>Draghi’s announcement of Open Market Transactions (OMT) to support sovereign short-end bond markets

Key Takeaway
Following Draghi’s announcement of Open Market Transactions (OMT) to support sovereign short-end bond markets, global equity stock prices and volumes roared. The jump in share turnover after weeks of moribund activity signalled that investor conviction over a euro break-up and peripheral contagion has receded. However, the ECB did not cut rates and GDP forecasts
both for 2012 and 2013 were lowered.

Longer term, it is supply side reforms that both Draghi and equity investors will need to see, in the short-term, the ECB has bought the most precious commodity of all, time. We are reinstating our Long EuroStoxx short German bund trade. We continue to believe that the Scandinavian and Swiss markets will outperform the EU region as their central banks loosen rates faster to counteract the slowdown in economic growth. Investors appear to have missed
that Sweden cut rates again last week while Denmark flirts with negative nominal rates (see Scandinavia: Embracing unorthodox monetary policy, 3 September, 2012).

“It is easier to rob by setting up a bank than by holding up a bank clerk”, Bertolt Brecht
The disappointing US August nonfarm payrolls data (96,000) puts the spot light back on
the Fed’s meeting this week with the likelihood of extended rate guidance and possibly a
MBS QE program. We continue to recommend a long position in the S&P homebuilders
and building materials (see US: For the price of one HK carpark you can buy 5 US homes,
6 August, 2012). The weakness in Asian economic data has been reflected in Korean and
Taiwanese industrial production for some time but the evidence of an unwanted inventory
build-up seems to have been overlooked by investors. The week-end’s release of August
Chinese industrial production (8.9% y-y) and inflation data points (CPI 2% y-y, PPI -3.5% yy)
to further softness in GDP data and trade data for the rest of Asia. There is plenty of room
for Asian central banks to cut rates and of course for the BoJ to follow suit.

For the first time in many months, it was a bad week for bonds. It was a good week for stocks and more importantly for equity volumes. Draghi essentially took away the tail risks of an imminent currency crisis with the backing of all but one dissenting EU central bank. Although the EU sovereign crisis is far from over, Draghi has bought time for the EU to undertake the supply side reforms to manage the fiscal crisis. While he did not commit to yield or spread targets, the markets appear to have missed that once again he reduced collateral rules and made further comments towards inflation targets. While the EU crisis has manifested itself as a fiscal problem, the reality is that there has been underlying balance of payments crisis. Ultimately, Europe like the US and the UK is going to have to run negative real interests for some time. Financial repression will be good for real returns of stocks versus government bonds, difficult for financials but extremely good for the lowest cost operators in each sector (see The long run, the short run and the in-between, 3rd Quarter 2012 outlook). Much like the transfer payments made between the core rich Europe to the periphery via TARGET 2, financial repression ultimately means changes in competitiveness between countries. Aside from changes in the exchange rate, higher inflation rates will ultimately erode competiveness if companies cannot make productivity gains quickly enough.

To read report in detail: INDIA STRATEGY

>ITC: Cigarettes - Steady profit growth in a pricing-driven quarter (JEFFERIES)

4Q12 was yet again a pricing-led quarter for cigarettes, with lower volume growth (<5% YoY) but much stronger margins (+210bps YoY) - clear evidence of ITC's pricing power and unique cost structure. We see the price-volume trend diverging further in FY13, post the sharp excise duty hikes, but expect overall segment profit growth to remain intact at 19%. Maintain Buy.


Cigarettes - Steady profit growth in a pricing-driven quarter: Cigarette revenues grew 11% YoY, slightly below expectations although EBIT growth at 20% was in-line. The impact of price hikes (beginning of 4Q) appears to have been higher than forecast on volumes (sub-5% growth, weaker than expected), as well as margins (31%, 140bps above estimates) - both effects offsetting each other. This is yet another indication of ITC's pricing power and cost structure in this business, which allows the company to pass on cost pressures (in the form of higher duties) and keep profit growth intact. We see this trend continuing in FY13 and expect the recent increase in excise duties (c22% YoY per stick on average) to be passed on, with a corresponding impact on volumes (-4% YoY in FY13E). Overall, we make marginal changes to our cigarette segment estimates (revenues and EBIT +2-3%) as most of the excise duty hike was already factored into our estimates.


Other businesses - FMCG losses narrow, capacity constraints in paper: The FMCG segment fared better than expected, as revenues grew in-line (+23% YoY) while losses were a third of our forecast. While improved profitability in the foods segment contributed, we believe a large part of the beat was due to lower ad spends - a trend witnessed in the rest of the industry as well. We do not expect these low levels of media spend to sustain, and keep our forecast for FMCG losses unchanged (Rs1.5bn in FY13E).


The paper segment was weaker in 4Q (revenues +7.4% YoY) mainly on account of capacity constraints and a relatively high base. With new capacity scheduled to contribute in FY13E, we expect revenue growth to recover going forward (+17% in FY13E, vs 13% in FY12). The hotels segment continued to be weak as revenues declined 5% YoY. Weak sentiment combined with increase in supply has likely impacted ARRs. We reduce our forecasts for the hotel segment (FY13E EBIT -9%) given the current run-rate.


Valuation/Risks
We raise our EPS estimates by c3% and roll forward our SOTP-based TP to FY14E. We value the cigarette business at Rs 207/share (25x FY14E, in-line with FMCG peers). Risks a) deterioration in cigarette regulatory environment, b) significantly higher losses in FMCG.


To read report in detail: ITC
RISH TRADER

>BHARAT FORGE LIMITED (JEFFERIES)

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.


Valuation/Risks
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
RISH TRADER

>ASHOK LEYLAND: Commercial vehicle demand has been surprisingly resilient this year

Volume revival in a steady market: Commercial vehicle demand has been surprisingly resilient this year despite a considerable slowdown in the economy. Underlying indicators, mainly related to the health of financiers’ CV loans, operator profitability and freight rates, continue to be healthy. Therefore, we view this as a mid-cycle slowdown rather than the beginning of a new down-cycle, and expect the industry to grow at high single-digit/low double-digit rates in the medium term. Amid the general strength in the market, though,
Ashok Leyland's (AL) volumes have suffered largely on the back of weak demand in the southern region and production issues at its Uttaranchal plant. We see a reversal in both of these factors - demand in south seems to be bottoming out, while production rampup at Uttaranchal should accelerate in the coming months. We expect AL’s MHCV volumes to grow at 10% p.a. in FY12E-14E. Aided by mix improvement/pricing and growth in nonvehicle businesses, we forecast revenue growth of 15% p.a. over FY12E-14E.


Profitability and cash flow to improve: Weak volumes and high commodity cost pressures have impacted AL’s margins in FY12E (-c150bps YoY). Going forward, we expect operating leverage as well as benefits from its tax-exempt plant to boost margins (c160bps expansion over FY12E-14E). Balance sheet health, on the other hand, is also set to improve as the company passes the peak in capex spends/JV investments. Lastly, we also forecast an improvement in its working capital cycle, which in the past few quarters has deteriorated on account of production mismatches and weak volumes.


Valuation/Risks
Our PT of Rs37 is based on an EV of 7.5x FY13E EBITDA (typical mid-cycle multiple). AL currently trades at an EV of 6x FY13E EBITDA, below its historical average. With revenue growth of 15% p.a. and EBITDA growth of 24% p.a. over FY12E-14E, we see significant potential upside to current valuations. Moreover, we observe a strong correlation between AL’s P/B multiples and return trends. Given our expectation of improving returns (25% in FY14E vs 17% in FY12E), we expect the stock to re-rate going forward. Risks a) a sharp decline in the CV industry and b) intense competition from new players


To read full report: ASHOK LEYLAND
RISH TRADER

>INDIA EQUITY STRATEGY: Rural growth - increasingly a mixed bag

India’s stellar rural growth is about the most consensus, verging on nearly unanimous, theme for investors in financial markets. Risks emanate precisely from this fact that rural growth is perceived as almost completely unaffected by the sharp slowdown in the rest of the economy. Early indicators and logical analysis of its drivers imply at least some caution in investments in the stock market.


Rural analysis – “mural” analysis
Plurality of rural India helps develop legends that make any report on the subject a captivating read right from the start. There are anywhere between 600,000 and 1 million villages in India with a combined population of over 700-million people. For anyone who starts by categorizing this continent-sized population as a single group, the first touch with the life in villages proves breath-taking, amid other things in its sheer diversity.


Less data, more pictures and anecdotes
It’s in the same unfathomable variety of rural India, the seeds of highly subjective and touchy-feely analysis are born. The reality is that there are extremely few real-time, objective data points on the economic life of rural Indians. All survey-based information on important parameters like land transactions, employment, wages or even expenditures on key consumables are generally available only sparsely and that too after long delays.


As a result, rural economy analysis has taken a highly pictorial form in the equity market industry in the last few years. A top-down discussion of the logical drivers of the rural economy are almost universally supplemented by the photos of well-paved roads, nicelybannered village shops or hard-working farmers with their gadgets or vehicles to prove the progress in the sector.


To be clear, photos replace charts in India’s rural economic discussions not just to make the reading more impressionable but mostly out of necessity of not having real-time data. The downside of the approach is obvious: a photo-based analysis is unlikely to show whether this diverse segment is growing at twice the speed in the previous period or a half. The long-term trends of better current state of affairs over the state many moons ago dominate the stories with little possible work on most recent trends and whether they are already in expectations or not.


As this report is not to introduce the sector or talk about its long-term trends or potential, but on marginal analysis – ie, whether growth in the periods ahead is likely to be lower or not – we will have to return to the traditional methods of available quantitative evidences and logical arguments.



Rural-only signals: some warning flags
All the above charts are for consumption across India and not just in rural provinces. The market is well aware of slowdown in the urban region which is likely the primary driver of most above series. The key question, of course, is whether there is any meaningful rural economic deceleration.


As we discussed above, there are extremely few real-time signals covering the vast rural economy. The two most encompassing, useful indicators are agricultural credit related data and tractor sales. Out of this, the former is definitely worrying. At below 8% YoY for the last two months, agricultural credit is growing at the lowest rates in over 15 years. More worryingly, there is a sharp increase in the sector’s non-performing assets with the largest State Bank of India.



Consumption is slowing – is it all urban?
It is true that India’s ongoing slowdown is led by the plunge in corporate investment cycle. That said, the associated impact from lack-of-supply caused inflation, high interest rates and reduced optimism have also begun to impact consumption. At around 6%, consumption growth is persisting close to the lowest levels seen in years. As the break-up of GDP growth also shows, all non-service related sectors (linked more to the rural economy) are decelerating sharply in recent quarters.





Main issue: investor expectations
Allow us to repeat one more time: for the vast and diverse rural India, the above evidences are scant and far from categorical in their conclusions. Painting a 700-million+ people segment with one boom or slowdown brush is simplistic in extreme even with best possible information. One can easily tell the rural tale even today with the same arguments that have been made repeatedly in the last five years to show that all is well. After all, there has been a great monsoon. Crop prices are still rising. Rural wages continue to benefit from government policies. And there are productivity increases. And even the most pessimists cannot claim that rural land prices, unlike urban property, are coming down.


The stock market conclusion is less ambivalent than the actual and potential rural growth trajectory because of the role played by lofty and unanimous expectations. We have created a basket of 15 stocks from the largest listed non-financial stocks that are generally considered a proxy on rural demand. As the following charts show, the basket has not only outperformed the benchmark handsomely in the last 18 months, the valuation premium too has expanded to the highest level in at least eight years.


To read the full report: EQUITY STRATEGY

RISH TRADER

>Equity Strategy: On longer, higher, cleaner growth (JEFFERIES)

Key Takeaway

To us, the Indian economy is off the celebrated 8%+ growth path. And now this should be the number one economic concern. The causes are not all in the global environment. We present a basket of signs to point that something is amiss. More importantly, we discuss what we deem as the true drivers of longterm growth and what policy action is needed as a solution. Until efforts are

being made to address growth, or we see signs of global stability, we maintain our defensive bias on equities.

Needed first and foremost – an admission that growth is off: We study the past relationships of 12 high frequency domestic economic indicators with GDP. All of them suggest that current domestic growth is likely lower than the headline published GDP growth with more slowdown ahead.

All other economic indicators imply that it doesn't feel like 7.7% GDP growth

To read more >>

>India Property Initiating Coverage: Cheap. Really? (Jefferies)

Key Takeaway

Property sector investment at inflection point is all about getting the timing right and fraught with risks. We are not trying to make a call on the cycle turning from here but presenting a case for remaining selective while investing in the sector given the far-reaching structural changes. We initiate coverage on eight companies with Oberoi Realty as our top Buy and DLF as our top

Underperform.

A free meal, no more

2011 has provided enough empirical evidence of a structural shift over the past five years. The shift to construction linked payment and buyers becoming selective has made development more capital intensive. Cheap land acquisition, a major value creator earlier, is no longer as lucrative with land owners demanding share in conversion gains. Increasing construction costs and manpower shortages are hindering growth prospects. Regulatory interference is rising and both equity and debt has become scarce and expensive. As a consequence the business is no longer as profitable as it used to be.

There will be new industry leaders that will emerge in this new era and the critical success factors will now shift to a) clean and converted land banks, b) strong balance sheets, c)

execution strengths, d) transparency, and e) lower litigation risks.

Challenging times ahead

After two years of strong volume growth across most cities, we are at the cusp of a cyclical volume slowdown. Recent trends indicate that residential volumes are beginning to slow down with a 14% YoY drop in All-India June-11 volumes on rising mortgage rates and alltime high property prices. With developers’ reluctance to cut prices, we believe that volume recovery will get pushed into 2H FY13. We expect a significant slowdown in Mumbai and Gurgaon volumes while Bangalore, Chennai and Pune expected to perform relatively better in FY12.

No gain in being bold

Realty sector has underperformed without any de-rating with consensus continuing to remain bullish on growth prospects and FII ownership at all-time highs. MSCI real estate index is up only 6% since Mar'09 and has underperformed both the autos and staples which are up 234% and 62% respectively. Despite that real estate sector has not seen any valuation de-rating vis-à-vis these sectors. Additionally, timing was critical for stock returns in the real estate sector. If one was a few months too early or late in catching the bottom for real estate stocks, most of the 2009 out-performance would have been lost.

Initiate coverage on the sector

Being selective remains the key to investing in the sector and we like management with positive cashflows, stronger balance sheets and low risks. We initiate on Oberoi, Sobha and Prestige with Buy ratings, Godrej properties and Unitech with Hold ratings and DLF, IBREL and HDIL with Underperform ratings.

To read the full report: India Property