Wednesday, May 9, 2012


The stress test of the European Banking Authority last year led to the conclusion that numerous banks, including major listed banks, would need additional capital to support the continuation of existing activities. Official estimates started low, but eventually converged on over 100 billion euros for the banks; even these numbers seem low compared to the real needs if banks were to maintain their former book of business, as enumerated in my earlier study. The numbers seemed much larger that what the markets or the banks' home countries could provide and the price of bank stocks tanked at the end of 2011.

To read paper in detail: CAVEAT EMPTOR


Not convinced about overall governance

Educomp’s fortunes appear to be declining fast in light of reduced funding from banks. We reiterate our view that the SPE will be consolidated once India converges to IFRS from 2013 onwards which will lead to negative OCF and FCF and D/E c.2:1. Management now
has admitted this. Our concerns on overall governance policies go further, principally: a common address of the auditor and the registered office of Edu Smart; cost allocation of resource coordinators and high turnover of company secretaries at Edu Smart. We change corporate governance rating from Amber to Red, lower our FV from Rs220 to Rs110 and downgrade our stance from Neutral to Sell.

See no improvement in stretched cash flow situation
We turned our long-running SELL stance on Educomp (since May 2009) to Neutral in August 2011 citing valuation. Our key thesis then was that an 80% fall in the stock price was factoring in most of the core business and overall governance issues. However, we now see growing reasons to question the sustainability of the core business model and also highlight some new
governance issues which need answering by management. With Educomp’s K- 12 initiative not growing as per expectations and its core business, Smart Class, likely to falter on growth due to funding requirements, we think that there are likely to be further earnings downgrades.

• Incremental securitization of smart class difficult – At the start of the
model, Edu Smart used to get Rs60 for every Rs79 securitized from banks
meaning a cost of debt of 10%. This quickly declined to Rs54 for every
Rs79 securitized resulting in cost of debt of 14% and zero cash balance for
Edu Smart at the end of year 1. While we had expected in May 2011 that
this funding would fall to Rs50 due to rising securitization costs, it has
actually declined to 45. Now either Educomp is paying securitization costs
of 22.25% in return for Rs79 securitized or it is securitising only Rs65 to
keep the rate at 14%. The shortfall of Rs14 implies that Edu Smart will find
it incrementally difficult to pay Educomp, thus stretching its cash flows.

• K-12 segment not that strong as perceived – Our channel checks of
Educomp’s K-12 schools in 2012 suggest no major improvement over 2011,
especially in schools which have been operational for more than 3-4 years.
The only segment that could have helped Educomp in offsetting concerns
of its core business is the K-12 segment, but things are not improving
enough to make any meaningful impact.

• Overall governance issues in the SPE are questionable: In our research
we notice that the statutory auditor of Edu Smart and registered address
of Edu Smart is same. We believe this compromises independence,
especially given any sense of excessive closeness between company and
auditor will naturally concern investors given longstanding concerns about
the structure of Edu Smart. Additionally, we are concerned about the cost
allocation of resource coordinators which should have been booked by
Edu Smart but is being booked by Educomp which is negative for minority
shareholders of Educomp. Furthermore, the high turnover of company
secretaries at Edu Smart also makes us uncomfortable on overall
governance policies.

Valuation: structurally declining model of core business
In our opinion, securitisation has always been a precursor to a big downfall and Educomp must have learnt this by now. Educomp currently trades at a FY13E P/E of 11.6. Our research indicates that growth in the smart class segment (60% of revenues and 90% of EBIT) is set to deteriorate as securitization of smart classes becomes incrementally more difficult. Moreover we are wary about the corporate governance standards of the company. We downgrade our EPS estimates by 50%. SELL Educomp.

To read report in detail: EDUCOMP SOLUTIONS

>CIPLA: Dymista approval a tad positive for Cipla (CLSA)

■ Dymista approval a tad positive for Cipla
US FDA approved Meda’s drug Dymista for Allergic Rhinitis. Being a partner, Cipla will benefit through product supplies over the longer term. The product is widely estimated to reach US$300-500m in annual sales over the coming years. Apart from approval (outside North America) related milestone payment (US$5m), we expect gradual increase in Cipla’s sales from product related supplies to Meda. Assuming Cipla supplies product at 10-15% of
sales, it could earn US$50-75m at peak sales.

■ Rupee weakening likely to aid margins
Cipla is one of strongest beneficiaries of a weakening rupee. We expect improving margins over the coming quarters on back of a weak rupee and a low base. We expect strong operating profit growth over coming quarters led by margin expansion and high margin product supplies.

■ Lexapro supplies to Teva, a short term boost
Teva launched Lexapro in March 2012 under six months exclusivity. Cipla benefits from formulation supplies (likely at high margin) during this period. This will help Cipla reported numbers though should be excluded while assigning a price to core earnings multiple. Additionally, a low base in domestic formulations could result in reasonable India growth. AIOCD data on domestic market suggests improving growth for Cipla.

■ Reasonable valuations, Upgrade to O-PF
Post 3QFY12 results, Cipla’s share has corrected more than 10%. We believe margin blip shown in 3Q could correct with multitude of positive triggers like Lexapro supplies and continued weakness in rupee. While we expect modest 12% growth in sales to Rs18.2bn, we see margins expanding by nearly 500bps YoY (low base) and flat QoQ resulting in 47% Ebitda growth and 36% PAT growth to Rs2.9bn (assuming higher tax rate). We upgrade the stock to
O-PF on back of multiple triggers and reasonable valuations while maintaining our target of Rs360/ share based on 19x one year forward earnings.

To read report in detail: CIPLA

>HAVELLS INDIA: Sylvania first debt tranche has been refinanced

 FY13E sales growth guidance of 15%-20% and EBITDA margin of 13%-13.5%
Given 9MFY12 performance (revenue/EBITDA/PAT growth of 25%/ 34%/44% and 90bps margin expansion in 9MFY12) and traction in lighting and consumer durable businesses (20%+ growth), FY13 guidance looks easily achievable with high possibility of actual results being closer to the higher end of guidance.

 Sylvania first debt tranche has been refinanced — First tranche of Eur40mn due in April 2012 has been refinanced and negotiations are on for a second tranche of Eur50mn due in April 2013. With current EBITDA run rate of EUR35-36mn (which is growing) and net debt of ~Eur125mn, Sylvania is self sufficient and can service the debt over a slightly longer time horizon.

 Raising target price to Rs633 (from Rs554) — We roll over India business P/E multiple of 18x and Sylvania EV/EBITDA of 5x from March 13E to September 13E. We have also raised our India business EPS estimate marginally by 4%/5% in FY13E/FY14E to factor in slightly higher revenues and 25bps higher EBITDA margin.
There is no change in Sylvania estimates.

 Maintain Buy — Havells has outperformed Sensex by 46%/ 12% over the past 6 months / 3 months respectively. However, business momentum remains robust with healthy EPS growth, cash flow generation and high RoEs. We believe the stock has plenty of steam left and maintain our Buy rating.

■ Risks — Downside risks to our target price include poorer performance from Sylvania, higher commodity prices, unsuccessful new-product launches, increase in competitive intensity and demand slowdown in India

To read report in detail: HAVELLS INDIA

>STRIDES ACROLAB: Acquired a USFDA-approved sterile formulation facility from Star Drugs and Research

Acquires USFDA approved sterile formulation facility for INR1.25b
During the quarter, STR acquired a USFDA-approved sterile formulation facility from Star Drugs and Research. The facility is located at Hosur, near Banglore, and has a capacity to manufacture 97m units of liquid vials. The company paid INR1.25b for the facility, largely from internal cash accruals. The net block of the acquired facility stands at INR680m. Acquisition of this facility provides STR immediate incremental sterile manufacturing capacity; all the existing capacities are fully booked due to drug shortages of sterile injectables, worldwide. This acquisition will help STR accelerate the launch of its approved products in the US market and give additional leverage to secure GPO contracts. The facility is expected to contribute to revenue from 3QCY12, as product site transfers will take about three months.

Specialty business in US to see significant ramp-up led by new capacities, product approvals and low competition
Specialty business in the US is likely to see significant ramp-up on the back of USFDA approval for STR’s new sterile injectable and oncology facilities at Bangalore and Penems facility in Brazil. STR is in the process of shifting manufacturing of all approved injectable products to its new facility, thereby eliminating capacity constraints. It has already shifted few key products to the new facility. STR has 73 product approvals in the sterile segment in the US, of which it has launched 42 products as against just 33 products till the end of 4QCY11 due to capacity constraints. STR plans to launch all approved products in CY12, which will boost revenue from the specialty business, significantly.

The company expects strong product approvals in this market even in CY12. Further, the management also mentioned that 6 of the 8 major players in injectable segment have been facing production issues, which in turn is helping STR to increase its revenue rapidly in the US market. STR is entering into long-term contracts ranging from 2-5 years with GPOs to establish its strong credentials as reliable supplier of injectable products in the US market. It expects to garner 15-25% market share in the products it has launched in the US, backed by Pfizer’s strong marketing and distribution set-up and lower competition. The management also mentioned that for the first time it has started developing products for Para-IV filings in the US market and plans to file 14 Para-IV products in the US in CY12. Further, it plans to file 14 products in the ophthalmic segment in CY12.

Upgrading earnings estimates by 21% for CY12 and by 15% for CY13

  • Based on 1QCY12 performance, we are upgrading our revenue estimates by 2% for each of CY12 and CY13.
  • However, given the much higher EBITDA margin in 1QCY12 and strong management guidance for CY12, we are upgrading our earnings estimates by 21% for CY12 and by 15% for CY13.
Valuation and view
STR is set to emerge as a specialty products company with revenue contribution from this segment rising from 28% in CY09 to an estimated 75% in CY13. It has an impressive specialty product pipeline. Large manufacturing capacities are in place to support revenue scale-up, coupled with best-in-class marketing partners like Pfizer and GSK. We believe that the sale of Ascent Pharma at attractive valuations will lead to significant improvement in the company’s financials. STR may unlock further value from the sale of the remaining pharma business, as its focus remains on the specialty business. We expect STR to post 24% earnings CAGR over CY11-13, led by revenue ramp-up from the SI (sterile injectables) segment and substantial reduction in interest cost owning to debt repayment. Core EBITDA margin will expand in line with changing product mix and higher capacity utilization. Return ratios are set to improve over CY11-13 and debt-equity will decline from 1.9x in CY10 to 0.7x in CY13. The stock trades at 11.7x CY12E and 11x CY13E EPS. Buy with a revised target price of INR823 (14x CY13E EPS), an upside of 28%.

To read report in detail: STRIDES ACROLAB

>EXIDE INDUSTRIES: Q4 FY12 - In line performance

“On a comeback trail”

Q4 FY12 - In line performance
On the back of strength shown from the 2wheeler segment, Exide was in a position to put up a sequential improvement in numbers. Total income increased by 16% qoq as well as yoy. At the EBITDA levels, there was an increase of 30% qoq and there was a flattish growth yoy. RM to sales moved up slightly sequentially to 67.2% since adverse forex movement offset the slight cut in lead prices. EBITDA margins surged to 14.6%, a growth of 160 bps qoq, as employee costs to sales went down to 5.2% of sales v/s 6% qoq and other expenses surprisingly came down to 12.9% v/s 14.2% sequentially against a difficult Q3. PAT declined 12.9% yoy while rising 37% qoq. The decline came on higher depreciation costs.

Replacement demand may provide the much needed traction in volumes
The volume improvement in the quarter was on the back of strong 2W battery numbers. The volumes grew 26% yoy and 4% qoq to 3.7mn while 4W volumes grew by 6% yoy to 2.38mn a growth of 16% qoq. On the industrial side, volume growth was 15.3% yoy and 20% qoq. On the capacity side, the company is through with 4W capacity expansion at 12mn units, while is still in the process of increasing 2W capacity to 22 mn in FY 13 which was close to 20mn in FY 12 and also the industrial capacity is slated for expansion to 2.5bn from 2.4bn units. The management expects replacement demand to be strong this year and hence expects to grow at 15-18% on the replacement side,higher than the market growth expected. In line with this, they are expecting to gain back their 36% market share in 4W replacement which had gone down to 23%, and currently stands at 30-31%. In Q3 FY12, the company functioned at 82% utilization rate on the 4W side, 73% on 2W side, while 72% on the industrial side. The replacement: OEM ratio in the year on the auto side was 1.14:1 lower than 1.22:1 in FY11. Going forward, we believe that 2W demand on the OEM side will be slightly soft as the sector has seen some slowdown off late, while on the 4W side OEM demand, we believe softness will continue over a couple of quarters with fuel prices moving up, while any further cut in interest rates will spur demand. On the replacement side, we believe that Q1 FY13 will see some turnaround from the demand for automobiles 3 years ago, both on 2W as well as 4W sides.

Margin improvement may come in coming quarters
In Q4, although the industrial margins grew by 380 bps, auto margins declined due to price cuts taken by the management in the 4W replacement side and pricing pressures from OEMs. However, although the company has taken 17% price cuts on car batteries with 5 year warranty, the management said that they have increased the prices on the other batteries in an attempt to realign prices with the industry and push up the demand on replacement side street expectations, the management in fact confirmed that this has led to some savings rather than margin erosion. The improvement seen in margins in this quarter is expected to continue going forward, as replacement demand is expected to pick up. Also softening of lead prices over the last few months is expected to continue. Softening of lead prices as seen in Q3 is expected to continue and help the margins going forward. We have already factored in about 270 bps improvement in margins in FY 13 to 16.1% over
13.4% in FY 12.

Outlook and valuation
We believe FY 13 will be a better year for Exide with replacement demand expected to pick up and OEM demand to improve in second half of the year following festive season, new launches and expected interest rate cuts. Margin improvement is also on the cards with lowering input costs and improving product mix. However, competition may lead to some margin weakness following any further price cuts in the replacement market. In line with positive expectation from the company going forward, we have slightly increased our FY 13E EPS from Rs 7.5 to Rs7.9 and have introduced FY 14E estimates.We have increased Exide's standalone business value at Rs123 (15.5x times FY 13E EPS of Rs 7.9) and insurance business at Rs13 taking the total TP to Rs136, thus upgrading the stock from Underperformer to Outperformer.

To read report in detail: EXIDE INDUSTRIES

>How the fiscal deficit slows growth and sparks inflation: Four transmission channels (Reasons for India’s structural weakness)

Structurally higher inflation due to governmental policies
The larger fiscal deficit has fuelled inflationary pressures by widening the consumption-investment gap. Subsidized oil prices and an expansion in inclusive growth schemes (without augmenting investment) increased consumption demand to unsustainably high levels. Since the RBI responded to these demand-side inflationary pressures by tightening rates, the burden of adjustment has fallen disproportionately on investments, and more so on private investment, which is more efficient than public investment but is being crowded out by the large fiscal deficit.

In the face of rising demand and limited production, a higher minimum support price (MSP) of food crops has fuelled food inflation. Demand is increasing faster now than during 2003-07 because the middle class is approaching the income threshold, at which demand for consumer durables and higher-protein food takes off. Since nearly half of the consumer basket is comprised of food prices, this has led to an unmooring of inflation expectations. Also, the rural employment guarantee scheme, where wage hikes are linked to CPI inflation, has set a floor on rural wages and exacerbated labour shortages. In the end, this has reinforced the wage-price spiral.

Not surprisingly, average wholesale price index (WPI) inflation has increased from close to 5% during the decade prior to 2008 to 7.0-7.5% post-2008 (Figure 7), with the majority of the increase due to higher food prices (Figure 8).

In the medium term, absent an increase in investment, we doubt that WPI inflation will fall sustainably below 6%. India‟s capital stock-to-GDP ratio at 1.79 in 2010, is one of the lowest in Asia (Figure 9). Plotting capital stock-to-GDP ratios against average CPI inflation rates for 2006-10 reveals that these two variables are negatively correlated, suggesting that persistently high inflation in India appears to be well-explained by the low investment rate

Falling investment capacity
Manufacturing investment, which was the main driver of capex during 2003-07 (Figure 11), has been crowded out by the rising cost of borrowing. Infrastructure investment has been held up due to a policy logjam in acquiring land and obtaining environmental clearances. Lower investment has also hurt productivity, due to the slower adoption of new technologies. As a result, investment has fallen from a peak of 38.1% of GDP in FY08 to 35.1% in FY11 (Figure 12).

The government has flip-flopped on policies and been noncommittal on reforms. For instance, the decision in November 2011 to allow Foreign direct investment (FDI) in multi-brand retail was reversed days after being implemented. The government is also retroactively looking at taxing cross-border deals and bringing in new general anti-tax-avoidance measures, which have increased investors‟ uncertainty over the taxation regime. Despite deregulating petrol prices, oil-marketing companies have not been allowed to raise petrol prices. All of this has hurt investor sentiment and diminished the pipeline of investment projects.

The savings rate has fallen due to high inflation
A rising savings rate had been one of the foundations of India‟s expanding potential growth rate. It has made investment financing sustainable due to an ample availability of domestic funding and reduced dependence on foreign capital. This cushion has slowly eroded. The gross domestic savings rate has fallen from 36.8% of GDP in FY08 to 32.3% in FY11 (Figure 13). While the rise in the central government‟s fiscal deficit has reduced public savings, private corporate savings have also fallen due to a higher cost of production.

Overall, household saving has remained broadly unchanged, but its composition has physical savings trending up and financial savings falling, due to high inflation (Figure 14). Households have moved into physical assets as a hedge against inflation and trimmed their financial assets as the real rate of return has fallen. This shift in the composition of household saving (away from financial assets) does not bode well for sustaining growth, since it reduces the funds available to finance investment and blocks savings into non-productive assets such as gold.

A lower savings rate widens the current account deficit
India‟s current account deficit deteriorated because imports remained relatively robust while export growth slowed during the global slowdown. In our view, import demand was fuelled by four factors: 1) strong consumption demand was boosted by consumption-biased fiscal policies; 2) high inflation led to demand for gold imports4; 3) inelastic oil demand due to subsidized fuel prices (Figure 15); and 4) higher coal imports caused by delays in domestic production from slow environmental clearances (Figure 15). The national income identity suggests that a wider current account deficit reflects gross domestic saving falling much more than investment.

The need to finance a rising current account deficit has increased the economy‟s dependence on capital inflows (Figure 17). The basic balance of payments (BoP) deficit, defined as the current account plus net FDI inflows, has widened to levels last seen during the 1991 BoP crisis (Figure 18). While FX reserves provide a buffer against sudden capital outflows, their use is limited. First, domestic liquidity is already tight and USD sales by the RBI would lead to further INR liquidity shortages, which would need to be countered via open market operations and/or cash reserve ratio cuts. Second, as the RBI uses its FX reserves to defend INR, its medium-term FX vulnerability would increase as the reserve ratio worsens.

To read report in detail: FISCAL DEFICIT


Initiating at Buy: Past Investment Phase

Key Takeaway
We initiate coverage of Bharat Forge (BFL) with a Buy rating and price target of Rs441. We believe that Bharat Forge is past its investment stage and will now benefit from improving asset utilisation. While some of its overseas subsidiaries are still under stress, we expect the management to take remedial action soon. Building blocks in place: Over the past few years, BFL has expanded its presence into newer markets and segments, even as it has maintained its hold over existing businesses. BFL is now the world’s largest independent forging company but still accounts for less than 1.5% share of the estimated global forging production. In the near term, we expect BFL to benefit from the rebound in the US truck market and increasing value addition in the Indian truck market. Expansion into non-auto segments should bring new growth opportunities and offset the cyclicality of the auto business.

It’s all about utilisation: Forging is a capital-intensive business with profitability contingent on asset utilisation and the extent of value addition (machining vs raw forging). BFL increased its raw forging capacity by over 60% in FY09/FY10, even as its end markets slowed down, leading to a sharp fall in utilisation levels (80% in FY08 to 34% in FY10). Since then, however, BFL has benefited from three factors, which will likely accelerate: a) higher utilisation of forging capacity, increasing to 57% in FY12E and to 65% in FY14E; b) higher proportion of machining, from 40% historically to c45% in FY14E; and c) higher proportion of non-auto sales, from <30% historically to c40% at stable state.

Subsidiaries and JVs - no more cash calls: BFL's overseas units account for c50% of global capacity but are operating at less than 50% utilisation. It has shut down one of its European plants and we expect BFL to take more such remedial actions in the future. Cumulatively, we expect the overseas subsidiaries to be self-funding, though they would contribute very little to profits in the near term. We are concerned with the profitability of the power equipment JV with Alstom given the intense competition in the TG space.

BFL stock has been sharply derated since 2008, initially due to slowdown in demand but subsequently due to concerns on its subsidiaries. Our SOTP-derived PT of Rs441 is based on: a) increasing asset utilization in its India operations, which we value at 16x FY14E; and b) no incremental cash calls from its JVs and subsidiaries, which we value at 0.5x FY13E BV to factor in our concerns on profitability. Risks: New expansion in the domestic business, cash calls from international subsidiaries and execution delays in power equipment JVs are key downside risks. Currency fluctuation is a risk for margins.

To read report in detail: BFL