India emerging companies - Why bother with small/mid-cap stock selection? :: Standard Chartered Research

 Reason #1: Under-researched stocks = Higher returns. For similar improvement in RoEs, under-researched stocks
have generated better returns1. The Indian small/mid-cap (SMID) space has also produced the maximum number of 10
baggers over the past decade in the region2.
 Reason #2: It’s not just beta. Post GFC, correlations of the BSE mid-cap index vs the Nifty has been falling while RoE
dispersion within the SMID space has magnified3, making stock selection more important.
 Reason #3: Alpha generation. Macro-economic cycles can be played via sector rotation strategies, but stock selection
can be a dominant performance driver between cyclical turns4.
 What’s a winning strategy? Investing in small/mid-caps (1) with high RoEs or (2) where the stock is discounting a high
cost of equity (i.e., low PB/RoE) has proved to be the most rewarding strategy over the past five years5.
Is there a method to the SMID madness? We have assessed the predictive capability of 10 financial parameters over
the past five years. We rank the SMID universe using the four factors that our backtests reflect as the statistically most
influential drivers of share price performance (RoE, PB/RoE, EPS growth, RoE momentum). Our backtests show that
selecting the top quartile stocks based on our four-factor merit order would have led to 20% CAGR over five years from
2008 to 20126. Our findings largely align with our regional Emerging Company approach of identifying “Value Creators”
(Refer report Value Creators by Jeremy Sutch).

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Aditya Birla Nuvo
From asset aggregator to asset allocator
 We initiate coverage on Aditya Birla Nuvo (ABNL) with an
Outperform rating and price target of INR 1,465 based on a
20% discount to NAV.
 We believe ABNL is transforming itself from an asset
aggregator to an asset allocator. Recent management
decisions suggest a focus on improving portfolio returns.
 ABNL is in the top quartile of our SMID universe.
 Its P/B valuation (ex-Idea) is near an all-time low, while
returns (ex Idea/financial services) are near all-time highs.
 Multiple catalysts ahead: (1) new banking licenses, (2)
improvement in telecom tariff, (3) turnaround at Pantaloons
and (4) asset sales. We have not assumed upside from
these in our base case valuation.
 OUTPERFORM (unchanged)
Poised to improve portfolio returns. ABNL has a suite of
established businesses whose returns are poised to improve in
the next few years, in our view. We see significant improvement
at Madura Retail and Idea in particular (c.60% of SOTP). We
also think ABNL is poised to transform from an asset
aggregator to an asset allocator over the next few years.
Recent initiatives suggest management focus is on improving
RoEs incrementally. While the insurance business is likely to
see a decline in margins over the next few years, we estimate
that based on its appraisal value, ABNL has generated an IRR
of c.15% on the investments.
Catalysts ahead. We believe ABNL could benefit from multiple
catalysts over the medium term. Key among them would be (1)
issue of banking licenses, (2) improvement in telecom tariffs,
(3) turnaround at Pantaloons and (4) asset sales. We have not
assumed any upside from any of these catalysts in our
valuation and estimate that put together, these events could
add over 20% to our base case NAV.
Valuations not reflecting ABNL’s evolution. ABNL (ex-Idea)
is trading near an all-time low P/B even as operating returns (ex
Idea and financial services) rebound. ABNL is currently trading
at over 40% discount to its SOTP-based NAV of INR 1,828/sh.
Risks. (1) Adverse regulatory developments for telecom and
insurance businesses; (2) Slower-than-expected tariff
rationalization for Idea; (3) Disappointments from Pantaloons;
and (4) Risks to NBFC book led by capital market shocks.


Motherson Sumi Systems
Group synergies and capacity ramp-up up to drive returns
 Motherson Sumi Systems (MSSL) is evolving into a
preferred full-system solutions provider for global OEMs.
 With the bulk of its capex behind, we expect management
to focus on executing its robust combined order backlog of
EUR 3.8bn at SMP/SMR.
 We expect FCF to improve while the debt burden is likely
to decline from here on.
 Valuations at 10x FY15E earnings appear attractive, in our
view, given improving return ratios over FY13-15E.
 We maintain Outperform with a price target of INR 270.
MSSL remains one of our top picks in the auto space.
 OUTPERFORM (unchanged)
Evolving into a full-system solutions provider for global
OEMs. Given its leadership in three business segments (wiring
harnesses, rear-view mirrors and plastic components), close
presence to customers (124 manufacturing facilities in 25
countries) and focus on increasing content per car, MSSL is
slowly evolving into a preferred full-system solutions provider
for global OEMs.
SMR/SMP to be the key growth drivers. We believe capacity
ramp-up at SMR’s new facilities and execution of new orders
are likely to boost the consolidated performance – order
backlog of EUR 1.35bn with SMR and EUR 2.4bn with SMP.
Furthermore, rising capacity utilisation and synergistic benefits
within group companies are likely to boost consolidated
earnings (we factor in 43% earnings CAGR over FY13-15E).
Bulk of capex behind, returns to improve. The company has
made substantial investments in capacity expansion across
businesses to execute the new orders received from global
OEMs. It invested INR 11bn in FY13. With the bulk of capex
behind (FY14E at INR 6.5-8bn), we expect management to
focus on capacity ramp-up at these facilities. Hence, return
ratios are likely to improve from here on, in our view.
Valuation. We expect MSSL to post 43% earnings CAGR over
FY13-15E driven by a robust order backlog and steady
performances in all segments. With the bulk of capex behind,
debt is likely to decline. Valuations at 10x FY15E earnings and
4.5x EV/EBITDA appear attractive given improving return
ratios. We maintain Outperform with a 12-month PT of INR 270
- we value the standalone business at one-year-forward
EV/EBITDA of 10x, SMR at 6x and SMP at 5x. MSSL remains
one of our top picks in the auto ancillary space.


Amara Raja Batteries
Charged up
 Amara Raja is well-placed to capitalise on growth
opportunities, given leadership in the telecom/UPS
segments and strong No. 2 in autos.
 Driven by sustained demand in both the auto and industrial
segments and improved pricing power, we expect Amara
Raja to post an 18% earnings CAGR over FY13-15E.
 Valuations appear favourable post the recent correction,
given robust earnings growth, strong return ratios and
negligible leverage.
 We maintain Outperform on attractive valuations (10x
FY15E earnings), with a 12-month PT of INR 325, implying
22% upside potential.
 OUTPERFORM (unchanged)
Another solid performance in FY13. Amara Raja posted
strong 42% earnings growth in FY13, driven by 26% revenue
growth and 80bps margin expansion – after posting 45%
earnings growth in FY12. Amara Raja remained FCF positive
(INR 2bn in FY13E) despite an aggressive capex of INR 1.3bn
in FY13. RoCE also improved to 32%.
Investing for growth. To cater to rising demand for its
products, Amara Raja has earmarked capex of c.INR 7.6bn
over FY14-15E (to increase 4W battery capacity to 12mn from
6mn, 2W battery capacity to 8.4mn from 4.8mn, medium VRLA
batteries to 3.6mn from 1.8mn, and large VRLA to 1,000mn Ah
pa from 780mn Ah).
Outlook appears promising. Amara Raja sustained strong
volume growth in the auto segment in FY13 (20% in 4Ws and
37% in 2Ws). Furthermore, it is well on course to secure bulk
supplies from 2W OEMs, which is a key long-term positive. The
pan-India launch of Amaron/Powerzone tubular inverter
batteries and Home UPS is likely to drive revenue growth in the
coming years, in our view. Led by strong demand for its
products, improved pricing power and recent price hikes, we
expect Amara Raja to maintain its margins and post 18%
earnings CAGR over FY13-15E.
Reiterate Outperform. Following the recent stock price
correction (down 18% over the past three months), Amara Raja
is trading at 10x FY15E earnings and 6.3x EV/EBITDA, very
attractive given 18% earnings CAGR over FY13-15E. Even on
PBR versus RoE, it looks good at 2.5x FY15E book for a RoE
of 28%. Maintain Outperform with a 12-month PT of INR 325,
valued at 13x one-year-forward PER.



Mindtree
Good business but rich valuations
 Mindtree’s (MTCL) pedigreed promoter-management team,
strong clientele and a defined dividend policy differentiates
it from other mid-cap IT services players.
 Its ROE grew 16ppt over FY11-13 after it exited the capex
intensive white label handset manufacturing + a strong
margin expansion in core services (+880 bps).
 However, we believe the structural positives are priced-in
(PER at 17% premium to 5-year median); thus, we stay at
In-Line with INR 850 price target.
 FY14 margin management is the key challenge; pick up in
Product Engineering Services demand (31% of revenue) +
new large deal wins are key upside risks, in our view.
 IN-LINE (unchanged)
Core focus + better margin = high ROE. MTCL’s ROE has
improved by 16ppt over FY11-FY13 to 30% (versus mid-cap
average of 21%, source: Bloomberg). MTCL’s decision to move
away from capex-intensive white label handset manufacturing
in FY11 coupled with 880bps EBITDA margin expansion in core
services over FY11-13 has aided the ROE improvement.
Pedigree promoter-management. MTCL, a mid-cap IT
services company, was incorporated in 1999 by 10 industry
professionals who came from Cambridge Technology Partners,
Lucent Technologies and Wipro. The company has two major
revenue segments – IT services (ITS) and Product Engineering
Services (PES). It focuses on financial services, travel and
manufacturing industry verticals and counts KPN (Netherland),
Microsoft, P&G, Volvo and Morgan Stanley as key clients.
Strong tier-II play, but positives priced in. A strong clientele,
diversified services and vertical mix and a well-defined dividend
policy are key strengths that differentiate MTCL from other midcap
peers. Near term, MTCL expects FY14 USD revenue
growth to be better than FY13 on the back of USD 165mn TCV
deal wins in 4QFY13. However, we believe at 9x FY14E EPS,
much of the positives are in the price. We therefore stay In-Line
(No surprises, 22 April 2013) with INR 850 price target.
PES, large deal participation key upside risk. Contrary to
management’s view, we expect margins to be under pressure
in FY14 given visa and wage cost. Pick up in PES business and
new large deal wins will be key upside to our estimates. PES
has been a drag (-4% in FY13) while IT services (+5% CQGR
over 1QFY12- 4QFY13) has been driving growth. Further,
MTCL has had limited large deal participation thus far – only
one USD 100mn+ deal in 4QFY11. Management’s renewed
focus on large deal should help.



Indraprastha Gas
Strong fundamentals at attractive valuation
 IGL, a monopoly gas distributor in the National Capital
Region, is our preferred play on rising traffic with stable
margins. Its sales volume trajectory is likely to pick up, led
by the introduction of 2,500 buses and 45,000 new autos.
 The year-long suspense on the IGL-PNGRB case is to end
soon as the Supreme Court hearing nears completion. The
Supreme Court order will be a key trigger and we expect
the court to uphold the Delhi High Court (HC) order and
keep pricing to consumers outside regulatory control.
 The PNGRB council, in its appeal to the Delhi HC, also
contended that there is no specific provision in the PNGRB
Act to regulate selling price to customers.
 We expect the stock price to claw back to pre-tariff order
levels and also factor in improved fundamentals.
 OUTPERFORM (unchanged)
Sound operational performance to sustain healthy RoEs.
IGL’s focus on profitable growth continues unabated.
EBITDA/scm has improved to INR 5.7 for FY13, the highest
ever, despite the rising price of spot LNG (accounts for 23% of
raw materials). We expect IGL’s spreads to remain healthy,
supported by the rising price for competing fuel (diesel prices
up 20% since August 12).
We expect IGL’s profitability to also be supported by volume
pickup led by the addition of 2,500 new buses by the state
government in FY14E and likely addition of 45,000 new autos
going forward. Margin management and volume pick up are
likely to help sustain profitability and support RoE at c.25%.
End game is near. Media reports (source: Economic Times)
suggest that the Supreme Court hearing on the IGL-PNGRB
case is nearing completion. The regulator is contesting the
Delhi HC judgment which prohibits regulation of (1) network
tariff, (2) compression charges and (3) final selling price.
We also believe that selling prices will not be regulated as the
PNGRB council in its HC appeal also contends against any
specific provision in the PNGRB Act to regulate final selling
price. The Delhi HC judgment has categorically mentioned that
unless prescribed in the Act, as in the case of the Electricity
Act, price fixing is a clog in the freedom of trade.
All concerns built in, upside not. The Supreme Court order
will be a key trigger and we expect the stock price to claw back
to pre-tariff order levels of ~INR 400 and factor in improved
fundamentals over the past one year. Attractive valuation of 10x
FY14E PER and RoE of 26% provide downside support.
Reiterate OP.


Gujarat State Petronet
Excessive pessimism blurs core value
 The current price factors in extreme pessimism of (1) c.22
mmscmd volumes (same as 4QFY13) over the next two
years, (2) conservative tariffs of INR 850/tcm to perpetuity
and (3) sub-par returns on cross country pipelines.
 We believe GSPL’s core Gujarat transmission network
value would largely be intact as take-or-pay aided tariff
uptick would largely compensate for weak transmission
volumes; to generate 12% post-tax adjusted RoCE.
 We now factor in complete value destruction from crosscountry
pipeline given the weak gas supply situation as
also the extremely back-ended nature of the project.
 We moderate our volumes, but increase tariff assumptions.
Reiterate Outperformer with PT of INR 94 (from INR 101).
 OUTPERFORM (unchanged)
Extreme pessimism in the price. The current price factors in
extreme pessimism as it builds in (1) bear case transmission
volumes of c.22mmscmd, 4QFY13 volumes, for the next two
years, inching up to 31mmscmd by FY18E, (2) conservative
tariffs of INR 850/tcm (average over FY10-12 but much lower
than the INR 1,119 in FY13), to perpetuity given market
concerns about validity of ‘take-or-pay’ applicability and (3) subpar
returns for cross-country pipelines, in our view.
Core business value largely intact... Despite market
concerns on the value of the core Gujarat transmission network
(INR 115/sh), we believe take-or-pay led tariff uptick would
largely compensate for the soft volumes, thereby cushioning
earnings downside. GSPL’s earnings over FY11-13 have
largely remained range bound at c.INR 5bn despite gas
transmission volumes coming off at c.28mmscmd in FY13 vs.
c36mmscmd in FY11. The implied tariff uptick was INR
1,119/tcm for FY13 vs. INR 777/tcm for FY11.
Cross country pipeline returns to be backended. We now
factor in complete value destruction on the cross-country
investment (INR 34/sh being the total equity contribution) given
the weak gas supply situation and the expected backended
improvement. This is against earlier RoE estimate of 6%.
We tweak our estimates and PT. We moderate our volumes
to 26/28/30mmscmd for FY14/15/16E against our earlier
estimate of 34/37/40mmscmd. However, we raise our tariffs to
an average of c. INR 1,160/tcm over FY14-16E against the
earlier estimate of INR 880/tcm. Our new PT factors in a
negative value of INR 26/sh vs. INR 16/sh earlier.


IRB Infrastructure Developers
On the growth highway
 IRB Infrastructure Developers (IRB) is the dominant toll
road operator in the high-density, high-growth corridors of
Gujarat-Mumbai and Mumbai-Pune. We expect its toll
collections to grow 2.5x over FY13-17E to INR 35bn.
 Strong in-house EPC capabilities and a healthy balance
sheet place it in a leading position in the road space.
 IRB has picked up pace in 4QFY13: (1) traffic grew 5-10%
across all key projects, (2) two new projects commenced
tolling and (3) it guided to three more ongoing projects
becoming operational in FY14.
 IRB is attractive on both NAV- and earnings-based
methods: (1) the stock trades at FY14E P/E, P/B and
EV/EBITDA of 6.2x, 1x and 6.7x, respectively, and (2) our
PT of INR 233 is based on a 20% discount to NAV.
 OUTPERFORM (unchanged)
Playing the growth corridor. IRB operates most of the
Mumbai-Ahmedabad stretch (400km) on NH8 (the Delhi-
Mumbai part of the golden quadrilateral) and another 400km in
the Mumbai-Pune corridor. These are high-traffic density and
high-growth corridors. Once its ongoing projects are completed
by FY16-17E, we expect IRB to have 7,000 lane kms under toll,
handling 1mn PCUs/day and collecting INR 35bn in toll revenue
with an INR 20bn toll EBITDA (2.5x over FY13-17E).
EPC catalyst for growth and execution. IRB has the
strongest EPC capability in the road sector, in our view. Its EPC
division comprises 2,500 staff and has a gross block of INR 5bn
with investments in equipment and quarries for crucial raw
materials. This helps speed up execution, generate 20%+
EBITDA margin in the EPC division and meet cash flows for
non-dilutive growth. IRB has a strong balance sheet: it has INR
12bn in cash and its DE of 2.4x is comfortable for the
infrastructure sector. It had a dividend yield of 3.2% in FY13.
Picking up execution pace. IRB’s execution picked up
strongly in 4QFY13 on three counts: (1) All key projects showed
strong toll revenue growth with the Mumbai-Pune Expressway
growing 5% YoY, Surat-Dahisar 6% YoY and Bharuch-Surat
10% YoY. Overall, toll revenue grew 10-12%+ YoY. (2) Two
projects commenced tolling in 4QFY13 – Ahmedabad-Vadodra
and Talegaon-Amravati. (3) Other ongoing projects are making
strong progress: Amritsar-Pathankot is 80% complete, Tumkur-
Chitradurga is 75% complete, while Jaipur-Deoli has been
completed and is awaiting toll notification. Thus, we expect all
current projects to be operational in FY14.
Attractive valuations. Despite its strong performance, IRB is
trading at very attractive valuations. On earnings based
valuations, it trades at FY14E P/E, P/B and EV/EBITDA of 6.2x,
1x and 6.7x, respectively. We value the company at a PT of
INR 233, a 20% discount to our NAV of INR 291.