Tuesday, May 29, 2012

>THE FLAWS OF FINANCE: Bad Models, or, Why We Need a Hippocratic Oath in Finance

As a child, watching my parents write postcards whilst we were all on holiday was an instructive experience. My mother would meticulously write out the card, scattering a few interesting holiday tidbits within the text. My father, whose sum total of postcards sent was invariably just one (to his office), opted for a considerably more efficient approach. His method is shown at the left in Exhibit 1.

I think we can construct a similar diagram to explain the Global Financial Crisis (GFC), represented at the right in  Exhibit 1. In essence, the GFC seems to have sprung from the interaction of the following four “bads”: bad models, bad behaviour, bad policies (which is really just bad behaviour on the part of central banks and regulators), and bad incentives. 

In an effort to rethink finance, I want to examine each of these factors in turn, beginning with bad models.

Bad Models, or, Why We Need a Hippocratic Oath in Finance
The National Rifle Association is well-known for its slogan “Guns don’t kill people; people kill people.” This sentiment has a long history and echoes the words of Seneca the Younger that “A sword never kills anybody; it is a tool in the killer's hand".

 I have often heard fans of financial modelling use a similar line of defence. However, one of my favourite comedians, Eddie Izzard, has a rebuttal that I find most compelling.  He points out that "Guns don’t kill people; people kill people, but so do monkeys if you give them guns.” This is akin to my view of  financial models. Give a monkey a value at risk (VaR) model or the capital asset pricing model (CAPM) and you’ve got a potential financial disaster on your hands.

The intelligent supporters of models are always quick to point out that financial models are, of course, an abstraction from reality. Just as physicists can study worlds without frictions, financial modelers should not be attacked for trying to reduce the complexity of the “real world” into tractable forms. Finance is often said to suffer from Physics Envy. This is generally held to mean that we in finance would love to write out complex equations and models as do those working in the field of Physics. There are certainly a large number of  market participants who would love this outcome.

To read paper in detail: THE FLAWS OF FINANCE

>STRATEGY: The flipside of policy inertia – rising FCF yields

  Sensex PER valuations belie the bottom-up pain. Though Sensex PER (12.5-13.0x) seemingly has more downside given (1) FY12-14E earnings CAGR of only 12%, (2) the still negative spread of earnings yield vs. risk free rate and (3) avg. Sensex PER of 11.5x during the GFC, we expect the rising FCF yields (focus of this report) to begin supporting valuations. The top-down market PER, however, has been supported by the increased weights in FMCG, IT and Pharma and the sustained premiums thereof, thus understating the severe de-rating in other sectors. It is also interesting to note that the India weight in benchmarked funds relative to MSCI EM has remained stable at an Overweight of ~1% during the past two years. Even the absolute India weight has declined only 190bps from the peak of 9.5% two years ago, suggesting significant sector rotation even as relative Over/Underweight has been stable.

  FCF yield at 2SD to provide downside support, identify stocks. Meanwhile, the flip-side of the collapse in the capex cycle is the rising FCF yields; the Sensex fwd FCF yield is now at 4.5%, higher than 2008-09 levels and almost at 2SD. We believe this could provide material downside support to market valuations notwithstanding the regulatory/policy overhangs. Continuing with our thesis, we map stocks based on the (1) FCF yield (FY13/14E avg.) and (2) the delta in FY13/14E yield vis-à-vis FY12. Stocks that stand out on both parameters are Apollo, Cairn, HZL, Crompton, M&M and TAMO. Stocks with high FCF yields but low deltas are HCLT, Ambuja, ACC, Infy, Bajaj Auto and BHEL. In the model portfolio, we reduce Staples to UW from EW and increase weight on Industrials (OW vs. EW), Financials (EW vs. UW, mainly through PSU banks) and Energy (Reliance). We also reduce weights in Pharma/Healthcare and Materials.

  FY12-14E earnings CAGR of 12% below nominal GDP growth now: Meanwhile, earnings have continued to slide – Sensex FY13/14E EPS stands at Rs1,216/1,338 (Rs1,247/1,372 in end-Feb). We don’t see too much further downside as margin expectations are low and gains from a weak rupee will start flowing through FY13 earnings. The Earnings Revision Index (ERI) for India has also declined from -0.5 in Sep-11 to -0.1 and has been stable in the past 3 months.

  Top picks: ACC, HCL Tech, DLF, ICICI Bank, Dr. Reddy’s. We replace Cipla with Dr. Reddy’s and drop HUVR, Tata Motors and Bharti from the top picks. Top Midcap Picks: Apollo, PLNG, Adani Ports, Sobha, YES Bank.

To read report in detail: INDIA STRATEGY

>Companies doing Buy-Back – Offers value to investors

Corporate that generates profit usually deploy it in two forms one in the form of dividends to reward the shareholders, the remainder portion is redeployed in the business for future growth. Theory suggests that if the management is able to generate higher returns by deploying the profits so generated in business, then they should conserve cash for investing. However if the business is not able to generate better returns, the profit generated should be paid out to the investors as dividend.

Another form of rewarding the shareholder is through share BuyBack as an alternative to the dividend payout which is more efficient and better alternaive to dividends.The advantage is that buy-backs give a boost to share price and give shareholders capital gains rather than income. The management of the company may also resort to share Buyback when they feel that the stock is under valued and the surplus cash can be utilised to enhance the shareholder value for the existing shareholders, as sharebuy back is also one way of improving earnings per share. It is an indirect way of increasing the promoter holding in the company and reducing the floating stock.

To read report in detail: BUY BACK OFFERS

>LARSEN & TOUBRO: Larsen & Toubro Electrical & Automation acquires UK-Based Thalest Group".

Investment Highlights
Q4 FY12 Results Update L&T Ltd. has reported net profit of Rs 19204.00 million for the quarter ended on March 31, 2012 as against Rs 15862.10 million in the same quarter last year, an increase of 13.89%. It has reported net sales of Rs 184609.00 million for the quarter ended on March 31, 2012 as against Rs 153842.10 million in the same quarter last year, a rise of 20.00%. Total income grew by 19.18% to Rs 187751.00 million from Rs. 157540.30 million in the same quarter last year. During the quarter, it reported earnings of Rs 31.36 a share.

Recommends Dividend: Larsen & Toubro Ltd has recommended a Dividend of Rs. 16.50/- per share (previous year Rs. 14.50/- per share)

Allotment of Shares: Larsen & Toubro Ltd has allotted 3,80,562 (Three Lakh Eighty Thousand Five Hundred Sixty Two) shares on May 14, 2012 to those grantees who had exercised their options under the Company’s Employee Stock Ownership / Option Schemes.

L&T bags Rs 1937 crore order from GVK for Construction of Road Infrastructure IC of L&T Construction has bagged a major order worth Rs 1937 crore from the GVK group for Design, Engineering, Procurement and Construction for 4 Laning of a major portion of Shivpuri - Dewas section of NH -3 in Madhya Pradesh totaling 235 Km. The project has to be completed in 27 months.

 L&T construction has bagged new orders valued over Rs 1880 crore
L&T Construction has bagged new orders valued over Rs 1880 crore across various business segments during the fourth quarter of FY2012.

The Infrastructure IC has secured new orders aggregating to Rs 1048 crore from The Government of West Bengal.

In the Water and Effluent Treatment business unit, L&T Construction has secured orders worth Rs 348 crore from Gujarat Water Infrastructure Limited for providing, supplying, lowering, jointing & commissioning of bulk water transmission by M.S.Pipeline at Surendranagar and Junagadh Districts in Gujarat.

In the Power Transmission & Distribution IC, new orders valued at Rs 263 crore have been bagged from esteemed clients. The orders include construction of e-BOP system for 2x600 MW Coal fired thermal power plant at Singhitarai in Chhattisgarh from a private developer and another order from DMRC for supply.

L&T Construction has also received additional orders worth Rs 221 crore from various ongoing projects.

To read report in detail: LARSEN & TOUBRO

>RELIANCE CAPITAL LIMITED: CCI clearance for sale of 26% stake in MF arm to Nippon Life and reversal of interest rate cycle positive

Impressive Q4FY2012 results & sale of stake in MF and Life Insurance arms are major triggers for RCap

 CCI clearance for sale of 26% stake in MF arm to Nippon Life and reversal of interest rate cycle positive for RCap: Recently, Competition Commission of India (CCI) approved the proposal of Japanese major Nippon Life to acquire 26% stake in Reliance Capital's (RCap) mutual fund arm Reliance Capital Asset Management (RCAML). CCI is of the opinion that the proposed combination is not likely to have any appreciable adverse effect on competition in India. The deal, (which took place on January 19, 2012) valued at an aggregate amount of Rs.1,450 crore, is the largest FDI deal in any Indian asset management company till date. The transaction pegs the valuation of RCAML at around Rs.5,600 crore ($1.1 billion) or about 7% of its overall assets under management (AUM) at the time of the transaction. This deal has been done at valuations which are better than some of the deals done in the recent past, at valuations of 1.5 - 3.5% of assets. Also, on April 17, 2012, RBI cut the Repo rate, after a period of 3 years, by 50 bps, signaling a reversal in the interest rate cycle, which will be positive for RCap.

■ Sale of 26% stake in Reliance Life Insurance another booster: Nippon Life has already invested $680 million in October 2011 for a 26% stake in Reliance Life Insurance Company (RLIC) pegging the total valuation of Reliance Life Insurance at more than to Rs.11,500 crore (at the then prevailing INR/USD rate). The deal value for a 26% stake in RCAML and RLIC amounts to Rs.4512 crore (according to the USD/INR exchange rate prevailing at the time of the deals), valuing these two businesses alone at Rs.17,100 crore. The market cap of the listed entity Reliance Capital is Rs.7,809 crore only. The proceeds from the stake sales have helped the company reduce its consolidated debt burden which has come down from Rs.20,000 crore in September 2011 to Rs.11,000 crore as on March 31, 2012. Another way to look at it is that based on the valuations of these two deals, the valuation of RCAML and RLIC alone comes to Rs.696/share whereas the stock of RCap, which has a range of other businesses in the financial services sector like broking, wealth management, private equity, etc, is trading at Rs.318/share only, which is a 54% discount to this valuation.

 Impressive Q4FY2012 results indicate the worst is over for RCap: We believe that the worst is over for RCap. On the back of adverse corporate newsflows, the company’s stock price has been punished very severely, more than it deserves. Also, the company has posted impressive Q4FY2012 results. While total income has increased by 26% YoY to Rs.1995 crore, the company has posted a net profit of Rs.329.3 crore against a net loss of Rs.6.5 crore in the corresponding period of the previous year, mainly due to significant improvement in operating margins contributed by less net claims incurred during Q4FY2012. For FY2012, net profit increased 57% YoY to Rs. 457.8 crore while total income increased 22% YoY to Rs.6,577 crore. For FY2012, the life insurance business posted PBT of Rs.372.6 crore against loss before tax of Rs.129.3 crore in FY2011.

■ Other businesses provide further comfort: The other businesses of the company provide further value to the company. Reliance Securities had 6.85 lakh broking accounts as on March 31, 2012. The distribution business, Reliance Money, has a pan-India distribution network of 6,000 outlets. Reliance General Insurance (RGI) is amongst the leading private sector general insurance companies in India with a private sector market share of 8%. Reliance Commercial Finance had a loan book size of Rs.13,260 crore (USD 2.6 billion), as on March 31, 2012.

■ Risk to View: Any further steep slowdown in the industrial economy could impact its profitability adversely.

■ Valuations: We believe that the stock price of the company has seen significant correction, more than it deserves, of 48% from its 52-week high of Rs.612/, on the back of adverse corporate news flows. We believe that the worst is over for the company and its Q4FY2012 results have been impressive. At the current market price of Rs.318/, the stock is trading at 11.9x its FY2014E EPS of Rs.26.8 / and 0.62x its FY2014E BV of Rs. 512/. We continue to recommend BUY on this stock with a fair value of Rs.440 which is 16.5x FY2014E EPS and 0.86x FY2014E BV.

To read report in detail: RELIANCE CAPITAL

>SUZLON ENERGY: Third consecutive year of loss on missed guidance

FY12 performance worse than expectations. Suzlon reported a net loss of INR4.8bn vs consensus of a loss of INR150m and our estimate of a INR339m net loss. When it reported its nine months’ results on 11 February, the company reduced its FY12 sales guidance to INR210-220bn (from INR240-260bn) and its EBIT margin guidance to 5-6% (from 7-8%). We attribute the higher-than-expected net loss to an EBIT margin of 4.2% (old schedule VI format), lower than guidance. Under the new format, EBIT works out to INR11.6bn, for a 5.5% EBIT margin, but the old schedule reporting applies for comparison with guidance,
in our view. Due to the shift in certain items from operating expenses to finance charges (of cINR2.8bn in FY12), both the finance charges and the EBIT margin are higher under the new format. The group’s order book remained flat q-o-q, with c5.7GW of orders valued at INR415bn.

FY13 EBIT guidance is lower than expectations. Suzlon has guided to FY13 revenue of INR270-280bn and an EBIT margin of 6%. On revenue, current consensus and HSBC’s forecast are in the range of INR254-256bn. Our EBIT margin forecast is 6.2%, and consensus is at 6.6%. Our forecasts are based on the old schedule VI; under the new format, our finance charge forecasts might be higher. The company will hold its annual results conference call on 29 May at 16.30 IST, after which we will revisit out forecasts and provide an update.

More funds required for meeting FY13 repayments. In our note of 27 March, Cash crunch seems more severe than expected, we highlighted that Suzlon (ex REpower) has debt repayments of cUSD700m in FY13 and is short cUSD600m (cINR30bn) to meet its repayment obligations. Besides the USD300m being raised from the banks, we believe the remaining deficit will be met through other sources/measures, as highlighted in our note.

Our blended DCF- and RoE-based TP remains INR20. Our DCF-based valuation is INR25.6 (average of two DCF approaches). We blend this with an RoE-implied PB value of INR13.2 to better capture the sector’s market value, reflecting the current uncertainties. This leads us to a target price of INR20 (rounded off). The stock is trading at a high premium to the average peer group on CY12e PE, which we believe is not justified given the debt overhang. At the average global peer group CY12e PE of 15.7x, the stock would be valued
at cINR13.9, which is lower than our target price.

Potential catalysts: (1) Performance below expectations over the next few quarters, (2) a slowdown in orders, (3) further rupee depreciation, and (4) news flow on decline in Suzlon’s Indian market share, given the increasing competition.

To read report in detail: SUZLON ENERGY


Earnings Highlights
• Strong revenue growth across segments: VATW’s 4QFY12 revenue of Rs6.71bn (31.8% YoY) was well above our estimate of Rs5.85bn, led by strong performance in the standalone and overseas businesses.

• Adjusted Ebitda beat our estimates: Adjusted for prior-period staff cost provisions, Ebitda grew 13.2% YoY, which is commendable considering that VATW has been expanding into new geographies. Ebitda beat was due to overseas staff costs reducing 16% YoY, indicating that the company’s efforts to reduce overheads through measures such as a new ERP system are bearing fruit. PAT was 8% above our estimates due to higher other income and lower tax.

• Order inflow miss due to slippage from 4QFY12 to 1QFY13:
Order inflow in 4QFY12 was below expectation at Rs9.3bn (vs.Rs11bn) due to lower standalone order inflow. This was because of a delay in industrial orders worth ~Rs3bn-4bn in India, which the company was expecting. However, the company is confident of winning these orders in 1QFY13. Order backlog stands at Rs37.3bn.

• Key order highlights: The Rs3.3bn Ulhasnagar WTP BOOT project moved into the order book and there were O&M orders worth Rs33m. The company highlighted a number of overseas order wins below the EUR10m mark. Revenue from Sri Lanka WTP has started kicking in from 4Q with 40% of the EPC work being completed. The company has completed 88% of the EPC work in the Chennai desalination plant and it expects O&M revenue to commence from 3QFY13.

Management commentary
• Higher focus by the government on water projects: The highpowered expert committee on new improved JNNURM envisages overall capex spending of Rs39trn over 20 years of which 20% would be on water, sewage and waste management. The overall O&M spending would be Rs20trn of which 55% would be on these areas.

• Order inflow strong despite trying circumstances: Order intake was strong despite slow decision making in municipalities in India. Orders worth Rs3bn-4bn in oil & gas and steel verticals did not materialise in 4QFY12 but are expected to be closed in 1QFY13. The company also received the first order in Qatar, a sea water reverse osmosis desalination project worth EUR7.5m.

• Strong order pipeline: VATW has set its sights on sewage treatment plants in seven sites in Mumbai. It is also in negotiation with municipalities in Delhi, Karnataka, Tamil Nadu and Orissa (each worth Rs2bn-5bn). There are also overseas orders worth EUR125m expected. The JV with Sumitomo is looking at orders of US$200mn– 1bn and is expected to win a large order this year.

• Business restructuring with increased focus on clients: The company continues with its decentralisation drive with local staff manning its offices in the overseas subsidiaries. This has helped cut down overheads in the overseas business. It is changing its segment classification from geography based to product based (such as municipal water, industrial water and desalination).

• Focus on emerging economies; little presence in troubled European economies: VATW is increasing its focus on emerging economies such as Romania and Turkey in Europe. It receives <20% of overseas revenue from the developed markets. The company expects the Middle East and North Africa (MENA) markets to return to normalcy this year. The EUR90m order from Libya is expected to materialise in 2012.

• Multiple margin drivers: Decentralisation, focus on emerging markets, and BOOT contracts will be the margin levers. There is little balance sheet impact from the BOOT projects as VATW only holds 10% equity in these projects.

• Actively exploring M&A opportunities: VATW has cash of Rs4bn and is looking at prospective M&A targets in Latin America and South East Asia.


>NMDC: Q4FY12 Results Update

Muted performance due to lower volumes; maintain buy

NMDC recorded muted performance (as was expected) in Q4FY12 with revenues at Rs25.9bn as sales volume were adversely affected by damage to Essar’s slurry pipeline and stood at ~6.4MT. NMDC had reduced iron ore prices for the quarter and blended realizations stood at ~Rs4054/tonne (~US$80/tonne). EBITDA stood at Rs19.8bn (margin of 76.2%) and PAT was down 11.6% QoQ to Rs16.4bn. NMDC is targeting sales volume of ~30 MT in FY13E and has shifted its pricing mechanism from export parity based to domestic demand-supply linked system. We see the change in pricing mechanism as a positive for the stock and also expect higher volume growth going ahead on expansion and better logistics. Acquisition of strategic stakes in various global mining assets remains a key positive trigger for the stock. We revise our volume estimates lower marginally (by ~3%) for FY13E/14E and maintain buy with a target price of Rs 227.

 Volumes subdued and pricing lower: Sales volumes stood at ~6.4MT, down ~24% YoY and flat QoQ as e-auction in Karnataka saw lower sales and Chhattisgarh sales were affected by damage to Essar’s slurry pipeline. Realizations dropped by ~8% QoQ as NMDC announced price cuts for both fines and lumps for the quarter in line with global softness in prices. Sales volume for FY12 stood at 27.3 MT and target for FY13E stands at ~30 MT.

 EBITDA margin falls as expected: As expected margin fell during the quarter and EBITDA stood at ~Rs19.8bn (margin at 76.2% and EBITDA/tonne of Rs3090) as volumes fell and realizations were lower due to price cuts.

 Pricing mechanism changed from export parity to domestic linked: NMDC has changed its pricing mechanism from being export parity based to the one linked with domestic demand-supply decided by a committee on a quarterly basis. NMDC revised prices upwards by ~8% QoQ for Q1FY13. Volumes continue to remain affected by damage to the Essar pipeline and company has taken various steps in increasing evacuation from Chhattisgarh mines (uniflow loop line system expected to result in 3MT increase in evacuation). Company has guided for a capex of ~Rs46bn for FY13E with ~Rs30bn to be spent on the 3 mtpa steel plant at Chhattisgarh. NMDC is targeting ~30 MT of production in FY13E and we revise our
FY13E/FY14E volume estimates lower by 3.2%/2.9%. Our realization estimates are lower in US$ terms for FY13E/14E by 3%/2.2%. We estimate 30 MT of iron ore sales in FY13E (Karnataka – 7.5MT and Chhattisgarh – 22.5MT), implying a growth rate of ~10%.

 Maintain Buy on attractive valuations: We remain positive on the company as we see volumes improving from FY13E onwards with higher e-auction sales volume from Karnataka, better evacuation from Chhattisgarh and expansion at Bailadila 11 B mines. We find the stock trading at attractive valuations with FY13E P/E of 8.8x and FY13E EV/EBITDA of 4.6x. We value the company at 6.5x FY14E EV/EBITDA to arrive at a target price of Rs227. We revise our target price upwards to Rs227 from Rs224. Maintain buy.


>INDIAN BANKING: Savings rate deregulation – Early trends

The current macro environment (high interest rate differential between SA and fixed-term deposits) and SB deregulation in Oct 11 have made SA deposit acquisition more challenging and competitive. Post deregulation, smaller new generation private banks that have raised rates have seen higher SA momentum, while large private sector banks are witnessing early weaknesses and PSU banks have seen a deterioration in SB deposits mobilisation. We expect smaller new generation private sector banks to gain market share at the cost of PSU banks in the initial phase. We expect the high SA interest rate environment to last only until small new generation banks reach the inflection point in terms of SA ratio, which also depends on how rate cuts pan out.

Macro environment not conducive for SA deposits growth
We expect the flight of deposits from savings accounts to fixed-term deposits to continue in FY13 as we expect liquidity conditions to remain tight for the rest of the year and interest rates to remain high in spite of an additional forecast 75bps cut for the rest of FY13. Further, we believe it would be reasonable t assume that the three new generation private sector banks that have increased their SA interest rates are likely to continue to offer higher SA interest rates than competitors to maintain their competitive advantage in terms of pricing differential.

SB Deregulation – divergent trends
Small new gen banks - Rate hikes helped initial gains: Since SA deregulation, Yes, Indusind and Kotak (not rated) have increased rates which has helped them to gain significant momentum on SA deposit mobilization (incremental SA deposit market share from 1% in Q1 FY12 to 4% as of Q4 FY12). Large Private banks – Holding the fort for now: Large private banks have managed to hold on to their CASA ratios and market shares over the last couple of quarters. ICICI, HDFC Bank & Axis Bank managed to maintain their SA ratio at 27.9% from Q1 to Q4 FY12.

PSU banks – Losing market share: The top 5 PSU banks have continuously lost market share (their combined SA market share decreased from 26.6% in Q1 FY11 to 25.2% in Q4 FY12 & SA ratio decreased from 26.4% in Q1 FY11 to 24.7% as of Q4 FY12).

How long will the high SA interest rate environment last?
Competitive positioning on key SA drivers...
Most banks have devised their current strategy based on their current positioning on four key SA drivers: (a) Interest rates; (b) rural branch network; (c) service quality; & (d) product portfolio. Three large private sector banks (ICICI, HDFC Bank and Axis) and SBI look better placed to handle higher competition while some of the larger PSU banks like, Union, PNB, BOB & BOI will likely continue to lose market share as the smaller private players gain market

... has determined banks’ current SA strategy
Large private banks (ICICI, HDFC Bank, Axis) are increasing their rural network, SBI is offering incentives (reducing minimum balance to zero) to increase incremental market share. PSU banks excluding SBI are offering Auto Sweep on SA accounts.

High SA rates will last for the next 12-18 months
Higher SA rates are highly dependent on how the rate cycle pans out and how quickly the new generation banks increase their SA Ratios. Based on our analysis, we calculate that a 25% SA ratio would be the tipping point for YES bank while the corresponding number is 35% for Indusind assuming a 75 -100 bps rate cut (see Table 15 &16), at which point the new generation banks may be forced to think long and hard about offering higher interest rates. We believe higher SA rates will last for the next 12-18 months, after which banks will likely be forced to revisit their high SA rate strategy.

To read report in detail: INDIAN BANKS

>BHARTI AIRTEL: Acquires 49% interest in Qualcomm's

  • Acquires 49% interest in Qualcomm's four circles - Delhi, Mumbai, Haryana and Kerala - US$165mn.
  • Bharti to get better ability to segment market using combination of 2G, 3G and 4G in 18 circles (85% of its India wireless revenue)
  • No material impact on earnings in near term, maintain Reduce

To read report in detail: BHARTI AIRTEL