The cash flow conundrum for India Inc :: Ambit

The cash flow conundrum for India Inc
Management decisions, more than external factors, drive RoCE (which,
in turn, appears to be the primary fundamental driver of share prices).
Our analysis shows that returning cash to shareholders is the most
powerful driver of RoCE. Unfortunately, we also find that Indian
corporates are amongst the most reluctant in the world to return cash.
In this note, we highlight 30 BSE200 firms that have consistently
delivered high RoCEs over the last ten years. We reiterate our BUY
stance on HCL Tech, Bajaj Auto, Sun Pharma, Asian Paints and
Cummins India. Also, CRISIL, Nestle, Lupin, Ipca Labs and GSK
Consumer find a place in this year’s iteration of our ten-baggers note.
Firms respond differently to the same external environment
We often find that within the same sector, some firms rise and others fall even
though they are subject to the same economic and regulatory forces. This is
exemplified by TVS’s fall as compared to Bajaj Auto’s rise or HCL Tech’s rise vs
Infosys’ fall. Moreover, we find that the dispersion in firm-level performance
over time is lower than the dispersion in performance across firms at a point
in time (see page 4). This suggests that business cycles or other externalities in
themselves do not produce as much variation in corporate performance as
company-level decisions for a universe of firms.
RoCE measures firm-level performance the best
Whilst management teams have a natural desire for growth and scale, growth
creates shareholder value only until the returns on capital exceed the cost of
capital. RoCE, therefore, is of utmost importance in assessing a firm’s
performance. Empirically, share price performance also supports the primacy
of RoCE as a share price driver (Exhibit A).
Capital allocation is the key to superior RoCEs
Each of the following capital allocation choices impact RoCE (Exhibit B):
 Business expansion (organic - capex; inorganic - acquisitions),
 Returning cash to stakeholders (dividends, share buybacks and debt
repayments), and
 Doing nothing (letting cash build up on the balance sheet).
Whilst, on one hand, unbridled expansion hurts RoCE, hoarding cash
compresses RoCE (Exhibit C). We find that returning cash to shareholders is
often the best way to improve RoCE. Unfortunately, we also find that Indian
firms are amongst the most reluctant in the world to return cash to
shareholders.
Investment implications: Focus on the kings of capital allocation
Sustaining superior RoCEs over long periods is not easy, but we highlight 30
BSE200 firms that have consistently delivered high RoCEs over the last ten
years. Of these, we have bottom-up BUYs on HCL Tech, Bajaj Auto, Sun
Pharma, Asian Paints and Cummins India whilst CRISIL, Nestle, Lupin,
Ipca Labs and GSK Consumer find a place in this year’s iteration of our tenbaggers note.

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Bottom-up BUY ideas
From the list of superior RoCE generators highlighted above, we reiterate five
bottom-up BUY ideas here:
HCL Tech: Whilst HCL Tech’s best-in-class RIM practice makes it the best
positioned amongst Indian peers to gain from the fast-growing re-bid-led RIM
market in the medium term, strong consulting capabilities in Axon position it better
for the longer term. Impressive hunting credentials in mid-sized clients over the
last eight quarters (CQGR of 3% vs TCS, Infosys and Wipro’s average of 2.2%) too
offer significant account mining opportunities ahead. Initiatives leading to
productivity improvement offer margin support. With the aggressive Axon
acquisition in 2008 and the best payout to shareholders (cumulative dividend as a
percentage of cumulative FCF), HCL Tech has been the best capital allocator
among tier-1 IT services firms, as indicated in our note dated, 6 June 2013,
’Capital allocation - the silent RoE killer‘. With an expectation of 20% EPS CAGR
over FY13-15, we value HCL Tech at Rs909/share, implying 13.5x FY14 P/E. We
retain our BUY stance.
Cummins India: Cummins is the number-one player in the non-auto engines
space in India due to its strong brand recall, superior product portfolio and
established distribution network. In the medium and large engine segment,
Cummins is an undisputed leader despite the longstanding presence of several
MNC players. We believe this is due to its three strong genset OEM partners who
help Cummins in providing excellent after-sales services and give Cummins a panIndia reach through their strong distribution networks. Nearly 80% of Cummins’
genset sales in India happen through these three genset OEM partners. The stock
trades at 15.6x FY14 P/E (at a 2% discount to its five-year average), 4.2x FY13
book value (4% discount to its five-year average) and 13.0x FY14 EV/EBITDA (at a
2% discount to its five-year average).
On capital allocation, Cummins has a phenomenal track record given that its RoE
has consistently remained above 20% in the last ten years (barring in FY04) with
average RoEs of 28% in the last ten years. At the same time, the company has also
maintained a healthy dividend payment ratio of above 30% for the past ten years,
with an average 57% in the past ten years.(Ambit_Cummins India_Company
Insight_Call option on recovery_27Feb2013)
Bajaj Auto: Whilst domestic motorcycle volumes continued to be subdued, we
expect the industry to recover in 2HFY14 and deliver volume growth of 6% in FY14
(vs flat YoY growth in FY13). Furthermore, amidst increasing competition in the
domestic motorcycle industry, we prefer Bajaj Auto due to: (a) its diversified
portfolio (with exports and 3Ws accounting for almost half of the company's
revenues); (b) its focus on premium motorcycles; (c) it being the distant secondlargest domestic motorcycle player with a market share of 23% in 1QFY14. The
company follows a frugal manufacturing strategy which involves outsourcing a
significant portion of the manufacturing operations (components) to a core group
of suppliers and it focusing on developing products/brands. As a result, the
company's average RoCE has significantly improved over the last ten years mainly
due to an improvement in the average capital employed turnover. The dividend
payout has been increasing (average of 50% in FY11-13 vs 40% in FY08-10) and
equity investments outside of the standalone business have been limited
(investments into the KTM and Indonesian venture totalling to 4% of the current
market capitalisation).
Sun Pharma: Sun Pharma has successfully transitioned from the commodity
generics segments to more niche segments such as dermatology and injectables
over FY05-13, thereby demonstrating its ability to spot growth opportunities and
ensure that the company is not overly dependent on specific segments for growth.
Sun has had a fairly successful track record of acquisitions in the US (unlike some
of its domestic peers) of turning around distressed assets and thus generating

value. This has enabled Sun Pharma to not only enlarge its product pipeline with
lower investments and leapfrog development timelines (e.g. URL Pharma and
Taro) but also establish strong beach-heads in lucrative US segments like derma
and generate best-in-class return ratios. We believe Sun’s presence in the branded
Indian formulation business as well as its growing stature in derma and the still
fledgling controlled substances business is likely to remain a source of sustainable
competitive advantage for the company. Also, the risk to Taro's profitability due to
increasing competition in key brands like Nystatin/Triamcinolone Acetonite are
likely to be offset by revenues from new products which are currently under clinical
trials. We reiterate our BUY stance on Sun Pharma.
The stock is currently trading at 29.2x FY14 earnings which is at a 27% premium to
its historical three-year average. We believe the premium valuations are justified
given its consistent track record of successful acquisitions, high profitability, and
extremely strong cash flows and return ratios. (Ambit_Sun Pharma_Initiation_Still
Shining_01Jul2013).
Asian Paints: The increased focus of Asian Paints’ management team on supply
chain efficiencies has helped it expand across product categories/geographies and
hence increase its market share amongst the top-5 players to ~53% in FY13 from
43% in FY06. Further improvements targeted for its distribution model combined
with scale benefits around brand building and operational leverage are likely to
see Asian Paints lead the product premiumisation trends in the sector. We expect
the firm to gain a market share of over 200bps, EBITDA margin expansion of
~200bps and EPS CAGR of 21.9% over FY13-18. Given that the stock currently
trades at 30.0x FY15E P/E, we see it as a strong growth stock with limited potential
for a further re-rating.
Also, note that the risk of its recent capital allocation decision of acquiring Sleek
could be the start of capital allocation decisions, which could negatively affect its
RoCEs in the future. (Ambit_Paints Sector Update_Asian Paints retains its
lustre_10Jul2013)