>ITC (ICICI SECURITIES)

Cigarettes to give kick

Budget announcement of nil excise hike for cigarettes is a huge positive for ITC; we expect its cigarettes segment to register volume growth of 5%, net sales growth of 19% and PBIT growth of 18% in FY10E. Complementing this growth, we expect the non-tobacco business’ PBIT to grow a strong 30% YoY in FY10E. Despite the recent run up in its stock price, ITC continues to trade at FY11E P/E of 17.7x, which is not only at a discount to its 5-year one-year forward median P/E of
19.5x but also attractive vis-à-vis peers. Re-iterate BUY and maintain our 12-month target price at Rs238/share.

■ Cigarettes – Expect 5%, 19% & 18% growth in FY10E volume, net sales & PBIT. We expect strong volume growth of 5% in FY10E on the back of nil excise hike and lower base. Due to base effect of price increases and new price hikes, we expect 6- 7% price growth in Cigarettes in FY10E (expect price hikes in some regional brands such as Bristol Filter in the short term). Also, while we expect Cigarettes’ gross sales to grow ~12%, nil excise hike will lead to ~19% growth in net sales and ~18% growth in Cigarettes PBIT in FY10E.

■ Concerns about VAT unwarranted for near term. With Budget announced for most states, we do not expect VAT to increase to 20% in the short term for all states. VAT for cigarettes remains unchanged for the state of Punjab, as per Budget announcement yesterday. Uncoordinated efforts by states to hike taxes on cigarettes will not largely impact ITC due to: i) flow of stocks from neighbouring states ii) high pricing power enabling ITC to absorb the minor impact of VAT increase in few states.

■ Non-tobacco business – All well except Hotels. We expect Non-Tobacco sales to grow 13% in FY10E on the back of strong performance in the paper & paperboard segment. Notably, on account of lower losses in Other FMCG and margin expansion in Paper & Paperboard, we expect Non-Tobacco PBIT to increase 30% YoY. However, we believe Hotels would disappoint and expect 8% decline in FY10E PBIT of the segment.

■ Expect healthy Q1FY10 results. We expect 6.5% YoY volume growth and 25% net sales growth for Cigarettes in Q1FY10E. Overall, owing to poor performance in agri and hotels segments, we expect net sales to grow only 9%. However, due to strong margin expansion in Cigarettes, Agri and Paper & Paperboard, we expect strong PAT growth of 24% in Q1FY10E.

■ Attractive valuations despite recent spike. While the stock has run up 10% in the past two sessions, ITC trades at FY11E P/E of 17.7x, which is not only at discount to its 5-year median P/E of 19.5x but also attractive vis-à-vis peers. Reiterate BUY and maintain our 12-month target price at Rs238/share (FY11E EPS of 20x).

To see full report: ITC

>INDIA STRATEGY (MORGAN STANLEY)

A NEW BULL MARKET?

• New bull markets are started by favorable liquidity conditions and attractive valuations. At the start of the rally (which commenced in March 2009), we had both these ingredients in place. Bull markets make progress as fundamentals improve. Fundamentals can come in various forms,
such as technology changes, favorable demographics, etc., but ultimately all these changes imply upward revision in growth forecasts. The ongoing rally got a shot in the arm with the decisive mandate from the electorate in mid-May, raising hopes that the new government can usher in
reforms that can elevate India’s growth back to its potential rate (7-7.5%) and higher. The budget document and other actions of the past month seem to be affirming the initial faith imposed by the market in this development. So we may be well on course to an improvement in fundamentals. Hence, the question is whether we are in a new bull market. There are three obvious possibilities:

• 1) The bear market that started in January 2008 continues, and we were just in a bear market rally. This means that we will either see new lows or at least retest the October or March lows. This scenario is possible if global markets wobble, the policy stimulus falls short of requirements,
and there is a drought. The bear case in our outlook for the BSE Sensex (9718) brings us close to this scenario, though not precisely to its March low.

• 2) What happened between January 2008 and March 2009 was a correction in the bull market that began in 2003. This scenario seems least probable given the extent to which the market fell in the 14 months from January 2008. At 61%, it was the worst fall of any bear market of the
past. The market convincingly broke its 200 DMA and stayed there for a reasonable amount of time. We had four successive falling tops and bottoms as well. The length of the correction at 61 weeks fell short of historical standards (except for the bear market of early 1990s, which
lasted for 55 weeks).

• 3) A new bull market began in March 2009. The market is now well over its 200 DMA, the breadth has been strong, and the gains are reminiscent of nascent bull markets of the past. The market is up 69% in from its March 2009 low. This compares with 37%, 27%, 25%, and 47% in the first 18 weeks of the previous four bull markets over the past two decades. In our bull-case scenario, the Sensex hits a new high over the next 12 months.

• What do we need to be sure that this sustains as a new bull market? The key difference between the 2003-08 period and now is that global growth is no longer supportive. To that extent, it needs an extra policy push to pull India’s growth rate back to 8.5%. In the near term, a bad monsoon or bad global outcome could delay or derail the fledgling bull market. The skeptic may argue that this “bull market” has not produced new leadership that is normally associated with new bull markets. The best-performing sectors are not different from the sectors that led the previous bull market. For that matter, the worst-performing sectors are the same, namely, Consumer Staples, Technology, and Healthcare. The jury is out on whether this is a new bull market given the lack of new sector leadership, i.e., this could still be a bear market rally. It may take time to confirm the rally (since March 2009) as a new bull market, and it is quite possible that sector leadership changes as this becomes a full-fledged bull market. Our bet is that the consumer will lead the charge and hence consumption sectors such as Autos, Media, Education, Retail, and midcap Staples could be the next bull market’s leaders.

To see full report: INDIA STRATEGY

>DEEPAK FERTILISERS AND PETROCHEMCIALS CORP LTD (GEPL)

OVERVIEW
The Indian chemical industry is all pervading, with chemicals finding applications in a variety of spheres. Having clocked around 8% CAGR growth over the last three years, it is undoubtedly one of the fastest growing sectors and is slated to double in absolute value terms in 2011 when compared to 2005.The Indian fertilizer industry, presently about 22 million tones is the third largest fertilizer producer in the world and constitutes 14% of the global production. Pick of the Week, this week is Deepak Fertilizer & Petrochemicals Corporation Limited (DFPCL), a company that is poised to cash in on the expected upswing in both these sectors. The company is one of the leading manufacturers of industrial chemicals such as methanol, ammonium nitrate, iso propyl alcohol, concentrates of nitric acid, propane liquid carbon-dioxide to mention a few. The company is one of the largest manufacturers of prilled Nitro Phosphate fertilizer and these products are marketed under the brand name Mahadhan. It has recently constructed a specialty mall Ishanya in Pune for interiors and exteriors thus bringing the architects, interior designers, manufacturers / retailers of interior / exterior products under one roof.

INVESTMENT RATIONALE
The company has an extensive product portfolio catering to an array of industries - agro-chemicals, defense, infrastructure, metal treatment mining, pharmaceuticals to mention a few. Owing to the nature of its manufacturing process, the company enjoys the operational flexibility to optimize its product mix depending on the future demand and supply scenario.. This product diversity thus gives DFPCL the flexibility to variate among its products and be in line with the market developments and de risk itself from commodity cycles. The company has technology tie ups with leading manufacturers which gives it the know-how for manufacturing some of its products like ammonia, AN, nitric acid, IPA, and bulk fertilizers. This is further supplemented with an enviable marketing and distribution network for timely supply of its wide range of products across the country. All these capabilities have endowed the company with considerable internal resilience, giving it the chance to rake in profits by concentrating its efforts on the growth opportunities, despite operating in cyclical markets.

The demand for DFPCL products have been rising but the company has not been able to match it through it’s in house capacity owing to a shortage of gas, thus leading to grossly underutilized capacity levels, forcing the company to fulfill the demand by importing (certainly more expensive when compared to producing at its own facilities) & trade (with marginal profits) in the same. This scenario is all set to turnaround hopefully by early next year – as increased domestic gas finds is expected to guarantee a continuous supply to fertilizer manufacturers, thus increasing production levels which leads to increased capacity utilization. The company is developing special crop specific and soil specific micro nutrients in order to give better yield to users. The companies umbrella brand Mahadhan, enjoys strong brand recognition & loyalty, thus enabling it to command premium over other players.

The current trend is to have a complete solution available under one roof. Identifying this opportunity particularly in respect to the office & home décor segment the company has set up a specialty mall Ishanya to take advantage of the growth expected in interiors & exteriors market. Ishanya is also expected to generate considerable income from non lease activities. Income from this venture is expected to contribute substantially in the future.

INVESTMENT CONCERNS
High volatility in input prices and uncertainty as regards to gas availability and pricing is a cause for concern. Companies trading activity (mostly fertilizers) depends on the market dynamics in the future.

VALUATIONS
At the CMP of Rs.74, DFPCL trades 4x its FY10E earnings of Rs.19. Long term investors can add more DFPCL to their portfolio.

To see full report: DFPCL

>INDIAN BANKS (CLSA)

Coming of age

Private banks will emerge stronger

Despite the growth and asset-quality issues facing global financials, Indian banks are likely to sustain their structural growth trajectory, driven by an under-penetrated financial-services sector, a conducive economic environment and a supportive regulatory regime. We estimate a 17% credit Cagr over FY09-14 and believe the current credit cycle is fairly manageable.

Over the next five years, bond-market development will lead to commoditisation of credit and margins will mainly be a function of retail liability franchise. As the distribution network and technological infrastructure become basic requirements - which are insufficient to drive profit on their own - softer skills such as service standards and product innovation will be critical to enhance the franchise. Fee growth is likely to be healthy as a pickup in corporate activity further boosts retail-fee momentum. We expect industry consolidation to continue, but big-scale M&A activity is unlikely. Meanwhile, Tier II public-sector-undertaking (PSU) banks will lose market share at a faster pace. However, regulatory relaxation will help improve the industry’s overall profitability.

Private banks are better positioned to leverage the changing industry landscape, as their superior servicing skills and innovation will drive market share gains in retail liabilities, allowing wider margins. Their ability to generate higher fee revenue means a wider ROE differential between them and the public banks. Our customer survey of 100 small/medium enterprises and 300 individuals highlights evolving customer preferences, suggesting that private banks’ market-share gains are structural. Although a few PSU banks have bridged the technological infrastructure gap to some extent, our on-the ground study suggests that they are significantly lacking on the more important soft skills.

Private banks will continue to grow earnings ahead of their PSU counterparts over the next five years, even as the diversity in profitability increases. We expect the ROE differential between the two segments to expand to 500- 600bps, leading to further widening of valuation multiples. On a three- to five-year investment horizon, we prefer private banks, especially ICICI Bank and Axis Bank, which still offer rerating potential on the back of their improving liability franchise. Be selective on PSU banks, where management continuity remains the key risk. We prefer only Tier I PSU banks for long-term investment. Some non-banking finance companies (NBFCs) like Housing Development Finance Corp (HDFC), Infrastructure Development Finance Corp (IDFC) and Reliance Capital can deliver returns over the longer term as they have built strong liability franchise and domain expertise.

Investment ideas
Our analysis of long-term returns indicates that private banks offer the best positioning to play the continuing story of the Indian banking sector. Their low market share, coupled with their ability to gain more, promises sustained healthy growth trajectory over the next five years. In our view:

■ Private banks could rerate, barring a couple of banks that trade over 4x, even from current levels, as they sustain their healthy earnings growth trajectory and report improvement in ROE.

■ Returns on public-sector banks will vary significantly as the valuation range expands, unlike in the past when most PSU bans have traded in a narrow band. We believe select PSU banks could re-rate marginally from current levels as they maintain stable earnings growth with high ROEs.

■ Short-term variations in the overall-return scenario are possible, especially given the triggers in the form of movement of bond yields (especially for banks like Oriental Bank of Commerce and Corporation Bank, which have a higher proportion of holding in non-held to maturity (HTM) category and are vulnerable to mark-to-market hits), NPL issues (corporate blowout might lead to short-term underperformance for the lead bankers) and other near-term factors. However, in our view, longterm sustainable stock returns are likely to revert to about 20% for private banks and to mid to high teens for well-run PSU banks.

■ Excluding a structural slowdown scenario for the Indian economy, ICICI Bank offers the best risk-reward from a three- to five-year perspective owing to its presence across the financial-services space. ICICI Bank has recently reorganised its operating structure, aiming to improve
profitability, a move that may address the long-due investor concern of frequent equity dilution, stemming from sub-par profitability metrics. Trading at a discount to most of its peers, ICICI may see a structural rerating, if it is able to demonstrate an improvement in its operating metrics to match up with its peers. Over time, we expect ICICI to expand its footprint further into rural banking, micro credit, and even explore overseas M&A. A sharp economic slowdown can expose ICICI to faster changes in its business environment than it can manage, leading to structural pain points like NPL.

To see full report: INDIAN BANKS