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STRATEGY

Demergers and alpha generation

March 2015

Saurabh Mukherjea, [email protected]: +91 99877 85848

Analysts:

Consultant: Anupam [email protected]

Gaurav Mehta, [email protected]

Nitin [email protected]

Pankaj Agarwal, [email protected]

Bhargav [email protected]

Rakshit Ranjan, [email protected]

Strategy

March 10, 2015 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

Strategy: Demergers and alpha generation………………………………………. 3

Section 1: The case for spin-offs……………………………………………………. 4

Section 2: Not all demergers are born Equal…………………………………….14

Tata Global Beverages (NOT RATED)…………………………………………….. 21

Voltas (SELL)………………………………………………………………………….. 25

Sadbhav Engineering (UNDER REVIEW)…………………………………………..29

Ashoka Buildcon (BUY)………………………………………………………………33

Bajaj Electricals (SELL)………………………………………………………………. 37

Banks & Financial Services…………………………………….…………...……... 41

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Demergers and alpha generation

History shows that demergers and spin-offs in India have huge upside potential provided they are not misused by promoters to sort out family and balance sheet issues. Investors play the demerger theme before, rather than after, corporate actions. Backed by sound business reasoning, demergers and spin-offs can generate significant alpha. Recent press reports also suggest that Nifty giants, L&T and ITC, could be restructured. In this thematic, we provide a framework to assess demergers and detail compelling case studies – SBI, HDFC, ICICI, Tata Global Beverages, Sadbhav, Ashoka Buildcon and Bajaj Electricals – that offer opportunities for serious value creation.

The case for spin-offs In India, big-bang demergers and restructurings are announced by large business families that, at times, also have unresolved family issues. Spin-offs can go beyond this and provide investors new businesses to pick and choose from. Spin-offs can also break conglomerate discounts and potentially provide financial prosperity to the parent as well as independence to the spun-off unit. In 2015, Max India and the Adani Group have announced restructuring plans. More importantly, recent press reports indicated that two of India’s largest conglomerates, and Nifty heavyweights – L&T and ITC – could also see major restructuring of their large and diversified businesses. A carve-out is better Between carving out an existing business unit and listing a non-related subsidiary, we prefer carving out a growing business that has become large enough to stand on its own. Whilst listing non-related subsidiaries is also useful, carve-outs show a management’s openness to change. In both cases, we emphasise the importance of minority interests. Complicated spin-offs that aim to shortchange minorities might work in bull markets but can leave the parent’s share price trading at a management discount. What past price performance tells us Investors play the demerger theme a year prior to the announcement (10% median outperformance to the Sensex for our set of 73 transactions made by BSE500 companies in the past decade). There is alpha, albeit modest, also to be made between the announcement date and ex-date as well (1% median outperformance). However, post-transaction, the combined market capitalisation of the parent (excluding the hived-off business) and newly listed companies has underperformed the Sensex on a one-year (-4%), two-year (-6% CAGR) and three-year (-10% CAGR) basis. Our favoured, compelling break-up themes In this note, we provide eight compelling break-up themes where our analysts believe there is value to be unlocked. These cover the Banking and Financial Services (BFSI) sector (HDFC, ICICI Bank and SBI), consumer sector (Tata Global Beverages through Starbucks, Voltas in room ACs), and infrastructure sector (road assets of Sadbhav Engineering and Ashoka Buildcon and Bajaj Electricals’ E&P business). The instinctive tendency of many market participants - who might be interested in these names or in the mega-demergers being mooted for ITC and L&T – will be to say that “the value of a pizza cannot increase just because you are now slicing the pizza up into smaller slices” but what this thematic shows – using copious amounts of data – is that if a demerger results in the pizza being divided in a specific way – say the veg parts go to one side and the non-veg parts to the other side – the value of the pizza does increase.

THEMATIC March 10, 2015

Strategy

Potential demerger candidates Tata Global Beverages (Spin-off: Starbucks)

Our stance: NR

Target Price: NA Upside: NA

Voltas (Spin-off: Room Air Conditioners Business)

Our stance: SELL

Target Price: `157 Downside: 41%

Sadbhav Engineering (Spin-off: Road Assets)

Our stance: UR

Target Price: UR Upside: NA

Ashoka Buildcon (Spin-off: Road Assets)

Our stance: BUY

Target Price: `184 Upside: 4%

Bajaj Electricals (Spin-off: Engineering and Projects)

Our stance: SELL


SBI (Spin-off: SBI Life)

Our stance: SELL


HDFC (Spin-off: HDFC Life)

Our stance: SELL


ICICI Bank (Spin-off: ICICI Pru Life)

Our stance: UR

Target Price: UR Upside: NA

Source: Bloomberg, Ambit Capital research

Consultant

Anupam Gupta

[email protected]

Analyst Details

Saurabh Mukherjea, CFA Tel: +91 99877 85848

[email protected]

Strategy


Section 1: The case for spin-offs In this section, we lay the background of demergers in India, after which we argue the case for demergers and the two forms they can take (carve-outs and subsidiary listing). We posit that carve-outs are better than listing subsidiaries because they strengthen the perception of management among investors. We end the section by highlighting the potential setbacks that result from demergers.

‘‘The days of the joint family are over. Families realise that if they can’t manage jointly, it is better to split. The joint family structure of business management is outdated.’’

- Dwijendra Tripathi, eminent historian (2008) (Source: http://www.business-standard.com/article/companies/the-changing-face-of-family-business-splits-110083100086_1.html)

Demergers – A background Business families – Fertile ground for demergers

Business families and conglomerates have been a hallmark of India Inc. Even today, out of the 40 non-BFSI stocks in the Nifty, 15 belong to prominent business families.

Exhibit 1: Major business families feature prominently in the Nifty

Company Family Market Cap (̀ bn) Weight in Nifty (%)

Reliance Industries Ambanis 2,873 4.7

TCS Tatas 5,379 4.5

Tata Motors Tatas 1,721 3.5

M&M Mahindras 752 2.0

Hero Moto Munjals 524 1.1

Bajaj Auto Bajaj 908 1.1

Ultratech Cement Birla 614 1.0

Tata Steel Tatas 630 0.8

Sesa Sterlite Agarwal 338 0.8

Grasim Ind Birla 357 0.8

Zee Ent Subhash Chandra 316 0.7

Hindalco Birla 328 0.6

Tata Power Tatas 228 0.5

Cairn Agarwal 458 0.5

Jindal Steel & Power Jindals 173 0.2

Source: NSE, Ambit Capital research. Note: Market capitalisation is as of 4 March 2015; weight in Nifty is as per NSE website for February 2015.

These business families have a long history of diversification, both related and unrelated to the core business. For example:

Reliance Industries began with textiles in the late seventies and pursued a strategy of backward vertical integration (polyester, fibre intermediates, plastics, petrochemicals, petroleum refining, and oil & gas exploration and production). In the noughties, it also diversified into telecom (Reliance Infocomm which was spun off to Reliance Communications of the Reliance-ADA Group and now Reliance Jio in the Reliance-MDA Group) and retail (Reliance Retail, a subsidiary of Reliance Industries).

The Tata Group has a huge empire spanning diverse industries such as IT, steel, and automobiles. Within these companies as well, there have been diverse businesses in the past (for example, Tata Steel’s cement business was sold to Lafarge in 1999).

Business families continue to occupy center-stage in the Nifty

Business families in India have been through their fair share of restructurings

The Reliance Industries and Bajaj Auto restructurings divided assets within the family

http://www.business-standard.com/article/companies/the-changing-face-of-family-business-splits-110083100086_1.html

Strategy


Conglomerates – Spinning off diversified businesses

Conglomerates in India have also expanded in many areas that appear unrelated to their core business:

L&T and ITC have diverse businesses within the listed parent. L&T has separately listed its financial services business and, in the past, has sold its cement business to the Birlas. ITC’s non-cigarette businesses include hotels, paperboards, IT as well as branded packaged foods.

L&T also stands out as an example of a diverse business under a single listed parent, eyed by raiders for its cash flow and attractiveness of individual units. In 1987, Manu Chhabria had attempted to wrest control of L&T. Reliance Industries acted as a temporary white knight in the 1990s and eventually, after a protracted battle, sold its stake to Grasim in 2001. Ultimately, in 2003, L&T sold its cement business to the Birlas in exchange for their stake in the company, bringing to an end a nearly two-decade-long corporate battle. Since then (2003-2015), L&T’s stock price has risen at a CAGR of 33% vs 20% for the Sensex.

More recently, media reports indicate that both L&T and ITC – which have a combined weight of 11% in the Nifty – could undergo restructuring. In case of L&T, when asked whether it would make sense to split the company into separate units and list them, Chairman AM Naik said, “That is what we will do. We have plans for L&T Infotech. In time, L&T will be 55 per cent of its size, as the holding company and the rest will be part of the overall group. All I am saying is seven companies will either be merged or listed, and that it is significant.” (Source: http://www.business-standard.com/article/companies/no-private-project-will-take-off-at-such-high-interest-rates-115030401072_1.html) (Please note that the emphasis is ours). We estimate that L&T’s non-core businesses of L&T Infotech (`174/share), L&T Finance holdings (`60/share) and L&T’s Realty subsidiaries (Seawood and L&T Realty Limited) account for 18% (`254/share) of our target price on L&T of `1,374/share.

Similarly, in case of ITC, British American Tobacco’s (BAT - which currently holds 32% stake in ITC) recent open offer for its Brazilian subsidiary, sparked speculation that BAT was possibly considering a strategic event for ITC as well. This could drive ITC to separate its non-tobacco businesses. A media report (Source: http://www.btvin.com/videos/watch/11403/itc-restructuring:-6-new-entities#tab1) suggested that ITC could be broken up into six separate entities (FMCG, hotels, agri, packaging, infotech, paperboards and specialty paper). ITC's non-tobacco businesses contribute approximately 40% to the company's Gross Sales and 15% to the company's EBIT.

Reasons for a demerger (1) Demergers can be driven by family splits

In the noughties, one of the key reasons for corporate restructuring and demergers was a split within business families. Two high-profile demergers were Reliance Industries (2005) and Bajaj Auto (2006). In case of Reliance, its power generation and distribution, financial services and telecommunication services businesses were demerged into four separate entities. Existing shareholders in Reliance Industries were given one share each of the four newly hived off companies. Out of these four, whilst Reliance Energy and Reliance Capital were already listed, Reliance Communications and Reliance Power were eventually listed. The hived-off businesses were controlled by the Reliance–Anil Ambani Group (R-ADAG), whilst the listed parent, Reliance Industries, remained with the elder brother, Mukesh Ambani.

Both L&T and ITC could see restructuring of their non-core businesses in the near future

L&T has been a target due to its well-managed, cash-generating assets

http://www.business-standard.com/article/companies/no-private-project-will-take-off-at-such-high-interest-rates-115030401072_1.html

http://www.btvin.com/videos/watch/11403/itc-restructuring:-6-new-entities#tab1

Strategy


Exhibit 2: The Dhirubhai Ambani Group split is the largest ever in India

Demerged Company Listed Company Market Cap today (̀ bn)

Reliance Communication Ventures

Reliance Communications (listed in February 2006) 166

Reliance Energy Ventures

Reliance Infra (earlier Reliance Energy and includes BSES, acquired earlier)

125

Reliance Capital Ventures Reliance Capital

114 Global Fuel Management Services

Reliance Power (merged with Reliance Natural Resources and listed in March 2007)

169

Source: BSE, Ambit Capital research; Note: Priced as of close of business on 4 March 2015

In case of Bajaj Auto, the listed business was restructured into three parts in 2007. The original business (Bajaj Auto) formed two subsidiaries: Bajaj Holdings and Investments (investments in group companies, surplus cash and equivalents) and Bajaj Finserv (wind power project and investments in the insurance companies). The existing shareholders of Bajaj Auto were given one share each of the two subsidiaries, which were listed in 2008. Whilst the elder brother, Rajiv Bajaj handles the automotive business at Bajaj Auto, his younger brother, Sanjiv Bajaj, heads the financial services business at Bajaj Finserv.

Exhibit 3: Bajaj Auto split its businesses between Rajiv Bajaj and Sanjiv Bajaj

Listed Company Market Cap (̀ bn)

Bajaj Auto 614

Bajaj Holdings 155

Bajaj Finserv 234

Source: BSE, Ambit Capital research; Note: Priced as of close of business on 4 March 2015

Other family restructuring efforts that followed the Reliance Industries and Bajaj Auto demergers included the OP Jindal Group (2009), the Rama Prasad Goenka Group (2010) and the Munjal Group (2010).

(2) Demergers can be driven by potential for value creation The business case for a demerger stems from providing flexibility and independence to the management of the hived-off business as well as an opportunity to grow balance sheets independent of the parent. Wipro, in 2012 and, more recently, Crompton Greaves announced the demerger of their consumer businesses from the listed parents that were in unrelated businesses. Parent companies can thus use spin-offs to unlock value for themselves as well as free the spun-off unit to fully explore its own growth potential. Demergers are also relevant in case of conglomerates and companies with many subsidiaries. L&T had 138 subsidiaries, 13 associates and 17 joint venture companies, as at 31 March 2014. M&M, with a core automotive business, had 118 subsidiaries, 7 joint ventures and 14 associates, as at 31 March 2014. Both L&T and M&M have a history of demerging and listing their subsidiaries. As mentioned earlier, L&T has separately listed its financial services business and, in the past, has sold its cement business to the Birlas. M&M has listed non-core subsidiaries, such as Tech Mahindra, as well as restructured its listed auto component businesses such as Mahindra CIE.

Exhibit 4: The Mahindra Group has a history of spin-offs

Company Market Cap (̀ bn) Comment

M&M Financial Services 146 IPO in 2006

Mahindra CIE 65 Listed companies - Mah CIE (prev. Amforge) and MUSCO

Mahindra Holidays 24 IPO in 2009

Mahindra Lifespace 21 Merger between GESCO (listed) and Mahindra Realty

Tech Mahindra 691 IPO in 2006

Source: Company, Ambit Capital research; Note: Priced as of close of business on 4 March 2015

Businesses are split from the listed parent company…

…and listed post family settlement

Demergers can set free the managements of growing businesses

Conglomerates in India have a complex network of businesses, often unrelated to the listed parent

Strategy


Case Study – ICI (UK) Restructuring in 1993

Thanks to the pursuit of new avenues for growth in the 1980s, Imperial Chemical Industries (ICI) had a diverse portfolio of businesses that had become increasingly difficult to handle. The company then became the target of a hostile takeover in 1991 by Hanson, as the true value of its best businesses was not adequately reflected in its valuation.

In 1993 ICI, Britain’s largest manufacturer at one time, and now owned by AkzoNobel, demerged its pharmaceuticals and agrochemicals into a separate company called Zeneca (subsequently merged with Astra to form AstraZeneca).

In a 1995 Harvard Business Review column, ‘Why ICI chose to Demerge,’ Geoffrey Owen and Trevor Harrison wrote:

“ICI’s problem wasn’t an unusual one. Changes in markets and technologies had overtaken the logic that held the component businesses together and bound them to the corporate parent. The parenting skills on which ICI’s earlier success had been based were no longer appropriate.” (Source: https://hbr.org/1995/03/why-ici-chose-to-demerge)

As ICI expanded its product profile and geographical presence, the older chemicals businesses in the portfolio weighed on the growing profitability of the pharmaceuticals business. Under a restructured ICI, both divisions were able to better pursue growth opportunities and unlock value. The column goes on to note the post-restructuring success:

“So far the demerger of ICI has been a clear financial success. The injection of new equity, a necessary ingredient to the restructuring plan, came in June 1993 with a £1.3 billion stock issue for Zeneca. In December 1994, the market capitalization of the two companies combined stood at £13.2 billion, compared with the £7.6 billion valuation of old ICI in July 1992, the time of the demerger announcement. Adjusted for the stock-issue proceeds, the combined valuation has increased by 57%, compared with 25% for the Financial Times Stock Exchange 100 index. “

The American experience has been along similar lines. The Schumpeter Blog in the Economist (http://www.economist.com/news/business/21577034-tips-creating-new-companies-out-old-ones-art-spin ) quotes the following data from Forbes Magazine:

“American companies completed more than 80 spin-offs worth at least $500m each between 2002 and 2012. The parent companies (or “spinners”) have delivered a return of 35%, compared with 22% for the S&P 500. The “spun” have delivered a return of 70%. Returns for firms in the Bloomberg Spin-Off Index were 47% over the past 12 months compared with 16% for the S&P 500.”

Benefits of a demerger Benefit 1: Demergers can lead to improved valuations

“The parent organization is an intermediary between investors and businesses.” - Andrew Campbell, Michael Gool and Marcus Alexander in Harvard Business Review (March 1995) (Source: https://hbr.org/1995/03/corporate-strategy-the-quest-for-parenting-advantage)

In the above article, the authors say that the parenting framework is an important tool in corporate strategy. This framework focuses on the competencies of the parent organisation and on the value created by the relationship between the parent and its businesses. The authors suggest that in cases where there is no fit between the parent’s skills and resources and the needs and opportunities of the businesses, the parent is likely to destroy value.

ICI, once Britain’s largest company, was broken up to form Zeneca, which is a pharma major today

Spin-offs work well when the parent skills do not fit with certain businesses within a company

https://hbr.org/1995/03/why-ici-chose-to-demerge

http://www.economist.com/news/business/21577034-tips-creating-new-companies-out-old-ones-art-spin

https://hbr.org/1995/03/corporate-strategy-the-quest-for-parenting-advantage

Strategy


Against this backdrop, we move to the valuation case for demergers. A large number of subsidiaries and the lumping of different businesses create distortion in the valuation of the listed entity. In the process, the underperforming business prevents the outperforming business from getting a full and fair market valuation. For example, pre-demerger, the valuation of Bajaj Auto’s core auto business would be masked by the high share of non-operating income in its earnings. Analysts would then resort to ‘ex-cash, core automotive business’ valuations as well as ‘sum-of-parts’ valuations (to which they would obviously apply a holding company discount).

Exhibit 5: High share of non-operating income for Bajaj, pre-demerger

(̀ mn) FY05 FY04

Dividends 330 261

Interest on debentures and bonds 606 690

Interest on government securities 1,281 492

Interest on inter-corporate deposits and others 104 126

Income from mutual fund units 24 580

Profit on sale of investments 1,457 1,113

Others 30 9

Total Non-operating income 3,832 3,271

Non-operating expenses (80) (374)

Net non-operating income 3,752 2,897

PBT 10,864 9,604

Net non-operating income (% of PBT) 34.5 30.2

Source: Company, Ambit Capital research

More recently in 2014, Crompton Greaves decided to demerge its consumer business from the listed parent company. As can be seen in the exhibit below, Crompton’s consumer business was significantly more profitable than its power and industrial businesses (in spite of the fact that the power and industrial businesses accounted for around 40x more capital employed than the consumer business).

Exhibit 6: Crompton Greaves’ consumer division will soon be demerged

FY14 (̀ bn) CG Power CG Consumer CG Industrial Systems

Net Sales 84.8 28.5 18.2

EBIT 2.3 3.4 1.3

Capital Employed 39.0 1.2 9.5

ROCE (%) 6.0 278.5 13.5


By unbundling units, spin-offs allow investors to select which business they want to invest in and which ones they want to avoid. In the process, demergers provide transparency and clarity on the valuations of the independent spun-off business vis-à-vis the same business that was previously embedded within the listed parent. Investors can then focus on the specific business of the hived-off entity which is independent of the parent. Thus, with a demerger, the spun-off entity can attract new investors and new capital for its core business.

In this context, Bill Huyett’s and Tim Koller’s research on spin-offs, published in the McKinsey Quarterly in August 2011 (Source: http://www.mckinsey.com/insights/corporate_finance/finding_the_courage_to_shrink) states:

“The real reason spin-offs are so valuable is tied to expected performance: increased valuations reflect the market’s expectation that performance will improve at both the parent company and the spun-off business once each has the freedom to change its strategies, people, and organization. Indeed, of the 85 spin-offs associated with a major restructuring of a company globally since 1992, spun-off businesses nearly

Lumping of different business creates distortion in the valuation of the listed entity

Crompton’s consumer business requires significantly less capital as compared to its other divisions

Spin-offs can provide new themes for investors

http://www.mckinsey.com/insights/corporate_finance/finding_the_courage_to_shrink

Strategy


doubled their growth rates and increased their operating profit margins by a median of 1.6 percent over five years. Among parent companies, profit margins increased 11 percent in the first year after the spin-off and an additional 3.5 percent by the fifth year. Also, one academic study concluded that spin-offs improve the allocation of capital, because researchers observed changes in strategy among spun-off businesses. They found that higher-profit businesses tended to increase their investment spending, while lower-profit ones tended to cut it.” (Note that the emphasis is ours.)

Huyett and Koller further note that spun-off companies can attract better-quality managerial talent as well, another key positive for the business as well as for investors:

“Spun-off companies may also attract more desirable management talent. In 2007, Tyco International split itself into three companies: Covidien, Tyco Electronics, and the original Tyco International. Shortly after the spin-off, then-CFO Chris Coughlin described the advantages, reporting that the health care business, Covidien, had made significant strides in attracting new talent that would probably not have been attracted to the old Tyco.”

Benefit 2: Addressing the conglomerate/holding company discount

The conglomerate or holding company discount is a subjective discount (an arbitrary number often between 15% and 20%) given by investors to the organisational structure of a company. The discount reflects investor concerns regarding the way minority interests would be treated within the overall corporate structure. It has nothing to do with the profitability of the listed parent's various businesses and subsidiaries. In terms of valuations, spin-offs can break the holding company/conglomerate discount that the parent’s stock suffers from.

Depending on how the businesses are structured, companies can use two methods:

Carving out operations: In this case, the business unit likely originated as a diversification that seemed logical to the management when it made the decision to diversify. It could either be a fully-owned subsidiary or a strategic business unit. As time goes by, the business becomes large and independent enough to be given a management and funding of its own. At this point, the management can decide to spin off the unit.

Listing unrelated, independent subsidiaries: This scenario is appropriate for companies with a large number of subsidiaries in diverse businesses that have few synergies with the listed parent, other than sharing the brand name. For example, as mentioned earlier, M&M has a history of listing its subsidiaries with businesses as diverse as real estate (Mahindra Realty), Information Technology (Tech Mahindra) and travel (Mahindra Holidays). Similarly, in 2011, L&T listed its first subsidiary, L&T Finance Holdings.

Benefit 3: Driving financial prosperity for parent and child

Demergers also provide an opportunity for the parent to raise funds by selling, in part or full, its stake in the demerged business. The parent can then use the funds for deleveraging its own balance sheet. Thus, spin-offs can potentially unlock financial prosperity for the parent and provide independence for the hived-off business.

Whilst this prosperity exists in theory, real life examples of meaningful deleveraging are hard to come by. This is because of promoter’s reluctance to sell their stakes in the spun-off business and use the funds to improve the balance sheet strength of the listed parent. Instead of selling down their stake to raise funds, Indian promoters cling on to their stakes and even find innovative ways to increase their control, as discussed later in this section.

Spun-off companies can also attract better-quality managerial talent

Conglomerate discounts reduce the overall value for the listed parent

Businesses that have become large enough to stand on their own can be spun off…

…as can independently run subsidiaries in unrelated businesses

Promoters can use demergers to sell their stake and repair their balance sheet from funds raised

Strategy


Two methods to demerge - Carve-outs and listing non-core, unrelated subsidiaries Method 1: Carve-out

Whilst both methods provide value unlocking opportunities, carving out a business unit from within a company is better than listing an unrelated subsidiary. This is because: (a) the demerger gives the business unit freedom to find and fund its own growth path; and (b) the perception of management improves as it is shown to be flexible and open to change and new ideas.

We provide examples of two big carve-outs that have worked:

(1) Marico demerged its skincare business, Marico Kaya, into a separately listed company in 2013. We compare the management philosophy during the diversification and following the demerger.

Marico’s FY2002-03 annual report explained the entry into skincare as follows: “Kaya Skin Clinic would attempt to fill the existing needs gap in the Skin Care Services business in India in this area. Marico would seek to create a differentiation as a corporate service provider offering safe, efficacious and credible Skin Care Services range at multiple locations backed by medical procedures & technology.”

Nearly a decade later, explaining the demerger of the skincare business, Mr. Harsh Mariwala, Chairman of Marico, said in an interview: “After all it was our FMCG roots which provided a stronger foundation in the consumer insights area. It was this self-belief on which we entered the skin care business. I do not see any room for self-doubt. It is a matter of tweaking the execution and hopefully the new entrepreneurial way of running the business will yield better results." (Source: http://www.thehindubusinessline.com/companies/why-marico-shed-its-kaya-skin/article4400584.ece)

When it was demerged, Kaya accounted for 7% of Marico’s revenues and reported a loss of `291mn at the PBIT level in FY12. However, the franchise had aggressive growth plans (smaller outlets called Kaya Skin Bars at half the cost of a regular skin clinic). By carving out Kaya from the listed parent, Marico has given independence to the skincare business (including finding strategic investors) and created a new investment opportunity (retail skincare chain) for investors interested in the theme.

Post demerger, the combined market capitalisation of Marico (ex-Kaya) and the newly listed Marico Kaya has outperformed the Sensex by 21% over one year and 27% CAGR over two years.

(2) Sun Pharmaceuticals demerged its innovative R&D business (covering the New Chemical Entity and New Drug Delivery System programmes) into a new company in 2006.

Explaining the rationale, the management said that its innovative R&D business had "tremendous potential for growth and long-term profitability." After nurturing the business in its initial years, the company's management believed that the business had reached a stage where it required “focused organisation”. Since the demerger took effect on 23 April 2007, the sum of the combined market capitalisation of Sun Pharma (ex-SPARC) and newly listed SPARC has outperformed the Sensex by 8% on a one-year basis, 19% on a two-year CAGR basis and 10% on a three-year CAGR basis.

Carve-outs must be executed transparently

An important caveat to our case for a carve-out is that management intent should be honest. There should be absolutely no corporate governance questions surrounding the demerger. Demerging profitable units only to retain, indeed increase, control through a separate, promoter-held company is a sham and will be called out as one. Unfortunately in India, promoters are overly attached to their businesses and resort to namesake demergers, likely as a ploy to play the expected stock price rally before the announcement. Investor activism is rising in

Marico’s entry into and exit from Kaya were grounded in its background in the FMCG business

Sun Pharma’s innovative R&D unit was spun off at an inflection point of growth

Upholding high standards of corporate governance is critical to make spin-offs work

http://www.thehindubusinessline.com/companies/why-marico-shed-its-kaya-skin/article4400584.ece

Strategy


India and we expect increased investor protests over such questionable corporate practices that negatively impact minority interests. We provide an example of Texmaco Limited’s transaction that raised issues over minority interests.

Texmaco demerger

On 23 February 2010, Texmaco’s Board of Directors approved the demerger of its heavy engineering and steel foundry divisions (along with all the assets and liabilities) into a new entity, Texmaco Machines Limited (TML), which was later renamed, Texrail.

All shareholders of Texmaco Ltd were issued 1:1 share ratio in Texrail to make the shareholding of TML a mirror image of Texmaco. However, the mirror image shareholding was done only for 70% of Texrail. Texmaco Infrastructure and Holding Ltd continues to hold the balance 30% of TML shares. Indirectly the promoters (Saroj Poddar and affiliates) exercise undue power on Texrail, as the Texmaco parent’s 30% voting rights will go to the promoters.

Whilst we agree with the point of value unlocking (highlighted in the management’s quotes below), the only rationale we see is that the promoter gets extra voting rights of 30% in Texrail as the majority shareholder in Texmaco Holdings.

"The two businesses of the company namely engineering and real estate, are in different stages of growth. The engineering business is well established and is poised to achieve greater heights with the development of railway infrastructure in the country. The real estate business, on the other hand, is at a fairly nascent stage. The valuations attributable to these businesses are driven by vastly different parameters. I believe that the separation of these businesses will unlock shareholder value by enabling greater management focus in each of the companies."

- Saroj Poddar, chairman of Texmaco (24 Feb 2010)

"The fund requirement for both the engineering and the real estate businesses differ significantly in both timing and quantum and the nature of investors that would prefer to participate in each of these businesses are also different. The de-merger will enable investors to participate in the business of their choice. It would also enable the management to raise funds in an efficient manner."

- Ramesh Maheshwari, Vice Chairman, Texmaco Ltd (24 Feb 2010)

Method 2: Listing non-core, unrelated subsidiaries - Improves parent perception

Companies can also choose to list subsidiaries that have become meaningfully large on their own accord. This method is applicable to large conglomerates like the Mahindra Group and L&T. As mentioned earlier, L&T had 138 subsidiaries, as at 31 March 2014, whilst M&M had 118 subsidiaries. Not all of these are relevant to the listed parent’s business. In all probability, investors are already using a theoretical sum-of-parts valuation and a holding company discount for the listed parent in the absence of any clarity as to when the listed parent would list the large subsidiaries.

A listing of the subsidiary breaks this holding company discount and provides investors an opportunity to invest separately in the newly listed subsidiary. In the process, it also improves corporate governance standards and perception of management (subject to fairness to minority interests). Thus, a listing strengthens the quality of valuation to the parent to the extent that there is a publicly available value to the listed parent’s holdings.

For example, in case of M&M, 40% of its market cap comprises market value of its investments. This transparency helps in the valuation of the core automobile business. If M&M had not listed these subsidiaries, the sum-of-parts would remain a theoretical exercise with no clarity on when the management would list its non-automobile holdings.

In the Texmaco demerger, the promoter ended up with extra voting rights

Listed parents with unlisted, large subsidiaries attract holding company discounts

Listing a subsidiary provides a market value for the parent’s investments

Strategy


Exhibit 7: Listed subsidiaries aid sum-of-parts valuation for M&M

Company Market Cap (̀ bn) M&M Share M&M Share (̀ bn)

M&M Financial Services 146 51% 75

Mah CIE 65 20% 13

Mahindra Holidays 24 75% 18

Mahindra Lifespace 21 51% 10

Tech Mahindra 691 27% 185

Market value of M&M's stakes 301

M&M - Parent Market Cap (`bn) 753

Source: Ambit Capital research, BSE, Company. Note: Priced as of close of business on 4 March 2015

The case against demergers Putting demergers in perspective

“Divestitures and spinoffs are the ugly stepchild of corporate strategy.”

– Emilie R Feldman, Assistant Professor of Management, The Wharton School, University of Pennsylvania (Source: http://knowledge.wharton.upenn.edu/article/hp-and-the-case-for-corporate-spinoffs/)

As a concept, demergers and spin-offs are relatively new outside of the US. At the London School of Economics’ (LSE) Center for Economic Performance (CEP), Thomas Kirchmaier noted that, “Demergers are an American invention of the 1920s and have been a common feature in America since the 1950s. In 1980, Geoffrey Howe, then British Chancellor of the Exchequer, introduced tax incentives for demergers to facilitate the de-conglomeration of British industry.” (Source: http://cep.lse.ac.uk/centrepiece/v06i1/kirchmaier.pdf).

In 2014, in the US, demergers were on the rise led by high-profile tech breakups (HP and Symantec splitting their operations and eBay spinning off Paypal). Until November 2014, the number of spin-offs was 30% higher than the whole of 2013 (Source: http://www.newyorker.com/magazine/2014/11/03/le-divorce-2). Since it was constituted in 2003, the Bloomberg Spin-off Index (which tracks 42 stocks over US$1 billion that were spun-off from US companies) has delivered a 21% CAGR vs 7% for the Dow Jones Industrial Average.

Exhibit 8: Spun-off companies have beaten the Dow over 2003-2015

Source: Ambit Capital research, Bloomberg; Note: Indices have been rebased to 100 starting from 1 January 2003.

So far we have made the business and valuation case for demergers and spin-offs. To avoid falling prey to a confirmation bias, we look at evidence against demergers. In a 2011 blog post, Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, summarises the costs of breaking up (Source: http://aswathdamodaran.blogspot.in/2011/09/breaking-up-is-easy-to-do.html):

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Demergers and spin-offs are relatively new outside the US

Even within the US, demergers were on the rise in 2014

Demergers can also result in loss of economies of scale and synergies as well as reduced access to capital

http://aswathdamodaran.blogspot.in/2011/09/breaking-up-is-easyto-do.html

http://knowledge.wharton.upenn.edu/article/hp-and-the-case-for-corporate-spinoffs/

http://cep.lse.ac.uk/centrepiece/v06i1/kirchmaier.pdf

http://www.newyorker.com/magazine/2014/11/03/le-divorce-2

Strategy


“1. Loss of economies of scale: Combining businesses into a company can create cost savings. Thus, a group of consumer product businesses may benefit from being consolidated into one unit, with shared advertising and distribution costs. Breaking up with result in a loss of these savings.

2. Reduced access to capital (and higher cost): If external capital markets (stock and bond) are undeveloped or under stress, combining businesses into a consolidated company can provide access to capital. How? The excess cash flows from cash rich businesses can be used to finance reinvestment needs in cash poor businesses.

3. Lost synergies: I am generally a skeptic about synergy but it does exist. In some multi-business companies, businesses feed off each other's successes, thus making the whole greater than the sum of its parts. Disney is a good example, especially in its kid-oriented products: its movie business generates opportunities for its licensing businesses and increases revenues at its theme parks. Separating Disney into independent movie, toy and theme park businesses will result in a loss of these benefits.”

In India, the concept of spin-offs has caught on only in the past two decades, with the biggest corporate restructuring, Reliance Industries, taking place in 2006. As explained earlier, promoters have resorted to demergers as a tool for settling family issues or untangling complicated business structures. Shareholder pressure has seldom been the driver of demergers in India largely because it is difficult to mount hostile takeovers in India due to the way Indian takeover law is written. Under Indian takeover law, any external investor whose stake in a listed entity exceeds 25% has to make an open offer for the rest of the business. In contrast, this limit is 30% in the UK, 33% in France and 50% in Indonesia. In the US, acquirers simply have to file disclosures under SEC law when they purchase more than 5% of a targeted company. In the absence of hostile takeovers – and assuming the absence of family disputes – an Indian promoter is unlikely to voluntarily demerge his most-promising subsidiary from his parent entity. As Emilie Feldman of Wharton says, “They (divestitures and spinoffs) are viewed as acknowledgements of failures, bowing to pressure from investors and competitors.” Promoters would thus be loath to admit that a past decision has gone astray and prefer to let a poorly performing unit feed off the better-performing unit. Besides being resistant to change, CEOs are reluctant to consider disruptive restructuring exercises, especially those that involve laying off employees. As we show in the next section, not all demergers succeed in unlocking value.

Shareholder pressure has seldom been the driver of demergers in India

No significant motivation for promoter in India to voluntarily demerge a promising business

Strategy


Section 2: Not all demergers are born equal "A spinoff is attractive when it is done under duress."

- Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University (Source: http://www.sba.pdx.edu/faculty/danr/danraccess/courses/fin449/Damodaran_interview_motley_fool_August05.pdf)

Our analysis of BSE500 stocks that demerged their business units reveals that Alpha is generated only close to the announcement. For the sample set of 73 transactions of BSE500 companies that have spun-off and listed their units in the past ten years, the median outperformance of 10% for the parent’s stock price occurred only one year prior to the announcement. The ‘announcement effect’ generated median outperformance of 1% for the parent’s stock price (in the 12 months following the announcement of the demerger). That said, post demerger outperformance boils down to company-specific transactions. On a median basis, the ‘sum of parent and spun-off parts’ (i.e. the combined market capitalisation of the newly spun-off unit plus the parent that trades excluding the spun-off unit) underperforms the Sensex across one year (-4%), two years (-6% CAGR) and three years (-10% CAGR).

Methodology

In the past decade, 73 demergers and spin-offs declared by BSE500 companies resulted in the listing of the demerged/spun-off unit. We analysed the price performances of these corporate actions and divided them across three periods:

Pre-announcement effect - One-year, two-year and three-year price performance of the parent stock before the announcement of the spin-off vs the one-year, two-year and three-year price performance of the Sensex. We provide an example of Zee Entertainment Enterprises in the exhibit below.

Exhibit 9: Zee’s stock outperforms the Sensex one year ahead of the split

Day of announcement 1yr prior 2yr prior 3yr prior

29/03/2006 29/03/2005 29/03/2004 28/03/2003

Zee stock price (`) 76 42 41 21

% change in Zee’s stock price 80.7 36.1 52.9

Sensex 11,183 6,368 5,571 3,115

% change in Sensex 75.6 41.7 53.1

% Over/(under) performance 5.1 (5.6) (0.2)

Source: Ambit Capital research, Bloomberg, Capitaline. Note: One-year performance is absolute, two-year and three-year performance is CAGR

Announcement effect - Absolute price performance of the parent stock between date of announcement and one day before the ex-date (i.e. last day of the parent stock trading as a combined unit) vs absolute price performance of the Sensex during the same period. We provide an example of Polaris Consulting below.

Exhibit 10: Polaris’s stock price benefits from the announcement effect

Day of announcement Ex-date

18/03/2014 09/10/2014

Polaris stock price 153 248

% change in Polaris’ stock price 61.8

Sensex 21,833 26,247

% change in Sensex 20.2

% Over/(under) performance 41.6

Source: Ambit Capital research, Bloomberg, Capitaline. Note: Price performances are on absolute basis.

Alpha is generated only close to the announcement

Pre-announcement effect captures investor anticipation ahead of the announcement

Announcement effect captures the investment opportunity before the listing of the new units

http://www.sba.pdx.edu/faculty/danr/danraccess/courses/fin449/Damodaran_interview_motley_fool_August05.pdf

Strategy


Post-demerger effect - We compare the market capitalisation of the parent on the last day of trading as a combined entity with the combined market capitalisation of the sum of the parts (i.e. parent plus newly listed spun-off stocks) over a one-year, two-year and three-year period. We compare this price performance with the Sensex over the corresponding one-year, two-year and three-year period to arrive at the out/underperformance. Thus, we exclude transactions where the spin-off has not yet resulted in a new listing (for example: Wipro’s consumer business, IDFC’s recently announced new entity for banking, etc.). Similarly, we exclude transactions where the spun-off entity was eventually delisted (for example, Nagarjuna Fertilizers stock was delisted in 2003) or acquired (for example, Samruddhi Cement was merged with Ultratech in 2010). Finally, we only include those transactions where the stock price performance of the parent and newly listed spun-off stocks is available for a period of one year and above (for example, we exclude Polaris’s spin off of Intellect Design Arena where the spun-off company was listed in 2014). For the post-demerger effect, we have used market capitalisation of the combined entity (parent post demerger and spun-off entities) instead of stock prices. This is for the sake of simplicity and to account for split ratios. Given the wide variation in returns, we have used median, instead of average, returns across all three periods. We provide an example of Bajaj Auto below.

Exhibit 11: The sum of Bajaj Auto’s parts beats the Sensex hollow

Ex-date 1yr after 2yr after 3yr after

Market Capitalisation (̀ mn) 13/03/2008 13/03/2009 15/03/2010 15/03/2011

Parent - Bajaj Auto 212,593 Bajaj Holdings & Investments - demerged 22,529 58,985 78,418

Bajaj Auto – demerged 75,250 264,713 395,261

Bajaj Finserv – demerged 20,950 47,738 75,532

Combined Market Capitalisation 212,593 118,729 371,436 549,211

% Change in Market Cap (44.2) 32.2 37.2

Sensex 15,357 8,757 17,165 18,168

% Change in Sensex (43.0) 5.7 5.8

% Over/(under) performance (1.2) 26.5 31.5

Source: Ambit Capital research, Bloomberg, Capitaline. Note: One-year performance is absolute, two-year and three-year performance is CAGR.

Based on the above framework, our analysis shows:

Pre-announcement: 10% outperformance but only on a one-year basis

A 10% median outperformance for a year prior to the date of announcement indicates that investors begin anticipating the news of the spin-off. This could be driven by statements of intent made by the management in the press or in analyst/investor interactions. Thus, by the time the management holds a board meeting to approve the spin-off, the news has been discounted in the stock price.

However, over a longer two- and three-year prior period, the stock prices of parent stocks underperform the Sensex. This could be driven by the poor performance of the business and where applicable by the lack of clarity on the restructuring of the company.

For example, the spin-off of Wipro’s consumer division has been discussed in the investment community since the late 1990s whilst the actual division was done only in 2012. Wipro’s stock price underperformed the Sensex on a one-year, two-year and three-year basis a year prior to the announcement in 2012.

Post demerger effect captures the sum-of-parts value

Stock prices run up in anticipation of corporate action

Strategy


Exhibit 12: Median out/(under)performance of the parent stock to Sensex ahead of the demerger announcement


Announcement Effect: Median outperformance of a modest 1%

The announcement effect lasts for the period between the announcement of the demerger and the last day of trading for the parent stock as a combined entity. The duration of this period depends on completion of the legal formalities for the transaction, including holding shareholder meetings and getting court approvals. For the 73 transactions in our study, this period lasted for a median of 272 days.

During this period (approximately one year), median outperformance of the parent stocks over the Sensex was a modest 1%. We believe this announcement effect Alpha indicates that returns are peaking and investors would prefer cashing out of the parent stock before it goes ex-transaction.

Post demerger effect: Consistent under-performance to the Sensex

On a post-transaction basis, the parent stock and the newly listed hived-off units – in total – underperformed the Sensex on a one-year, two-year and three-year basis.

Exhibit 13: Median out/(under) performance of the parent and newly listed stocks to the Sensex after the demerger announcement


Instead of concluding that demergers don’t work, we believe the correct takeaway for this data would be that only well-planned demergers work. Bad businesses would continue to produce bad results even after the demerger, whilst good businesses would grow in value with transparency in valuations. For example, in case of Bajaj Auto (refer to Exhibit 11 above), the core auto business and financial services have taken separate paths of growth and succeeded in unlocking value.

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Before ex-date as well, there exists an opportunity for Alpha

Post demerger, the price performance is business- and stock-specific

Century Ply’s valuation had a dramatic rerating post demerger

Strategy


Within midcaps we highlight two examples. First, the demerger of the ferro alloys and cement division of Century Plyboards into Star Ferro and Cement which was listed in 2013. This demerger improved the quality of Century’s core plyboard business earnings and hence valuations.

Exhibit 14: Century Ply’s post demerger rerating beat the Sensex

Ex-date 1yr after Latest

Market capitalisation (̀ mn) 17-07-2013 17-07-2014 04-03-2015

Parent - Century Ply 12,919 Century Ply – demerged 18,996 53,488

Star Ferro & Cement 11,209 36,170

Combined Market Capitalisation 12,919 30,204 89,658

% Change 133.8 228.2

Sensex 19,949 25,561 29,381

% Change 28.1 26.8

% Over/(under) performance 105.7 201.4

Source: Ambit Capital research, Bloomberg Capitaline. Note: One-year performance is absolute, latest (i.e. from ex-date until recent stock price is on CAGR basis.

Second, Orient Paper demerged its cement business in 2011. This demerger improved the visibility of the paper and consumer durables business of Orient Paper whilst providing a new, listed cement business for investors interested in the cement sector.

Exhibit 15: Orient's perception also improved post demerger

Ex-date 1yr after Latest

Market Capitalisation (̀ mn) 06-03-2013 06-03-2014 04-03-2015

Parent - Orient Paper & Industries 14,873 Orient Paper –demerged 2,766 4,251

Orient Cement – demerged 8,820 38,044

Combined Market Capitalisation 14,873 11,585 42,295

% Change (22.1) 68.9

Sensex 19,253 21,514 29,381

% Change 11.7 23.6

% Over/(under) performance (33.9) 45.3

Source: Ambit Capital research, Bloomberg, Capitaline. Note: One-year performance is absolute, latest (i.e. from ex-date till recent stock price is on CAGR basis)

Investors are indifferent to demergers of businesses that will remain weak irrespective of demergers. In 2011, Essar Shipping Ports & Logistics demerged into Essar Shipping and Essar Ports. Post-transaction, the combined market capitalisation of the three businesses has underperformed the Sensex.

Exhibit 16: Essar demerger has failed to outperform the Sensex Market Capitalisation (̀ mn) Ex-date 1yr after 2yr after 3yr after

17/05/2011 16/05/2012 16/05/2013 16/05/2014

Parent - Essar Shipping, Ports & Logistics 58,459 Essar Ports – demerged 36,531 37,975 28,540

Essar Shipping – demerged 6,034 4,843 3,397

Total 58,459 42,564 42,818 31,937

% change in Market Cap (27.2) (14.4) (18.3)

Sensex 18,137 16,030 20,247 24,122

% change in Sensex (11.6) 5.7 10.0

% Out/(under)performance (15.6) (20.1) (28.2)

Source: Ambit Capital research, Company, Bloomberg. Note: One-year performance is absolute, two-year and three-year performance is CAGR.

Similarly, Orient’s paper and consumer durables business saw a rerating post demerger

Stock price performance post a demerger tends to reflect the core strengths of the business

Strategy


Note that the RoCEs for Essar Ports and Essar Shipping have not improved much (refer to Exhibits 17 and 18). Exhibit 17: Whilst Essar Ports’ RoE has risen…

Source: Ambit Capital research, Capitaline

Exhibit 18: ….Essar Shipping’s RoEs have remained dismal

Source: Ambit Capital research, Capitaline

A checklist before demerging

As shown earlier, all demergers and spin-offs do not work and investors typically play the pre-announcement theme rather than wait for the post-demerger story to play out. To navigate through the decision-making process, we have prepared a checklist for promoters and CEOs to consider before choosing a demerger. We believe that if all the 15 questions can be answered in the positive, there should be a strong case for the management to consider hiving off its business unit.

Exhibit 19: The demerger checklist

Question Reply

Business related 1 Is the business unit (BU) in an area of business largely unrelated to the parent? 2 Is there visible growth potential for the BU? 3 Can the BU manage this potential growth without the support of its parent? 4 Does the BU have the potential to generate RoCEs and RoEs that are higher than its

cost of equity? 5 Are the BU's RoCEs and RoEs much higher than that of the parent? 6 Is the BU independently funded to a large extent, i.e., can it raise funds on its own

balance sheet?

7 Is the BU independent of the parent for day-to-day operations, with no visible synergies?

8 Does the BU have its own independent CEO, CFO and top management? 9 Can the BU attract better talent if hived off? 10 Is the BU significantly free from any regulatory issues that negatively impact the

parent? 11 Is the overall promoter holding structure in the listed stock clear and simple? 12 Is the listed parent stock the main business of the promoter? 13 Does the management have a track record of high dividend payouts, buybacks, etc? 14 Has the management been known to accept failure and cut loss-making decisions? 15 Is the promoter free from litigation and regulatory issues? Source: Ambit Capital research

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Our demerger checklist covers key aspects to consider before considering a demerger

Strategy


Demergers to watch out for

We believe there are compelling businesses that qualify for a demerger from their parent unit. We list below recently declared demergers as well as a few potential demergers that have been discussed in the media.

Exhibit 20: Demergers in the news

Company Demerger /restructure/ IPO planned Comment

Max India Three verticals, namely: (a) Life Insurance, Health, (b) allied business, and (c) other investment activities

To be executed

Adani Group Port and power business to be spun off; Adani Ent to focus on mining and Transmission business to be listed

To be executed

Crompton Greaves

Crompton Consumer Products to be hived off into a separate company To be executed

HDFC IPO for HDFC Life Likely after clarity on Insurance Bill

ICICI Bank IPO for ICICI Prudential Life Insurance Likely after clarity on Insurance Bill

SBI IPO for SBI Life Likely after clarity on Insurance Bill

Bajaj Electricals Hiving off its Engineering and Projects business No clarity

Tata Motors Listing of Jaguar & Land Rover overseas No clarity

Havells Listing of Sylvania overseas No clarity

Bharti Listing of Africa business Recently denied by management

Source: Ambit Capital research, Media Reports

In the next section, we look at some of the above possible spin-offs as well as other compelling case studies that we believe are potential candidates for a demerger or spin-off.

An upturn in the economy and improved investor sentiment should drive more demergers in the next 2-3 years

Strategy


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Key financials – consolidated (` mn) Year to March FY11 FY12 FY13 FY14

Net Sales 60,032 66,400 73,510 77,376

EBITDA 6,081 6,231 7,685 7,519

EBITDA (%) 10.1% 9.4% 10.5% 9.7%

EPS (`) 4.1 5.8 6.0 7.8

RoE (%) 5.6% 7.3% 8.9% 6.4%

RoCE (%) 8.1% 8.1% 9.8% 8.3%

P/E (x) 38.1 27.2 25.9 20.1


Tata Global – Second-largest player in branded tea globally Tata Global Beverages (TGB) is the second-largest tea player globally, with a presence in over 70 countries. It has reported 11% revenue CAGR over the past ten years supported by acquisitions in key markets (Tetley in 2000, Good Earth in 2005 and Eight O’Clock Coffee in 2006). In 2012, TGB entered into a 50:50 JV with Starbucks to open retail stores in India.

Healthy cash generation but weak margins over the last decade In FY14, the company’s consolidated revenue was at `77.4bn, 91% of which relates to branded products with the balance relating to plantation of tea, coffee, pepper, etc. The geographical split of its revenues includes 33% from India, 21% from the UK, 27% from US/Canada, and 19% from RoW. TGB’s EBITDA margins declined from 17% in FY07 to 9% in FY12 and have remained almost flat in the last two years. The sharp decline in EBITDA margins over the past decade was due to: (a) product mix deterioration; and (b) raw material inflation not fully passed through given lower product pricing power and lower bargaining power against the channel. TGB had a healthy cash conversion ratio (pre-tax CFO/EBITDA) of ~140% in FY02-08. However, this has slightly moderated in FY09-14 to ~84% due to an increase in its working capital requirements from ~6% of sales in FY02-08 to ~20% in FY09-14. It generated positive free cash flows of `3.5bn in FY14.

Tata-Starbucks JV likely to deserve a rich valuation after 2-3 years

The Tata-Starbucks JV opened 12/30/21 outlets across India in FY13/FY14/9MFY15. Howard Schultz, the global CEO of Starbucks, had mentioned 18 months ago that the company was planning to open “a thousand stores in India in the not so distant future”. Given the fast pace of new store openings for Tata Starbucks so far, the firm can achieve a store count of ~200 in India by end-FY18 with an average revenue per store of ~`20mn.

We believe that the Tata-Starbucks JV is likely to attract a valuation multiple of 3-4x sales in FY18 due to the following: (a) ~25% expected CAGR of organised QSR industry size for India; (b) strong aspirational brand recall for Starbucks; and (c) proven track record of Tata Group around execution of expansion including in retail (Titan). Hence, we expect the value unlocking potential from a possible demerger of Tata-Starbucks JV to be equivalent to `6.0bn-8.0bn (i.e. 6-8% of the current market cap of Tata Global Beverages).

We believe that TGB will be incentivised to do such a demerger after another 2-3 years due to: (a) separate allocation of balance sheet capital towards business expansion; and (b) segregation of management responsibilities for the Tata-Starbucks JV so that management bandwidth is NOT constrained in a rapidly expanding business model.

Valuation We do not have a stance on TGB. It is currently trading at 19.8x consensus FY16 P/E, a 45% discount to the average P/E multiple of FMCG companies.

COMPANY INSIGHT TGBL IN EQUITY March 10, 2015

Tata Global BeveragesNOT RATED

Analyst Details Rakshit Ranjan, CFA +91 22 3043 3201 [email protected]

Ritesh Vaidya +91 22 3043 3246 [email protected]

Consumer Staples: Beverages

Recommendation Mcap (bn): `98/US$1.6 3M ADV (mn): `348/US$5.6 CMP: `158

Flags Accounting: AMBER Predictability: AMBER Earnings Momentum: RED

Catalysts

Management commentary around demerger possibility for Tata Starbucks

Announcement regarding export of coffee beans from Tata Starbucks to Starbucks stores across Asia

Performance


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Exhibit 1: EBITDA margins and revenue growth over the last ten years (consolidated)


Exhibit 2: RoCE and RoE over the last ten years (consolidated)


Exhibit 3: Operating cashflow and free cashflow over the past ten years (consolidated)


Exhibit 4: TGB has maintained a healthy store opening rate for Starbucks


Exhibit 5: Forward EV/EBITDA over the past five years


Exhibit 6: Forward P/E evolution over the past five years


Exhibit 7: Explanation for our flags

Segment Score Comments

Accounting AMBER In the past, TGB has reported high cash conversion and efficient management of working capital. However, the working capital has deteriorated slightly due to higher inventory and loans and advances. Consequently, we have assigned a lower rating to the quality of its accounting.

Predictability AMBER The price volatility of its key products (tea and coffee) and weak pricing power affect the predictability of its sales and EBITDA over the longer term.

Treatment of minorities RED Our accounting analysis indicates that the company has low RoEs which are negatively affected by low PAT margins and asset turnover. This we believe is the result of its acquisitions which have failed to add significant value so far.


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13.0%

15.0%

17.0%

19.0%

25,000

35,000

45,000

55,000

65,000

75,000

85,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenues (Rs mn) EBITDA Margin (%, RHS)

0.0%

4.0%

8.0%

12.0%

16.0%

20.0%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoCE (pre-tax) (%) RoE (%)

- 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

CFO (Rs mn) FCF (Rs mn)5

10

15

20

25

30

35

FY13 FY14 9MFY15

70

90

110

130

150

170

190

210

Mar

-10

Mar

-11

Mar

-12

Mar

-13

Mar

-14

Mar

-15

11

13x12x

109x

50

100

150

200

Mar

-10

Mar

-11

Mar

-12

Mar

-13

Mar

-14

Mar

-15

15x

23x21x

19x17x



Balance sheet (consolidated)

Year to March (̀ mn) FY11 FY12 FY13 FY14

Shareholders' equity 617 618 618 618

Reserves and surpluses 38,954 45,039 47,483 57,870

Total net worth 50,652 56,317 56,240 67,729

Debt 11,854 10,440 11,092 14,819

Deferred tax liability 637 657 540 463

Total liabilities 63,143 67,414 67,872 83,010

Gross block 46,006 52,339 55,081 64,983

Net block 37,589 42,436 44,343 51,810

CWIP 437 492 907 596

Investments (non-current) 4,842 5,068 5,760 6,784

Cash & cash equivalents 9,973 7,362 6,977 7,252

Debtors 5,733 6,518 7,129 6,543

Inventory 10,697 11,607 13,829 15,185

Loans & advances 7,104 7,954 8,524 10,346

Total current assets 34,777 34,792 36,928 39,925

Current liabilities 11,021 10,998 14,934 11,369

Provisions 3,481 4,376 5,132 4,735

Total current liabilities 14,502 15,374 20,067 16,104

Net current assets 20,276 19,418 16,862 23,821

Total assets 63,143 67,414 67,872 83,010


Income statement (consolidated) Year to March (̀ mn) FY11 FY12 FY13 FY14

Net Sales 60,032 66,400 73,510 77,376

% growth 4% 11% 11% 5%

Operating expenditure 53,951 60,170 65,825 69,857

EBITDA 6,081 6,231 7,685 7,519

% growth -11% 2% 23% -2%

Depreciation 994 961 1,051 1,291

EBIT 5,087 5,269 6,634 6,228

Interest expenditure 1,210 704 844 865

Non-operating income 972 945 860 818

Adjusted PBT 4,848 5,511 6,650 6,181

Tax 2,023 1,417 1,641 1,845

Adjusted PAT 2,825 4,094 5,009 4,336

Extraordinary expense/(income) (95) (225) 282 (888)

Reported PAT after minority interest 2,543 3,561 3,727 4,805




Cash flow statement (consolidated)

Year to March (̀ mn) FY11 FY12 FY13 FY14

EBIT 5,087 5,269 6,634 6,228

Depreciation 994 961 1,051 1,291

Others 336 (359) 256 (675)

Tax (2,023) (1,417) (1,641) (1,845)

(Incr)/decr in net working capital (2,640) (960) (3,727) (58)

Cash flow from operations 1,754 3,495 2,573 4,941

Capex (net) (854) (1,183) (1,725) (1,457)

(Incr)/decr in investments (103) (636) (3,534) (388)

Other income (expenditure) 1,077 3,246 5,420 783

Cash flow from investments 120 1,427 160 (1,062)

Net borrowings (7,594) (420) 2,348 (969)

Interest paid (1,210) (704) (844) (865)

Dividend paid (1,939) (1,705) (1,756) (1,876)

Cash flow from financing (11,931) (5,082) 1,015 (4,498)

Net change in cash (10,058) (160) 3,749 (619)

Closing cash balance 9,920 2,780 6,608 7,182

Free cash flow 900 2,311 848 3,484


Ratio analysis (consolidated) Year to March (%) FY11 FY12 FY13 FY14

EBITDA margin (%) 10.1% 9.4% 10.5% 9.7%

EBIT margin (%) 8.5% 7.9% 9.0% 8.0%

Net prof. margin (%) 4.7% 6.2% 6.8% 5.6%

Dividend payout ratio (%) 68.6% 41.7% 35.1% 43.3%

Net debt: equity (x) 0.0 0.1 0.1 0.1

Working capital turnover (x) 3.0 3.4 4.4 3.2

Gross block turnover (x) 1.3 1.3 1.3 1.2

RoCE (pre-tax) (%) 8.1% 8.1% 9.8% 8.3%

RoIC (%) 9.6% 8.8% 10.9% 8.2%

RoE (%) 5.6% 7.3% 8.9% 6.4%


Valuation parameters (consolidated)

Year to March FY11 FY12 FY13 FY14

Diluted EPS (`) 4.1 5.8 6.0 7.8

Book value per share (`) 63.3 73.2 77.1 93.9

Dividend per share (`) 2.0 2.2 2.2 2.3

P/E (x) 38.1 27.2 25.9 20.1

P/BV (x) 2.5 2.1 2.0 1.7

EV/EBITDA (x) 16.2 16.0 13.1 13.8

EV/EBIT (x) 19.3 18.9 15.2 16.7



Key financials – consolidated (` mn) Year to March FY13 FY14 FY15E FY16E FY17E Net Sales 55,310 52,660 58,642 67,008 76,764 EBITDA 1,497 2,656 3,967 4,695 5,367 EBITDA (%) 2.7% 5.0% 6.8% 7.0% 7.0% EPS (`) 3.0 6.8 10.1 11.9 13.1 RoE (%) 6.5% 13.0% 17.2% 17.6% 17.0% RoCE (%) 10.4% 10.1% 13.8% 14.3% 14.4% P/E (x) 42.2 33.8 24.8 21.3 19.4


A leading room AC and HVAC Tata Group company Voltas, a Tata Group company, is the market leader in the domestic room air-conditioners industry, with ~21% market share as on December 2014. Further, Voltas is a leading player in the MEP segment (mechanical (HVAC), electrical and plumbing), providing project management and engineering services for buildings/infrastructure in India and the Middle East.

Geographic reach supported EMP; product positioning supporting UCP During FY03-07, Voltas lost market share to Korean room air conditioner players such as LG and Samsung. Due to intense competition, Voltas reported a cumulative EBITDA loss of `211mn in FY03-07. Voltas changed its product positioning to a ‘value for money’ brand through successive innovative product launches such as energy saving ACs (2007), sensible cooling AC (2010) and all weather ACs (2012). New brand positioning, flexi-sourcing model and increase in distribution reach made Voltas the market leader in domestic room ACs. Simultaneously, Voltas leveraged on its domestic track record in the MEP segment to win large orders in the Middle East such as Sidra Medical Project (Qatar) and Burj Khalifa (Dubai) over FY04-10. The company’s foray into international markets coupled with a sharp rise in demand from domestic commercial real estate led to 30% revenue CAGR and 56% EBITDA CAGR over FY04-09 in the electromechanical projects (EMP) segment. However, slowdown in demand and aggressive bidding by Voltas over FY09-14 led to a sharp decline in EBITDA margin over FY10-14 of 3% vs 6.7% over FY05-09.

Is Voltas’ room AC franchise undervalued?

Voltas has built an unmatched franchise in the room AC segment (21% market share) through: (a) a ‘value for money brand’ (b) flexi-sourcing model, and (c) strong dealer network. Voltas reported industry-leading FY14 EBIT margin of ~12.5% in the UCP segment and post-tax FY14 RoCE before adjustment for unallocated expense of 70%.

We believe there are limited synergies between the unitary cooling products (UCP) and the EMP business. Whilst the UCP segment accounted for 39% of FY14 revenues, it accounted for 72% of FY14 EBITDA. Hence, Voltas can improve capital allocation if it were to demerge the asset-light UCP segment from the loss-making EMP segment. Voltas is trading at 19.4x FY17E EPS. A demerger of the room AC business could fetch Voltas’ UCP segment an FY17E P/E multiple of 20x, comparable with other consumer durable companies such as Whirlpool (24x FY17E EPS) and IFB Industries (17.5x FY17E EPS). This would still imply a marginal ~8% downside for the consolidated entity.

Valuations reflect unmatched room AC franchise We reiterate our SELL stance on Voltas. The current valuation of 21x FY16E EPS has limited room to expand, as RoEs are likely to remain at ~16-17% and EPS growth would moderate in FY16E. Even if assign a valuation of 20-22x FY16 EPS for both the EMP and UCP businesses, we still cannot justify an upside from current levels. Also, Voltas’s EBIT margin recovery in the EMP segment would be limited (4% in FY16) due to intense competition and sluggish demand.

COMPANY INSIGHT VOLT IN EQUITY March 10, 2015

VoltasSELL

Analyst Details

Nitin Bhasin

+91 22 3043 3241

[email protected]

Tanuj Mukhija, CFA +91 22 3043 3203

[email protected]

Engineering & Construction

Recommendation Mcap (bn): `90/US$1.5 6M ADV (mn): `626/US$10.1 CMP: `267 TP (12 mths): `157 Downside (%): 41

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: GREEN

Catalysts

Continued weak demand in commercial real estate over FY14-17

Low profitability in the EMP segment over FY14-17 led by intense competition

Market share loss in UCP segment to aggressive Japanese players

Performance (%)


50

100

150

200

250

300

15,00017,00019,00021,00023,00025,00027,00029,00031,000

Ma

r-14

Ma

y-1

4

Jul-

14

Sep-

14

Nov

-14

Jan-

15

Ma

r-15

Sensex Voltas (RHS)

Voltas




Exhibit 2: RoCE and RoE over the last ten years (consolidated)


Exhibit 3: Operating cashflow and free cashflow over the past ten years (consolidated)


Exhibit 4: UCP segment - Driver of revenue growth


Exhibit 5: Forward P/E evolution over the past ten years


Exhibit 6: Forward P/B evolution over the past ten years


Exhibit 7: Explanation for the flags on the cover page

Field Score Comments

Accounting GREEN In our accounting analysis of BSE500 companies, we have classified Voltas as an ’engineering and construction (E&C) company‘. Voltas ranks second in our accounting analysis of E&C companies on account of a higher rank in CFO/EBITDA, gross block/gross turnover and capital WIP-gross block.

Predictability AMBER Whilst the company has communicated clearly to clients about the challenging environment especially in the EMP segment, cost overruns in the Middle East have increased the volatility in its earnings.

Earnings momentum GREEN Over the last six months, consensus EPS estimates for FY15 and FY16 have been revised upwards by 5%.

Source: Ambit Capital research

0%

5%

10%

15%

5,000

25,000

45,000

65,000

85,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

E

FY16

E

FY17

E

UCP (Rs.mn)Engineering (Rs.mn)Electro-Mechanical (Rs.mn)EBITDA Margin(%, RHS)

10%

20%

30%

40%

50%

0%

10%

20%

30%

40%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

E

FY16

E

FY17

E

ROE (%)ROCE (%)Share of UCP revenue (%, RHS)

(3,000) (2,000) (1,000)

- 1,000 2,000 3,000 4,000 5,000 6,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

E

FY16

E

FY17

E

CFO before tax (Rs mn) FCF

-100%

-50%

0%

50%

100%

5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

EFY

16E

FY17

E

Unitary Cooling Products (Rs mn)EBIT Margin(%, RHS)Post ROCE (%, RHS)

-

50

100

150

200

250

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

E

FY16

E

FY17

E

Price-Earnings(x)

-

10

20

30

40

50

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

E

FY16

E

FY17

E

Price-Book value (x)

Voltas


Income statement

Particulars (̀ mn) FY14 FY15E FY16E FY17E

Revenue 52,660 58,642 67,008 76,764

Adjusted EBITDA 2,656 3,967 4,695 5,367

Adjusted EBITDA margin 5.0% 6.8% 7.0% 7.0%

Net interest and financial charges 226 214 109 55

Other income 1,002 1,178 1,191 1,033

Adjusted PBT 3,184 4,680 5,498 6,030

Provision for taxation 941 1,311 1,540 1,688

Adjusted Consolidated PAT 2,238 3,353 3,939 4,320

Adjusted EPS (diluted) ` 6.8 10.1 11.9 13.1


Balance sheet Particulars (̀ mn) FY14 FY15E FY16E FY17E

Total Networth 18,193 20,733 23,666 26,786

Loans 2,629 1,629 1,129 1,129

Sources of funds 20,980 22,537 24,989 28,131

Net block 2,103 2,210 2,335 2,475

Investments 7,320 7,320 7,320 7,320

Total Current Assets 36,975 41,862 48,924 56,818

Cash and bank balances 2,818 5,134 7,523 9,793

Sundry debtors 13,352 14,620 16,523 18,718

Inventories 9,010 9,737 10,926 12,323

Loans and advances 3,108 3,213 3,488 3,996

Current liabilities and prov. 26,476 29,913 34,647 39,539



Cash Flow statement

Particulars (̀ mn) FY14 FY15E FY16E FY17E

CFO 2,966 4,091 3,701 3,495

CFI (3,049) 208 173 (77)

CFF (787) (1,982) (1,485) (1,148)

Free cash flow 2,725 3,735 3,298 3,038


Key ratios Particulars FY14 FY15E FY16E FY17E

Net debt/Equity (0.0) (0.2) (0.3) (0.4)



ROCE 10.1% 13.7% 14.2% 14.3%

ROE 13.0% 17.2% 17.6% 17.0%

P/E (x) 33.8 24.8 21.3 19.4

P/B (x) 4.6 4.0 3.5 3.1

EV/EBITDA (x) 31.2 20.5 16.9 14.4


Voltas


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Background Sadbhav (SEL) is a construction and asset developer, with a presence in road, mining and irrigation. SEL, through controlled expansion, has emerged as one of the best EPC franchises in India with a history of strong execution and on-schedule completion. Its 78% subsidiary, SIPL, has a portfolio of 13 road assets which run through India’s most industrially developed states.

A sensible developer with strong execution capabilities Sadbhav reported 25% construction revenue CAGR and 4.5x average gross block turnover in FY07-14. EPC execution slowed down in FY13 (32% revenue decline) but rebounded sharply with 30%/35% revenue growth in FY14/9MFY15. The company has an order book of `87bn, implying 4.0x book-bill. It recently won contracts worth `7.2bn and management estimates further order inflows of `20bn-25bn in FY16, as NHAI’s order awarding pace picks up (the FY16 budget has doubled the Government’s outlay on roads). Loans taken to fund SIPL’s equity deficit alongside delayed payments from SPVs led to an increase in standalone debt/equity to 1.1x in FY15. The management highlighted that equity issuances at SIPL and receipts of pending payments from SPVs (in 4QFY15) should reduce standalone leverage to 0.8x in FY16. Sadbhav’s BOT revenues recorded 53% CAGR in FY08-14, as its operational asset portfolio increased to 10 in FY14 (vs 1 in FY08). The commissioning of three assets in FY16 and the scaling up of the recently commissioned assets (Maharashtra Border Check Post and Rohtak Panipat) will sustain the strong growth momentum. The company’s consolidated/standalone CFO CAGR across FY08-14 was 49%/66%.

SIPL listing to fund future growth capital We expect 12-17% equity IR` for most of SIPL’s assets and >25% for its two unique ring assets—Ahmedabad Ring Road and Maharashtra Border Check Post. SIPL recently filed for listing to provide a partial (50%) exit to its private equity investors and to raise capital to build a larger road portfolio and repay the debt taken from the parent. Listing of the roads subsidiary should aid the valuation discovery of SIPL, as it offers investors an opportunity to play for the expected traffic revival in India, without exposure to the cyclical and working-capital-intensive construction business. Receding competition in the BOT space, better terms in the upcoming bids and stake acquisition opportunity in stuck road projects, positions SEL favourably in the roads sector. SIPL owns a large, cash generative and well-funded asset portfolio (a rarity amongst developers in India) and hence it could list at a premium (~2.5-3x equity invested) to global toll road operators (1.5-2x equity invested) which implies a valuation of `45-50bn, just 5-10% upside. SIPL’s recent minority transactions at 4x P/B were higher than consensus estimates.

Valuation - A quality developer commanding premium valuations Post the significant rerating in the last 12 months, Sadbhav trades at rich valuations—2.7x consolidated FY16 P/B (vs 2.0x for Ashoka and IRB). Given that few Indian road developers have a strong management track record, execution capability and are relatively ‘Good & Clean’, the rich multiples might sustain; its trade-dependent traffic might also lead to upside surprises.

COMPANY INSIGHT SADE IN EQUITY March 10, 2015

Sadbhav EngineeringUNDER REVIEW

Infrastructure: Roads

Recommendation Mcap (bn): `61.1/US$1.0 6M ADV (mn): `74.6/US$1.2 CMP: `357 TP (12 mths): UR

Flags Accounting: AMBER Predictability: AMBER Earnings momentum: AMBER

Catalysts

Pick up in order inflows in FY16, with NHAI awards gathering pace

Ramp up in traffic growth with pick up in capex cycle/industrial output

Successful completion of SIPL’s IPO in early FY16

Performance


20,000

24,000

28,000

32,000

50

125

200

275

350M

ar-1

4

May

-14

Jul-

14

Sep-

14

Nov

-14

Jan-

15

Mar

-15

SADE Sensex (RHS)

Analyst Details

Nitin Bhasin

+91 22 3043 3241

[email protected]

Achint Bhagat

+91 22 3043 3178

[email protected]

Key financials Year to March FY13 FY14 FY15E FY16E FY17E

Operating Income (̀ mn) 21,596 27,325 39,491 48,928 60,101

EBITDA (` mn) 3,941 4,456 8,882 10,813 14,516

EBITDA margin (%) 18.2 16.3 22.5 22.1 24.2

Net Profit (`) -534 -773 847 2,030 1,019

ROE (%) 0.6% -0.3% 6.3% 13.9% 6.5%

ROIC (%) -3.9% 6.4% 8.6% 9.5% 11.7%

P/B(x) 3.0 2.8 2.6 2.3 1.9


Sadbhav Engineering



Source: Company, Ambit Capital research. Note: Forward-looking estimates are our previously published estimates

Exhibit 2: RoCE and RoE decline due to large assets becoming operational (significant losses in initial years)

Source: Company, Ambit Capital research. Note: Forward-looking estimates are our previously published estimates.

Exhibit 3: We expect a 48% consolidated cash flow CAGR over the next three years


Exhibit 4: Sharp revenue growth and margin expansion likely as under-construction assets are commissioned


Exhibit 5: Forward P/E evolution over the past ten years


Exhibit 6: Sadbhav trades at a premium to both IRB and Ashoka




Accounting AMBER Sadbhav’s accounts appear average in comparison to peers like Ashoka, given its longer cash conversion cycle and low CFO-EBITDA.

Predictability AMBER Sadbhav has often disappointed with lagged disclosures on key developments such as stake sale in a large SPV, toll stoppages and a High Court case.

Earnings Momentum AMBER Consensus earnings estimates have been marginally downgraded in the last month.


10 12 14 16 18 20 22 24 26

-

10

20

30

40

50

60

70

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

E

FY16

E

FY17

E

(%)(` bn)

Revenue EBITDA margin (RHS)

-5

0

5

10

15

20

25

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

E

FY16

E

FY17

E

(%)

RoCE RoE

40

45

50

55

60

65

70

75

-

2

4

6

8

10

12

14

FY12 FY13 FY14 FY15E FY16E FY17E

(%)(` bn)

Revenue EBITDA margin (RHS)

0

1

2

3

4

5

6

Jun-

06

Feb-

07

Oct

-07

Jun-

08

Feb-

09

Oct

-09

Jun-

10

Feb-

11

Oct

-11

Jun-

12

Feb-

13

Oct

-13

Jun-

14

Feb-

15

(X)

Sadbhav PB (x) Average one-yr fwd P/B

- 0.5 1.0 1.5 2.0 2.5 3.0 3.5

Oct

-10

Feb-

11

Jun-

11

Oct

-11

Feb-

12

Jun-

12

Oct

-12

Feb-

13

Jun-

13

Oct

-13

Feb-

14

Jun-

14

Oct

-14

Feb-

15

(X) One-yr fwd P/B

Ashoka Sadbhav IRB

Sadbhav Engineering


Balance sheet (Consolidated)

Y/E March (̀ mn) FY14 FY15E FY16E FY17E

Share capital 158 158 158 158

Reserves and surplus 12,830 13,513 15,263 15,830

Total Networth 13,012 13,695 15,445 16,012

Minority 1,035 710 685 310

Loans 57,311 69,873 79,023 78,790

Sources of funds 71,674 84,595 95,470 95,428

Gross Block 52,514 57,120 58,970 91,412

Net block 45,562 47,973 47,473 76,465

Capital work-in-progress 11,605 20,745 30,605 5

Investments 327 327 327 327

Inventories 579 769 977 1,147

Sundry debtors 8,895 8,753 11,047 13,025

Cash and bank balances 934 3,531 3,750 3,048


Other current assets 2,692 2,632 2,684 2,881


Current Liabilities 7,889 8,454 10,679 12,402

Provisions 2,127 2,221 2,337 2,510

Current liabilities and provisions 10,016 10,675 13,016 14,911


Misc Expenses - - - -

Application of funds 71,674 84,595 95,470 95,428


Income statement (Consolidated) Y/E March (̀ mn) FY14 FY15E FY16E FY17E

Revenue 27,325 39,491 48,928 60,101

% growth 37.8% 32.7% 23.9% 22.8%

Total expenses 23,703 30,609 38,115 45,585

Adjusted EBITDA 4,456 8,882 10,813 14,516


Net depreciation / amortisation 1,305 2,195 2,350 3,451

EBIT Reported 3,459 6,687 8,463 11,066

Net interest 4,556 5,715 5,859 9,571

Other income 312 323 333 344

Adjusted PBT (1,097) 1,295 2,937 1,839

Reported PBT 119 1,295 2,937 1,839

Provision for taxation 396 658 884 1,208

Adjusted PAT (773) 847 2,030 1,019

PAT margin -0.1% 2.1% 4.1% 1.7%

Reported PAT (35) 847 2,030 1,019

Adjusted EPS (diluted) ` (4.9) 5.4 12.8 6.4


Sadbhav Engineering


Cash flow statement (Consolidated)


PBT 4 1,295 2,937 1,839

Depreciation 1,901 2,195 2,350 3,451

Others 3,995 5,278 5,479 9,240

Direct taxes paid (396) (658) (884) (1,208)

Change in working capital 302 1,841 (1,803) (2,437)

CFO 3,674 9,061 8,435 11,852

Purchase of fixed assets (10,906) (11,324) (13,746) (11,710)

Investments 351 176 323 333

Interest received 312 323 333 344

Others - - - -

CFI (11,170) (13,423) (11,377) (1,497)

Proceeds from borrowings 11,670 12,562 9,150 (233)

Equity raised 1,015 - - -

Interest and finance charges paid (4,472) (5,715) (5,859) (9,571)

Dividends paid (106) (70) (164) (280)

CFF 8,107 6,777 3,127 (10,085)

Net change inflow/(outflow) 611 2,415 185 270

Cash at the beginning 735 934 3,531 3,750

Cash at the end 934 3,531 3,750 3,048

Free cash flow (7,651) (4,685) (3,275) 10,010


Ratio analysis (Consolidated) Performance ratios FY14 FY15E FY16E FY17E

Growth (YoY) Sales 32% 38% 25% 24%

EBITDA 56% 46% 22% 41%

Adj. PBT -44% -535% 157% -33%

Adj PAT -54% -432% 144% -52%

EBITDA Margin (%) 13% 12% 12% 12%

Debt:Equity 4.4 5.1 5.1 4.9

Net debt/Equity 4.3 4.8 4.9 4.7



ROCE 6.4% 8.6% 9.4% 4.0%

ROE -0.3% 6.3% 13.9% 6.5%


Valuation parameters (Consolidated)

Valuation metrics FY14E FY15E FY16E FY17E

Adjusted EPS basic (`) (0.2) 5.4 12.8 6.4

Adjusted EPS diluted (`) (0.2) 5.4 12.8 6.4

BVPS 82 87 98 101

P/E (45.0) 41.1 17.1 34.1

P/B 2.8 2.6 2.3 1.9

EV/EBITDA 20.1 11.2 10.0 7.5



Background Ashoka Buildcon (ABL), a mid-sized roads contractor and developer, has been in the road construction business for over three decades. It entered the BOT space in 1997 and currently has a portfolio of 25 road assets, out of which 8 large projects are in its subsidiary, Ashoka Concessions Limited (ACL) (in which SBI Macquarie owns ~39%). ABL’s strong balance sheet, lifecycle road development experience and financial discipline position it amongst the strongest road developers in India.

Commissioning of large projects to drive strong cash flow growth ABL’s consolidated FY14 revenue was `18.1bn; EPC and toll revenue accounted for 78% and 17% of overall revenues. It recorded EPC revenue CAGR of 37% over FY09-14 alongside stable 12-13% EBITDA margins. ABL’s current order book of `33bn implies 2.3x LTM book-to-bill, providing nominal growth visibility. However, we expect significant order inflows in the next few quarters, as NHAI’s order awards, which should favour ABL given its execution/balance sheet capacity pick up. We expect construction revenue CAGR of 15% over FY15-18 with a high likelihood of an upward surprise. ABL’s toll revenues have recorded 15% CAGR over FY09-14; commissioning of three large projects in FY15-16 will drive 30% revenue CAGR over FY14-18E. Note that four of the company’s large road assets lie on NH-6 (passing through mineral-rich east Indian states), where traffic growth has been muted due to the iron ore mining ban. Resolution of the mining ban would drive strong traffic growth; we currently estimate ~7-8% traffic growth for FY16/17. Asset holding subsidiary (ACL) offers value unlock opportunity We expect ACL to bid aggressively for road BOT projects as competition reduces, given lack of financial capacity with most players. Alongside this build out of its portfolio and cash generation from operational assets, ABL could list ACL for: (1) valuation discovery and further growth capital: A separate asset operator’s valuation is higher than an EPC-and-developer given that investors can choose not to stay invested in the construction business which is cyclical and working-capital-intensive; and (2) potential exit to SBIM: SBIM has infused `7bn in ACL at a committed equity IRR of 12% and could be seeking an exit in FY19. Primary equity issuance at ACL will provide it more growth capital for building an even larger road asset portfolio, in which the competitive advantage is strengthened with scale/operational assets. Alongside, SBIM could amplify the portfolio by bringing in its secondary assets that were acquired over the last few years. As the Dhankuni construction is completed in the next six months, nearly all of ACL’s invested equity (pending `1.1bn) will generate strong cash flows. A conservative 2x multiple to the equity invested in ACL (`16bn) implies a valuation of `32bn, an upside potential of 10% from current levels. Valuation - At a relative discount to other (less disciplined) peers Ashoka is trading at consolidated 1.7x FY16 P/B. Our SOTP valuation of `184 includes: (a) `60 for the EPC business, implying a reasonable 8x FY16 EPS (high-quality EPC companies trade at 10.5-11.0x in upcycles), (b) `107 for ACL, implying a very low 1.3x FY16 equity invested and (c) `17/share for smaller roads. Catalysts: Project wins and traffic growth.

COMPANY INSIGHT ASBL IN EQUITY March 10, 2015

Ashoka BuildconBUY

Infrastructure: Roads

Recommendation Mcap (bn): `25/US$0.4 6M ADV (mn): `36.4/US$0.6 CMP: `181 TP (12 mths): `184 Upside (%): 1

Flags Accounting: GREEN Predictability: GREEN Earnings momentum: AMBER

Catalysts

Pick-up in order inflows in 4QFY15 and FY16, with NHAI awards gathering pace

Ramp up in traffic growth with resumption of iron ore mining

Sharp toll income growth from FY16 onwards, with commissioning of large BOT road contracts

Performance


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ASBL Sensex (RHS)

Analyst Details

Nitin Bhasin +91 22 3043 3241

[email protected]

Achint Bhagat

+91 22 3043 3178 [email protected]

Key financials (standalone)

Year to March FY13 FY14 FY15E FY16E FY17E Operating Income (` mn) 16,377 15,546 16,645 18,584 22,791

EBITDA (` mn) 2,022 1,984 2,019 2,268 2,804

EBITDA margin (%) 12.3 12.8 12.1 12.2 12.3

Adjusted EPS (`) 22.2 22.4 18.8 24.1 28.5

ROE (%) 12.5% 13.1% 9.9% 11.4% 12.0%

ROCE (%) 9.5% 9.3% 8.5% 8.3% 9.5%

P/B(x) 2.9 2.6 2.4 2.1 1.9


Ashoka Buildcon




Exhibit 2: RoCE and RoE drop on account of rising investment in long-gestation road assets

Source: Company, Ambit Capital research.

Exhibit 3: We expect a 27% consolidated cash flow CAGR over the next three years


Exhibit 4: Commissioning of large contracts to drive strong revenue growth and margin expansion of ACL


Exhibit 5: ASBL’s recent re-rating is driven by rising hopes of strong order inflows and traffic recovery


Exhibit 6: Ashoka trades at a relative discount to Sadbhav and IRB




Accounting GREEN Based on our accounting analysis of Ashoka, IRB and Sadbhav, we believe that Ashoka’s quality of accounts is better than its peers with better cash conversion and cash management.

Predictability GREEN Ashoka has made timely announcements of project wins and given regular updates on status of projects, project-wise cash flows, etc.

Earnings Momentum AMBER Consensus earnings estimates have been downgraded by 8% in the last month.


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Ashoka 1 yr. fwd. PB (RHS) (x)

Avg. 1 yr fwd. PB (RHS)

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Ashoka Sadbhav IRB

Ashoka Buildcon


Balance sheet (standalone)


Share capital 527 527 527 527

Reserves and surplus 9,103 10,102 11,382 12,899

Total Networth 9,629 10,628 11,909 13,426

Loans 2,732 2,732 3,032 3,032

Sources of funds 12,354 13,353 14,934 16,451

Gross Block 5,084 5,884 6,884 7,384

Net block 2,569 2,919 3,368 3,268

Capital work-in-progress 210 210 210 210

Investments 7,719 7,719 7,719 7,719

Inventories 3,907 4,167 4,604 5,640

Sundry debtors 1,704 2,280 2,546 3,122

Cash and bank balances 1,219 1,362 2,497 4,102


Other current assets 1,619 1,642 1,833 2,185


Current Liabilities 8,931 9,617 10,728 13,142

Provisions 826 826 826 826

Current liabilities and provisions 9,757 10,443 11,554 13,968


Application of funds 12,355 13,353 14,934 16,451


Income statement (standalone) Y/E March (̀ mn) FY14 FY15E FY16E FY17E

Revenue 15,546 16,645 18,584 22,791

% growth -5.1% 7.1% 11.6% 22.6%

Total expenses 13,582 14,626 16,316 19,987

Adjusted EBITDA 1,984 2,019 2,268 2,804


Net depreciation / amortisation 434 450 550 600

EBIT Reported 1,551 1,569 1,718 2,204

Net interest 334 287 303 318

Other income 475 166 454 362

Adjusted PBT 1,691 1,448 1,869 2,248

Reported PBT 1,691 1,448 1,869 2,248

Provision for taxation 499 449 589 730

Adjusted PAT 1,192 999 1,280 1,517

PAT margin 7.7% 6.0% 6.9% 6.7%

Reported PAT 1,192 999 1,280 1,517

Adjusted EPS (diluted) ` 7.5 6.3 8.1 9.6


Ashoka Buildcon


Cash flow statement (standalone)


EBIT 1,551 1,569 1,718 2,204

Depreciation 434 450 550 600

Others 384 50 256 68

Direct taxes paid (499) (449) (589) (730)

Change in working capital 153 (507) 5 (12)

CFO 2,023 1,113 1,940 2,130

Purchase of fixed assets (800) (800) (1,000) (500)

Investments (265) - - -

Interest received 257 116 198 293

Others - - - -

CFI (808) (684) (802) (207)

Proceeds from borrowings - - 300 -

Equity raised - - - -

Interest and finance charges paid (334) (287) (303) (318)

Others - - - -

CFF (334) (287) (3) (318)

Net change inflow/(outflow) 881 142 1,135 1,605

Cash at the beginning 338 1,219 1,362 2,497

Cash at the end 1,219 1,362 2,497 4,102

Free cash flow 958 313 940 1,630


Ratio analysis (standalone) Performance ratios FY14 FY15E FY16E FY17E

Growth (YoY) Sales -5% 7% 12% 23%

EBITDA -2% 2% 12% 24%

PBT -1% -14% 29% 20%

PAT 17% -16% 28% 19%

EBITDA Margin (%) 13% 12% 12% 12%

Debt:Equity 0.3 0.3 0.3 0.2

Net debt/Equity 0.2 0.1 0.0 (0.1)

Working capital turnover (x) 24 12 8 6

Gross block turnover (x) 5 4 4 4

ROCE 9% 9% 8% 9%

ROE 13% 10% 11% 12%


Valuation parameters (standalone)

Valuation metrics FY14E FY15E FY16E FY17E

Adjusted EPS basic (`) 8 6 8 10

Adjusted EPS diluted (`) 22 19 24 29

BVPS 61 67 75 85

P/E 21.1 25.1 19.6 16.5

P/B 2.6 2.4 2.1 1.9

EV/EBITDA 5.0 4.8 3.9 2.6



Key financials – consolidated (` mn) YE March (̀ mn) FY13 FY14 FY15E FY16E FY17E

Operating income 33,875 40,298 44,086 50,900 58,536

EBITDA (%) 3.3 2.0 2.7 5.2 5.6

EPS (`) 2.7 - 0.5 0.4 11.2 14.6

RoE (%) 7 - 1 1 15 17

RoCE (%) 8 5 7.9 12.9 15.3

P/E (x) 81.6 NA 501.7 19.5 15.0

P/BV (x) 3.0 3.1 3.1 2.8 2.5


Background Bajaj Electricals (BJE) is a strong player in lighting and consumer durables, with leadership in small appliances. Over FY11-14, this segment reported strong RoCE of 85% driven by high asset turns (average of 3.6x in FY11-14). Its Engineering & Projects (E&P) segment (28% of FY14 revenues) reported losses of `1.0bn in FY14 (15% of FY14 net worth) and `1.1bn in 9MFY15.

Current revenue, profitability and organic cashflow generation In FY14, BJE reported revenue of `40.3bn, 72% of which was from the non-E&P business and 28% from the E&P business. The E&P business reported strong growth of 67% in FY14 and 19% YoY in 9MFY15 vs the non-E&P business’ single-digit revenue growth of 7% in FY14 and 2% in 9MFY15.

BJE’s APAT has declined from `1.5bn in FY11 to a loss of `53mn in FY14, led by deterioration in the EBIT of the E&P business from `740mn in FY11 to an EBIT loss of `1.0bn in FY14 and `1.1bn in 9MFY15. The EBIT margin of the non-E&P business has declined from 9.6% in FY11 to 6.8% in FY14 and 5.5% in 9MFY15. The non-E&P business, with RoCE of 85% over FY11-14, is the only cash-generating business. BJE’s non-E&P business enjoyed capital employed turnover of 4.5x in FY14 (vs 2.1x for the E&P business). Consequent to the E&P losses, BJE reported a CFO decline from `1.1bn in FY11 to –`65mn in FY14.

Does the company have assets that are being valued sub-optimally? Whilst concerns of the E&P business burning the cash flows of the non-E&P business will abate after the demerger, we do not see any upside from demerger of E&P business, given the rich valuation of the non-E&P business at 27.3x on FY16 P/E (14% premium to peers) despite the weakening franchise. Moreover, we do not see the E&P business getting re-rated from our implied valuation of 3.5x in FY16, as the risk of further provisioning on the legacy receivables (`2bn outstanding as at the end of December 2014) persists. However, an upside to the non-E&P business’ valuation can emerge if the interest cost of the non-E&P business reduces. This can happen, if we assume that the consumer business funds the E&P business. If this is true then the profitability of the consumer business for FY16 can increase by 78%, as the interest expense of `902mn in FY16 should shift to the E&P business from the non-E&P business. Thus, the value of the non-E&P business increases by 77% from `205/share to `364/share. Assuming the valuation of the E&P business reduces to nil, the SOTP would increase by 63%. Valuation Bajaj’s consumer business is trading at 27.3x FY16 EPS, a justified discount of 14% to peers (assuming the E&P business is valued at `13/share; implied 3.3x FY16 P/E, ~60% discount to peers). This is because we expect the consumer business to report lower EPS CAGR of 7.3% over FY14-17E vs 20.7% for peers (Havells standalone, VGuard, Finolex Cables and TTK Prestige). We believe the roll out of the ‘TOC’ strategy is a risk to BJE’s consumer franchise, as it is currently creating disruptions in the channel, which in turn is hurting BJE’s growth. Our SOTP-based target price of `204/share values the consumer business at `191/share and the E&P business at `13/share.

COMPANY UPDATE BJE IN EQUITY March 10, 2015

Bajaj ElectricalsSELL

Capital Goods

Recommendation Mcap (bn): `22/US$0.4 6M ADV (mn): `116/US$1.8 CMP: `218 TP (12 mths): `204 Downside (%): 9

Flags Accounting: AMBER Predictability: RED Treatment of minorities: RED

Catalysts

Sustained loss of market share in consumer and lighting business over the next 18 months

E&P loss in 1HFY16

Performance


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BJE Sensex on RHS

Analyst Details

Bhargav Buddhadev

+91 22 3043 3252

[email protected]

Deepesh Agarwal +91 22 3043 327

[email protected]

Bajaj Electricals


Exhibit 1: EBITDA margin has declined to a ten-year low in FY14…


Exhibit 2: …so is the case with RoCE and RoE …


Exhibit 3: …and cash flow generation


Exhibit 4: EBIT margin of non-E&P business has been declining over the FY09-14


Exhibit 5: Forward P/E evolution over the past five years


Exhibit 6: Forward P/B evolution over the past five years


Exhibit 7: Explanation for our flags Segment Score Comments

Accounting AMBER In our accounting analysis of consumer durables, Bajaj scores in the median quadrant. It scores well on inventory days, CWIP and contingent liabilities. However, it scores poor on CFO/EBITDA, receivable days and cash yield.

Predictability RED Over the past three quarters, the stock has surprised consensus negatively by reporting a loss due to the weak performance of the non-E&P business.

Earnings momentum RED Over the past six months, consensus FY16 EPS estimates have been downgraded by 37%.


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Bajaj Electricals


Balance sheet

Year to March (̀ mn) FY13 FY14 FY15 FY16E FY17E

Cash 500 544 4,225 3,408 3,124

Debtors 12,020 16,450 13,060 14,854 17,082

Inventory 4,212 4,467 4,952 5,739 6,235

Loans & advances 2,130 2,020 2,409 2,733 3,383

Other Current Assets - - - - -

Investments 297 673 673 673 673

Fixed assets 2,349 2,518 2,648 2,928 3,251

Miscellaneous 82 - - - -

Total assets 21,590 26,673 27,967 30,334 33,746

Current liabilities & provisions 12,723 16,387 16,169 18,159 20,952

Debt 1,661 3,443 4,922 4,442 3,942

Other liabilities - Deferred Tax Liability - 79 - 253 - 253 - 253 - 253

Total liabilities 14,305 19,577 20,838 22,347 24,641

Shareholders' equity 199 205 205 205 205

Reserves & surpluses 7,086 6,891 6,924 7,782 8,901

Total networth 7,285 7,096 7,129 7,987 9,106

Net working capital 5,639 6,551 4,252 5,167 5,747

Net debt (cash) 1,161 2,899 697 1,034 818


Income statement Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17E

Operating income 33,875 40,298 44,086 50,900 58,536

% growth 9.3 19.0 9.4 15.5 15.0

Operating expenditure 32,767 39,480 42,899 48,245 55,274

EBITDA 1,109 818 1,187 2,655 3,261

% growth (53.2) (26.2) 45.1 123.6 22.8

Depreciation 144 247 291 261 300

EBIT 965 571 896 2,394 2,961

Interest expenditure 690 783 1,023 902 909

Non-operational income / Exceptional items 416 153 171 241 208

PBT 691 (60) 45 1,733 2,260

Tax 178 (7) - 589 768

Reported PAT 513 (53) 45 1,144 1,492

Adjustments 247 - - - -

Adjusted PAT 266 (53) 45 1,144 1,492

% growth (77.5) (120.0) (183.8) 2,469.0 30.4


Bajaj Electricals


Cash flow statement

Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17E

PBT 690 (60) 45 1,733 2,260

Depreciation 144 247 291 261 300

Interest 671 728 1,023 902 909

Tax (398) (302) - (589) (768)

(Incr) / decr in net working capital 173 (1,294) 2,299 (915) (580)

Others 142 614 - - -

Cash flow from operating activities 1,422 (65) 3,658 1,392 2,121

(Incr) / decr in capital expenditure (608) (472) (422) (541) (622)

(Incr) / decr in investments 404 (376) - - -

Others 203 83 - - -

Cash flow from investing activities (1) (765) (422) (541) (622)

Issuance of equity 12 41 - - -

Incr / (decr) in borrowings (439) 1,844 1,479 (480) (500)

Others (1,030) (1,017) (1,034) (1,188) (1,282)

Cash flow from financing activities (1,457) 867 445 (1,668) (1,782)

Net change in cash (36) 38 3,681 (817) (284)


Ratio analysis Year to March (%) FY13 FY14 FY15E FY16E FY17E

EBITDA margin 3.3 2.0 2.7 5.2 5.6

EBIT margin 2.8 1.4 2.0 4.7 5.1

Net profit margin 1.5 -0.1 0.1 2.2 2.5

Return on capital employed 7.9 5.2 7.9 12.9 15.3

Return on equity 7.2 -0.7 0.6 15.1 17.5

Current ratio (x) 1.5 1.4 1.5 1.5 1.4


Valuation parameters

Year to March FY13 FY14E FY15E FY16E FY17E

EPS (`) 2.7 -0.5 0.4 11.2 14.6

Book value per share (`) 73.2 69.2 69.6 77.9 88.9

P/E (x) 81.6 NA 501.7 19.5 15.0

P/BV (x) 3.0 3.1 3.1 2.8 2.5

EV/EBITDA (x) 22.8 30.9 21.3 9.5 7.7

EV/Sales (x) 0.7 0.6 0.6 0.5 0.4

EV/EBIT (x) 26.2 44.2 28.2 10.5 8.5

CFO/EBITDA 164% 29% 308% 75% 89%

Gross Block Turnover (x) 11.3 11.5 11.2 11.5 11.7

Working Capital Turnover (x) 5.7 6.6 8.2 10.8 10.7


Banks & Financial Services


Banks & Financial Services Subsidiaries do not contribute significantly to banks’ profits and valuations Most large Indian banks have different non-banking businesses as part of their consolidated operations with asset management, life insurance, NBFC business being the major non-bank businesses.

In the heydays of the 2004-08 boom, banks’ insurance, asset management and investment banking/broking subsidiaries used to command lofty valuations. In some cases, these subsidiaries used to contribute up to 70% of the parent bank’s sum-of-the-parts valuation. However, weak capital markets coupled with a spate of regulatory changes has led to muted growth and lower profitability in these businesses over the last 5-6 years. On the other hand, the core lending business of the banks grew at a rapid pace of ~20% CAGR over FY08-14. Hence, the non-lending businesses of these banks have become an insignificant part of the overall earnings and valuation for most large listed banks.

Exhibit 1: Contribution from non-lending business in consolidated profits of the banks is not meaningful Bank SBI ICICI Bank HDFC Ltd Kotak Mahindra Bank

% contribution of different businesses in Consolidated profits FY08 FY14 FY08 FY14 FY08 FY14 FY08 FY14

Standalone lending business 75% 77% 96% 77% 90% 68% 27% 58%

Other Lending business 25% 20% 8% 6% 15% 22% 10% 20%

Life Insurance 0% 5% -17% 10% -7% 6% -2% 7%

Asset Management 1% 1% 1% 1% 3% 2% 2% 2%

Investment Banking/Broking 2% 2% 7% 2% 0% 0% 53% 7%

Others -3% -5% 5% 4% 0% 2% 10% 6%

Total 100% 100% 100% 100% 100% 100% 100% 100%


As the table above shows, the share of asset management and stock-broking/investment banking business in the overall profitability of banks has either come down significantly or has been stagnant over FY08-14. On the other hand, the share of profits from the life insurance businesses has increased over FY08-14, as the life insurance business has increased substantially due to lower strain from new business growth. However, growth has come down significantly in the insurance business over FY08-14.

Exhibit 2: The sharp drop in growth for the life insurance industry Year of deal FY05-08 FY08-14

Growth in new business premium for life insurance industry in India 53% 4%

Source: IRDA, Ambit Capital research.

Hence, the overall contribution of subsidiaries in the overall valuation of these banks has come down significantly. Moreover, the contribution of insurance, and asset management and stock-broking/investment banking is ~9-13% of the overall valuation of these entities.

Exhibit 3: Contribution from non-lending business in negligible in SOTP valuations of these entities % contribution of different businesses in Consolidated valuation

SBI ICICI Bank

HDFC Ltd

Kotak Mahindra

Valuation Methodology

Standalone lending business 77% 77% 46% 75% Excess return to equity model

Other Lending business 12% 6% 40% 12% Excess return to equity model; P/B multiple

Life Insurance 6% 10% 9% 2% Multiple of NBAP profits; Embedded value

Asset Management 1% 2% 3% 2% % of AUM

Investment Banking/Broking 2% 2% 0% 9% P/E multiple

Others 2% 3% 2% 0%

Total 100% 100% 100% 100%

Source: Company, Ambit Capital research.

Currently consensus values the asset management business of these banks at 4-5% of AUM. Whilst there are no listed asset managers in India, most of the stake sales/deals in

The share of insurance, asset management and investment banking/stock-broking businesses in the overall profitability and valuations of the banks has come down significantly between FY08 and FY14

Analyst Details

Pankaj Agarwal, CFA

+91 3043 3206

[email protected]

Ravi Singh

+91 3043 3181

[email protected]

Aadesh Mehta, CFA +91 3043 3239

[email protected]



the sector have happened at 3-6% of AUM in the past. Hence, the valuation assigned by consensus to the asset management businesses seems fair.

Exhibit 4: Recent deals in asset management Year of deal Investor Investee Stake Bought Deal Value as a % of AUM

2015 Nippon Life Reliance AMC 9% 3.2%

2012 L&T Fin Fidelity (India) 100% 6.2%

2012 Invesco Religare 49% 6.4%

2012 Nippon Life Reliance AMC 26% 6.6%

2011 GS Benchmark 100% 4.1%

2009 Nomura LIC AMC 35% 2.7%

2008 IDFC Stand C MF 100% 5.7%

Source: Company, Media reports, Ambit Capital research.

These AUM-based valuations are implying 20-30x earnings multiples for the asset management businesses. Whilst not strictly comparable, stock-brokers that have similar business characteristics (growth linked to equity markets with low capital intensity) trade at 15-20x earnings. So the current ~30-50% premium over stock-brokers seems to be largely capturing the higher stability and higher entry barriers in the business as compared to stock-broking. However, faster growth of the industry over the next 4-5 years (>25% CAGR) could lead to better valuations for the asset management business relative to what is built into the share prices of the banks. Currently, consensus values the life insurance business of these banks at ~2.5-3.5x of embedded value. Whilst there are no standalone listed insurance companies in India, valuations of Max India Ltd and Bajaj Finserve Ltd (whose insurance business constitute major part of the overall valuation of these entities) are not materially different to what consensus is assuming. The implied valuation of Max’s and Bajaj’s insurance business is ~3.5x EV and 2.0x EV respectively. Also, in a recent deal, HDFC sold a 1.5% stake in its insurance business at an implied valuation of 2.6x trailing EV. Hence, the valuation assigned by consensus to the insurance business of banks looks fair.

Exhibit 5: Recent life insurance deals Year of deal Investor Investee Stake Bought Deal Value as a multiple of EV

2014 Premji Invest HDFC Life 1% 2.6x

2012 Mitsui Sumitomo Max Life 26% 2.9x

2011 Nippon Life Reliance Life 26% ~3.0x

Source: Company, Media Reports, Ambit Capital research.

Like the asset management business, higher industry growth could lead to better valuations for these businesses. However, with regulatory changes around products like Unit Linked Insurance Plans (the highest-selling product during FY05-08) and with regulators tightening regulations around insurance misspelling, it would appear that the industry is unlikely to see the growth it witnessed during FY05-08. Due to strict RBI regulations, all the banks are running their insurance business/asset management/NBFC business as separate subsidiaries with separate management teams and operations. The banks are by and large just the holding companies of these non-bank businesses rather than being involved in day-to-day operations. Hence, the case for demerger of these businesses does not anyway arise insofar it is not obvious what is the incremental advantage of a demerger. Moreover, these non-bank subsidiaries of banks publish separate annual reports with their audited financial statements. Hence, it is relatively easier for the investors to analyse and value these businesses and assign valuations. As explained in the earlier section, we believe that consensus is fairly valuing insurance and asset management business of these banks and it does not look like that valuations of these subsidiaries are underappreciated by the market just because they are part of a bigger business. Hence, mere listing of these subsidiaries might not lead to any value creation for the stock holders and higher valuation for these businesses would only crystalize if the business fundamentals significantly improves for these businesses. However, given that the AMC/insurance business combined is not contributing more than 9-13% of overall valuation of any of these stocks, the appreciation in the valuation of these subsidiaries has to be in excess of 50% (vs current consensus expectations) to impact the valuation of listed entities by 5% or more.

Recent deals in the asset management/life insurance business and growth trends of these industries imply that consensus is fairly valuing asset management and life insurance subsidiaries of the banks

Upside potential in the valuation of asset management and life insurance business of banks is more a function of higher-than-expected growth trends in these industries rather than these businesses being separately listed



Tata Global Beverages (TGBL IN, NOTE RATED) - Stock price performance


Voltas (VOLT IN, SELL) - Stock price performance


Sadbhav Engineering (SADE IN, UNDER REVIEW) - Stock price performance


Ashoka Buildcon (ASBL IN, BUY) - Stock price performance


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Bajaj Electricals (BJE IN, SELL) - Stock price performance


State Bank of India (SBIN IN, SELL) - Stock price performance


HDFC Bank (HDFCB IN, SELL) - Stock price performance


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Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Bagul Consumer (022) 30433264 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Real Estate (022) 30433205 [email protected]

Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave, CFA Healthcare (022) 30433212 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Prashant Mittal, CFA Derivatives (022) 30433218 [email protected]

Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Midcaps – Chemical / Retail (022) 30433242 [email protected]

Ritesh Vaidya Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Sandeep Gupta Media / Midcaps (022) 30433211 [email protected]

Tanuj Mukhija, CFA E&C / Infra / Industrials (022) 30433203 [email protected]

Utsav Mehta, CFA Technology (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Shaleen Silori India (022) 30433256 [email protected]

USA / Canada

Ravilochan Pola - CEO Americas +1(646) 361 3107 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction



Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

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