>Indian Companies Likely to Reassert ROE Superiority

• Key Debate: India has always enjoyed a superior ROE relative to the rest of the world as well as emerging markets. Hitherto, this advantage has been driven by a combination of superior asset turn, a degree of overestimation of the life of assets driving down depreciation expense, inferior quality of earnings (i.e., book adjustments to shore up profits) and strong financial leverage effect despite low debt-equity. Strong cost cutting in the early part of this decade also helped the ROE cause. However, in the recent down cycle, India has lost most of its ROE edge. The key question is whether Indian companies will regain their ROE superiority which is critical to the premium valuations of their shares relative to the world?

• ROE drivers go through cyclical correction in 2008: The downturn in the previous growth cycle has taken India’s ROE gap with the rest of the world to a 13-year low (since our data series starts) of 2.6%. India’s key ROE drivers have gone through a sharp cyclical correction notably asset turn but profit margins as well. This analyses is based on the respective MSCI indices.

• Seven out of 10 sectors witness sharp fall in ROE: The ROE fall in 2008 is pretty pervasive across sectors with healthcare, industrials and materials leading the fall and technology, utility and telecoms holding up pretty well.

• Indian companies more geared than before: During the previous cycle Indian companies have increased net financial gearing which is now higher than its peer group in the emerging world as well as the Asian region. This has caused financial leverage effect to stay at high levels relative to the world and also cause a sharp upswing in interest expenses by the end of 2008 relative to EM and AXJ.

• Capex cycle strains balance sheet and return ratios: India’s margin superiority (an outcome of low costs) is intact though the gap has narrowed a tad in 2008. Indian companies’ EBITDA margin was 3.2ppt higher than the AXJ average in 2008. The biggest drop across the ROE drivers has been in the utilization of assets. Clearly, India’s big capex cycle in 2006 and 2007 has hurt asset turn. The capex cycle has also strained the balance sheet causing capital costs to rise and hurt return ratios.

• Earnings quality improves a tad: At the end of 2008, earnings quality seemed to have improved a bit as it had for the rest of the world. The gap in depreciation expense with the rest has also narrowed and, to that extent, some of the bad factors that drove India’s ROE superiority in the past have lost their influence. Pertinently, return on assets has dropped to a low point in history which shows how bad 2008 was for Corporate India.

• ROE superiority likely to return in 2010: As growth accelerates we expect India companies to reassert their ROE superiority versus AXJ and EM. The bulk of the relative performance should come from improving asset turn which should also set us up for a new capex cycle in 2011. Margin performance should also improve due to the cost cutting that Indian companies have undertaken in 2008 combined with the conducive macro environment. On that basis, India’s relative multiples to EM can sustain at the current 20%-odd levels in 2010.

To read the full report: INDIA STRATEGY

>EXIDE INDUSTRIES LIMITED (ALCHEMY)

ALL CHARGED UP!
We met the management of Exide Industries. Following are the key highlights: New opportunities offers visibility of ~15-18% growth till FY11E Exide expects the battery industry in India to more than double over the next five years. The company aims to grow at a faster rate than industry by eating into the market-share from the unorganized sector. The company has undertaken a host of new initiatives to gain market share. This includes:

■ Expansion of its existing sales network
■ Introduction of new products
■ Acquisition of two smelters to recycle lead from old batteries.

Exide could gain from stronger demand for inverters
We expect Exide to be a key beneficiary of stronger demand for inverters in near term due to rise in power deficit. Exide has over 40% share in the inverter market and derives about 15% of its total revenue from inverters at a higher margin.

Market Leader in OEM Segment
Exide Industries (EIL) is the largest player in the Indian auto battery industry with a market share of almost 77%.

EIL is also the biggest supplier to almost all OEMs in the Indian Auto Industry and thus the biggest beneficiary of the strong demand being witnessed by the auto majors in all segments.

The company supplies brands like EXIDE, SF, SONIC and Standard Furukawa in the domestic market. It exports brands like DYNEX, INDEX and SONIC.

Market Leader in Organised Battery Replacement Market
Around 50% of the battery replacement market is organised. In this market, EIL is yet again a market leader with 65% market share. With a higher margin in the replacement segment compared to margins earned in OEM segment, EIL continues to maintain higher margins compared to most of its peers.

Recommendation and Valuation
We have revised upwards our estimates driven by likely upside to volumes owing to strong demand in the auto sector and inverters and likely increase in market share owing to new products and sales network expansion.

Accordingly our EPS stands revised for FY11 from 7.4 to Rs8.0. The stock is currently trading at a P/E of 13.7xFY11E. We maintain accumulate on the stock.

To read the full report: EXIDE INDUSTRIES

>CAPITAL GOODS SECTOR (RBS)

While the outlook has improved in recent times, we feel stocks are trading at the upper end of their valuation bands and are unlikely to rerate further. Hence, we are Neutral on the sector. Stock picking is a judicious balance of long-term outlook and low risk in meeting near-term numbers. Thus, Buy BHEL and CGL.

Sector trading at the upper end of its valuation band; initiate coverage at Neutral
The capital goods and engineering space has seen a fundamental shift over the past six months, with a new government promising more on infrastructure, improved liquidity conditions and softer commodity prices. However, this structural shift is already reflected in share prices, in our view, and the sector is trading at the upper end of its valuation band, capping near-term upside potential. Stocks appear to be pricing in medium-term valuations, on a two- to three-year horizon. Hence, we initiate coverage at Neutral on a 12-month view.

Stocks unlikely to touch past valuation peaks, in our opinion
The bull argument for the sector, from a valuation standpoint, is that stocks are still trading well below historical highs seen in 2007, at which time valuations were explained by PEGs. While stocks may yet see some liquidity-driven PE expansion, we believe they are unlikely to repeat 2007 PEs when viewed from the PEG angle. If one compares the growth exhibited by these companies over FY05-08 with that in FY09-12F, one finds that sales, EBIDTA and PAT growth is much slower now. Similarly, the operating leverage story that played out in the earlier period will now be much more muted. Finally, the delta we saw in RoE and RoCE earlier is unlikely to be repeated because capital goods companies are themselves in capex mode. Slowing order books and stretching working capital cycles also means free cash flow generation is much lower than in the past. What is different this time around is the global cost of capital. At an all-time low, this variable is driving up the valuations of many sound companies. Could this be the dark horse in the valuation game?

Relative stock picking is the order of the day; Buy BHEL, Crompton Greaves
In the current scenario, we believe stock picking has become relative instead of absolute. Of the core bellwether stocks, BHEL and Larsen & Toubro, we prefer BHEL on a 12-month perspective. This is based on our view that downside risk is greater than upside, thus we advocate stocks with lower beta. While Larsen has multiple drivers to fire when the going is good, it is precisely this that increases its beta. Among the T&D stocks, we pick Crompton Greaves, because we believe the traditional valuation gap between Crompton and its MNC peers should shrink within the next year. The other key reason for choosing BHEL and Crompton is that we believe they are the least likely to disappoint in terms of FY11 numbers.

To read the full report: CAPITAL GOODS SECTOR

>CAMLIN FINE CHEMICALS LTD (GEPL)

OVERVIEW: Food shelf life is a primary concern for both food manufacturers and marketers. A food product’s ability to uphold standards of safety and quality for prolonged periods directly affects sales and customer satisfaction. Antioxidants are designed to reduce the development of oxidative rancidity which limits the shelf life of oils, margarine, snacks, dressings, meat products and other products. Apart from extending shelf life, antioxidants also ensure a consistent quality from batch to batch providing a minimum of variation in taste, odour, color and texture of the product. Consumer’s interest in and awareness of the health properties of antioxidants has been rising in recent years. Not only has this increased global sales of antioxidants (whether used as a food preservative or to provide a health enhancing or functional benefit), but demand for foods recognized as being naturally rich in antioxidants are also growing. One company which intensively understands the complex processes and interactions resulting from lipid oxidation in foodstuffs is Mumbai based Camlin Fine Chemicals Ltd (CFC) as it is engaged in manufacture of food antioxidants. Apart from manufacturing food antioxidants this company is also involved in manufacture of Industrial Antiocidram (used in industries like paints, polymers, resins and plastics), artificial sweetener (Sucralose), bio diesel additives, natural shelf life enhancers (used for fruits, flowers and vegetables).

INVESTMENT RATIONALE: In order to give an idea of the company’s plans going forward in the food antioxidants segment it shall be prudent to quote what the management has said in the annual report - “This business unit is the biggest contributor to the company in terms of volume and growth and the company is also the world’s largest manufacturer of Food grade antioxidants, TBHQ and BHA with market share of about 35% world wide and 70% in India. The company has laid out an aggressive plan for increasing world wide market share above 50% by making an entry into growing food processing markets like Asia, Middle East and South America”. Under the industrial antioocidarm, CFC has plans to launch three products which have already gone through trial runs and technology transfer at plant levels. Seeing the huge market potential for these products the company has already created adequate capacity for these products. The artificial sweetener business of the company also has a bright future because of the growing health awareness. Sucralose, the new age sweetener has begun business in South America, Europe, India and Central America. CFC has filed a process patent for this product.

The company is also involved in manufacture of products under bio diesel additives segment which enables stabilizing of the fuel from oxidation. The world wide demands for these products are in excess of 70 million metric tones. The natural products preservation has been the focus worldwide. CFC has also ventured into this segment and has developed products, though under initial trials. This product shall help in maintaining color, freshness, aroma and prevents spoilage when in transportation and storage. The company expects to file patents for this and many more new products also. Through its subsidiary the company is also engaged in Nutraceuticals like gluosamine and its salts which are used as a supplement in bone management in conditions like osteoarthritis. The company has in the last three years grown at an average growth of 23% and this was primarily due to enhancing its product basket in the food antioxidants product range. One can expect this growth to be maintained in the near future as CFC has ambitious products in the pipeline to be launched soon.

INVESTMENT CONCERNS: Delay in product development could affect future growth and Competition from China could be a major cause of concern.

VALUATION: At the current market price of Rs.65 CFC’s projected FY 10E EPS of Rs. 9.1 is
discounted 7x. Long term investors can add this to their portfolio.

To read the full report: CAMLIN FINE CHEMICALS