J.P. Morgan - Indian Equities - The Shrinking Cash-Pie

Global risk aversion and disappointing quarterly earnings led to marginal decline in equity indices last week; exporters and private sector banks outperformed

· The beat percentage in quarterly earnings reported for our coverage universe fell from 45% to 30% over the week

· The softening bias in long bond yield reversed last week as the expert committee recommendation on monetary policy reduced probability of a rate cut

· Expectations are low from the RBI and the FOMC policy meetings

· FIIs turned marginal sellers towards the end of the week

· The relative size of cash in the overall money supply has been reducing for structural reasons; the trend has positive implications for monetary policy and beyond

External and internal discomfort. Recent economic indicators and country specific news flows * have adversely impacted global risk appetite. Of the two key macro views – acceleration in DM growth and stabilization in EM growth, the later is making investors more nervous. The re-balancing process of global growth seems to have entered a short-term bumpy phase. India is usually a victim of any unfavorable developments in global markets given the over-dependence on FII flows. Domestic factors were mixed last week. Quarterly earnings had a disappointing bias (see details below). Opinion polls indicate an improved performance for the BJP. MSCI India (US$) corrected 2%, largely due to INR depreciation. Exporters and private sector banks outperformed. In the current week, RBI (28th Jan) and the FOMC (28, 29th) meetings would impact investor sentiment.

Monetary policy towards a new road. The expert committee on monetary policy submitted its report last week. The report, if implemented, may have structural significance, in our view. Our economics team expects the key recommendations to be accepted. Three implications of these policy suggestions would have:

1. Headline CPI inflation would become more important. The suggested target CPI levels are 8% in 12 months and 6% in 24 months.

2. With a defined medium-term inflation target, the volatility in rate expectations should reduce. Theoretically the reduced volatility in the yield curve would be good for real sectors and also for equity market over the medium term.

3. These monetary policy measures have well-known limitations. In the absence of a complementary fiscal and supply side response, the effectiveness may not reach to the desired and optimal levels.

Expectations of a rate cut, post the submission of this expert committee report, have reduced. 10 year benchmark treasury yield has risen over 20 bps. Note that the RBI meeting is a quarterly one and there would be official changes in growth and inflation estimates, which would impact investor sentiment.

A disappointing week of 3Q FY earnings reports. After a good start of quarterly earnings, the surprise bias turned disappointing last week. Companies across the sectors – Financials, Consumers and Cement – disappointed. See below key highlights:

· Only ~ 30% of Indian large cap companies have reported earnings

· Adjusted profit for the J.P. Morgan covered large-cap companies grew 14% yoy (See sectoral details below).

· IT Services companies (ex TCS) have managed to meet elevated expectations. Company managements indicated an improved demand environment for the year ahead.

· NBFCs and private sector banks have reported increased asset quality stress and in select cases planned slowdown in the credit growth momentum.

· Consumer companies have reported margin pressures on account of higher A&P spending, as revenue growth momentum has moderated

· RIL reported a marginal beat on higher GRMs and higher other income.

For our coverage universe, we expect an earnings growth of 14%, ex Energy.

FII turned sellers towards the end of the week, DII remain sellers. FIIs’ buying patterns this year across EMs are mixed. Taiwan by far remains the leading EM to attract FII flows (US$ 1.4 bn); the second leading destination, India, has received US$ 520 mn. As per the latest EPFR data, FIIs’ Indian overweight as on December end was 160 bps. FIIs turned sellers of Indian debt also. Increased uncertainty in the currency market is making investors nervous. The money flow indicator suggests increased buying interest in Consumer Discretionary and Industrials last week.

The healthy shrinkage in India’s cash pie. Indian is different from the rest of the world in many a respect. The difference is particularly notable in the inflation dynamics. The risk of deflation persists for some of the key DMs. In India a 12-month forward CPI target of 8% looks ambitious. Without going into the well known reasons of stubborn inflation dynamics, just highlighting a few developments on internal value of currency, RBI announced a measure to replace old notes (prior to 2005) last week. See some facts below:

1. The relative size of “currency with public” in the overall money supply has been declining for structural reasons. As the reach of banking service broadens the need to carry “currency” reduces. There are a few sectors which are still cash intensive, but increasingly the economy is getting more cash-less.

2. The growth rate of M3 and currency with public growth has been 17% and 14% oya over the last two decades. Currency with public used to be 20% of M3 two decades back. Currently the ratio is just 13%.

3. In the current monetary tightening phase, the slowdown in Currency with Public has been much sharper, driven by the RBIs policies. Aside of the cyclical aspects, the Indian central bank has been announcing policies with structural significance e.g. report on monetary policy, financial inclusion , new banking licenses etc. These measures are likely to have impact on effectiveness of monetary policy and also on the real economy over the medium to long term, in our view.

Figure 1: Average annual growth rate of money supply and currency with public in India

Source: Bloomberg

Table 1: Quarterly Earnings Growth – Large cap companies

Sector	3Q FY13 PAT (INR bn)	3Q FY14 Adjusted PAT (INR bn)	Adjusted PAT Growth (% YoY)
Consumer Discretionary	10	11	4
Consumer Staples	24	27	16
Energy	89	84	(5)
Financials	46	54	18
Health care	2	2	2
Industrials	11	11	(1)
IT Services	86	117	36
Materials	9	7	(25)
Telecom	3	4	64
Utilities	0	0	NA
Total	279	317	14
Ex Energy	190	233	22

Source: J.P. Morgan

Figure 2: 3Q earnings reports vs. J.P. Morgan expectations

Source: J.P. Morgan

*Chinese PMI, Political developments in Thailand and Turkey.

Maruti Suzuki - Good Q3 overlooked by Suzuki's ambitions:: LKP

Gujarat foray of Suzuki puts a cloud of uncertainty over the stock

Suzuki Motor Corp (SMC) would be investing Rs30 bn in the Gujarat plant at Mehsana for a capacity of 2.5 lakh which would come on stream by 2017. This was initially planned to be done by MSIL. This will be a contract manufacturing agreement wherein SMC would sell vehicles solely to MSIL as per their demand. The price of the vehicle to be sold by SMC to MSIL will be including only the cost of production actually incurred by the subsidiary plus just adequate cash (net of taxes) to cover incremental capex requirements. Return on this investment for SMC would be realized only through growth and expansion of MSIL’s business. This means after the initial capacity of 2.5lakhs units have been setup, the financing of the second unit with similar capacity will be done from the earnings of the sale of first 2.5lakh cars. According to the management this would not hamper the net margins of MSIL but would be maintained at current levels (~8%). SMC would sell vehicles to MSIL at zero % profit margins and would earn only 56% of the profit earned by MSIL. The rational given by SMC is cheap money in Japan plus lack of investment opportunities in Japan thus saving MSIL from straining its balance sheet from incurring capex itself. This would in turn save depreciation costs to MSIL. Given that MSIL has excess cash and investments to the tune of Rs 80 bn on their balance sheet, the rationale behind SMC investing in Gujarat plant through establishing a new subsidiary is still unclear despite the management stating that this move is EPS accretive. This to our mind puts an overhang on the stock especially because going forward this subsidiary could end up with a capacity equivalent to MSIL’s existing capacities.

Strong set of numbers in Q3 FY14

Maruti Suzuki India Ltd (MSIL)’s Q3 FY14 numbers were in-line with our expectations. The topline fell by 2.7% yoy and grew by 4.1% qoq at Rs108.9 bn. The company’s numbers are to be compared on sequential basis as the SPIL merger had not happened in the last year same quarter. Volumes in the quarter decreased by 4.4% yoy while growing at 5% qoq to 2.88 lakh units. EBITDA grew by 2.5% qoq while margins remained almost stable at 12.8% qoq. Company’s efforts on vendor rationalization, localization and cost reduction at the employee costs front along with reduction in ocean freight on low export demand led to stable and strong margin performance. Net realizations grew by just 1.4% yoy, while declined 0.5% qoq as discounting grew sequentially and exports remained weak. RM to sales came went up to 73.5% from 71.1% qoq as ASPs declined and RM cost increased on unfavorable currency. Employee costs to sales moved down to 2.82% of net sales as there was a one-time bonus payment to employees in the last quarter. Other expenses also moved down to 13.5% from 14.8% qoq as the ocean freight charges for MSIL fell on the back of lower exports. Depreciation moved up 8% qoq as the  Manesar Phase 3 (which commissioned this quarter) plant got commissioned this quarter along with the SPIL engine plant which recently got merged. Other income fell by 16% qoq to Rs1.17 bn. Tax rate moved down to 23.1%, lower than our expectations. In line with operational outperformance PAT surpassed market expectations at Rs6.82bn.

Outlook and Valuation

MSIL’s volume performance has been shaky in FY 14 on the back of the weak macros. However, with expectations of economy revival in FY 15 along with new launches from the company in the form of an SUV XA Alpha in FY 15 and compact car Celerio in Q4 FY14, we believe the strength in volume will return. MSIL is aproxy to the recovery in auto industry. Considering the resilience observed in margins despite a few concerns, we are maintaining our margin forecast for FY14E/15E to 12.3%/12.8%, while slightly increasing our volume forecast for FY 14E/15E as well to 1.2%/6.5% respectively. However, the Gujarat plant investment by Suzuki is a new overhang on the stock as the uncertainty behind the rationale of SMC to invest in an altogether new subsidiary in India will play on the minds of the investors. Although the real impact of this development will be felt in FY 17/18 when the plant goes on stream in the near to medium term the impact of this will be negligible. We are downgrading the stock to Neutral from BUY, but slightly increasing our target price on better volume expectations in FY 15E to Rs 1,828

Sesa Sterlite- Rating: Sell; Target Price: Rs160; CMP: Rs194; Centrum

Rating: Sell; Target Price: Rs160; CMP: Rs194; Downside: 17.4%



Subdued performance; start-up of projects further delayed



We maintain Sell on Sesa Sterlite (SSLT) with a target price of Rs160
on account of i) subdued operational performance during Q3 with sharp
cut in volume guidance at HZL and further delays in start-up of new
projects at BALCO & VAL thereby diluting the volume growth potential
and ii) high debt on standalone books with operations not fully
utilised and non-integrated (VAL faces bauxite & alumina shortage, SEL
faces coal linkage and evacuation issues and Sesa's iron ore
operations restart visibility is low). We cut our FY14E/15E EBITDA
estimates by 3.7%/6.2% to factor in lower volumes.

$ Disappointing performance from zinc and power operations:
Operational performance disappointed in zinc with lower volumes
(Lead/silver down by 20%/30% YoY, International zinc volumes at 85kt,
down 18% YoY). Al business was robust with stable volumes and lower
costs (CoP down 12%/18% YoY for BALCO/VAL). Power business remained
subdued on volume front and disappointed on realizations, iron ore
operations remained shut, oil & gas was largely stable while copper
business was robust with highest ever volumes and strong TcRc margins.

$ Operational performance lower than expectations: Consolidated EBITDA
was ~8% lower than our estimates due to lower than expected operating
profits from zinc and power operations.  PAT stood at Rs18.7bn (~5%
lower than est.) as other income was lower due to MTM losses, partly
offset by lower taxes due to reversal of provisioning made earlier. We
reduce our FY15E EBITDA estimates by ~6% due to cut in volumes at
VAL/BALCO from new projects, lower merchant power PLF at SEL/BALCO and
lower mined metal output at domestic zinc operations.

$ Unutilized capacities a drag on returns: The group is saddled with
unutilized capacities at VAL (1.25 mtpa smelter remains
non-operational) and BALCO (325ktpa smelter and 1200 MW power plant's
commercial start-up has been repeatedly delayed). We believe the drag
of high debt (~Rs840bn) and CWIP on returns will continue as new
capacities are not integrated and offer low returns potential. There
is as yet no clarity from management on their potential start-up.

$ Valuations and risks - recommend Sell: We arrive at SOTP fair value
of Rs160 for Sesa Sterlite after shifting our valuation base to
Dec'15E and factoring in reduction in our EBITDA estimates due to
further delay in commissioning of projects. We continue to assign 20%
holding company discount to HZL and BALCO as we wait for clarity on
consolidation of holding post buyout of GoI stake. Stake buyout in HZL
and BALCO could lead to an upside of ~Rs30-35/share in our target
price but current valuations suggest that market has already factored
this in, thereby leaving no room for further upside.



Thanks & Regards

Just Dial - Q3FY14 Result Update - Operating matrices:: Centrum

Rating: Hold; Target Price: Rs1,130; CMP: Rs1,290; Downside: 13%



Operating matrices disappoint



We maintain Hold rating on Just Dial and believe the company could
face pressure on the back of slower growth in paid campaigns coupled
with low usage & search request impacting pricing as in Q3FY14
results. High A&P spends of Rs0.6-1bn for transaction led businesses
will impact near term profitability, affecting valuations. While
strong revenues for transaction led businesses in FY15 could act as a
positive trigger, we believe it is too early to gauge its success and
hence see low visibility for earnings upgrade.

$ Q3FY14 results below expectations: The company posted 25.9% YoY
growth in sales to Rs1199mn (est .Rs1211mn). Operating profit was up
40.6% YoY to Rs333mn (9% below expectation) with strong operating
leverage expanding margins by 291bps to Rs27.8% despite 27.4% YoY
increase in employee cost led by higher headcount in sales force.
Sequentially, admin & other expenses increased 36.7% on higher A&P
spend (Rs50mn) in the quarter. Adj PAT was up by 86% YoY to Rs298mn,
2.4% above expectations driven by high other income (up 214% YoY) on
the back of Rs6bn in cash and investments and lower tax rate of 25.9%
against 31% in Q3FY13.

$ Operating matrices disappoint: During the quarter, the company
stopped zero down payment scheme for campaigns to take quality signups
which impacted paid campaigns for the quarter to 249K (up 27.9% YoY
and 4.6% QoQ).  Both usage (115.6mn) and search (274.9mn) data were
down on a sequential basis by 5.7% on the back of seasonality and
design change in the website. Revenue/usage was up 0.3%YoY while
revenue/paid campaign was down 1.6% YoY. The company has hiked prices
across paid clients during the quarter which will help increase
realizations.

$ Focus on vendors for Search-Plus: Management believes the early
adaptation of 10 services under Search Plus has been encouraging with
focus on consumer experience and expanding the depth and breadth of
the service. The company is currently looking at vendor communication
and empanelment and will later look at their monetization. Management
believes this could have an advertising budget of Rs0.6-1bn in FY15.
We do not anticipate significant revenues from these businesses by
FY15E and have not factored in higher A&P spends currently.

$ Maintain Hold: We have lowered our revenue estimates for FY14/FY15
on the back of slowdown in usage and paid campaigns while increasing
our operating margins on high fixed cost business model. We maintain
Hold with a revised target price of Rs1130 (40x Dec 2015). We believe
higher A&P spends for transaction led business could impact near term
profitability while lower growth in paid campaigns and pressure on
pricing could act as a key risk. Upside could be strong revenues from
transaction-led business in FY15 leading to margin expansion.



Thanks & Regards

--
--

J.P. Morgan - India Strategy - Surprise Rate Hike

India Strategy Surprise Rate Hike ... Balanced with Dovish Guidance

· In the Quarterly Monetary Policy Review announced earlier today, the RBI surprised financial markets by increasing the Repo Rate by 25 bps (vs consensus expectations of no change).

· The future guidance, however, sought to comfort markets. The Central Bank opined that “if the disinflationary process evolves according to this baseline projection, further policy tightening in the near term is not anticipated at this juncture”.

· Consequently:

o The Repo rate stands increased by 25 bps from 7.75% to 8.00%.

o The Marginal standing facility rate stands increased by 25 bps to 9.00%.

o The CRR remains unchanged at 4.0%.

· Key statements from the Policy that merit attention:

o Explaining the rationale for the rate hike ‘An increase in the policy rate will not only be consistent with the guidance given in the Mid-Quarter Review but also will set the economy securely on the recommended disinflationary path.’

o On future guidance ‘The extent and direction of further policy steps will be data dependent, though if the disinflationary process evolves according to this baseline projection, further policy tightening in the near term is not anticipated at this juncture.’

o On medium-term inflation targets ‘Urjit Patel Committee has indicated a “glide path” for disinflation that sets an objective of below 8 per cent CPI inflation by January 2015 and below 6 per cent CPI inflation by January 2016’.

o On the RBI’s growth forecast ‘If policy actions succeed in delivering the desired inflation outcome, real GDP growth can be expected to firm up from a little below 5 per cent in 2013-14 to a range of 5-6 per cent in 2014-15, with risks balanced around the central estimate of 5.5 per cent’.

· Market reaction. Financial markets are disappointed (though not spooked) with the policy announcement today.

o 10-year treasury yields remain largely unchanged at 8.76% (they have been risen by nearly 20 bps since the release of the Urjit Patel Committee recommendations).

o The Benchmark equity index – NIFTY – has lost a marginal 0.3%; Bank Nifty is down about 1%.

o The INR though has appreciated a marginal 0.3%.

· Outlook and portfolio stance. We have been arguing for Indian Equities to stay range-bound over the near term given an absence of meaningful upside catalysts. Valuations are middling, Growth continues to weaken with limited stimuli available and the Political situation is fluid (most recently in India Strategy: 1H 2014 – Walking the Tight Rope, January 27). We maintain that stance. If anything the RBI’s policy stance reinforces it. Our portfolio stance in biased towards global sectors. We remain underweight most local cyclicals including financials.

-- 

J.P. Morgan - RBI hikes rates and deftly moves closer to flexible inflation targeting

The RBI hiked policy rates by 25 bps (Repo: 8 %) and deftly moved closer to a flexible inflation targeting approach, committing to a glide path that would bring CPI headline inflation down to below 8% in a year’s time, as per the recommendations of the Urjit Patel Committee Report (see,” RBI Expert Committee recommends move to flexible inflation targeting,” Morgan Markets, January 22, 2014).

Markets were surprised by the rate hike because with the RBI choosing to stay on hold in December, headline inflation moderating by 130 bps since then, food prices continuing to correct, growth continuing to disappoint, and uncertainty about when the Committee report would be adopted, the majority – but not all -- market participants had expected the RBI to stay on hold (Consensus and JP Morgan: on hold). However, we had expected it to be a very close call since one of the pre-conditions for staying on hold in the December guidance – that core must moderate -- had not been met (see, “RBI likely to stay on hold, but it’s a close call,” Morgan Markets, January 27, 2014). Before today’s review, we had penciled in 75 bps of rate hikes in 2014 and, after today’s hike, re-affirm our view of another 50 bps of hikes in the second half of the calendar year.

To its credit, the central bank indicated that one of the reasons for today’s hike is that it takes its guidance very seriously. The guidance had explicitly indicated that barring a substantial moderation in headline inflation and a moderation in core inflation, the RBI would act. And while the first condition had been met, the second had not (see, “RBI’s CPI dilemma: it depends what “is” is”, Morgan Markets, January 13, 2014) triggering the hike.

Don’t miss the forest for the trees

But only focusing on last review’s guidance, this review’s action, and the rate outlook in the near future runs the risk of missing the forest for the trees. Because, today’s monetary policy review – both explicitly and implicitly – signals a significant departure from the extant multiple-indicator approach towards a flexible inflation-targeting framework based on the headline CPI.

• For starters, the RBI has focused exclusively on headline CPI inflation in the policy review, adopting the glide-path recommended by the Urjit Patel Committee of bringing headline CPI to below 8% in a year’s time. The RBI indicated that today’s hike was necessitated by the fact that, absent policy action today, there were “upside risks to the central forecast of 8%.” This clearly indicates the primacy of a quantitative CPI headline target in monetary policy decision-making. Revealingly, there was absolutely no mention or forecasts of the WPI, which used to dominate previous reviews.
• Interestingly (and to the RBI’s credit) there was no talk about a growth-inflation trade-offs. The Governor reiterated at the press conference (and we strongly concur) that at current levels of retail inflation and inflationary-expectations, there is no trade-off between growth and inflation. The policy backed up this line of thinking by indicated that “if policy actions succeed in delivering the desired inflation outcome, real GDP growth can be expected to firm-up from a little below 5 percent in 2013-2014 to a range of 5-6 percent in 2014-15” This clearly suggests that the central bank believes – and we agree – that bringing down inflation from current levels is itself growth-enhancing and not growth-inhibiting. It also reinforces the primacy of bringing down headline CPI inflation above other objectives over a one-year horizon.

Where to from here?

One of the many advantages of laying out a transparent, quantitative target to be met in a year’s time (Headline CPI at 8% in a year) is that it takes away the uncertainty of the past (about whether the primary objective was growth, headline CPI, core CPI, headline WPI, core WPI, the exchange rate) and is therefore better able to anchor both market and household expectations.

However, even if there clarity on the end-goal, there can still exist differences on the assumptions needed to get there. The RBI noted that “the extent and direction of future policy steps will be data dependent, though, if the disinflationary process evolves according to this baseline projection, further policy tightening in the near-term is not anticipated at this juncture”

With food prices continuing to correct sharply in January – and expected to do so until the general elections – and growth momentum likely to weaken further in 1Q14 (on the sharp fiscal squeeze needed for the government to meet its budgeted fiscal deficit) expected to put some downward pressure on core inflation, we expect the RBI to stay on hold at the April 1^st review. (Per the Urjit Patel Committee recommendations, monetary policy will move to a two-month cycle instead ofa six week cycle).

However, under our baseline assumption of a growth pick-up in the second half of the year, post the elections, we expect inflation momentum to rise, and pencil in another 50 bps of rate hikes in the second half of the calendar year, consistent with our view that output gaps may not be as negative as presumed (see, “Special Report: India in 2014 – five questions that keep us awake, “ MorganMarkets, January 27, 2014)

Markets are likely to focus on the timing and likelihood of the next rate action. But the more important message from today’s review is that the transition to a more transparent, rule-based monetary policy framework at the central bank, with price stability as its overarching medium-term objective, is well and truly on.

 

Disclaimer: this author served on the Urjit Patel Committee to strengthen and revise the monetary policy framework.

Gail India - Q3FY14 Result Update: LKP

Strong performance by LPG segment driven by absence of subsidy burden boosts profit

GAIL’s Q2FY14 adjusted net profit of Rs13.3bn was in line with our estimate. As GAIL’s subsidy sharing was provisionally capped at Rs14bn (which it has already shared in H1FY), GAIL’s subsidy share during the quarter was meagre Rs13mn. Net revenues at Rs159.8bn registered a jump of 28.1% yoy mainly on account 51.4% increase in LPG and OLHC and 31.3% increase in gas trading revenues. GAIL’s gas transmission volume during the quarter declined by 8.6% yoy to 96mmscmd (qoq +1mmscmd) and continues to get affected due to fall in volumes from RIL’s KG D6. Gas transmission tariff increased by 35.1% yoy to Rs1,281/tcm. Petchem sales volume declined by 14.8% yoy (qoq +0.9%) while realizations increased by 24.2%/2.3% yoy/qoq. Petchem margin during the quarter declined by 566bps sequentially to 28.8% (yoy -1,088bps) due to high LNG cost and lower PMT supply. Gas trading segment’s EBIT during the quarter increased by 69.2% to Rs5.05bn as trading margin increased by 51.9% yoy to $0.32/mmbtu.

Valuation and view

In the near term, we believe that concerns relating to lack of growth in GAIL’s key gas transmission segment would continue to be an overhang on the stock. The increase in APM gas price would negatively impact GAIL’s petchem business while lack of gas supply from RIL’s KG D6 would affect its LPG extraction business. However (the likely) exemption of GAIL from subsidy sharing mechanism would help abate the impact of higher APM gas price as can be seen from result of the current quarter. We believe this would eliminate GAIL’s dependence on adhoc government policies with respect to sharing of subsidy burden.

We maintain our NEUTRAL rating on GAIL with SOTP based price target of Rs360. At the CMP, the stock is trading at 9.5x and 6.6x FY15e earnings and EV/EBITDA respectively.

Actual v/s Estimates

Y/E, Mar (Rs. m)	Q3FY14	Q2FY14	qoq (%)	Q3FY13	yoy (%)	LKP Estimates	Deviation (%/bps)
Revenue	159,806	139,446	14.6%	124,743	28.1%	148,650	7.5%
EBITDA	22,317	14,055	58.8%	19,722	13.2%	22,214	0.5%
EBITDA (%)	14.0%	10.1%	389 bps	15.8%	-184 bps	14.9%	-98 bps
APAT	13,345	9,157	45.7%	12,849	3.9%	13,221	0.9%
RPAT	16,794	9,157	83.4%	12,849	30.7%	13,221	27.0%