Friday, March 9, 2012

>INDIA STRATEGY: The “Sell-Side” Consensus Ratings: The Bear Hug (MORGAN STANLEY)

• Key Debate: The Indian market has rallied 15% since the start of the year, downward revisions to aggregate earnings and GDP growth estimates have slowed, and the conviction level of the buy side (if FII inflows is an indicator) has gone up. Will all this lead to change in the views of sell-side analysts, which have fallen to their lowest level since April 2010.

 What’s New: In the latest run of our bi-annual update on the consensus ratings, the sell-side conviction level on Morgan Stanley coverage stocks has fallen to 0.3 – a 22-month low from 0.42 in Aug-2011. A score greater than 0.3 implies a “buy” or equivalent rating, while a score of less than -0.1 implies a sell or an equivalent rating. Across market cap segments, we notice that consensus views are highly dispersed – with no particular market cap segment standing out as the most bullish or bearish call for consensus.

 We assign a 1 point to a buy rating, -1 point to a sell rating, and 0 score to a hold. We find that the consensus has a “buy” or equivalent rating on 59% of our coverage universe (of 130 stocks), down from 68% in Aug-11. Similarly, Morgan Stanley analysts have a “buy” (equivalent) rating for 41% of the universe vs. 46% in Aug-11. This suggests that Morgan Stanley analysts remain more bearish than consensus.

• MS Analysts vs. Consensus: Morgan Stanley analysts agree with consensus ratings on less than half of our coverage universe with consensus (62 out of the 130 stocks covered) – the lowest level since Feb-09.

• Out of the 68 stocks where they disagree, Morgan Stanley analysts have a “buy” (equivalent) rating on only 12 stocks, while consensus has a “buy” rating on 37 stocks, suggesting a more bullish consensus.

• Within the Morgan Stanley coverage universe, there are 35 stocks, or 27% of our coverage universe, in which 70% or more of the Street has a “buy” or equivalent rating. Morgan Stanley analysts differ with the street on 13 out of these 35 stocks. On the other hand, there are only four stocks on which 60% or more of the Street has a “sell” or equivalent rating. Notably, Morgan Stanley analysts have a “buy” (equivalent) rating on two of these stocks. Please see pages 4 and 5 for the most bullish and bearish consensus calls along with the contrarian calls between Morgan Stanley and consensus.

• Consensus Sector Calls: The average consensus ratings have fallen since Aug-11 for five out of the 10 sectors, with Industrials leading the charge. On the other hand, Technology gained the most. The consensus ratings are most positive for Energy & Financials, while they remain least positive for Telecoms (see page 6).

• Conclusion: The sell-side consensus conviction seems to be approaching a low point. However, the consensus seems to be more constructive than Morgan Stanley analysts. The opportunity, in our view, lies at the stock level. See page 5 (and the table on the front page) highlights these calls.

To read full report: INDIA STRATEGY


Promoters, public, FIIs and MFs are the major equity stakeholders in a listed corporate entity. Of the stakeholders, FIIs have been major investors in Indian corporates as is evident from the accompanying chart (Exhibit 1) with their holding in BSE 500 companies moving up from 11% in December 2009 to 12.2% in December 2011. The optimism displayed by FIIs in the Indian corporate growth story arises from the fact that the Indian economy remained relatively insulated from the global economic meltdown mostly on account of the strong domestic consumption, thrust on infrastructure development and a strong banking system. The resilience of the Indian economy reaffirmed the faith of FII investors who have increased their holding in Indian companies. After pulling out | 53,052 crore in CY08 during the global economic meltdown, FIIs have invested | 85,368 crore in CY09 and | 1,34,294 crore in CY10. In CY11, FII investments in equity have been volatile with a cumulative net outflow of | 3358 crore. Q1CY11 was characterised by a pre-Budget selloff with FIIs being net sellers to the tune of | 3100 crore while Q2CY11 had seen positive inflows to the tune of | 5171 crore and Q3CY11 has seen an outflow of | 2961 crore. Lastly, Q4CY11 has registered a net outflow of | 2450 crore. FII holding has declined by 4.1% in Q4CY11 with the BSE 500 index correcting by 9.5% to 5779 level in December 2011 from 6386 levels in September 2011.

To read full report: SHAREHOLDING PATTERN

>DLF alleges INR2.8bn fraud; 4Q write-off likely

Event: According to a news report in the Times of India today, DLF has filed two complaints alleging that it was cheated out of INR2.8bn by Hyderabad based developer GSG Group, with whom it had entered into joint ventures to develop projects. The story states that as per the complaint registered by DLF with the police, the promoter of GSG Group entered into a JV with DLF to develop three projects but failed to keep its commitment on any of them and has also failed to return to DLF advances of INR2.8bn. These transactions took place between October 2006 and August 2008, while the total land area under question is 280 acres, according to the article. The report also states that the promoter of GSG Group at the moment is absconding.

Our view: This alleged fraud could result in DLF writing off INR2.8bn from its balance sheet in 4QFY12, and we estimate that this one-time loss could wipe out its profit for the quarter. While the amount is small in relation to the size of the company, we believe this case could raise questions about DLF’s management capabilities considering that despite the GSG Group failing to meet its commitment on the first project (the complaint alleges that GSG Group “deceitfully” mortgaged an alreadys old property against the advance, according to the Times of India article), DLF entered into two further alliances with the group where, too, the group failed to keep its commitment or return DLF’s advance payment, according to the report. Also, the company filed a complaint 3.5 years following the latest transaction –in our view, a significant and very surprising delay in taking action.


>MICROSOFT CORPORATION: “Windows 8 – It’s Alive” (Positive Assessment of Windows 8 Consumer Preview)

No Surprises, Consumer Preview Looked Solid

■ First take on Windows 8 Consumer Preview
We attended Microsoft’s Consumer Preview of Windows 8 at the Mobile World Congress in Barcelona. The product looked very stable. It was running live and with live apps from the app store. The User Interface has been finished and the fit and finish looked very good. We liked the ability to use touch together with the mouse and keyboard in any combination to permit users to have the optimum experience in any of the many form factors we expect from OEM partners. The adaptation for mouse and keyboard was better than we had expected, improving the potential upgrade opportunity for notebooks and Ultrabook touch devices. We continue to expect the release to manufacturing (RTM) by August and general availability (GA) by late September or October.

 Criticism will likely be from UI changes
The main concern may center on the difference of the overall user experience, and how jarring this change is for the end-user. Obviously, people like the touch interface of the iPad, so the fact that there is change to accommodate a new user experiences is not bad in and of itself. The issue is more how this is implemented across devices from tablets to Ultrabook touch and notebook devices, and desktops. The Windows team has made significant changes to the UI in order to optimize the experience for the introduction of touch across devices. Our assessment is that the changes are easily discoverable and enable new experiences and form factors, and while they will require users to reorient to the new interface, this is a positive end result and is well implemented across devices. Not just about competing with Apple and Android on tablets Also, in our view the key will be not just enablement of touch, but collaboration among workgroups with the new Office and integration of cloud services such as storage through SkyDrive to provide sharing of data and apps across devices. This is a big opportunity for innovation; it is not just about competing on tablets with Apple and Android. Reiterate our Buy rating on the shares and favorable valuation Still like the shares at current levels, which are trading at 10.3x our CY12 earnings estimate (ex-cash) and 9.2x EV to unlevered free cash flow.

To read full report: MICROSOFT

>RESPONSIVE INDUSTRIES LIMITED: Accreditations to help in exports demand

Presence in niche product segments within PVC market; competition primarily in global markets Responsive is a dominant PVC-based product manufacturer in India and manufactures wide varieties of PVC flooring, PVC leather cloth, PVC rigid blister pack, and PVC soft sheeting. PVC flooring and PVC leather cloth cumulatively formed around 91.8 per cent of the total revenues for the company on a standalone basis in FY11. Both these products find application in various industries. Responsive manufactures a wide variety of PVC flooring, which finds application in residential, commercial spaces, public transport, hospitals, theatres etc. The PVC leather cloth (or artificial leather cloth as it is commonly known) find application in railway and bus seats, automobile upholstery, three-wheeler canopy, hospital bed covers, soft luggage, footwear, etc.

With over 63.9 per cent of the standalone revenue from the international market, the key competition is from the international PVC flooring and PVC leather cloth manufacturers such as Tarkett Inc., Armstrong World Industries Inc., James Halstead Plc., Gerflor Group and LG Hausys Ltd. In India, the company has the largest PVC flooring and PVC leather cloth manufacturing capacities. Responsive had around 44,000 million tonnes per annum (MTPA) of PVC products capacity as at the end of FY11, which is scheduled to increase to 90,000 MTPA by the end of FY12.

Demand from railways, automobile sector to support growth in PVC flooring and PVC leather cloth 
Although, PVC leather cloth finds various end uses, it is commonly used in railways, public transport and automobiles as seat cover. PVC leather cloth is also used in three-wheelers for upholstery and canopy. Also PVC flooring is used as a floor covering in automobiles and public transports. Responsive is the preferred supplier for PVC leather cloth for Indian Railways, various State Transport Corporations and automobile and three-wheeler Original Equipment Manufacturers (OEMs). The company has around 85 per cent market share in the domestic surface transport and 95 per cent market share in the domestic three-wheeler upholstery and canopy market. The company also supplies around 98 per cent of Indian Railways' requirement for PVC flooring and artificial leather used in passenger coaches. 

We expect healthy demand for PVC products from both Indian Railways and Automobiles sector going forward. The Indian Railways is expected to add around 44,000 new coaches during FY13 – FY20 resulting in 5,500 new coaches per year as per the „Railway Vision 2020‟ report. This would result in sustained demand for the artificial leather seat covers and PVC floorings. Also, as per CARE Research automobiles sales is expected to grow at a CAGR of 9-10 per cent over the next 5 years. In addition, there is a strong demand expected from the replacement market too. Given the market leadership, we expect demand from railways and automobiles segment to fuel growth in demand for Responsive.

Shift to PVC flooring options and low penetration level of pucca flooring in domestic market to result in strong demand for PVC flooring from domestic market PVC flooring (or vinyl flooring) is more economical and relatively easy to install and maintain. Also, it offers durability and is more affordable than most other flooring options. While the international floorings market is estimated to be around USD 150 billion, the Indian flooring market is still relatively nascent. The penetration of pucca floorings in India is still low when compared to the world average. The growth in pucca floorings (marble, granite, ceramic, vitrified tiles) has been supported by the commercial, residential construction in last few years. Compared to conventional marble flooring which costs anywhere between Rs. 400-2500 per sq metres, or ceramic flooring (higher end) which cost around Rs.300-600 per sq metres, PVC flooring is a cheaper alternative costing around Rs. 200-300 per sq metres. Also, PVC flooring is more durable, provides more design options than other conventional flooring options and requires less time to fix resulting in savings in labour cost and wait-time, and is therefore emerging as a cost-effective alternative to conventional floorings both for new constructions and replacement market.

Axiom Cordages Limited (Axiom) to benefit from growth in shipping ropes demand Axiom, a subsidiary of Responsive, is a manufacturer of synthetic ropes with an annual capacity of 52,500 MTPA. The company manufactures a variety of synthetic ropes such as 3-strands, 4-strands, 8-strands and 12-strands ropes, from polymers such as polyester, nylon, and polypropylene. Exports formed around 61.1 per cent of its total revenues and 36.9 per cent of total production.

To read full report: RESPONSIVE INDUSTRIES

>INFORMATION TECHNOLOGY SECTOR: Rest of the World (RoW) performance was subdued during the quarter

■ Decent result in a seasonally weak quarter
Despite operating in an uncertain macroeconomic condition and the December quarter being a seasonally weak quarter (due to lower number of working days); large cap IT companies delivered reasonable revenue growth in constant currency (CC) terms in a range 3.7% - 4.5% QoQ. However, adverse cross currency movement has dented the Dollar revenue growth which was in the range of 2% - 4.6% QoQ.

In December quarter on an average the rupee has depreciated around 11% against the US dollar which has aided large cap IT companies to report rupee revenue run rate in the range of 11.4% – 15.4% QoQ.

■ Mid cap a mixed bag
During the quarter Midcap IT companies delivered a mixed bag of performance. Companies such as Hexaware, Eclerx, KPIT Cummins and NIIT Technologies delivered over 3.5% sequential revenue growth in dollar terms and Persistent, Polaris, Mastek, Mindtree and Geometric delivered sub 3% revenue growth. 

■ Pricing to remain Stable
Pricing by and large continues to remain stable. Among Tier-I companies, Infosys pricing increased by 0.8% in constant currency terms. Although HCL Tech pricing has gone down in reported currency, in terms of constant current it has seen a slight increase. For Wipro and TCS; though the like-to-like pricing remained stable, revenue productivity during the quarter was up due to effort and service mix. Among the mid cap IT companies, Eclerx and Mind Tree saw a price hike in the range of 2.5 – 3.5% YoY and the price increase of the latter was partially due to one time transition revenue. For KPIT Cummins on a like-to-like basis newer contracts got minor pricing uptick while for Geometric and Hexaware pricing was largely stable. Going forward IT companies expect pricing to remain stable unless the business proposition changes.

■ Margin expanded due to favorable currency
Margins expanded well during the quarter, for all IT companies under our coverage, largely aided by rupee depreciation. In the large cap space Infosys topped the list in margin expansion (EBIDTA) with 300 bps, while in the mid cap segment Persistent, Polaris and Eclerx margins expanded over 6% sequentially.

Companies such as Cognizant, Wipro and Geometric witnessed margin expansion less than a percentage. Mastek reported a swing of 11.1% in its EBIDTA margins, which was mainly on account of change in Forex accounting treatment (adopted AS-30) where the MTM on any forward contract is reflected directly in the reserves under the Balance sheet, leaving no trace on P&L. Going forward, rupee appreciation is likely to act as a headwind; however, increasing offshore effort and moderate wage hikes are likely to curtail margin downside.

■ Growth by Vertical
During the quarter, BFSI segment continued to grow at a reasonable pace with Wipro and Infosys in the large cap and Mastek; Geometric and NIIT Technologies in the mid cap grew over 3% sequentially in dollar terms.

In the Manufacturing vertical, Tier I companies posted a positive growth for the sixth consecutive quarters. Infosys and HCL Technologies posted a sequential growth of 4.5% and 3.8% well above their respective overall revenue growth. In the Retail & Transportation segment, HCL Tech has outpaced its peers by registering a sequential growth of 5.6%, TCS and Wipro grew 3.7% and 3.6% respectively. After the stupendous run in last few quarters, Energy & Utilities segment of Tier I companies took a pause, however Infosys has bucked the trend and reported 8.9% sequential growth. Life science segment was under lime light during the quarter with HCL Technologies reporting a sequential growth of 15.4% and Infosys grew by 9%.

■ Growth by Geography
By and large revenue from North America increased for most of the IT companies, barring a few like Sasken, Mindtree and Polaris which de-grew by 6.14%, 1.54% and 0.22% respectively. Eclerx in the Tier II and HCL Tech in the Tier I continue to top their respective pack by growing 12.57% and 7.48% QoQ respectively.

Infosys revenue from Europe grew 14% QoQ after posting a subdued performance for last two quarters. Mindtree’s European revenue grew 11.9% QoQ, posting a double digit sequential growth for 5 consecutive quarters and tops the Tier II pack. We expect Europe to grow faster compared to US, because of the low penetration of offshoring in Europe compared to US. Moreover the current economic distress in Europe will force the European companies to become cost efficient thus leading to more offshoring. 

By and large Rest of the World (RoW) performance was subdued during the quarter; revenue from RoW for HCL Technologies degrew by 16.07% QoQ and amongst Tier II vendors Eclerx, Sasken and Mastek revenue degrew by 30%, 23.7% and 10.6% respectively.

To read full report: IT SECTOR


>India – Time for a bold budget

  • FY13 budget should attempt fiscal consolidation; the deficit should shrink to 5.3% of GDP from 5.8%
  • Expenditure compression will be difficult to achieve; the proportion of capital spend should rise
  • Indirect tax rates might be increased and the emphasis will be on non-tax revenue to reduce the deficit
  • RBI OMOs will be required to relieve supply pressure as gross market borrowing is likely to be INR 5.4trn
The Finance Minister (FM) will present the FY13 (starts 1 April 2012) central government budget on 16 March. We expect the FY12 fiscal deficit to be 5.8% of GDP (1.2% of GDP higher than the budget) but moderate fiscal consolidation should bring this down to 5.3% of GDP in FY13. Revenue growth is likely to be limited by lower nominal GDP growth in FY13 but indirect tax rates could be nudged up to provide revenue support. The new direct tax code (DTC) and uniform goods and services tax (GST) are likely to be deferred until FY14 and only a few small steps are likely to be announced to smooth the transition. Dependence on divestment proceeds and other forms of non-tax revenue are likely to continue in the FY13 budget.

The government urgently needs to reduce unproductive expenditure on subsidies to demonstrate its commitment to fiscal consolidation. Deregulation of all administered prices on fuel and fertiliser products is unlikely to happen immediately but some price increases are possible to reduce the subsidy burden and signal policy direction. Although in the near term these price corrections could be inflationary, the Reserve Bank of India (RBI) is likely to focus more on the medium-term impact of fiscal consolidation to tame structural inflation pressures. Monetary policy can only be eased substantially in FY13 if the budget outlines a credible fiscal consolidation plan.

Even if fuel subsidies are brought down, new pressures could emerge from food subsidies, allocations for bank recapitalisation and debt restructuring for power distribution utilities. Overall, the expenditure-to-GDP ratio in FY13 might not improve substantially from FY12. We would view the budget positively were the FM to improve the quality of fiscal spending by increasing the share of capital expenditure (13% of total expenditure in FY12) on infrastructure projects.

The outcome of state elections on 6 March will determine the final shape of the budget. A positive result for the ruling United Progressive Alliance (UPA) could prompt the FM to take bold steps towards fiscal consolidation. The announcement of a fiscal deficit below 5% of GDP is possible, but markets would closely scrutinise all the assumptions behind such an optimistic projection. In our baseline scenario we expect gross market borrowing to be around INR 5.4trn, which is marginally higher than current market estimates. In such a case, we believe support from the RBI via open market operations (OMOs) will again be required in FY13 to avoid supply pressure in the rates markets.

FY13 budget backdrop
The backdrop to the FY13 budget announcement due on 16 March is interesting from the following perspectives:
■ Growth, particularly investment activity, has decelerated substantially and demands policy attention. While inflation has edged down, it has yet to settle within the RBI’s comfort zone. The complexity of the macro backdrop is exacerbated by an uncertain global environment.
 The last three budgets have all been criticised as being populist, with scant regard for fiscal discipline. Therefore, returning to a sustainable fiscal path will be a policy priority.
 This is all the more important because the RBI has indicated that its ability to ease monetary policy depends on the extent of fiscal consolidation.
 The FY12 fiscal deficit could exceed the initial target of 4.6% of GDP by close to 1.2% of GDP. If so, markets would scrutinise all the assumptions behind the FY13 budget even more closely.
 The FY14 budget (to be presented February 2013) will be the last before the 2014 national elections and is likely to be a populist one. Logically, the FY13 budget is therefore the one to push through some hard decisions.
 As the FY13 budget will be presented almost immediately after the five state election results are announced; the outcome could force the FM to shift the focus of the budget to suit political needs.
 FY13 will be the first year of the 12th Five-Year Plan (FYP). A reorientation of expenditure to meet its objectives will be a critical challenge for this budget, given that close to 40% of the resource requirements for the FYP are allocated from the budget.

Strategies and issues
The path of fiscal consolidation: All eyes will be on the FY13 fiscal deficit estimate as the FM presents his budget, but it will be equally important to present a credible roadmap. The Thirteenth Finance Commission suggested a fiscal consolidation roadmap in December 2009 to bring down the fiscal deficit to 3% of GDP by FY14.

According to that roadmap, the FY13 fiscal deficit should have been 4.2% of GDP. Adhering to that target will be impossible in FY13. However, committing credibly to return to this path of consolidation within a stipulated time frame will be critical to convince investors of the seriousness of government efforts. Policy makers need to acknowledge that fiscal deficit reduction should be a policy priority, much like stimulating growth, controlling inflation or redistributing wealth.

Expenditure measures to determine the quality of fiscal consolidation: Often, how government earns its revenue and where it spends it matters more than the extent of the fiscal deficit. Expenditure containment has always been the biggest challenge in India. For a brief period during FY06-07 the expenditure-to-GDP ratio was reduced to below 14% but it increased sharply to close to 16% in an effort to stimulate the economy after the 2009 financial crisis. The majority of fiscal expenditure is sticky, with very little scope for reduction. In FY12, almost half of the total spend was on interest rates, subsidies and defence. If we add around 20% of total expenditure on salaries of public-sector employees, then only 30% of the total spend is discretionary.

Reducing the number of fiscal schemes could be one way of curtailing expenditure
So, efforts to reduce expenditure can come from two broad directions. First, the deployment of resources to promote ‘inclusive’ growth. In the 11th FYP the government has spent close to INR 7trn (14% of total government spend during this period) on the top 13 flagship programmes of rural development and poverty alleviation to promote inclusive growth. Political considerations dictate that substantial resources need to be allocated for this purpose even in FY13; however, there is ample scope for better utilisation. Overlaps between different government-sponsored schemes need to be corrected by reducing the number of such schemes. In this context, the
FM should consider the recommendations of a recent committee report which suggested reducing the number of centrally sponsored schemes to 59 from 147.

Subsidy reduction through an increase in administered prices, better targeting and increased capital spending would be important in terms of expenditure management
Second, the FM himself admitted recently that he is “losing sleep” over subsidies. While complete deregulation of diesel, cooking gas and fertiliser prices will be difficult to achieve immediately, the FM should seriously consider increasing prices to reduce the extent of the subsidy. Any step in this direction would reduce distortion and should be viewed as a positive reform. This will also be necessary because food subsidies are likely to rise substantially once the National Food Security Act is passed by parliament (expected by mid-2012) and the FM might also have to provide for bank recapitalisation in the FY13 budget. On the positive side, it is possible that he will unveil some plans for the direct transfer of cash subsidies, taking advantage of the unique identification numbers that are being assigned to the entire population. This will help to better target subsidies and could potentially reduce leakages in subsidy distribution.

Another aspect of the uneven nature of spending is that capital expenditure is only 13% of total spending now; it was close to 23% in 2004-05, during the first two years of the ruling UPA’s term. When insufficient infrastructure spending acts as a drag on potential growth, there is an urgent need to increase it. Correcting this imbalance will be one of the most critical aspects of the FY13 budget.

Staggered overhaul of the tax regime: Rising revenue generation on the back of high growth led to the fiscal deficit dropping to 2.5% by FY08 from 6% in FY02. During this period the tax-to-GDP ratio increased to 12% from 8%, a significant achievement. The tax-to-GDP ratio is again close to 10% in FY12 and the emphasis in the FY13 budget should be on increasing it. Indirect tax reductions implemented in 2008 to minimise the impact of the global financial crisis have not yet been reversed.

Revenue foregone because of different types of tax incentives was 6.6% of GDP in FY11 (slightly better than 8.15% of GDP in FY09) but revenue collection could be further improved by removing some of these incentives.

Two major structural reforms to overhaul the direct and indirect tax system – a new direct tax code (DTC) and a uniform goods and service tax (GST) – are on the agenda but are unlikely to be implemented in the FY13 budget. However, the FM might want to introduce some changes in the tax structure so that the move to the new system is staggered and non-disruptive. Some of the measures expected in the FY13 budget could include a reclassification of the income tax brackets, increasing the excise and customs duties and bringing more services within the tax net. Some elements of the GST are still being debated with the states and hence some clarity
on the expected timeline of the introduction of GST could be included in the budget. Also, addressing the issue of ‘black money’ could arise in the budget and a tax amnesty scheme is one of the policy tools available. The last such scheme, in 1997, resulted in INR 105bn of revenue, with more than 450,000 people disclosing nontaxed income under the scheme. However, recent media reports suggest that such measures may not be included in the budget.

The government is keen to convert   assets into cash flow but over dependence on this route raises question marks over sustainable fiscal consolidation
Sustainable fiscal consolidation should not be based on non-tax revenue: With the economy likely to grow below trend in FY13, the FM cannot rely on unexpected windfalls in terms of tax revenue collection. However, non-tax revenue could be an important way of achieving a lower fiscal deficit number. The government has been contemplating different mechanisms to convert assets into cash flow. In its simplest form, the government divests shares in public-sector companies to fund social-sector programmes. In FY12, the government has fallen short of its divestment target because of depressed equity markets. So, in FY13, the strategy could be to auction off these stakes to institutional investors rather than taking the IPO route. This has been made possible by recent regulatory changes. The first such transaction could take place in FY12, which would prepare the government for more such auctions in FY13. Also, there have been some innovative suggestions about how to utilise some of the government’s private-sector stock holdings held in an entity called SUUTI.

These assets could possibly be transferred to a special purpose vehicle which could then leverage them by borrowing from banks. The borrowed amount could then be used to participate in the public-sector divestment programme. Not all the stakeholders have yet agreed on the modalities of this scheme but the budget could indicate whether the finance ministry is considering this as an option or not.

Most of India’s natural assets are government-owned. Revenue from selling the right to exploit them could be a potential source of income. In FY11, the government received more than INR 1trn from auctioning 3G spectrum. FY12 did not see any such bonanza but in FY13 the government is likely to budget substantial revenue from auctioning of 2G licences; 122 that were issued in 2008 were cancelled by a recent court order. Auctioning of new coal blocks could be another way of generating revenue. While such measures might improve the FY13 fiscal deficit, we are wary of the sustainability of such a process.

Supply-side reforms should complement any efforts of fiscal consolidation

Going beyond the fiscal deficit, planting: Although focus on the fiscal deficit estimate is inevitable, the FY13 budget will give the FM an opportunity to announce significant supply-side reform. These could be aimed at addressing some of the infrastructure bottlenecks, particularly in the power sector. Also, any clarity on land acquisition issues would be a positive.

Fiscal and monetary policy interface

Fiscal consolidation can have a near-term inflationary impact but  the RBI should focus on the medium-term benefits

January’s monetary policy statement emphasised that substantial monetary policy easing has to be preceded by fiscal consolidation – both the extent of the fiscal deficit and quality of fiscal spending matter. In the recent past, much fiscal spending has been in the form of cash transfers without matching asset creation. Also, the right to employment, education, food, etc., has taken the form of entitlements which do not incentivise productivity growth in the rural economy and risk creating an environment of continued dependence on such schemes. Consumption demand draws support from this fiscal stance and the impact of interest rate policy on inflation may be largely neutralised.

Another factor is that some of the possible measures to reduce the fiscal deficit could be inflationary in the short run – such as increasing the administered prices of diesel, cooking gas, fertiliser, power, etc., to reduce subsidies. The RBI is likely to support such a fiscal correction because in the medium term those price changes should reduce demand and bring down inflation. However, in the short run, it is important to ensure that inflationary expectations remain anchored, even while price corrections occur. The March monetary policy statement will be released just a day before the budget. This could make the choice of monetary policy action even more difficult.

FY12 – A year of considerable slippage
The FM is likely to confirm substantial slippage from the budgeted FY12 fiscal deficit target. Against a budgeted fiscal deficit of 4.6% of GDP, we think the government is likely to end FY12 with a fiscal deficit of 5.8% of GDP, not very different from the 6% fiscal deficit witnessed in FY09. Several factors, both on the revenue and expenditure fronts, have contributed to this slippage. We discuss these in detail below.

Indirect tax collection should meet the revised FY12 target, while net direct tax collections could fall short because of large refunds
Net tax collection has been hit: Despite a reduction in excise duty and customs duty on petroleum products at the beginning of FY12, indirect tax collection (excise, customs and services and other taxes account for 42-43% of total tax generation) has held firm. Growth of 15.1% y/y FYTD (April-January FY12) is not far from the 17% y/y growth targeted for FY12 as a whole. Indeed, with almost 80% of the targeted collection already with tax officials, much in line with the historical performance, the government is set to achieve its revised target of INR 3.92trn from indirect taxes. Gross direct tax collection remains relatively unscathed. Personal income tax collection growth has been robust, at 20% FYTD, much in line with targeted growth.
Corporate tax collection (which accounts for c.38% of total tax collection) has grown by 12%, much lower than the budgeted growth of 20%. However, this is likely to improve in the next two months. Close to 30% of corporate taxes are collected in the last quarter of the fiscal year. Thus, even as direct tax growth has slowed to 14.6% y/y FYTD, far lower than projected growth of 20% y/y for FY12, we believe significant slippage here is unlikely as we end FY12.

The biggest worry for tax collection arises from the huge tax refunds this year. For the first 10 months of FY12, tax refunds stood at INR 790bn, almost two-and-a-half times more than the previous year. Given such huge refunds, 9% growth in net tax collection versus the 20% targeted does not surprise us. According to official estimates, refunds for FY12 as a whole will be INR 200-250bn higher than in FY11, making it difficult to meet the tax collection target. Hence slippage of INR 203bn (0.23% of GDP) in net tax collection looks highly likely in FY12.

Non-tax revenue will not provide respite as it did in FY11: Unlike FY11 when spectrum auctions generated extraordinary revenue of INR 1.05trn (1.3% of GDP), which helped fiscal deficit consolidation, little support is expected in FY12. In fact, given the lack of clarity on regularity policies regarding spectrum auctions, the government is set to miss the targeted INR 140bn of revenues which it expected to raise via this route. Such a loss should be partially offset by additional dividend receipts from state-owned enterprises. However, the expected increase in dividend payments is not a consequence of better company performances. It is more a result of government persuasion to push such enterprises to raise the dividend payout to the government as revenue proceeds were expected to be below target. While INR 65bn of higher dividends have already been confirmed by some companies, we believe another INR 40bn of dividend receipts is likely. Nevertheless, marginal slippage of INR 52bn (0.06% of GDP) on non-tax revenues cannot be ruled out.

Disappointment on divestment prompts a change in strategy: With little progress on the divestment front – the government has collected INR 11bn versus a targeted INR 400bn – considerable slippage looks likely. The government now proposes to use the auction route rather than the IPO route to divest its stake in a state-owned oil company. If successful, this could partially bridge the gap, but we expect slippage of at least 0.30% of GDP on the budgeted divestment proceeds. Overall, we expect a total revenue-collection shortfall of 0.6% of GDP.

Subsidies likely to overshoot budget estimates by 0.8% of GDP but spending cap on ministries could help manage expenditure growth
Burgeoning subsidies to bloat expenditure: The FY12 budget targeted a 12.5% decline in subsidies; instead they look likely to rise significantly. Given the weaker Indian rupee (INR) and increasing oil prices, oil companies’ total losses are likely to be c.INR 1.4trn. If the government bears 40% of these losses, subsidies are likely to exceed the budget estimate by INR 600bn (0.5% of GDP). Indeed, the government announced INR 450bn of subsidy payments to oil companies in the first nine months of FY12. Similarly, fertiliser subsidies could be INR 100-120bn higher than the INR 500bn target in FY12. They already breached the targeted amount by INR 50bn in the first nine months of FY12. Hence, subsidy expenditure is at risk of exceeding the target by as much as 0.8% of GDP.

However, the finance ministry has instructed other ministries not to spend more than 33% of their budgeted spend in Q4-FY12, to avoid bunching up of expenditure in the last quarter of the fiscal year. Given that several ministries were slow to spend in the first nine months, expenditure for the full fiscal year could be INR 300bn lower. Even factoring this in, expenditure is likely to be higher by 0.6% of GDP in FY12. The fiscal deficit in FY12 is likely to be at 5.8% of GDP, much wider than the initial target of 4.6%.

FY13 – Back to fiscal consolidation
With such substantial slippage in the FY12 fiscal deficit target, it will be imperative that the FY13 budget puts India back on the path of fiscal consolidation. This needs to be achieved both by boosting revenues and curtailing expenditure.

An increase in income tax exemption limits could be counterbalanced by higher indirect tax rates
Measures needed to support tax collection: A slower nominal GDP growth (we expect it to be 14% y/y versus 15.7% in FY12) could weigh on revenue generation. Therefore the government will be conscious that fiscal austerity should not substantially dampen growth. While we do not expect a reduction in tax rates owing to fiscal constraints, an increase in the individual income tax exemption limit could be considered in order to offset inflationary pressures. This could provide some respite to private consumption. Growth in private consumption (which accounts for 60% of overall GDP) slowed to 6.5% y/y in FY12 from 8.1% y/y in FY11. Current talks indicate that the government is considering increasing individual tax exemption limits in the range of USD 415-2,500 per person. Assuming the number of tax assesses at 34.8mn, as was the case in FY11, this could provide a direct stimulus of 0.1-0.5% of GDP and have a multiplier impact on the overall economic activity as personal disposable income increases. While a corresponding loss in revenue will be inevitable, this should be offset to some extent as other tax collection improves on a higher level of economic activity.

The government could also garner some resources by withdrawing some of the tax stimulus provided post the financial crisis. A 1ppt increase in excise tax to 11% is one such widely mooted measure. This alone could boost revenue collection by c.0.2% of GDP. Given the impending implementation of GST, such a measure would have to be coupled with a similar increase in services taxes, currently at 10%. However, as the services tax collection as a percentage of GDP (0.9%) is half that of excise tax collection, the corresponding impact of a 1% increase in services taxes would be an additional contribution equivalent to c.0.1% of GDP to the tax coffers. Under GST there will be only a small list of services which will not be taxed, but ahead of this the FM might want to bring more services under the tax umbrella in FY13 and increase service tax collection. An increase in customs duty is also under consideration. However, this could have a significant impact on price pressure and might not be favoured by policy makers.

Non-tax revenues and divestment proceeds could be better: Overall revenue collection is also likely to receive some support from higher non-tax revenue collection. Specifically, spectrum auctions in FY13 are likely to provide the government with relatively higher proceeds than FY12. According to our equity analysts, spectrum auctions in FY13 are likely to generate INR 160-320bn (0.2-0.4% of GDP) of revenue.

Similarly, capital receipts could be higher, as revenue realisation from divestment proceeds could be boosted by improved global economic conditions, especially in H2-FY13. It is highly likely that the government will once again target divestment of INR 300-400bn (0.3-0.4% of GDP) when it presents FY13 budget on 16 March.

Even after price corrections, fuel subsidies are likely to remain high; additional subsidies may be included in the FY13 budget
A reduction in recurrent expenditure is necessary: While the government might have limited room to manoeuvre on most of the rigid and recurrent expenditure (interest payments, defence, subsidies and salaries), it could still take certain measures – especially related to petroleum products – to cap the overall subsidy burden. Our equity team estimates that every USD 10/bbl increase in crude oil prices increases the petroleum products subsidy burden by 0.3% of GDP. Since the Indian crude basket is expected to stay at elevated levels – we expect it to be USD 118/bbl, 8% higher than FY12 – oil company losses could be higher than the INR1.4-1.5trn recorded in FY12. If the government does not pass on any of the burden to consumers, the petroleum subsidy could once again be high, at 0.7% of GDP in FY13. However, if the government decides to increase diesel prices by INR 2/litre, kerosene by INR 1/litre and cooking gas prices by INR 50/cylinder, the fuel subsidy burden could be lower by 0.14% of GDP. Similarly, some respite is likely as the government plans to increase the price of urea and link it to the price of gas in an attempt to reduce its burgeoning fertiliser subsidy bill. For a start, it is considering increasing urea prices by a flat 10%. If the new fertiliser subsidy scheme is implemented the government could save c.0.11% of GDP.

Such savings on subsidies (up to 0.25% of GDP) are necessary to free up resources for additional subsidies which are likely to be introduced in FY13. For instance, while full implementation of the Food Security Act is unlikely in FY13, recent talks suggest that the government will allocate a token amount of INR 50bn (c.0.06% of GDP) to start this plan. More importantly, resources will be needed to provide funds for the national electricity fund (NEF) which, in turn, will subsidise the interest rate on loans taken by State Electricity Boards (SEBs) for cutting distribution losses. The SEBs have accumulated bank debt of INR 1.8trn because of huge losses incurred from selling electricity below cost and various other inefficiencies associated with electricity distribution. Given the size of this debt, SEBs are finding it difficult to raise working capital at reasonable rates. Thus we expect the government to provide them with financial support via an interest-rate subsidy of INR 250bn in the next two years. This subsidy will be performance-linked and aimed at an efficient distribution system. If implemented, it could increase the subsidy burden by c.0.13% of GDP.

Growth in spending on planned projects could be lower in FY13
Gross budgetary support might grow at a slower pace: Although the planning commission is seeking an 18% increase in gross budgetary support (GBS) – financial assistance provided by central government to planned schemes, such as the employment guarantee scheme and Bharat Nirman project – fiscal constraint might restrict this to just 11% as reported by newspapers. In FY12, the GBS increase was targeted at 16% y/y. However, as this is the first year of 12th FYP, the government might be under pressure to allocate a sufficient amount to infrastructure development.

With an improvement in the tax-to-GDP ratio and no worsening of the expenditure-to-GDP ratio, we expect a fiscal deficit to be 5.3% of GDP in FY13

Our baseline projection for the budget: Details of the budget can be finalised up to a few days before the budget. State election results due on 6 March may influence the tone of the budget statement. However, at this stage we expect the FM to announce a FY13 budget deficit target of 5.3% of GDP, marginally lower than our initial estimate of 5.5% of GDP. Our expectation is based on the assumption that the government is able to raise the gross tax collection-to-GDP ratio to 10.8% of GDP versus 10.4% in FY12 via a combination of indirect tax increases and improved economic activity. Also, higher proceeds from spectrum auctions and divestment plans should support overall revenue collection. On other hand, we assume expenditure will remain at 14.8% of GDP (14.75% in FY12). This is because any reduction in the subsidy burden is likely to be absorbed by fresh subsides and infrastructure expenditure requirements.

Under optimistic assumptions the FM can announce fiscal deficit to GDP at less than 5%, but will be difficult to achieve that target
Risk scenarios: We also look at two alternative scenarios in which the FM could forecast a fiscal deficit target either higher or lower than our core case. For instance, if excise and services taxes are increased by 2% instead of 1% each this would reduce the fiscal deficit by additional 0.3% of GDP from our core case of 5.3% of GDP. Also, if the government increases administered product prices by more than we have assumed above or provisions for a lower subsidy burden at the beginning of the year, projecting an expenditure-to-GDP ratio of 14.5% instead of 14.8% as in our core case would not be difficult. Hence, a fiscal deficit of 4.8% of GDP could easily be managed.

Similarly, if the government opts for a more populist budget, a fiscal deficit projection of 5.5% of GDP would be inevitable. For instance, if it allocates a higher amount to the Food Security Act or fails to implement the new urea policy in the budget, we could easily see additional strain on the fiscal deficit equivalent to 0.2% of GDP.

Government borrowing to be the same as last year but markets expect a lower amount

Our gross borrowing forecast is higher than the market’s and support from RBI OMO demand will be required to alleviate supply pressure
In FY13, our estimates of fiscal financing indicate that government borrowing will be at the same level as last year. We believe the government is unlikely to end FY12 with a cash surplus significantly higher than INR 300bn, which is required to redeem c.INR 260bn worth of GoISecs maturing on 6 April 2012. In the absence of a cash surplus cushion, the government is likely to follow its historical pattern of financing c.85-90% of the fiscal deficit via market borrowing (see Table 2). This – in our most probable scenario – implies net market borrowing of c. INR 4.3-4.5trn (INR 5.2-5.4trn gross) via GoISecs and c.INR 200bn via T-bills (note that the amount of outstanding T-bills increased by c.INR 1.16trn during FY12). Our FY13 market borrowing estimate is close to the actual level the government borrowed from the market in FY12 (INR 4.36trn). Even with a market borrowing estimate similar to last year’s we believe RBI support will be important to balance the demand-supply equation in FY13, albeit less than in FY12. With c.95% of FY13 redemptions due in H1-FY13, the market borrowing calendar is likely to be front-loaded in H1-FY13. As such, we expect reinvestment demand to limit the impact of a front-loaded issuance calendar on GoISec yields.

The rates market expects FY13 net market borrowing in the range of c.INR 3.8-4.2trn (INR 4.7-5.1trn gross), close to our optimistic scenario. We believe an announcement closer to the lower end of this range would boost sentiment in the immediate term and soften yields; we would expect the benchmark 10Y GoISec to soften by c.10bps.


>SUPRAJIT ENGINEERING LIMITED: Added new customers like Volkswagen for Polo in India, BMW for Germany & Europe, Nissan, Palio, Arvin Meritor and Brozer (Germany)

Suprajit Engineering promoted by Mr Ajith Kumar Rai manufactures control cables, speedometer cables, speedometers etc for two wheelers and four wheeler industry. It also manufactures cables for non automotives and for replacement market. SEL commands 45% market share in the two wheeler segment and 35% market share in the four wheeler segment. The company’s current installed capacity is 110 Mn cables p.a. operating at 80% utilization.

Suprajit has grown at a CAGR of 19% during FY09-FY11. We expect it to grow by 20% and 25% in FY12E and FY13E respectively, on the back of capacity expansion and addition of new customers in the non automotive space. It is trading at 6.7 and 5.1 times its FY12 and FY13 estimated EPS. We have valued Suprajit 7.5 times its FY13 EPS arriving at a fair value of Rs 30 an upside potential of 47% from current levels.

■ Strong market share – Suprajit commands 45% market share in two wheeler segment and 35% in the four wheeler segment. It is a sole supplier to TVS and 80% of the cable requirements of Bajaj and Hero Moto is met by Suprajit.
Capacity Expansion to boost revenues – The company’s total current capacity is around 110 Mn cables p.a. operating at 80% capacity utilization. By Dec 2012, the company will be adding another 40 Mn cable capacity which will boost its topline going forward.
Addition of new customers – Suprajit added new customers like Volkswagen for Polo in India, BMW for Germany & Europe, Nissan, Palio, Arvin Meritor and Brozer (Germany). In the non automotive space customers like John Deere, Kubota, Club Car, JCB etc. will help in the next phase of volume growth.
Growth in high margin non automotive and replacement market – Suprajit is growing quite aggressively in the non automotive and replacement market segment where the margins are also higher as compared to automotive segment. In the non automotive segment the company commands 18% operating margins and in replacement market it enjoys 5% higher margins than in automotive space.
 Strategic locations of plants - Suprajit has set up manufacturing facility at 8 different locations across the country to be close to its main customers in the North, West and Southern belts. Haridwar plant next to Hero Honda, Pantnagar plant next to Bajaj, the planned Sanand plant next to Tata Nano, etc. which gives Suprajit a logistic advantage.
 Elite Clientele – In the two wheeler space the company’s major customers are TVS, Bajaj Auto and Hero Moto. In the four wheeler segment the company’s customers are Tata Motors, Mahindra and Mahindra, Hyundai, Ford and General Motors. Major exports customers are General Motors, Suzuki and Piaggio.

>SHOPPERS STOP LIMITED: Near term pain, Long term growth story intact

SSL has posted 3QFY12 results and the numbers were below expectation. Key highlights of result are as follow:

Key Highlights
 Standalone net sales for SSL increased by 9.2% YoY to ` 5418.3 mn. The moderation in
topline growth was mainly due to decline in LTL sales growth of 1%. This was mainly led
by 9% decline in LTL volume partially offset by increase in ASP by 8%. Apparel sales
(contributes 57.2% to the topline) were impacted due to ~18% YoY increase in prices.
Apparel prices are likely to soften in 1HFY13E and management expect healthy volume
growth in 3QFY13E. On the positive side, gross margin improved marginally by 10 bps
YoY to 35.4% and contribution of Bought out/Concession sales declined to 50.3% as
compared to 55.2% in 3QFY11, implying declining inventory risk.
 EBITDA declined by 19.7% YoY to ` 413.5 mn mainly due to increase in employee cost,
rental expense and other operating expense by 31.4%, 20.4% and 18.5% YoY to ` 331.3
mn, ` 471.6 mn and ` 701.5 mn respectively. This increase in operating expenses were
due to opening of 6 SS stores in the qtr, which leads to front loading of employee, rental
and operating cost. Overall, EBITDA margin declined by 275 bps YoY to 7.6%.
 Interest cost increased by 204.8% YoY to ` 75.5 mn due to increase in debt led by new
store capex and increase in working capital requirement. Standalone debt as of 31st Dec
2011 stood at ` 2875.2 mn as compared to that of ` 1487.2 mn on 31st March 2011.
Overall, PAT declined by 30.8% YoY to ` 192.9 mn.
 Hypercity: For 3QFY12, Hypercity posted net sales of ` 1976.2 mn (up 29.3% YoY),
EBITDA of ` -111.3 mn (down 26.8% YoY) and PAT of -245.1 mn (down 34.1% YoY).
The LTL sales growth was 12%, with LTL volume growth of 18% and decline in ASP of
6%. Out of total 12 stores, 5 stores were EBITDA positive in 3QFY12 with store EBITDA
of ` 7.9 mn as compared to loss of ` 13.4 mn in 3QFY11.

Outlook: We have revised our estimates based on the existing economic and business
scenario. Going ahead, we expect healthy sales traction in Shoppers Stop, as the new stores gets ramp-up. However, operating overheads will take 15-20 months to get fully absorbed and hence will keep overall EBITDA margin under pressure. We expect sales and EBITDA to grow at CAGR of 23.4% and 22.1% during FY11-FY14E period respectively. We expect the company to post EBITDA margin of 7.0%, 7.5% and 7.9% in FY12E, FY13E and FY14E respectively. Overall, we expect PAT to grow at CAGR of 22.3% during FY11-FY14E. We have assumed 8 store addition each in FY13E and FY14E. Hypercity is progressing well and is expected to be EBITDA positive at company level in next 12-15 months.

Valuations: At CMP, the stock is trading at P/E ratio of 40.4x and 30.7x FY12E and FY13E earnings respectively. Our fair value of the stock based on SOTP methodology comes to` 298/share. We have valued standalone SSL on DCF valuation method, 51% stake in Hypercity on EV/sales multiple of 1.0x and all equity investments as on FY11 balance sheet on book value. We have revised our rating from Accumulate to Neutral. Upside risk to stock price in the near term could be policy change as regards the FDI in multi-brand retail (the favorable change at the centre, i.e probable change in UPA constituents post results of the ongoing state elections could possibly lead to this policy change). The stock will continue to command the perceived acquisition premium in anticipation of the favorable outcome. We will revisit our rating post outcome of this event.