Ambit Strategy Thematic IndianCoffee 17Nov2014

STRATEGY

Saurabh Mukherjea, [email protected]: +91 22 3043 3174

Analysts:

The Indian Coffee Can Portfolio

November 2014

2014 2024

Gaurav Mehta, [email protected]: +91 22 3043 3255

Pankaj Agarwal, [email protected]

Rakshit Ranjan, [email protected]

Sagar [email protected]

Bhargav [email protected]

Nitin [email protected]

Ashvin Shetty, [email protected]

Aditya [email protected]

Anupam [email protected]

Karan [email protected]

Strategy

November 17, 2014 Ambit Capital Pvt. Ltd.

CONTENTS STRATEGY

The Indian Coffee Can Portfolio……………………………………………………………… 3

Section 1: The case for a Coffee Can Portfolio…………………………………………….. 4

Section 2: Constructing the Indian Coffee Can Portfolio…………………………………. 7

Section 3: How the Coffee Can is different to our other portfolio constructs…………14

Section 4: Today’s Coffee Can for 2014-2024…………………………………………… 16

COMPANIES

ITC (NOT RATED) …………………………………………………………………………….. 19

HDFC Bank (SELL) ……………………………………………………………………………. 25

HCL Tech (BUY) ………………………………………………………………………………. 31

Axis Bank (BUY) ………………………………………………………………………………. 37

Asian Paints (SELL) …………………………………………………………………………… 43

Godrej Consumer (SELL) ……………………………………………………………………. 49

Marico (BUY) ………………………………………………………………………………….. 55

Berger Paints (SELL) ………………………………………………………………………….. 61

Page Industries (BUY) ………………………………………………………………………...67

IPCA Laboratories (BUY) ……………………………………………………………………..73

Gruh Finance (NOT RATED) ………………………………………………………………… 79

Balkrishna Industries (BUY) …………………………………………………………………. 83

City Union Bank (BUY) ………………………………………………………………………. 89

eClerx (UNDER REVIEW) ……………………………………………………………………..95

V-Guard (BUY) ……………………………………………………………………………….101

Mayur Uniquoters (NOT RATED) …………………………………………………………. 107

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 Indian Coffee Can Portfolio

We introduce the Coffee Can Portfolio for investors who have the ability to hold stocks for very long periods of time (ideally, for ten years). Our portfolio consists of large-cap and small-cap stocks that have delivered 10% sales growth and 15% RoCE every single year over FY05-14. Detailed back-testing shows that this portfolio, including a ‘large-cap only’ version, beats benchmarks across all time periods. The portfolio also performs admirably well in stress tests of maximum drawdown (in periods like the Lehman crisis). Left untouched for a decade, this portfolio, coupled with the power of compounding, generates returns that are substantially higher than the benchmark. The case for a Coffee Can Portfolio Thirty years ago, Robert Kirby of Capital Guardian Trust spoke of how a ‘Coffee Can Portfolio’ of stocks selected using superior research and left untouched for a decade can deliver superior returns over the long term. Over and above the quality of the stock selection process, three other factors help the Coffee Can Portfolio generate superior returns: (a) no churn – this reduces transaction costs; (b) the power of compounding – stocks that do well over the long term become disproportionately large in the overall portfolio; and (c) the long holding period of the portfolio helps the investor effectively neutralise the ‘noise’ that distracts from the core investment thesis of a stock.

Constructing the India Coffee Can Portfolio (CCP) We use two filters to build the CCP: (a) sales growth of 10% per annum or more for each of the past ten years; and (b) RoCE of >15% every year for the past ten years. Back-testing of these filters over five ten-year periods (from 2000 to 2014) shows that the CCP, including a large-cap version, beats the Sensex in each iteration and delivers alpha ranging from 0.7% to 13% on a CAGR basis for the ten-year iterations. Furthermore, relative to the Sensex, the CCPs also have lower ‘maximum drawdown’. How is the CCP different from our other portfolios? Over the past four years, we have created two different approaches to cater to investors’ needs. Our quarterly ‘Good & Clean’ portfolio is focused on investors who are looking for short-term returns. The ten-bagger portfolio is based on our ‘greatness’ framework and is ideal for investors looking at a 1-3 year horizon. Our latest construct, the Coffee Can Portfolio, is for investors with a longer term investment horizon (ideally, ten year) because there is a strong body of evidence that says that longer time periods are a powerful driver of superior investment returns.

So here is the CCP for 2014…to be bought now and opened ten years hence! Our 2014 CCP consists of 16 stocks, including four banks. The list includes large-caps with hugely successful franchises (ITC, HDFC Bank, HCL Tech, Axis Bank and Asian Paints) as well as robust, fast-growing mid-caps/small-caps (Godrej Consumer, Marico, IPCA Labs, GRUH Finance, Berger Paints, Page Industries, Balkrishna Industries, City Union Bank, eClerx, V-Guard Industries and Mayur Uniquoters).

Our research clearly shows that valuation at the entry-point does not make a difference for those who are willing to invest for the truly long run. Hence, valuation parameters play no role whatsoever in the construction of the CCP.

The Coffee Can Portfolio, including the large-cap version, beats the Sensex in each of the five iterations that were run over 2000-2014 CAGR returns for ten-year period starting… CCP All-cap CCP Large-cap Sensex

30 June 2000 – 30 June 2010 16.7% 17.8% 14.1%

29 June 2001 – 30 June 2011 21.7% 23.6% 18.5%

28 June 2002 – 29 June 2012 19.0% 19.3% 18.3%

30 June 2003 – 28 June 2013 25.1% 27.5% 18.3%

30 June 2004 – 30 June 2014 31.6% 18.2% 18.1%

Source: Bloomberg, Ambit Capital research

THEMATIC November 17, 2014

Strategy

The Indian Coffee Can Portfolio ITC Our stance: NR

Mcap (US$ bn): 47.7 ADV - 6m (US$ mn): 40.6

HDFC Bank Our stance: SELL


HCL Tech Our stance: BUY


Axis Bank Our stance: BUY


Asian Paints Our stance: SELL


Godrej Consumer Our stance: SELL


Marico Our stance: BUY


Berger Paints Our stance: SELL


Page Inds Our stance: BUY


IPCA Labs Our stance: BUY


Gruh Finance Our stance: NR


Balkrishna Inds Our stance: BUY


City Union Bank Our stance: BUY


eClerx Our stance: UR


V-Guard Inds Our stance: BUY


Mayur Uniquoters Our stance: NR


Source: Bloomberg, Ambit Capital research Analyst Details Saurabh Mukherjea, CFA +91 99877 85848 [email protected]

Gaurav Mehta, CFA +91 22 3043 3255 [email protected]

Karan Khanna +91 22 3043 3251 [email protected]

Consultant: Anupam Gupta [email protected]

Strategy


Section 1: The case for a Coffee Can Portfolio “You can make more money being passively active than actively passive.”

– Robert G Kirby

In 1984, Robert G Kirby of Capital Guardian Trust wrote an article titled, ‘The Coffee Can portfolio’ in the Journal of Portfolio Management (Source: http://www.iijournals.com/doi/abs/10.3905/jpm.1984.408988). In this article, Kirby narrated an interesting experience with a female client.

Following the sudden death of his client’s husband who handled her financial affairs, Kirby was intrigued to see that the husband had secretly piggy-backed the recommendations made by Kirby for the wife’s portfolio. However, the husband had managed to outperform the portfolio that Kirby managed for the wife by applying a twist to Kirby’s advice: he paid no attention to the sale recommendations. He had simply put US$5,000 for every purchase recommendation, tossed the share certificate in the safe deposit box and forgotten about it.

On evaluating the portfolio, Kirby noticed several small holdings (with a value of less than US$2,000) and large holdings (with values in excess of US$8,000). However, one jumbo holding worth over US$800,000 stood out since it exceeded the value of his wife’s portfolio (which Kirby was managing) and was made from a small investment in Haloid, which later resulted in a ‘zillion shares’ of Xerox.

Kirby coined it the term ‘Coffee Can Portfolio’ because the concept harkens back to the Wild West, when Americans, before the widespread advent of banks, saved their valuables in a coffee can and kept it under a mattress.

Why the Coffee Can Portfolio (CCP) works

The simplicity of the Coffee Can rests on three foundations:

No churn: By holding a portfolio of stocks for over ten years, a fund manager resists the temptation to buy/sell in the short term. With no churn, the Coffee Can approach reduces transaction costs which add to the overall portfolio performance over the long term. We illustrate this with an example below.

Assume that you invest US$100mn in the CCP which kicks off on 30 June 2004 (discussed in greater detail in Section 2 of this note). Assume further that you churn this portfolio by 25% per annum (implying that a typical position is held for four years). Assuming a total price impact cost and brokerage cost of 100bps for every trade done over a ten-year period, this portfolio would generate CAGR returns of 30.8%. Left untouched, however, the same portfolio would have generated CAGR returns of 31.5%. This implies ~4.4% of the final corpus (~US$67mn in value terms) is lost to churn over the ten-year period. Thus, a US$100mn portfolio that would have grown to US$1.53bn over the ten-year period (30 June 2004 - 30 June 2014) in effect grows to US$1.46bn due to high churn.

To further demonstrate how ‘churn’ and ‘turn’ destroy ‘return’, we quote an extract from ‘Investing – The Last Liberal Art’ (2nd edition, 2013) by Robert G. Hagstrom. In this book, the author refers to an interesting experiment conducted by a behavioural economist at the University of California. We reproduce the extract below:

“In 1997, Terence Odean, a behavioral economist at the University of California, published a paper titled, Why do Investors Trade Too Much? To answer his question, he reviewed the performance of 10,000 anonymous investors.

Over a seven-year period (1987-1993), Odean tracked 97,483 trades among ten thousand randomly selected accounts of a major discount brokerage. The first thing he learned was that the investors sold and repurchased almost 80 percent of their portfolios each year (78 percent turnover ratio). Then he

Robert Kirby of Capital Guardian Trust wrote about The Coffee Can Portfolio in 1984

Kirby coined the term, ‘Coffee Can Portfolio’

Even moderate churn has an impact on overall portfolio returns…

Strategy


compared the portfolios to the market average over three different time periods (4 months, 1 year and 2 years). In every case, he found two amazing trends: (1) the stocks that the investors bought consistently trailed the market, and (2) the stocks that they sold actually beat the market1.

Odean wanted to look deeper, so he next examined the trading behavior and performance results of 6,465 households. In a paper titled, “Trading Is Hazardous to Your Wealth” (2000), Odean, along with Brad Barber, professor of finance at University of California, Davis, compared the records of people who traded frequently versus people who traded less often. They found that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns2. The implication here is that people who might have suffered the most from myopic loss aversion and acted upon it by selling stocks and did less well – much less well – than those who were able to resist the natural impulse and instead hold their ground.“

Power of compounding: Holding a stock for a period as long as 10 years allows the power of compounding to play out. Thus, over the longer term, winning stocks are rewarded disproportionately as compared to losing stocks whose weight naturally reduces in the portfolio. The power of this powerful phenomenon is explained in detail in Section 2 of this note.

Neutralising the negatives of “noise”: Unlike investing in indices (which are typically constructed on simplistic measures such as market capitalization), the CCP uses a disciplined framework (sales growth of more than 10% per annum and ROCE of more than 15% every year for 10 consecutive years) to filter stocks from the listed universe of stocks with a market capitalization of more than Rs1bn. In this process, the CCP is indifferent to specific sectors, flavor-of-the-day themes and approaches such as chasing earnings and momentum. This filter results in the CCP having a healthy mix of large cap stocks (with large franchises and steady-state growth) and mid/small cap stocks (which have have greater growth potential but are at a more nascent stage of their development).

The CCP’s indifference to short term trends (such as economic booms & busts, sector-specific fads, performance blips in companies, etc) allows it to outperform the benchmark consistently. In other words, the benchmark responds to – or reflects - every trend, fad and fashion in the market whilst the CCP is indifferent to these trends, fads and fashions – which are typically temporary in nature - and even out over the longer term.

The CCP is also an effective way of killing ‘noise’ that interferes with the investment process. In “Investing – The Last Liberal Art”, Hagstrom also talks about the “chaotic environment, with so much rumor, miscalculation, and bad information swirling”. Such an environment was labelled “noise” by Fischer Black, the inventor of the Black-Scholes formula. Hagstrom goes on to say:

“Is there a solution for noise in the market? Can we distinguish between noise prices and fundamental prices? The obvious answer is to know the economic fundamentals of your investment so you can rightly observe when prices have moved above or below your company’s intrinsic value. It is the same lesson preached by Ben Graham and Warren Buffett. But all too often, deep-rooted psychological issues outweigh this commonsensical advice. It is easy to say we should ignore noise in the market but quite another thing to master the psychological effects of that noise. What investors need is a process that allows

1 Terence Odean, “Do investors trade too much?” American economic review (December 1999)

2 Terence Odean and Brad Barber, "Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors," Journal of Finance 55, no. 2 (April 2000)

…whilst compounding results in a natural rebalancing of winners and losers in a portfolio

By its design, the CCP is indifferent to short-term trends, sectors, themes, and approaches such as chasing earnings or momentum

Strategy


them to reduce the noise, which then makes it easier to make rational decisions.”

As an example, we highlight how, over the long term, Hero MotoCorp’s stock price has withstood short-term news such as disappointing monthly sales, aggressive competitive launches as well as the split with Honda.

Exhibit 1: Hero MotoCorp’s stock price has compounded at an impressive 18% CAGR over 2004-2014


The chart shown above highlights that over the past ten years there are two extended time periods when Hero’s share price has not gone anywhere – 2006 to 2008 and then 2010 to 2013. In fact for five of the past ten years, Hero’s share price has been flat. And yet, in the remaining half of the past decade, Hero has performed so well that the 10-year CAGR of the share price is 18%. At its simplest, this is why the Coffee Can concept works – once you have identified a great franchise and you have the ability to hold on it for a long period time, there is no point trying to be too precise about timing your entry or your exit. As soon as we try to time that entry/exit, we run the risk of “noise” rather than fundamentals driving our investment decisions.

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Section 2: Constructing the Indian Coffee Can Portfolio “It would be fun and interesting (and maybe very rewarding) to have someone come along and give the idea a try.”

– Closing lines of Robert Kirby’s 1984 article on the Coffee Can Portfolio

A: Simple filters to screen stocks for the Coffee Can Leaving aside stocks from the Financial Services sector for now, we use three filters to screen listed Indian companies. These filters are as simple as they are difficult to achieve. We believe these filters should be a bare minimum for investors looking to stay invested in a business for ten years.

Market cap of more than Rs1bn: India is the least liquid among the world’s 15 largest equity markets. Thus, for institutional clients, we believe a market capitalisation of Rs1bn is the bare minimum to take a position in the stock. Stocks smaller than this tend to be illiquid and create high impact costs.

Return on Capital Employed of 15% every year for consecutive years:

1 Why RoCE? Whilst management teams have a natural desire for growth and scale, growth creates shareholder value only when the returns on capital exceed the cost of capital. RoCE, therefore, is of utmost importance in assessing a firm’s performance. Our empirical work on share price performance of Indian companies also supports the primacy of RoCE as a share price driver (see the exhibit below).

Exhibit 2: RoCE drives share prices (This chart is based on data from March 2002 to March 2012)

Source: Bloomberg, Ambit Capital research. Note* The universe in 2002’s BSE200 firms (ex-financials); performance relative to the BSE200 Index.

2 Why 15%? We use 15% as a minimum because we believe that if a company can deliver 15% RoCE over ten consecutive years, it is a proxy for the annual returns investors can expect from that stock. We also believe this is well justified theoretically by adding the risk-free rate (8.5% in India) and an equity risk premium of 6.5%. This equity risk premium, in turn, is calculated as 4% (the long-term US equity risk premium) plus 250bps to account for India’s rating (BBB- as per S&P). Note further that over the past 20 years and 30 years, the Sensex has delivered returns of around 16% per annum, thus validating our point of view that 15% is a sensible figure to use as a minimum RoCE criteria.

Revenue growth of 10% every year: India’s nominal GDP growth rate has averaged 15% over the past ten years. A firm operating in India should, therefore, be able to deliver sales growth of at least 15% per annum. However, very few listed companies, only 5 out of the ~1,100 firms run under our screen, have managed to achieve this! Therefore, we reduce this filter rate modestly to 10% i.e. we look for companies that have delivered revenue growth of 10% per annum every year for ten consecutive years.

5.9%

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Superior revenue growth Superior RoCE Superior on both

Median outperformance - Ten-year CAGR

We filter stocks with a market cap of more than Rs1bn on the basis of 10% sales growth and 15% RoCE for every year for ten consecutive years

15% RoCE also works as a proxy for the annual returns that investors can expect from that stock

Very few listed companies manage to achieve a sales growth that matches India’s nominal GDP growth rate of 15%

Strategy


In summary, our filters for non-Financial Services stocks focus on a minimum market cap of Rs1bn, RoCE of 15% for more over ten consecutive years and sales growth of 10% for more over ten consecutive years. In effect, a healthy RoCE protects the franchise and sales growth expands the franchise.

For Financial Services stocks, we keep the market-cap limit of Rs1bn and modify the filters on RoE and sales growth as follows:

ROE of 15%: We prefer Return on Equity over Return on Assets because this is a fairer measure of the bank’s ability to generate higher income efficiently on a given equity capital base over time.

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

B: Back-testing proves the strength of the Coffee Can Portfolio Using the above filters, we ran back-tests of the CCP over five ten-year periods (2000-2010, 2001-2011, 2002-2012, 2003-2013 and 2004-2014) on the listed companies universe (ex-BFSI). We also ran a separate ‘large-cap CCP’ consisting solely of stocks that were in the top-100 stocks by market cap (at the start of the period under consideration). We also stress-tested these results for maximum drawdown (52.4% from December 2007 to December 2008) to test the strength of the portfolio during periods of market volatility: First, we calculate CAGR returns for each of the five portfolios and the Sensex; Next we compute the maximum drawdown (defined as the maximum drop in

cumulative returns from the highest peak to the lowest subsequent trough); and

Finally, we calculate the risk-adjusted returns; i.e. returns in excess of the risk-free rate (assumed at 8%, comparable to the currently prevailing 8.2% ten-year Government Bond Yield) divided by the absolute maximum drawdown.

The results are revealing and have been summarised as under: Each of the five CCPs has outperformed the benchmark Sensex. Even the sub-set of the CCP i.e. the large-cap version of the CCP has been

successful in beating the Sensex. On a risk-adjusted basis (where we define risk as maximum drawdown), all the

iterations of the all-cap portfolio as well as the large-cap portfolio have outperformed the Sensex.

The large-cap versions of the CCP have outperformed the all-cap versions in 2000, 2001, 2002 and 2003 (both on an absolute basis as well as risk-adjusted basis). The 2004 version of the all-cap version of the CCP however, has delivered superior returns compared with the 2004 large-cap version.

Exhibit 3: Back-testing results of five iterations of the Coffee Can Portfolio

Kick-off year* All-cap CCP (start)

All-cap CCP (end)

Annualised ten-year return

Large-cap CCP (start)

Large-cap CCP (end)

Annualised ten-year return

2000 400 1,870 16.7% 300 1,549 17.8% 2001 400 2,855 21.7% 200 1,661 23.6% 2002 600 3,427 19.0% 400 2,346 19.3% 2003 700 6,585 25.1% 500 5,680 27.5% 2004 800 12,469 31.6% 400 2,138 18.2% Source: Bloomberg, Capitaline, Ambit Capital research. Note: Portfolio at start denotes an equal allocation of Rs100 for the stocks qualifying to be in the CCP for that year. *The Portfolio kicks off on 30th June of every year.

We summarise the results of each of the five iterations in the next five pages.

We use RoE of 15% and loan growth of 15% as filters to screen BFSI stocks

Five iterations of the CCP that we rerun from 2000 to 2014 prove the potential of the CCP to beat the benchmark

Strategy


Period 1: 2000-2010 (2.6% alpha relative to the Sensex; 16.7% per annum absolute returns) All-cap portfolio stocks: NIIT, Cipla, Hero MotoCorp, Swaraj Engines

Large-cap portfolio stocks: NIIT, Cipla, Hero MotoCorp

In the first iteration, both versions of the CCP outperformed the benchmark. Whilst the all-cap CCP delivered a 16.7% return (2.6% alpha to the Sensex), the large-cap portfolio delivered a 17.8% return (3.8% alpha to the Sensex). The maximum drawdown for both the portfolios in this period was also less than the maximum drawdown for the Sensex.

Exhibit 4: First iteration summary

2000-2010* All-cap CCP Large-cap CCP Sensex

CAGR returns 16.7% 17.8% 14.1%

Maximum drawdown** -42.2% -39.2% -52.4%

Excess returns 0.21 0.25 0.12

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2000. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from June 2000 to March 2003 for the all-cap CCP and large-cap CCP, and from December 2007 to December 2008 for the Sensex.

The four stocks that constituted the first iteration of the Coffee Can Portfolio consisted of one IT, one pharma company, and two companies from the automobile/auto-ancillary sector. These were NIIT, Cipla, Hero MotoCorp and Swaraj Engines. The star performer during this period was Hero MotoCorp which proved to be a ten-bagger whilst NIIT’s stock price collapsed 78% in this period.

Exhibit 5: Portfolio performance during the first iteration

Company Price at Start (Rsbn) Price at End (Rsbn) Share price CAGR

FY2000-10 PAT CAGR

Date from/to 30/06/2000 30/06/2010

NIIT 295 65 -14.1% -11%

Cipla 69 339 17.2% 23%

Hero Moto 198 2,049 26.4% 27%

Swaraj Engines 118 378 12.4% 7%

Portfolio* 400 1,870 16.7%

Sensex 4,749 17,701 14.1%

Source: Bloomberg, Ambit Capital research. Note: *Portfolio price at start of Rs400 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs400 at the start to Rs1,870 at the end.

Exhibit 6: Hero MotoCorp rose exponentially whilst NIIT collapsed in 2000-2010

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs400 at the start to Rs1,870 at the end.

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Hero Motocorp was the star performer, whilst NIIT was the laggard in Period 1

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Period 2: 2001-2011 (3.2% alpha relative to the Sensex; 21.7% per annum absolute returns) All-cap portfolio stocks: Cipla, Hero MotoCorp, Apollo Hospitals and Roofit Inds

Large-cap portfolio stocks: Cipla, Hero MotoCorp

Both versions of the CCP performed well during the second iteration as well, beating the Sensex. The large-cap CCP gave an impressive alpha of 5.1% for this iteration. The portfolio was remarkably steady as compared to the maximum drawdown, delivering an excess return of 0.36x-0.39x.

Exhibit 7: Second iteration summary 2001-2011* All-cap CCP Large-cap CCP Sensex CAGR returns 21.7% 23.6% 18.5% Maximum drawdown** -37.7% -39.7% -52.4% Excess returns 0.36 0.39 0.20

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 29 June 2001. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from June 2001 to March 2003 for the all-cap CCP and large-cap CCP, and from December 2007 to December 2008 for the Sensex.

During the second iteration as well, the Coffee Can Portfolio consisted of four stocks with two repeats (Cipla and Hero MotoCorp from the Period 1) and two new entries (Apollo Hospitals and Roofit Industries). During this period, note that one of the stocks in the portfolio, Roofit Industries, was delisted during 2001-2011. Despite this, the portfolio performed admirably. The star performer yet again was Hero MotoCorp whose stock price rose 13x whilst Cipla was a laggard at 3.6x.

Exhibit 8: Portfolio performance during the second iteration

Company Price at Start (Rsbn)

Price at End (Rsbn)

Share price CAGR

FY01-11 PAT CAGR

Date from/to 29/06/2001 29/06/2011 Cipla 91 331 13.7% 19% Hero Motocorp 145 1,877 29.2% 22% Apollo Hospitals 40 478 28.1% 19% Roofit Inds. 106 NA NA NA Portfolio* 400 2,855 21.7% Sensex 3,457 18,846 18.5%

Source: Bloomberg, Ambit Capital research. Note: NA - Data for Roofit is not available because the company was delisted during this period. *Portfolio price at start of Rs400 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs400 at the start to Rs2,855 at the end.

Exhibit 9: Hero MotoCorp continued its stellar performance during 2001-2011

Source: Bloomberg, Ambit Capital research. Note: Data for Roofit Ind is not available from FY03 onwards. Value at start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs400 at the start to Rs2,855 at the end.

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Strategy


Period 3: 2002-2012 (0.7% alpha to the Sensex; 19.0% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Gujarat Gas, Aurobindo Pharma

Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India

The third iteration has the weakest results for the five periods under our analysis. During this period, the Coffee Can delivered an alpha of just 0.7%, even as the large-cap Coffee Can delivered a higher alpha of 1.0%. However, both versions of the Coffee Can performed well during maximum drawdown, delivering excess returns of 0.26-0.32x, higher than the first iteration for the portfolio.

Exhibit 10: Third iteration summary

2002-2012* All-cap CCP Large-cap CCP Sensex

CAGR returns 19.0% 19.3% 18.3%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 28 June 2002. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from June 2007 to December 2008 for the all-cap CCP, from December 2006 to December 2008 for the large-cap CCP and from December 2007 to December 2008 for the Sensex.

The Coffee Can Portfolio expanded in size during the third iteration. Compared with the four stocks in the first two iterations, six stocks qualified to be part of the Coffee Can Portfolio in the third iteration. Cipla and Hero MotoCorp were repeated yet again whilst the other four stocks were Infosys, Container Corporation, Gujarat Gas and Aurobindo Pharma.

Exhibit 11: Portfolio performance during the third iteration


FY02-12 PAT CAGR

Date from/to 28/06/2002 29/06/2012

Infosys 411 2,509 19.8% 26%

Hero Motocorp 308 2,149 21.4% 17%

Cipla 75 317 15.4% 18%

Container Corpn. 99 613 20.0% 13%

Guj Gas Company 50 310 20.0% 17%

Aurobindo Pharma 24 110 16.6% 11%

Portfolio* 600 3,427 19.0%

Sensex 3,245 17,430 18.3%


Exhibit 12: During this phase, the portfolio broadly tracked the Sensex


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Infosys

(Rs)

Despite a comparatively weaker performance, the CCP still beat the Sensex in Period 3

Strategy


Period 4: 2003-2013 (6.8% alpha to the Sensex; 25.1% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Sun Pharma, Container Corporation of India, Gujarat Gas, Aurobindo Pharma

Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Sun Pharma

Whilst the all-cap version of the Portfolio delivered a 7% alpha, the large-cap version gave a higher 9% in the fourth iteration. In a maximum drawdown situation, both versions remained steady and beat the Sensex, thereby delivering excess returns of 0.60-.0.88x.

Exhibit 13: Fourth iteration summary 2003-2013* All-cap CCP Large-cap CCP Sensex

CAGR returns 25.1% 27.5% 18.3%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2003. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from June 2007 to December 2008 for the all-cap CCP, from September 2008 to December 2008 for the large-cap CCP and from December 2007 to December 2008 for the Sensex.

Barring one addition (Sun Pharma), the Coffee Can Portfolio in its fourth iteration was the same as that in the third iteration. Performance was driven by Sun Pharma’s stellar performance. However, the performance of the large-cap version was better than the all-cap version of the Coffee Can Portfolio.

Exhibit 14: Portfolio performance during the fourth iteration


FY03-13 PAT CAGR

Date from/to 30/06/2003 30/06/2013 Infosys 408 2,499 19.9% 26% Cipla 60 392 20.6% 20% Hero Motocorp 253 1,663 20.7% 13% Sun Pharma.Inds. 16 506 41.1% 30% Container Corpn. 115 719 20.1% 13% Aurobindo Pharma 37 181 17.1% 14% Guj Gas Company 45 191 15.4% 18% Portfolio* 700 6,585 25.1% Sensex 3,607 19,396 18.3%


Exhibit 15: Sun Pharma delivered a stellar performance in Period 4


-

1,000

2,000

3,000

4,000

5,000

6,000

7,000


GujGas

Auro Pharma

ConCor

Sun Pharma

Hero Moto

Cipla

Infosys

(Rs)

Sun Pharma powered through to be the best-performing stock in Period 4

Strategy


Period 5: 2004-2014 (13% alpha to the Sensex; 31.6% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Gujarat Gas, Alok Industries, Munjal Showa and Havells India

Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India

The most recent iteration of our Coffee Can Portfolio has yielded the best results, with a whopping 13% alpha over the Sensex. The Portfolio was equally divided between large-caps and mid-caps/small-caps. The higher share of the mid-caps/small-caps was instrumental in delivering higher alpha during this period.

Exhibit 16: Fifth iteration summary 2004-2014* All-cap CCP Large-cap CCP Sensex CAGR returns 31.6% 18.2% 18.1% Maximum drawdown** -64.1% -33.9% -52.4% Excess returns 0.37 0.30 0.19

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2004. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to December 2008 for the all-cap CCP, from December 2006 to December 2008 for the large-cap CCP and from December 2007 to December 2008 for the Sensex.

The price performance among mid-cap/small-cap stocks was extreme: Havells’ stock price rose 89x whilst Alok Industries’ stock price fell 70% by the end of the iteration. As a result, the price performance of the large-cap portfolio (18% CAGR) lagged that of the all-cap portfolio (32% CAGR).

Exhibit 17: Portfolio performance during the fifth iteration


FY04-14 PAT CAGR

Date from/to 30/06/2004 30/06/2014 Infosys 690 3,256 16.8% 24% Hero Motocorp 508 2,635 17.9% 11% Cipla 85 438 17.8% 16% Container Corpn. 188 1,189 20.2% 10% Guj Gas Company 43 415 25.4% 17% Alok Inds. 45 14 -10.9% 19% Munjal Showa 34 142 15.4% 12% Havells India 3 235 56.7% 37% Portfolio* 800 12,469 31.6% Sensex 4,795 25,414 18.1%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of Rs800 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs800 at the start to Rs12,469 at the end.

Exhibit 18: Havells India was the star performer in Period 5


-

2,000

4,000

6,000

8,000

10,000

12,000

14,000


Havells

Munjal Showa

Alok Inds.

Guj Gas

ConCor

Cipla

Hero Moto

(Rs)

The CCP delivered its highest alpha, a whopping 13% to the Sensex, in Period 5

Extreme price performance among mid-cap/small-cap stocks sets apart Period 5 from the earlier iterations of the CCP

Strategy


Section 3: How the Coffee Can is different to our other portfolio constructs "Forever is a good holding period."

– Warren Buffett

Over the years, we have developed various portfolio constructions for investors based on their outlook. We have summarised these below:

‘Good and Clean’ (G&C): We began this portfolio in 2011. The G&C portfolios are constructed each quarter using: (i) a battery of financial tests based on the previous fiscal year’s data; and (ii) our forensic accounting model. Each G&C portfolio typically runs for a quarter before we revise it. Thus, we believe this portfolio is ideal for investors aiming to beat benchmarks over the short term. The methodology is:

Within each sector, we first identify firms that do well on our ‘greatness’ and ‘accounting’ frameworks;

We then overlay our macro outlook and valuation filters to identify sectors which are placed favourably; and

The sector-level champions from step 1 (for the sectors identified in step 2) constitute our G&C portfolio.

Please click here for the latest G&C portfolio published on 25th July 2014.

Ten-bagger: We first unveiled this portfolio - built using our ‘greatness’ framework - in January 2012. [See our 19th January 2012 note - ‘Tomorrow’s ten baggers’ - for the framework behind this construct note; click here for the note.] This framework studies a firm’s structural strengths by focusing not on absolutes but rather on improvements over a period of time and the consistency of those improvements.

A basic sketch of the underlying process behind the making of a great firm has been recaptured in Exhibit 19 below.

Exhibit 19: The ‘greatness’ framework

Source: Ambit Capital Research

We rank the BSE500 universe of firms (excluding financial services firms and excluding firms with insufficient data) on our ’greatness‘ score, which consists of six equally weighted headings—investments, conversion to sales, pricing discipline, balance sheet discipline, cash generation and EPS improvement, and return ratio improvement. Under each of these six headings, we further look at two kinds of improvements:

Our G&C portfolio is ideal for investors aiming to beat benchmarks over the short term

The ten-bagger framework studies a firm's structural strength and focuses on improvements over a period of time and the consistency of those improvements

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://webambit.ambit.co/reports/Ambit_Strategy_Thematic_Good&Clean8_25Jul2014.pdf

http://webambit.ambit.co/reports/Ambit_Strategy_Thematic_Tomorrow%E2%80%99stenbaggers_19Jan2012.pdf

Strategy


Percentage improvements in performance over FY11-13 vs FY08-10; and

Consistency in performance over FY08-13 i.e. improvements adjusted for underlying volatility in financial data

A complete list of factors that are considered whilst quantifying greatness has been mentioned in Exhibit 20 below.

Exhibit 20: Factors used for quantifying greatness Head Criteria

1 Investments a. Above median gross block increase (FY11-13 over FY08-10)*

b. Above median gross block increase to standard deviation

2 Conversion to sales a. Improvement in asset turnover (FY11-13 over FY08-10)*

b. Positive improvement in asset turnover adjusted for standard deviation

c. Above median sales increase (FY11-13 over FY08-10)*

d. Above median sales increase to standard deviation

3 Pricing discipline a. Above median PBIT margin increase (FY11-13 over FY08-10)*

b. Above median PBIT margin increase to standard deviation

4 Balance sheet discipline a. Below median debt-equity decline (FY11-13 over FY08-10)*

b. Below median debt-equity decline to standard deviation

c. Above median cash ratio increase (FY11-13 over FY08-10)*

d. Above median cash ratio increase to standard deviation

5 Cash generation and PAT improvement a. Above median CFO increase (FY11-13 over FY08-10)*

b. Above median CFO increase to standard deviation

c. Above median adj. PAT increase (FY11-13 over FY08-10)*

d. Above median adj. PAT increase to standard deviation

6 Return ratio improvement a. Improvement in RoE (FY11-13 over FY08-10)*

b. Positive improvement in RoE adjusted for standard deviation

c. Improvement in RoCE (FY11-13 over FY08-10)*

d. Positive improvement in RoCE adjusted for standard deviation

Source: Ambit Capital research; Note: * Rather than comparing one annual endpoint to another annual endpoint (say, FY08 to FY13), we prefer to average the data out over FY08-10 and compare that to the averaged data from FY11-13. This gives a more consistent picture of performance (as opposed to simply comparing FY08 to FY13).

The ten-bagger portfolio focuses on structural plays that are financially strong firms (with credible management teams) and remain consistent performers on a cross-cyclical basis. Companies are identified based on their relentless improvement in financial performance over long periods of time (usually, six years). This portfolio is ideal for conventional buy-and-hold investors with a 1-3 year horizon. Adding the Coffee Can for long-term investors with a ten-year outlook To this suite of portfolios, we now add the Coffee Can which is ideal for long-term investors with a ten-year outlook. In the table below, we summarise our portfolio recommendations for investors.

Exhibit 21: Our suite of Portfolios for investors looking to invest in India

Type of Investor Recommended Ambit Portfolio

Returns over recommended time period

Short-term investor with quarterly performance focus Good and Clean Portfolio

The 12 instalments of our ‘Good & Clean’ portfolio have delivered a staggering 27.7% alpha over the past four years

Conventional buy-and-hold investor with 1-3 year horizon Ten-bagger portfolio

The three iterations of our ten-baggers portfolios have generated over 30% alpha over the past three years

Long-term investor with ten-year outlook Coffee Can Portfolio Average alpha of 5% over five ten-year

iterations Source: Ambit Capital Research

In the next section, we discuss the rationale used for constructing the India Coffee Can Portfolio.

The Coffee Can Portfolio is ideal for long-term investors with a ten-year outlook

Strategy


Section 4: Today’s Coffee Can for 2014-2024 “Great investing requires a lot of delayed gratification.”

– Charlie Munger

Introducing the candidates for Coffee Can 2014-2024

We screened India’s listed universe of non-BFSI stocks with a market capitalisation of more than Rs1bn that have delivered 10% sales growth and 15% RoCE every year for the past year. The list is mentioned in the exhibit below.

Exhibit 22: The short list of firms with superior RoCEs and superior sales growth over the last ten years (FY05-14)

Superior on both Share price performance (CAGR relative to Sensex) Market cap (Rsbn)* FY15 P/E

ITC 11% 2,966 28.8

HCL Tech 12% 1,134 15.5

Asian Paints 19% 622 42.3

Godrej Consumer 21% 319 37.2

Marico 17% 205 37.2

Berger Paints 19% 126 40.6

Page Ind 47% 109 53.9

IPCA 14% 80 18.4

Balkrishna Inds. 18% 80 12.2

Astral Polytechnik# 53% 41 38.9

eClerx 30% 39 15.3

V-Guard Inds. 33% 27 26.5

Mayur Uniquoters 76% 19 26.4

Insecticide India 23% 10 18.3

Source: Bloomberg, Capitaline, Ambit Capital research; Note: Share price performance has been measured over a ten-year period (i.e. March 2004 to March 2014). In case of firms with a shorter listing history, the performance has been measured over the shorter period (not less than 5 years). * Market cap as on 31 October 2014. Page Inds, eClerx, V-Guard and Insecticides India were not listed throughout the ten-year period and hence the financial data used is based on Draft Red Herring Prospectus as provided by Capitaline, for periods prior to their IPOs. # Comments withheld on this company due to internal policy.

We note that the stocks identified by this filter are the same as those in our ‘Cusp of Greatness’ report (published on 14th July 2014), as we had used the same filter and the same time period in that report as well. However, whilst that report focused on mid-cap/small-cap stocks, in this report we add commentary on the first four large-cap names (ITC, HCL Tech, Asian Paints and Godrej Consumer). As before, we exclude Insecticides India from this report due to its size.

We run a similar filter for India’s listed BFSI stocks with a market cap of more than Rs1bn and: (a) an RoE of 15%; and (b) loan growth of 15% for every consecutive year for the past ten years. In a universe of 507 firms, a meagre 5 firms managed to pass this test (representing a small fraction of ~1%). This handful of firms is shown in the exhibit below.

Exhibit 23: The very short list of BFSI firms with superior RoEs and superior loan book growth (over FY05-14)

Share price performance (CAGR relative to Sensex) Market cap (Rsbn)* FY15 P/E

HDFC Bank 11% 2,185 20.5 Axis Bank 11% 1,087 15.4 Gruh Finance 34% 85 39.8 City Union Bank 12% 49 12.9 Dewan Housing 11% 49 7.9

Source: Bloomberg, Capitaline, Ambit Capital research; Note: Share price performance has been measured over the last ten-year period (i.e. March 2004 to March 2014). * Market cap as on 31 October 2014.

From the above list, we exclude Dewan Housing due to our standard G&C filters.

The Coffee Can 2014-2024 features some of India’s most-successful franchises as well as the most-compelling investment themes

We add four large-cap stocks (ITC, HCL Tech, Asian Paints, and GCPL) to our ‘Cusp of Greatness’ list of stocks

Only 1% of stocks in the BFSI universe meet our screening filters

http://webambit.ambit.co/reports/Ambit_Strategy_Thematic_14Jul2014.pdf

Strategy


An introduction to our stock-specific sections

In the rest of this note, we provide two-pagers for 16 of the 19 stocks (excluding Insecticides India, Dewan Housing and Astral Polytechnik) that have made the cut in our filters and constitute the CCP for India. Our notes focus on two critical points that lie at the heart of any business.

Any investor taking a ten-year call must be convinced that the underlying business has strong competitive advantages and the management has a proven ability to take judicious capital allocation decisions:

Sustainable competitive advantages allow firms to add more value than their rivals and to continue doing so over long periods of time. In our May 2014 thematic, ‘The Great Indian Midcaps’, we applied John Kay’s “Innovation, Brands and Reputation, Architecture, Strategic Asset” (IBAS) framework to analyse six firms. In the company-specific sections that follow, we have given our view on the underlying sustainable competitive advantage for the company. We also provide our view on what the company is doing to strengthen the franchise further.

Capital allocation: Capital allocation is perhaps the single most-important decision through which a management adds value to the firm’s shareholders. More importantly, effective capital allocation is not just about growing but growing profitably. Thus, in the stock-specific sections that follow, we provide our views on the capital allocation skills of the companies as well as 10-year pie charts on how the companies (excluding the Financial Services companies) have raised and spent capital in the past decade. We believe these 10-year pie-charts capture the essence of the cash-generating abilities of the business and the management’s discretion in utilising these cashflows.

Exhibit 24: Summary of key attributes for stocks in the CCP

Company Competitive advantages

Accounting quality

Capital allocation

Treatment of minorities

Succession planning Overall Comments

ITC

Strong cigarette franchise; risk around succession planning

HCL Tech

Strong capital allocation and sales and delivery metrics; AMBER flag in treatment of minorities

Asian Paints

Strong brand franchise, capital misallocation risk

Godrej Consumer

Risk around capital allocation, lack of focus on RoCE

Marico

Strong brand equity, RoCE back in focus

IPCA

Sustainable low cost advantage and high focus on brand equity and cash flow generation

Berger Paints

Maintained #2 position, RoCE improvement on the cards

Page Ind

Market leader, strong growth visibility, aspirational brand recall

Balkrishna Inds.

Strong player in OHT tyre exports with sustainable low cost advantage

eClerx

Niche KPO with high-quality client base

V-Guard Inds.

Strong franchise in south India along with strong capital allocation; high competition in the sector and redundancy of core product remains a risk

Mayur Uniquoters

Building scale, harnessing high-value clients

HDFC Bank

Clear long-term vision and execution track record

Axis Bank

Strong diversified franchise, risk around succession planning

Gruh Finance

HDFC parentage and deep hinterland penetration are competitive advantages.

City Union Bank

Conservative lender with established niche - Stable RoA and RoE

Source: Ambit Capital research; Note: = rating of 4/4; = rating of 3/ 4 and so on.

For a ten-year view, investors must convince themselves that the underlying businesses have strong competitive advantages…

…and their managements have a proven track record of judicious capital allocation

http://webambit.ambit.co/reports/Ambit_Strategy_Thematic_22May2014.pdf

Strategy


Why valuations are NOT a consideration whilst constructing the CCP?

Whilst we acknowledge that from a tactical standpoint valuations play an important role in shaping short-term returns, we have not paid any heed to valuations whilst constructing the CCP. So why are we ignoring valuations?

Over long periods, it is how the underlying fundamentals evolve for the firm that plays a more important role in determining returns than the beginning of the period valuation itself. Put another way, over long periods how a business fundamentally performs is overwhelmingly the most important driver of investment returns (so much so that the valuation at the time of entering the stock becomes almost irrelevant). This point can be understood better with the following exhibits that plot ten-year returns over FY02-12 vs FY02 valuations as measured by P/B and P/E at the beginning of the period (in 2002).

Exhibit 25: Valuation impact on long-term returns - P/B

Source: Ambit Capital research; Note: FY02-12 returns here are stock returns relative to the Sensex

The value of the R-squared makes the story self-explanatory. A zero for this value indicates that the beginning-of-period valuations do not play any meaningful role in explaining stock returns over the next ten years. This holds true for both P/B (as seen in Exhibit 25 above) and P/E (as seen in Exhibit 26 below) as the measures of valuation.

Exhibit 26: Valuation impact on long-term returns - P/E

Source: Ambit Capital research; Note: FY02-12 returns here are stock returns relative to the Sensex

Asian Paints, Berger Paints, and HDFC Bank are three stocks from our conventional coverage on which we have a ‘SELL’ stance and which are in the portfolio. So why are these stocks in the CCP? Firstly, all the three stocks are what we would call ‘valuation-driven SELLs’. As valuations have NOT been considered whilst creating the CCP, these SELL stances are not relevant from the point of the view of the CCP. Secondly, since our conventional coverage is based on a one-year horizon whereas the CCP is based on a ten-year horizon, we have not paid heed to these valuation-driven SELLs whilst constructing the CCP.

R2 = 0.000

-80%

-60%

-40%

-20%

0%

20%

40%

60%

- 5.0 10.0 15.0 20.0 25.0

FY02 Price to Book

FY0

2-F

Y1

2 r

etu

rns

R2 = 0.001

-80%

-60%

-40%

-20%

0%

20%

40%

60%

- 10.0 20.0 30.0 40.0 50.0 60.0 70.0

FY02 Price to Earnings

FY0

2-F

Y1

2 r

etu

rns

Our research shows that underlying fundamentals play a more important role in determining stock price returns than the beginning of the period valuation itself


ITC has the largest cigarette business in India with >70% market share. It has leveraged its wide distribution and cash flows from the cigarettes business to rapidly expand and fund investments in its non-cigarette FMCG business, which has become the third-largest FMCG business in India. However, there are concerns around succession planning once the current Chairman Mr. YC Deveshwar (YCD) retires in 2017, as the next line of command lacks experience and will have only 5-6 years to go before retirement from the point they get the top job. Largest tobacco company on course to become an FMCG major ITC has been present in India for over 100 years and is India’s largest tobacco company with >70% market share in the branded Indian cigarette market. In the last 15 years, the company has diversified its revenue base beyond cigarettes (~62% of gross sales) and it now derives ~17%/11%/7% of its gross from the FMCG/Agri products/Paper business. ITC commands ~10% market share in the biscuit market and along with its personal care business it is among the top-three FMCG companies in India. ITC’s moats are its distribution network and cash-rich tobacco business On the back of its strong cigarette franchise, ITC has developed the most expansive distribution network in India. It has leveraged this distribution muscle to rapidly scale up its FMCG business. The high cash generation of its tobacco business is ITC’s second critical competitive advantage. ITC’s tobacco business has ~70% operating profit margins and 100%+ RoCE with strong cash flows which fund ITC’s investments in its other nascent businesses. Higher dividend payout ratio indicative of prudent capital allocation About 47% of ITC’s operating cash flows have been deployed towards dividend payouts, with an increase in the payout ratio from 28% a decade ago to over 60% consistently over FY08-13. The capex needed for the non-cigarettes FMCG business has NOT been material (4% of CFO over FY04-13) despite this division being 30% of HUL’s size and the third-largest non-cigarettes FMCG business in India. Cash accumulation remains strong on the balance sheet at `15bn annually leaving further headroom to increase dividend payout. Succession planning post YCD is an area of concern Mr. YC Deveshwar (YCD) is due to retire in 2017. He has been the sole driver of value creation over the past 15 years. Neither of the next level of senior management (Mr. Grant, Mr. Anand and Mr. Dhobale) will be under 60 years of age in 2017 and hence they will not have more than 5-7 years of tenure as Chairman. ITC has never appointed an external recruit as its Chairman in the past. As a result, we have concerns around succession planning. Diversifying beyond cigarettes to drive next leg of growth Having realised the limited growth potential of its tobacco business, ITC has been investing heavily to grow its non-cigarette FMCG business. With continued brand investments and strong innovation focus, the FMCG business should become the driver of growth for ITC in the near future. In its tobacco business, ITC continues to invest in new product development and improving product quality and packaging to retain its leadership in cigarettes.

COMPANY INSIGHT ITC IN EQUITY November 17, 2014

ITCNOT RATED

Consumer

Recommendation Mcap (bn): `2,838/US$46.2 3M ADV (mn): `1,962/US$31.9 CMP: `774 TP (12 mths): NA Upside (%): NA

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

Catalysts

Consistent profitability by ITC’s non-cigarette FMCG

Softening/predictability of Government’s stance on cigarette taxation

Performance


300

330

360

390

20,000 22,000 24,000 26,000 28,000 30,000

Nov

13

Jan

14

Mar

14

May

14

Jul 1

4

Sep

14

Nov

14

Sensex ITC (RHS)

Key financials Year to March FY10 FY11 FY12 FY13 FY14

Operating income (` mn) 181,532 211,676 247,984 296,056 328,826

EBITDA (` mn) 60,740 71,534 84,996 103,318 120,988

EBITDA Margin (%) 33.5% 33.8% 34.3% 34.9% 36.8%

Adjusted EPS (`) 5.1 6.3 7.8 9.4 11.1

RoCE (%) 27.6% 31.6% 34.0% 34.5% 34.3%

P/E (x) 71.4 58.1 47.1 39.1 33.0

Source: Company, Ambit Capital research

Analyst Details

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

Ritesh Vaidya +91 22 3043 3246 [email protected]

ITC


Exhibit 1: Except for FY07-09, sales growth and profitability has been consistent for ITC


Exhibit 2: Return ratios have also improved continuously over the last decade except for FY07-09


Exhibit 3: Cash generated from operations for ITC (FY04-14)…


Exhibit 4: ..has been utilised to increase dividend payout and enter new business segments


Exhibit 5: ITC P/E band chart for the last 7 years


Exhibit 6: ITC EV/EBITDA band chart for the last 7 years


30.0%

31.0%

32.0%

33.0%

34.0%

35.0%

36.0%

37.0%38.0%

50

100

150

200

250

300

350

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenues (Rs. Bn) EBITDA margin (%) RHS

22.0%

26.0%

30.0%

34.0%

38.0%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoCE RoE

CFO, 81%

Proceeds from

shares, 6%

Interest received,

13%

Dividend paid51%

Interest paid1%

Net Capex (incl.

acquisitions)

30%

Purchase of Investments

-Subsidiaries

& Others

Increase in cash and

cash equivalents

5%

50

100

150

200

250

300

350

400

Nov

-07

Nov

-08

Nov

-09

Nov

-10

Nov

-11

Nov

-12

Nov

-13

Nov

-14

20x

32x29x

26x23x

50

100

150

200

250

300

350

400

Nov

-07

Nov

-08

Nov

-09

Nov

-10

Nov

-11

Nov

-12

Nov

-13

Nov

-14

6x

7.5x

9x

10.512x

ITC


Exhibit 7: Explanation for our flags

Segment Score Comments

Accounting GREEN The company in the past has shown high levels of cash conversion and efficient working capital management and is professionally managed.

Predictability GREEN The company has high pricing power in its cigarettes business and has consistently seen margin expansion in the segment. Further, FMCG losses are declining and hence, visibility of earnings is very high.

Treatment of minorities AMBER

Before YCD took charge of ITC in 1996, ITC had a chequered past with several failed diversification attempts into power and global commodity trading. In 1991, ITC started a financial services venture which was finally sold to ICICI in 1995, as the business suffered large-scale write-offs. Under YCD, ITC made failed attempts at entering the golf course development/accessories and greeting cards business. Since 2002 however, ITC has been more prudent with its capital allocation. It increased its dividend payout to over 60% and has looked to expand its FMCG franchise.


Exhibit 8: ITC – ‘Three-quarters of the pie’ on our STAR* framework

Criteria Score (%) Comment

Competitive advantage

ITC’s cigarette business with >70% market share lends it two competitive advantages: a) ITC has developed the largest pan-India distribution network, b) The high cash generation from the cigarette business allows it to fund investments in its nascent businesses

Accounting quality The company in the past has shown high levels of cash conversion and efficient working capital management and is professionally managed.

Capital allocation

ITC under the leadership of Mr. YC Deveshwar (YCD) has been very prudent with its capital allocation. It has increased its dividend payout ratio and invested in growing businesses for the future like its non-cigarette FMCG business. However, with concerns around succession planning we remain sceptical around the capital allocation abilities of the next leader.

Centrality of political connect ITC is not part of Ambit’s Connected Companies Index and does not appear to rely on political connections.

Treatment of minorities

Before YCD took charge of ITC in 1996, ITC had a chequered past with several failed diversification attempts into power and global commodity trading. In 1991, ITC started a financial services venture which was finally sold to ICICI in 1995, as the business suffered large-scale write-offs. Under YCD, ITC made failed attempts at entering the golf course development/accessories and greeting cards business. Since 2002 however, ITC has been more prudent with its capital allocation. It increased its dividend payout to over 60% and has looked to expand its FMCG franchise.

Succession planning

YCD is due to retire in 2017. The next successor if appointed from the next level of senior management would then get only 5-6 year tenure. ITC hasn’t till date appointed an external recruit as its Chairman. Due to this lack of visibility around the next Chairman we remain cautious around ITC’s succession planning ability.

Total (%)

Source: Company, Ambit Capital research. Note: = rating of 4/4; = rating of 3/ 4 and so on. *STAR: Sustainable and Tenable Advantages Rank.

ITC


Balance sheet (` mn)

Year to March FY10 FY11 FY12 FY13 FY14

Shareholders' equity 3,818 7,738 7,818 7,902 7,953

Reserves & surpluses 136,826 151,795 180,101 214,977 254,667

Total networth 140,644 159,533 187,919 222,879 262,620

Debt 1,077 992 791 664 511

Deferred tax liability 7,850 8,019 8,727 12,037 12,970

Total liabilities 149,571 168,543 197,437 235,580 276,101

Gross block 119,679 127,658 141,444 169,444 185,449

Net block 81,424 83,451 90,992 112,093 120,127

CWIP 10,090 13,334 22,768 14,878 22,957

Investments 57,269 55,547 63,166 70,603 88,234

Cash & equivalents 11,263 22,432 28,189 36,150 32,894

Debtors 8,581 9,076 9,824 11,633 21,654

Inventory 45,491 52,675 56,378 66,002 73,595

Loans & advances 13,061 14,181 17,154 22,401 22,635

Other current assets 2,884 3,475 1,412 6,414 10,197

Total current assets 81,279 101,840 112,957 142,600 160,975

Current liabilities 34,991 44,579 48,334 52,007 56,246

Provisions 45,499 41,048 44,111 52,588 59,947

Total current liabilities 80,491 85,628 92,445 104,595 116,193

Net current assets 788 16,212 20,512 38,006 44,782

Total assets 149,571 168,543 197,437 235,580 276,101


Income statement (` mn) Year to March FY10 FY11 FY12 FY13 FY14

Operating income 181,532 211,676 247,984 296,056 328,826

% growth 16.3% 16.6% 17.2% 19.4% 11.1%

Operating expenditure 120,792 140,141 162,988 192,738 207,838

EBITDA 60,740 71,534 84,996 103,318 120,988

% growth 25.0% 17.8% 18.8% 21.6% 17.1%

Depreciation 6,087 6,560 6,985 7,956 8,999

EBIT 54,653 64,975 78,011 95,363 111,989

Interest expenditure 648 481 779 865 30

Non-operating income 6,147 8,188 11,744 12,344 14,632

Adjusted PBT 60,153 72,682 88,975 106,842 126,591

Tax 19,543 22,806 27,352 32,658 38,739

Adjusted PAT/ Net profit 40,610 49,876 61,624 74,184 87,852

% growth 24.4% 22.8% 23.6% 20.4% 18.4%

Extraordinaries - - - - -

Reported PAT / Net profit 40,610 49,876 61,624 74,184 87,852

Minority Interest - 1 2 3 4

Share of associates 1,072 303 958 1,897 1,062 Adjusted Consolidated net profit 41,682 50,178 62,579 76,078 88,910


ITC


Cash flow statement (` mn)


EBIT 60,801 73,163 89,755 107,707 126,621

Depreciation 6,087 6,560 6,985 7,956 8,999

Others (1,469) (313) (71) 2,445 903

Tax (19,543) (22,806) (27,352) (32,658) (38,739)

(Incr) / decr in net working capital 34,725 (4,254) 1,457 (9,533) (10,033)

Cash flow from operations 80,601 52,351 70,775 75,916 87,751

Capex (12,741) (11,831) (23,960) (21,168) (25,113)

(Incr) / decr in investments (28,891) 1,722 (7,619) (7,437) (17,631)

Others - - - - -

Cash flow from investments (41,633) (10,109) (31,579) (28,605) (42,744)

Net borrowings (698) (85) (201) (127) (153)

Interest paid (648) (481) (779) (865) (30)

Dividend paid (44,517) (40,015) (34,524) (41,561) (55,452)

Others 7,848 9,509 2,066 3,202 7,371

Cash flow from financing (38,015) (31,072) (33,439) (39,351) (48,263)

Net change in cash 953 11,170 5,757 7,961 (3,256)

Closing cash balance 11,263 22,432 28,189 36,150 32,894

Free cash flow 67,859 40,520 46,815 54,749 62,638


Ratio analysis Year to March FY10 FY11 FY12 FY13 FY14

Gross margin (%) 61.4% 61.6% 61.2% 59.2% 60.0%

EBITDA margin (%) 33.5% 33.8% 34.3% 34.9% 36.8%

EBIT margin (%) 33.5% 34.6% 36.2% 36.4% 38.5%

Net profit margin (%) 22.4% 23.6% 24.8% 25.1% 26.7%

Dividend payout ratio (%) 94.0% 69.0% 57.7% 55.9% 54.0%

Net debt: equity (x) (0.1) (0.1) (0.1) (0.2) (0.1)

Working capital turnover (x) 1.1 19.1 21.2 32.7 34.5

Fixed assets turnover (x) 1.5 1.7 1.8 1.7 1.8

RoCE (%) 27.6% 31.6% 34.0% 34.5% 34.3%

RoE (%) 29.2% 33.2% 35.5% 36.1% 36.2%


Valuation parameters


EPS (`) 5.1 6.3 7.8 9.4 11.1

Diluted EPS (`) 5.1 6.3 7.8 9.4 11.1

Book value per share (`) 18.0 20.4 24.0 28.5 33.6

Dividend per share (`) 4.8 4.4 4.5 5.3 6.0

P/E (x) 71.4 58.1 47.1 39.1 33.0

P/BV (x) 20.4 18.0 15.3 12.9 10.9

EV/EBITDA (x) 45.8 39.4 33.4 27.7 23.9

Price/Sales (x) 7.7 13.4 11.6 9.8 8.9


ITC


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Key financials – standalone (` mn) Year to March FY13 FY14 FY15E FY16E FY17E

Net Revenues (` mn) 226,637 264,023 308,909 369,385 445,045

Operating Profits (` mn) 114,276 143,601 172,667 210,711 260,447

Net Profits (` mn) 67,263 84,784 99,920 122,192 147,975

EPS (`) 28.3 35.3 41.4 50.6 61.3

RoA (%) 1.82% 1.90% 1.86% 1.87% 1.83%

RoE (%) 20.3% 21.3% 21.1% 21.9% 22.2%

P/B (x) 6.11 5.13 4.39 3.70 3.09


Since its inception 20 years ago, HDFC Bank has focused on building a granular retail franchise on both sides of the balance sheet and maintained a conservative approach on the balance of growth and asset quality. With a stable management team at the helm, the bank will seek to further penetrate its retail offering on a pan-India basis and fill the gaps in its corporate banking offering as the economic climate improves. Numero uno in Indian banking Established in 1994, HDFC Bank is India’s second-largest private sector bank by assets. It has ~4% market share in total bank credit. Retail loans form 48% of the bank’s loans, with a market-leading presence in most retail product categories. Its corporate business has focussed on working capital financing. Strong retail franchise, stable management HDFC Bank has differentiated itself from its peers through its strategic focus on a granular low-cost franchise along with a market-leading position in most retail products since its early years. Over the last 20 years, the bank has taken a longer-term approach of protecting its margins and asset quality rather than pursuing near-term aggressive growth. Superior margins and controlled asset quality have driven healthy average RoEs of ~18% in the last ten years. A stable management team and use of technology from the beginning have further facilitated the bank’s consistent performance. Acquirer in the past, recent focus on rapid organic scale-up A superior profitability has allowed HDFCB to sustain its capital position mainly through internal profit generation without undue dilution of its shareholders. The bank has made two acquisitions (Times Bank in 1999 and Centurion Bank of Punjab in 2008) in the past, but its recent focus has been on organic growth through accelerated branch network expansion on a pan-India basis. High visibility on succession planning Aditya Puri (MD & CEO) has led HDFC Bank since its inception, and following the recent clarification by the RBI that about 70 years is the maximum age limit for private bank CEOs, Mr Puri can serve for another six years. Many members in the bank’s senior management team have been with bank for more than ten years and hence offer ample options for succession planning. Ripe for growth in retail; filling the gaps on corporate banking HDFC Bank has expanded its branch network by ~70% in the last three years with a pan-India focus, putting in place drivers to further strengthen its retail banking business. There have been few gaps in corporate banking, investment banking and project finance, and the bank has selectively hired and built teams in recent years to play a bigger role, as the economic recovery sets in the next 12-18 months.

COMPANY INSIGHT HDFCB IN EQUITY November 17, 2014

HDFC BankSELL

BFSI

Recommendation Mcap (bn): `2,246/US$36.5 3M ADV (mn): `1,807/US$29.4 CMP: `930 TP (12 mths): `717 Downside (%): 23

Flags Accounting: GREEN Predictability: GREEN Treatment of Minorities: GREEN

Catalysts

Increase in retail loan growth in FY16-17

Capital infusion bolstering tier-1

Better income traction in corporate banking

Performance


90 100 110 120 130 140 150

Nov

-13

Dec

-13

Feb-

14

Mar

-14

May

-14

Jun-

14

Aug

-14

Sep-

14

Nov

-14

Sensex HDFC Bank

Analyst Details

Pankaj Agarwal, CFA +91 22 3043 3206 [email protected]

Ravi Singh +91 22 3043 3181 [email protected]

Aadesh Mehta, CFA +91 22 3043 3239 [email protected]

HDFC Bank


Exhibit 1: Loan growth and net interest margins


Exhibit 2: RoA and RoE


Exhibit 3: Gross NPA and provision coverage ratio


Exhibit 4: Tier-1 capital ratio


Exhibit 5: Forward P/E evolution over the long term

Source: Company, Ambit Capital research; Trading band=Mean+1SD

Exhibit 6: Forward P/B evolution over the long term

Source: Company, Ambit Capital research; Trading band=Mean+1SD

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

0%

10%

20%

30%

40%

50%

60%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Loan growth - LHS Net interest margins - RHS

0%

5%

10%

15%

20%

25%

0.00%0.20%0.40%0.60%0.80%1.00%1.20%1.40%1.60%1.80%2.00%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoA - LHS RoE - RHS

0%

20%

40%

60%

80%

100%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Gross NPA - LHS Provision coverage ratio - RHS

9.6

%

8.6

%

8.6

%

10

.3%

10

.6%

13

.3%

12

.2%

11

.6%

11

.1%

11

.8%

0%

2%

4%

6%

8%

10%

12%

14%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Tier-1 capital ratio

0

200

400

600

800

1000

1200

Jun-

06D

ec-0

6Ju

n-07

Dec

-07

Jun-

08D

ec-0

8Ju

n-09

Dec

-09

Jun-

10D

ec-1

0Ju

n-11

Dec

-11

Jun-

12D

ec-1

2Ju

n-13

Dec

-13

Jun-

14

16.8x

20.4x

24.0x

0

200

400

600

800

1000

Jun-

06D

ec-0

6Ju

n-07

Dec

-07

Jun-

08D

ec-0

8Ju

n-09

Dec

-09

Jun-

10D

ec-1

0Ju

n-11

Dec

-11

Jun-

12D

ec-1

2Ju

n-13

Dec

-13

Jun-

14

3.02x

3.56x

4.11x

HDFC Bank




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’s conservative approach towards growth and asset quality imparts sufficient predictability to its financial performance.

Treatment of minorities GREEN We did not find any material example of unfair treatment to minorities. Lately, the bank’s sensible approach

towards a possible merger with HDFC Ltd has been comforting from the investors’ point of view.


Exhibit 8: HDFC Bank - Three ‘quarters of the pie’ on our STAR* framework


Competitive advantage Strong retail franchise with long-term track record

Accounting quality Nothing unusual in the accounting

Capital allocation An acquirer in the past, but recent focus on organic build-up

Centrality of political connect HDFC Bank is not part of Ambit’s Connected Companies Index and does not appear to have any questionable political connections.

Treatment of minorities Sensible approach towards a possible merger with HDFC a positive

Succession planning Stable management team with high visibility on continuity

Total (%)


HDFC Bank


Balance sheet

Year to March (Rs mn) FY13 FY14 FY15E FY16E FY17E

Networth 362,141 434,786 511,543 606,053 726,345

Deposits 2,962,470 3,673,375 4,371,316 5,464,145 6,830,181

Borrowings 330,066 394,390 448,203 525,224 619,773

Other Liabilities 348,642 413,444 496,133 620,166 775,208

Total Liabilities 4,003,319 4,915,995 5,827,195 7,215,588 8,951,507

Cash & Balances with RBI & Banks 272,802 395,836 467,999 552,796 650,576

Investments 1,116,136 1,209,511 1,487,744 1,835,232 2,274,449

Advances 2,397,206 3,030,003 3,540,536 4,419,965 5,523,514

Other Assets 217,175 280,645 330,916 407,595 502,969

Total Assets 4,003,319 4,915,995 5,827,195 7,215,588 8,951,507


Income statement

Year to March (Rs mn) FY13 FY14 FY15E FY16E FY17E

Interest Income 350,649 411,355 485,526 572,496 681,486

Interest Expense 192,538 226,529 268,599 311,728 364,832

Net Interest Income 158,111 184,826 216,927 260,768 316,654

Total Non-Interest Income 68,526 79,196 91,982 108,617 128,391

Total Income 226,637 264,023 308,909 369,385 445,045

Total Operating Expenses 112,361 120,422 136,242 158,674 184,598

Employees expenses 39,654 41,790 45,815 51,970 58,687

Other Operating Expenses 72,707 78,632 90,427 106,704 125,911

Pre Provisioning Profits 114,276 143,601 172,667 210,711 260,447

Provisions 16,764 15,873 22,412 26,963 37,928

PBT 97,512 127,728 150,255 183,748 222,519

Tax 30,249 42,944 50,335 61,556 74,544

PAT 67,263 84,784 99,920 122,192 147,975


Key ratios

Year to March FY13 FY14 FY15E FY16E FY17E

Credit-Deposit (%) 80.9% 82.5% 81.0% 80.9% 80.9%

CASA ratio (%) 47.7% 45.6% 45.3% 45.0% 44.7%

Cost/Income ratio (%) 49.6% 45.6% 44.1% 43.0% 41.5%

Gross NPA (̀ mn) 23,346 29,893 38,475 39,069 54,518

Gross NPA (%) 0.97% 0.98% 1.08% 0.88% 0.98%

Net NPA (̀ mn) 4,690 8,200 13,466 13,674 19,081

Net NPA (%) 0.20% 0.27% 0.38% 0.31% 0.35%

Provision coverage (%) 79.9% 72.6% 65.0% 65.0% 65.0%

NIMs (%) 4.57% 4.39% 4.28% 4.24% 4.15%

Tier-1 capital ratio (%) 11.1% 11.8% 10.7% 10.3% 10.1%


HDFC Bank


Du-pont analysis


NII / Assets (%) 4.3% 4.1% 4.0% 4.0% 3.9%

Other income / Assets (%) 1.9% 1.8% 1.7% 1.7% 1.6%

Total Income / Assets (%) 6.1% 5.9% 5.8% 5.7% 5.5%

Cost to Assets (%) 3.0% 2.7% 2.5% 2.4% 2.3%

PPP / Assets (%) 3.1% 3.2% 3.2% 3.2% 3.2%

Provisions / Assets (%) 0.5% 0.4% 0.4% 0.4% 0.5%

PBT / Assets (%) 2.6% 2.9% 2.8% 2.8% 2.8%

Tax Rate (%) 31.0% 33.6% 33.5% 33.5% 33.5%

ROA (%) 1.8% 1.9% 1.9% 1.9% 1.8%

Leverage 11.2 11.2 11.4 11.7 12.1 ROE (%) 20.3% 21.3% 21.1% 21.9% 22.2%


Valuation Year to March FY13 FY14 FY15E FY16E FY17E

EPS (Rs) 28.3 35.3 41.4 50.6 61.3

EPS growth (%) 28% 25% 17% 22% 21%

BVPS (Rs) 152.2 181.2 211.9 251.0 300.9

P/E (x) 32.9 26.3 22.5 18.4 15.2

P/BV (x) 6.11 5.13 4.39 3.70 3.09


HDFC Bank




Key financials (` mn) Year to March FY13 FY14 FY15E FY16E FY17E

Net Revenues (US$ mn) 4,687 5,360 5,995 6,877 7,849

EBIT (̀ bn) 50.4 79.4 86.3 101.5 115.9

EBIT margins 19.6% 24.1% 23.5% 24.0% 24.0%

Diluted EPS (`) 56.4 90.2 105.0 123.6 140.8

RoE 31.8% 37.2% 33.5% 31.9% 29.3%

P/E 28.6 17.8 15.3 13.0 11.4

EV/EBITDA 18.2 12.0 11.4 9.7 8.5


HCL Tech has built significant competitive advantages around its industry-leading IMS practice, an innovative approach to application management services and highly effective sales & execution that are unlikely to be replicated by its peers. These competitive advantages, combined with its strong capital allocation track record translate into a high score on our proprietary CAPOM framework (Rank 2 of 6).

Fourth-largest India-listed IT services company Established in 1991, HCLT is the fourth-largest Indian-listed IT company in terms of revenues. It is one of the largest Indian companies in the fast-growing infrastructure management services (IMS) segment, with 31% share of LTM revenues amongst the top-6 Indian IT firms. It was one of the earliest movers in this segment and has built better capabilities than its peers. Strong competitive advantages built on multiple legs HCLT has sustainable advantages built through a strong capital allocation track record, optimal portfolio mix with leadership in the fast-growing IMS segment, good account mining track record and a highly effective sales organisation structure. We believe that these would enable the company to sustain high return ratios and deliver faster growth than its peers. Indeed, its FY14 RoE of 36% is second only to TCS amongst the top-5 IT vendors in India. The company’s return profile has improved steadily in the last three years. Among the best capital allocators in Indian IT HCLT is amongst the best capital allocators in the large-sized IT services pack and it also has high RoEs. It has the best capex productivity over the last five years (6.2x vs 4.0x for peers) and has a conservative yet successful acquisition strategy. It acquired Axon in 2009 by paying a sum equal to almost half its own market cap. This enabled the company to win significantly larger deals and a base in Europe. Whilst HCLT’s dividend payout has averaged an impressive 31% in the last three years, this has room to improve given that the top-5 Indian IT firms have a dividend payout ratio of 35%. Given its strong competitive advantages, we believe that its high return ratios are sustainable. Due focus on succession planning The company is led by Mr. Anant Gupta, President and CEO. He replaced Mr. Vineet Nayar in 2013. HCLT provides formal training (for instance, sponsoring vertical heads for Harvard Management programmes) and on-the-job training through additional responsibilities to build a second line of command. The company also profiles its employees and has created top-10 performer bands and 100 Best CEO Club to groom future leaders. We believe that HCLT’s succession planning is in line with its peers. What is being done to strengthen the franchise further? The company is now focused on larger-sized, more complex deals in the IMS segment. Although HCLT was a laggard in application management services, its growth is now accelerating due to cross-sell opportunities at IMS clients and differentiated innovations such as ALT ASM. It is also innovating to improve its positioning in engineering services outsourcing and digitalisation opportunities.

COMPANY INSIGHT HCLT IN EQUITY November 17, 2014

HCL TechnologiesBUY

Technology

Recommendation Mcap (bn): `1,130/US$18.4 3M ADV (mn): `1,684/US$27.4 CMP: `1,611 TP (12 mths): `2,110 Upside (%): 31

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

Catalysts

Acceleration of revenue growth in the IMS service line post 3QFY15

Continued acceleration in the software service segment to widen growth base

Consensus expects contraction in EBIT margins over FY14-17 which may not happen

Performance


5008001,1001,4001,7002,000

15,000

18,000

21,000

24,000

27,000A

ug-1

3

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Sensex (LHS) HCLT (Rs) (RHS)

Analyst Details Sagar Rastogi +91 22 3043 3291 [email protected]

Utsav Mehta +91 22 3043 3209 [email protected]

http://webambit.ambit.co/reports/Ambit_Technology_Thematic_10Jul2014.pdf

HCL Technologies


Exhibit 1: The company’s margins have grown steadily in the last three years…


Exhibit 2: …resulting in a marked improvement in profitability


Exhibit 3: Sources of funds over the last ten years (FY04-13)


Exhibit 4: Utilisation of funds over the last ten years (FY04-13)


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


Exhibit 6: Forward EV/EBITDA evolution over the past ten years


0%

5%

10%

15%

20%

25%

30%

-

1,000

2,000

3,000

4,000

5,000

6,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenue(US$mn) (LHS) EBIT margins (RHS)

10%

15%

20%

25%

30%

35%

40%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoE RoCE

CFO88%

Other income

5%

Equity raised

4%

Debt raised3%

Dividend paid33%

Capex31%

Acquisition17%

Investments10%

Increase in cash6%

Interest paid3%

468

1012141618202224

Apr

-05

Apr

-06

Apr

-07

Apr

-08

Apr

-09

Apr

-10

Apr

-11

Apr

-12

Apr

-13

Apr

-14

P/E

HCLT P/E 6 yr avg 4 yr avg

3579

1113151719

Oct

-05

Oct

-06

Oct

-07

Oct

-08

Oct

-09

Oct

-10

Oct

-11

Oct

-12

Oct

-13

Oct

-14

EV/ EBITDA

HCLT EV/ EBITDA 6 yr avg 4 yr avg

HCL Technologies




Accounting GREEN

The company has amongst the leanest working capital cycles (receivable + unbilled revenue days at 87, lower than the average of 91 for top-5 Indian IT vendors), high capex productivity and strong cash flow generation (five-year FCF/ NI of 66% in line with the peer average). 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 topline growth targets and the associated timeframe. HCLT has significantly surprised in its quarterly EPS with an average surprise of 11% (positive or negative) in the last eight quarters. Over these eight quarters, the company had a positive surprise on EPS five times. However, its sales figures have been largely in line with consensus expectations (revenue surprise of 1% over the same period).


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.


Exhibit 8: HCL Tech – ‘Three-quarters of the pie’ on our STAR* framework


Competitive advantage The company has built strong capabilities in its industry leading IMS practise. Further, it has created differentiated innovations such as ALT ASM.

Accounting quality The company ranks in the top quartile of our accounting framework. It has a lean working capital cycle, strong cash flow generation and high capex productivity.

Capital allocation Its capital allocation track record has been good, with a conservative, yet successful acquisition track record. Further, despite its dividend pay-out ratio is lower than peers, it is an impressive 31% (3 year average).

Centrality of political connect HCLT is not a part of Ambit’s Connected Companies Index and does not have any questionable political connection.

Treatment of minorities Minority shareholders were treated unfairly by HCL Infosystems, a group company owned by the same promoters.

Succession planning The company has not faced issues with top level management transition in the past and has programmes to create multiple layers of management.

Total (%)


HCL Technologies


Income statement

Year to March (̀ bn) FY13 FY14 FY15E FY16E FY17E

Revenue (US$ mn) 4,687 5,360 5,995 6,877 7,849

Growth 12.9% 14.4% 11.9% 14.7% 14.1%

Revenue 257.3 329.6 367.8 422.9 482.7

Cost of goods sold 172.4 209.7 236.7 268.1 306.3

SG&A expanses 34.5 40.4 44.8 53.3 60.5

EBITDA 57.1 86.8 91.1 107.4 123.0

Depreciation 6.7 7.3 4.7 5.9 7.1

EBIT 50.4 79.4 86.3 101.5 115.9

EBIT Margin 19.6% 24.1% 23.5% 24.0% 24.0%

Other Income 1.6 (0.2) 8.6 10.2 11.5

PBT 52.0 79.3 94.9 111.8 127.4

Tax 12.2 15.5 20.8 24.6 28.0

Rate (%) 23.5% 19.5% 21.9% 22.0% 22.0%

Reported PAT 39.8 63.8 74.1 87.2 99.3

Diluted Adj EPS 56.4 90.2 105.0 123.6 140.8

DPS 12.0 22.0 32.0 32.0 36.0


Balance sheet Year to March (̀ bn) FY13 FY14 FY15E FY16E FY17E

Net Worth 142.9 200.0 242.8 304.1 373.8

Other Liabilities 22.1 22.0 20.6 20.7 20.7

Capital Employed 165.1 222.0 263.4 324.8 394.5

Net Block 76.9 82.6 89.7 97.6 106.0

Other Non-current Assets 23.0 23.5 26.7 26.8 26.8

Curr. Assets 130.7 197.5 239.7 307.0 383.3

Debtors 44.6 56.6 64.8 74.5 85.1

Unbilled revenues 17.1 20.2 25.2 29.0 33.1

Cash & Bank Balance 49.8 99.6 124.5 174.6 232.1

Other Current Assets 19.1 21.2 25.2 29.0 33.1

Current Liab. & Prov 65.4 81.6 92.7 106.6 121.7

Net Current Assets 65.2 115.9 147.0 200.4 261.7

Application of Funds 165.1 222.0 263.4 324.8 394.5


HCL Technologies


Cash flow statement

Year to March (̀ bn) FY13 FY14 FY15E FY16E FY17E

Net Income 39.8 63.8 74.1 87.2 99.3

Depreciation 6.3 6.8 4.2 5.4 6.6

CF from Operations 46.5 71.1 78.8 93.1 106.4

Cash for Working Capital 4.8 (0.8) (5.8) (3.3) (3.7)

Net Operating CF 51.2 70.3 73.0 89.7 102.7

Net Purchase of FA (5.8) (6.5) (12.8) (13.5) (15.4)

Others (1.6) (6.8) 0.3 (0.0) (0.0)

Net Cash from Invest. (5.1) (12.9) (12.5) (13.5) (15.5)

Proceeds from Equity & other - - - - -

Dividend Payments (9.8) (18.4) (26.4) (26.4) (29.7)

Cash Flow from Fin. (25.2) (6.9) (37.9) (26.4) (29.7)

Free Cash Flow 45.4 63.8 60.3 76.2 87.3

Opening cash balance 25.1 51.6 101.9 124.8 174.6

Net Cash Flow 20.9 50.6 22.6 49.8 57.6

Closing Cash Balance 46.1 102.2 124.5 174.6 232.1


Ratio analysis FY13 FY14 FY15E FY16E FY17E

Growth

Revenue growth (US$) 12.9% 14.4% 11.9% 14.7% 14.1%

EBIT growth (̀ ) 50.3% 57.6% 8.7% 17.6% 14.1%

EPS growth 62.9% 60.1% 16.4% 17.6% 13.9%

Return Ratios (%)

RoE 32% 37% 33% 32% 29%

RoCE 25% 33% 28% 27% 25%

ROIC 34% 54% 52% 55% 58%

Turnover Ratios

Receivable days (Days) 88 85 89 89 89

Fixed Asset Turnover (x) 3.4 4.1 4.3 4.5 4.7


Valuation parameters


P/E 28.6 17.8 15.3 13.0 11.4

EV/EBITDA 18.2 12.0 11.4 9.7 8.5

EV/Sales 4.0 3.2 2.8 2.5 2.2

Price/Book Value 8.0 5.7 4.7 3.7 3.0

Dividend Yield (%) 0.7% 1.4% 2.0% 2.0% 2.2%


HCL Technologies





Net Revenues (Rs mn) 162,174 193,569 216,578 253,664 299,001

Operating Profits (Rs mn) 93,031 114,561 125,507 147,703 176,709

Net Profits (Rs mn) 51,794 62,181 70,061 84,016 102,196

EPS (Rs) 22.1 26.5 29.8 35.8 43.5

RoA (%) 1.65% 1.72% 1.70% 1.74% 1.77%

RoE (%) 18.5% 17.4% 17.1% 17.8% 18.6%

P/B (x) 3.37 2.93 2.55 2.21 1.90


Having built a formidable corporate and commercial franchise in the early years of its existence, Axis Bank has decisively de-risked and diversified its franchise towards retail in recent years. The bank is a good example of how professional management at a bank with quasi-government ownership can drive high branch and employee productivity and build market share. With a diversified balance sheet mix, adequate capital, and strong profitability, the bank is well placed to exploit opportunities across a wider range of banking vis-a-vis the last cycle.

Changing with the times Established in 1994, Axis Bank is India’s third-largest private sector bank by assets. It has ~3% market share in total bank credit. Whilst the bank has historically been a leader in corporate and commercial banking, it has also aggressively built its retail franchise (33% of loans) in the last three years. Solid roots in corporate banking; efficient retail network With leading PSU mutual fund and insurance companies as promoters, Axis Bank cornered a significant market share in cash management and transaction businesses and built a formidable corporate and commercial banking franchise in its early years. Over the years, the bank built a highly diversified branch network entirely organically, which has led to among the best branch and employee productivity and has facilitated the retail scale-up of the bank. Investing in organic growth Unlike its large banking peers, Axis Bank has made investments in organically creating a wide diversified branch network on a pan-India basis. The bank has also been a pioneer in investing in ATM network, technology and infrastructure. The bank has a leading market share in transaction banking, cash management and loan syndication and has one of the highest productivity (per branch and per employee), which underscore the effectiveness of the bank’s investments. Axis Bank is well capitalised with tier-1 capital at 12.6%. Professional approach to succession planning The current MD & CEO, Shikha Sharma, was appointed in 2009. She is 55 years old and her second three-year term ends in May 2015. Whilst the RBI now allows private bank CEOs to work until the age of 70 years, the board of Axis Bank began looking for a successor when the last chairman turned 60. In any event, succession is likely to take place through a professional process that will consider both internal and expernal candidates. Well placed to explore a wider range of opportunities As corporate asset quality began to come under stress in 2011, Axis Bank was early to de-risk its balance sheet by lowering the share of corporate loans and wholesale funding and by building a retail franchise. With a diversified balance sheet mix now and improving outlook for GDP growth over FY16-17, the bank is well placed to exploit opportunities across a wider spectrum of banking in corporate, commercial, retail, rural and international banking.

COMPANY INSIGHT AXSB IN EQUITY November 17, 2014

Axis BankBUY

BFSI

Recommendation Mcap (bn): `1,126/US$18.3 3M ADV (mn): `1,618/US$26.3 CMP: `477 TP (12 mths): `450 Upside (%): -6


Catalysts

Sequential decline of stressed asset accretion over FY15-16

Increase in loan growth in FY16

Turn in the investment cycle to provide fee income opportunities

Performance


90 120 150 180 210 240

Nov

-13

Jan-

14

Mar

-14

May

-14

Jul-

14

Sep-

14

Nov

-14

Sensex Axis Bank

Analyst Details




Axis Bank







Source: Company, Ambit Capital research;




Source: Company, Ambit Capital research; Note: Trading band=Mean+1SD



0.0%0.5%

1.0%1.5%2.0%

2.5%3.0%

3.5%4.0%

0%

10%

20%

30%

40%

50%

60%

70%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14


0%

5%

10%

15%

20%

25%

0.00%

0.50%

1.00%

1.50%

2.00%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoA - LHS RoE - RHS

0%10%

20%30%

40%50%60%

70%80%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Gross NPA - LHSProvision coverage ratio - RHS

8.9

%

7.3

%

6.4

% 10

.2%

9.3

%

11

.2%

9.4

%

9.5

%

12

.2%

12

.6%

0%

2%

4%

6%

8%

10%

12%

14%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14


0

100

200

300

400

500

600

Jun-

06D

ec-0

6Ju

n-07

Dec

-07

Jun-

08D

ec-0

8Ju

n-09

Dec

-09

Jun-

10D

ec-1

0Ju

n-11

Dec

-11

Jun-

12D

ec-1

2Ju

n-13

Dec

-13

Jun-

14

8.7x

13.5x

18.4x

-50

50

150

250

350

450

550

650

Jun-

06D

ec-0

6Ju

n-07

Dec

-07

Jun-

08D

ec-0

8Ju

n-09

Dec

-09

Jun-

10D

ec-1

0Ju

n-11

Dec

-11

Jun-

12D

ec-1

2Ju

n-13

Dec

-13

Jun-

14

1.56x

2.27x

2.97x

Axis Bank





Predictability GREEN The bank has one of the best track records of long-term profitability. Going forward, whilst credit cost could be elevated, the bank has built buffers in its operating profitability and capital position.

Treatment of minorities GREEN We did not find any material example of unfair treatment to minorities.


Exhibit 8: Axis Bank - Three ‘quarters of the pie’ on our STAR* framework


Competitive advantage Solid roots in corporate banking; efficient retail network


Capital allocation Efficient investment in building an organic retail network

Centrality of political connect Axis Bank is not part of Ambit’s Connected Companies Index and does not appear to have any questionable political connections.

Treatment of minorities No material instance of unfair treatment of minorities.

Succession planning Likely to be a smooth professional process

Total (%)


Axis Bank


Balance sheet

Year to March (` mn) FY13 FY14 FY15E FY16E FY17E

Networth 331,079 382,205 438,798 507,422 591,202

Deposits 2,526,136 2,809,446 3,230,862 3,812,418 4,613,025

Borrowings 439,511 502,909 593,687 722,352 879,435


Total Liabilities 3,405,607 3,832,449 4,428,814 5,240,752 6,321,934


Investments 1,137,375 1,135,484 1,267,735 1,495,607 1,803,972

Advances 1,969,660 2,300,668 2,740,395 3,269,846 3,981,787

Other Assets 94,222 113,910 87,162 81,191 60,285

Total Assets 3,405,607 3,832,449 4,428,814 5,240,752 6,321,934


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

Interest Income 271,826 306,412 349,164 404,112 476,371




Total Income 162,174 193,569 216,578 253,664 299,001





Provisions 17,501 21,070 21,712 23,235 25,308

PBT 75,531 93,490 103,795 124,468 151,401

Tax 23,736 31,310 33,733 40,452 49,205

PAT 51,794 62,181 70,061 84,016 102,196


Ratio analysis Year to March FY13 FY14 FY15E FY16E FY17E

Credit-Deposit (%) 78.0% 81.9% 84.8% 85.8% 86.3%

CASA ratio (%) 47.0% 47.4% 46.8% 46.3% 45.7%


Gross NPA (̀ mn) 23,934 31,464 33,061 45,916 49,157

Gross NPA (%) 1.20% 1.36% 1.20% 1.39% 1.23%

Net NPA (̀ mn) 7,041 10,246 9,918 18,366 22,121

Net NPA (%) 0.36% 0.45% 0.36% 0.56% 0.56%


NIMs (%) 3.18% 3.40% 3.36% 3.37% 3.35%



Axis Bank


Du-pont analysis


NII / Assets (%) 3.1% 3.3% 3.3% 3.3% 3.3%



Cost to Assets (%) 2.2% 2.2% 2.2% 2.2% 2.1%

PPP / Assets (%) 3.0% 3.2% 3.0% 3.1% 3.1%


PBT / Assets (%) 2.4% 2.6% 2.5% 2.6% 2.6%

Tax Rate (%) 31.4% 33.5% 32.5% 32.5% 32.5%

ROA (%) 1.7% 1.7% 1.7% 1.7% 1.8%

Leverage 11.2 10.1 10.1 10.2 10.5 ROE (%) 18.5% 17.4% 17.1% 17.8% 18.6%


Valuation parameters Year to March FY13 FY14 FY15E FY16E FY17E

EPS (`) 22.1 26.5 29.8 35.8 43.5

EPS growth (%) 8% 20% 13% 20% 22%

BVPS (`) 141.5 162.7 186.8 216.0 251.7

P/E (x) 21.5 18.0 16.0 13.3 11.0

P/BV (x) 3.37 2.93 2.55 2.21 1.90


Axis Bank




Key financials – consolidated (` mn) Year to March FY13 FY14 FY15E FY16E FY17E Net Sales 109,707 127,148 148,609 175,904 208,240 EBITDA 17,319 19,979 25,060 30,405 36,665 EBITDA (%) 15.8% 15.7% 16.9% 17.3% 17.6% EPS (`) 11.6 12.8 16.5 20.4 24.5 RoE (%) 36.3% 33.1% 36.1% 38.0% 38.9% RoCE (%) 35.3% 30.7% 34.7% 36.7% 37.7% P/E (x) 55.9 43.5 39.3 31.9 26.4


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 spends, will allow the firm to continue gaining market share from its peers in the future. We expect 18% revenue CAGR and 23% EPS CAGR over FY14-19. However, we see a risk to its RoCE from capital misallocation through M&A.

Asian Paints controls ~50% share of organised decorative paints Founded in 1942, Asian Paints now has ~50% market share in the organised decorative paints industry. Market share gains over the last decade have resulted in 17% revenue CAGR and 23% earnings CAGR. The firm has diversified into home décor, with the recent acquisitions of Sleek (kitchen fittings) and Ess Ess (bathroom fittings).

Distinct sustainable competitive advantages in the paints division Focus on supply chain efficiencies (including the use of technology to accurately forecast demand and track the performance of dealers) enables Asian Paints to outperform its peers around product availability in shops whilst expanding its product portfolio and distribution network. Further, thanks to scale-related benefits around a larger marketing budget, Asian Paints benefits most from premiumisation of consumer demand. Sustainability of these competitive advantages is driven by retention of a high-quality middle management team. These advantages have led to RoCEs sustaining at 35% over FY05-14.

Capital misallocation likely to be an overhang on RoCEs The firm has stated that the ‘home improvement’ division is likely to be larger than the paints division in the longer term, even though home improvement is a lower RoCE business than paints. Also, the de-listing of Berger International is intended to help the firm explore ‘more options’ with regards to international expansion despite the business generating sub-par returns historically. This comes at a time when the firm is beginning to generate surplus capital amidst an inter-generational shift amongst promoters.

Transition of control from second to third generation of promoters Members from the second generation of the promoter families stepped down from executive roles on the board in FY10, leaving the non-promoter executives - Mr. P.M. Murty and then Mr. K.B.S. Anand - as the CEO & MD. Since then, several incremental responsibilities have been awarded to the senior members of the third generation of the promoter family who have a proven track record in executive roles at Asian Paints. However, there remains a risk of capital misallocation, as the third generation drives inorganic growth.

Initiatives taken to further strengthen the franchise Recent initiatives by Asian Paints including installing GPS tracking on vehicles in the supply chain and bar-coding of all stocks at a depot level should further improve supply chain efficiency, a key strength which will enable the firm to sustain its market leadership. Moreover, the firm continues to extend its consumer connect with upgraded branding initiatives, expansion of “experience stores” and expansion of its home solutions network.

COMPANY INSIGHT APNT IN EQUITY November 17, 2014

Asian PaintsSELL

Consumer Discretionary: Paints

Recommendation Mcap (bn): `622/US$10.1 6M ADV (mn): `835/US$13.6 CMP: `649 TP (12 mths): `559 Downside (%): 14

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

Catalysts

Capital misallocation on account of acquisitions being RoCE-dilutive

Disclosures on RoCEs of Sleek, Ess Ess and the Ethiopian paints business

Announcement of large acquisitions in India and abroad over the next 1-3 years

Performance


400450500550600650700

18,000

20,500

23,000

25,500

28,000O

ct-1

3

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Sensex Asian Paints (RHS)

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

Aditya Bagul +91 22 3043 3264 [email protected]

Asian Paints


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


Exhibit 2: RoCE and RoE over the last ten years


Exhibit 3: Sources of funds over the last ten years


Exhibit 4: Utilisation of funds over the last ten years




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


10%

12%

14%

16%

18%

20%

22%

-

30,000

60,000

90,000

120,000

150,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenue (Rs mn) EBITDA Margin (% RHS)

20%

30%

40%

50%

60%

20%

30%

40%

50%

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%


, 10%


cash equivalents,

9%

- 5

10 15 20 25 30 35 40 45

Apr

-05

Oct

-05

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

APNT P/E 6 Yr Avg 4 Yr Avg

-

2

4

6

8

10

12

14

Apr

-05

Oct

-05

Apr

-06

Oct

-06

Apr

-07

Oct

-07

Apr

-08

Oct

-08

Apr

-09

Oct

-09

Apr

-10

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-10

Apr

-11

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

APNT P/B 6 Yr Avg 4 Yr Avg

Asian Paints




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 concerns around Asian Paints’ capital allocation, as the firm pursues its inorganic growth aspirations with recent acquisitions like Sleek and Ess Ess. These along with increasing contribution of overseas business will be RoE-dilutive.


Exhibit 8: Asian Paints – ‘Three-quarters of the pie’ on our STAR* framework


Competitive advantage Sustained advantage around product portfolio, supply chain and brand recall

Accounting quality Highly cash generative , efficient working capital management

Capital allocation Key risk as new acquisitions and overseas business are RoCE dilutive,

Centrality of political connect Asian Paints is not part of Ambit’s Connected Companies Index and does not appear to have any questionable political connections

Treatment of minorities Risk of capital misallocation could lead to lower FCF and compressed RoCE in future

Succession planning 3rd generation promoter family members occupying managerial positions. However day to day operations run by professional management team.

Total (%)


Asian Paints


Balance sheet (standalone)

Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17E

Shareholders' equity 959 959 959 959 959

Reserves and surpluses 32,884 39,433 46,281 54,594 64,667

Total net worth 33,843 40,392 47,241 55,553 65,626

Debt 2,377 2,400 2,400 2,400 2,400



Gross block 33,851 36,621 38,621 40,621 42,621

Net block 23,967 24,202 23,568 22,795 21,881

CWIP 592 716 1,000 1,000 1,000

Investments (non-current) 2,807 7,212 4,000 4,000 4,000

Cash & cash equivalents 7,520 9,317 19,231 27,978 38,573

Debtors 9,809 11,103 12,214 14,458 17,116

Inventory 18,303 20,699 24,836 29,398 34,802

Loans & advances 3,211 3,767 4,886 5,783 6,846



Provisions 5,394 6,679 6,922 8,193 9,699


Net current assets 11,562 13,587 24,524 34,243 45,989

Total assets 39,371 47,131 54,507 63,452 74,285


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

Net Sales 109,707 127,148 148,609 175,904 208,240

% growth 14% 16% 17% 18% 18%


EBITDA 17,319 19,979 25,060 30,405 36,665

% growth 14% 15% 25% 21% 21%

Depreciation 1,546 2,457 2,633 2,773 2,913

EBIT 16,919 18,864 24,037 29,564 36,071

Interest expenditure 366.5 422.2 336.042 336.042 336.042

Non-operating income 1145.2 1342.2 1610.64 1932.768 2319.3216

Adjusted PBT 16,552 18,442 23,701 29,228 35,735

Tax 4,957 5,715 7,347 9,061 11,435

Adjusted PAT 11,595 12,727 16,353 20,167 24,299

Extraordinary expense/(income) 0 -99.6 0 0 0

Reported PAT after minority interest 11,139 12,188 15,826 19,534 23,540


Asian Paints


Cash flow statement (standalone)


Net profit before tax 16,552 18,442 23,701 29,228 35,735

Depreciation 1,546 2,457 2,633 2,773 2,913

Others (259) (415) 336 336 336

Tax (4,385) (4,802) (7,347) (9,061) (11,435)

(Incr)/decr in net working capital (1,587) (1,682) (1,022) (972) (1,152)


Capex (net) (6,367) (2,336) (2,284) (2,000) (2,000)

(Incr)/decr in investments 973 (4,113) 3,212 - -

Other income (expenditure) 551 421 - - -

Cash flow from investments (4,843) (6,029) 928 (2,000) (2,000)

Net borrowings (1,016) (369) - - -

Interest paid (371) (423) (336) (336) (336)

Dividend paid (4,621) (5,467) (8,978) (11,222) (13,467)


Net change in cash 1,018 1,712 9,915 8,746 10,595


Free cash flow 5,501 11,664 16,017 20,305 24,397


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

EBITDA margin (%) 15.8% 15.7% 16.9% 17.3% 17.6%

EBIT margin (%) 15.4% 14.8% 16.2% 16.8% 17.3%

Net prof. margin (%) 10.2% 9.6% 10.6% 11.1% 11.3%


Net debt: equity (x) (0.2) (0.2) (0.4) (0.5) (0.6)


Gross block turnover (x) 3.2 3.5 3.8 4.3 4.9

RoCE (pre-tax) (%) 48.5% 46.1% 50.4% 53.2% 55.5%

RoIC (%) 46.4% 39.2% 48.4% 61.9% 73.9%

RoE (%) 36.3% 33.1% 36.1% 38.0% 38.9%


Valuation parameters (standalone)


Diluted EPS (`) 11.6 12.7 16.5 20.4 24.5



P/E (x) 55.9 51.1 39.3 31.9 26.4

P/BV (x) 18.4 15.4 13.2 11.2 9.5

EV/EBITDA (x) 33.8 29.3 23.4 19.3 16.0

EV/EBIT (x) 36.9 33.1 26.0 21.1 17.3


Asian Paints




Key financials – Consolidated (` mn) Year to March FY13 FY14 FY15E FY16E FY17E


EBITDA (` mn) 9,824 11,503 12,972 14,942 17,208

EBITDA Margin (%) 15.3% 15.1% 14.7% 14.8% 15.0%

Adjusted EPS (`) 19.6 22.2 25.8 30.4 35.3

RoCE (%) 15.1% 16.1% 17.5% 20.3% 21.9%

P/E (x) 48.1 42.6 36.6 31.0 26.8


Godrej Consumer (GCPL) has a strong domestic franchise built around its market leadership in household insecticides (HI), hair color and the second largest soaps business in India. However, the series of overseas acquisitions made since FY05 have faced serious issues resulting in reduction in overall RoCE from ~130% in FY05 to ~15% in FY14. In the domestic business GCPL faces market share saturation in HI and high competitive intensity in soaps and hair color. With its continued focus on acquisitions, RoCE deterioration remains a risk for the company. GCPL has made several international acquisitions over FY08-14 Godrej Consumer (GCPL), the flagship company of the Godrej Group, is a household and personal care products company. It is a leader in the domestic insecticides space with key brands such as Good Knight and HIT (Insecticides), Cinthol and Godrej No.1 (Soaps) and Expert (hair care). Through ten overseas acquisitions since FY05, the company now has ~50% of its revenues coming from Africa, Latin America, Indonesia and the UK. Expect GCPL to face significant headwinds with regards to growth GCPL has a strong domestic franchise in the HI and soaps category with almost 60% and 10% market share respectively. However, in HI we believe GCPL’s share is reaching saturation and the firm faces intense competition from global HI majors like SC Johnson and Reckitt Benckiser. In the fully penetrated soaps category where premiumisation is the only growth driver, GCPL is losing share as it lacks a strong premium portfolio. In the international portfolio, Indonesia is the best performer but faces slowing growth due to market share saturation. Africa and LatAm have generated sub-optimal return ratios so far for GCPL. 26% sales CAGR target presents more risks than rewards around M&A GCPL’s 26% sales CAGR target over FY11-21 is likely to include substantial capital allocation for M&A. However, with the international portfolio’s RoCEs declining from 16% in FY08 to 7% in FY14, we see the risk of a sustained drag on ROCEs, due to challenges around management bandwidth, integration expertise and incentive to consolidate the existing portfolio before further acquisitions are pursued. Inorganic growth ambitions are expected to keep dividend payout ratio at the current level of ~25%. Family-owned and professionally managed GCPL is a professionally managed company with Vivek Gambhir as the MD. The promoter, Adi Godrej, serves as the Chairman and oversees longer term strategy including inorganic plans for the company. Mr. Godrej’s younger daughter, Nisaba, is actively involved in the business and serves as the Executive Director looking at the innovation function at GCPL. We expect her to assume greater responsibilities in GCPL after Mr.Godrej retires. Headwinds for existing business, acquisition ambitions – a key risk Changes in the product portfolio include: (a) recent relaunch of Cinthol branded soaps; and (b) cross pollination of HI portfolio from Indonesia and hair color portfolio from LatAm. However, we forecast only 14%/16% sales/EPS CAGR over FY14-18 due to the headwinds around market share saturation in HI and macro/integration issues in the international business. Due to overseas acquisitions, RoCEs should remain at ~18-20% over FY14-18.

COMPANY INSIGHT GCPL IN EQUITY November 17, 2014

Godrej ConsumerSELL

Analyst Details



Consumer


Flags Accounting: AMBER Predictability: AMBER Earnings Momentum: AMBER

Catalysts

Integration issues in its acquisitions in Africa and LatAm

Increased competitive intensity in the domestic HI and soaps category

Performance (%)

Source: Bloomberg, Ambit Capital Research

68078088098010801180

20,000 22,000 24,000 26,000 28,000 30,000

Nov

13

Jan

14

Mar

14

May

14

Jul 1

4

Sep

14

Nov

14

Sensex GCPL (RHS)

Godrej Consumer


Exhibit 1: Revenue has grown at a CAGR of 34% over FY05-14 due to series of acquisitions since FY06


Exhibit 2: Return ratios have deteriorated rapidly due to low yielding overseas acquisitions


Exhibit 3: CFO over the last ten years…..


Exhibit 4: …has been utilized to fund inorganic growth


Exhibit 5: GCPL P/E band chart for the last 7 years


Exhibit 6: GCPL EV/EBITDA band chart for the last 7 years


14%

15%

16%

17%

18%

19%

20%

21%

4,000

14,000

24,000

34,000

44,000

54,000

64,000

74,00084,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

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

20%40%60%80%100%120%140%160%180%200%

10.0%

30.0%

50.0%

70.0%

90.0%

110.0%

130.0%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoCE RoE (RHS)

CFO, 57%

Proceeds from

shares, 18%

Debt raised, 21%

Interest received,

5%Dividend

paid17%

Interest paid5%

Net Capex (incl.

acquisitions)

68%


cash equivalents

10%

50

200

350

500

650

800

950

1100

Nov

-07

Nov

-08

Nov

-09

Nov

-10

Nov

-11

Nov

-12

Nov

-13

Nov

-14

14x

38x

32x

26x

20x

50

200

350

500

650

800

950

1100

Nov

-07

Nov

-08

Nov

-09

Nov

-10

Nov

-11

Nov

-12

Nov

-13

Nov

-14

8x

13x

18x

23x

28x

Godrej Consumer




Accounting AMBER

In the past, Godrej Consumer has reported excellent cash conversion, efficient management of working capital in the domestic business, and reasonable levels of loans and advances and contingent liabilities. However, its working capital management in its international business has been weak. Working Capital days have kept fluctuating from a low of 7 in FY06 days to 51 days in FY12. Due to lack of disclosures, it is difficult to get a handle on the the debt level at each of its overseas businesses.


Whilst the company has seen strong performance in its domestic business, its increased focus on overseas businesses in Africa and Latin American has led to volatility in its reported numbers at the EBITDA margin level. EBITDA margin for the international have moved in a range of ~5% in FY06 to ~16% in FY12 and are currently down to ~11%. This variability in the margins makes the predictability of international business earnings difficult.


GCPL has financed a slew of acquisitions by cutting back on dividend payouts since FY06. By and large, these acquisitions have faced slowing growth, lower profitability and integration issues. This has resulted in a dip in GCPL’s RoE from ~190% in FY05 to 23% in FY14.


Exhibit 8: GCPL – ‘Half pie’ on our STAR* framework



Due to the scale of GCPL’s household insecticide business, it is one of the first companies globally to acquire the latest ‘Active’ ingredient. It is the domestic market leader in hair colour and #2 in soaps. However, it faces headwinds around market share saturation and higher competitive intensity for its domestic and overseas business, which have diluted its competitive advantages.

Accounting quality

In the past, Godrej Consumer has reported excellent cash conversion, efficient management of working capital in the domestic business, and reasonable levels of loans and advances and contingent liabilities. However, its working capital management in its international business has been weak.

Capital allocation

GCPL has financed a slew of acquisitions by cutting back on dividend payouts since FY06. Slowing growth, lower profitability and integration issues for these acquisitions has resulted in a dip in GCPL’s RoCE from ~130% in FY05 to 17% in FY14.

Centrality of political connect GCPL is not part of Ambit’s Connected Companies Index and does not appear to rely on political connections.

Treatment of minorities GCPL has cut down on its dividend pay-out in order to finance acquisitions which have deteriorated the RoEs from ~170 in FY05 to 23% in FY14

Succession planning

GCPL is a family owned but professionally managed company. There are slight concerns over the leadership capabilities of the next generation of the promoter family, but the presence of a professional management team gives some comfort.

Total (%)


Godrej Consumer


Balance Sheet (` mn) Year to March FY13 FY14 FY15E FY16E FY17E



Total net worth 33,130 37,754 43,359 49,750 57,000

Minority Interest 2,095 2,251 2,966 3,824 4,853

Debt 19,486 17,017 9,517 3,017 517

Other long term liabilities 273 294 294 294 294

Deferred tax liability (140) (203) (203) (203) (203)


Gross block 21,575 22,511 23,411 24,311 25,211

Net block 15,876 15,689 15,710 15,730 15,748

CWIP 1,409 1,671 1,671 1,671 1,671

Goodwill 29,085 35,525 35,525 35,525 35,525

Investments - 343 343 343 343


Debtors 7,288 7,113 8,438 9,653 10,970

Inventory 10,471 10,821 12,536 14,342 16,298

Loans & advances 3,995 3,769 4,822 5,516 6,268

Other current assets - - - - -



Provisions 585 559 723 827 940



Total assets 54,844 57,113 55,933 56,682 62,461


Income statement (` mn)



% growth 31.7% 18.6% 15.7% 14.4% 13.6%


EBITDA 9,824 11,503 12,972 14,942 17,208

% growth 14.8% 17.1% 12.8% 15.2% 15.2%

Depreciation 770 819 879 880 882

EBIT 9,054 10,685 12,093 14,061 16,326

Interest expenditure 775 1,074 531 251 -

Non-operating income 678 627 690 759 835

Adjusted PBT 8,957 10,238 12,252 14,569 17,161

Tax 1,792 2,104 2,757 3,351 4,119


% growth 15.2% 14.3% 19.7% 18.9% 17.8%

Extraordinaries 1,289 59 - - -


Minority Interest (493) (596) (715) (858) (1,029)

Share of associates - - - - -

Adjusted Consolidated net profit 7,961 7,597 8,781 10,360 12,013


Godrej Consumer


Cash Flow statement (` mn)


EBIT 9,732 11,312 12,783 14,820 17,161

Depreciation 770 819 879 880 882

Others 282 (960) 184 607 1,029

Tax (1,792) (2,104) (2,757) (3,351) (4,119)

(Incr) / decr in net working capital 4,613 3,969 (2,735) 208 226


Capex (9,845) (7,334) (900) (900) (900)

(Incr) / decr in investments - (343) - - -

Others - - - - -

Cash flow from investments (9,845) (7,676) (900) (900) (900)

Net borrowings 717 (2,469) (7,500) (6,500) (2,500)

Interest paid (775) (1,074) (531) (251) -

Dividend paid (1,984) (2,083) (3,175) (3,969) (4,763)

Others 572 (354) (184) (607) (1,029)


Net change in cash 2,289 (620) (3,936) 938 5,986


Free cash flow 3,759 5,702 7,454 12,265 14,279


Ratio Analysis Year to March FY13 FY14 FY15E FY16E FY17E

Gross margin (%) 53.9% 53.2% 53.0% 53.1% 53.2%

EBITDA margin (%) 15.3% 15.1% 14.7% 14.8% 15.0%

EBIT margin (%) 15.2% 14.9% 14.5% 14.7% 15.0%



Net debt: equity (x) 0.3 0.2 0.1 (0.0) (0.2)

Working capital turnover (x) (301.0) NA (60.8) (60.8) (60.8)


RoCE (%) 15.1% 16.1% 17.5% 20.3% 21.9%

RoE (%) 23.4% 23.0% 23.4% 24.1% 24.4%


Valuation Parameter Year to March FY13 FY14 FY15E FY16E FY17E

EPS (`) 19.6 22.2 25.8 30.4 35.3

Diluted EPS (`) 19.6 22.2 25.8 30.4 35.3



P/E (x) 48.1 42.6 36.6 31.0 26.8

P/BV (x) 9.7 8.5 7.4 6.5 5.6

EV/EBITDA (x) 33.8 28.7 25.2 21.4 18.1

Price/Sales (x) 5.0 4.2 3.7 3.2 2.8


Godrej Consumer




Marico’s outstanding performance over the last decade was supported by its market-leading brands, strong distributor relationships and superior HR policies. Since FY14, the company has made changes around: (a) shift in control to a professional management team; (b) a focus on organic expansion to deliver growth; and (c) a new bonus structure for the management team focused on long-term goals. We believe Marico will deliver 17% sales CAGR and 22% EPS CAGR over FY14-18E due to market share gains in Saffola and value added hair oils. RoCE is likely to expand from 17% in FY13 to 43% by FY18E.

A strong player in hair oils and premium edible oils markets Since 1990, Marico has been operating in the niche coconut hair oil (27% of sales) and premium edible oil (15% of sales) category under the Parachute and Saffola brand names respectively. It holds 50%+ market share in each of these categories. Over the last decade, it has entered the high-growth Value added hair oil (VAHO) category (18% of sales) through a mix of organic & inorganic initiatives. Marico currently has a market share of 30% in this category. Strong brands and robust systems and processes give it the edge Through 40 years of investment in brands Marico has developed Parachute and Saffola into strong brands which hold more than 50% market share in their respective product categories despite severe competitive pressures. Marico has a robust pan-India distribution outreach of 4mn outlets backed by best-in-class technical support and processes, making it one of the most-preferred business partners across distributors. Using professional HR systems and processes that are superior to its domestic peers, Marico has fostered a competitive and meritocratic culture amongst employees. This is a key intangible asset and helps underpin the firm’s high-quality middle management team. Renewed focus on driving improvement in RoCE After a series of overseas acquisitions and the acquisition of Paras in India, Marico’s RoCEs halved to 17% in FY13 from 41% in FY08. However, since FY14, the management has realigned its focus on improving RoCEs through prudent capital allocation. Following the demerger of the capital consumptive Kaya business, Marico plans to use surplus cash to increase the dividend payout ratio (which has already been increased to 50% in FY14 from 18% in FY13). We expect RoCE to increase to 43% by FY18 from 17% in FY13. Professional management to lead the company In March 2014, Harsh Mariwala stepped down as the MD, handing over the control to a professional management team led by Saugata Gupta. Mr. Mariwala’s focus on operating Marico in a professional manner since its inception has helped create a senior management team capable of driving the next phase of growth for Marico even in the promoter’s absence. Changes implemented to drive the next leg of growth Since FY14, changes have been made around: (a) shift in control from a promoter-led management team to professionals; (b) management incentive structures, giving greater weightage to long-term growth drivers; and (c) capital deployment focus on organic growth. This should drive 22% EPS CAGR over FY14-18E with RoCE expansion from 17% in FY13 to 43% in FY18E.

COMPANY INSIGHT MRCO IN EQUITY November 17, 2014

MaricoBUY

Consumer

Recommendation Mcap (bn): `201/US$3.3 3M ADV (mn): `97/US$1.6 CMP: `314 TP (12 mths): `313 Upside (%): 0

Flags Accounting: AMBER Predictability: AMBER Treatment of Minorities: AMBER

Catalysts

Increase in dividend payout ratio

Strong volume growth with market share gains in VAHO and Saffola

Lower input cost inflation especially for copra

Performance


200230260290320350

20,000 22,000 24,000 26,000 28,000 30,000

Nov

13

Jan

14

Mar

14

May

14

Jul 1

4

Sep

14

Nov

14

Sensex Marico (RHS)



Key financials Year to March FY13 FY14 FY15E FY16E FY17E


EBITDA (` mn) 6,258 7,480 8,809 10,555 12,668

EBITDA Margin (%) 13.6% 16.0% 16.3% 16.8% 17.3%

Adjusted EPS (`) 5.6 7.5 9.2 11.1 13.4

RoE (%) 17.1% 21.5% 31.5% 36.6% 41.0%

P/E (x) 45.0 33.6 27.5 22.8 18.9


Marico


Exhibit 1: Revenue has recorded a CAGR of 19% over FY05-14 with EBITDA margin expansion of 720bps


Exhibit 2: Return ratios expanded over FY05-08 but contracted sharply thereafter due to a series of acquisitions


Exhibit 3: Cash generated from operations for Marico (FY05-13)…

Source: Company, Ambit Capital research. Note: Size of the pie represents cumulative funds raised (through various sources such as CFO, equity, debt, etc) and spent (on capex, debt repayment, interest, dividend paid, etc) over FY04-13.

Exhibit 4: …has gone to fund low-margin international expansion


Exhibit 5: Marico P/E band chart for the last 7 years


Exhibit 6: Marico EV/EBITDA band chart for the last 7 years


8.0%9.0%10.0%11.0%12.0%13.0%14.0%15.0%16.0%17.0%

8,00013,00018,00023,00028,00033,00038,00043,00048,00053,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenues (Rs mn) EBITDA margin (%) RHS

15.0%

25.0%

35.0%

45.0%

55.0%

65.0%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoCE RoE

CFO, 62%Proceeds

from shares, 14%

Debt raised, 21%

Interest received,

2%

Dividend received,

1%Debt

repayment3%

Dividend paid10%

Interest paid6%

Net Capex (incl.

international

acquisitions72%


-Subsidiaries

& Others4%


cash equivalents

5%

0

50

100

150

200

250

300

350

Nov

-07

Nov

-08

Nov

-09

Nov

-10

Nov

-11

Nov

-12

Nov

-13

Nov

-14

14x

30x26x

22x18x

0

50

100

150

200

250

300

350

Nov

-07

Nov

-08

Nov

-09

Nov

-10

Nov

-11

Nov

-12

Nov

-13

Nov

-14

8x

12x

16x

20x

24x

Marico




Accounting AMBER

In the past, Marico has reported strong cash conversion, effective management of working capital and low levels of loans and advances. But it still ranks lower than the overall FMCG average, as it runs the risk of contingent liabilities related to excise duty evasion on its coconut oil sales (representing ~30% of total equity) working against it.


Marico is strongly influenced by commodity price volatility which largely impacts the growth rate of its coconut oil portfolio. However, with improving inventory management and strong brand equity for Parachute, Marico has over the years improved its ability to manage copra price volatility. This has improved its volume and margin predictability particularly for the domestic business. Predictability of the international business performance (~25% of sales) still remains poor.


In the past, Marico has done capital misallocation by pursuing unprofitable overseas acquisitions and diversifying into the ‘Kaya Skin Clinic’ business in 2002. During this period, return ratios were impacted, as RoEs came down from 63% in FY08 to only 23% in FY13. However, during our recent discussions, the management clearly said that it would avoid acquisitions in the near term and drive growth through the organic route. This should drive a pickup in RoEs to ~46% by FY18.


Exhibit 8: Marico Limited – ‘Three-quarters of the pie’ on our STAR* framework



Marico has competitive advantages around: a) strong brand equity of Parachute and Saffola, b) 4mn widespread distribution and is seen by distributors as one of the most preferred business partner and c) Superior HR policies which have fostered a competitive and meritocratic work culture.

Accounting quality

Marico’s accounting quality is poorer than its FMCG peers. Specifically, we have concerns around the company’s low cash conversion ratio ratios, poor FCF, higher proportion of contingent liabilities and lower proportion of auditor fees as a percentage of sales vs its FMCG peers.

Capital allocation Increasing focus on organic growth and higher dividend payout ratio is a step in the right direction for capital allocation. However, previous low RoCE acquisitions continue to depress the consolidated RoCE.

Centrality of political connect Marico is not part of Ambit’s Connected Companies Index and does not appear to rely on political connections.

Treatment of minorities Marico has a strong track record in corporate governance.

Succession planning The promoter recently stepped down in favour of a professional CEO. Harsh Mariwala’s son Rishabh is independently pursuing his venture and is not involved with Marico. Though, at a later stage, Rishabh’s involvement with Marico cannot be ruled out.

Total (%)

Source: Company, Ambit Capital research. Note: = rating of 4/4; = rating of 3/ 4 and so on *STAR: Sustainable and Tenable Advantages Rank.

Marico


Balance sheet (consolidated) (` mn)




Total networth 19,815 13,606 15,598 18,177 21,372

Minority Interest 351 358 508 658 808

Debt 7,907 5,259 3,259 1,259 -

Deferred tax liability 58 96 96 96 96


Gross block 17,009 9,634 10,634 11,634 12,634

Net block 12,748 6,334 6,616 6,858 7,062

CWIP 1,477 44 44 44 44

Goodwill 3,955 2,543 2,543 2,543 2,543

Investments 1,516 3,105 3,105 3,105 3,105


Debtors 1,966 2,232 2,733 3,174 3,695

Inventory 8,627 7,962 9,110 10,581 12,318

Loans & advances 2,555 1,474 1,822 2,116 2,464

Other current assets 1,562 1,892 2,278 2,645 3,080



Provisions 1,214 857 1,518 1,763 2,053 Total current liabilities 8,941 10,330 12,147 14,107 16,424


Total assets 28,131 19,319 19,461 20,190 22,276


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


% growth 14.7% 2.0% 18.3% 16.1% 16.4%


EBITDA 6,258 7,480 8,822 10,825 12,977

% growth 29.2% 19.5% 17.9% 22.7% 19.9%

Depreciation 866 769 718 758 796

EBIT 5,392 6,711 8,104 10,067 12,182



Adjusted PBT 5,187 6,946 8,447 10,478 12,720

Tax 1,462 1,905 2,365 2,986 3,752


% growth 15.0% 35.3% 20.6% 23.2% 19.7%

Extraordinaries 332 - - - -


Minority Interest 98 187 150 150 150

Share of associates - - - - - Adjusted Consolidated net profit 3,959 4,854 5,932 7,342 8,817

Reported Consolidated net profit 3,959 4,854 5,932 7,342 8,817


Marico


Cash flow statement (consolidated) (` mn)


EBIT 5,767 7,290 8,703 10,614 12,757

Depreciation 866 769 718 758 796

Others (295) (487) (256) (136) (38)

Tax (1,462) (1,905) (2,365) (2,986) (3,752) (Incr) / decr in net working capital (201) 2,538 (566) (613) (724)


Capex (10,072) 7,078 (1,000) (1,000) (1,000) (Incr) / decr in investments 1,440 (176) - - -

Others - - - - - Cash flow from investments (8,632) 6,902 (1,000) (1,000) (1,000)

Net borrowings 278 (2,648) (2,000) (2,000) (1,259)

Interest paid (580) (345) (256) (136) (38)

Dividend paid (749) (2,632) (3,458) (4,280) (5,140)

Others 6,088 (8,086) (226) (346) (444) Cash flow from financing 5,036 (13,711) (5,940) (6,762) (6,881)

Net change in cash 1,079 1,397 (706) (125) 1,158


Free cash flow (5,397) 15,284 5,234 6,637 8,039


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

Gross margin (%) 51.9% 48.8% 48.8% 49.7% 50.1%

EBITDA margin (%) 13.6% 16.0% 15.9% 16.8% 17.3%

EBIT margin (%) 12.5% 15.6% 15.7% 16.5% 17.0%



Net debt: equity (x) 0.3 0.1 (0.0) (0.1) (0.2)



RoCE (%) 17.1% 21.5% 31.5% 37.5% 41.7%

RoE (%) 23.2% 29.0% 40.6% 43.5% 44.6%


Valuation parameters (consolidated) Year to March FY13 FY14 FY15E FY16E FY17E

EPS (`) 5.6 7.5 9.2 11.4 13.7

Diluted EPS (`) 5.6 7.5 9.2 11.4 13.7



P/E (x) 55.8 41.7 34.1 27.6 23.0

P/BV (x) 9.7 14.2 12.4 10.6 9.0

EV/EBITDA (x) 33.2 27.2 22.9 18.5 15.3

Price/Sales (x) 4.4 4.3 3.7 3.1 2.7


Marico




Key financials – standalone (` mn)


Net Sales 33,464 38,697 44,753 52,672 61,986

EBITDA 3,712 4,314 5,206 6,180 7,458

EBITDA (%) 11.1% 11.1% 11.6% 11.7% 12.0%

EPS (`) 6.3 7.2 8.7 11.0 13.9

RoE (%) 22.9% 24.1% 24.7% 26.5% 28.1%

RoCE (%) 18.6% 17.4% 18.3% 21.1% 24.5%

P/E (x) 57.4 50.3 41.8 33.0 26.0


Berger has retained its #2 position in a highly competitive paints industry over the past five years through: (a) expansion of dealer/depot network; (b) increased width and depth of its product portfolio; (c) renewed focus on premiumising its product portfolio; and (d) IT investments to improve distribution efficiencies. We expect Berger to deliver 17% revenue CAGR and 24% EPS CAGR over FY14-18, with market share gains from Kansai and Akzo. Berger establishes itself as India’s #2 paints player Berger Paints is the second-largest manufacturer of decorative paints in India, with a market share of ~17%. The firm was established in 1923 and has gone through several ownership changes since then. However, since 1991, a majority stake in the company has been owned by UK Paints Group led by the Delhi based Dhingra brothers. The company’s key sub-brands include Luxol, Bison, Rangoli, Weathercoat, Silk and Breathe Easy. Initiatives taken to bridge the gap with Asian Paints Berger’s competitive advantages include: (a) a strong focus on product innovation (like Designer Finishes, Easy Clean, and Weathercoat All Guard) with Berger being the first company to launch tinting machines; (b) several decades old relationships with institutional buyers and dealers for economy products; and (c) focused IT investments to drive supply chain efficiencies. Whilst these competitive advantages are sustainable against its peers like Kansai Nerolac and Akzo Nobel, we expect Asian Paints to outperform Berger in supply chain efficiencies. Prudent capital allocation Berger’s capital allocation over the past decade has either been used to expand core capacities, pay dividends or de-leverage the balance sheet. The firm has refrained from making large non-core acquisitions which could have jeopardised longer-term RoCEs. We believe RoCEs will revive to 27% by FY18 from an average of 18% over FY09-14 due to an increase in asset turns from 2.2x in FY14 to 3.0x in FY19. Professionally-run organisation with limited promoter involvement The promoter group follows a ‘hands-off’ approach and is involved in only strategic decision-making. Strategy execution at the ground level is completely managed by professionals and this has helped nurture an entrepreneurial management team over the past 20 years. Whilst members of the promoter family occupy certain junior managerial positions, we believe that operational control will remain in the hands of professionals. What is being done to strengthen the franchise further? The company is implementing the following initiatives to strengthen its franchise: (a) a better incentivised sales team to help expand the dealer network; (b) IT-related investments to enable centralised MIS, which will help improve supply chain efficiencies; and (c) branding investments in premium products like Berger Silk. These initiatives will help Berger gain market share from Akzo and Kansai in the future.

COMPANY INSIGHT BRGR IN EQUITY November 17, 2014

Berger PaintsSELL

Consumer discretionary: Paints


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

Catalysts Positive impact of recent marketing

and distribution initiatives

Improvement in FCF generation in

FY15

Performance

Source: Bloomberg, Ambit Capital research.

200

300

400

500

18,000

20,500

23,000

25,500

28,000

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Sensex Berger Paints (RHS)

Analyst Details



Berger Paints














8%

9%

10%

11%

12%

13%

-

10,000

20,000

30,000

40,000

50,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14


20%

25%

30%

35%

40%

15%

17%

19%

21%

23%

25%

27%

29%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoCE RoE (% RHS)

CFO, 60%

Proceeds from

shares, 7%

Debt raised, 29%

Interest received,

4%

Dividend received,

0%

Debt repayment,

3%Dividend paid, 17%

Interest paid, 10%

Net Capex, 58%

Purchase of

Investments , 4%


cash equivalents

, 8%

-

5

10

15

20

25

30

35

Apr

-05

Oct

-05

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

BRGR P/E 6 Yr Avg 4 Yr Avg

- 1 2 3 4 5 6 7 8

Apr

-05

Oct

-05

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

BRGR P/B 6 Yr Avg 4 Yr Avg

Berger Paints




Accounting AMBER Whilst Berger scores well on cash conversion, related party advances and return on surplus cash, its working capital cycle (65-70 days) and RoEs (~25%) are inferior relative to Asian Paints (working capital cycle of 12-14 days and RoEs of 38-40%).

Predictability AMBER Although the macro demand for paints in India is not very volatile across economic cycles, the low pricing power of Berger Paints in the industry results in volatility of EPS growth over time.

Treatment of minorities GREEN Our accounting analysis does not raise any major concerns around dubious transactions by promoters. Berger

has been in a capex mode for the last four years and has allocated surplus cash towards its core operations.


Exhibit 8: Berger Paints – ‘Three-quarters of the pie’ on our STAR* framework


Competitive advantage Product innovation, relationships with institutional buyers and dealers is the key strength. However the supply chain benefits lag Asian Paints.

Accounting quality Whilst Berger scores well on cash conversion, related party advances and return on surplus cash, its working capital cycle and RoEs are inferior relative to Asian Paints.

Capital allocation Prudent capital allocation for core capex, payment of dividends or deleveraging company

Centrality of political connect Berger is not part of Ambit’s Connected Companies Index and does not appear to have any questionable political connections

Treatment of minorities No major concerns around dubious transactions by promoters and capital allocation.

Succession planning Promoters follow “hands off” approach. Members of promoter family occupy managerial positions, however operational control to remain with professional management team.

Total (%)


Berger Paints






Total net worth 9,532 11,207 13,070 15,574 18,774

Debt 5,497 6,235 5,835 4,235 2,235



Gross block 9,795 13,220 14,220 15,220 16,220

Net block 6,040 8,638 8,792 8,992 9,173

CWIP 1,674 1,333 500 500 500

Investments (non-current) 108 907 907 907 907


Debtors 4,114 4,857 5,617 6,466 7,440

Inventory 6,364 6,957 8,045 9,325 10,804

Loans & advances 1,194 1,301 1,504 1,770 2,083



Provisions 922 1,081 1,250 1,472 1,732



Total assets 15,436 17,980 19,444 20,347 21,547



Net Sales 33,464 38,697 44,753 52,672 61,986

% growth 14% 16% 16% 18% 18%


EBITDA 3,712 4,314 5,206 6,180 7,458

% growth 22% 16% 21% 19% 21%

Depreciation 567 707 845 801 819

EBIT 3,145 3,607 4,360 5,379 6,640



Adjusted PBT 3,082 3,500 4,283 5,430 6,888

Tax 898 1,006 1,285 1,629 2,066

Adjusted PAT 2,184 2,494 2,998 3,801 4,821 Extraordinary expense/(income) 0 0 0 0 0



Berger Paints





Depreciation 567 707 845 801 819

Others (1,222) (1,315) (1,364) (1,772) (2,185)

Tax (843) (1,022) (1,285) (1,629) (2,066) (Incr)/decr in net working capital (2,049) (2,049) (2,049) (2,049) (2,049)


Capex (net) (2,179) (2,431) (167) (1,000) (1,000)

(Incr)/decr in investments (92) (803) - - -

Other income (expenditure) 230 220 - - - Cash flow from investments (2,041) (3,014) (167) (1,000) (1,000)

Net borrowings 2,080 525 (400) (1,600) (2,000)

Interest paid (327) (424) (400) (257) (138)

Dividend paid (484) (619) (1,135) (1,297) (1,622)

Cash flow from financing 1,281 (499) (1,935) (3,154) (3,760)

Net change in cash 446 (429) 1,703 (16) 223


Free cash flow (974) 653 3,638 3,138 3,982



EBITDA margin (%) 12.0% 12.1% 12.5% 12.6% 12.8%

EBIT margin (%) 10.3% 10.2% 10.6% 11.1% 11.5%

Net prof. margin (%) 6.5% 6.4% 6.7% 7.2% 7.8%


Net debt: equity (x) 0.3 0.4 0.2 0.0 (0.1)



RoCE (pre-tax) (%) 26.2% 24.4% 26.2% 30.1% 35.0%

RoIC (%) 23.9% 21.5% 22.1% 25.7% 29.8%

RoE (%) 25.0% 24.1% 24.7% 26.5% 28.1%




Diluted EPS (`) 6.3 7.2 8.7 11.0 13.9



P/E (x) 57.4 50.3 41.8 33.0 26.0

P/BV (x) 2.6 2.2 1.9 1.6 1.3

EV/EBITDA (x) 32.5 28.2 23.4 19.6 16.0

EV/EBIT (x) 37.8 33.2 27.6 22.2 17.9


Berger Paints




Key financials – standalone (` mn) Year to March FY13 FY14 FY15E FY16E FY17E Net Sales 8,758 11,876 15,567 20,267 26,177 EBITDA 1,766 2,511 3,323 4,358 5,647 EBITDA (%) 20.2 21.1 21.3 21.5 21.6 EPS (`) 100.9 137.8 182.5 243.5 318.7 RoE (%) 59.3 61.2 60.8 61.5 61.0 RoCE (%) 42.4 41.9 44.8 49.4 51.1 P/E (x) 96.8 70.8 53.5 40.1 30.6


Over the last 20 years, Page Industries has successfully transformed the ‘Jockey’ brand into a market leader in the fast-growing, organised innerwear segment. Jockey’s highly aspirational brand image has been built by consistent delivery of comfortable, durable and affordable products. Page is likely to outperform its peers over FY14-20 amidst a strong macro tailwind for mid-premium innerwear through: (a) backward integrated manufacturing (delivering high-quality product at affordable prices); and (b) aggressive distribution expansion along with an aspirational brand recall for ‘Jockey’. We build in 28% revenue CAGR and 29% earnings CAGR over FY14-20E with RoEs of ~60% over this period.

Dominated India’s mid-premium innerwear over 1995-2014 Page Industries commenced operations in India in 1995 in the mid and premium category of the innerwear segment under the brand name, ‘Jockey’. The company has market share of ~20% in men's mid/premium innerwear and ~4% in women's mid/premium innerwear segments. It is the largest player in the organised innerwear space in India. Competitive advantages include manufacturing, distribution and brand Page has generated revenue CAGR of 36% & earnings CAGR of 38% over FY06-14 with an average RoE of 58% over this period through a combination of three key competitive advantages. Firstly, its backward-integrated manufacturing process gives it better control on the quality and commerciality of product development. This is difficult to replicate as it is highly labour-intensive and calls for regular hiring, training and retention of a skilled workforce. Secondly, an aggressive distribution franchise, built over 20 years, enables Page to create push-based demand. And thirdly, its aggressive advertising focuses on maintaining an aspirational brand recall for ‘Jockey’. Prudent capital allocation approach adopted historically Given the long-term growth potential in innerwear, the management does not intend to invest in non-core businesses over the foreseeable future. The surplus capital generated is utilised for core capex (41% of cash generated) and the rest has been returned to shareholders (49% of cash generated) through an average dividend payout ratio of 56% over FY05-14. Promoter’s son is actively involved in R&D and strategic decision-making Although Page’s promoters are a part of the executive senior management team, decision-making at a functional level is carried out in an independent and professional manner. Mr. Sunder Genomal, Managing Director, is 60 years old and his son, Mr. Shamir Genomal, is the Chief Strategy Officer and he also heads the R&D and product innovation function. Initiatives underway to strengthen R&D, distribution and branding To strengthen Page’s R&D capabilities, the company recently hired two senior executives, Ms. Shelagh Margaret Commons (experienced in global innerwear industry) and Mr. Nihal Rajan (ex-Levi Strauss & Co). Two key initiatives are underway in distribution: (a) rapid expansion of exclusive brand outlets to help push new SKUs into multi-brand outlets; and (b) IT investments to help track sales of products from distributors to retailers. The firm is also stepping up its investment behind advertisements (spends to record 30% CAGR in FY14-18 vs 16% CAGR over FY10-14) to expand its presence into new categories like leisurewear. The firm is also working on expanding the e-commerce sales channel.

COMPANY INSIGHT PAG IN EQUITY November 17, 2014

Page IndustriesBUY

Consumer Discretionary

Recommendation Mcap (bn): `109/US$1.8 3M ADV (mn): `88/US$1.4 CMP: `9,796 TP (12 mths): `9,265 Downside (%): 5


Catalysts Robust sales growth during FY15

despite a weak macro for demand

Successful rollout of new products

New advert campaign on TV/ print

media

Performance


4000

5000

6000

7000

8000

9000

18,000

20,000

22,000

24,000

26,000

28,000

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Sensex Page Industries (RHS)



Page Industries














10%

12%

14%

16%

18%

20%

22%

-

3,000

6,000

9,000

12,000

15,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14


30%

60%

90%

120%

20%

30%

40%

50%

60%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoCE RoE (% RHS)

CFO, 67%

Proceeds from

shares, 9%

Debt raised, 23%

Interest received,

2%

Dividend received,

0%

Debt repayment,

1%

Dividend paid, 49%

Interest paid, 7%

Net Capex, 43%


, -1%


cash equivalents,

1%

- 5

10 15 20 25 30 35 40

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

PAG P/E 6 Yr Avg 4 Yr Avg

-

5

10

15

20

25

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

PAG P/B 6 Yr Avg 4 Yr Avg

Page Industries




Accounting GREEN Page Industries' cash conversion has remained healthy, resulting in cumulative CFO (pre-tax)/EBITDA of more than 72% in FY05-14. Page has maintained effective control on the working capital cycle, and hence despite high sales growth, working capital days have increased marginally from 63 days in FY09 to 69 days in FY14.

Predictability GREEN The underpenetrated nature of the industry, the growth of the middle class and continued efforts by management have enabled Page (with its strong brand franchise) to deliver consistent performance. Page has delivered growth of above 25% YoY consistently in both revenues and net profits over the last eight years.

Treatment of minorities 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.


Exhibit 8: Page Industries gets a ‘Full pie’ on our STAR* framework


Competitive advantage Near monopoly within its segment, with efficient inhouse manufacturing despite it being labour intensive and complete control over product development, strong brand and well-incentivised dealer network.

Accounting quality Superior accounting quality as compared to peers.

Capital allocation Cash-generative business; management has maintained financial discipline and a high dividend payout.

Centrality of political connect Page is not part of Ambit’s Connected Companies Index and does not appear to have any questionable political connections.

Treatment of minorities Promoters have a very small and non-competing apparel business in India, but good overall track record of corporate governance.

Succession planning Promoter family members occupying managerial position alongside professional management team. Although no formal succession plan is formulated the function specific control is likely to be with the professional management

Total (%)


Page Industries






Total net worth 2,135 2,890 3,806 5,028 6,628

Debt 1,007 1,632 1,162 1,322 1,262



Gross block 1,860 2,404 3,125 3,917 4,712

Net block 1,322 1,728 2,272 2,845 3,377

CWIP 138 36 36 36 36


Cash & cash equivalents 46 35 34 39 34

Debtors 581 727 853 1,111 1,434

Inventory 2,350 3,626 3,796 4,942 6,383

Loans & advances 130 328 426 555 717



Provisions 216 241 256 333 430



Total assets 3,199 4,617 5,063 6,445 7,985



Net Sales 8,758 11,876 15,567 20,267 26,177

% growth 26% 36% 31% 30% 29%


EBITDA 1,766 2,511 3,323 4,358 5,647

% growth 21% 42% 32% 31% 30%

Depreciation 114 139 176 219 262

EBIT 1,652 2,372 3,147 4,138 5,384



Adjusted PBT 1,657 2,334 3,085 4,115 5,386

Tax 531 797 1,049 1,399 1,831

Adjusted PAT 1,125 1,537 2,036 2,716 3,555

Extraordinary expense/(income) - - - - -



Page Industries





Depreciation 114 139 176 219 262

Others 74 67 62 23 (2)

Tax -516 -750 -1,049 -1,399 -1,831

(Incr)/decr in net working capital -457 -1,051 98 -805 -1,012

Cash flow from operations 871 740 2,372 2,154 2,803

Capex (net) -449 -473 -721 -792 -795

(Incr)/decr in investments 7 19 - - -


Cash flow from investments -419 -441 -643 -691 -664

Net borrowings 238 543 -470 160 -60

Interest paid (80) (97) (140) (124) (129)

Dividend paid (596) (756) (1,120) (1,494) (1,955)

Cash flow from financing -438 -310 -1,730 -1,458 -2,144

Net change in cash 14 -11 0 5 -5

Closing cash balance 46 35 34 39 34

Free cash flow 430 280 1,729 1,463 2,139



EBITDA margin (%) 20.2% 21.1% 21.3% 21.5% 21.6%

EBIT margin (%) 18.9% 20.0% 20.2% 20.4% 20.6%

Net prof. margin (%) 12.8% 12.9% 13.1% 13.4% 13.6%


Net debt: equity (x) 0.5 0.6 0.3 0.3 0.2



RoCE (pre-tax) (%) 62.5% 63.6% 68.0% 74.9% 77.5%

RoIC (%) 42.8% 41.4% 43.5% 48.1% 49.8%

RoE (%) 59.3% 61.2% 60.8% 61.5% 61.0%


Valuation parameters (standalone) Year to March FY13 FY14 FY15E FY16E FY17E

Diluted EPS (`) 100.9 137.8 182.5 243.5 318.7



P/E (x) 96.8 70.8 53.5 40.1 30.6

P/BV (x) 51.0 37.7 28.6 21.7 16.4

EV/EBITDA (x) 62.2 44.0 33.1 25.3 19.5

EV/EBIT (x) 66.5 46.6 35.0 26.6 20.5


Page Industries




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

Net Revenues (` mn) 28,131 32,818 35,387 42,185 50,098

Operating Profits 4,876 6,575 7,154 8,931 10,304

Net Profits 3,686 5,333 5,226 6,573 7,615

Diluted EPS 29.2 42.3 41.4 52.1 60.3

RoE (%) 23.0 27.2 24.1 24.8 23.6

P/E (x) 25.0 17.3 17.7 14.0 12.1


IPCA has built an enviably profitable and growing franchise in the India and export market by playing to its strengths. The company’s sustainable competitive advantage is around innovation and cost management. It has innovated around manufacturing processes and formulations such that the product is more cost-efficient and patient-friendly. This has aided IPCA in building brand equity in front of Indian doctors. At the same time, IPCA has managed costs efficiently, as reflected by its consistent RoCE. Brand IPCA is showcased through various publications in medical journals like Lancet and through its dominance in therapy areas like malaria and pain in India. Market domination in segment like malaria and rheumatology IPCA currently manufactures 350 formulations and 80 APIs across various therapeutic segments and sells in India (38% of sales in FY14), regulated markets (20%) and emerging markets (25%). IPCA is an emerging player in most geographies and it dominates in segments like malaria (34% market share) and rheumatology (46% market share) in India. Innovation and established brand - the key competitive advantages IPCA’s excellence in process re-engineering, innovation in formulations, established brand in front of doctors, relationship with regulators and cost leadership are its key competitive advantages. Its cost competitiveness may decline over time, but as the company scales up the value chain, the other factors are likely to sustain (the key factor being ‘brand’). IPCA has been able to sustain RoCE and RoE of >15% led by high cash generation and rational capital allocation owing to tight working capital investment and low capex. Prudent capital allocation as evidenced by strong EBITDA margins Rational capital allocation has been IPCA’s forte, as evidenced by its comparable gross and EBITDA margins vs its peers despite owning plain-vanilla products. The company has spent 60.3% of its cash on capex aimed at increasing manufacturing capacity and vertical integration. The gross block turnover has remained stable at ~1.9x over the last decade, indicating that investments in capex have yielded sales. IPCA pays ~15% of its profits (at par with peers) as dividend, consistently ploughing back most of the profits. No management transition in sight IPCA has not hired any external talent in the top management in the past decade and continues to be a promoter-run business. The first-generation entrepreneur, Mr. Premchand Godha, still plays an active role in execution whilst his sons, Mr. Pranay Godha (Head of exports) and Prashant Godha (Head of domestic business), are now well entrenched in the company. We believe a management transition is not in sight. Higher focus on R&D spend and innovation through 505(b)2 ventures Whilst it continues to strengthen its regulatory ties and maintains its intense cost focus, IPCA has become more growth-oriented since the second generation of the Godha family has taken over. We see higher focus on R&D spend and scaling up the value chain and an end to the legacy of vertical integration in every product. The company’s 505(b)2 ventures in the US also show that it is looking to derive more out of its innovation capabilities.

COMPANY INSIGHT IPCA IN EQUITY November 17, 2014

IPCA LaboratoriesBUY

Healthcare


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

Catalysts

Award of tenders in Africa in the near term

Progress on 505(b)(2) projects in FY16

Progress on resolution of FDA issues by FY16

Performance


600650700750800850900

20,000 21,500 23,000 24,500 26,000 27,500 29,000

Nov

-13

Dec

-13

Jan-

14M

ar-1

4A

pr-1

4M

ay-1

4Ju

n-14

Jul-

14

Sep-

14O

ct-1

4Sensex Ipca, RHS

Analyst Details

Aditya Khemka +91 22 3043 3272 [email protected]

Paresh Dave, CFA +91 22 3043 3212 [email protected]

IPCA Laboratories






Exhibit 3: Sources of funds over the last ten years (FY03-14)


Exhibit 4: Utilisation of funds over the last ten years (FY03-14)






0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenue growth Operating margins, RHS

10%

15%

20%

25%

30%

35%

40%

10%

15%

20%

25%

30%

35%

40%

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoCE RoE, RHS

CFO, 71.8%

Proceeds from

shares, 0.0%

Debt raised, 26.1%

Interest received,

1.8%Dividend received,

0.2%

Net Capex, 60.3%

Purchase of

investment, 1.6%

Debt repayment

, 15.9%

Dividend paid, 12.0%

Interest paid, 8.2%


cash equivalent,

2.1%

0

5

10

15

20

25

Mar

-05

Sep-

05

Mar

-06

Sep-

06

Mar

-07

Sep-

07

Mar

-08

Sep-

08

Mar

-09

Sep-

09

Mar

-10

Sep-

10

Feb-

11A

ug-1

1Fe

b-12

Aug

-12

Feb-

13A

ug-1

3Fe

b-14

Aug

-14

IPCA P/E 6 yr avg 4 yr avg

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Mar

-05

Sep-

05

Mar

-06

Sep-

06

Mar

-07

Sep-

07

Mar

-08

Sep-

08

Mar

-09

Sep-

09

Mar

-10

Sep-

10

Feb-

11A

ug-1

1Fe

b-12

Aug

-12

Feb-

13A

ug-1

3Fe

b-14

Aug

-14

IPCA P/B 6 yr avg 4 yr avg

IPCA Laboratories




Accounting GREEN

In our forensic analysis of 360 companies, IPCA scores above the pharma industry average (comprising 26 companies). IPCA scores high on ratios of: (a) cash yield; (b) fixed asset turnover; (c) contingent liabilities and (d) change in depreciation rates. However, IPCA has weaker scores on: (a) CFO / EBITDA; and (b) provisioning for debtors outstanding for more than six months.


Overall, the management has made appropriate disclosures in its earnings calls, meetings and interviews regarding product filings, acquisitions and business outlook. However, the unpredictability of the institutional generics, US business (post Ratlam and Indore FDA Form 483s) and API business makes us assign AMBER on predictability.

Treatment of minorities GREEN We have no evidence of IPCA mistreating the minorities.


Exhibit 8: IPCA Labs — ‘Full pie’ on our STAR* framework


Competitive advantages Excellence in innovation in formulations, established brand and cost leadership

Accounting quality IPCA is in the top quartile among peers on this criteria.

Capital allocation Rational capital allocation has been IPCA’s forte, as evidenced by its comparable gross and EBITDA margins vs its peers despite owning plain-vanilla products

Centrality of political connect IPCA is not part of Ambit’s Connected Companies Index and does not appear to rely on political connections.

Treatment of minorities We have no evidence of IPCA mistreating the minorities.

Succession planning The first-generation entrepreneur still plays an active role in execution whilst his sons are now well entrenched in the company.

Total (%) Sustainable low cost advantage and high focus on brand equity and cash flow generation


IPCA Laboratories


Balance sheet (consolidated)


Total Assets 26,970 32,103 37,234 43,554 50,783

Fixed Assets 12,334 15,185 18,902 22,321 23,015

Current Assets 14,545 16,827 18,240 21,142 27,676

Investments 90 92 92 92 92

Total Liabilities 26,970 32,103 37,234 43,554 50,783


Reserves and Surplus 15,285 19,344 23,592 28,935 35,124

Total net worth 15,538 19,597 23,844 29,187 35,377

Total debt 6,170 6,026 6,026 6,026 6,026





Net revenues 28,131 32,818 35,387 42,185 50,098

% growth 19.3% 16.7% 7.8% 19.2% 18.8%

Operating Expenditure 21,899 24,712 27,276 32,164 38,063

Core EBITDA 6,232 8,106 8,111 10,020 12,035

% growth 21.4% 30.1% 0.1% 23.5% 20.1%

Depreciation 867 1,031 1,283 1,581 1,805

Interest expense 334 269 262 262 262

Adjusted PBT 5,031 6,806 6,565 8,176 9,967

Tax 1,345 1,472 1,339 1,603 2,352

Reported net profit 3,686 5,333 5,226 6,573 7,615


Cash flow statement (consolidated)


PBT 4,543 6,306 6,891 8,668 10,041

Depreciation 867 1,031 1,283 1,581 1,805

Tax 916 1,305 1,665 2,095 2,427

Net Working Capital (1,444) (1,041) (158) (1,779) (2,169)

CFO 3,445 5,346 6,479 6,505 7,475

Capital Expenditure (2,993) (3,924) (5,000) (5,000) (2,500)

Investment 250 - - - -

Other investments 119 111 134 134 38

CFI (2,624) (3,813) (4,866) (4,866) (2,462)

Issuance of Equity 3 - - - -

Inc/Dec in Borrowings 442 (282) - - -

Net Dividends (468) (661) (978) (1,230) (1,425)

Other Financing activities (339) (306) (262) (262) (262)

CFF (361) (1,361) (1,241) (1,493) (1,688)

Net change in cash 460 171 372 146 3,326

Free Cash Flow 452 1,422 1,479 1,505 4,975


IPCA Laboratories


Ratio analysis (consolidated)


Revenue growth 19.3 16.7 7.8 19.2 18.8

Core EBITDA growth 21.4 30.1 0.1 23.5 20.1

APAT growth 16.3 44.7 (2.0) 25.8 15.8

EPS growth 16.2 44.6 (2.0) 25.8 15.8

Core EBITDA margin 22.2 24.7 22.9 23.8 24.0

EBIT margin 17.3 20.0 20.2 21.2 20.6

Net profit margin 13.1 16.3 14.8 15.6 15.2

ROCE (%) 26.6 27.2 30.6 25.6 27.3

Reported RoE (%) 23.0 27.2 24.1 24.8 23.6

Debt Equity ratio (X) 0.4 0.3 0.3 0.2 0.2

Current Ratio 3.8 3.5 3.2 3.2 3.6

CFO/EBITDA (x) 0.6 0.7 0.8 0.6 0.6

Gross Block turnover (x) 1.8 1.7 1.5 1.5 1.6

Working Capital Turnover (x) 2.6 2.7 2.8 2.9 2.5


Valuation parameters (consolidated) Year to March FY13 FY14 FY15E FY16E FY17E

EPS 29.2 42.3 41.4 52.1 60.3

Book Value ( per share) 123.1 155.3 188.9 231.3 280.3

P/E (x) 25.0 17.3 17.7 14.0 12.1

P/BV (x) 5.9 4.7 3.9 3.2 2.6

EV/EBITDA(x) 15.7 12.0 12.0 9.7 8.1

EV/Sales (x) 3.5 3.0 2.8 2.3 1.9

EV/EBIT (x) 20.0 14.8 13.6 10.9 9.5


IPCA Laboratories




Key financials (` mn) Year to March FY10 FY11 FY12 FY13 FY14

Total income 1,270 1,570 1,960 2,400 2,980

PAT 690 920 1,200 1,460 1,770

RoA (%) 2.7% 3.1% 3.2% 3.0% 2.8%

RoE (%) 28.4% 31.6% 34.1% 33.3% 32.2%

EPS (`) 1.9 2.5 3.3 4.0 4.9

BVPS (̀ ) 7.3 8.8 10.6 13.5 16.7

P/E (x) 122.2 91.6 70.2 57.7 47.6

P/B (x) 31.8 26.5 21.8 17.2 13.9


HDFC’s parentage and GRUH’s deep hinterland penetration underpin GRUH’s access to lower cost of funding, superior sourcing of low ticket customers, lower credit costs and low opex. High profitability (average RoEs of ~28%) along with a robust loan growth (average growth of ~28%) over the past ten years demonstrates the strength of GRUH’s competitive advantages.

Play on the rural mortgage opportunity Set up in 1986, GRUH is a subsidiary of HDFC (which owns 59% in GRUH). It provides housing loans in rural and semi-urban areas, operating primarily in the Gujarat and Maharashtra, which account for 72% of its loan book. With a modest loan book of ~`79bn, GRUH accounts for less than 1% market share in mortgages and has averaged loan growth of ~28% over FY05-14, making it a promising play on the rural mortgage opportunity in India. Parentage and deep penetration drive competitive advantages GRUH’s competitive advantages are built on: (i) HDFC’s parentage which enables it to get a better rating and hence lower cost of funding, and (ii) Local area knowledge through deep penetration (~80-95% of talukas in Maharashtra and Gujrat over past 20 years) have enabled superior sourcing of low ticket customers (whilst ~86% of GRUH’s loan book consists of ticket sizes below ̀ 3mn, credit costs have been minimal, averaging at ~20bps over past ten years). Sourcing of low ticket customers in hinterland consequently helps GRUH to secure low cost financing from NHB and lower risk weights on assets. High RoEs (average RoEs of ~28%) along with robust loan growth (average growth of ~28%) over the past ten years demonstrate GRUH’s competitive advantages.

A prudent and well-calibrated diversification into non-home states GRUH’s credit costs and opex/AUM have remained benign at an average of 20bps and 104bps respectively over the past ten years, despite venturing away from its home states of Gujarat and Maharashtra in FY04-09 into newer geographies (such as Rajasthan, MP, Karnataka, Tamil Nadu and Chhattisgarh). Its RoEs have averaged ~33% in the past four years, implying that it has not raised capital despite recording 30% CAGR over the same period. It has sustained a generous dividend payout of ~40% over FY05-14.

Succession planning would be driven by its parent HDFC The current term of GRUH’s Managing Director, Mr. Sudhin Choksey, ends in FY18. Given that GRUH enjoys strong management support from HDFC (HDFC’s vice chairman and managing director are GRUH’s Chairman and non-executive director respectively), HDFC would ensure a competent successor to Mr. Choksey. Diversification would drive sustainable growth over the long term A well-calibrated and judicious diversification would bear fruit in the long term in terms of a more sustainable growth and lower asset quality geographical risks. With low penetration and lower capacity utilisation in newer geographies (penetration at ~10-30% and new branches under-utilised by ~35-60%), its newer branches offer considerable room for growth and operating leverage.

COMPANY INSIGHT GRHF IN EQUITY November 17, 2014

GRUH FinanceNOT RATED

BFSI

Recommendation Mcap (bn): `85/US$1.4 3M ADV (mn): `80/US$1.3 CMP: `233 TP (12 mths): NA Upside (%): NA


Catalysts

Successful diversification into newer geographies of Rajasthan, MP, Karnataka, Tamil Nadu and Chhattisgarh

Performance


50

100

150

200

250

10,000

15,000

20,000

25,000

30,000

Nov

-13

Jan-

14

Mar

-14

May

-14

Jul-

14

Sep-

14

Nov

-14

Sensex Gruh Finance

Analyst Details Aadesh Mehta, CFA +91 22 3043 3239 [email protected]



GRUH Finance


Exhibit 1: NIMs and loan growth over the past ten years


Exhibit 2: RoA and RoE over the past ten years


Exhibit 3: Sources of funds – FY14


Exhibit 4: Geographical mix of loan book – FY14


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


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


3.2%

3.5%

3.8%

4.1%

4.4%

4.7%

5.0%

15%

20%

25%

30%

35%

40%

45%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Loan growth (%) (LHS) NIMs (%) (RHS)

1.5%

1.9%

2.3%

2.7%

3.1%

3.5%

22%

24%

26%

28%

30%

32%

34%

36%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoE (%) (LHS) RoA (%) (RHS)

46%

30%

16%

9%

NHB

Bank loans

Public deposits

Others

37%

36%

12%

7%5%

2% 2%

Maharashtra

Gujarat

Madhya Pradesh

Karnataka

Rajasthan

Chhatisgarh

Tamil Nadu

10131619222528313437

Apr

-10

Oct

-10

Apr

-11

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

5 yr avg One year fwd PE

19x

33x

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

Apr

-10

Oct

-10

Apr

-11

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

5 yr avg One year fwd PB

5.5x

8.9x

GRUH Finance




Accounting GREEN We do not find anything unusual in the accounts of the company and we believe that the reported numbers are a true reflection of the profitability of the company.

Predictability GREEN Increasing diversification along with deeper penetration into newer geographies augur well for GRUH’s profitability and growth given that it currently has a modest loan book of `79bn.

Treatment of minorities GREEN

Despite its parent HDFC’s domination of the Board of the company by virtue of its majority shareholding, there is a negligible risk to mistreatment of minorities given the clean track record of the HDFC management. We have not come across any instances wherein the HDFC management has mistreated the minority shareholders of its other subsidiaries or associate companies (HDFC Bank).


Exhibit 8: Gruh Finance – ‘Three-quarters of the pie’ on our STAR* framework


Competitive advantage HDFC’s parentage and deep rural penetration are its competitive advantages.


Capital allocation Well calibrated and judicious diversification into newer geographies.

Centrality of political connect GRUH is not part of Ambit’s Connected Companies Index and does not appear to have any questionable political connections.

Treatment of minorities Negligible risk to mistreatment of minorities given the clean track record of the HDFC management.

Succession planning Support of HDFC’s management would ensure a competent successor.

Total (%)


GRUH Finance


Balance sheet

Year to March (̀ mn) FY10 FY11 FY12 FY13 FY14

Stockholders’ Equity 2,650 3,180 3,860 4,910 6,070

Borrowed Funds 23,230 29,660 38,330 49,150 64,470


Loan Assets 24,490 31,720 40,670 54,380 70,090

Other assets 1,390 1,120 1,520 (320) 450

Total assets 25,880 32,840 42,190 54,060 70,540


Income statement Year to March (̀ mn) FY10 FY11 FY12 FY13 FY14


Fees & Other Charges 120 140 170 220 270

Total income 1,270 1,570 1,960 2,400 2,980

Operating Cost 250 320 390 460 560

Operating Profit 1,030 1,270 1,590 1,980 2,460

Provisions & Write Offs (net) 80 10 (40) 10 20

Profit Before Tax 940 1,260 1,630 1,970 2,440

Tax 250 340 430 510 670

Profit After Tax 690 920 1,200 1,460 1,770


Ratio analysis Year to March (%) FY10 FY11 FY12 FY13 FY14

Capital Adequacy Ratio (%) 16.6 13.3 14.0 14.6 16.4

Debt Equity Ratio (times) 9.0 9.0 10.0 10.0 11.0

Gross NPAs (%) 1.1 0.8 0.5 0.3 0.3

Net NPAs (%) - - - 0.1 -

Net Interest Margin (%) 4.6 4.9 4.8 4.5 4.3

Opex to Avg Assets (%) 1.0 1.1 1.0 1.0 0.9

Cost to Income Ratio (%) 20.0 20.0 20.0 19.0 19.0

RoAs (%) 2.7 3.1 3.2 3.0 2.8

RoEs (%) 28.4 31.6 34.1 33.3 32.2


Valuation parameters Year to March FY10 FY11 FY12 FY13 FY14

Diluted EPS (`) 1.9 2.5 3.3 4.0 4.9


P/E (x) 122.2 91.6 70.2 57.7 47.6

P/BV (x) 31.8 26.5 21.8 17.2 13.9



Key financials – standalone (` mn) Year to March FY13 FY14 FY15E FY16E FY17E Net Sales 31,906 35,767 38,963 45,117 51,363 EBITDA 6,644 8,938 9,532 10,822 12,270 EBITDA (%) 20.8% 25.0% 24.5% 24.0% 23.9% EPS (`) 36.8 50.5 47.0 53.6 65.9 RoE (%) 28% 30% 22% 20% 20% RoCE (%) 19% 20% 17% 19% 23% P/E (x) 18.8 13.7 14.7 12.9 10.5 Source: Company, Ambit Capital research

Balkrishna Industries (BKT) has built a substantial export business over the years in the niche area of off-highway tyres (OHT) by successfully leveraging India’s low cost of manufacturing. Its current global OHT market share of 4% would likely increase, due to: (1) higher capacities from the new Bhuj facility (total achievable capacity of 300k MT by FY16 vs 220k MT in FY14) for product portfolio expansion into industrial and mining tyres; (2) OEM tie-ups; and (3) entry into newer geographies. Extensive OHT business built over the years BKT is the leading exporter of off-highway tyres (OHT) such as farm, industrial/construction and mining tyres from India. BKT has succeeded in building an extensive global OHT business due to India’s low cost manufacturing advantage and lack of focus by other domestic manufacturers. The company primarily caters to Europe (54% of total volumes) and the Americas (19%). It has about ~4% market share in the global OHT market.

Sustainable low cost advantage BKT’s primary competitors in the global OHT business are tyre majors like Michelin and Bridgestone. Despite not commanding the same brand equity as the global majors, we believe BKT is poised to gain market share in the global OHT business driven by: (a) its low cost advantage (BKT’s employee costs are 5-7% of sales vs 25-30% for its peers) which enables it to price its products nearly 15-30% cheaper than its peers; (b) increasing defocus of the global majors on the OHT space; (c) the ‘niche nature’ of the OHT business (BKT has >2,000 SKUs) which has kept Chinese competition away; and (d) the high capex-intensive nature of the business (which restrains the domestic conventional tyre makers from focussing on OHT). BKT enjoys better RoICs than its domestic and global peers driven by its higher operating margin.

Capital primarily allotted to core business BKT narrowed its focus on the niche OHT segment in 1995. Since then management has maintained its focus on OHT. Nearly 80% of cash flow from operations generated and debt raised over FY05-14 have been invested as capex in the OHT business. However, BKT has never pushed its balance sheet beyond net debt:EBITDA of 2.7x. Given the high capex requirements, the payouts to shareholders have been relatively low at 5.4% over FY10-14 and we expect the same to sustain in the future as well.

Second generation in charge; third generation’s role increasing BKT is a promoter-driven company. Whilst there is no explicitly stated succession plan, it appears that Rajiv Poddar (Managing Director and Arvind Poddar’s son), who joined the company in January 2009 and recently became a Joint Managing Director, will take over as the third generation promoter to run the company. Note, however that Arvind Poddar is just 57 years old.

Increasing focus on OTR tyres Whilst BKT’s competitive advantages will help it grow in the farm tyre business, it has also been increasing its focus in industrial/construction and mining tyres (known as off the road or OTR tyres), which account for nearly two-thirds of the total OHT market but where BKT has less than 2% market share. The new Bhuj facility would help BKT bridge the gaps in its OTR offerings particularly in the large/ultra large mining and radial OTR tyres. The company is also increasing its marketing efforts by establishing sales offices, strengthening its sales team and establishing warehouses in the export markets.

COMPANY INSIGHT BIL IN EQUITY November 17, 2014

Balkrishna IndustriesBUY

Auto and Auto ancillaries


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

Catalysts

Continued recovery in demand for OHT across geographies

Improving capacity utilisation and benign rubber prices

Improvement in FCF generation over FY15-17

Performance


100

300

500

700

900

15,000

20,000

25,000

30,000

Nov

-13

Jan-

14

Mar

-14

May

-14

Jul-

14

Sep-

14

Nov

-14

Sensex Balkrishna (Rs)

Analyst Details Ashvin Shetty, CFA +91 22 3043 3285 [email protected]

Ritu Modi +91 22 3043 3292 [email protected]

Balkrishna Industries


Exhibit 1: Strong revenue growth and EBITDA margin over the years


Exhibit 2: Improving profitability led to an improvement in return ratios


Exhibit 3: Geographical spread


Exhibit 4: BKT uses funds mainly for capex to fund its strong underlying growth


Exhibit 5: On P/E, Balkrishna trades at a premium of 73% to its historical four-year average


Exhibit 6: On EV/EBITDA, Balkrishna trades at a premium of 134% to its historical four-year average


12.0%

14.0%

16.0%

18.0%

20.0%

22.0%

24.0%

26.0%

28.0%

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

FY09 FY10 FY11 FY12 FY13 FY14

Revenues (Rs mn) EBITDA margin (RHS)

10%

15%

20%

25%

30%

35%

40%

FY09 FY10 FY11 FY12 FY13 FY14

RoCE RoE

Europe, 54%

America, 19%

India, 12%

Others, 15%

0

2

4

6

8

10

12

14

Nov

-08

Mar

-09

Jul-

09

Nov

-09

Mar

-10

Jul-

10

Nov

-10

Mar

-11

Jul-

11

Nov

-11

Mar

-12

Jul-

12

Nov

-12

Mar

-13

Jul-

13

Nov

-13

Mar

-14

Jul-

14

Oct

-14

BKT P/E 6 year average 4 year average

0

2

4

6

8

10

12

14

Nov

-08

Mar

-09

Jul-

09

Nov

-09

Mar

-10

Jul-

10

Nov

-10

Mar

-11

Jul-

11

Nov

-11

Mar

-12

Jul-

12

Nov

-12

Mar

-13

Jul-

13

Nov

-13

Mar

-14

Jul-

14

Oct

-14

EV/EBITDA 6 year average 4 year average





Accounting AMBER

The company has significantly higher debtor days and operating working capital cycle as compared to its peers. However, this is primarily due to its global customer base alongside its centralised manufacturing structure (in India) which results in significant transit time in delivering the goods to the customers (exports account for nearly 90% of overall revenues).

Predictability AMBER Given the high nature of fixed costs (including depreciation and interest expenses), any marginal outperformance/underperformance at the top-line level tends to have a magnified impact at the net earnings level. However, this is an industry-wide phenomenon.


We have not come across any instances where the interests of the minority shareholders have been violated. A significant portion of the company’s capital has been allocated in the core business and the promoters do not seem to have any business interests outside of BKT.


Exhibit 8: Balkrishna Industries – ‘Three-quarters of the pie’ on our STAR* framework



BKT operates in a niche segment where its core competitive advantage is its low-cost structure/locational advantage. Despite not commanding the same brand equity as global majors like Michelin and Bridgestone, we believe BKT is poised to gain market share in the global OHT business driven by: (a) its cost advantage; (b) increasing de-focus of the global majors on the OHT space; (c) ‘high variety low volume’ business, which discourages the entry of Chinese players; and (d) high capex-intensive nature of business restraining the domestic conventional tyre makers from focussing on the OHT segment.

Accounting quality

BKT is in the third quartile as compared to its peers on accounting quality. A significantly higher working capital cycle is the primary reason for BKT having a relatively modest score on accounting quality. That said, BKT’s cash generation is best-in-class and the company is ranked 1 on pre-tax CFO/EBITDA among its peers.

Capital allocation Given the capital-intensive nature of the tyre business and BKT's ambitious expansion plan (new plant at Bhuj), nearly 88% of CFO has been reinvested in capex. This and the consequent low pay-outs to shareholders adversely impact BKT's scoring on capital allocation.

Centrality of political connect BKT is not part of Ambit’s Connected Companies Index and does not appear to rely on political connections for its profitability.

Treatment of minorities Our study of BKT’s annual report suggests that BKT has refrained from transactions that could impact minority shareholder interests.

Succession planning BKT is a promoter-driven company. It is run by the second generation of the Poddar family and the third generation has also joined the ranks.

Total








Total net worth 14,190 18,845 23,151 28,089 34,202

Debt 20,744 23,500 23,500 20,000 14,500

Deferred tax liability 999 1,722 1,722 1,722 1,722


Gross block 17,842 30,014 39,686 40,133 41,150

Net block 12,777 23,294 30,597 28,329 26,583

CWIP 11,810 6,172 500 500 500



Debtors 5,045 6,185 6,737 7,801 8,881

Inventory 4,326 5,291 5,763 6,674 7,598

Loans & advances 2,938 3,432 3,734 4,315 4,904



Provisions 215 276 291 311 331



Total assets 35,933 44,067 48,375 49,813 50,425



Net Sales 31,906 35,767 38,963 45,117 51,363

% growth 13% 12% 9% 16% 14%


EBITDA 6,644 8,938 9,532 10,822 12,270

% growth 31% 35% 7% 14% 13%

Depreciation 1,077 1,650 2,370 2,714 2,764

EBIT 5,567 7,288 7,163 8,108 9,506



Adjusted PBT 5,347 7,174 6,730 7,626 9,234

Tax 1,794 2,293 2,187 2,440 2,863

Adjusted PAT 3,553 4,880 4,543 5,186 6,371

Extraordinary expense/(income) (5) - - - -








Depreciation 1,077 1,650 2,370 2,714 2,764

Others 191 387 554 634 431

Tax (1,410) (1,758) (2,187) (2,440) (2,863)

(Incr)/decr in net working capital 291 (1,518) (930) (1,791) (1,818)


Capex (net) (9,605) (8,581) (4,000) (446) (1,017)

(Incr)/decr in investments (7) (3,936) 3,650 - -


Cash flow from investments (9,593) (12,407) (350) (446) (1,017)

Net borrowings 3,610 4,325 0 (3,500) (5,500)

Interest paid (261) (251) (554) (634) (431)

Dividend paid (169) (170) (226) (237) (248)

Cash flow from financing 3,181 3,904 (780) (4,370) (6,179)

Net change in cash (911) (2,565) 5,407 1,926 552

Closing cash balance 2,662 99 5,506 7,432 7,984

Free cash flow (4,104) (2,643) 2,536 6,296 6,732



EBITDA margin (%) 20.8% 25.0% 24.5% 24.0% 23.9%

EBIT margin (%) 17.4% 20.4% 18.4% 18.0% 18.5%

Net prof. margin (%) 11.1% 13.6% 11.7% 11.5% 12.4%


Net debt: equity (x) 1.3 1.0 0.8 0.4 0.2



RoCE (pre-tax) (%) 19.4% 20.0% 17.4% 19.2% 22.6%

RoIC (%) 12.9% 13.6% 11.7% 13.1% 15.6%

RoE (%) 28.4% 29.5% 21.6% 20.2% 20.5%




Diluted EPS (`) 36.8 50.5 47.0 53.6 65.9

Book value per share (`) 147 195 240 291 354


P/E (x) 18.8 13.7 14.7 12.9 10.5

P/BV (x) 4.7 3.5 2.9 2.4 2.0

EV/EBITDA (x) 12.8 9.5 8.9 7.8 6.9

EV/EBIT (x) 15.2 11.6 11.8 10.5 8.9




Net Revenues (` mn) 8,976 10,606 12,583 14,608 17,859

Operating Profits (` mn) 5,234 5,810 6,992 7,955 9,853

Net Profits (` mn) 3,220 3,471 4,033 4,834 6,037

EPS (`) 6.8 6.4 6.8 8.2 10.2

RoA (%) 1.56% 1.45% 1.51% 1.55% 1.59%

RoE (%) 22.3% 18.9% 17.1% 16.7% 18.0%

P/B (x) 2.62 2.43 1.97 1.72 1.48


City Union Bank has a long-term track record of superior profitability due to its focus on its niche in MSME/trade-based and conservative collateralised lending. A strong capital base, steady profitability, presence in a relatively lucrative geography (Tamil Nadu) and expanded branch network have placed the bank well to benefit from a recovery in the macro-economic climate.

A Tamil Nadu–based specialist lender City Union Bank (CUBK) is a 110-year-old bank based in Tamil Nadu, from where ~73% of the bank’s business originates. The bank has ~3% branch market share in Tamil Nadu. MSME/trade accounts for 49% of its loan book. Gold loans (agri and personal loans) account for 16% of the bank’s loan book. Long-term track record of conservative lending with pricing power The bank’s competitive advantage is its business model that is based on its long-term relationships in a state which offers relatively lucrative opportunities on the credit side. A long-term track record in MSME/trade-based lending and a conservative focus on collateralised lending have allowed the bank to deliver superior net interest margins along with stable asset quality. On the back of these factors, CUBK has delivered stable RoAs of ~1.5% and RoEs of ~20% in the last ten years. Strongly capitalised with tier-1 ratio of 15.5% A significant share of gold loans (16% of loan book), which carries nil risk weight, has allowed CUBK to optimise its capital consumption, as risk-weighted assets to total assets is low at ~55%. Having historically used a rights issue to raise capital, the bank raised capital through a QIP in July 2014. This makes the bank well-funded for a recovery in loan book growth in FY16-17E and to meet the rising capital requirement under Basel-III. Currently, the bank has among the highest tier-1 capital ratios, at 15.5%, as compared to its peers. Stable management in place for long term Dr. N. Kamakodi was appointed as the MD & CEO of the bank in 2011. He is 40 years old and runs the bank with the support of many families that have a stake in the bank. Earlier, his father, Mr. V. Narayanan, was the MD & CEO of the bank over 1980-2004. The bank has a highly diffused ownership held across a large number of families. Well primed for a macro-economic recovery CUBK is likely to continue focusing on its home market in Tamil Nadu due to the bank’s small size and better opportunities within the state itself. The bank has historically been proactive in upgrading its technology and has invested in expanding its branch network to strengthen its liability base. A strong capital base, steady profitability and expanded branch network (number of branches up 73% in the last three years) place the bank well to benefit from any recovery in the macro-economic climate.

COMPANY INSIGHT CUBK IN EQUITY November 17, 2014

City Union BankBUY

BFSI

Recommendation Mcap (bn): `54/US$0.9 3M ADV (mn): `68/US$1.1 CMP: `91 TP (12 mths): `90 Upside (%): -1


Catalysts

Recovery of loan growth in FY16 Decline in stressed assets accretion

during 2HFY15 and FY16

Rising productivity of new branches

Performance


90 110 130 150 170 190 210

Nov

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Jan-

14

Mar

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May

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Jul-

14

Sep-

14

Nov

-14

Sensex City Union Bank

Analyst Details Ravi Singh +91 22 3043 3181 [email protected]



City Union Bank











Source: Company, Ambit Capital research. Note: Trading band=Mean+1SD



0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

0%5%

10%15%20%

25%30%

35%40%

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14


0%

5%

10%

15%

20%

25%

30%

1.30%1.35%1.40%1.45%1.50%1.55%1.60%1.65%1.70%1.75%

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoA - LHS RoE - RHS

0%

10%

20%

30%

40%

50%

60%

70%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Gross NPA - LHSProvision coverage ratio - RHS

10

.8%

10

.9%

11

.2%

11

.5%

12

.4%

11

.8%

11

.7%

13

.3%

14

.4%

0%2%

4%6%

8%10%12%

14%16%

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14


0102030405060708090

100

Jun-

06D

ec-0

6Ju

n-07

Dec

-07

Jun-

08D

ec-0

8Ju

n-09

Dec

-09

Jun-

10D

ec-1

0Ju

n-11

Dec

-11

Jun-

12D

ec-1

2Ju

n-13

Dec

-13

Jun-

14

4.9x

6.7x

8.5x

0102030405060708090

Jun-

06D

ec-0

6Ju

n-07

Dec

-07

Jun-

08D

ec-0

8Ju

n-09

Dec

-09

Jun-

10D

ec-1

0Ju

n-11

Dec

-11

Jun-

12D

ec-1

2Ju

n-13

Dec

-13

Jun-

14

0.93x

1.26x

1.59x

City Union Bank





Predictability GREEN The bank’s conservative approach towards growth and asset quality imparts sufficient predictability to its financial performance.


Whilst its practice of capital-raising only through rights issue has been questioned in the past, the bank has recently shown flexibility by opting for a QIP. We did not find any material example of unfair treatment to minorities.


Exhibit 8: City Union Bank - Three ‘quarters of the pie’ on our STAR* framework


Competitive advantage A business model with pricing power yet conservative lending


Capital allocation Strong capital position; made investments in network expansion

Centrality of political connect City Union Bank is not part of Ambit’s Connected Companies Index and does not appear to have any questionable political connections.

Treatment of minorities Except for last QIP, the bank has raised capital through rights

Succession planning CEO has support of promoter families and has a long tenure ahead

Total (%)


City Union Bank




Networth 16,407 20,249 27,024 30,961 36,101

Deposits 203,048 220,169 246,589 295,907 369,884

Borrowings 4,767 3,050 3,050 3,580 4,216


Total Liabilities 229,771 249,938 284,104 339,600 421,458


Investments 52,668 59,536 71,805 86,185 107,662

Advances 152,461 160,968 177,208 213,057 266,401

Other Assets 6,937 7,638 8,115 8,284 7,725

Total Assets 229,771 249,938 284,104 339,600 421,458



Interest Income 21,888 25,459 27,702 31,632 37,942




Total Income 8,976 10,606 12,583 14,608 17,859





Provisions 1,204 1,674 1,950 1,913 2,308

PBT 4,030 4,136 5,041 6,042 7,546

Tax 810 665 1,008 1,208 1,509

PAT 3,220 3,471 4,033 4,834 6,037


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

Credit-Deposit (%) 75.1% 73.1% 71.9% 72.0% 72.0%

CASA ratio (%) 16.8% 17.8% 18.6% 19.1% 19.6%


Gross NPA (̀ mn) 1,731 2,931 3,852 4,652 5,603

Gross NPA (%) 1.16% 1.84% 2.16% 2.16% 2.08%

Net NPA (̀ mn) 964 1,973 2,388 2,698 3,082

Net NPA (%) 0.63% 1.23% 1.35% 1.27% 1.16%


NIMs (%) 3.11% 3.27% 3.28% 3.33% 3.34%



City Union Bank


Du-pont analysis (standalone)


NII / Assets (%) 3.0% 3.2% 3.2% 3.2% 3.3%



Cost to Assets (%) 1.8% 2.0% 2.1% 2.1% 2.1%

PPP / Assets (%) 2.5% 2.4% 2.6% 2.6% 2.6%


PBT / Assets (%) 2.0% 1.7% 1.9% 1.9% 2.0%

Tax Rate (%) 20.1% 16.1% 20.0% 20.0% 20.0%

ROA (%) 1.6% 1.4% 1.5% 1.5% 1.6%

Leverage 14.3 13.1 11.3 10.8 11.3 ROE (%) 22.3% 18.9% 17.1% 16.7% 18.0%


Valuation parameters (standalone) Year to March FY13 FY14 FY15E FY16E FY17E

EPS (`) 6.8 6.4 6.8 8.2 10.2

EPS growth (%) -1% -6% 7% 20% 25%

BVPS (̀ ) 34.6 37.3 45.9 52.5 61.3

P/E (x) 12.2 14.2 13.2 11.0 8.8

P/BV (x) 2.62 2.43 1.97 1.72 1.48


City Union Bank




Key financials (` mn) Year to March FY10 FY11 FY12 FY13 FY14

Net Revenues (` mn) 2,570 3,420 4,729 6,605 8,410

EBIT (̀ bn) 933 1,254 1,770 2,291 3,204

EBIT margins 36% 37% 37% 35% 38%

Diluted EPS (`) 25.1 41.1 53.0 56.9 83.7

RoE 40% 61% 55% 44% 50%

P/E 51.4 31.4 24.3 22.7 15.4

EV/EBITDA 36.1 26.9 19.1 14.2 10.2


eClerx’s competitive advantages include its niche focus, strong knowledge management system, sticky customer franchise and proven ability to mine clients. These are not easily replicable as evidenced by the company’s industry-leading RoCEs. It has a strong capital allocation track record with a high dividend payout ratio and a conservative acquisition strategy. Our BUY stance and estimates are ‘under review’.

A unique knowledge process outsourcing company eClerx specialises in providing middle and back office support to companies across the world, including many Fortune 500 companies. Almost all delivery employees are based offshore. The company has recorded 34% revenue CAGR over FY09-14 whilst sustaining RoCEs in excess of 40%. It has three segments – financial services (~40% of revenues), digital marketing services (~40%) and cable and telecom (~20%). Competitive advantages to sustain in the long term eClerx has built superior knowledge management processes, domain knowledge and automation capabilities which enable it to offer faster deployment and better quality of service to customers vs most peers as well as most captives. These competitive advantages are difficult to replicate especially since peers prefer to focus on low-volume, simpler processes. This is evidenced in its sticky customer franchise, ability to mine clients and superior returns vis-à-vis peers (FY14 RoE of 50% vs 20% for peers). Proven track record of good capital allocation eClerx’s dividend payout ratio has remained consistently high in the last three years (average of 47% vs 32% for Indian IT mid-caps). Thus a significant portion of the company’s profits not allotted towards capex has been returned to shareholders. The cash on books is high (42% of net worth), possibly to provide for an acquisition. The company is not very acquisitive, with only one acquisition made (Agilyst) since it listed. The acquisition was successful and added to the company’s growth and reduced customer concentration. Expect continuity in management team eClerx’s promoters, Anjan Malik and PD Mundhra, are young (in their 40s) and hence, the company has no stated succession policy. Senior management like Mr. Mistry (Principal, Digital) and Mr. Gupta (CFO) have been with the organisation for more than 10 years. Our discussions with the management suggest that the company is making an effort to promote talent internally. Further improving the franchise eClerx has focused on reducing client concentration risk by pursuing non-top-5 clients’ business more aggressively (29% of LTM revenues). It has a new HR policy to reduce attrition, boost collaboration as it prepares to move up the value chain, and tackle more complex processes. Further, the management has indicated that it is likely to make an acquisition in the near future. An acquisition may provide an additional growth engine and also reduce customer concentration risk.

COMPANY INSIGHT ECLX IN EQUITY November 17, 2014

eClerx UNDER REVIEW

Technology

Recommendation Mcap (bn): `39/US$0.6 3M ADV (mn): `58/US$0.9 CMP: `1,290 TP (12 mths): UR Upside (%): UR

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

Catalysts Revenue acceleration driven by

client-specific issues getting resolved

over the next three quarters

Potential EPS-accretive acquisition in

the next 12 months

Performance


600

900

1,200

1,500

15,000

18,000

21,000

24,000

27,000

Aug

-13

Sep-

13N

ov-1

3D

ec-1

3Fe

b-1

4M

ar-1

4M

ay-1

4

Jun-

14A

ug-1

4Sensex (LHS) eClerx (Rs) (RHS)

Analyst Details

Sagar Rastogi

+91 22 3043 3291 [email protected]

Utsav Mehta +91 22 3043 3209

[email protected]

eClerx


Exhibit 1: eClerx’s margins have been steady in the last five years


Exhibit 2: Its return ratios have not dipped below 40% since listing






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


Exhibit 6: Forward EV/EBITDA evolution over the past five years


0%

10%

20%

30%

40%

50%

60%

-

20

40

60

80

100

120

140

160

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenue(US$mn) (LHS) EBIT margins (RHS)

10%

60%

110%

160%

210%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

RoE RoCE

CFO84%

Proceeds from IPO in

200810%

Non op-income

6%

Cumulative funds raised (FY05-14)

Dividend paid38%

Acquisitions24%

Increase in cash24%

Capex14%

Cumulative funds spent (FY05-14)

4

6

8

10

12

14

16

18

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-

14

May

-14

Sep-

14

P/E

ECLX P/E 4 yr avg

4

6

8

10

12

14

16

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-

14

May

-14

Sep-

14

EV/ EBITDA

ECLX EV/ EBITDA 4 yr avg

eClerx




Accounting GREEN

The company has a lean working capital cycle (receivable + unbilled revenue days at 79), lower than the average of 93 for mid-sized IT vendors), and strong cash flow generation (five year FCF/ NI of 74% vs 47% peer average). Further, the company has carried marginal related party transactions in the last five years. As a result, the company ranks in the top quartile within the Indian IT universe in our accounting framework.


The company does not provide specific annual or quarterly guidance on revenues or margins. It provides a qualitative outlook on its business. eClerx surprises regularly on its quarterly EPS with an average surprise of 9% (positive or negative) in the last eight quarters on consensus expectations Over these eight quarters, the company had a positive surprise on EPS five times. However, its sales figures have been largely in-line with consensus expectations (revenue surprise of 1% over the same period).


There have been no significant related party transactions made by the company in the last five years. Further, both promoters hold their stake in the company in their individual names and the holding structure is transparent. Lastly, the company’s dividend payouts are high (47% average in the last three years) and it had proposed a buyback in 2013 (which failed). The share price moved significantly above the proposed buyback price and hence did not garner interest. The company has not indicated another buyback in the future.


Exhibit 8: eClerx – ‘Full pie’ on our STAR* framework


Competitive advantage eClerx scores on technology processes and strong relationships with clients but is vulnerable to competition from large IT companies.

Accounting quality The company is in the top quartile among peers on this criteria. It has a lean working capital cycle, strong cash flow generation and has marginal related party transactions in the last five years.

Capital allocation Its business model generates high RoCEs and dividend payout has been high. Further, the company is conservative on acquisitions.

Centrality of political connect eClerx is not part of Ambit’s Connected Companies Index and does not have any questionable political connection.

Treatment of minorities The promoters hold shares in their individual names and there have been no anti-minority transactions so far.

Succession planning Promoters are relatively young (under 45 years of age) and have a professional background. Further, the senior management have been with the company for over 10 years providing an able second in-line command.

Total (%)


eClerx


Balance sheet

Balance sheet (̀ mn) FY11 FY12 FY13 FY14

Net Worth 2,384 3,432.0 4,383.3 5,890

Other Liabilities - 1.7 9.9 19

Capital Employed 2,384 3,433.7 4,393.2 5,908

Net Block 370 488.7 1,355.2 1,559

Other Non current Assets 70 88.4 144.8 216

Curr. Assets 3,088 4,038.8 4,521.3 6,138

Debtors 659 421.8 654.8 996

Cash & Bank Balance 1,794 2,685.4 2,700.1 3,560

Other Current Assets 635 931.5 1,166.5 1,581

Current Liab. & Prov 1,144 1,182.2 1,628.2 2,005

Net Current Assets 1,943 2,856.6 2,893.2 4,133

Application of Funds 2,384 3,433.7 4,393.2 5,908


Income statement Income statement (̀ mn) FY11 FY12 FY13 FY14

Revenue (US$ mn) 76 98 122 138

Revenue 3,420 4,729 6,605 8,410

EBITDA 1,345 1,899 2,546 3,535

Depreciation 91 129 256 331

EBIT 1,254 1,770 2,291 3,204

EBIT Margin 36.7% 37.4% 34.7% 38.1%

Other Income 240 223 (181) 110

PBT 1,494 1,993 2,109 3,314

Tax 166 394 393 759

Reported PAT 1,328 1,599 1,716 2,555

PAT Margin 38.8% 33.8% 26.0% 30.4%

Diluted EPS 41.1 53.0 56.9 83.7

DPS 29.0 23.0 25.0 35.0


Cash flow statement

In ̀ mn FY11 FY12 FY13 FY14

PBT 1,392 1,992 2,109 3,316

Cash for Working Capital (324) 113 (348) (791)

Taxes (166) (384) (403) (767)

Net Operating CF 1,020 1,721 1,533 1,950

Net Purchase of FA (240) (251) (267) (212)

Net Cash from Invest. 332 (832) (349) (1,117)

Proceeds from Equity & other 25 33 70 85

Dividend Payments (335) (758) (597) (911)

Cash Flow from Fin. (310) (725) (527) (825)

Free Cash Flow 780 1,469 1,266 1,734

Opening cash balance 472 1,515 1,687 2,349

Net Cash Flow 1,042 163 658 8

Closing Cash Balance 1,515 1,686 2,349 2,406


eClerx


Financial ratios

FY11 FY12 FY13 FY14

Growth

Revenue (US$) 37% 29% 25% 14%

EPS 64% 29% 7% 47%

Return Ratios (%)

RoE 61% 55% 44% 50%

RoCE 51% 49% 48% 48%

Turnover Ratios

Receivable days (Days) 71 31 36 44

Fixed Asset Turnover (x) 9.9 11.0 7.2 5.8


Valuations

FY11 FY12 FY13 FY14

P/E 31.4 24.3 22.7 15.4

EV/EBITDA 26.9 19.1 14.2 10.2

EV/Sales 10.6 7.7 5.5 4.3

Price/Book Value 16.7 11.6 9.1 6.7

Dividend Yield (%) 2.2% 1.8% 1.9% 2.7%


eClerx





Net Sales 13,602 15,176 18,342 22,194 25,967

EBITDA 1,099 1,226 1,651 2,108 2,532

EBITDA (%) 8.1 8.1 9.0 9.5 9.8

EPS (`) 21.1 23.6 33.0 42.5 53.8

RoE (%) 26.7 24.3 27.8 29.6 30.1

RoCE (%) 20.6 19.9 24.4 27.0 28.4

P/E (x) 42.7 38.3 27.3 21.2 16.7


V-Guard has grown from a regional player in south India to a successful pan-India player through product portfolio expansion, competitive pricing and expansion of distribution network. We expect the company’s sustainable competitive advantage around the scalability of its asset-light manufacturing model to continue as the capacity expansion of vendors is not a challenge. To further strengthen its franchise the company is making huge investments in advertising.

Transformation from a regional player to a national player Founded in 1977 with the stabiliser as its flagship product, V-Guard is the market leader in light electricals in Kerala and is amongst the top-3 brands in the other four south states. In the past six years, it has graduated from a regional to a pan-India player (non-south revenue share at 30% in FY14 vs 5% in FY08). Asset-light business model a sustainable competitive advantage V-Guard has an asset-light business model with an average gross block turnover of 4.9x and consistently strong pre-tax RoCE of 27% over FY05-14. This is driven by V-Guard's meticulously built supplier network (small-scale manufacturing units of stabilisers) which we believe is scalable. The capacity of these units can be expanded by 50% through the introduction of semi-automated machines with minimal additional capex.

Judicious capital allocation reflected in robust RoCEs V-Guard scores well on capital allocation: (a) V-Guard’s RoCE has been strong at 27% over the past 10 years; (b) the company has not diversified into low-margin businesses for the sake of growth; (c) capex on electrical cables (largest capex item over the past ten years) has led to cables and wires becoming the largest product in its portfolio; (d) expansion outside the south has already achieved breakeven; and (e) V-Guard’s dividend payout has remained healthy at 33% of profit since listing. Second generation in charge V-Guard does not have an explicitly stated succession plan. Mr. Mithun Chittilappilly (son of Kochouseph Chittilappilly, V-Guard’s founder) who joined in FY06 is only 33 years old. In FY12, Mithun took over from his father as the Managing Director. Since he joined in FY06, V-Guard's revenues have grown at a robust 37% CAGR. V-Guard has also attracted talent from leading companies in the consumer durables and light electrical space. What is being done to strengthen the franchise further? To strengthen the franchise further the company has done the following: (a) It has consistently added new products to its portfolio and grown them successfully. The latest successful addition is fans, which has reached a turnover of `1bn in FY14 (launched in FY10). (b) It has a consistently high spend on advertisement. V-Guard’s FY14 advertisement spends to sales at 3.9% in FY14 was higher than Havells’ 2.4% and Bajaj’s 2.2%. Consequent to an ad spend CAGR of 29% over FY11-14, V-Guard has gained market share in all the products under its portfolio over FY12-14. (c) It recruited senior marketing employees from leading competitors to attain a smooth expansion of the franchise into non-South market.

COMPANY UPDATE VGRD IN EQUITY November 17, 2014

V-Guard IndustriesBUY

Capital Goods

Recommendation Mcap (bn): `27/US$0.4 3M ADV (mn): `39/US$0.6 CMP: `910 TP (12 mths): `1,009 Upside (%): 11

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

Catalysts Improvement in revenue share of

non-south to 50% by FY17

Strong festive demand in FY15 to

result in strong growth for V-Guard

Performance


16,000

19,000

22,000

25,000

28,000

350

550

750

950

1,150

Oct

-13

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

V-Guard Sensex on RHS

Analyst Details Bhargav Buddhadev +91 3043 3252 [email protected]

Deepesh Agarwal +91 3043 3275 [email protected]

V-Guard Industries


Exhibit 1: Strong revenue CAGR of 31% over FY05-14 alongside robust average EBITDA margin of 10.3% over FY05-14…


Exhibit 2: …led to V-Guard achieving pre-tax RoCE and RoE of 27.1% and 31.3% respectively over FY05-14


Exhibit 3: CFO forms the largest component of funds raised over the past decade (FY05-14)

Source: Company, Ambit Capital research. Note: Size of the pie represents cumulative funds raised (through various sources such as CFO, equity, debt, etc) and spent (on capex, debt repayment, interest, dividend paid, etc) in the past 10 years

Exhibit 4: High spend on capex to fund rising growth momentum (FY05-14)

Source: Company, Ambit Capital research. Note: Size of the pie represents cumulative funds raised (through various sources such as CFO, equity, debt, etc) and spent (on capex, debt repayment, interest, dividend paid, etc) in the past 10 years





6.0

7.0

8.0

9.0

10.0

11.0

12.0

13.0

- 2,000 4,000 6,000 8,000

10,000 12,000 14,000 16,000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Sales (Rsmn) EBITDA margin (%) on RHS

-

10

20

30

40

50

60

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Pre-tax ROCE (%) ROE (%)

CFO, 56%

Capital raised, 17%

Interest, dividend recd, 2%

Debt, 25%

Investments (net),

3% Dividend, 25%

Interest, 25%

capex, 45%

Others, 5%

-

200

400

600

800

1,000

1,200

Mar

-08

Sep-

08

Mar

-09

Sep-

09

Mar

-10

Sep-

10

Mar

-11

Sep-

11

Mar

-12

Sep-

12

Mar

-13

Sep-

13

Mar

-14

Sep-

14

14x

9x

29x

19x

24x

-

200

400

600

800

1,000

1,200

Mar

-08

Sep-

08

Mar

-09

Sep-

09

Mar

-10

Sep-

10

Mar

-11

Sep-

11

Mar

-12

Sep-

12

Mar

-13

Sep-

13

Mar

-14

Sep-

14

2.5x

7.0x

4.0x

5.5x

1.0x

V-Guard Industries




Accounting AMBER In our accounting analysis of light electrical companies, V-Guard scores low due to its poor working capital cycle and low CFO/EBITDA. Expansion in the non-south market has been the reason for V-Guard’s poor cash conversion. However, its working capital cycle has improved from 96 days in FY11 to 61 days in FY14.

Predictability GREEN Given its detailed disclosure (this is the only company in the sector which gives product-wise disclosures) and transparency of the management guidance, the predictability over topline and bottomline performance is strong.


Whilst V-Guard remains the largest company for the Chittilapilly family, it is also involved in other businesses such as theme parks (Wonderla Holidays, which was listed in May 2014) and garments (V-Star Creations). So far, there have been no incidences of mistreatment of minorities by the promoters. The Chittilapilly family holds a 66% stake in the company and this stake is held in their individual names.


Exhibit 8: V-Guard Industries gets ‘three-quarters of the pie’ on our STAR (Sustainable and Tenable Advantages Rank) framework Criteria Score (%) Comment

Competitive advantage Whilst V-Guard is ranked 1 in light electricals in Kerala, it is still not ranked among the top-five players in the non-south market. Competition in the sector remains tough.

Accounting quality V-Guard is in the second quartile; expansion beyond south India has kept its CFO/EBITDA low.

Capital allocation V-Guard is a cash-generative company with low capex and high RoCEs; the management has maintained healthy payout ratios (average ~33% since listing in 2008).

Centrality of political connect V-Guard is not part of Ambit’s Connected Companies Index and does not appear to have any questionable political connections.

Treatment of minorities The promoter family has other unrelated businesses; no major anti-minority transactions so far.

Succession planning Business remains promoter driven, with the second generation currently in charge.

Total (%)

Weaknesses Use of stabilisers could become redundant in the future, and beyond stabilisers, V-Guard’s newer products are more competitive. V-Guard remains a regional player.

Source: Company, Ambit Capital research. Note: = rating of 4/4; = rating of 3/ 4 and so on

V-Guard Industries



Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17

Cash 150 28 - 150 19 424

Debtors 1,988 2,121 2,513 2,919 3,344

Inventory 2,486 2,525 3,216 3,770 4,269

Loans & advances 454 381 612 741 867

Other Current Assets 2 1 1 1 1

Investments - - - - -

Fixed assets 1,470 1,662 1,794 2,051 2,209

Miscellaneous - - - - -

Total assets 6,549 6,718 7,986 9,500 11,113

Current liabilities & provisions 2,282 2,473 3,278 4,088 4,926

Debt 1,574 992 700 400 -

Other liabilities - Deferred Tax Liability 79 95 95 95 95




Total networth 2,613 3,158 3,912 4,917 6,092

Net working capital 2,646 2,554 3,063 3,341 3,553

Net debt (cash) 1,425 964 850 381 - 424


Income statement (standalone) Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17


% growth 36.9 11.6 20.9 21.0 17.0


EBITDA 1,099 1,226 1,651 2,108 2,532

% growth (10.3) 11.5 34.7 27.7 20.1

Depreciation 114 120 168 193 216

EBIT 985 1,106 1,482 1,915 2,315

Interest expenditure 200 211 154 88 -

Non-operational income / Exceptional items 36 48 37 42 52

PBT 822 943 1,366 1,869 2,368

Tax 193 241 382 561 710

Reported PAT 629 702 983 1,308 1,657

Adjustments - - - - -

Adjusted PAT 629 702 983 1,308 1,657

% growth (21.2) 11.6 40.1 33.1 26.7


V-Guard Industries



Year to March (̀ mn) FY13 FY14 FY15E FY16E FY17

PBT 822 943 1,366 1,869 2,368

Depreciation 114 120 168 193 216

Interest 180 191 154 88 -

Tax (255) (189) (382) (561) (710)

(Incr) / decr in net working capital (772) (23) (509) (278) (212)

Others 16 66 - - -

Cash flow from operating activities 105 1,108 797 1,311 1,661

(Incr) / decr in capital expenditure (253) (324) (300) (450) (375)

(Incr) / decr in investments - 25 - - -

Others - 19 - - -

Cash flow from investing activities (253) (280) (300) (450) (375)

Issuance of equity (2) - - - -

Incr / (decr) in borrowings 560 (567) (292) (300) (400)

Others (310) (359) (383) (392) (481)

Cash flow from financing activities 248 (926) (674) (692) (881)

Net change in cash 100 (98) (177) 169 405



EBITDA margin 8.1 8.1 9.0 9.5 9.8

EBIT margin 7.2 7.3 8.1 8.6 8.9

Net profit margin 4.6 4.6 5.4 5.9 6.4

Return on capital employed 20.6 19.9 24.4 27.0 28.4

Return on equity 26.7 24.3 27.8 29.6 30.1

Current ratio (x) 2.2 2.0 1.9 1.8 1.8




EPS (`) 21.1 23.6 33.0 42.5 53.8


P/E (x) 42.7 38.3 27.3 21.2 16.7

P/BV (x) 10.3 8.5 6.9 5.6 4.6

EV/EBITDA (x) 25.3 22.7 16.9 13.2 11.0

EV/Sales (x) 2.0 1.8 1.5 1.3 1.1

EV/EBIT (x) 28.3 25.2 18.8 14.5 12.0


V-Guard Industries




Key financials - standalone Y/E Mar (̀ mn) FY10 FY11 FY12 FY13 FY14 Revenues 1,647 2,486 3,109 3,692 4,556 Adjusted EBITDA 282 410 533 690 932 EBITDA margin (%) 17.1% 16.5% 17.1% 18.7% 20.5% Adjusted EPS (`) 3.0 4.7 6.2 4.0 13.1 ROCE (%) 64.0% 68.4% 64.9% 62.9% 58.7% ROIC (%) 59.9% 77.1% 66.1% 57.6% 51.9% P/E (x) 151.6 97.2 73.6 112.7 34.5


Mayur Uniquoters’ scale, focus on quality, innovation and well-established relationship with domestic footwear manufacturers and domestic/global auto OEMs set it apart in a fragmented synthetic leather industry. The company’s stellar capital allocation track record and consistent RoCE expansion is a testament of its well-entrenched competitive advantages which are sustainable over the long term.

The largest Indian synthetic leather manufacturer Mayur Uniquoters, India’s largest synthetic leather manufacturer has built: (a) strong manufacturing capabilities (five Italian coating lines, sixth line to be commissioned in FY15); and (b) strong relationships with large auto OEMs and footwear manufacturers in the last two decades. Mayur reported revenue/EBITDA CAGR of 32%/51% and its RoCE averaged 43% over FY09-14. Exports recorded 55% CAGR over FY08-14 (23% of sales in FY14 vs 9% in FY10). Scale, product and relationships—the key competitive advantages Mayur has built its competitive advantage by: (a) continuously adding scale, (b) maintaining its focus on product quality/innovation, and (c) forging strong relationships with footwear and auto OEMs in India and now global auto OEMs. Product quality and innovation has helped Mayur expand its clientele and gain market share from unorganised competitors. Its track record of consistent RoCE improvement (40% in FY14 vs 10%/21% in FY05/FY09) and strong growth (10-year sales CAGR: 30%) are a testament of its strong competitive advantages. Textbook capital allocation in the past decade Mayur’s scale increased 5x (to ~30mn metres in FY14 from 6mn metres in FY04). This was supplemented by an increase in asset turnover (to 3.5x over FY08-14 vs 2.4x over FY04-08) and expansion in EBITDA margin (to 16.6% over FY09-14 vs 11% over FY04-08), thus leading to sharp RoCE improvement (to 40% in FY14 vs 10% in FY05). Mayur has concertedly maintained moderate dividend payouts (10% of CFO over FY05-14), as it re-invested 64% of the cash accruals for enhancing scale, which in turn drove the sharp sales growth. First-generation promoter but developing a second line of management Mayur is a first-generation promoter-driven company, wherein the business is largely built by Mr Suresh Poddar. The promoter’s son Mr Manav Poddar, and son-in-law, Mr Arun Kumar Bagaria, have been inducted into the Board and they manage the marketing and production functions. The company has started hiring senior leather industry professionals at key functions such as production, sales, and distribution, to develop a second line of management. Expanding clientele; entering new product segments Alongside consistent scale elevation in PVC (sixth coating line to be commissioned in November 2014; seventh line planned already), the company is setting up the largest Indian polyurethane leather plant (to be commissioned by end-FY16). Furthermore, it is expanding its presence in North America (has set up a marketing subsidiary) and reaching out to new markets in Europe to supply synthetic leather to the furnishing industry. Moreover, the company has increased supplies to premium auto OEM clients to ensure higher realisations.

COMPANY INSIGHT MUNI IN EQUITY November 17, 2014

Mayur UniquotersNOT RATED

Industrials

Recommendation Mcap (bn/mn): `19/US$312 3M ADV (mn): `27/US$0.4 CMP: `442


Catalysts

Strong volume growth post commissioning of the new coating line in 3QFY15

Margin improvement in 2HFY15 with falling crude prices and rising premium sales

Addition of auto OEM clients in the US and rising supplies to the furnishing industry in Europe

Performance


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MUNI (LHS) SENSEX

Analyst Details Achint Bhagat +91 22 3043 3178 [email protected]

Nitin Bhasin +91 22 3043 3241 [email protected]

Mayur Uniquoters


Sharp revenue growth and margin expansion… Exhibit 1:


…translated into sharp RoCE and RoE expansion Exhibit 2:over the last ten years


CFO accounted for 79% of the cash source over Exhibit 3:the last ten years


Almost two-thirds of cash generated/raised was Exhibit 4:deployed for capacity expansions


P/E multiples have re-rated several times over Exhibit 5:the last three years


Mayur is trading at peak P/B multiple of 4.4xExhibit 6:


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RoCE (LHS) RoE (RHS)

CFO, 79%

Proceeds from

shares, 1%

Interest, dividend recd, 4%

Debt Proceeds,

16%

Dividend paid, 19%

Interest paid, 4%

Net Capex , 68%

Purchase of

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Mayur Uniquoters


Explanation for our flags Exhibit 7:


Accounting GREEN On our forensic accounting screener of 127 mid-cap stocks, Mayur ranks 11th due to its high CFO/EBITDA (80% conversion ratio), low audit fees and no material unclassified loans or contingent liabilities.

Predictability GREEN

The management has made timely announcements regarding expansion and has usually met its guided targets both in terms of capacity commissioning and utilisation-level ramp-up. Moreover, margins have been stable and have not been susceptible to unpredictable operating cost (raw material, power and fuel, fixed expenses) volatilities.


The company does not have any major unlisted subsidiaries (held partly by the promoter) nor does it carry out any related party transactions to the detriment of the minority shareholders. The promoter does not hold any shares in the company through unlisted subsidiaries.


Mayur Uniquoters — ‘Full pie’ on our STAR* framework Exhibit 8:


Competitive advantages Capacity leadership and relationships with domestic/Global auto OEMs and Indian footwear manufacturers

Accounting quality Ranks 11th amongst 127 mid-cap companies with a market capitalization of `5bn-20bn. CFO/EBITDA conversion ratio of 80% in the last 10 years.

Capital allocation Re-invested 80% CFO for capacity expansion. Strong sales growth and material RoCE expansion in the last decade.

Centrality of political connect Mayur is not part of Ambit’s Connected Companies Index and does not have any questionable political connection.

Treatment of minorities No instance of anti-minority transactions in the past decade; uncomplicated holding structure and no material insider transactions.

Succession planning Promoter-led business with no explicit succession plan.

Total (%)


Mayur Uniquoters




Share capital 54 54 54 108 108

Reserves and surplus 366 556 805 1,076 1,503

Total Networth 421 610 859 1,185 1,611

Loans 44 78 29 46 157

Sources of funds 482 708 918 1,266 1,827

Net block 231 313 451 547 977

Capital work-in-progress 3 34 40 189 266

Investments 1 1 1 1 1

Cash and bank balances 196 228 190 107 134

Sundry debtors 256 316 406 565 671

Inventories 98 146 307 442 638

Loans and advances 27 40 34 68 125

Total Current Assets 586 742 1,072 1,351 1,741

Current liabilities and provisions 338 382 667 869 1,177

Net current assets 248 360 405 482 564

Application of funds 482 708 918 1,266 1,827


Income statement (standalone) Year to March (̀ mn) FY10 FY11 FY12 FY13 FY14

Revenue 1,647 2,486 3,109 3,692 4,556

yoy growth 43% 51% 25% 19% 23%

Total expenses 1,366 2,076 2,642 3,115 3,764

EBITDA 282 410 533 690 932

yoy growth 136% 46% 30% 30% 35%

Net depreciation / amortisation 22 27 39 52 70

EBIT 266 394 511 666 879

Net interest and financial charges 13 19 20 24 43

Other income 6 11 17 27 18

PBT 252 375 492 642 836

Provision for taxation 90 122 158 206 269

Adjusted PAT 162 253 334 436 568

yoy growth 163% 56% 32% 31% 30%

Reported PAT 162 253 334 436 568

EPS (`) 3 5 6 4 13


Mayur Uniquoters




Net profit before tax 252 375 492 642 836

Depreciation 22 27 39 52 70

Others 1 (3) (2) (4) 43

Tax (83) (141) (153) (194) (269)

(Incr)/decr in net working capital 17 (89) (91) (213) (109)

Cash flow from operations 216 172 281 272 555

Capex (net) 25 130 127 365 506

(Incr)/decr in investments 10 - (117) (19) 38

Other income (expenditure) 6 8 9 14 5

Cash flow from investments

Net borrowings (34) 34 (23) 181 111

Issuance/buyback of equity - - - - -

Interest paid (28) (45) (69) (96) (46)

Dividend paid (6) (7) (8) (9) (43)

Cash flow from financing (69) (18) (99) 77 22

Net change in cash 138 32 (50) (10) 126

Free cash flow (before investments) 191 42 154 (93) 48


Ratio analysis (standalone)


EBITDA margin (%) 17.1 16.5 17.1 18.7 20.5

EBIT margin (%) 16.1 15.9 16.5 18.0 19.3

Net prof. (bef min int) margin (%) 9.8 10.2 10.7 11.8 12.5

RoCE (pre-tax) (%) 64 68 65 63 59

RoIC (%) 60 77 66 58 52

RoE (%) 49 51 48 46 42

Source: Company, Ambit Capital research, Note: * excluding revaluation reserve



P/E (x) 152 97 74 113 35

P/B(x) 46.6 32.1 22.8 16.6 12.2

Debt/Equity(x) 0.1 0.1 0.0 0.0 0.1

Net debt/Equity(x) -0.4 -0.2 -0.1 0.0 0.1

EV/EBITDA(x) 68.8 47.3 36.4 28.1 20.8

Source: Company, Ambit Capital research, Note: * excluding revaluation reserve

Mayur Uniquoters


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]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

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

Karan Khanna Strategy (022) 30433251 [email protected]

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

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

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

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

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 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]

Deepak Sawhney India / Asia (022) 30433295 [email protected]

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

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

Hitakshi Mehra India (022) 30433204 [email protected]

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

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

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

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

Mayur Uniquoters


Explanation of Investment Rating Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >5%

Sell <5%

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Ambit Strategy Thematic IndianCoffee 17Nov2014

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