in India and 10%+ EBITDA margin globally in two-three years. We have raised FY13/14e EBITDA margin to around 13.3% in India from 12.9% and maintain assumption of 8% globally.

 Strong product pipeline for 20%+ sales growth
New product pipe line is very robust and is key to management target of over 20% revenue growth. The company has just launched air coolers. It will soon get into UPS, inverters and kitchen appliances. We have raised our 15% sales growth expectation to 18% in FY13 and 15.5% in FY14. Upside could come from faster
ramp up of new products.

■ Rising cash-flow to boost valuation
We expect the decline in capex, expansion of margin, and tight control over working capital to boost the cashflow of Havells like never before. Stronger cash flow will be key to a re-rating. We have valued Havells on a sum of part basis with (1) India entity at PE of 16.5x FY13E EPS of Rs31.9/sh, which is a 5% premium to Indian peers, and (2) Sylvania, the global entity at PE of 12.5x, and at a 15% discount to global peers.

To read full report: HAVELLS

>LARSEN TOUBRO: Presence in diversified businesses LIKE Turnkey projects, construction, engineered products & systems, electrical & electronic products & systems, IT& Engineering services, Machinery Valves etc

 Best stock to play the Indian infrastructure theme
We believe L&T is best placed to benefit from the gradual recovery in the capex cycle, given its diverse exposure to sectors, strong balance sheet and cash flow generation as compared to its peers, which grapple with issues such as strained cash flow, high leverage and limited net worth and technological capabilities.

 Presence in diversified businesses
Larsen & Toubro’s business as a whole are diversified in nature with the presence in different areas of businesses like Turnkey projects, construction, engineered products & systems, electrical & electronic products & systems, IT& Engineering services, Machinery Valves & Industrial Consumables, Financial Services, Shipbuilding etc would help the company to withstand the concerns in particular sectors.

 Strong order book
As of 3QFY2012, L&T stands tall on an order backlog of 1, 45,768 crore against Rs 114,882 crore at the end of Q3 FY11 and Rs 142,185 crore at the end of Q2 FY12. With the current order book, book to book ratio (BTB ratio) stands at 3x its TTM revenue. L&T’s order book is majorly dominated by the infra (40%) and power (29%) segments. Process (15%), hydrocarbon (11%) and others (5%) constitute the balance part of the order book.

 Outlook and Valuations: Attractive; Initiate Coverage with ‘BUY’
Larsen and Toubro (L&T) had posted good set of numbers for 3QFY2012, which mainly on account of robust top-line growth and higher other income. Order inflow for the quarter grew by stunning 28.2% to 17,129 crore covering some of the lost ground in 1HFY2012. We prefer L&T over its peers being the market leader and fundamentally the strongest infrastructure company. We maintain L&T as our top pick in the sector. Hence, we initiate a ‘Buy’ recommendation on Larsen with the target price of Rs. 1433 with a ‘Buy’ below Rs.1075 for those who have a moderate to aggressive risk appetite, as the stock looks very attractive at the current levels, given the steep price correction in the recent past and the improved outlook on the infrastructure space going ahead. Risks At the macro level, the current global economic scenario is the most worrying risk factor, as a fall of the global economy into a double-dip recession may lead to a slower growth in our economy. Apart from that, the other concerns include the stiff competition in each of the industries which would cause aggressive bidding and a drop in order inflow, persistence of the higher interest rate leading to drop etc. The company may also get affected by the delays in the execution of the long gestation projects, which might affect the cash flow from the projects that have a specific concession period. Apart from these, the increasing debt level also poses some risk to the future journey of L&T as it will increase the financial burden in the form of interest. The company’s debt to equity ratio, currently, stands at 1.52:1, which is further poised to go up as more projects are set to kick in.

To read the full report: L&T

VOLTAS: EMP division was strong adjusting for the onetime loss

■ What's changed
Voltas reported a Q3FY12 loss of Rs. 2.0bn after taking one-time impact of Rs. 2.8bn in the loss making Qatar contracts. As a result, 3Q EBITDA margins of 7.5% (350-400 bps above GS and Bloomberg consensus estimates) were more normalized. Revenue for the quarter at Rs 11.6bn also came in above our and consensus expectation, due to better than expected execution on the EMP orders. Order inflow at Rs 9.6bn was slightly above our expectation, with the order book growing 8% yoy partly due to order inflow and partly on account of restatement of the book on yrend foreign exchange rates.

■ Implications
Though the performance of EMP division was strong adjusting for the onetime loss, giving further visibility on normalized margins, we believe that margins are unlikely to go back to historical levels of 8-9% because recent
projects have been bid at lower margins: we expect FY13E EBIT margin of 6.5% for this segment. In addition, the EPS segment is also facing headwinds on the back of a change in the ownership of principal which may result in loss of some domestic contracts for Voltas: we expect revenue growth of 8% in FY13E. Increasing competition and a prolonged winter also leave little to expect from the UCP segment. These headwinds across all segments are the key reason for our Neutral rating.

■ Valuation
We incorporate the one-off in FY12E EPS, but increase EPS for FY13E-14E by 12-16% based on higher inflows, as a result increasing our PE-based 12-m fwd TP to Rs 113 (from Rs 97). The stock trades at 12-m fwd P/B of 2.3X, which in our view is justified given the muted growth: we expect FY11-13E revenue CAGR of 8% and ROEs of 21% vs. 39% over FY05-10.

 Key risks
Downside risks: lower volumes in the UCP segment. Upside risks: pick-up in order inflows in the Middle East.

To read full report: VOLTAS

>Crude Oil: Geopolitical tensions around Iran driving prices higher •

Oil prices have risen amidst increasing geopolitical tensions around Iran
Oil markets have increasingly focused on the escalating geopolitical tensions over the Middle East in general and Iran in particular. Iran is the second largest oil producer in OPEC, with an output of around 3.5 million barrels per day (mbpd), accounting for almost 4% of global oil production. In response to rising geopolitical concerns, the front-month Brent oil price has risen by around 12% in the month of February and hit a 9-month high of USD 125.55/bbl, while long speculative positions on oil have also increased. We had earlier highlighted the upside risks posed by geopolitical tensions to oil prices in our December report1.

The US, the European Union (EU) and Israel have been engaged in efforts to diplomatically isolate Iran over its alleged nuclear weapons program. The US recently imposed additional unilateral sanctions on Iran and froze Iranian Central Bank’s assets in the US. Earlier, US had classified the Central Bank of Iran (CBI) as a centre for money laundering, and also passed a law that would punish any foreign financial institution that did  business with the CBI. [For further details on Iran related sanctions, please refer to Appendix] Efforts have been stepped up to discourage countries from importing oil from Iran. Meanwhile, risks of a military conflict remain high-ranking US and Israeli officials repeatedly stressing that “all options remain on table”, an apparent allusion to military strike, in order to deal with Iran’s alleged nuclear weapons program. We attempt to briefly evaluate the risks to oil supply and energy security emanating from the current crisis over Iran.

Diplomatic efforts have increased to embargo Iranian oil out of world market
The EU on January 23rd agreed to halt oil imports from Iran from July onwards. Such an oil embargo will force EU to seek other sources of oil supply, and is likely to push up oil prices. The EU decision comes amidst increasing diplomatic pressure on Iran’s major trading partners – China, India, Japan and South Korea – to halt oil imports from the country and aid in its diplomatic isolation.

To read the full report: CRUDE OIL

>SHIPPING CORPORATION OF INDIA: Disappointment continues, downgrade to Sell

Shipping Corporation of India’s (SCI) Q3FY12 results continued to remain weak and was below expectations. Apart from the container liner segment which continues to report losses, the bulk division (adjusted for profit from sale of ships) also remained in red. The company reported losses of Rs390mn at the EBIT level (adjusted for profit from sale of ships). We believe SCI would remain impacted by lower freight rates and higher operating costs, which would result in operational losses for FY12 and FY13. We have lowered our estimates and downgrade the stock to Sell. We believe that the recent run-up in the stock is not sustainable; especially given that the global supply glut and slower demand growth is likely to mar the shipping industry until the end of 2013.

■ Q3 results below expectations: Revenue grew 29.1% YoY to Rs11,475mn, 13.5% above our estimate mainly on the back of foreign exchange gain of Rs1,686mn included in other operating income. EBITDA plunged 26.8% YoY to Rs1,180mn while margins declined 785pp YoY to 10.3%. Operating expenses (including bunker costs) at 69.2% of revenue increased 14.5pp YoY and 265bp higher than anticipated. Bunker cost at 42.2% of revenue increased 18.5pp YoY and 145bp QoQ to Rs4,082mn.

 ■ Operational losses across segments: Though SCI reported EBIT profits in its bulk division at Rs1,377mn in Q3 these were not the operating profits at it included Rs1,751mn profit from the sale of eight old vessels. The container liner segment continued its losses at Rs241mn. This led to overall operational (EBIT) loss of Rs390mn vs. a profit of Rs600mn last year.

■ Forex movement further dents profitability resulting in losses at net level: SCI managed to report profits at net level only from profits from the sale of ships and foreign exchange gain booked under other operating income. Adjusted for the forex gain of Rs1,686mn and Rs784mn MTM loss on forex borrowings charged to interest cost in accordance with AS-16, adjusted PAT came at a loss of Rs161mn vs. our estimate of a loss of Rs149mn. If we adjust for the profit form sale of ships, the loss further increases to Rs1,919mn.

 Estimates lowered, downgrade to Sell: We have revised our estimates to factor in losses in bulk and liner segments. We have also factored in the impact of changes in foreign exchange in interest cost. We expect SCI to report a net loss of Rs1.2bn in FY12 and a marginal loss of Rs147mn in FY13. We continue to value the company at 0.4x P/B (which factors in the company’s dismal performance) but roll-forward it to FY13. Hence, we downgrade the stock to Sell with a target price of Rs60.


>RANBAXY LABORATORIES: Exceptionals wipe off operating gains

Ranbaxy’s 4QCY11 numbers were a mixed bag. The company capitalized on its launch of generic Lipitor and AG version of Caduet to clock net sales slightly ahead of our estimates at Rs37.3bn (up 79.2% YoY). While operating EBITDA was up 273.6% YoY at Rs8.6bn, the pre-exceptional PAT of Rs5.0bn was more than offset by extraordinary items – the DoJ settlement provision of Rs26.4bn and loss on derivative positions of Rs8.3bn - resulting in a net reported loss of Rs29.8bn.

We raise CY12 EPS estimates to Rs36.6 due to higher market share garnered in generic Lipitor (currently at ~42%) and introduce our CY13 EPS estimate at Rs29.9. This assumes Ranbaxy will be able to launch generic Provigil and Diovan during CY12. We upgrade the stock from a Sell to a Hold with a target price of
Rs419, valuing the company at 14x CY13.

Key highlights
 Ranbaxy wrote off inventory amounting to Rs621mn during the quarter. Other expenses increased significantly by ~123% YoY to Rs14.3bn, as a result of payments made to Teva in connection with generic Lipitor sales (details not disclosed). However, the impact on EBITDA was mitigated by higher margin sales from FTF opportunities. The company recorded an impairment charge on a fermentation facility of Rs820mn, which resulted in depreciation spiking up by 63.2% YoY to Rs1.6bn.

■ Sales in the domestic market were up 16% YoY to Rs3.9bn i.e. marginally above market growth. The OTC business, which is 16% of total domestic sales, grew at a brisk 20% YoY during CY11; however, Ranbaxy saw lower than anticipated growth in its anti-infectives portfolio.

 The North America region sales grew at a staggering 201.5% YoY to US$407, on the back of generic Lipitor and Caduet sales. Management stated that price erosion in Lipitor was ~65% and the company had a market share of ~42% at end-CY11.

 Pursuant to its consent decree with US FDA/ Department of Justice (DoJ), Ranbaxy made a provision of Rs26.4bn and agreed to forfeit three FTF opportunities. However, management claimed that the loss of these opportunities would not impact sales growth significantly.