>INDIA CONSTRUCTION (RELIANCE EQUITIES)

Slow earnings recovery

■ Order inflows likely to revive, but not rapidly
On average, companies in our coverage universe saw a 22% decline in order booking in 4Q FY09 and grew just 8% in entire FY09 (pulled up mainly by strong order inflow for HCC, which grew 143% YoY). We expect an improvement in FY10, but the pick-up in order flow will likely remain moderate owing to high fiscal deficit restraining government spending and a slowdown in private-sector capex. We estimate order inflow growth of 15–20% in FY10 (-50% for HCC, due to the high base in FY09) and 20–25% in FY11.

■ Earnings growth to be much lower than pre-FY09 levels, in the near term
After a rather forgettable FY09, earnings are likely to pick up from the current fiscal onwards. However, earnings growth is unlikely to reach pre-FY09 levels in a hurry. For companies in our coverage, we expect earnings CAGR of 17% over FY09–11E compared to 52% in FY03–08. We expect slow recovery on account of: (1) low revenue visibility (owing to low order inflows in FY09); (2) depressed EBITDA margins; and (3) high interest costs (despite a significantly lower cost of debt).

■ Quality of earnings remains weak, equity dilution risk lingers
Our biggest concern about the sector has been negative cash flows generated primarily due to an elongating working capital cycle. We expect the cycle to remain stretched, resulting in: (1) low or negative cash flows; (2) rising debt and low interest coverage; and (3) low return ratios (with ROIC below 12%). This will eventually lead to a series of equity dilutions, as was seen in the past.

■ Optimism is overdone, we are cautious on the sector
Post elect ion results, all construction stocks have run up significantly on the back of optimism that the new government will push infrastructure spending aggressively. We believe an improvement in earnings is likely to be gradual rather than dramatic, thus leaving room for disappointment. Thus, we believe that construction stocks are not likely to trade at the high multiples they commanded in 2007-08. We are upgrading Simplex to Buy based on our revised valuation and maintain our Sell rating on HCC, IVRCL and NCC.

To see full report: INDIA CONSTRUCTION

>INDIA STRATEGY (RELIANCE EQUITIES)

BOOM AND BUST

Resistance is futile
As the markets gain new heights, investors are now worried whether the rise is too fast to last. We worry as well. But our analysis suggests resistance might be futile. On the back of a sharply improving 2011 earnings that, in turn, should benefit from rising availability and falling cost of capital, we expect the BSE Sensex to rise to 18000 in the next 200 days. In this note we go through the rationale and help you position for that rise.

■ 18000 by year end
We expect the BSE Sensex to trade between 17x and 19x FY11 earnings by December 2009, which, in turn, is expected to rise by an impressive 17-22% over FY10. There is scope, however, for a further rise in the market’s multiples. Put simply, India is at a significantly superior growth and risk category relative to its past cycles or competing global investment destinations. Past cycles have seen better than 20x one-year forward earnings.

■ Global forces to determine returns
Domestic factors like elections might appear to trigger the rally, but make no mistake: the Indian market will be dominated by global dynamics. The excess liquidity created by the global monetary authorities WILL drive asset prices, and in particular emerging markets, higher. Capital costs are key for consumer and investment demand in India. On the back of expected greater credit availability and falling credit costs, our economist expects Indian FY11 GDP growth of 7%. The global asset allocation shift will magnify the dollar-denominated returns from markets like India, feeding a virtuous cycle.

■ Material risks remain and are rising
While we wish it could be a one-way bet, risks are indeed rising in global markets that could, in turn, impact India. The wall of liquidity could well fuel inflation in developed markets resulting in monetary tightening. Such a tightening would impact the key driver of Indian earnings—the availability and cost of capital. For the moment, though, rising global bond yields are a good sign. Indian markets have significantly outperformed global and most other emerging markets but this is not new and could continue as many domestic investors have been sceptical and are playing catch up. It is extremely rare for Indian markets to have just a 12-14 week rally: the average is 53 weeks.

■ Launching Reliance Equities International Model Portfolio: “REIMP”
We launch our model portfolio, REIMP, along with a recommended sectoral asset allocation. This is a synthesis of our bottom-up and top-down view.

Nice run but where next?
In late March, we set our Sensex target for the year end (December 2009) at 13700 and launched our deep value portfolio, REIDV. Little did we realise how “short sighted” the target would prove to be. As we watched the post election relief rally in amazement, the question arose: what is the year-end target now? Cutting to the chase, we now see the market in the 16500-19000 range by December 2009, i.e., about 15-30% upside from here.

The market currently trades at about 15.5x our March 2011 bottom up earnings estimates or about 19x March 2009 earnings. This might appear fairly expensive. Figure 1 below suggests that, relative to the history of the market, it really is not. At the cusp of the cycle, it is usual for analyst estimates to lag significantly. Analysts wait for hard data prior to revising earnings. Alas, markets do not wait for such niceties. Markets typically move ahead of analysts and such other mere mortals discounting somewhat incomplete or inconclusive data and more distant future earnings resulting in a significant expansion or contraction of trailing P/Es.

We base our revised target on what we consider to be the most plausible scenario but with a margin of safety—a Grahamesque concept. Our target is based on FY11E EPS growth of 17-22% and a P/E of 17-19x FY11E. Looking at it from a trailing earnings perspective, our target implies a trailing P/E of 22x FY09 consensus earnings. In the last two market recoveries, one-year forward P/Es crossed 20x while trailing P/Es crossed 25x.


To see full report: INDIA STRATEGY

>HDFC (RELIANCE Equities)

Growth revives but margins a tad lower

■ Early signs of revival in mortgage demand
After a dismal third quarter in which loan approvals declined 8% YoY as HDFC turned cautious on developer loans, approvals improved reasonably with 17% growth YoY. Net of sell-downs to HDFC Bank, outstanding loans grew by 17% YoY. Management has guided to an 18-20% loan growth target for FY10E (with most of the rise coming in the last two quarters).

■ Excess liquidity takes toll on margins. Other income surprises positively
In the aftermath of the domestic liquidity crunch during 2Q–3Q FY09, HDFC carried excess liquidity which took its toll on spreads (down 11 bps YoY). Going forward, spreads are expected to remain stable with an upward bias as repricing of liabilities kicks in.

■ Asset quality and operating efficiency remarkable as always
Despite market concerns, GNPA ratios (both 180 and 90-days past due) continued to improve YoY, a trend we have seen throughout the current fiscal.

■ Raising our target price to reflect greater comfort on demand
HDFC has delivered in a difficult environment: its asset quality is at a 10-year low, and spreads have been maintained showing negligible impact of SBI's lower interest rate loan gimmick. The only concern is on demand, though signs of a revival are evident. The stock currently trades at 15x earnings (sub-value at Rs 588.) Given this backdrop and HDFC’s sustainable core RoE (upwards of 25%), core business can trade upwards of 20x earnings. We upgrade our target price to Rs 2,378 from Rs 1,943. Buy.

To see ful report: HDFC