Market Calls

1. FEDERAL BANK: Met new CMD; Focus on improving systems and process; Growth to remain moderate in near term; Buy

We met the new MD & CEO of Federal Bank (FB IN, Mkt Cap US$1.6b, CMP Rs435, Buy), Mr Srinivasan who has a tenure of five years, to understand strategy of the bank under his leadership. Key takeaways:

– With large balance sheet, capabilities and distribution strength already in place, key focus will be on improving risk management systems and processes (to tackle NPA issues and have quality growth ahead).

– Balance sheet growth will remain moderate till back end processes improve. Federal Bank will continue to focus on Retail and SME as the prime growth drivers.

– SME regions will be the focus areas for branch expansion. Planning to scale up branch network to 1,000 branches in next 2 years from ~700 currently.

– Once branch expansion and investment in technology/manpower picks up, C/I ratio will increase to 40%+ vs 35% reported in FY10.

– While RoA of the bank will remain strong at ~1.3%, RoE is likely to remain in mid teens till FY12 as growth moderates.

About Mr Shyam Srinivasan:

– Mr Srinivasan has taken charge as Managing Director & CEO of Federal Bank with effect from 23rd September 2010.

– He joined Federal Bank after having worked with leading multinational banks in India and overseas across Middle East, India and South East Asia, where he has worked in retail lending, wealth management and SME banking.

– Before joining Federal Bank, Shyam Srinivasan was with Standard Chartered Bank, where he was responsible for strategy, development and management of the bank’s Consumer Banking Business spread across a large network of branches in India employing over 6,000 people.

– Prior to that, he was Country Head of Standard Chartered Bank’s consumer franchise in Malaysia.

– Mr Srinivasan is an alumnus of IIM Kolkata and Regional Engineering College, Tiruchirapally. He has completed a Leadership Development Program from the London Business School and has served on the Global Executive Forum (the top 100 executives) of Standard Chartered Bank from 2004 to 2010.

Improving systems and process for quality growth ahead

– Under the leadership of Mr Srinivasan, key focus of the bank is to improve risk management systems and processes to tackle asset quality issues.

– For retail loans, bank is in the process of improving recovery mechanism by introducing scorecard system. 13 regional retail hubs are already in place, however, not operating at the optimal levels. Recently, bank has withdrawn sanctioning power at the branch level.

– For growing large corporate loans, newer products and high end corporate systems to be placed to garner new business.

– Mr Srinivasan mentioned that the bank will continue to focus on Retail and SME loans as the growth drivers.

Branch expansion and employee related strategy

– New branch expansion will be made based on opportunity to grow SME loans (SME hubs) and current account deposits. Planning to scale up branch network to 1,000 branches in next 2 years from ~700 branches as on 1QFY11.

– More than 95% staff of the bank is unionized; focus of the management will be to increase conversation and transparency to improve productivity.

– The bank is looking to hire 1,000+ employees in FY11 to its existing staff strength of 7,800+. More than 30% of the staff is recruited in last three years. This coupled with natural attrition will bring down average age of employees.

– Large scale top management change is not expected and bank will look at internal and external talent for key positions.

Growth to remain moderate

– Immediate focus of Federal Bank is to improve systems and process for quality growth ahead. In the process, it is not averse to moderating growth.

– In the near term, management expects to grow in line with or marginally lower than industry.

– On the liability side, the bank will remain focused on CASA (29% as of 1QFY11) and NRI deposits (16% as of 1QFY11).

– On the non interest front, immediate focus of the bank will be to improve forex, treasury and third party distribution income.

Valuations and view: Execution remains a challenge; Return ratio in mid teen till FY12

– While distribution network and systems are in place, successful execution of strategies in a highly unionized set up will remain a challenge, in our view.

– We estimate EPS of Rs36 in FY11 and Rs43 in FY12 i.e. FY10-12 EPS CAGR of 25%. We expect RoA to remain strong at 1.3%+ over FY10-12. However, excess capital will keep RoE in FY10-12 lower at 13-14%.

– The stock trades at FY12E P/E of 10x and P/BV of 1.3x. Maintain Buy with a revised target price of Rs505 (1.5x FY12E BV of Rs337).

2. IT 2QFY11 PREVIEW: Key things to watch – Acceleration in growth trajectory, Discretionary traction, and Outlook on supply-side pressure

We expect continued momentum in 2QFY11 US$ revenues with growth in the range of 4.2-6% QoQ across top 4 IT companies. Infosys EBITDA margin is expected to recover 120bp QoQ while wage hike across HCL Tech and promotion impacts at TCS and Wipro will keep the margins curbed. Key expectations:

– Infosys to outperform on revenue growth with 6% QoQ growth (v/s 5.6% at Wipro and 4.7% at TCS)

– EBITDA margins at Infosys expected to recover 120bp QoQ to 32.9%. Promotion impacts at TCS and Wipro to curtail margins. HCL Tech margins to be hit the hardest on wage hikes becoming effective from July 2010

– Expect Infosys to marginally up its US$ revenue growth guidance to 20-22% (v/s 19-21% earlier); full-year EPS guidance to remain largely unchanged due to sharp rupee appreciation towards the end of the quarter

– Expect stock upsides if pintujose@agio.in US$ revenue growth exceeds 7% QoQ; 85fcf43ea6cf8a7ff98be9df3cd33d13 Infosys FY11 US$ revenue growth guidance exceeds 22%; 1 Discretionary demand traction returns after missing out in the last quarter, indicating possibility of mix-based pricing improvement; and NULL Demand scenario in Europe improves.

– We prefer playing the sector through companies gaining from pintujose@agio.in pick-up in discretionary demand, 85fcf43ea6cf8a7ff98be9df3cd33d13 better operational scope, and 1 greater MNC offshoring.

– We prefer Infosys, HCL Tech and Mphasis on these parameters. Amongst the other top tier companies, we prefer TCS over Wipro.

– Infosys remains our top large cap pick, while Mphasis remains our top mid cap pick.

Infosys to outperform on revenue growth after below-estimate 1QFY11

– We expect Infosys to post the best 2QFY11 results among the top tier universe with US dollar revenue growth of 6% QoQ, ahead of its guided range of 4.1-5.1%. We expect Infosys to beat peer group growth rates for the quarter.

– Wipro and TCS are expected to follow with 5.6% QoQ and 4.7% QoQ growth, respectively.

– Cross currency to positively impact US$ revenues; HCL Tech to benefit the most (0.8% impact of cross currency on US$ revenue), as over a quarter of the company’s billing happens in Euro/GBP.

– Growth is expected to be broad-based, led by BFSI, with improved traction in Manufacturing/discretionary service lines.

Infosys margins to recover; Promotions to impact EBITDA margins at TCS, Wipro

– We expect Infosys EBITDA margins to rebound 120bp QoQ to 32.9% after 230bp QoQ decline in 1QFY11; the recovery driven by: pintujose@agio.in Sequential constant currency growth; 85fcf43ea6cf8a7ff98be9df3cd33d13 Favorable QoQ currency movements and 1 Operating cost efficiencies.

– Impact of promotions at TCS to lead to 20bp QoQ decline in EBITDA margins to 29.1%.

– ~20,000 promotions in 2QFY11 and RSUs to select employees to drag IT Services EBIT margins down at Wipro by 90bp QoQ to 23.6%.

– We expect HCL Tech EBITDA margin to decline 210bp QoQ to 15.8%, taking largest hit across top-4 on account of wage inflation which became effective from the beginning of the quarter.

Expect upward revision in Infosys’ US dollar revenue guidance; EPS guidance to remain largely unchanged

– For FY11 we expect Infosys to give a US dollar revenue growth guidance of 20-22% (v/s 19-21% earlier).

– We expect EPS guidance to remain largely unchanged in this quarter on account of ~4% appreciation in the Rupee in the month of September.

– We expect Infosys and Wipro to guide for 4-6% QoQ growth in 3QFY11.

What will the stocks react positively to?

Top-tier IT stocks underperformed the Sensex over the past six months as business improvement was built into estimates, and valuations are 18.5-20x FY12E earnings. Absolute upsides from current levels will be driven by changes in guidance, commentary or results suggesting movement in growth trajectory from 20-25% range to 25-30% range. The key things to watch out for to ascertain this would be:

– Pricing up-ticks: Determinants of this will be: (a) growth skewed towards discretionary service lines like package implementation/products/consulting, and (b) continued increase in demand for IT services returning pricing power to top-tier IT companies.

– Higher guidance suggesting shift in growth trajectory from 20-25% to 25-30%: We believe an increase in Infosys guidance beyond 22% could be a significant indicator of growth trajectory, moving to 25-30% quickly.

– Market share gains on impending deal renegotiations, where incumbents are MNC vendors. US$37b worth of deals are expected to come up for renegotiation over a few months. With most of the deals being Infrastructure Management Services (IMS) focused, a sudden acceleration in deal wins or deal ramp-ups in this service line would be keenly watched.

– Improvement in business traction in Europe and a shift towards longer term transformational deals v/s short term RoI focused deals, could lead to upsides.

We remain positive on the long term outlook of the industry; prefer Infosys, HCL Tech, Mphasis

– We expect IT demand to revive in FY11 with 19-25% volume growth and expect 2QFY11 results to reinforce this expectation.

– We prefer playing the sector through companies gaining from pintujose@agio.in a pick-up in discretionary demand, 85fcf43ea6cf8a7ff98be9df3cd33d13 better operational scope, and 1 greater MNC offshoring.

– We prefer Infosys, HCL Tech and Mphasis on these parameters. Amongst the other top tier companies, we prefer TCS over Wipro.

– Infosys remains our top large cap pick, while Mphasis remains our top mid cap pick.

3. INDIA ECONOMICS: US Fed Quantitative Easing-II, and what it holds for India

The QE-II measure by US Fed is expected to be largely beneficial for India irrespective of its likely impact on US recovery. At the margin, increased money flow expected to India would ease financing constraints for both Indian corporates and the Government. It is likely to have a more sobering impact on interest rates in different financial market segments. However, it is likely to lead to further rally in asset prices and complicate RBI’s monetary and currency management apart from heightened stability concerns.

The US Fed Measure

– The minutes of the US Fed FOMC meeting and the pronouncement of officials contain an indication that the Fed “is prepared to provide additional accommodation if needed”, widely touted by commentators as Quantitative Easing – II (QE-II). The measure comes on the back of reduced growth estimates by Fed staff.

– However, no indication of timeline or the magnitude of easing has been spelt out. The market appears to have put the November 3 Fed meeting as the date of announcement of ~US$700b purchase of Government securities.

– The financial market has already started discounting QE-II with 10-year treasury yields falling to a new low of 2.42%, dollar losing ground (Dollex at 78) and a rally in commodity prices (e.g. oil around US$84-5).

– The measure is likely to have widespread implication for the world financial market and is being intensely debated.

Implications for India

The move will have major implications for India’s financial markets through four channels, viz, i) money flow, ii) interest rates, iii) asset prices and inflation and iv) monetary policy. Needless to add, the expectation channel would act on top of all these and perhaps much ahead of real measure and its consequence being played out.

Money flow

– It has been estimated that global funds have nearly US$1.7t as AUM and close to ~US$300b is dedicated for emerging markets and Asia. Besides, Indian portfolio seems to be undergoing a phase of rebalancing more accurately reflecting its MSCI weight. It is likely that a part of the quantitative easing would find its way through emerging markets this may lead to an increase in FII flows from the current US$2-2.5b per month to US$3-3.5b.

– Excess capital flow would enhance the financing constraint for the Indian corporates directly as FIIs have been actively participating in the huge line up of IPOs of ~US$20b as well as Government securities (due to an enhancement in the regulatory limit on Government securities holding).

– Indirectly, this leads to an increase in the balance of payments surplus that would help creation of monetary base at a time when deposits (~14%) are lagging behind of credit growth (~20%).

Interest rates

– By easing the funding gap, it is likely to have a sobering impact on the interest rates of various segments of the financial market most direct being the impact on Government securities market where the interest rate differential between US and India is ruling close to its historical high and therefore likely to come down.

– Secondly, by reducing the funding gap and facilitating direct substitution of bank credit by foreign sources of funds, the move is likely to put a downward pressure on lending rates as well.

Asset prices and inflation

– The move is likely to fuel further liquidity driven rally in the Indian markets. Concerns have been expressed in various circles about sharp rise in equity and housing prices, necessitating a cautious approach for both market participants and regulators.

– The dollar going down will have implications for world commodity prices. This means India’s already challenging inflationary situation might be complicated further as the benefit of benign international prices enjoyed so far would no longer be there.

– With oil prices firming up and outlook further hardening it would have a direct impact on India’s inflation and already challenged inflationary expectations. Besides, international food price outlook has also become complicated due to drought and wildfire in Russia and Brazil. These factors may wane India’s high base advantage and the impact of a good monsoon on a significant part of the commodity basket used for compilation of inflation.

Monetary policy in India

– The move complicates conduct of monetary policy a great deal for RBI. On the one hand, RBI’s tightening measures would to some extent be nullified by a super-loose monetary policy in the US through ways described above. On the other hand, it would renew concerns of financial stability leading the Central bank to take incremental regulatory policy (e.g. increasing risk weight of lending to housing, real estate, equities and commodities) in its mid-term review of policy scheduled on November 2, 2010 (just a day prior of Fed meeting and hence not having the benefit of hindsight of Fed measure).

– A second challenge may emanate from hardening outlook for Rupee. India has so far not joined the currency war led by China and joined by many other export oriented countries including Japan, South Korea, and Switzerland. With much higher inflation in India, RBI’s non-intervention is likely to lead to further appreciation of real as well as nominal Rupee, adversely affecting India’s export prospects. However, the move would ease the money creation process and balance of payments position at a situation when an increased current account deficit has prevented accumulation of capital flows.

4. SINTEX 2QFY11: Below est due to execution spillover; Mgmt guidance and our estimates unchanged; FY10-12E EPS CAGR of 31%; Buy

– Sintex Industries (SINT IN, MCap US$1.3b, CMP Rs424, Buy) 2QFY11 results are below estimates as heavy monsoons throughout the country led to spillover of execution into subsequent quarters.

– Management has reiterated its FY11 guidance of 25% growth in revenue and 30-35% growth in PAT.

– We maintain our estimates for FY11 and FY12; FY10-12E EPS CAGR is 31% with RoE improving from 18% levels to 20%.

– Stock trades at an inexpensive P/E of 11x FY12E EPS of Rs39. We maintain Buy with a target price of Rs468 (12x FY12E EPS).

2QFY11 below estimates due to execution delays

– Sintex reported 2QFY11 consolidated revenue of Rs9.2b, 10% below our estimate of Rs10.2b. The management mentioned that during the quarter, execution of monolithic and pre-fab projects was affected due to heavy monsoons throughout the country.

– As the company accounts for revenue only on full completion of projects (and not percentage completion method), we believe there is a spillover of 2Q revenue into subsequent quarters. This is evident from a segment-wise analysis. For instance, 2Q pre-fab revenue is down 2% YoY and up only 12% YoY for 1HFY11. However, the company maintains its full year growth guidance of at least 20%, implying robust 26% growth in 2H given the spillover effect.

– 2QFY11 EBITDA margin at 18.6% is in line with estimate of 18.5%. One-off MTM forex gain of Rs150m is almost fully offset by one-off interest cost of Rs46m and prior period tax of about Rs80m. Adjusted PAT at Rs1b is up 34% YoY, ~11% below our estimate of Rs1.1b.

Source : Motilal Oswal

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