17 June 2014

Infosys (INFO IN) Vishal Sikka will be the next CEO of Infosys; this could likely be a long haul even if he's the right man for the job:: JPMorgan

Infosys (INFO IN)
Vishal Sikka will be the next CEO of Infosys; this could likely be a long haul even if he's the right man for the job

Overweight

Price Target: Rs4,000.00
PT End Date: 31 Mar 2015

· The event: Dr. Vishal Sikka will take over as the CEO & MD of Infosys (from Mr. S.D. Shibulal) on Aug. 1st, 2014. Dr. Sikka was the CTO of SAP and the principal architect behind the enormously successful SAP-HANA (SAP’s analytics engine) (he resigned from SAP in May 2014). Dr. Sikka was also the member of the executive board of SAP and is regarded very highly for his technology skills. Dr. Sikka will be the first non-founder CEO of Infosys. Mr. U.B. Pravin Rao, the current president and whole-time director at Infosys, will be the new Chief Operating Officer (COO) effective Jun. 14, 2014. Notably, Mr. N.R. Narayana Murthy and Mr. S. Gopalakrishnan will step down from the position of Executive Chairman and Executive Vice Chairman, respectively, effective Jun 14, 2014.However, they will continue on the Board till Oct. 10, 2014 as Non-executive Chairman and Non-executive Vice Chairman, respectively. Mr. K.V. Kamath will take over as the Non-executive Chairman of the Board on Oct. 11, 2014. Also, the Executive Chairman’s office will be dissolved effective Jun 14, 2014 and Dr. Rohan Murthy will also quit the company on the same date.
· Our take: Dr. Sikka is a brave, unconventional choice, but his handling of a services business needs watching. We believe Dr. Sikka is a good choice from the perspective that IT Services is increasingly being software-driven or having software-like characteristics in the digital or SMAC (social, mobile, analytics, cloud) age. A service business model is a kind of software-cum-services offering with business process & application services layered on top of that software. Dr. Sikka having been a CTO at a leading, innovative software firm can probably appreciate the changing technology paradigm and articulate business models therein, which is a positive. However, our concern is that Dr. Sikka has been focused more on the R&D/product development side and has presumably not handled large P&Ls/operations. Products, Platforms and Solutions (PPE) accounts for less than 6% of Infosys’s revenues, while 94-95% is traditional IT services. We believe Dr. Sikka is yet to handle traditional IT services business, which is significantly different from products business. Mr. Pravin Rao’s appointment as the COO might help, but how Dr. Sikka handles the services business needs watching. We believe Dr. Sikka’s appointment is a brave, unconventional choice in the SMAC age (i.e. considering technology champions from scale software companies), it also comes with the risk tag of maybe too much of a “technocrat” image and relative inexperience at running services business.
· Assuming Infosys’s key intent of getting Dr. Sikka is to develop maturity and differentiation in products, platforms & solutions (PPS), (which constitutes less than 6% of Infosys’s revenues or a meager 2% excluding its banking product Finacle), it will likely take a relatively long time (may be 8-10 years) and business model transformation for PPS to be a distinctive differentiator (and only will be so, once it reaches critical mass, say 20-25% of overall revenues). For the foreseeable future, it is expected to be the dominant IT Services core (94-95% of Infosys’s revenues) that would wholly determine Infosys’s growth and market share, in our view. Infosys, we believe, cannot afford continued market-share loss in IT Services even as it hopes to scale up PPS under Dr. Sikka. Infosys is predominantly a services company; hence it might be a relatively new business model for Dr. Sikka to handle/operate.
· Infosys’s recovery might get delayed as Dr. Sikka will take some time to understand Infosys. Although Dr. Sikka would bring in fresh thinking to the organization as a technology visionary, but being an outsider he would likely take time to figure out Infosys’s issues, culture, ways of working, politics, competitive landscape, onerous task of rebuilding a team – all of which will take time to show results (given Infosys’s size). We believe Infosys’s expected recovery to industry-level revenue growth by FY16E will likely get pushed out further (maybe to FY17E or even beyond). All in all, we believe the company will take a longer-than-earlier expected time to get back to respectable growth trajectory.
· Dr. Sikka’s appointment might drive another wave of top-level resignation at Infosys. Infosys had been evaluating internal candidates for the CEO position as well. We believe Dr. Sikka’s appointment might drive another wave of resignation from the internal CEO hopefuls. However, the organization will likely stabilize after that. Also, we believe Mr. Murthy’s stepping down should provide significant freedom to Dr. Sikka to rebuild the organization as per his vision, a positive in our view.
· To sum up, we believe two aspects that could likely not work in favor of DrSikka despite his impressive professional pedigree - (a) he is an outsider to Infosys, and (b) he is an outsider to the IT Services industry. Even if he is the right man for the CEO job at Infosys (time will only say so), we believe this might be a really long haul for both Dr. Sikka and Infosys.
· Our estimates are under review post this development.

 

Investment Thesis

Infosys appears to have more realistic targets in the current environment, which we believe is positive. Its win rates in the bread-and-butter segments (including large deals) seem to be improving. The company has also said it is prepared to temper the near-term margin profile for market share. The growth focus is encouraging, in our view. The other positives are: (a) strong deals wins over the last 3-4 quarters provide some visibility into CY14, (b) meaningful headroom for cost-optimization (and margin expansion) through rationalizing cost structure, increasing offshore effort and taking out redundant onsite costs, (c) management seems committed to bring the company back to industry-level growth rates, and (d) a relatively healthy demand environment in CY14 coupled with improved win rates should boost growth.

Valuation

We stay OW on Infosys with a Mar-15 price target of Rs4,000. Our price target is based on a one-year forward P/E of 16.5x, at a modest (~15%) discount to TCS’s target multiple of 19.0x. We believe the discount is justified as TCS’s revenue growth and margin profile are better than Infosys’s, in our view. Notably, our exchange rate assumption is Rs60/US$ for the next two years (FY15 and FY16).

 

Risks to Rating and Price Target

Downside risks: Lower-than-expected volume growth, weakness in the demand environment, a meaningful decline in pricing/realizations, an adverse US immigration bill, meaningful rupee appreciation (vs the US$), and higher-than-expected attrition.

J.P. Morgan - India: April IP delivers gift to Modi!

India: April IP delivers a housewarming gift to the new government

 
 
IP surged in April (+1.7% m/m, sa) on the back of a solid sequential advance in March (+ 0.8 % m/m, sa) to print at a 13-month high of 3.4% oya, significantly above expectations (Consensus: 1.9% oya, JP Morgan 1.1%). The only caveat to the good news is that all of the upward surprise to the print came from the notoriously lumpy and volatile capital goods sector which grew 16% month-on-month (seasonally-adjusted). Ex-capital goods, IP actually contracted 0.1% -- which is what we had penciled in for overall IP – to print at a more subdued 1.9% oya.
The capital goods surge is likely linked to yesterday’s news that May witnessed very strong engineering exports growth. In fact, the generally strong exports outturn in May created upside risks to our April IP forecast. Given how strongly IP and exports are correlated, to the extent that exports continue to perform well, IP will benefit as a result. But exports orders have ticked down the last two months, and given the volatility and lumpiness of capital goods production, a significant payback can be expected in May. But, for now, policymakers and markets should be relieved that 2Q industrial growth is off to a very solid start.
The other elements of IP were very much in line with expectations. April IP had grown solidly on the back of surging consumer non-durables which was unlikely to sustain. Expectedly, therefore, non-durables did suffer a significant payback, contracting 3.5% sequentially (m/m, sa) and 3.3% in year-on-year terms.
Conversely, and expectedly, durables had a better month, as had been expected from the May auto sales numbers, growing 1.6% sequentially (m/m, sa) -- the first sequential advance in 3 months. This was not enough, however, to generate a positive year-on-year print, with durables still contracting 7.6% oya.
Key to IP in the coming months will be exports and the strength of the monsoon. If the fading of export orders sustains and the MET is right about a sub-normal/deficient monsoon, which will drag down rural demand, the joy in the April IP may be short-lived. But if exports continue to flourish on the back of firming global demand and inflation continues to tick down -- creating purchasing power -- more such positive surprises may be in the offing.
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JPMorgan: Infosys (INFO IN) Revenue growth recovery will likely get delayed due to the management change; this could be a long haul for Infosys Price Target: Rs4,000.00

Infosys (INFO IN)
Revenue growth recovery will likely get delayed due to the management change; this could be a long haul for Infosys

Overweight

Price Target: Rs4,000.00
PT End Date: 31 Mar 2015

Infosys announced that Dr. Vishal Sikka will be the next CEO of Infosys effective Aug. 1, 2014. Mr. Sikka has excellent credentials in products business, but his exposure to (traditional) IT services has been limited. Even if he is the right man for the job (only time will tell), he will take time to understand the company and devise & implement his strategy/vision for Infosys. Hence, we believe that Infosys is unlikely to return to an industry-level growth rate in FY16 as previously expected. To sum up, we believe this will likely be a really long haul for both Mr. Sikka and Infosys.
· Infosys revenue growth recovery will likely be delayed to FY17E or beyond. Dr. Vishal Sikka is an outsider to Infosys and the IT services industry; hence, he will likely take some time to understand the company, its cultural fabric, competitive landscape, politics, ways of working and the issues Infosys is facing. Infosys is a large company with more than 160,000 employees working on diverse service offerings/industry verticals and Dr. Sikka might take considerable time before getting comfortable in his new role. Hence, we believe the company will be on auto-pilot for the next few months. Mr. Murthy and Mr. Gopalakrishnan’s exit suggests that Dr. Sikka will likely devise his own strategy to run the company, which might not necessarily be a continuation of the current strategy. The crafting of the new strategy/vision and its implementation might take 4-8 quarters, in our view. Hence, we do not expect Infosys to return to an industry-level growth rate in FY16. However, Dr. Sikka’s communication of his strategy/vision can be a key catalyst in the next 1-3 quarters.
· Dr. Sikka has impressive credentials on the products side, but his performance in services business needs watching. Dr. Sikka was the CTO of SAP and the principal architect behind the enormously successful SAP-HANA (SAP’s analytics engine) and he is highly regarded as a technocrat. However, so far, he has not handled a services business and P&L responsibility. Though we admit that the line between products and services is incrementally blurring, there is a significant difference in running a predominantly services company (with minor product component) and a product company (with minor services component). Notably, Infosys generates less than 6% of its revenues from products, platforms and services (PPS), while more than 95% revenues originate from services. Hence, even if Mr. Sikka is the right man for the job at Infosys (only time will say so), he will take some time to understand the workings of Infosys. However, the bigger risk is that if the new organization puts excessive focus on products, platforms and solutions, traditional ‘bread-and-butter’ services might get neglected, which could cause revenue growth drag and further market share loss (which has been the case earlier as well when the company intensified focus on consulting and system integration at the cost of traditional IT services, as a result Infosys lost market share in ‘bread-and-butter’ services). Hence, Dr. Sikka’s views/strategy on traditional ‘bread-and-butter’ IT services need watching.
· Dr. Sikka’s appointment will likely provide the much-needed stability to the organizational structure. Infosys’s top management has been in a state of flux over the last one year with 12 senior leaders leaving the company (including Mr. Ashok Vemuri and Mr. B.G. Srinivas, the initially expected front runners for the top job). Though we expect a few more exits as the internal CEO hopefuls might resign, the organization will likely stabilize after that in our opinion. More importantly, the exit of top-leaders also drives attrition at mid-management level i.e., account managers at the client end & project/program managers at the delivery end. We believe that mid-level managers are the true value zones in an IT firm as they are the ones who manage on-the-ground issues, effectiveness of servicing & ensuring predictable outcomes. Senior management helps open doors but it is mid-management that is the key to mining & deepening accounts, in our view. The stability at the top level will likely help check the attrition at the mid-management level providing continuity. Moreover, Infosys has decided to promote 12 leaders to Executive Vice President (EVP) position, which might act as a morale booster.
· Some of the initiatives taken for the three-plank strategy might continue based on their merit. Under Mr. Murthy, Infosys had hinged its revival strategy on three identified planks: (a) Sales effectiveness, (b) delivery productivity (e.g., development and use of tools/solutions, particularly for the bread-and-butter business, reworking role ratios/span of control), and (c) cost optimization. The company has taken several initiatives to deliver on these three parameters, but we did not see firm signs of progress on the first two planks (sales effectiveness and delivery productivity). Mr. Murthy’s commentary suggests that the new leadership might re-evaluate these initiatives and continue some of these based on their merits. We believe taking a hard look at the earlier initiatives is a positive.
· We are maintaining our estimates pending further review post the management change.

Investment Thesis

Infosys appears to have more realistic targets in the current environment, which we believe is positive. Its win rates in the bread-and-butter segments (including large deals) seem to be improving. The company has also said it is prepared to temper the near-term margin profile for market share. The growth focus is encouraging, in our view. The other positives are: (a) strong deals wins over the last 3-4 quarters provide some visibility into CY14, (b) meaningful headroom for cost-optimization (and margin expansion) through rationalizing cost structure, increasing offshore effort and taking out redundant onsite costs, (c) management seems committed to bring the company back to industry-level growth rates, and (d) a relatively healthy demand environment in CY14 coupled with improved win rates should boost growth.

Valuation

We stay OW on Infosys with a Mar-15 price target of Rs4,000. Our price target is based on a one-year forward P/E of 16.5x, at a modest (~15%) discount to TCS’s target multiple of 19.0x. We believe the discount is justified as TCS’s revenue growth and margin profile are better than Infosys’s, in our view. Notably, our exchange rate assumption is Rs60/US$ for the next two years (FY15 and FY16).

 

Risks to Rating and Price Target

Downside risks: Lower-than-expected volume growth, weakness in the demand environment, a meaningful decline in pricing/realizations, an adverse US immigration bill, meaningful rupee appreciation (vs the US$), and higher-than-expected attrition.

J.P. Morgan - India Metal & Mining

Indian MM equities have been the best performing sector post elections, up ~22% v/s the broader MSCI India which was up 6%. Large cap stocks in the sector have rallied ~30-50%. While the election results are cited as the key catalyst for the sharp move, in our view, massively under-weight investor positioning, especially among Foreign Investors (please see chart below from our strategist team on weights) has driven the sharp rerating as positioning shifts from one extreme pre elections, to another extreme post elections. How much the actual holding has changed will only be known post the June quarter, when the company wise holding data is available. Our conversations with investors highlight a rush to buy these names, irrespective of valuations, fundamentals and earnings momentum, with some investors asking us to look at these names in a FY17/18E basis.
 
Given the sharp run up in the Indian MM universe, and U turn in investor positioning, we would NOT be surprised to see profit booking in these names over the next few weeks, though it could likely require a market cool off.
 
On a pure operating framework we highlight the following trends:
 
a) Steel- Spreads remain elevated, domestic prices steady, while demand weak: Raw Material (Iron ore + coking coal) have fallen at a faster rate than steel prices, implying spread expansion. This is particularly visible in Europe, and we expect this to flow through to TATA’s Q1/Q2 FY15 numbers. Domestic demand in India remains weak, while prices are steady.
b) Aluminum and Zinc- Prices remain elevated v/s March quarter: LME prices remain elevated, with premiums for aluminum increasing.
c) COAL India continues to miss targets (April and May): While the stock remains bid up on ‘reform expectations’ the company missed production and off take targets for April and May. Arguably investors are looking at FY17/18/19 estimates (as some told us on our downgrade), however continuous disappointment on operating numbers would be challenge to the ‘Bulls’.
 
What would you buy NOW?: This is the one common question we are getting from investors. While investors are now willing to look at stocks on FY17 and FY18, we are comfortable with a valuation framework on FY16 as of now, given the visibility. On this parameter, there is still potential upside v/s our PT on TATA, Hindalco and JSW Steel; the latter two have relatively underperformed in the last 1-2 weeks.
 
Change in FII portfolio weights (March 2010 – March 2014)
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Source: CMIE, J.P. Morgan. Data for BSE 500 universe
 
Global Steel YTD’14 stock Performance
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Source: Bloomberg
 
Global Non-Ferrous YTD’14 stock Performance
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Source: Bloomberg
 
Global Steel CY15/FY16 EV/EBITDA  
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Source: Company reports, J.P. Morgan estimates
 
Global Non-Ferrous CY15/FY16 EV/EBITDA
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Source: Bloomberg
 
YTD performance of Zinc, Aluminum and Steel Spread
 
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Source: Bloomberg, J.P. Morgan estimates

J.P. Morgan - India: a par for the course May CPI print

-- India: a par for the course May CPI print 


 
 
Unlike the IP surprise, May CPI printed exactly in line with expectations. The headline print moderated to 8.3% oya in May (JP Morgan: 8.3%, Consensus: 8.4%) from 8.6% in April. The moderation was both on account of a favourable base effect from the previous year as well as a slight dip in the sequential monthly momentum (+0.5% m/m, sa in May versus 0.6% the previous two months). But even as the quarterly, annualized momentum remains below the year-on-year rate, it ticked up in May to 5.9% q/q, saar from 4.2% q/q, saar the previous month.
There were no great surprises on the food front. For a second straight month, food prices rose 0.6% m/m, sa – in line with what the high frequency food price data had suggested – causing year-on-year food inflation to print at 9.3% oya – exactly what it has averaged over the last four months. The concern is that a deficient monsoon has the potential to cause food inflation to surge from already elevated levels.
Instead, all eyes were on core inflation. Here the news was mixed. The not-so-good news was that April core CPI was revised up from 7.8% oya to 8%. But the good news is that the momentum of core inflation ticked down for a second straight month to +0.4% m/m in May, sa from +0.5% in April and 0.7% in March. As a result of this, the quarterly annualized momentum of core has also softened to 7.6% q/q, saar from 8.3% in March. Within core, except for housing, the seasonally-adjusted monthly momentum of most components of core has softened meaningfully in the last two months (in the range of 0.2 to 0.4 %m/m, sa) except for housing. All this should give the RBI some comfort, but all eyes are now on the delayed monsoon.
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JPMorgan India: Composite PMI at a 11 month high, but masks inner tensions

India: Composite PMI at a 11 month high, but masks inner tensions

 
 
In a sign that perhaps economic growth may have bottomed – even though any upturn is expected to remain modest – the May composite PMI rose to a 11 month high, but largely on the back of the services sector even as manufacturing momentum remained muted. Furthermore, conflicting signals were not limited to just activity in the two sectors. Even the emanating price signals from manufacturing and services were a bit surprising given the circumstances, suggested multiple cross currents at play.
Services firm up
In the details, the composite May PMI business activity index printed at 50.7 – up a solid 1.2 pts from the April reading of 49.5 – and the highest reading since June 2013. The only quibble was it was driven almost exclusively by the services sector. Business activity within services rose a solid 1.7 pts to 50.2, the second successive increase and the first reading above the 50 threshold in almost a year. And the same message came through in the forward looking component, with the new order index also rising for a second successive month, and breaching 50 for the first time in almost a year.
Even as manufacturing continues to stagnate
In contrast, the manufacturing PMI continues to remain disappointingly stagnant. The headline index was flat for a third consecutive month, printing at 51.4 vis-à-vis 51.3 the previous two months. The output index, too, remained flat vis-à-vis April, and is lower than in the previous few months. The only solace is that new orders ticked up – as did export orders . The latter, in particular, will be a relief after the sharp slump in export orders in April, following the growth disappointment in developed markets in 1Q. To be sure, the lift in new orders, did cause the orders/inventory ration to tick-up, but largely because of the sharp fall-off last month.
A price signal dissonance
Similarly, there was slight dissonance among price signals. The good news is that – despite some pick-up in activity and orders for two consecutive months – services price pressures continue to be contained. Both input and output prices moderated in May, and both indices are at a 10 month low. The question remains if services growth were to continue firming up – at least in the PMI – will price pressures also begin to firm up? As the chart below demonstrates, output prices appear meaningfully correlated with business activity with a lag of 3-6 months, as one would accept. They key will be how input prices evolve – particularly wages – given their relatively important role in services.
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In contrast, despite continuing activity weakness, manufacturing output prices surprisingly ticked up by almost a full point to 51.7 from 50.9 in April. With the input price index still ticking down (54 in may from 54.6), we will treat the output price dynamic as noise for now, unless the same trend persists next month.
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J.P. Morgan - India IT Services

India IT Services
Impact of INR-USD on demand/growth: The demand curve is not inelastic and responds inversely to secular INR movements

· We see undue investor focus on Indian IT companies’ FY15/16 margins and EPS due to the strengthening INR. To us, a greater worry from structural INR appreciation is the impact that this has on secular (or medium-to-long term) growth of the Indian IT industry (and thus, the impact on P/E of stocks). This possibility is hardly discussed at all as it is commonly believed that INR-USD dynamics do not affect secular demand and revenue growth (which is not the case, in our view).Demand is not an inelastic/inflexible curve ‑ investment capacity and pricing philosophies also shape the secular demand curve for the industry and for individual companies. These factors are susceptible to secular shifts in INR/USD trends. For example, the advantages of a weak INR regime are clear. Besides the short-term boost to EPS, the weak INR will likely release excess margins that (a) are invested in accelerating market-share penetration in newer markets/service-lines and in lower-margin contracts/geographies, (b) allow greater pricing flexibility and (c) afford leeway to take more bets - vendors will likely shy from exercising these levers at stronger INR-USD levels (they would probably do much less of these if for example, the INR-USD was at 55 than they would if INR-USD was at 60). A weak INR regime, thus, hastens the process of expanding the addressable market and results in potentially higher revenue growth over the medium-to-longer term (though with differing results among vendors).
· The reverse is true in a structurally stronger INR environment. In a stronger INR environment (more specifically, when the strength of the INR takes it to a higher stable level), firms have less investment capacity, have less room for pricing flexibility, cannot afford to take as many major bets, may be warier of entering emerging/newer markets if economics don’t make sense – all of these constraints limit the pace of addressable market expansion and thus, revenue growth; most of these constraints would not hold as much in a weaker INR environment. Thus, unless the industry takes a margin reset, we see somewhat of an inverse relationship between INR-USD levels and secular growth rate of the industry contrary to the belief of some (though we can’t quantify this or draw the precise nature of this relationship; see figure below for a representation).
· Thus, the industry’s secular growth in an exchange rate regime reverting tightly around INR-USD of 60 will be different from that with exchange rate mean-reverting tightly around INR-USD of 55. Correspondingly, this should impact the P/E of the industry and companies therein. Investor expectations of a structurally strengthening INR-USD also impact P/E of the industry/companies but such an impact on P/E is likely to be only temporary if these expectations do not become reality. (Note: A structurally stronger INR is NOT our base-case; we still work with average exchange rate of Rs 59-60 for FY15/16 - hence, we stay OW on Tech Mahindra, Infosys, HCLT on moderate valuations and improving demand trends in the coming quarters.)
Figure 1: The industry’s secular (medium-to-long term) growth varies inversely with the INR’s secular strength with consequences for industry & company P/E – demand is not inelastic, a weaker INR regime releases ‘excess’ margins that gives firms substantial leeway on investments, pricing, and ability to take multiple bets - all of which help quicken the pace of addressable market expansion resulting in better secular top-line growth – room for pulling such growth levers gets squeezed by a structurally stronger INR unless the industry (or the influential players) take a margin reset – this is a bigger worry than near-term EPS/margin impact; but we are not building the case for a structurally stronger INR

J.P. Morgan - Property and Non Bank Financials

Property and Non Bank Financials
Housing for all identified as a key thrust area by Urban Development Ministry

The Urban Development Minister, in one of his first interviews, has marked “Housing for All” as a key priority, and to bring down rates of housing finance as an area of immediate focus. Given the current high level of interest rates it might be difficult to achieve this unless some special regulatory dispensation is given (additional reduced risk weights/ provisioning) apart from improved coordination across ministries. LICHF (OW), Prestige Estates (OW), JPIN (N), HDIL (UW) and Puravankara (Not Covered) are some of the key participants in the low cost housing space and any focused measure by the government could be positive over the medium term.
· Affordable housing is far more than just lower interest rates: Our interactions with various industry participants have indicated that lower mortgage rates alone might not improve affordable housing stocks. Faster approvals and higher FAR (Indian cities have low FSIs) and lower financing costs will be required. A lot of the developers have been stuck in the past on account of cost inflation / project delays in such projects and hence the propensity to do so many might not be there just yet unless some regulatory sops are given.
· Experiment has been successful only in a few cities: India’s urbanization has been haphazard with infrastructure not matching the pace of urban population growth. Except for a few satellite towns like Gurgaon / Noida and parts of Bangalore, many states have not been able to deal with it effectively. The 100 smart city project of the government is a step in the right direction here but implementation remains the key.
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