ambit+ +economy+&+strategy +this+could+be+heaven+for+stock+pickers++apr2

7/31/2019 Ambit+ +Economy+&+Strategy +This+Could+Be+Heaven+for+Stock+Pickers++Apr2

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April 11, 2012

Economy & Strategy UPDATE

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 AmbitCapital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.

This could be heaven for stock pickersThe old India story (+8% growth, heavy investment in infra, aconcerted macro thrust delivered to a powerful economy) is dead. Thenew India could be heaven for the diligent stock picker who isprepared to go to the smaller cities, visit the workshops of small-midcap companies and see the vitality of Indias million mutinies(without worrying about whether the 3-month ADV of the stock inquestion is above US$3mn). It is in these new power centres that India

will continue to buzz even as the old India story dies.

The immediate term picture: Limited repo rate cuts, economic growthin line with the new normalFactoring in the impact of two sets of developments that have unfolded over the

past month namely: (1) A significant jump in the INR price of Brent, and (2) Theadministration of a 2% point increase in central excise duty rates leads us to shiftour expected trajectory of inflation higher by ~50bps (see exhibit A on the right).

Feeding this inflation dynamic into our Taylor Model reconfirms our view of limitedrepo rate cuts being administered in FY13 (cumulatively 50bps). Whilst repo ratecuts are likely to be limited, the RBI is likely to undertake meaningful interventionto counter the tight liquidity situation in the form of CRR rate cuts and liquidity infusions over the course of FY13.

We expect GDP growth in FY13 to be recorded at 7.3% YoY, a 10bps downgrade v/s our previous estimate on account of lower than expected repo rate cuts (see pg6 for details).

With GDP growth in line with the subdued new normal of 7%, with structurally high cost of capital, with rising demand for liquidity and a clear diffusion of power away from the Centre, stock selection skills will come to the fore in FY13.

The big picture: Is India imploding?The contours of the political and economic changes currently underway in Indiacan be viewed through the lens of three long term trends that have been in play over the past 50 years: (1) The relentless demise of national parties, (2) Theascendancy of formerly suppressed communities and parties that champion their cause, and (3) The relentless rise of individual aspirations.

The three key implications of these historical trends are likely to be: (1) Thefragmentation of political power ultimately leading to the Third Front (of non-Congress and non-BJP parties) triggering a mid-term General Elections next year;(2) The creation of new wealth and power centres in cities such as Lucknow,Kolkata and Patna; and (3) The continued absence of national macroeconomicthrust as the two national parties lose their grip on power whilst the ascendantregional and caste based parties lack any national economic agenda.

Investment implications: Bet on aspirations and management teamsThe fragmentation of political power is likely to manifest itself in the form of continued underperformance of Heavy / Infra related sectors (see exhibit Con the right). Simultaneously this is likely to be accompanied by the rise of wellmanaged states such as Bihar, Maharashtra and Gujarat (see exhibit B on theright).

Even as Indias GDP growth rate settles at the new normal of 7% YoY, the rise of individual aspirations is likely to mean the continued outperformance of stocksfocused on aspirational consumption (see exhibit C on the right).

More generally, well managed, cash generative companies with brands,distribution, some innovative technology and demand underpinned by aspirationalconsumption will thrive in the new India even as the Power, Infra, Heavy Engineering sectors and the Banks who lent to them, flounder.

Analyst contacts

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

Ritika Mankar MukherjeeTel: +91 22 3043 [email protected]

Exhibit A: Expected inflationtrajectory* shifts higher onaccount of (1) higher INR prices ofcrude and (2) excise duty hikes

4%

5%

6%

7%

8%

1QFY13 2QFY13 3QFY13 4QFY13 A v g

Q t r l y W P I I n f l a t i o n

( Y o Y , i n

% )

New Estimate Old Estimate

Source: CEIC, Ambit Capital research

Exhibit B: The rise of well managed

states

Jharkhand

Punjab

UP

KarnatakaOrissa

AP WB

Rajasthan

CG

Kerala

MP

Haryana

Tamil Nadu

Gujarat

Bihar

1%

2%

3%

4%

5%

5% 6% 7% 8% 9% 10% 11% 12% 13% 14%

Real GDP growth (CAGR, in % over FY09-12)

F i s c a

l d e f

i c i t ( i n F Y 1 2

, a s a

% o

f G D P )

Maharashtra

Source: CEIC, Ambit Capital research (Refer to pg11 for more details)

Exhibit C: Aspirational consumptionplays have outperformed over thepast decade

0%

5%

10%

15%

20%

25%

30%

35%

Sales PAT Stock Price

M e d

i a n

C A G R ( i n

% )

Aspirational Essentials BSE 500

Source: CEIC, Ambit Capital research (Refer to pg12 for details)


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Ambit Capital Pvt Ltd 2

CONTENTSIn the immediate term: Limited repo rate cuts, economic growthin line with the new normal 3

The big picture: Is India imploding? 9

Investment implications .11

Appendix I 13

Appendix II ..14


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In the immediate term: Limited repo rate cuts,economic growth in line with the new normal

Summary: Factoring in the impact of two sets of developments that have unfoldedover the past month namely: (1) A significant jump in the INR price of Brent(currently at INR6,400/barrel v/s our initial base case of INR5,500/barrel for FY13:see exhibit 1 on the next page); and (2) The administration of a 2% increase incentral excise duty rates leads us to shift our expected trajectory of inflation higher by ~50bps (see exhibit 2 on the next page).

Feeding this inflation dynamic into our Taylor Model reconfirms our view of limitedrepo rate cuts being administered in FY13. We expect the total quantum of reporate cuts in India to be limited to 50bps in FY13 with the first rate cut likely to beadministered on April 17, 2012.

Just like the RBIs monetary policy tightening agenda over CY10 saw the RBIadminister repo rate hikes whilst actively working to generate a deficit liquidity situation, we expect the RBI to pursue the reciprocal of this strategy in FY13. Whilstrepo rate cuts are likely to be limited, the RBI is likely to undertake meaningfulintervention to counter the tight liquidity situation in the form of CRR rate cuts andliquidity infusions over the course of FY13.

The lower-than-expected cut in policy rates in turn leads us to trim our GDPgrowth forecast marginally by 10bps to 7.3% YoY. We re-iterate our expectation of marginally higher GDP growth in FY13 (v/s the 6.9% that the Indian economy islikely to deliver in FY12) in view of an incrementally supportive globalmacroeconomic environment.

With GDP growth in line with the new subdued normal of 7%, with structurally high cost of capital, rising demands on liquidity and a clear diffusion of power away from the Centre, investors stock selection skills will come to the fore (refer to

page 9 of this note for details).

The higher rupee prices of crude to drive inflation higher

The past month has been witness to a phenomenal rise in the INR price of crude(12% QoQ increase over 4QFY12: see exhibit 1 on the next page). Closer home,the announcement of the Union Budget on March 16, 2012 saw the central exciseand service tax rates being hiked by 2% points for FY13.


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Exhibit 1: The run up in the INR prices of crudeover the past quarter

5000

5500

6000

6500

0 3 - 0

1 - 1 2

1 7 - 0

1 - 1 2

3 1 - 0

1 - 1 2

1 4 - 0

2 - 1 2

2 8 - 0

2 - 1 2

1 3 - 0

3 - 1 2

2 7 - 0

3 - 1 2

I N R p r

i c e s o f c r u d e

( I N R / b a r r e l

)


Exhibit 2: Our expected inflation trajectory* shiftshigher on account of: (1) higher INR prices ofcrude; and (2) excise duty hikes

4%

5%

6%

7%

8%

1QFY13 2QFY13 3QFY13 4QFY13 A v g

Q t r l y W P I I n f l a t i o n

( Y o Y , i

n % )

New Estimate Old Estimate


*Assumptions made: (1) Petrol prices are increased by INR 4/litre anddiesel prices are increased by INR 1/litre in 1QFY13. Diesel prices areincreased by INR2/litre in 2QFY13. (2) INR prices of crude average out atINR6000 per barrel in 1HFY13 and at INR5500 per barrel in 2HFY13.

Factoring in the impact of these two sets of developments into our inflation model(refer to the Appendix I for details) leads us to raise our expected inflationtrajectory in FY13 by ~50bps (see exhibit 2).

Whilst we expect the INR to remain under pressure in FY13 (in view of the widening current account deficit and weakening capital flows), our Oil & Gasanalyst Dayanand Mittal, highlights that the current dollar crude price is buildingin significant geo-political risk premium of US$15-US$20/barrel (i.e. 15% of thecurrent price of crude). He expects this geo-political risk premium to halve in2HFY13 given: (a) The weakness in global oil demand; and (b) The improvementin supply from Libya, traditionally a major supplier of Brent. Consequently, webuild in an average INR price of crude at 6,000 INR/barrel for 1HFY13 and 5,500INR/barrel for 2HFY13 in our inflation model.

Moving on to the impact of higher indirect tax rates, given that the WPI basketfocuses on goods versus services the impact of the increase on the WPI gauge islikely to be more on account of the excise duty hike. Given those categories wherethe increase in excise duty rates is likely to be passed through fully amounts to10% of the WPI basket (Dairy Products: 0.6% , Canning and processing food:0.4%, Bakery products: 0.4% , Beverage & Tobacco: 1.8% , Metal Products: 1.7%and Transport Equipment: 5.2%), we build in an additional layer of 20bps (200bps

excise duty increase x 10% weightage = 20bps) on account of excise duty ratehike.

leaving limited scope for repo rate cuts in FY13Feeding our higher inflation expectation into our Taylor Model reconfirms our view of limited repo rate cuts being administered in FY13. We expect the total quantumof repo rate cuts in India to be limited to 50bps in FY13 with the first rate cut likely to be administered on April 17, 2012 (see exhibit 3 below).

The rate cuts are likely to be motivated by the need to revive economic growth but will be capped by the extent of inflation. Inflation in turn is likely to reflect adownward trajectory in 1HFY13 but rise incrementally in 3QFY13 (see exhibit 2

above for details) as the second round impact of fuel and food inflation beginsaffecting the core gauge.


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Exhibit 3: We expect the RBI to cut policy rates by 50bps in FY13

6.0

6.5

7.0

7.5

8.0

8.5

9.0

0 4 - 2 0 1 1

0 6 - 2 0 1 1

0 8 - 2 0 1 1

1 0 - 2 0 1 1

1 2 - 2 0 1 1

0 2 - 2 0 1 2

0 4 - 2 0 1 2

0 6 - 2 0 1 2

0 8 - 2 0 1 2

1 0 - 2 0 1 2

1 2 - 2 0 1 2

0 2 - 2 0 1 3

R e p o r a

t e ( i n % p

. a . )


Exhibit 4: The RBI actively created a deficitliquidity situation whilst tightening the repo ratein CY10

-3%-2%-1%0%1%2%3%4%

0 4

- 2 0 0 8

0 7

- 2 0 0 8

1 0

- 2 0 0 8

0 1

- 2 0 0 9

0 4

- 2 0 0 9

0 7

- 2 0 0 9

1 0

- 2 0 0 9

0 1

- 2 0 1 0

0 4

- 2 0 1 0

0 7

- 2 0 1 0

1 0

- 2 0 1 0

0 1

- 2 0 1 1

0 4

- 2 0 1 1

0 7

- 2 0 1 1

1 0

- 2 0 1 1

4%

5%

6%

7%

8%

9%

R e p o r a

t e ( i n

% p . a . )

Liquidity in banking system (Left Scale : Net surplus , as a % of deposits)Net liquidity injections (Left Scale : Net OMO purchases, as a % of deposits)Repo Rate ( Right Scale)

L i q u

i d i t y

i n b a n

k i n g s y s

t e m

/ N e t

O M O

i n

j e c t

i o n s

( a s a

% o f d e p o s i

t s )


However, an analysis of the broader monetary policy stance assumed by the RBIover the last tightening phase suggests that the initiation of the RBIs monetary policy tightening over CY10 saw the RBI actively working to generate a deficitliquidity situation (see exhibit 4 above), in a bid to expedite monetary policy transmission.

Exhibit 5: The consistently rising demands onliquidity in India since CY11 . . .

-8%-7%

-6%-5%-4%-3%-2%-1%0%

0 3 - 2 0 0 5

0 9 - 2 0 0 5

0 3 - 2 0 0 6

0 9 - 2 0 0 6

0 3 - 2 0 0 7

0 9 - 2 0 0 7

0 3 - 2 0 0 8

0 9 - 2 0 0 8

0 3 - 2 0 0 9

0 9 - 2 0 0 9

0 3 - 2 0 1 0

0 9 - 2 0 1 0

0 3 - 2 0 1 1

0 9 - 2 0 1 1

C u r r e n t a / c

& f i s c a

l d e f

i c i t

( a s a

% o f

G D P )

Current Account (4QMA , as a % of GDP)Fiscal Deficit (4QMA , as a % of GDP)


Exhibit 6: . . . and the declining financial savingsof Indian households

13%10%

12% 13%

25%

23%

0%

5%

10%

15%

20%25%

30%

FY10 FY11

G r o s s

H o u s e

h o l d S a v i n g s

( a s a

% o f

G D P )

HH : Financial HH: Physical Household


Given the rising demands on liquidity in India imposed by the twin deficits (seeexhibit 5 above) and the concomitant decline in the internal sources of liquidity inthe form of household financial savings (see exhibit 6 above), the liquidity situationin India is likely to remain vulnerable to the quantum of capital inflows into India.

Much like the RBI forced a deficit liquidity situation on the banking system in Indiain CY10 to expedite the transmission of monetary policy tightening; the RBI is likely to intervene to counter the tight liquidity situation in the economy in FY13 as it cutsrepo rates marginally. RBIs measures aimed at liquidity augmentation in FY13 arelikely to assume the form of both explicit CRR cuts and as well as liquidity infusions.


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Economy & Strategy


We trim our GDP growth forecast by 10bpsFeeding the lower-than-expected cut in policy rates into our GDP growth model(refer to the Appendix II of this note for details) leads to lower investment growthfor FY13 and hence lower industrial sector growth (given that industrial sector growth is a function of the extent of capacity creation in an economy).

Exhibit 7: We trim our investment growth forecast by 30bps in view of limitedrepo rate cuts in FY13(%) FY11(actuals)

FY12(CSO estimates)

FY13 (ourold estimate)

FY13 (ournew estimate) Difference

GDP 8.4% 6.9% 7.4% 7.3% -10bps

Agriculture 7.0% 2.5% 2.9% 2.9% 0bps

Industry 7.2% 3.9% 6.2% 6.0% -20bps

Services 9.3% 9.4% 9.0% 8.9% -10bps

Investment demand 7.5% 5.6% 7.3% 7.0% -30bps


Whilst a subset of services in India (called Community Social and PersonalServices) is driven by Government expenditure, more than 75% of the services

sector growth is driven by the pace of activity in the industrial sector.Consequently, the lower industrial sector growth number leads to a 10bpsreduction in services sector growth as well.The cumulative impact of a lower-than-expected policy rate cuts in India translatesto a 10bps reduction in our projected GDP growth rate for FY13 (see exhibit 7above).

Marginal improvement in GDP growth in FY13 (v/s FY12) to bedriven by sectors with improved access to capitalGiven that the Indian economy is in many ways like a small company that is

working capital deficient, historically an increase in global risk aversion levels isaccompanied by a sharp V shaped dip in Indias investment growth (see exhibit 8below).In our note dated February 27, 2012 we made the point that, with France,Germany and USA headed towards presidential elections, comprehensive QE islikely to be administered on both sides of the Atlantic in FY13. Since then,following the administration of LTRO by the ECB (in 3Q & 4Q FY12), there hasbeen a clear uptick in equity flows into India (see exhibit 9 below).


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Exhibit 8: Investment growth in India suffers in years that are characterized by a financial crisis

-5%

0%

5%

10%

15%

20%

F Y 9 6

F Y 9 7

F Y 9 8

F Y 9 9

F Y 0 0

F Y 0 1

F Y 0 2

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1

F Y 1 2

F Y 1 3

I n v e s t m e n

t d e m a n

d g r o w

t h ( y o y , i

n % )


Exhibit 9: Clear uptick in FII flows into India in4QFY12

-1000

100200300400

500600700800

0 6 - 2 0 1 0

0 8 - 2 0 1 0

1 0 - 2 0 1 0

1 2 - 2 0 1 0

0 2 - 2 0 1 1

0 4 - 2 0 1 1

0 6 - 2 0 1 1

0 8 - 2 0 1 1

1 0 - 2 0 1 1

1 2 - 2 0 1 1

0 2 - 2 0 1 2

N e t

F I I f l o w s ( i n

I N R b n )

FII : Total FII: Equity

Source: EPFR Global, Ambit Capital research

Given that our macro model points to incrementally higher investment growth inIndia in FY13 on account of an incrementally supportive global risk environment,

we proceed to identify sectors within the economy that are likely to drive theincrementally higher investment growth in India due to improved access to capital.

Whilst Financial Services-dominated new capital raised in FY12 recording a 221% YoY jump; Power, Non-ferrous metals and Roads are three sectors that haverecorded above system-average credit growth rates. From a Government supportperspective, Power, Civil Aviation and Roads are likely to be beneficiaries of improved Government capex.

Exhibit 10: Financial Services recorded a 221% YoY increase in new capital raised in FY12 YTD

0100

200

300

400

500

600

Total Banks Financials N e w

C a p

i t a l R a i s e

d ( i n I N R b n )

FY10* FY11* FY12*

Source: Bloomberg, Ambit Capital researchNote : Data available till Jan 2012

Exhibit 11: Sectors such as Power, Non-ferrousmetals and Roads have recorded an increase inshare in total bank credit over FY12 YTD

0.4%

0.2% 0.2%

0.1% 0.1% 0.1%

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

P o w e r

N o n - f

e r r o u s m

e t a l s

R o a

d s

I r o n

& S t e e

l

C e m e n

t

M i n i n g

I n c r e a s e

i n s h a r e o f

b a n k c r e d

i t

( i n % )


New capital raised: Financial Services dominate new capital raised Whilst the overall quantum of new capital raised in FY12 YTD (SEBI dataavailable until Jan 2012) was recorded at INR280bn i.e. a 46% YoY

contraction, a sectoral analysis of the data suggests that Financial Servicesdominated capital raises in FY12 YTD. Whilst capital raised by banks recorded


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Economy & Strategy


a 186% YoY jump in FY12 YTD, Financial Services recorded a 333% increasein new capital raised over the same period (see exhibit 10 above).

Bank credit: Power , Non-ferrous metals and Roads experience above-average bank credit growth

Whilst bank credit growth has decelerated from 21% YoY in FY11 end to 16% YoY as at February 2012, credit growth to sectors such as Mining (40% YoY) ,

Non-ferrous Metals (38% YoY), Roads (26% YoY) as well Power (23% YoY)continues to grow at an above average pace.

An analysis of the constitution of bank credit over FY12 year to date (i.e. fromend-FY11until February 2012) suggests that the share of Power in total bank credit has increased by 40bps over this period whilst that of Non-ferrousmetals and Roads has increased by 20bps each (see exhibit 11 above for details).

Government capex : Power, Civil Aviation and Roads emerge asGovernment capex focus areas

Whilst the Central Government failed to deliver on fiscal consolidation, theUnion Budget envisages a shift in expenditure in favour of capital expenditure.

The Central Government envisages a 31% YoY increase in capex as againstflat growth in FY12 as per the Union Budget for FY13. Making the assumptionthat the Indian states budget for the same extent of capex growth in FY13 as

was the case in FY12, then State and Central capex together is likely to recorda YoY growth of 24% YoY thus pushing Government (State + Centre) capex asa percentage of nominal GDP to 4.2% of GDP the highest in 5 years.

A sectoral break-up of Central Government capex suggests that three key ministries namely Power (66% YoY), Civil Aviation (231% YoY) and RoadTransport & Highways (18% YoY) are budgeted to record a meaningfulincrease in Central Government capex (see exhibit 13 below).

Exhibit 12: Central Government capex in FY13 isbudgeted to expand at 31% YoY

39%

0%

31%

12%18%

24%18%

24%

9%

0%

10%

20%

30%

40%

50%

FY11 FY12 FY13 (BE) G r o w t h

i n C a p e x

( Y o Y , i

n % )

Central : Capex All States : Developmental Capex Total Govt. Capex


Exhibit 13: The Union Budget envisages a meaningfulincrease in spends on Power, Civil aviation and RoadTransport & Highway Ministries

0

20

40

60

80

100

120

Power Civil Aviation RoadTransport &Highways

C e n

t r a l C a p

i t a

l E x p

b y

M i n i s t r y

( I N R b n

)

FY12 FY13



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The big picture: Is India imploding? As major FIIs unwind their positions in India in the wake of the uncertainty causedby the notification of a new set of General Anti Avoidance Rules (GAAR), asdomestic retail investors prefer to invest their money in gold rather than in thestock market and as rumours of a military coup make it to page 1 of the major national dailies, it is easy to feel despondent about India. Seasoned FIIs say thatIndia is an uninvestable imploding democracy. So, is it all over for India? Will thecountry now go to sleep for another decade or two?

Viewing the past in proper perspective

To get a sense of Indias future at this despondency filled hour, it is worth lookingat a longer sweep of its history, rather than the few wretched years of the currentUPA regime. When you look at that longer sweep of Indian history, a few featuresstand out:

The demise of national parties : In almost every decade post Independence,the largest party in the Lok Sabha (the Congress for the most part and the BJPin some years over the past 20 years) has systematically lost vote shareindicative of the demise of national parties and the concomitant rise of regional parties. The percentage of Lok Sabha seats won by the largest party in Lok Sabha has trended down systematically from 74% in the 1st Lok Sabhato 38% in the 15 th Lok Sabha (current governing body).

The relentless demise of the national parties is arguably driven by the rise of more regional, more working class, non- Brahmin , non-English speaking elites.Hence regardless of how the national parties perform vis--vis the KPIs thatinvestors focus on (growth, inflation, interest rates, exchange rates), they areoperating against the tides of social change in India.

The ascendancy of the suppressed : The adoption by the national parties,particularly the UPA, of an explicit pro-poor agenda (aimed at wooing

disadvantaged castes and classes) shows how powerfully democracy hasswung the balance of power in favour of economically disempowered groups.

Not only is their cause represented by regional parties like the TMC, BSP, DMK parties whose raison detre is to lift the disadvantaged - their cause is now represented by every party as it is the only cause which matters at the ballotbox. Once again, the simplistic KPIs of growth and inflation are no longer toorelevant to Indian politics, which is now largely about the rise of groups whohave never wielded power in India.

The relentless rise of individual aspirations : At the level of the individual,the analogue of the previous bullet is a relentless rise in aspirations. As V.S.Naipaul memorably put it in his 1989 masterwork, India: A Million Mutinies

Now, The book was dedicated to a further idea: that India was, in the simplest way, on the move, that all over the vast country men and women hadmoved out of the cramped ways and expectations of their parents andgrandparents and were expecting more. These men and women want their children to be well educated and healthy. They want to live in pucca homesand purchase products which signal to the community around them that they are moving up in the world. This dynamic, which we have analysed in detail inannual Megathemes notes, predates Indias 1991 economic reforms and has alife of its own, unrelated to the incompetence of our administrators.


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So what will the future bring for us? Three key implications of the weakening of national parties, the rise of powerfulstates and the rise of individuals and their aspirations is likely to be: (1) Thefragmentation of political power, (2) The concomitant creation of new wealthcentres and (3) The continued absence of national macroeconomic thrust asnational parties are overwhelmed by coalition management and as regionalparties lack national focus.

The fragmentation of political power

A highlighted in our previous emails, power in India is migrating away from theCongress in New Delhi to the States, to regional parties, to the regulators (TRAI,SEBI, RBI etc.), to the watchdogs (CVC, CAG, Competition Commission, ElectionCommission etc.) and the Courts.

Focusing specifically on the political fragmentation of power, we expect two key developments over the next 18 months:

The rise of the Third Front : Why should I just be a kingmaker if I canbecome the King myself? that is the question that at least half a dozenregional Indian political leaders (including members of the UPA and NDA

coalitions) are asking themselves today. Having seen the demise of thenational parties, they can sense that there is a power vacuum in Delhi.Obviously, they want to fill this vacuum themselves. To do so they have to co-operate with each other and agree to the outline of a power sharingagreement. These discussions are under way and will reach a climax over thenext year at which point..

.Mid-term General Elections : will become a plausible event. At present,neither of the two main political parties have the will to trigger another election. A year hence, with critical State elections lined up in BJP strongholdsof Gujarat, Madhya Pradesh and Chattisgarh over the next 18 months, the BJP

will be more predisposed to vote with the Third Front and bring down the UPA.

The creation of new power and wealth centres As political and policymaking power migrates from Delhi to the States, we expectthe previously unassuming State Capitals like Lucknow (UP accounts for 15% of Lok Sabha seats), Kolkata (Bengal accounts for 8% of Lok Sabha seats), Patna (7%)and Gandhinagar (5%) to become important power centres. And as we all know,in India with great power comes not great responsibility but great wealth.

The continued absence of national macroeconomic thrust

The new political elite does not have any political and economic ideology as such(beyond cornering rents for the specific group that they represent). To be fair, for Indian regional and caste based parties, their ascension to a position of power,after centuries of suppression by foreign and local elites, has been so rapid thatthey cannot be realistically expected to do anything else other than to grab power and use it for their narrow self-interested ends.

Whilst it is likely to take a decade for such parties to have any view on what shouldbe Indias economic policy, this does not mean that Indias democracy is a failure.In fact in all likelihood, this is another stage in the countrys evolution from afeudal, and then colonial, society to one which seeks to accommodate theaspirations of dozens of castes, religions and ethnicities. The old guard schooledin posh schools and elite colleges claimed to represent India. The new elite doesnot believe in this old guard but is yet to find its own intellectuals who canarticulate how India should be run.


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Economy & Strategy


Investment implicationsFor those looking for a grand India story to back (8%-9% growth, heavy investmentin infra, the smooth administration of a powerful economy by capable politicians),there wont be such a story any more. In a country as diverse as India, asevolutionary and as irreverent as India, to expect this sort of China-type story tobe sustained was/is unrealistic.

Instead, the new India story will be focused on the micro rather than macro:

A few well managed states As India becomes a more federal country, the more able state level Chief Ministers will be able to distinguish themselves even as the Centre crumbles. As NitishKumar has shown in Bihar, even in a state known for serial economic and socialfailure, an able Chief Minister can independently drive growth.

The scorching 3-year CAGR of real economic growth in three states of Bihar (12.8% p.a.), Maharashtra (11.8% p.a.) and Gujarat (10.2% p.a.) is indicative of the rise of the economic might of States even as the national economy falls prey toeconomic rudderlessness (see exhibit 14 below). States such as these will continueto grow in economic and hence political significance in sharp contrast to thenation.

Exhibit 14: The rise of economically and fiscally powerful States such as Bihar,Maharashtra and Gujarat is likely to continue as the nation stumbles

Bihar

MaharashtraGujarat

Tamil Nadu

Haryana

MPKerala

CG

Rajasthan

WB AP

OrissaKarnataka

UP

Punjab

Jharkhand

1%

2%

3%

4%

5%

5% 6% 7% 8% 9% 10% 11% 12% 13% 14%

Real GDP growth (CAGR, in % over FY09-12)

F i s c a l

d e f i c i t ( i n F Y 1 2

, a s a

% o f

G D P )


Note: (1) Empty bubbles indicate states run by non-Congress Governments. Red dotsindicate states run by a Congress majority whilst the mild coloured bubbles indicate

States where the Congress is a part of the ruling Government in combination withan ally. (2) Real GDP growth CAGR for Maharashtra, Gujarat, Madhya Pradesh &Rajasthan refer to the CAGR over FY09-FY11 in the absence of updated data for FY12.

Over the course of the next few months, we will provide clients with clarity on how to benefit from the efficiency of well managed States.

The continued rise of individual aspirations

The aspiration which seeps out of almost every aspect of the Indian underclassexistence is and will continue to be a powerful driver for this country. Suchaspirations have already meant that a basket of aspirational stocks (with noparticular regard to quality) has outperformed essential stocks by 7% CAGR andthe BSE100 by twice as much over the past decade (see exhibits 15 & 16 below;refer to our note Megathemes 2.0 dated November 9, 2012 for details).

In fact the inability of heavy sectors to outperform is also a direct corollary of theabsence of a powerful central macroeconomic thrust.


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Exhibit 15: Stocks focused on aspirationalconsumption have outperformed over the pastdecade

0%

5%

10%

15%

20%

25%

30%

35%

Sales PAT Stock Price

M e d

i a n

C A G R ( i n % )

Aspirational Essentials BSE 500

Source: CEIC, Ambit Capital research.Note: Period under study- FY01-FY11. Both Aspirational stocks andEssential stocks are a subset of BSE 500.Refer to pg30-31of out note

Megathemes 2.0 for an exhaustive list.

Exhibit 16: B2C sectors have been clear outperformersover FY08-11

R2 = 0.476

(10)

-

10

20

30

40

50

60

70

-20% -10% 0% 10% 20% 30% 40%

FY08-11 revenue CAGR

F Y 0 8

- 1 1 s h a r e p r

i c e

C A G R Auto

Cons Durables

Healthcare

Realty

MetalsTMT

Power Oil & GasPSUs

Capital Goods

BanksFMCG

IT

Source: CEIC, Ambit Capital research.

Exhibit 17: Cash generative companies havedeliver superior share price performance

6%

18%

14%

21%

0%

5%

10%

15%

20%

25%

FY09-11 FY06-11

C A G R i n s t o c

k p r

i c e

( i n % p . a .

)

BSE 500 Cash Generators

Source: CEIC, Ambit Capital research.

Note: Cash generators are defined as BSE500 ex-financials with CFO greater than NP for the period spanning FY05-11as well as a positive CFO in FY05 as well as FY11.

Exhibit 18: Cash generative sectors are likely tocontinue to outperform the broader market

y = 26.051x + 22.669R 2 = 0.0747

-

1020

30

40

50

60

70

-40% -20% 0% 20% 40% 60%

Op Cashflows (FY08-11 CAGR)

S h a r e h o l

d e r r e

t u r n s

i n %

( F Y 0 8

- 1 1 C A G R )

Healthcare

Banks

Consumer Durables

Auto

IT

FMCG

Oil & Gas

PSUsCapital Goods

Power Realty

BSE100 3 yr CAGR


Well managed, capital efficient small-mid cap companies

As highlighted over the past year, Indian companies which dont generate freecashflow and dont have sustainable competitive advantages other than politicalconnectivity will struggle in the new dispensation. A corollary of this is that theBanks which have lent to these companies will also struggle in FY12. On the other hand, well managed, cash generative companies with brands, distribution, someinnovative technology and demand underpinned by aspirational consumption willthrive in the new India (see exhibits 17 and 18 above). Examples of such plays areExide, Eicher, Cummins India, Kirloskar Oil Engines, Agrotech, Greaves Cotton,Elgi Equipment and Voltas.


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Appendix I

Exhibit 19: The structure and assumptions underlying our inflation model for FY13 WPIConstituents Weightage* Definition Modeling technique Key assumption(s) made

Core 32% Manufacturing excludingchemicals , metals and food

Regression analysis using the

following explanatory variables:output gap, food inflation andregulated fuel price inflation

GDP growth in FY13 is recorded at7.3%

Regulatedfuel 7%

Diesel, Petrol , LPG andKerosene

Regression analysis using theretail prices of fuels asexplanatory variables

(1) Petrol prices are increased by INR 4 per litre in 1QFY13 (2) Dieselprices are increased by INR 3 litreover 1HFY13

Fuel floaters 26%

Fuel excluding regulatedfuel, metals (both fromprimary articles andmanufacturing) andchemicals.

Regression analysis using globalcrude oil prices in INR terms asexplanatory variables

Global crude oil prices average INR 6,000 per barrel over 1HFY13 andINR 5,500 per barrel over 2HFY13

Food 29%

Primary articles excludingminerals and the foodcomponent of manufacturing.

Historical seasonality trendsadjusted for deviations

India receives normal rainfall andhistorical seasonality trends are

repeated in FY13.Coal &electricity 6% Historical trends

Historical trends are repeated inFY13

WPI 100%


Note: The weightages used are as per the WPIs specification only the combinations used by our model are unique.


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Appendix II Ambits supply-side GDP growth model

Our supply-side GDP forecasting framework rests on four interdependent models(see exhibit 20 below for details) with a model dedicated to forecasting 1) farmsector growth, 2) investment demand growth, 3) industrial sector growth and 4)

services sector growth. The combined output from each of these 4 models is usedto predict GDP growth.

Exhibit 20: The structure of Ambits GDP growth model

GDP

Agriculture ServicesInvestment

Industry

Source: Ambit Capital research

Each of the above highlighted four constituents of GDP is predicted using a set of macroeconomic variables (see exhibit 21 below for details) with each coefficient inour partial-equilibrium GDP framework being significant at a 95% degree of confidence. Further, each model is characterized by an adjusted R square (astatistical parameter indicative of the explanatory power of the model) of 55% or more.

Exhibit 21: Explanatory variables used to predict GDP constituentsSignificance at95% degree of

confidence Adjusted R square

1. Farm Sector Growth ModelDrivers

Rainfall adjustment factor Increase in Minimum Support Prices

Lagged farm sector growth 73%

2. Industrial Sector Growth ModelDrivers

GFCF Growth 55%3. Investment Demand Growth

Model Drivers

Economic Crisis Factor Policy Rate

Lagged GFCF growth

GDP growth

63%

4. Services Sector Growth ModelDrivers

Industrial sector growth

Union Government expenditure60%

Source: Ambit Capital research


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Institutional Equities TeamSaurabh Mukherjea, CFA Head of Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail Aadesh Mehta Banking / NBFCs (022) 30433239 [email protected]

Anand Mour FMCG (022) 30433169 [email protected]

Ankur Rudra, CFA Technology / Telecom / Education (022) 30433211 [email protected]

Ashvin Shetty Automobile (022) 30433285 [email protected]

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

Chhavi Agarwal Construction / Infrastructure (022) 30433203 [email protected]

Dayanand Mittal Oil & Gas (022) 30433202 [email protected]

Gaurav Mehta Derivatives Research (022) 30433255 [email protected]

Hardik Shah Technology / Education Services (022) 30433291 [email protected]

Jatin Kotian Metals & Mining / Healthcare (022) 30433261 [email protected]

Krishnan ASV Banking (022) 30433205 [email protected] Bhasin Construction / Infrastructure / Cement (022) 30433241 [email protected]

Pankaj Agarwal, CFA NBFCs (022) 30433206 [email protected]

Parita Ashar Metals & Mining / Media / Telecom (022) 30433223 [email protected]

Rakshit Ranjan, CFA Mid-Cap (022) 30433201 [email protected]

Ritika Mankar Mukherjee Economy (022) 30433175 [email protected]

Ritu Modi Cement (022) 30433292 [email protected]

Shariq Merchant Consumer (022) 30433246 [email protected]

Sales

Name Regions Desk-Phone E-mail

Deepak Sawhney India / Asia (022) 30433295 deepaksawhney@ambitcapital .com

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

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

Pramod Gubbi, CFA India / Asia (022) 30433228 [email protected]

Sarojini Ramachandran UK +44 (0) 20 7614 8374 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Kausalya Vijapurkar Editor (022) 30433284 [email protected]


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Economy & Strategy

Explanation of Investment Rating

Investment Rating Expected return(over 12-month period from date of initial rating)

Buy >5%

Sell

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