Schneider

Cover Story

A New Orbit

December 2014
On the heels of a new government committed to infrastructure and growth, India stands on the cusp of a transformation.

Change is the only constant. And, the Indian economy is proof of this. While a year ago, the scenario looked gloomy with a sub 5-per-cent GDP growth, increasing CAD and fiscal deficit, consistently higher inflation, slower industrial production growth, policy paralysis and, most important, the steeply depreciating rupee against the dollar, things have now changed for the better. In recent estimates, the International Monetary Fund (IMF) has increased India´s GDP growth expectations for FY15 to 5.6 per cent - from an earlier estimate of 5.4 per cent in June 2014 - while reducing global GDP growth targets. FY16 estimates remained unchanged at 6.40 per cent. While IMF has increased estimates for India, it reduced the growth rate expectation for 2014 to

3.4 per cent, and 3.8 per cent for 2015.
The possible weaker performance of Japan, Europe and Latin American countries is seen as a reason behind the cut in growth rates. More heartening, in its World Economic Growth Calendar, IMF has called India a $2 trillion economy, making it the 10th largest in the world. And in 2016, it is expected to overtake Russia and Italy. What a change a year can bring - from a market losing its charm to a destination of growth and opportunity!

Talking about expected growth factors, a lot of green shoots are clearly visible. Let´s take a look at the different parameters. We have already discussed the economic growth factor earlier in the story where GDP growth is expected to witness some traction. For FY15, it is pegged at 5.6-5.7 per cent and is expected to enter the 7 per cent mark in FY17. So, on the growth front, it is a major positive indication.

IIP: Showing improvement
One important parameter to gauge growth is the Index of Industrial Production (IIP). And the IIP numbers that were lagging around a year ago have shown some improvement in the past months, indicating some recovery. A gradual revival was visible in June 2014 but there was only a marginal growth of 0.50 per cent in July. However, we feel this is a temporary blip; with the government focusing on infrastructure, improvement is expected ahead. Although the 0.40 per cent growth in August created doubts in the minds of investors, the numbers in September witnessed improvement as the IIP growth was at 2.50 per cent.

CAD and fiscal deficit narrows
One major worry for India was the increasing current account deficit. With corrective actions from the government in sync with the RBI, the strategy has paid off with the CAD declining under tolerance levels - it stands at just 1.70 per cent in FY14. Even the fiscal deficit is lower at 4.50 per cent in FY14. With prudent strategies implemented by the government, we do not expect any threat in the near to medium term. In addition, the fiscal consolidation road map is already laid down and fiscal deficit is estimated at 3.6 per cent in FY16 and just 3 per cent in FY17.

With improvement in the fiscal deficit, the outlook is quite stable on the sovereign ratings front too. This bodes well for Indian companies planning to raise funds and in terms of attracting foreign fund flows. With increased fund flows, even the investment cycle is catching up at a reasonable pace.

Our discussions with leading management from the large and mid-cap companies have revealed that they are going ahead with their capex plans. The effect of the same will only be visible in H2FY15 though.

Inflation - gradually contracting
Further data on the inflation front is also quite soothing; for the month of August, the Consumer Price Index (CPI) was at 7.80 per cent as against 7.96 per cent in July 2014. So inflation is moderating and with the monsoon reviving towards the end of the season, food and vegetable prices are also likely to witness some cool-off. However, a sudden and sharp drop is not expected on the inflation front. We do believe that RBI will continue to keep rates on hold till the CPI trajectory moves into its comfort zone. On the inflation trajectory, our view is that with crude coming to below $100 per barrel, the positive rub-off impact across the value chain could be quite strong. Also, the food inflation basket is moving into a period where the base effect could work in its favour. This could lead to a sharper leg down in inflation and thereby set the tone for an easing cycle.

With RBI maintaining interest level status-quo, the above graph clearly indicates contracting inflation. As interest rates have peaked out, the only way for them from here would be downwards. With inflation remaining sticky, RBI is not yet in a position to cut repo rates but we feel there is no expectation of any rate hike.

Core sector - growth revives
If we consider the infrastructure sector as a whole, it is mainly dependent on the eight core sectors: Steel, cement, coal, power, crude oil, natural gas, fertilisers and petroleum refinery products. Core sector output growth accelerated to 5.8 per cent in August 2014 compared to 2.7 per cent in July 2014, as steel, coal, cement and power production expanded significantly. Even the analysts and economists were of the opinion that the data indicated green shoots in the economy. The cumulative April-August figures showed 4.4 per cent expansion, slightly higher than 4.2 per cent growth clocked for the first five months of the last financial year.

Stable and pro-reforms government - the biggest positive
The one decisive factor that has brought a sea change to the Indian economy has been the change of government at the Centre. Coalition dharma had led to a clear policy paralysis in the earlier government, which was made worse by the many scams that emerged, really affecting India´s image as an investment destination. However, with the BJP government coming to power with a clear-cut majority, a stable and proactive government at the Centre is expected to bring the change India needs.

When Prime Minister Narendra Modi took charge on May 26, 2014, the world looked at him with high expectations as India was in dire need of a strong leader who could steer the country towards the path of growth and bring in renewed hope and optimism to a crumbling economy. As the government completes 130 days in office, it has already become evident that Modi walks the talk when he speaks about minimum government and maximum governance.

The new government has a clear and, most important, flat structure. Modi has made it clear that his government wants to do away with the Planning Commission and replace it with a think tank. As soon as he assumed power, he made efforts to bring in efficiency - government officials now reach office on time and are putting in at least 12-hour days.

While we feel it would be unfair to judge the performance of any government so soon, a lot of groundwork has clearly been done by Team Modi. The biggest achievement, in our view, is that of the Oil and Gas Ministry.

It has managed to bring solace in terms of regulating fuel prices and major price hikes have been averted to a certain extent. In fact, with crude prices witnessing a decline, fuel prices have actually reduced.

During these days, the government has been busy executing tasks from its pre-election manifesto. Indeed, Modi has been very proactive; even before assuming office, he had begun nurturing diplomatic relations with other countries. Inviting SAARC leaders to his swearing-in ceremony marked a renewal of foreign policies that had remained paralysed for long. Another feather in his cap was the BRICS summit where he bargained hard and was able to launch the much-awaited New Development Bank and Contingent Reserve Arrangement.

Union Budget - a smart act
When the new government presented the Budget within 45 days, it was hailed as a progressive one with focus on long-term benefits. Although it did not have major reforms or market-shaking policies, it certainly had something for everyone. The general notion was that if the steps outlined in the Budget were implemented, India would stand to progress. Tax reforms would lead to some more money going into the common man´s pockets and fund allocation would boost sectors like manufacturing, infrastructure, irrigation, health and sanitation, among other initiatives.

The Railway Budget focused on greater efficiency, giving a go ahead to the much-awaited bullet trains. The government´s plan to allow 100-per-cent foreign direct investment (FDI) in Railways, excluding train operations and safety, could well put the cash-strapped sector on the reform track. Industry leaders feel that apart from modernising and giving a boost to infrastructure, this move is also expected to generate employment. Along with the Railways, the government has also cleared the FDI proposal in the defence and insurance sectors, where the investment cap has been raised from 26 per cent to 49 per cent.

One of the biggest achievements of the Modi government was the launch of the Jan Dhan Yojana with the aim to provide every poor and backward household a bank account. On the day of the launch itself, 1.5 crore bank accounts were opened. Apart from this, the government has set aside Rs 2,037 crore to clean the Ganga. Moreover, Modi has laid emphasis on cleaning India; toilets in every school and household are high on the agenda and there are plans to hand over one village each to MPs with a view to developing them efficiently. This holds great opportunity for sanitaryware and tile companies.

Digital India is another focus area for the government. It has launched a host of portals where every common man can participate in governance and plans to connect the most backward areas in the country through the Internet. Online clearance, especially for the green zone, would certainly make the execution cycle faster and eventually help address supply side constraints.

Focus on infrastructure
The infrastructure and manufacturing sectors have been given paramount importance in this Budget as these are job-creating verticals. Banks will now be encouraged to extend long-term loans for infrastructure projects without any regulatory pre-emptions such as CRR, SLR and priority sector lending norms. The Budget has allocated a total of Rs 37,880 crore to the National Highways Authority of India (NHAI) for the construction of highways, and an additional Rs 3,000 crore to boost road connectivity in the Northeast. For the current year, it has targeted the completion of 8,500 km of national highways, which are a known real-estate catalyst and will have long-reaching implications on the markets of the cities they connect. Increased connectivity will raise the scope of real-estate development there and have an impact on property valuations over the mid to long term.

The development of 16 new ports has been proposed at an outlay of Rs 11,000 crore. Additionally, an allocation of Rs 11,600 crore has been made for the development of outer harbour port projects. The combined effect of these provisions will be an increase in demand for commercial office space from the manufacturing sector in India´s major port cities.

As for the housing sector, the Budget has allocated Rs 4,000 crore to low-cost housing schemes. Apart from this, the government has also indicated a relaxation of FDI norms for the affordable housing sector. Although such incentives for low-cost housing have been announced in the past, the real task lies in the fast execution of these initiatives.

Smart cities - a smart move towards urbanisation
As promised in the new government´s manifesto, it has proposed the creation of 100 smart cities across India. To this end, the Budget has allocated Rs 7,060 crore. This will have positive implications for real estate across all segments - residential, commercial, retail and hospitality. Smart cities, by definition, imply considerable demand for technology-enabled services, and this is a big positive for IT/ITeS companies in India. Significantly, as much as one-third of the country´s demand for office space emanates from this sector.

Housing for all by 2022
Availability of adequate liquidity is vital to the efficient development of the real-estate sector. It is envisaged that over $2 trillion needs to be invested to achieve the government´s vision of ´housing for all by 2022´. India has a significant housing deficit, as almost a fifth of urban and rural households have access to limited housing facilities. To achieve this vision, it is estimated that India needs to develop houses at the rate of 30,000-35,000 units per day for the next eight years (about 9 crore houses, including 6 crore of existing shortage). A majority of these houses need to be in the affordable segment, requiring investment of over $2 trillion.

The challenge is significant but not impossible if supported by the right policy mix, especially improvement of institutional investment in the sector. The government has announced new policy decisions in the Budget; however, large-scale development of affordable housing projects is still a challenging proposition for many private developers.

Japan, China and the US-flood of funds
As stated earlier, India´s Prime Minister means business and he has endeavoured to showcase the country as a great investment opportunity. He launched his ´Make in India´ campaign in Delhi this September where more than 3,000 global CEOs were invested. The results are already becoming apparent with Japan promising investment of over $35 billion, followed by another $100 billion being committed by China. The icing on the cake was the US visit, which will again bring a flood of funds into the Indian markets. At current levels, capital is scarce and the commitment of capital by these three countries will provide the much-needed impetus; what´s more, the technology they will bring in will be a further advantage.

Efforts to start yielding results
A stable government by the BJP was a prime factor behind the equity markets rallying ahead of the polls and the momentum sustaining hence. However, the overall feeling is that the reforms process is yet to catch pace. We are of the opinion, though, that the seeds sown will soon yield results with the real effects visible from the second half of this fiscal. Whatever clearances are to be made are already being done and the investment cycle will improve soon.

The automobile industry has already improved in the past three months and the commercial vehicle industry is also on a revival path. If the government succeeds in its aim to add growth to the manufacturing sector, things will move much faster. One of the best initiatives, right now, is faster clearance by the Project Monitoring Group (PMG). A recent update suggests that there are 467 projects worth Rs 23 lakh crore still pending for clearance. Of these, there are 57 projects where hardly any action can be taken. Besides that, 180 projects worth Rs 6.5 lakh crore have been lying for facilitation with PMG (of this, 155 projects worth Rs 5.5 lakh crore have already been cleared) and around 220-225 projects entailing Rs 11 lakh crore are under consideration. We believe faster clearance by the PMG will bring the infrastructure sector very much on track.

Crude price decline - a crucial advantage
One crucial advantage for the Indian economy and equities is declining crude prices along with a stable currency. In the preceding week, the Brent crude prices went below $80 per barrel to touch the $78-per-barrel mark. On technical parameters, crude has broken the crucial support level of 200-day moving average.

There are two views regarding the event, though. One indicates that there is some weakness in global growth and hence crude prices are on the decline. However, we feel that with India being a net importer of crude there are a lot of advantages. Further, the decline in crude price will eventually result in lower prices for petrol and diesel. This may help us reduce inflation.

Global markets - what to expect
While there is inherent strength in Indian equities, there is a lot of linkage with global equity indices. Thus, much depends on how the global markets behave going ahead. The biggest worry at present is about the stance the US Fed will take with its economy slowly on a revival path. With QE already being taken out of the system, there is fear of the FIIs taking a flight back to safe havens. Further, if interest rates are increased along with this, the situation may worsen.

However, we feel that the market has already factored in the unwinding of QE by the US Fed. Now, it is slowly factoring in the expected rate hike in the US. However, to compensate for the same, Japan and European countries are likely to pour in more stimulus. With regard to other emerging economies, we believe weakness bodes well for Indian equities as it provides a comparative advantage. There are a few geopolitical risks associated with countries like Russia, Ukraine, Syria and Iran. However, it has historically been observed that these issues affect us only in the short term and eventually can be taken as buying opportunities. Recently, a few issues have emerged with expected recession in European economies and slower than expected growth in China. However, one needs to understand that recognising the problems itself is half the work done. There is enough time to take a corrective course of action.

IT sector - growth drivers intact
In the past three months, IT stocks have outperformed the broader indices by around 19 per cent, led by positive outlook on the sector and favourable movement of the rupee against the dollar. Recent data points, management commentary and increased deal wins by Tier-I vendors have all been indicative of revenue growth acceleration for IT companies going forward. Looking at the performance of Indian IT companies in recent quarters, growth momentum has been good with improvement in the topline and bottomline.

We believe that growth seen in the past few quarters is likely to be maintained. In 2QCY14, Information Services Group´s (ISG) measurement of the deal market registered one of the strongest ever quarters measured by ACV (annual contract value) at $6.4 billion up 7 per cent (Q-o-Q) despite being a seasonally weak quarter of the year.

This follows around a 30 per cent sequential rise in ACV in 1Q, making 1HCY14 ACV of $12.4 billion (up 35 per cent YoY), the strongest since 2010. We believe that such strong deal activity augurs well for the Indian IT sector and underpins our view that Indian IT companies are likely to report a stronger 15 per cent dollar revenue CAGR in FY14-FY16E vs 13 per cent in FY14. ISG suggested that in Europe, Indian companies continue to gain market share from American peers through enhanced local presence and demonstration of tech leadership. Dual trends of increased penetration and market share gains for Indian IT in Europe support the view that Europe is a key growth driver for the sector.

Realty sector - not yet out of the woods
Over the past two years, the real-estate sector has witnessed sluggish growth. The factors that affected the sector as a whole were consistently higher inflation leading to higher interest rates, a weak rupee, and lower GDP growth. These resulted in negative investor sentiments and lower investments. While these were the macro factors, on the micro front, realty companies witnessed issues like slowdown on sales volumes. This affected cash flows and created financial worries for most companies. The rising debt burden also affected financials as even the repayment of short-term debt proved difficult.

In such a scenario with sales volumes declining, realty players did not reduce prices. As a result, most funds remained stuck in single projects, making it difficult to create additional funds. Adding to the woes was that even banks, a major source of funds for realty, stayed aloof with stringent RBI norms. Fund raising was difficult from the equity markets as well with realty stocks trading at multi-year lows. In such a scenario, the only option for many players was to sell non-core assets. Not just smaller companies but even bigger players like DLF, Orbit Corporation, Unitech and HDIL had to go ahead with the sale of non-core assets.

However, with the change in government, there is now a ray of hope for realty players. With a pro-reforms government likely to change the Land Acquisition Bill Act, the sector is beginning to see light at the end of the tunnel. The positive moves are expected to lead to a change in investor sentiment. Further, with the advent of the Real Estate Investment Trusts (REITs), things are expected to get even better. Apart from that, the ´smart city´ concept is another positive as are the advantages that will accrue from relaxation in FDI caps and regulations. What´s more, the new government has also given a boost to the sector by announcing favourable policies in the Union Budget while the RBI´s stance toward cutting rates has helped boost investor sentiment and will consequently push increasing investment into the sector.

Market cap analysis
If the performance of construction and contraction companies is considered over the past one year, it clearly indicates that while the scenario was quite challenging, the performance on the bourses was totally different. If the growth in market capitalisation of a majority of construction and contracting companies is observed, it shows a different picture. Let´s take a deeper look.

In the construction and contracting segment, the overall market cap of 27 companies increased by 104 per cent. Just to put the figures in perspective, there are two companies (NBCC and Simplex Projects) that have appreciated by more than 600 per cent (six-fold) since October 2013. Even companies like NCC that were under pressure on account of higher debt pressure and had to whether affects of state separation managed to appreciate five-fold. In total there are 15 companies where the market cap has appreciated more than 100 per cent with L&T, which is a construction bellwether appearing at the 15th position with an appreciation of 105 per cent. That said, even a large company like L&T witnessed a significant up-move. In a nutshell, the appreciation has been broad-based. Some companies (in the small category) have witnessed a decline in the market cap as well. Rather historically, larger companies have always see majority appreciation, and the situation has been similar this time as well.

One observation in the construction as well as realty companies has been the increased debt burden in the past few years. As mentioned earlier, few attempts have been made by infrastructure companies to reduce debts either by raising funds through equity or selling non-core assets. While some companies managed to raise funds through the QIP route, the response was quite lukewarm. And now, despite the market touching an all time high, several QIPs are still trading below the offer prices. In the case of realty companies, several managed a good performance on the bourses. However, the out-performance was limited to a few stocks only. While the overall growth in market cap of leading companies was just 24 per cent, a few even eroded the wealth of investors. And, two companies managed to post appreciation of more than 200 per cent. In the realty segment, declining sales volume and steady realisation ensured that the quarterly results are severely affected. Leading companies witnessed a significant fall in revenues as well as bottom line. Like in the case of infrastructure companies, realty companies have been facing debt pressures too. Further, what worsened the scenario was DLF being penalised by SEBI. While this is a different matter all-together, whether the action taken is justified for the investors or not, it has certainly affected the entire realty sector.

Taking stock
If we consider the current situation, the Indian infrastructure sector seems to be at a point of inflection. The scenario has definitely changed for the better, evident from the fact that most infra stocks are gaining traction on the bourses. A few of them have gone ahead with QIP to raise funds. Just to put the figures in perspective, of a total of 21 QIPs on YTD basis, around eight were from infrastructure companies. While a few have gone ahead with QIPs or private placements, many have lined up for a primary floor also. The big ones like Lavasa Corporation and GMR Energy are already planning to tap the markets. With the stock markets reviving and hovering near all-time highs, we believe many other companies would also try to capitalise on the opportunity.

Apart from raising funds from the primary and secondary markets, many companies are also coming out of corporate debt restructuring (CDR).

Domestically, it is evident that the government is providing the much-needed impetus to public projects, with faster clearance. Even private orders have witnessed traction as capex, kept on hold for a long time, has been started by mid and large companies. However, it will take some time for these orders to trickle into the order book of construction and contracting companies. Another noticeable factor, here, is that when the domestic order book was drying up, some large companies focused on global markets. L&T was one such company that followed this strategy to sustain growth. Although the margins in the global markets were a tad lower than domestic markets, the consistent inflow of orders kept the financial performance of the company on track. More and more companies are likely to follow suit and go global.

As for domestic markets, as stated earlier, the green shoots are already visible and the positivity in the infrastructure sector will soon bear fruit. Industry experts suggest that the benefits of the current revival will be seen in the last quarter of FY15 and thereafter. India Inc is also likely to put in a superior performance in H2FY15. The earnings downgrade is a thing of the past and one can expect an upgrade in earnings from September 2014 quarter results or December 2014 quarter results. The scenario is conducive for the markets; we expect the Indian economy to soon enter a new orbit.