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India Equity Research Reports, IPO and Stock News
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Strategy
A matter of (anti)trust. The recent regulatory action by the Competition Commission
of India (CCI) against DLF, a real estate company, raises the possibility of regulatory
intervention in some other sectors where we see possible anti-competitive practices or
abuse of dominant positions. We identify the cement and oil and gas sectors as the
most vulnerable to potential regulatory action by the CCI. Valuations of several stocks in
these sectors do not factor in potential regulatory risks.
CCI is no longer a toothless entity; it has wide powers to penalize unfair trade practices
The recent regulatory action by the CCI against DLF for using its dominant position to impose
unfair conditions on its customers shows that the CCI is willing to utilize its powers to penalize
companies indulging in unfair trade practices. This may have significant implications for several
sectors, in our view. The new competition law has become fully enforceable from June 1, 2011
after years of delay; the law itself was enacted in January 2003.
Competition law may clash with Government policy and other regulations in a few cases
We see several cases where the competition law may be at odds with the prevalent Government
policy. For example, the Government’s policy to sell certain fuels below market prices may be an
example of predatory pricing even though it has certain social objectives. Similarly, the higherthan-
regulated returns of the Indian gas transmission and distribution (T&D) sector raise questions
about the efficacy of current regulations.
Cement and energy sectors most vulnerable to regulatory intervention, in our view
A steep increase in cement prices and their sustenance at high levels despite weak fundamentals
raises suspicions about price collusion. There are no such doubts in the Indian oil and gas sector
with the Government-owned companies fixing prices of auto and cooking fuels jointly and selling
them below cost, a clear case of anti-competitive and predatory pricing. The higher-than-regulated
returns of the Indian gas T&D companies suggest a possible abuse of dominant positions in the
absence of proper regulatory supervision.
We strike a cautionary note, whether or not these sectors are under the scanner
We note that valuations of Indian cement and gas T&D companies do not factor risks to earnings
and valuations stemming from any potential regulatory action by the CCI. We do not know if the
CCI will investigate the above-mentioned issues at all. However, we see severe negative
implications for earnings and compression in multiples if it is proven that the companies have
indeed indulged in anti-competitive practices; penalties would be additional.
The facts and the risks: A cautionary tale
Our analysis of CROCI and ROE of the top companies in the major sectors in India
shows that their return on investment has been very high historically. (1) High entry
barriers (general difficulty of doing business in India favors incumbents), (2) limited
competition, (3) slack regulations and (4) a benign taxation regime have allowed companies
to earn returns well above WACC or COE or ‘reasonable’ returns. We compute the average
CROCI and ROE of the companies in the BSE-30 Index at 19.9% and 19.4% in FY2006-11.
We expect changes to all the aforementioned factors over a period of time, which may
result in lower financial returns compared to historical levels. We have indeed seen a decline
in ROE (see Exhibit 1 that gives the ROE of the BSE-30 Index companies) and CROCI (see
Exhibit 2) over the past few years due to (1) enhanced competition (automobiles, telecom),
(2) withdrawal of tax exemptions (technology, telecom) and (3) increasing maturity of
businesses (technology). We had examined these issues in detail in our March 15, 2010
report titled Good times may not last for a few industries.
In our view, the recent empowerment of the CCI may hasten the process. Even if the
CCI does not indict industries or companies for anti-competitive practices, we believe its
mere presence and fear of onerous penalties will likely curb potential anti-competitive
practices. We see several cases of anti-competitive practices in the country currently. In fact,
many of the extant regulations and policies of the Government of India perpetuate these
practices. It would be interesting to see if the CCI’s decisions (if any) challenge the
Government’s hegemony and regulations that artificially restrict competition in some sectors.
We believe two sectors—cement and downstream gas—are particularly vulnerable
to potential regulatory intervention. We are not making any claims that the companies
in the sectors are indulging in anti-competitive practices. Also, it is too early to comment on
CCI’s eventual role in reshaping competitive dynamics in various sectors; its role will likely
evolve over a period of time. We do not wish to indulge in undue speculation. However, it
would be best for investors to be aware of the risks from any potential regulatory
intervention, especially as valuations are quite expensive for several stocks in the
aforementioned sectors.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Strategy
A matter of (anti)trust. The recent regulatory action by the Competition Commission
of India (CCI) against DLF, a real estate company, raises the possibility of regulatory
intervention in some other sectors where we see possible anti-competitive practices or
abuse of dominant positions. We identify the cement and oil and gas sectors as the
most vulnerable to potential regulatory action by the CCI. Valuations of several stocks in
these sectors do not factor in potential regulatory risks.
CCI is no longer a toothless entity; it has wide powers to penalize unfair trade practices
The recent regulatory action by the CCI against DLF for using its dominant position to impose
unfair conditions on its customers shows that the CCI is willing to utilize its powers to penalize
companies indulging in unfair trade practices. This may have significant implications for several
sectors, in our view. The new competition law has become fully enforceable from June 1, 2011
after years of delay; the law itself was enacted in January 2003.
Competition law may clash with Government policy and other regulations in a few cases
We see several cases where the competition law may be at odds with the prevalent Government
policy. For example, the Government’s policy to sell certain fuels below market prices may be an
example of predatory pricing even though it has certain social objectives. Similarly, the higherthan-
regulated returns of the Indian gas transmission and distribution (T&D) sector raise questions
about the efficacy of current regulations.
Cement and energy sectors most vulnerable to regulatory intervention, in our view
A steep increase in cement prices and their sustenance at high levels despite weak fundamentals
raises suspicions about price collusion. There are no such doubts in the Indian oil and gas sector
with the Government-owned companies fixing prices of auto and cooking fuels jointly and selling
them below cost, a clear case of anti-competitive and predatory pricing. The higher-than-regulated
returns of the Indian gas T&D companies suggest a possible abuse of dominant positions in the
absence of proper regulatory supervision.
We strike a cautionary note, whether or not these sectors are under the scanner
We note that valuations of Indian cement and gas T&D companies do not factor risks to earnings
and valuations stemming from any potential regulatory action by the CCI. We do not know if the
CCI will investigate the above-mentioned issues at all. However, we see severe negative
implications for earnings and compression in multiples if it is proven that the companies have
indeed indulged in anti-competitive practices; penalties would be additional.
The facts and the risks: A cautionary tale
Our analysis of CROCI and ROE of the top companies in the major sectors in India
shows that their return on investment has been very high historically. (1) High entry
barriers (general difficulty of doing business in India favors incumbents), (2) limited
competition, (3) slack regulations and (4) a benign taxation regime have allowed companies
to earn returns well above WACC or COE or ‘reasonable’ returns. We compute the average
CROCI and ROE of the companies in the BSE-30 Index at 19.9% and 19.4% in FY2006-11.
We expect changes to all the aforementioned factors over a period of time, which may
result in lower financial returns compared to historical levels. We have indeed seen a decline
in ROE (see Exhibit 1 that gives the ROE of the BSE-30 Index companies) and CROCI (see
Exhibit 2) over the past few years due to (1) enhanced competition (automobiles, telecom),
(2) withdrawal of tax exemptions (technology, telecom) and (3) increasing maturity of
businesses (technology). We had examined these issues in detail in our March 15, 2010
report titled Good times may not last for a few industries.
In our view, the recent empowerment of the CCI may hasten the process. Even if the
CCI does not indict industries or companies for anti-competitive practices, we believe its
mere presence and fear of onerous penalties will likely curb potential anti-competitive
practices. We see several cases of anti-competitive practices in the country currently. In fact,
many of the extant regulations and policies of the Government of India perpetuate these
practices. It would be interesting to see if the CCI’s decisions (if any) challenge the
Government’s hegemony and regulations that artificially restrict competition in some sectors.
We believe two sectors—cement and downstream gas—are particularly vulnerable
to potential regulatory intervention. We are not making any claims that the companies
in the sectors are indulging in anti-competitive practices. Also, it is too early to comment on
CCI’s eventual role in reshaping competitive dynamics in various sectors; its role will likely
evolve over a period of time. We do not wish to indulge in undue speculation. However, it
would be best for investors to be aware of the risks from any potential regulatory
intervention, especially as valuations are quite expensive for several stocks in the
aforementioned sectors.
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