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  • India strategyMarket strategy

    Find CLSA research on Bloomberg, Thomson Reuters, CapIQ and themarkets.com - and profit from our evalu@tor proprietary database at clsa.com

    Mahesh Nandurkar, [email protected]+91 22 6650 5079

    Abhinav Sinha+91 22 6650 5069

    Rohit Kadam+91 22 6650 5037

    22 April 2014

    IndiaMarket Strategy

    www.clsa.com

    Drawing from Gujarat PSUsA look into the financial & stock performances of Gujarat state PSUs suggests better days ahead for the larger central Government PSUs should Modi become the next prime minister. Mr Modi has recently stated that he believes PSU performance can be improved by empowering the management. Some successful turnaround stories from Gujarat viz. GSFC raises hopes for the likes of MTNL & PSU banks. Empowerment wouldalso come with greater competition. While potentially lower oil subsidies will be a positive for oil marketing cos HPCL, BPCL and IOC; it will also mean greater private sector competition. Our top PSU picks are SBI, PFC, REC, BoB, ONGC, Oil India and Power Grid.

    Gujarat state PSUs are among the most profitableq According to the latest Government report on SLPE (State Level Public Enterprises

    FY10), only 3 state Governments have cumulative profit making enterprises.q Gujarat PSUs top that list with a cumulative profit Rs5.8bn. Third state in that list is

    Madhya Pradesh with Rs1bn profit another BJP ruled state. The rest are all loss making at the cumulative level.

    q The 6 major listed Gujarat PSUs (GMDC, GSPL, GSFC, GALK, GIPL and GNVFC) with a cumulative market cap US$2.4bn, have grown net profits by 13% cagr over the last 5 years and 19% cagr over the last 10 years.

    Mr Modi believes in giving greater freedom to PSU managementq Mr Modi recently said in an interview that disinvestment is not the only option for a

    loss making PSU. He believes in professionalising the management and giving a chance to turn around through technology upgradation.

    q GSFC (Gujarat State Fertiliser Corporation) was an ailing company with Rs4bn loss in FY03. Mr Modi gave a free hand to the top bureaucrats in negotiating a turn-around without any political interference. Now it makes a 15% RoE.

    q Similarly to turn around the power distribution companies, power thefts were reduced and some dedicated police stations were set-up, feeder lines for agri and residential use were separated to minimise subsidy and farmers were made to pay for power.

    q GSPC, the holding company for various state owned oil & gas businesses, has been allowed to expand well beyond the state and now has a portfolio of 64 blocks including 11 international blocks in Egypt, Yemen, Australia and Indonesia.

    q In a rare move of reverse privatisation, GSPC acquired Gujarat Gas when its MNC owner British Gas decided to sell. GSPCs consortium partners BPCL, ONGC pulled out due to some procedural delays.

    BJP manifesto / Modi silent on disinvestment of PSUsq During the previous NDA rule (1998-2004), total disinvestment proceeds were

    around US$5.5bn for the Government of India. Since then, over the last 10 years, total disinvestment has been around US$21bn.

    q The BJP manifesto, however, doesnt make any specific mention of disinvestment. q Also the recent comment by Mr Modi, makes us believe that disinvestment is

    unlikely to be a top priority for the potential BJP Government.

    Will the fate of the larger national PSUs improve?q Driven by better financial performance, Gujarat PSUs have significantly

    outperformed the PSU index and have performed in line with the broader market over the last 5, 10 years.

    q A potential turnaround could work wonders for some of the ailing PSUs viz. MTNL. PSU banks also stand to benefit if the banks are allowed to work without political interference and are made more efficient through technology upgradation.

    q For oil PSUs and Coal India, while subsidy reduction and empowering the management will be a positive but potential increase in private sector competition could work negatively.

    q Our top PSU picks are SBI, PFC, REC, BoB, ONGC, Oil India and Power Grid.

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  • Drawing from Gujarat PSUs India strategy

    22 April 2014 [email protected] 2

    Financial performance of Gujarat based PSUsFigure 1

    10 year revenue CAGR for listed Gujarat PSUs

    Source: CLSA, ACE Equity; Note: Calculation over FY03-FY13

    Figure 2

    10 year profit CAGR for listed Gujarat PSUs

    Source: CLSA, ACE Equity; Note: Guj State Ferti calc from FY04-FY13, all others from FY03-FY13

    Figure 3

    5 year and 10 year ROEs

    Source: CLSA, ACE Equity; Note: Calculation over FY03-FY13

    4%

    7%

    12%

    13%

    19%

    30%

    0% 5% 10% 15% 20% 25% 30% 35%

    Gujarat Ind Power

    Gujarat Alkalies

    Gujarat Narmada Fertil

    Guj State Fertil

    Guj Mineral Develop

    Guj State Petronet

    12%

    12%

    22%

    24%

    25%

    42%

    0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

    Guj State Fertil

    Gujarat Narmada Fertil

    Guj Mineral Develop

    Gujarat Alkalies

    Gujarat Ind Power

    Guj State Petronet

    0

    5

    10

    15

    20

    25

    Gujarat IndPower

    Guj StatePetronet

    GujaratNarmada

    Fertil

    Guj MineralDevelop

    GujaratAlkalies

    Guj StateFertil

    5 year average ROE 10 year average ROE%

    4 out 6 listed PSUs have shown respectable to

    good revenue CARG over 10 years

    Impressive PAT growth for all

    ROEs north of 20% for some

  • Drawing from Gujarat PSUs India strategy

    22 April 2014 [email protected] 3

    State-wise comparison of PSUsFigure 4

    Total net profits for all state PSUs in FY10

    Source: National Survey on State Level Public Enterprises

    Figure 5 Figure 6

    States with most profitable power discoms States with most loss making power discoms

    Source: SEBs, CLSA; Note: Subsidy received basis Source: SEBs, CLSA; Note: Subsidy received basis

    Figure 7

    Top 10 states with investments in PSUs

    Source: CLSA

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    Delhi WestBengal

    Gujarat Kerala Sikkim Karnataka

    Rs bn

    (250)

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    UttarPradesh

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    0100200300400500600700800900

    1,000 Rs bn

    Gujarat, Kerala and Madhya Pradesh are the

    only states showing a profit

    Gujarat the only state in the top 3 which is also

    profit making amongst its PSUs

  • Drawing from Gujarat PSUs India strategy

    22 April 2014 [email protected] 4

    Stock performance Figure 8

    Stock performance Sensex vs BSE PSUs vs Gujarat PSUs

    Source: CLSA, Gujarat PSU index computed using market weighting from Bloomberg. Includes all companies in figure 1 except Guj State Ferti

    Some Initiatives to improve efficiency of the power sector.

    Hard crack down on power thefts in the state; set up police stations solely for this purpose.

    Redeployed all employees during re-organisation of GSEB (Gujarat State Electricity Board); no layoffs to keep morale high.

    In May 2003, the Gujarat government passed the Gujarat Electricity Industry (Reform and Reorganisation) Act, which divided the GSEB into a holding company, a power generation company, a power transmission company and four distribution companies. It was amongst the first states to do so.

    Separated feeder lines into those for agricultural needs and household needs; arrested misuse of subsidised power for agriculture.

    GSEB is independent from state polity and has been able to make regular tariff revisions.

    (15)

    (10)

    (5)

    0

    5

    10

    15

    20

    25

    1 year 3 year 5 year 10 year

    Sensex BSE PSU Gujarat PSU%

    Gujarat PSUs have far outperformed the broader

    BSE PSU index

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  • Drawing from Gujarat PSUs India strategy

    22 April 2014 [email protected] 5

    Figure 9

    Kirit Parikh (former member of Planning Commission in a media article)

    Source: Business Today; dated Feb 2012

    Political will goes a long way says Kirit Parikh praising the Gujarat

    model

    The Gujarat experience clearly shows what strong political will to reform the electricity sector can achieve. Of the many innovations the state tried, the separation of feeders for supply towards agricultural use was a master stroke. It not only helped farmers get quality power at fixed time but also ensured that leakages were curtailed. It enabled measurement of the power used for agricultural purposes as well, so as to arrive at the exact quantum of subsidy that needs to be reimbursed to the distribution companies.

    Today feeder separation is being adopted by many others states.Also the manner in which pilferage was tackled is interesting. I know how the CEO of a state-run distribution company that supplied to one half of a particular city in Gujarat was fully empowered to take all measures to match the low T&D losses of a private sector company that supplied to the other half of the city. The state has also been proactive in promoting renewable energy. By offering to buy solar power at `12.50 per unit, the state will soon see over 350 MW of power from solar energy.

    It is true that the cost of electricity is higher in Gujarat but that is because the states electricity regulator has proactively raised prices as costs of generation rose. This makes sense in the long term.As can be seen, companies foraying into Gujarat are not too concerned about paying a couple of rupees more for consistent and good quality power. The challenge that the state faces is on the T&D loss front where there is still scope for reduction by four percentage points or so. More needs to done there.

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  • Is Dilip Shanghvi's big bet worth the risk?

    When Sun Pharma announced earlier this month that it would acquire troubled drug maker Ranbaxy

    Laboratories from Daiichi Sankyo of Japan in a $3.2-billion all-stock deal, many observers had wondered

    if Dilip Shanghvi, the well-respected promoter of Sun Pharma, had thrown good money after bad money.

    Ranbaxy has had its share of trouble with the United States Food & Drug Administration, or FDA; as a result,

    four of its Indian factories are barred from selling in the US, the world's largest market. Now, as the dust settles

    down, there is near unanimity of view that Shanghvi may have made a brilliant purchase.

    The acquisition offers Sun Pharma synergies to grow not only in the global market but also leadership in the Rs

    85,000-crore Indian market. At 19-20 per cent per annum, India happens to be one of the fastest growing

    markets in the world. And with lifestyle diseases on the rise, it's believed to be moving up the value curve as

    well. From the second position in India with a market share of 5.4 per cent, Sun Pharma will become the leader

    with a share of 9.2 per cent, ahead of US-based Abbott (6.5 per cent, it had acquired the domestic formulations

    business of Piramal Healthcare for $2.12 billion in 2010). Sun Pharma and Ranbaxy will lead the Indian market

    in as many as 13 therapeutic categories. Amongst the top 300 products, 31 will be from the stables of Sun

    Pharma and Ranbaxy. Moreover, Sun Pharma will be able to leverage Ranbaxy's strong presence in the rural

    markets to push its line of products into new areas.

    Ranbaxy will give Sun Pharma a strong position in the over-the-counter (medicines can be sold without a

    doctor's prescription) space with brands like Revital and Volini. The two brands together have an annual

    turnover of almost $80 million. "If one uses a multiple of seven to arrive at their value (as was done when

    Abbott acquired the formulations business of Piramal Healthcare), these two alone are worth over $550

    million," a consultant who was engaged by a private equity fund to acquire Ranbaxy told Business Standard

    recently. Another fund and a US-based generics company too were eyeing Ranbaxy, the consultant had

    disclosed.

    A fillip to global ambitions

    The overseas business too will get a boost. In the US, the Sun Pharma-Ranbaxy combine will have an annual

    turnover of $2 billion, accounting for 47 per cent of its turnover. It will have one of the largest portfolios of 629

    abbreviated new drug applications (which seek to launch generic versions of patented medicine), of which 180

    are pending approvals. Experts say the partnership will boost Ranbaxy's first-to-file opportunities, which give

    180-day exclusivity to sell a medicine after it goes off patent. "Ranbaxy now finds a partner in Sun Pharma for

    the manufacture and launch of Diovan, Valcyte and Nexium. The timely launch of these molecules could

    potentially add revenue of $400-500 million during the 180-day exclusivity from the US market. We expect the

    two companies to work together to ensure timely launches and believe the deal improves clarity on the

    monetisation of Ranbaxy's first-to-file pipeline," a report from Elara Capital says.

    The unsuccessful suitor mentioned above discloses that Ranbaxy has a branded products business in the US,

    which is unaffected by the FDA alerts and is over $100 million in size. However, the real challenge for

    Shanghvi is to clear the FDA ban on the four Ranbaxy plants in India. According to Sun Pharma Chairman

    Israel Makov, the company would have to do a lot of work to get FDA to revoke the ban, and that's perhaps

    why it has not put any time-frame for this.

  • "We have to do a lot in the field to satisfy its requirements; once we do it, we will have the ban revoked,"

    Makov said in an interview to reporters earlier. Within two months of Daiichi Sankyo's acquisition of Ranbaxy

    for $4.6 billion in July 2008, FDA had issued an import alert on the Dewas and Paonta Sahib plants of the

    Indian company for violation of good manufacturing practices, which affected sales of 30 generic drugs in the

    US. In September last year, the import alert was extended to the Mohali plant. And this year it was the turn of

    the Toansa unit.

    Fixing Ranbaxy's woes

    Industry experts are hopeful that Shanghvi will be able to turn around Ranbaxy and rectify these issues. Bhavik

    Narsana, corporate partner, Khaitan & Co, says: "Sun Pharma has stressed on the importance of good

    manufacturing practice compliance as a top priority. Sun Pharma with its recent and past experience in handling

    FDA looks very well placed to turn the situation around for Ranbaxy." (A Sun Pharma unit in Gujarat was

    banned from shipping its produce to the United States last month.)

    At the moment, Sun Pharma earns 17 per cent of its revenue from outside India and the US; with Ranbaxy

    under its belt, this will rise to 31 per cent. The two will have operations in 65 countries with 47 manufacturing

    facilities across the globe. The merged entity will benefit from economies of scale in procurement,

    manufacturing and marketing. Sun Pharma can use Ranbaxy's production units to feed markets in Asia, Africa,

    Europe and South America. Individually, they might be smaller than the US but collectively they are just as big.

    (Ranbaxy faces import alerts from no other country apart from the US.) Ranbaxy is particularly strong in South

    Africa, Brazil, Russia and Malaysia. The acquisition gives Sun Pharma a foothold in these fast-growing

    markets. Also, with Daiichi Sankyo becoming a 9 per cent shareholder, Sun Pharma can access its pipeline of

    branded products.

    The combined entity will have revenues of $4.2 billion, says a report from Centrum Broking. Ranjit Kapadia of

    Centrum Broking says: "We expect Sun Pharma to report consistent performance due to strong growth of its

    major brands in the domestic market and strong product pipeline for the US market. The merged entity will

    derive 31 per cent revenues from emerging markets of Russia, Romania, South Africa, Brazil and Malaysia."

    Shanghvi, the fourth-richest man in India, has earned a reputation as a turnaround man after he nursed two

    distressed companies he had purchased - Taro Pharma of Israel and US-based Caraco-back to health. If he can

    turn around Ranbaxy, this reputation will be further enhanced.

    A win-win deal for Daiichi

    According to experts, this is a win-win deal for both Sun Pharma and Ranbaxy. Even Daiichi Sankyo will gain.

    "In this deal, where the shares are being swapped, the value is not a final one. Unlike a cash transaction, here

    the value of the 9 per cent stake offered to Daiichi Sankyo will increase very fast, given the great reputation of

    Sun Pharma," says Sujay Shetty of PricewaterhouseCoopers. The Japanese drug maker will get a good exposure

    to Sun, which will become the fifth-largest global generic player, he adds.

    "For Daiichi Sankyo, the merger is an opportunity to pursue new development in its hybrid business model

    through the new partnership with Sun Pharma," says a statement from the company when the deal was

    announced. Indeed, the purpose of its Ranbaxy acquisition was to create a hybrid model, which would give it

    patented as well as generic products in its portfolio. There is a global movement towards generics and every

    patent-driven company wants a piece of the action. That model survives. At present,

  • Daiichi Sankyo owns approximately 63.41 per cent of Ranbaxy.

    Ranbaxy may get a makeover

    The deal is expected to change the tarnished image of Ranbaxy, many experts feel. N Chandramouli, chief

    executive, Trust Research Advisory, a communications and media services provider, says: "Sun Pharma's

    buyout of Ranbaxy is a clear sign of how effective management builds hope for a brand.

    Ranbaxy was struggling with several issues simultaneously and seemed to be on the downhill. However, with

    Sun Pharma's entry, the despondency has turned positive, especially since it was bought 40 per cent cheaper

    than Daiichi Sankyo's price in 2008. Overall, this deal increases Sun Pharma's trust quotient manifold."

    SUN-RISE

    * 1983: Sun Pharma comes into existence with a basket of five psychiatry drugs and a facility in Vapi, Gujarat

    * 1987: Expands to become a pan-India player

    * 1994: It goes public

    * 1996: Acquires an API plant from Knoll Pharma

    * 1997: Buys stake in TDPL, MJ Pharma. First global buyout of US-based Caraco Pharma

    * 1998: Acquires speciality brands from Natco Pharma

    * 1999: Buys Milmet labs, Gujarat Lyka Organics

    * 2000: Buys Pradeep Drug Company

    * 2005: Buys plant in Ohio and business of ICN, Hungary from Valeant Pharma

    * 2007: De-merges R&D business into new company, lists on stock exchanges

    * 2010: Buys majority stake in Taro Pharma

    * 2012: Buys Dusa Pharma and generic business of URL Pharma

    * 2013: Becomes the first pharma scrip to cross Rs 1- lakh crore market-cap

    * 2014: Acquires Ranbaxy Ltd for $3.2 billion

  • Infofax Daily 22 April 2014

    Your daily Eye on Asian Economies 1

    INDIA FX RESERVES AND INR: Indias foreign reserves have jumped USD34bn since end-August 2013. The RBI is poised to limit INR gains while not being averse to gradual depreciation later this year.

    INDIA FX RESERVES AND INR Shifting RBI tactic Indias foreign reserves have risen steadily since hitting a low in August 2013. That low point also coincided with the weakest level on INR/USD. The increase in foreign reserves is a combination of lower current account (CA) deficit, increase in debt inflows because of RBIs tempting leveraged deposits for non-resident Indians and increased portfolio inflows. It also indicates a more active RBI in the currency market, which has limited the appreciation of the INR. We reiterate that the central bank will limit INR gains from here on despite a favourable election outcome. Further, it is unlikely to be averse to gradual INR depreciation later this year. Foreign reserves

    Source: CLSA, Bloomberg

    The current stock of total foreign reserves of USD309.4bn implies a jump of USD34bn since the low point in August. Foreign reserves are equivalent to a comfortable 7.2 months of our FY15 forecast of the total import bill. Note that the effective total foreign reserves stock is lower at USD278.1bn as the RBI has a net forward outstanding USD sale of USD31.3bn. The import cover will still be a decent 6.5 months (the full forward position is unlikely to be cleared in just one year). It is not a coincidence that the INR has rallied since end-August. The appointment of Raghuram Rajan as RBIs Governor, and the related combination of policy clarity and coherence, along with corrective measures to reverse the lack of confidence in the INR have paid off. INR has appreciated 10.4%

    against the USD since end-August, positioning it as the best-performing EM currency. Still, despite that rebound, at the current level INR/USD is 9% weaker than it was at the end of 2012. INR/USD

    Note: Rise indicates appreciation, Source: CLSA, Bloomberg

    Having achieved its initial objective of reversing the extreme bearish bets on the INR, the RBI has to shift focus to a more sustainable approach towards the INR (see India: The moment of truth, 2Q14 Eye on Asian Economies). The central bank is understandably - and correctly, in our view - not fixated on any specific INR level but is mindful of letting the currency, buoyed by investor optimism over the election result, appreciate excessively. Real effective exchange rate

    Source: CLSA, Bloomberg, RBI, BIS

    The REER appreciation in recent months indicates that the currency has become less competitive (see

    50

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    Jan 06 Jan 08 Jan 10 Jan 12 Jan 14

    (USD bn)

    Total foreign reserves

    Foreign currency assets

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    52

    54

    56

    58

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    64

    66

    68

    70Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14

    (INR/USD, reverse axis)

    70

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    100

    105

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    Jan 06 Jan 08 Jan 10 Jan 12 Jan 14

    (Index, 2004-

    05=100)

    BIS REER (rebased)

    RBI CPI-based REER

    Prepared for: [email protected]

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  • 22 April 2014 Infofax Daily

    2014 CLSA Limited. IMPORTANT: The content of this report is subject to and should be read in conjunction with the disclaimer and Legal and Regulatory Notices of CLSA group of companies (excluding CLSA Americas, LLC) (CLSA) as set out at www.clsa.com/disclaimer.html, a hard copy of which may be obtained on request from CLSA Publications or CLSA Compliance Group, 18/F, One Pacific Place, 88 Queensway, Hong Kong, telephone +852 2600 8888. 01/01/2014

    third chart). The RBI recently announced a more relevant CPI-based (instead of WPI-based) REER time series. This shows some variation from the BIS REER data. The dichotomy between the two REERs could be because of different weights being used by the two institutions and the RBIs reliance on the new CPI time series from January 2011. Now, the Reserve Bank will surely give more credence to its own improved REER yardstick. This shows that the currency is around 4% overvalued. While RBIs initial objective was to reverse the negative outlook on INR and it may not have been too bothered by the REER appreciation, the same cannot be said at the current juncture. The Reserve Banks approach towards the INR should balance the possibility of near-term appreciation pressure with medium-term dynamics which argue for gradual depreciation. This has to be managed while replenishing the war chest of foreign reserves, and is a key reason why the central banks intervention in the currency market has increased. In fact, the last mistake it should commit is to allow significant INR appreciation which in turn begins to hurt the export sector. As it is Indias exports are not doing well, having declined in YoY terms for the second consecutive month in March

    (see Infofax Daily, IP and exports remain weak, 14 April). The central bank will be mindful about allowing INR appreciation because of higher portfolio inflows. We reiterate our non-consensus forecast of INR63-65/USD by yearend even if it strengths to INR58-59/USD in the very near-term. This is far from being catastrophic but goes against typical expectation more likely wishful thinking - of INR appreciation. This profile is in line with our long-held view of the INR reverting to its pre-2002 pattern of gradual annual depreciation (see Special Report, Balancing act). The combination of Indias economic recovery, possible easing of restrictions on gold imports, pick-up in non-gold and non-oil imports, global liquidity tightening, higher US bond yields and Indias chronically high relative inflation will all work to engineer a weaker INR. Thus, even if INR/USD strengthens in the very near term because of a jump in portfolio inflows triggered by a positive election outcome, the RBI will limit the gain from the current level. However, it wont be averse to gradual depreciation in the INR.

    [email protected]

    Prepared for: [email protected]

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  • Indian financialsSector outlook

    Find CLSA research on Bloomberg, Thomson Reuters, CapIQ and themarkets.com - and profit from our evalu@tor proprietary database at clsa.com

    Aashish [email protected]+91 22 6650 5075

    Prakhar Sharma+91 22 6650 5058

    Akshat Agarwal+91 22 6650 5065

    22 April 2014

    IndiaFinancial services

    www.clsa.com

    Headwinds from ownership capsOver past 6 months, banks (+20%) have outperformed market (+9%), but we see some headwinds from peaking ownership levels. Seven Indian financials have reached or are close to the cap on foreign ownership limit; even insurance companies are nearing their cap. These two factors can limit returns from financial stocks particularly for the likes of HDFC Bank and IDFC; IndusInd, ING Vysya and PNB are at caution limit. Stocks that still have headroom for foreign investors are HDFC (24ppt), SBI (8ppt) and ICICI (5ppt). Positive surprises can come if HDFC Bank is permitted to raise cap and if some FIIs in Axis convert holding into GDR.

    FIIs 26% stake in banks is O-WT vs. MSCI, but in line with Sensex q Foreign Institutional Investors (FII) own 20% of Indian market and their ownership

    in banks is higher at 26%; they own 37% of private banks and 10% of PSU banks.q In the overall portfolio of foreign investors (FII plus ADR/ GDR), banks have a

    weightage of 20%; overall weight of financials (including NBFCs) is at 29%.q Foreign investors are overweight on financials versus MSCI as well as Sensex (see

    figure 2-3).

    Foreign buying in 5 private banks is restricted; MSCI is cuttingq Foreigners can own 74% of equity in private banks and within this the FII holding

    cant exceed 49%; although banks can set a lower internal limit.q With foreign investors increasing ownership in private banks, foreign holding levels

    are hitting the regulatory caps.q Five private banks, HDFC Bank, Axis, IndusInd, ING Vysya and City Union, are

    either at the max foreign holding cap or are at caution limit i.e. 200bps below cap.q Among leading NBFCs, IDFC is at peak foreign holding limit and among PSUs, PNB

    is at the caution limit.q With most private banks having exhausted headroom for foreign investors, MSCI

    has also been trimming their weight in its Indices.q Axis is already out of MSCI and ICICI and HDFC Bank have seen significant cuts.

    Insurance companies also near their max holding in financialsq As per Irda norms, insurance companies investment in financial sector (banks and

    NBFCs, but not infra-NBFCs) cant exceed 25% of Ulip assets.q We understand that many insurers are near the cap and hence it would be difficult

    for them to increase weight on financials.q Limited headroom can affect in two ways: (1) insurers many need to trim positions

    if financial stocks outperform by 15ppt or so and (2) financial companies that plan to raise domestic capital may also face some challenges.

    q In this regard, Insurers have asked Irda to raise this limit from 25% to 30%.

    Safer heavensq Cuts by MSCI can lead to short-term underperformance given that ETFs (owning 1-

    2%) and other passive funds (similar size as ETFs) would also cut their holdings.q Financials where (1) foreign holding is below cap, (2) capital raising isnt needed in

    near-term and (3) weight in MSCI is zero or negligible are safer-heavens.q HDFC Ltd (24ppt), SBI (8ppt) and ICICI (5ppt) have sufficient headroom.

    Stocks that can surprise positivelyq In case of HDFC Bank, a positive surprise can come if government recognises HDFC

    Ltds 23% stake as domestic and raises foreign holding limit from 49% to 66%.q This will create headroom for foreign investors and encourage MSCI to reinstate the

    weight of HDFC Bank back to 7-7.5% versus 1.7-1.8% from June 2014.q Axis has been excluded from MSCI as it reached the FII limit of 49% although there

    is headroom available in the GDR segment where holding is at 3% vs. cap of 13%.q If some FII holders convert into GDRs then it will create headroom for new

    investors and increase possibility of restatement in MSCI.

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  • Headwinds from ownership caps Indian financials

    22 April 2014 [email protected] 2

    Figure 1

    Shareholding pattern of Indian banks

    Note: Based on latest / Dec-13 shareholding. Source: Companies, Ace Equity, CLSA

    Figure 2 Figure 3

    20% of foreign investors portfolio is in banks and ...their overall weight to financials is at 29%

    Note: Based on latest shareholding. * MSCI weight is after the recent cut to HDFC Banks weight. Source: Reports, Ace Equity, CLSA

    Figure 4

    Weight of banks in foreign investor portfolio

    Note: Based on latest / Dec-13 shareholding. Source: Ace Equity, CLSA

    37%

    64%

    20%

    26%

    10%

    37%

    9%1%

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    Promoters FII ADR/GDR DII Others

    20%

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    Weight of Indian banks(% of portfolio)

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    Weight of Indian banks + NBFCs(% of portfolio)

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    3 3 32 2

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    Dec-12 Mar 13 Jun 13 Sep 13 Dec 13 Now

    Share of banks in portfolio of FIIs and ADR/ GDR

    Private banks PSU banks(% of total holding)

    FIIs own 26% stake in banks versus 20% stake

    in the market

    Over past year, peak weight of banks in foreign investor

    portfolio was 22%

  • Headwinds from ownership caps Indian financials

    22 April 2014 [email protected] 3

    Figure 5

    Regulatory cap on foreign holding in Indian banks and NBFCs

    Private banks PSU banks NBFCsTotal foreign holding 74%

    20% 100%of which FII holding 49%FDI (including ADR/ GDR) 24%

    Source: RBI, CLSA

    Figure 6

    Summary of actual, cap and headroom among private banks

    Bank FII holding Total foreign Headroom Comment

    Actual Cap Actual CapAxis Bank 49 49 52 62 0 Foreign buying restricted. Room can be created if

    FIIs convert into GDR.City Union Bank 25 24 29 24 0 Foreign buying restricted; bank can raise internal

    limit to create headroomFederal Bank 41 49 48 74 8 Headroom availableHDFC Bank 34 49 51 49 0 Foreign buying restricted. Room can be created if

    holding of HDFC is treated as domestic / ADR is treated as FDI.

    ICICI Bank 40 49 69 74 5 Headroom availableIndusInd Bank 45 49 72 74 2 At caution limitING Vysya Bank 29 30 72 74 1 At caution limitKarnataka Bank 22 49 22 49 27 Headroom availableKarur Vysya Bank 26 40 26 40 14 Headroom availableKotak Mahindra Bank 33 37 36 74 4 Headroom availableSouth Indian Bank 47 49 47 49 2 Headroom availableYes Bank 40 49 40 60 9 Headroom availableNote: Based on latest available shareholding. FII includes NRI also. Source: Ace Equity, RBI, Companies, CLSA

    Figure 7

    Headroom available among private banks

    Note: Based on latest available shareholding. Source: Ace Equity, RBI, Companies, CLSA

    Figure 8

    Foreign shareholding levels and cap in key PSU banks

    Foreign holding Cap CommentBank of Baroda 16% 20% Headroom availableBank of India 11% 20% Headroom availablePunjab National Bank 18% 20% At caution limitState Bank of India 12% 20% Headroom availableNote: Based on latest available shareholding. Source: RBI, Ace Equity, companies, CLSA

    0

    0

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    0 5 10 15 20 25 30

    Axis Bank

    City Union Bank

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    ING Vysya Bank

    IndusInd Bank

    South Indian Bank

    Kotak Mahindra Bank

    ICICI Bank

    Federal Bank

    Yes Bank

    Karur Vysya Bank

    Karnataka Bank

    (%)

    Foreign holding in private banks is capped at 74%

    Among larger banks, ICICI has more headroom

    PNB is the only leading PSU bank at caution limit

  • Headwinds from ownership caps Indian financials

    22 April 2014 [email protected] 4

    Figure 9

    Foreign shareholding levels and cap in NBFCs

    Foreign holding

    Actual Cap HeadroomHDFC 76% 100% 24%IDFC 53% 53% 0%MMFS 42% 49% 8%PFC 11% 24% 13%REC 19% 35% 16%Shriram Trans. Fin. 49% 74% 25%Note: Based on latest available shareholding. Source: RBI, Companies, CLSA

    Figure 10

    Exchange Traded funds own 1-2% in leading Indian financials

    Note: Based on latest shareholding. Source: Bloomberg, CLSA

    Figure 11

    HDFC Bank: Timeline of events and way forward

    Source: Company, RBI, News reports, CLSA

    Figure 12

    Issues facing domestic insurance companies

    NormInvestment in financial sector shouldn't exceed 25% of AUM of Ulip schemes.

    Infrastructure NBFCs are exempt from this limit.

    StatusMost funds are operating very close to the cap.

    Inflows into equity schemes are subdued.

    Impact

    Insurance companies limited scope to increase holding in financials.

    15-20% outperformance by financials may also force insurers to trim holdings.

    Ability of financial companies to raise domestic capital may be constrainedSource: Irda, Reports, CLSA

    0.0

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    IndusInd

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    ICICI

    Yes

    HDFC Bank

    HDFCETF holding in financial stocks

    (% of total)

    Dec-13 Dec-13/ Jan-14 Feb-14 Feb-Now Recently Way forward

    RBI clarifies that cap on foreign holding in HDFC Bank is 49% versus actual holding of 52% (FII 35% and ADR 17%).

    HDFC submits application to FIPB to raise cap on foreign holding to 66%.

    MSCI cuts weight on HDFC Bank from 7-7.5% to 5-5.5%.

    Government evaluting application and whether HDFC Ltd's 23% holding is foreign holding.

    MSCI announces another cut to weight of HDFC Bank from 5-5.5% to 1.7-1.8% from June 2, 2014.

    If HDFC Ltd's holding isnt treated as foreign holding then foreign holding cap can be raised.

    Otherwise, foreign holding in bank will hit regulatory cap of 74%. Bank may explore a domestic issue.

    Among NBFCs, IDFC is at peak FII holding levels

    Conversion into bank will need foreign holding to

    fall to sub 50%

    In addition to ETFs, other passive funds may also

    own 1-2%

    Changes to MSCI weights will force benchmarked

    funds to replicate

    Insurers are constrained from increasing weight on

    Indian financials

  • See Appendix A-1 for Analyst Certification, Important Disclosures and non-US research analyst disclosures. Citi Research is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Certain products (not inconsistent with the authors published research) are available only on Citi's portals.

    22 April 2014 15 pages Asia | India

    India Infrastructure Insights #37 Road to Revival Getting Unclogged Slowly But Surely

    Indias road sector has been in the grip of a long-drawn and deep slowdown due to execution delays, aggressive bidding by developers, project cost escalation, levered balance sheets of developers, and inordinate delay in efforts by NHAI / Government to sort out the impediments to projects execution. As a part of Citis India Infrastructure Tour 2014 we met NHAI, industry experts and road developers to assess prospects for recovery post General Elections 2014. Our conclusions are:

    NHAI well placed to order in FY15E NHAI has been working slowly but steadily on land acquisition, which is one of the thorniest issues holding up project execution. In FY14, NHAIs land acquisition activities increased ~20-40%. Further, the quality of projects getting awarded has improved substantially with ~80% of land being acquired at the time of appointed date.

    Ordering pipeline juicy - but will developers bite? NHAI expects to award ~2300Kms (~Rs150bn) on EPC and ~3300kms (~Rs300bn) on PPP in FY15E. Majority of land acquisitions and approvals for these are already in place. Only question is whether private developers will be willing to take on new projects.

    NHAI construction spending has started increasing Expenditure on NHAI projects till Jan14, at Rs280bn, increased by 15% compared to the same period in FY13. This is an indication of an improvement in actual construction on the ground due to several measures taken by NHAI.

    Building blocks in place to clear road log-jam The scheme to re-schedule premiums has been put in place. NHAI has already started cancelling stalled road projects. After developers take a call on whether or not they want to go for premium rescheduling (and start construction), NHAI will proceed with cancelling and re-tendering of stuck road projects. This much-needed clarity on the final fate of stalled projects gives wings to our optimism.

    But health and risk appetite of developers are stumbling blocks Given stretched balance sheets, developers risk appetite will take time to improve. Our interactions suggest that a combination of (1) improving traffic growth due to industrial revival (2) fresh equity raising (3) equity infusion by financial investors and (4) attractive IRRs due to a sharp decline in competitive intensity should help restore developers financial health, leading to increased risk appetites.

    Road is a sector in which the new government can make a lot of difference Problems in the road sector are already substantially resolved and rather easy to fix. More devolution of decision-making power to NHAI could substantially speed up the work and hasten pace of awards. Besides immediate target award of ~5600kms in FY15E, NHAI reckons that ~16000kms of road projects are yet to be awarded. Further, another ~18000kms of expressways are also being targeted to be awarded.

    Citi Research

    Equities

    Atul Tiwari, CFA +91-22-6175-9866 [email protected]

    Venkatesh Balasubramaniam +91-22-6175-9864 [email protected]

    Vaishnavi G +91-22-6175-9872 [email protected]

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  • India Infrastructure Insights #37 22 April 2014 Citi Research

    2

    On our 4-day India Infrastructure Tour 2014, we met developers (IRB and IL&FS Transportation), senior officials in the National Highways Authority of India (NHAI) and numerous industry experts/ consultants. Our key findings are:

    Activity has been very slow over past 2-3 years

    NHAI awarded ~6800kms in FY12, ~1128kms in FY13. ~1646kms was awarded in FY14, mostly on EPC mode. ~900kms more could have been awarded in FY14 had the election code of conduct not come into force.

    Sharp decline in headline numbers masks improvement in quality of projects being awarded

    While the headline number of kilometers awarded has declined sharply over the past few years, the projects now being awarded are in a much better state of preparedness. The big leap in project awards by NHAI during FY10-FY12 happened because projects were awarded without land / approvals being in place, as developers were eager to pick them up and NHAI was eager to meet its target.

    However, having learned its lessons, NHAI is awarding only projects where the majority of land is in place. ~80% of land is usually available on appointed date. This significantly increases chances that projects which are being awarded now, though fewer in number of kilometers, will get executed faster.

    Significant land acquisition in progress; 2300kms (~Rs150bn) in EPC likely to be awarded in FY15

    NHAI has made significant progress in land acquisition over the past few years. In FY14 ~11,882 hectares of land was notified v/s 8,002 hectares in FY13. Similarly ~8003 hectares was acquired in FY14 v/s 6762 hectares in FY13.

    Expenditure on land acquisition increased to Rs63bn in FY14 from Rs46bn in FY13.

    As a result, NHAI expects to award ~2300kms of EPC projects in FY15E

    NHAI ready with ~3300Kms of BOT projects (~Rs300bn) in FY15E

    NHAI is also ready to award ~3300kms of BOT road projects with a large part of land acquisition already complete. Of course, the actual award will depend on the response to bids from BOT road developers.

    But BOT roads remain clogged due to lack of interest from private road developers

    Despite a huge amount of background work being done by NHAI (land acquisition and clearances), the award of BOT projects has been muted. This is mainly due to a lack of interest by road developers in new BOT road projects.

    In FY14, 21 projects put out by NHAI for bidding did not attract a single bid. This is in stark contrast to the situation 2-3 years ago, when a typical project would attract 15-20 bidders.

    And several BOT projects are stuck due to unwillingness of developers to carry out construction

    Hyper-aggressive financial bids and increase in total projects cost (TPC) due to delays in execution have made several already bid BOT projects financially

    India Roads Road To Revival

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  • India Infrastructure Insights #37 22 April 2014 Citi Research

    3

    unviable. The developers have been hoping for a bailout from government/ NHAI to make these projects commercially viable and start construction.

    Legally, developers seem to be on strong wicket; NHAI too is accommodating due to its own financial gains

    Legally, the developers seem to be on rather solid ground, as in most of these cases it appears that all the conditions precedent to contract award (land/ environmental approval) have not been met / met with much delay by NHAI.

    On the other hand, in the case that these projects are cancelled and re-awarded, the new discovered premiums would be much lower than current premiums and this would impact NHAIs cash flows. As a result, NHAI also seems to be inclined to make these BOT projects work under currently bid premiums.

    However, efforts to make these unviable projects work seem to be failing

    However, the formulae to re-schedule premiums do not solve the underlying problem of BOT projects being unviable in the current environment.

    To be fair, road developers could not have been given much more than what they have received under the formulae, given the current legal environment and public opinion. Also, the blame for quoting the hyper-aggressive bids lies with the road developers.

    Premium rescheduling scheme in essence is a financing from NHAI to road developers at 25-75bps lower interest cost (than available in the market) and with a flexible repayment schedule.

    Premium rescheduling will only make already viable / under construction projects slightly more attractive. Other projects, which are fundamentally unviable, will ultimately have to be scrapped

    As a result, only those projects that are already under construction and that developers have already concluded are viable will benefit from premium rescheduling. Examples of such viable projects which have approached NHAI for premium restructuring are IRBs Ahmedabad-Vadodara and Tumkur-Chitradurga projects.

    Projects in which developers seem to have bid aggressively and that cannot be made to work even after premium rescheduling will ultimately have to be cancelled and rebid.

    NHAI is aware of the issue of fundamental unviability of projects and is going ahead with the cancellation of projects

    NHAI has already cancelled 25-30 projects. Further, NHAI expects that 15-20 projects should approach it for premium re-scheduling. Once this happens, NHAI will proceed to cancel the rest of the projects, in case developers are still unwilling to start the construction.

    We believe that fast progress on this front is essential to unclog the pipeline of BOT projects in the country.

    Good news is that situation is close to getting resolved

    Two factors that have held up the award and construction of new BOT projects are close to getting resolved.

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  • India Infrastructure Insights #37 22 April 2014 Citi Research

    4

    First factor was the decision by NHAI / demand by developers and banks to award projects only with ~80% of land under possession. NHAI seems to have done a lot of ground work on this front and the pipeline of projects seems to be healthy.

    Second factor was what to do with projects which are stuck. With premium rescheduling being finalized, projects will either undergo premium rescheduling or will get cancelled and be re-awarded. Either way, the situation, which has been festering for a long time, will get resolved.

    Lack of new road developers poses some challenges to recovery

    Over past few years, a number of smaller players have vacated the roads sector. Well-established and larger players have their plates full and balance sheets are highly levered (if not stretched).

    In such a scenario, the key question to ponder is even if the above-mentioned problems were to get resolved, who is going to bid for these road projects?

    On our trip, this question was hotly debated. We have to accept that there are no clear answers available as of now. However, some possible options for restoring the financial health of BOT developers are:

    1. A few new projects could be won by current incumbents like IRB and L&T, which have some balance sheet capacity to take on new projects.

    2. Once stock prices rally, hopefully fresh equity could be raised by larger players which would de-lever their balance sheets and re-ignite their appetite for new projects.

    3. There was a near-unanimous view that since competitive intensity has reduced substantially, new projects will have much better IRR; a factor conducive to attracting new interest from participants.

    4. Financial players looking for stable returns over the long term would take-over already operational projects from road developers, freeing equity for new projects. New substitution norms, already in force, should facilitate this process.

    5. As economic growth improves, traffic should improve, leading to more cash flows in road projects. This will lead to equity generation in hands of current incumbents as well as improvement in economic attractiveness of new projects.

    We admit that it is difficult to pin-point which and how of these steps will play out. We believe that the chances are high that a combination of the above-mentioned factors will work in tandem to attract new players to the sector apart from enabling current incumbents to bid for new projects.

    Most of the enabling conditions for the above factors to operate are already in place i.e. NHAI with decent project pipeline and resolution of long pending issues.

    Bank funding situation is not as grim from bottom-up perspective

    Another pressing worry for recovery in the sector is the ability and willingness of banks to fund incremental road projects. This worry has arisen due to capital constraints in the banking system, especially PSU banks which have traditionally been the main source of debt for road (or other infrastructure) projects.

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  • India Infrastructure Insights #37 22 April 2014 Citi Research

    5

    However, the corporates and industry experts that we spoke to have so far not seen any problem in bank lending to new road projects. Of course, lending standards are now tighter, in-house construction margins are being scrutinized more and requirement to bring in equity up-front is being more vigorously enforced. This has stretched timelines required to financially close projects.

    However, for prudently bid projects with land and clearances in place, debt funding is not a concern as per our discussions with industry participants.

    So what would it take on part of new Government to improve things?

    Road stocks have been rallying on the hopes of a more stable and decisive government at the center. But what can the new government do to revive the road sector? Our discussions suggest a 2-pronged approach:

    1. Faster decision-making and giving NHAI more power to make decisions Currently the cabinet approves all PPP road projects one by one and this takes a lot of time. Due to this NHAI has to approach the cabinet 6-8 months before it actually plans to bid out projects and this causes distortions in total project cost (TPC). As a result, devolving power to NHAI board would go a long way to speeding up the things.

    2. More active engagement with State Governments, especially in domain of land acquisition and approval to shift utilities.

    Plenty of projects yet to be awarded if things improve

    According to NHAI, ~16000kms of roads (including 9700km of 2 laning) are still to be awarded. On top of this, ~18000kms of expressways (6 lanes) are also being targeted to be awarded.

    Figure 1. India Infrastructure Comparables

    RIC Code/ Reco Price Mcap P/BV RoE P/E EV/E Rs US$mn FY14E FY15E FY16E FY14E FY15E FY16E FY14E FY15E FY16E FY14E FY15E FY16E L&T Parent Adj Core LART.BO/1 1,322 19,997 2.6 2.1 1.9 14.6% 14.8% 15.4% 23.0 17.8 15.0 15.1 11.4 9.8 L&T Cons LART.BO/1 1,322 19,997 3.3 3.0 2.7 12.6% 15.5% 14.8% 27.5 23.4 19.3 na na na IRB Cons IRBI.BO/1 119 646 1.1 1.0 0.9 13.7% 14.2% 9.9% 8.4 7.4 9.8 6.0 6.1 5.5 Ashoka Buildcon ABDL.NS/NR 99 255 1.3 1.2 1.0 9.3% 8.0% 7.2% 13.6 14.2 14.6 10.9 8.0 5.7 Sadbhav Engineering SADE.NS/NR 134 333 2.2 2.0 1.7 10.5% 12.0% 12.8% 21.4 17.0 13.7 11.2 9.1 7.8 ITNL ILFT.NS/NR 142 574 0.7 0.6 0.6 11.1% 10.5% 11.3% 6.4 6.1 5.5 8.7 7.5 6.2

    Source: Citi Research estimates and Bloomberg Consensus for not-rated (NR) companies

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    Project awards remained subdued

    Project award activity fell sharply in FY13 and the trend continued in FY14 (till January) as well. Projects awarded (BOT+EPC) by NHAI stood at 1,041km in FY14 YTD (till Jan) v/s 1,128km awarded in FY13.

    Figure 2. Projects Awarded By NHAI Subdued in FY14

    Source: NHAI and Citi Research

    Subdued interest despite shift to EPC mode

    Over FY09-13, an overwhelming majority of projects were awarded on BOT (Build-Operate-Transfer) mode. The contribution of projects awarded on EPC (Engineering Procurement and Construction) mode was negligible.

    However in FY13, 16 BOT projects with a total project cost of Rs186bn failed to attract any bids. This led to the award of only 1128kms BOT projects v/s original target of 8800km. As a result, in the beginning of FY14, NHAI targeted to award more than 50% of total FY14E target of 7300km on EPC basis.

    However, NHAI managed to award a mere 1,041km in FY14 YTD (till Jan 14), of which 819km was awarded on EPC basis.

    3,477

    678 374

    1,304

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    1,730 1,219

    643

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    Road Project Status (Till Jan 2014)

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  • Sequoia Capital: Creating Disruptions, and Billionaires W hen Doug Leone arrived in Mount Vernon, New York in 1968, the 11-year-old Italian immigrant didnt have a clue. He flunked a math quiz in school because the terms true and false bewildered him. He wore unsightly slacks from Sears that invited classmates teasing. After school he watched McHales Navy alone on a black-and-white television, hoping to learn colloquial phrases that would help him fit in. A few years later Leone began to get his bearings. I was working on boats as a teenager, sweating like a pig during a summer job, Leone recalls. I could look across and see all the kids at the country clubs swimming pool. The young guys were talking to the girls. And I was saying to myself: I cant wait until I meet you in the business world. You just made your big mistake, letting me in. Ambition. Vulnerability. Vindication. Lots of successful immigrants bottle up those feelings as they rise to prominence. They hide old slights and do their best to blend into Americas aristocracy. Not Leone. Even in his perch as a managing partner at venture firm Sequoia Capital, Leone still carries himself like a hard-luck striver, scrambling for his first decent break. A lot of what keeps me going is fear, he confides. Step inside Sequoias spartan offices at Silicon Valleys capital of capital, Sand Hill Road, and see what happens when a handful of hungry perfectionists like Leone band together. Start at the entryway, packed with framed copies of financing documents for 98 companies. The hit parade begins with Apples initial public offering in 1980; it includes the likes of Oracle, Cisco, Yahoo, Google and LinkedIn. These are Sequoias children. Since its founding in 1972 Sequoia has backed startups that now command a staggering $1.4 trillion of combined stock market value, equivalent to 22 percent of Nasdaq. Yet Sequoia doesnt display its heritage with the well-heeled pride you might find at other top-tier venture firms, let alone the likes of JPMorgan or KKR. At Sequoia the historic IPO filings are crammed into drab, drugstore-quality frames. Sequoia partners dont enjoy luxurious private offices; instead they toil at stand-up desks in a big open hall. Conference rooms are adorned with cheap plastic wastebaskets. Its as if Sequoias partners havent fully realised that they might be rich. The past year Sequoias scrappy methods have produced the firms biggest gains ever. A record nine Sequoia partners appear on the Forbes Midas List of the most successful venture capitalists, thanks to the firms lucrative investment in companies such as Airbnb, Dropbox, FireEye, Palo Alto Networks, Stripe, Square and WhatsApp. At the No 1 spot is Sequoia partner Jim Goetz, who backed WhatsApp in 2011, well before Facebook agreed to buy the mobile-messaging company for $19 billion. Leone ranks No 6, followed by colleagues Michael Moritz, Alfred Lin, Roelof Botha, Neil Shen, Michael Goguen, Bryan Schreier and Kui Zhou. Base pay at Sequoia isnt meant to be dazzling. While the salaries of the firms nine general partners can top $1 million, Sequoia doesnt bother with Wall Street-style guaranteed bonuses, and some of Sequoias more junior partners have taken pay cuts to join. Thats an easy sacrifice to make. The capital gains vastly exceed base pay.

  • Consider Sequoia Venture XI Fund, which in 2003 raised $387 million from about 40 limited partners, chiefly

    universities and foundations. Eleven years later Venture XI has booked $3.6 billion in gains, or 41 percent a

    year, net of fees. Sequoias partners stand to collect 30 percent, or $1.1 billion, while limited partners get 70

    percent, or another $2.5 billion. Look for even more outsize returns from Venture XIII (2010), which is up 88

    percent a year so far, and Venture XIV (2012). The latter two will split the $3 billion or so Sequoia takes home

    from the WhatsApp deal. Add it up and Sequoia is turning its own partners into billionaires while keeping

    outside investors purring.

    Weve hired more than 200 outside money managers since I came here in 1989, says Notre Dames

    investment chief, Scott Malpass. Sequoia has been our number one performer by far.

    Sequoia opened for business in 1972, when Don Valentine, a gruff sales and marketing executive in Silicon

    Valleys chip industry, decided to try his hand at venture capital. The son of a Yonkers, New York truck driver

    (a few miles from where Leone grew up), Valentine was blessed with an eye for mavericks who could launch

    great companies. Youll find him in the history books as the fellow who bankrolled Steve Jobs in 1978, even

    though the 22-year-old Apple founder, by Valentines later account, smelt odd and looked like Ho Chi Minh.

    When Valentine ceded managerial control of Sequoia in the mid-1990s, Moritz and Leone jointly took over.

    Superficially they are nothing alike. Moritz started out as a staff writer for Time magazine; he is an Oxford

    graduate who coins clever phrases all the time. Leone earned a mechanical engineering degree from Cornell

    and then sold computers for Hewlett-Packard, Prime Computer and Sun Microsystems; he curses to get his

    point across. Moritz won a full partnership at Sequoia after barely two years; Leone needed five.

    Yet both fit the Sequoia mould: Feisty, decisiveand ready to back the dentmakers of the world. Every time

    we invest in a little company, its a battle against the odds, Moritz explains. Were always outgunned by

  • companies that are far larger than us, who have threatened us and the founders with extinction. Its incredibly

    thrilling to prove everyone wrong. You cant get a bigger rush than that.

    These days Leone serves as senior partner. Moritz remains an

    active investing partner but shed his administrative duties in

    2012 after being diagnosed with an unspecified illness that, he

    said, could dim his quality of life in the next five to 10 years.

    In a recent interview with Forbes Moritz said that staying as

    fit as possible is the key to everything, adding that he had

    been swimming for 90 minutes early that morning. Asked if

    there was any change in his health outlook, Moritz added:

    Who knows what fate will deliver?

    Sequoias partners hear 200 or more pitches a month, while

    typically funding only two. Regardless of whether a meeting

    ends with yes or no, founders describe their hour with

    Sequoia as one of lifes most intense experiences. Moritz is the

    detective, listening to each detail of a founders story and

    asking a few eerily perceptive questions. Botha, Lin and

    Schreier are the growth hackers, looking for ways consumer-

    oriented startups can rocket ahead even faster. Goguen and

    Goetz are the mechanics, drawing on 25 years apiece of

    experience with enterprise technology companies to gauge a

    startups chances of prevailing.

    Then theres Leone. The boy from Genoa likes to challenge

    founders right away to find out who is tough enough to

    succeed. Tony Zingale, a seasoned Silicon Valley executive,

    recalls a 1990s meeting in which Leone grabbed Zingales

    rsum, flipped it across the desk and snarled: What do you know about running a startup? They bickered for

    10 minutes before Leone declared: Okay, now we know you are a smart m-effer. Now we can have the

    meeting.

    Today Zingale is CEO of Jive Software, a Sequoia-backed provider of enterprise/social software. It doesnt

    matter that Leone can deal out rejections that feel like a punch in the mouth, Zingale says. Slights are forgotten

    fast; Leone regularly speaks of Zingale as part of the Sequoia family. Hes another fiery Italian, so we get along

    well, says Zingale.

    Borge Hald, the CEO and co-founder of Medallia, encountered Leones sharp tongue in 2012, when the

    customer service software company was looking for its first outside capital infusion. Most other venture firms

    were sucking up to us and saying we were so good that they wouldnt change a thing, Hald recalls. Doug

    challenged us. He said that we needed to build our sales efforts in a big way. He said that in a world thats full

    of a struggle between energy and chaos, all we amounted to was entropy. In this case Leones harsh critique

    paid off; Medallia signed with Leone even though passive competitors offered richer terms.

    Part of Sequoias edge with entrepreneurs comes from a willingness to move fast on the best prospects. Pitch to

    Sequoia partners on Monday morning and, if everything goes well, you can have a handshake agreement on

    funding that afternoon. Ask for a term sheet and youll get the essentials on a single page, rather than a long

    Image: Ethan Pines for Forbes

    Sequoia Managing Partner Doug Leone: A lot of what keeps me going is fear.

  • lawyers memo. Among the fans of Sequoias speed is Elon Musk, the CEO of Tesla Motors. Musk remembers

    that in 1999, when he was building what became PayPal, Sequoia wired him $5 million to get started, even

    though lawyers hadnt finished all their paperwork.

    Dont complicate our lives, explains Adi Tatarko, the CEO of Houzz, a home decorating site. She and her

    husband, Alon Cohen, co-founded the site in 2009 and have been racing to build it ever since. When Houzz

    raised money in 2011, another venture firm might have offered a higher valuation. But Sequoia won their

    loyalty, she says, by being very direct and really fast.

    Tatarko and Cohen grew up in Israel, Musk in South Africa, Hald in Norway. A Forbes analysis shows that a

    whopping 59 percent of the startups underlying Sequoias Midas List calculations were built by at least one

    foreign-born co-founder. Put flags in a world map and you will see Sequoia connecting with entrepreneurs born

    in Ukraine, Ireland, Finland, Greece, India, Pakistan, Venezuela and a dozen other countries. (By contrast,

    Kauffman Foundation data show that barely a quarter of all US startups have at least one immigrant co-

    founder.)

    Sequoias ties to Silicon Valleys brightest immigrants are hardly an accident. Italian-born Leone rubs

    shoulders with fellow partners from Wales (Moritz), South Africa (Botha), Hong Kong (Lin) and old-line parts

    of the northeastern US who think of themselves as immigrants, too. Native Californians are rare at the firm.

    Everyone is an outsider, still trying to win acceptanceand successin a new land.

    As a result Sequoias partners dont mind hunting for great new startups in the ratty coffee shops and low-rent

    offices where such companies often are born. Other venture capitalists let success draw them into Pebble Beach

    golf tournaments or the rarefied venues of Davos and Aspen gabfests. We dont go there, Leone says. Thats

    not where the next founders are.

    The venture capital business often seems as strife-torn as a Kardashian marriage. Ambitious younger partners

    feud with old-timers. Battles rage within firms about who is good versus lucky, who deserves a bigger share of

    the profits and who should be booted out. Throw in some personal feuds or indiscreet conduct and pretty soon

    VCs quarrels become a feast for lawyers.

    Sequoia is the long-running exception. Thanks to some unusual quirks in the firms hiring habits, everyday

    work practicesand paySequoia has been able to stay harmonious and rejuvenate its leadership as needed,

    without any fuss. Older partners cash out. New ones take their place. The firm runs in line with Leones idea of

    a big Italian family: Lots of personalities, plenty of back-and-forth but a determination to stick together no

    matter what. Women? Sequoia has none in top US investment roles but says it hopes to hire one someday.

    We want people who come from humble backgrounds and have a need to win, Leone says. And we want a

    culture where people continuously share credit. Sequoia does hire some recent business school graduates to

    serve as nonvoting junior partners. But the firms bigger partnership slots go to seasoned tech executives like

    Alfred Lin (Zappos), Bryan Schreier (Google) or Omar Hamoui (AdMob). These men are known quantities;

    they have worked for years at one of Sequoias portfolio companies.

    Schreier, for example, pitched three of his own startup ideas to Sequoia in 2008. Moritz didnt like any of

    themparticularly a hastily conceived idea about making phones with big buttons so that elderly people could

    use them. But, as Moritz now recalls, the best thing about Bryan was Bryan. The big-button phones could

    wait. Sequoia regarded Schreiers earnest, self-effacing personality as just right for the firm itself.

    Sequoias partners gather each Monday at 8 am to debate investment prospects and review existing portfolio

  • companies. Unwritten house rules reward the humble. Its about getting to the right decision, rather than

    being right yourself, says Jim Goetz. If you talk for more than 90 seconds at a time, adds Aaref Hilaly, a new

    partner (ex-Clearwell), youve probably gone on too long.

    Unlike Wall Streets activist investorswho agitate for big shakeups that might rocket stock prices upward in a

    single daySequoias partners help companies relentlessly with the little stuff that will never warrant a press

    release. When WhatsApp was having trouble hiring engineers, Goetz met at least half a dozen candidates and

    their spouses for dinner, where he reassured them that this low-key startup really did have a bright future.

    When Stripes 23-year-old co-founder, John Collison, wanted help pitching his companys payment services to

    a big East Coast financial company, Sequoias Moritz walked him through two rehearsals, sharing ideas about

    how to sharpen up the story.

    When Sequoia partners sweat the details with startup founders, much of the conversation involves tidbits of

    tribal knowledge picked up during the 42 years of firm history. Dropbox, for example, regularly invites

    Sequoia partner Bill Coughrana former head of engineering at Googleto share thoughts about how to keep

    expanding without creating hair balls of complexity.

    On a recent visit Coughran leaned back in a plastic chair and reminisced about the four big engineering needs

    of Googles search division, at a time when ranking seemed thrilling and indexing seemed dreary. Didnt

    anyone want to index? Yes, Coughran said: The moment he talked about Googles desire to crank up its

    indexing capabilities 30-fold over the next several years, indexing suddenly became exciting, too. Dropboxs

    head of engineering, Aditya Agarwal, smiled. Now he had a new tactic to get people excited about Dropboxs

    quests, too.

    Founders push back if Sequoia tries to offer too much advice. Nir Zuk, the founder of Palo Alto Networks, a

    computer security company, says hes told Goetz: If you want to work for me as a product manager, Id hire

    you in a heartbeat. But you cant come to board meetings every six weeks and tell me you know more than our

    full-time product managers do. It just doesnt work that way. Overall, though, Zuk says that what he likes most

    about Sequoia is that its partners are fellow entrepreneurs who have gone through what were going through.

    They understand us.

    Sequoia doesnt always get it right. In the dot-com bust of 2000 the firm suffered big losses from duds such as

    eToys and Webvan, an online grocer. More recently it sank $25 million into failed photo app Color, which

    ended up selling at a loss to Apple. Even in Venture XI, the fabulously successful 2003 fund, Sequoia ran up

    more than $100 million of losses on startups that turned out to be, um, shutdowns.

    Periodic losing investments come with the territory. What vexes Sequoia much more are the meetings with

    tomorrows legendary founders, when, at the end of the pitch, the firm somehow ends up saying no instead of

    yes. Pinterest slipped awayand so did Twitter. In 2007 Sequoia had a chance to take a 10 percent stake in

    Twitter when the fledgling site was valued at just $20 million. (Twitters market cap today is more than 1,000-

    fold higher.)

    Live and learn. Sequoia investors put on their hair shirts in 2011 and tried to identify a fixable mistake in their

    Twitter analysis. Their conclusion: They had been too stubborn about seeking their ideal target of a 20 percent

    to 30 percent stake in startups. Twitter CEO Jack Dorsey had wanted to sell only a smaller amount. In

    hindsight, says Botha, Sequoia should have agreed. Going forward, partners now are willing to take smaller

    stakesat higher than usual priceswhen an extraordinary startup is in play.

  • The worst misstep happened in 2006, when Facebook founder Mark Zuckerberg taunted Sequoia by showing

    up late at a meeting, wearing pajama bottoms, to discuss an eccentric side business called Wirehog. The farcical

    presentation was a way of sticking it to Sequoia, author David Kirkpatrick later reported. (Zuckerberg at the

    time was taking advice from fellow entrepreneur Sean Parker, who had his own gripes with Sequoia.) Snub

    accomplished, Zuckerberg won funding from Accel Partners instead, in a deal that eventually produced about a

    300-to-1 payoff for that venture firm.

    Today relations with Facebook have been mended; since 2012 the big social network has paid top dollar for two

    Sequoia-funded companies, Instagram and WhatsApp. Even Moritz, who suffered through the pajama

    presentation, insists that it only deepened his appreciation of Zuckerbergs pluck. At the end of his slide

    show, Moritz recalls, he had this slide saying: A Mark Zuckerberg Production. I remember privately

    admiring the bravado and self-confidence to insert that line. I would never have had the courage to do that at

    his age.

    Other venture capitalists salute Sequoias results, though they cant resist the temptation to quibble a bit with

    its style. Theres a ton of respect, says David Sze of Greylock Partners. We are both completely dedicated to

    creating huge successful outcomes to change the world. They are a little more acerbic; we are a little more

    collaborative.

    Years ago, when Kayak co-founders Steve Hafner and Paul English were pitching their travel search engine,

    Hafner asked Sequoias partners to help him test the service by offering up airport codes (such as JFK or SFO).

    When Leone hesitated, some wag interjected: Doug doesnt know any. He flies private. The comment was a

    sly dig at superthrifty Leone, who did most of his flying on United at the time and had just agreed, with some

    trepidation, to rent a few hours of private jet service annually, via NetJets. But Hafner didnt know this. He was

    put off his game, and the presentation sputtered. The two were initially turned down before English returned

    uninvited a day later and convinced the firm to give Kayak a second look.

    Theres a stereotype in Silicon Valley that venture capitalists become unhelpfully harsh when companies are

    stumbling and are in too much of a hurry to cash out when things are going well. Sequoia, however, turns those

    tenets upside down. CEOs such as Brad Peters of Birst, a business-intelligence software company, say Sequoia

    gives them time and guidance to sort out snags. But Sequoia becomes insatiable when it sees a company doing

    well and believes that it could be doing even better.

    At a recent San Francisco dinner with a dozen CEOs of portfolio companies, for example, Sequoias Lin asked

    how many attendees used a technique called net promoter scores to gauge customer enthusiasm. Just about

    everyones hands shot up.

    Now, how many of you look at why your ratings come in the way they do? he asked.

    Only if the numbers are bad, one CEO replied.

    Why dont you look at them when something goes right? Lin shot back. That was a key part of the winning

    formula at Zappos during his time there as chief operating officer. Do more of what dazzles your happiest

    customers, and CEOs can turn strong expansion into hellacious growth.

    Sequoia is equally stubborn about maximising gains from its top-performing companies. (Back in 1979 Sequoia

    sold its Apple stock after holding it for just 18 months, and Sequoia partners arent about to make that mistake

    again.) Unlike other venture firms, which run their limited partners investment funds for 10 years, Sequoia

  • often looks for ways to extend its partnerships lives for as much as 16 or 17 years. Sequoia held its Google stock

    for nearly two years after that company went public; it held onto Yahoo even longer in the 1990s.

    An especially intense test of Sequoias willingness to buy and hold involves ServiceNow, a software company

    providing help-desk services to corporate customers. In July 2011 an unexpected suitor offered to buy the

    company for $2.5 billion. Sequoia had become a significant investor in late 2009, leading a $41 million

    investment round, with Leone joining the board. Cashing out at that point would have brought Sequoia about a

    10-to-1 return on its investment.

    Most of ServiceNows directors thought the offer was intriguing. Only Leone regarded it as insulting. Rallying

    some of his colleagues, he worked up a 12-page analysis arguing that directors would be giving away the

    company, even at a $4 billion valuation. To his eye, even though ServiceNow was early in its growth curve, its

    participation in the fast-growing software-as-a-service sector made it a company with vastly better potential

    than outsiders could see.

    After some debate ServiceNows directors turned down the offer. A year later ServiceNow went public and

    attracted a $2 billion valuation. Leones disdain looked a bit of, until ServiceNow shares took off post-IPO.

    Current market value: $8.3 billion.

    Simple math says that Leones stubbornness made nearly $6 billion more for ServiceNows shareholders,

    including company founder Fred Luddy. But its more primal than that: People like Leone still remember those

    rich kids at the swimming pool, enjoying the easy life. Theres no reason to slow down until old rivals are left

    far in the dust.

    How Sequoia Solved China

    American venture firms have a mixed record starting Chinese franchise funds. New Enterprise Associates has

    kept only a modest footprint since entering the market in 2003. Kleiner Perkins has seen a wave of partner

    turnover since 2007. Not Sequoia. Since 2005 its China hands, Neil Shen and Kui Zhou (on the list at 33 and

    81, respectively), have guided each of the first three funds to better returns than the last (its 2007 fund is up 33

    percent a year; the 2010 fund is up 37 percent), while racking up wins such as Qihoo 360, Vipshop and IPO-

    bound JD.com. The secret? Diversity of bets (LED makers, wealth management, fast food) and Shen himself.

    One of Chinas early web moguls as co-founder of travel site Ctrip.com, Shen is aggressive and well connected.

    He recruits cold-call pros to sniff out potential portfolio companies and nurtures a formidable network of

    founders. Says Jenny Lee, a managing partner at rival firm GGV Capital: Among the franchise funds its only

    Sequoia. Many havent worked out very well, and this is the one that actually has. My view is its because of Neil

    Shen.

  • INVESTMENT MANAGEMENT

    APRIL 2014

    Connecting the Dots

    The Widening FunnelOver the past few weeks, markets have almost exclusively obsessed over one thing the upcoming General elections. Frankly, we are nauseated by the way every discussion at work or a conversation at social gathering quickly derails into one about politics. The amount of bandwidth invested in analyzing vote-shares and swings, possible alliance math, voter turnout ratios, opinion polls and psephologists views is understandably huge. But whats disconcerting is the growing opinion that this election result will have binary consequences- it will either set us on to a multi-year bull run or else descend the economy and markets into an irreparable chaos. As always, we feel that the truth lies somewhere in the middle.

    Its a worthwhile exercise to look at diverse high-frequency indicators as a sort of a dashboard for the economy. In most developed countries one would get an aggregate Lead Economic Indicator (LEI) index with some predictive power for economic health but in India we dont have that luxury. The idea of the dashboard is to look for signs of improvement or growth that can point towards a stabilizing economy with a few green shoots. We show a representative panel (Display 1) with some indicators that are improving; some that are getting less bad while others that continue to deteriorate. Electricity generation is clearly improving and so is consumer inflation while corporate margins are stabilizing and steel production growth is getting less bad. Commercial vehicle sales and same store sales growth for urban consumption proxies continue to deteriorate.

    AUTHORS

    AMAY HATTANGADIExecutive DirectorMorgan Stanley Investment Management

    SWANAND KELKARExecutive DirectorMorgan Stanley Investment Management

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  • 2CONNECTING THE DOTS

    We understand the limitations of this approach one, these are at best co-incident and not leading indicators and two, they may not be fully representative of the entire economy but nonetheless are good starting points to understand the emerging contours of growth. When growth gets concentrated in only a few sectors, as was the case in India for past few years, money rushes into these

    small oases causing what investors call an earnings re-rating. This narrow funneling of the market also shows in concentrated outperformance of stocks of the Nifty 50 stocks, only 30% (i.e. 15 stocks) outperformed the overall benchmark in 2013 down from almost 60% of them outperforming the benchmark in 2009 and a decadal average of about 50% (Display 2).

    Display 1: Macro Dashboard of Economic Indicators

    2Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14

    3

    4

    5

    6

    7

    8

    9

    10

    Gross Electricity Generation growth 12m MA (%) LT average (%)

    Electricity Generation

    A. Improving

    4Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

    6

    8

    10

    12

    Headline CPI (%)

    Consumer Price Inflation

    10Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

    12

    14

    16

    18

    20

    22

    24

    India ex Fin ex oil EBITDA Margin (%) LT average (%)

    Corporate Margins

    B. Getting Less Bad

    -5Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14

    0

    5

    10

    15

    20

    25

    Steel Production growth 3m MA (%) LT 3m average (%)

    Steel Production

    -40Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-13Jan-12 Jan-14

    -20

    0

    20

    40

    60

    80

    CV Sales growth 12m MA (%) LT average (%)

    Commercial Vehicle

    C. Deteriorating

    -10

    1Q11

    2Q11

    3Q11

    4Q11

    1Q12

    2Q12

    3Q12

    4Q12

    1Q13

    2Q13

    3Q13

    4Q13

    1Q14

    2Q14

    3Q14

    0

    10

    20

    30

    40

    50

    Same Store Sales Growth (SSSG) %

    Quick Service Restaurant - SSSG

    Note: Jubilant FoodWorks Ltds data is used as a proxy for urban consumption.

    Source: CMIE, Company Data, Jefferies.

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  • 3THE WIDENING FUNNEL

    Display 2: The Narrowing of OutperformanceUniverse: Nifty Index

    Number of stocks out-performing Nifty

    % of stocks out-performing Nifty

    2009 29 58%

    2010 23 46%

    2011 23 46%

    2012 22 44%

    2013 15 30%

    Source: Bloomberg, Morgan Stanley Research.

    The economy we feel is in the process of gradually bottoming out but growth is neither going to roar back nor be even-paced across various sub-sectors. This obviously has investing implications, specifically for the erstwhile darlings that have been beneficiaries of a significant re-rating in a growth scarce environment. Some leading stocks in the Consumer Staples (FMCG) sector have reported remarkably steady operating profit growth, in the range of 18-20% over the past few years, however, the high valuations ascribed to these stocks are not independent of growth opportunities available elsewhere. When growth was plentiful like in 2009, investors accorded these stocks a forward Price-Earnings Ratio (PE) of about 20 times but in growth-scarce periods like 2013, a similar earnings profile was worth its weight in gold with a PE of 30 times or higher (Display 3).

    Display 3: Consumer Sector Re-rating

    0%

    5%

    10%

    Q4F

    09

    1QF1

    0

    2QF1

    0

    3QF1

    0

    4QF1

    0

    1QF1

    1

    2QF1

    1

    3QF1

    1

    4QF1

    1

    1QF1

    2

    2QF1

    2

    3QF1

    2

    4QF1

    2

    1QF1

    3

    2QF1

    3

    3QF1

    3

    4QF1

    3

    1QF1

    4

    2QF1

    4

    3QF1

    4

    15%

    20%

    25%

    30%

    Plentiful growthenvironment

    5x

    10x

    15x

    20x

    25x

    30x

    Growth scarceenvironment

    4Q MA EBIT PE (RHS)

    Note: EBIT and PE data is of a leading Consumer Staples company.Source: Company Data, Morgan Stanley Research, Data as of Mar. 31, 2014.

    We stumbled across an interesting parallel in the world of cricket. When India scored less than 100 runs in a Test innings, Rahul Dravids contribution to the total was almost 20%.1 One can easily imagine this run-scarce scenario - generally on testing overseas pitches where one man stands up to the challenge. As run-getting gets easier, say for instance when India makes between 300 to 400 runs in a Test innings, Dravids contribution falls to about 11% of the team total - these are most likely dry and flat wickets at home where other batsmen hog the limelight. Its not that Dravid does poorly in these run-fests but the conditions are better suited to a different batting style. Something similar plays out with Hindustan Unilever (HUL) as well. In a tough environment, where the market is trading at a PE of 12-13 times, HUL commands a multiple of over 28 times. As money-making gets easier with market PE normalizing to 15-16x, HUL loses some of its relative sheen. Display 4 shows how HUL behaves like the Rahul Dravid of the markets!

    Display 4: Rahul Dravid and Hindustan Unilever

    24

    25

    26

    12 to 13x 13 to 14x 14 to 15x 15 to 16x

    27

    28 HUL PE

    Sensex PE

    Runs

    HUL Vs. Sensex

    10

    12

    14

    1 to 100 101 to 200 201 to 300 301 to 400

    16

    20

    R Dravid runs as % of team total

    18

    Source: Bloomberg, Company Data, espncricinfo.com, Barclays Research. HUL data from Jan. 2006 to Aug. 2012; Rahul Dravid data from June 1996 to Jan. 2012.

    1 For all Test innings in which Rahul Dravid batted for India. He scored 23 runs in 2 innings playing for ICC World XI which is not included here.

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  • CONNECTING THE DOTS

    2014 Morgan Stanley 7863758_CH

    www.morganstanley.com/indiamf

    Important Disclosures:

    As a part of Compliance disclosure, Amay Hattangadi and Swanand Kelkar hereby declare that as of today, [including our related accounts] we do not have any personal positions in the securities mentioned above. However, one or more Funds managed by Morgan Stanley Investment Management Private Limited may have positions in some of the securities mentioned in the missive.

    The opinions expressed in the articles and reports on the website are those of the authors as of the time of publication. We have not undertaken, and will not undertake, any duty to update the information co