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ECONOMY & STRATEGY February 2015 2004 - 2014 2014 onwards Rural India: At the crossroads Analysts: Saurabh Mukherjea, CFA [email protected] Tel: +91 22 3043 3174 Ritika Mankar Mukherjee, CFA [email protected] Tel: +91 22 3043 3175 Nitin Bhasin [email protected] Ashvin Shetty, CFA [email protected] Pankaj Agarwal, CFA [email protected] Rakshit Ranjan, CFA [email protected] Bhargav Buddhadev [email protected] Ritesh Gupta, CFA [email protected] Economy & Strategy CONTENTS Rural India: At the crossroads…………………………………………………………………. 3 Executive summary of sector specific impacts………………………………………………..4 Rural and semi-urban India: What are we seeing on the ground?.............................. 5 How will the rural demand story evolve in the coming years?................................... 11 Can the rural India story stage a comeback under the NDA?....................................14 SECTOR Consumer………………………….………………………….………………………………..15 Automobiles………………………….………………………….……………………………. 22 Cement………………………….………………………….………………………………….. 28 Home building materials………………………….………………………….………………36 NBFCs………………………….………………………….………………………….…………42 Light Electricals………………………….………………………….…………………………. 48 Agri Inputs………………………….………………………….………………………………. 61 February 24, 2015 Ambit Capital Pvt. Ltd. Page 2 Economy & Strategy THEMATIC Whilst the lower tier of rural India may recover, this will take time Whilst the effects of weak monsoon and weak commodity prices might be temporary, the Government is set to use the DBT platform to plug leakages and to better target subsidy spends. Whilst the plugging of leakages will adversely affect the top tier of the rural economy, the lower tiers will benefit owing to the superior targeting. Furthermore, in a bid to create jobs, the Modi Government is likely to administer a ‘big push’ to the infrastructure sector (see our note dated 16 February for details) which will buoy the rural economy, albeit with a lag. Investment implications Even if we assume that the NDA moves swiftly on DBT and big-ticket capex focused on road building and low-cost housing, we are likely to see a lull for 26 quarters, during which the old game of pilfering subsidies comes to an end with the new construct yet to fire. The companies which appear to be the most exposed are those that have relied heavily on rural India to drive their growth through the downturn including M&M (MM IN, unrated) as SUVs and tractors account for ~70% of its total volumes, Maruti (MSIL IN, SELL) as ~30% of its revenues comes from rural sales, HUL (HUVR IN, SELL) as 40% of its revenues come from rural segments, Colgate (CLGT IN, SELL) as 35% of its revenues come from rural segments, MMFS (MMFS IN, SELL) as >95% of its loan book is driven by rural India, Havells (HAVL IN, SELL) as ~30% of its revenues come from rural India, Ambuja (ACEM IN, SELL) as ~35% of revenues come from rural segments and Ramco Cements (TRCL IN, SELL) as ~35% of its revenues come from rural segments. 60% 24% 26% 40% 20% 20% 23% 18% 9% 2% 0% -1% -20% FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 (BE) Expenditure on subsidies (YoY change, in %) 83% 80% Source: CEIC, Ambit Capital research Exhibit B: Government expenditure growth has slowed down in FY15 30% 20% 10% FY15 (YTD) FY14 FY13 FY12 FY11 FY10 0% FY09 The NDA Government seems to have hit the brakes on these subsidies Despite creating allocations for subsidies and plan spends in the FY16 Union Budget, the new Government seems to have hit the brakes on subsidy spends and MSP hikes. As per the latest data available, total expenditure growth over Apr-Dec 2014 was at 6% YoY vs budget estimates of 13% YoY and the ten-year average growth rate of 13% YoY. Similarly, Minimum Support Prices (MSPs) for rice and wheat grew at 4% YoY in FY15 vs an average growth of 9% YoY in the previous decade (see Exhibit C on the right). This combined with poor monsoons and global moderation in food prices has weakened rural demand. 100% FY08 Growth in rural India was fuelled by a blast of subsidies The average top-line growth of 15.2% YoY recorded in the FMCG space over FY09-15 was driven mainly by the dramatic levels of subsidies pumped into the rural economy by the previous Government. For instance, India’s subsidy bill under the UPA regime grew at a staggering CAGR of 19% p.a. during FY05-14 (see Exhibit A on the right). Most research studies suggest that ~40% of the subsidies disbursed by the Central Government are lost in the form of leakages. This in turn implies that ~US$17bn or 0.8% of GDP alone was pilfered in FY15 itself, thereby buoying the incomes of the top tiers of the rural economy. Govt. expenditure (YoY change, in %) After seven years of frenetic growth, the rural and semi-urban India story now faces a serious challenge, as the old construct of pilfered subsidy cash being used to buy land, gold, SUVs, cars, 2Ws, electricals and other aspirational items by the rural elite comes to an end. The NDA will gradually unveil new rules which will govern rural growth henceforth. However, even if one takes an optimistic view of the NDA’s as yet unproven execution skills, it will take at least 2-3 quarters for the NDA construct – centered on capex and DBT – to bite. In the meantime, the unwinding of the previous UPA construct will condemn a range of reasonably well-managed companies to a spate of poor results. Exhibit A: Subsidies under the UPA regime grew at a CAGR of 19% p.a. Source: CEIC, Ambit Capital research Exhibit C: Rate of MSP increases has slowed down in the past two years 15% Avg. Growth in MSPs (YoY change, in %) Rural India: At the crossroads February 24, 2015 14% 11% 10% 4% 5% 4% 0% Avg. FY08-13 Avg. FY14-15 Rice Wheat Source: CEIC, Ambit Capital research Analyst Details Saurabh Mukherjea, CFA +91 22 3043 3174 [email protected] Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision. Economy & Strategy Executive impacts summary of sector-specific Exhibit 1: The slowdown in rural demand will impact sectors and stocks which rely heavily on rural India Sector Consumer Automobiles Cement and Homebuilding NBFCs Light Electricals Agri Inputs Impact Adversely affected stocks Volume growth rates in consumer staples have moderated from 9-10% over FY08-12 to 5-6% over FY13-15E. Discretionary consumer revenue growth rates have moderated from 25-30% to 13-15% over the same period. Whilst the moderation in FY13 and FY14 was led predominantly by weakness in urban demand, that in FY15 has been driven mainly by weakness in rural demand. Going forward, we expect rural demand revival to lag behind urban by 6-12 months, although the longer-term rural consumption story remains intact. HUL, Colgate and Dabur have the highest exposure to rural demand in our coverage universe. GCPL, HUL and Jubilant Foodworks are our TOP SELL ideas and Page is our TOP BUY idea. Whilst rural prosperity has aided auto volume growth in recent years (domestic 2W sales recorded a CAGR of 8% and Maruti’s rural sales witnessed a CAGR of 14% over FY11-14), a moderation in rural income and prosperity may negatively impact rural demand. However, we believe this negative impact would be offset to some extent by the moderating cost of ownership helped by declining fuel prices and falling interest rates. We believe the impact would be higher on PVs and SUVs (given the high ticket size) as compared to 2Ws. We expect Mahindra & Mahindra to be the most impacted followed by Maruti Suzuki to a smaller extent. Whilst we believe the impact would be muted on 2Ws (being relatively small-ticket-sized items), we remain concerned of the rising competitive intensity in and high penetration of 2Ws in rural India. Rural housing forms 40% of overall cement sales in India, which is largely supported by agricultural income and rural wages. Poor agri output, low MSP growth and moderation in rural wage growth has constricted rural income growth and resultantly led to a slowdown in housing construction. Our discussions with managements and primary data sources suggest that the ‘rural wealth effect’ also supported mid-ticket housing construction in nearby towns, which has declined materially in recent months. Companies such as Ambuja Cements and Ramco Cements have high exposure to rural/retail markets and are the most susceptible to a slowdown in rural cement consumption. We believe that the unwinding of the wealth effect in rural India could lead to: (i) some demand decline in aspirational and discretionary plays in the auto sector such as passenger cars and UVs; and (ii) decline in property prices in semi-urban/rural India, which could affect the loan against property and self-employed segment. MMFS, with ~47% exposure to cars and UVs in the rural space, would be the most impacted amongst auto-financers. Repco, with ~20%/56% exposure to LAP/selfemployed segment and with higher contribution of increasing ticket sizes in its loan growth, would be the most impacted amongst Housing Finance Companies (HFCs). Magma is our TOP BUY idea. Revenue growth for the Indian light electricals (LE) industry has deteriorated significantly since November led by sluggish demand due to: (a) slowdown in industrial capex and tight liquidity; (b) weak consumer sentiment due to recessionary environment in rural areas led by weak monsoon and falling crop prices (especially cash crops); and (b) falling copper prices which is leading to inventory de-stocking at distributors’ end and delay in purchases from the end customers in anticipation of falling prices. However, there is an expectation that demand will improve in FY16 if copper prices stabilise and if the monsoon season is good. Moderating growth in MSPs and lower farm realisations would impact farmer sentiment in FY16. However, we believe the growth rates could still be supported by good monsoons and healthy absolute MSP levels. Whilst sustained weaker growth in MSPs for the next 2-3 years would clearly hit growth, we believe that if such a reduction in subsidies is used to invest in irrigation/storage infrastructure then this would be a positive step from a medium- to long-term perspective. Reduction in leakages and a move to DBT for a significant proportion of subsidies would also give more cash in the hands of farmers. On the agrochem side, we believe that growth rates for agrochem players would be supported by rising adoption of high-value molecules (due to increasing awareness amongst farmers), rising adoption of herbicides (rising cost of labour due to urban migration) and fungicides (due to demand for high-quality agri produce). Companies having higher share of generic products may be impacted more if weak realisations persist for long. PI Industries is our TOP BUY idea. HUL, CLGT M&M, Maruti Ambuja Cements, Cements Ramco MMFS, Repco Havells, Bajaj Electricals No adverse effect on stocks Source: Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 4 Economy & Strategy Rural and semi-urban India: What are we seeing on the ground? Ritika Mankar Mukherjee, CFA, [email protected], +91 22 3043 3175 The most recent set of company results point to a material slowdown across those B2B and B2C companies that rely on rural demand. This spans sectors from FMCG to twowheelers and light electricals as well as cement (see the exhibit below) The most recent set of company results point to a material slowdown across those B2B and B2C companies that rely on rural demand Exhibit 2: The most recent set of results point to a slowdown in sales growth… Revenue growth* (YoY change, in %) 1QFY14 2QFY14 3QFY14 4QFY14 1QFY15 2QFY15 3QFY15 Change (3QFY15 vs 2QFY15 Hero -1% 11% 11% 6% 14% 20% -1% -21% V-Guard Havells (standalone) TVS Bajaj Electricals (non-E&P) Finolex Cables HUL 17% -12% -14% 26% 35% 2% -17% -19% 2% 22% 12% 12% 21% 16% 5% -11% -4% 18% 14% 22% 30% 34% 28% -6% 9% 17% 6% 0% 40% -4% -10% -5% 7% 1% 5% 3% 3% 7% 3% -4% 7% 9% 9% 10% 13% 11% 8% -3% Maruti -5% 27% -3% -5% 11% 17% 15% -2% Dabur 11% 10% 13% 14% 11% 12% 12% 0% Colgate 14% 14% 14% 12% 11% 11% 12% 1% M&MFS* 4% 4% 5% 4% 6% 6% 7% 1% Company Source: Bloomberg, Ambit Capital research. Note: *For M&MFS, gross NPAs are given instead of revenue Exhibit 3: … and a slowdown in volume growth Volume growth* (YoY change, in %) Company 1QFY14 2QFY14 3QFY14 Hero -5% 6% TVS -5% 4% -10% Maruti M&MFS* 3QFY15 Change (3QFY15 vs 2QFY15 20% -2% -22% 31% 26% -5% 13% 17% 12% -5% 4QFY14 1QFY15 2QFY15 7% 4% 10% 0% 10% 18% 20% -7% -5% 34% 30% 27% 21% 15% 14% 10% -4% HUL 4% 5% 4% 3% 5% 5% 3% -2% Dabur 9% 11% 9% 9% 8% 9% 7% -2% Colgate 9% 10% 10% 7% 5% 7% 5% -2% Source: Bloomberg, Ambit Capital research. Note: *For M&MFS, loan book growth is reported instead of volume February 24, 2015 Ambit Capital Pvt. Ltd. Page 5 Economy & Strategy Leaving the results aside, our extensive discussions over the past month with primary data sources and management teams across India point to the following: A marked slowdown in volume growth (and underlying demand growth) in cement, gensets, FMCG, light electricals, two wheelers and tractors. A drying up of black money across the rural and semi-urban economy with the result that working capital management has become a challenge for listed companies and for their distributors and dealers. A stagnation in rural land prices for the first time in a decade. A marked slowdown in construction activity and real estate sales in rural India and in Tier 2/3/4/5 cities. (Tier 1 cities like the National Capital Region and Mumbai already had subdued growth or declining growth in their real estate markets.) A drop in the demand for gold and jewellery especially outside Tier 1 cities. So what is going on? Why has growth in rural India slowed down so abruptly? Commentary from the senior managements of these companies as well as our own channel checks suggest that five sets of factors are responsible for this visible slowdown in rural demand, namely: Sub-par South-West monsoons in FY15, Slowdown in Government spending on rural India, Moderation in prices of agricultural commodities globally, Clear slowdown in rural wage inflation, and Decline in property and gold prices. In the section below, we elaborate on each of these dynamics. Factor #1: Sub-par South-West monsoons in FY15 Note that 53% of the area under production in India is rainfall-dependent and hence history points to a positive relationship between the extent of summer rains and the agricultural sector performance in India (see the exhibit below). Exhibit 4: The magnitude of the South-West monsoon and agricultural sector GDP are positively related R² = 0.5444 0% -10% -20% -30% -5% 5% 15% 20% Kharif foodgrain production (YoY change, in %) Monsoon rains (% departure from LPA) 10% -15% Exhibit 5: The sub-normal South-West monsoons led to a contraction in kharif production in FY15 16% 15% 9% 10% 5% 1% 0% -5% -2% -7% -10% Agricultural GDP (YoY change, in %) FY11 Source: CEIC, Ambit Capital research, Note: Data pertains to FY01-FY14 FY13 FY14 FY15 Source: CEIC, Ambit Capital research As the South-West monsoon in FY15 was below normal (11% below the long-period average), kharif crop production (i.e. the summer crop) declined by 7% YoY in FY15 (see the exhibit above). It is critical to note that kharif production in India accounts for 51% of the total agricultural production and hence poor South-West rains affect agricultural sector production in a given year meaningfully. February 24, 2015 FY12 Ambit Capital Pvt. Ltd. As the South-West monsoon in FY15 was below normal (11% below the long-period average), kharif crop production (i.e. the summer crop) declined by 7% YoY in FY15 Page 6 Economy & Strategy Factor #2: Slowdown in Government spending on rural India The generous spends on rural India administered by the previous Government had played a pivotal role in driving demand in rural India. For instance, MSPs for rice and wheat were increased at an average rate of 14% YoY and 11% YoY respectively over FY08-13. This pace of increases decelerated meaningfully from FY14 onwards, as MSP growth rates slowed down to 4% YoY for wheat and rice (see the exhibit below). 40% 5% 5% 4% 4% 4% Rice FY15 FY14 FY13 FY12 FY11 FY10 FY09 FY08 0% 9% 10% 4% 0% 0% FY15 (E) 2% 0% FY14 2% FY13 10% 15% 10% FY12 8% 8% 20% FY11 15%16% 11% 25% 21% 21% FY10 18% 20% 30% FY08 30% 34% FY07 33% 32% Growth in Govt's plan expenditure (YoY change, in %) Growth in MSPs (YoY change, in %) 40% Exhibit 7: The Government’s plan expenditure is set to grow at 4% YoY in FY15 FY09 Exhibit 6: The slower growth in MSPs in the past two years has dampened rural demand The generous spends on rural India administered by the previous Government had played a pivotal role in driving demand in rural India Wheat Source: CEIC, Ambit Capital research Source: CEIC, Ambit Capital research. Note: FY15 factors the Rs800bn cut in plan expenditure. Another channel through which the NDA has turned off the supply of cash to rural India is the Food Corporation of India (FCI). In FY14, the FCI – a notoriously corrupt institution – spent a staggering `0.9 trillion. By the time the General Elections were held in May 2014, the FCI’s grain stockpile was a record 62mn tonnes. Since then, this stockpile has steadily come down and now stands at 35mn tonnes. Provided the FCI does not embark upon a buying spree in the final month of FY15, the reduction in its stockpile would suggest that the FCI’s outlay will dramatically reduce in FY15 (relative to FY14). Pace of growth in the Government’s Plan spending also decelerated from an average of 17% YoY over FY07-14 to 4% YoY in FY15 Besides a pullback in spending on grains, the pace of growth in the Government’s Plan spending also decelerated from an average of 17% YoY over FY07-14 to 4% YoY in FY15 (see the exhibit above). Within the Plan expenditure category, Government spending on the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) also slowed down meaningfully. Whilst the quantum of jobs created by this scheme is limited, this employment guarantee scheme plays a critical role in providing an artificially inflated minimum wage. 400 40 300 200 20 100 - 0 FY13 FY14 FY15* Households provided work (Left scale) Total expenditure (Right scale) Source: nrega.nic.in. Note: *FY15 is till 31 January 2015 February 24, 2015 40,000 50 40 30 20 10 0 30,000 20,000 10,000 FY13 FY14 FY15* Avg. employment provided per household (days) 500 Exhibit 9: Number of Gram Panchayats not spending money has risen by 39% YoY in FY15 YTD Number of gram panchayats with no expenditure 60 Total spending on MGNREGA (in ` bn) Households alloted work (in million) Exhibit 8: Spending on MGNREGA has slowed down with a 26% decline in expenditure on this scheme No. of gram panchayats with no expenditure (Left scale) Avg. employment provided per household (days, Left scale) Source: nrega.nic.in. Note: *FY15 is till 31 January 2015 Ambit Capital Pvt. Ltd. Page 7 Economy & Strategy The latest data shows that out of the total `400bn earmarked for FY15, the spending on the scheme until January 2015 has been only `288bn (i.e. 72% of total). Also, the total number of households allotted work has been declining (see the exhibits above). The data also suggests that the number of Gram Panchayats (i.e. the local body which has the primary responsibility of the scheme) with no expenditure has increased by 39% YoY. Thus, average employment provided per household (days) has fallen sharply by 24% YoY. Factor #3: Moderation in prices of agricultural commodities globally The latest data shows that out of the total `400bn earmarked for FY15, the spending on the MNREGA scheme until January 2015 has been only `288bn Besides the lower Government spending and sub-par monsoons, another factor that has dampened rural demand has been the moderation in the prices of agricultural commodities globally (particularly non-cereals). International futures prices (YoY change, in %) Exhibit 10: The prices of agricultural commodities have fallen dramatically in international markets 60% 47% 40% 26% 21% 20% 11% 4% 0% -7% -8% -20% -4% -21% -19% -11% -40% -60% -42% Cotton CY11 Sugar CY12 CY13 Soyabean CY14 Source: CEIC, Ambit Capital research Cotton prices have fallen by 8% YoY in CY14 (vs a 4% YoY rise in CY13), as per data from the CME Group (see the exhibit above for details regarding futures prices). Three states namely Gujarat, Maharashtra and Andhra Pradesh are the top-three producers of this crop and have suffered the consequences of the fall in cotton candy prices. Sugar prices have fallen by 7% YoY in CY14 (vs a 19% YoY rise in CY13), as per data from the CME Group (see the exhibit above for details regarding futures prices). Three states namely Uttar Pradesh, Maharashtra and Karnataka are the top-three producers of sugarcane and have suffered the consequences of the fall in sugar prices. Soyabean prices have fallen by 11% YoY in CY14 (vs a 4% YoY rise in CY13) as per data from CME group (see the exhibit above for details regarding futures prices). Three states namely Madhya Pradesh, Chhattisgarh and Gujarat are the top-three producers of this crop and have suffered the consequences of the fall in soyabean prices. February 24, 2015 Ambit Capital Pvt. Ltd. Besides the lower Government spending and sub-par monsoons, another factor that has dampened rural demand has been the moderation in the prices of agricultural commodities globally (particularly non-cereals) Page 8 Economy & Strategy Exhibit 11: The farmers in the states which are the largest producers of cotton, sugarcane and soybean have been the most affected by the fall in prices Source: Ministry of Agriculture, Govt. of India, Ambit Capital research Factor #4: Clear slowdown in rural wage inflation The pace of growth in average daily wages in rural India systematically rose from 6% YoY in CY06 to a staggering 21% YoY by CY11. However, this pace has been systematically decelerating since CY11 and has fallen to 4% YoY in CY14 YTD (see the exhibit below). Exhibit 12: The growth rate in rural wages has slowed down considerably in the past year Exhibit 13: The difference between rural and inflation turned negative during Sep-Dec 2014 urban 1.6% 21% 20% 18% 17% 15% 15% 15% 10% 10% 6% 7% 4% 5% Source: RBI, Ambit Capital research. Note: *CY14 excludes December 2014 1.2% 1.2% 0.8% 0.4% 0.0% -0.1% -0.4% -0.8% CY14* CY13 CY12 CY11 CY10 CY09 CY08 CY07 CY06 0% Average spread between rural and urban CPI inflation (YoY change, in %) 25% Avg. daily rural wages (YoY change, in %) The pace of growth of rural wages has declined systematically since CY11 and has fallen to 4% YoY in CY14 YTD -0.6% CY12 CY13 CY14 CY14 (Jan-Aug) (Sep-Dec) Source: CEIC, Ambit Capital research Yet another indicator namely the spread between rural and urban inflation points to a deflation that is underway in the rural economy. This spread turned negative over Sep-Dec 2014 after being positive over Jan-Aug 2014 (see the exhibit above). The main source of job creation in India over the past five years has been construction. Therefore, with construction activity slowing down sharply over the past six months, this source of demand for labour has dried up. February 24, 2015 -0.2% Ambit Capital Pvt. Ltd. With construction activity slowing down sharply over the past six months, this source of demand for labour has dried up. Page 9 Economy & Strategy 5% 5% 12/2014 2% 09/2014 1% 06/2014 1% 03/2014 09/2013 1% 06/2013 03/2013 2% 12/2013 4% 12/2012 09/2012 06/2012 03/2012 12/2011 14% 12% 12% 12% 10% 10% 8% 6% 3% 4% 1% 2% 0% -2% -2% -4% 09/2011 Construction GDP (YoY change, in %) Exhibit 14: Slowdown in construction has adversely affected job creation in the last year Source: CEIC, Ambit Capital research. Factor #5: Decline in property and gold prices Besides the adverse income effect in rural India, the wealth effect too has been negative, as the prices of the two asset classes that are the most popular in rural India, namely property as well as gold, have come under pressure off late. The pace of growth in housing prices has moderated from 24% YoY in FY12 to 9% YoY in FY15 YTD. In fact, the decrease is more profound in Tier 2 cities (see the exhibit below). The moderation in property prices in Tier 2 cities reflects the overall slowdown in property prices in rural India. In fact, going beyond Tier 2 cities, rural land prices across India seem to be stagnating for the first time in a decade. 35% 31% 9% 2% FY13 FY14 -4% -1% 2% Patna 2% 5% Lucknow 2% Gold prices (YoY change, in %) 30% Jaipur FY12 Exhibit 16: Gold prices have fallen by 13% since the peak in September 2012 30% Faridabad 35% 29% 30% 25% 20% 15% 10% 5% 0% -5% -10% Bhopal Housing prices (YoY change, in %) Exhibit 15: Housing prices in Tier 2 cities have stopped rising lately The prices of the two asset classes that are the most popular in rural India, namely property as well as gold, have come under pressure off late 24% 25% 20% 15% 10% 5% 0% FY15* Source: RBI, Ambit Capital research. Note: *Till 2QFY15 -5% CY11 CY12 CY13 -1% CY14 -3% Source: CEIC, Ambit Capital research Similarly, falling gold prices too have created an adverse wealth effect for rural households. Whilst it is difficult to know the exact reason behind falling gold and land prices, a believable explanation is that the expenditure by the UPA Government on subsidies and MSPs (subsidies equal to average of 2% of GDP over FY05-14, out of which around 40% seems to have been pilfered by the rural elite and then invested in land, real estate and gold) has been stopped by the new PM. February 24, 2015 Ambit Capital Pvt. Ltd. Page 10 Economy & Strategy How will the rural demand story evolve in the coming years? Given the material sales slowdown in companies that are driven by rural demand and given the factors driving this slowdown, it is easy to conclude that the rural demand story in India is likely to remain under pressure. However, it is critical to note that: Both Factor #1 (i.e. sub-par South-West monsoons in FY15) as well as Factor #3 (i.e. moderation in prices of agricultural commodities globally) are likely to be temporary rather than structural. According to a study done by OECD and Food and Agricultural Organisation (FAO), “Crop prices are expected to drop for one or two more years, before stabilizing at levels that remain above the pre-2008 period”. Factor #5 (i.e. the decline in property and gold prices) is likely to affect the rural elite more profoundly than the rural middle and lower income classes. Factor #4 (i.e. the slowdown in rural wage inflation) is the ‘consequence’ of the above-stated factors rather than the ‘cause’. Factor #2 (i.e. slowdown in Government spending on rural India) which was so far in the form of social spends is likely to be replaced, at least partially, by infrastructure spend. In fact, analysing the rural population in India through the lens of two-tiers provides a more nuanced answer to the question, ‘How will the rural demand story evolve in the coming years?’ Whilst we expect the top-tier of the rural economy to remain under pressure going forward, the lower tier is likely to regain its purchasing power over the next few quarters, as: (1) The ramp-up of the DBT platform will create better targeting of subsidies for the lower socio-economic-classes (SECs), which in turn will make up for some of the losses that the rural economy will suffer as the subsidy leakage game comes to an end. Whilst we expect the top-tier of the rural economy to remain under pressure going forward, the lower tier is likely to regain its purchasing power over the next few quarters (2) The increased spending on infrastructure (T&D, roads, freight corridors, affordable housing) that the Union Government is expected to undertake from FY16 onwards is likely to create jobs in the rural economy. Exhibit 17: The ‘top-tier’ in the rural economy is likely to remain under pressure going forward whilst the lowest tier is likely to regain its purchasing power over the next few quarters Tiers of the rural economy Factors supporting demand over FY09-14 Likely way forward 1) 1) Top-tier 2) 1) Lower-tier 2) Leakages in the subsidy disbursement mechanism benefited the top-tier of the rural economy disproportionately. Research shows that 40% of all the Government subsidies are lost in leakages. This leakage thus amounts to an average of 0.9% of GDP over FY09-14 or a cumulative sum of `3.7trn ($60bn). Corruption in the infrastructure spending mechanism also benefitted the top-tier of the rural economy. The lower tier benefitted by the sharp increases in MSP prices. For instance, MSPs for rice and wheat were increased at an average rate of 14% YoY and 11% YoY respectively over FY08-13. This pace of increases decelerated meaningfully from FY14 onwards, as MSP growth rates slowed to 4% YoY for wheat and rice. The lower tier benefited from sharp increases in the quantum of Central Government subsidies. The remaining 60% of this amounted to an average of 1.4% of GDP over FY09-14 or a cumulative sum of `5.5trn 2) 1) 2) We expect the Government’s subsidy spends to amount to only 1.5% of GDP in FY16 and this is likely to be targeted efficiently through the DBT platform, thereby benefiting entirely the lower-tier of the rural economy. As the Government steps up capex on roads, railways, defence, power T&D and low-cost housing, some proportion of the money is likely to flow back into the hands of the toptier of the rural economy. We expect the Government’s subsidy spends to amount to only 1.5% of GDP in FY16 and this is likely to be targeted efficiently through the DBT platform, thereby benefiting entirely the lower-tier of the rural economy. As the Government steps up capex on roads, railways, defence, power T&D and low-cost housing, this is likely to create jobs for the lower tier economy albeit with a lag. Source: Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 11 Economy & Strategy Ramp-up of the DBT mechanism likely to benefit the lower strata of rural India at the cost of the top-tier Rural India can be divided into two tiers, namely: The top-tier, constituting the ‘rural elite’ which includes large farmers, village heads and middlemen, and The middle-income and lower-tier which consists of small, marginal and landless farmers besides including self-employed professionals. Over FY09-14, the Central Government’s subsidy bill expanded at a CAGR of 15% vs a CAGR of 12% over FY04-08. However, this benefitted the top-tier disproportionately owing to the corruption in the system and vast leakages in the subsidy transfer mechanism. Over FY09-14, the Central Government’s subsidy bill expanded at a CAGR of 15% vs a CAGR of 12% over FY04-08 Our sources suggest that once the PMJDY has universal coverage and the bank accounts are seeded through Aadhaar cards, the Government eventually plans to route all transfers, including fertiliser subsidies, food subsidies, petroleum subsidies, pensions as well as scholarships through the Direct Benefits Transfer (DBT) platform. In fact, the Finance Minister has already passed an order saying that henceforth all schemes involving the transfer of cash or other benefits from the Government to the citizenry has to go through the DBT platform. In specific, whilst the seeding of the Aadhar card as well as the bank account are challenges that the Government is grappling with, the Government is aiming to achieve the following: Move the disbursement of LPG subsidies (0.05% of GDP in FY16) onto the DBT platform by March 2015, and Move the disbursement of food and kerosene subsidies (0.9% of GDP and 0.03% of GDP in FY16 respectively) onto the DBT platform by September 2015. As leakages in the subsidy mechanism are reduced and as the DBT mechanism becomes more ubiquitous, there is likely to be a redistribution of wealth in favour of the poorest deciles of society (which, ironically, will hit aspirational consumption, and help small ticket consumption). Besides the ramp-up of the DBT mechanism, the current Government’s explicit effort aimed at checking pilferage in the subsidy disbursement mechanism is likely to also magnify this effect (see the exhibit below). As leakages in the subsidy mechanism are reduced and as the DBT mechanism becomes more ubiquitous, there is likely to be a redistribution of wealth in favour of the poorest deciles of society Exhibit 18: Steps taken by the current Government to check pilferage from the subsidy system Step Description Date Publication of the Shanta Kumar This committee was formed within two months of the new Government coming to power. The report committee report recommends transferring food subsidies onto the DBT platform to check leakages. Forcing the Food Corporation of Out of the total food subsidy bill of `1.15trn in FY15, the operating cost of FCI alone is `940bn. India (FCI) to make its Recently the Government has forced the FCI to get rid of surplus stock and it also plans to withdraw operations more efficient FCI from grain-surplus states to bring down the huge operating costs of FCI. Transferring the LPG on to the The Government has transferred the LPG onto the DBT platform and this marks the first in a list of DBT subsidies to be transferred onto the DBT. Rapid progress on Aadhaar and The Government’s commitment to roll out all the subsidies on to the DBT platform is visible in the PMJDY rapid progress made on PMJDY and rolling out Aadhaar cards which is a prerequisite for the DBT. Source: Media reports, Ambit Capital research. Note: PMJDY stands for Pradhan Mantri Jan Dhan Yojna Jan 2015 FY15 Jan 2015 FY15 Government focus on infrastructure funding likely to create jobs in rural India As night follows day, Government spending in India follows a five-year cycle in which the Government inevitably slows down spending growth in the first year post-election. Then it gradually ramps up spending growth with an aim of climaxing it in the run-up to the General Election (see the exhibit below). February 24, 2015 Ambit Capital Pvt. Ltd. Page 12 Economy & Strategy Exhibit 19: Government spending increases in the run-up to the General Elections Govt. expenditure (YoY change, in %) 30.0% GE-2009 25.0% GE-1999 20.0% GE-2004 15.0% 10.0% 5.0% FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 0.0% Source: CEIC, Ambit Capital research. Note: GE refers to General Elections. Whilst the Government was undertaking meaningful expenditure growth over the last five years, infrastructure creation in India had come to a halt. 0.3% FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 0.0% 0.2% under-investment in electricity 0.1% 0.1% 0.1% 0.1% 0.0% 0.1% 0.0% 0.0% -0.1% -0.1% FY11 FY10 FY09 FY08 FY07 Source: Planning Commission, Ambit Capital research FY12 -0.1% -0.2% FY06 Exhibit 23: …which has led to slower employment in the construction sector 80% 0.2% 0.2% -0.1% Source: Planning Commission, Ambit Capital research Number of people employed in construction (growth over specified period) Exhibit 22: …and generation… 0.0% -0.1% growth in 73% 70% 60% 45% 50% 40% 30% 20% 13% 10% 0% FY00-FY05 FY05-FY10 FY10-FY12 Source: NSSO, various rounds, Ambit Capital research As highlighted in our note dated February 16, 2015, we expect the Government to step up capex on roads, railways, defence, power T&D and low-cost housing. Whilst some proportion of the money is likely to flow back into the hands of the top-tier of the rural economy (as infrastructure spends are increased), this impetus is likely to create jobs for the lower tier economy albeit with a lag. February 24, 2015 FY12 5.6% 5.0% 0.0% FY11 6.5% FY10 10.0% 0.1% FY09 11.6% 9.3% 9.9% 0.2% FY08 15.0% 15.0% 0.3% FY07 15.0% 0.4% 0.3% 0.3% 0.2% 0.2% 0.1% 0.1% 0.0% -0.1% -0.1% -0.2% FY06 20.0% GFCF in roads and bridges (as % of GDP, change from previous yr.) 20.1% Source: CEIC, Ambit Capital research GFCF in electricity (as % of GDP, change from previous year) Exhibit 21: …which has resulted in under-investment in roads and bridges… 25.0% FY06 GFCF growth (YoY, 2 yr. moving average) Exhibit 20: Investment growth in the economy collapsed in the last two years… Ambit Capital Pvt. Ltd. We expect the Government to step up capex on roads, railways, defence, power T&D and low-cost housing Page 13 Economy & Strategy Can the rural India story stage a comeback under the NDA? Several investors have asked us whether rural India can at all stage a revival under the NDA, given its supposedly ‘business class’ oriented sympathies (as opposed to the UPA’s more ‘rural underclass’ oriented sympathies). Leaving aside political considerations (no politician who aspires to win elections in India can ignore the rural and semi-urban vote bank), there are a few other reasons for believing that the rural India story will regain some of its vitality once the temporary impacts arising from the sub-par monsoons subside: As the NDA Government settles down into its capex programme, we should see the road-building and low-cost house building programmes kick off from 2HFY16. These programmes are likely to once again create demand for construction labour and thus have a positive effect on wage growth. Whilst rural wage growth is unlikely to recover to the 15-21% levels seen over CY09-12, a mean reversion from the 4% wage growth seen in CY14 seems likely. (For more details on how much fiscal slack the NDA has for its capex programs, click here for our 16 February 2015 pre-budget note.) Food inflation accounts for half of the CPI. Within food inflation, the rising cost of fruit, vegetables, poultry and dairy accounts for three-quarters of inflation. As per capita income continues to rise in India, demand for more nutritious food i.e. fruits, vegetables, poultry and dairy will continue to outstrip supply. This should continue to generate not only food price inflation but should also – with some support from the Government – encourage the creation of a rural cold chain and food processing industry. The Shanta Kumar Committee’s recommendations on this front seem likely to be pursued enthusiastically by the PM given the twin electoral benefits – lower CPI inflation for all alongside rural job creation. Over the past ten years, the vast majority of industrial jobs have actually been created in rural India as almost all new factories in India tend to come up in rural India rather than urban India. Over CY03-12, 75% of all the new factories in India were set up in rural areas. Similarly 70% of all new manufacturing jobs in India were created in rural areas. The pattern of greenfield rather than brownfield development is likely to continue given that it is next to impossible to get affordable brownfield land for new factories. Hence, as the capex cycle recovers gradually through FY16 and FY17, we should see this additional source of labour demand kicking in for rural India. That said, even if we assume that the NDA has considerable skill in executing projects (something which is yet to be proven), it will take at least 2-3 quarters for these sources of demand to kick in. Not only will the private sector capex cycle get off the ground slowly, even Government capex will have to follow its traditional path of Request for Proposals, vetting of bids, identification of L1 bids, signing off by the relevant minister, etc. Hence, it appears that the traditional drivers of rural India’s prosperity (generous subsidies which partly were stolen by the rural elite and then were channelled into land, gold and real estate) would be missing for 2-6 quarters without the new drivers kicking in. Over the past ten years, the vast majority of industrial jobs have actually been created in rural India as almost all new factories in India tend to come up in rural India rather than urban India Traditional drivers of rural India’s prosperity (generous subsidies which partly were stolen by the rural elite and then were channelled into land, gold and real estate) would be missing for 2-6 quarters without the new drivers kicking in The companies which appear to be the most exposed at these crossroads are those that have relied heavily on rural India to drive their growth through the downturn: M&M (MM IN, Unrated): SUVs and tractors account for ~70% of total volumes. Maruti (MSIL IN, SELL): ~30% of revenues come from rural India. HUL (HUVR IN, SELL): 40% of revenues come from rural India. Colgate (CLGT IN, SELL): ~35% of revenues come from rural India. MMFS (MMFS IN, SELL): >95% of loan book is rural India. Havells (HAVL IN, SELL): ~30% of revenues come from rural India. Ambuja (ACEM IN, SELL): ~35% of revenues come from rural India. Ramco Cements (TRCL IN, SELL): ~35% of revenues come from rural India. February 24, 2015 Ambit Capital Pvt. Ltd. Page 14 Economy & Strategy Consumer Rural consumption moderated in FY14 and FY15 Rakshit Ranjan, CFA, [email protected], +91 22 3043 3201 Volume growth rates in consumer staples have moderated from 9-10% over FY08-12 to 5-6% over FY13-15E. Discretionary consumer revenue growth rates have moderated from 25-30% to 13-15% over the same period. Whilst the moderation in FY13 and FY14 was led predominantly by weakness in urban demand, that in FY15 has been driven mainly by weakness in rural demand. Going forward, we expect rural demand revival to lag behind urban by 6-12 months, although the longer-term rural consumption story remains intact. HUL, Dabur and Britannia have the highest exposure to rural demand in our coverage universe. GCPL, HUL and Jubilant Food are our TOP SELL ideas and Page is our TOP BUY idea. Revenue growth rates in the consumer sector have moderated substantially over the past 2-3 years. Exhibit 24: Consumer sales growth across staples and discretionary has been on a downward trend since FY12 FMCG average volume growth YoY 11.0% Consumer Discretionary Value growth YoY (RHS) 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 4QFY13 3QFY13 2QFY13 1QFY13 4QFY12 3QFY12 2QFY12 1QFY12 4.0% Source: Company, Ambit Capital research; Note: Average growth has been calculated using sales growth for stocks under our coverage Exhibit 25: FMCG value growth slowed down over FY11-14 Exhibit 26: Consumer discretionary value growth slowed down over FY12-14 FMCG average value growth YoY 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Consumer Discretionary avg. value growth YoY 37% 32% 27% 22% Source: Company, Ambit Capital research FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 FY06 12% FY05 FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 FY06 FY05 17% Source: Company, Ambit Capital research As highlighted in the exhibits above, after a period of exceptionally robust revenue growth rates over FY08-12, both the consumer staples as well as consumer discretionary sectors have seen a steady moderation in growth over FY13-15. Moreover, the moderation in revenue growth has been particularly strong in 3QFY15. February 24, 2015 Ambit Capital Pvt. Ltd. Page 15 Economy & Strategy Rural India has contributed substantially to the consumer sector’s revenue growth rates As highlighted in the exhibit below, staples companies like HUL and Colgate generate the highest proportion of revenues from rural India. Discretionary firms, on the other hand, do not have a meaningful exposure to rural sales. Exhibit 27: Consumer staples vs discretionary have higher exposure to rural India Consumer Staples Rural sales as % of consolidated sales Britannia 30-35% Colgate 35-40% Dabur 30-35% GCPL 15-20% GSK Consumer 24-26% HUL HUL and Colgate have one of the highest rural exposures in our coverage >40% Marico* 30% Nestle 30-35% Consumer Discretionary Rural sales as % of total sales Asian Paints 15% Berger Paints 12% Pidilite Industries 7% Jubilant Foodworks 0% Bata India 4% TTK Prestige 8% Page Industries 4% Source: Company, Ambit Capital research As highlighted in the exhibit below, industry data suggests that rural demand growth acceleration was steeper than urban demand growth acceleration over FY05-11. Exhibit 28: Rural value growth picked up pace after CY05 Urban (%) 30 Rural (%) Overall FMCG (%) 25 20 Rural growth accelerated at a faster pace than urban over FY05-11 15 10 5 (5) CY03 CY05 CY07 CY09 CY11 (10) Source: Industry, Ambit Capital research Nielsen data suggests that moderation in demand growth over CY12 and CY13 was led mainly by urban growth moderation whilst rural growth rates remained relatively robust. As a result, towards the end of FY14, rural revenue growth rates for many firms were 2-3x higher than urban growth rates. February 24, 2015 Ambit Capital Pvt. Ltd. Page 16 Economy & Strategy Exhibit 29: Nielsen data suggests moderation in urban value growth over CY12-13 Overall Rural 25% 25% 20% Urban 21% 19% 17% 22% 19% 21% 20% 18% 17% 17% 14% 15% Rural growth has also decelerated in the past 9-12 months 15% 13%12% 14% 12% 10% 10% 5% 2008 2009 2010 2011 2012 2013 Source: Nielsen report However, rural demand has also seen a substantial moderation over the past 912 months, thereby resulting in the narrowing of the ratio between rural and urban growth rates to 1-2x. Exhibit 30: Rural growth has moderated over the last 3-4 quarters, as highlighted by key management commentaries Company Quarter Management Comments 3QFY14 “Second half of 2013 is showing slowdown in rural sales vs. first half across all categories.” “If you go back in time of rural growth, it used to outstrip urban growths significantly. But if you see as these curves have started 1QFY15 coming down, both the urban curves and the rural curves have started coming down, but they are also narrowing, which means the days of rural outstripping it substantially is not there.” HUL 2QFY15 “The decline in rural market has been with a lag….the rural growth is muted but faster than urban growth.” “The market appears to be showing some signs of a pickup in recent months as reported by Nielsen across several categories, but 3QFY15 more so in rural than in urban. We will have to look at another quarter or two to really come to a conclusion whether the upliftment in the growth in rural markets is sustainable or not.” “Now there is a squeeze in rural income over the last couple of quarters, at least the rural income is not being as buoyant as what it 4QFY14 was and the rural markets which were instrumental in driving growth are now no longer driving growth.” “Our trajectory of growth was significantly driven by rural over the last couple of years…..our rural growth has slowed down from 1QFY15 13-14% to 11-12%.” Dabur 2QFY15 “We did expect that rural demand will soften (during the quarter) which it has.” “Rural showed a surprising resilience this quarter, reversing a few quarters of downward trend and grew at a much higher pace in 3QFY15 fact than urban. Now having said that I don’t think this rural growth is sustainable.” Source: Company, Ambit Capital research Our view of the drivers of the historical consumer demand trends across India Festive season in 3QFY15 has failed to bring about a revival in footfalls for discretionary consumption categories, unlike what was previously expected, due to a combination of the following factors: Lack of asset value creation continues to dampen consumer sentiment: One of the drivers of consumer sentiment across India (particularly in rural India) includes a ‘feel good factor’ related to asset value creation. This in turn is related, predominantly, to an increase in land/real estate/gold valuations. No such rise in asset values for households has been visible over the past 12-18 months. Euphoria around political stability is yet to translate into consumer spending: The Government’s delayed progress around restarting the investment cycle including infrastructural projects has resulted in a delay in expansion plans by corporates and hence has led to a lack of hope in a meaningful revival in new job creation over the next 12 months. This has resulted in a lack of consumer spending despite a gradual fall in consumer price inflation rates. Credit offtake remains low: As per the RBI, YoY credit growth in the banking system has continued to moderate across all categories like services (including tourism and hotel services and wholesale trade), industrials (predominantly MSME entities) and export credit. A revival in credit growth is a direct indicator of a rise in discretionary consumer spends and hence an upcoming revival in staples category spends. February 24, 2015 Ambit Capital Pvt. Ltd. Lack of asset value creation, delay in restarting the investment cycle by the government and lower credit offtake have led to slowdown in consumer demand Page 17 Economy & Strategy Demand revival expectations have been delayed to mid-FY16 at the earliest: A revival in consumer demand is likely to be driven by a combination of the two factors: (a) disposable household income revival (likely only in mid-FY16) due to sustained low inflation, and gradual rise in job creation over the next 12-24 months; (b) revival in discretionary consumer demand in 1HFY16 due to a gradual translation of positive sentiment around economic growth into retail consumer spends. Consequently, we expect discretionary consumer demand to revive in 1HFY16 and staples consumer demand to revive in 2HFY16. Lower inflation, job creation and conversion of consumer sentiment into actual consumer demand should increase discretionary demand in 1HFY16 followed by staples pick-up by 2HFY16 We expect rural demand revival to lag behind urban; long-term rural consumption story intact Timing of rural vs urban demand revival: We expect the new Government’s initiatives to drive economic growth, which will result in a combination of: (a) sustained low consumer price inflation; and (b) new job creation. This should in turn result in a rise in disposable household income for urban consumers, and hence lead to an urban-led revival in the consumer sector’s revenue growth rates over the next 6-12 months. However, we expect rural demand acceleration to lag behind that of urban by 6-12 months due to a combination of the following: (a) it will not be before 2HFY16 when the NDA Government’s expected capex programmes will result in wage growth through demand creation for construction labour; and (b) there is a gestation period of 6-12 months for the Direct Benefits Transfer (DBT) schemes to be fully implemented for food, kerosene and LPG subsidies. Impact of rural demand revival on FMCG growth rates: Over FY08-13, the elite-rural households were getting a disproportionately higher share of a large rural welfare budget from the Government through the black economy route (as highlighted on page 11). However, in the future, in light of how the new Government’s rural welfare schemes are likely to be executed, we expect that the elite-rural will see a substantial reduction in household income. Instead, a higher proportion of these welfare spends by the Government will be received by the non-elite-rural households, albeit in a smaller overall budget of welfare schemes. We believe that this phenomenon will NOT result in a substantial moderation in the quantum of rural FMCG growth rates over the medium to longer term because: (a) elite-rural households do NOT contribute substantially to small-ticket consumption segments within the overall rural sector; and (b) given the nondiscretionary nature of consumer demand in FMCG segment, we do NOT expect a lifestyle downgrade for elite-rural households to the extent that it leads to a reduction in their consumption of FMCG products. The cut-down in black money for the elite-rural could impact nearterm rural FMCG demand; however, the longer-term rural FMCG demand prospects remain solid Hence, overall rural growth rates for the FMCG sector from FY17 onwards are likely to be similar to those achieved over FY08-13. However, we see a high possibility of weak rural spends in FY16 amidst a revival in urban spends in 2HFY16, as highlighted previously. Impact of rural demand revival on discretionary consumer growth rates: Elite-rural contributes meaningfully to the rural revenues of discretionary consumer categories. Therefore, these revenues WILL see an adverse impact from the theme discussed in the previous bullet (unlike FMCG). However, since the contribution of rural to overall sales for most of these players is less than 10-15%, the overall impact from the theme on the revenue growth rates will be up to a maximum of 150-200bps with an average of ~50bps moderation in revenue CAG` for these discretionary companies. Rural discretionary demand could be impacted over the longer term due to the reduction in black money with the elite-rural; however, only 10-15% of discretionary sales come from rural areas As highlighted in the table below, factoring in these expectations of a demand revival, we forecast higher revenue CAGR and EPS CAGR for most firms across our consumer sector coverage universe. February 24, 2015 Ambit Capital Pvt. Ltd. Page 18 Economy & Strategy Exhibit 31: Revenue CAGR and EPS CAGR are likely to increase for FY15-18 vs FY13-15 for most companies in our coverage Consumer Staples Company Sales EPS FY13-15 FY15-18 FY13-15 FY15-18 Britannia 13% 16% 48% 15% Colgate 12% 14% 6% 19% Dabur 13% 13% 18% 17% GSK CH 16% 14% 16% 17% GCPL 15% 14% 12% 16% HUL 10% 13% 16% 17% Marico 11% 17% 29% 23% Nestle 9% 15% 4% 19% FY13-15 FY15-18 FY13-15 FY15-18 Pidilite Inds Ltd 17% 17% 10% 23% TTK Prestige Ltd 2% 21% -10% 33% Jubilant Foodworks 22% 27% -3% 36% Berger Paints 15% 17% 15% 26% Asian Paints 15% 19% 12% 26% Bata India 22% 10% 13% 21% Page Inds 33% 32% 36% 35% Consumer Discretionary Company Source: Company, Ambit Capital research Despite an expected demand revival, we retain our SELL stance on most companies We have used a DCF-based approach towards valuing all the covered stocks in the consumer sector. This approach also differentiates the longevity of growth rates of the firms on the basis of the following parameters: (a) longevity of category growth rates; (b) position of the company on a competitive advantage framework; (c) key man risk in the senior management team; (d) potential to leverage on the existing portfolio to enter into new categories in the future; and (e) diversification of the product portfolio. Although we expect both rural as well as urban growth rates to remain robust in the long term, we currently have a SELL stance on most stocks under coverage (with the exception of Page, TTK Prestige and Marico) due to a combination of one or more of the following factors: (a) current rich valuations more than adequately factor in the growth revival; (b) lack of sustainable competitive advantages amidst high competitive intensity for some firms in a few categories will constrain market share gains (unlike what could have been achieved in the past by the same firm); and (c) penetration saturation in certain categories (like soaps and detergents, hair oil and oral care) will result in a moderation in growth rates vs what has been achieved over the past decade. February 24, 2015 Ambit Capital Pvt. Ltd. Page 19 Economy & Strategy Exhibit 32: Consumer valuation summary Company Name CMP Mcap (`) ($mn) Stance Target Upside/ Price Downside P/E FY16E EV/EBITDA ROCE (%) Implied P/E FY17E FY16E FY17E FY16E FY17E FY16E FY17E EPS Growth Rev growth FY14-17 FY14-17 Consumer Staples HUL Nestle Dabur 892 30,625 SELL 700 -22% 40.8 35.9 31.0 26.7 84.3% 76.4% 32.0 28.2 15% 12% 7,052 9,643 SELL 5,600 -21% 49.0 41.6 25.6 22.1 47.1% 61.5% 38.9 33.0 14% 13% 272 7,525 SELL 200 -27% 37.4 32.0 27.6 23.3 31.1% 31.4% 27.5 23.5 17% 12% Godrej Consumer 1,190 6,422 SELL 750 -37% 41.2 36.0 17.4 15.0 18.4% 19.8% 26.0 22.7 14% 13% GSK Consumer 5,800 3,813 SELL 4,950 -15% 34.8 30.5 26.2 22.3 33.9% 34.0% 29.7 26.0 14% 13% Colgate 1,905 4,112 SELL 1,480 -22% 37.6 32.0 25.5 21.6 83.9% 83.2% 29.2 24.9 19% 13% 360 2% 29.1 24.3 20.2 16.8 39.9% 43.8% 29.6 24.6 25% 18% Marico Britannia Median Consumer Discretionary Pidilite Inds Ltd 355 2,025 3,635 UR 3,038 SELL 1,480 -27% 37.6 32.4 23.0 19.5 45.0% 43.7% 27.5 23.7 24% 16% -22% 37.6 32.2 25.6 21.8 42.4% 43.7% 29.4 24.8 16% 13% 575 4,678 SELL 370 -36% 43.9 36.1 29.8 24.9 26.2% 26.8% 28.3 23.3 22% 17% TTK Prestige Ltd 3,460 639 BUY 3,907 13% 25.4 19.9 16.9 13.4 26.0% 31.9% 28.7 22.4 26% 16% Jubilant Foodworks 1,626 1,689 SELL 928 -43% 66.6 48.9 28.9 21.6 20.0% 22.7% 38.0 27.9 23% 25% 214 2,355 SELL 157 -27% 38.1 31.3 22.7 19.7 20.0% 21.2% 28.0 23.0 24% 16% Berger Paints Asian Paints 825 12,568 SELL 649 -21% 40.6 33.9 26.1 21.8 35.3% 36.0% 31.9 26.7 19% 17% Bata India 1,255 1,280 SELL 1,174 -6% 36.3 26.6 22.7 17.3 21.0% 24.8% 34.0 24.9 15% 14% Page Inds 11,768 2,083 BUY 13,000 10% 45.2 34.1 29.8 22.5 48.8% 51.7% 49.9 37.6 36% 32% -21.3% 40.6 33.9 26.1 21.6 26.0% 26.8% 31.9 24.9 23% 17% Median Source: Company, Ambit Capital research Stock implications Top BUY recommendations Page Industries, TP `13,000, 10% upside, Mcap US$2.1bn Sustainable demand momentum for Page in the future will be supported by: (a) macro tailwinds resulting from low penetration, low ticket size and high utility; (b) expansion of distribution network and product portfolio; and (c) market share gains through an aspirational brand recall. Page’s new product launches will utilise the company’s efficient manufacturing, wide distribution and strong aspirational brand, which will propel revenue growth further (~32% in FY15-18E vs 35% in FY10-15). Its recently initiated IT investments should address the inefficiencies in its distribution channel and hence support scalability across product segments and SKUs. Competitive threats to Page’s leadership are low (in a large growing opportunity), due to: (a) Rupa’s/Maxwell’s lack of control on distribution and manufacturing with poor aspirational connect; and (b) hurdles for international brands like FCUK, CK, USPA and Hanes to build a strong distribution network beyond modern retail into hosiery stores. Our implied valuation of 50x FY16E EPS (TP of `13,000) factors in the longevity of the growth momentum from low macro penetration, further market share gains, and several unexplored sub-segments in the women’s category. Page’s exemplary financials (healthy EPS growth of 36% and RoCE of ~47% in FY14-17E) justify a 25% premium to quality consumer peers. Page Industries currently trades at 45x/ 34x FY16/FY17 EPS. February 24, 2015 Ambit Capital Pvt. Ltd. Page 20 Economy & Strategy Top SELL recommendations Godrej Consumer, TP `750, ~33% downside, Mcap US$5.9bn Slowdown in domestic soaps category due to intense MNC competition and saturating market share in household insecticides are likely to help it deliver only 12.4% domestic business revenue CAGR over FY14-18E. Moderation of growth in Indonesia due to saturation in key categories and integration issues in Africa are likely to result in only ~14% revenue CAGR over FY14-18E in GCPL’s international business, which has seen its RoCEs drop from 14% in FY08 to 7% in FY14. The stock is trading at expensive valuations of 38.7/33.8x FY16/17E EPS with sales CAGR and EPS CAGR of only 16% over FY15-18E and RoCE of less than 20% over FY15-18E. HUL, TP `700, 18% downside, Mcap US$31.7bn HUL’s Soaps & Detergents (S&D) portfolio (~50% of sales) faces intense competitive pressure from organised and unorganised peers in a soft input cost environment, and hence price-led growth for this part of the portfolio will be minimal to zero in the near term. (Note that the company took 5% price cuts on S&D in December 2014). Also, uncertainty around urban demand recovery should keep the demand for HUL’s personal care products such as skin and hair care (~20% of sales) muted for the next 2-3 quarters. Over the long term, HUL faces very high penetration levels in S&D and Tea (~60% of sales) and high competitive intensity in oral care (5% of sales) from Colgate and in premium skin care categories from L’Oreal. Consequently, we expect HUL’s overall volume growth rates to remain subdued (5-6% CAGR over FY14-18E). After the recent ~20% rally in the share price, the stock currently trades at 41.6x/36.6x FY16/17E EPS with sales/EPS CAGR of 13%/16% over FY15-18E. These rich valuations more than adequately factor in the inherent strengths of the business and the benefits from a soft input cost environment Jubilant Foodworks, TP `928, 43% downside, mcap US$1.7bn Jubilant’s SSG faces pressure from: (a) 35-40% price hikes over the past 20 months amidst price elastic demand; (b) high competitive intensity; and (c) store splits in tier-1 cities. A revival in discretionary consumer demand will be partly offset by these headwinds. Two comments by the management in the 3QFY15 conference call support our thesis on Jubilant Foodworks: (a) the improvement in SSG was ‘Cosmetic’ i.e. on account of a favourable base effect and the company does NOT see any meaningful revival in the consumer sentiment as yet, and (b) the management reiterated that it will take the firm at least 3-6 more quarters before it reaches high single-digit SSG, which is slightly more pessimistic We expect SSG of 4%/10% in 4QFY15/FY16, resulting in revenue CAGR of 25% over FY14-17E. Operating leverage benefits will accrue to EBITDA margins only once SSG for the firm exceeds 10-11%. Moreover, we expect a ~150bps EBITDA margin drag from Dunkin Donuts to continue for another three years (which the management confirmed on the call). As a result, we forecast 350bps EBITDA margin expansion to 16.4% over FY15-19E. The stock currently trades at 66x FY16 P/E with 22% FY14-17 EPS CAGR and 22% RoCE. Jubilant’s key profitability metrics (EPS CAGR and RoCE) and its competitive advantages compare unfavourably against other higher-quality discretionary consumption plays such as Page, Bata and Asian Paints, which trade at a 40% discount to Jubilant’s P/E multiple. February 24, 2015 Ambit Capital Pvt. Ltd. Page 21 Economy & Strategy Automobiles Demand trends deteriorating in recent months Ashvin Shetty, CFA, [email protected], +91 22 3043 3285 Whilst rural prosperity has aided auto volume growth in recent years (domestic 2W sales recorded a CAGR of 8% and Maruti’s rural sales witnessed a CAGR of 14% over FY11-14), a moderation in rural income and prosperity may negatively impact rural demand. However, we believe this negative impact would be offset to some extent by the moderating cost of ownership helped by declining fuel prices and falling interest rates. We believe the impact would be higher on PVs and SUVs (given the high ticket size) as compared to 2Ws. We expect Mahindra & Mahindra to be the most impacted followed by Maruti Suzuki to a smaller extent. Whilst we believe the impact would be muted on 2Ws (being relatively small ticket size items), we remain concerned of the rising competitive intensity in and high penetration of 2Ws in rural India. The domestic PV industry’s volumes, after witnessing a YoY growth of 8% in 2QFY15, have been deteriorating in recent months. The industry volume growth moderated in 3QFY15 to 3% YoY and remained at similar levels in January 2015. The fall has been steep for the utility vehicles segment, with 3QFY15 volumes declining 6% YoY (vs 22% YoY growth in 2QFY15). Similarly, motorcycle volumes grew strongly until September 2014 (19% YoY growth in September 2014), post which there has been a significant moderation, with volumes declining 6% YoY in January 2015. -5% 1QFY14 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 -10% Domestic motorcycle industry ('000s) YoY growth - RHS Source: SIAM, Company, Ambit Capital research PV YoY growth 3QFY15 0% 2QFY15 5% 1QFY15 10% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% 4QFY14 15% 3QFY14 2,850 2,800 2,750 2,700 2,650 2,600 2,550 2,500 2,450 2,400 Exhibit 34: …so has been the case with passenger vehicles, especially utility vehicles 2QFY14 Exhibit 33: Motorcycle volumes have declined significantly in 3QFY15… UV YoY growth Source: SIAM, Company, Ambit Capital research Over the past five years (FY09-14), the domestic motorcycle industry has recorded a CAGR of 12%, whereas the domestic passenger vehicle industry has recorded a CAGR of 10%. The growth in passenger vehicle category is mainly driven by strong CAGR (18%) in the SUV segment. However, in 9MFY15, SUV volumes have increased only 6% YoY whilst motorcycle volumes have witnessed a 5% YoY growth. This is significantly lower than the average CAGR recorded by these vehicle categories over the past five years (FY09-14). February 24, 2015 Ambit Capital Pvt. Ltd. Page 22 Economy & Strategy Exhibit 35: 9MFY15 YoY growth for motorcycle and SUVs is significantly lower than the average CAGR over FY09-14 Domestic UV industry ('000s) Domestic passenger car industry ('000s) 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 4QFY13 3QFY13 2QFY13 1QFY13 4QFY12 3QFY12 2QFY12 1QFY12 4QFY11 3QFY11 2QFY11 1QFY11 4QFY10 75% 65% 55% 45% 35% 25% 15% 5% -5% -15% -25% Domestic motorcycle industry ('000s) Source: SIAM, Ambit Capital research major surprises/ The 3QFY15 results for the major PV and 2W companies (Maruti Suzuki, Bajaj Auto, Hero MotoCorp and TVS Motor) were a mixed bag. Whilst the aggregate revenue growth for the four companies was broadly in line with our expectations, the EBITDA margin performance was marginally lower than our expectations. The YoY revenue growth decelerated in 3QFY15 (reflecting the underlying volume trends) vs 2QFY15. The revenue growth for these four companies was 11% YoY vs a 19% YoY growth in 2QFY15. The aggregate gross margin (calculated as aggregate gross profit of all four companies divided by their aggregate revenues) improved from 29.0% in 2QFY15 to 29.7% in 3QFY15. This is largely attributable to the softening of commodity prices and change in product mix. The gross margin for all the companies exceeded our expectations except for Hero MotoCorp whose gross margin remained flat QoQ and was ~60bps lower than our expectations. The EBITDA margin for Bajaj Auto and TVS Motor exceeded our expectations driven by higher export realisations (for Bajaj Auto) and operating leverage benefits (for TVS Motor). However, EBITDA margin for Hero MotoCorp and Maruti Suzuki were lower than our expectations due to higher operating expenses and one-time events. The aggregate EBITDA margin (calculated as aggregate EBITDA of all four the companies divided by their aggregate revenues) declined from 13.9% in 2QFY15 to 13.7% in 3QFY15. 24% 19% 20% 16% 12% 11% 12% 8% 4% 2% 1QFY15 2QFY15 3QFY15 Revenue YoY growth February 24, 2015 2% 90 48 1% (60) (212) 2% 77 (29) TVS 0% 6 10 Total 1% 39 (53) Source: Company, research Ambit Capital 15.0% 14.6% 14.2% 13.8% 13.4% 13.0% Gross margin Source: SIAM, Company, Ambit Capital research; Note: We have considered standalone financials for Maruti Suzuki, Bajaj Auto, Hero MotoCorp and TVS Motor Company Bajaj Hero MotoCorp Maruti 31.0% 30.5% 30.0% 29.5% 29.0% 28.5% 28.0% 27.5% 27.0% 0% 4QFY14 Divergen Gross EBITDA ce vs Revenue margin margin Ambit (bps) (bps) Exhibit 37: Whilst gross margins improved, EBITDA margin deteriorated in 3QFY15 3QFY14 in 3QFY15 as 2QFY14 Exhibit 36: Revenue growth moderated compared to 1HFY15 Revenues were in line whilst EBITDA margin was marginally lower than expectations 3QFY15 No 2QFY15 – 1QFY15 roundup 4QFY14 3QFY15 results disappointments EBITDA margin - RHS Source: SIAM, Company, Ambit Capital research; Note: We have considered standalone financials for Maruti Suzuki, Bajaj Auto, Hero MotoCorp and TVS Motor Company Ambit Capital Pvt. Ltd. Page 23 Economy & Strategy Management commentaries – More negatives than positives on demand An analysis of the 3QFY15 results commentaries and our recent management discussions pertaining to demand indicate that most auto manufacturers/auto financiers are witnessing subdued demand (see the exhibit below). Exhibit 38: Recent management commentaries on demand Company 3QFY15 – Management commentary Maruti Suzuki “Rural continues to record healthy growth.” “Not seen any significant slowdown in the rural demand on the automotive segment. Bolero continues to do well. However, tractor sales have been impacted by lower farm income and monsoons. Expect another 6 months for tractor sales to pick up.“ “Rains have been reasonably good, even though a little bit untimely. Will have to wait for a couple of months to see how the harvesting would be. January was a bit slow. Hoping that things will improve in February and March.” “Demand in the rural belts has been impacted as the crops have not been too good. With the marriage season starting in March, expect demand to pick up.” Mahindra & Mahindra TVS Motor Hero MotoCorp* Vehicle financiers “So far the rural balance sheet is doing much better on credit quality. This is driven by growth in better performing areas like Maharashtra and Gujarat. Entering into Karnataka which is again better performing.” “Whilst there are higher delinquencies in the tractor business due to rural economic slowdown in the last 4-5 Magma Fincorp quarters, given the higher risk rates, it is one of the more-profitable product-lines. The outlook is positive and continues to remain positive going into the future.” “Rural economy continues to remain under pressure. Below average monsoon has put pressure on the Mahindra & Mahindra Financial Services yields.” Source: Company. Note: * As per our discussions with the company. Bajaj Finance On-the-ground checks corroborate subdued demand trends We carried out a round of dealer checks across 2Ws and PVs categories to understand: (a) how the demand is panning out in the new calendar year; (b) the demand outlook; (c) the dealer inventory levels; and (d) the trends in incentives/discounts. Exhibit 39: Our dealer survey points towards subdued demand Domestic PVs Current demand trends Promotions and incentives Inventory levels Near-term outlook Market share trends Domestic 2Ws 0-5% YoY decline in sales. Demand is subdued due to Around 5% YoY growth seen in sales. January sales have increase in prices (owing to excise duty benefit rollback). been impacted to some extent by price hikes to compensate Demand in most rural areas impacted by monsoon and for the excise duty benefit rollback. lower crop prices. Discounts on Maruti’s petrol cars, however, came down as compared to December 2014. Average cash discounts on popular petrol models: Alto and Wagon R – `25k; no discounts offered on Swift petrol models. No discounts/promotional schemes. Average discount on popular diesel models: Swift - `20k; Dzire – `10k; Ertiga – `15k; Bolero - `35k; Scorpio - `15k and XUV5OO - `12k. Exchange bonuses offered by all manufacturers on all models at most dealers. Inventory levels are at an average level of around 4-5 Inventory at average levels of 4-5 weeks. weeks. Demand likely to remain at similar levels for some time. Demand to improve only post April due to marriage season Pickup expected only after April driven by lower fuel prices and income from crop harvest. and income from crop harvest. Maruti continues to outperform peers and retains its leadership on the back of strong response to new launches (Celerio, Ciaz) and demand shift towards petrol variants. Honda (due to its scooter leadership) and TVS (due to M&M continues to face tough environment with demand successful response to launches) have been able to clock due to: (a) weak demand for UVs as compared to other better than industry sales growth. passenger cars; (b) diesel-dominated portfolio; and (c) market share loss in UVs to competitors accentuated by lack of new launches. Source: Dealer checks February 24, 2015 Ambit Capital Pvt. Ltd. Page 24 Economy & Strategy Subdued demand trend: Dealers highlighted that the demand for PVs and motorcycles across India has slowed down. The demand in rural areas has been particularly impacted by the weak monsoon and lower crop prices. Most dealers expect demand to remain at similar levels, with a pick up likely only after April driven by lower fuel prices and higher income from crop harvest. Inventory levels back to normal: Dealers of both PVs and 2Ws indicate that inventory levels are close to the normalised levels. Dealers highlighted that inventory levels were above average in December 2014 in anticipation of the rollback of the excise duty benefit wef January 2015. However, with many manufacturers observing plant maintenance shutdowns in January and with subdued despatches, the inventory levels for both PVs and 2Ws are back to normal. Discount levels have moderated: In the PV space, discounts have come down as compared to December 2014. Average cash discounts on popular petrol models are: Alto and Wagon R – `25k (vs `32k in December); no discounts offered on Swift petrol model (vs `5k in December). Average discount on popular diesel models are: Swift - `20k (vs `5k); Dzire – `10k (vs `5k); Ertiga – `15k (vs `10k); Bolero - `35k; Scorpio - `15k and XUV5OO - `12k. Maruti, TVS and HMSI continue to outpace peers: In the PV space, Maruti has been able to outperform the industry mainly on the back of the success of its new launches (Celerio and Ciaz) and the demand shift in favour of petrol variants. M&M, on the other hand, has been losing market share (154bps YoY in AprilJanuary 2015) due to lack of new launches and a diesel-dominated portfolio. In the case of 2Ws, Honda Motorcycle and Scooters India (HMSI) and TVS have been able to garner market share driven by a strong scooter portfolio and a spate of successful launches. Current demand for PVs and 2Ws is subdued Maruti, TVS, and HMSI continue to outpace their peers Where do we go from here? Rural prosperity has aided vehicle growth in recent years… During the last 2-3 years, the demand for motorcycles and passenger vehicles in the urban markets were impacted by high inflation, surging interest rates and the general economic slowdown (impacting consumer sentiment). At the same time, however, demand remained buoyant in the rural markets. Whilst Maruti’s overall volumes recorded a negative CAGR of 2% over FY11-14, its rural sales saw a healthy 14% CAGR over the same period. Similarly, rural sales helped the domestic two-wheeler (2W) industry (including mopeds) to post a volume CAGR of 8% over FY11-14. Exhibit 40: Maruti’s rural sales have outpaced urban sales in recent years Exhibit 41: Higher exposure to rural areas helped 2Ws outperform PV sales in recent years 70% 33% 60% 50% 31% 29% 40% 30% 20% 27% 25% 23% 20% 10% 0% 21% 19% 5% -10% -20% 17% 15% -5% FY11 FY12 FY13 FY14 30% 25% 15% 10% 0% -10% FY11 Urban YoY growth - LHS Rural YoY growth - LHS Rural sales as % of total domestic sales Source: Company, Ambit Capital research February 24, 2015 FY12 2W YoY growth FY13 FY14 PV YoY growth Source: SIAM, Ambit Capital research Ambit Capital Pvt. Ltd. Page 25 Economy & Strategy Our discussions with the dealers and managements of auto companies indicated that the higher pace of growth in the rural areas was attributable to increasing rural prosperity. This improvement in income levels in rural India in recent years was driven by higher minimum support prices (MSPs), increased government spending in rural areas such as that under the MNREGA scheme and increasing real estate prices in rural areas. Furthermore, automobile sales in rural areas were also driven by relatively lower penetration levels. These factors helped rural India overcome the negative impact of the overall general economic slowdown and contribute significantly to vehicle sales growth. A moderation in rural income levels may impact rural demand, offset to some extent by declining cost of ownership Our channel checks and our macro team (please refer to the thematic portion) now suggest a likely moderation in rural income due to: (a) sub-par South-West monsoons in FY15; (b) slowdown in Government spending on rural India; (c) moderation in prices agricultural commodities globally; and (d) clear slowdown in rural wage inflation. We believe this could have a negative impact on vehicle demand in rural areas. We, however, expect the negative impact to be offset to some extent by lower cost of ownership on the back of declining fuel prices and moderating interest rates. Passenger vehicles sales in rural India to be impacted more than motorcycles sales… We expect moderation in rural income/wealth to have a higher impact on the sales of big-ticket items like passenger cars and sports utility vehicles (SUVs). We expect the impact to be somewhat muted on the two-wheeler space on account of its low-ticket size and it being a pre-dominant mode of transport in rural areas. We expect Mahindra & Mahindra (M&M) to be most impacted and Maruti Suzuki to be impacted by a smaller extent on account of moderation in rural demand for passenger vehicles. …however, we remain concerned of rising penetration levels of motorcycles in rural India competition/high Whilst we expect the impact of moderation of rural income/prosperity to be somewhat muted for the 2W industry (which has ~40% of sales coming from rural sales), we remain concerned of the rising competitive intensity in the domestic 2W space as well as increasing penetration levels of motorcycles in rural India. Increasing competitive intensity in domestic 2Ws, with Honda’s aggression and rapid scooterisation are likely to impact the domestic 2W market share of incumbents like Hero and Bajaj Auto. Overall, we expect Hero and Bajaj to lose a market share of about 421bps (to 39.2%) and 327bps (to 11.6%) in domestic 2Ws (ex-mopeds) over FY14-17. Exhibit 42: Sector comparative valuation Mcap US$ mn EV/EBITDA (x) FY15 P/E (x) FY16 FY17 FY15 FY16 CAGR (FY14-17) FY17 Sales EBITDA Price perf (%) EPS 3m RoE 1 yr FY15 FY16 FY17 Tata Motors* 28,017 5.4 4.9 4.5 12.8 11.0 9.9 14 18 22 10 49 25 23 22 Maruti Suzuki 17,311 15.5 11.7 9.4 29.7 21.1 16.0 18 25 34 7 110 16 19 21 M&M 12,262 16.5 13.9 11.7 22.1 18.6 15.9 10 12 7 (1) 30 18 19 20 Bajaj Auto 10,421 12.7 10.9 9.7 19.0 16.1 14.3 14 13 12 (16) 23 32 33 32 8,550 13.7 11.2 9.6 19.6 15.7 13.4 13 14 24 (11) 37 43 45 44 Eicher Motors 7,384 40.4 24.1 16.0 68.5 41.0 27.9 33 58 61 15 246 29 37 39 Ashok Leyland 3,166 24.6 14.8 10.8 NA 28.0 16.9 26 133 NA 31 342 3 14 20 TVS 2,304 22.9 15.9 11.8 39.2 25.0 17.9 23 38 45 27 264 24 30 32 18.9 13.4 10.4 30.1 22.1 16.5 Hero Motocorp Average Source: Bloomberg, Ambit Capital research. Note: Proforma figures are arrived at by adjusting EBITDA/PAT for normalised R&D spends (by expensing 70% of R&D costs instead of current 20%). February 24, 2015 Ambit Capital Pvt. Ltd. Page 26 Economy & Strategy Stock implications Mahindra & Mahindra (MM IN, Mcap US$11.3bn, Not Rated) We believe the impact of moderation in rural demand for passenger vehicles would have the most impact on M&M. This is because its Bolero and Scorpio models which are essentially sold in rural areas constituted nearly 67% of M&M’s total passenger vehicle volumes in 9MFY15. There are already signs of demand stress in these models, with their aggregate sales declining 4% in 9MFY15. Besides moderation in rural demand, M&M also faces the following challenges: (i) Increasing competition in the utility vehicle space with a number of recent and planned launches from the competition. M&M’s market share in the domestic UV space has come down from 47.7% in FY13 to 41.7% in FY14 and further to 36.9% in 9MFY15; and (ii) the narrowing gap between the diesel and petrol prices (from 31% in August 2012 to 19% currently) is resulting in shift away from diesel vehicles to petrol vehicles. M&M with its diesel-dominated portfolio is getting negatively impacted by this shift. Maruti (MSIL IN, Mcap US16.8bn, SELL, TP `3,100, 13% downside) – Urban dominance and shift to petrol cars saves the day Rural areas contributed close to 32% of Maruti Suzuki’s sales in FY14 and recorded 14% volume CAGR over FY11-14. Whilst we believe Maruti would be impacted by the moderation in rural demand, the impact would be offset to a significant extent by the following factors: (i) the narrowing gap between the diesel and petrol prices (from 31% in August 2012 to 19% currently) is resulting in a shift away from diesel vehicles to petrol vehicles; Maruti, with a strong portfolio of petrol cars is well positioned to benefit from this shift, and (ii) An uptick in the demand for passenger vehicles in the urban markets (constituting nearly 68% of Maruti’s sales) on the back of moderating cost of ownership can help offset the weakness in rural demand. We expect Maruti Suzuki to deliver a healthy 15% volume CAGR over FY15-17. Similarly, we expect Yen depreciation relative to INR to help EBITDA margins improve from 12.0% in 1HFY15 to 13.7% in 2HFY15 and further to 14.2% in FY16/FY17. However, the declining diesel mix and high discounts are likely to disappoint most consensus margin upgrades (average 15-15.5% for FY16/FY17). Furthermore, the stock is currently trading at 17.2x FY17 earnings vs the historical average of 15.0x, which looks expensive. Hero MotoCorp (HMCL IN, Mcap US8.8bn, SELL, TP `2,650, 4% downside): Hero has been able to hold on to its market share in domestic motorcycles in the last 18 months on the strength of its strong distribution network in rural areas. However, with Honda fast spreading its reach in the interiors of India, we believe Hero is highly susceptible to market share loss (our expectation of 276bps in FY14-17). Further, lack of a credible scooters portfolio (scooters contribute to only ~11% of volumes) and rising scooterisation in W industry (from 26% in FY14 to 31% in FY17) would adversely affect its overall domestic 2W market share. Whilst we factor in strong export volume growth on a low base, we believe this is insufficient to mitigate the domestic market share loss. Rising competitive intensity in the domestic 2W market, costs required to set-up a brand and distribution network in the exports market, and the deteriorating product mix (rising share of scooters and lower cc models) will restrict significant EBITDA margin expansion. We expect Hero’s margin to increase by just 40bps in FY14-17, much lower than the management’s target (~300bps). The stock is trading at 15x FY17 EPS; falling market share and the resultant poor EPS growth would drag multiples lower; our 12-month TP of `2,650 implies exit 14x FY17 EPS. February 24, 2015 Ambit Capital Pvt. Ltd. Page 27 Economy & Strategy Cement Demand deceleration across segments in 3QFY15 Nitin Bhasin, [email protected], +91 22 3043 3241 Moderation in retail/rural demand, amid persistent weakness in institutional demand, curtailed cement industry’s growth in 3QFY15. Demand remains weak in 4Q and price hikes led by production cuts have been rolled back. Rural housing forms 40% of the overall cement demand in India, which is suffering owing to poor farm output and moderation in rural wages. Moreover, unwinding of the ‘rural wealth effect’ has impacted housing growth in Tier 3/4 towns. Large-cap cement companies’ valuations remain lofty (3550% premium to the five-year average) and we prefer efficiently run midcaps available at reasonable valuations such as Orient Cement. Cement - Infra holds the key now that the momentary blip in rural housing is behind us After several quarters of muted demand growth, cement demand grew sharply during 2QFY12-1QFY13 as retail demand grew sharply, owing to a sharp increase in housing construction in both rural markets and tier II/III cities. The subsequent deceleration in 2QFY13 was primarily due to the slowdown in infrastructure construction (both public and private capex). However, rural/retail demand continued to post strong growth rates which helped sustain mid- to single-digit volume growth for the industry. Quote from ACC’s Chief commercial officer on rural demand in 2010: “The demand in the rural markets of North and East increased due to a very good harvest and remunerative minimum support prices (MSP) announced by the Government. The disposable funds available in the hands of the farmers were partly used for meeting their basic needs such as housing and the balance was put aside in the form of savings to meet their future needs”. Lately, cement volume grew by ~8% in 1HFY15 (after several quarters of volume growth at 3-5%). Industry participants highlight that the strong growth in 1H was supported by the delayed monsoons and pick-up in retail demand after the General Elections (due to improvement in consumer sentiment). However, volume growth decelerated to 4% in 3Q, due to weakness in institutional sales and moderation in housing construction in Tier 2/3 and rural cities. We highlight that cement consumption in large retail markets such as south India declined sharply (evident from Ramco Cement’s volume decline of 10% YoY for the second-consecutive quarter). Strong growth in rural demand supported industry growth rates in the last 3-4 years Moderation in rural demand growth amid persistent weakness in institutional demand leading to deceleration in demand growth Quote from Shree Cement’s Whole-time director, Mr Prashant Bangur in February 2015: The dispatch scenario is very gloomy. The January-March quarter is generally a good quarter, but not this time. Pricing is weak, specifically in north India. Exhibit 43: Rural/retail demand kept industry volume growth (YoY) positive despite macro adversities Tapering growth rates - sharp decline in infrastructure construction, moderate retail demand growth 9.3% 7.9% 7.0% 2.1% 3.8% 9.8% 9.2% 10.1% Significant drop in infrastructure, yet strong retail demand kept growth rates in mid-single digits 8.5% 8.0% 4.9% 5.7% 5.7% 4.8% 5.6% 4.9% Pick-up in 1H driven by postelection positive sentiment, subsequent deceleration due to low retail demand 2.7% 4.4% 3.5% 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 4QFY13 3QFY13 2QFY13 1QFY13 4QFY12 3QFY12 2QFY12 1QFY12 4QFY11 3QFY11 2QFY11 1QFY11 0.1% 4QFY10 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Strong retail demand growth led to high single-digit growth Source: Ministry of Statistics and Programme Implementation (MOSPI), Ambit Capital research; Note: MOSPI data is not the most representative but given lack of other sources we use MOSPI data; cumulative volume of top-10 companies also shows a similar trend February 24, 2015 Ambit Capital Pvt. Ltd. Page 28 Economy & Strategy Whilst cement prices surged in 1H (10-15% increase across India with the maximum hikes in south and west India), this was supported by production cuts (15 days/month of production holidays in Andhra Pradesh). However, prices fell subsequently in 3Q, as demand growth tapered. Prices were hiked sharply again in January 2015, but companies highlight that these have been rolled back in certain regions such as west India (primarily Gujarat), north India and certain pockets of east India (Jharkhand and Bihar), due to an insignificant improvement in demand. A Delhi-based dealer on cement prices: “In January, cement manufacturers increased prices by almost `.30 per cement bag; however most of this was rolled back in February”. Price hikes being rolled back owing to weak demand An Indore-based dealer on cement prices: “For Indore prices in January were increased by `.15 per bag, but it had to be rolled back in February due to low demand. For the rest of Madhya Pradesh, prices were hiked by about `.10 per bag in January, which again was rolled back in February”. Exhibit 44: Sharp price hikes undertaken in January 2015 (supported by production cuts); companies and channel partners indicate roll backs of price hikes due to low demand (`/ 50kg bag) 360 340 South 320 North 300 West 280 Central 260 East Jan-15 Nov-14 Sep-14 Jul-14 May-14 Mar-14 Jan-14 Nov-13 Sep-13 Jul-13 May-13 Mar-13 Jan-13 Nov-12 Sep-12 Jul-12 May-12 240 Source: Industry participants, Ambit Capital research Retail-focused players grow slower than the industry UltraTech reported volume growth of 10% in 3QFY15, out of which 6% was on account of sales from the recently acquired Jaypee’s Gujarat unit; hence, the company’s like-to-like growth was a mere 4%. Shree’s volume grew by 10% YoY due to its rising market share in north India and sales in Bihar post capacity additions. The volumes of ACC, a dominant retail player, dropped by 2% YoY and Ramco Cement’s volumes dropped by 11% YoY, as retail demand weakened in their key markets. Other regional players grew in mid-single digits, barring players such as OCL and Heidelberg, which grew due to significant capacity additions. Realisation and EBITDA/tonne for the large part of the industry grew marginally (by 2.6% and 3.3% YoY, respectively). February 24, 2015 Ambit Capital Pvt. Ltd. Page 29 Economy & Strategy Exhibit 45: Company-wise quarterly performance assessment Large/pan-India Volume (mn tonnes) Realisation (`/tonne) SepDecDec- SepDecDec- Sep14 13 14 14 13 14 14 19.9 19.3 20.5 4,743 4,554 4,627 795 UltraTech* 10.4 10.0 11.0 5,200 4,796 5,000 872 797 872 9.8% 4.3% 9.4% 5.6% -3.8% 0.0% 3.9 3.4 3.7 3,656 3,468 3,618 766 702 714 10.0% 4.3% 1.7% -4.1% -1.0% -6.8% ACC 5.6 5.9 5.8 4,650 4,773 4,572 674 618 440 -1.5% -4.2% -28.8% 2.5% -1.7% -34.7% Mid-caps 9.4 9.1 9.6 4,230 3,983 4,180 695 522 598 5.2% 4.9% 14.5% 1.9% -1.2% -13.9% Orient Cement 1.0 1.0 1.0 3,740 3,499 3,740 799 510 597 5.1% 6.9% 17.1% 4.0% 0.0% -25.3% JK Lakshmi Cement 1.5 1.4 1.5 3,928 3,530 3,683 612 445 486 6.0% 4.3% 9.2% 3.1% -6.2% -20.6% Sagar Cement 0.3 0.3 0.3 3,714 3,596 3,714 261 65 175 2.4% 3.3% 170.3% 0.0% 0.0% -32.9% Dalmia 1.5 1.6 1.7 4,745 4,335 4,616 798 756 702 3.1% 6.5% -7.1% 10.0% -2.7% -12.0% Ramco Cement 1.9 1.9 1.7 4,595 4,332 4,570 958 787 750 -11.3% 5.5% -4.7% -11.3% -0.5% -21.7% OCL India 0.9 0.8 1.1 4,430 4,449 4,434 558 615 802 35.9% -0.3% 30.3% 23.3% 0.1% 43.7% Prism Cement 1.3 1.1 1.2 4,060 3,841 4,271 518 114 356 6.3% 11.2% 213.3% -7.1% 5.2% -31.3% Particulars Shree Heidelberg Cement Sector average EBITDA (`/tonne) YoY growth DecDecEBITDA/ Volume Realisation 13 14 tonne 726 722 6.4% 1.6% -0.6% Volume 2.8% QoQ growth EBITDA/ Realisation tonne -2.4% -9.3% 1.0 1.0 1.1 3,905 3,774 3,804 542 285 556 19% 0.8% 95.3% 5.8% -2.6% 2.6% 29.3 28.4 30.1 4,578 4,371 4,484 763 660 682 6.0% 2.6% 3.3% 2.5% -2.0% -10.6% Source: Company, Ambit Capital research; Note: *UltraTech includes sales of the acquired Jaypee Cement unit in Gujarat Rural demand remains a secular opportunity Rural housing accounts for ~40% of the cement demand in India, out of which ~15% is supported by welfare initiatives such as Indira Aawas Yojana and the balance 85% demand is supported by agricultural income and rural wages. The sharp increase in rural income in the last 3-4 years was led by higher MSPs, higher welfare allocations and higher rural wages, which in turn led to significant improvement in rural demand. As per Census 2011, the rural housing count increased at a CAGR of 2.1% over FY0111; however, pucca houses grew at 4%. Nearly 50% of the houses in rural India are still kutcha/semi-pucca and we believe that the shift would continue to drive rural cement consumption. Exhibit 46: Rural accounts for 40% of overall cement consumption in India Industrial , 10% Commerical, 10% 40% of cement demand comes from rural housing Exhibit 47: High proportion of kutcha/semi-pucca houses Kutcha, 17.0 Rural Housing , 40% Semi-Pucca, 27.6 Infrastructur e , 15% Pucca, 55.4 Urban Housing, 25% Source: Company, Ambit Capital research Source: Company, Ambit Capital research Commentary of primary data sources on demand dynamics of rural cement/home building materials Our checks with industry participants suggest that rural demand in the last five years should be demarcated into two components: ‘Gradual and steady’ and ‘Aberration’. ‘Gradual and steady’: This segment primarily consists of the agri-dependent population that constructs houses gradually (from a mud-house to concrete flooring and concrete walls/roof in a phased manner). Demand growth from this segment has remained steady, barring minor volatilities, depending on the farm output. ‘Aberration’: This segment constitutes the population that amassed significant wealth (unexpectedly) due to a sharp increase in land prices (mainly in north and west India), which enabled them to construct houses (typically outside the rural markets) and purchase vehicles, white goods, etc. Industry experts believe that cement demand February 24, 2015 Ambit Capital Pvt. Ltd. Retail-institutional mix of top6 cement companies Company Retail Institutional UltraTech 73 27 ACC 82 18 Ambuja 80 20 Shree 65 35 Ramco 80 20 India Cement 70 Source: Company, research 30 Ambit Capital Page 30 Economy & Strategy from this customer base will moderate in the coming years. However, this should not impact overall cement demand materially. We highlight that the base level of the rural economy (which our Economy team defines as the ‘lower tier’, is highly dependent on agricultural income and support from the Government through subsidies and MSPs (a point also made by the cement managements). Whilst the poor rainfall and low MSPs in FY15 have reduced disposable income, our Economy team holds the view that the Government would route all subsidies through the Direct Benefits Transfer scheme, which would facilitate redistribution of wealth in favour of the lower tier of the rural population. Hence, we do not see a major impediment to the long-term rural housing construction story and expect the segment to report a 5-7% CAGR over the next 4-5 years (in line with the historical averages). How important are rural sales for cement companies? Not only is rural cement consumption a large demand component, but more importantly it provides price stability, given that rural clients (first-time/continuing home builders) are brand-conscious and purchasers of Tier 1 brands. The large brands have invested a significant amount on brand building and setting up distribution in these markets. The tier-I brands usually have a strong channel influence and hence their bargaining power in rural markets is significantly better than Tier 2/3 brands; however, the weakness in urban/institutional markets led to some of the Tier 3/4 brands investing in branding/reach in these markets. Exhibit 48: Some of the key rural marketing initiatives of cement companies Company Strategy UltraTech The company does several educational seminars with masons and contractors. It also meets the sarpanch in the villages to establish its brand in micro markets. ACC ACC Cement ventured out to establish the superiority of ACC Suraksha blended cement and to build an image of premium cement for the brand. To reach the opinion leaders viz. architects, engineers, contractors, etc., the assistance of the regional local press was sought and other direct marketing efforts such as field meetings with small groups of masons and customers were made. Ambuja Holcim hired NCAER to conduct a detailed study on the rural market of India and planned several initiatives. The company will seek participation in government programmes as well as private housing by engaging local government, local builders and skilled manpower. Shree The company plans to open 2,000 new dealers in rural India over the next one year and it has set a target of 40% revenue (from 20%) from the rural market in two years. Ramco Ramco appointed Percept Out of Home, Rural Vertical, as their outdoor activity partner to promote their brand, ‘Ramco,’ across south India. Rural vertical will be carried out in three phases. In the first phase, pre-publicity activity will take place through branded mobile van units, retail branding, in-shop branding, gate arches and other visibility mediums including signages, leaflets, danglers, posters and kiosks. In the second phase, a ‘Mystery Shopper’ contest will be announced, and in the third phase, the Mystery Shopper’s name will be declared after a Lucky Draw. Apart from increasing brand visibility, Percept Out of Home, Rural Vertical, will also be reaching out and motivating the dealer network with loyalty programmes. Binani It is creating awareness for its cement brand in rural India. It is increasing its penetration in the rural market and villages through retail outlets. The company is targeting villages with a population of 5,000-12,000 in the districts of Panchmahal, Dahod, Jamnagar, Porbandar, and Junaghad in Gujarat and identifying 118 new retailers. The company will reach another 300 villages with a population of 10,000. Source: Company, Ambit Capital research Our view on the sector and does it need a revisit? We had estimated volume growth of 8%/10% for FY15/FY16 in our cement thematic, ‘How expensive can it get?’ in October 2014; we had assigned a 20-year average multiplier of 1.2x to our Economy team’s GFCF assumption. However, given the weak 3Q and no significant improvement in 4Q, we believe that demand growth in FY15 would be 6-7% at best (vs 9MFY15 volume growth of 6%). However, the key question is whether our FY16 estimates of a double-digit volume growth faces downside risk? Companies believe that it would take a few quarters for infrastructure execution to ramp-up and they remain hopeful that the budget announcements would be followed by on-ground changes; our checks also suggest Prolonged demand weakness that roads projects could be awarded in March/April 2015 which should be a poses a downside risk to our 10% marginal kicker. Possible reduction in housing construction in tier-II/III/IV markets FY16 volume growth estimate (due to the wealth effect), could be adequately offset by the Government’s impetus on infrastructure and affordable housing; however, it hinges on the effective February 24, 2015 Ambit Capital Pvt. Ltd. Page 31 Economy & Strategy implementation of these programmes. Whilst we retain our volume growth estimate of 10% in FY16 for now, we might need to revisit our estimates if the implementation of the infrastructure orders remains tepid as our key thesis for the 10% volume growth were: (a) infrastructure/ institutional-housing pick up; and (b) revival in South India (an otherwise declining market—earlier AP and now TN). Pricing growth to be 7-8% at best We factor in a price hike of 8% in FY16 for cement companies under our coverage (assuming the recent price hikes sustain). Based on our discussions with cement companies, further price hikes seem difficult to push in Feb/Mar 2015, and hence we do not build in over-optimistic realisation growth assumptions with demand stability. Note that prices have grown higher than 10% only in four out of the last twenty years; moreover, barring FY12, in the other three years, capacity utilisation was higher than 90%. Note that apart from FY05-08, the three-year cement price CAGR has been 1-6% over the six three-year periods. Exhibit 49: Cement price has grown by 1-6% for most of the three-year periods, barring FY05-08 15.3% 14.9% 10.6% 8.7% 7.6% 8.4% 9.6% 8.0% 7.3% 4.7% 8.0% 7.5% 5.9% 4.7% 4.6% 2.1% FY95-98 5.4% 1.4% 0.9% FY99-02 8.5% 8.0% FY02-05 FY05-08 Cement Price CAGR FY08-11 Cement demand CAGR FY11-14 FY14-16E Capacity CAGR Source: CMA, Ambit Capital research Exhibit 50: Prices declined due to poor demand and sharp capacity increase 30% 100% 90% 20% Rolling 3-year cement capacities CAGR Rolling 3-year cement despatches CAGR 80% Cement price growth 70% Annual capacity utilisations (RHS) 10% -10% FY16E FY15E FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 FY06 FY05 FY04 FY03 FY02 FY01 FY00 FY99 FY98 FY97 FY96 0% 60% 50% Source: CMA, Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 32 Economy & Strategy Valuations building in unreasonable hope Despite the unexciting 3QFY15 earnings, cement stocks remain expensive given the hope of strong demand and pricing growth with a recovery in cement demand. We believe that the cement stocks are trading at extremely rich valuations, without any significant change in the underlying fundamentals and also pricing in pricing expectations which are unlikely to be met. The exhibit below shows that cement stocks (represented by the blended valuations of the top-5 companies) are trading at peak multiples (across the last two cycles), i.e. a 63% premium to the ten-year average. Whilst we understand that the earnings multiple looks expensive at the cusp of a cyclical recovery (margins and RoCE bottoming out), we do not think that the current multiples are justified by the growth expectations and RoCEs (we believe that RoCEs would remain at nearly half of the peak levels of FY05-08 in FY15-18). Stocks trading at peak valuations and results disappointments have not dampened the hope for a strong demand and pricing revival We highlight that multiple times in the last 2-3 quarters, cement companies have missed consensus earnings expectations significantly, which is yet to be seen in the stock price (for instance, ACC reported the lowest unitary EBITDA in the last 17 quarters alongside a volume decline of 2% YoY). Investors believe that the near-term disappointments will be adequately offset by the strong growth expectations but how much more than 10% that we are already building in; general argument around demand growth from Infrastructure/ institutional activity should be considered in the light of the fact that this is a brand-agnostic/bargain seeking demand. We believe earnings disappointments for a few more quarters could de-rate these expensive stocks significantly. Exhibit 51: Cement stocks are trading at all-time peak EV/EBITDA multiples… (%) (X) 40 16 14 12 10 8 6 4 2 35 30 25 20 One-yr fwd EV/EBITDA Jan-15 Sep-14 May-14 Jan-14 Sep-13 May-13 Jan-13 Sep-12 May-12 Jan-12 Sep-11 May-11 Jan-11 Sep-10 May-10 Jan-10 Sep-09 May-09 Jan-09 Sep-08 May-08 Jan-08 Sep-07 May-07 Jan-07 Sep-06 May-06 Jan-06 Sep-05 May-05 Jan-05 Sep-04 15 EBITDA margin Source: Ambit Capital research, Company, Bloomberg. Note: The chart includes UltraTech, Ambuja, ACC, Shree and Ramco Cement Exhibit 52: …despite the materially lower margins and RoCEs One-yr fwd EV/EBITDA Jan-15 Sep-14 May-14 Jan-14 Sep-13 May-13 Jan-13 Sep-12 May-12 Jan-12 Sep-11 May-11 Jan-11 Sep-10 May-10 Jan-10 Sep-09 May-09 Jan-09 Sep-08 May-08 Jan-08 Sep-07 May-07 Jan-07 Sep-06 May-06 Jan-06 Sep-05 May-05 Jan-05 (%) 40 35 30 25 20 15 10 5 Sep-04 (X) 16 14 12 10 8 6 4 2 ROCE Source: Ambit Capital research, Company, Bloomberg. Note: The chart includes UltraTech, Ambuja, ACC, Shree and Ramco Cement February 24, 2015 Ambit Capital Pvt. Ltd. Page 33 Economy & Strategy Relative valuation Large-cap cement companies continue to trade at a significant premium to mid-cap peers, although consensus expects higher growth and RoEs for the mid-cap peers. Whilst the valuation discount of the mid-sized peers can be explained by exposure to one or two regions (at best) and high leverage, these factors can erode earnings significantly in times of weak demand and poor pricing. However, we believe that certain mid-cap peers such as Orient Cement have shown capital discipline and cost controls and have upcoming capacities in large regions recovering from growthrestricting challenges (AP/Maharashtra). We prefer such high-quality mid-caps over the expensive large-cap space. Exhibit 53: Relative valuation summary Capacity Advt 6m Mcap Rating (mn tonnes) (` bn) FY15 FY16 FY17 US$ mn EV/EBITDA P/E EV/tonne CAGR (FY15-17) (x) (x) US$ (%) US$ mn FY15 FY16 FY17 FY15 FY16 FY17 FY15 FY16 FY17 Sales EBITDA ROE (%) EPS FY16 FY17 Large cap UltraTech 62.0 67.0 72.0 SELL 808 13,468 Ambuja* 28.0 30.0 31.0 SELL 396 Grasim^ ACC* Shree Cement ** JPA # Total / Average Mid cap Ramco Cements ** Jk Lakshmi Cement Century Tex# JK Cement Prism Cement # Birla Corp # India Cements Total / Average Small Cap Dalmia Bharat #@ Orient Cement OCL India Mangalam Cement Sagar Cement Total / Average NA 10.7 19.6 14.5 11.2 35 25 19 229 212 197 18 32 37 16 18 6,604 7.0 19.0 14.7 12.1 27 25 21 210 196 190 13 25 15 15 17 NA NA NR 340 5,670 4.8 8.9 6.7 5.3 18 13 10 NA NA NA 15 30 33 10 12 30.1 33.6 33.6 SELL 294 4,899 9.1 19.1 14.2 11.2 26 23 18 154 138 138 14 30 20 15 17 21.0 25.0 28.0 366 6,095 2.6 22.2 15.9 12.4 44 28 20 293 246 220 21 34 49 22 24 23.4 23.4 23.4 SELL 58 974 22.7 28.0 25.0 23.0 (12) 46 16 575 575 575 7 10 NA 1 3 164 179 188 377 6,285 9.5 19 15 13 23 27 17 292 274 264 15 27 30 13 15 12.5 13.0 14.5 SELL 76 1,274 1.2 14.3 10.7 8.5 33 20 14 130 125 112 17 30 55 14 18 9.0 10.0 11.0 NR 42 700 2.1 14.2 9.1 6.3 27 20 12 101 91 83 26 50 51 14 21 12.8 12.8 12.8 NR 47 785 8.0 14.7 10.7 NA (228) 33 NA 119 119 119 NA NA NA 8 NA 10.8 10.8 10.8 NR 50 834 1.1 14.5 9.5 6.8 42 20 11 113 113 113 23 45 99 13 22 8.0 8.0 8.0 NR 54 894 1.0 19.6 11.8 7.9 99 28 13 153 153 153 17 57 NA 17 28 10.5 10.5 10.5 NR 35 585 0.6 9.1 6.6 4.9 16 11 8 55 55 55 15 37 47 11 15 18.5 18.5 18.5 NR 30 504 5.4 8.2 6.4 5.7 41 13 8 59 59 59 11 20 NA 6 9 82 84 86 48 797 2.8 14 9 6.7 4 21 11 104 102 99 18 40 63 12 19 13.7 18.0 18.0 NR 36 607 0.5 16.1 8.5 6.3 (191) 26 10 92 70 70 32 60 NA 4 11 5.0 8.0 9.0 BUY 34 560 0.6 12.8 8.3 5.7 20 18 11 133 83 74 32 49 36 19 25 6.7 6.7 6.7 NR 31 522 0.3 10.2 7.7 6.0 22 14 9 89 89 89 16 30 54 17 21 3.5 3.5 3.5 NR 7 121 0.7 8.7 5.6 4.4 18 9 6 49 49 49 21 42 75 15 19 2.5 3.5 3.5 NR 6 96 0.0 17.4 6.9 4.8 114 16 10 59 42 42 35 91 NA 13 11 31 40 41 23 381 0.4 13 7 5 (3) 16 9 84 67 65 27 54 55 13 18 UR Source: Ambit Capital research, Bloomberg, Company February 24, 2015 Ambit Capital Pvt. Ltd. Page 34 Economy & Strategy Stock implications TOP BUY idea - Orient Cement – TP `214; 25% upside Orient Cement’s cost competiveness (13-14% lower cost than the industry average) facilitated market share gains in AP and Maharashtra (9.5% in FY14 vs 7% in FY09) despite the adverse market conditions. Post the corporate restructuring and management revamp, Orient is adding scale—(commencement of 3mn tonne expansion in Karnataka in 1QFY16 followed by 2-3mn tonne brownfield expansions). With expanding geographical presence and market share gains, we estimate 21%/38%/31% volume/EBITDA/EPS CAGR over FY15-18E. The stock is trading at 8x FY16 EBITDA, at a 15% discount to Ramco, despite higher growth/better RoCEs. The growth levers to scale support our implied 8.2x exit FY17 EBITDA. TOP SELL idea - Ambuja Cement – TP `208; 22% downside Ambuja’s long-dated capacity expansion at a time when regional players aggressively built scale has led to market share erosion in key markets like north and west India (it has lost its leadership position to Shree Cement in north India). The company’s market share dropped to 8.1% in CY14 vs 10.1% in CY07. Significant increase in industrywide capacities (up 40% over CY09-13) amidst Ambuja’s minimal additions (up 12%) would lead to continued loss of market share and lower growth than industry for at least the next two years. Holcim controls the capital allocation decisions of Ambuja and in the last five years it has preferred to hoard cash rather than invest for growth. With Holcim merging with Lafarge globally, the management’s bandwidth in India might be limited and delay decision-making in India. Also, the management’s guidance on the savings generated from ACC’s absorption appears to be overestimated. The stock is trading at 14.3x one-yr fwd EV/EBITDA, a 50% premium to its five-year average. We find valuations expensive and despite building in a strong 31% EBITDA CAGR in CY13-15, we expect RoCEs to remain low (14.5-15.5% vs five-year average of 16.5%). Our target price of `208 implies 8.8x CY16 EBITDA. February 24, 2015 Ambit Capital Pvt. Ltd. Page 35 Economy & Strategy Home building materials Achint Bhagat, [email protected], +91 22 3043 3178 Industry participants (corporates/channel partners) highlight demand deceleration across home improvement products such as plyboards, tiles and pipes. Sharp reduction in liquidity with mid-to-small real estate developers and slowdown in low-ticket semi-urban and rural housing led to weak demand growth in 3QFY15 and we do not hear any significant improvement in 4Q. Although industry volumes remain weak, we note that certain players with enhanced capacities, distribution and a strengthened brand are fast gaining market share and hence growing significantly higher than industry average. Tiles, ply and pipes Limited rural exposure Home building materials such as tiles, plyboards, and pipes have consistently reported strong growth rates in the last decade (see Exhibit 54). For most of these categories, the key growth driver was rising penetration in tier-II/III/IV cities alongside higher aspirational consumption. From our channel checks and management discussions, we understand that the rural consumption of home improvement products such as tiles and plyboards is limited due to the low-ticket housing pattern. Home improvement products do not have a significant exposure to the rural market Exhibit 54: Home building materials reported strong revenue growth in the last decade FY04 FY09 `mn `mn Sectors Sector growth / nominal GDP growth (x) FY04- FY09- FY04FY04FY09FY04`mn 09 14 14 09 14 14 FY14 Revenue CAGR Paints 39,159 91,240 206,024 18% 18% 18% 1.2 1.2 1.2 Light electricals 55,872 121,581 251,971 17% 16% 16% 1.1 1.1 1.1 Pipes 4,613 16,434 46,993 29% 23% 26% 1.9 1.6 1.8 Tiles 8,630 21,059 46,128 20% 17% 18% 1.3 1.2 1.2 Adhesives 6,538 19,863 42,832 25% 17% 21% 1.6 1.1 1.4 Plyboards 2,899 14,862 34,597 39% 18% 28% 2.6 1.3 1.9 Sanitaryware 1,744 4,919 15,447 23% 26% 24% 1.5 1.8 1.6 119,454 289,959 643,992 19% 17% 18% 1.3 1.2 1.2 10,733 19% 17% 18% 1.3 1.2 1.2 Total Size (` mn) Total Size (USD mn) 1,991 4,833 Source: Ambit Capital research, Company; Note: we consider only the organised players for the respective sectors What has caused the recent slowdown? Muted real construction, high channel inventory, poor liquidity of the developers and channel, and moderation in aspirational consumption have led to deceleration of volume growth for most categories. Dealers in smaller towns believe that it could take a few quarters before real estate construction gathers pace and industry volumes recover. Plyboards - Organised players replacing unorganised Industry volume growth has moderated in the last 2-3 quarters on account of lower offtake from retail customers in tier-II/III markets. Distributors highlight that plyboard sales in rural markets are limited and hence the lower agri income does not have a major impact on plyboard sales. Industry participants highlight that industry volumes declined by 2% in 3QFY15; however, organised players’ sales in the mid category of plyboards grew sharply with rising distribution network across smaller towns. The export ban of face timber from Myanmar led to waning competitiveness of unorganised players and facilitated market share gains and better pricing power of organised players (price hikes of 10% YTD). Century Ply, on the back of February 24, 2015 Ambit Capital Pvt. Ltd. Page 36 Economy & Strategy enhanced capacities and consistent brand-building initiatives and dealer channel ramp-up, has outpaced competition in the last 18 months (volume growth of 13% in 9MFY15 vs 2-3% growth of the industry). Larger brands gain market share as unorganised players lose sheen Similar to most home building categories, plyboards’ sales decelerated in the last 2-3 quarters due to the slowdown in residential housing construction. Century Ply has been able to gain market share post the recent capacity additions through significant investments in brand building and expansion of its dealer network. Dealers in smaller cities highlight that the larger brands support the dealers through better inventory management with timely despatches (within 24-48 hours), which reduces dealers’ inventory investments. Century Ply’s and Greenply’s affordable segment brands, Sainik and Ecotec have found increasing acceptance in tier-II/III cities. Leading brands gain market share owing to strengthening brand and distribution The exhibit below highlights the revenue growth of Century and Greenply (in ply and laminates); whilst industry volumes have slowed down, it is not visible in the exhibit below, as these two players have significantly improved market share due to the raw material constraints faced by the unorganised players. Exhibit 55: Slowdown in industry volume growth not visible in Century’s and Greenply’s sales growth given continuous market share gains YoY growth 27 2019 11 8 14 98 7 13 16 13 9 7 9 7 3QFY15 2QFY15 1 1QFY15 1 2QFY13 (2) 1QFY13 4QFY12 3QFY12 2QFY12 2 14 12 22 4QFY14 11 23 18 3QFY14 9 1QFY12 Lam 2QFY14 25 1QFY14 25 19 4QFY13 24 3QFY13 23 4QFY11 30 25 20 15 10 5 (5) Ply Source: Company, Ambit Capital research; Note: we add segment-wise revenues of both Century Ply and Greenply for the above chart Dealer checks—housing slowdown Dealers highlight that although real estate construction in large cities was muted for the last 2-3 years, individual housing construction in smaller towns kept plyboard demand stable. However, growth rates tapered in FY15, as housing/real estate construction in smaller towns decelerated. Dealers highlight that the use of plyboard in low-ticket and rural housing is limited and hence rural consumption does not have a direct impact on plyboard sales. A large addressable market We believe that the organised plyboard industry has significant room to grow, as furniture penetration increases in India alongside the rising share of the organised segment (with the shift in consumer preference towards branded products). A gradual adoption of GST, continuing thrust by the companies in brand-building, increasing reach and portfolio expansion across price points will increase the market share of organised players. Managements estimate that the organised players’ share could increase to 50% by FY20 (from 30% of the `150bn market); given that Century and Greenply hold two-third of the market share, these players are well poised to grow in the future. Exhibit 56: Plyboard relative valuation summary Companies Mcap EV/EBITDA (x) US$ FY15 FY16 mn 1,144 15.6 13.1 Rating CMP TP Up/ Down Century Plyboard BUY 211 215 2% 752 22.1 18.1 Green Ply NR 1,010 NA NA 392 9.1 8.1 PLYBOARDS (Avg) P/E (x) FY15 FY16 25.0 33.7 16.3 P/B (x) RoE (x) CAGR (FY14-16) FY15 FY16 FY15 FY16 Sales EBITDA EPS 22.0 7.7 5.9 31.4 24.8 17.3 24.2 44.1 25.8 12.1 9.1 39.5 38.4 21.1 31.2 63.8 18.1 3.3 2.7 23.2 11.2 13.4 17.1 24.4 Source: Bloomberg, Company, Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 37 Economy & Strategy Century Plyboards, our top pick in the plyboards segment Century is doing the right things in terms of building scale, distribution and brand recall to position itself strongly to participate effectively in the large growth opportunity. We estimate 24%/31% sales/EBITDA CAGR and 50% earnings CAGR over FY14-17E. We expect strong volume growth and margins to sustain beyond FY16 as well, given that the company is increasing scale, adding product-lines and assuring long-term raw material procurement. Our 12-month target price of `215 for Century Ply implies an inexpensive 14.2x FY17 EPS. Multiples should remain rich/ even get further rich if the management is able to increase the asset turnover of the company by using more outsourcing capacities, reducing working capital intensity and increasing the dividend payout ratio (to 30%). Tiles: Evident slowdown; top-2 brands gain market share Slowdown in real estate construction in tier-II/III cities led to volume growth deceleration of tiles in 9MFY15. Dealers highlight that channel inventory remains high, which could lead to poor volume growth for 2-3 quarters. However, management teams/industry participants believe that the secular opportunity is intact, as not only is the penetration low (only 11% Indian households have tiles/mosaic flooring) but unorganised players (50% market share) have been ceding market share to organised players, given product premiumisation, rising brand awareness and significant improvement in distribution. Kajaria and Somany, the two strongest franchises, have been continuously increasing scale (through own capacities and forming JVs with unorganised players) alongside brand building, which has enabled market share gains and higher-than-industry volume growth in recent years. Note in the exhibit below that revenue growth decelerated from 2QFY15 onwards (3QFY15 appears due to the low base of 3QFY14 since the Morbi cluster was shutdown). Note that the below exhibit represents sales growth, and given the sharp increase in realisations for players such as Somany (due to rising mix of premium products), the growth appears high despite lower industry volume growth. Moreover, we highlight that Kajaria and Somany reported single-digit volume growth for the first time in the last 12 quarters (barring 3QFY14) in 2QFY15. Exhibit 57: Revenue growth (YoY) has decelerated from 2QFY15 onwards (3QFY15 revenue growth appears high due to low base) Tiles YoY growth (%) 35 30 30 26 28 30 27 26 23 25 20 20 22 20 18 16 15 10 13 13 12 10 3 5 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 4QFY13 3QFY13 2QFY13 1QFY13 4QFY12 3QFY12 2QFY12 1QFY12 4QFY11 3QFY11 - Source: Company, Ambit Capital research. Note: * Revenue growth of top-5 companies February 24, 2015 Ambit Capital Pvt. Ltd. Page 38 Economy & Strategy Exhibit 58: Kajaria’s volume growth rates have decelerated Kajaria Voume growth (%) 30% 28% 24% 25% 20% 13% 15% 24% 21% 20% 16% 15% 3QFY15 is an aberration due to the low base of last year, as a large manufacturing cluster, Morbi, was shut down for two months 15% 11% 7% 10% 4% 5% 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 4QFY13 3QFY13 2QFY13 1QFY13 4QFY12 0% Source: Company, Ambit Capital research Primary data sources/managements—industry volume growth moderates; top franchises gaining market share Industry participants highlight that whilst industry growth rates have moderated, Kajaria and Somany are gaining market share over both unorganised players and organised manufacturers like H&R Johnson and Nitco. Dealers ascribe the share gains to: (a) industry-leading design innovation and branding initiatives to create a ‘pull’ brand recall, (b) improvement in distribution network and continuous expansion in dealer network. For instance, Somany’s management highlighted a three-pronged strategy to improve distribution: (a) increasing footprint in smaller towns (50-60 dealers added in 1H), (b) upgrading the exclusive showrooms to larger format tiles, and (c) adding new exclusive tiles showrooms (for large format tiles). Kajaria and Somany continue to grow higher than industry growth rates by displacing the unorganised players Our view - Stick to high-quality franchises Although the industry growth rates have decelerated, leading brands such as Kajaria and Somany continue to gain market share, given continuous product innovation and ahead-of-the-curve design launches; these companies will continue to grow materially higher than the industry average. Moreover, both these players are expanding their product-lines into sanitaryware and faucets, which are growing in scale. Steadily Somany plans to enter into the wellness faucet range from the entry mid-level products and it will possibly set up a faucet manufacturing unit next year. Whilst the valuations are rich, we expect these to sustain given the sustenance of the profitability and market share gain, making these larger profitable-cash-generating franchises. Exhibit 59: Tiles and Sanitaryware relative valuation summary Mcap EV/EBITDA (x) Companies Rating CMP TP P/E (x) P/B (x) RoE (x) CAGR (FY14-16) Up/ US$ mn Down FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16 2,208 18.3 14.6 37.6 27.5 6.8 5.0 19.5 21.2 17.2 19.6 48.3 8.6 7.0 26.6 26.5 22.0 23.4 32.0 Sales EBITDA EPS TILES AND SANITARY WARE (Average) Kajaria Ceramics NR 783 NA NA 1,001 18.7 15.0 36.6 28.6 Somany Ceramics NR 368 NA NA 230 15.4 12.0 32.2 22.3 5.4 2.4 18.3 22.3 21.2 21.2 48.9 Cera Sanitaryware NR 2,637 NA NA 536 27.8 22.0 49.0 38.0 10.6 8.5 25.2 24.5 11.9 12.4 13.5 HSIL NR NA 441 11.5 9.3 32.8 21.0 2.5 2.2 8.0 11.5 14.0 21.4 98.5 416 NA Source: Company, Bloomberg, Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 39 Economy & Strategy Plastic piping—Rural/irrigation slowdown, housing moderation and now declining raw material prices Plastic piping companies (Supreme and Astral) are primarily selling pipes for urban/semi-urban and rural housing with agricultural usage forming very less share of pipes sold for them. Finolex has a larger share of pipes sold for agricultural usage and rural housing. Continuous product innovation (fittings, use-specific pipes), ease of usage by intermediaries, active engagement with intermediaries and expanding capacities/reach have helped both Supreme and Astral (more so Astral) gain market share over smaller organised and unorganised players. Whilst Supreme’s pipe volumes grew at 37% CAGR over FY10-14, Astral’s volumes grew at 31% CAGR over the same period. However, for the last nine months now, the volumes have declined for the industry but Astral continues to post low/mid-teen volume growth given product portfolio/reach/capacity expansion; Supreme posted marginal decline in volumes. Industry participants highlight that alongside real-estate slowdown, PVC price decline was one of the major reasons for declining volumes. Declining PVC prices impacted channel inventory amid soft demand PVC resin prices declined by 27% from `80/kg in June 2014 to `58/kg in December 2014. As a result, the volume growth of PVC pipes was weak in 2QFY15 and 3QFY15, as the intermediaries delayed the purchase of PVC pipes in anticipation of lower PVC pipe prices. CPVC volumes increased ~17% YoY in 3QFY15, as CPVC prices were stable. Astral reported revenue growth of 14% YoY led by revenue growth of 18% YoY in the CPVC segment. Supreme Industries reported volume growth of 12% YoY in 3QFY15 after a 7% YoY decline in 2QFY15. Finolex Industries was the worst hit due to lower PVC resin prices, as PVC pipe volumes declined 8% YoY in 3QFY15. The EBITDA margins of organised companies declined by ~200-300bps in 3QFY15 due to inventory loss in PVC resin. Supreme sales YoY 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 4QFY13 3QFY13 2QFY13 Supreme Industries Astral sales YoY Astral Polytechnik Finolex Industries Finolex sales YoY Source: Ambit Capital research, Company 1QFY13 2QFY12 3QFY15 2QFY15 1QFY15 0% -20% 4QFY14 4% 0% 3QFY14 8% 20% 2QFY14 40% 1QFY14 12% 4QFY13 60% 3QFY13 16% 2QFY13 80% 1QFY13 20% 4QFY12 100% 4QFY12 Exhibit 61: Sharp fall in EBIT margin in 2QFY15 and 3QFY15 3QFY12 Exhibit 60: Astral the outperformer, Finolex the laggard Volume growth of PVC pipes was weak in 2QFY15 and 3QFY15, as the intermediaries delayed the purchase of PVC pipes in anticipation of lower PVC pipe prices Source: Ambit Capital research, Company Dealer checks—stability in prices to lead to inventory re-stocking Our dealer checks suggest that demand for PVC pipes would pick-up after the prices of PVC stabilise (which have actually increased over last two weeks). Dealers believe that an annual volume growth of 10-12% is sustainable for the next five years (marginally ahead of the last five years) because of rising acceptance of the product and gradual shift to pucca houses and better construction practices. Dealers believe it is too early to suggest that this slowdown in housing and agriculture activity is a structural slowdown. Astral has very low exposure to rural housing and agriculture (less than 10%). Sales to rural housing and agriculture account for 35% of the total volumes sold by Supreme Industries. Rural housing and agriculture account for more February 24, 2015 Ambit Capital Pvt. Ltd. Page 40 Economy & Strategy than 85% of the total volumes sold by Finolex Industries. Thus, Finolex Industries would be the most affected by a slowdown in rural housing. Supreme Industries—efficient capital allocator amid volume moderation; stock valuation rich We like Supreme Industries owing to its unmatched distribution and manufacturing reach, superior capital allocation by high-quality management and consistent product innovation. Supreme is setting up a manufacturing facility in Kharagpur, east India, to further increase reach; it launched bathroom fittings and composite cylinders to expand its product portfolio. We believe that Supreme will generate cumulative operating cash flow of `16.8bn in FY14-17E, which would be sufficient to fund its mega capex plans of `7.9bn in FY14-17, creating a snowball effect. However, we put our stance on Supreme Industries UNDER REVIEW, as the stock price continues to rally despite the recent weakness in performance (CMP of `680/share is above our 12-month TP of `653). We do not find little margin of safety in valuation of 24x FY16E EPS given its stagnating plastic piping franchise which is losing market share to Astral. Secondly, its foray into composite cylinders, though promising, is yet to yield results. Relative to peers, Supreme trades at a discount to Astral, which trades at 32x FY16E EPS; Finolex Industries is trading at 14x FY16E EPS, a justified discount to Supreme and Astral. Astral PolyTechnik (NOT RATED)—graduating to a larger home building brand from a fast-growing pipes franchise Astral has continuously gained market share over its peers through its focus on product innovation, reach expansion and more recently large brand investments (to influence the intermediaries, a practice followed by cement, paints and adhesives manufacturers/brands). As a result, the company’s revenues not only grew at 38.6% CAGR over FY10-14, but it also sustained/improved its RoCE/RoE, leading to multiple re-ratings; Astral is currently trading at 32X FY16 EPS (consensus; yet to build in impact of acquisitions) much closer to adhesives (34x FY16E EPS) and paints companies (33.4x FY16E EPS) than the other home building categories such as cement (20x FY16E EPS), tiles and sanitaryware (22x FY16E EPS). Whilst we believe that the core franchise and the acquired adhesives businesses should continue to grow faster over FY15-17, effective integration of these businesses is the key for sustenance of 30%+ growth rates beyond FY17 alongside higher RoCEs. Exhibit 62: Relative valuation summary - Pipes Mcap EV/EBITDA (x) Companies Rating CMP TP Up/ Down PIPES Astral Poly NR 448 NA NA Supreme BUY 661 NA NA Industries Source: Company, Ambit Capital research, Bloomberg February 24, 2015 P/E (x) P/B (x) RoE (x) CAGR (FY14-16) US$ mn FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16 2,867 20.2 16.1 36.3 27.0 8.8 6.5 26.8 28.6 17.0 19.1 35.5 853 28.3 20.0 51.3 33.6 9.2 7.5 22.1 23.8 33.7 30.4 40.8 1,349 15.6 12.3 30.4 21.7 7.0 5.9 24.1 29.1 13.7 11.7 15.8 Ambit Capital Pvt. Ltd. Sales EBITDA EPS Page 41 Economy & Strategy NBFCs Aadesh Mehta, CFA, [email protected], +91 22 3043 3239 Auto financers The results declared by auto NFBCs over the past 2-3 quarters demonstrate stress in the rural economy underpinned by slowing growth and increasing pressure on asset quality. We believe the unwinding of the wealth effect in rural India could lead to some demand decline in aspirational and discretionary plays in the auto sector such as passenger cars and UVs. MMFS, with ~47% exposure to these products, would be the most impacted. Slowing growth, deteriorating asset quality for NBFCs AUM growth for auto NBFCs has slowed down meaningfully to 9% in 3QFY15 vs >20% in most of FY13. However, disbursement trends have been mixed, with commercial vehicle financiers like Shriram Transport (SHTF) and Sundaram Finance demonstrating improving disbursement growth vs declining disbursement trends for M&M Finance (MMFS), Magma Fincorp (MGMA) and Cholamandalam Finance (CIFC) which have a higher proportion of cars/utility vehicles/tractors/light commercial vehicles. Exhibit 63: AUM growth remains muted for most NBFCs… Exhibit 64: …but CV NBFCs are showing improving trends 25% 40% 20% 30% 15% 20% Disbursement growth (%, YoY) 10% 10% 0% 5% -10% 0% 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 -20% SHTF AUM growth - All auto NBFCs Source: Company, Ambit Capital research MMFS MGMA CIFC FY13 FY14 9MFY15 SUF Source: Company, Ambit Capital research Similar trends are visible in asset quality as well, where both credit costs and gross NPAs have increased sharply over the last 2-3 quarters. However, similar to the growth trends, asset quality is stabilising for CV lenders (SHTF and SUF) but deteriorating for MMFS, Magma and CIFC which have a relatively higher non-CV portfolio. Exhibit 65: Increasing credit costs… Exhibit 66: … across most NBFCs 2.0% 3% 1.8% 3% Credit costs (%) 2% 1.6% 2% 1.4% 1% 1.2% 1% 1.0% 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 0% SHTF MMFS MGMA CIFC 9MFY13 9MFY14 9MFY15 Credit costs/AAUM - All auto NBFCs Source: Company, Ambit Capital research February 24, 2015 SUF Source: Company, Ambit Capital research Ambit Capital Pvt. Ltd. Page 42 Economy & Strategy Current trends are weakest in the past five years… We observe that the current trends have been weakest for auto financing NBFCs in our coverage over the past 5 years not only in loan growth but also in terms of asset quality, as demonstrated by the exhibit below. Exhibit 67: Current trends are weakest in the past five years 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 AUM growth SHTF 0% 25% 25% 23% 20% 24% 22% 20% 16% 11% 13% 16% 19% 24% 25% 22% 15% 7% 4% 3% 7% MMFS 13% 21% 29% 31% 42% 44% 47% 47% 47% 41% 39% 36% 32% 35% 34% 30% 27% 21% 15% 14% 10% MGMA NA NA NA NA NA 17% 20% 23% 24% 26% 29% 31% 31% 35% 28% 23% 20% 10% 12% 13% 13% Gross NPA (%) SHTF 2.4% 2.8% 2.5% 2.6% 2.4% 2.6% 2.7% 2.7% 2.8% 3.1% 3.0% 2.9% 2.9% 3.2% 3.1% 3.3% 3.6% 3.9% 3.7% 3.7% 3.6% MMFS 8.7% 6.4% 6.9% 5.8% 5.6% 4.0% 4.6% 4.0% 4.1% 3.0% 3.8% 3.9% 4.0% 3.0% 4.2% 4.1% 4.8% 4.4% 6.2% 6.3% 7.1% MGMA 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 1.3% 1.6% 2.2% 2.9% 3.6% 3.6% 4.1% 4.5% 4.9% Source: Company, Ambit Capital research What led to such trends? Based on our discussions with management teams and ground-level staff and also based on management commentaries, we believe that the slowdown in rural India is one of the main drivers for the weak trends for auto NBFCs. The slowdown in rural India has been driven by: (i) (ii) (iii) (iv) (v) Crop failures in some big states like Madhya Pradesh, Uttar Pradesh and Maharashtra due to adverse weather conditions. Pressure on yields in key cash crops such as cotton and sugarcane. Decelerating increase in minimum support prices (MSPs) for major crops (wheat and paddy) from 9-12% CAGR over FY07-14 to ~4% over FY14-15. Low government spending in rural India in recent years. Declining/stagnating real estate prices impacting wealth, and in turn impacting the spending tendencies of rural India. What lies ahead? Going forward, we believe that the slowdown related to crop failures/lower crop yields should abate with better rains. Hence, growth and asset quality issues in the tractor segment seem to be transient in nature and should abate in the next 2-3 quarters. However, with the wealth effect unwinding in rural India due to declining/decreasing real estate prices, we could see weakness in aspirational and discretionary purchases like passenger cars, which could persist for a longer time. Hence, NBFCs with higher exposure to cars/utility vehicles could continue to see lower growth going forward. Despite an expected pickup/decline interest rates, we are SELLers on most auto financers… Despite the declining interest rates and pickup in auto sales, we expect auto lenders to miss consensus expectations on earnings growth for FY15-17E due to: (i) higher competition pressuring yields; (ii) regulatory changes limiting decline in cost of funds and bringing down accounting profits; and (iii) asset quality issues in rural India keeping credit costs high. Barring Magma Fincorp, which is trading at 0.8x FY17 P/B, we continue to find risk-reward unfavourable in other auto financing NBFCs. February 24, 2015 Ambit Capital Pvt. Ltd. Page 43 Economy & Strategy Exhibit 68: Auto financers – Relative valuation snapshot Mcap Reco. TP US$bn P/B P/E EPS CAGR ROA ROE ` Upside/ downside FY16E FY17E FY16E FY17E FY15-17E FY16E FY17E FY16E FY17E Shriram Transport 4.6 SELL 990 -21% 2.7 2.3 19.0 15.2 22% 2.0% 2.1% 14.9% 16.3% M&M Finance 2.4 SELL 230 -12% 2.2 1.9 13.9 11.4 25% 2.5% 2.5% 16.0% 17.0% Magma Fincorp 0.3 BUY 155 56% 1.0 0.9 8.3 5.9 37% 1.2% 1.3% 14.2% 15.6% Sundaram Finance 2.7 NA NA NA 5.3 4.6 29.7 25.1 17% 3.0% 3.2% 18.7% 19.9% Cholamandalam 1.3 NA NA NA 2.4 2.1 15.8 12.2 27% 2.1% 2.3% 17.0% 18.0% 2.7 2.4 17.3 14.0 26% 2.1% 2.3% 16.2% 17.4% Average Source: Bloomberg; Note: * Estimates for SUF and CIFC are consensus estimates. MMFS would be the most impacted… We find MMFS (47% of AUM exposed towards passenger vehicles) to be the most impacted due to the continued slowdown in this segment going forward. Magma (BUY, 55% upside) also has 26% of its AUM in passenger cars but the decreasing proportion of this segment and increasing proportion of tractors, used CVs and mortgage loans (from a small base) mean that Magma is relatively better positioned to improve its profitability. Cholamandalam (Not Rated) should also be relatively immune to these trends due to the increasing diversification on its loan book. CV financiers like SHTF (SELL, 10% downside) and SUF (Not Rated) should be relatively less impacted by the rural wealth effect and these companies would continue to be a play on the overall improvement in the Indian economy. Mortgage financers The results for mortgage lenders over the past few quarters have been healthy and stable, albeit not reflecting the slowdown in property prices in rural and semi-urban India. We believe the unwinding of the wealth effect in semi-urban/rural India could see a meaningful decline in property prices, which could affect loan against property products and the self-employed set of customers. Repco, with ~20%/56% exposure to LAP/self-employed segment and with higher contribution of increasing ticket sizes in its loan growth would be most impacted amongst HFCs. Disbursements have seen a blip Loan growth for rural/semi-urban mortgage financers (Repco Finance and Gruh Finance) is holding up, although some growth moderation has been clearly visible in the last couple of quarters. However, disbursement trends are showing weakness, with slightly lower disbursement growth in 9MFY15 vs FY14. Exhibit 69: AUM growth is robust… 32% 31% 30% 29% 28% 27% 26% 25% 24% 23% Exhibit 70: …disbursements showing mixed trends 50% AUM growth (%, YoY) Disbursement growth (%, YoY) 40% 30% 20% 10% 4Q14 1Q15 GRHF Source: Company, Ambit Capital research February 24, 2015 2Q15 3Q15 0% 46% 19% 23% GRHF FY13 REPCO FY14 12% 47% 19% REPCO 9MFY15 Source: Company, Ambit Capital research Ambit Capital Pvt. Ltd. Page 44 Economy & Strategy However, asset quality trends for mortgage lenders remained stable, in continuation with the trends observed in the previous quarters. Exhibit 71: Asset quality continues to be steady 3.0% Gross NPAs (%) 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 1QFY14 2QFY14 3QFY14 4QFY14 1QFY15 GRHF 2QFY15 3QFY15 REPCO Source: Company, Ambit Capital research The trends and management commentaries highlight that property prices in semiurban and rural markets have slowed down, with certain pockets even experiencing a decline in prices. However, the management teams have highlighted that the growth trends would remain at the historical levels, due to the relatively small size of their loan book and due to scope for further customer penetration in India especially in the self-employed segment. Current trends in line with past seven years… We observe that mortgage financers have mainly sustained their trends over the past 7 years both in terms of growth and asset quality, as demonstrated by the exhibit below. Exhibit 72: Current trends are weakest in the past five years FY08 FY09 FY10 FY11 FY12 FY13 FY14 1Q15 2Q15 3Q15 GRHF 29% 18% 17% 30% 28% 34% 29% 29% 29% 28% REPCO 50% 52% 41% 47% 35% 26% 32% 31% 30% 27% HDFC 29% 17% 15% 20% 20% 21% 16% 15% 15% 14% LICHF 25% 26% 38% 34% 23% 23% 17% 17% 17% 18% 1.1% 0.9% 1.1% 0.8% 0.5% 0.3% 0.3% 0.4% 0.4% 0.6% REPCO 1.3% 1.0% 1.2% 1.2% 1.4% 1.5% 1.5% 2.5% 1.7% 2.0% HDFC 0.8% 0.8% 0.8% 0.8% 0.7% 0.7% 0.7% 0.7% 0.7% 0.7% LICHF 1.7% 1.1% 0.7% 0.5% 0.4% 0.6% 0.7% 0.8% 0.6% 0.6% AUM growth (%) Gross NPA (%) GRHF Source: Company, Ambit Capital research What lies ahead? With the unwinding of the wealth effect, real estate prices could start moderating, the evidence of which is already visible from our channel checks. Property prices have been a key driver of loan growth for these rural mortgage financers over FY129MFY15, contributing to at least half of the growth. Exhibit 73: Growth driven by customer acquisition and increase in ticket sizes FY12-9MFY15 CAGR Loan book No. of Customers Avg. Ticket size LICHF 20% 9% 10% GRUH 32% 16% 14% REPCO 28% 10% 17% Source: Company, Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 45 Economy & Strategy Hence, a decline in property prices could result in lower than historical growth levels for these lenders going forward and this could have a bearing on asset quality, which has been pristine over the last 4-5 years. Nevertheless, to some extent, these rural lenders could sustain growth through increased penetration, as most of the houses financed in rural India are for selfconstruction (~50% of the houses in rural India are still kutcha/semi-pucca) and such construction of low-ticket-size properties is not affected much by property prices but more by prices of raw materials like cement and structures. Exhibit 74: High proportion of semi-pucca and kutcha houses indicate scope for further penetration of rural mortgage financers in India Kutcha, 17.0 Semi-Pucca, 27.6 Pucca, 55.4 Source: Company, Ambit Capital research Despite an expected decline interest rates, we are SELLers on LICHF/HDFC… With declining interest rates, stable asset quality and stable growth, valuations of mortgage financiers have expanded significantly in the recent past with many of them trading at their historical peak multiples. However, the growth and earnings trajectory of these financiers could disappoint consensus expectations due to: (i) slowdown in growth due to softening real estate prices and increasing competition from banks; (ii) competition from banks putting pressuring on yields; and (iii) asset quality pressure if the real estate prices keep on coming down. We continue to maintain our SELL stance on HDFC Ltd and LIC Housing Finance. Exhibit 75: Mortgage financers – Relative valuation snapshot Mcap Reco. US$bn TP Up/ down P/B P/E EPS CAGR ROE FY16E FY17E 33.5 SELL 908 -32% 6.1 NA 34.1 NA 7% 1.9% NA 22.4% NA LIC Housing Finance 3.7 SELL 330 -28% 2.3 2.0 14.4 12.6 13% 1.4% 1.4% 17.3% 17.2% Indiabulls Housing Finance 3.6 NA NA NA 3.0 2.6 9.8 8.2 19% 4.0% 4.0% 32.9% 34.2% Gruh Finance 1.6 NA NA NA 10.9 8.9 39.8 30.2 27% 2.5% 2.5% 29.6% 32.7% Dewan Housing Finance 1.0 NA NA NA 1.4 1.2 8.2 6.6 24% 1.4% 1.4% 17.9% 19.4% Repco Home Finance 0.7 NA NA NA 4.4 3.8 26.0 21.3 24% 2.4% 2.2% 18.2% 19.2% 4.7 3.7 22.0 15.8 19% 2.3% 2.3% 23.0% 24.5% HDFC ` FY16E FY17E FY16E FY17E ROA Average FY15-17E FY16E FY17E Source: Bloomberg; Note: * Estimates for HDFC and LICHF are Ambit estimates. February 24, 2015 Ambit Capital Pvt. Ltd. Page 46 Economy & Strategy Repco would be more impacted than Gruh… That said, we believe that decline in property prices could impact both the growth and asset quality of Repco Finance and Gruh Finance. However, between these two companies, Gruh Finance seems to be better placed than Repco Finance, as: Repco has a smaller rate of customer acquisition than Gruh finance. Repco’s growth has come more from an increase in loan ticket sizes rather than increased customer acquisition. Repco’s loan book CAGR has been at 28%, with the increase in ticket sizes accounting for 17% CAGR and with the increase in customer count accounting for ~10% CAGR as compared to Gruh’s customer count growth of 16% and ticket size growth CAGR of 14%. Repco has a higher proportion of loan against property at ~20% as compared to ~4% for GRHF. Given that home loans are collateralised against the residence of the borrower, which a borrower would part with only as a last resort, asset quality in home loans are less linked to a decline in property prices. Repco’s loan book would be more exposed to property prices than GRHF. Repco also has a higher proportion of self-employed customers at ~56%, as compared to ~39% for GRHF. Given that self-employed customers have more volatile cash flows and sucking out of the black economy, Repco’s loan book would be more exposed to property prices than GRHF. Further, Repco has more exposure in semi-urban regions where the slowdown in more prominent as compared to GRUH. However, at valuations of 4.2x FY16E P/B for Repco and 10.5x FY16E P/B for Gruh, the odds are certainly against investors in the light of declining real estate prices February 24, 2015 Ambit Capital Pvt. Ltd. Page 47 Economy & Strategy Light Electricals Demand is falling off the cliff Bhargav Buddhadev, [email protected], +91 22 3043 3252 Revenue growth for the Indian light electricals (LE) industry has deteriorated significantly since November led by sluggish demand due to: (a) slowdown in industrial capex and tight liquidity; (b) weak consumer sentiment due to recessionary environment in rural areas led by weak monsoon and falling crop prices (especially cash crops); and (b) falling copper prices which is leading to inventory de-stocking at distributors’ end and delay in purchases from the end customers in anticipation of falling prices. However, there is an expectation that the demand will improve in FY16 with an expectation of stable copper prices and a better monsoon. We prefer regional players like V-Guard that are expanding into pan-India franchises with higher PAT growth (31% PAT CAGR over FY14-17E vs 11% and 7% for Havells and Bajaj Electricals’ non-E&P business). Revenue growth in 9MFY15 has slowed down to 8% vs 19% CAGR over FY10-14 Exhibit 76: Revenue growth for light electrical companies have tapered down from 19% CAGR over FY10-14 to 8% in 9MFY15 19% revenue CAGR over FY10-14 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 4QFY13 3QFY13 2QFY13 1QFY13 4QFY12 3QFY12 2QFY12 1QFY12 4QFY11 3QFY11 2QFY11 1QFY11 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% 4QFY10 Revenue growth YoY (%) 8% revenue growth in 9MFY15 Source: Company, Ace Equity, Ambit Capital research; Note: We have taken revenue growth for the sum of the revenues of Havells standalone, Bajaj Electricals non-E&P, V-Guard, Finolex Cables (electrical cables and wires), Crompton Greaves (consumer business), Orient (electric consumer business), Surya Roshni (electrical business) and Khaitan Electric as a representative for the sector The industry growth has declined from 19% over FY10-14 to 8% in 9MFY15 due to: Deterioration in demand environment since 3QFY15: The demand environment YTD has been weak due to slowdown in the industrial capex (IIP growth in 9MFY15 at 2.1% vs 3.5% over FY10-14) and liquidity challenges. This has impacted the B2B (project led) demand severely; real estate activity which has been a major revenue driver for the light electrical companies is going through tough times, with several developers announcing price corrections in several parts of India. Also, consumer sentiment has turned adverse due to the recessionary environment in rural areas led by weak monsoon, falling crop prices (especially cash crops), high inflation and higher interest rates. Fall in the copper prices: Average copper prices since September have declined by 27% in INR terms and are down YoY as on February 18. This is impacting demand especially from the distributors to stock inventory, as they fear inventory losses. Note that the fall in copper prices is immediately passed on to the end consumer by cutting the prices of finished goods. Also, demand from the end customers tends to be weak, as they delay purchases in anticipation of a further February 24, 2015 Ambit Capital Pvt. Ltd. Page 48 Economy & Strategy drop in prices. Whilst volume growth in cables and wires has been reasonable at 11%, 9% and 7% on a YoY basis for Finolex Cables, Havells and V-Guard in 3QFY15, revenue growth has been weak at 5%, 6% and 3% respectively, given the cut in finished good prices. Limited scope for further shift in the share from unorganised sector to organised sector: Bulk of the growth in the past was led by a shift in market share in favour of organised players. Our channel checks and discussions suggest limited scope for further shift in market share given the share of the organised players has already peaked to 65% in FY14 from 54% in FY10. Stagnation of the share of organised players in the paint industry at 65% in the last three years corroborates this argument. Exhibit 77: Share of organised players has increased from 30% to 65% in the last eight years Share of organised players (%) FY06 FY10 FY14 Domestic switchgears 40% 43% 70% Industrial switchgears 60% 72% 80% Switches 25% 50% 70% Cables and wires 20% 56% 62% Lighting & Luminaries 25% 40% 55% Fans 40% 55% 70% Industry 30% 54% 65% Source: Industry, Ambit Capital research Exhibit 78: Limited scope for further expansion, as share of organised players in paints has stagnated at 65% since the last three years 400 (` bn) 70% Paints 65% 60% 200 55% 50% 2010 2011 2012 2013 2014 Unorganised as % of total Organised as % of total Source: Industry, Ambit Capital research 3QFY15 results round-up The 3QFY15 results season was a disappointment for light electrical companies, given weak revenue growth and EBITDA margin decline. Companies under our coverage (Havells, V-Guard, Crompton and Finolex Cables) recorded revenue growth of 12% to -3% YoY (we have included the performance of the consumer businesses only; for instance, we have excluded Sylvania’s and Bajaj’s E&P performance whilst calculating Havells’ and Bajaj’s consumer revenue growth performance). Gross margin improvement of 30-380bps YoY has not flowed down into the EBITDA margin which remained flat YoY, due to poor operating leverage. Companies which are not under our coverage, Orient Paper and Industries, Surya Roshni and Khaitan Electric also reported weak revenue growth of -6% to 3% and EBITDA margin decline of 130-1,320bps. The weak revenue growth was on account of: (a) sluggish B2B demand (project-led) given weak private sector capex (led primarily by liquidity crunch), (b) weak recovery in the B2C demand given only a marginal improvement in the consumer sentiment and (c) weakness in the re-stocking of the inventory by the channel given the declining copper prices (down 9% YoY in 3QFY15 in INR terms) February 24, 2015 Ambit Capital Pvt. Ltd. YoY revenue growth for 3QFY15 was disappointing at 12% to 3%... …led by weak consumer sentiment, poor industrial capex and weakness in re-stocking (given declining copper prices) Page 49 Economy & Strategy Exhibit 80: ….led by weak demand and sliding copper prices Revenue growth YoY (%) Gross margin YoY change (bps) EBITDA margin YoY change (bps) 12.0% 30bps -280bps 500 5.3% 180bps 50bps 450 Crompton 11.1% NA 30bps* Bajaj -3.6% NA -210bps* Finolex 3.4% 380bps 270bps Orient -6.0% NA -130bps* Khaitan -35% -640bps -1320bps Surya Roshni -3.7% NA 80bps Source: Company, Ambit Capital research; Note: * For Crompton, Bajaj and Orient Paper we have compared the change in the EBIT margin; NA – Not available 400 350 Jan-15 Nov-14 Sep-14 Jul-14 May-14 Mar-14 Jan-14 Nov-13 Sep-13 300 Jul-13 Havells May-13 V-Guard MCX Copper Spot `/kg Jan-13 Company Mar-13 Exhibit 79: 3QFY15 results for light electrical companies were weak… Source: Bloomberg, Ambit Capital research The reduction in EBITDA margin was primarily led by unfavourable operating leverage given weak revenue growth. Gross margins, however, improved by 30-380bps for companies under our coverage led by falling copper prices. Companies have not passed on the entire drop in copper prices, as they are trying to offset the weak revenue growth through higher gross margins. Gross margin improved by 30380bps across companies led by a fall in copper prices Our discussions with dealers suggests that the demand environment in January has also been weak; until the copper prices stabilise or some sops for the housing sector are announced in the budget or until the summer sets in by mid-February, even the fourth quarter is likely to be weak on revenue growth. In our 4QFY15 forecasts, we have assumed YoY revenue growth of -2% to 5% for Havells, Finolex and Crompton. Whilst for V-Guard we have assumed revenue growth of 13% due to improvement in its non-south market share, for Bajaj we have assumed revenue growth of 14% due to lower base impact. Exhibit 81: Our 4QFY15 forecasts for light electrical companies do not assume any significant recovery Gross margin YoY change (bps) EBITDA margin YoY change (bps) 13.0% 130bps 140bps 5.1% -210bps -80bps 14.3% NA 250bps Finolex -1.6% 110bps -20bps Crompton -2.2% NA 190bps Company Revenue growth YoY (%) V-Guard Havells Bajaj Source: Company, Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 50 Economy & Strategy The story of the 3QFY15 results season Here are some of the key trends of the results reported by the three light electrical companies under our coverage: a) Sluggish revenue growth; V-Guard’s revenue growth is the strongest at 12% led by strong performance in non-south V-Guard’s 3QFY15 revenue growth of 12% was the highest amidst its peers led by 18% YoY growth in non-south. The revenue growth was led by stabilisers, fans and digital UPS which saw strong growth of 23%, 42% and 30% respectively. Crompton, Bajaj, Finolex and Havells reported YoY revenue growth of 11%, 3%, -4% and 5% respectively. The revenue performance of V-Guard though was lower than our expectation of 20% YoY growth due to: (1) lower growth of 8% YoY in cables and wires segment (though volume growth was strong at 14% YoY but realisations declined 7% YoY due to fall in copper prices) and (2) an 8% YoY decline in pumps due to restrictions put in Karnataka on digging bore wells. Exhibit 82: V-Guard amidst peers… reported the strongest growth V-Guard’s revenue growth at 12% YoY was the highest amidst its peers led by 18% YoY growth in non-south Exhibit 83: …led by strong growth of 23%, 42% and 30% YoY in stabilisers, fans and digital UPS Product 3QFY15 revenue (` mn) growth in % YoY Stabilisers 684 23% 20.0% Fans 228 42% 10.0% Digital UPS 305 30% Water Heaters 702 21% 1,210 8% Pumps 373 -9% LT Cables 124 -27% 43 -25% 284 151% 3,954 12% Revenue growth YoY (%) -30.0% -40.0% Source: Company, Ambit Capital research Surya Khaitan Orient Finolex Bajaj Crompton -20.0% Havells -10.0% V-Guard 0.0% Wires UPS Others Total Source: Company, Ambit Capital research For Havells, apart from the electrical consumer durables segment which reported 12% YoY growth, all other segments reported marginal-to-flat growth (of 0-6%). The cables and wires business which is its largest segment by revenues reported a 4% YoY revenue growth given the 9% YoY decline in copper prices during 3QFY15. Also, as copper prices fall, the prices of cables and wires also fall given the commoditised nature of the business. In switchgears, which is the most profitable segment, revenue grew by only 6% YoY given the weak institutional demand; EBIT margins contracted by 110bps YoY. Given that Finolex Cables has already launched switchgears in 4Q, we expect Havells’ margins in switchgears to remain under pressure. In domestic appliances, Havells seems to be struggling given the meagre 12% YoY growth (vs 23% in 1HFY15). Our discussions with primary data sources suggest that Havells is struggling in domestic appliances due to its aggressive pricing. In some products it competes head on with MNC players like Philips. This poor performance in the domestic appliance is worrisome given that the management is targeting higher growth in this segment over FY15-17; the domestic appliance market in India is at `50bn and it recorded 25% CAGR over FY09-14. Bajaj and TTK Prestige, leaders in this segment, recorded sales of more than `19.4bn per annum as compared to less than `2.8bn for Havells. February 24, 2015 Ambit Capital Pvt. Ltd. Havells is struggling in domestic appliances, with growth decelerating to 12% YoY in 3QFY15 vs 23% in 1HFY15 Page 51 Economy & Strategy Exhibit 84: Apart from consumer durables, all other categories reported marginal-to-flat YoY growth Exhibit 85: Decelerating growth in consumer durables (includes appliances) is a worry, as this is the biggest driver of future growth 35% YoY Growth (%) in electrical consumer durables 30% Switchgears Cables and Lightning & Wires Fixtures 1QFY15 2QFY15 Electrical consumer durables 3QFY15 Source: Company, Ambit Capital research 3QFY15 0% 1HFY15 5% FY14 10% FY13 15% 40% 35% 30% 25% 20% 15% 10% 5% FY12 20% FY11 25% Source: Company, Ambit Capital research For Bajaj, the non E&P segment disappointed, with revenue growth declining by 3.6% YoY led by a revenue decline of 6.2% YoY and 2.3% YoY in lighting and consumer durables. Whilst in lighting, Bajaj is getting impacted by its minimal presence in the LED segment, the market share loss in other categories is due to high attrition. BJE is facing attrition with the recent exits of the Head of Morphy Richards and the Head of Lighting. We fear more attrition as well from the senior management in the near future given the large opportunity available in the market, with several regional players aspiring to become pan-India players. Bajaj’s non-consumer business is losing steam given the severe underperformance in growth relative to its peers Alongside the head of businesses leaving, in several instances the senior VPs also start leaving the firm given the industry trend of the head taking key team members as well. Note that several players have been launching new categories like fans, lighting and appliances. The reason for this attrition seems to be the cultural change in the company, with Anant Bajaj becoming the new person in command (which reminds us of the earlier ED’s exit). Lighting margin 9% 5% 7% 3% 5% 1% Lighting 3QFY15 2QFY15 1QFY15 4QFY14 3% Consumer durable on RHS Source: Company, Ambit Capital research For Finolex Cables, whilst the volume growth was strong at 11% YoY in electrical wires and power cables, the ~4% drop in average realisation in November (~7% YoY) due to a drop in copper prices led to revenue growth of only 3%. All the sectors except auto saw double-digit volume growth; the auto business was weak due to weak primary sales, as channel inventory during the quarter was high; lower demand is likely in 4Q due to the rollback of the excise duty cut. Communication cables’ revenue February 24, 2015 EBIT 11% Consumer durable on RHS Source: Company, Ambit Capital research with 13% 3QFY14 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 1QFY14 4QFY13 3QFY13 -20% 2QFY13 -10% 1QFY13 0% case 7% 2QFY14 10% the 1QFY14 20% is EBIT margin (%) 9% 4QFY13 30% so 3QFY13 40% 35% 30% 25% 20% 15% 10% 5% 0% -5% 2QFY13 Revenue growth YoY (%) 50% Exhibit 87: …and 1QFY13 Exhibit 86: Bajaj’s non-E&P’s revenue have been declining since the past four quarters Ambit Capital Pvt. Ltd. Finolex Cables has reported sluggish revenue growth since the last four quarters given the slowdown in industrial capex Page 52 Economy & Strategy grew 35% YoY led by strong demand from Reliance Jio. We expect electrical cables and wires’ revenue growth to improve in FY16 led by recovery in the auto sector; our Auto analyst expects a pick-up in commercial vehicle and four-wheeler passenger vehicle sales from FY16 onwards. Also, communication cables’ revenue growth is likely to revive led by revenue booking for the NOFN order and fibre optic capex by Reliance Jio. -30% capex, as Nov-14 Sep-14 Jul-14 May-14 Mar-14 Jan-14 Jul-13 May-13 -2% Mar-13 3QFY15 2QFY15 1QFY15 4QFY14 3QFY14 2QFY14 -20% 1QFY14 -10% 4QFY13 0% 3QFY13 0% 2QFY13 2% 1QFY13 10% 4QFY12 4% 3QFY12 20% 2QFY12 6% 1QFY12 30% industrial IIP growth YoY (%) 8% Nov-13 Revenue growth YoY (%) 40% Exhibit 89: …given sluggish represented from IIP growth Sep-13 Exhibit 88: : Finolex Cables has been reporting sluggish revenue growth for the last four quarters… -4% -6% Source: Company, Ambit Capital research Source: MOSPI, Ambit Capital research b) Gross margins improve for all players; Havells reports the highest improvement Gross margins for all the companies under our coverage have improved by 30380bps led by a 9% YoY decline in copper prices in 3QFY15. Other than cables and wires, prices across other product categories have not seen much decline, as companies are trying to offset sluggish revenue growth with higher gross margins. Even the prices of electrical cables and wires have corrected with a lag (whilst the prices of electrical cables and wires declined by 4% from October to December 2014, it declined further by 5% in January 2015). Consequently, Finolex reported the highest YoY increase (380bps) in gross margin, as it has the highest percentage of copper cost to revenue at 61% in FYT14. Exhibit 90: Finolex Cables showed the highest YoY improvement in gross margins… YoY improvement in gross margin (bps) 400 350 300 250 200 150 100 50 0 V-Guard Havells Finolex Source: Company, Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 53 Economy & Strategy Dealer checks indicate weak demand but dealers expect a pick-up in FY16 Our discussions with eight channel partners across India (Delhi, NCR, Lucknow, Mumbai, Pune, Jabalpur, and Chennai) in the last week of December suggest that demand has remained weak so far in 4QFY15 led by no signs of pick-up in consumer sentiment, persistent slowdown in real estate activity and weak industrial capex. However, there is an expectation that demand should pick-up in FY16 led by an expectation of increased allocation in the Budget towards rural schemes like MNREGA and affordable housing. Several companies have started focusing on Tier 3/4 cities given the saturation in Tier 1/2 cities. Companies like Havells and Anchor have launched products like Reo switches and Rider switches, and Bajaj Electricals is guiding for a launch of a separate brand targeted towards tier-III and tier-IV cities. Exhibit 91: Demand deceleration is evident from our channel checks Product Market size (`bn) in FY14 Volume Volume growth so growth in far in 3QFY15 Unorganised 4QFY15 share (YoY) (YoY) Market share in FY14 Organised share Comment Gainers Losers V-Guard Havells Slowdown in real estate activities has led to demand deceleration Finolex KEI Funding challenges have led to a slowdown in project (B2B) demand and stalled any hopes of a recovery over the next 4-6 months Legrand Havells Similar to housing wires, domestic switchgears have seen a demand deceleration due to weak real estate activity Havells Anchor Slowdown in real estate has impacted demand for switches Electrical cables and wires Housing wires 84 -2% 5% 35% Industrial and power cables 125 -2% 5% 35% Polycab - 20% Finolex - 9% Havells - 9% V-Guard - 6% Polycab - 20% KEI – 12% Finolex - 11% Havells - 9% Switchgear and switches Domestic switchgears 24 0% 5% 30% Switches 21 0% 5% 35% Havells - 29%, Legrand - 25% Schneider - 16% Anchor - 35% Havells – 20% Fans Premium 27 5% 6.5 Small appliances 65 8% Crompton Havells 35% Havells - 10% Luminous, Polycab Bajaj 35% Racold – 25% V-Guard – 21% 20% V-Guard AO Smith – 9% Induction cooktops 6 Stabiliser 12 79 Philips + Preethi – 20% Bajaj – 15% Havells Maharaja – 9% TTK Prestige – 23% 50% Philips – 15% TTK Prestige Bajaj Electrical – 15% V-Guard – 25% 67% Capri – 9% V-Guard Premiere – 7% Luminous – 23% Microtech – 12% 15% V-Guard Sukam – 11% V-Guard – 1% 30% 8% UPS, digital UPS Crompton – 22% Orient – 13% Bajaj – 11% 10% Sub-economy 28 and economy Consumer appliances Electric water heaters 10% 10% 10% 13% 10% 10% After an impressive growth in 1HFY15 due to an extended summer, demand has moderated in 2HFY15 Strong winter (temperature dropped to the lowest in AO Smith, five years in Delhi) has led to strong demand for Racold, Bajaj water heaters; V-Guard’s Pebble series is helping the company to gain market share Bajaj Bajaj The demand recovery which was visible during the festival season in September and October has disappeared and the volume growth from November has decelerated compared with 2QFY15 Everest Sukam After registering a splendid growth of 26% in 1HFY15, stabiliser, UPS and digital UPS have seen a moderation in growth due to decline in power outages across India Lighting & Fixtures CFL, LED, lighting 23 40% 6% Luminaries 36 5% 40% Philips – 23% Bajaj – 24% Crompton – 15% Havells – 7% Philips - 35% Havells – 13% Bajaj – 11% Syska, Philips, Chinese players Syska, Havells Bajaj, Crompton The decline in LED prices by 60% over the past one year is leading to a fast shift in demand from CFL to LED Consequently, traditional CFL players are losing market share to Philips, Syska and Chinese players Weak industrial capex and consequent poor project Bajaj, Philips, demand (B2B demand constitutes 50% of the overall Crompton market) have impacted demand materially Source: Industry, Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 54 Economy & Strategy Here are the key takeaways from our channel checks: Deceleration in demand since November: Demand since November 2014 has not recovered across several categories, as per our discussions with channel partners. Whilst the recovery in B2C demand has been slower than our expectation, B2B (project) demand has slowed down further. The liquidity challenges have stalled any hope of a revival in project orders for the next 3-5 months. Consequently, demand for cyclical products, such as electrical cables and wires, switchgears and lightings, has been impacted more than the demand for consumerled products such as consumer appliances and fans. Cyclical products such as electrical cables and wires, switchgears and lightings are likely to grow at a slower pace of -2 to 5% YoY vs consumer-led products such as consumer appliances and fans, which are likely to grow by 8% YoY. Stabilisers and inverters, which registered a healthy growth of 26% in 1HFY15, are likely to see a moderation in growth (10% YoY growth in 2HFY15E), as power outages have declined across India. Falling raw material prices may lead to margin expansion: Margin expansion will likely be a silver lining for the light electrical companies. Our channel checks suggest that the prices of the final products have not declined (expect for wires), despite a 12% and 25% correction in copper and crude prices (key raw material for PVC and plastic) in INR terms over the last three months. Cables and wires have seen price cuts of 9%. Management teams suggest that companies are looking at improving margins, as topline growth has been lower than their expectation and industry margins have been depressed for the last two years. Exhibit 92: Copper and crude prices have corrected by 12% and 25% respectively over the past three months 430 5,500 410 5,000 Exhibit 93: This should aid in margin expansion, as it forms a major component of the raw material cost FY14 (in ` mn) Share of cables and wires in total revenue Finolex V-Guard 94% Havells 36% 41% 1,876 449 2,212 8.0% 3.0% 4.7% 10.6% 9.1% 8.7% 4,500 390 4,000 Total plastic / PVC consumed 3,500 - as a % of revenue 350 3,000 - as a % of total raw material consumed 330 2,500 4-Feb-15 21-Jan-15 7-Jan-15 24-Dec-14 10-Dec-14 26-Nov-14 12-Nov-14 370 MCX copper spot (Rs/kg) MCX crude spot (Rs/barrel) Source: Bloomberg, Ambit Capital research Total copper consumed 14,288 3,505 8,701 - as a % of revenue 61.1% 23.1% 18.4% - as a % of total raw material consumed 80.9% 70.9% 34.2% Source: Company, Ambit Capital research; Note: We have excluded the goods purchased from vendors, as the break-up of the raw material consumption therein is not available; we have excluded Bajaj Electricals from the above analysis as the break-up of raw material consumption segment-wise is not available and the company also operates in the E&P business Demand likely to pick up in FY16 led by expectation of increased allocation towards rural spending and stabilisation of copper prices: Inventory levels (especially for cables and wires) in the channel are currently very low given the falling copper prices (prices of cables and wires are cut whenever there is a fall in the copper prices and vice versa given the commoditised nature of the business). However, since the first week of February, copper prices have started stabilising; if this trend continues or if the prices started trending upwards then companies could see strong revenue growth led by re-stocking from the channel partners. Furthermore, there is an expectation amidst corporates and channel partners that the upcoming Budget may dole out more allocation towards rural spending (schemes like MNREGA, Indira Awaas Yojna, etc) and affordable housing, which can lead to a recovery in rural demand. Further, if in FY16, the monsoon is relatively better as compared to FY15 and prices of cash crops start recovering, this should help in supporting rural demand. February 24, 2015 Ambit Capital Pvt. Ltd. Page 55 Economy & Strategy V-Guard continues to gain market share: The non-south dealers highlighted that V-Guard continues to gain market share in the non-south market. Whilst it is gaining market share from Havells and Polycab in wires, it is gaining market share from AO Smith, Racold and Havells in water heaters. V-Guard’s brand perception is improving in the non-south market. Bajaj continues to lose market share across categories due to the rollout of its new marketing strategy (‘Theory of Constraints’). In lighting, Syska is gaining market share from Havells, owing to its strong brand promotion and strong range of LED products. Across categories, the market share for Havells has plateaued, given the rising competitive intensity in the industry, and the lower than industry incentives by Havells to dealers. Whilst the strength of the channel was the biggest competitive advantage for Havells in gaining market share across categories over the past decade, this advantage seems to be fading, with the company focusing more on controlling the channel to maximise profits. V-Guard continues to gain market share in non-south market Bajaj is losing market share due to the channel friction caused by the implementation of its strategy ‘theory of constraints’ Exhibit 94: V-Guard gaining market share in non-south market Product Gaining market share from Housing wires Havells, Polycab Stabiliser Everest, unorganised players UPS, digital UPS Luminous, Sukam Water heater AO Smith, Racold, Havells Source: Industry, Ambit Capital research Industry growth would likely decline in the coming decade; we prefer regional players Although we expect a pick-up in rural demand in FY16 (we have modelled 14% revenue growth for our coverage universe in FY16 vs 5% in FY15), we believe the industry growth will slow down to the low teens in the coming decade (FY15-24) vs high teens during FY04-14. Our discussions with channel partners suggest that the bulk of the growth in the last decade was led by a shift in market share for organised players from ~30% in FY06 to ~65% in FY14. Furthermore, with likely demand saturation in tier-I and tier-II cities (as per our discussions with channel partners) and with companies now shifting focus to tier-III and tier-IV cities, the market size is likely to see decelerate, as the per square feet spend in tier-III and tier-IV cities is 30% lower than tier-I and tier-II cities. Moreover, with the rising trend of premiumisation kicking in, the life of a product has increased, which in turn is likely to lead to deceleration in the replacement market. Exhibit 95: Share of organised players has increased from 30% in FY06 to 65% in FY14 Share of organised players (%) FY06 FY10 FY14 Domestic switchgears 40% 43% 70% Industrial switchgears 60% 72% 80% Switches 25% 50% 70% Cables and wires 20% 56% 62% Lighting & Luminaries 25% 40% 55% Fans 40% 55% 70% Industry 30% 54% 65% Source: Industry, Ambit Capital research February 24, 2015 Ambit Capital Pvt. Ltd. Page 56 Economy & Strategy Negative outlook on pan-India players but positive on regional players Given our expectation of deceleration in revenue growth for the industry over the next decade, we believe the revenue growth for pan-Indian players like Havells and Bajaj Electricals will decelerate in the coming decade as compared to the last decade. Alongside this, competition has intensified significantly in the last five years, with single product companies launching new product categories (companies like V-Guard, Polycab and Luminous which were hitherto selling stabilisers, electrical wires and inverters have launched new categories like fans, switchgears, switches and lighting) and regional players like V-Guard, Polycab and Finolex Cables becoming pan-India players. Exhibit 96: Several new companies have entered into new product categories… Company Flagship product New products launched V-Guard Stabilisers Fans, switchgears, induction cooktops Havells Switchgear Consumer appliances Polycab Electrical wires Fans, lighting, switchgears, switches Anchor Switches Electrical cables, lighting, switchgears Luminous Invertors Fans, switches, CFL, switchgears Source: Company, Industry, Ambit Capital research Exhibit 97: …and several regional players have expanded on a pan-India basis Company Strong in Expanding in Comment V-Guard South North, West, East Finolex Cables South, West North and East Polycab West North, South, East Revenue share from non-south increased from 5% in FY08 to 30% in FY14 Revenue share from North and East increased from 10% in FY08 to 20% in FY14 Data not available RR Kabel West North, South, East Data not available Source: Company, Industry, Ambit Capital research We reiterate BUY on V-Guard and Finolex Cables and SELL on Havells and Bajaj. Exhibit 98: Relative valuation – light electricals Mcap CMP US$mn INR Havells (consolidated) 2,659 270 Havells *(standalone) 2,604 263 TTK Prestige 592 3,295 V-Guard 463 982 Company TP Upside/ (Downside) INR (%) FY15 FY16 FY17 FY14 FY15 FY16 FY17 SELL 248 -8% 40.3 30.1 22.8 28.7 23.1 26.0 NA NA NA 35.9 32.3 25.2 23.9 19.8 19.1 BUY 3907 BUY 1267 STANCE P/E (x) RoE (%) CAGR (FY14-17) Revenue EPS 28.1 8.7 18.6 21.3 13.4 10.5 19% 33.93 23.88 18.68 19.1 26.7 32.0 36.2 16.2 25.5 29% 31.2 19.6 32.9 36.1 24.4 17.8 24.3 23.3 28.2 Finolex Cables (standalone) 613 254 BUY 318 25% 19.3 16.0 13.3 20.5 17.2 18.3 19.6 11.2 14.0 Finolex Cables (core 613 254 NA NA NA 17.5 13.9 11.1 25.1 20.2 21.4 22.6 11.2 14.7 business)# Bajaj (non-E&P) 364 226 SELL 204 -10% 32.0 41.3 28.8 19.4 10.5 16.8 24.6 11.2 7.3 Average (excl. Havells consolidated and Finolex 29.1 25.3 19.1 21.3 19.1 22.1 25.4 13.8 17.5 Core) Source: Bloomberg, Ambit Capital research; Note: * We have calculated standalone P/E by reducing Ambit’s fair value of Sylvania of Rs9/share), # we have taken core EPS and P/E for Finolex Cables by reducing the fair value of investments of Rs75/share from CMP and reducing the investment income from EPS; ^ we have reduced the Ambit fair value of Rs13/share for the E&P business from CMP for calculating Bajaj’s non-E&P valuation; Prices as on 18 February 2015 February 24, 2015 Ambit Capital Pvt. Ltd. Page 57 Economy & Strategy Stock implications Top BUYs V-Guard (BUY, Mcap US$463mn, TP `1,267/share, 29% upside) Fast emerging as a pan-India player: V-Guard is strengthening its non-south franchise by beefing up its distribution network and recruiting marketing employees from leading competitors. Consequently, the company is gaining market share in all the five product categories in non-south. Expansion of scale in non-south is margin-accelerative: Non-south’s EBITDA margins have starting improving with expanding scale (improved from -1.3% in FY12 to 1.5% in FY15). There is tremendous scope for further improvement, as non-south EBITDA margin is 980bps lower than south margin. Product diversification: V-Guard is successfully reducing its dependence on stabilisers by launching new products. The revenue share of stabilisers has declined from 37% in FY08 to 18% in FY14 led by strong growth in newer products such as inverters, fans, induction cooktop and switchgears At CMP, V-Guard is trading at a one-year forward P/E multiple of 25.7x, a 91% premium over its five-year average forward P/E multiple of 13.3x. The premium is justified and is likely to widen further, as the company achieves scale in the nonsouth market, leading to improvement in margin by 180bps and in RoE by 680bps over FY14-17E. Moreover, V-Guard is trading at 17.8x FY17 P/E, a 30% discount to Havells standalone despite higher FY14-17E EPS CAGR of 33% vs Havells’ 10.5% and 7000bps higher FY17E RoE of 31.2% vs Havells’ 22.8%. We believe a ‘growth company’ like V-Guard deserves to trade closer to the price multiple of a ‘market leader’ like Havells. We value V-Guard at `1,267, implying FY17 P/E of 22.9x (a 7% discount to Havells). Finolex Cables (BUY, Mcap US$613mn, TP `318/share, 25% upside) Beneficiary of a recovery in industrial capex; operating at 60% utilisation: Empirical evidence suggests a strong correlation between IIP growth (represents B2B businesses) and Finolex’s revenue growth. Finolex is already sitting on a meagre 60% utilisation given its recent brownfield expansion at Roorkee (north India). Consequently, if revenue growth picks up, Finolex will see favourable operating leverage. Also, its J-Power system joint venture has recently received certification for 132KV which means it will be a beneficiary as and when the capex on strengthening the T&D infrastructure picks up. Thus, a recovery in the capex cycle remains the biggest catalyst for the stock. EBITDA margin to expand given positive impact of operating leverage: Finolex’s EBITDA margins in the past have expanded in line with a high revenue growth led by the favourable impact of operating leverage. Given our expectation of revenue growth of 15% in FY16 and 17% in FY17, we expect EBITDA margins to improve from 10.5% in FY14 to 11.2% in FY16 and 11.7% in FY17. Entry into high-margin product (switchgear): Finolex is geared to launch switchgears in FY16. As three players (Legrand, Havells and Schneider) account for ~70% of the LV switchgear market (~`50bn), there is ample of opportunity for Finolex to grab market share. Industry participants suggest that Finolex is well placed to succeed, as: (1) technology is no longer an entry barrier to manufacture switchgears, (2) its brand is already perceived as ‘safe’ (its wires are known for higher conductivity), and (3) it already has a distribution network that can be leveraged to sell switchgears in the replacement market (~50% of the market). On core EPS, the stock is trading at 13.9x, a 48% discount to its peers despite its FY16E core RoE of 21% vs peers’ 22% and FY14-17E core EPS CAGR of 15% (vs peers’ 18%). We have calculated core P/E by excluding the investment income from EPS and excluding the fair value of investments of `71/share from CMP. However, as the company increasingly invests in new product categories (like switchgears which are high-margin and niche categories) and also increases its advertisement spend to further improve its premium pricing in cables and wires, we expect its RoIC to improve to 24.6% in FY16 from 20.4% in FY14. As this happens, we expect the valuation multiples to re-rate closer to its peers. February 24, 2015 Ambit Capital Pvt. Ltd. Page 58 Economy & Strategy Top SELLs Havells (SELL, Mcap US$2.7bn, TP `248/share, 8% downside) Havells to lose market share: Havells will lose market share from hereon due to a rise in competitive intensity and attrition at the senior marketing level. Havells has not launched any blockbuster new products in the last three years apart from domestic appliances wherein its range is restricted to the premium category (20% of market). Losing market share is not uncommon in LE, given low barriers to entry and reducing scope for product innovation/portfolio expansion. Havells has already seen stagnation in market share in switchgears and fans. Life after QRG’s demise may not be the same: Our discussions with exemployees and channel partners suggest that Mr Anil Gupta (CMD) is not as aggressive and as quick a decision-maker as Mr Qimat Rai Gupta (QRG). However, he is more professional and process-oriented. His connection with dealers is good, but he does not enjoy the same ‘emotional’ bond as dealers enjoyed with QRG. The next 9-12 months will be a testing time for Anil, as he engages with channel partners (Havells’ key strength) in the absence of QRG. Ability to launch new product categories is limited: Whilst Havells is the most-diversified light electrical company, it also has limited avenues to expand its product portfolio given there are very few product categories wherein Havells is not amongst the top-four players. Our discussion with the channel suggests that security systems and pipes are the only two product categories which Havells can enter by leveraging its existing distribution network. However, competition in this segment is very high given that both these product categories are B2B and hence scope for earning similar margins as the light electrical business is limited. Havells’ standalone franchise (after adjusting for Sylvania’s fair value of 9/share; implied FY17E EPS of 5.8x) is currently trading at its all-time high multiple of 25.2x on FY17E EPS. Whilst Havells is a market leader in the light electrical sector, it is also the most expensive stock in the sector despite its lowest EPS CAGR of 10.5% over FY14-17E (vs 16.1% for Finolex Cables, the second-lowest, and 22.0% for the sector). Moreover, Havells standalone is likely to see a deterioration of RoE of 270bps over FY14-17E vs an 880bps improvement for peers over FY1417E. Bajaj Electricals (SELL, Mcap US$364mn, TP `204/share, 10% downside) Theory of constraints weakening the franchise: The implementation of the new marketing strategy (Theory of Constraints - ToC) is leading to channel friction and causing market share loss. Under this strategy, a first time for the industry, BJE will not dump its products to distributors at the end of the month in order to protect its gross margin. In an industry where pricing and dealer push is the main driver, unless BJE improves customer-connect, growth rates (11%) will be lower than industry (~15%) over FY14-17E. Currently only 20% of the region has been covered under the ToC and a pan-India rollout of the ToC by end-FY16 (management guidance) looks unlikely and hence we model lower than industry growth for Bajaj over FY14-17E. Continuing attrition and stagnating franchise: Post the exit of Mr Ramakrishnan in 2012, BJE’s consumer business has stagnated alongside weak financials due to multiple senior management exits; channel partners/peers suggest continuing attrition risk. BJE has not only lost market share in products such as appliances, lighting, and fans but also has been unable to launch any new categories, the growth driver for most of its peers. The consumer business grew 13% over FY12-14 vs 24%/18% for V-Guard/ Havells. February 24, 2015 Ambit Capital Pvt. Ltd. Page 59 Economy & Strategy E&P is not showing any signs of improvement: The performance of the E&P business continued to disappoint. Despite the management guiding for a turnaround of the E&P business every quarter since the last four quarters, the company continues to report losses. Even, as on date, the receivables pertaining to the old legacy projects remain elevated at `2bn; hence, there is still a likelihood of some pending losses on BJE although we are not assuming any losses in 4Q. Bajaj’s consumer business is trading at 29.0x FY17 EPS, a unjustified 50% premium to peers (assuming the E&P business is valued at `11/share; implied 3.3x FY16 P/E, ~60% discount to peers), despite the consumer business to report lower EPS CAGR of 7.3% over FY14-17 vs 19.5% for peers (Havells standalone, V-Guard, Finolex Cables and TTK Prestige). We believe the roll out of TOC is a risk to BJE’s consumer franchise, as it is currently creating disruption in the channel which in turn is hurting BJE’s growth. Our SOTP-based target price of `204/share values the consumer business at `191/share (implied FY16 P/E of 26.3x; 16% discount to Havells) and the E&P business at `13/share (implied FY16 P/E of 3.3x; ~60% discount to peers). February 24, 2015 Ambit Capital Pvt. Ltd. Page 60 Economy & Strategy Agri Inputs Ritesh Gupta, CFA, [email protected], +91 22 3043 3242 Moderating growth in MSP prices and lower farm realisations would impact farmer sentiment in FY16. However, the growth rates could still be supported by good monsoons and healthy absolute MSP levels. Whilst sustained weaker growth in MSPs for the next 2-3 years would clearly hit growth, if such a reduction in subsidies is used to invest in irrigation/storage infrastructure then this would be a positive step from a medium- to long-term perspective. Reduction in leakages and a move to DBT for a significant proportion of subsidies would also give more cash in the hands of farmers. On the agrochem side, growth rates for agrochem players would be supported by rising adoption of high-value molecules (due to increasing awareness amongst farmers), rising adoption of herbicides (rising cost of labour due to urban migration) and fungicides (due to demand for high-quality agri produce). Companies with higher share of generic products may be impacted more if weak realisations persist for long. PI Industries is our TOP BUY. Divergent growth rates in FY15 so far… In agrochemicals, the growth rates in FY15 have been divergent so far, with certain players growing at mid-to-high single digits whilst certain players such as PI, UPL and Bayer growing handsomely at 16-18% YoY. Players with a higher share of generic molecules and lack of new differentiated product launches clearly struggled in the absence of a differentiated proposition to the farmer at a time when acreages were declining and output prices were also subdued. Exhibit 99: 9MFY15 domestic business sales growth 20% 16% 17% 18% Bayer UPL 15% 10% 5% 8% 8% Excel Cropcare Dhanuka 10% 2% 0% Rallis Insecticide India PI Source: Company. Note: Estimated growth for Rallis India, as it does not report the segment separately. FY15 has been a challenging year “FY15 has been a challenging year following the very turbulent southwest monsoon. Kharif season was quite volatile in a sense and the result of that, the numbers are there now. The food grains output has fallen by 7% and across crops there has been a sharp fall. So the erratic rainfall, rice spells and reduced crop acreages all have led to lower kharif yields and lower production. This was coupled with the lower crop prices. Crop prices for most of the crops softened. So that together they have led to lower incomes for the farmer arising out of kharif as we entered into rabi. In addition to this lower farm income, there is also a tight cash flow constraint in the market also led by the shortage of urea which is also drawing out a lot of cash from the market. So this is the fall-out of the kharif and the situation in the marketplace. So as we go down into the rabi, the crop acreage to-date is actually down 5%. And the monsoon has been deficient or the departure from normal is around 33%. So water deficit and commodity prices have impacted the post rain sowing across the country. Barring wheat in a few geographies, area under maze, oilseeds and pulses particularly got affected. Area under these crops has dropped by over 15%.” - V Shankar, MD Rallis (3QFY15 call) February 24, 2015 Ambit Capital Pvt. Ltd. Page 61 Economy & Strategy Exhibit 100: Kharif sowing patterns (in ‘000 acres) Area sown reported Crop name Normal Normal area for area as whole Kharif on due date season Rice This % of normal year for whole 2014 season Absolute Change over (+/-) Last year 2013 Normal as on due Last year date 391 362 380 97 376 18.5 3.6 72 75 78 109 82 3.4 -3.8 Total Coarse Cereals 208 198 182 88 196 -15.7 -13.7 Total Cereals 599 560 562 94 572 2.8 -10.1 Total Pulses 108 107 102 95 109 -5 -6.7 Soybean 100 104 110 111 122 5.9 -12 Total oil seeds 183 180 178 98 195 -1.7 -16.4 Cotton 110 111 127 116 114 15.5 12.2 47 48 49 104 50 0.4 -1.6 9 9 8 92 8 -0.4 -0.2 1,055 1,015 1,027 97 1,049 11.6 -22.9 Maize Sugarcane Jute All crops Source: GoI Exhibit 101: Rabi season (in ‘000 acres) Area sown reported (in lakh hectares) Crop name Normal Average area for area as on whole Rabi due date season Wheat Absolute Change over (+/-) This year 2014 % of normal for whole season Last Average as year on due 2013 date 105 315 9.6 -9.3 Last year 290 296 306 Rice 43 15 15 36 18 0.4 -2.3 Maize Total Coarse Cereals Total Cereals 13 13 15 113 15 1.9 -0.6 62 60 57 92 60 -3.7 -3.3 396 372 378 96 393 6.3 -14.8 Total Pulses 132 141 139 105 154 -2.7 -15.8 87 88 79 92 89 -8.2 -9.2 614 601 596 97 636 -4.6 -39.8 Total oil seeds all crops Source: GoI Dhanuka’s growth was aided by new launches but we believe lower soya acreages and higher competition for Targa Super impacted growth rates. Rallis had its own challenges related to strict working capital norms and lack of new differentiated products. …however, adoption by farmers of good cost proposition products and response to good farmer connect programmes remains strong Bayer Cropscience India continues to deliver strong growth rates despite a bad crop season driven by a mix of steady innovation rates of 25% (sales contribution from products launched over the last four years) and price hikes taken over the year. We believe the ability to take price hikes in a seemingly bad season without a significant impact on volumes clearly shows the strength of the brand enjoyed by the company. Our channel checks suggest that Bayer’s efforts on distribution expansion and strong farmer connect initiatives have been aiding its growth rates. PI Industries continued to witness good success driven by the success of Nominee Gold and Osheen. Our channel checks suggest Osheen too had a spectacular season. Steady rice acreages and MSP prices also aided the growth momentum. Nominee Gold continues to grow well driven by rising penetration of the product. Melsa (launched in FY14) also has been gaining traction. In-licensed products account for nearly 70% of the company’s revenues. PI’s 9MFY15 growth of 16% was in line with the domestic growth of 18% in the last four years. February 24, 2015 Ambit Capital Pvt. Ltd. Page 62 Economy & Strategy UPL delivered strong growth rates driven by good growth in the herbicide portfolio (led by wheat) and good performance of core brands such as Ulala, Lancer Gold, Starthene Power, Saaf, and Saathi. New products, Iris and Eros, both herbicides performed well ahead of the management’s expectations. Clearly, a higher share of differentiated products, good alignment to herbicides/fungicide products and strong farmer connect are few key drivers that we believe are incrementally becoming important. Farmers are ready to pay 4x the price (as demonstrated in case of certain products such as Rynaxypyr) till the time they are more than compensated by savings in labour (due to lower number of sprays) and better yields. Pesticides account for 15-20% of farmers’ crop expenditure but farmers can clearly improve yields by 30-40%. Exhibit 102: Quotes from recent calls/press releases on the domestic performance in 3QFY15 Speaker Comment “The performance shown by us in the domestic agri-inputs comes on the back of our strong brand introductions over the last few years and the ongoing farmer connect initiatives that we run. I am pleased that we have been able to deliver Mayank Singhal, CEO, PI despite unfavourable agro-climatic scenario. We have a very capable product portfolio, that is showing progressively Industries better volumes YoY and it is our belief that the new broad spectrum insecticide launched by us will trace a similar growth trajectory going forward.” “In the crop protection category, let me also add that category like herbicides, which used to be very small, not very long ago is increasing at a very, very fast pace, purely because it brings in a labour-saving device. It helps in cutting down costs and agony for the farmers in finding adequate labour to do the farming. There is also a lot of requirement of V Shankar, CEO, Rallis India fungicides particularly on fruits and vegetables. And fruits and vegetables has been a growing category in India and value-added fruits and vegetables are increasing in a very handsome way. So these are all good, good opportunities unfolding. There is room for good technology; there is room for value-added solutions. So I do see that all these categories have very, very robust future.” “We have launched in India two products and both are herbicides. One is Iris, which is for soybean and the pulse crops. The other herbicide we have launched is rice herbicide. It is called Eros, which is used in the transplanted rice. Both the UPL Management herbicides, they have performed well, especially the update of the herbicides is going quite well in our country because of the increasing labour shortages and obviously the cost of labour also has significantly gone up.” Source: Bloomberg transcripts, company press releases Exhibit 103: Agrochemicals and seeds growth rates 25% 18% 16% 12% FY15Q3 FY15Q2 FY15Q1 FY14Q4 2% FY14Q3 FY14Q1 FY13Q4 FY13Q3 FY13Q2 FY13Q1 FY12Q4 FY12Q3 FY12Q2 FY12Q1 FY11Q4 FY11Q3 FY11Q2 FY11Q1 FY10Q4 FY10Q3 FY10Q2 FY10Q1 FY09Q4 FY09Q3 FY09Q2 50% 41% 45% 40% 32% 35% 27% 30% 26% 22% 25% 21% 20% 19% 18% 19% 18% 18% 20% 15% 16% 14% 13% 12% 15% 11% 10% 5% 5% 5% 0% Subdued growth in 2Q/3Q due to channel inventory correction post a weak Kharif season. Weak monsoons and bigger crops such as cotton had lower pest incidence. Base was also 34% high after two good seasons of FY13 and FY14. FY14Q2 FY12 growth rates were subdued despite normal monsoons due to lower pest incidence in rice and sugarcane. Growth rates were healthy driven by new product introductions, rising MSPs and high pest incidence. Source: Company data February 24, 2015 Ambit Capital Pvt. Ltd. Page 63 Economy & Strategy Exhibit 104: India domestic agrochemicals growth rates have been quite healthy over the last six years (` mn) Revenues FY08 FY09 FY10 FY11 FY12 FY13 FY14 6 Year CAGR BASF India Ltd - Agri 3,702 3,277 4,863 6,309 7,914 9,229 10,448 19% Bayer CropScience - Agrochem 6,421 9,825 11,599 13,255 14,207 16,283 20,450 21% Bayer CropScience - Actives 1,251 1,657 1,029 3,992 4,634 5,543 6,292 31% Dhanuka Agritech Ltd. 2,486 3,368 4,081 4,910 5,292 5,823 7,384 20% Excel Crop Care Ltd. 5,342 7,009 6,486 7,394 6,950 7,791 9,841 11% Gharda Chemicals Ltd. 8,433 8,433 8,948 9,864 10,583 11,591 11,591 5% Insecticides (India) Ltd. 1,976 2,637 3,774 4,501 5,218 6,167 8,641 28% Meghmani Organics Ltd. 6,001 7,914 8,163 10,451 10,622 10,585 11,783 12% Nagarjuna Agrichem Ltd. 4,148 6,054 6,529 5,701 6,431 6,006 6,358 7% PI Industries Ltd. – Domestic Business 3,703 4,057 4,140 5,800 6,133 6,869 8,860 16% Rallis India Ltd. – Domestic Pesticide Business 5,002 6,052 7,323 8,421 8,181 8,835 10,161 13% Sabero Organics Gujarat Ltd. Syngenta India Ltd. UPL Ltd. - India Agrochemicals Growth % (y/y) 2,073 3,773 4,303 4,108 3,584 5,148 7,240 23% 11,927 13,802 17,553 20,771 25,399 29,617 30,686 17% 8,011 10,326 11,970 14,940 17,190 18,050 22,710 19% 70,475 88,184 100,761 120,417 132,338 147,538 172,445 16% 25% 14% 20% 10% 11% 17% Source: Company, Ambit Capital research High MSPs are not the only factors driving agrochemical growth rates Most of the leading agrochemical players have recorded strong growth rates over the last few years led by but not limited to: (1) growth in MSP prices, (2) rising adoption of patented molecules, and (3) growth in herbicides due to rising labour rates. Exhibit 105: Agrochemical companies have been driving the high cost:benefit value proposition of pesticides to farmers India Crop Yield Avoidable Loss Cost: Benefit Cotton (non BT) 40-90 1:7 Paddy 21-51 1:7 Mustard 35-75 1:12 Sunflower 36-51 1:8 Groundnut 29-42 1:26 Maize 20-25 1:3 Pulses 40-88 1:4 Sugarcane 8-23 1:13 Vegetables 30-60 1:7 Fruits 20-35 1:4 Source: IARI We believe only 30% of arable area is under pesticide treatment. States like Punjab, Haryana, and Andhra Pradesh lead pesticide consumption whilst UP, MP, and Orissa lag on the consumption curve. Farmer awareness is on the rise, as the younger generation is more educated. Also, private efforts on educating farmers have been rising. This is driving increased use of pesticides. February 24, 2015 Ambit Capital Pvt. Ltd. Page 64 Economy & Strategy Rapid growth in patented molecules India’s crop protection industry is mostly generic, with around 80% of the molecules (vs 50% globally) being generic and with the distribution network and brand image acting as the product differentiator. However, the patented or proprietary offpatent segment is growing at a rapid pace. After India became TRIPS-compliant and started giving product patent protection, MNCs have turned more comfortable in launching their patented products into India. Indian companies too have been able to in-license many patented products from global innovators in this better IP environment. Case study: Coragen (a Dupont product) This new product from Dupont is able to drive much more value growth for the company on a per acre basis, materially increasing the overall market size. The product requires much lower dosage, resulting in better gross margins for the company. The company is also able to charge a premium (measured in pricing realisation/acre of area under usage) on these products, further aiding gross margins. It’s a win-win for farmers as well, as their consumption goes down significantly, and yield improvement takes care of additional costs. The product, as per farmer checks, seems to be aiding yields by 5-7 tonnes/acre. Exhibit 106: Product comparison – Coragen Coragen (new technology) Dosage Cost Number of Sprays Yield Caldan, Thimet (Old technology) 60 ml (paddy, soybean, tomato, arhar, chilli) 150ml (sugarcane) 1600/acre/spray 250ml – 1000ml 350/acre/spray 1 3 35-37 tonne/acre 28-30 tonne/acre Source: Dupont Management Interview, Hindu Business Line Change into pest-specific chemistry a key driver Farmers are incrementally moving toward target pest-specific chemistries rather than general ones. This is driving a tremendous change in value realisations as well as product effectiveness. To break up the growth in the agrochemicals space, nearly 60% would be due to improved chemistries and 40% would be from an increase in treated area. However, the long gestation period of registration of ~5-10 years is a big challenge in terms of bringing new products to the market. With strong 16-18% growth over the last couple of years, many companies have aggressively been launching new products. MNCs have launched a couple of blockbuster products from their parent’s portfolio whilst Indian companies too have been aggressive on licensing from other MNCs that do not have a strong Indian distribution. The exhibit below highlights the key factors for such a shift towards higher value chemistries. Exhibit 107: Whilst affordability could be challenged by lower growth in MSPs, rising farmer awareness and improved distribution reach will continue to aid agrochemicals growth rates Reason Explanation Rural affordability for higher-priced agri inputs is on the rise driven by better realisation over the last few years. Farmers incrementally focus on better yields and invest more if they see some signs of benefit. Availability of credit too has improved. Improved efforts by agrochemical companies to educate farmers about advanced chemistries have led to increased adoption of high-value agrochemicals. A significant proportion of this pesticide consumption is non-specific in nature, Improved farmer awareness commanding lower value. Crop- and pest-specific solutions are still limited despite significant growth over the last decade. On the supply side, both Indian and foreign players have been launching new products and focusing on engaging with Availability farmers. Companies have improved their distribution reach, which has led to far deeper availability of branded products. Source: Ambit Capital research Better affordability February 24, 2015 Ambit Capital Pvt. Ltd. Page 65 Economy & Strategy Rising labour shortage to promote adoption of weedicides Various factors such as urban migration, NREGA spends and other opportunities in the rural ecosystem have led to a decline in the availability of agriculture labour. As a result, wages have shot up significantly in rural areas. That has also driven incrementally better economics for use of weedicides. Newer generations are also less keen on manual labour and look for weedicide solutions. Herbicides brands such as Targa Super, Nomine Gold, and Roundup have gained significant scale over the last few years Launch of new products and awareness creation by individual companies amongst farmers have also helped overall growth rates. Over the past few years, Nominee Gold (Rice herbicide, PI Industries), Targa Super (Soybean crop herbicide, Dhanuka Agritech) have gained tremendous success, achieving a revenue size of `2bn-3bn in a small period of 4-5 years since launch. Monsanto’s Roundup also doubled its size from `0.9bn in FY11 to `2.1bn in FY14. PI Industries’ Nominee Gold continued to register strong growth rates in FY15 as well driven by rising adoption and better rice acreages (up 4% YoY). Targa Super witnessed some impact in FY15 due to lower soybean acreages (down 12% YoY). “In the crop protection category, let me also add that category like herbicides, which used to be very small, not very long ago is increasing at a very, very fast pace, purely because it brings in a labour saving device. It helps in cutting down costs and agony for the farmers in finding adequate labour to do the farming. There is also a lot of requirement of fungicides particularly in fruits and vegetables. And fruits and vegetables has been a growing category in India and valueadded fruits and vegetables are increasing in a very handsome way.” Slowdown in wage inflation to impact herbicide growth momentum? Whilst we agree that wage inflation slowed down in FY15 but this is unlikely to affect the strong trends in weedicide growth, as the cost proposition for weedicide is better. However, we agree that a sustained low single-digit growth in rural wages for multiple years may slow down the expansion in herbicide penetration. Monsoons are important for weedicide consumption given that a dry season leads to lower requirements for weedicide sprays. Exhibit 108: India pesticides segment breakup - Mr. V Shankar, MD, Rallis India during the 3QFY15 post-results conference call Exhibit 109: Worldwide pesticides segment breakup Biopesticides and Others, 4 Fungicides, 16 Others, 7 Insecticides, 22 Herbicides, 44 Herbicides, 15 Insecticides, 65 Fungicides, 27 Source: FICCI Source: FICCI Exhibit 110: Rural wage inflation has slowed down but continues to make a case on a cost basis for rising adoption of chemical weedicides (YoY growth in %) Exhibit 111: Rising urbanisation challenges on availability of 25% 21% 17% 20% 10% 6% 7% 15% 10% 4% 5% 75 72 February 24, 2015 CY14* CY13 CY12 CY11 CY10 CY09 CY08 CY07 CY06 0% Source: RBI posing (in %) 18% 15% 15% trends are rural labour 1991 2001 68 67 2011 2014E Source: ICAR Ambit Capital Pvt. Ltd. Page 66 Economy & Strategy Exhibit 112: Monsanto Weedicide Glyphosate (generic) grew by 2.4x over FY11-14 (indexed revenues) 235 250 200 156 150 100 113 100 50 FY11 FY12 FY13 FY14 Source: Monsanto annual report Monsoons are a dampener but FY16 to be a fresh slate Over the last few years, agrochem growth rates have been in healthy double digits due to: (1) rising aggression on farmer engagement programmes and distribution expansion by MNCs and top Indian players, (2) strong growth in herbicides (led by increasing adoption of chemicals over physical labour) and fungicides (rising demand for better-quality fruits and vegetables), and (3) introduction of new-age molecules (such as Rynapyxyr) which drove up value realisations per acre significantly. Demand for high-quality fruits and vegetables is clearly rising driven by growth in organised retail and growing affluence of consumers in India. Fruits and vegetables contributed 13-14% to the agrochemical pie 4-5 years back and now they contribute close to 20% of overall pesticide consumption. Pricing remains sticky, and even if inflation comes off significantly, farmers will continue using agrochem products due to the benefits of the product. Exhibit 15 below clearly shows that growth rates have held up strongly even in bad monsoon years such as FY10 and FY13. Growth may sustain in healthy double digits in FY16 Many industry participants expect market growth to remain in double digits despite moderation in MSP growth. In addition, organised players are gaining market share from lower-end players which thrived due to lesser availability and reach of branded products. These players believe unless MSPs start declining meaningfully or growth remains muted for the next 2-3 years, current industry growth rates will not face a material downside, as farmers are still getting much more benefit for every rupee invested in pesticides. Clearly, drop in acreages, bad weather trends (such as fewer incidences of pests and lower incidence of weeds due to weak monsoons), and irreversible damage to standing crops impact pesticide consumption. But these are temporary impacts and vary every year. Many participants also believe that direct investments such as in irrigation infrastructure and storage facilities are much more beneficial than subsidy or free cash distribution programmes like MNREGA. In addition, lower base from weaker FY15 sales and inventory correction in channel in 2HFY15 will also support sales growth in FY16. February 24, 2015 Ambit Capital Pvt. Ltd. Page 67 Economy & Strategy Exhibit 113: Agrochem growth for top-15 players aggregated has held up well despite bad monsoons over the last few years Agrochem growth (%) 30% Monsoon Departure vs. Normal (%) 25% 20% 20% 17% 14% 10% 10% 2% 2% FY11 FY12 11% 6% 10% 0% -10% FY09 -2% FY10 FY13 -7% FY14 FY15E -12% -20% -22% -30% Source: Company data, Ambit research. Note: Agrochemicals growth is based on sum of leading 15 companies’ sales. Global commodity price crash “I think in India the agri commodity prices are relatively lower as compared to the global prices. Wheat is still around $300 or there about or little bit plus. India’s wheat prices are in the range of $220 at the farmer level. So I think there is still a lot of gap between what the Indian farmer gets and what the global farmer gets. I do not think the subsidies will be disrupted in a big way and also in a short span of time. So I think we should not see much impact of commodity prices as far as the Indian consumption is concerned on a lot of cash crops. Prices are still good, the price of oil seeds continues to be good, the only commodity which is coming under major attention globally is corn where the prices have dipped below $4 per bushel. But in India corn is not a very significant crop price; here rice and wheat are the major drivers and both come under MSP. So what you are saying is right for the rest of the world, it will not have major impact on consumption…” - For agrochem growth, good monsoons are important but geographical and time distribution are also important Mr. Kapil Mehan, MD, Coromandel International Limited (2Q FY15 earnings conference call) Channel inventory levels a concern for next year’s growth? We extensively checked with various industry participants (dealer, sales officers, midlevel managers) if unsold inventory with the channel will choke next year’s growth. What we understand is that such issues would be player-specific. Most of the credible industry players were forced to take corrections in 2HFY15 to aid receivable collections and meet expiry norms. Some of the industry players such as Syngenta took inventory correction in 3Q. Bayer apparently had already been cautious on inventory placements and its channel inventory seems to be in control. General feedback in our channel checks was that MNC players were careful enough to rotate their unused inventories from one state to another. Some domestic players corrected channel inventory in 3Q and the current quarter. Rallis also pulled back inventory placement post 1Q once the company realised that the season was not panning out as per their expectations. Player such as Insecticides India and Excel had higher inventories. We believe pureplay generic players will face higher difficulties next year, as considerable inventories are already there in the channel. Some of our channel checks suggest that the inventories in the system are higher by about 20% for generics. Nonetheless, even the players whose channel inventories are controlled will face repercussions of the channel inventories of other generic players. We believe 4Q will again be muted given the inventory correction in the channel. February 24, 2015 Ambit Capital Pvt. Ltd. Page 68 Economy & Strategy Exhibit 114: Management commentary on inventory Management Comment “Given these sets of conditions, demand has been muted along with the inventory, which is already there in the pipeline. And therefore, as you know, our way of working is to align our sales and V Shankar, MD, Rallis placements to consumption. So all this has resulted in volumes being a bit mute on the domestic side. And we have made sure that our focus on cash and collections is relentless and it continues.” “As per the information definitely in the industry there is huge M K Dhanuka, MD, Dhanuka Agritech inventory available, but with Dhanuka that is not the case. We have normal inventory, which we have usually every year.” Source: Company Players with excess inventories of generics to face pressure on margins The other bigger challenge for the players with higher inventories on their books is that the prices for some generics (led by price cuts from the Chinese) have already started to drop post the crude price correction. Players sitting on inventories with higher costs might see pressure on gross margins, as they liquidate their inventories at market prices, which could be lower. Exhibit 115: Inventory levels – A concern for next year? Inventory Days Consolidated data Payables Days Receivable Days Cash Conversion Cycle 1HFY15 1HFY14 1HFY15 1HFY14 151* 109 145 130 119 141 126 120 91 93 56 53 119 113 154 153 Rallis 124 105 130 123 81 85 76 67 Dhanuka 170 161 54 68 166 162 283 255 Insecticide India 173 144 141 130 121 128 153 142 Excel Crop care 136 91 133 125 112 123 114 89 PI Bayer India 1HFY15 1HFY14 1HFY15 1HFY14 Source: Company. Note: PI inventory was higher due to stocking of finished products in CSM business for delivery in 3Q. Drop in cotton acreages could be a concern? Cotton acreages are likely to go down next year, as prices have not been so attractive over recent months. This could have a potential impact on agrochem demand, as cotton is one of the largest contributors for the agrochem industry. Industry participants believe it is too early to comment on any demand impact, as acreage is just one of the parameters. Pest incidence and monsoon trends are few other parameters that control agrochem demand. An example is that last year despite record acreages for cotton, agrochem demand was weak given low pest incidence and monsoon. In addition, the farmer has very limited choices apart from cotton as soybean prices too have been muted. Agrochemicals account for nearly 20% of farmer’s cost but have much more impact on driving yields if pest incidence is high. Hence in that scenario, whatever be the end prices, demand on agrochem is not likely to be impacted materially. Agri valuations have significantly re-rated Valuations for agrochemicals have significantly re-rated over last few months driven by increasing institutional holding of the space and sustenance of earnings growth trajectory and superior RoEs of the space. We believe such premium could sustain due to structural changes such as rising farmer awareness, labour shortage, rising demand for quality farm output and improved product availability sustaining healthy double digits growth rates. Low penetration and consumption levels in both agrochem and seeds would continue to aid superior growth rates in case of sustained efforts by private players and infrastructure improvement support by the Government. In addition, exports is also turning out to be a sizable opportunity driven by growing generics share globally, rising government incentive, increasing propensity of agrochemical players to outsource low technology manufacturing, and improving competitiveness of India vs China for relatively complex agrochemicals. February 24, 2015 Ambit Capital Pvt. Ltd. Page 69 Economy & Strategy Exhibit 116: Agri Inputs valuation summary ADVT P/E P/B EV/EBITDA ROE CAGR (FY14-FY17) MCap - 6m (USD (USD FY15E FY16E FY17E FY15E FY16E FY17E FY15E FY16E FY17E FY15E FY16E FY17E Sales EBITDA EPS mn) mn) Company Name Global Agri Majors Monsanto Dow Chemicals FMC Corp 60,198 6.6 21.2 18.2 15.9 7.7 7.0 5.6 12.8 11.7 10.5 37.0 42.5 43.9 57,202 7.9 17.0 17.0 14.0 3.1 2.3 2.2 9.4 8.9 8.0 16.5 15.0 18.6 -0.1% 8,533 1.3 27.8 16.9 14.2 5.5 5.4 4.3 14.9 11.0 9.8 19.9 31.0 31.0 7.7% 9.6% 27.0% Syngenta 32,594 1.6 18.7 17.2 15.4 3.4 3.2 3.0 14.3 12.1 10.9 17.6 18.3 19.6 2.2% 4.0% Bayer AG 118,022 4.1 20.8 18.1 16.0 4.7 4.3 3.9 12.5 11.0 10.1 21.4 21.8 23.3 6.1% 5.9% 27.0% 86,932 4.0 15.1 15.0 13.7 2.7 2.5 2.3 8.7 8.6 8.1 17.8 17.0 17.6 0.1% 3.6% BASF 4.8% 9.1% 9.5% 11.3% -5.7% 6.4% 4.3% Domestic Agro Chemical Players PI Industries 1,372 1.3 32.8 25.7 20.3 9.6 7.4 5.8 22.3 17.7 13.9 30.8 30.5 29.8 20.8% 25.7% 27.3% Rallis India Bayer CropScience UPL Ltd Dhanuka Agritech Insecticides India Excel Crop Care 743 1.5 29.1 22.0 17.9 5.6 4.8 4.1 1.7 12.8 10.6 20.8 23.9 25.2 13.5% 16.3% 19.2% 2,071 1.3 34.1 28.4 22.8 6.1 5.1 4.2 23.8 19.3 16.3 19.1 17.0 20.5 16.9% 21.9% 25.4% 2,942 10.9 15.5 13.1 11.2 3.0 2.5 2.1 9.0 8.0 7.1 20.1 20.2 20.1 11.9% 12.8% 19.5% 455 0.4 26.5 21.8 18.2 6.9 5.5 4.5 20.0 16.1 13.5 28.4 28.0 27.8 16.5% 20.1% 18.7% 159 0.9 17.1 12.1 9.1 3.3 2.7 2.1 11.6 9.0 7.1 21.2 24.3 25.9 19.9% 30.2% 39.5% 203 0.3 12.9 10.9 DNA 3.6 3.0 DNA 8.5 7.3 DNA 27.8 27.4 DNA 998 2.8 20.4 16.5 13.4 8.1 5.8 4.3 19.6 16.0 13.1 46.7 40.6 36.6 19.8% 27.7% 30.5% 932 3.1 44.7 33.6 28.7 15.3 13.2 11.2 39.3 30.8 26.6 33.4 37.9 42.1 10.6% 12.9% 18.0% DNA DNA DNA Domestic Seeds Players Kaveri Seeds Monsanto India Source: Company Stock implications PI Industries (Market cap US$1.1bn, ADV – US$2mn, 12-month TP `650) PI’s domestic business (40% revenue share) has a differentiated approach of inlicensing new molecules (nearly 70-75% of revenues) from global innovators, thus providing it with superior growth rates, better margins, and increased ‘pull’ effect for its products. In the domestic business, it introduced two new products, MELSA and PIMIX, in FY14 and KEEFUN in 3QFY15, which should aid growth rates going forward. KEEFUN is a promising product which has both insecticidal and fungicidal properties. The product caters to the fruits and vegetables segment which accounts for 20% consumption of pesticides in India. Nominee Gold (>30% of domestic sales) is growing well, driven by improving adoption of direct seeded rice. Osheen (>10 of domestic sales) has also been growing at a good pace driven by enhanced efficacy of the product on insects infesting the rice crop. The business is also well shielded by the faster-growing CSM business. Rallis India (Market cap US$ 0.8bn, ADV – US$ 2.1mn, 12-month TP ` 255) Rallis’s domestic portfolio accounts for nearly 55% of its revenues. The domestic business has underperformed its peers over the last few years due to lack of aggression on new innovative products (such as Applaud and Takumi which had a differentiated proposition to farmers at the time of their launch many years back). However, it significantly stepped up its innovation pipeline in FY15 and launched three new products in 1HFY15. Initial feelers are that the products are not great products though they will aid growth rates, given Rallis’s strong distribution channel. Our channel checks suggest that Rallis may feel some pressure on domestic margins, due to some price correction for generics led by Chinese importers. We are awaiting more clarity on this before building it into our numbers. Going forward, we believe the trajectory for the stock price would be governed by exports growth and Metahelix business’ performance (specifically margin improvement). February 24, 2015 Ambit Capital Pvt. Ltd. Page 70 Economy & Strategy Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected] Research Analysts Industry Sectors Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 Desk-Phone E-mail [email protected] Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected] Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected] Aditya Bagul Consumer (022) 30433264 [email protected] Aditya Khemka Healthcare (022) 30433272 [email protected] Ashvin Shetty, CFA Automobile (022) 30433285 [email protected] Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected] Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected] Karan Khanna Strategy (022) 30433251 [email protected] Krishnan ASV Real Estate (022) 30433205 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected] Paresh Dave, CFA Healthcare (022) 30433212 [email protected] Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected] Prashant Mittal, CFA Derivatives (022) 30433218 [email protected] Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 [email protected] Ravi Singh Banking / Financial Services (022) 30433181 [email protected] Ritesh Gupta, CFA Midcaps – Chemical / Retail (022) 30433242 [email protected] Ritesh Vaidya Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected] Ritu Modi Automobile (022) 30433292 [email protected] Sagar Rastogi Technology (022) 30433291 [email protected] Sumit Shekhar Economy / Strategy (022) 30433229 [email protected] Sandeep Gupta Media / Midcaps (022) 30433211 [email protected] Tanuj Mukhija, CFA E&C / Infra / Industrials (022) 30433203 [email protected] Utsav Mehta, CFA Technology (022) 30433209 [email protected] Sales Name Regions Sarojini Ramachandran - Head of Sales UK Desk-Phone E-mail Dharmen Shah India / Asia (022) 30433289 [email protected] Dipti Mehta India / USA (022) 30433053 [email protected] Hitakshi Mehra India (022) 30433204 [email protected] Nityam Shah, CFA USA / Europe (022) 30433259 [email protected] Parees Purohit, CFA UK / USA (022) 30433169 [email protected] Praveena Pattabiraman India / Asia (022) 30433268 [email protected] Shaleen Silori India (022) 30433256 [email protected] +44 (0) 20 7614 8374 [email protected] USA / Canada Ravilochan Pola - CEO Americas +1(646) 361 3107 [email protected] Production Sajid Merchant Production (022) 30433247 [email protected] Sharoz G Hussain Production (022) 30433183 [email protected] Joel Pereira Editor (022) 30433284 [email protected] Nikhil Pillai Database (022) 30433265 [email protected] E&C = Engineering & Construction February 24, 2015 Ambit Capital Pvt. 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