STRATEGY - Ambitreports.ambitcapital.com/reports/Ambit_Strategy_Thematic_TheSensex... · Our profiling analysis reveals the following trends for Sensex entrants since 1995: (a)

STRATEGY

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June 2015

The Sensex in 2025

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EntrantsExits

Analysts:

Saurabh Mukherjea, CFA

[email protected]

Nitin Bhasin

[email protected]

Rakshit Ranjan, CFA

[email protected]

Pankaj Agarwal, CFA

[email protected]

Sagar Rastogi

[email protected]

Aditya Khemka

[email protected]

Ritesh Gupta, CFA,

[email protected]

Consultant: Anupam Gupta

[email protected]

Gaurav Mehta, CFA

[email protected]

Ashvin Shetty, CFA

[email protected]

Ritika Mankar Mukherjee, CFA

[email protected]

Karan Khanna

[email protected]

Strategy

June 22, 2015 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

Strategy: The Sensex in 2025……………………………………………………….. 3

Executive summary…………………………………………………………………… 4

Section 1: Sensex churn set to rise……………………………………………….. 12

Section 2: Plotting the past………………………………………………………… 15

Section 3: How does the headline equity index evolve…………………………18 as the economy changes?

Section 4: Predicting the next 15 entrants………………………………………. 32

COMPANIES

HCL Technologies (BUY) ………………………………………………………………… 45

Kotak Mahindra Bank (SELL) ……………………………………………………………. 49

Asian Paints (SELL) ………………………………………………………………………… 53

Nestle (SELL) ………………………………………………………………………………… 57

Eicher Motors (SELL) ………………………………………………………………………. 61

IndusInd Bank (BUY) ……………………………………………………………………… 65

Pidilite Industries (SELL) ………………………………………………………………….. 69

Page Industries (BUY) …………………………………………………………………….. 73

Torrent Pharma (BUY) ……………………………………………………………………..77

PI Industries (BUY) …………………………………………………………………………. 81

Appendix 1: Indices used in each country………………………………………. 85

Appendix 2: Sensex Exits…………………………………………………………… 88

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.

The Sensex in 2025

As the Indian economy transforms, we expect 15 replacements in the Sensex in the coming decade. Having identified the exit candidates in our May 2015 report ‘Sensex exits: The decadal story’, we now identify the likely entrants. We use historical data from India and other emerging markets (EMs) to identify the key trends and themes. We then apply our proprietary Ambit filters on listed stocks for a shortlist of ten entrants. For the remaining five unlisted stocks, we choose from large sectors which are relatively unrepresented in the Sensex such as e-commerce, insurance, consumer discretionary services and defence.

Sensex churn is set to rise… Our 5th May 2015 report, ‘Sensex exits: The decadal story’ highlighted two critical aspects on Sensex churn: (a) The constitution of the BSE Sensex is dynamic and India’s churn ratios are higher than other large markets; and (b) Modi’s ‘resets’ will transform India’s economy, sending Sensex churn higher from its recent lows. After peaking at 67% (or 20 replacements in a 30-stock index) in the years following the 1991 reforms, Sensex churn fell to a low of 27% (8 replacements) from 2004 to 2014. We expect a reversion to 50% churn, implying that 15 companies will exit the Sensex in the next decade. Having identified the exit candidates (see pg 5), we now identify the entrants over the next decade. …and getting the entrants right can be rewarding Our profiling analysis reveals the following trends for Sensex entrants since 1995: (a) half the entrants came from the top-100 listed stocks based on the beginning-period market capitalisation; (b) ~10% came from the next 100 stocks by market-cap; (c) ~6% came from below the top-200 stocks by market-cap, and (d) the remaining one-thirds entered on account of fresh listings. As expected, the lesser-known entrants from the ‘sub-200’ stocks delivered stellar returns over the subsequent ten-year period (60% CAGR vs 22% CAGR for top-100); examples include Dr. Reddy’s, Cipla and Infosys. Lessons from other markets Provided the Indian economy simply replicates its performance of the past ten years over the next ten years, per capita income should double to US$4,000 from the current level of around US$2,000. Based on the history of other countries that made such a transition, we expect four big shifts within the Sensex over the next decade: (a) the share of the consumer staples sector will decline; (b) the share of the consumer discretionary sector will rise; (c) the share of Banking and Financial Services (BFSI) will also rise; and (d) the share of industrials may not necessarily rise. Predicting the 15 entrants To predict the 10 entrants from the listed universe, we applied our proprietary Ambit filters like the ‘greatness’ score, Coffee Can Portfolio and P-75 Index. The entrants from the listed world are: Page Industries, Eicher Motors, Asian Paints, Nestle and Pidilite (from Consumer Staples/Discretionary), HCL Tech (IT Services), and Kotak Mahindra Bank and IndusInd Bank (BFSI). To these eight stocks from the top-100 by market-cap, we add Torrent Pharma and PI Industries from the next 100 by market-cap. For the remaining five stocks that will enter through IPOs, we pick from four themes that will dominate the next decade: (a) E-commerce (Flipkart and Paytm); (b) Insurance (ICICI Prudential Life Insurance); (c) Consumer Discretionary Services (Café Coffee Day); and (d) Disinvestment (Hindustan Aeronautics Limited).

THEMATIC June 22, 2015

Strategy

Sensex Entry Candidates (FY16-25)

Name Ticker Mcap (US$mn)

6m ADV (US$mn)

HCL Tech HCLT IN 19,838 37.5

Kotak Mahindra Bank

KMB IN 18,322 25.1

Asian Paints APNT IN 10,528 20.3

Nestle India NEST IN 8,683 6.1

Eicher Motors EIM IN 7,797 28.5

IndusInd Bank IIB IN 6,794 13.9

Pidilite Industries PIDI IN 4,197 4.1

Page Industries PAG IN 2,506 2.8

Torrent Pharma TRP IN 3,310 2.1

PI Industries PI IN 1,350 2.0

Flipkart N/A N/A N/A

Paytm N/A N/A N/A

I-Pru Life N/A N/A N/A

Café Coffee Day N/A N/A N/A

Hind. Aeronautics N/A N/A N/A

Source: Bloomberg, Ambit Capital Research. Note: N/A = data not available since companies are not yet listed

Analyst Details

Saurabh Mukherjea, CFA

+91 22 3043 3174 [email protected]

Gaurav Mehta, CFA +91 22 3043 3255

[email protected]

Consultant

Anupam Gupta [email protected]

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_Sensexexits_05May2015.pdf


Strategy


Executive summary The transformation of the Indian economy will increase Sensex churn to 50% over the next decade from 30% over the past decade. Our May 2015 thematic, ‘Sensex exits: The decadal story’ identified the companies that are likely to exit the Sensex over the next ten years. This thematic report takes our work to its logical conclusion by identifying the entrants.

We begin by analysing the nature of Sensex churn and recapping our list of Sensex exit candidates. For identifying Sensex entrants, we use historical data from India and other emerging markets (EMs) to identify the key trends and themes. We then apply our proprietary Ambit filters on the listed stocks for a shortlist of ten entrants. For the remaining five unlisted stocks, we choose from large sectors that are largely unrepresented in the Sensex.

Sensex churn set to rise Note that the constitution of the Sensex is extremely dynamic, and ‘churn’ in the Sensex is in fact the only constant. Furthermore, ‘churn ratios’ in India are higher than that of other developed as well as emerging markets. Our analysis of Sensex churns over a 10-year window from 1986 to date (ie: 1986-1996, 1987-1997 and so on, to 2004-2014) shows that the churn ratio of the Sensex tends to rise when the economy is undergoing irreversible structural changes.

Exhibit 1: The Sensex churn ratio has a tendency to rise when the economy undergoes structural changes

Source: Ambit Capital research, Bloomberg. Note: Sensex churn has been calculated as the percentage number of companies forming a part of the Sensex in year ‘t’ that get exited from the index by year ‘t+10’. For example, 50% in the 1986-96 period suggests 15 of the 30 Sensex constituents in Dec’86 were no longer part of the index 10 years later, i.e. Dec’ 96

The current economic-political environment will usher in an era of change which will drive Sensex churn higher. We have focused on this theme in detail in our report ‘Sensex exits: The decadal story,’ dated 5 May 2015 (click here for details). Please refer Appendix 1 on Pg 85 for a detailed summary.

In this report, we have posited that Sensex churn, which has fallen to historical lows, will now rise driven by Prime Minister Narendra Modi’s resets to the Indian economy. To recap, these resets are:

Reset 1: Shifting India’s savings landscape away from gold and land towards the formal financial system

Reset 2: Disrupting crony capitalism in India

Reset 3: Re-defining India’s subsidy mechanisms

Thus, we expect Sensex churn to rise to 50% in the next decade (2015 to 2025) from historical lows of 27% during the most-recent decadal bucket (2004 to 2014). This means that 15 stocks will be replaced in the Sensex in the upcoming decade. In our

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Sensex churn - 10-year window

India’s churn ratios are higher than those in other markets

Modi’s ‘resets’ will disrupt the way business was traditionally done in India

Sensex churn – currently at historical lows – is set to rise in the next decade



Strategy


‘Sensex exits: The decadal story’ report, we elaborated on a framework to identify 15 stocks that would exit (see the exhibit below).

Exhibit 2: Exit candidates from Sensex over the next decade**

Name Ticker Mcap (US$ bn)

6M ADV (US$ mn)

Exit hypothesis

Reliance Industries RIL IN 47 54 Uncertainty on profitability of large investments in retail and telecom; downstream margins likely to remain muted

O N G C ONGC IN 41 26 Falling subsidies unlikely to aid profitability; uncertainty on production growth makes earnings growth a challenge

State Bk of India SBIN IN 30 89 Relaxation of Government protection, rising capital requirements and competition from stronger private sector peers and introduction of new players

Bharti Airtel BHARTI IN 26 32 High spectrum costs, new competition from Jio will weigh on Indian business profitability; African business will remain a drag on consolidated profits

Larsen & Toubro LT IN 25 53 High competitive intensity in a fragmented industry, no discernible competitive advantages in most sectors; L&T’s large size will be a constraint

NTPC NTPC IN 18 15 Increase in competition from private sector, decline in power deficit and end of preferential treatment from Coal India for fuel linkages

M & M MM IN 12 23 Utility vehicle business under threat from foreign car companies’ superior offerings; tractor business bearing the brunt of slowdown in rural demand

Bajaj Auto BJAUT IN 11 16 Rising competitive intensity in domestic and export markets; exports further hit from macro-economic challenges in key geographies

B H E L BHEL IN 9 18 Boiler-turbine-generator industry in structural downturn; over-capacity issues (and thus greater competition) will plague BHEL and its peers

Vedanta* SSLT IN 8 17 RoEs will trend lower towards global peers’; mine acquisition costs will rise under MMDR Act as global iron ore and steel demand stays weak

Hero Motocorp HMCL IN 8 35 Over-dependence on legacy models, uncertain indigenous technology, shift towards scooters and rising competition from Honda

Tata Steel TATA IN 5 33 Downturn in steel prices to hurt global business; loss of low-cost raw material advantage under MMDR Act to hurt domestic business

Hindalco Industries HNDL IN 4 19 Weak aluminium prices and premiums to hurt global business; lack of cheap captive coal will mute RoCEs of new domestic smelters

Tata Power Co. TPWR IN 3 5 RoEs will remain lower than cost of equity; rise in coal prices and structural changes in sale of power will impact long-term prospects

Source: Bloomberg, Ambit Capital research. Note: *This is Sesa Sterlite; Market-cap data is as of 17 June 2015. ** For internal compliance reasons, one of the 15 companies in this table has been taken out.

Historically, where have Sensex entrants come from? Intuitively, the size of a company at the beginning of the decade should play an important role in determining whether or not the company will be in the index a decade later. To put a number to the probability of being included in the Sensex a decade hence, we analyse the historical Sensex entrants on a rolling ten-year basis beginning with the year 2000, on the basis of their market-caps as of the beginning of the decade (which in turn implies examining data going back until 1990). Basis this, we categorise these entrants into four buckets:

The ‘top-100’ bucket which comprises the entrants that belonged to the top-100 firms on market-cap as of the beginning of the decade;

The ‘101-200’ bucket which comprises the entrants that belonged to the next 100 firms on market-cap as of the beginning of the decade;

The ‘beyond top-200’ bucket which comprises the entrants that belonged to the listed universe outside of the top 200 on market-cap as at the beginning of the decade; and

The ‘fresh issuances’ bucket that comprises firms that were not listed as at the beginning of the decade but have entered the index on account of fresh listings.

Our analysis of these fresh entrants starting from the year 1990 to date has been reproduced in Exhibit 3 below.

Intuitively, size at the beginning should play an important role in determining whether or not a company will be in the index a decade later

Strategy


Exhibit 3: Nearly half the entrants historically have come from the ‘top-100’ stocks as at the start of the decade

% entrants coming from:

Period 'Top-100' bucket '101-200' bucket 'Beyond top-200' bucket

'Fresh issuances' bucket

1990-00 33% 11% 6% 50%

1991-01 33% 6% 11% 50%

1992-02 47% 16% 11% 26%

1993-03 45% 20% 15% 20%

1994-04 60% 10% 10% 20%

1995-05 50% 25% 5% 20%

1996-06 50% 7% 7% 36%

1997-07 46% 8% 0% 46%

1998-08 38% 8% 0% 54%

1999-00 43% 0% 7% 50%

2000-10 44% 0% 13% 44%

2001-11* 44% 6% 6% 44%

2002-12* 57% 7% 7% 29%

2003-13* 56% 11% 0% 33%

2004-14* 75% 13% 0% 13%

Average 48% 10% 6% 36%

Source: Bloomberg, Capitaline, Ambit Capital research. Note: * indicates this is on a free float market-cap basis.

Key findings from Exhibit 3 are summarised below:

~48% of the entrants historically have come from the top-100 stocks based on market-cap as of the beginning of the decade. This suggests that nearly half the fresh entrants over a ten-year window belong to the top-100 stocks on beginning-period market-cap;

~10% stocks come from the next-100 stocks (i.e. beginning-period market-cap rank between 101-200);

~6% of the entrants come from the listed universe outside of the top-200 stocks; and

The remaining 36% of the stocks entered the index on account of fresh listings. This suggests that nearly one-thirds of all the fresh entrants enter the index on account of mega IPOs over the decade.

Owning a future Sensex entrant has been a winning proposition On an average, firms entering the index have delivered 29% returns (in CAGR terms) over the decade. However, what is more interesting is the composition of these returns. Whilst firms that enter the index from the top-100 bucket (basis beginning-period market-cap) have managed to deliver 22% CAGR returns historically, firms entering the index from the next 100 bucket have managed to deliver an impressive 36% CAGR return. Following this logic further, firms that enter the index from outside the top-200 stocks, however, have been blazing winners (having delivered 60% CAGR returns over the ten-year period).

Nearly half the entrants come from the top-100 stocks on beginning-period market-cap

Firms that enter the index from outside of the top-200 stocks tend to be blazing winners

Strategy


Exhibit 4: The further an entrant is from the Sensex at the beginning of the decade, the higher its investment returns over the course of the decade

Average share price returns over the decade for stocks coming from:



1990-00 18% 25% 64% N/A

1991-01 13% 4% 50% N/A

1992-02 10% 34% 35% N/A

1993-03 12% 43% 57% N/A

1994-04 17% 28% 57% N/A

1995-05 24% 42% 67% N/A

1996-06 43% 35% 75% N/A

1997-07 35% 49% N/A N/A

1998-08 22% 39% N/A N/A

1999-00 23% N/A 65% N/A

2000-10 24% N/A 70% N/A

2001-11* 24% 68% 63% N/A

2002-12* 28% 54% 60% N/A

2003-13* 22% 30% N/A N/A

2004-14* 21% 24% N/A N/A

Average 22% 36% 60% N/A

Source: Bloomberg, Capitaline, Ambit Capital research. Note: This is the average share price performance over the decade for firms entering the sensex by the end of the decade. * indicates this is share price performance for firms belonging to the respective buckets constructed on a free float market-cap basis.

Thus, close to half of the 15 Sensex entrants of the next decade are likely to come from the top-100 stocks ranked by market-cap today. Another 10% are likely to come from the next 100 stocks by market-cap (below the top 100). About 6% should come from the universe beyond the top-200. Finally, a third of the entrants are likely to be new offerings.

Established trends from other emerging markets The key takeaways from analysing trends in other countries that went from US$2K per capita income to US$4K per capita income point to the following changes in ‘sectoral market capitalisation shares’ in India’s benchmark equity index.

Insight #1: The market-cap share of India’s Consumer Staples sector is set to decline over the next decade.

Exhibit 5: Cross-country evidence suggests that the Consumer Staples sector’s market-cap (as a share of the broader market’s market cap) declines as per capita incomes rise

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Malaysia (CY94-13), Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13) and Philippines (CY94-13).

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The share of ‘Consumption’ in GDP declines as per capita incomes rise

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Insight #2: The market-cap share of India’s Consumer Discretionary sector is set to rise over the next decade.

Exhibit 6: Cross-country evidence suggests that the ‘Consumer Discretionary’ sector’s market-cap (as a share of the broader market) secularly increases

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include India (CY94-13), Thailand (CY94-13) and Korea (CY94-13). We have included Korea in this section owing to data insufficiency problems in other countries that are part of our preferred sample set i.e. for Indonesia, Philippines and Malaysia.

Insight #3: The market-cap share of India’s Financial Services sector is set to rise over the next decade.

Exhibit 7: Financial sector’s market-cap rises as per capita income rises

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13, Malaysia (CY94-13) and Turkey (CY04-13). We have included Turkey in this section owing to data insufficiency problems in other countries in our preferred sample set i.e. for the Philippines.

Insight #4: The market-cap share of India’s Industrials sector may not necessarily rise.

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The ‘Consumer Discretionary’ sector’s market-cap first falls but then secularly rises as per capita incomes rise

The share of ‘Savings’ in GDP initially increases as per capita incomes rise but starts declining after a certain level

Strategy


Exhibit 8: At low levels of per capita income, market-cap share of ‘Industrial’ appears unclear...

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Malaysia (CY94-13), Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13) and the Philippines (CY94-13)

Exhibit 9: … and so is the case at higher per capita income

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Malaysia (CY94-13) and Thailand (CY94-13)

Predicting the next 15 entrants Having established the broad shape of where the entrants will come from (both in terms of size and in terms of sector), we proceed to identify the likely entrants.

We believe five entrants will list through IPOs and these will come from sectors that are significantly under-represented in the Sensex.

Exhibit 10: The five stocks that will enter the Sensex through IPOs Name Sector Rationale

Flipkart E-commerce Already India's biggest e-commerce company in terms of valuations; poised to benefit from the boom in e-commerce

Paytm Digital Payments Increasingly taking on banks in the digital payments space; strong parentage with investment from Alibaba (China)

ICICI Prudential Life Life Insurance Play on increasing share of BFSI in general and insurance in specific as economic growth increases

Café Coffee Day Coffee Conglomerate

Well placed to benefit from the shift towards consumer discretionary from consumer staples; largest coffee conglomerate in India.

Hindustan Aeronautics Ltd (HAL) Defence

Government-owned defence major; key beneficiary of the 'Make in India' theme; ideal candidate for a big-bang disinvestment-led IPO

Source: Ambit Capital research

Within the listed universe, we use our proprietary filters such as the ‘greatness’ framework, Coffee Can Portfolio and P-75 list of connected companies to arrive at the other ten stocks (see the exhibit below).

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New entrants via IPOs will come from sectors that are not represented in the Sensex

Strategy


Exhibit 11: The most likely Sensex entry candidates over the coming decade

Company Name Ticker Mcap (US$ mn)

6M ADV (US$ mn)

FY16 P/E

FY16 P/B Entry hypothesis

Top 100 stocks on free-float mcap

HCL Tech HCLT IN 19,838 37.5 15.8 4.3 Leader in Infra management services; scores high on our capital allocation, portfolio mix, operational excellence and management framework

Kotak Mahindra Bank KMB IN 18,322 25.1 25.8 3.7 Among the best-run private sector banks; loan book growth will increase post the ING Vysya integration

Asian Paints APNT IN 10,528 20.3 37 12 Enduring leadership position set to sustain led by supply-chain and scale efficiencies, market share gains and proven management

Nestle NEST IN 8,683 6.1 42.2 17.5 Established brand equity and pricing power position; will gain from shift in consumer spend towards discretionary segment

Eicher Motors EIM IN 7,797 28.5 49 14.6 Leader in niche motorcycle segment; well placed to gain from rise in consumer discretionary spend

IndusInd Bank* IIB IN 6,794 13.9 19.1 3.5 Leader in CV financing; expansion in new areas led by strong franchise will drive market share gains and above-system loan book growth

Pidilite Industries PIDI IN 4,197 4.1 42.7 10.2 Sustainable brand leadership and superior fundamentals make Pidilite a high-quality defensive play in the consumer sector

Page Industries PAG IN 2,506 2.8 57.3 32.2 Greater growth longevity than most consumer companies; sustained competitive advantages will support premium valuations

Next 100 stocks on free-float mcap

Torrent Pharma TRP IN 3,310 2.1 21.6 6.6 Increasing presence in generics (US, Europe) and branded markets (India and EMs); new management driving high RoCEs

PI Industries PI IN 1,350 2 28.5 7.6 Leading agro-chemical player with proven track record; entry into new specialty chemicals areas for custom manufacturing should sustain high growth phase

Unlisted Flipkart N/A N/A N/A N/A N/A Already India's biggest e-commerce company in terms of valuations; poised to

benefit from the boom in e-commerce

Paytm N/A N/A N/A N/A N/A Increasingly taking on banks in the digital payments space; strong parentage with investment from Alibaba (China)

I Pru Life N/A N/A N/A N/A N/A Play on increasing share of BFSI in general and insurance in specific as economic growth increases

Café Coffee Day N/A N/A N/A N/A N/A Well placed to benefit from the shift towards consumer discretionary from consumer staples; largest coffee conglomerate in India

Hind. Aeronautics N/A N/A N/A N/A N/A Government-owned defence major; key beneficiary of 'Make in India' theme; ideal candidate for a big-bang disinvestment-led IPO

Source: Bloomberg, Capitaline, Ambit Capital research. Note: We have also filtered this list for clean accounting quality using our forensic accounting framework. * Whilst IndusInd Bank meets the RoA cut-off of 1.1% in six out of the last ten years, we have included the bank as it is ranked the best bank on our ‘greatness’ framework.

Looking at the 15 entrants (currently listed plus fresh listings in totality), we can classify them into the following sectors:

Automobile (Consumer Discretionary): Eicher Motors

Chemicals: PI Industries

Consumer/Retail (includes Consumer Discretionary): Asian Paints, Nestle India, Pidilite, Page Industries and Café Coffee Day

Banking and Financial Services: Kotak Mahindra Bank, IndusInd Bank and ICICI Prudential Life Insurance

Defense: Hindustan Aeronautics Limited

Healthcare: Torrent Pharmaceuticals

Technology: HCL Tech, Flipkart and Paytm

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_Forensicaccounting_22Dec2014.pdf

Strategy


Pulling it all together Pulling all of this together gives us the Sensex in 2025 (see the exhibit below).

Exhibit 12: Sensex 2015 versus Sensex 2025 Sensex Today Sensex in 2025 Automobile Automobile Tata Motors Tata Motors Maruti Suzuki Maruti Suzuki M&M Eicher Motors Bajaj Auto Hero Moto Banking / Financial Services Banking / Financial Services HDFC Bank HDFC Bank State Bank of India Kotak Mahindra Bank HDFC IndusInd Bank ICICI Bank ICICI Bank Axis Bank Axis Bank

ICICI Prudential Life

Chemicals

PI Industries Consumer / Retail Consumer / Retail ITC ITC Hindustan Unilever Hindustan Unilever

Asian Paints

Nestle India

Pidilite Industries

Page Industries

Café Coffee Day E&C / Infra / Industrials Defense L&T Hindustan Aeronautics Healthcare Healthcare Sun Pharma Sun Pharma Dr Reddy Dr Reddy Cipla Cipla

Torrent Pharmaceuticals Metals & Mining / Oil & Gas Metals & Mining / Oil & Gas Reliance Ind Coal India Coal India ONGC Vedanta Tata Steel Hindalco Power Utilities / Capital Goods Power Utilities / Capital Goods

NTPC GAIL

BHEL GAIL Tata Power Technology Technology

TCS TCS

Infosys Infosys

Wipro Wipro

HCL Tech

Telecom Internet

Bharti Airtel Flipkart

Paytm

Source: Bloomberg, Ambit Capital research.

In the next decade, the Sensex will see huge changes in its composition

Strategy


Section 1: Sensex churn set to rise "Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected."

- George Soros (as quoted by The Telegraph in January 2015 on his retirement)

The constitution of the Sensex makes it dynamic, and Indian churn ratios are higher than those in developed and emerging markets. Further, structural changes in India’s economy drive up Sensex churn, as was seen in the 1990s at the end of the Licence Raj era. With Prime Minister Modi driving similar structural changes in the Indian economy over the next decade, we expect Sensex churn to revert to higher levels of 50%, after reaching historical lows of 30% during 2004-2014.

Churn is the only constant in the Sensex….

Note that the constitution of the Sensex is extremely dynamic, and ‘churn’ in the Sensex is in fact the only constant. This aspect has been discussed in detail in our earlier report, ‘Decadal changes in the Sensex’ dated June 28, 2012 (click here for details) and also in our recent report ‘Sensex exits: The decadal story’ dated May 5, 2015 (click here for details). Furthermore, ‘churn ratios’ in India are higher than that of other developed as well as emerging markets (see the exhibit below).

Exhibit 13: The Indian market is characterised by a high churn ratio*

Source: Bloomberg, Ambit Capital research. Note: * Churn is defined as the number of companies which get ejected from the index over a given period of time / total number of companies in the index. This chart has been reproduced without any changes from our June 28, 2012 note: ‘Decadal changes in the Sensex’

Our analysis of Sensex churns over a 10-year window from 1986 to date (ie: 1986-1996, 1987-1997 and so on to 2004-2014) shows that the churn ratio of the Sensex tends to rise when the economy is undergoing irreversible structural changes. For instance, the 10-year period spanning 1992-2002, when the era of the ‘Licence Raj’ came to an end, saw the Sensex’s churn ratio rise to 60% (vs the 53% churn ratio in the Sensex over 2002-12). In light of the three resets that Modi is likely to engineer, the next ten years in India appear likely to be akin to the 1990s rather than the noughties, as the period spanning 1992-2002 too was a decade defined by irrevocable structural changes being administered by the political leadership.

(Note: We have calculated the Sensex’s churn ratio in the following manner - 18 of the 30 constituents of the Sensex in 1992 were no longer part of the index in 2002. Thus, Sensex saw a churn of 60% over the 1992-02 period. Similarly, 16 of the 30 constituents of the Sensex in 2002 exited the index by 2012. Consequently, churn over the 2002-12 period was at 53%.)

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Sensex churn rises when the economy is undergoing irreversible structural changes

http://reports.ambitcapital.com/reports/Ambit_SensexDecadalChanges_28Jun2012.pdf


http://reports.ambitcapital.com/reports/Ambit_SensexDecadalChanges_28Jun2012.pdf

Strategy


Exhibit 14: The Sensex churn ratio shows a tendency to rise when the economy undergoes structural changes


The churn in the Sensex peaked in the four years following the momentous reforms launched by PV Narsimha Rao (as PM) and Manmohan Singh (as Finance Minister). A whole host of businesses which had flourished behind the protectionist barriers created by the ‘Licence Raj’ in industries were ejected from the Sensex. These industries include: (1) Textiles (Aditya Birla Nuvo, Bombay Dyeing, Century Textiles and Future Polyester), (2) Automobiles (Hindustan Motors and Premier), (3) Steel (Mukand Limited), (4) Paper (Ballarpur Industries), and (5) Heavy engineering (Bharat Forge, Cummins India, Siemens and Voltas (although this final group of companies subsequently adapted well in the post-Licence Raj period).

Post-1995, Sensex churn has fallen remarkably relative to the volatile era of the early 1990s. Sensex incumbents grew rapidly in size, and we attribute this to the following reasons:

a) Large business groups ramped up domestic capacities in a licence-free era and followed them up with large acquisitions in the noughties (Reliance, Tata Steel and Hindalco).

b) Export-led companies like software (Infosys and TCS) and pharmaceuticals expanded.

c) The noughties also saw the rise of infrastructure companies (L&T) and banks/financial institutions which funded their expansion (ICICI Bank) and also benefited from the rise in overall GDP growth (HDFC Bank) from 3.9% in FY03 to 8% in FY04, 7.1% in FY05, 9.5% in FY05 and 9.6% in FY01.

d) Finally, towards the end of the noughties, the rise in rural-led consumption benefited auto (Hero MotoCorp, Bajaj Auto, M&M and Maruti) and FMCG (HUL and ITC) stocks.

…and churn is now set to rise

The current economic-political environment will usher in an era of change which will drive Sensex churn higher. We have focused on this theme in detail in our report ‘Sensex exits: The decadal story’ dated 5 May 2015 (click here for details). Please refer Appendix 1 on Pg 85 for a detailed summary.

In this report, we have posited that Sensex churn – which has fallen to historical lows – will now rise driven by Prime Minister Narendra Modi’s resets to the Indian economy. To recap, these resets are:

Reset 1: Shifting India’s savings landscape away from gold and land towards the formal financial system;

Reset 2: Disrupting crony capitalism in India; and

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… and from those levels, Sensex churn fell as incumbents entrenched themselves in the post-liberalisation era

Modi’s ‘resets’ will disrupt the way business was traditionally done in India


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Reset 3: Re-defining India’s subsidy mechanisms.

Thus, we expect Sensex churn to rise to 50% in the next decade (2015 to 2025) from historical lows of 27% during the most-recent decadal bucket (2004 to 2014). This means that 15 stocks will be replaced in the Sensex in the upcoming decade.

In our ‘Sensex exits: The decadal story’ report, we elaborated on a framework to identify 15 stocks that would exit (see the exhibit below).

Exhibit 15: Sensex exits in the next decade*

Number Stock name Market Cap (̀ bn)

1 Reliance Inds 3,014

2 ONGC 2,618

3 State Bank of India 1,930

4 Bharti Airtel 1,688

5 L&T 1,592

6 NTPC 1,130

7 M&M 779

8 Vedanta 512

9 BHEL 589

10 Bajaj Auto 686

11 Hero Moto 504

12 Tata Steel 296

13 Hindalco 245

14 Tata Power 197

Source: Bloomberg, Ambit Capital research. Note: Market cap data is as of 17 June 2015. * For internal compliance reasons, the name of the 15 stocks on the “exits” list has been removed from this report.

We now bring this investment theme to its logical conclusion by identifying 15 stocks that will replace these outgoing candidates in the next decade. We begin with analysing past trends which show us the source of entrants into the Sensex.

Sensex churn – currently at historical lows – is set to rise in the next decade

Our framework to identify exit candidates was based on Ambit proprietary filters such as Coffee Can Portfolio, Greatness Framework and P-75 Index

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Section 2: Plotting the past "I always remind myself that what one observes is at best a combination of variance and returns. Not just returns."

- Nassim Nicholas Taleb (Fooled by Randomness, 2001)

Summary: Basis our analysis of Sensex entrants over the past 25 years, the key takeaways from this section are:

Nearly half of the Sensex entrants over a ten-year window come from the top 100 stocks based on beginning-period market-cap;

Nearly one-thirds of the fresh entrants primarily enter the index on account of mega IPOs over the decade;

The remaining 16% stocks that enter the index belong to the universe outside of the top-100 stocks on beginning-period market-cap (with 10% coming from the 101-200 universe and 6% coming from the beyond top-200 universe); and

Firms that enter the index from outside of the top-200 stocks tend to be blazing winners.

Background From our discussions in the previous section, we note that churn in the Indian markets has historically been relatively high. Further, after having peaked at 67% in the years following the 1991 reforms (implying 20 replacements in a 30-stocks index), this churn has fallen to historical lows of 27% (i.e. 8 replacements) in the most recent ten-year period (2004-14). With the structural changes emanating from the three resets likely changing the way in which business is conducted in India (much the same way as the 1991 liberalisation measures ended the ‘Licence Raj’), even a conservative assumption of 50% churn in the index over the next decade would mean that as many as 15 of the current Sensex constituents are likely to be replaced over the coming years. The logical question then that follows would be which are the likely 15 companies that will replace these 15 stocks discussed earlier?

Where do Sensex entrants come from? In order to answer this question, we turn to history as a guide and analyse where the past Sensex entrants have come from. Intuitively, the size of a company at the beginning of the decade should play an important role in determining whether or not the company will be in the index a decade later. This is also a point we had highlighted in our 20 November 2012 note, “The Nifty in 2022”. To put a number to the probability of being included in the Sensex a decade hence, we analyse the historical Sensex entrants on a rolling ten-year basis beginning with the year 2000, on the basis of their market-caps as of the beginning of the decade (which in turn implies examining data going back until 1990). For example, for the 1990-2000 period, we first look at all the fresh entrants that were included in the index in the decade leading up to December 2000. Next, we rank these firms on the basis of their market-cap at the beginning of the decade, i.e. as of December 1990. Basis this, we categorise these entrants into four buckets:

The ‘top-100’ bucket which comprises the entrants that belonged to the top-100 firms on market-cap as of the beginning of the decade;

The ‘101-200’ bucket which comprises the entrants that belonged to the next 100 firms on market-cap as of the beginning of the decade;

The ‘beyond top-200’ bucket which comprises the entrants that belonged to the listed universe outside of the top 200 on market-cap as at the beginning of the decade; and

The ‘fresh issuances’ bucket that comprises firms that were not listed as at the beginning of the decade but have entered the index on account of fresh listings.

Intuitively, size at the beginning should play an important role in determining whether or not a company will be in the index a decade later

We categorise the entrants into four buckets based on beginning-period market-cap

http://reports.ambitcapital.com/reports/Ambit_Strategy_TheNiftyin2022_20Nov2012.pdf

Strategy


Our analysis of these fresh entrants starting from the year 1990 to date has been reproduced in Exhibit 16 below.

Exhibit 16: Nearly half the entrants historically have come from the ‘top-100’ stocks as at the start of the decade

% entrants coming from:



1990-00 33% 11% 6% 50%

1991-01 33% 6% 11% 50%

1992-02 47% 16% 11% 26%

1993-03 45% 20% 15% 20%

1994-04 60% 10% 10% 20%

1995-05 50% 25% 5% 20%

1996-06 50% 7% 7% 36%

1997-07 46% 8% 0% 46%

1998-08 38% 8% 0% 54%

1999-00 43% 0% 7% 50%

2000-10 44% 0% 13% 44%

2001-11* 44% 6% 6% 44%

2002-12* 57% 7% 7% 29%

2003-13* 56% 11% 0% 33%

2004-14* 75% 13% 0% 13%

Average 48% 10% 6% 36%

Source: Bloomberg, Capitaline, Ambit Capital research. Note: * indicates this is on a free float market-cap basis.

Key findings from Exhibit 16 are summarised below:

~48% of the entrants historically have come from the top-100 stocks based on market-cap as of the beginning of the decade. This suggests that nearly half of the fresh entrants over a ten-year window belong to the top-100 stocks on beginning-period market-cap;

~10% stocks come from the next 100 stocks (i.e. beginning-period market-cap rank between 101 and 200);

~6% of the entrants come from the listed universe outside of the top-200 stocks; and

The remaining 36% of the stocks entered the index on account of fresh listings. This suggests that nearly one-thirds of all the fresh entrants enter the index on account of mega IPOs over the decade.

Owning a future Sensex entrant has been a winning proposition Firms that enter the index over a decade do so after a prolonged period of outperformance. Whilst this is intuitive, an empirical assessment reinforces the conclusion as well. Exhibit 17 below demonstrates the share price returns of firms entering the index over a ten-year window, starting from the year 1990. On an average, firms entering the index have delivered 29% returns (in CAGR terms) over the decade. However, what is more interesting is the composition of these returns. Whilst firms that enter the index from the top-100 bucket (basis beginning-period market-cap) have managed to deliver 22% CAGR returns historically, firms entering the index from the next 100 bucket have managed to deliver an impressive 36% CAGR returns. Following this logic further, firms that enter the index from outside the top-200 stocks, however, have been blazing winners (having delivered 60% CAGR returns over the ten-year period).

Nearly half the entrants come from the top-100 stocks on beginning-period market-cap

Firms that enter the index from outside of the top-200 stocks tend to be blazing winners

Strategy


Exhibit 17: The further an entrant is from the Sensex at the beginning of the decade, the higher its investment returns over the course of the decade

Average share price returns over the decade for stocks coming from:



1990-00 18% 25% 64% N/A

1991-01 13% 4% 50% N/A

1992-02 10% 34% 35% N/A

1993-03 12% 43% 57% N/A

1994-04 17% 28% 57% N/A

1995-05 24% 42% 67% N/A

1996-06 43% 35% 75% N/A

1997-07 35% 49% N/A N/A

1998-08 22% 39% N/A N/A

1999-00 23% N/A 65% N/A

2000-10 24% N/A 70% N/A

2001-11* 24% 68% 63% N/A

2002-12* 28% 54% 60% N/A

2003-13* 22% 30% N/A N/A

2004-14* 21% 24% N/A N/A

Average 22% 36% 60% N/A

Source: Bloomberg, Capitaline, Ambit Capital research. Note: This is the average share price performance over the decade for firms entering the sensex by the end of the decade. * indicates this is share price performance for firms belonging to the respective buckets constructed on a free float market-cap basis.

Thus, close to half of the 15 likely entrants in the index over the past decade are likely to be from the top-100 stocks on market-cap today. Another 10% should likely come from the next-100 stocks on market-cap below the top-100 today. About 6% should come from the universe beyond the top-200 whilst a good one-third of the entrants are likely to be new offerings.

Before moving on to a discussion on the most likely Sensex entry candidates, we first discuss the likely sectoral make of the index a decade hence, basis the underlying changes in the economy, in the next section.

Strategy


Section 3: How does the headline equity index evolve as the economy changes? "Countries have choices, and those choices have substantially determined whether they succeeded or failed."

- Alan Beattie, “False Economy – A Surprising Economic History of the World (2009)”.

The key takeaways from analysing the trends in other countries that went from US$2K per capita income to US$4K per capita income point to the following changes in ‘sectoral market capitalisation shares’ in India’s benchmark equity index:

Insight #1: The market-cap share of India’s Consumer Staples sector is set to decline over the next decade.

Insight #2: The market-cap share of India’s Consumer Discretionary sector is set to rise over the next decade.

Insight #3: The market-cap share of India’s Financial Services sector is set to rise over the next decade.

Insight #4: The market-cap share of India’s Industrials sector may not necessarily rise.

Economies change as per capita income grows As economies differ from one another along multiple dimensions such as resource endowments, social structures and political development, the paths to economic development that various countries follow also tends to be different. For instance, an increase in a country’s per capita income from say, US$1K to US$5K, may take a few years or decades, may or may not be accompanied by increased profitability of listed firms, may or may not be accompanied by a reduction in inequalities and so on and so forth.

However, history suggests that as a country transitions from a per capita income of US$2K to US$4K, certain striking similarities seem to repeat themselves across countries. These similarities primarily relate to:

The demand-side constitution of GDP i.e. the share of consumption, investments and savings in GDP; and

The corresponding shares of listed B2C companies, industrials and financial services providers in total market capitalisation.

Moreover, despite the vast dissimilarities that exist in the manner a country develops, this transition ‘feels’ remarkable for the reasons described below.

Living in a developed country like Korea in the 1970s felt a lot like living in India today

Whilst Korea today is a developed country with a per capita income of US$26K, it made this critical transition from a US$2K to US$4K per capita income country over seven years beginning CY82. Before this transition (i.e. in the 1970s and 1980s), South Korea’s per capita income was similar to that of India’s in the noughties. Moreover, living in the capital city of Seoul in the 1970s ‘felt’ a lot like living in suburban India today, as evinced by the account of Ha-Joon Chang, a Korean development economist who was born in 1963 and who teaches at the University of Cambridge.

“The house I was born and lived in until I was six was in what was then the north-western edge of Seoul, Korea’s capital city. It was one of the small (two-bedroom) but modern homes…It was made with cement bricks and was poorly heated, so it was rather cold in winter—the temperature in Korea’s winter can sink to 15 or even 20 degrees below zero. There was no flushing toilet, of course: that was only for the very rich.

Despite the vast dissimilarities thatexist in the manner a country develops, this transition ‘feels’ remarkable

Strategy


Yet my family had some great luxuries that many others lacked, thanks to my father, an elite civil servant in the Finance Ministry....We owned a black-and-white TV set, which exerted a magnetic pull on our neighbours. One family friend, an up-and-coming young dentist at St Mary’s, one of the biggest hospitals in the country, somehow used to find the time to visit us whenever there was a big sports match on TV—ostensibly for reasons totally unrelated to the match. In today’s Korea, he would be contemplating upgrading the second family TV in the bedroom to a plasma screen.

A cousin of mine who had just moved from my father’s native city of Kwangju to Seoul came to visit on one occasion and quizzed my mother about the strange white cabinet in the living room. It was our refrigerator (the kitchen being too small to accommodate it).”

— Ha-Joon Chang, Bad Samaritans (2007)

Clearly, the South Korean economy underwent dramatic economic changes in the decades that followed (see the exhibit below).

Exhibit 18: Area around Gangnam bus terminal, Seoul in the 1980s

Source: The Korea Herald, Ambit Capital research

Exhibit 19: Modern day area around the Gangnam district, Seoul

Source: The Korea Herald, Ambit Capital research

Whether India will be able to make this sort of transition into a developed country is unclear, given India’s current economic structure; however, it is relatively certain that India’s per capita income will double from US$2K to US$4K over the coming decade. Over the past decade, India’s GDP per capita in current US dollars has compounded at 8% and currently stands at US$1,627, according to the IMF. If we assume that the rate of compounding stays at 8%, India’s GDP per capital should be around US$3,925 a decade hence.

Given the extraordinary commonalities experienced by other countries that undergo this per capita transition, these common trends can be used to discern profitable investment opportunities in India over the coming decade.

Given India’s current economic structure, it is relatively certain that India’s per capita income will double from US$2K to US$4K over the coming decade

Strategy


Section 3.1: The transition from a per capita income of US$2K to US$4K is accompanied by critical economic changes The last three decades have seen a range of countries transitioning from being characterised by a US$2K per capita income (PCI) to US$4K PCI (see the exhibit below).

Exhibit 20: A range of countries transitioned from being characterised by a US$2K per capita income (PCI) to US$4K over the last three decades

Country Starting year Time taken to double PCI from US$2K to US$4K (in yrs)

Russia CY01 4

China CY06 5

Poland CY91 6

Korea CY82 7

Sri Lanka CY08 7

Indonesia CY07 8

Malaysia CY88 8

Turkey CY80 13

Chile CY80 15

Thailand CY93 16

Average 9

Source: IMF, Ambit Capital research.

Whilst the time period over which these countries made the transition varied from 4 years (Russia over CY01-04) to 16 years (Thailand over CY93-08), the average time taken by this sample of 10 countries amounted to approximately a decade.

A focus on the 5 countries that took 7-13 years to complete this per capita income transition namely Korea, Sri Lanka, Indonesia, Malaysia and Turkey (see rows highlighted in red in the exhibit above) yields four critical insights:

(1) Average GDP growth recorded over the period when the country’s PCI doubled from US$2K to US$4K was meaningfully higher than the previous decade (see the exhibit below).

Exhibit 21: The doubling of a country’s per capita income from US$2K to US$4K is accompanied by a pick-up in GDP growth rates

Source: CEIC, IMF, Ambit Capital research. Note: PCI refers to per capita income.

(2) The share of savings in GDP rises on an average by 700bps over the period when a country’s PCI doubles from US$2K to US$4K (see the exhibit below).

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Whilst the time period over which these countries made the transition varied from 4 years (Russia) to 16 years (Thailand), the average time taken by this sample of 10 countries was approximately a decade

Strategy


Exhibit 22: The doubling of a country’s per capita income from US$2K to US$4K is accompanied by a pick-up in the country’s savings ratio

Source: CEIC, IMF, Ambit Capital research. Note: PCI refers to per capita income

(3) The share of investment in GDP rises on average by 800bps over the period when a country’s PCI doubles from US$2K to US$4K (see the exhibit below).

Exhibit 23: The doubling of a country’s per capita income from US$2K to US$4K is also accompanied by a pick-up in the country’s investment ratio


(4) The share of consumption in GDP falls on average by 700bps over the period when a country’s PCI doubles from US$2K to US$4K (see the exhibit below).

Exhibit 24: The doubling of a country’s per capita income from US$2K to US$4K is accompanied by a fall in the country’s consumption to GDP ratio


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Furthermore, the share of food in consumption declines as a country’s per capita income moves from US$2K to US$4K whilst the share of the non-food component declines (see the exhibit below).

Exhibit 25: The share of food in total consumption expenditure has been declining in Korea as its per capita income has been increasing…

Source: CEIC, Ambit Capital research

Exhibit 26: … as has been the case in India as well


Interestingly, most countries that undergo this per capita income transition display the above-mentioned characteristics irrespective of the structure of their economies from a supply-side perspective i.e. the share of agriculture, industry and services in their GDP varies considerably (see the exhibit below).

Exhibit 27: Malaysia, Sri Lanka, Indonesia, Korea and Turkey had variable economic structures from a supply-side perspective when their per capita income was US$2K

Source: CEIC, IMF, Ambit Capital research, Note: PCI refers to per capita income

The above-mentioned insights are relevant because India is expected to make this pivotal transition from a country with a per capita income of US$2K currently to a country with a US$4K per capita income over the coming decade.

Over the past ten years, India’s per capita income has risen from US$830 in CY05 to US$1808 in CY15, a CAGR of 8%. From hereon, according to IMF estimates, India’s per capita income is set to double from this level to US$3,900 in CY25 (implying a CAGR of 8%).

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India is likely to transition from a country with a per capita income of US$2K currently to a country with a US$4K per capita income over the coming decade

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Exhibit 28: The IMF expects India’s per capita income to increase 2x and hit ~US$4K by CY25 over the next decade

Source: IMF, CEIC, Ambit Capital research, Note: This is based on the assumption that India’s real GDP growth rate over CY16-25 will be recorded at an average of 9% YoY (vs 7.5% YoY over CY05-14 as per the old GDP series).

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Section 3.2: What will be the corresponding change in Sensex composition? As India transitions from being a US$2K per capita income country to a US$4K per capita income country, like other countries that have undergone this transition, India too is likely to experience: (1) a pick-up in its GDP growth rate; (2) a rise in its savings as well as investment ratio; and (3) a decline in its consumption to GDP ratio (with the share of non-food consumption increasing).

These patterns have been repeated in other countries as well and can be used to forecast the likely changes that India’s economy will undergo as its per capita income doubles over the next decade. More pertinently, this dynamic can be used to forecast changes in ‘sectoral market capitalisation shares’ in India’s benchmark equity index.

The subsequent note comprises four key insights:

Insight #1: The market-cap share of India’s Consumer Staples Index is set to decline over the next decade.

Insight #2: The market-cap share of India’s Consumer Discretionary Index is set to rise over the next decade.

Insight #3: The market-cap share of India’s Financial Sector Index is set to rise over the next decade.

Insight #4: The market-cap share of India’s Industrials Index may not necessarily rise.

A note on the sample of countries used

The cross-country analysis below is based on macro and market capitalisation data for Malaysia (CY94-13), Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13) and the Philippines (CY94-13). Data sufficiency–related problems led us to eliminate certain countries. For instance, Korea (which completed its transition from a US$2K per capita income country to a US$4K per capita income country over CY82-90) had to be eliminated, as its market-cap data for this period by sector is not available.

Thailand and Indonesia have been included, as macro and market-cap data are available when these two countries underwent this transition.

Malaysia underwent this transition in the seven-year period beginning CY82. Given that market-cap data for this period is not available, we have focussed on the time period spanning CY94-13 to understand trends beyond the US$4K threshold.

India and the Philippines are yet to undergo this transition and are currently in the midst of this transition. We have focussed on the time period spanning CY94-13 for both these relatively less-developed countries to understand the trends in the run-up to the US$2K threshold.

Refer to Appendix 2 on Pg 88 for details regarding sectoral as well as headline indices used in each country.

India too is likely to experience: (1) an increase in its GDP growth rate, (2) a rise in its savings as well as investment ratio, and (3) a decline in its consumption to GDP ratio (with the share of non-food consumption increasing)

Strategy


Insight #1: The market-cap share of India’s Consumer Staples Index is set to decline over the next decade

Cross-country evidence suggests that the share of ‘Consumption’ in GDP declines as per capita incomes rise (see the exhibit below).

Exhibit 29: Cross-country evidence suggests that the share of ‘Consumption’ in GDP declines as per capita incomes rise (PFCE stands for Private Final Consumption Expenditure)

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13), the Philippines (CY94-13) and Malaysia (CY94-13).

Furthermore, the share of ‘food’ in consumption declines as a country’s per capita income increases whilst the share of the non-food component (which includes consumer discretionary goods such as 2Ws and 4Ws) increases (see the exhibit below).

Exhibit 30: The share of food in total consumption expenditure has been declining in Korea as its per capita income has been increasing…


Exhibit 31: … as has been the case in India as well


Correspondingly, cross-country evidence suggests that the Consumer Staples sector’s market-cap (as a share of the broader market) secularly declines as per capita incomes rise (see the exhibit below).

R² = 0.5139

30%

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Food Non Food

The share of ‘Consumption’ in GDP declines as per capita incomes rise

The Consumer Staples sector’s market-cap secularly declines as per capita incomes rise

Strategy


Exhibit 32: Cross-country evidence suggests that the Consumer Staples sector’s market-cap (as a share of the broader market’s market cap) declines as per capita incomes rise

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Malaysia (CY94-13), Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13) and Philippines (CY94-13).

The above exhibit also suggests that even after per capita incomes breach a relatively high threshold, the share of the Consumer Staples sector’s market-cap, as a share of the broader market’s capitalisation, continues to decline (see the exhibits above).

India’s own experience so far has been reflective of this broader cross-country trend whereby the share of ‘Consumption’ in GDP as well as the share of the ‘Consumer Staples’ sector’s market-cap has been declining as India’s per capita income has increased from US$380 to US$1500 over CY94-13 (see the exhibits below).

Exhibit 33: The share of ‘Consumption’ in India declined as per capita income rose...

Source: CEIC, World Bank, Ambit Capital research, Note: The time period covered is CY94-13; PFCE stands for Private Final Consumption Expenditure

Exhibit 34: ... with the share of the ‘Consumer Staples’ sector’s market-cap also declining over this period

Source: CEIC, World Bank, Ambit Capital research, Note: The time period covered is CY94-13.

The same trend was also visible in Indonesia, a country which is the closest peer to India in terms of per capita incomes (see the exhibit below).

R² = 0.4599

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R² = 0.8509

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Strategy


Exhibit 35: Indonesia too saw the share of ‘Consumption’ in GDP decline as its per capita income rose...

Source: CEIC, World Bank, Ambit Capital research, Note: The time period covered here is CY96-13. PFCE stands for Private Final Consumption Expenditure.

Exhibit 36: ... with the share of the ‘Consumer Staples’ sector’s market-cap also declining over this period

Source: CEIC, World Bank, Ambit Capital research, Note: The time period covered here is CY96-13.

Insight #2: The market-cap share of India’s Consumer Discretionary Index is set to rise over the next decade

As highlighted earlier, the share of ‘food’ in consumption declines as a country’s per capita income increases whilst the share of the non-food component (which includes consumer discretionary goods such as 2Ws and 4Ws) increases (see the exhibit below).

Correspondingly, cross-country evidence suggests that the ‘Consumer Discretionary’ sector’s market-cap secularly rises as per capita incomes rise (see the exhibit below).

Exhibit 37: Cross-country evidence suggests that the ‘Consumer Discretionary’ sector’s market-cap (as a share of the broader market) secularly increases

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include India (CY94-13), Thailand (CY94-13) and Korea (CY94-13). We have included Korea in this section owing to data insufficiency problems in other countries that are part of our preferred sample set i.e. for Indonesia, Philippines and Malaysia.

India’s own experience corroborates this broader cross-country trend whereby the share of the ‘Consumer Discretionary’ sector’s market-cap declined until CY06 (when India’s per capita income breached the US$1000 mark) and has been rising since then (see the exhibits below).

R² = 0.5153

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(Per capita income in current USD)

The ‘Consumer Discretionary’ sector’s market-cap first falls but then secularly rises as per capita incomes rise

In India, the share of the ‘Consumer Discretionary’ sector’s market-cap declined until CY06 and has been rising since then

Strategy


Exhibit 38: The share of the ‘Consumer Discretionary’ sector’s market-cap first fell and then has been rising since India’s per capita income hit US$1K

Source: CEIC, World Bank, Ambit Capital research

Exhibit 39: The share of ‘Transport Equipment’ in Korea has been systematically rising

Source: CEIC, World Bank, Ambit Capital research

The same trend was also visible in Korea, a country with much higher per capita incomes than India (see the exhibit above). This in turn suggests that the share of consumer discretionary goods in GDP is likely to rise systematically even beyond the US$4K level.

Insight #3: The market-cap share of India’s Financial Sector Index is set to rise over the next decade

Cross-country evidence suggests that the share of ‘Savings’ in GDP initially increases as per capita incomes rise (see the exhibit below). However, after breaching a certain per capita income level, the share of ‘Savings’ in GDP starts declining (see the exhibit below). The inflexion point at which this rise becomes a decline is sufficiently high and in this case amounts to about US$6000.

Exhibit 40: Cross-country evidence suggests that the share of ‘Savings’ in GDP initially rises as per capita incomes rise and then declines after a certain threshold of per capita income is hit

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13, Malaysia (CY94-13) and the Philippines (CY94-13).

Correspondingly, cross-country evidence suggests that the ‘Financial Services’ sector’s market-cap (as a share of the market-cap of the broader market) initially rises and as per capita incomes rise (see the exhibits below).

R² = 0.3859

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R² = 0.8741

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The share of ‘Savings’ in GDP initially increases as per capita incomes rise but starts declining after a certain level

Strategy


Exhibit 41: Financial sector market-cap rises as per capita income rises

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13, Malaysia (CY94-13) and Turkey (CY04-13). We have included Turkey in this section owing to data insufficiency problems in other countries in our preferred sample set i.e. for the Philippines.

India’s own experience so far corroborates this broader cross-country trend whereby the share of savings in GDP as well as the share of the ‘Financial Services’ sector’s market-cap has been increasing as India’s per capita income has increased from US$380 to US$1500 over CY94-13 (see the exhibits below).

Exhibit 42: The share of ‘Savings’ in India increased as per capita income rose...

Source: CEIC, Bloomberg, Ambit Capital research, Note: The time period covered is CY94-13

Exhibit 43: ... with the share of the ‘Financial Services’ sector’s market-cap also rising over this period

Source: CEIC, Bloomberg, Ambit Capital research, Note: The time period covered is CY94-13

Insight #4: The market-cap share of India’s Industrial Sector Index may not necessarily rise

Cross-country evidence suggests that the share of ‘Investments’ in GDP initially rises as per capita incomes rise. However, after breaching a certain per capita income level, the share of ‘Investment’ in GDP follows no specific trend (see the exhibit below on the right).

R² = 0.1599

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The share of savings in GDP as well as the share of the ‘Financial Services’ sector’s market-cap has been increasing as India’s per capita income has been increasing

The share of ‘Investments’ in GDP initially rises as per capita incomes rise

Strategy


Exhibit 44: Cross-country evidence suggests that the share of ‘Investment’ in GDP initially rises as per capita incomes rise...

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Malaysia (CY94-13), Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13) and the Philippines (CY94-13).

Exhibit 45: … but the trend is ambiguous at higher levels of per capita income

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Malaysia (CY94-13) and Thailand (CY94-13).

As regards the ‘Industrial’ sector’s market-cap (as a share of the market-cap of the broader market), cross-country evidence suggests that the ‘Industrial’ sector’s market-cap follows no specific trend at low levels of per capita income as well as at high per capita income levels (see the exhibits below).

Exhibit 46: At low levels of per capita income, the market-cap share of the ‘Industrial’ appears unclear...

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Malaysia (CY94-13), Indonesia (CY96-13), India (CY94-13), Thailand (CY94-13) and the Philippines (CY94-13)

Exhibit 47: … and so is the case at higher per capita income

Source: CEIC, World Bank, Ambit Capital research, Note: Countries covered include Malaysia (CY94-13) and Thailand (CY94-13)

R² = 0.1379

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The ‘Industrial’ sector’s market-cap follows no specific trend at low levels of per capita income

Strategy


India’s own experience so far has been reflective of this broader cross-country trend whereby the share of ‘Investments’ in GDP has been rising as India’s per capita income rose from US$380 to US$1500 over CY94-13 (see exhibit below). However, the share of the ‘Industrials’ sector’s market-cap has followed no specific pattern (see the exhibit below).

Exhibit 48: The share of ‘Investments’ in India rose as per capita income rose...

Source: CEIC, Ambit Capital research, Note: The time period covered is CY94-13.

Exhibit 49: … but the trend regarding the market-cap share of ‘Industrials’ in the broader market remains ambiguous

Source: CEIC, Ambit Capital research, Note: The time period covered is CY94-13.

R² = 0.9185

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The share of ‘Investments’ in GDP has been rising as India’s per capita income rose from US$380 to US$1500

Strategy


Section 4: Predicting the next 15 entrants "Coming up with names is not the problem. It’s deciding which to discard and which to buy and how long to hold on to them that takes the work."

- Ralph Wanger and Everett Maitlin in “A Zebra in Lion Country (1999)”.

Summary: Having established the broad shape of where the entrants will come (both in terms of size and in terms of sector), we proceed to identify the likely entrants. We believe five entrants will list through IPOs and these will come from sectors that are significantly under-represented in the Sensex. Within the listed universe, we use our proprietary filters such as the ‘greatness’ framework, Coffee Can Portfolio and P-75 list of connected companies to arrive at ten stocks that are set to enter the Sensex in the next decade.

In this section we first discuss the five potential mega IPOs headed for the Sensex followed by a discussion on ten Sensex bound stocks from the currently listed universe.

Mega IPOs to look forward to In order to identify five stocks, we start with underlying themes that will gain traction in the next decade. The sweeping changes in the economy, triggered by the Modi reset, could potentially result in new sectors listing on the bourses in the next decade. We see three specific themes playing out:

1. Sectors with significant Private Equity funding:

India’s e-commerce industry has attracted the attention of Venture Capital (VC) and Private Equity (PE) funding. Along with the overall economic growth story (as detailed in Section 2 of this report), India’s e-commerce opportunity is also being driven by a rapid increase in Internet users in general (267mn users as at December 2014, up from 19mn in December 2010) and broadband access in particular (86mn from 11mn during the same period). Mobile penetration – which is instrumental in increasing e-commerce adoption via apps on smartphones –is now nearing 100% in India with 970mn wireless subscribers (March 2015) and a population of 1.21bn (Census 2011).

NASSCOM pegs India’s e-commerce revenues in FY14 at US$10.5bn and estimates it to grow at 33% in FY15 to US$14bn (Source: http://www.financialexpress.com/article/industry/companies/nasscom-pegs-e-commerce-revenue-growth-at-33-to-14-billion-in-fy15/41450/)

VC and PE players have chased this growth rapidly by funding e-commerce startups in India. This funding has led to a proliferation of e-commerce platforms and the emergence of brands such as Flipkart, Ola and Snapdeal in the past few years. With every round of funding, the valuations of these e-commerce companies have risen steadily. There are currently seven Indian companies that are part of the Wall Street Journal’s Global “Billion Dollar Startup Club” (see Exhibit 50 below).

Exhibit 50: The Indian companies in WSJ's Billion Dollar Startup Club

Company Valuation (US$bn) Total Equity Funding (US$ mn) Last Valuation

Flipkart 15.0 3,000 April 2015

Ola Cabs 2.5 677 April 2015

InMobi 2.5 216 Dec 2014

Snapdeal 2.0 1,000 Oct 2014

Paytm (One97 Comm) 1.9 593 March 2014

Quikr 1.0 350 Sept 2014

Zomato 1.0 163 March 2015

Source: Wall Street Journal website, The Billion Dollar Startup Club section as on 11 June 2015, Ambit Capital research

We identify five, as yet unlisted, companies that can potentially enter the Sensex

India’s e-commerce market is currently witnessing a VC/PE-funded boom

WSJ’s elite club of startups features seven Indian companies

Strategy


At an estimated valuation of US$15bn, Flipkart is already larger than 11 of the listed Sensex stocks, as can be seen in the exhibit below.

Exhibit 51: Flipkart vs select Sensex stocks

Company Market-cap (US$bn)

Flipkart 15.0

M&M 12.1

Bajaj Auto 10.7

BHEL 9.2

Dr Reddy’s 8.9

Vedanta 8.0

Hero Moto 7.9

Cipla 7.7

GAIL 7.9

Tata Steel 4.6

Hindalco 3.8

Tata Power 3.1

Source: WSJ, Bloomberg, Ambit Capital research. Note: Flipkart valuation is based on the WSJ Billion Dollar Startup Club as per 17 June 2015. Market-cap for Sensex stocks is as per 17 June 2015.

As these companies grow larger, VC/PE funds could likely seek an exit. Whilst SEBI’s current listing norms appear restrictive with regards to profits (track record of distributable profits for at least three out of the immediately preceding five years) and promoter holding (locked in for three years), SEBI is reportedly mulling a new platform aimed at helping start-ups (Source: http://goo.gl/Gy6nOz). Moreover, a NASDAQ listing is always an option for these start-ups and has been utilised in the past by tech companies such as MakeMyTrip (in August 2010) and much earlier by Rediff (in 2000).

Thus, whilst under current norms, a listing appears unlikely in the near term, we believe that in the next decade, these startups will look at an IPO to: (a) fund their growth on a larger scale; (b) provide exits to their PE investors; and (c) compete on a global platform. We highlight that, Alibaba, the Chinese-owned global e-commerce major, holds the record for the biggest IPO in the world, raising US$25bn in 2014, topping the Agricultural Bank of China’s 2010 IPO of US$22bn (Source: http://goo.gl/9fzKSF).

Most likely Sensex entry candidates: As outlined above, we expect the large e-commerce startups to list in the coming decade. Out of these, we choose Flipkart and Paytm for their leading positions (both in terms of scale and valuation) among competition.

2. Sectors that will come into play via disinvestment:

In the current Sensex, eight of 30 stocks had issued shares through an IPO in the past 15 years (i.e. after 2000). Out of these eight stocks, we note that five (Coal India, ONGC, Maruti, NTPC and GAIL) were driven by Government-led disinvestment. The listing of these stocks provided investors with stocks to play meaningful investment themes, ranging from passenger cars to coal mining. Their IPOs were also large and eventually these stocks were included in the Sensex.

Flipkart is already larger than many Sensex stocks

VC/PE investors will seek to exit in the next decade, providing an opportunity for a public listing of these startups

Current listing norms could turn more amenable in the next decade

Our choices: Flipkart and Paytm

Big-ticket disinvestment will return under the current Government

Strategy


Exhibit 52: Large IPOs since 2000 that resulted in Sensex stocks

Company Year of IPO IPO Size (̀ bn) Entered Sensex in

Coal India Oct 2010 150 2011

ONGC March 2004 95 2003

Cairn India Dec 2006 58 2007

TCS Aug 2004 54 2005

NTPC Oct 2004 54 2005

Bharti Airtel Jan 2002 8 2003

Maruti Suzuki June 2003 10 2004

GAIL India Feb 2004 16 2012

Source: SEBI, BSE, Bloomberg, Ambit Capital research

In FY04, the last year of the then BJP-led National Democratic Alliance, the Government raised `155bn, a record at that time, and among only four of 12 instances where the actual disinvestment receipts exceeded targets.

Exhibit 53: Disinvestment trends from FY92 to FY04

Source: Department of Disinvestment, Ambit Capital research

Over the next decade, we expect the current NDA Government to aggressively divest its stake in certain Central Public Sector Enterprises (CPSEs). For FY16 alone, the Government has set a steep target of `695bn and recently, Finance Minister Arun Jaitley reiterated plans to stick to these targets (Source: http://goo.gl/x1Sss2).

As most of the large (Maharatna and Navratna) CPSEs are already listed (except Hindustan Aeronautics Limited and Rashtriya Ispat Nigam Limited), the Government would look at Follow-up Public Offers (FPOs) for raising funds. For new issues, the Government could choose from smaller CPSEs (Miniratna – Category I with 55 companies and Category II with 17 companies). These include Airports Authority of India, Housing & Urban Development Corporation (HUDCO), India Tourism Development Corporation (ITDC), Indian Railway Catering & Tourism Corporation (IRCTC) as some of the interesting CPSEs that could open up new investment themes if they were listed in the next decade. We highlight recent media reports citing Government plans to corporatise and sell shares of the Airports Authority of India (AAI) (Source: http://goo.gl/gMgpah)

Most likely Sensex entry candidate: We believe that the current NDA Government would opt for at least one large IPO in the next decade to convey its commitment to divestment. Of the two remaining Navratna CPSEs yet to list, we choose Hindustan Aeronautics Limited (HAL) as the mostly likely among Government-led disinvestments to make it into the Sensex in the next decade. We see HAL as a play on the role of defense in Prime Minister Modi’s “Make in India” theme.

020406080

100120140160180

FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04

Target Receipts Actual Receipts(` bn)

Disinvestment receipts touched a new record in FY04

The BJP-led NDA Government has a track record for big-ticket IPOs of public sector companies…

…and has set a steep target for FY16

Almost all CPSEs are listed, but many options exist among smaller ones

Our choice: Hindustan Aeronautics Limited

Strategy


3. Sectors where regulatory hurdles may potentially ease:

Increasing clarity on regulatory issues in sectors such as insurance and real estate could boost IPOs from these sectors and provide potential entrants into the Sensex.

In insurance, the Indian Parliament passed the Insurance Bill in March 2015 (Lok Sabha on 4 March 2015 and Rajya Sabha on 12 March 2015), paving the way for a hike in the FDI limit in insurance companies to 49% from 26%. This will pave the way for large Banking and Financial Services (BFSI) entities like ICICI Bank and SBI to list their insurance joint ventures. As highlighted in our thematic report, ‘Demergers and alpha generation’ dated March 10, 2015 (click here for details), the contribution of the life insurance businesses of these entities ranges from 6% to 10% of the ‘sum-of-the-parts’ valuation of the listed parent (see Exhibit 54 below). Whilst this may not seem much from the parent’s perspective, the listing of the insurance sector will provide a meaningfully large theme for investors in the next decade.

Exhibit 54: Contribution from non-lending business is negligible in the SOTP valuations for these banks and NBFCs % contribution of different businesses in Consolidated valuation

SBI ICICI Bank

Kotak Mahindra Valuation Methodology

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

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

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

Asset Management 1% 2% 2% % of AUM Investment Banking/Broking 2% 2% 9% P/E multiple Others 2% 3% 0% Total 100% 100% 100%

Source: Company, Ambit Capital research.

In real estate, SEBI approved Real Estate Investment Trusts (REITs) in 2014. Whilst this was seen as a positive for rolling out REITs in India, doubts persist on taxation issues such as minimum alternate tax and distribution tax of these entities. As and when these doubts are cleared by the Government, listing of REITs could provide an interesting investment theme for investors.

Most likely Sensex entry candidate: From the above, we choose ICICI Prudential Life Insurance as the most likely candidate to enter the Sensex in the next decade. Whilst HDFC Life will also likely list, we see higher probability of ICICI Prudential Life making it into the Sensex due to its larger size (ICICI Prudential is larger in terms of premiums at `153bn vs `148bn for HDFC Life, as well as assets under management at `1trn vs `670bn for HDFC Life.

Finally, we add Café Coffee Day (CCD) as our fifth Sensex entry candidate through an IPO. CCD is India’s largest coffee conglomerate and a play on consumer discretionary which, as Section 2 shows, will increase in size over the longer term.

We summarise our choices of companies that will enter the Sensex through IPOs in the next decade in the following exhibit.

Exhibit 55: Five stocks that will enter the Sensex through IPOs Name Sector Rationale

Flipkart Ecommerce Already India's biggest e-commerce company in terms of valuations; poised to benefit from the boom in ecommerce

Paytm Digital Payments Increasingly taking on banks in the digital payments space; strong parentage with investment from Alibaba (China)

ICICI Prudential Life Life Insurance Play on increasing share of BFSI in general and insurance in specific as economic growth increases

Café Coffee Day Coffee Conglomerate

Well placed to benefit from the shift towards consumer discretionary from consumer staples; largest coffee conglomerate in India

Hindustan Aeronautics Ltd (HAL)

Defence Government-owned defence major; key beneficiary of 'Make in India' theme; ideal candidate for a big-bang disinvestment-led IPO


We now provide a snapshot of these companies along with their financials (where available):

With regulatory hurdles lifted, India’s insurance sector could see a few big-ticket listings

Listing of REITs could also open up a new theme for investing

Our choice: ICICI Prudential Life

We add Café Coffee Day as a Consumer Discretionary play

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_Demergers_10Mar2015.pdf

Strategy


Flipkart Introduction: Formed in September 2007 by Sachin Bansal and Binny Bansal, Bengaluru-based Flipkart is the largest e-retail company in India, with a gross merchandise value (GMV) run-rate of US$4bn. With more than 10 million downloads on the Android store, it is the eighth most-downloaded free app in India. The company stocks 20 million products across more than 70 categories and has 26 million registered users and 20,000 employees.

Financials: Flipkart is registered in Singapore and its financials are therefore not in the public domain. Its current gross merchandise value (GMV) run-rate is US$4bn and the company aims to increase that to US$8bn by December 2015. This is higher than peers such as Snapdeal and Amazon India. Flipkart’s various Indian subsidiaries reported revenues of `30.3bn and losses of `7.2bn in FY14 (http://goo.gl/lj8YPy).

Funding: Flipkart’s largest investors are Tiger Global and Intervision Services Holding (Naspers, South Africa), which between them hold close to 50% in the Singapore entity, whilst Sachin Bansal and Binny Bansal hold 8.7% each (http://goo.gl/8txtbB). Flipkart raised US$1.9bn in 2014 (from DST Global, Tiger Global and Naspers) and raised a further US$550mn in March 2015 (http://goo.gl/OMYUIu, http://goo.gl/OYZuMp).

Rationale for inclusion as a Sensex entry candidate: Flipkart’s current size (US$15bn valuation, as per WSJ’s Billion Dollar Startups) already places it ahead of many Sensex stocks. E-retail is already a compelling theme among private investors and, in the next decade, should move to the public investment domain. According to BCG, the Indian e-commerce market’s GMV is likely to increase from US$16bn-17bn in 2014 to US$60bn-70bn in 2019, an annual growth rate of more than 30-34%. As it grows larger in size and achieves profitability, Flipkart has a good chance of finding its way into the Sensex in the next decade.

Paytm Introduction: Paytm is the flagship brand of One97 Communications, a digital goods and mobile commerce company founded by Vijay Shekhar Sharma. In FY13, Paytm received a licence from the RBI for semi-closed digital wallet which it launched in FY14. It also provides an online B2C marketplace. As of June 2015, the company claims that there are 50 million wallets registered on its platform. Headquartered in New Delhi, One97 has an employee strength of 1,200.

Financials: One97 has provided financial statements for FY14, a snapshot of which is provided in the exhibit below. Founder, Vijay Shekhar Sharma held a 37% stake in the company, whilst SAIF III Mauritius Company held 35%, as at March 31, 2014. On the e-retail marketplace, Paytm reported a GMV run-rate of US$1.5bn in June 2015 and plans to achieve GMV of US$3bn-4bn by end-FY16 (http://goo.gl/NqJble).

Valued at US$15bn, Flipkart is the highest-ranked Indian startup in the WSJ elite startup list

Given its size and growth path, Flipkart is well placed as a potential Sensex entrant

Paytm is making rapid strides in the digital payments space

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Exhibit 56: One97 Summary Financials

(̀ mn) Profit & Loss Account FY13 FY14

Total Revenue 2,233 1,978

Total Expenses (1,499) (1,744)

EBIDTA 733 235

Depreciation, amortization (234) (182)

Finance expenses (5) (11)

PBT 495 41

Tax (142) (21)

PAT 352 20

Balance Sheet FY13 FY14

Liabilities Shareholder funds (incl. share application money) 2,980 3,000

Non-current liabilities 36 23

Current liabilities 496 564

Total Liabilities 3,512 3,586

Assets Fixed Assets 480 403

Non-current assets 206 205

Deferred Tax assets (net) 34

Loans and advances 60 224

Other non-current assets 384 16

Current Assets 2,766 2,704

Total Assets 3,895 3,586

Source: Company, Ambit Capital research

Funding: Paytm shot into the limelight in February 2015 when it raised funding from Alipay Financial (part of Alibaba, the Chinese e-commerce company) for its mobile commerce and digital wallet operations. In March 2015, Ratan Tata, Chairman Emeritus, Tata Sons, joined Paytm as an advisor and made a minor investment in the company.

Rationale for inclusion as a Sensex entry candidate: One97 also features on the WSJ’s Billion Dollar Startup Club (see Exhibit 50), with an estimated valuation of US$1.9bn. Given its convenience over cash and ease of use via mobile apps, digital wallets are witnessing rapid growth. Paytm is already a large player (50mn digital wallets) in this space. Moreover, using its platform, it can potentially provide a wider array of financial services. For instance, it can distribute financial products such as mutual funds. When it lists, it will likely be a significant Indian financial services company. The presence of Alibaba provides a competitive edge.

Paytm can potentially disrupt India’s payment infrastructure over the longer term

Strategy


ICICI Prudential Life Insurance Introduction: ICICI Prudential Life Insurance Company (IPLIC) is a joint venture between ICICI Bank and Prudential (UK). As at end-FY15, ICICI Bank held a 74% stake in the venture, whilst Prudential held the remaining 26%. IPLIC was among India's first private sector life insurance companies when the Insurance Regulatory Development Authority of India (IRDA) was formed, and approvals were given to private players in 2000. In FY15, IPLIC became the first private life insurer in India to achieve Assets Under Management (AUM) of `1 trillion. On a “Retail Weighted Received Premium” (RWRP) basis, IPLIC is the leading player among private life insurance companies.

Exhibit 57: Financials - Key financial parameters (̀ bn) FY13 FY14 FY15

Retail Weighted Received Premium 33.1 32.5 46.0

Profit After Tax 15.0 15.7 16.3

New Business Profit 5.3 4.3 5.3

Solvency ratio (%) 396.0 372.0 337.0

Assets under Management 741.6 806.0 1,001.8

Return on Equity (%) 31.2 32.7 33.9


Rationale for inclusion as a Sensex entry candidate: As written by our BFSI Team in the “Demergers and Alpha Generation” report dated March 10, 2015, consensus values the life insurance business of banks at ~2.5-3.5x of embedded value. This is also well supported by deals (Max India, Bajaj Finserve and HDFC Life) in the sector. Whilst the growth rates in the sector have sobered (4% growth in new business premium over FY08-14) relative to the past (53% over FY05-08), we believe a listing from the insurance sector has a high probability given that regulatory uncertainty has lifted, with the passage of the Insurance Bill. Given IPLIC’s dominant position in the sector and our thesis of BFSI maintaining its share in overall GDP (as outlined in Section 2), we expect the company to stand a good chance of entering the Sensex in the next decade.

Café Coffee Day Introduction: Café Coffee Day (CCD) was founded by entrepreneur VG Siddhartha and is part of Coffee Day Global Limited. CCD opened its first outlet in 1996. As per its website, CCD has more than 1,423 cafes spread across 200 cities/towns in India. CCD’s founder VG Siddhartha has varied interests including financial services (Way2wealth) and logistics (SICAL). CCD’s group companies include Coffee Day Beverages (dispensing machines), Coffee Day Fresh & Ground (retail stores), Coffee Day Exports (exporting green coffee) and Coffee Day Hotels & Resorts (resorts).

Financials: Being a privately held company, CCD has not yet publicly released its financial statements. As per news reports, CCD had revenues of `15bn (Source: http://goo.gl/kWHjOZ). In 2010, a group of investors (KKR India Advisors, New Silk Route PE Asia Fund and Standard Chartered Equity PE Fund) had invested US$149mn in CCD’s holding company. News reports suggest that CCD is preparing for an IPO to raise `11.5bn in the near to medium term, ahead of which earlier this year, CCD had reportedly done a pre-IPO placement among domestic investors (Source: http://goo.gl/OCt4PN).

Rationale for inclusion as a Sensex entry candidate: CCD’s founder, VG Siddhartha has aggressive growth plans for CCD. As far back as 2011, he was quoted as saying that he wanted CCD to be in the ”top four retail coffee brands in the world”. (Source: http://goo.gl/SMb6rB). We believe CCD’s IPO could provide an interesting new theme in the Quick Service Restaurant (QSR) sector, which is itself a play on overall Consumer Discretionary Services.

ICICI Prudential is among India’s foremost insurance companies

ICICI Prudential Life is our pick as a new theme – insurance – in India’s BFSI sector

CCD’s huge retail network is a key competitive advantage

CCD is a unique play on Consumer Discretionary Services

Strategy


Hindustan Aeronautics Limited Introduction: Incorporated in 1940, Hindustan Aeronautics Limited (HAL) is fully owned by the Government of India. HAL operates under the administration of the Ministry of Defense and Department of Defense Production and manufactures, assembles and maintains various types of fighter jets, helicopters, etc. HAL also makes equipment for structures for aerospace launch vehicles and satellites of the Indian Space Research Organization. HAL is based in Bengaluru and its employee strength was 32,108 as of March 31, 2014.

Exhibit 58: Summary Financials for HAL (` mn) Profit & Loss Account FY13 FY14

Total Revenue 1,76,435 1,77,533

Total Expenses (1,35,452) (1,35,730.64)

EBIDTA 40,983 41,802

Depreciation, amortization (6,013) (6,025)

Finance expenses - -

PBT 34,970 35,777

Tax (5,001) (8,852)

PAT 29,969 26,925

Balance Sheet FY13 FY14

Shareholder funds 1,33,782 1,50,146

Non-current liabilities 86,077 74,194

Current liabilities 3,55,428 4,14,443

Total Liabilities 5,75,287 6,38,784

Fixed Assets 21,111 22,729

Non-current Investments 7,073 7,074

Loans and advances 1,355 1,332

Other non-current assets 1,19,431 61,803

Current Assets 4,26,316 5,45,846

Total Assets 5,75,287 6,38,784


Rationale for inclusion as a Sensex entry candidate: The NDA Government raised FDI in India’s defense sector to 49% from 26% in August 2014. This was soon followed by the ambitious ‘Make in India’ campaign launched by the Government in September 2014 which focuses on boosting manufacturing infrastructure across various sectors, including defense manufacturing. India has the third-largest armed forces in the world and meets 60% of its requirements by imports. The Government plans to invest `250bn over the next 7-8 years. HAL is well placed to be a key beneficiary of this initiative given its long history and manufacturing capabilities. News reports also suggest that the Indian Government has revived plans to list HAL to help meet its disinvestment target of `695bn in FY16. HAL’s listing could provide a new investment theme on defense manufacturing. As it grows in size, we believe, HAL is a likely candidate for entering the Sensex in the next decade, following its listing.

Sensex-bound stocks from the currently listed universe To identify potential Sensex entrants from the current listed universe, we use a five step process to identify ten firms that are most likely to enter the index over the coming decade.

Step 1: Efficient capital allocation

Over the past four years, we have successfully used our greatness framework to measure the efficiency of a firm’s capital allocation. The framework looks for firms that judiciously invest capital and turn those investments into sales, profits, balance sheet strength and most importantly free cash flows which then feed back into the future growth needs of the firm.

HAL is currently owned and run by the Government of India

HAL can provide a meaningful exposure to the defense theme in India

We use a five-step process to identify the ten firms from the current listed universe

Strategy


Exhibit 59: The ’greatness‘ framework


This framework has been the basis of stock selection for both our tenbagger and Good & Clean portfolios. For more details on the framework please refer to our latest tenbagger note here. For a firm to be considered for Sensex inclusion, the ‘greatness’ score should be 67% or higher. Thus, at the first step, we weed out all firms that fail to meet this cut-off.

We however make an exception for Asian Paints. Whilst the company fares reasonably well on 'greatness' over FY09-14, (the company's greatness score is 58%), using the financials of the last ten years, the company fares well on all the parameters on 'greatness'. Further, on a ten-year basis, the company's greatness score is far more superior to both Berger Paints and Pidilite Industries. Thus, given the company's size and given the company's historical track record, we make this the only exception to the greatness cut-off.

Step 2: Consistent financial performance

Once filtered for ‘greatness’, we test the universe for consistency of financial performance using our twin filters of growth and profitability (we had used these same filters for creating our Coffee Can Portfolio in November last year).

a) Consistent sales growth of more than 10%: With the country’s nominal GDP having grown at 15% per annum on average over the last several years, we measure the consistency of growth by using a more relaxed filter of 10% sales growth in at least seven of the past ten years.

b) Consistent RoCE of over 15%: With 15% being the approximate cost of capital in the country, we use a profitability filter of 15% or more on pre-tax ROCE in at least seven of the past ten years.

For the Financials space, we modify the filters on RoCE and sales growth as follows:

a) RoAs of 1.1% for banks (and RoEs of 15% for non-banking financials): Whilst we have used RoE (net profit to average equity) as the return measure for NBFCs, we have used RoA (net profit to average assets) for banks. Whilst the underlying profitability of operations reflects in both RoA and RoE, RoE is also impacted by the leverage or capital position of the bank. Historically, many banks (especially PSU banks) have delivered high RoEs due to high leverage despite weak underlying profitability. Therefore, for banks RoAs is a better metric to use.

We identify banks that have delivered RoAs in excess of 1.1% (and NBFCs that have delivered RoEs in excess of 15%) in at least seven out of the last ten years.

b) Loan growth of 15%: We believe consistency of loan growth is an indication of a lender’s ability to lend over business cycles. Strong lenders ride the down-cycle

We start with our greatness framework to identify the most-efficient capital allocators

We check the resultant firms for consistency in financial performance using our twin filters of growth and profitability

b. Conversion of investment to sales (asset turnover, sales)

c. Pricing discipline (PBIT margin)

d. Balance sheet discipline (D/E, cash ratio)

a. Investment (gross block)

e. Cash generation (CFO)

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_Tenbaggers4_05Jan2015.pdf

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_IndianCoffee_17Nov2014.pdf

Strategy


better, as their competitive advantages surrounding their origination, appraisal and collection process ensure that they continue their growth profitably either through market share improvements or upping the ante in sectors which are resilient during a downturn. Therefore, we identify banks/financial institutions that have managed to deliver 15% loan growth in at least seven of the past ten years.

Step 3: Ambit’s P-75 companies

As the next step, we screen the residual universe to eliminate stocks that are part of Ambit’s P-75 companies i.e. companies whose core competitive advantage is politically connectivity.

We believe such companies are on a weaker footing given the impact of Modi’s three resets, especially the one pertaining to disruption of crony capitalism.

Our P-75 index, the index of the 75 most politically ‘connected’ companies in India, neatly captures the demise of the connected company model in India.

Whilst this connected company model worked well until October 2010, the share prices of these connected companies plummeted post the 2G spectrum allocation report publication. Further, even the brief pre-General Election rally was snuffed out once the market realised that Modi was in no way going to favour the crony capitalists (see the exhibit below).

Exhibit 60: The connected companies index has consistently underperformed the BSE500 since the release of the CAG report in October 2010

Source: Bloomberg, Ambit Capital research

Thus, any company in our universe that is part of Ambit’s P-75 companies automatically is disqualified from becoming a probable Sensex entrant.

Step 4: Market-cap buckets

The fourth filter that we use pertains to the size of the company as at the beginning of the period. From our previous discussions, we note that nearly half of the Sensex entrants historically have been firms belonging to the top-100 stocks on free float market-cap as of the beginning of the period. This would mean that around eight of the ten entrants from the current listed universe should belong to the top-100 stocks on free-float market-cap as of today.

Further, the remaining 16% entrants come from the universe outside of the top-100 companies. This would mean that the remaining two companies should belong to the residual universe (outside of the top-100 companies).

Step 5: Pick and choose from the short-list

In the final step, from the stocks that clear all our filters, we choose the ones where we have the maximum conviction.

Stocks from the top-100 universe on free-float market-cap that clear all our filters have been shown in Exhibit 61 below. Out of these, stocks which we believe would likely enter the Sensex ten years hence have been shown in Exhibit 62 below.

60 100 140 180 220 260 300 340

Jan/

09

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/09

Sep/

09

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10

May

/10

Sep/

10

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11

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/11

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11

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12

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/12

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12

Jan/

13

May

/13

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13

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14

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/14

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/15

Ambit Connected Cos Index BSE 500

We carve out firms that are politically connected

The fourth filter relates to the size of the company at the beginning of the decade

Finally, we short-list stocks where we have the maximum conviction

Publication of CAG report in Oct' 10 was an inflection point

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Exhibit 61: Stocks from the top-100 universe that clear all our filters Company name Ticker

Kotak Mahindra Bank Ltd. KMB IN

HCL Technologies Ltd. HCLT IN

Lupin Ltd.* LPC IN

IndusInd Bank Ltd. IIB IN

Asian Paints Ltd. APNT IN

Nestle India Ltd. NEST IN

Eicher Motors Ltd. EIM IN

Titan Company Ltd. TTAN IN

Britannia Industries Ltd. BRIT IN

Shriram Transport Finance Company Ltd.# SHTF IN

LIC Housing Finance Ltd.# LICHF IN

Sundaram Finance Ltd.# SUF IN

Rural Electrification Corporation Ltd.# RECL IN

Power Finance Corporation Ltd.# POWF IN

Page Industries Ltd. PAG IN

Pidilite Industries Ltd. PIDI IN

Source: Bloomberg, Capitaline, Ambit Capital research. Note: * Lupin is already entering the Sensex on 22 June and hence has not been considered. # indicates we do not have a ‘greatness’ framework for these firms. We have also filtered this list for clean accounting quality using our forensic accounting framework.

Exhibit 62: Likely Sensex entrants over the next decade Company name Ticker

Kotak Mahindra Bank Ltd. KMB IN

HCL Technologies Ltd. HCLT IN

IndusInd Bank Ltd. IIB IN

Asian Paints Ltd. APNT IN

Nestle India Ltd. NEST IN

Eicher Motors Ltd. EIM IN

Page Industries Ltd. PAG IN

Pidilite Industries Ltd. PIDI IN

Source: Bloomberg, Capitaline, Ambit Capital research. *Whilst IndusInd Bank meets the RoA cut-off of 1.1% in six out of the last ten years, we have included the bank as it is ranked the best bank on our ‘greatness’ framework. We have also filtered this list for clean accounting quality using our forensic accounting framework.

Similarly, stocks from the next 100 universe on free-float market-cap that clear all our filters and which we believe would likely enter the index a decade later have been shown in Exhibits 63 and 64 below.

Exhibit 63: Stocks from the 101-200 universe that clear all our filters Company name Ticker

Mahindra & Mahindra Financial Services Ltd.# MMFS IN

Shriram City Union Finance Ltd.# SCUF IN

Amara Raja Batteries Ltd. AMRJ IN

Glaxosmithkline Consumer Healthcare Ltd. SKB IN

Emami Ltd. HMN IN

City Union Bank Ltd. CUBK IN

Torrent Pharmaceuticals Ltd. TRP IN

Ipca Laboratories Ltd. IPCA IN

Dewan Housing Finance Corporation Ltd.# DEWH IN

PI Industries Ltd. PI IN

Persistent Systems Ltd. PSYS IN

Berger Paints India Ltd. BRGR IN

Gruh Finance Ltd.# GRHF IN

Vakrangee Ltd. VKI IN

The South Indian Bank Ltd. SIB IN

Source: Bloomberg, Capitaline, Ambit Capital research. Note: # indicates we do not have a ‘greatness’ framework for these firms. We have also filtered this list for clean accounting quality using our forensic accounting framework.

Exhibit 64: Likely Sensex entrants over the next decade

Company name Ticker

Torrent Pharmaceuticals Ltd. TRP IN

PI Industries Ltd. PI IN

Source: Bloomberg, Capitaline, Ambit Capital research. We have also filtered this list for clean accounting quality using our forensic accounting framework.





Strategy


The final list We present the results of our five-step screening of the listed companies’ universe to identify the most likely Sensex entry candidates over the next ten years in Exhibit 65 below.

Exhibit 65: The most likely Sensex entry candidates over the coming decade


6M ADV (US$ mn)

FY16 P/E

FY16 P/B Entry hypothesis

Top 100 stocks on free-float mcap

HCL Technologies Ltd. HCLT IN 19,838 37.5 15.8 4.3 Leader in Infra Management Services; scores high on our capital allocation, portfolio mix, operational excellence and management framework

Kotak Mahindra Bank Ltd.

KMB IN 18,322 25.1 25.8 3.7 Among the best-run private sector banks; loan book growth will pick up post ING Vysya integration

Asian Paints Ltd. APNT IN 10,528 20.3 35.9 11.9 Enduring leadership position set to sustain led by supply-chain and scale efficiencies, market share gains and proven management

Nestle India Ltd. NEST IN 8,683 6.1 42.2 17.5 Established brand equity and pricing power position; will gain from shift in consumer spend towards discretionary segment

Eicher Motors Ltd. EIM IN 7,797 28.5 49 14.6 Leader in niche motorcycle segment; well placed to gain from rise in consumer discretionary spend

IndusInd Bank Ltd.* IIB IN 6,794 13.9 19.1 3.5 Leader in CV financing; expansion in new areas led by strong franchise will drive market share gains and above-system loan book growth

Pidilite Industries Ltd. PIDI IN 4,197 4.1 40.3 9.8 Sustainable brand leadership, superior fundamentals make Pidilite a high-quality defensive play in consumer sector

Page Industries Ltd. PAG IN 2,506 2.8 61.3 31.9 Greater growth longevity than most consumer companies; sustained competitive advantages will support premium valuations

Next 100 stocks on free-float mcap

Torrent Pharmaceuticals Ltd. TRP IN 3,310 2.1 21.6 6.6

Increasing presence in generics (US, Europe) and branded markets (India and EMs); new management driving high RoCEs

PI Industries Ltd. PI IN 1,350 2 28.5 7.6 Leading agro-chemical player with proven track record; entry into specialty chemicals should sustain high growth phase

Unlisted

Flipkart N/A N/A N/A N/A N/A Already India's biggest e-commerce company in terms of valuations; poised to benefit from the boom in e-commerce

Paytm N/A N/A N/A N/A N/A Increasingly taking on banks in the digital payments space; strong parentage with investment from Alibaba (China)

I Pru Life N/A N/A N/A N/A N/A Play on increasing share of BFSI in general and insurance in specific as economic growth increases

Café Coffee Day N/A N/A N/A N/A N/A Well placed to benefit from the shift towards consumer discretionary from consumer staples; largest coffee conglomerate in India

Hind. Aeronautics N/A N/A N/A N/A N/A Government-owned defence major; key beneficiary of 'Make in India' theme; ideal candidate for a big-bang disinvestment-led IPO

Source: Bloomberg, Capitaline, Ambit Capital research. Note: We have also filtered this list for clean accounting quality using our forensic accounting framework. *While IndusInd Bank meets the RoA cut-off of 1.1% in six out of the last ten years, we have included the bank as it is ranked the best bank on our ‘greatness’ framework.

Note that in Exhibit 65 above we have only considered firms from the top-200 companies on free-float market-cap as of today. Historical trends suggest that ~6% of the fresh entrants belong to the universe outside of the top-200 companies. Thus, in today’s context, this would mean that 1 of the likely 15 entrants may be from this universe. However, given that we do not cover most of these names (in the universe outside top 200), we could not pick a name to be included in the list of entrants. We however present the universe outside of the top-200 companies that clear all our cut-offs in Exhibit 66 below.


Strategy


Exhibit 66: The list of firms outside of the top-200 companies that meet our criteria for inclusion


6M ADV (US$ mn) FY16 P/E FY16 P/B

Abbott India Ltd. BOOT IN 1,288 0.3 29.9 7.1

Hexaware Technologies Ltd. HEXW IN 1,229 6.9 20.1 5.8

Balkrishna Industries Ltd. BIL IN 1,058 1.5 12.6 2.4

eClerx Services Ltd. ECLX IN 738 1.1 17.0 5.7

Astral Poly Technik Ltd. ASTRA IN 718 0.8 32.2 6.8

Kitex Garments Ltd. KTG IN 678 2.1 34.1 12.1

Dhanuka Agritech Ltd. DAGRI IN 456 0.3 23.6 5.8

Cera Sanitaryware Ltd. CRS IN 400 0.6 30.6 6.1

Vinati Organics Ltd. VO IN 400 0.3 19.3 4.8

Ratnamani Metals & Tubes Ltd. RMT IN 386 0.3 12.2 2.3

Kewal Kiran Clothing Ltd. KEKC IN 411 0.1 33.5 7.3

Poly Medicure Ltd. PLM IN 339 0.3 39.1 9.1

Mayur Uniquoters Ltd. MUNI IN 290 0.4 23.2 5.4

Huhtamaki PPL Ltd. HPPL IN 256 0.2 DNA DNA

Suprajit Engineering Ltd. SEL IN 229 0.2 19.6 4.9

Source: Bloomberg, Capitaline, Ambit Capital research. Note: We have also filtered this list for clean accounting quality using our forensic accounting framework.

Of this list we only cover Balkrishna Industries and eClerx Services with SELL ratings on both. Further, we do not think that either of these can compound at 37% CAGR for the next ten years.

(Assuming that the smallest constituent of the Sensex currently, i.e. Hindalco, compounds at 15% over the next ten years, its free-float market cap would have grown to `680bn. The largest company on free float market-cap from the universe outside the top 200 listed above is Balkrishna Industries. For Balkrishna to reach this milestone, it will have to compound at ~37% over the next ten years.)

In the next section, we move into company-specific discussions on the likely entrants along with our bottom-up views on why these companies are headed for the Sensex.



Well-positioned in Infrastructure Management Services (IMS)

HCL Technologies is the fourth-largest India listed IT services company with revenues of US$6bn (FY15E). The company has received a high score on our proprietary CAPOM (Capital allocation, portfolio mix, operational excellence, management) framework due to its prudent capital allocation (FY15E RoE of 40%), excellent portfolio mix (IMS, engineering), tight execution and a relatively stable senior management team. Over the last ten years, the company’s shares have compounded annually at 25% vs 15% for the Sensex. HCLT’s key parameters Parameter Result Comment

RoCE Trajectory

FY09: 28%, FY10: 20%, FY11: 24% FY12: 29%; FY13: 38%; FY14: 44%

RoCE troughed in FY11, as the company invested heavily in new projects, resulting in EBIT margin compression. Over FY12-14, it has benefitted from this strategy.

Sales (US$) Growth Trajectory

FY09: 17%, FY10: 24%, FY11: 31% FY12: 17%; FY13: 13%; FY14: 14%

Strong revenue growth in FY11 was accompanied by margin contraction. Since then, even though growth rates have tapered, the company’s profitability has increased materially

EPS Growth Trajectory

FY09: 27%, FY10: -6%, FY11: 29% FY12: 46%; FY13: 66%; FY14: 61%

Due to strong margin expansion over FY11-14, the company’s EPS growth has been above 45% in each of the last three years.

Share price returns (CAGR)

3yr/5yr/10yr 55%/36%/25%

Due to the strong growth in EPS, the company’s three-year return has been upwards of 50%. HCLT has outperformed the Sensex in the last three, five and ten years.

Greatness Model (decile)

FY10-14: D1*

HCLT performs well on almost all parameters which include balance sheet discipline, sales improvement and pricing discipline.

Source: Company, Bloomberg, Ambit Capital research; *Note: D1 is the best decile followed by D2, D3,

Improved profitability after a period of investments in new projects In the past decade (FY05-14), HCLT’s revenues (organic)/EPS have increased by 23% each. RoCE has remained above 19% and has accelerated from 24% in FY11 to 44% in FY14, due to EBIT margin improvement from 16% over FY05-11 (average) to 20% over FY12-14 (average). EBIT margins suffered over FY09-11, as it took on new projects which were margin-dilutive initially (re-badged employee costs, high onsite proportion) but became profitable over time. HCLT has comfortably outperformed the index on returns HCLT’s share price has outperformed the Sensex by 12% CAGR in the last ten years led by strong revenue/EPS growth. The company’s corporate governance track-record is reasonably good. However, minorities were unfairly treated by HCL Infosystems, a sister concern in 2005-06 (see Exhibit 7 on the next page). Strong positioning in IMS and engineering services to support growth HCLT has the highest exposure (34% of FY14 revenues) to the IMS segment; it also has a leadership position in this segment. Cost pressures and a large underpenetrated market (<5% vs ~10% for overall IT services) have led to faster growth in this service-line (20% vs 11% for industry, FY15, USD, YoY). It is also the largest player in engineering services, which is emerging as a high growth segment (13% growth LTM YoY). Emergence of the public cloud is the key risk to its IMS business. Slightly under-valued HCLT is currently trading at 16x FY16E EPS, a 15% premium to its five-year average multiple which is justified given its improved profitability and scale. Given the company’s strong track record of cash conversion (FY10-14 pre-tax CFO/ EBITDA of 97%), good capital allocation, strong competitive advantages in the fast-growing IMS space and its FY15-17E EPS CAGR of 14% (second-highest after TechM on an adjusted basis), we believe there is scope for further re-rating. Our TP of `1,100 implies an FY17E P/E of 17x.

COMPANY UPDATE HCLT IN EQUITY June 22, 2015

HCL TechnologiesBUY

Technology

Recommendation Mcap (bn): `1,274/US$20 6M ADV (mn): `2,403/US$37 CMP: `906 TP (12 mths): `1,100 Upside (%): 21

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: AMBER

Performance (%)


90 100 110 120 130 140 150

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

SENSEX HCLT

Analyst Details

Sagar Rastogi +91 22 3043 3291

[email protected]

Utsav Mehta, CFA +91 22 3043 3209

[email protected]

http://reports.ambitcapital.com/reports/Ambit_Technology_Thematic_10Jul2014.pdf

HCL Tech


Exhibit 1: Margins have improved in the last three years (FY12-14)…


Exhibit 2: …resulting in sharp improvement in profitability


Exhibit 3: HCLT’s funds have been largely accrued internally in the last ten years (FY05-14)


Exhibit 4: Dividend has accounted for the largest share of funds deployed (FY05-14)


Exhibit 5: HCLT is justifiably trading at a premium to its four- and six-year average on a P/E basis


Exhibit 6: … and on a EV/ EBITDA basis


Exhibit 7: Explanation for our flags Segment Score Comments

Accounting GREEN HCLT has a stable depreciation rate, high capex productivity and strong cash flow generation. As a result, the company ranks in the top quartile within the Indian IT universe in our accounting framework.

Predictability AMBER

Unlike certain peers, the company does not provide specific annual or quarterly guidance on revenues or margins. It also has not indicated medium-term top-line growth targets and the associated timeframe. HCLT’s quarterly EPS has been a significant surprise, with an average surprise of 9% in the last eight quarters. However, its sales figures have been largely in line with consensus expectations (revenue surprise of 1% over the same period).

Treatment of minorities AMBER

Minorities were treated unfairly by HCL Infosystems, a sister concern belonging to the same promoter group as HCLT. HCL Infosystems, among other things, was a reseller of Nokia phones in India. The promoters reduced their stake in HCL Infosystems from 61% in June 2005 to 57% in December 2005. In February 2006, Nokia decided to set up its own distribution channels in India and as a result, HCL Infosystems’ market share reduced to 50% from 100%. This led to the stock price correcting by about 30%. There has been no other such incident over the past eight years.


12%

16%

20%

24%

28%

0

50100

150200

250300

350

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenues (Rs bn) (LHS) EBIT margin (RHS)

20%

25%

30%

35%

40%

45%

50%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoE RoCE

CFO90%

Other income

6%

Equity raised

3%

Debt raised1%

Dividend paid28%

Capex24%

Acquisition15%

Investments25%

Increase in cash6%

Interest paid2%

468

1012141618202224

Sep-

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1-year forward P/E(consensus)

P/E 6 yr avg 4 yr avg

468

101214161820

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-06

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1-year forward EV/EBITDA(consensus)

EV/EBITDA 6 yr avg 4 yr avg

HCL Tech


Income statement (US GAAP) (̀ bn) FY13 FY14 FY15E FY16E FY17E

Revenue (US$ mn) 4,687 5,360 5,958 6,789 7,863

Growth 12.9% 14.4% 11.2% 13.9% 15.8%

Revenue 257.3 329.6 369.3 420.9 487.5

Cost of goods sold 172.4 209.7 240.0 274.2 317.9

SG&A expanses 34.5 40.4 45.8 54.1 62.4

EBITDA 57.1 86.8 88.0 98.3 114.2

Depreciation 6.7 7.3 4.5 5.8 7.0

EBIT 50.4 79.4 83.5 92.6 107.2

EBIT Margin 19.6% 24.1% 22.6% 22.0% 22.0%

Other Income 1.6 (0.2) 8.9 10.6 11.8

PBT 52.0 79.3 92.4 103.1 119.0

Tax 12.2 15.5 20.0 22.2 25.6

Rate (%) 23.5% 19.5% 21.6% 21.5% 21.5%

Reported PAT 39.8 63.8 72.4 81.0 93.4

Diluted Adj EPS 28.2 45.1 51.3 57.4 66.2


Balance sheet (US GAAP)

Balance sheet (̀ bn) FY13 FY14 FY15E FY16E FY17E

Net Worth 142.9 200.0 239.2 288.0 345.1

Other Liabilities 22.1 22.0 18.2 18.2 18.2

Capital Employed 165.1 222.0 257.4 306.2 363.3

Net Block 76.9 82.6 88.0 95.7 104.3

Other Non-current Assets 23.0 23.5 29.9 29.9 29.9

Curr. Assets 130.7 197.5 224.6 277.6 341.4

Debtors 44.6 56.6 65.3 74.4 86.2

Unbilled revenues 17.1 20.2 30.5 34.7 40.2

Cash & Bank Balance 49.8 99.6 102.8 138.8 180.6

Other Current Assets 19.1 21.2 26.1 29.7 34.4

Current Liab. & Prov 65.4 81.6 85.1 97.0 112.4

Net Current Assets 65.2 115.9 139.5 180.6 229.1

Application of Funds 165.1 222.0 257.4 306.2 363.3


Cash flow statement (US GAAP)

Cash flow (̀ bn) FY13 FY14 FY15E FY16E FY17E

Net Income 41.0 63.8 72.3 81.0 93.4

Depreciation 6.7 7.3 4.4 5.3 6.5

CF from Operations 47.7 68.7 73.3 86.7 100.4

Cash for Working Capital (1.9) (1.9) (22.9) (5.1) (6.6)

Net Operating CF 45.8 66.8 50.4 81.6 93.8

Net Purchase of FA (5.8) (6.5) (12.7) (13.5) (15.6)

Others (18.9) (45.3) 0.1 (0.0) (0.0)

Net Cash from Invest. (24.7) (51.8) (12.6) (13.5) (15.6)

Proceeds from Equity & other 0.3 0.3 0.1 - -

Dividend Payments (8.1) (13.1) (31.4) (32.2) (36.3)

Cash Flow from Fin. (20.0) (12.2) (34.3) (32.2) (36.3)

Free Cash Flow 40.0 60.3 37.7 68.1 78.2

Opening cash balance 25.1 51.6 103.0 102.9 138.8

Net Cash Flow 1.1 2.9 3.5 35.9 41.8

Closing Cash Balance 46.1 102.2 102.8 138.8 180.6


HCL Tech


Ratios (US GAAP)

FY13 FY14 FY15E FY16E FY17E

Growth

Revenue growth (US$) 12.9% 14.4% 11.2% 13.9% 15.8%

EBIT growth (̀ ) 50.3% 57.6% 5.1% 10.9% 15.8%

Valuation (x)

P/E 32.2 20.1 17.7 15.8 13.7

EV/EBITDA 20.7 13.6 13.4 12.0 10.4

EV/Sales 4.6 3.6 3.2 2.8 2.4

Price/Book Value 9.0 6.4 5.4 4.4 3.7

Dividend Yield (%) 0.7% 1.2% 1.9% 2.2% 2.4%

Return Ratios (%)

RoE 32% 37% 33% 31% 30%

RoCE 25% 33% 27% 26% 25%



Structural play on Indian financial services Kotak Mahindra Bank (KMB) is a diversified financial services firm and one of the best-run banks in India. Over the last ten years, the company’s shares have compounded annually at 33% vs 15% for the Sensex and 18% for the Bankex Index. The recent merger of ING Vyasa Bank has allowed KMB to fill some gaps in the business. Given the current size, KMB can continue growing its balance sheet and earnings faster than its peers.

Key Parameters Parameter Result Comment

RoA Trajectory FY10:1.70%, FY11:1.85%, FY12:1.86% FY13:1.83%; FY14:1.75%; FY14:1.93%

Lower credit cost and operational efficiency supported strong RoAs

Sales Growth Trajectory

FY10: 25%, FY11: 41%, FY12: 33% FY13: 24%; FY14: 9.4%; FY14: 25%

Barring FY14, KMB has generated >24% loan growth by skilfully managing loan mix


FY10:102%, FY11: 38%, FY12: 32% FY13: 25%; FY14: 7%; FY14: 24%

Low credit cost has been the key drivers of superior EPS growth


3yr/5yr/10yr 42%/39%/33% Strong share price return over the last 3 years


FY09-13: NA FY10-14: NA

Source: Company, Bloomberg, Ambit Capital research

RoA of more than 1.7% in the last six years Over FY05-15, KMB’s loan book has expanded at 32% CAGR. The bank has generated average RoA of 1.5% and RoE of 13% which is above average in Indian context. Over the last six years, KMB has generated RoA above 1.7% due to low credit costs and improving non-interest income. KMB has also increased its CASA ratio from 19% in FY06 to ~36% in FY15. Well-run franchise has been sufficiently rewarded Over the last ten years, KMB’s shares have delivered annualised returns of 33% vs the Sensex return of 15% and the Bankex return of 18%. The bank has strong franchise in car, commercial vehicles, tractor finance and business banking, supporting strong margins of 4.7-4.9%. Low exposure to stressed sectors, such as infra, has led to strong asset quality performance and low credit costs. RoAs thus have been strong, averaging at 1.8% in FY10-15. Strong capital ratios (16% on an average in FY10-15) have capped the leverage, leading to RoA of ~14%. Strong franchise + Merger synergy = Growth above industry Whilst we believe integration of the acquired ING Vysya Bank with KMB has its challenges in a muted economic environment, the merger does fill some gaps in KMB’s geographic presence and business offering. Over the longer term, once the integration is behind the bank, we expect that KMB can continue to grow its loan book ~5 percentage points faster than the Indian banking system, thanks to the high-quality management team, strong profitability and currently small market share (<1%). Whilst we expect RoAs to moderate from current levels, these will remain comparable with the best in its peerset (like IIB and Axis). We are SELLers due to the elevated multiple at which the bank trades Our SOTP valuation of the bank is `960 (implied consolidated FY16E P/B of 2.6x and consolidated FY16E P/E of 20.2x). The bank is currently trading at a 15% and 17% premium to its historical P/B and P/E. It is trading at a 29% premium and 70% premium to its peers on P/E and P/B respectively. Over the long term, we expect earnings growth to be the key driver of share price return, even as the valuation multiple moderates closer to those of its peers.

COMPANY UPDATE KMB IN EQUITY June 22, 2015

Kotak Mahindra BankSELL

BFSI

Recommendation Mcap (bn): `1,177/US$18.3 6M ADV (mn): `1,611/US$25.1 CMP: `1,298 TP (12 mths): `960 Downside (%): 26

Flags Accounting: GREEN Predictability: GREEN Earnings Momentum: GREEN

Performance (%)


90100110120130140150160

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

KMB IN SENSEX

Analyst Details

Pankaj Agarwal, CFA +91 3043 3206

[email protected]

Ravi Singh +91 22 3043 3181

[email protected]

Aadesh Mehta, CFA

+91 22 3043 3239

[email protected]

Kotak Mahindra Bank


Exhibit 1: Volatile loan growth and NIMs


Exhibit 2: RoA and RoE are stable


Exhibit 3: Stable Gross NPAs


Exhibit 4: The bank has strong Tier I capital


Exhibit 5: KMB is trading at its peak P/E…


Exhibit 6: …and also P/B


Exhibit 7: Explanation for our flags

Segment Score Comments

Accounting GREEN We did not find anything unusual in the accounts of the bank and we believe that the reported numbers are a true reflection of the profitability of the bank. The bank has made adequate disclosures of its ESOP accounting and revenue recognition norms.

Predictability GREEN The bank has one of the best track records of long-term profitability.

Earnings Momentum GREEN After consolidating loan book growth for a while (FY14 loans up 9% YoY), KMB is now accelerating loan book growth (up 25% YoY in FY15). The bank is likely to continue with a similar momentum in the near term and medium term.


4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

0%10%20%30%40%50%60%70%80%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Loan growth % NIM % (RHS)

0.7%

1.2%

1.7%

2.2%

2.7%

6%

8%

10%

12%

14%

16%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

RoE RoA (RHS)

2.5% 2.

8%

4.1%

3.6%

2.0%

1.6%

1.5% 2.

0%

1.9%

0%1%1%2%2%3%3%4%4%5%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Gross NPAs

8.8%

14.5

%

16.0

%

15.2

%

18.0

%

15.7

%

14.7

%

17.9

%

16.2

%

0%

5%

10%

15%

20%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Tier I ratio

0

250

500

750

1,000

1,250

1,500

Sep-

05

Jun-

06

Mar

-07

Dec

-07

Sep-

08

Jun-

09M

ar-1

0

Dec

-10

Sep-

11

Jun-

12

Mar

-13

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-13

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14

Jun-

15

26.6x

20.8x

15.0x

0

250

500

750

1,000

1,250

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15

4.1x

3.1x

2.1x

Kotak Mahindra Bank


Balance sheet (standalone)

Year to March (̀ mn) FY13 FY14 FY15 FY16E FY17E

Networth 94,470 122,751 141,411 243,368 274,638

Deposits 510,288 590,723 748,603 1,491,567 1,834,627

Borrowings 204,106 128,956 121,497 274,719 313,600

Other Liabilities 28,073 33,424 48,610 84,549 93,001

Total Liabilities 836,937 875,853 1,060,121 2,094,203 2,515,867

Cash & Balances with RBI/Banks 36,892 59,799 62,624 113,486 115,157

Investments 288,734 254,845 304,211 598,658 725,819

Advances 484,690 530,276 661,607 1,300,927 1,580,938

Other Assets 26,621 30,933 31,679 81,132 93,953

Total Assets 836,937 875,853 1,060,121 2,094,203 2,515,867


Income statement (standalone)


Interest Income 80,425 87,671 97,199 181,784 212,585

Interest Expense 48,368 50,471 54,961 107,690 126,091

Net Interest Income 32,057 37,200 42,237 74,094 86,494

Total Non-Interest Income 11,607 13,997 20,285 34,420 40,937

Total Income 43,663 51,198 62,522 108,514 127,430

Total Operating Expenses 22,097 25,426 32,547 58,691 68,392

Employees expenses 10,751 11,722 14,497 27,804 31,946

Other Operating Expenses 11,346 13,705 18,050 30,887 36,446

Pre Provisioning Profits 21,566 25,772 29,975 49,824 59,038

Provisions 1,822 3,047 1,645 5,910 7,694

PBT 19,745 22,725 28,330 43,913 51,344

Tax 6,113 7,699 9,670 14,052 16,430

PAT 13,631 15,025 18,660 29,861 34,914


Ratio analysis (standalone) Year to March FY13 FY14 FY15 FY16E FY17E

Credit-Deposit (%) 95.0% 89.8% 88.4% 87.2% 86.2%

CASA ratio (%) 29.2% 31.9% 32.1% 32.4% 32.6%

Cost/Income ratio (%) 50.6% 49.7% 52.1% 54.1% 53.7%

Gross NPA (̀ mn) 7,581 10,594 12,372 23,028 27,379

Gross NPA (%) 1.55% 1.98% 1.85% 1.75% 1.71%

Net NPA (̀ mn) 3,114 5,736 6,091 9,672 11,499

Net NPA (%) 0.64% 1.08% 0.92% 0.74% 0.73%

Provision coverage (%) 58.9% 45.9% 50.8% 58.0% 58.0%

NIMs (%) 4.44% 4.49% 4.51% 3.99% 3.90%

Tier-1 capital ratio (%) 14.7% 17.9% 16.2% 14.6% 13.5%


Kotak Mahindra Bank


Du-pont analysis (standalone)

Year to March FY13 FY14 FY15 FY16E FY17E

NII / Assets (%) 4.3% 4.3% 4.4% 3.8% 3.8%

Other income / Assets (%) 1.6% 1.6% 2.1% 1.8% 1.8%

Total Income / Assets (%) 5.8% 6.0% 6.5% 5.6% 5.5%

Cost to Assets (%) 3.0% 3.0% 3.4% 3.0% 3.0%

PPP / Assets (%) 2.9% 3.0% 3.1% 2.6% 2.6%

Provisions / Assets (%) 0.2% 0.4% 0.2% 0.3% 0.3%

PBT / Assets (%) 2.6% 2.7% 2.9% 2.3% 2.2%

Tax Rate (%) 31.0% 33.9% 34.1% 32.0% 32.0%

ROA (%) 1.8% 1.8% 1.9% 1.6% 1.5%

Leverage 8.6 7.9 7.3 8.4 8.9

ROE (%) 15.7% 13.8% 14.1% 13.0% 13.5%


Valuation parameters Year to March FY13 FY14 FY15 FY16E FY17E

Consolidated EPS (`) 29.3 32.1 39.4 48.9 57.8

EPS growth (%) 19% 10% 23% 24% 18%

Consolidated BVPS (`) 205.0 247.6 287.3 371.2 425.0

P/E (x) 48.6 44.3 36.1 29.1 24.6

P/BV (x) 6.94 5.75 4.95 3.83 3.35



Strong competitive advantages ensure enduring leadership position Asian Paints’ best-in-class supply chain is the biggest driver of its competitive advantage in the paints sector. This, backed by the high-quality middle-management team and scale advantages around distribution expansion and advertisement spend, will allow the firm to continue to gain market share from its peers in the future. Over the last ten years, the company’s shares have compounded annually at 37% vs 16% for the Sensex. Key Parameters Parameter Result Comment

RoCE Trajectory FY09: 45%, FY10: 71%, FY11: 55% Stable RoCE performance despite improving

margin profile indicates less than optimal capital allocation FY12: 50%; FY13: 47%; FY14: 45%

Sales Growth FY09: 25%, FY10:22%, FY11: 15% Market share gains and product mix improvement leads to consistent revenue growth Trajectory FY12: 25%; FY13: 15%; FY14: 17%

EPS Growth FY09: -3%, FY10: 110%, FY11: 1% Volatility in the earnings growth primarily due to volatility of the input prices Trajectory FY12: 17%; FY13: 13%; FY14: 9%

Share price returns 3yr/5yr/10yr 36%/32%/35% Stellar fundamentals drive consistent stock

returns (CAGR)

Greatness Model (decile) FY10-14: D4

The company fares well on cash conversion; however, lower capacity utilisation has impacted return ratios.

Source: Company, Bloomberg, Ambit Capital research. *Note: D1 is the best decile followed by D2, D3, D4 and so on.

Market share gains/margin expansion drive 24% earnings CAGR Supply chain efficiencies along with strong brand recall helped Asian Paints improve its market share in the organized decorative segment from 44% (FY05) to over 57% currently, generating a stable revenue CAGR of ~19%. EBITDA margins have expanded by ~300bps over the last 10 years, generating earnings CAGR of ~24% and average RoCEs of ~35%. Efficient working capital management has ensured healthy cash conversion of over 80% over FY05-14. 37% share price CAGR on ~24% earnings CAGR (FY05-15) Strong earnings growth along with improving market share has led to the stock outperforming the Sensex by ~20% points per annum in the last 10 years. However, the recent rally (~30% rise: Oct’14- Apr’15) possibly due to the benefits expected from the crude price fall seems unjustified (click here for detailed note). The company fares well on corporate governance checks. Market share gains to continue, capital misallocation overhang remains Asian Paints will continue to gain market share by 100bps pa over the next 3-5 years from Kansai Nerolac and Akzo Nobel especially in the premium segment due to: (a) continued improvement in supply chain, (b) scale advantages around advertisement spends, and (c) a superior management team. We highlight capital misallocation risks (RoCE impact of ~10ppts), as the company explores investment opportunities (which have substantially lower profitability vs Indian decorative business) like: (a) African countries which may be good growth stories 10-20 years from now, (b) expansion in the Middle East; and (c) expansion in home improvement through prospective acquisitions in India (beyond Sleek and Ess Ess).

Euphoria around benefits from softening crude prices overdone We expect Asian Paints to deliver revenue/ earnings CAGR of 17%/23% with average RoCE of 34% over FY15-19 due to strong competitive advantages around supply chain, premium brand recall and superior management team. The stock rallied meaningfully in 2HFY15 due to consensus earnings upgrades on the back of fall in crude oil price, which we believe was over exaggerated. Our DCF-based valuation model generates a fair value of `680 (~4% downside) with an implied multiple of 30x FY17E EPS. Asian Paints is currently trading at 37x/31x FY16/FY17E EPS and at a 10-15% premium to other paints companies which we believe is justified given the sustained competitive advantages of the firm.

COMPANY UPDATE APNT IN EQUITY June 22, 2015

Asian PaintsSELL

Analyst Details

Rakshit Ranjan, CFA


Aditya Bagul +91 22 3043 3264

[email protected]

Consumer

Recommendation Mcap (bn): `676/US$10.5 6M ADV (mn): `1302/US$20.3 CMP: `708 TP (12 mths): `680 Downside (%): 4

Flags Accounting: GREEN Predictability: GREEN Earnings Momentum: AMBER

Performance (%)


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15

Sensex (LHS) APNT (RHS)

http://reports.ambitcapital.com/reports/Ambit_ConsumerStaples_Paints_Crudepricerelated_03Dec2014.pdf

Asian Paints


Exhibit 1: EBITDA margins and revenue growth over the last ten years (FY05-15)


Exhibit 2: RoCE and RoE over the last ten years (FY05-15)


Exhibit 3: Sources of funds over the last ten years (FY05-15)


Exhibit 4: Utilisation of funds over the last ten years (FY05-15)


Exhibit 5: Forward P/E evolution


Exhibit 6: Forward P/B evolution




Accounting GREEN Asian Paints has, in the past, reported high cash conversion, efficient management of working capital and low levels of loans and advances and contingent liabilities. Consequently, we give a high rating to the quality of its accounting.

Predictability GREEN Due to a combination of high pricing power, presence across products, categories and SKUs, and predominant exposure to consumer-activity-led sectors of the economy, we expect earnings to remain stable for Asian Paints.


Our accounting analysis does not raise any major red flags with respect to dubious transactions by promoters. However, we raise concern over the capital allocation of the firm, as it continues its inorganic growth aspirations with recent acquisitions like Sleek and Ess Ess, which along with increasing contribution of overseas business will be RoE-dilutive.


0%

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-

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140,000

FY05

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FY09

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FY11

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FY14

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60%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

ROCE (%) ROE (%) (RHS)

CFO, 92%

Debt raised, 4%

Interest received, 1%

Dividend received, 4%

Debt repayment,

3%

Dividend paid, 36%

Interest paid, 4%

Net Capex, 38%

Purchase of Investments

, 10%

Increase in cash and

cash equivalents,

9%

-

10

20

30

40

50

Mar

-05

Oct

-05

May

-06

Dec

-06

Jul-

07Fe

b-08

Sep-

08

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-09

Nov

-09

Jun-

10Ja

n-11

Aug

-11

Mar

-12

Oct

-12

May

-13

Dec

-13

Jul-

14Fe

b-15

1 Yr Forward P/E 4 Yr Avg 6 Yr Avg

-

5

10

15

Mar

-05

Nov

-05

Jul-

06M

ar-0

7

Nov

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ar-0

9N

ov-0

9Ju

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Jul-

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3

Nov

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Jul-

14M

ar-1

5

1 yr Forward P/B 4 yr Avg 6 Yr Avg

Asian Paints


Balance Sheet


Net Worth 33,843 40,392 47,424 56,843 68,217

Total Debt 2,377 2,400 4,099 2,500 2,500

Others 3,152 4,338 4,438 4,808 5,234

Current Liabilities 28,495 33,242 33,164 41,390 48,927

Total Liabilities 67,866 80,372 89,125 105,540 124,877

Fixed Assets 25,002 26,332 28,560 29,786 28,849

Investments 2,807 7,212 15,878 4,000 4,000

Current Assets 40,058 46,829 44,684 71,752 92,026

Total Assets 67,866 80,372 89,122 105,538 124,875

Source Ambit Capital research

Income Statement


Net Income 109,707 127,148 141,827 160,715 189,981

% Growth 14% 16% 12% 13% 18%

Gross Profit 45,323 53,741 62,113 70,892 82,493

EBITDA 17,319 19,979 22,353 28,415 33,914

PBIT 16,919 18,865 21,391 27,660 33,381

PBT 16,552 18,442 21,044 27,198 33,031

PAT 11,139 12,288 14,226 18,397 22,035

EPS 11.6 12.8 14.8 19.2 23.0

EPS Growth 13% 10% 16% 29% 20%


Cashflow statement Year to March (̀ mn) FY13 FY14 FY15 FY16E FY17E

EBIT 16,919 18,864 21,391 27,660 33,381

Depreciation 1,546 2,556 2,659 2,774 2,937

Others (5,010) (5,739) (6,495) (8,431) (10,570)

Change in working capital (1,587) (1,682) (5,206) 3,752 (1,042)

Cash flow from operations 11,868 14,000 12,349 25,755 24,705

Cash flow from investments (4,843) (6,029) (13,553) 7,878 (2,000)

Cash flow from financing (6,007) (6,259) (5,494) (11,039) (11,011)

Change in cash 1,018 1,712 (6,699) 22,595 11,694

Free cash flow 5,501 11,664 7,461 21,755 22,705


Ratio/ Valuation Parameters


Gross margin (%) 41.3% 42.3% 43.8% 44.1% 43.4%

EBITDA margin (%) 15.8% 15.7% 15.8% 17.7% 17.9%

Net profit margin (%) 10.2% 9.7% 10.0% 11.4% 11.6%

Net debt: equity (x) (0.2) (0.2) 0.0 (0.4) (0.5)

RoCE (%) 35.3% 30.7% 30.7% 33.8% 34.3%

RoE (%) 36.3% 33.1% 32.4% 35.3% 35.2%

P/E (x) 61.1 43.5 47.9 37.0 30.9

Price/Sales (x) 6.2 5.4 4.8 4.2 3.6

EV/EBITDA (x) 37.0 34.2 28.5 22.5 18.8


Asian Paints


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COMPANY UPDATE NEST IN EUITY June 22, 2015

India’s leading packaged foods company

Nestle India is one of India’s largest packaged companies, with a presence in milk products and nutrition, chocolates and confectionery, prepared dishes & cooking aids, and beverages. Its key brands include Nescafé, Maggi, Everyday, KitKat and Cerelac, most of which are market leaders in their respective categories. Over the last ten years, the company’s shares have compounded annually at 24% vs 15% for the Sensex.


RoCE Trajectory CY09: 174%, CY10: 159%, CY11: 70% CY12: 45%; CY13: 40%; CY14: 35%

Starting CY11, Nestle more than doubled its capex plans to augment capacity. This led to a reduction in RoCEs.


CY09: 19%, CY10: 22%, CY11: 20% CY12: 11%; CY13: 9%; CY14: 8%

Nestle pruned its product portfolio over this period in order to drive margin expansion instead of volume growth.


CY09: 23%, CY10: 25%, CY11: 18% CY12: 11%; CY13: 3%; CY14: 7%

Slowdown in sales growth coupled with margin contraction has led to slow down in EPS growth.

Share price returns (CAGR) 3yr/5yr/10yr 9%/15%/24%

Slowdown in volume growth and loss in market share over the last three years have led to slower share price appreciation vs the prior period.

Greatness Model (decile) CY09-13: D3*

Deterioration in RoCE over the last three years has led to a lower ranking on the ‘greatness’ framework.

Source: Company, Bloomberg, Ambit Capital research. *Note:D1 is the best decile followed by D2, D3, D4 and so on.

A tale of two halves: CY05-10/CY11-14 sales CAGR of 20%/9% Over CY05-10, Nestle reported sales/EPS CAGR of 20%/21%, as the premium positioning of Nestle’s product portfolio benefited from an increase in consumer demand over this period. However, over CY11-14, sales/EPS CAGR slowed down to 9%/7% due to slowdown in consumer spending and the company’s flawed change in strategy to focus on profitability instead of volume growth. Since CY11, Nestle has almost doubled its capacity. However, the slowdown in consumer spending has impacted the utilisation of these new facilities, resulting in RoCEs falling from ~170% in CY09 to ~40% in CY14. Outperformance over 10 years led by robust EPS growth Nestle has outperformed the Sensex, as its share price increased at 24% CAGR over the last ten years. Most of this outperformance was front-ended, as the company delivered robust 21% EPS CAGR over CY05-10. However, over the last three years, Nestle (9% CAGR) has underperformed the Sensex (15% CAGR) due to a marked slowdown in its EPS growth to 7% CAGR over CY11-14. Market leadership + premium positioning = 13% EPS CAGR over 10 years We estimate that around 70% of Nestlé’s revenues relate to products where it is a market leader and also has a premium positioning. This, we believe, lends the company significant brand equity and pricing power to maintain/gain share to deliver 5-6% volume growth and pass on 6-7% price hikes thus delivering ~13% EPS CAGR over the next ten years. From CY15 the management has indicated a shift in focus on volume growth instead of its earlier focus on margin expansion. Premium valuations to continue over the longer term Nestlé deserves to trade at a premium to the FMCG sector given its strong cash generation, superior brand recall and leadership control over some of the fastest-growing aspirational consumption sectors currently in India. However, at current valuations of 51.3/38.3x CY15/16E P/E, the valuations remain stretched particularly in spite of the Maggi controversy. We remain SELLers.

NestleSELL

Consumer Staples

Recommendation Mcap (bn): `558/US$8.7 3M ADV (mn): `571/US$8.9 CMP: `5,785 TP (12 mths): `5,100 Downside (%): 13

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

Performance (%)


90 100 110 120 130 140 150

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

Sensex Nestle

Analyst Details

Rakshit Ranjan, CFA

+91 22 3043 3201

[email protected]

Ritesh Vaidya +91 22 3043 3246

[email protected]

Nestle




Accounting GREEN In the past, Nestlé has reported excellent cash conversion, efficient management of working capital, and low levels of loans and advances and contingent liabilities. Consequently, we give a high rating to its accounting quality.

Predictability AMBER With discretionary spending under pressure over the past few quarters, Nestlé’s revenue growth has been well below the FMCG average and consensus estimates. However, EBITDA margins have been more stable, within a 200bps band.


Nestle reduced its dividend payout ratio from ~90% in CY08 to ~50% in CY13 to fund the company’s capex plans. However, in March 2013, the company announced a staggered increase in its royalty rate from 3.5% to 4.5%, resulting in higher payments to the parent but impacting Nestle India’s profits.


Exhibit 1: EBITDA margins and revenue growth over the CY05-14


Exhibit 2: RoCE and RoE over CY05-14


Exhibit 3: Sources of funds over the last ten years (CY05-14)


Exhibit 4: Utilisation of funds over the last ten years (CY05-14)






18.5%19.0%19.5%20.0%20.5%21.0%21.5%22.0%

20,000

40,000

60,000

80,000

100,000

120,000

CY

05

CY

06

CY

07

CY

08

CY

09

CY

10

CY

11

CY

12

CY

13

CY

14

Revenues (Rs mn) EBITDA margin (% RHS)

50.0%

70.0%

90.0%

110.0%

130.0%

40.0%60.0%80.0%

100.0%120.0%140.0%160.0%180.0%

CY

05

CY

06

CY

07

CY

08

CY

09

CY

10

CY

11

CY

12

CY

13

CY

14

RoCE (%) RoE (%, RHS)

CFO, 85%

Debt raised, 10%

Interest received,

5%Debt

repayment, 10%

Dividend paid, 41%

Interest paid, 1%

Net Capex, 39%

Purchase of Investments

, 6%

Increase in cash, 4%

20.0

30.0

40.0

50.0

60.0

70.0

Jun

05

Jun

06

Jun

07

Jun

08

Jun

09

Jun

10

Jun

11

Jun

12

Jun

13

Jun

14

Jun

15

NEST 1-yr Fwd P/E 10 yr Avg 5 yr Avg

15.0

20.0

25.0

30.0

35.0

40.0

Jun

05

Jun

06

Jun

07

Jun

08

Jun

09

Jun

10

Jun

11

Jun

12

Jun

13

Jun

14

Jun

15

NEST 1-yr Fwd P/BV 10 yr Avg 5 yr Avg

Nestle


Balance sheet (` mn)

Year to December CY13 CY14 CY15E CY16E CY17E

Shareholders' equity 964 964 964 964 964

Reserves & surpluses 22,723 27,408 29,897 34,980 40,902

Total networth 23,688 28,372 30,861 35,944 41,866

Minority Interest - - - - -

Debt 11,895 196 - - -

Deferred tax liability 2,155 2,227 2,227 2,227 2,227

Total liabilities 37,737 30,795 33,088 38,171 44,093

Gross block 49,032 50,090 51,590 53,090 54,590

Net block 33,693 31,766 29,553 26,969 23,977

CWIP 2,947 2,448 2,947 2,947 2,947

Goodwill - - - - -

Investments 8,511 8,118 8,118 8,118 8,118

Cash & equivalents 7,494 4,458 8,485 18,305 29,454

Debtors 843 991 1,068 1,211 1,360

Inventory 7,359 8,441 8,275 9,387 10,541

Loans & advances 2,258 1,820 2,135 2,422 2,720

Other current assets 38 152 - - -

Total current assets 17,992 15,863 19,962 31,325 44,076

Current liabilities 11,333 11,383 12,812 14,534 16,322

Provisions 14,073 16,017 14,681 16,654 18,702

Total current liabilities 25,406 27,400 27,493 31,188 35,025

Net current assets (7,414) (11,537) (7,531) 137 9,051

Total assets 37,737 30,795 33,088 38,171 44,093


Income statement (` mn) Year to December CY13 CY14 CY15E CY16E CY17E

Operating income 90,619 98,063 97,426 110,522 124,116

% growth 9.1% 8.2% -0.6% 13.4% 12.3%

Operating expenditure 71,535 78,230 78,865 86,261 96,748

EBITDA 19,084 19,832 18,560 24,260 27,369

% growth 6.4% 3.9% -6.4% 30.7% 12.8%

Depreciation 3,300 3,375 3,713 4,084 4,493

EBIT 15,785 16,457 14,847 20,176 22,876

Interest expenditure 365 142 30 - -

Non-operating income 1,222 1,359 1,525 1,722 1,958

Adjusted PBT 16,642 17,674 16,342 21,898 24,833

Tax 5,609 5,897 5,393 7,226 8,195

Adjusted PAT/ Net profit 11,033 11,777 10,949 14,672 16,638

% growth 3.3% 6.7% -7.0% 34.0% 13.4%

Extraordinaries 138 70 - - -

Reported PAT / Net profit 11,033 11,777 10,949 14,672 16,638

Minority Interest - - - - -

Share of associates - - - - -

Adj. Consol net profit 11,033 11,777 10,949 14,672 16,638 Reported Consol net profit 11,033 11,777 10,949 14,672 16,638


Nestle


Cash flow statement (` mn)

Year to December CY13 CY14 CY15E CY16E CY17E

EBIT 17,007 17,816 16,372 21,898 24,833

Depreciation 3,300 3,375 3,713 4,084 4,493

Others 169 (70) (30) - -

Tax (5,609) (5,897) (5,393) (7,226) (8,195)

(Incr) / decr in net working capital 3,513 1,088 20 2,153 2,235


Capex (4,456) (949) (1,999) (1,500) (1,500)

(Incr) / decr in investments (4,862) 393 - - -

Others - - - 1 2

Cash flow from investments (9,318) (557) (1,999) (1,500) (1,500)

Net borrowings 1,393 (11,699) (196) - -

Interest paid 365 142 30 - -

Dividend paid (5,471) (7,107) (8,460) (9,589) (10,717)

Others (224) (128) (30) - -


Net change in cash 5,124 (3,035) 4,026 9,820 11,149

Closing cash balance 7,494 4,458 8,485 18,305 29,454

Free cash flow 13,923 15,364 12,683 19,409 21,866


Ratio analysis Year to December CY13 CY14 CY15E CY16E CY17E

Gross margin (%) 54.5% 53.9% 55.6% 56.2% 56.5%

EBITDA margin (%) 21.1% 20.2% 19.1% 22.0% 22.1%

EBIT margin (%) 18.8% 18.2% 16.8% 19.8% 20.0%


Dividend payout ratio (%) 49.0% 60.0% 77.3% 65.4% 64.4%

Net debt: equity (x) 0.2 (0.2) (0.3) (0.5) (0.7)

Working capital turnover (x) (6.1) (6.1) (6.1) (6.1) (6.1)

Gross block turnover (x) 1.8 2.0 1.9 2.1 2.3

RoCE (%) 33.2% 34.6% 34.3% 41.2% 40.5%

RoE (%) 53.0% 45.2% 37.0% 43.9% 42.8%


Valuation parameters Year to December CY13 CY14 CY15E CY16E CY17E

EPS (`) 114.4 122.1 113.6 152.2 172.6

Diluted EPS (`) 114.4 122.1 113.6 152.2 172.6

Book value per share (`) 245.7 294.3 320.1 372.8 434.2

Dividend per share (`) 48.5 63.0 75.0 85.0 95.0

P/E (x) 50.9 47.7 51.3 38.3 33.8

P/BV (x) 23.7 19.8 18.2 15.6 13.4

EV/EBITDA (x) 29.7 28.1 29.8 22.4 19.4

Price/Sales (x) 6.2 5.7 5.8 5.1 4.5



Dominant player in the niche leisure bike segment Eicher Motors has built a strong presence in the niche leisure bike segment and enjoys a dominant position in the 250-500cc domestic motorcycle space (98% market share). It is also the third-largest player in the Medium and Heavy Commercial Vehicles (MHCV) segment, with a market share of 11% in domestic trucks. Over the last ten years (FY05-CY14), the company’s shares have compounded annually at 48% vs 16% for the Sensex.

Key Parameters

Parameter Result Comment

RoCE Trajectory CY09: 13%, CY10: 63%, CY11: 65% CY12: 33%; CY13: 27%; CY14: 28%

Strong sales growth in Royal Enfield (RE) was offset to some extent by weak demand in the commercial vehicle segment, leading to lower RoCEs in recent years.


CY09: 28%, CY10: 50%, CY11: 29% CY12: 13%; CY13: 7%; CY14: 28%

Strong demand for RE bikes led to superlative performance in the last five years.


CY09: 152%, CY10: 140%, CY11: 62% CY12: 5%; CY13: 21%; CY14: 56%

EPS growth driven by strong sales growth and EBITDA margin expansion.


3yr/5yr/10yr 102%/89%/48% Share price performance has largely tracked the fundamentals.

Greatness Model (decile) FY09-14: D1* Eicher scores relatively well on all

parameters of the ‘greatness’ model. Source: Company, Bloomberg, Ambit Capital research. *Note: D1 is the best decile followed by D2, D3, D4 and so on. Strong demand for RE bikes led to strong performance in last five years Over the past 10 years (FY05-CY14), Eicher’s consolidated revenues have recorded a CAGR of 16% with an average EBITDA margin of only 6.8% and RoCE of 25%. However, RE (Royal Enfield) bikes have reported strong demand on the back of product improvements, broadening user base and strong pull created in favour of leisure bikes from Harley Davidson/Triumph; thus, Eicher’s consolidated revenue CAGR was at 24% with an average EBITDA margin of 9.1% and RoCE of 38% over CY09-14. The company’s cash conversion (CFO/EBITDA) has remained strong and has averaged at 144% over CY09-14. Share price performance has largely tracked the fundamentals Eicher’s share price has delivered 48% CAGR over the last 10 years and a stronger 89% CAGR and 102% CAGR over the last 5 years and 3 years, respectively. This reflects the trends in its financial performance. RE’s domestic volumes to touch 1mn units by FY20 We expect RE’s strong volume momentum to continue and clock 45% CAGR over CY14-FY17 and touch 1mn units by FY20 on the back of strong dealer roll-out, product portfolio expansion and limited competition. For the CV business, whilst the market share of Volvo Eicher Commercial Vehicles (VECVs) in the heavy trucks (HD) segment declined from 4.6% in CY13 to 3.9% in CY14, we expect the new Pro-series truck launch and distribution expansion to lead to market share gain. However, VECV’s market share of 7.0% by FY18 would be much lower than the management’s target of 15.0%. Overall, we expect consolidated revenues, EBITDA and net earnings to deliver 30%, 37% and 37%, respectively over CY14-FY20.

Trading at a significant premium to peers and historical average We value RE at `13,100/share, implying 30.0x FY17 core net earnings and a 100% premium to Hero/Bajaj’s multiples. We value VECV (Eicher’s share) at `2,700/share, implying 10.7x FY17E EBITDA and a 20% premium to Ashok Leyland. We believe Eicher’s current valuation multiple (28.4x FY17E EPS) fully captures in the long-term domestic potential for Royal Enfield and market share gains in heavy commercial vehicles.

COMPANY UPDATE EIM IN EQUITY June 22, 2015

Eicher MotorsSELL

Auto & Auto ancillaries

Recommendation Mcap (bn): `489/US$7.6 3M ADV (mn): `2,374/US$37.1 CMP: `18,027 TP (12 mths): `15,800 Downside (%): 12


Performance


90 120 150 180 210 240 270

Jun-

14Ju

l-1

4A

ug-1

4Se

p-14

Oct

-14

Nov

-14

Dec

-14

Jan-

15Fe

b-1

5M

ar-1

5A

pr-1

5M

ay-1

5

Sensex Eicher Motors

Analyst Details

Ashvin Shetty, CFA

+91 22 3043 3285

[email protected]

Ritu Modi


Eicher Motors


Exhibit 1: EBITDA margins and revenue growth over FY05-CY14


Exhibit 2: RoCE and RoE over FY05-CY14


Exhibit 3: Capital allocation of Eicher Motors over the last ten years (FY05-CY14)




Exhibit 5: Forward EV/EBITDA evolution




Accounting GREEN Eicher’s key accounting ratios such as CFO to EBITDA stand out amongst its peers (for CY14, Eicher’s CFO as a percentage of EBITDA at 119% is much higher than the average 95% of listed peers, namely Tata Motors and Ashok Leyland). On Ambit’s forensic accounting, Eicher is categorised in the 2nd decile of the Auto universe (comprising eight companies).

Predictability AMBER Whilst the volumes are reported by the company on a monthly basis (in line with the industry practice), the margin performance reported in the quarterly earnings tends to be unpredictable due to the high nature of fixed costs involved in the business. However, this is an industry-wide phenomenon.

Earnings momentum AMBER Bloomberg shows no significant upgrades/downgrades to consensus numbers in recent weeks.


0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

-

20,000

40,000

60,000

80,000

100,000

FY05

FY06

FY07

FY08

9MD

ec08

CY0

9

CY1

0

CY1

1

CY1

2

CY1

3

CY1

4Revenue (Rs mn) EBITDA margin (RHS)

-20%-10%0%10%20%30%40%50%60%70%80%

-10%

0%

10%

20%

30%

40%

FY05

FY06

FY07

FY08

9MD

ec08

CY0

9

CY1

0

CY1

1

CY1

2

CY1

3

CY1

4

RoE RoCE (Post tax) - RHS

5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 50.0

Jan-

10

May

-10

Sep-

10

Jan-

11

May

-11

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14M

ay-1

4

Sep-

14

Jan-

15

May

-15

Eicher 1-yr fwd P/E Avg 1-yr fwd P/E

-

5.0

10.0

15.0

20.0

25.0

Jan-

10

May

-10

Sep-

10

Jan-

11

May

-11

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13M

ay-1

3

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Eicher 1-yr fwd EV/EBITDA Avg 1-yr fwd EV/EBITDA

Eicher Motors


Balance sheet (consolidated)*

Year to December (̀ mn) CY12 CY13 CY14 FY16E FY17E


Reserves & surpluses 17,279 20,284 24,888 36,907 50,716

Total networth 17,549 20,554 25,159 37,178 50,987

Minority Interest 9,485 10,397 10,851 12,677 14,974

Debt 389 839 584 584 584

Deferred tax liability 1,232 1,805 2,394 2,394 2,394


Gross block 15,260 22,993 31,609 47,900 53,299

Net block 9,918 16,561 23,199 35,643 37,482

CWIP 6,197 5,551 5,867 2,500 1,131

Cash & Cash equivalents 14,481 15,151 15,553 26,094 42,396

Debtors 4,459 5,125 5,622 10,906 11,247

Inventory 4,888 5,268 6,455 12,617 13,316

Loans & advances 4,771 5,709 7,380 14,514 15,113



Provisions 1,704 2,159 3,213 5,872 6,082


Net current assets 12,540 11,482 9,920 14,717 30,355

Total assets 28,655 33,595 38,986 52,832 68,939

Source: Company, Ambit Capital research; Note: The company has changed its accounting year-end from December to March, and hence FY16 is for 15 months ended March 31, 2016

Income statement (consolidated)* Year to December (̀ mn) CY12 CY13 CY14 FY16E FY17E

Net Sales 63,899 68,098 87,383 167,034 175,827

% growth 13% 7% 28% 53% 32%


EBITDA 5,490 7,132 11,148 25,985 29,101

% growth -1% 30% 56% 86% 40%

Depreciation 822 1,300 2,198 3,846 3,560

EBIT 4,669 5,831 8,950 22,139 25,541

Interest expenditure 38 79 98 76 61

Non-operating income 1,366 545 666 1,748 1,879

Adjusted PBT 5,997 6,298 9,518 23,811 27,359

Tax 1,249 1,452 2,909 6,741 7,831 Adjusted PAT before minority interest 4,749 4,846 6,609 17,069 19,528

% growth -5% 2% 36% 107% 43%

Minority Interest 1,506 1,314 864 2,243 2,832 Adjusted PAT after minority interest 3,243 3,531 5,746 14,827 16,696

Reported PAT after minority interest 3,243 3,531 5,746 14,827 16,696


Eicher Motors


Cashflow statement (consolidated)*

Year to December (̀ mn) CY12 CY13 CY14 FY16E FY17E

Net Profit Before Tax 5,997 6,706 9,926 23,811 27,359

Depreciation 822 1,300 2,198 3,846 3,560

Others (1,308) (819) (833) (1,671) (1,818)

Tax (1,077) (1,504) (2,810) (6,741) (7,831)

(Incr) / decr in net working capital 391 1,491 2,020 4,557 581


Capex (net) (7,820) (7,054) (9,682) (12,924) (4,030)

(Incr) / decr in investments - - - (6,000) (1,000)

Other income (expenditure) 1,051 731 598 1,748 1,879

Cash flow from investments (6,769) (6,324) (9,084) (17,176) (3,151)

Net borrowings (43) 610 (255) - -

Issuance/buyback of equity 4 17 79 (0) 0

Interest paid (40) (80) (98) (76) (61)

Dividend paid (895) (1,020) (1,348) (2,008) (3,337)

Cash flow from financing (974) (474) (1,622) (2,085) (3,398)

Net change in cash (2,918) 377 (205) 4,541 15,301


Free cash flow (2,995) 120 820 10,877 17,821


Ratio analysis (consolidated)* Year to December (%) CY12 CY13 CY14 FY16E FY17E

EBITDA margin (%) 8.6% 10.5% 12.8% 15.6% 16.6%

EBIT margin (%) 7.3% 8.6% 10.2% 13.3% 14.5%

Net profit (bef min. int.) margin (%) 7.4% 7.1% 7.6% 10.2% 11.1%

Dividend payout ratio (%) 17% 21% 22% 17% 15%

Net debt: equity (x) (0.4) (0.3) (0.2) (0.2) (0.5)

Working capital turnover (x) (51) (35) (26) (27) (20)

Gross block turnover (x) 5.1 3.6 3.2 4.2 3.5

RoCE (pre-tax) (%) 41.3% 34.0% 40.2% 64.7% 86.3%

RoIC (%) 32.7% 26.6% 28.4% 46.4% 61.6%

RoE (%) 29.2% 27.6% 30.7% 43.8% 44.3%


Valuation parameters (consolidated)*

Year to December CY12 CY13 CY14 FY16E FY17E

EPS after minority interest (`) 120 146 227 547 617

Diluted EPS (`) 119 145 226 545 613

Book value per share (`) 650 760 928 1,372 1,881

Dividend per share (`) 20 30 50 93 95

P/E (x) 151.0 124.3 79.7 41.4 29.4

P/BV (x) 27.7 23.7 19.4 13.1 9.6

EV/EBITDA (x) 87.9 67.7 43.3 23.2 16.6

EV/EBIT (x) 103.3 82.7 53.9 27.2 18.9



COMPANY UPDATE IIB IN EQUITY June 22, 2015

Premium CV financier; scaling-up other businesses as well IndusInd Bank (IIB) is the best-in-class vehicle financier with unmatched reach and a unique business model. Further, it has been filling gaps in its liability franchise and product suites in other segments (like loan against property, tractor loans and credit cards). The improving outlook for vehicle financing, along with rising CASA ratio and fee income, should help IIB deliver industry-leading earnings growth. Over the last ten years, the bank’s shares have compounded annually at ~35%, vs Bankex return of ~18% and Sensex return of ~15%.


RoA Trajectory FY10: 1.1%, FY11: 1.4%, FY12: 1.6% FY13: 1.6%; FY14: 1.8%; FY15: 1.8%

Lower credit cost and support of fee income helped post strong RoAs

Loan Growth Trajectory

FY10: 30%, FY11: 27%, FY12: 34% FY13: 26%; FY14: 24%; FY15: 25%

Strong CV business and scale-up of franchise have supported loan book CAGR of 25% over 10 years


FY10:104%, FY11:45%, FY12: 39% FY13: 18%; FY14: 32%; FY15: 26%

Improving NIMs and fee income have driven EPS growth

Share price returns (CAGR) 3yr/5yr/10yr 42%/39%/33% Superior loan growth and expanding RoAs

have led to share price out-performance Greatness Model (decile) FY09-13: NA FY10-14: NA Source: Company, Bloomberg, Ambit Capital research

10-year loan book CAGR at 25%; RoAs have also improved IIB has a competitive edge in terms of geographical reach and the business model of its CV finance business. Since the new management took charge in FY08, the bank has been filling gaps in its liability franchise and product suites in other segments. Since end-FY10, when IIB accelerated its network expansion, the number of branches has more than tripled and CASA as a percentage of total borrowed funds has risen from 20% (in FY10) to 34% currently. Since FY08, loan book has expanded at a CAGR of 27%, with RoA expanding from 0.3% in FY08 to 1.8% in FY15. IIB outperformed the Sensex/Bankex by ~20%/17% Over the last ten years, IIB has outperformed the Sensex by 20% and Bankex by 17%. Its new-generation private sector banking peers (e.g. HDFC, Axis, ICICI, Kotak) have delivered annualised return of 27%, and IIB has delivered ~35%. Its superior loan growth, improving liability franchise, strength in CV lending and momentum in fee income have helped the bank to generate superior earnings growth and share price returns. Known for CV lending, now strengthening other businesses IIB has been diversifying its presence into other retail products and wholesale banking. The bank has scaled-up its LAP, credit card, home loan distribution in recent years. The recent acquisition of RBS's diamond & jewellery financing business is an example of a targeted scale-up in wholesale banking. We expect the bank to continue delivering a loan book growth 5-10 percentage points higher than banking system growth over the next 5-10 years, with stable profitability. It has been a turnaround and scale-up story and the bank would continue to seek selective market share gain (it still accounts for <1% credit market share). Superior earnings growth justify the valuations Our target price of `1,030 values the bank at 19.2x P/E and 3.8x P/B (both FY17). At 19.4x FY16E EPS, the current valuation reflects the earnings growth potential. We expect earnings CAGR of 25% along with sustained valuation multiple to drive share price return. The stock is trading at a ~10% discount to peers average (HDFC Bank & Kotak). However, relative to its peers, IIB is likely to deliver superior earnings growth (25% EPS CAGR in FY15-17E).

IndusInd BankBUY

BFSI

Recommendation Mcap (bn): `436/US$6.8 6M ADV (mn): `895/US$13.9 CMP: `818 TP (12 mths): `1030 Upside (%): 26

Flags Accounting: AMBER Predictability: GREEN Earnings Momentum: GREEN

Performance (%)


95110125140155170185

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

IIB IN SENSEX

Analyst Details

Ravi Singh


Pankaj Agarwal, CFA +91 3043 3206

[email protected]

Aadesh Mehta, CFA

+91 22 3043 3239

[email protected]

IndusInd Bank




Accounting AMBER

Compared with some of its peers, IIB’s revenue recognition policy for guarantees (excluding deferred payment guarantees) and LC (letter of credit) appears aggressive, as it books on transaction date/’when due’ rather than amortising the income over the life of the product. However, the short tenor (~6 months) of such instruments implies that the impact on the reported annual numbers is unlikely to be significant.

Predictability GREEN Low exposure to stressed segment on the corporate book and long-term track record in the retail CV book lends predictability to earnings in the current environment.

Earnings Momentum GREEN We expect earnings momentum to pick up for IIB in the future with a pick-up in the CV cycle and decrease in interest rates;

we expect ~25% EPS CAGR in FY15-17E.


Exhibit 1: Loan growth of 26% (FY07-15 CAGR)


Exhibit 2: RoAs have expanded in last seven years


Exhibit 3: Stressed assets have decreased and are now stable


Exhibit 4: The bank has sufficient and stable Tier-I buffer


Exhibit 5: P/E band chart


Exhibit 6: P/B band chart


1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0%5%

10%15%20%25%30%35%40%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Loan growth % NIM % (RHS)

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

0%

5%

10%

15%

20%

25%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

RoE RoA (RHS)3.

1%

3.0%

1.6%

1.2%

1.0%

1.0%

1.0% 1.1%

0.8%

0%

1%

1%

2%

2%

3%

3%

4%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Gross NPAs

7.3%

6.7% 7.

5%

9.7%

12.3

%

11.4

% 13.8

%

12.7

%

11.2

%

0%2%4%6%8%

10%12%14%16%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Tier I ratio

0

150

300

450

600

750

900

Sep-

05

Jun-

06

Mar

-07

Dec

-07

Sep-

08

Jun-

09

Mar

-10

Dec

-10

Sep-

11

Jun-

12

Mar

-13

Dec

-13

Sep-

14

Jun-

15

19.3x

14.4x

9.6x

25

200

375

550

725

900

Mar-05

Dec-0

5Sep-0

6

Jun-07M

ar-08D

ec-08

Sep-09

Jun-10

Mar-11

Dec-1

1Sep-1

2Jun-13M

ar-14

Dec-1

4

3.1x

2.2x

1.4x

IndusInd Bank


Balance sheet


Networth 74,069 86,347 102,451 121,002 145,058

Deposits 541,167 605,023 741,344 937,800 1,191,006

Borrowings 94,596 147,620 206,181 253,089 309,216

Other Liabilities 21,107 27,297 37,330 46,628 58,249

Total Liabilities 730,938 866,287 1,087,306 1,358,517 1,703,530

Cash & Balances with RBI/Banks 68,487 67,694 107,791 132,445 163,020

Investments 196,542 215,630 248,594 315,468 391,872

Advances 443,206 551,018 687,882 869,331 1,099,496

Other Assets 22,703 31,944 43,039 41,274 49,141

Total Assets 730,938 866,287 1,087,306 1,358,517 1,703,530


Income statement


Interest Income 69,832 82,535 96,920 118,052 146,369

Interest Expense 47,504 53,628 62,717 75,737 92,900

Net Interest Income 22,329 28,907 34,203 42,315 53,469

Total Non-Interest Income 13,630 18,905 24,039 30,058 37,590

Total Income 35,958 47,812 58,242 72,372 91,060

Total Operating Expenses 17,564 21,853 27,259 33,815 41,925

Employees expenses 6,615 8,093 9,805 11,997 14,652

Other Operating Expenses 10,949 13,760 17,455 21,818 27,273

Pre Provisioning Profits 18,395 25,960 30,982 38,557 49,134

Provisions 2,631 4,676 3,891 5,720 6,778

PBT 15,764 21,283 27,092 32,837 42,356

Tax 5,152 7,203 9,155 10,836 13,978

PAT 10,612 14,080 17,937 22,001 28,379


Ratio analysis Year to March FY13 FY14 FY15 FY16E FY17E

Credit-Deposit (%) 81.9% 91.1% 92.8% 92.7% 92.3%

CASA ratio (%) 29.3% 32.5% 34.1% 35.1% 35.6%

Cost/Income ratio (%) 48.8% 45.7% 46.8% 46.7% 46.0%

Gross NPA (̀ mn) 4,578 6,208 5,629 8,352 11,677

Gross NPA (%) 1.03% 1.12% 0.81% 0.96% 1.06%

Net NPA (̀ mn) 1,368 1,841 2,105 3,257 4,671

Net NPA (%) 0.31% 0.33% 0.31% 0.37% 0.42%

Provision coverage (%) 70.1% 70.4% 62.6% 61.0% 60.0%

NIMs (%) 3.54% 3.75% 3.64% 3.58% 3.60%

Tier-1 capital ratio (%) 13.8% 12.7% 11.2% 10.8% 10.3%


IndusInd Bank


Du-pont analysis


NII / Assets (%) 3.4% 3.6% 3.5% 3.5% 3.5%

Other income / Assets (%) 2.1% 2.4% 2.5% 2.5% 2.5%

Total Income / Assets (%) 5.5% 6.0% 6.0% 5.9% 5.9%

Cost to Assets (%) 2.7% 2.7% 2.8% 2.8% 2.7%

PPP / Assets (%) 2.8% 3.3% 3.2% 3.2% 3.2%

Provisions / Assets (%) 0.4% 0.6% 0.4% 0.5% 0.4%

PBT / Assets (%) 2.4% 2.7% 2.8% 2.7% 2.8%

Tax Rate (%) 32.7% 33.8% 33.8% 33.0% 33.0%

ROA (%) 1.6% 1.8% 1.8% 1.8% 1.9%

Leverage 10.9 10.0 10.3 10.9 11.5

ROE (%) 17.8% 17.6% 19.0% 19.7% 21.3%


Valuation parameters Year to March FY13 FY14 FY15 FY16E FY17E

EPS (`) 20.3 26.8 33.9 41.6 53.6

EPS growth (%) 18% 32% 26% 23% 29%

BVPS (̀ ) 141.7 164.3 193.5 228.5 274.0

P/E (x) 40.4 30.6 24.2 19.7 15.3

P/BV (x) 5.78 4.99 4.23 3.58 2.99



Sustained competitive advantages; capital allocation less than optimal Pidilite has cemented its position as the leader in India’s adhesive market through its flagship brand, Fevicol. Pidilite’s strong brand and distribution make it a high-quality defensive play in the consumer space. However, capital allocation in its international subsidiaries and uncertainty over the final outcome of the elastomer project have been an overhang on the company’s growth prospects. Over the last ten years, the company’s shares have compounded annually at 39% vs 16% for the Sensex. Key Parameters Parameter Result Comment

RoCE Trajectory FY09: 14%, FY10: 26%, FY11: 32% Stable RoCE performance with stable

margins and a less than optimal capital allocation in international subsidiaries FY12: 31%; FY13: 35%; FY14: 33%

Sales Growth FY09: 16%, FY10: 10%, FY11:21% Strong brand recall and continual improvement in distribution has led to consistent revenue growth Trajectory FY12: 18%; FY13: 18%; FY14: 16%

EPS Growth FY09: -36%, FY10: 146%, FY11: 12% Earnings volatility primarily due to fluctuation in input costs Trajectory FY12: 5%; FY13: 33%; FY14: 6%

Share price returns 3yr/5yr/10yr 52%/39%/40%

Consistent compounding on strong fundamentals, recent rally on impact of crude price drop not completely justified (CAGR)

Greatness Model FY10-14: D2*

Pidilite scores well on growth and pricing discipline but misses out on capital allocation and balance sheet discipline (decile)


Brand recall/strong distribution network drives consistent performance Supply chain efficiencies and strong brand recall for its flagship product, ‘Fevicol,’ (~50% of revenue) have helped Pidilite generate stable revenue CAGR of ~19%. EBITDA margins have remained stable at ~15% over the last 10 years, generating ~22% earnings CAGR and ~29% average RoCEs. Efficient working capital management has ensured healthy cash conversion of >90% in FY05-14. 39% share price CAGR on ~22% CAGR earnings growth (FY05-15) Pidilite’s share price has rallied recently by ~34% (Oct’14-Apr’15) possibly due to the anticipated benefits from the fall in crude prices. Whilst this rally looks overdone, strong earnings growth over the longer term alongside improving market share have led to the stock outperforming the Sensex by ~20% CAGR in the last 10 years. Pidilite fares well on our corporate governance checks. Competitive strengths intact; capital misallocation overhang remains Due to Pidilite’s strong brand recall in the Indian adhesives and sealants segment, lack of organised competition for its flagship product (Fevicol) (accounting for >50% of total sales), and high customer loyalty, we continue to view Pidilite as a high-quality defensive play in the consumer sector. It has reported 17% revenue CAGR in FY10-15 and we expect this revenue growth momentum to continue in FY15-18. However, the performance of its international subsidiaries, uncertainty over the final outcome of the elastomer project, and rising competition in construction chemicals from Berger and Asian Paints, may have a material impact on Pidilite’s performance in the future.

Punchy valuations more than adequately factor in business strengths Due to the strong fundamentals including brand recall and distribution strength, we estimate earnings CAGR of 22% for Pidilite over FY15-18E, which promises a consistent compounding of shareholder returns over the longer term. The stock is currently trading at 43x/35x FY16/FY17E, which: (a) more than adequately factors in the tailwinds from commodity prices; and (b) does not fully appreciate the overhang from lower RoCE businesses. Pidilite trades at a ~15% premium to Asian Paints which we believe is unjustified given Asian Paints’ superior competitive advantages and scale benefits.

COMPANY UPDATE PIDI IN EUITY June 22, 2015

Pidilite IndustriesSELL

Consumer

Recommendation Mcap (bn): `270/US$4.2 6M ADV (mn): `264/US$4.1 CMP: `526 TP (12 mths): `390 Downside (%): 26


Performance (%)


200300400500600700

24,000

26,000

28,000

30,000

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

Sensex (LHS) Pidilite (RHS)

Analyst Details

Rakshit Ranjan, CFA +91 22 3043 3201

[email protected]

Aditya Bagul +91 22 3043 3264

[email protected]

Pidilite Industries






Exhibit 3: Sources of funds over the last ten years (FY05-15)


Exhibit 4: Utilisation of funds over the last ten years (FY05-15)







Accounting GREEN Pidilite has, in the past, reported high cash conversion, efficient management of working capital and low levels of loans and advances and contingent liabilities. Consequently, we give a high rating to the quality of its accounting.

Predictability AMBER Pidilite’s competitive advantages ensure high pricing power; despite its strong presence across product categories, the company’s earnings are subject to volatility in input costs (crude and VAM).

Treatment of minorities AMBER Our accounting analysis does not raise any major red flags with respect to dubious transactions by promoters. However, we raise concern over the capital allocation of the firm, as the elastomer project remains on hold and incremental investments in international subsidiaries are RoCE-dilutive.


0%

5%

10%

15%

20%

-

10,000

20,000

30,000

40,000

50,000FY

05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenue (Rs mn) EBITDA margin (%)

0%

10%

20%

30%

40%

0%

10%

20%

30%

40%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoCE (%) ROE% (RHS)

CFO, 84%

Debt raised, 16%

Debt repayment

, 19%

Dividend paid, 24%

Net Capex,

47%

Purchase of

Investments, 14%

Increase in cash

and cash equivalent

s, 2%

-

10 20

30

40 50

Mar

-05

Nov

-05

Jul-

06M

ar-0

7N

ov-0

7

Jul-

08M

ar-0

9N

ov-0

9Ju

l-10

Mar

-11

Nov

-11

Jul-

12M

ar-1

3N

ov-1

3Ju

l-14

Mar

-15

1 Yr Forward P/E 4 Yr Avg 6 Yr Avg

-

5

10

15

Mar

-05

Nov

-05

Jul-

06

Mar

-07

Nov

-07

Jul-

08M

ar-0

9N

ov-0

9

Jul-

10M

ar-1

1N

ov-1

1Ju

l-12

Mar

-13

Nov

-13

Jul-

14M

ar-1

5

1 yr Forward P/B 4 yr Avg 6 Yr Avg

Pidilite Industries


Balance Sheet


Net Worth 16,515 19,526 22,706 26,690 31,585

Total Debt 510 459 584 - -

Others 508 579 617 617 617

Current Liabilities 8,219 8,719 9,240 11,127 13,078


Fixed Assets 10,747 11,872 14,403 14,796 15,169

Investments 2,931 2,603 3,599 3,639 3,679

Current Assets 12,074 14,809 15,146 20,000 26,431

Total Assets 25,752 29,284 33,148 38,435 45,280


Income Statement


Net Income 36,781 42,832 48,441 56,728 66,516

% Growth 18% 16% 13% 17% 17%

Gross Profit 16,700 19,171 21,627 25,641 30,065

EBITDA 6,002 6,667 7,678 9,559 11,441

PBIT 6,021 6,304 6,986 9,034 11,013

PBT 5,866 6,141 6,830 9,034 11,013

PAT 4,292 4,515 5,125 6,364 7,749

EPS 8.4 8.8 10.0 12.4 15.1

EPS Growth 32% 5% 14% 24% 22%


Cashflow statement

Year to March (̀ mn) FY13 FY14E FY15 FY16E FY17E

EBIT 6,021 6,304 6,986 9,034 11,013

Depreciation 686 812 1,178 1,107 1,127

Others (1,337) (1,816) (1,851) (2,710) (3,304)

Change in working capital (961) (1,969) (727) 823 (516)


Cash flow from investments (3,266) (1,936) (3,709) (1,500) (1,500)


Change in cash (1,373) (262) 277 3,791 3,965

Free cash flow 1,142 1,394 1,877 6,754 6,819


Ratios and Valuation Parameters


Gross margin (%) 45.4% 44.8% 44.6% 45.2% 45.2%

EBITDA margin (%) 16.3% 15.6% 15.9% 16.9% 17.2%


Net debt: equity (x) (0.1) (0.1) (0.0) (0.2) (0.3)

RoCE* (%) 37.9% 34.1% 32.3% 36.1% 37.8%

RoE (%) 28.8% 25.1% 24.3% 25.8% 26.6%

P/E (x) 63.3 60.2 53.0 42.7 35.1

Price/Sales (x) 7.4 6.3 5.6 4.8 4.1

EV/EBITDA (x) 45.2 40.6 35.4 28.0 23.0


Pidilite Industries




Largest branded innerwear player in India Page operates in the mid/premium innerwear market, with a market share of ~30%/~8% in the men's/women’s segments; it has seen rapid expansion in the leisurewear segment over FY10-15 (~48% CAGR). Over the last eight years, the company’s shares have compounded annually at 60% vs 11% for the Sensex. Key Parameters Parameter Result Comment

ROCE Trajectory FY09: 42%, FY10:44%, FY11: 46% Efficient capital allocation and improving

EBITDA margins have led to superior RoCE FY12: 54%; FY13: 57%; FY14:58%

Sales Growth FY09: 32%, FY10: 36%, FY11: 42% Market share gains + ~17% category value

CAGR + launch of leisurewear segment Trajectory FY12: 42%; FY13: 26%; FY14: 36%

EPS Growth FY09:33%, FY10: 25%, FY11: 48% Improving EBITDA margin profile driven by mix change towards leisurewear and pricing power Trajectory FY12: 54%; FY13: 25%; FY14:

37% Share price

3yr/5yr/10yr 72%/76%/NA Consistent performance despite weak macro has led to meaningful re-rating of the stock returns (CAGR)

Greatness Model FY09-14: D1* Page scores well across all parameters

(decile) Source: Company, Bloomberg, Ambit Capital research. *Note: D1 is the best decile followed by D2, D3, D4 and so on.

Brand + Distribution + Integrated manufacturing = Recipe for success Over the past 10 years, Page’s revenues have reported a CAGR of ~36%, with an average EBITDA margin of ~20% and RoCE of ~35%. This strong performance can be attributed to: (a) aspirational brand recall for ‘Jockey’; (b) well-incentivised distribution network generating a push for new product launches; (c) product innovation with in-house manufacturing; and (d) tailwinds from low penetration levels in the mid/premium segment. Efficient working 60% share price CAGR on ~36% CAGR earnings growth (FY07-15) Aided by strong fundamentals of the company, the shares have re-rated and delivered over 60% CAGR returns over the last 8 years with an average dividend payout ratio of 56%. Page has delivered consistent earnings growth over the past decade despite a volatile macro demand environment. The firm fares well on our corporate governance checks. Greater growth longevity than most other consumer companies Tailwinds from low category penetration (click here for detailed note), launch of new product categories (eg kidswear) and innovation-led new product launches lead us to expect revenue CAGR of ~31% (FY15-21). Implementation of various IT initiatives and further improvement in the distribution network along with strict control over working capital will, we believe, enable the company to improve its working capital and EBITDA margins and deliver RoCEs of >60% over this period. Based on our understanding of the macro potential, even in FY20, the penetration levels in the mid/premium segment would be ~15% (vs ~10% currently), with Page commanding a market share of ~35% in FY20. Sustained competitive advantages support punchy valuations Page Industries has re-rated from ~35x earnings to 55x over the last 12-18 months which is justified, given the: (a) entry into new product categories enhancing the growth visibility and (b) continual improvements in systems and processes, enabling the company to improve its margin profile. Page is currently trading at 57x/42x FY16/FY17E EPS. Page’s exemplary financials (37% EPS CAGR in FY15-21E and ~57% RoCE) support the valuation premium vs most consumer companies. We retain BUY (TP of `16,500; implied multiple of 63x/46x FY16/FY17E EPS respectively). Competitive threats to Page’s leadership are low (in a large growing opportunity, due to: (a) Rupa’s/Maxwell’s lack of control on distribution and manufacturing with poor aspirational connect; and (b) hurdles for international brands like FCUK, Calvin Klein, USPA and Hanes to build a strong distribution network beyond modern retail into hosiery stores.

COMPANY UPDATE PAG IN EQUITY June 22, 2015

Page IndustriesBUY

Consumer

Recommendation Mcap (bn): `157/US$2.5 6M ADV (mn): `180/US$2.8 CMP: `14,950 TP (12 mths): `16,500 Upside (%): 10


Performance (%)


5000

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15000

20000

24,000

26,000

28,000

30,000

Jun-

14

Aug

-14

Oct

-14

Jan-

15

Mar

-15

May

-15

Sensex Page Industries

Analyst Details

Rakshit Ranjan, CFA


Aditya Bagul +91 22 3043 3264

[email protected]

http://reports.ambitcapital.com/reports/Ambit_PageIndustries_CompanyInsight_20Jan2015.pdf

Page Industries






Exhibit 3: CFO and debt primary sources of funds (FY05-15)


Exhibit 4: Rational capital utilisation through capex and dividend (FY05-15






Exhibit 7: Explanation for our flags Segment Score Comment

Accounting GREEN Page Industries' cash conversion has remained healthy and this has resulted in cumulative CFO (pre-tax)/EBITDA of above 70% in FY05-15. Page has maintained effective control on the working capital (WC) cycle, and hence despite high sales growth, WC days have increased marginally from 63 days in FY09 to 65 days in FY15E.

Predictability GREEN Historically, Page Industries has beaten consensus estimates on net profit most of the time. The company has either missed consensus revenue estimates by less than 1% or it has beaten revenue estimates by 1-4%.

Earnings momentum GREEN Our accounting analysis does not raise any major red flags with respect to dubious transactions by promoters.

Also, with the high levels of cash generation, the company has returned the excess cash to the shareholders. Source: Ambit Capital research

10%

12%

14%

16%

18%

20%

22%

24%

0

2000

4000

6000

8000

10000

12000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenue (Rs mn) EBITDA margin (RHS)

30%

50%

70%

90%

110%

130%

20%

30%

40%

50%

60%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

ROCE ROE(RHS)

CFO, 66%Proceeds from

shares, 7%

Debt raised, 24%

Interest received,

2%

Dividend received,

0%

Debt repayment

8%

Dividend paid44%

Interest paid6%

Net Capex37%

Increase in cash

and cash equivalent

s5%

- 10

20 30 40

50 60

Mar

/07

Oct

/07

May

/08

Dec

/08

Jul/

09

Feb/

10

Sep/

10

Apr

/11

Nov

/11

Jun/

12

Jan/

13

Aug

/13

Mar

/14

Oct

/14

May

/15

PE 4 yr Avg 6 yr Avg

-

10

20

30

40

Mar

/07

Oct

/07

May

/08

Dec

/08

Jul/

09

Feb/

10

Sep/

10

Apr

/11

Nov

/11

Jun/

12

Jan/

13

Aug

/13

Mar

/14

Oct

/14

May

/15

P/B 4 yr Avg 6 yr Avg

Page Industries


Balance Sheet


Shareholders’ funds 2,135 2,890 3,868 5,178 6,984

Borrowings 1,007 1,632 1,344 1,350 1,350

Net Fixed assets (incl. CWIP) 1,459 1,764 2,174 2,748 3,279

Inventories 2,350 3,626 4,435 4,816 6,169

Cash and cash equivalents 46 35 44 362 768

Working Capital 1,730 2,853 3,152 3,784 5,057


Source: Ambit capital research

Income Statement


Net Sales 8,758 11,876 15,424 20,441 27,129

Raw materials cost 4,203 5,659 7,212 9,710 12,886

Employees cost and comm. on sales 1,436 1,881 2,585 3,163 4,083

Other Admin, S&D expenses 640 906 1,228 1,467 1,880

EBITDA 1,766 2,511 3,171 4,463 6,078

Depreciation 114 139 176 218 263

Interest expense 80 104 155 105 105

PBT 1,657 2,334 2,933 4,283 5,900

Tax expenses 531 797 973 1,371 1,888

Net profit (excl. exceptional items) 1,125 1,537 1,960 2,913 4,012

EPS (`) 100.9 137.8 175.7 261.1 359.7


Cash flow Statement


Changes in Working Capital (457) (1,051) (290) (314) (867)

Cash flow from operating activities 871 740 1,908 2,779 3,323

Capex (449) (473) (721) (792) (795)

Cash flow from investing activities (419) (441) (627) (649) (605)

Dividend paid (596) (756) (940) (1,602) (2,206)

Cash flow from financing activities (438) (310) (1,382) (1,701) (2,312)

Free cash flow 430 280 1,281 2,130 2,718


Valuation Ratios


P/E (x) 148.2 108.5 85.1 57.3 41.6

ROE (%) 59.3 61.2 58.0 64.4 66.0

Net debt/equity (x) 0.5 0.6 0.3 0.2 0.1

Asset turnover excluding cash (x) 3.2 3.1 3.2 3.5 3.7

Gross margin (%) 52.0 52.3 53.2 52.5 52.5

EBITDA margin (%) 20.2 21.1 20.6 21.8 22.4

Net profit margin (%) 12.8 12.9 12.7 14.2 14.8

Dividend yield (%) 0.3 0.4 0.5 0.8 1.1


Page Industries




Moving closer to large-cap peers Torrent Pharma (TRP) is one of India’s major pharmaceutical companies, with a presence in generic markets like US and Europe, branded markets like India and emerging markets (EMs) like Brazil and Philippines. Over the last ten years, the company’s shares have compounded annually at 36% vs 16% for the Sensex. Key Parameters Parameter Result Comment

RoCE Trajectory FY09: 23%, FY10: 30%, FY11: 25% FY12: 26%; FY13: 30%; FY14: 33%

Torrent’s RoCEs have declined from the peak of FY09 due to significant infrastructure build-in EMs. But RoCE has recovered in FY14 owing to the Cymbalta launch in the US and operating leverage in India and Brazil.


FY09: 20%, FY10: 15%, FY11: 15% FY12: 22%; FY13: 17%; FY14: 32%

Consistent sales growth from India and EMs (especially Brazil) coupled with entry in the US generics market led to sales CAGR of 20.5% over FY0-14.


FY09: 27%, FY10: 18%, FY11: (23)% FY12: 5%; FY13: 52%; FY14: 53%

Consolidated PAT growth has increased as the India business grew faster (resulting in positive operating leverage) led by management change and one-off sales in the US.


3yr/5yr/10yr 62%/36%/36% Torrent has outperformed the Sensex over FY05-14 and has provided healthy returns over the near term (FY11-15).


FY09-14: D2*

Torrent receives a high score on our ‘greatness model’ on account of improvement in sales, pricing discipline and return ratios.


RoCEs in upward trajectory post management turnaround Over the past decade (FY05-14), Torrent’s revenues have expanded at 26% CAGR led by improving domestic sales, brand establishment in emerging markets and key product launches in US generics. Post the management turnaround in FY11, profitability and RoCEs have shown a steady upward trend; focus on creating bigger brands and low new product launches, and change in the incentive programme for Medical Representatives (M`) led to RoCEs improving from 25.4% in FY11 to 32.9% in FY14. The company has an excellent capital allocation track record due to high returns from investments in India, Brazil, the US and other Asian markets. TRP was one of the very few Indian pharma companies to enter in the branded EM markets whilst the other companies focused on US generics. Outperformance to Sensex led by creation of moats around its business Torrent has outperformed the Sensex by 26% over FY05-14, as it has created moats around its business by expanding its footprint in the domestic market and has established itself as a brand in key emerging markets like Brazil and the Philippines. Furthermore, with its entry in the US markets with key products like Cymbalta and Abilify, the company has further de-risked its revenue portfolio. Investments in innovation – A foot forward As per the management, the company is working on New Chemical Entities (NCEs) on three products. Two products are in Phase 1 and two products are in Phase 2 (in the cardiology segment). The company has no intention of out-licensing the product, and it will conduct all the required clinical trials and also commercialise the product. Also, Zyg Pharma (derma filings in the US) and Reliance LS (biosimilars in India) add to longer-term visibility to earnings. About to graduate from a mid-cap to a large-cap We value Torrent at `1,477, implying 19.4x FY17E EPS vs the current trading multiple of 18.6x FY16E EPS (ex-Abilify). It is trading at a 30% discount to the large-cap average FY16E forward P/E. On an mcap-to-FCFE basis, it is trading at 29x FY17E vs 36-51x for Sun Pharma, Lupin and Dr Reddy’s. We have chosen mcap-to-FCFE, as it keeps taking unquantified one-off hits (forex loss and one-off revenue from Cymbalta in the US) on its P&L to keep the balance sheet clean.

COMPANY UPDATE TRP IN EQUITY June 22, 2015

Torrent PharmaBUY

Healthcare


Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: GREEN

Performance (%)


50

100

150

200

250

May

-14

Aug

-14

Oct

-14

Jan-

15

Mar

-15

Sensex Torrent Pharma

Analyst Details

Aditya Khemka

+91 22 3043 3272

[email protected]

Paresh Dave, CFA +91 22 3043 3212

[email protected]

Torrent Pharma


Exhibit 1: EBITDA margins and revenue growth over the last ten years (FY05-FY14)


Exhibit 2: RoCE and RoE over the last ten years (FY05-FY14)


Exhibit 3: Sources of funds over the last ten years (FY05 – FY14)


Exhibit 4: Utilisation of funds over the last ten years (FY05-FY14)






Exhibit 7: Explanation for our flags Field Score Comments

Accounting GREEN

In our forensic analysis of 360 companies, Torrent scores higher than the pharma industry average (comprising 26 companies). Torrent scores high on ratios of: (a) gross block conversion; (b) change in depreciation rates; (c) audit fees; and (d) non-operating expenses. However, Torrent has weaker scores on: (a) cash yield; and (b) volatility in sales and distribution costs.

Predictability AMBER Overall, the management has made timely announcements in its earnings calls, meetings and interviews regarding product filings, acquisitions and business outlook. However, the unpredictability of emerging markets and innovative projects make us assign an AMBER flag on predictability.

Earnings momentum GREEN Consensus FY16 EBITDA and EPS have been upgraded by 6.8% and 11.5% respectively; and consensus FY17 EBITDA and EPS have been upgraded by 1.0% and 5.2% respectively over the past three months.


0%

5%

10%

15%

20%

25%

30%

-

10,000

20,000

30,000

40,000

50,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenue (Rs Mn) EBITDA margins (% RHS)

10%

15%

20%

25%

30%

35%

10%

15%

20%

25%

30%

35%

40%

45%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoE RoCE, RHS

CFO, 68.8%

Debt raised, 26.3%

Interest received,

4.4%

Dividend received,

0.2%

Net Capex, 47.5%

Dividend paid, 19.1%

Interest paid, 7.2%

Increase in cash

and cash equivalent

, 26.1%

0.0

5.0

10.0

15.0

20.0

25.0

Mar

-05

Mar

-06

Mar

-07

Mar

-08

Mar

-09

Mar

-10

Mar

-11

Mar

-12

Mar

-13

Mar

-14

Mar

-15

TRP 1 yr fwd PE

TRP P/E 4 yr Avg 6 yr Avg

0.01.02.03.04.05.06.07.08.0

Mar

-05

Mar

-06

Mar

-07

Mar

-08

Mar

-09

Mar

-10

Mar

-11

Mar

-12

Mar

-13

Mar

-14

Mar

-15

TRP 1 yr fwd PB

TRP P/E 4 yr Avg 6 yr Avg

Torrent Pharma


Revenue mix (` mn)

Year-ended 31 Mar FY13 FY14 FY15E FY16E FY17E

Domestic formulations 10,240 11,610 16,185 19,775 22,947

Exports 18,280 26,290 27,385 40,230 42,649

Brazil 5,020 5,330 6,058 6,967 8,360

US 3,550 4,738 6,856 13,285 18,946

One off - 3,022 1,464 6,133 -

ROW 3,210 3,900 3,767 4,144 4,972

Rest of Europe 2,577 3,495 3,495 3,670 4,037

Germany 3,923 5,805 5,745 6,032 6,334

Others 610 700 90 100 100

Insulin 3,000 3,230 2,480 2,604 2,734

Total 32,130 41,830 46,140 62,709 68,430


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

Net revenues 32,111 41,847 46,530 63,432 69,184

Material Cost 9,258 12,435 14,150 17,889 21,362

General Expenses 9,650 11,644 14,100 16,590 19,393

Employee cost 6,233 7,411 8,420 9,683 11,135

Core EBITDA 6,970 10,357 9,860 19,269 17,294

Depreciation 827 870 1,910 2,044 2,169

Interest expense 338 586 1,750 1,894 1,669

Adjusted PBT 6,191 8,440 9,400 16,331 14,034

Tax 1,467 1,801 1,890 3,284 2,822

Reported net profit 4,724 6,639 7,510 13,048 11,212


Balance Sheet

Year to March (in ̀ mn) FY13 FY14 FY15E FY16E FY17E

Total Assets 37,528 50,042 74,172 84,603 91,082

Fixed Assets 11,051 14,095 34,950 37,906 38,236

Current Assets 25,633 33,483 36,758 44,234 50,382

Investments 844 2,464 2,464 2,464 2,464



Reserves & surplus 13,796 18,179 23,053 31,521 38,798

Total networth 14,219 19,025 23,899 32,367 39,644

Total debt 7,030 11,418 25,040 21,040 16,040


Deferred tax liability/(asset) 258 -182 -182 -182 -182


Torrent Pharma


Cash Flow statement

Year to March (in ̀ mn) FY13 FY14 FY15E FY16E FY17E

PBT 5,816 8,440 9,400 16,331 14,034

Depreciation 827 870 1,910 2,044 2,169

Tax (1,325) (2,617) (1,890) (3,284) (2,822)

Net Working Capital (4,218) (1,197) (1,577) (1,952) (1,877)

CFO 1,535 5,994 6,734 14,034 12,596

Capital Expenditure (2,844) (3,982) (22,650) (5,000) (2,500)

Investment 427 424 2,860 1,000 578

Other investments - - - - -

CFI (2,417) (3,558) (19,790) (4,000) (1,922)

Issuance of Equity - - - - -

Inc/Dec in Borrowings 1,340 4,141 13,622 (4,000) (5,000)

Net Dividends (831) (2,667) (990) (2,636) (4,580)

Other Financing activities (312) (610) (1,750) (1,894) (1,669)

CFF 197 864 10,882 (8,529) (11,248)

Net change in cash (685) 3,300 (2,174) 1,504 (574)


FCF 1,030 6,427 (14,823) 10,077 11,173


Valuation Parameters

Year to March FY13 FY14 FY15E FY16E FY17E

EPS 25.6 39.2 44.4 77.1 66.3

Book Value ( per share) 168.0 112.4 141.2 191.3 234.2

P/E (x) 49.4 32.2 28.5 16.4 19.1

P/BV (x) 7.5 11.2 9.0 6.6 5.4

EV/EBITDA(x) 30.8 21.0 23.7 11.8 12.9

EV/Sales (x) 6.9 5.2 4.6 3.4 3.1

EV/EBIT (x) 32.6 23.5 19.0 11.6 13.5


Ratios Year to March FY13 FY14 FY15E FY16E FY17E

Revenue growth 17.7 32.2 13.6 36.3 9.1

Core EBITDA growth 33.6 48.6 (4.8) 95.4 (10.3)

APAT growth 52.4 53.4 13.1 73.7 (14.1)

EPS growth 52.4 53.4 13.1 73.7 (14.1)

Core EBITDA margin 21.7 24.8 21.2 30.4 25.0

PBT margin 19.3 20.2 20.2 25.7 20.3

Net profit margin 14.7 15.9 16.1 20.6 16.2

ROCE (%) 25.5 27.5 22.4 28.5 23.0

Reported RoE (%) 36.1 39.9 35.0 46.4 31.1

Net Debt Equity ratio (X) 0.1 0.2 0.8 0.4 0.2

CFO/EBITDA (x) 0.2 0.6 0.7 0.7 0.7

Gross Block turnover (x) 2.5 3.0 1.8 1.6 1.6

Working Capital Turnover (x) 9.3 6.8 7.7 10.5 8.1

Current Ratio 1.6 1.7 1.4 1.4 1.4



Firing on twin growth engines PI is a leading agrochemicals company in India with two lines of business: (1) domestic agrochemicals (40% of revenues); and (2) custom synthesis and manufacturing (CSM) business (60% of revenues). Under the CSM business, the company offers process research and caters to the customised manufacturing needs of agrochemical giants In the domestic business, it has been focusing on niche in-licensed molecules marketed through nationwide distribution network. Key Parameters Parameter Result Comment

RoCE Trajectory

FY09: 14%, FY10: 17%, FY11: 20% FY1: 18%; FY13: 16%; FY14: 24%

RoCEs have improved due to: (a) improving asset turns led by continuous improvement in product mix and process efficiencies, & (b) improving margins due to rising share of CSM business and better domestic margins


FY09: 25%, FY10: 17%, FY11: 33% FY12: 22%; FY13: 31%; FY14: 39%

PI commercialised nearly 18 molecules over the last 6-8 years. This aided growth in the CSM business (~45% CAGR). On the domestic side, success of new products aided significant growth of ~16% CAGR.


FY09: 163%, FY10: 73%, FY11:56% FY12: 25%; FY13: 17%; FY14: 83%

EPS growth has been led by consistent expansion in EBITDA margins from 9% in FY08 to ~20% in FY15 and reduction in debt.

Share price returns (CAGR) 3yr/5yr/10yr 82%/85%/64

%

Stock has seen significant re-rating over the last two years led by improving RoCEs and consistent delivery ahead of consensus expectations.

Greatness Model (decile) FY09-13: D1* FY10-14:

D1* PI scores well across all our parameters owing to a good capital allocation and accounting scores,


Exemplary execution driving superior financial performance Over the past decade (FY05-14), we credit the management for strong execution—22%/30%/38% sales/EBITDA/PAT CAGR driven by 16%/45% CAGR in the domestic/CSM business. PI’s RoCE improved from 10% to 26% driven by improvement in asset turnover and EBITDA margins over the last decade, alongside superior cash conversion (90% CFO/EBITDA). After two decades of sowing, the reaping has just begun PI’s share price has outperformed the Sensex by 50% over FY05-15 driven by superior PAT CAGR of 38% and earnings P/E multiple expansion. Global talent on PI’s Board has helped build a sound risk-mitigated business model to direct its growth effectively. PI’s recent performance should be considered an outcome of the promoter’s superior execution and good foresight (over the last two decades) to build a credible CSM business. We expect PI to continue to deliver superior earnings driven by superior execution amidst a fairly large, CSM opportunity and under-penetrated Indian agrochem space. Entry into other specialty chemical segments to drive growth PI is widening its ambit from agrochemicals to other speciality chemicals which will expand its addressable market. Whilst PI’s current market share in the global agrochem CSM (pegged at ~US$5-6bn) is relatively small (low single digit), we expect the CSM business to report ~20% sales CAGR over the next decade. On the domestic side, we expect continued new product launches will drive 15-20% sales CAGR over the next 5-10 years. Margin expansion and improved asset turnover should drive better earnings growth and return ratios. Earnings multiples to re-rate with consistent rise in RoCEs Our DCF-based 12-month target price of `825 implies 25x P/E multiple which is fair given earnings growth expectations of ~35% over FY15-FY17 and sustainable RoCEs of ~30%. PI’s multiples have significantly re-rated with high earnings growth trajectory and improved RoCEs. Current multiples of 20x are in line with its peers Rallis/Dhanuka but at a discount of ~20% vs Bayer. PI should command better multiples given its superior execution and return ratios.

COMPANY UPDATE PI IN EQUITY June 22, 2015

PI IndustriesBUY

Agri Inputs



Performance (%)

Source: Bloomberg, Ambit Capital Research

60

110

160

210

260

Jun-

14Ju

l-1

4A

ug-1

4Se

p-14

Oct

-14

Nov

-14

Dec

-14

Jan-

15Fe

b-1

5M

ar-1

5A

pr-1

5M

ay-1

5

PI Inds. Sensex

Analyst Details

Ritesh Gupta

+91-22-30433242 [email protected]

PI Industries


Exhibit 1: Superior growth on both revenues and EBITDA margins


Exhibit 2: RoCE has been consistently expanding driven by improved margins and better asset utilisation


Exhibit 3: Operating cash flows have been the primary source of cash…


Exhibit 4: …which have been judiciously utilised for capacity building


Exhibit 5: P/Es have re-rated consistently driven by superior earnings growth and improving return ratios


Exhibit 6: : Forward P/B also has followed similar trend alongside improved utilisation of assets



Accounting GREEN On our forensic accounting screener of 16 agrochemicals and seeds stocks, PI ranks in the top quartile due to high CFO/EBITDA (90% conversion ratio), low audit fees and no material unclassified loans or contingent liabilities.

Predictability GREEN PI’s management has been guiding conservatively and has mostly delivered results that were better than expectations. Earnings momentum GREEN Consensus EPS estimates recently saw upward revisions post the 4Q results.


0%

5%

10%

15%

20%

25%

-

5,000

10,000

15,000

20,000

25,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Revenue (Rs mn) EBITDA Margin (% RHS)

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

0%

5%

10%

15%

20%

25%

30%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

ROCE ROE ( % RHS)

CFO70.8%

Interest and dividend income3.6%

Equity shares issued20.0%

Borrowings5.5%

Capex71.7%

Investments0.0%

Interest Paid

18.7%

Dividend Paid5.7%

Increase in cash3.9%

- 5

10 15 20 25 30 35

Apr

-06

Oct

-06

Apr

-07

Oct

-07

Apr

-08

Oct

-08

Apr

-09

Oct

-09

Apr

-10

Oct

-10

Apr

-11

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

Apr

-15

One-yr fwd P/E 4-yr avg P/E 6-yr avg P/E

-

2.0

4.0

6.0

8.0

10.0

Apr

-06

Oct

-06

Apr

-07

Oct

-07

Apr

-08

Oct

-08

Apr

-09

Oct

-09

Apr

-10

Oct

-10

Apr

-11

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

One-yr fwd P/B 4-yr avg P/E 6-yr avg P/E

PI Industries


Income statement Summary

Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17E

Net Sales 11,514 15,955 19,403 23,506 29,384

% growth 31.0% 38.6% 21.6% 21.2% 25.0%


EBITDA 1,826 2,910 3,727 4,691 6,399

% growth 26.0% 59.4% 28.1% 25.9% 36.4%

Depreciation 220 316 498 552 635

EBIT 1,606 2,595 3,230 4,139 5,764

Interest expenditure 238 139 97 98 58

Non-operating income 82 158 420 250 275

Adjusted PBT 1,450 2,613 3,552 4,291 5,981

Tax 477 733 1,094 1,202 1,555

Adjusted PAT 974 1,912 2,459 3,090 4,426

% growth 19.7% 96.2% 28.6% 25.7% 43.2%

Extraordinary income/ (expense) (1) (44) - - -

Reported PAT after minority interest 973 1,880 2,459 3,090 4,426


Balance Sheet Summary Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17E


Reserves and surpluses 5,182 6,809 8,795 11,417 15,218

Total net worth 5,317 6,945 8,931 11,553 15,354

Debt 2,172 1,223 1,223 223 (0)

Deferred tax liability 483 437 437 437 437


Gross block 6,178 6,829 8,329 10,079 11,079

Net block 4,781 5,267 6,269 7,467 7,832

CWIP 605 425 425 425 425

Investments (non-current) 5 5 5 5 5

Cash & cash equivalents 161 438 611 1,134 3,618

Debtors 2,625 2,568 3,827 3,671 4,589

Inventory 2,418 3,188 3,243 4,122 5,152

Loans & advances 695 1,194 1,168 1,346 1,603



Provisions 224 324 555 633 789


Net current assets 2,650 2,951 3,935 4,359 7,572

Miscellaneous expenditure - - - - -

Total assets 7,972 8,605 10,591 12,213 15,791


PI Industries


Cash flow Statement Summary

Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17E

Net profit before tax 1,450 2,613 3,552 4,291 5,981

Depreciation 220 316 498 552 635

Others 155 84 (323) (152) (217)

Tax (380) (743) (1,094) (1,202) (1,555)

(Incr)/decr in net working capital (425) (81) (810) 99 (729)


Capex (net) (1,510) (640) (1,500) (1,750) (1,000)

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

Other income (expenditure) 63 138 420 250 275

Cash flow from investments (1,447) (502) (1,080) (1,500) (725)

Net borrowings (402) (1,097) - (1,000) (223)

Issuance/buyback of equity 4 (6) (82) (0) 0

Interest paid (251) (115) (97) (98) (58)

Dividend paid (76) (272) (390) (468) (625)

Cash flow from financing 452 (1,451) (570) (1,566) (905)

Net change in cash 25 236 174 523 2,484

Free cash flow (before investments) (490) 1,548 324 1,839 3,114


Ratio analysis Year to March FY13 FY14 FY15E FY16E FY17E

PBT margin (%) 12.6% 16.4% 18.3% 18.3% 20.4%

Net profit margin 8.5 12.0 12.7 13.1 15.1

Dividend payout ratio (%) 13.1% 14.2% 13.8% 13.2% 12.3%

Net debt/Equity(x) 0.38 0.11 0.07 (0.08) (0.24)

RoCE (post-tax) (%) 16.2% 23.9% 26.3% 27.7% 31.9%

RoIC (%) 16.5% 24.8% 27.9% 30.0% 38.5%

Working Capital Turnover 6.0 8.7 8.9 9.0 10.4

Gross Block Turnover 2.2 2.5 2.6 2.6 2.8


Valuation parameters Year to March FY13 FY14 FY15E FY16E FY17E

EPS (`) 7.7 14.0 18.1 22.7 32.5

Diluted EPS (`) 7.6 14.0 18.1 22.7 32.5


Dividend per share (`) 1.0 2.0 2.5 3.0 4.0

P/E (x) 83.6 45.2 35.1 28.0 19.5

P/BV (x) 16.2 12.4 9.7 7.5 5.6

EV/EBITDA (x) 48.4 30.0 23.4 18.6 13.6

EV/EBIT (x) 55.1 33.6 27.0 21.0 15.1

EV/Sales (x) 7.7 5.5 4.5 3.7 3.0


PI Industries


Appendix 1: Sensex Exits Our thematic report, ‘Sensex Exits: The decadal story’, dated May 5, 2015 (click here for details) made a case for a rise in Sensex churn driven by the economic changes of the current National Democratic Alliance (NDA) Government and identified 15 stocks that would exit the Sensex in the next decade. We made our case on the following thesis:

Modi ‘resets’ will transform the Indian economy

India’s Prime Minister, Narendra Modi, is likely to engineer three critical resets over the next four years to the Indian economy. We have detailed our work on this topic in our report titled ‘Modi hits the reset button’, dated 23rd March 2015 (click here for details). To summarise, these changes are as follows:

Reset 1: Shifting India’s savings landscape away from gold and land towards the formal financial system: This will be led by a crackdown against black money – a process which began in the Union Budget which contained measures explicitly aimed to disincentivise the black economy and curb the demand for gold. Modi also aims to expand the white economy, by exponentially increasing the number of households with access to banking services through the ambitious Prime Minister’s Jan Dhan Yojana (PMJDY) which was launched in August 2014.

Reset 2: Disrupting crony capitalism in India: Prime Minister Modi is keen to disrupt the crony capitalist model in sectors ranging from food and real estate to improve the standard of living for the electorate. Measures to achieve this include: a) curbing corruption in the Government machinery (e.g. widening direct benefit schemes to increase the number of beneficiaries and crackdown on corrupt bureaucrats and politicians); and b) taking on business groups on issues like gas pricing (Reliance Industries), corporate espionage (prominent corporates that are part of Ambit’s P-75 list of connected companies) and coal block allocation (Jindal Steel & Power).

Reset 3: Re-defining India’s subsidy mechanisms: The Modi-led Government will: (a) compress the quantum of subsidies that the Central Government pays for, as is already evident from the last two budgets that this Government has prepared; and (b) improve targeting of subsides in India by creating and then using the direct benefit transfer (DBT) platform. Over and above this, Modi has also halted other large-scale fiscal transfers towards rural India. The most important amongst these is the Food Corporation of India’s enormous programme for buying food grains at Minimum Support Prices (MSPs). As a result, the FCI’s transfer of resources from the Centre to the states has halted in large parts of the country.

These three resets will disrupt the way business is conducted in India in much the same way that the liberalisation measures of 1991 ended the ‘License Raj’. In particular, we expect the ‘resets’ to have three significant impacts:

Inflation should fall structurally;

GDP growth will be adversely impacted in the short term; and

The cost of factors of production should decline thus making it easier for entrants to go head-to-head with entrenched incumbents.

Why Sensex Churn will rise

Our analysis of Sensex churns over a 10-year window from 1986 to date (i.e. 1986-1996, 1987-1997 and so on to 2004-2014) shows that the churn ratio of the Sensex tends to rise when the economy is undergoing irreversible structural changes. For instance, the 10-year period spanning 1992-2002, which saw the era of the ‘License Raj’ coming to an end, saw the Sensex’s churn ratio rise to 60% (vs the 53% churn ratio in the Sensex over 2002-12).

Sensex churn set to revert to higher levels, led by Modi resets

Reset 1: Shift in savings towards financial savings

Reset 2: Attacking corruption at every level

Reset 3: Overhaul of India’s subsidy system

A disruption in ‘business as usual’ is imminent

Sensex churn rises when the economy is undergoing irreversible structural changes


http://reports.ambitcapital.com/reports/Ambit_Economy&Strategy_Thematic_Resetbutton_23Mar2015.pdf

PI Industries


Exhibit 1: Sensex churn ratio shows a tendency to rise when the economy undergoes structural change


Owning a Sensex exit candidate is a losing proposition

Stocks that eventually exit the Sensex do so after a long period of underperformance. Indeed, this is among the reasons why they lose their relevance to their benchmark before eventually bowing out. Whilst on an average these stocks have underperformed the Sensex by ~7% on a CAGR basis over the next decade, what is more interesting is its performance and underperformance until the time of exit from the Sensex. On an average, these stocks have delivered -10% CAGR returns until the time of exit. Further, relative to the Sensex, the underperformance (until the time of exit from the Sensex) is as high as -20% (in CAGR terms).

Exhibit 2: Sensex exit stocks - Massive underperformance until the time of exit from the Sensex

Period Number of exits from the Sensex

Median performance of exiting stocks over the decade

Median underperformance (rel. to the Sensex)

of exiting stocks over the decade

Median performance of exiting stocks until exit

from the Sensex

Median underperformance (rel. to Sensex) of exiting stocks until exit from the

Sensex

1991-01 18 -15% -20% -12% -23%

1992-02 19 -8% -11% -9% -17%

1993-03 20 -1% -6% -16% -14%

1994-04 20 -2% -7% -27% -18%

1995-05 20 5% -6% -24% -33%

1996-06 14 8% -7% -21% -25%

1997-07 13 10% -8% -22% -31%

1998-08 13 6% -6% -6% -18%

1999-09 14 9% -5% -9% -11%

2000-10 16 13% -5% -3% -16%

2001-11 16 13% -4% 7% -17%

2002-12 14 21% 2% 14% -19%

2003-13 9 6% -8% 0% -11%

2004-14 8 13% -2% -9% -25%

Average 15 6% -7% -10% -20%


0%

10%

20%

30%

40%

50%

60%

70%

Jan-

86

Jan-

87

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

% o

f se

nse

x co

s. c

hu

rne

d o

ut

ove

r th

e n

ext

10

yrs

Sensex churn- 10 yr window

A long period of underperformance usually precedes the stock’s exit from the Sensex

PI Industries


Identifying 15 Sensex Exit candidates

We summarise our four-step process of identifying a Sensex exit candidate in the checklist below.

Exhibit 3: Checklist for Sensex exit candidates Step Criteria Parameters

1 Coffee Can filters in reverse Non BFSI: Highest number of years within FY05-14 where sales growth was <10%

Non BFSI: Highest number of years within FY05-14 where RoCE was <15%

Banks and financials: Highest number of years within FY05-14 where loan growth was <15%

Banks: Highest number of years within FY05-14 where RoA was <1.2%

NBFCs: Highest number of years within FY05-14 where RoE was <15%

2 Greatness Framework* Featuring in the lowest decile

3 Politically Connected Company Part of Ambit's P-75 Index

4 Benefits from distortions in economy Belongs to a sector that is unnaturally insulated from Foreign Competition

Source: Ambit Capital research.

Identifying the Sensex exit candidates

We present the results of our four-step screening of potential Sensex exit stocks over the next 10 years.

Exhibit 4: Exit candidates from Sensex over the next decade*

Name Ticker Mcap (US$ bn) 6M ADV (US$ mn) Exit hypothesis

Reliance Industries RIL IN 47 54 Uncertainty on profitability of large investments in retail and telecom; downstream margins likely to remain muted

O N G C ONGC IN 41 26 Falling subsidies unlikely to aid profitability; uncertainty on production growth makes earnings growth a challenge

State Bk of India SBIN IN 30 89 Relaxation of Government protection, rising capital requirements and competition from stronger private sector peers and introduction of new players

Bharti Airtel BHARTI IN 26 32 High spectrum costs, new competition from Jio will weigh on Indian business profitability; African business will remain a drag on consolidated profits

Larsen & Toubro LT IN 25 53 High competitive intensity in a fragmented industry, no discernible competitive advantages in most sectors; L&T’s large size will be a constraint

NTPC NTPC IN 18 15 Increase in competition from private sector, decline in power deficit and end of preferential treatment from Coal India for fuel linkages

M & M MM IN 12 23 Utility vehicle business under threat from foreign car companies’ superior offerings; tractor business bearing the brunt of slowdown in rural demand

Bajaj Auto BJAUT IN 11 16 Rising competitive intensity in domestic and export markets; exports further hit from macro-economic challenges in key geographies

B H E L BHEL IN 9 18 Boiler-turbine-generator industry in structural downturn; over-capacity issues (and thus greater competition) will plague BHEL and its peers

Vedanta* SSLT IN 8 17 RoEs will trend lower towards global peers’; mine acquisition costs will rise under MMDR Act as global iron ore and steel demand stays weak

Hero Motocorp HMCL IN 8 35 Over-dependence on legacy models, uncertain indigenous technology, shift towards scooters and rising competition from Honda

Tata Steel TATA IN 5 33 Downturn in steel prices to hurt global business; loss of low-cost raw material advantage under MMDR Act to hurt domestic business

Hindalco Industries HNDL IN 4 19 Weak aluminium prices and premiums to hurt global business; lack of cheap captive coal will mute RoCEs of new domestic smelters

Tata Power Co. TPWR IN 3 5 RoEs will remain lower than cost of equity; rise in coal prices and structural changes in sale of power will impact long-term prospects

Source: Bloomberg, Ambit Capital research. Note: *This is Sesa Sterlite; Market-cap data is as of 17 June 2015. * For internal compliance reasons, the name of the 15 companies on the “exits” list has been removed from this report.

We have chosen 15 exit candidates from this list on the following basis:

The top nine companies with scores of less than 45 qualify automatically for exiting the Sensex, based on our framework detailed above. These nine companies are Tata Power, NTPC, Hindalco, Tata Steel, Hero Motocorp, State Bank of India, Sesa Sterlite (Vedanta), Bharti Airtel and Reliance Industries.

The remaining six candidates have been chosen from companies with a score of 45-50, based on our analysts’ conviction of the long-term prospects of these companies against the backdrop of the Modi reset. These six companies are M&M, L&T, Bajaj Auto, BHEL and ONGC. (For internal compliance reasons, the name of one of the companies on the “exits” list has been removed from this report.)

Our four-step process screens for stocks that are most likely to exit the Sensex

PI Industries


Appendix 2: Indices used in each country Exhibit 5: Consumer staples index Country Exchange Years Description

India Bombay Stock Exchange (BSE) CY94-13 For consumer staples we have included stocks such as HUL and ITC included in the BSE’s Sensex which consists of 30 blue-chip stocks.

Indonesia Indonesia Stock exchange (Bursa Efek Indonesia) CY96-13

The Consumer Goods Industry Index contains all listed companies that are engaged in Indonesia's consumer goods sector. This sector is further subdivided into: foods and drinks, tobacco, pharmaceuticals, cosmetics and household products, and household appliances.

Malaysia Bursa Malaysia CY94-13 The Consumer Goods Industry in Bursa Malaysia contains all the consumer-focused companies such as British American Tobacco Malaysia and Nestle Malaysia Berhad.

Thailand Stock Exchange of Thailand (SET) CY94-13 We have included the agri-business and food and beverages index from the Stock Exchange of Thailand.

Source: CEIC, Bloomberg, Ambit Capital research

Exhibit 6: Consumer discretionary index

Country Exchange Years Description

India Bombay Stock Exchange (BSE) CY94-13 For consumer discretionary we have included stocks such as Bajaj auto, Hero MotoCorp, Mahindra and Mahindra, Maruti Suzuki India Ltd and Tata Motors Ltd in the BSE’s Sensex which consists of 30 blue-chip stocks.

Korea KOSPI CY94-13 We have included the ‘Transport Equipment Index’ from the KOSPI.

Thailand Stock Exchange of Thailand (SET) CY94-13 We have included the ‘Automotive index’ in the Stock Exchange of Thailand.


Exhibit 7: Financial sector index

Country Exchange Years Description

India Bombay Stock Exchange (BSE) CY94-13 For the financial sector, we have included stocks such as HDFC Bank, Axis Bank Ltd, ICICI Bank and SBI in the BSE’s Sensex which consists of 30 blue-chip stocks.

Indonesia Indonesia Stock exchange (Bursa Efek Indonesia) CY96-13 The financial sector index contains all the financial sector stocks listed in Indonesian

Stock Exchange.

Malaysia Bursa Malaysia CY94-13 The financial sector index contains all the financial sector stocks listed in Bursa Malaysia.

Thailand Stock exchange of Thailand (SET) CY94-13 The financial sector index contains all the financial sector stocks listed in the Stock Exchange of Thailand (SET)

Philippines Philippines Stock Exchange CY94-13 The financial sector index contains all the financial sector stocks listed in the Philippines Stock Exchange

Turkey Borsa Istanbul CY04-13 The financial sector index contains all the financial sector stocks listed in Borsa Istanbul.


Exhibit 8: Industrial sector index Country Exchange Years Description

India Bombay Stock Exchange (BSE) CY94-13 For the industrial sector, we have included stocks such as L&T and BHEL in the BSE’s Sensex which consists of 30 blue-chip stocks.

Indonesia Indonesia Stock exchange (Bursa Efek Indonesia) CY96-13 We have included ‘Basic Industries’ index which contains industrial stocks listed in

Indonesia Stock Exchange.

Malaysia Bursa Malaysia CY94-13 We have included ‘Industrial products’ index which contains industrial stocks listed in Bursa Malaysia.

Thailand Stock exchange of Thailand (SET) CY94-13 We have included stocks under ‘Industrial materials and machinery’ listed in Stock Exchange of Thailand.

Philippines Philippines Stock Exchange CY94-13 We have included stocks under ‘Industrial’ listed in Philippines Stock Exchange.


PI Industries


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]

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]

Krishnan V India / Asia (022) 30433295 [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

PI Industries


HCL Technologies Ltd (HCLT IN, BUY)


Kotak Mahindra Bank Ltd (KMB IN, SELL)


Asian Paints Ltd (APNT IN, SELL)


Nestle India Ltd (NEST IN, SELL)


0200400600800

1,0001,200

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

HCL TECHNOLOGIES LTD

0

500

1,000

1,500

2,000

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15KOTAK MAHINDRA BANK LTD

0

200

400

600

800

1,000

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

ASIAN PAINTS LTD

0

2,000

4,000

6,000

8,000

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

NESTLE INDIA LTD

PI Industries


Eicher Motors Ltd (EIM IN, SELL)


Indusind Bank Ltd (IIB IN, BUY)


Pidilite Industries Ltd (PIDI IN, SELL)


PI Industries Ltd (PI IN, BUY)


05,000

10,00015,00020,00025,000

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

EICHER MOTORS LTD

0200400600800

1,000

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

INDUSIND BANK LTD

0

200400

600

800

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

PIDILITE INDUSTRIES LTD

0

200

400

600

800

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

PI INDUSTRIES LTD

PI Industries


Torrent Pharmaceuticals Ltd (TRP IN, BUY)


0

500

1,000

1,500

Jun-

12

Aug

-12

Oct

-12

Dec

-12

Feb-

13

Apr

-13

Jun-

13

Aug

-13

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

TORRENT PHARMACEUTICALS LTD

PI Industries


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock Disclaimer

This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Ambit Capital. AMBIT Capital Research is disseminated and available primarily electronically, and, in some cases, in printed form.

Additional information on recommended securities is available on request.

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India, L&T, NTPC, M&M, BHEL, Hero MotoCorp, Hindalco, Tata Power, Tata Motors, Maruti, HDFC Bank, Axis Bank, ITC, Dr Reddy, Cipla, TCS, ICICI Bank, Lupin, Shriram Transport Finance, REC, PFC and City Union Bank.

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Documents

STRATEGY - Ambitreports.ambitcapital.com/reports/Ambit_Strategy_Thematic_TheSensex... · Our profiling analysis reveals the following trends for Sensex entrants since 1995: (a)