Election 16 April09 Strategy

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Election 16 April09 Strategy

  1. 1. Strategy INDIA INDIA April 16, 2009 BSE-30:11,285 Abstain for now. We suggest a more defensive portfolio in light of (1) the market’s fair valuations based on FY2010E earnings and (2) the impending national elections. We see limited upside to our fair valuations in most large-cap. stocks (barring banking and select commodity stocks) after the recent steep increase in their stock prices. We recommend selling certain expensive large-cap. stocks given the potential downside risks to earnings and consequent de-ratings. Defensive portfolio in light of valuations, impending national elections We have partly changed our Model Portfolio to reflect a more cautious stance in light of (1) the market’s relatively full valuations based on FY2010E earnings and (2) the impending INSIDE national elections. We have increased our weight on defensive sectors and stocks and Go defensive for proportionately reduced weight on our erstwhile favorites (commodities and banks). now…pg3 Valuations appear full without earnings upgrades Not much value in We find the Indian market’s valuations relatively full at 12.5X FY2010E EPS and 10.6X large-cap. FY2011E EPS. Our bottom-up fair valuation for the market of 11,000 (based on individual target prices of underlying stocks) suggests marginal downside for the market. We note that stocks…pg9 many of the heavyweight stocks are trading above our fair valuation with only banks and selective commodity stocks offering moderate upside to our fair valuations for those stocks. Top-five sell We believe it is too early to focus on FY2011E earnings; our bottom-up BSE-30 Index based on ideas…pg12 FY2011E target prices is 12,500. Earnings downgrades may have stopped but upgrades uncertain We see low risks of further steep downgrades to earnings for FY2010E and FY2011E. We now model FY2010E earnings (on ex-energy basis) at -2.5%, down from a peak of 16% growth in June 2008. We are less certain about the start of the earnings-upgrade cycle, if any. We have seen modest upward revisions recently in case of auto, cement and technology; the latter mostly due to the assumption of a weaker rupee. However, we have also seen downgrades in industrials and telecom of late. Top-five sell ideas: GAIL, HDFC, L&T, RCOM, Tata Motors We recommend investors sell certain large-cap. stocks in order to capitalize on the steep increase in their share prices over the past few weeks. We see earnings risks in these names Sanjeev Prasad sanjeev.prasad@kotak.com based on sector- and company-specific issues and fear a consequent de-rating of multiples if Mumbai: +91-22-6634-1229 earnings disappoint, which we see as quite likely. Bhavesh Shah bhavesh.shah@kotak.com Mumbai: +91-22-6634-1498 This report has been produced without independent discussion with the companies covered herein. Information in this report must not be relied upon as having been authorized or approved by such companies, their respective shareholders or any of their respective affiliates or advisors. In particular, any opinions contained in this report are entirely those of the authors, who have no authority whatsoever to give any information or make any representation or warranty on behalf of such companies, their respective shareholders Kotak Institutional Equities Research or any of their respective affiliates or advisors. These are professional opinions formed in good faith based on publicly available information applying professional techniques and analysis that would be reasonable in the Important disclosures appear circumstances. Neither Kotak Securities Limited nor any of these persons accepts any liability whatsoever for any at the back loss howsoever arising from any use of this report or its contents or otherwise arising in connection therewith. For Private Circulation Only. In the US, this document may only be distributed to QIBs (qualified institutional buyers) as defined under rule 144A of the Securities Act of 1933. This document is not for public distribution and has been furnished to you solely for your information and may not be reproduced or redistributed to any other person. The manner of circulation and distribution of this document may be restricted by law or regulation in certain countries, including the United States. Persons into whose possession this document may come are required to inform themselves of, and to observe, such restrictions.
  2. 2. Strategy TABLE OF CONTENTS Overview: Defensive for now..................................................................3 Valuation: Limited upside for the market and most large-cap. stocks......9 Top sells: GAIL, HDFC, L&T, RCOM, Tata motors ..................................12 The prices in this report are based on the market close of April 15, 2009. 2 KOTAK INSTITUTIONAL EQUITIES RESEARCH
  3. 3. Strategy OVERVIEW: DEFENSIVE FOR NOW We suggest investors move to a more defensive portfolio to protect recent gains and safeguard against any potential disappointments arising from (1) further deterioration in global macro-economic conditions or negative change in the current somewhat sanguine view about the pace of global recovery and (2) unfavorable outcome of India’s national elections (results due by mid-May 2009). We find the valuation of the market fair and valuations of several large-cap. stocks rich. A more defensive portfolio in light of valuations and national elections We discuss the key changes in our Model Portfolio and Top-10 list below. Model Portfolio. We discuss the key changes and highlights below. Exhibit 1 gives our Model Portfolio. Reduced weight on banking/finance sector to 200 bps overweight from 450 bps overweight previously. We have reduced weight on the sector through HDFC (no position versus 1.7% earlier) and ICICI Bank (100 bps underweight versus neutral earlier). We make up for the underweight positions in HDFC and ICICI Bank through SBI, PNB Bank, Union Bank and REC. Increased weight on consumer sector. We have increased weight on the consumer sector through HUL (100 bps overweight from 200 bps underweight) and ITC (200 bps overweight from 150 bps overweight). No change in view on energy. We retain our positive stance on upstream stocks despite their strong outperformance over the past several months and even in the past one month. We still see modest upside to our fair valuations for both Cairn and ONGC and expect the stocks to outperform any downturn in the market. We have marginally increased weight of ONGC by 50 bps to 200 bps. However, we do not expect meaningful absolute returns from current levels in the short term since we expect crude prices to be range-bound (US$45-55/bbl) over the next few months due to (1) weak seasonal demand in 2QCY09 and (2) current high global inventories; the impact of OPEC production cuts (3.5 mn b/d or 83% compliance based on March 2009 data) will be felt from 3QCY09. We continue to have a positive view on crude price over the next 1-3 years and expect crude prices to reach US$70-75/bbl (our long-term normalized price for crude price) by CY2011E. We suggest a weight of around 10% in RIL (unchanged), the maximum permissible for domestic funds and many India-dedicated overseas funds. We would have ideally liked to make this near 15% (same as weight in the BSE-30 Index) but we follow the same constraints as any real portfolio versus our ‘paper’ portfolio. Nonetheless, we see downside risks to RIL’s earnings from weaker-than-expected refining margins and stronger-than-expected rupee. We compute that (1) current refining margins will result in FY2010E EPS being lower by 37% versus our base-case estimate of Rs137 and (2) rupee-dollar exchange rate of Rs50/US$ versus our base-case forecast of Rs53.25/US$ will result in FY2010E EPS of Rs123. Reduced weight on industrials further. We recommend an underweight position in BHEL (-200 bps versus neutral previously). We see BHEL’s valuations very expensive at 18.7X FY2010E EPS after a 49% increase in our projected EPS. We also find L&T’s valuations extremely rich at 17X FY2010E EPS (15.9X adjusted for value of BOT projects and investments) in the context of a weak operating environment and related high risks to earnings. Reduced weight on metals. We have reduced our hugely overweight position on metals (9.6% weight previously versus 4% in BSE-30 Index to 8.1% versus 4.6% in BSE-30 Index) through lower weights on Tata Steel (neutral versus 100 bps overweight previously) and JSPL (300 bps overweight versus 400 bps previously). KOTAK INSTITUTIONAL EQUITIES RESEARCH 3
  4. 4. Strategy We maintain our positive view on Sterlite Industries (150 bps overweight as before) despite the fact that the stock is now trading very close to our fair valuation of Rs440. We believe our fair valuation is conservative in light of low multiples (5X FY2010E EBITDA) used by our metals team for valuation of metals businesses in the SOTP-based valuation of Sterlite. Intra-sector change in technology. We have reduced the weight of Infosys to 200 bps underweight after a relatively weak FY2010E revenue (3-7% decline in US$ revenues) and EPS guidance (Rs97-101) post its 4QFY09 results. We retain our preference for Wipro, which continues to be in our Top-10 list also. Wipro stock has outperformed Infosys 11.3% over the past one month and 8.5% since March 25, 2009, the day we introduced Wipro in our Top-10 list. Utilities. We have retained our 350 bps overweight on Tata Power (TPWR) despite the stock having delivered 33% absolute return over the past one month. We are now neutral on utilities (excluding JSPL) and see NTPC as an outright sell at current levels in light of its rich valuations (2.6X FY2010E BV and 14.4% ROE; 18.5X FY2010E EPS). We find NTPC’s valuations simply too rich for it to be considered to be a defensive play. We are not comfortable enough with RELI’s financials (particularly cash on books) currently to accord it a larger weight in the Model Portfolio and hence keep it as neutral in the portfolio. However, this stock could deliver very high returns over the next 12-15 months (see our report dated March 23, 2009 titled The Fab Fifteen) if the management can successfully address issues on (1) cash on balance sheet and (2) execution. Exhibit 1: Overweight banking, consumers, metals and pharmaceuticals Kotak Institutional Equities Model Portfolio 15-Apr Weightage (%) Diff. 15-Apr Weightage (%) Diff. Company Price (Rs) Rating BSE-30 KS reco. (bps) Company Price (Rs) Rating BSE-30 KS reco. (bps) Mahindra & Mahindra 473 ADD 1.2 1.2 — Larsen & Toubro 878 SELL 5.9 2.9 (300) Maruti Suzuki 847 REDUCE 1.5 1.5 — Industrials 9.5 4.5 (500) Tata Motors 282 SELL 1.3 — (128) Automobiles 4.0 2.7 (128) Hindalco Industries 62 ADD 1.0 — (96) Jindal Steel and Power 1,477 BUY — 3.0 300 Punjab National Bank 475 BUY — 1.5 150 Sterlite Industries 421 BUY 1.5 3.0 150 State Bank of India 1,295 BUY 4.6 7.1 250 Tata Steel 293 BUY 2.1 2.1 — Union Bank 166 BUY — 1.5 150 Metals 4.6 8.1 354 PSU Banking 4.6 10.1 550 Glenmark Pharmaceuticals 195 BUY — 1.0 100 HDFC 1,771 SELL 5.4 — (543) Ranbaxy Laboratories 200 ADD 0.4 — (42) HDFC Bank 1,083 BUY 4.6 6.6 200 Sun Pharmaceuticals 1,218 BUY 1.3 4.3 300 ICICI Bank 443 ADD 6.2 5.2 (100) Pharmaceuticals 1.7 5.3 358 Rural Electrification Corp. 99 BUY — 1.0 100 Pvt. Banking/Financing 16.2 12.8 (343) DLF 257 REDUCE 0.8 — (83) Real estate 0.8 — (83) ACC 616 REDUCE 0.8 — (80) Grasim Industries 1,621 REDUCE 1.4 1.4 — Infosys Technologies 1,371 BUY 8.4 6.4 (200) Jaiprakash Associates 123 BUY 1.3 1.3 — TCS 578 REDUCE 1.8 — (178) Cement 3.5 2.7 (80) Wipro 269 ADD 1.0 3.0 200 Technology 11.2 9.4 (178) Hindustan Unilever 235 REDUCE 3.2 4.2 100 ITC 185 ADD 6.1 8.1 200 Bharti Airtel 685 ADD 5.7 4.7 (100) Consumers 9.4 12.4 300 Reliance Communications 230 SELL 2.1 — (209) Telecom 7.8 4.7 (309) Cairn India 208 BUY — 4.0 400 Oil & Natural Gas Corporation 895 ADD 4.8 6.8 200 NTPC 198 REDUCE 3.1 — (307) Reliance Industries 1,830 REDUCE 15.8 9.9 (585) Reliance Infrastructure 710 BUY 1.3 1.3 — Energy 20.6 20.8 15 Tata Power 899 BUY 1.8 5.3 350 Utilities 6.2 6.6 43 Bharat Heavy Electricals 1,667 REDUCE 3.6 1.6 (200) BSE-30 11,285 100.0 100.0 — Note: 1. Weights are with respect to April 15, 2009 prices. Source: Bloomberg, Kotak Institutional Equities estimates 4 KOTAK INSTITUTIONAL EQUITIES RESEARCH
  5. 5. Strategy Top-10 list. There is no change to our Top-10 list (see Exhibit 2). Exhibit 2: Biased towards solid long-term stocks Kotak Institutional Equities Top-10 List Mkt cap. CMP Target EPS (Rs) P/E (X) EV/EBDITA (X) Companies Sector Rating (US$ mn) (Rs) (Rs) 2008 2009E 2010E 2008 2009E 2010E 2008 2009E 2010E State Bank of India Banking BUY 16,387 1,295 1,600 107 136 124 12.2 9.6 10.4 — — — Sun Pharmaceuticals Pharmaceuticals BUY 5,056 1,218 1,800 75 87 86 16.3 14.0 14.2 13.8 10.9 10.1 ITC Consumer products ADD 13,985 185 200 8 9 10 22.4 21.4 19.0 14.3 13.2 11.7 Oil & Natural Gas Corporation Energy ADD 38,377 895 950 93 104 104 9.7 8.6 8.6 3.6 3.2 2.9 Sterlite Industries Metals BUY 5,978 421 440 64 48 47 6.5 8.8 9.0 2.8 4.7 4.7 Cairn India Energy BUY 7,794 208 225 (0.1) 4.2 4.4 0.0 49.4 47.0 48.0 28.9 21.1 HDFC Bank Banking BUY 9,186 1,083 1,250 46 54 66 23.5 20.2 16.5 — — — Tata Power Utilities BUY 4,012 899 1,000 32 65 90 28.2 13.8 10.0 13.0 9.8 9.3 Wipro Technology ADD 7,881 269 280 22 25 27 12.1 10.6 10.0 9.7 7.5 6.4 Jindal Steel and Power Metals BUY 4,558 1,477 1,400 83 180 172 17.9 8.2 8.6 13.1 5.8 5.6 BSE-30 11,285 Source: Company, Bloomberg, Kotak Institutional Equities estimates No change in investment thesis—favor solid companies with strong balance sheets; limited options now given the re-rating in our preferred picks We would recommend that investors rotate their portfolios towards high-quality, liquid stocks rather than into aggressive and high-beta stocks now. Our key underlying investment theme remains—favoring large-cap., solid stocks with strong balance sheets (low debt, high operating or free cash flow, low capex or capex accounted for by cash on balance sheet or operating cash flow). We do not believe global and domestic conditions have changed so dramatically to favor investment in companies with (1) weak balance sheets and (2) poor corporate governance. We had been selectively biased in favor of (1) large-cap., solid commodity stocks such as Cairn, JSPL, ONGC and Sterlite among others and (2) inexpensive banking names, particularly public sector banks where we believe the risks of NPLs are largely overdone and largely reflecting in the stocks’ inexpensive valuations. We stick with the same names and see a smaller correction in these names versus other high-beta names in case of a market correction. As discussed previously, we also recommend solid, defensive stocks now as a protection against any large market correction. We are not comfortable with the sudden change in risk appetite for almost all stocks, as seems to the case over the past two weeks. We attribute the recent steep increase in share prices of several stocks to (1) the market’s increased risk appetite, (2) resultant ‘re-rating’ of inexpensive valuations in many stocks and (3) related increase in liquidity. Exhibit 3 highlights the sharp recovery in high-beta stocks from their 52-week lows compared to the defensive stocks. It’s another thing that the high-beta stocks are still down significantly from their 52-week highs. KOTAK INSTITUTIONAL EQUITIES RESEARCH 5
  6. 6. Strategy Exhibit 3: Sharp recovery of stocks with high beta Performance of stocks in BSE-30 Index (%) Beta Price (Rs) Change (%) (#) Current 52-W low 52-W low 1 month High-beta stocks Jaiprakash Associates 1.8 123 47 161 73 Reliance Infrastructure 1.8 710 353 101 52 ICICI Bank 1.7 443 252 76 43 DLF 1.5 257 124 107 68 Tata Steel 1.5 293 138 113 75 Sterlite Industries India 1.5 421 165 156 48 Hindalco Industries 1.4 62 37 70 48 Reliance Communications 1.3 230 131 75 57 Larsen & Toubro 1.3 878 556 58 43 Reliance Industries 1.2 1,830 930 97 42 Mahindra & Mahindra 1.2 473 235 101 37 Low-beta stocks HDFC 1.1 1,771 1,116 59 29 HDFC Bank 1.1 1,083 774 40 30 BHEL 1.1 1,667 981 70 22 Tata Power 1.1 899 530 70 35 Tata Motors 1.1 282 122 131 74 State Bank of India 1.0 1,295 892 45 36 Wipro 0.9 269 180 49 20 ACC 0.8 616 365 69 9 Bharti Airtel 0.8 685 483 42 23 Grasim Industries 0.8 1,621 824 97 8 Maruti Suzuki India 0.7 847 428 98 19 ONGC 0.7 895 538 66 27 NTPC 0.7 198 113 75 16 ITC 0.6 185 132 40 12 Ranbaxy Laboratories 0.5 200 133 50 44 TCS 0.5 578 415 39 14 Infosys Technologies 0.5 1,371 1,040 32 6 Hindustan Unilever 0.4 235 185 27 3 Sun Pharmaceuticals 0.3 1,218 953 28 20 Note: 1. Beta is computed on last two years' weekly data. Source: Bloomberg, Kotak Institutional Equities Liquidity is a follower and not an indicator; valuations matter ultimately We note that the recent surge in liquidity in the domestic market may not last. The surge was led by (1) reversal of FII outflows, (2) investment by domestic MFs that had been hitherto sitting on large amounts of cash and (3) continued investment by life insurance companies that typically receive large amounts of premiums in the month March. Exhibit 4 shows the large investment by FIIs over the past two weeks in contrast to continuous outflows over the past several months, Exhibit 5 shows the large cash position of domestic MFs as of February, 2009, a portion of which may have got invested in March and April based on daily data on investments released by SEBI (see Exhibit 6) and Exhibit 7 shows the slowdown in premium collections (new premiums) by life insurance companies over the past few months. 6 KOTAK INSTITUTIONAL EQUITIES RESEARCH
  7. 7. Strategy Exhibit 4: FIIs have invested US$964 mn in the past 15 trading sessions Net FII flows in cash market (US$ mn) FII flows (US$ mn) 400 300 200 100 - 19-Mar 20-Mar 23-Mar 24-Mar 25-Mar 26-Mar 27-Mar 30-Mar 31-Mar 1-Apr 2-Apr 6-Apr 8-Apr 9-Apr 13-Apr (100) (200) Source: Bloomberg Exhibit 5: Cash position of mutual funds has increased to Exhibit 6: MFs have invested US$347 mn in March 2009 around 22% in February 2009 Net MF flows in cash market (US$ mn) AUM and cash of various equity schemes (US$ bn) MF flows (US$ mn) AUM (US$ bn) Cash (US$ bn) 180 Cash (%) - RHS 60 24 130 50 20 80 40 16 30 12 30 20 8 1-Mar 3-Mar 5-Mar 9-Mar 13-Mar 17-Mar 19-Mar 23-Mar 25-Mar 27-Mar 31-Mar 2-Apr 8-Apr (20) 10 4 (70) 0 0 Apr-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Aug-08 Oct-08 Jun-07 Dec-08 Feb-09 Jun-08 (120) Source: Bloomberg Source: MFI explorer, Kotak Institutional Equities KOTAK INSTITUTIONAL EQUITIES RESEARCH 7
  8. 8. Strategy Exhibit 7: There is considerable slowdown in premium collections (new premium) by life insurance companies Premium income (individual business adjusted for single premium) (%) 20 15 15 14 10 5 1 0 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 (10) (5) (13) (20) (17) (21) (30) (25) (34) (40) Source: IRDA, Kotak Institutional Equities We would continue to focus on valuations as the only guiding principle for investment and not on liquidity or a liquidity-driven rally. We discuss valuations and the related issue of earnings in the next section. 8 KOTAK INSTITUTIONAL EQUITIES RESEARCH
  9. 9. Strategy VALUATION: LIMITED UPSIDE FOR THE MARKET AND MOST LARGE-CAP. STOCKS We see limited potential upside to the market (fair valuation of 11,000 for BSE-30 Index based on individual fair valuation of stocks on FY2010E basis) and in most large-cap. stocks under our coverage barring banking and select commodity (E&P) stocks. Even in the case of sectors/stocks with some upside to our fair valuations, we see issues that may, in the short term, constrain a further re-rating of the sectors/stocks. Not much value left on current earnings, outlook Exhibit 8 compares our fair valuation of BSE-30 stocks with their current stock prices and also gives their key valuation parameters. As can be seen, many stocks are trading near or above our fair valuations. In our view, it is too early to move to FY2011E as the basis for valuation. Exhibit 8: Many stocks in BSE-30 Index are trading near or above our fair valuations Valuation summary of BSE-30 Index stocks, March fiscal year-ends, 2008-10E P/E (X) EV/EBITDA (X) Price (Rs) Upside 2008 2009E 2010E 2008 2009E 2010E Current Target (%) Reliance Communications 8.7 8.6 11.5 6.5 6.7 6.9 230 150 (35) Tata Motors 7.7 15.2 14.8 5.6 11.6 8.5 282 195 (31) DLF 5.6 8.6 11.3 5.4 8.8 10.2 257 190 (26) Larsen & Toubro 23.1 18.2 17.0 15.2 11.3 10.3 878 650 (26) Jaiprakash Associates 25.1 23.1 17.3 14.2 12.6 10.5 123 105 (14) Hindalco Industries 4.5 8.1 26.4 5.9 5.5 7.6 62 55 (12) Bharat Heavy Electricals 28.5 27.9 18.7 15.4 14.6 10.1 1,667 1,475 (12) Reliance Industries 17.4 18.5 13.4 11.3 10.8 6.7 1,830 1,625 (11) ACC 9.6 10.9 13.5 5.0 5.4 6.5 616 550 (11) HDFC 20.6 23.1 20.6 — — — 1,771 1,600 (10) NTPC 21.2 22.4 18.5 11.8 12.5 11.9 198 180 (9) Maruti Suzuki 14.1 18.2 14.6 7.6 10.1 7.5 847 780 (8) Grasim Industries 5.7 7.2 8.6 3.7 4.4 4.4 1,621 1,500 (7) ICICI Bank 11.1 13.5 14.6 — — — 443 420 (5) Mahindra & Mahindra 12.4 21.9 13.6 9.2 14.7 8.6 473 450 (5) TCS 11.3 10.9 9.9 8.4 8.0 6.7 578 550 (5) Tata Steel 3.9 2.4 5.3 4.1 3.4 4.5 293 280 (4) Bharti Airtel 19.4 15.5 14.0 11.8 8.6 7.6 685 675 (1) Hindustan Unilever 29.0 25.7 21.9 23.5 19.0 16.1 235 245 4 Wipro 12.1 10.6 10.0 9.2 7.6 6.4 269 280 4 Sterlite Industries 6.5 8.8 9.0 2.3 3.4 3.6 421 440 5 Oil & Natural Gas Corporation 9.7 8.6 8.6 3.6 3.2 2.9 895 950 6 ITC 22.4 21.4 19.0 14.3 12.5 11.0 185 200 8 Infosys Technologies 17.3 13.4 13.2 11.8 8.8 8.0 1,371 1,500 9 Tata Power 28.2 13.8 10.0 12.6 9.3 8.9 899 1,000 11 HDFC Bank 23.5 20.2 16.5 — — — 1,083 1,250 15 State Bank of India 12.2 9.6 10.4 — — — 1,295 1,600 24 Reliance Infrastructure 18.9 11.9 12.6 7.2 6.9 7.8 710 970 37 Sun Pharmaceuticals 16.3 14.0 14.2 13.8 10.9 10.1 1,218 1,800 48 Ranbaxy Laboratories 8.6 (24.7) 22.5 8.2 (120.0) 8.2 200 340 70 Source: Kotak Institutional Equities estimates We see upside to our fair valuations in case of a few banking names and select commodity (E&P) stocks only. We do not see meaningful scope for (1) re-rating of banking stocks in the short term, in light of uncertainty surrounding the nature and policies of a new government; the banking sector will be most exposed to a new government’s economic and social policies and (2) re-rating of oil stocks given that we expect crude oil prices to be largely range-bound in US$45-55/bbl over the next 3-4 months. Exhibit 9 shows the valuation of the broad market (BSE-30 Index) on various parameters. As can be seen, the market’s valuation has increased by about 20% from recent lows of February 2009. The broad market has historically traded at 10-14X 12-month forward earnings (barring periods of excessive optimism or pessimism). However, we do not rely on broad market valuation as an investment guide and focus more on a bottom-up approach for valuation and stock selection. As a matter of caution, we note that the broad market is trading at 13.6X on ex-energy basis and 14.3X on ex-energy, ex-metals basis. KOTAK INSTITUTIONAL EQUITIES RESEARCH 9
  10. 10. Strategy Exhibit 9: Market's valuation has increased by about 20% from recent lows of February 2009 Valuation parameters of BSE-30 Index Sensex 10X 12 months rolling forward P/E (X) P/B (X) RoE (%) (RHS) 12X 15X 28 6 30 20,000 24 15,000 20 4 16 20 10,000 12 2 5,000 11,285 8 12.3 2.2 0 4 0 10 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 20 Sensex EV/EBITDA (X) M3 adj P/E (X, RHS) Poly. (M3 adj P/E (X, RHS)) 2.0 16 20,000 16,000 1.3 12 12,000 8,000 0.7 8 7.5 4,000 0.7 4 0 0.0 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Oct-01 Apr-99 Feb-00 Oct-06 Dec-00 Aug-02 Jun-03 Apr-04 Feb-05 Dec-05 Aug-07 Jun-08 Apr-09 Source: Bloomberg, Kotak Institutional Equities estimates Earnings upgrades—too early to call Exhibit 10 has our earnings growth and valuations across different sectors. We believe the operating environment in many sectors is still fairly uncertain and it may be too early to assume that downside risks to earnings have largely abated. Exhibit 10: Valuation summary of BSE-30 sectors, March fiscal year-ends, 2008-10E Mkt cap. Adj mkt cap. EPS growth (%) PER (X) EV/EBITDA (X) Price/BV (X) Div. yield (%) RoE (%) (US$ mn) (US$ mn) 2008 2009E 2010E 2008 2009E 2010E 2008 2009E 2010E 2008 2009E 2010E 2008 2009E 2008 2009E 2010E Automobiles 10,094 6,089 6.0 (37.9) 25.0 11.1 17.9 14.3 7.0 11.6 8.2 2.4 1.8 1.6 1.9 0.7 21.6 10.3 11.2 Banking 43,907 31,998 43.9 11.7 (1.3) 15.3 13.7 13.8 — — — 2.0 1.8 1.7 1.6 1.5 13.3 13.3 12.4 Cement 5,097 3,377 25.7 (18.1) (17.3) 6.9 8.5 10.2 4.1 4.7 5.0 1.9 1.6 1.5 2.7 2.8 28.0 19.4 14.3 Consumers 23,350 14,366 14.9 7.6 14.4 24.8 23.0 20.1 17.1 14.6 12.7 8.6 7.7 6.8 3.0 2.7 34.8 33.4 33.8 Diversified 3,322 1,993 20.7 22.7 33.4 28.3 23.1 17.3 14.2 12.6 10.5 3.5 3.0 2.6 0.0 0.0 12.2 13.0 15.3 Energy 85,374 31,610 13.9 7.6 17.7 12.8 11.9 10.1 6.2 5.7 4.6 2.3 1.9 1.7 1.9 2.1 18.2 16.0 16.7 Industrials 25,774 14,541 23.7 13.9 28.5 26.3 23.1 18.0 15.3 12.8 10.2 5.9 4.6 3.8 0.9 1.0 22.4 20.1 21.1 Metals 12,504 7,028 13.2 13.1 (44.5) 4.9 4.3 7.8 4.0 3.8 4.8 0.8 0.6 0.6 1.8 1.6 16.2 14.1 7.5 Pharmaceuticals 6,482 2,593 82.1 (37.8) 47.6 14.3 22.9 15.5 11.2 16.2 9.6 4.1 2.8 2.0 1.6 2.0 28.8 12.4 12.6 Property 8,447 1,267 304.9 (35.0) (24.4) 5.6 8.6 11.3 5.4 8.8 10.2 2.2 1.8 1.6 1.6 1.6 39.9 20.9 14.0 Technology 33,654 17,136 19.1 15.7 5.7 13.7 11.8 11.2 9.8 8.2 7.1 4.5 3.6 3.0 2.4 2.2 32.7 30.4 26.4 Telecom 34,219 11,977 74.9 16.5 (4.4) 14.0 12.0 12.6 9.4 7.8 7.3 3.4 2.7 2.2 0.3 0.5 24.6 22.6 17.8 Utilities 38,455 9,472 9.9 9.0 19.6 21.5 19.7 16.5 11.4 11.2 10.9 2.5 2.3 2.1 1.6 1.7 11.7 11.8 12.9 BSE-30 330,679 153,447 28.8 4.9 3.2 13.5 12.9 12.5 7.7 7.5 6.8 2.6 2.2 1.9 1.7 1.7 19.3 16.7 15.3 BSE-30 ex-Energy 245,305 121,837 35.5 3.8 (2.5) 13.8 13.3 13.6 8.5 8.4 8.2 2.7 2.3 2.0 1.6 1.5 19.7 17.0 14.8 BSE-30 ex-Energy, Com. 227,703 111,433 40.9 3.3 6.2 15.7 15.2 14.3 10.5 10.2 9.1 3.2 2.7 2.4 1.6 1.5 20.1 17.6 16.4 Note: (a) EV/EBITDA excludes Banking sector. Source: Bloomberg, Company, Kotak Institutional Equities estimates We have seen a few upgrades recently in the earnings of auto, cement and technology sectors (mostly related to a change in views on the rupee-dollar exchange rate and would probably reverse given weak guidance by Infosys post its 4QFY09 results and recent strength in the rupee). However, we are not sure if this is a sign of further upgrades in earnings by our analyst team. On the other hand, there have been cuts in the earnings of the industrials and telecom sectors, Exhibit 11 shows that our earnings forecasts (on an ex-energy basis) have largely stabilized of late at a small negative figure, with -2.5% being the most recent. 10 KOTAK INSTITUTIONAL EQUITIES RESEARCH
  11. 11. Strategy Exhibit 11: Our earnings forecast for BSE-30 Index (ex-Energy) has stabilized of late Expected growth in BSE-30 Index (ex-Energy) earnings for FY2008, FY2009E and FY2010E (%) 2008 2009E 2010E 40 30 20 10 0 Apr-07 Jun-07 Aug-07 Oct-07 Feb-08 Apr-08 Feb-09 Apr-09 Dec-07 Jun-08 Aug-08 Oct-08 Dec-08 (10) Source: Kotak Institutional Equities estimates At this point, we see scope for meaningful upgrades to earnings only in the banking sector since we have built large loan-loss provisions into our earnings models. On the flip side, we see downside risks to earnings of energy, industrials, metals, technology and telecom sectors. Exhibit 12 gives the changes to earnings growth of various sectors over the past three months. Exhibit 12: We see downside risks to earnings of energy, industrials, metals, technology and telecom sectors Changes to earnings growth of BSE-30 Index sectors over the past three months, March fiscal year-end, 2010E (%) Dec-08 Jan-09 Feb-09 Mar-09 Current Automobiles (5.3) 18.5 21.0 20.1 25.0 Banking 5.4 2.9 0.4 0.1 (1.3) Cement (21.1) (21.9) (21.9) (21.2) (17.3) Consumers 14.7 14.4 14.4 14.4 14.4 Diversified 30.8 33.4 33.4 33.4 33.4 Energy 21.2 12.4 6.9 17.7 17.7 Industrials 26.4 29.4 29.4 26.0 28.5 Metals (19.1) (33.8) (49.3) (46.3) (44.5) Pharmaceuticals NA 48.6 44.5 47.6 47.6 Property 6.2 (26.3) (24.4) (24.4) (24.4) Technology 5.9 4.6 4.6 9.0 5.7 Telecom 22.5 2.9 2.9 (4.4) (4.4) Utilities 13.7 11.2 17.6 18.5 19.6 BSE-30 Index 10.8 3.5 — 3.0 3.2 BSE-30 ex-Energy 6.7 0.1 (2.6) (2.6) (2.5) Source: Kotak Institutional Equities estimates KOTAK INSTITUTIONAL EQUITIES RESEARCH 11
  12. 12. Strategy TOP SELLS: GAIL, HDFC, L&T, RCOM, TATA MOTORS We recommend investors cut positions in certain large-cap. stocks, which are trading well above our respective fair valuations for the stocks. We also see (1) significant downside risks to consensus earnings due to specific company and sector issues and (2) potential negative developments, which the street appears to be ignoring currently in the aforementioned stocks. Five best sell ideas—GAIL, HDFC, LT, RCOM, TTMT We discuss our five best sell ideas in detail below. GAIL (GAIL, CMP: Rs254, TP: Rs240). We find GAIL’s valuations full at current levels (see Exhibit 13, our reverse valuation exercise for GAIL) and see downside risks to consensus earnings for FY2010E and FY2011E in light of new regulations for gas transportation pipelines. Our FY2010E and FY2011E EPS estimates at Rs19.7 and Rs20.7, respectively, are significantly below consensus estimates of Rs21.8 and Rs23.5. We calculate a steep 35% decline in transportation tariffs of GAIL’s key extant pipelines (HVJ and DV) based on the new regulations, which came into effect from November 20, 2008. Exhibit 13: GAIL's stock price is ascribi ~US$1 bn to new pipelines ng Estimation of implied valuation of new pipelines of GAIL (Rs) Scenario A Scenario B Comments 1. Valuation of extant businesses Existing pipelines, LPG production and chemicals Scenario A represents base-case EPS estimates and scenario B assumes reduction in FY2009E EPS of GAIL 23 21 transmission tariffs as per the new regulations Appropriate P/E multiple (X) 7.0 7.0 Given that FY2009E were boosted by high LPG and petrochemical prices/margins Valuation of extant businesses 163 150 Valuation of extant businesses (US$ bn) 4 4 Reasonable in the context of replacement value, returns 2. Valuation of investments and E&P segment ONGC and others ONGC shares 31 31 51.4 mn shares valued at 0.8X our 12-month target price of Rs950 Others 19 19 Estimated value of Myanmar gas 10 10 Estimated value of Cambay (CB-ONN-2001/1) oil 4 4 Total value of investments 64 64 Valuation of GAIL ex-new pipelines 227 213 Current stock price 254 254 3. Valuation of new businesses New pipelines Market-ascribed value of new businesses 28 41 Market-ascribed value of new pipelines (US$ bn) 0.7 1.0 DCF value for (Dahej–Vijapur–GREP expansion [DVGREP], Dadri–Bawana–Nangal [DBN] and Estimated valuation of announced pipelines 22 22 Chainsa–Gurgaon–Jhajar–Hissar [CGJH]) Includes announced pipelines Jagdishpur–Haldia, Dabhol–Bangalore and Market-ascribed value of new pipelines 6 19 Kochi–Kanjirrkod-Bangalore/Mangalore which will take time Market-ascribed value of new pipelines (US$ bn) 0.1 0.5 Source: Kotak Institutional Equities estimates A section of the street believes the impact would be muted while GAIL management believes that the new regulations will not apply to it. We find the latter view untenable in light of the new regulations, which have already been notified by the government of India. The new regulations under a notification of the government of India dated November 20, 2008 clearly state that the regulations shall apply to entities: a) authorized by the Central Government under regulation 17 of the Petroleum and Natural Gas Regulatory Board (Authorizing Entities to Lay, Build, Operate or Expand Natural Gas Pipelines) Regulations, 2008 for laying, building, operating or expanding a natural gas pipeline before the appointed day; b) laying, building, operating or expanding a natural gas pipeline before the appointed date and authorized by the Board for such activities under regulation 18 of the Petroleum and Natural Gas Regulatory Board (Authorizing Entities to Lay, Build, Operate or Expand Natural Gas Pipelines) Regulations, 2008; 12 KOTAK INSTITUTIONAL EQUITIES RESEARCH

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