India 2014 Outlook: Cycle getting back in gear: IIFL

Cycle getting back in gear

The year 2014 will herald the beginning of a more broad-based
market rally and will be a better year for Indian equities. Most
macro variables, including real growth and current account, will
turn for the better, inflation will likely peak in the early part of the
year, and rate cycle will gradually become supportive. Quality of
growth will be better as a gradual turnaround in the investment
cycle will lead the recovery. The momentum in earnings
downgrade will reverse and there is a rising probability of an
upgrade cycle kicking in. Thus, the environment will be supportive
for a valuation re-rating. The key known unknown is the outcome
of the May 2014 elections and as of now, it is too close to call.
Investment cycle – turning around: Private sector capital formation,
the key swing factor in capital formation growth (down from +12%
during FY07-11 to -5% in FY14ii), will start to recover this year, driven
by an acceleration in execution rates. Given the large size of projects
under implementation (~US$1.4 trillion) a pickup in execution rates
from the current historic lows would by itself have a more-thanproportionate
impact on growth in capital formation.
Earnings, rate cycle - will be supportive: A continued slowdown in
demand side pressures, slower growth in wages, lower food inflation,
and a more stable rupee, augur well for mitigation of inflationary
pressures. The monetary policy will gradually turn more
accommodative. The turnaround in ex-agricultural GDP growth will drive
the recovery in Ebidta and net profit margins; in all likelihood,
FY15/FY16 earnings estimates will see upgrades.
Portfolio positioning - cyclical bias: In the backdrop of a broader
cyclical recovery, we overweight financials and domestic industrials. IT
and Autos are the other key O/Ws as we believe that both these sectors
will see positive earnings surprises. In contrast, FMCG will be negatively
impacted due to the consumption slowdown and earnings momentum
will be weak. Apart from FMCG, Energy is the other key underweight,
given lacklustre growth.

Top􀀃large􀍲cap􀀃buys
􀅂 Dr􀀃Reddys􀀃
􀅂 Hero􀀃Motocorp􀀃
􀅂 ICICI􀀃Bank􀀃
􀅂 L&T􀀃
􀅂 Wipro􀀃

Top􀀃mid􀍲cap􀀃buys
􀅂 Crompton􀀃Greaves􀀃
􀅂 IPCA􀀃Labs􀀃
􀅂 The􀀃Ramco􀀃Cements􀀃
􀅂 Motherson􀀃Sumi􀀃
􀅂 Shriram􀀃Transport􀀃
􀀃
Dark􀀃horses
􀅂 Ashok􀀃Leyland􀀃
􀅂 Bharti􀀃
􀅂 Infosys􀀃
􀅂 SBI
􀅂 Sesa􀀃Sterlite
􀀃
Key􀀃overweight􀀃sectors
􀅂 Consumer􀀃Discretionary􀀃
􀅂 Financials􀀃
􀅂 Industrials􀀃
􀅂 Information􀀃Technology􀀃

Key􀀃underweight􀀃sectors
􀅂 Consumer􀀃Staples􀀃
􀅂 Energy􀀃
􀅂 Materials􀀃

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We believe that 2014 would be a much better year for Indian equities
for the following reasons:
1. The macro economic outlook will turn for the better. GDP growth will
pick up pace, current account will further improve, inflation will peak
in the early months, and the rate cycle will eventually turn more
supportive.
2. A revival in the investment cycle will lead the turnaround in growth ;
a likely pickup in execution rates from the current historic lows will
be the initial driver for the turnaround and in our view, growth will
be much more broad based and qualitatively better.
3. The downgrade momentum in earnings estimates will likely reverse
and the favorable turnaround in macro economic variables will drive
upgrades in FY15/FY16 consensus estimates; Ebidta and PAT
margins will likely trough out in FY14.
4. An improving macro outlook will mitigate the pressure from rising
NPLs in the banking system and the trend will stop worsening; credit
costs may still be high, but may not surprise on the negative side.
Valuations, which are at median or below median levels for large-cap
and mid-small cap indices, will likely see an expansion as earnings
upgrades start to kick in and cost of capital / equity risk premium comes
down. We assume that the global growth environment will be supportive
and price of risk will remain range bound at the current levels. The
outcome of May 2014 elections potentially remains a market moving
event and a determinant of a more sustained upturn in the growth
cycle; as of now, it is too close a contest to call.
GDP growth – improving outlook
After near halving of growth rates between FY11-FY14 from 9.3% to an
estimated 4.8%, we believe that growth rates will see a gradual
acceleration to 5.3-5.5% in FY15. FY14 will likely be the trough year in
the current growth cycle. A pickup in the capital formation cycle will
principally lead the recovery in growth; the consequent recovery in
industrial growth will have a benign impact on services sector growth.
Between FY11 and FY14, YoY growth in the industry collapsed from
9.2% to 1.6% and that of fixed capital formation from 14% to 2% (real
terms).

As we argue in the following section, a pickup in execution rates from
the current abysmally low levels will lead the recovery in growth in
capital formation. Exports will be an added engine of growth. In our
view, the cyclical upturn in investments would more than make up for
the potential slowdown in consumption growth. A sentiment turnaround
in the event of a stronger pro-growth political combination being elected
to power in the May 2014 general elections will accelerate the pace of
recovery and drive upgrades to FY16 GDP growth estimates.
Investment cycle – likely to turn around
As we highlighted in our 25th Nov13 note ‘Capex cycle – close to
trough’, we believe that the investment cycle is bottoming out and
capital formation growth will turn around in FY15. Household and
government capex have held up reasonably well through the current
slowdown. However, growth in private sector capital formation has
collapsed from an average of 12% in FY07-FY11 to an estimated –5% in
FY14 (in nominal terms). The reasons for the collapse in growth are well
documented; inter alia, these include policy inaction, mining bans as a
consequence of past irregularities, issues relating to fuel availability /
PPAs / health of SEBs for the power sector, the rising share of nonproductive
CWIP, weakening balance sheets, and a sharp downswing in
business sentiment. Not only have new project announcements hit an
all-time low at 3.5% of GDP (from the FY07-09 average of 40%),
execution rates (defined as projects completed in a year as a % of total
projects under implementation) are down to nearly a third of FY05-10
average.

While a turnaround in new project announcements is sometime away,
execution rates can pick up quickly if approvals are expedited or
sentiment turns around. Given the large size of projects currently under
implementation (US$1.4 trillion or 80% of GDP - 2x that of the FY01-03
downturn as % of GDP), even a retracement to historic median levels
would mean a more than 2x jump in execution rates and a concomitant
recovery in capital formation growth. As project completion quickens,
asset sweating, cash flows and capital productivity will all get better.

In the past few months, we have already seen some positive policy
action in the power sector: loan restructuring of large loss making SEBs
is complete, an improved model PPA is in place, a few FSAs have been
signed and approvals have been expedited. In the case of roads where
no construction has started in almost 8000kms of highway projects
awarded in the past two years, the government is trying to design a
package to alleviate cash flow issues for aggressively bid projects; a few
contracts may get cancelled as well, but either factors would help revive
the sector over the next 2-3 quarters. Faster environmental clearances,
now all the more likely with the change in the environment minister (the
earlier one was perceived to have created many roadblocks delaying
key approvals), will positively impact investments in the mining and
metals sector. The tailwind of improved export competitiveness and
faster growth in exports will be one of the drivers for a pickup in
manufacturing investments, although a broader sentiment turnaround
would be crucial to accelerate the pace.


Of course, for sustainability of the recovery a few more factors such as
more concerted government effort to expedite approvals for large
projects, better profit outlook, and lower cost of capital, have to fall into
place. More importantly, the May 2014 elections need to throw up a
stronger pro-growth political coalition to power as that can drive faster
improvement in business confidence and sentiment. All said it is fair to
say that the share of GFCF in GDP will rise in FY15 and it now looks
increasingly probable that this momentum will further gain strength in
FY16.
Inflation – sticky but peaking out
Of all, high inflation has been the biggest thorn in India’s flesh. The
disinflationary impact from a sharp slowdown in growth has had little
impact on headline inflation numbers as pressure from food prices have
remained unrelenting, despite abundant monsoon rainfall. However, we
believe that inflation is close to its peak for the following reasons: 1) the
momentum of unabated rise in vegetable prices (up almost 100% YoY
in WPI, 60% YoY in CPI for Nov-13) is now behind us; 2) the arrival of
new crop and a bumper winter crop should ease the price pressures on
cereals (up 11% YoY currently) even as prices for non food-grain crops
in general continue would see a downward bias; 3) although high wage
growth has already started to weaken both in urban and rural areas, in
our view it will continue to weaken; 4) a continued slowdown in
consumption momentum will further mitigate demand-side pressures,
5) rupee will likely be stable at 61-63/USD (as argued below) keeping
inflation from imported goods in check. As of now, the government still
seems committed to containing fiscal deficit close to budgeted levels,
although some slippage is inevitable, given the slowdown in revenue
collections.

While inflation may remain elevated in the initial months and would
rather ease gradually, the bias is on the downside. By Dec 2014, we
estimate WPI to come down to 5.5% (down 200bps from the last print)
and CPI to 8.0% (down 320bps from last print). More structurally,
inflation can come down only if the supply-side response sees a
significant improvement and from that perspective, a turnaround in
investment cycle will be critical; however, it is fair to assume that
cyclical and food-price linked pressures would wane in 2014 and
headline inflation will gradually fall.


Current account deficit: under 3% of GDP
It is a well known fact that India’s current account deficit (CAD)
worsened substantially in FY13 (US$88bn, 4.8% of GDP). Between
FY10-13, net oil and gold imports almost doubled. This, coupled with a
slowdown in export growth, had a debilitating impact on India’s current
account. The 11% depreciation of INR vs. USD in the past 18 months
has restored considerable competitiveness; export growth has already
seen a sharp pickup and non-oil / non-gold imports are on a declining
trend. Quantitative restrictions and a sharp increase in import duty have
had the effect of driving down FY14 gold imports by almost 50%. We
estimate that FY14 CAD will be down 50% YoY to US$45bn or 2.5% of
GDP. CAD is unlikely to be an intractable issue in the next 12-18
months.

Capital flows and rupee: well-behaved
Through the rupee’s tumultuous phase in 2012 and 2013, FII flows into
equities and FDI remained remarkably sticky and stable. An estimated
cumulative amount of US$100bn came under these two heads and this
helped India offset the sharp deterioration in FY13 current account.
However, FII flows into debt markets were much more volatile with
US$7bn of inflows in 2012 and US$8bn of outflows in 2013. The good
news is that the total FII stock of ownership in debt is US$20bn, one
that India can comfortably manage in the event of any further outflows.
RBI has also further shored up its FX reserves through the US$35bn
swap (from non-resident deposits and fresh banking capital). If our
hypothesis of pickup in growth and a slowdown in inflation plays out,
capital inflow momentum will likely remain benign. RBI’s interventions
in FX market has also sent out an unambiguous signal that it is
comfortable with the 61-63 range for the INR/USD; current REER
calculations too suggest that rupee is under-valued at these levels. In
our view, the rupee is unlikely to see any material swings in 2014,
barring unforeseen events.

Fiscal deficit: Still early to call FY15
Between FY08 and FY12, India’s fiscal deficit rose fourfold and there
was a palpable deterioration in government finances. Since
Chidambaram took over as Finance Minister in July 2012, his focus on
expenditure management has helped contain fiscal deficit at close to
budgeted levels. However, the environment remains challenging, as
FY14 tax collections are likely to be 8% lower than budgeted levels. As
of now, indications are that the FM’s focus on expenditure control is
unrelenting, though there is a lurking fear that the government may
turn populist in the run-up to the May 2014 elections. We estimate FY14
fiscal deficit at 5.1% of GDP, marginally higher than the budgeted
4.8%. One of the key challenges for the new government would be to
bring down fiscal deficit to more manageable levels and we may have to
wait until the outcome of May 2014 elections to have a better view on
the likely FY15 / FY16 fiscal roadmap.

Rate cycle: will turn benign
Despite a sharp deceleration in growth, RBI’s leeway to use monetary
policy as a tool to revive growth was constrained by continued negative
surprises on inflation and the sharp depreciation of the rupee in mid-
2012. Rates may still go up in 1Q14, if headline WPI and CPI surprise
on the negative side, but we believe that the interest rate cycle is close
to the peak, given our hypothesis that inflation will gradually come off in
the coming months. Policy rates may remain elevated in the initial
months, but we believe that the rate cycle will turn more benign in the
latter part of 2014.

Politics: improving tidings, still a close call
The outcome of the May 2014 general elections can potentially be a
market-moving event; understandably so, as the policy morass of the
Congress-led UPA-II government is one reason why growth in capital
formation and business sentiment has been so badly dented. There is
justifiable hope that the emergence of BJP-led coalition can help
turnaround sentiment and growth. There is no denying the fact that BJP
is on the ascendancy. However, to get close to the magic number of
190-200 seats (from 116 in the current Lok Sabha), the minimum that
BJP will need to put together a post-poll coalition, the party needs to
dramatically improve its tally in the states of UP and Bihar (and our
recent road trip to UP suggests that BJP has started to make significant
inroads there), do better in the states of Maharashtra and Karnataka, as
also get coalitions in some of the states such as AP right. While this
seems achievable, it is still a daunting task. The chances of a third front
(a coalition of non-Congress, non-BJP regional parties) emerging as the
largest political coalition with or without the outside support of Congress
is no less either. Unfortunately, markets may not perceive a third front
as growth-friendly and that makes the May 2014 election a potential
binary event. The situation could of course change in the coming
months but for now it is too early to place odds on the potential election
outcome especially in the context of the emergence of anti-corruption
party AAP (but for whose emergence, BJP would have won significantly
more seats in the recent Delhi state elections). The Congress party
slumping to its worst ever seat share looks probabilistically more likely.

Earnings cycle: Momentum to reverse for the better
From the FY11 peak of 9.6% India’s real ex-agricultural GDP growth will
nearly halve to 4.8% in FY14. As we had highlighted in our earlier note
(What drives corporate profit growth, 10 April13) corporate profit
growth has a high degree of correlation with real ex-agricultural GDP
growth. It is understandable that such a sharp fall in real growth in the
past three years would thus have had a more-than-proportionate
negative impact on margins and profit growth during this period.
For a static universe of 140 companies within IIFL coverage universe,
FY14 profit growth of 5.5% would just be marginally better than the
FY09-crisis year growth but almost two-thirds lower than the past
decade’s average. Profit growth between FY11 and FY14 (when real GDP
growth significantly slowed) for this universe averaged 7.5% against
preceding five-year average of nearly 20%.
For smaller companies outside our coverage, the fall in earnings has
been even stark. For a broader sample of 1800 companies, FY13 Ebidta
and PAT margins were at decade low of 13.6% and 5.1% respectively;
for the bottom 1000, the respective numbers were 9.2% and -1.4%.
Sharp spike in NPLs and higher credit costs have hurt earnings of banks
and that has been an added drag.
In our view, the broader market earnings growth will bottom out in
FY14 and as real GDP growth starts to turn around, corporate profit
growth will pick up too. Better operating and financial leverage will aid a
recovery in net profit margins, although the fuller impact of the
recovery will reflect in earnings with a lag. We believe that the earnings
downgrade cycle is behind us and current consensus FY15/FY16
earnings estimates will see upgrades. Earnings momentum will thus be
supportive.

NPLs: Pain may linger for some time, unlikely to worsen
Between FY11-FY14 when ex-agriculture real GDP halved, gross non
performing loans (GNPLs) of the IIFL banking coverage universe
doubled from 2.2% of loans to an estimated 4.4%; restructured loans
rose from 3.7% to an estimated 7.0%. PSU banks account for 85% of
GNPLs, 95% of restructured loans although they account for only 76%
of system loans. The sharp deterioration in asset quality is attributable
less to the cyclical slowdown and more to the stress arising from
infrastructure projects (infra sector alone accounts for 21% of bad
loans) stuck due to a number of prickly issues. As we have highlighted
in the earlier section (on why Investment cycle is on the road to
recovery), the government has started to address some of these issues
in the power and roads sector. However, while we wait for the new
government to more aggressively address some of the sticky issues the
momentum has already started to turn for the better. Given our
hypothesis of a cyclical turnaround in 2014, we expect the stress that
arose because of growth slowdown will likely start to wane as well. The
improvement in the macro-economic environment typically reflects on
asset quality with a lag and it is possible that credit costs may still be
high in FY15. However, outlook and direction of change will be more
important; in our view, that trajectory will turn for the better in the
coming months.

Nifty: current valuations assume a high equity risk premium
Market valuations have seen a de-rating over the past three years;
large-cap indices like Nifty are still trading close to the historic median
whereas mid-small caps are trading at much lower than median levels,
especially on a price-to-book basis. This is understandable as earnings
downgrades have been much more severe for mid-small caps as they
had to bear the brunt of the slowdown pain. Cyclical downturn adversely
impacted Ebidta margins, even as higher borrowing costs accentuated
the pain at the PAT margin level. As macro variables start to look up as
we hypothesize earnings outlook will start to improve. Earnings
recovery for mid-small caps will understandably be sharper.


Our two-stage earnings discount model also suggests that at the current
levels of Nifty, implied Equity Risk Premium (ERP) is close to 6.5% (this
assumes a risk free rate of 9% and a terminal growth of 7%). Current
ERP is well above its historic median. As we have highlighted in the
table below, even marginal changes in ERP or terminal growth tends to
have an exaggerated impact on fair value. In our view, current
valuations do not price in a potential earnings upgrade cycle and thus
the risk-reward for the Nifty at current valuations is favorable.

Portfolio Strategy – Overweight IT, domestic cylicals
We are moving away from a pure bottom-up portfolio construction to a
mix of top-down and bottom-up. We would have a neutral bias for
telecom and pharmaceutical sectors whereas our key overweight and
underweight sectors would be as follows:
Key overweight sectors:
1. Information Technology: Earnings momentum remains strong,
upgrade cycle is still intact, and valuations are reasonable despite
the stellar performance in the past year. Our bias is towards large
caps as valuation gap vs. mid-caps is too narrow.
2. Financials: This sector remains a good proxy to play the improving
top-down story. Our bias would be to own cheaper private sector
banks and NBFCs as larger weights within the sector.
3. Engineering & Construction: A play on the upturn in the investment
cycle, this sector will see sustained earnings upgrades and
valuations will re-rate.
4. Autos: A large number of good companies to own, valuations are
attractive, growth momentum is reasonable.
Key underweight sectors:
5. FMCG: Consumption growth is weakening, earnings upgrade cycle is
behind us, risk of downgrades rising, valuations are too rich and the
sector will underperform in a cyclical upturn.
6. Energy: Earnings momentum remains lacklustre, valuations are
cheap, but we do not see any re-rating drivers.


 IIFL􀀃recommended􀀃portfolio􀀃stance􀀃
Sectors􀀃 Nifty􀀃weight IIFL􀀃weight􀀃
Consumer􀀃Discretionary 9.0 10.0􀀃
Consumer􀀃Staples 10.5 7.0􀀃
Energy􀀃 11.7 7.0􀀃
Financials􀀃 26.5 30.0􀀃
Health􀀃Care􀀃 6.0 6.0􀀃
Industrials􀀃 5.2 8.0􀀃
Information􀀃Technology 17.0 20.0􀀃
Materials􀀃 8.3 6.0􀀃
Telecommunication􀀃Services 1.9 2.0􀀃
Utilities􀀃 3.9 4.0􀀃
Total 100.0 100.0􀀃
Source:􀀃NSE,􀀃IIFL􀀃Research􀀃


Top large-cap buys
Company􀀃
Valuation􀀃 􀀃
Mkt􀍲Cap PE􀀃(x) PB􀀃(x)􀀃 EPS􀀃Cagr􀀃(%) RoE􀀃(%) 􀀃Investment􀀃rationale􀀃
(US$􀀃m) FY15ii FY15ii􀀃 FY14􀍲FY16ii􀀃 FY15ii􀀃 􀀃
Dr􀀃Reddy’s􀀃
(DRRD􀀃IN􀀃
CMP:􀀃Rs2,535)􀀃
6,973 17.0 3.8􀀃 20.5 25.0 􀁸 Recent􀀃limited􀍲competition􀀃product􀀃launches􀀃and􀀃pipeline􀀃provide􀀃comfort􀀃of􀀃sustained􀀃high􀍲teen􀀃growth􀀃in􀀃the􀀃US;􀀃
the􀀃business􀀃grew􀀃27%􀀃in􀀃FY13,􀀃expect􀀃FY14􀀃growth􀀃>23%􀀃(all􀀃in􀀃USD).􀀃
􀁸 India􀀃business􀀃should􀀃sustain􀀃mid􀍲teen􀀃growth;􀀃large􀀃established􀀃Russia􀀃and􀀃smaller􀀃‘other􀀃emerging􀀃market’􀀃branded􀀃
businesses􀀃will􀀃continue􀀃to􀀃deliver􀀃~20%􀀃growth.􀀃One􀀃of􀀃the􀀃front􀍲runners􀀃in􀀃biosimilars􀀃world􀍲wide;􀀃already􀀃launched􀀃
several􀀃products􀀃in􀀃EMs;􀀃partnership􀀃with􀀃Merck􀀃KGaA􀀃for􀀃regulated􀀃markets.􀀃
􀁸 We􀀃project􀀃17%+􀀃core􀀃earnings􀀃Cagr􀀃over􀀃FY14􀍲FY16,􀀃better􀀃than􀀃what􀀃we􀀃believe􀀃is􀀃priced􀀃in􀀃the􀀃stock.􀀃Valuation􀀃at􀀃
~17x􀀃FY15ii􀀃core􀀃earnings􀀃is􀀃still􀀃at􀀃10􀍲20%􀀃discount􀀃to􀀃peers;􀀃potential􀀃to􀀃re􀍲rate􀀃15􀍲20%.􀀃
Hero􀀃Moto􀀃
(HMCL􀀃IN􀀃
CMP:􀀃Rs2,075)􀀃􀀃
􀀃
6,706 13.8 5.6􀀃 27.2 45.7 􀁸 Consumer􀀃acceptance􀀃of􀀃the􀀃new􀀃brand,􀀃confidence􀀃in􀀃product􀀃quality􀀃as􀀃affirmed􀀃by􀀃the􀀃5􀍲year􀀃warranty􀀃program􀀃
and􀀃resultant􀀃stabilization􀀃in􀀃market􀍲share􀀃places􀀃Hero􀀃in􀀃a􀀃strong􀀃position􀀃into􀀃a􀀃potential􀀃recovery􀀃in􀀃2W􀀃demand.􀀃
􀁸 Stable􀀃 market􀀃 share􀀃 will􀀃 bring􀀃 back􀀃 pricing􀀃 power􀀃 and􀀃 margins.􀀃 In􀀃 addition,􀀃 Hero􀀃 is􀀃 working􀀃 on􀀃 a􀀃 “margin􀀃
transformation􀀃 project”,􀀃 which􀀃 can􀀃 drive􀀃 300􀍲400bp􀀃 of􀀃 margin􀀃 gains􀀃 led􀀃 by􀀃 alternative􀀃 sourcing􀀃 and􀀃 cost􀀃 cutting.􀀃
Launch􀀃of􀀃new􀀃models􀀃based􀀃on􀀃Hero’s􀀃own􀀃R&D􀀃will􀀃remove􀀃Street􀀃concerns􀀃on􀀃technology.􀀃
􀁸 Stock􀀃is􀀃trading􀀃at􀀃13.8x􀀃FY15􀀃EPS.􀀃Our􀀃estimates􀀃do􀀃not􀀃build􀀃in􀀃margin􀀃expansion;􀀃a􀀃100bp􀀃cost􀀃saving􀀃can􀀃add􀀃8%􀀃to􀀃
our􀀃EPS􀀃estimate.􀀃
ICICI􀀃Bank􀀃
(ICICIBC􀀃IN􀀃
CMP:􀀃Rs1,099)􀀃
􀀃
20,527 11.8 1.6􀀃 15.7 13.9 􀁸 ICICIBC􀀃 is􀀃 strongly􀀃 positioned􀀃 as􀀃 regards􀀃 profitability,􀀃 capitalization􀀃 and􀀃 financing􀀃 flexibility.􀀃 A􀀃 cyclical􀀃 upturn􀀃may􀀃
further􀀃improve􀀃the􀀃operating􀀃environment􀀃in􀀃the􀀃medium􀀃term.􀀃
􀁸 Asset􀀃 quality􀀃 is􀀃 likely􀀃 to􀀃 be􀀃 tackled􀀃 through􀀃 pro􀍲active􀀃 loan􀀃 workouts􀀃 like􀀃 restructuring,􀀃 forcing􀀃 asset􀀃 sales􀀃 and􀀃 re􀍲
financing.􀀃Hence,􀀃we􀀃believe􀀃ICICIBC􀀃should􀀃be􀀃able􀀃to􀀃contain􀀃slippages􀀃and􀀃GNPA􀀃ratios.􀀃
􀁸 We􀀃estimate􀀃15.5%􀀃earnings􀀃CAGR􀀃through􀀃FY14􀍲16ii􀀃with􀀃ROA􀀃of􀀃1.6%􀀃and􀀃RoE􀀃of􀀃14􀍲15%􀀃through􀀃FY16ii.􀀃The􀀃bank􀀃
will􀀃easily􀀃comply􀀃with􀀃Basel􀀃III􀀃requirements􀀃of􀀃capital􀀃and􀀃could􀀃potentially􀀃monetize􀀃investments􀀃in􀀃subsidiaries.􀀃􀀃
L􀀃&􀀃T􀀃
(LT􀀃IN􀀃
CMP:􀀃Rs1,070)􀀃
16,038 18.4 2.8􀀃 11.7 15.9 􀁸 As􀀃 the􀀃 cycle􀀃 turns,􀀃 there􀀃 is􀀃 a􀀃 sharp􀀃 pickup􀀃 in􀀃 execution􀀃 rate􀀃 –􀀃 FY03􀀃 witnessed􀀃8ppt􀀃 improvement􀀃 YoY.􀀃 With􀀃 order􀀃
coverage􀀃of􀀃2.6x,􀀃every􀀃ppt􀀃improvement􀀃in􀀃execution􀀃will􀀃drive􀀃2%􀀃upside􀀃to􀀃revenue􀀃estimate.􀀃This􀀃would􀀃more􀀃than􀀃
offset􀀃margin􀀃risks.􀀃
􀁸 Domestic􀀃 order􀀃 inflow􀀃 has􀀃 lagged􀀃 so􀀃 far􀀃 but􀀃 improved􀀃 political􀀃 will􀀃 and􀀃 administrative􀀃 efficiency􀀃 could􀀃 kick􀀃 start􀀃
investments􀀃 in􀀃 roads,􀀃 railways􀀃and􀀃 metros.􀀃 Sustained􀀃 activity􀀃 in􀀃Middle􀀃 East􀀃and􀀃better􀀃 hit􀀃 rate􀀃 will􀀃 drive􀀃 overseas􀀃
inflows􀀃as􀀃well.􀀃
􀁸 Better􀀃traction􀀃in􀀃monetisation􀀃of􀀃asset􀀃business􀀃will􀀃reduce􀀃funding􀀃requirements􀀃from􀀃the􀀃parent􀀃balance􀀃sheet.􀀃
Wipro􀀃
(WPRO􀀃IN􀀃
CMP:􀀃Rs559)􀀃
22,309 15.8 3.4􀀃 13.6 23.6 􀁸 Signs􀀃 of􀀃 restructuring􀀃 that􀀃were􀀃 visible􀀃 only􀀃 in􀀃 lower􀀃 attrition􀀃and􀀃 higher􀀃 client􀀃 satisfaction􀀃have􀀃 started􀀃becoming􀀃
evident􀀃in􀀃a􀀃better􀀃revenue􀀃growth􀀃and􀀃large􀀃deal􀀃wins.􀀃Healthy􀀃traction􀀃in􀀃infra.􀀃services􀀃and􀀃deal􀀃wins􀀃even􀀃in􀀃BFSI􀀃
gives􀀃confidence􀀃over􀀃the􀀃sustainability􀀃of􀀃an􀀃improvement􀀃in􀀃its􀀃revenue􀀃growth􀀃
􀁸 Wipro’s􀀃has􀀃amongst􀀃the􀀃best􀀃margin􀀃levers􀀃within􀀃top􀍲4􀀃vendors.􀀃A􀀃greater􀀃increase􀀃in􀀃SG&A􀀃expenses􀀃than􀀃peers􀀃
over􀀃the􀀃past􀀃two􀀃years􀀃is􀀃one􀀃of􀀃the􀀃reasons􀀃for􀀃its􀀃margin􀀃levers􀀃
􀁸 Despite􀀃the􀀃narrowing􀀃of􀀃gap􀀃in􀀃growth􀀃rates,􀀃its􀀃valuations􀀃continue􀀃to􀀃be􀀃at􀀃a􀀃material􀀃discount􀀃to􀀃TCS.

Top mid-cap buys
Company􀀃
Valuation􀀃
Mkt􀍲Cap PE􀀃(x) PB􀀃(x)􀀃 EPS􀀃Cagr􀀃(%) RoE􀀃(%) Investment􀀃rationale􀀃
(US$􀀃m) FY15ii FY15ii􀀃 FY14􀍲FY16ii􀀃 FY15ii􀀃
Crompton􀀃
Greaves􀀃
(CRG􀀃IN􀀃
CMP:􀀃Rs129)􀀃
1,336 19.0􀀃 2.0􀀃 51.4 11.0 􀁸 Profitability􀀃 of􀀃 domestic􀀃 power􀀃 systems􀀃 business􀀃 being􀀃 supported􀀃 by􀀃 higher􀀃 contribution􀀃 from􀀃 exports.􀀃 This􀀃 should􀀃
continue􀀃helped􀀃by􀀃favourable􀀃currency.􀀃Completion􀀃of􀀃low􀍲margin􀀃orders􀀃means􀀃that􀀃risks􀀃to􀀃profitability􀀃remain􀀃low.􀀃
􀁸 Healthy􀀃 margin􀀃 for􀀃 consumer􀀃 product􀀃 segment􀀃 despite􀀃 seasonally􀀃 lower􀀃 revenues􀀃 in􀀃 2Q􀀃 lends􀀃 comfort.􀀃 Enhanced􀀃
distribution􀀃and􀀃lower􀀃competition􀀃from􀀃Chinese􀀃imports􀀃would􀀃help􀀃sustain􀀃segment􀀃performance.􀀃
􀁸 Despite􀀃constant􀀃currency􀀃revenue􀀃decline,􀀃overseas􀀃subsidiaries􀀃have􀀃turned􀀃the􀀃corner􀀃with􀀃Ebitda􀀃breakeven􀀃in􀀃2Q.􀀃
Except􀀃 Canada􀀃 and􀀃 USA,􀀃 other􀀃 subsidiaries􀀃 have􀀃 become􀀃 profitable.􀀃 Management􀀃 remains􀀃 confident􀀃 of􀀃 full􀀃 year􀀃
breakeven􀀃for􀀃overseas􀀃subsidiaries.􀀃
IPCA􀀃Labs􀀃
(IPCA􀀃IN􀀃
CMP:􀀃Rs724)􀀃
1,479 15.6􀀃 3.7􀀃 21.7 26.5 􀁸 Large􀀃contribution􀀃from􀀃domestic􀀃formulations􀀃business􀀃(32%);􀀃strength􀀃in􀀃chronic􀀃pain􀀃medicines􀀃and􀀃anti􀍲malarials.􀀃
Expect􀀃to􀀃deliver􀀃mid􀍲high􀀃teen􀀃growth􀀃in􀀃medium􀀃term.􀀃
􀁸 Focus􀀃on􀀃branded􀀃formulations􀀃in􀀃global􀀃emerging􀀃markets;􀀃management􀀃plans􀀃to􀀃tap􀀃newer􀀃geographies􀀃to􀀃maintain􀀃
high􀀃growth.􀀃Institutional􀀃anti􀍲malarial􀀃business􀀃sales􀀃remain􀀃strong􀀃as􀀃well.􀀃
􀁸 USFDA􀀃clearance􀀃of􀀃Indore􀀃plant􀀃raises􀀃growth􀀃prospects􀀃in􀀃the􀀃US􀀃market.􀀃
􀁸 Trading􀀃at􀀃~15x􀀃FY15ii􀀃core􀀃earnings,􀀃at􀀃discount􀀃to􀀃large􀀃cap􀀃peers;􀀃gradual􀀃re􀍲rating􀀃to􀀃large􀀃cap􀀃multiples􀀃likely.􀀃
Motherson􀀃
Sumi􀀃
(MSS􀀃IN􀀃
CMP:􀀃Rs183)􀀃
2,604 13.6􀀃 4.2􀀃 27.0 35.0 􀁸 Motherson􀀃Sumi’s􀀃(MSSL)􀀃wiring􀀃harness􀀃business􀀃is􀀃a􀀃direct􀀃play􀀃on􀀃recovery􀀃in􀀃the􀀃Indian􀀃auto􀀃sector􀀃as􀀃well􀀃as􀀃on􀀃
India’s􀀃emergence􀀃as􀀃a􀀃production􀀃hub􀀃for􀀃exports.􀀃MSSL’s􀀃India􀀃revenue􀀃has􀀃outpaced􀀃auto􀀃industry􀀃by􀀃a􀀃big􀀃margin;􀀃
hence,􀀃a􀀃recovery􀀃in􀀃Indian􀀃auto􀀃will􀀃drive􀀃an􀀃even􀀃stronger􀀃revenue/earnings􀀃growth􀀃for􀀃MSSL.􀀃
􀁸 MSSL’s􀀃subsidiaries􀀃(SMR􀀃&􀀃SMP)􀀃will􀀃benefit􀀃from􀀃an􀀃increasing􀀃order􀀃book􀀃(EUR6.6bn􀀃new􀀃orders􀀃in􀀃last􀀃1.5􀀃years)􀀃
and􀀃 a􀀃 potential􀀃 recovery􀀃 in􀀃 the􀀃 European􀀃 car􀀃 market.􀀃We􀀃 estimate􀀃10%􀀃 revenue􀀃 Cagr􀀃 over􀀃 FY14􀍲16􀀃combined􀀃 with􀀃
margin􀀃expansion􀀃from􀀃operational􀀃improvement􀀃to􀀃result􀀃in􀀃earnings􀀃of􀀃these􀀃subsidiaries􀀃doubling􀀃over􀀃FY14􀍲16.􀀃
􀁸 We􀀃forecast􀀃a􀀃27%􀀃consolidated􀀃EPS􀀃CAGR􀀃over􀀃FY14􀍲FY16.􀀃Stock􀀃is􀀃trading􀀃at􀀃13.8x􀀃FY15􀀃EPS.
The􀀃Ramco􀀃
Cements􀀃
(TRCL􀀃IN􀀃
CMP:􀀃Rs192)􀀃
738 19.6􀀃 1.7􀀃 25.2 9.2 􀁸 We􀀃 expect􀀃 demand􀀃 to􀀃 revive􀀃 in􀀃 southern􀀃 region􀀃 in􀀃 FY15􀀃 after􀀃 remaining􀀃 sluggish􀀃 for􀀃 the􀀃 past􀀃 4􀀃 years􀀃 with􀀃 likely􀀃
improvement􀀃in􀀃political􀀃environment􀀃in􀀃Andhra􀀃Pradesh.􀀃
􀁸 Pace􀀃 of􀀃 cement􀀃 capacity􀀃 addition􀀃 is􀀃 likely􀀃 to􀀃 reduce􀀃 in􀀃 the􀀃 southern􀀃 region􀀃 going􀀃 forward􀀃 and􀀃 is􀀃 likely􀀃 to􀀃 improve􀀃
utilisation􀀃gradually􀀃in􀀃the􀀃next􀀃2􀍲3􀀃years􀀃(from􀀃~60%􀀃now􀀃to􀀃~70%􀀃in􀀃FY16).􀀃
􀁸 Ramco􀀃Cements,􀀃a􀀃south􀀃based􀀃cement􀀃company􀀃with􀀃12.5mtpa􀀃capacity􀀃is􀀃trading􀀃at􀀃USD􀀃74/tonne􀀃(40%􀀃discount􀀃to􀀃
replacement􀀃cost),􀀃which􀀃is􀀃attractive􀀃from􀀃a􀀃medium􀀃term􀀃perspective,􀀃in􀀃our􀀃view.􀀃Any􀀃revival􀀃in􀀃discipline􀀃in􀀃south􀀃
region􀀃could􀀃boost􀀃earnings.􀀃
Shriram􀀃
Transport􀀃Fin.􀀃
(SHTF􀀃IN􀀃
CMP:􀀃Rs673)􀀃
2,469 9.2􀀃 1.6􀀃 19.6 18.1 􀁸 We􀀃 believe􀀃 STFC􀀃 will􀀃 incrementally􀀃 benefit􀀃 from􀀃 increasing􀀃 financing􀀃 requirements􀀃 in􀀃 the􀀃 CV􀀃 space,􀀃 medium􀀃 term􀀃
impact􀀃of􀀃better􀀃monsoons,􀀃partial􀀃removal􀀃of􀀃bans􀀃on􀀃mining􀀃and􀀃better􀀃outlook􀀃for􀀃the􀀃capital􀀃goods􀀃sector.􀀃
􀁸 Despite􀀃the􀀃adverse􀀃operating􀀃environment,􀀃STFCs􀀃business􀀃model􀀃has􀀃been􀀃intact.􀀃An􀀃improvement􀀃in􀀃the􀀃CV􀀃cycle􀀃
could􀀃drive􀀃a􀀃large􀀃upgrade􀀃in􀀃our􀀃earnings􀀃outlook􀀃driven􀀃by􀀃better􀀃growth,􀀃margins􀀃and􀀃credit􀀃cost􀀃estimates.􀀃
􀁸 Over􀀃FY14􀍲16ii,􀀃P/E􀀃 re􀍲rating􀀃 to􀀃12.5x􀀃12􀍲month􀀃 forward􀀃EPS􀀃 (last􀀃cycle􀀃peak􀀃 15.7x,􀀃 currently􀀃 9.3x􀀃 FY15ii􀀃EPS)􀀃and􀀃a􀀃
~45%􀀃earnings􀀃growth􀀃over􀀃FY14􀍲16ii􀀃suggest􀀃a􀀃large􀀃upside.


Dark horses
Company􀀃
Valuation􀀃
Mkt􀍲Cap PE􀀃(x) PB􀀃(x)􀀃 EPS􀀃Cagr􀀃(%) RoE􀀃(%) Investment􀀃rationale􀀃
(US$􀀃m) FY15ii FY15ii􀀃 FY14􀍲FY16ii􀀃 FY15ii􀀃
Ashok􀀃Leyland􀀃
(AL􀀃IN􀀃
CMP:􀀃Rs17)􀀃
743 13.9 1.1􀀃 NM 7.9 􀁸 M&HCV􀀃 volume􀀃 growth􀀃 has􀀃 a􀀃 very􀀃 strong􀀃 correlation􀀃 with􀀃 IIP􀀃 growth.􀀃 Improvement􀀃 in􀀃 IIP􀀃 may􀀃 drive􀀃 demand􀀃 for􀀃
M&HCVs􀀃in􀀃FY15.􀀃Also􀀃the􀀃current􀀃CV􀀃down􀍲cycle􀀃has􀀃been􀀃longer􀀃than􀀃past􀀃down􀍲cycles􀀃(12􀍲18􀀃months),􀀃implying􀀃that􀀃
an􀀃uptick􀀃may􀀃not􀀃be􀀃too􀀃far.􀀃􀀃􀀃
􀁸 Ashok􀀃Leyland􀀃has􀀃the􀀃highest􀀃operating􀀃and􀀃financial􀀃leverage􀀃among􀀃Indian􀀃Auto􀀃companies.􀀃Its􀀃employee􀀃cost􀀃is􀀃the􀀃
highest􀀃among􀀃auto􀀃peers.􀀃While􀀃these􀀃factors􀀃hurt􀀃in􀀃a􀀃slowdown,􀀃it􀀃magnifies􀀃earnings􀀃growth􀀃in􀀃a􀀃recovery.􀀃
􀁸 Stock􀀃is􀀃trading􀀃at􀀃14.0x􀀃our􀀃FY15􀀃EPS.􀀃However,􀀃if􀀃the􀀃CV􀀃cycle􀀃picks􀀃up􀀃pace,􀀃earnings􀀃can􀀃potentially􀀃double􀀃in􀀃FY16􀀃
over􀀃FY15􀀃levels.
Bharti􀀃Airtel􀀃
(BHARTI􀀃IN􀀃
CMP:􀀃Rs330)􀀃
21,362 24.8 1.9􀀃 50.8 8.0 􀁸 While􀀃 overall􀀃 industry􀀃 dynamics􀀃 in􀀃 India􀀃 has􀀃 improved,􀀃 Bharti􀀃 has􀀃 also􀀃 streamlined􀀃 distribution/employee􀀃 base,􀀃
launched􀀃innovative􀀃products􀀃to􀀃seed􀀃the􀀃data􀀃market􀀃and􀀃improved􀀃capex􀀃productivity.􀀃We􀀃build􀀃in􀀃18%􀀃India􀀃Ebitda􀀃
Cagr􀀃over􀀃FY13􀍲16ii.􀀃
􀁸 Africa􀀃 operations’􀀃 performance􀀃 improved􀀃 in􀀃 2QFY14􀀃 and􀀃 we􀀃 believe􀀃 it􀀃 is􀀃 close􀀃 to􀀃 bottoming􀀃 out.􀀃 We􀀃 estimate􀀃
2.5%/8.5%/8.5%􀀃Ebitda􀀃growth􀀃(in􀀃US$)􀀃in􀀃FY14/15/16.􀀃
􀁸 900/1800MHz􀀃base􀀃prices􀀃have􀀃been􀀃cut􀀃by􀀃57%/26%􀀃from􀀃March􀀃2013􀀃levels􀀃and􀀃hence􀀃spectrum􀀃payouts􀀃would􀀃get􀀃
crystallised􀀃at􀀃significantly􀀃lower􀀃levels.􀀃Valuation􀀃is􀀃attractive􀀃at􀀃6.7x􀀃FY15ii􀀃EV/Ebitda􀀃and􀀃16%􀀃FY13􀍲16ii􀀃Ebitda􀀃Cagr.􀀃
Infosys􀀃
(INFO􀀃IN􀀃
CMP:􀀃Rs3,486)􀀃
32,388 16.1 3.6􀀃 17.1 24.3 􀁸 Margin􀀃fall􀀃at􀀃Infosys􀀃in􀀃the􀀃past􀀃two􀀃years􀀃was􀀃primarily􀀃led􀀃by􀀃deterioration􀀃in􀀃its􀀃delivery􀀃levers􀀃(age􀀃pyramid,􀀃onsite􀀃
cost􀀃inflation􀀃etc.).􀀃While􀀃‘correcting’􀀃its􀀃delivery􀀃is􀀃a􀀃delicate􀀃issue􀀃and􀀃will􀀃take􀀃time,􀀃the􀀃margin􀀃levers􀀃are􀀃significant.􀀃
􀁸 Infosys’􀀃earlier􀀃re􀍲organization􀀃has􀀃streamlined􀀃its􀀃sales􀀃operations􀀃and􀀃has􀀃improved􀀃its􀀃deal􀀃traction.􀀃The􀀃company􀀃
has􀀃 also􀀃 been􀀃 aggressive􀀃 in􀀃 bidding􀀃 for􀀃 infrastructure􀀃 services􀀃 deals􀀃 which􀀃 has􀀃 resulted􀀃 in􀀃 a􀀃 better􀀃 growth􀀃 for􀀃 the􀀃
company􀀃in􀀃2013.􀀃􀀃
􀁸 Given􀀃the􀀃narrowing􀀃of􀀃gap􀀃in􀀃growth􀀃rate􀀃vs􀀃TCS􀀃and􀀃margin􀀃levers,􀀃we􀀃expect􀀃its􀀃re􀍲rating􀀃to􀀃continue.􀀃
State􀀃Bank􀀃of􀀃
India􀀃
(SBIN􀀃IN􀀃
CMP:􀀃Rs1,767)􀀃
19,553 9.1 1.0􀀃 18.1 12.0 􀁸 SBIN􀀃 is􀀃 currently􀀃 facing􀀃 a􀀃 number􀀃 of􀀃 headwinds􀀃 such􀀃 as􀀃 poor􀀃 asset􀀃 quality,􀀃 slowing􀀃 loan􀀃 growth􀀃 and􀀃 gross􀀃
under􀍲provisioning􀀃all􀀃culminating􀀃into􀀃significantly􀀃eroded􀀃tier􀀃1􀀃capital.􀀃􀀃
􀁸 Despite􀀃this,􀀃any􀀃change􀀃in􀀃the􀀃economic􀀃and􀀃regulatory􀀃environment,􀀃improving􀀃corporate􀀃credit􀀃cycle􀀃or􀀃pickup􀀃in􀀃
loan􀀃growth􀀃would􀀃provide􀀃a􀀃disproportionately􀀃beneficial􀀃environment􀀃to􀀃SBIN.􀀃
􀁸 The􀀃stock􀀃may􀀃potentially􀀃re􀍲rate􀀃faster􀀃in􀀃such􀀃a􀀃case.􀀃Its􀀃ROA􀀃and􀀃ROE􀀃profile􀀃could􀀃improve􀀃materially􀀃(from􀀃the􀀃0.7%􀀃
and􀀃12%􀀃trajectory􀀃estimated􀀃now).
Sesa􀀃Sterlite􀀃
(SSLT􀀃IN􀀃
CMP:􀀃Rs202)􀀃
9,688 5.9 0.8􀀃 18.0 14.4 􀁸 SSLT􀀃trades􀀃at􀀃a􀀃discount􀀃to􀀃the􀀃sum􀀃of􀀃intrinsic􀀃value􀀃of􀀃its􀀃businesses􀀃due􀀃to􀀃lack􀀃of􀀃fungibility􀀃of􀀃cash􀀃of􀀃Cairn􀀃and􀀃
Hindustan􀀃Zinc􀀃(HZ).􀀃􀀃
􀁸 Buyout􀀃of􀀃government’s􀀃stake􀀃in􀀃HZ􀀃􀍲􀀃a􀀃potential􀀃trigger,􀀃and􀀃subsequent􀀃merger􀀃of􀀃HZ􀀃could􀀃unlock􀀃value􀀃(Rs42/share)􀀃
for􀀃SSLT’s􀀃shareholders.􀀃Similarly,􀀃merger􀀃of􀀃Cairn􀀃could􀀃add􀀃Rs24/share.􀀃
􀁸 Stable􀀃 operating􀀃 performance􀀃 of􀀃 zinc􀀃 and􀀃 oil􀀃 businesses􀀃 (~70%􀀃 of􀀃 attributable􀀃 Ebitda),􀀃 resumption􀀃 of􀀃 iron􀀃 ore􀀃
operations􀀃and􀀃likely􀀃improvement􀀃in􀀃copper􀀃and􀀃aluminium􀀃businesses􀀃suggest􀀃a􀀃better􀀃outlook􀀃for􀀃FY15.􀀃Improving􀀃
cash􀀃flow􀀃and􀀃moderate􀀃capex􀀃would􀀃reduce􀀃leverage􀀃and􀀃strengthen􀀃balance􀀃sheet􀀃over􀀃FY14􀍲16.􀀃