Friday, June 15, 2012

>HDFC Ltd – SWOT Analysis

■ Structural de-rating in the making; Downgrade to UP
We downgrade HDFC Ltd to an anti-consensus Underperform rating from Outperform with a TP of Rs550, which offers 17% downside. We believe a structural de-rating is likely because the quality of earnings and ROE reported is being driven more by its corporate book and aggressive accounting practices. Mortgage profitability is declining structurally and regulations have become adverse. All this would make it tougher for HDFC Ltd to sustain its super-normal multiples/valuations. Though near-term catalysts are absent, the de-rating call is more a longer-term view as the stock appears fundamentally overvalued.

■ ROE driven by corporate book; getting riskier structurally
Over the past eight years, HDFC has increased the share of the corporate book (loans to real estate developers, lease rentals etc) in the overall loan portfolio from 29% to 37%. The issue is that housing loan profitability has been falling structurally and the company has been resorting to higher-risk non-retail categories to drive up ROE. We estimate the non-retail book now generates more than 30% of ROE and contributes more than 65% to HDFC’s profits.

■ Retail housing loan profitability falling structurally
Over the past several years, competition in retail housing has picked up, and some of HDFC’s peers have grown at exceptional rates. The premium product pricing that HDFC Ltd used to enjoy no longer exists. Competition is intense and likely to increase since banks have limited opportunities in the corporate segment this year. Retail business ROE has also been affected by regulatory changes and we estimate the retail business now generates a poor ROE of around 13-14% compared with 20%-plus five years ago.

■ Accounting practices used to inflate earnings and ROE
Over the past two years, HDFC Ltd has been adopting aggressive accounting practices by passing provisioning through reserves and also making the adjustments for zero-coupon bonds (ZCBs) through reserves. We believe FY11 and FY12 earnings are overstated by 38% and 24% respectively and reported ROE would have been 600 and 400 bps lower at 16% and 18% respectively if the adjustments had been made through the P&L. In other words, earnings growth has been managed, in our view.

■ Regulations – another overhang
We also think investors are underestimating the longer-term implications of regulatory changes and consequently this also presents a strong case for derating in our view. The regulator has increased the provisioning requirements, has banned pre-payment charges, and asked for re-alignment of rates for old and new customers, all of which could have an impact, especially in a predatory pricing environment. We also expect capital requirements to be increased, similar to the banking and NBFC sector, and this is one big event risk (with a high probability of happening) that the market is not factoring in, in our view.

■ TP cut by 30%, driven by sharp cut in multiples
We cut our TP by 30% to Rs550 on account of a sharp reduction in our target multiple. We are now valuing the core business at 2.0x P/BV compared to 4.0x previously. The reduction in multiple is on account of: i) lower retail business ROE driven by lower spreads in the retail business and higher capital requirements; and ii) a sharp reduction in corporate business ROE driven by factoring in credit losses and higher capital requirements.

To read report in detail: HDFC

>INDIAN BANKS: How intense is the credit cycle and what is factored in ?

Our detailed corporate health check for ~3500 listed companies indicates that the credit cycle is getting deeper with breadth of mid and small cap companies facing stress increasing at a brisk pace along with an elongated down cycle, leading to higher ultimate delinquencies. But the good part is asset for large caps (excl. Infra, ~60% of debt) have held up relatively better and more importantly, stress sectors have already seen large scale recognition, either as NPA or restructured asset. We do not see a significant rebound in the credit cycle near term and hence, prefer ICICI/Axis, where corporate underwriting has been robust and our sensitivity analysis indicates 15% upside even considering ~15-20% write-offs. PSU banks’ adj. valuation is undemanding indicated in our rating upgrades in some PSU names after 4Q12 but the BUY case for PSU banks is more contingent upon a fast recovery
and more importantly front ended monetary easing.

 Corporate health check – Analysing pain points: We ran a detailed Interest coverage (IC) analysis of all listed companies to understand breadth/depth of the credit cycle. The bad news: (1) IC, for mid corporate and SMEs, has come to levels below 08-09 levels with increasing intensity - 25% of mid and SME companies with IC of <1x. (2) The bigger worry is that IC for mid and small caps have remained low for 3-4 quarters now and elongated stress time leads to ultimate delinquency. The good news: (1) Some pockets in large caps are seeing some incremental stress but overall IC levels remain comfortable and this reduces asset quality risks as they constitute ~60% of the total Rs15trn of industrial credit we analysed.

 What levels of stress is recognized/discounted? Though the credit cycle is building up, segmental data provided by SBI/PNB indicate that 10-25% of total exposure in some stress sectors has already been recognized (either NPA or restructured), though intensity continues to increase. Engineering/construction still remains vulnerable as stress recognition remains lower than stress indicated by our IC analysis.

 Factoring risks not captured through our IC analysis: Infra risks/delays are still to hit P&L and hence, our IC analysis does not capture Infra/power risks. Our bottom-up analysis indicates that ~20GW of thermal plants face fuel/off take issues (~20% of capacities commissioned in 09-15E). Though we expect large restructuring in private power space, strong promoter financials in some cases, extension of loan tenure and most importantly systemically acceptable level of cost of power produced (Rs3.1-3.2/unit) even assuming 25% imported coal blending, will significantly limit ultimate delinquencies.

 Stress testing- ICICI/Axis remain top Buys : Our stress test indicates that valuations for ICICI/Axis is ~15% lower than their LT averages after considering ~15-17% hit to book values. The hit on PSU banks book is larger at ~30% of book given NPA shortfalls and higher restructuring, but that seems to be fcatored to some extent in valuations. The credit cycle is getting elongated and challenging and easing modetary stance now will bring some relief to asset quality.

To read report in detail: INDIAN BANKS

>ONGC: Targeting to raise production 2x and market cap 4x by 2030

In its analyst meet, ONGC indicated that mature fields are declining at a faster pace of 8‐9%. Crude production costs have inched up to USD44/bbl – a point which the company may use to negotiate with government for higher FY13 realization. The Perspective Plan 2030 aims to double production implying 75% of incremental production from OVL. We are disappointed with the faster decline in maturing fields (earlier estimate at 6%) and cut our crude production forecast to 1.9% CAGR over FY13‐15E from 4.7% earlier. Thus, we lower our fair value to INR321/share.

■ Marginal fields declining at a faster rate
ONGC has indicated that production from mature fields (15 fields contributing to 80% of production) is declining at 8‐9%, faster than earlier decline rates of 6%. Production from redevelopment projects and marginal fields is expected to compensate for this, curbing the net decline rate to 1‐2%. IOR/EOR projects, so far, have added 72 mm toe to production and are expected to cumulatively add 171 mmtoe by 2030.

■ Cost of crude production inching up; net realization ought to rise
Production costs (incl. levies and taxes) have gone up from USD38/bbl to USD 44/bbl due to recent increase in cess, and will keep escalating due to higher cost of services and manpower. With net realization from nominated fields at USD55/bbl, profit is restricted at USD10/bbl. If costs grow 8% YoY, they will reach USD61/bbl in five years.

■ Targeting to raise production 2x and market cap 4x by 2030
By 2030, the company envisages to raise production 2x from 62mtoe to 130mtoe (4‐5% CAGR vs. 2% CAGR in past 56 years), revenue 3x and market cap 4x (implies 8% CAGR price appreciation). Of the 68 mtoe production increase, it expects 52 mtoe from OVL (75%), implying a spate of acquisitions ahead. OVL’s blocks in Syria and Sudan are facing disruptions, while growth in Sakhalin and Imperial is more than two years away.

■ Outlook: Lower fair value to INR321 on weak production growth
We have lowered our production forecasts, incorporating faster pace of decline from maturing fields. We estimate crude production (nominated, JVs) to post 1.9% CAGR over FY13‐15E, with maturing fields declining at 7.6% CAGR. We lower FY13E and FY14E EPS by 9% and 13% to INR30.4 and INR32.2, respectively, and value ONGC at INR321 due to INR22 reduction in ONGC standalone valuation. Maintain BUY.


>RAYMOND: Moving towards an asset-light model:

  Strong branded retail play: Leveraging on its strong five decade old brand, Raymond is spurring ahead and expanding its retail presence which is currently at 853 stores, up from 584 in FY09 and targeting 100 stores/year, going forward. The might of the brand is further accentuated by the fact that 78% of its stores are franchises. Besides, its franchise model involves outright purchase of stocks by franchise owners, thus, limiting the company¡¦s working capital.

  Focused restructuring paves the way: Raymond has been on a strong upward trajectory post its FY08-11 restructuring. Strong scale-up in revenues and cost savings have emanated from the series of restructuring activities undertaken which includes transfer of its Thane operations, closure of its loss-making denim factories, realignment of its brand strategy, as well as stabilisation of ERP. With the restructuring complete, we expect a clear runaway, going forward.

  Moving towards an asset-light model: Keeping a strong eye on return ratios which are currently low, Raymond targets to remain asset-light by focusing on its franchise-strategy on the retail side as well as outsourcing of routine manufacturing processes.

 All-round growth: Besides the textile & garments segment, which is expected to grow at 15% CAGR over the next two years, the company expects strong growth of 28% CAGR for its engineering division as well which includes the tools & files as well as the auto components segment.

  Valuations: We have used a host of consumption names with retail bend for comparison since there is no strict peer group for the company. These trade at an average PER of 26x FY13 & 23x FY14, albeit with much higher return ratios than Raymond. Accounting for the same, we are valuing Raymond at a PER of 12x FY14 which gives us a value of Rs467/share. Further, the prime land in Thane owned by the company provides an option-value of Rs244-326/ share, although not included in our target price. We initiate coverage on the stock with
a ¡¥BUY¡¦.


>Manmohan Singh promises to speeden up infrastructure development

Prime Minister Manmohan Singh on Wednesday (June 06, 2012) sent a strong signal by outlining an ambitious agenda to put infrastructure projects on the fast track. He promised a big push to infrastructure development and pledged quick action in awarding airports, highways and port projects in a meeting with ministers and top officials from the power, coal, aviation, railways, highways and shipping ministries. With Indian economy in doldrums and general elections round the corner, this was anticipated. The Prime Minister said that infrastructure development was a key part of the strategy to revive the India growth story and has outlined an impressive target for the same.

Despite huge infrastructure growth opportunity, the world’s second fastest growing economy has been a laggard when it came to developing its infrastructure. Be it macro conditions, lack of effective government policy or just plain underperformance by companies. To bridge the infrastructure deficit to achieve an inclusive growth as well as accelerate GDP growth, investment in infrastructure across segments is likely to increase tremendously in the 12th Five Year Plan period as against 11th Plan.

The government’s projected investment in 12th Plan is Rs40,152 bn as compared to an investment of Rs19,481 bn in the 11th Plan. The government has plans to rely more on infrastructure investment by private sector and has targeted for private investment contribution of 50% in 12th Plan as compared to 37% in the 11th Plan and 25% in the 10th Plan. This indicates increased PPP projects/participation in future.

To read report in detail: INFRASTRUCTURE DEVELOPMENT


>Larsen and Toubro - Call to order: Policy, demand hold key; company update; Buy

We analysed key verticals like Power, Metals, Hydrocarbons and Infrastructure to gauge the depth and diversity of L&T’s order intake. Our bottoms up analysis deduce that the order intake in FY13E-FY14E would grow at a CAGR of 11%-12%, led by a recovery across segments. We foresee strong growth in Hydrocarbons, Power T&D & Railways over FY13E-14E, given strong project pipeline & L&Ts clear focus. While policy traction will remain critical on various issues including coal & land availability etc, overall demand sentiment will also play a major role to determine the extent of industrial capex recovery. We maintain Buy with a TP of INR 1528.

Bottoms up imparts visibility for order intake growth
We appraised projects in key verticals like Process, Power, Infrastructure, Hydrocarbons etc to review our FY13E & FY14E fresh intake assumptions. While we could gather confidence regarding overall new order intake growth of 10-11 % over next two years, we believe Hydrocarbons, Power T&D and Railways (DFCC+Metro) will support order inflow growth in the coming years.

Policy traction, demand sentiment hold key to recovery
 As interest rates begin to come down, we remain optimistic about higher spending by the private sector. However, we also believe that policy action by the government in key areas like coal, iron ore, gas and environmental clearances would be critical to lift the sentiment as well as industrial capex hence this is the number one variable for the sector.

Outlook and valuations: Positives loom large; maintain ‘BUY’
We continue to consider L&T as a benchmark indicator of the domestic industrial capex spending. Given the rate reversal and expected policy clarity in issues like coal, mining and large project clearances, we remain positive on the company over the next 12-15 months. Moreover, value unlocking in subsidiaries like IDPL and the sale of switchgear business etc could further support the stock which currently trades at a P/E of 15.8x and 13.9x on FY13E and FY14E earnings respectively on a consol basis. We maintain BUY/SO rating on L&T with a revised target price of INR1528 (earlier INR1457).

>Sterlite acquires 24.5% stake in Raykal

Sterlite Industries has purchased 24.5% stake in Raykal Aluminum (Raykal) for INR 2bn. Raykal owns prospecting licences (PL) in bauxite mines in Orissa which can potentially feed Vedanta Aluminium‘s (VAL) 1mtpa alumina refinery. Though directionally positive, we believe mine commencement is 3-4 years away considering approvals and mine development processes. With uncertainties in obtaining mining approvals in India and the back-ended nature of mine commencement, we think it’s too early cheer on this development. We maintain ‘BUY’ with a target price of INR146.

Sterlite acquires 24.5% stake in Raykal with option to go to 100%
As per media reports and the Form 6K filed with SEC, Sterlite has acquired the 24.5% stake of Dubal Aluminium in Raykal in February 2012; the balance stake is with Larsen & Toubro (L&T). This JV was formed to set-up a 3mtpa alumina plant but this project never materialized. Raykal holds PL allotted in 1992 for bauxite mines located in Rayagad and Kalahandi districts of Orissa (VAL’s refinery is in Kalahandi). The entire bauxite excavated will be available to Raykal/Sterlite. Sterlite also has the right to acquire the entire stake of L&T in Raykal based on certain milestones (100% equity stake for total consideration of INR18.1bn). As per media reports the mine includes some forest area (challenges in approvals) and has reserves of 250-280mt.

Outlook and valuations: directionally positive; maintain BUY
Our estimates indicate that VAL’s aluminium cost of production would reduce from current levels of ~USD 1,950/t to USD 1,750/t as a result of captive bauxite. Assuming the mine commences in 4 years, we estimate its DCF value at ~INR29bn based on estimated reserves of 250mt. At the Sesa-Sterlite merged entity level this would translate to benefit of IN10/share (versus Sesa CMP of INR188). However, considering the above issues of approvals and mine commencement, we are not incorporating this in our valuation. We maintain ‘BUY/SO’ recommendation with a target price of INR146. At CMP of INR101, Sterlite trades at FY13E EV/EBITDA of 3.1x.