STRATEGY - Repco HomeSTRATEGY Research Analysts: November 2016 The Coffee Can Portfolio 2016 Karan Khanna, CFA [email protected] Tel: +91 22 3043 3251 ... Asian Paints · 2017-4-6

STRATEGY

Research Analysts:

November 2016

The Coffee Can Portfolio 2016

Karan Khanna, [email protected]: +91 22 3043 3251

Year 1 Year 10

Nitin [email protected]

Prashant Mittal, [email protected]

Rakshit Ranjan, [email protected]

Aadesh Mehta, [email protected]

Ravi [email protected]

Sagar [email protected]

Paresh Dave, [email protected]

Abhishek Ranganathan, [email protected]

Anuj [email protected]

Ashvin Shetty, [email protected]

Nikhil [email protected]

Strategy

November 17, 2016 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

SECTOR

The Coffee Can Portfolio 2016 …………………………………………………….3

Executive Summary ……………………………………………………………………4

The case for a Coffee Can portfolio ……………………………………………….9

A framework for constructing the Indian Coffee Can portfolio ……………….13

Does the approach work? Results from our back-testing ……………………..15

Performance of the Coffee Can portfolios launched in ……………………….18 2014 and 2015

Optimal way to deploy fresh funds each year ………………………………….21

The ideal life of a Coffee Can portfolio ……………………………………….…24

Today’s Coffee Can for 2016-2026 ……………………………………………..26

Appendix 1: How the Coffee Can is different to our …………………………131 other portfolio constructs

Appendix 2: Performance of the 14 back-tested ……………………………..133 Coffee Can portfolios

Appendix 3: John Kay’s IBAS Framework ……………………………………..150

COMPANIES

HDFC Bank (SELL): Flawless execution …………………………………………..27

Axis Bank (BUY): A strong core ……………………………………………………33

HCL Technologies (BUY): Set to surf the IoT wave ……………………………..39

Asian Paints (BUY): A legend built over several decades ……………………..45

Lupin (BUY): Dukes have castellated the fort …………………………………...51

Cadila (BUY): Inches make champions ………………………………………….57

Britannia (SELL): On a steady growth path ……………………………………...63

LIC Housing Finance (SELL): The old lady of housing finance ………………..69

Page Industries (BUY): ‘Inner’ Strength ………………………………………….75

Amara Raja Batteries (SELL): Competitive edge under threat ………………..81

GRUH Finance (NOT RATED): Will it stand the test of time? …………………89

Dr Lal PathLabs (NOT RATED): Long-term growth path ……………………….95

eClerx (SELL): No room for error ………………………………………………..101

Astral Poly (NOT RATED): A ‘fanatic’ challenger ………………………………107

Relaxo Footwears (NOT RATED): The nimble footed giant …………………113

REPCO Home Finance (NOT RATED): Swimming against the tide …………119

Cera Sanitaryware (NOT RATED): A super-efficient Superbrand …………..125

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

THEMATIC November 17, 2016

The Coffee Can Portfolio 2016 In this annual update of our coffee can portfolio, we further augment the case for this unique construct. The previous editions of the coffee can portfolio (CCP) have done remarkably well, with 18.4% outperformance and 9.6% outperformance (in CAGR terms) for the two iterations since publication in Nov ’14 and Nov ’15 respectively. That said, our analysis suggests for the true potential of the coffee can construct to play out, the portfolio should be left untouched for a decade. Asian Paints, HDFC Bank, Page and Astral are some prominent stocks that again appear in this year’s portfolio. Relaxo, Repco and Dr Lal are the new entrants.

The case for a Coffee Can Portfolio The coffee can construct hinges on investing in high quality franchises (which have a superior track record of financial performance over the preceding decade) for a very long period of time – a decade to be precise. The virtues of such a construct include: (a) significantly raising the probability of making returns; (b) reducing costs by avoiding churn; (c) allowing the power of compounding to work its magic; and (d) removing the negatives of “noise”. Back-tests prove the potential of the CCP to beat the benchmark Both on a live basis as well as in back-tests, the previous 16 iterations of the Coffee Can Portfolio have handsomely outperformed the Sensex as well as broader market indices, such as the BSE200 index. Further, on a total returns basis (i.e. including dividends), the Coffee Can Portfolio’s returns are +1% to +3.7% points higher than the returns under a share price only scenario. True potential of the CCP is realised over the long term Whilst the portfolio continues to do well even over a shorter duration (say, five years), terminating it at the end of year 5 (and investing the proceeds in the CCP for year 5) results in a loss of potential alpha of ~3.3% points (in CAGR terms). That said, in case the need for fresh deployment of funds arises, we also showcase that doing so in successive coffee can iterations also leads to benchmark-beating returns (8-9% excess IRRS under various scenarios). Today’s Coffee Can for 2016-2026 Six stocks from the previous CCP do not make it to this year’s portfolio: ITC, Marico, GSK Consumer, Colgate Palmolive, Berger and V-Guard Inds. Fresh additions to this years’ portfolio are Relaxo, Repco and Dr. Lal PathLabs. Whilst we do not advocate annual rebalancing of the portfolio, clients who are interested in the 2016 CCP should refer to the exhibit on the right.

Strategy

The Indian Coffee Can Portfolio 2016

HDFC Bank Our stance: SELL

Mcap (US$ bn): 47.6 ADV - 6m (US$ mn): 25.9

Axis Bank Our stance: BUY


HCL Technologies Our stance: BUY


Asian Paints Our stance: BUY


Lupin Our stance: BUY


Cadila Health. Our stance: BUY


Britannia Inds. Our stance: SELL


LIC Housing Fin. Our stance: SELL


Page Industries Our stance: BUY


Amara Raja Batt. Our stance: SELL


GRUH Finance Our stance: NR


Dr Lal PathLabs Our stance: NR


eClerx Services Our stance: SELL


Astral Poly Our stance: NR


Relaxo Footwear Our stance: NR


Repco Home Fin Our stance: NR


Cera Sanitary. Our stance: NR


Source: Bloomberg, Ambit Capital research. Note: Mcap as of 15 November 2016 Research Analysts

Karan Khanna, CFA

+91 22 3043 3251

[email protected]

Nitin Bhasin

+91 22 3043 3241

[email protected]

Prashant Mittal, CFA

+91 22 3043 3218

[email protected]

Sixteen iterations of the Coffee Can Portfolio have outperformed the Sensex Kick-off year*

All-cap CCP (start)

All-cap CCP (end)

CAGR return

Outperformance relative to Sensex

2000 500 3,831 22.6% 6.6%

2001 600 9,802 32.2% 11.7%

2002 800 7,709 25.4% 5.1%

2003 900 10,175 27.4% 7.2%

2004 1,000 16,849 32.6% 12.7%

2005 900 6,643 22.1% 6.0%

2006 1,000 6,376 20.4% 9.0%

2007 1,500 7,828 19.5% 10.8%

2008 1,100 5,724 22.1% 11.2%

2009 1,100 4,843 22.7% 11.5%

2010 700 2,042 18.7% 9.5%

2011 1,400 2,550 12.1% 2.7%

2012 2,200 5,356 23.3% 9.9%

2013 1,800 4,762 34.8% 21.4%

2014 1,600 2,331 22.2% 21.0%

2015 2,000 2,387 19.3% 13.4%

Source: Bloomberg, Ambit Capital research. Note: *Returns for 10 year-period from 2000-2006 (starting 30th June); CAGR returns for portfolios since 2007 until 30th Sep’16 (except for live portfolios for 2014 and 2015 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in Nov ’15 and Nov ’16 respectively).

Strategy


Executive Summary The case for a Coffee Can Portfolio

We first introduced the Coffee Can Portfolio in our 17 November 2014 thematic: “The Indian Coffee Can Portfolio” for investors who have the ability to hold stocks for very long periods of time (i.e. for ten years or more). The coffee can construct essentially hinges on investing in quality franchises with superior long-term historical track records of financial performance over longer periods of time.

We believe at the portfolio level, there are four factors that work in favour of the coffee can construct. These are:

Higher probability of returns over the long term: Over longer periods of time (for example, the last 30 years), the Sensex has returned ~15% CAGR. That said there have been intermittent periods of unusually high drawdowns. For example, an investor entering the market near the peak in early Jan ‘08 would have lost over 60% of value in just about fourteen months of investing. Thus, whilst over longer time horizons, the odds of profiting from equity investments are very high; the same cannot be said of shorter time horizons.

A longer time horizon allows the power of compounding to work its magic: Holding a portfolio of stocks for periods as long as 10 years or more allows the power of compounding to play out its magic. Over the longer term, the portfolio gets dominated by the winning stocks whilst underperforming stocks keep declining and eventually become inconsequential. Thus, the positive contribution of the winners disproportionately outweighs the negative contribution of the losers to eventually help the portfolio compound handsomely.

Neutralising the negatives of “noise”: Empirically, investing and holding for the long term has been the most effective way of killing ‘noise’ that interferes with the investment process.

Using Lupin’s illustration in the note we show that one of the reasons the coffee can construct works well is because the ability to hold on to a great franchise for a long period of time allows you to let fundamentals drive your investment decision rather than “noise.”

No churn: Finally, the coffee can construct allows an investor to hold a portfolio of stocks for over 10 years without any churn. With no churn, the coffee can approach reduces transaction costs which add to the overall portfolio performance over the long term.

Laying a framework for constructing the Indian Coffee Can Portfolio

To identify stocks for our Coffee Can Portfolio, we start with the basic principles of investing. At the very basic level, a company doing well would mean that it is profitable and is growing. These twin filters of growth and profitability, in our view, are sufficient to assess the success of a franchise.

We, therefore, select stocks with a long-term track record of delivery on revenue growth and RoCE. For financial services stocks, we modify these filters slightly and look for a long-term track record of delivery on loan book growth and RoE.

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_IndianCoffee_17Nov2014.pdf

Strategy


Note that even our work suggests a combination of superior RoCE and revenue growth has been a winner in the Indian context (see exhibit 1 below):

Exhibit 1: A combination of superior RoCE and revenue growth is a winner in the Indian context*

Source: Bloomberg, Ambit Capital research. Note: * The universe is 2006’s BSE200 firms (ex-financials); performance relative to the BSE200 Index; the chart is based on price data from 31 March 2006 to 31 March 2016. The red bars denote the 10-yr share price performance of top quartile stocks on revenue growth, RoCE as well as a combination of both from the BSE200 universe.

For the Coffee Can Portfolio, we therefore look for firms that have delivered a minimum pre-tax RoCE of 15% or more and sales growth of at least 10% or more over ten consecutive years. For financial services stocks, we seek to identify firms that have delivered a minimum RoE of 16% and loan book growth of at least 10% or more for ten consecutive years.

Back-test proves the potential of the coffee can construct to beat the benchmark

Using the filters discussed above, we run back-tests of the framework for each of the last 16 years. Results from our back-test suggest that each of the previous 16 coffee can portfolios has comprehensively outperformed the benchmark Sensex index both on an absolute as well as on a risk-adjusted basis.

Further, even if we were to use broader market indices, such as the BSE200 index, each of the previous sixteen iterations of the coffee can portfolios still beat the benchmark BSE200 index quite comprehensively.

Performance of the live Coffee Can Portfolio launched in 2014 and 2015

We launched the first Coffee Can Portfolio for investors in our 17 November 2014 thematic: “The Indian Coffee Can Portfolio” (to be held from 2014-2024). We followed this up with the second Coffee Can Portfolio that was launched in our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!”

Since publication in November 2014, the first Coffee Can Portfolio has generated total CAGR returns of 17.6% vs total CAGR returns of -0.8% for the benchmark Sensex index. Similarly, the second Coffee Can Portfolio that was launched in 2015 has generated total CAGR returns of 11.7% vs total CAGR returns of 2.1% for the benchmark Sensex index since initiation.

That said both these portfolios have witnessed a churn of 30-35%. With reasonably high levels of churn, the obvious question one would ask is whether to rebalance the 2014 and 2015 portfolios to include stocks that feature in this year’s iteration?

We advise investors to refrain from rebalancing the coffee can portfolios. A Coffee Can Portfolio that is rebalanced every year underperforms the Coffee Can Portfolio that is left untouched for a decade by ~5.3% points (on a median basis; in CAGR terms, see exhibit 2 below):

2.6%

4.9%

11.1%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Superior on Revenuegrowth

Superior on RoCE Superior on both

Average outperformance, 10-year CAGR


http://reports.ambitcapital.com/reports/Ambit_Stratey_Thematic_TheCoffeeCanPortfoliothecoffeeworks_02Nov2015.pdf

Strategy


Exhibit 2: Share price CAGR returns over 10-year period for CCP with and without rebalancing

2000- 2010

2001-2011

2002-2012

2003-2013

2004-2014

2005-2015

Median CAGR

CCP without rebalancing 19.3% 28.5% 22.4% 25.4% 30.8% 20.5% 23.9%

CCP with rebalancing 18.5% 22.6% 22.0% 17.0% 18.7% 13.5% 18.6% Difference (w/o minus with rebalancing) 0.8% 5.9% 0.4% 8.4% 12.0% 6.9% 5.3%

Source: Bloomberg, Ambit Capital Research Note: Dates refer to the first year and last year of the ten-year holding period. Performance has been measured over a 10-yr period starting from June of the first year and ending with June of the last year. This exhibit has been reproduced without any changes from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!”

An optimal way to deploy fresh funds each year

The coffee can construct advocates the “buy and hold” approach. That said one of the challenges investors face is how to deploy the fresh fund inflows that are received every year.

Here we evaluate two scenarios: (1) where the fresh fund inflows that are received every year are assumed to remain constant; and (2) where the fresh fund inflows that are received every year are assumed to increase by 20% each year. We further assume that every year as an investor receives fresh fund inflows, these funds are deployed in the Coffee Can Portfolio for that particular year.

Our analysis suggests that under both the scenarios, the IRR for the Coffee Can Portfolio is significantly higher than the IRR for Sensex. Further, whilst the number of stocks in the portfolio are high (~43 stocks on an average for the seven completed coffee can portfolios), the top ~23% of the stocks comprise 65-75% of the total portfolio value by the end of year 10 under both the scenarios.

We believe this brings out a very important aspect of the coffee can construct which is that allowing the power of compounding to work its magic is a much more important driver of long-term returns than the most ideal stock selection itself. Thus, even whilst the number of stocks in the portfolios is fairly high, over time the losing stocks become insignificant while the portfolio returns are gradually dominated by the winners.

An ideal life of a Coffee Can Portfolio

Historically, we have advocated a minimum holding period of ten years for the Coffee Can Portfolio as we believe that the benefits of the coffee can construct can only be realised by investing in quality franchises with a superior long-term track record of financial performance, over longer periods of time. That said one of the questions several investors have asked us is “how do the returns as well as risk profile fare over a shorter period of time (such as five years)?”

Results from our analysis reveal that each of the previous sixteen iterations of the Coffee Can Portfolio has handsomely outperformed the benchmark Sensex index over a shorter time horizon (i.e. five years). So, given the outperformance even over a shorter time period, would the investor be better off if he terminates the Coffee Can Portfolio at the end of 5 years instead of 10 years?

Our analysis suggests for the coffee can construct to work its magic, the portfolio should be left untouched for the decade. Whilst the Coffee Can Portfolio over a shorter time horizon does indeed outperform the benchmark Sensex index, terminating the portfolio at the end of, say, 5 years (and investing the funds from the exiting stocks in fresh stocks that make it to the Coffee Can Portfolio in year five) results in ~3.3% points lower alpha for the portfolio vs keeping the portfolio untouched for a decade.


Strategy


Today’s coffee can for 2016-26

Having discussed the virtues of the coffee can construct and establishing the ideal life for a Coffee Can Portfolio, we screen the entire spectrum of listed companies with market-cap greater than `1bn using our twin filters of growth and profitability.

The list of firms that makes it to this year’s edition of our Coffee Can Portfolio has been summarised in exhibit 3 below. The coffee can continues to feature some of India’s most successful franchises as well as the most-compelling investment themes. Using John Kay’s IBAS (Innovation, Brand, Architecture and Strategic Assets) framework, we evaluate these companies in the ensuing sections of the note. Appendix 3 of the note gives you more colour regarding John Kay’s IBAS framework and Ambit’s bestselling book, The Unusual Billionaires, gives you details regarding just how successful the coffee can companies have been over years.

http://reports.ambitcapital.com/reports/Ambit_TheUnsualBillionaires_03Aug2016.pdf

Strategy


Exhibit 3: Summary of the 2016 Coffee Can Portfolio

Company Ticker Mcap Free Float

Mcap ADV-6m

(Median) Accounting Decile

Greatness Score Ambit

Stance Comments P/E P/B RoCE*

($mn) ($mn) ($mn) (%) FY16 FY17E FY16 FY17E FY16

HDFC Bank HDFCB IN 47,610 35,232 23.2 N/A N/A SELL Credible execution track record driving consistent high earnings growth while maintaining asset quality 25.6 21.5 4.4 3.8 1.9

Axis Bank AXSB IN 17,489 11,368 68.3 N/A N/A BUY Despite facing asset quality stress, capability to generate strong operating profits provides comfort 13.9 28.2 2.2 2.1 1.7

HCL Tech. HCLT IN 16,641 6,490 20.6 D2 92% BUY Set to capitalise on competitive advantages in IMS and ES to build a strong IOT offering 19.7 13.7 4.1 3.4 34.2

Asian Paints APNT IN 15,151 7,121 15.0 D1 50% BUY Deserve high valuation due to a) resilient repainting cycle in weak macro, b) greater pricing power and c) ability to successfully drive transition to value added services in home improvement category

58.4 47.3 18.0 15.1 47.2

Lupin LPC IN 10,365 5,493 22.7 D6 100% BUY Ability to adapt to changing environment and be successful is the secret sauce to Lupin 30.3 23.1 6.3 5.1 24.6

Cadila Health. CDH IN 5,907 1,477 3.8 D5 46% BUY Early investments in innovation like biosimilars, NCEs/NDDS are provide competitive edge in EMs/regulated markets 25.8 25.0 7.3 6.0 29.0

Britannia Inds. BRIT IN 5,633 2,760 8.0 D2 83% SELL Will play on the width of the portfolio and leverage its cost efficiencies vs peers 46.5 39.2 21.2 15.9 71.9

LIC Housing Fin. LICHF IN 3,987 2,392 15.0 N/A N/A SELL LIC’s support is key strategic asset. But earnings momentum should decline due to declining real estate prices and competitive headwinds.

15.9 12.4 2.9 2.4 1.4

Page Inds. PAG IN 2,702 1,324 2.0 D3 88% BUY Will grow due a) aspirational brand b) in-house manufacturing and c) control on distribution channel 77.3 61.0 35.6 27.7 54.7

Amara Raja Batt. AMRJ IN 2,552 1,225 3.9 D3 83% SELL Low cost advantage with Johnson Controls' parentage to continue driving market share gains market share gains albeit at lower pace than before

34.7 29.8 8.1 6.7 35.8

GRUH Finance GRHF IN 1,705 699 0.8 N/A N/A NR Best play in affordable housing due to innovative credit scoring, strong local knowledge and support of the parent HDFC 46.6 38.6 13.6 11.3 2.4

Dr Lal Pathlabs DLPL IN 1,477 177 0.7 N/A N/A NR Set to enjoy long growth ramp driven by market share gains from unorganised, acquisitions and socio economic tailwinds driving penetration

73.8 59.1 19.3 15.2 31.5

eClerx Services ECLX IN 874 437 0.4 D2 42% SELL Competitive advantage a thing of past as regulatory driven challenges in BFSI and rise of automation threaten business model 15.9 15.2 5.3 4.5 51.5

Astral Poly ASTRA IN 758 303 0.2 D1 58% NR Transitioning from a pipes manufacturer to a larger building materials franchise; capitalising the brand recall and replicating its architecture to become a challenger brand in adhesives

49.8 35.6 6.5 5.6 18.2

Relaxo Footwear RLXF IN 727 182 0.1 D1 92% NR Focus on brand building and premiumisation provide Relaxo the pricing power in a value offering without compromising on volume growth

40.2 36.3 10.1 DNA 29.7

Repco Home Fin. REPCO IN 626 388 0.6 N/A N/A NR Strong positioning in affordable housing due to local area knowledge and an innovative origination strategy 27.7 22.0 4.4 3.7 2.2

Cera Sanitary. CRS IN 490 221 0.2 D5 67% NR Second largest in scale but the most profitable sanitaryware manufacturer. With competition rising, Cera has plugged gaps in its product portfolio, now catering to all market segments

39.1 30.5 7.7 6.4 25.1

Source: Bloomberg, Capitaline, Ambit Capital Research. Note: *RoA for BFSI stocks. Mcap data as of 15 November 2016.

Strategy


The case for a Coffee Can Portfolio The coffee can approach to portfolio construction

In our 17 November 2014 thematic: “The Indian Coffee Can Portfolio”, we introduced the Coffee Can Portfolio for investors who have the ability to hold stocks for very long periods of time (for ten years or more). For investors who are not familiar with the coffee can construct, the term ‘coffee can’ was coined by Robert G Kirby of Capital Guardian, who in his 1984 note (click here for the note) narrated an incident involving his client’s husband who had purchased stocks recommended by Kirby in US$5000 denomination each but did not ever sell anything from the portfolio. This process led to enormous wealth creation for the client over a period of about 10 years mainly on account of one position transforming to a jumbo holding worth over US$800,000 which came from a zillion shares of Xerox. Impressed by this approach of ‘buy and forget’ followed by this gentleman, Kirby coined the term ‘Coffee Can Portfolio’ - the concept harkens back to the Wild West, when Americans, before the widespread advent of banks, saved their valuables in a coffee can and kept it under a mattress.

Why does the approach work?

The simplicity of the coffee can approach to portfolio construction rests in four factors that work in favour of longer investment horizons at the portfolio level:

Higher probability of returns over the long term: As is well understood, equities as an asset class are prone to extreme movements in the short term. For example, whilst the Sensex has returned ~15% CAGR returns over the last 30 years, there have been intermittent periods of unusually high drawdowns. In Jan ‘08, for instance, an investor entering the market near the peak in January would have lost over 60% of value in just about fourteen months of investing. Thus, whilst over longer time horizons, the odds of profiting from equity investments are very high; the same cannot be said of shorter time frames.

In his book, ‘More than you know’, Michael Mauboussin illustrates this concept using simple math in the context of US equities. We use that illustration and apply it in the context of Indian equities here.

We note that the Sensex’s returns over the past 30 years have been ~14% on a CAGR basis, whilst the standard deviation of returns has been ~29%. Now using these values of returns and standard deviation and assuming a normal distribution of returns (a simplifying assumption), the probability of generating positive returns over a one-day time horizon works out to ~51.1%.

Note, however, that as the time horizon increases, the probability of generating positive returns goes up. The probability of generating positive returns goes up to ~68% if the time horizon increases to one year; the probability tends towards 100% if the time horizon is increased to 10 years (see Exhibit 4 below).

Exhibit 4: Probability of gains from equity investing in India increases disproportionately with increase in holding horizon

Source: Bloomberg, Ambit Capital research. Note: This chart has been inspired by similar work done by Michael Mauboussin in the Western context.

50%

60%

70%

80%

90%

100%

1 Hour 1 Day 1 Week 1 Month 1 Year 10 Year 100 Years

Pro

ba

bilit

y o

f g

ain

s

Years

Robert Kirby of Capital Guardian introduced the concept of ‘Coffee Can Portfolio’ in 1984

Four factors work in favour of the Coffee Can approach to portfolio construction

Firstly, the probability of generating positive returns increases disproportionately with increase in holding horizons


https://goo.gl/sQu0JI)

Strategy


Power of compounding: Holding a portfolio of stocks for periods as long as 10 years or more allows the power of compounding to play out its magic. Over the longer term, the portfolio comes to be dominated by the winning stocks whilst losing stocks keep declining to eventually become inconsequential. Thus, the positive contribution of the winners disproportionately outweighs the negative contribution of losers to eventually help the portfolio compound handsomely. We elaborate the power of this powerful phenomenon in much greater details in the ensuing sections of the note as well as Appendix 2 (Performance of the 14 back-tested Coffee Can Portfolio) using historical case studies. We will illustrate the point using simple mathematics here.

Let’s consider a hypothetical portfolio that consists only of two stocks. One of these stocks, stock A, grows at 26% per annum whilst the other, say stock B, declines at the same rate, i.e. at 26% per annum. Overall, not only do we assume a 50-50 strike rate, we also assume symmetry around the magnitude of positive and negative returns generated by the winner and the loser respectively.

In Exhibit 5 below, we track the progress of this portfolio over a 10-year holding horizon. As time progresses, stock B declines to irrelevance while the portfolio value starts converging to the value of holding in stock A. Even with the assumed 50% strike rate with symmetry around the magnitude of winning and losing returns, the portfolio compounds at a healthy 17.6% per annum over this 10-year period, a pretty healthy rate of return. This example demonstrates how powerful compounding can be for investor portfolios if only sufficient time is allowed for it to work its magic.

Exhibit 5: A hypothetical portfolio with 50% strike rate and symmetry around positive and negative returns

Source: Ambit Capital research

Neutralising the negatives of “noise”: Empirically, investing and holding for the long term have been the most effective way of killing ‘noise’ that interferes with the investment process. This has also been corroborated by Robert G. Hagstrom in his recent book, “Investing – The Last Liberal Art” (2nd edition, 2013). In this book, the author talks about the “chaotic environment, with so much rumour, miscalculation, and bad information swirling”. Such an environment was labelled “noise” by Fischer Black, the inventor of the Black-Scholes formula. Hagstrom goes on to say:

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

0

100

200

300

400

500

600

0 1 2 3 4 5 6 7 8 9 10

Stock A

Stock B

Portfolio

Secondly, compounding results in a natural rebalancing of winners and losers in a portfolio

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

26%

-26%

17.6%

10 yr CAGR

Strategy


As an example, we highlight how, over the long term, Lupin’s stock price has withstood short-term disappointments to eventually compound at an impressive 29% CAGR since Jan’04 (see Exhibit 6 below).

Exhibit 6: Lupin’s stock has compounded at an impressive 29% CAGR since Jan’ 04

Source: Bloomberg, Ambit Capital research

However, the chart shown above also highlights that over the past 13 years, there have been several extended time periods when Lupin’s share price has not gone anywhere – such as from Jan’ 04 to Mar ’08, Nov ’10 to Feb ’13 and more recently since Mar ‘15. In spite of remaining flat over these periods, Lupin has performed so well in the remaining five years that the 13-year CAGR for the stock is 29%. At its simplest, this is why the concept of investing for longer time horizons works – once you have identified a great franchise and you have the ability to hold on it for a long period time, there is no point trying to be too precise about timing your entry or your exit. As soon as you try to time that entry/exit, you run the risk of “noise” rather than fundamentals driving our investment decisions. To further demonstrate how ‘churn’ and ‘turn’ destroy ‘return’, we quote again from ‘Investing: The Last Liberal Art’ by Hagstrom. In this book, the author refers to an interesting experiment conducted by a behavioural economist at the University of California. We reproduce the extract below:

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

Over a seven-year period (1987-1993), Odean tracked 97,483 trades among ten thousand randomly selected accounts of a major discount brokerage. The first thing he learned was that the investors sold and repurchased almost 80 percent of their portfolios each year (78 percent turnover ratio). Then he compared the portfolios to the market average over three different time periods (4 months, 1 year and 2 years). In every case, he found two amazing trends: (1) the stocks that the investors bought consistently trailed the market, and (2) the stocks that they sold actually beat the market1.

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

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

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

-

500

1,000

1,500

2,000

2,500

3,000

3,500

Jan-

04

Aug

-04

Mar

-05

Oct

-05

May

-06

Dec

-06

Jul-

07

Feb-

08

Sep-

08

Apr

-09

Nov

-09

Jun-

10

Jan-

11

Aug

-11

Mar

-12

Oct

-12

May

-13

Dec

-13

Jul-

14

Feb-

15

Sep-

15

Apr

-16

Strategy


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

Assume that you invest US$100mn in a hypothetical portfolio on 30 June 2006. Assume further that you churn this portfolio by 50% per annum (implying that a typical position is held for two years) and this portfolio compounds at the rate of Sensex Index. Assuming a total price impact cost and brokerage cost of 100bps for every trade done over a ten-year period, this portfolio would generate CAGR returns of 8.8%. Left untouched, however, the same portfolio would have generated CAGR returns of 9.8%. This implies ~8.6% of the final corpus (~US$22mn in value terms) is lost to churn over the ten-year period. Thus, a US$100mn portfolio that would have grown to US$252mn over the ten-year period (30 June 2006 - 30 June 2016) in effect grows to US$230mn due to high churn.

Having built the case for a coffee can construct, in the next section we discuss the framework we use to identify stocks for the Coffee Can Portfolio.

Finally, churn has a significant impact on overall portfolio returns

Strategy


A framework for constructing the Indian Coffee Can Portfolio There are multiple rule-based approaches that one can use for portfolio construction. For example, Joel Greenblatt’s ‘Magic Formula’ and Joseph Piotroski’s ‘F-score’ screener are some of the well-known approaches that can be used for portfolio construction. Even at Ambit, we use our proprietary ‘greatness’ framework to identify quality franchises that have consistently been showing an improvement in their financial performance over a six-year period. [Note: We have now made both our proprietary ‘greatness’ and ‘accounting’ frameworks available for access to our clients using ‘HAWK’. Please contact your sales representative if you are yet to receive your login credentials for access to the ‘HAWK’ platform.]

Thus, whilst there are multiple rule-based approaches for portfolio construction most of these rule-based approaches however usually require a periodic rebalance of the portfolio and will, hence, not be directly useful for the coffee can construct.

We, therefore, start with the basic principles of investing for our stock selection. At the very basic level, a company doing well would mean that it is profitable and is growing. The twin filters of growth and profitability, in our view, are sufficient to assess the success of a franchise. Our tests of stock selection, therefore, center around a long-term track record of delivery on revenue growth and RoCE generation.

Exhibit 7: A combination of superior RoCE and revenue growth is a winner in the Indian context*

Source: Bloomberg, Ambit Capital research. Note: * The universe is 2006’s BSE200 firms (ex-financials); performance relative to the BSE200 Index; the chart is based on price data from 31 March 2006 to 31 March 2016. The red bars denote the 10-yr share price performance of top quartile stocks on revenue growth, RoCE as well as a combination of both from the BSE200 universe.

Specifically, we use the following filters.

Pre-tax return on capital employed of 15% for each of the last ten years

Why pre-tax RoCE? Whilst management teams have a natural desire for growth and scale, growth creates shareholder value only when the returns on capital exceed the cost of capital. RoCE, therefore, is of utmost importance in assessing a firm’s performance. Our empirical work on the share price performance of Indian companies also supports the primacy of RoCE as a share price driver (see the exhibit above). As shown in the exhibit above, BSE200 firms (ex-BFSI) with superior revenue growth (in the top quartile) during the 10-year period over FY06-16 outperformed the BSE200 Index by 2.6% on a CAGR basis. However, firms with a superior RoCE growth gave a higher outperformance of 4.9%. The best outperformance during this period was given by firms that were superior on both revenue growth and RoCE at 11.1%.

Why 15%? The weighted average cost of capital (before taxes) for Indian companies is around 13-14% (assuming an equal mix of debt and equity; ~11% cost of debt and ~15% cost of equity). Adding the risk-free rate (7.5-8% in India) and an equity risk premium of 6-6.5% too gives a cost of capital broadly in that

2.6%

4.9%

11.1%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Superior on Revenuegrowth

Superior on RoCE Superior on both

Average outperformance - 10-year CAGR

We start with the basic investing principles for our stock selection

Stocks with superior RoCE have outperformed their peers over the last ten-year period

15% RoCE is the minimum return required to beat the cost of capital in India

hawk.ambit.co

Strategy


range. The equity risk premium, in turn, is calculated as 4% (the long-term US equity risk premium) plus 250bps to account for India’s rating (BBB- as per S&P).

We, thus, use 15% as a minimum because we believe that that is the bare minimum return required to beat the cost of capital which for the vast majority of listed companies is at least 14%.

Further, from our earlier discussions, we note that over the past 30 years, the Sensex has delivered returns of around 15% per annum, validating our point of view that 15% is a sensible figure to use as a minimum RoCE (pre-tax) criteria.

Revenue growth of 10% every year for each of the last ten years: India’s nominal GDP growth rate has averaged 15% over the past ten years (FY05-14). A firm operating in India should, therefore, be able to deliver sales growth of at least 15% per annum. However, very few listed companies (only 8 out of the ~1,480 firms run under our screen), have managed to achieve this! Therefore, we reduce this filter rate modestly to 10%; i.e. we look for companies that have delivered revenue growth of 10% per annum every year for ten consecutive years.

In summary, our filters focus on a minimum pre-tax RoCE of 15% or more and sales growth of 10% for more over ten consecutive years.

For financial services stocks, we modify the filters on RoE and sales growth as follows:

Return on equity of 16% for each of the last ten years: We prefer return on equity over return on assets because it is a fairer measure of the bank’s ability to generate higher income efficiently on a given equity capital base over time.

We use 16% as a minimum because we believe that is the bare minimum return required to meet the cost of equity for Indian lenders (for the vast majority of Indian lenders, cost of equity is at least 15%).

Loan growth of 15% every year for each of the last ten years: We believe loan growth of 15% is an indication of a bank’s ability to lend over business cycles. Strong lenders ride the downcycle better as competitive advantages surrounding their origination, appraisal and collection process ensure that they continue their growth profitably either through market-share improvements or upping the ante in sectors which are resilient during a downturn.

Finally, for all the stocks considered for the Coffee Can Portfolio, we put a market-cap threshold of `1bn. India is the least liquid among the world’s 15 largest equity markets. Thus, for institutional clients, we believe a market capitalisation of `1bn is the bare minimum to take a position in the stock. Stocks smaller than this tend to be illiquid and create high impact costs.

Whilst these twin filters of revenue growth and RoCE may appear simplistic in nature, through our approach we are not looking for optimal candidates with the highest growth and highest RoCE, as reversion to mean is an accepted fact in corporate life. Instead, we base our selection on a system of guard rails which helps us assess which firms have what it takes to protect themselves and march ahead through good as well as bad times. This approach is also different to that taken in our other portfolio constructs that focus on comparatively shorter holding periods, where we are more focused on directional progress. More details on these can be found in the Appendix 1 - How the Coffee Can is different to our other portfolio constructs.

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

We use RoE of 16% and loan growth of 15% as filters to screen BFSI stocks

We use a market-cap threshold of `1bn

Strategy


Does the approach work? Results from our back-testing Having built a case for the coffee can construct and a framework for identifying these coffee can stocks, we now discuss results from our back-testing of the framework.

Using the twin filters of growth and profitability discussed in the previous section, we ran back-tests of the CCP over the last sixteen years (i.e. portfolios initiated annually from 2000 to 2015), including seven portfolios that have run their entire course of ten-years (2000-2010, 2001-2011, 2002-2012, 2003-2013, 2004-2014, 2005-2015 and 2006-2016) and nine portfolios (starting 2007) which have not yet completed their 10 years. We also show the performance of a separate ‘large-cap CCP’ consisting solely of stocks that were in the top-100 stocks by market cap (at the start of the period under consideration). We have also stress-tested these results for maximum drawdown to test the strength of the portfolio during periods of market volatility: First, we calculate CAGR returns for each of the 16 portfolios and the Sensex;

Next, we compute the maximum drawdown (defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough); and

Finally, we calculate the risk-adjusted returns; i.e. returns in excess of the risk-free rate (assumed at 8%, comparable to the last ten year average 10-yr Government bond yield of 7.9%) divided by the absolute maximum drawdown.

Performance of the previous coffee can portfolios vs Sensex using share price returns

In the exhibit below, we have shown the performance of each of the preceding 16 coffee can portfolios vs Sensex based on share price returns (without including any dividends):

Exhibit 8: Back-testing results of sixteen iterations of the Coffee Can Portfolio (vs Sensex index) using share price returns Kick-off year*

All-cap CCP (start)

All-cap CCP (end)

CAGR return


Large-cap CCP (start)

Large-cap CCP (end)

CAGR return


2000 500 2,923 19.3% 5.3% 400 2,602 20.6% 6.5%

2001 600 7,366 28.5% 10.0% 300 2,685 24.5% 6.0%

2002 800 6,057 22.4% 4.1% 500 3,348 20.9% 2.6%

2003 900 8,668 25.4% 7.1% 600 6,754 27.4% 9.1%

2004 1,000 14,618 30.8% 12.6% 500 3,097 20.0% 1.9%

2005 900 5,795 20.5% 6.0% 500 2,517 17.5% 3.1%

2006 1,000 5,414 18.4% 8.6% 600 2,524 15.4% 5.7%

2007 1,500 6,697 17.5% 10.3% 1,000 3,892 15.8% 8.6%

2008 1,100 5,167 20.6% 11.4% 800 3,136 18.0% 8.8%

2009 1,100 4,431 21.2% 11.7% 900 2,780 16.8% 7.4%

2010 700 1,892 17.2% 9.7% 300 903 19.3% 11.7%

2011 1,400 2,361 10.5% 2.7% 400 860 15.7% 8.0%

2012 2,200 5,118 21.9% 10.3% 500 1,018 18.2% 6.5%

2013 1,800 4,564 33.1% 21.3% 600 1,234 24.8% 13.0%

2014 1,600 2,290 21.0% 21.4% 700 950 17.6% 18.0%

2015 2,000 2,366 18.3% 13.8% 1,200 1,308 9.0% 4.5%

Source: Bloomberg, Capitaline, Ambit Capital research. Note: Portfolio at start denotes an equal allocation of `100 for the stocks qualifying to be in the CCP for that year. *The Portfolio kicks off on 30th June of every year. CAGR returns for all the portfolios since 2007 have been calculated until 30th Sep’16 (except for the live portfolios for the years 2014 and 2015 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in Nov ’15 and Nov ’16 respectively).

We back-test the framework and the results are revealing

Strategy


Performance of the previous coffee can portfolios vs Sensex using total shareholder returns

In the exhibit below, we have shown the performance of each of the preceding 16 coffee can portfolios vs Sensex using the total shareholder returns (i.e. assuming that dividends are reinvested back into the same stock on the ex-dividend date).

We summarise the results of each of these 16 iterations in the table below. For details on the portfolio constituents, please refer to the Appendix 2.

Exhibit 9: Back-testing results of 16 iterations of the Coffee Can Portfolio (vs Sensex index) using total shareholder returns Kick-off year*

All-cap CCP (start)

All-cap CCP (end)

CAGR return



Large-cap CCP (end)

CAGR return


2000 500 3,831 22.6% 6.6% 400 3,338 23.6% 7.6%

2001 600 9,802 32.2% 11.7% 300 3,622 28.3% 7.8%

2002 800 7,709 25.4% 5.1% 500 4,182 23.7% 3.3%

2003 900 10,175 27.4% 7.2% 600 7,791 29.2% 9.0%

2004 1,000 16,849 32.6% 12.7% 500 3,679 22.1% 2.1%

2005 900 6,643 22.1% 6.0% 500 2,968 19.5% 3.4%

2006 1,000 6,376 20.4% 9.0% 600 2,918 17.1% 5.7%

2007 1,500 7,828 19.5% 10.8% 1,000 4,426 17.4% 8.7%

2008 1,100 5,724 22.1% 11.2% 800 3,444 19.3% 8.5%

2009 1,100 4,843 22.7% 11.5% 900 3,054 18.3% 7.2%

2010 700 2,042 18.7% 9.5% 300 959 20.4% 11.2%

2011 1,400 2,550 12.1% 2.7% 400 914 17.0% 7.6%

2012 2,200 5,356 23.3% 9.9% 500 1,066 19.5% 6.1%

2013 1,800 4,762 34.8% 21.4% 600 1,286 26.4% 12.9%

2014 1,600 2,331 22.2% 21.0% 700 969 18.9% 17.8%

2015 2,000 2,387 19.3% 13.4% 1,200 1,323 10.3% 4.3%


The results are revealing and can be summarised as follows: Each of the 16 CCPs has comprehensively outperformed the benchmark

Sensex index. Even the sub-set of the CCP, i.e. the large-cap version of the CCP has been

successful in beating the Sensex on all 16 occasions.

On a risk-adjusted basis (where we define risk as maximum drawdown), all the 16 iterations of the all-cap portfolio as well as the large-cap portfolio have outperformed the Sensex.

The large-cap versions of the CCP have outperformed the all-cap versions in 2000, 2003, 2010 and 2011 (both on an absolute basis as well as risk-adjusted basis). In the other versions, however, the all-cap version of the CCP has delivered superior returns as compared to the respective large-cap versions on an absolute basis.

Using total shareholder returns, the total portfolio returns improve by +1% to +3.7% points (average 1.9% points) versus using only the share price returns.

16 iterations of the CCP that we initiated from 2000 to 2015 prove the potential of the CCP to beat the Sensex and the BSE200

Strategy


Performance of the previous coffee can portfolios vs BSE200 index using total shareholder returns

From exhibits 8 and 9 above we note that the previous sixteen iterations of the coffee can portfolios have comprehensively outperformed the benchmark Sensex index in all the iterations. Further, using total shareholder returns versus only the share price returns, the total returns for the portfolio improve by +1% to +3.7% points.

In exhibit 10 below, we now plot the performance of these portfolios vs broader market indices, such as the BSE200 index. The results, however, remain the same with all the sixteen all-cap coffee can portfolios and fifteen of the sixteen large-cap coffee can portfolios managing to beat the benchmark BSE200 index comprehensively (see Exhibit 10 below):

Exhibit 10: Back-testing results of sixteen iterations of the Coffee Can Portfolio (vs BSE200 index) Kick-off year*

All-cap CCP (start)

All-cap CCP (end)

CAGR return

Outperformance relative to BSE200


Large-cap CCP (end)

CAGR return

Outperformance relative to BSE200

2000 500 3,831 22.6% 5.1% 400 3,338 23.6% 6.1%

2001 600 9,802 32.2% 9.8% 300 3,622 28.3% 5.9%

2002 800 7,709 25.4% 4.9% 500 4,182 23.7% 3.2%

2003 900 10,175 27.4% 7.7% 600 7,791 29.2% 9.5%

2004 1,000 16,849 32.6% 13.4% 500 3,679 22.1% 2.8%

2005 900 6,643 22.1% 6.2% 500 2,968 19.5% 3.6%

2006 1,000 6,376 20.4% 8.1% 600 2,918 17.1% 4.9%

2007 1,500 7,828 19.5% 9.9% 1,000 4,426 17.4% 7.8%

2008 1,100 5,724 22.1% 10.1% 800 3,444 19.3% 7.3%

2009 1,100 4,843 22.7% 10.2% 900 3,054 18.3% 5.9%

2010 700 2,042 18.7% 8.6% 300 959 20.4% 10.4%

2011 1,400 2,550 12.1% 0.9% 400 914 17.0% 5.9%

2012 2,200 5,356 23.3% 7.6% 500 1,066 19.5% 3.8%

2013 1,800 4,762 34.8% 17.5% 600 1,286 26.4% 9.1%

2014 1,600 2,331 22.2% 16.5% 700 969 18.9% 13.2%

2015 2,000 2,387 19.3% 8.7% 1,200 1,323 10.3% -0.4%


Strategy


Performance of the coffee can portfolios launched in 2014 and 2015 In our 17 November 2014 thematic: “The Indian Coffee Can Portfolio”, we had launched the first Coffee Can Portfolio for investors (to be held from 2014-2024). We followed this up with the second Coffee Can Portfolio that was launched in our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!”

Whilst the whole premise of our Coffee Can Portfolio is based on holding the portfolio stocks for a period of 10 years without being perturbed by the short-term fluctuations in the share prices, a look at the performance of these portfolios suggests that both these portfolios have done extremely well vs. the Sensex.

The Coffee Can Portfolio launched in 2014 has generated total returns of 17.6% (on a CAGR basis) vs total CAGR returns of -0.8% for the benchmark Sensex index since initiation.

Similarly, the Coffee Can Portfolio launched in 2015 has generated total CAGR returns of 11.7% vs total CAGR returns of 2.1% for the benchmark Sensex index since initiation (see Exhibits 11 and 12 below):

Exhibit 11: Performance of the 2014 Coffee Can Portfolio since initiation

Company Value at start (`)

Value at end (`) Total return

CAGR Date from/to 14-Nov-14 11-Nov-16

ITC 100 103 2%

Asian Paints 100 145 21%

Godrej Consumer 100 149 22%

Marico 100 153 24%

Ipca Labs. 100 82 -9%

Berger Paints 100 170 31%

Page Industries 100 149 22%

Balkrishna Inds 100 147 21%

eClerx Services 100 148 22%

Mayur Uniquote 100 100 0%

V-Guard Inds. 100 220 49%

HCL Technologies 100 100 0%

HDFC Bank 100 139 18%

Axis Bank 100 106 3%

City Union Bank 100 168 30%

GRUH Finance 100 131 15%

Portfolio* 1,600 2,212 17.6%

Sensex 100 98 -0.8%

Outperformance 18.4%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,600 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period (11 November 2016). Thus, for this period, the value of the portfolio rose from `1,600 at the start to `2,212 at the end.

We launched the first two iterations of the Coffee Can Portfolio in Nov ’15 and Nov ‘16

Both these portfolios have done extremely well vs the Sensex index



Strategy


Exhibit 12: Performance of the 2015 Coffee Can Portfolio since initiation

Company Value at start (`) Value at end (`) Total return CAGR Date from/to 01-Nov-15 11-Nov-16

HCL Technologies 100 90 -9%

ITC 100 111 11%

Lupin 100 76 -23%


Cadila Health. 100 92 -8%

Britannia Inds. 100 96 -4%

Marico 100 129 28%

GlaxoSmith C H L 100 90 -10%

Colgate-Palm. 100 101 1%

Amara Raja Batt. 100 107 7%



eClerx Services 100 103 3%

Astral Poly 100 101 1%

V-Guard Inds. 100 222 117%

Cera Sanitary. 100 115 15%

HDFC Bank 100 117 16%

Axis Bank 100 106 6%

LIC Housing Fin. 100 110 9%

GRUH Finance 100 119 18%

Portfolio* 2,000 2,241 11.7%

Sensex 100 102 2.1%

Outperformance 9.6%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `2,000 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period (11 November 2016). Thus, for this period, the value of the portfolio rose from `2,000 at the start to `2,241 at the end.

Note that amongst the stocks in our Coffee Can Portfolio 2014, five stocks missed out on making it to the Coffee Can Portfolio for the year 2015. These were Godrej Consumer, Ipca Labs, Balkrishna Industries, Mayur Uniquoters and City Union Bank.

Similarly, from our Coffee Can Portfolio for the year 2015, 6 stocks miss out on making it to this year’s Coffee Can Portfolio. Please see the section on ‘Today’s Coffee Can for 2016-2016’ on Pg 19 for details on this year’s candidates. The stocks that do not make it to this year’s portfolio are:

Exhibit 13: Stocks that do not make it to this year’s iteration of the Coffee Can Portfolio

Company name Reasons for exclusion

ITC ITC delivered sales growth of 2% in FY16; hence does not clear the coffee can filter on ten consecutive years of sales growth in excess of 10%

Marico Marico delivered sales growth of 7% in FY16; hence does not clear the coffee can filter on ten consecutive years of sales growth in excess of 10%

GSK Consumer GSK Consumer's sales have been flat in FY16; hence does not clear the coffee can filter on ten consecutive years of sales growth in excess of 10%

Colgate Palmolive Colgate Palmolive delivered sales growth of ~4.5% in FY16; hence does not clear the coffee can filter on ten consecutive years of sales growth in excess of 10%

Berger Paints Berger Paints delivered sales growth of ~7.2% in FY16; hence does not clear the coffee can filter on ten consecutive years of sales growth in excess of 10%

V-Guard Industries V-Guard Industries delivered sales growth of ~6.7% in FY16; hence does not clear the coffee can filter on ten consecutive years of sales growth in excess of 10%

Source: Company filings, Ambit Capital research

6 stocks miss out on making it to this year’s Coffee Can Portfolio

Strategy


Should investors rebalance the coffee can portfolios for the years 2014 and 2015?

With 6 out of last year’s 20 stocks not featuring in this year’s Coffee Can Portfolio, the obvious question one would ask is whether to rebalance the 2014 and 2015 portfolios to include the stocks figuring in this year’s iteration.

Here we point investors to our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” In our 02 November 2015 note, we compared the results of a “buy and hold” strategy vs an annual rebalancing strategy of the Coffee Can Portfolio over six ten-year iterations starting year 2000.

The results from our analysis have been reproduced in Exhibit 14 below:

Exhibit 14: Share price CAGR returns over 10-year periods for CCP with and without rebalancing

2000- 2010

2001-2011

2002-2012

2003-2013

2004-2014

2005-2015

Median CAGR

CCP without rebalancing 19.3% 28.5% 22.4% 25.4% 30.8% 20.5% 23.9%

CCP with rebalancing 18.5% 22.6% 22.0% 17.0% 18.7% 13.5% 18.6% Difference (w/o minus with rebalancing) 0.8% 5.9% 0.4% 8.4% 12.0% 6.9% 5.3%

Source: Bloomberg, Ambit Capital Research Note: Dates refer to the first year and last year of the ten-year holding period. Performance has been measured over a 10-yr period starting from June of the first year and ending with June of the last year. This exhibit has been reproduced without any changes from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!”

As can be seen in the results above (Exhibit 14), the Coffee Can approach without rebalancing has outperformed with rebalancing approach on all six occasions. The median CAGR for CCP without rebalancing over these six iterations was 23.9% vs 18.6% for CCP with rebalancing. These results reaffirm the advantage of the “buy and hold” approach over an annual rebalancing approach even with the weights of repeating stocks unchanged in the portfolio.

How should investors deploy fresh capital received every year?

Whilst the coffee can construct advocates the “buy and hold” approach, we agree that one of the challenges investors face is using the coffee can construct. How should investors deploy fresh fund inflows that are received every year? We discuss this aspect in the next section.

We advise investors to refrain from rebalancing the coffee can portfolios



Strategy


Optimal way to deploy fresh funds each year From our previous discussions, we note that the coffee can construct advocates the “buy and hold” approach, i.e. once invested the portfolio should be kept untouched for a decade. That said, we agree that as fund managers, one of the challenges investors face is how the fresh fund inflows that are received every year should be deployed.

To address this, we discuss two scenarios:

In Scenario 1, the fresh inflows every year are assumed to remain constant.

In Scenario 2, the fresh inflows received every year are assumed to grow at 20% each year over the 10-year life of a particular Coffee Can Portfolio.

Scenario 1 - Fresh fund inflows every year are assumed to remain constant

In scenario 1, we assume that `100 is invested in the initial Coffee Can Portfolio (say for example the Coffee Can Portfolio that was launched in Jun ’00). We further assume that the `100 invested in the initial coffee can is left untouched and is allowed to compound over the subsequent ten years. Each year, as the investor gets fresh fund inflows (the fresh fund inflows are assumed to remain constant at `100 each year; dividends declared during the year are invested in the portfolio for the subsequent year), the funds received are deployed in that year’s Coffee Can Portfolio. So, for example, in Jun ’01, when an investor receives `100 more, these funds are deployed in the Coffee Can Portfolio for the year 2001 (and allowed to compound over the remaining 9 years of the initial coffee can). Any dividends that were declared by any of the stocks in the initial Coffee Can Portfolio too are deployed in the Coffee Can Portfolio for the year 2001. Similarly, in Jun ‘02, when the investor receives another `100, these funds are deployed in the Coffee Can Portfolio for the year 2002 along with any dividend declared by stocks in the coffee can portfolios for the years 2000 and 2001 (and all these funds are allowed to compound over the remaining 8 years of the initial coffee can), and so on.

We repeat this exercise for each of the subsequent coffee can portfolios (i.e. the coffee can portfolios for the years 2001-11, 2002-12, 2003-13, 2004-14, 2005-15 and finally for the years 2006-16).

The results from the analysis have been summarised in exhibit 15 below:

Exhibit 15: Portfolio returns assuming constant fund inflows every year

Total stocks Weight in the portfolio (%):

Portfolio IRR Sensex IRR Alpha (Portfolio vs Sensex) Top 5 stocks Next 5 stocks Remaining

stocks Overall

2000-10 30 62.33 23.70 13.96 100.00 29.7% 21.4% 8.3%

2001-11 31 57.78 24.44 17.79 100.00 29.5% 21.0% 8.5%

2002-12 36 53.14 26.56 20.30 100.00 25.1% 16.9% 8.2%

2003-13 46 54.65 24.29 21.05 100.00 23.3% 15.1% 8.1%

2004-14 48 53.88 17.50 28.63 100.00 25.6% 15.7% 9.9%

2005-15 50 49.15 18.10 32.76 100.00 21.6% 13.5% 8.1%

2006-16 57 46.48 15.66 37.86 100.00 19.9% 10.2% 9.7%

Average 43 53.92 21.46 24.62 100.00 25.0% 16.3% 8.7%

Median 46 53.88 23.70 21.05 100.00 25.1% 15.7% 8.3%


Number of stocks: As can be seen in Exhibit 15 above, a typical portfolio, assuming fresh funds received every year are invested in the Coffee Can Portfolio for that particular year, has about 43 stocks.

How should investors deploy fresh funds every year under the CCP construct?

We evaluate this under two scenarios

In scenario 1 we assume the fresh fund inflows to be constant each year

Strategy


Portfolio returns are significantly higher than Sensex returns for each of the seven iterations: Not only has each of the seven portfolios delivered healthy IRR (average IRR for the seven portfolios is ~25.0%), each of the portfolios has quite comprehensively beaten the benchmark Sensex index (with an average outperformance of ~8.7%).

Portfolio weight: Note that whilst the number of stocks in the portfolio is high, the top 5 stocks (in terms of value of the stock in the portfolio by the end of year 10) comprise around 54% of the portfolio value by the end of year 10. Further, the next 5 stocks constitute ~21.5% of the portfolio value by the end of year 10. The more interesting thing to note, however, is that the remaining 33 stocks comprise only the remaining 24.6% of the portfolio value at the end of year 10. This means ~23% of the stocks comprise ~75% of the total portfolio value.

Scenario 2- Fresh fund inflows every year are assumed to grow at 20% each year over the 10-year life of a particular Coffee Can Portfolio

In scenario 2, we assume that `100 is invested in the initial Coffee Can Portfolio (say for example the Coffee Can Portfolio that was launched in Jun ’00). Further, just like the previous scenario, we assume that the `100 invested in the initial coffee can is left untouched and is allowed to compound over the subsequent ten-year period. In this scenario, however, we assume that the fresh fund flows received by the investor grow at 20% each year. So, for example, in Jun ’01, the investor receives fresh inflows of `120 (i.e. a 20% increase over the `100 received in Jun ’00), which is then invested in the Coffee Can Portfolio for the year 2001 and is then allowed to compound over the remaining 9 years of the initial coffee can. Here again we assume that any dividends that were declared by any of the stocks in the initial Coffee Can Portfolio are deployed in the Coffee Can Portfolio for the year 2001. Similarly, in Jun ’02, the investor receives `144 more (i.e. a 20% increase over the `120 received in Jun ’01), which along with any dividend declared by stocks in the coffee can portfolios for the years 2000 and 2001, is then invested in the Coffee Can Portfolio for the year 2002 and is allowed to compound over the remaining 8 years of the initial coffee can; and so on.

We repeat this exercise for each of the subsequent coffee can portfolios (starting with the coffee can for the years 2001-11 and ending with the coffee can for the years 2006-16).

Exhibit 16 below summarises the results from our analysis.

Exhibit 16: Portfolio returns assuming fund inflows every year grow at 20%

Total stocks Weight in the portfolio (%):

Portfolio IRR Sensex IRR Alpha (Portfolio vs Sensex) Top 5 Next 5 Others Overall

2000-10 30 55.29 23.94 20.77 100.00 29.9% 21.4% 8.4%

2001-11 31 49.65 25.15 25.20 100.00 28.3% 19.7% 8.5%

2002-12 36 45.04 25.26 29.70 100.00 23.4% 14.3% 9.1%

2003-13 46 48.16 21.75 30.09 100.00 20.4% 13.0% 7.4%

2004-14 48 45.94 15.40 38.66 100.00 24.8% 15.3% 9.6%

2005-15 50 41.37 16.58 42.05 100.00 22.4% 13.5% 8.9%

2006-16 57 38.40 16.54 45.06 100.00 20.1% 9.9% 10.2%

Average 43 46.26 20.66 33.07 100.00 24.2% 15.3% 8.9%

Median 46 45.94 21.75 30.09 100.00 23.4% 14.3% 8.9%


Exhibit 16 above suggests that whilst the total number of stocks in the portfolio would remain the same, the top 5 stocks (in terms of value of the stock in the portfolio by the end of year 10) comprise around 46% of the portfolio value by the end of year 10. Further, the next 5 stocks constitute ~21% of the portfolio value by the end of year 10. The remaining 33 stocks, however, continue to comprise only ~33% of the portfolio value by the end of year 10. Here again, the key thing to note is that ~23% of the stocks comprise ~67% of the total portfolio value by the end of year 10. The portfolio IRR remains healthy at ~24.2% (vs ~15.3% for the Sensex index).

In scenario 2, we assume the fresh fund inflows to increase by 20% each year

Under both the scenarios, the portfolio continues to generate healthy IRRs vs the Sensex index

Strategy


We believe exhibits 15 and 16 above bring out a very important aspect of the coffee can construct; which is, allowing the power of compounding to work its magic is a much more important driver of long-term returns than the most ideal stock selection itself. This is also similar to what we had seen in Exhibit 5 on page 10, where even with a 50% strike rate and perfect symmetry around the returns generated by winning and losing stocks, the portfolio when left untouched for longer periods of time compounds well. This is because over time the losing stocks become insignificant while the portfolio returns are gradually dominated by the winners.

What is the ideal life for a Coffee Can Portfolio?

Having discussed the virtues of the coffee can construct, in the next section we will discuss how the returns as well as risk profile for the Coffee Can Portfolio are over a shorter time horizon. Further, using historical analysis, we will discuss whether an investor should terminate the Coffee Can Portfolio over a shorter time horizon or would he be better off keeping the portfolio untouched for a decade.

The more important thing to note is that ~23% of the stocks comprise 65-75% of the end portfolio value

Strategy


The ideal life of a Coffee Can Portfolio The entire coffee can construct is premised on investing in quality franchises with a long-term track record of superior financial performance over longer periods of time. Further, as discussed in the preceding sections of the note, one of the reasons the coffee can construct works well is because a longer period of time (usually ten years) allows the power of compounding to play out its magic. Over the longer term, the coffee can construct allows the portfolio to be dominated by the winning stocks whilst losing stocks keep declining to eventually become inconsequential.

Performance of the coffee can portfolios over a shorter time horizon

Whilst, historically, we have advocated a 10-year holding period for the Coffee Can Portfolio, one of the questions that several investors have asked us is how are the returns as well as the risk profile over a shorter period of time (such as five years).

In that context, in exhibit 17 below, we have shown the returns as well as the risk profile for each of the preceding 16 iterations of the Coffee Can Portfolio over a shorter time horizon (i.e. 5 years).

Exhibit 17: Performance of the previous 16 iterations of the Coffee Can Portfolio over a 5-year period Kick-off year*

All-cap CCP (start)

All-cap CCP (end)

CAGR return



Large-cap CCP (end)

CAGR return


2000 500 1,150 18.1% 7.3% 400 925 18.2% 7.4%

2001 600 2,409 32.1% 4.3% 300 1,320 34.5% 6.8%

2002 800 4,006 38.0% 0.1% 500 2,667 39.8% 1.8%

2003 900 3,771 33.2% 0.9% 600 3,089 38.8% 6.5%

2004 1,000 3,904 31.3% 4.7% 500 1,769 28.8% 2.2%

2005 900 2,525 22.9% 1.6% 500 1,606 26.3% 4.9%

2006 1,000 2,029 15.2% 1.5% 600 1,458 19.4% 5.7%

2007 1,500 2,685 12.3% 7.4% 1,000 1,968 14.5% 9.5%

2008 1,100 2,670 19.4% 10.2% 800 1,875 18.6% 9.3%

2009 1,100 3,529 26.3% 12.6% 900 2,203 19.6% 6.0%

2010 700 1,764 20.3% 9.2% 300 708 18.7% 7.6%

2011 1,400 2,335 10.8% 1.6% 400 828 15.6% 6.5%

2012 2,200 5,356 23.3% 9.9% 500 1,066 19.5% 6.1%

2013 1,800 4,762 34.8% 21.4% 600 1,286 26.4% 12.9%

2014 1,600 2,331 22.2% 21.0% 700 969 18.9% 17.8%

2015 2,000 2,387 19.3% 13.4% 1,200 1,323 10.3% 4.3%


The results can be summarised as follows: Even over shorter time horizons, each of the 16 CCPs has outperformed the

benchmark Sensex index. Even the sub-set of the CCP i.e., the large-cap version of the CCP, has been

successful in beating the Sensex on all 16 occasions.

On a risk-adjusted basis (where we define risk as maximum drawdown), 14 out of the 16 iterations of the all-cap portfolio as well as the large-cap portfolio have outperformed the Sensex.

What is the optimal holding period for a Coffee Can Portfolio?

Exhibit 17 above suggests that each of the previous sixteen iterations of the Coffee Can Portfolio has handsomely outperformed the benchmark Sensex index; both on an absolute basis as well as on a risk-adjusted basis.

Given the outperformance for the coffee can portfolios even over a shorter time period (i.e. 5 years), the obvious question one would ask is whether investors should terminate the Coffee Can Portfolio after 5 years instead of 10 years.

We analyse the CCP returns over a shorter time horizon

Even over shorter time horizons, the 16 iterations of the CCP that we initiate from 2000 to 2015 have beaten the benchmark Sensex index

Should investors terminate the CCP after 5 years instead of 10 years?

Strategy


To answer this, in exhibit 18 below, we have summarised the portfolio returns under two different scenarios:

Scenario 1- Each of the seven completed coffee can portfolios are left untouched for a decade.

Scenario 2- Each of these seven coffee can portfolios is allowed to compound for the first 5 years of the life of the portfolio. At the end of year 5, the portfolio value of stocks that does not clear our coffee can filters in year 5 is equally allocated to the fresh stocks that meet the coffee can criteria in year 5. So, for example, from the Coffee Can Portfolio for the year 2000, Cipla, Hero MotoCorp and HDFC continued to meet the coffee can thresholds in 2005. NIIT and Swaraj Engines however failed to meet the coffee can criteria in 2005. Hence, we allocate the portfolio value of NIIT and Swaraj Engines at the end of year 5 equally to all the fresh stocks that meet our coffee can thresholds in 2005 (in this case: Infosys, Container Corporation, Geometric, Havells India, Ind-Swift and Munjal Showa). We repeat this exercise for the periods of 2001-11, 2002-12, 2003-13, 2004-14, 2005-15 and 2006-16.

In both the scenarios we assume a total price impact cost plus brokerage cost of 100bps for every trade done over the ten year period. The portfolio attributes under each of the two scenarios discussed above can be seen in exhibit 18 below:

Exhibit 18: Performance of the coffee can portfolios under the two scenarios

Phase

Scenario 1 Scenario 2 Scenario 1 vs Scenario 2

CAGR returns for the portfolio

Growth of `99 invested at the beg

of the period*

CAGR returns for the portfolio

Growth of `99 invested at the beg

of the period*

Excess CAGR returns under

Scenario 1

Loss of terminal portfolio value

under Scenario 2 2000-10 22.6% 759 22.7% 769 -0.2% 1%

2001-11 32.2% 1,617 24.9% 913 7.3% -44%

2002-12 25.4% 954 23.3% 803 2.1% -16%

2003-13 27.4% 1,119 25.7% 976 1.7% -13%

2004-14 32.6% 1,668 28.6% 1,222 4.1% -27%

2005-15 22.1% 731 21.4% 686 0.8% -6%

2006-16 20.4% 631 13.3% 344 7.1% -45%

Average 26.1% 22.8% 3.3% -21%

Source: Bloomberg, Ambit Capital research. Note: * after considering Re 1 in terms of brokerage and price impact cost.

The results from our analysis (see exhibit 18 above) have been summarised below:

Under scenario 1, if an investor invests `100 in each of the seven coffee can portfolios, the average returns generated by the investor over the seven iterations of the portfolio is ~26.1%.

Under scenario 2, if the same investor invests `100 in each of the seven coffee can portfolios (but decides to replace the exiting stocks in year 5 with stocks that clear the coffee can filters in year 5), the average returns generated by the investor over the seven iterations is ~22.8%.

Points 1 and 2 above suggest that if an investor decides to run the Coffee Can Portfolio over a shorter time horizon (i.e. 5 years instead of 10 years), the overall investment returns are lower by ~3.3% points.

In six out of the seven iterations, the portfolio value at the end of year 10 is higher if the initial Coffee Can Portfolio is kept untouched for the decade.

The more astounding thing to note is that in two of the iterations (i.e. 2001-11 and 2006-16), the portfolio value at the end of year 10 is lower by 44% and 45% respectively if an investor decides to churn the portfolio in year 5.

The results from our analysis yet again bring out the point that for the coffee can construct to deliver its magic, the portfolio should be left untouched for the decade. A shorter time horizon does not allow the power of compounding to work its magic.

Which are the stocks that clear our Coffee Can filters for 2016-2026?

Having discussed the virtues of the coffee can construct and establishing the ideal time horizon over which one should remain invested in a typical Coffee Can Portfolio, we now introduce the Coffee Can candidates for 2016-2026 in the next section.

Our analysis suggests for the coffee can construct to play its magic, the CCP should be left untouched for a decade

Strategy


Today’s Coffee Can for 2016-2026 Introducing the Coffee Can candidates for 2016-2026

We screened India’s listed universe of non-BFSI stocks with a market capitalisation of more than `1bn that have delivered 10% sales growth and 15% RoCE (pre-tax) every year for the past year. The list is mentioned in the exhibit below.

Exhibit 19: The short list of firms with superior RoCE (pre-tax) and superior sales growth over the last ten years (FY06-16)

Superior on both Ticker Share price performance (ten-year CAGR rel. to Sensex) (%)

Mcap (US$bn)

FY17 P/E

HCL Technologies HCLT IN 17% 16.7 13.7

Asian Paints APNT IN 30% 15.2 47.3

Lupin LPC IN 31% 10.4 23.1

Cadila Health. CDH IN 22% 5.9 25.0

Britannia Inds. BRIT IN 22% 5.6 39.2

Page Industries PAG IN 47% 2.7 61.0

Amara Raja Batt. AMRJ IN 50% 2.6 29.8

Dr Lal PathLabs DLPL IN N/A 1.5 59.1

eClerx Services ECLX IN 29% 0.9 15.2

Astral Poly ASTRA IN 49% 0.8 35.6

Relaxo Footwear RLXF IN 59% 0.7 36.5

Cera Sanitary. CRS IN 47% 0.5 30.5

Source: Bloomberg, Capitaline, Ambit Capital research; Note: Share price performance has been measured over a ten-year period (i.e. 31 March 2006 to 31 March 2016). In case of firms with a shorter listing history, the performance has been measured over the shorter period (not less than 3 years). * Market-cap as on 10 November 2016. Page Industries, Dr. Lal PathLabs, eClerx Services, Astral Poly and Cera Sanitaryware were not listed throughout the ten-year period and hence the financial data used is based on Draft Red Herring Prospectus as provided by Capitaline, for periods prior to their IPOs.

As mentioned in the preceding sections, from our previous Coffee Can Portfolio, stocks like Marico, GSK Consumer, Colgate Palmolive, Berger Paints, V-Guard Industries and ITC do not find a place in this year’s coffee can.

The new additions this year include Dr. Lal PathLabs and Relaxo Footwear.

We run a similar filter for India’s listed BFSI stocks with a market-cap of more than `1bn and: (a) an RoE of 16%; and (b) loan growth of 15% for every consecutive year for the past ten years. In a universe of 127 firms, a meagre 6 firms managed to pass this test (representing a small fraction of ~5%). This handful of firms is shown in the exhibit below.

Exhibit 20: The very short list of BFSI firms with superior RoE and superior loan book growth (over FY05-15)

Superior on both Ticker Share price performance (Ten year CAGR rel. to Sensex) (%)

Mcap US$bn)

FY17 P/E

HDFC Bank HDFCB IN 21% 47.7 21.5

Axis Bank AXSB IN 20% 17.5 28.2

LIC Housing Fin. LICHF IN 29% 4.0 12.4

GRUH Finance GRHF IN 40% 1.7 38.6

Repco Home Fin REPCO IN 50% 0.6 22.0

Muthoot Cap. Serv MTCS IN 30% 0.1 DNA

Source: Bloomberg, Capitaline, Ambit Capital research; Note: Share price performance has been measured over the last ten-year period (i.e. 31 March 2006 to 31 March 2016). In case of firms with a shorter listing history, the performance has been measured over the shorter period (not less than 3 years). * Market-cap as on 10 November 2016. Repco Home Finance was not listed throughout the ten-year period and hence the financial data used is based on Draft Red Herring Prospectus as provided by Capitaline, for periods prior to its IPO.

From the above list, we exclude Muthoot Capital Services due to its size.

Having identified the coffee can stocks for this year’s iteration of the Coffee Can Portfolio, in the ensuing sections we will evaluate each of the companies forming part of our Coffee Can Portfolio using John Kay’s IBAS framework.

John Kay’s IBAS framework has been discussed in greater details in Appendix 3: John Kay’s IBAS Framework.

Coffee Can 2016-2026 continues to feature some of India’s most-successful franchises as well as the most-compelling investment themes

Only 6 BFSI stocks meet our screening filters

In the ensuing sections we evaluate the stocks that feature in this year’s CCP using John Kay’s IBAS framework


Flawless execution Since inception, HDFC Bank has focused on building a granular retail franchise on both sides of the balance sheet. It has maintained a conservative approach towards lending (gross NPA of 1.02%). With a stable management team at the helm, the bank was able to expand its retail offering on a pan-India basis and fill the gaps in its corporate banking offering. However, the valuation premium over peers largely captures superior earnings growth of the bank in the medium term (20% EPS CAGR over FY17-18E). Further, with 20-odd new banks, we believe that the competitive intensity will rise for low-cost liabilities and customer data. We remain SELLers with a TP of `1,225 (15x one-year forward EPS and 2.9x one-year forward BVPS).

Competitive position: STRONG Changes to this position: STABLE

Banking on low-cost liabilities

Established in 1994, HDFC Bank is India’s largest private sector bank in terms of assets. It holds ~4% market share in the total banking industry. The bank’s retail loans form 51% of the loan book, with market-leading presence in most of the retail product categories. Its corporate business has focused on working capital financing. HDFC Bank has differentiated itself from its peers through its strategic focus on granular low-cost franchise. Superior margins and controlled asset quality have driven healthy average RoE of ~18% in the last ten years. A stable management team and use of technology, since beginning, have further facilitated the bank’s consistent performance.

Mastering the word “execution”

HDFC Bank focused on two key principles in its business – building a stable and low-cost liability base and winning clients by offering unique solutions (such as technology-led capture of capital market floats). The bank has taken a long-term approach of protecting its margins and asset quality rather than pursuing near-term aggressive growth (e.g. avoided project finance-led growth in last six years). Superior profitability has allowed HDFC Bank to sustain its capital position mainly through internal profit generation without undue dilution of its shareholders’ fund. The bank has made two acquisitions in the past, but its recent focus has been on organic growth through accelerated branch network expansion on a pan-India basis.

Going beyond IBAS framework

Risk-averse culture and ability to use technology (systems and processes) to create a unique offering have been key differentiators. Despite the relatively low advertising budget and lack of celebrity endorsements, its high level of brand recall is a testimony of the bank’s strengths. HDFC Bank is known for its focus on systems and processes; this has helped the bank in terms of business continuity. The bank’s key strategic asset has been its low-cost funding franchise (cost of funds of 5.5% vs peer average of 6.2%), which has helped it effectively compete with other banks without taking higher asset quality risks.

Premium valuation justified by robust growth

Over the years, HDFC Bank has moved in the right direction on most parameters. HDFC Bank’s higher NIM (4.1%), improving cost-to-income ratio (48%) and lower credit costs (40bps) are driving the current RoA of 1.8%. However, with 20-odd new banks, we believe that the competitive intensity will increase for low-cost liabilities and customer data. We expect earnings CAGR of 20% over FY17-18E and average RoE of 19.2% over FY17-18E for HDFC Bank. We remain SELLers with a TP of `1,225 (2.9x one-year forward BVPS).

STRATEGY NOTE HDFCB IN EQUITY November 17, 2016

HDFC Bank

SELL

BFSI

Recommendation Mcap (bn): `3,230/US$48.5 3M ADV (mn): `1,798/US$27.0 CMP: `1,244 TP (12 mths): `1,225 Downside (%): 2

Flags Accounting: GREEN Predictability: GREEN Earnings Momentum: GREEN

Performance


708090

100110120130

Nov

-15

Dec

-15

Jan-

16

Feb-

16M

ar-1

6A

pr-1

6M

ay-1

6Ju

n-16

Jul-

16A

ug-1

6Se

p-1

6O

ct-1

6

HDFC Bank Sensex

Research Analysts

Pankaj Agarwal, CFA

Tel: +91 22 3043 3206

[email protected]

Ravi Singh

Tel: +91 22 3043 3181

[email protected]

Rahil Shah

Tel: +91 22 3043 3217

[email protected]

HDFC Bank


Exhibit 1: HDFC Bank loan book is diversifying towards retail

Source: Company, Ambit Capital research

Exhibit 2: Key financial parameters over the last decade

FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 1HFY17*

Loan book (` bn) 582 792 989 1,258 1,600 1,954 2,397 3,030 3,655 4,646 4,944

Loan book growth (%) 39.8% 36.1% 24.9% 27.3% 27.1% 22.2% 22.7% 26.4% 20.6% 27.1% 18.1%

Operating profits (` mn) 28,331 41,975 51,790 64,297 77,254 93,906 114,276 143,601 174,045 213,635 118,437

Net profits (` mn) 12,629 17,221 22,449 29,487 39,264 51,671 67,263 84,784 102,159 122,962 66,942

EPS (`) 6.5 8.1 10.6 12.9 16.9 22.0 28.3 35.3 42.1 48.6 26.4

Gross NPAs (%) 1.66% 1.81% 1.95% 1.43% 1.05% 1.01% 0.97% 0.98% 0.93% 0.94% 1.02%

Net NPAs (%) 0.59% 0.66% 0.63% 0.31% 0.19% 0.18% 0.20% 0.27% 0.25% 0.28% 0.30%

Tier 1 (%) 8.8% 10.2% 10.6% 13.3% 12.2% 11.6% 11.1% 11.8% 13.7% 13.2% 13.3%

RoA (%) 1.30% 1.28% 1.31% 1.45% 1.57% 1.68% 1.82% 1.90% 1.89% 1.89% 1.78%

RoE (%) 18.0% 16.7% 16.1% 16.1% 16.7% 18.7% 20.3% 21.3% 19.4% 18.3% 17.5%

Source: Company, Ambit Capital research. Note: *1HFY17 operating profits, net profits and EPS numbers not annualized

Exhibit 3: The key things to note from evolution

Time period Phase Key developments

1994-1999 A corporate bank with a difference

The initial management team was built mostly by hiring young bankers from foreign banks like Citibank, Bank of America and HSBC.

The bank focused on raising low-cost liabilities, finding gaps in the existing offerings of competing banks, capturing transactional and cash management business from the corporates rather than lending money to them.

The bank implemented a fully integrated online banking automation system as compared to other popular offline systems which were used by other competitors.

2000-2008 Building the retail bank

In FY04, the bank struck a deal with its parent company (HDFC) to become a distributor of HDFC’s home loans for a fee of 0.7% of the loan and the right to buy back 70% of the loans originated by it.

Extensive focus on retail loans allowed the bank to post a retail loan book CAGR of 67% over FY00-08 and contributed 57% of the loan book by FY08.

Focused on selling third-party products and acquiring point-of-sale terminals.

2009-Present Reaching the hinterland and taking on Silicon Valley

HDFC Bank acquired Centurion Bank of Punjab (CBOP) in May 2008. CBOP was one-fifth of HDFC Bank in terms of balance sheet and half in terms of branches.

HDFC Bank focused on improving rural foot prints. The bank set up dedicated desks at semi-urban and rural branches to cater to agriculture loans.

HDFC Bank started a major push towards ‘digital banking’. Various initiatives like PayZapp wallet, loans in ten seconds, etc. were launched.


0%

5%

10%

15%

20%

25%

0%10%20%30%40%50%60%70%80%90%

100%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

1H

FY1

7

Home Vehicle Other retail Non-retail RoE (RHS)

HDFC Bank


Exhibit 4: Competitive mapping of HDFC Bank with other comparable peers

Company Loan book - ` bn (FY16)

Loan CAGR (FY12-16) CASA (FY16) NIMs (FY16) RoE (FY16) Net NPAs

(FY16) Tier 1(FY16)

State Bank of India 14,637 14.1% 42.6% 2.8% 7.3% 3.81% 9.9%

HDFC Bank 4,646 23.8% 43.2% 4.5% 18.3% 0.28% 13.2%

ICICI Bank 4,353 15.0% 45.8% 3.5% 11.4% 2.98% 13.1%

Axis Bank 3,388 18.9% 47.3% 3.6% 16.8% 0.74% 12.5%

Kotak Mahindra Bank 1,187 32.3% 38.1% 4.0% 9.2% 1.06% 15.3%

IndusInd Bank 884 27.6% 35.2% 3.9% 17.3% 0.36% 14.9%


Exhibit 5: Mapping HDFC Bank and its peers on IBAS

Company Innovation Brand Architecture Strategic asset

Overall rank Comments

HDFC Bank

The bank scores highly on all parameters: Innovation (origin as an upstart bank, transaction banking, technology-led solution, capital markets strategy to capture floats, forays in rural and digital banking); brand (wide geographical and demographical reach); architecture (little churn in senior management, highly focused on systems and processes, meeting unmet demands of customers); and strategic assets (wide branch network, large and sticky retail deposits franchise, strong asset quality and a good capital raising track record)

ICICI Bank

The bank has mixed scores on IBAS: Innovation (present across all segments of financial services, pioneer in using technology); brand (wide geographical and demographical reach, but marred by negative asset quality cycles); architecture (cyclical ups and downs on growth and asset quality indicate inadequate quality of engagement with employees and customers); and strategic assets (wide branch network, large and sticky retail deposits franchise, leading franchises in most financial services businesses)

Axis Bank

The bank scores highly on most parameters: Innovation (evolution of the bank’s retail liabilities, retail assets, DCM business, SME banking and wholesale banking in high quality leading franchises); brand (wide geographical and demographical reach; successful transition from a quasi-PSU brand to new-age banking brand); architecture (strong and independent board, an employee-friendly environment and a flexible culture open to changes with track record of seamlessly re-orienting under three leaders with different management styles); and strategic assets (best-in-class franchise in areas of transaction banking, such as cash management, payments, business banking and government businesses, wide branch network, large and sticky retail deposits franchise).

Kotak Mahindra Bank

The bank scores highly on most parameters: Innovation (evolution from an NBFC to a universal financial services conglomerate); brand (strong brand but with limited reach, receive a fill up from ING Vysya Bank acquisition); architecture (conservative corporate culture with high focus on costs and risk pricing, even at the cost of growth); and strategic assets (leading franchises in number of lending and non-lending financial service businesses).

IndusInd Bank

The bank has mixed scores on IBAS: Innovation (overhauling of entire corporate banking, and launching and scaling up of retail products under new management); brand (strong niche brand in vehicle finance and other niche segments, yet to evolve into a prominent high-street brand); architecture (strong and well-knit senior management team; strong long-term relationship-based customer connect in vehicle finance); and strategic assets (unmatched differentiated vehicle finance franchise, structured mid-market corporate banking franchise, rapidly expanding branch network).

State Bank of India

The bank has mixed scores on IBAS: Innovation (has built presence across all segments of financial services businesses over the long term, but constraints linked with being PSU bank limit rapid innovations and adopting best practices from peers); brand (wide geographical and demographical reach, but underwhelming perception for standards of customer service); architecture (poor alignment of employee-reward programme with commercial success of the bank, HR practices are not comparable with private sector peers); and strategic assets (wide branch network, large and sticky retail deposits franchise and leading franchises in most financial services businesses).

Source: Company, Ambit Capital research; Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

HDFC Bank


Exhibit 6: Loan book growth has been stable at around 20% with improvement in NIM


Exhibit 7: Due to efficiencies in operations, RoA of the bank has improved over the years


Exhibit 8: Gross NPAs and provision coverage ratio has shown healthy trends


Exhibit 9: Tier-1 ratio has been strong over past years


Exhibit 10: HDFC Bank is trading at its historical multiple

Source: Bloomberg, Company, Ambit Capital research

Exhibit 11: Share price performance v/s BSE Bankex


Exhibit 12: Explanation for our flags

Segment Score Comments

Accounting GREEN Similar to all other Indian private sector banks, HDFC Bank uses intrinsic value of stock option to account ESOP expense. However, the bank disclosed that if Black Scholes model-based fair valuation was used, net profit would be adjusted lower by 10% in FY14, FY15 and FY16.

Predictability GREEN The bank has one of the best track records of long-term profitability. It has delivered on the guidance with very little room in variation.

Earnings momentum GREEN Consensus EPS estimates for FY17 and FY18 have been reduced by 6% and 7% respectively in past one year. We expect 20% EPS CAGR over FY17-18E.


4.1%

4.2%

4.3%

4.4%

4.5%

4.6%

4.7%

0%5%

10%15%20%25%30%35%40%45%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Loan growth Net interest margins (RHS)

0%

5%

10%

15%

20%

25%

0.0%

0.5%

1.0%

1.5%

2.0%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

RoA RoE (RHS)

0%

20%

40%

60%

80%

100%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Gross NPAs Provision coverage ratio (RHS)

8.8

%

10.2

%

10.6

%

13.3

%

12.2

%

11.6

%

11.1

%

11.8

%

13.7

%

13.2

%

0%2%4%6%8%

10%12%14%16%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Tier 1

1

2

3

4

5

6

Jun-05

Mar-0

6

Dec-0

6

Sep-07

Jun-08

Mar-0

9

Dec-0

9

Sep-10

Jun-11

Mar-1

2

Dec-1

2

Sep-13

Jun-14

Mar-1

5

Dec-1

5

Sep-16

PB Avg. PB

0

100

200

300

400

500

600

700

Nov

-06

May

-07

Nov

-07

May

-08

Nov

-08

May

-09

Nov

-09

May

-10

Nov

-10

May

-11

Nov

-11

May

-12

Nov

-12

May

-13

Nov

-13

May

-14

Nov

-14

May

-15

Nov

-15

May

-16

HDFCB IN SENSEX

HDFC Bank


Balance sheet

Year to March (` mn) FY14 FY15 FY16 FY17E FY18E

Net worth 434,786 620,094 726,778 839,240 973,785

Deposits 3,673,375 4,507,956 5,464,242 6,393,163 7,671,796

Borrowings 394,390 452,136 530,185 621,072 744,570

Other liabilities 413,444 324,844 367,251 459,064 573,830

Total liabilities 4,915,995 5,905,031 7,088,456 8,312,538 9,963,980

Cash & balances with RBI & banks 395,836 363,315 389,188 444,353 517,306

Investments 1,209,511 1,516,418 1,638,858 1,965,391 2,402,834

Advances 3,030,003 3,654,950 4,645,940 5,457,757 6,565,548

Other assets 280,645 370,348 414,470 445,037 478,292

Total assets 4,915,995 5,905,031 7,088,456 8,312,538 9,963,980


Income statement


Interest income 411,355 484,699 602,214 700,351 812,190

Interest expense 226,529 260,742 326,299 368,171 424,461

Net interest income 184,826 223,957 275,915 332,180 387,729

Total non-interest income 79,196 89,964 107,517 125,533 147,419

Total income 264,023 313,920 383,432 457,714 535,148

Total operating expenses 120,422 139,875 169,797 198,323 229,189

Employees expenses 41,790 47,510 57,022 67,504 76,131

Other operating expenses 78,632 92,366 112,775 130,819 153,058

Pre-provisioning profits 143,601 174,045 213,635 259,391 305,959

Provisions 15,873 20,750 27,256 36,870 39,744

PBT 127,728 153,295 186,379 222,521 266,215

Tax 42,944 51,136 63,417 74,544 89,182

PAT 84,784 102,159 122,962 147,976 177,033


Key ratios


Credit-Deposit (%) 82.5% 81.1% 85.0% 85.4% 85.6%

CASA ratio (%) 45.6% 44.6% 43.8% 43.1% 41.8%

Cost/Income ratio (%) 45.6% 44.6% 44.3% 43.3% 42.8%

Gross NPA (` mn) 29,893 34,384 43,928 56,792 64,125

Gross NPA (%) 0.98% 0.93% 0.94% 1.03% 0.97%

Net NPA (` mn) 8,200 8,963 13,204 15,334 17,314

Net NPA (%) 0.27% 0.25% 0.28% 0.28% 0.26%

Provision coverage (%) 72.6% 73.9% 69.9% 73.0% 73.0%

NIMs (%) 4.39% 4.40% 4.52% 4.57% 4.47%

Tier-1 capital ratio (%) 11.8% 13.7% 13.2% 13.1% 12.7%


HDFC Bank


Du-pont analysis

Year to March FY14 FY15 FY16 FY17E FY18E

NII/Assets (%) 4.1% 4.1% 4.2% 4.3% 4.2%

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

Total Income/Assets (%) 5.9% 5.8% 5.9% 5.9% 5.9%

Cost to assets (%) 2.7% 2.6% 2.6% 2.6% 2.5%

PPP/Assets (%) 3.2% 3.2% 3.3% 3.4% 3.3%

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

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

Tax rate (%) 33.6% 33.4% 34.0% 33.5% 33.5%

RoA (%) 1.90% 1.89% 1.89% 1.92% 1.94%

Leverage 11.2 10.3 9.6 9.8 10.1

RoE (%) 21.3% 19.4% 18.3% 18.9% 19.5%


Valuation


EPS (`) 35.3 42.1 48.6 58.5 70.0

EPS growth (%) 25% 19% 16% 20% 20%

BVPS (`) 181.2 247.4 287.5 332.0 385.2

P/E (x) 36.1 30.3 26.2 21.8 18.2

P/BV (x) 7.04 5.16 4.44 3.84 3.31



A strong core A strong and independent Board, an employee friendly culture, and a DNA flexible to changes form the foundation of Axis Bank’s long-term success. These strengths have helped the bank transform from a quasi-PSU bank to a new-age universal bank over the past two decades under three different leaders. The bank’s strength on both sides of the balance sheet is visible in its strong operating profitability, which enables it to absorb higher credit cost of ~200bps in FY17-18E and still deliver average ROE of 13.2% and EPS CAGR of 13% over FY16-18E. Axis Bank is trading at ~30% discount to peers despite superior steady-state ROE. We are BUYers with TP of `600 (2.2x FY18 P/B). The key risks to our BUY stance are a prolonged economic slowdown and continued deadlock in the power sector. These could lead to higher asset quality risks due to Axis Bank’s higher exposure to the power and SME sectors.

Competitive position: MODERATE Changes to this position: STABLE

A long term track-record on RoE and growth

In last ten years (FY07-16), Axis Bank’s RoA and RoE have averaged at 1.5% and ~19%, respectively, along with loan book CAGR of 31%. However, in 1HFY17, the performance has taken a hit due to asset quality stress with RoA and RoE of 0.7% and ~7%, respectively. The underlying drivers of the bank’s long-term performance are: (a) strong liability franchise (focus on branch/ATM network, government business, SME banking supporting CASA in early years and focus on a granular retail term deposits franchise in recent years); (b) superior fee-income generation (average fee income to assets at 1.8% (FY07-16), and; (c) controlled operating efficiency (average cost to fee income of 43% (FY07-16).

From strong retail liability franchise to a universal bank

Axis Bank’s journey in the noughties was mostly about building a low-cost liability base (cost of funds of 5.7% now) by employing a well thought out branch and ATM expansion, customer segmentation and sales model. Over the last five years, the bank leveraged its retail liability base to build its retail asset franchise (42% of total loans now; vs 20% in FY12). The acquisition of ENAM (equities and investment banking business), international expansion, and a relationship-based model strengthened the bank’s corporate banking franchise.

Ticking all boxes of IBAS framework

Multiple innovations were involved when the bank ramped up its low cost deposit franchise during FY00-09 and when the bank ramped up its retail franchise during Ms. Sharma’s tenure (FY09-current). Transition of brand from UTI Bank to Axis Bank was an exemplary success. A strong and independent Board, an employee friendly culture and a flexible culture open to changes has defined the success of Axis Bank, which has seamlessly reoriented itself under three leaders with different management styles. Beyond plain-vanilla banking, Axis Bank has best-in-class franchise in areas of transaction banking, such as cash management, payments, business banking and government businesses.

Significant discount to peers despite strong profitability

Asset quality challenges in the corporate loan book have led to a de-rating of the stock. However, strong operating profitability (3.1% of assets) can more than offset the average credit cost of 200bps over FY17-18E and can help generate average ROE of 13.2% and EPS CAGR of 13% over FY17-18E. Axis Bank is trading at 1.8x FY18 P/B, ~15% discount to its cross-cycle valuations and ~30% discount to its peers despite better steady-state ROE. Our target price of `600 implies FY18E P/B of 2.2x and FY18E P/E of 13.7x (20% upside).

STRATEGY NOTE AXSB IN EQUITY November 17, 2016

Axis Bank

BUY

BFSI

Recommendation Mcap (bn): `1,190/US$17.9 3M ADV (mn): `7,049/US$106 CMP: `499 TP (12 mths): `600 Upside (%): 20

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: AMBER

Performance


70

90

110

130

150

Nov

-15

Dec

-15

Jan-

16

Feb-

16M

ar-1

6A

pr-1

6M

ay-1

6Ju

n-16

Jul-

16A

ug-1

6Se

p-1

6O

ct-1

6

Axis Bank Sensex

Research Analysts

Pankaj Agarwal, CFA

Tel: +91 22 3043 3206

[email protected]

Ravi Singh

Tel: +91 22 3043 3181

[email protected]

Rahil Shah

Tel: +91 22 3043 3217

[email protected]

Axis Bank


Exhibit 1: Axis Bank loan book is diversifying towards retail



FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 1HFY17*

Loan book (` bn) 369 597 816 1,043 1,424 1,698 1,970 2,301 2,811 3,388 3,532

Loan book growth (%) 65.3% 61.8% 36.7% 27.9% 36.5% 19.2% 16.0% 16.8% 22.2% 20.5% 18.5%

Operating profits (` mn) 12,639 22,259 37,249 52,405 64,157 74,309 93,031 114,561 133,854 161,036 85,696

Net profits (` mn) 6,590 10,710 18,154 25,145 33,885 42,422 51,794 62,181 73,587 82,237 18,746

EPS (`) 4.7 6.0 10.1 12.4 16.5 20.5 22.1 26.5 31.0 34.5 7.9

Gross NPAs (%) 1.13% 0.83% 1.09% 1.25% 1.11% 1.06% 1.20% 1.36% 1.45% 1.78% 4.53%

Net NPAs (%) 0.72% 0.42% 0.40% 0.40% 0.29% 0.28% 0.36% 0.45% 0.47% 0.74% 2.20%

Tier 1 (%) 6.4% 10.2% 9.3% 11.2% 9.4% 9.5% 12.2% 12.6% 12.1% 12.5% 12.0%

ROA (%) 1.07% 1.17% 1.41% 1.53% 1.60% 1.61% 1.65% 1.72% 1.74% 1.67% 0.70%

ROE (%) 21.0% 17.6% 19.1% 19.2% 19.3% 20.3% 18.5% 17.4% 17.8% 16.8% 6.9%

Source: Company, Ambit Capital research. Note: *1HFY17 operating profits, net profits and EPS numbers not annualized



1994-1999 The early years – a shaky start

Axis Bank framed initial strategy to leverage UTI’s customer base, brand and branch network.

Axis Bank’s strategy to lend to mid-corporates backfired in the late 1990s as the economic slowdown led to a significant deterioration in asset quality by end FY2000.

Low investment in branches and ATMs meant that Axis Bank suffered on the liability side as well with CASA ratio of just 17% by the end of FY2000.

2000-2009

The P Jayendra Nayak era – An unusual and inspirational banker who transformed the bank

Dr Nayak was able to win the confidence of senior management of Axis with his clarity of thought and communication on the bank’s future plans and employee friendly policies.

Another major transformation, apart from starting ESOPs scheme, at the beginning of Nayak’s era was IT upgrade at the bank; all branches were brought on an online, real-time, centralised core banking platform.

Axis Bank aggressively expanded its branch and ATM networks between FY2000 and FY09, the fastest rate amongst peers. Hence, Axis Bank’s CASA, EPS and ROE grew at a rapid pace during Nayak’s tenure.

2009-Present The Shikha Sharma era – Seamless reorientation

Ms Sharma changed the business model from product-focused to customer-focused. She hired some of her ex-colleagues to implement her vision.

Deterioration in corporate asset quality has been a sobering experiencing for the bank with risks in infrastructure loan book emerging from unexpected areas, e.g., environmental and judicial changes.

Use of technology has helped the bank in huge productivity gains in terms of reducing branch sizes and better employee productivity.


0%

5%

10%

15%

20%

25%

0%

20%

40%

60%

80%

100%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

1H

FY1

7

Retail Corporate SME Agri RoE (RHS)

Axis Bank


Exhibit 4: Competitive mapping of Axis Bank, with other comparable peers

Company Loan book - ` bn (FY16)

Loan CAGR (FY12-16)

CASA (FY16)

NIMs (FY16)

RoE (FY16)

Net NPAs (FY16)

Tier 1 (FY16)

State Bank of India 14,637 14.1% 42.6% 2.8% 7.3% 3.81% 9.9%

HDFC Bank 4,646 23.8% 43.2% 4.5% 18.3% 0.28% 13.2%

ICICI Bank 4,353 15.0% 45.8% 3.5% 11.4% 2.98% 13.1%

Axis Bank 3,388 18.9% 47.3% 3.6% 16.8% 0.74% 12.5%

Kotak Mahindra Bank 1,187 32.3% 38.1% 4.0% 9.2% 1.06% 15.3%

IndusInd Bank 884 27.6% 35.2% 3.9% 17.3% 0.36% 14.9%


Exhibit 5: Mapping HDFC Bank and its peers on IBAS

Company Innovation Brand Architecture Strategic asset


HDFC Bank

The bank scores highly on all parameters: Innovation (origin as an upstart bank, transaction banking, technology-led solution, capital markets strategy to capture floats, forays in rural and digital banking); brand (wide geographical and demographical reach); architecture (little churn in senior management, highly focused on systems and processes, meeting unmet demands of customers); and strategic assets (wide branch network, large and sticky retail deposits franchise, strong asset quality and a good capital raising track record)

ICICI Bank

The bank has mixed scores on IBAS: Innovation (present across all segments of financial services, pioneer in using technology); brand (wide geographical and demographical reach, but marred by negative asset quality cycles); architecture (cyclical ups and downs on growth and asset quality indicate inadequate quality of engagement with employees and customers); and strategic assets (wide branch network, large and sticky retail deposits franchise, leading franchises in most financial services businesses)

Axis Bank

The bank scores highly on most parameters: Innovation (evolution of the bank’s retail liabilities, retail assets, DCM business, SME banking and wholesale banking in high quality leading franchises); brand (wide geographical and demographical reach; successful transition from a quasi-PSU brand to new-age banking brand); architecture (strong and independent board, an employee-friendly environment and a flexible culture open to changes with track record of seamlessly re-orienting under three leaders with different management styles); and strategic assets (best-in-class franchise in areas of transaction banking, such as cash management, payments, business banking and government businesses, wide branch network, large and sticky retail deposits franchise).

Kotak Mahindra Bank

The bank scores highly on most parameters: Innovation (evolution from an NBFC to a universal financial services conglomerate); brand (strong brand but with limited reach, receive a fill up from ING Vysya Bank acquisition); architecture (conservative corporate culture with high focus on costs and risk pricing, even at the cost of growth); and strategic assets (leading franchises in number of lending and non-lending financial service businesses).

IndusInd Bank

The bank has mixed scores on IBAS: Innovation (overhauling of entire corporate banking, and launching and scaling up of retail products under new management); brand (strong niche brand in vehicle finance and other niche segments, yet to evolve into a prominent high-street brand); architecture (strong and well-knit senior management team; strong long-term relationship-based customer connect in vehicle finance); and strategic assets (unmatched differentiated vehicle finance franchise, structured mid-market corporate banking franchise, rapidly expanding branch network).

State Bank of India

The bank has mixed scores on IBAS: Innovation (has built presence across all segments of financial services businesses over the long term, but constraints linked with being PSU bank limit rapid innovations and adopting best practices from peers); brand (wide geographical and demographical reach, but underwhelming perception for standards of customer service); architecture (poor alignment of employee-reward programme with commercial success of the bank, HR practices are not comparable with private sector peers); and strategic assets (wide branch network, large and sticky retail deposits franchise and leading franchises in most financial services businesses).


Axis Bank


Exhibit 6: Loan book growth has been stable at around 20% with improvement in NIMs


Exhibit 7: Due to efficiencies in operations, RoA of the bank is improving


Exhibit 8: Though the gross NPAs of the bank is increasing, the provisioning coverage ratio is strong


Exhibit 9: Tier 1 ratio has been strong over the past four years


Exhibit 10: Forward P/B evolution


Exhibit 11: Share price performance v/s BSE Bankex




Accounting GREEN

Similar to all other Indian private sector banks, Axis Bank uses intrinsic value of stock option to account ESOP expense. However, Axis Bank disclosed that if Black Scholes model based fair valuation was used, net profit would be adjusted lower by 1% in FY14, FY15 and FY16. For fee income on letters of credit (LC), Axis Bank books the income ’when due’ rather than amortising the income over the period of LC.

Predictability AMBER Due to uncertainty around the slippages in the corporate loan book it is difficult to predict exact trajectory of the bank earnings. Over a long term, however, Axis Bank has reported stable operating performance.

Earnings momentum AMBER FY17/FY18E consensus EPS estimates have been reduced by 52% and 32% respectively in past one year. We expect 13% EPS CAGR in FY16-18E.


0%

1%

2%

3%

4%

0%10%20%30%40%50%60%70%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Loan growth Net interest margins (RHS)

0%

5%

10%

15%

20%

25%

0.0%

0.5%

1.0%

1.5%

2.0%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

RoA RoE (RHS)

0%10%20%30%40%50%60%70%80%

0.0%

0.5%

1.0%

1.5%

2.0%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Gross NPAs Provision coverage ratio (RHS)

6.4

%

10.2

%

9.3

%

11.2

%

9.4

%

9.5

% 1

2.2

%

12.6

%

12.1

%

12.5

%

0%

2%

4%

6%

8%

10%

12%

14%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Tier 1

0

1

2

3

4

5

Mar

-05

Dec

-05

Sep-

06

Jun-

07

Mar

-08

Dec

-08

Sep-

09

Jun-

10

Mar

-11

Dec

-11

Sep-

12

Jun-

13

Mar

-14

Dec

-14

Sep-

15

Jun-

16

PB Avg. PB

0

100

200

300

400

500

600

700

Nov

-06

Jun-

07

Jan-

08

Aug

-08

Mar

-09

Oct

-09

May

-10

Dec

-10

Jul-

11

Feb-

12

Sep-

12

Apr

-13

Nov

-13

Jun-

14

Jan-

15

Aug

-15

Mar

-16

Oct

-16

AXSB IN SENSEX

Axis Bank


Balance sheet


Net worth 382,205 446,765 531,649 574,973 661,393

Deposits 2,809,446 3,224,419 3,579,676 4,224,017 5,111,061

Borrowings 502,909 797,583 992,264 1,235,895 1,455,223

Other Liabilities 137,889 150,557 151,088 181,305 217,566

Total Liabilities 3,832,449 4,619,324 5,254,676 6,216,190 7,445,243

Cash & Balances with RBI/Banks 282,387 360,990 333,254 387,729 466,920

Investments 1,135,484 1,175,502 1,220,062 1,409,171 1,697,661

Advances 2,300,668 2,810,830 3,387,737 4,068,902 4,920,197

Other Assets 113,910 272,001 313,623 350,388 360,464

Total Assets 3,832,449 4,619,324 5,254,676 6,216,190 7,445,243


Income statement


Interest Income 306,412 354,786 409,880 451,432 522,096

Interest Expense 186,895 212,545 241,551 262,359 299,522

Net Interest Income 119,516 142,241 168,330 189,073 222,574

Total Non-Interest Income 74,052 83,650 93,715 113,523 125,306

Total Income 193,569 225,892 262,044 302,596 347,880

Total Operating Expenses 79,008 92,037 101,008 119,518 139,366

Employees expenses 26,013 31,150 33,760 40,165 46,524

Other Operating Expenses 52,994 60,888 67,248 79,353 92,843

Pre Provisioning Profits 114,561 133,854 161,036 183,078 208,514

Provisions 21,070 23,277 37,099 104,510 51,791

PBT 93,490 110,578 123,937 78,568 156,723

Tax 31,310 36,990 41,700 26,320 52,502

PAT 62,181 73,587 82,237 52,248 104,221


Key ratios


Credit-Deposit (%) 81.9% 87.2% 94.6% 96.3% 96.3%

CASA ratio (%) 47.4% 45.5% 48.0% 47.5% 46.1%

Cost/Income ratio (%) 40.8% 40.7% 38.5% 39.5% 40.1%

Gross NPA (` mn) 31,464 41,102 60,875 170,029 132,092

Gross NPA (%) 1.36% 1.45% 1.78% 4.07% 2.64%

Net NPA (` mn) 10,246 13,167 25,221 59,510 39,628

Net NPA (%) 0.45% 0.47% 0.74% 1.46% 0.81%

Provision coverage (%) 67.4% 68.0% 58.6% 65.0% 70.0%

NIMs (%) 3.40% 3.53% 3.62% 3.50% 3.44%

Tier-1 capital ratio (%) 12.6% 12.1% 12.5% 11.3% 10.8%


Axis Bank


Du-pont analysis


NII / Assets (%) 3.3% 3.4% 3.4% 3.3% 3.3%

Other income / Assets (%) 2.0% 2.0% 1.9% 2.0% 1.8%

Total Income / Assets (%) 5.3% 5.3% 5.3% 5.3% 5.1%

Cost to Assets (%) 2.2% 2.2% 2.0% 2.1% 2.0%

PPP / Assets (%) 3.2% 3.2% 3.3% 3.2% 3.1%

Provisions / Assets (%) 0.6% 0.6% 0.8% 1.8% 0.8%

PBT / Assets (%) 2.6% 2.6% 2.5% 1.4% 2.3%

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

ROA (%) 1.7% 1.7% 1.7% 0.9% 1.5%

Leverage 10.1 10.2 10.1 10.4 11.0

ROE (%) 17.4% 17.8% 16.8% 9.4% 16.9%


Valuation


EPS (`) 26.5 31.0 34.5 21.9 43.7

EPS growth (%) 20% 17% 11% -36% 99%

BVPS (`) 162.7 188.5 223.1 241.3 277.6

P/E (x) 18.8 16.1 14.5 22.7 11.4

P/BV (x) 3.07 2.65 2.24 2.07 1.80



Set to surf the IoT wave HCLT’s prescient bets on infrastructure management services (IMS) and engineering services (ES) have enabled it to deliver FY06-16 revenue CAGR of 21% (USD) vs. 18% for larger peers. Strong capabilities in these segments also position it well for the upcoming Internet-of-Things era, as it is able to counter customer-spend deflation (30-40% at each deal renewal). It has had a stellar capital allocation track record as is visible from FY06-16 median RoCE of 21%; its large acquisition of Axon (55% of overall capital invested, FY09) has been marquee deal in industry. Current valuation of 12x FY18E EPS, implying 7% revenue CAGR over FY16-26, vs 21% over FY06-16, offer margin of safety. We are BUYers with a TP of `950, implying 15x FY18E EPS. Key risk: longevity of the business, especially IMS which faces 30-40% deflation due to cloud.


One of the better performing large Indian IT services companies

Since FY08, performance of top firms has diverged in terms of revenue/earnings growth due to differences in capital allocation, portfolio mix, operational excellence and management quality. HCLT has been one of the better performers on these metrics. Its bold bets on IMS and Axon have paid off. Capabilities in IMS, Indian IT’s fastest growing segment, continue to strengthen. Finally, an excellent sales effort driven by Vineet Nayar (CEO from 2007-13) has allowed it to penetrate and grow marquee clients. Over the past ten years, HCLT’s revenues and profits have grown at 21% CAGR (USD; vs 18% for larger peers) and 25% CAGR (Re terms, vs 23% for larger peers). Rode the IMS wave, now well-positioned for IoT HCLT began as the R&D division of HCL Enterprise, which developed an indigenous microcomputer in 1978. The inherited culture is a key ingredient of its success in outsourced engineering services (#1 in India, top-5 globally). Over 1996-2003, HCL formed a JV with Perot Systems which gave it access to high-value US clients. It missed out on the “Y2K bug” boom because management thought it was temporary low-end work. However, since then, two large bets paid off. It pioneered offshore delivery of IMS in 2003-04 (36% of FY16 revenues, no. 2 globally after IBM) and acquired Axon in 2009 (gave it relationships with CXOs in large organizations). Its next big bet is on IoT, which would require it to build on its capabilities in IMS and engineering services.

Second only to TCS on our IBAS framework

HCLT has consistently innovated to lower its cost structure. HCLT posted average EBIT margin of 19% (FY06-16) despite offering 30-40% cost-savings to clients on each deal renewal and steady wage inflation; depreciation of INR vs. USD would have helped though. HCLT scores well on brand as it occupies a high client mind share (source: third-party industry analyst reports) as well as a good reputation among employees as is reflected in lower attrition of 17% (vs peer median of 19%). HCLT’s decent positioning on architecture and strategic assets are based on strong sales architecture it has built over years and client-connect.

Low valuation (12x FY18 EPS) implies market concerns on longevity

IMS (40% of Sep-16 revenues) is at risk of 30-40% deflation from the cloud. However, there is significant room to gain share from high-cost vendors. All Indian vendors together cater to less than 5% of global IMS spend. HCLT’s investments in moving up the value-chain (higher scale and complexity, automation) position it well. Further, top-notch capabilities in IMS and engineering will likely lead to leadership in the emerging IoT/automation era. We expect 10%/11% revenue/NOPAT CAGR over FY16-26E.

STRATEGY NOTE HCLT IN EQUITY November 17, 2016

HCL Technologies

BUY

Technology

Recommendation Mcap (bn): `1087/US$16 3M ADV (mn): `1,515/US$23 CMP: `771 TP (12 mths): `950 Upside (%): 23%

Flags Accounting: GREEN Predictability: GREEN Earnings Momentum: AMBER

Performance


HCLT’s forensic score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

HCLT’s greatness score analysis


708090

100110120

Nov

-15

Dec

-15

Jan-

16

Feb-

16M

ar-1

6A

pr-1

6M

ay-1

6Ju

n-16

Jul-

16A

ug-1

6Se

p-1

6O

ct-1

6

HCL Tech. Sensex

Research Analysts

Sagar Rastogi

+91 22 3043 3291

[email protected]

Sudheer Guntupalli

+91 22 3043 3203

[email protected]

HCL Technologies


Exhibit 1: Evolution of HCL Technologies

Source: Ambit Capital research, company


(` mn) FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Revenues ($ mn) 1,266 1,763 2,078 2,574 3,320 4,035 4,539 5,180 5,822 6,235

Revenue growth (%) 38% 39% 18% 24% 29% 22% 12% 14% 12% 7%

Net profits 10,049 13,732 9,787 12,156 14,361 21,014 36,313 57,138 73,209 73,365

EPS 14.7 13.4 7.3 8.9 10.3 15.0 25.8 40.4 51.9 51.9

CFO 9,941 15,282 21,272 11,811 14,584 18,493 27,096 63,481 55,422 71,067

CFO pre-tax/ EBITDA 0.8 1.1 1.0 0.5 0.6 0.5 0.5 0.8 0.6 0.8

FCF 6,312 8,786 17,507 6,864 7,353 10,021 22,490 57,527 44,110 61,310

Debt equity (x) 0.00 - 0.70 0.42 0.31 0.20 0.11 0.05 0.02 0.03

RoE (%) 24% 26% 18% 21% 19% 22% 29% 35% 35% 29%

ROCE* (%) 37% 26% 27% 20% 24% 31% 41% 46% 40% 38%

Source: Company, Ambit Capital research. Note: *This is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator.



FY07-15 IMS and ES ramp up / Inorganic growth

HCLT pioneered global offshore delivery of IMS and ES starting in 2003-04. However, strong growth of IMS (36% CAGR) and ES (21% CAGR) over FY06-16 helped HCLT maintain industry leading overall revenue growth (21% CAGR vs 15% for Wipro, 16% for Infosys and 19% for TCS) during this period.

HCLT acquired Capital Stream, US based leader in providing comprehensive Straight through Processing (STP) solutions to commercial banks and finance companies, for $40mn. In FY13, HCLT sold off a part of capital stream to Linedata for $45mn.

In FY09, HCLT announced the acquisition of Axon, to add SAP implementation capabilities. At an EV of $765mn, Axon represented 55% of total capital invested by HCLT in FY09. This was also the largest buyout by an Indian IT firm.

During FY11-15, the company slowed down its inorganic growth spending just 6% of its Free Cash Flows during this period on acquisitions.

FY15- Cloud/IoT

In FY16 HCLT spent 19% of FCF on big ticket acquisitions like Volvo’s external IT business and end to end internal outsourcing.

In FY17, the company announced that it will buy majority stake in Geometric in a share swap deal estimated at $200mn to bolster its engineering and R&D practise. In addition to Volvo and Geometric, the company announced seven other deals in the last eighteen months

To remain insulated from cloud disruption and build on IoT capabilities.


0%5%10%15%20%25%30%35%40%45%50%

5001,0001,5002,0002,5003,0003,5004,0004,5005,0005,5006,0006,500

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Software services Infrastructure services BPO

IMS and ES ramp up Cloud / IOT

HCL Technologies


Exhibit 4: Competitive mapping of HCLT, TCS, Infosys, Wipro and TechM

Company Sub-Segment positioning

FY16 revenue

($)

Revenue CAGR

FY10-16

Industry market

share

EBITDA margin (FY16)

Pre-tax ROCE

(FY16)

Pre-tax CFO/EBITDA

(FY10-16)

Capex/CFO (FY10-16)

TCS 2 16,544 17% 38% 28% 53% 93% 16%

Infosys 4 9,501 12% 22% 27% 35% 97% 31%

Wipro 3 7,346 9% 17% 22% 23% 94% 26%

HCLT 1 6,235 16% 14% 21% 38% 84% 20%

TechM NA 4,038 27% 9% 16% 29% 67% 56%


Exhibit 5: Mapping HCLT and peers on our IBAS framework

Company Innovation Reputation Architecture Strategic asset


TCS

Overall, TCS ranks on top of our IBAS framework. It has constantly innovated in areas of offshoring, pyramid correction, code re-use and moving up the value chain in terms of IT services (which is also reflected in its industry leading EBIT margin 26.5%, FY16). TCS developed the reputation of a “value for money” vendor which makes it a preferred choice of clients especially for annuity kind of Run The Business (RTB) projects. It also has the reputation of an employee friendly organization which is reflected in its low attrition rate (15%, FY16). Focus on delivery, unique organizational structure driving margin expansion makes TCS score well on architecture aspect. Client connects ($50mn clients = 78 which is almost 2x of the nearest competitor), make it rank well on strategic assets aspect.

Infosys

Infosys ranks second on our IBAS framework along with HCLT. The company scores well in areas of offshoring, pyramid correction, code re-use which is reflected in its high EBIT margins (25%, FY16). However, it could not establish a niche for itself in any particular vertical or service line which makes it an average scorer on reputation aspect. It lags well behind TCS in terms of its organizational structure (issues regarding placement of consulting practise in hierarchy) and strategic assets (client connects).

Wipro

Wipro lags behind other four big players on (overall score of ¼) on our IBAS framework. Wipro is not as successful as TCS/Infosys in terms of pyramiding, code re-use which is also reflected in its lower EBIT margin (19%, FY16). Though the company has been at the forefront of adopting new technologies, it could not scale them up (and hence given away market leadership to HCLT in IMS). Strategic assets (client connects) are not strong (as in the case of TCS or Infosys) as it used to rotate relationship managers every 18 months. Wipro runs a silo-ed organizational structure which lacks vertical based selling experience. These factors make the company score low on architecture and strategic assets.

HCLT

HCLT ranks second on our IBAS framework along with Infosys. The company maintained decent margins (20%, FY16) and ROCE (24%, FY16) by keeping utilization (85%) high, pyramid correction and code re-use. The company has built a strong reputation of being among top-2 IMS vendors globally (ahead of all Indian peers) and top-5 ES vendors (ahead of all Indian peers) globally which makes it score well on Reputation. The company has built the architecture of an aggressive sales led organization with client relationships in IMS and ES become strategic assets to cross sell other services.

TechM

Though the current EBIT margins of TechM are significantly lower than its peers (13.3%, FY16), this cannot be interpreted as weakness of the company in terms of offshoring, pyramid correction and code re-use. Margins of the company have taken a hit because of recent acquisitions like LCC (normalized margin is 19.4% in FY14). The company has built the reputation of being the strongest player in telecom segment (ahead of all Indian peers). The company also has the DNA of successful growth derived in inorganic route and marquee clients especially in telecom segment. Overall, the company fits into above average bucket on IBAS framework.

Source: Company, Ambit Capital research, Note: - Strong; - Relatively Strong; - Average; - Relatively weak

HCL Technologies


Exhibit 6: Cash flow from operations was the significant source of cash for the firm over last decade (FY06-16)


Exhibit 7: The company returned a significant part of its cash flows to shareholders as dividends over FY06-16


Exhibit 8: Valuations are at a discount to historical average


Exhibit 9: HCLT’s share price performance vs Sensex




Accounting GREEN Our proprietary forensic accounting tool Hawk places HCL Tech in ‘Zone of safety’ in terms of accounting policies.

Predictability GREEN The management issues annual guidance and earnings surprises over the past eight quarters have averaged less than 5%.

Earnings momentum AMBER Bloomberg shows downgrades to earnings estimates for the sector as a whole and even for HCLT on the back of uncertainty over US presidential election and subsequent H-1B reforms.


Exhibit 11: Forensic score evolution


Exhibit 12: Greatness score evolution


80%

16%

4%

CFO Asset sale Cash Flow from Financing

60%

33%

7%

Dividend Capex Acquisitions

10

12

14

16

18

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

Apr

-15

Oct

-15

Apr

-16

Oct

-16

1 year forward P/E (consensus)

P/E Avg

- 100 200 300 400 500 600 700

Oct

-06

May

-07

Nov

-07

May

-08

Dec

-08

Jun-

09

Jan-

10

Jul-

10

Jan-

11

Jul-

11

Feb-

12

Aug

-12

Feb-

13

Sep-

13

Mar

-14

Sep-

14

Apr

-15

Oct

-15

May

-16

SENSEX HCLT

HCL Technologies


Balance sheet (consolidated)*

Balance sheet (` bn) FY14 FY15 FY16 FY17E FY18E FY19E

Net Worth 183.3 229.7 277.5 320.6 368.5 428.2

Other Liabilities 24.7 18.0 22.2 25.2 25.1 25.1

Capital Employed 208.1 247.7 299.6 345.8 393.6 453.3

Net Block 81.4 85.5 106.4 148.5 175.5 204.6

Other Non-current Assets 23.7 29.6 40.0 40.0 40.0 40.0

Current Assets 179.3 215.1 247.4 272.6 305.4 353.1

Debtors 52.9 63.3 76.5 83.2 91.9 104.2

Unbilled revenues 21.4 29.5 29.7 27.2 30.0 34.0

Cash & Bank Balance 83.8 97.1 117.4 133.5 151.8 178.9

Other Current Assets 21.1 25.3 23.9 28.8 31.8 36.0

Current Liab. & Prov 76.3 82.5 94.2 115.3 127.3 144.4

Net Current Assets 103.0 132.6 153.3 157.3 178.1 208.8

Application of Funds 208.1 247.7 299.6 345.8 393.6 453.3


Income statement (consolidated)*

Income statement (`bn) FY14 FY15 FY16 FY17E FY18E

Revenue (US$ mn) 5,180 5,822 6,235 6,934 7,662

Growth 14.1% 12.4% 7.1% 11.2% 10.5%

Revenue 314.7 357.9 409 464 513

Cost of goods sold 201.7 231.4 274.9 317.1 352.5

SG&A expanses 39.9 43.2 52.2 54.3 57.5

EBITDA 80.4 88.4 88 102 116

Depreciation 7.2 5.1 5.7 9.1 13.9

EBIT 73.2 83.4 82.1 92.8 102.5

EBIT Margin 23.3% 23.3% 20.1% 20.0% 20.0%

Other Income (0.9) 8.5 10.1 9.0 9.2

PBT 72.3 91.9 92.2 101.8 111.7

Tax 15.2 18.7 18.8 21.6 24.0

Rate (%) 21.0% 20.3% 20.4% 21.3% 21.5%

Reported PAT 57.1 73.2 73.4 80.2 87.7

Diluted Adj EPS 40.4 51.9 52 57 62


HCL Technologies


Cash flow statement (consolidated)*

Cash flow (` bn) FY14 FY15 FY16 FY17E FY18E

Net Income 57.4 73.2 73.4 80.2 87.7

Depreciation 7.2 5.1 5.7 8.6 12.8

CF from Operations 64.2 73.4 73.5 88.5 101.6

Cash for Working Capital (0.7) (17.9) (2.4) 9.0 (2.5)

Net Operating CF 63.5 55.4 71.1 97.5 99.1

Net Purchase of FA (6.0) (11.3) (9.8) (39.0) (40.6)

Others (37.5) (17.2) (33.1) (4.1) (0.5)

Net Cash from Invest. (43.5) (28.5) (42.8) (43.1) (41.0)

Proceeds from Equity & other 0.3 0.2 0.0 - -

Dividend Payments (11.3) (24.7) (33.7) (40.1) (39.7)

Cash Flow from Fin. (16.9) (28.8) (28.4) (43.7) (39.7)

Free Cash Flow 57.5 44.1 61.3 58.5 58.6

Opening cash balance 46.2 85.9 103.6 119.8 133.4

Net Cash Flow 3.1 (1.9) (0.1) 10.7 18.4


Ratio analysis (consolidated)*

FY14 FY15 FY16 FY17E FY18E

Growth

Revenue growth (US$) 14.1% 12.4% 7.1% 11.2% 10.5%

EBIT growth (`) 54.5% 13.9% -1.5% 13.1% 10.4%

EPS growth (`) 57.0% 28.3% 0.1% 9.3% 9.4%

Valuation (x)

P/E 20.0 15.6 15.6 14.3 13.1

EV/EBITDA 13.0 11.8 11.9 10.3 9.0

EV/Sales 3.3 2.9 2.6 2.3 2.0

EV/NOPAT 14.3 12.6 12.8 11.3 10.2

Price/Book Value 6.2 5.0 4.1 3.6 3.1

Dividend Yield (%) 1.0% 2.1% 2.7% 3.0% 3.0%

Return Ratios (%)

RoE 35% 35% 29% 27% 25%

RoCE 30% 29% 24% 23% 22%

ROIC 46% 48% 39% 37% 35%

Turnover Ratios

Receivable days (Days) 86 95 95 87 87

Fixed Asset Turnover (x) 3.9 4.3 4.3 3.6 3.2



A legend built over several decades Asian Paints is India’s largest decorative paints player with over 50% organised market share. Its foundation is built around high quality professionals, proactive use of technology, effective functioning of its Board and strong dealer relationships. Current high valuations are justified by a combination of: a) resilient repainting demand in a weak macro: industry likely to deliver volume CAGR of ~12% over the next decade; b) greater pricing power vs historical levels provides sustainability to current higher levels of EBITDA margins; and c) ability to successfully drive the next phase of evolution towards providing value added services in the broader home improvement category. We expect 18%/23% revenue/EPS CAGR over FY16-FY20 amid 15%/12% decorative paint industry revenue CAGR over FY15-25/FY25-35. Our DCF-based fair value of `1,270 (32% upside) implies FY18E P/E of 43x.


16.4% industry revenue CAGR over FY06-16; Asian Paints gaining share

Over FY06-16, India’s organised decorative paints industry has delivered revenue CAGR of 16.4%. This has been driven by: a) shift from unorganised to organised products; b) premiumisation from distempers to emulsions; c) shrinking repainting cycles; and d) urbanisation. Asian Paints has reported 18% revenue growth over this period, gaining 10% market share. Asian Paints has revenue and earnings with remarkable consistency

Asian Paints is a rare example of a large Indian company, held by multiple promoters and yet run by a high-calibre, professional, management team. The remarkable consistency in revenue growth (18-20% revenue CAGR in each of the previous 6 decades), earnings growth (consistently rising PBT margin over the past 40 years), and disciplined capital deployment (~32% average RoCE over the past two decades) stands testimony to their calibre.

Asian Paints has built moats around supply chain, talent and IT

In a voluminous product category with over 1,800 SKUs, Asian Paints has built impregnable competitive advantages around supply chain through extensive use of the technology to forecast demand accurately, shorten product delivery times and better manage working capital. Asian Paints has consistently led the evolution of the paints industry by pioneering initiatives like supplying directly to dealers rather than through distributors and using IT in demand forecasting. The firm’s architecture is built around: a) nurturing professional talent in a unique work culture; b) consistent use of technology for operating efficiency improvements; and c) a truly independent and empowered Board of Directors.

Valuations – what’s the right multiple for an enduring franchise?

Asian Paints’ valuations have undergone a re-rating from 35x to 43x over the past two years. Resilience of decorative paints category demand and higher pricing power over the past two years vs a decade ago were the key factors. However, the current valuations do NOT adequately factor in the likelihood of Asian Paints transitioning from a decorative paints company to a provider of value-added offerings in the broader home décor sector. Our DCF factors in longevity of Asian Paints’ growth profile given market share gains in paints. This industry growth will be driven by decreasing repainting cycle (from 10.6 years currently to 8.5/7.5 years by FY25/FY35) and a rise in the share of organised sector. Our fair value of `1,270 implies 32% upside and 43x FY18E P/E.

STRATEGY NOTE APNT IN EQUITY November 17, 2016

Asian Paints

BUY

Consumer Discretionary

Recommendation Mcap (bn): `995/US$14.9 3M ADV (mn): `1,109/US$16.6 CMP: `963 TP (12 mths): `1,270 Downside (%): 32


Performance


Asian Paints’ forensic score analysis


Asian Paints’ greatness score analysis


80

100

120

140

160

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

Asian Paints Sensex

Research Analysts

Rakshit Ranjan, CFA

+91 22 3043 3201 [email protected]

Dhiraj Mistry, CFA


Asian Paints


Exhibit 1: Evolution of Asian Paints

Source: Company, Ambit Capital research.


(Fig in ` mn) FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Revenues 36,700 44,072 54,632 66,809 77,062 96,322 109,707 127,148 141,828 155,341

Revenue growth (%) 21% 20% 24% 22% 15% 25% 14% 16% 12% 10%

Net profits 2,886 4,365 4,230 8,828 8,814 10,205 11,595 12,727 14,549 18,317

EPS 3.0 4.3 4.2 8.7 8.8 10.3 11.6 12.8 14.8 18.5

CFO 2,697 4,798 3,894 10,632 7,613 8,263 11,868 14,000 11,877 23,333

Pre-tax CFO / EBITDA 90% 101% 87% 112% 88% 83% 94% 94% 81% 112%

FCF 1,760 1,718 794 6,679 6,052 1,532 5,501 11,664 7,501 15,274

Debt equity (x) 0.3 0.2 0.1 0.1 (0.2) (0.1) (0.2) (0.2) 0.0 (0.0)

RoE (%) 40% 47% 37% 57% 43% 40% 36% 33% 32% 34%

Pre-tax ROCE (%) 46% 56% 47% 74% 59% 54% 50% 48% 45% 49%




1942-1967 Founders take it to the #1

Asian Paints chose decorative paints instead of price driven industrial paints business

Asian Paints built its distribution starting with smaller cities and later expanded to larger cities

Asian Paints became India’s largest paints company in 1967

1967-1997 Professional management helps scale up operations

Started hiring professional from top business schools of India

Asian Paints strengthened system and processes across functions during 1967-1987

Joint venture company viz. Asian PPG Industries Pvt. Ltd was set up along with PPG Industries

1997-2016

Business process re-engineering and acceleration of market share gains

In 1997 chairman Champaklal Choksey passes away; Atul Choksey resigns; Ashwin Choksi appointed as MD

Booz Allen Hamilton (consultant) helped improve operational efficiencies during 1998-2001

Market share increased from 38% in 1997 to 54% in 2015

Appointed Mr. PM Murty as Managing Director & CEO in 2009

Appointed Mr. KBS Anand as Managing Director & CEO in 2011

Acquisition of Sleek Group (modular kitchen) in 2013 and ESS ESS bathroom products in 2014


Exhibit 4: Competitive mapping of Asian Paints with other peers

Company Sub-segment Positioning FY16 revenue

Revenue CAGR FY10-

16

Decorative paint market

share

EBITDA Margin (FY16)

Pre-tax RoCE

(FY16)

Pre-tax CFO/EBITDA

(FY10-16)

Capex/CFO (FY10-16)

Asian Paints #1 155,341 15% 54% 18% 49% 95% 38%

Berger Paints #2 46,341 16% 18% 14% 32% 84% 57%

Kansai Nerolac #3 38,302 14% 16% 15% 27% 83% 31%

Akzo Nobel #4 27,401 17% 10% 11% 30% 97% 49%


0%

20%

40%

60%

80%

-

25

50

75

100

125

150

175

FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Renenue (Rs. bn) Pre-tax ROCE (RHS)

Asian Paints


Exhibit 5: Mapping Asian Paints and its peers on IBAS

Asian Paints

Berger Paints

Kansai Nerolac

Akzo Nobel Comments

Innovation

Asian Paints has regularly innovated around products by staying close to its customers

Empowerment of professionals to take control of middle and senior management as early as 1969

Attempting a transition from a products company to a services company (home décor company)

Brand

Asian Paints has consistently maintained its focus on advertising from as early as the 1950s

Asian Paints advertising expense is 1.3x of summation of other 3 competitors

Architecture

Nurtured professional talent in a unique work culture by rapid career progression for those who perform and allowing creativity

Proactive investments in technology Independent board of directors are high quality professionals with relevant

experience

Strategic asset

Asian Paints has created a network of factories and depots across the country with 8 factories, 6 regional distribution centre and 125 depots

Deep rooted relationships with >35,000 dealers

Overall

Source: Company, Ambit Capital research, Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

Exhibit 6: Sources of funds over the last decade


Exhibit 7: Application of funds over the last decade


Exhibit 8: Asian Paints forward P/E evolution


Exhibit 9: Asian Paints’ share price performance v/s Sensex


Cash flows from

operations, 96%

Dividend received,

5%

Dividend paid 38%

Interest paid 3%

Net Capex 40%

Purchase of Investments

4%

Increase in cash and

cash equivalents

5%

20

30

40

50

Oct

-11

Feb-

12

Jun-

12

Oct

-12

Feb-

13

Jun-

13

Oct

-13

Feb-

14

Jun-

14

Oct

-14

Feb-

15

Jun-

15

Oct

-15

Feb-

16

Jun-

16

Oct

-16

Asian Paints 1 year fwd P/E Average of 5yr P/E

-

500

1,000

1,500

2,000

Oct

06

Oct

07

Oct

08

Oct

09

Oct

10

Oct

11

Oct

12

Oct

13

Oct

14

Oct

15

Oct

16

APNT Sensex

Asian Paints




Accounting GREEN Asian Paints scores well on cash conversion, related party advances and return on surplus cash; its working capital cycle; RoE and provisions for debtors outstanding for more than six months are better than peers.

Predictability GREEN Predictability of earnings remains high for Asian Paints given: (a) high correlation of industry volume growth rates with GDP; (b) strong correlation of raw material costs with crude and foreign exchange rates; and (c) market share changes across various players in the industry.

Earnings Momentum GREEN On the back of higher-than-expected volume growth, Asian paints' consensus EPS estimates have been upgraded by 4% for FY17 and FY18 over the past six months.






Asian Paints


Balance sheet

Year to March (` mn) FY15 FY16 FY17E FY18E FY19E

Shareholders' equity 959 959 959 959 959

Reserves & surpluses 46,464 55,093 66,344 81,032 99,467

Total networth 47,424 56,053 67,303 81,991 1,00,426

Minority Interest 2,637 2,942 3,552 4,254 5,061

Preference share capital 0 0 0 0 0

Debt 4,099 3,060 3,060 3,060 3,060

Deferred tax liability 1,799 2,176 2,176 2,176 2,176

Total liabilities 55,959 64,231 76,092 91,481 1,10,723

Gross block 41,123 51,105 57,105 59,105 61,105

Net block 26,600 34,031 36,642 34,994 33,216

CWIP 1,960 1,108 1,000 1,000 1,000

Investments 15,878 20,982 20,982 20,982 20,982

Cash & equivalents 2,044 4,204 7,561 22,622 41,329

Debtors 11,799 12,483 14,538 17,438 20,833

Inventory 22,585 20,640 28,106 33,714 40,277

Loans & advances 5,404 4,683 5,815 6,975 8,333

Other current assets 2,853 3,303 1,938 2,325 2,778

Total current assets 44,685 45,313 57,958 83,075 1,13,550

Current liabilities 25,573 28,326 32,253 38,688 46,219

Provisions 7,591 8,877 8,238 9,882 11,805

Total current liabilities 33,164 37,203 40,491 48,570 58,025

Net current assets 11,520 8,110 17,467 34,505 55,525

Miscellaneous 0 0 0 0 0

Total assets 55,959 64,231 76,092 91,481 1,10,723


Income statement


Operating income 1,41,828 1,55,341 1,76,877 2,12,167 2,53,468

% growth 11.5% 9.5% 13.9% 20.0% 19.5%

Operating expenditure 1,16,993 1,19,749 1,42,970 1,69,413 2,02,545

Operating profit 22,354 28,086 33,906 42,754 50,923

% growth 11.9% 25.6% 20.7% 26.1% 19.1%

Depreciation 2,659 2,880 3,388 3,648 3,778

EBIT 19,695 25,207 30,518 39,106 47,145

Interest expenditure 348 405 346 346 346

Non-operating income 1,697 2,007 2,469 3,061 3,857

Adjusted PBT 21,045 26,809 32,641 41,821 50,656

Tax 6,495 8,491 10,119 12,964 15,703

Adjusted PAT/ Net profit 14,549 18,317 22,522 28,856 34,953

% growth 14% 26% 23% 28% 21%

Prior Period Items 0 0 0 0 0

Reported PAT / Net profit 14,549 18,317 22,522 28,856 34,953

Minority Interest 322 531 610 702 807

Share of associates 0 0 0 0 0

Adjusted Consolidated net profit 14,227 17,787 21,912 28,155 34,146

Reported Consolidated net profit 14,227 17,787 21,912 28,155 34,146


Asian Paints


Cashflow statement


EBIT 21,392 27,214 32,987 42,167 51,002

Depreciation 2,683 2,880 3,388 3,648 3,778

Others (1,367) (1,124) - 0 -

Tax (6,329) (8,154) (10,119) (12,964) (15,703)

(Incr) / decr in net working capital (4,502) 2,517 (6,001) (1,977) (2,313)

Cash flow from operations 11,877 23,333 20,256 30,874 36,764

Capex (4,377) (8,059) (5,892) (2,000) (2,000)

(Incr) / decr in investments 306 (832) - - -

Other income (expenditure) 816 847 - - -

Others (1,523) (648) - - -

Cash flow from investments (4,778) (8,691) (5,892) (2,000) (2,000)

Net borrowings 1,531 (1,139) - - -

Issuance of equity - - - - -

Interest paid (345) (401) (346) (346) (346)

Dividend paid (6,947) (7,642) (10,661) (13,467) (15,711)

Others - - - - -

Cash flow from financing (5,761) (9,182) (11,007) (13,813) (16,057)

Net change in cash 1,339 5,460 3,356 15,061 18,707

Closing cash balance 10,669 16,130 7,561 22,622 41,329

Free cash flow 7,501 15,274 14,364 28,874 34,764


Ratio analysis

Year to March (%) FY15 FY16 FY17E FY18E FY19E

EBITDA margin (%) 15.8% 18.1% 19.2% 20.2% 20.1%

EBIT margin (%) 15.1% 17.5% 18.6% 19.9% 20.1%

Net profit margin (%) 10.3% 11.8% 12.7% 13.6% 13.8%

Dividend payout ratio (%) 50.0% 50.1% 48.7% 47.8% 46.0%

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

Working capital turnover (x) 15.0 39.8 17.9 17.9 17.9

Gross block turnover (x) 3.8 3.5 3.4 3.8 4.4

Post-tax RoCE (%) 31.4% 32.7% 34.2% 36.5% 36.5%

Pre-tax RoCE (%) 45.4% 49.2% 51.0% 54.3% 54.1%

RoIC (%) 34.7% 34.9% 37.2% 44.3% 53.2%

RoE (%) 32.4% 34.4% 35.5% 37.7% 37.4%


Valuation parameters


EPS (`) 14.8 18.5 22.8 29.4 35.6

Diluted EPS (`) 14.8 18.5 22.8 29.4 35.6

Book value per share (`) 49.4 58.4 70.2 85.5 104.7

Dividend per share (`) 6.1 7.5 9.5 12.0 14.0

P/E (x) 64.9 51.9 42.2 32.8 27.1

P/BV (x) 21.0 17.8 14.8 12.2 9.9

EV/EBITDA (x) 41.6 33.3 27.5 21.8 18.3

EV/EBIT (x) 46.8 36.8 30.3 23.7 19.6



Dukes have castellated the fort Lupin transitioned from API to plain oral solids to complex generics due to management’s vision/agility in tapping changing dynamics. Lupin is one of the biggest beneficiaries of GDUFA given presence in complex generics and pipeline of ~150 ANDAs. Management is preparing for the next leap through innovation. Success should be driven by (a) investment in innovative pursuits in complex therapeutic areas; (b) industry-leading R&D spends (12% of FY16 sales) and an experienced team; and (c) previous experience in marketing branded products in the USA. Stock trades at 16x FY18E EPS; material re-rating from present 16x (peers at ~20x) will be driven by earnings surprises (our estimates are 20% ahead of consensus) as visibility improves. Risks: a) adverse pricing environment in the USA; and b) failure in executing innovative projects.


Vision to move from oral solids to complex generics materialises

Lupin has championed the art of business evolution (from plain oral solids to complex generics) without compromising on profitability and stakeholder interests. Lupin transitioned from anti-TB company (more than 50% of revenues in FY06) to higher growth CVS/Diabetes/CNS resulting in revenue CAGR of 23% over FY06-16E. In the USA, Lupin evolved its revenue profile from plain oral solids to filing for complex generics. Revenue per ANDA improved from US$3.7mn in FY08 to US$6.5mn in FY16. Over the past couple of years, Lupin’s investments in the USA have come to the fore as it has added differentiated products and expect them to materialise in medium term. From India to USA; journey from weak product portfolio to complex one

Until FY07, Lupin had India-heavy revenue profile with product portfolio in slow-growing acute therapies. The management realised changing trends in Indian pharma consumption and switched to lifestyle disease chronic products which grew faster than IPM. Similarly, in the US market, Lupin’s management realised product-specific opportunities and capitalised during FY13-16 (US revenue CAGR of 23%). Lupin’s capability to adapt to changing environment has led to margin/RoCE expansion from 24%/22% in FY07 to 28%/25% in FY16. During this period, while its peers focused on acquisition to grow, Lupin primarily grew organically. Early entry into the Japanese market and investments in innovative pursuits (NCEs/NDDS; R&D at 12% of sales) should provide the next big leap.

Ranks 2nd on sector IBAS framework; brands and strategic asset fortified

Focus on creating strategic assets through investment in Japan, presence in complex generics in the USA and de-risking of the US business through multiple USFDA-approved facilities to strengthen its business mix. The company has credible branded franchise in India with a broad-based product portfolio (Top 10 brands contribute only 20% of revenue). Limited key man risk is led by decentralised decision making. Scope to improve MR productivity in India for top rank.

Visibility on growth drivers lends comfort on valuations

Lupin trades at 16x FY18E EPS (20% discount to its peers and five-year average). We believe valuations will improve, given: a) well-entrenched promoters; b) strong balance sheet; and c) excellence in execution. Also, earnings momentum is likely to sustain led due to a) unfolding of pipeline of ~150 ANDAs in the USA and 25% net profit CAGR over FY16-18E; b) investments in longer-term growth drivers like complex injectables, ophthalmics, respiratory and dermatology; and c) high visibility of earnings through large pipeline in the USA and growth acceleration in India.

STRATEGY NOTE LPC IN EQUITY November 17, 2016

Lupin

BUY

Healthcare

Recommendation Mcap (bn): `658/US$9.9 3M ADV (mn): `1,824/US$27.4 CMP: `1,459 TP (12 mths): `1,851 Upside (%): 27

Flags Accounting: AMBER Predictability: AMBER Earnings Momentum: RED

Performance


Lupin’s forensic score analysis


Lupin’s greatness score analysis


708090

100110120

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

Lupin Sensex

Research Analyst

Paresh Dave, CFA

+91 22 3043 3212

[email protected]

Lupin


Exhibit 1: Evolution of Lupin

Source: Company and Ambit Capital research. Note: RoCE is pre-tax RoCE.



Revenues 21,509 28,709 38,296 48,708 58,195 70,829 96,413 112,866 127,700 142,085

Revenue growth (%) 33.5% 33.4% 27.2% 19.5% 21.7% 36.1% 17.1% 13.1% 11.3%

Net profits 3,086 4,083 5,015 6,816 8,625 8,677 13,141 18,364 24,032 22,707

EPS 7.0 9.2 12.0 15.6 19.2 19.4 29.3 40.8 53.5 50.4

CFO 1,779 2,585 4,695 6,764 7,969 5,592 12,510 20,040 27,331 -3,689

CFO (pre-tax)/ EBITDA 58.0% 58.4% 79.2% 85.7% 87.6% 70.2% 83.6% 90.9% 100.4% 44.1%

FCF 8 240 1,308 72 3,693 540 7,098 14,787 18,655 -61,435

Debt equity (x) 1.0 0.9 0.9 0.4 0.4 0.4 0.2 0.1 0.1 0.7

RoE (%) 41.2% 37.9% 37.1% 34.1% 29.5% 23.8% 28.5% 30.3% 30.4% 22.9%

RoCE* (%) 23.9% 26.7% 24.9% 27.1% 25.0% 24.1% 32.2% 39.3% 37.5% 23.9%




FY05-FY07 Indian business drives growth

Lupin derived 60% of its revenues from its Indian business comprising primarily of anti-TB portfolio (contributing 50% of the Indian business).

Within its Indian business, the company relied on acute portfolio which is a low-margin business (consolidated EBITDA margins <20%). Its US business was negligible contributing ~15% of the overall revenues with products in plain vanilla oral solids and entering as follow-on generic player, garnering revenue per ANDA of <US$3mn.

RoCE at <20% with investment in R&D at ~4% of sales. High debt to equity at 1x led to RoE at ~40%.

FY08-12 Making in-roads in US market

Revenue growth accelerated (25% CAGR over FY08-12) led by higher revenue contribution from the US business (34% of overall revenues) led by the launch of limited competition generics. Revenue per ANDA increased from US$4mn to US$5mn.

Indian business reported 22% CAGR over FY08-12 led by launch of chronic products. Improvement in sales force efficiency led by chronic therapy (MR productivity increased from `2mn in FY08 to `4.3mn in FY12). Chronic therapies contribute ~45% of the Indian business.

Led by US business and chronic revenues in India, gross margins expanded from 58% in FY08 to 62% in FY12, however EBITDA margins remained flat at 21% due to increase in R&D spends from 5% of sales in FY08 to 7.5% in FY12. The company reduced its debt-to-equity ratio to 0.4x. Entered Japanese market though acquisition of Irom Pharma which also led to slip in RoCE from 22% in FY11 to 18% in FY12.

FY13 – Current US business gains momentum

Led by launch of limited competition products in the US market, overall revenues reported 19% CAGR over FY12-16. Its Indian business (now majority portfolio being of chronic therapy) grows at 16% CAGR.

Lupin’s presence in the Japanese market improved led by Irom acquisition and revenues grew by 12% CAGR over FY12-16. As of FY16, Japan contributes 10% of the overall revenues. The company is also fortifying its presence in RoW markets (specifically South Africa) through acquisition of Pharma dynamics. RoW market reported 22% revenue CAGR over FY12-16.

Led by the US business, EBITDA margins improved from 21% in FY12 to 27.7% in FY16 despite increase in R&D spends from 8% in FY12 to 12% in FY16. Acquisitions fuelled by FCF generation of `40bn over FY13-15. RoCE improved from 18% in FY12 to 27% in FY15; dipped in FY16 to 16% due to acquisition of Gavis for US$880mn.


0%

5%

10%

15%

20%

25%

30%

0

20

40

60

80

100

120

140

160

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

` B

n

India US generics Others (RoW, API) RoCE, RHS

Indian business driven growth with India contributing 60% of overall revenues

Making in-raods in the US business led by launch of plain oral solids and enetering chronic space in Indian business.

Benefits of patent cliff with Lupin launching limited competiion products in the US market

Lupin


Exhibit 4: Competitive mapping of Lupin, with other comparable generic pharma peers

Company Positioning FY16 revenue

Revenue CAGR

FY10-16

Revenue per ANDA (US$ mn)

EBITDA Margin

(median FY10-16)

Pre-tax RoCE

(median FY10-16)

Median Pre-tax CFO/

EBITDA (FY10-16)

Cumulative R&D as % of

Sales (FY10-16)

Sun Pharma #1 282,697 38% 5.1 34% 25% 91% 7%

Lupin #2 142,085 20% 7.3 24% 26% 86% 8%

Cadila #5 98,376 18% 6.5 21% 24% 82% 7%

Torrent #4 66,764 23% 2.2 22% 27% 91% 4%

Dr. Reddy’s #3 156,978 14% 7.0 23% 23% 85% 8%

Cipla #6 136,783 17% 1.9 21% 19% 92% 5%

Ipca #8 28,850 10% 1.4 18% 24% 92% 4%

Aurobindo #7 138,961 25% 4.1 22% 21% 65% 4%


Exhibit 5: Mapping Lupin and its peers on IBAS

Innovation Brand Architecture Strategic Asset

Overall Comments

Sun

Visionary management has built its business through acquisitions and fortified its moats through innovative pursuits like MK3222. The company has strong brand equity in India with base business reporting stellar growth over FY11-15.

Lupin

Marginally lower than Sun Pharma but has the ability to scale up in the US market through launch of complex generics. The company has focused on creating strategic assets through investment in Japan and maintaining low-cost structure.

Cadila

Need to look out for Cadila's innovative pursuits. Whilst the innovative revenues would be from India and EMs in the near term, success in these geographies would be incrementally positive for its regulated market expectations.

Torrent

Torrent Pharma’s biosimilar outlook coupled with improvement in productive MR in the Indian business help to strengthen moats. However, the company entered late in the US business and will have to use the inorganic route to improve its position. It continues to be best in class in the EM markets and expect EM revenues to cushion ventures in regulated markets.

Dr. Reddy’s

Best in class innovation profile as it leads the pack in biosimilar evolution. However, it falters on brands in India and EMs due to predominant presence in acute therapy in India and volatility in its EM business.

Cipla

Apart from inhalers, limited investment in innovation. Base business in India lags its peers implying lower brand equity for its excising portfolio. Senior management churn results in weak architecture.

Ipca

Serious compliance issues at its faculties hamper its prospects in the US market. Yet to prove capability in innovative pursuits. Low-cost structure is the only advantage for the company.

Aurobindo

Limited investment in innovation, no branded generic business and average cost structure despite presence in complex generics lead to lowest position on IBAS.


Exhibit 6: Increase in debt towards funding of Gavis acquisition in 2015


Exhibit 7: Lupin focused on organic growth through capex in relevant markets (like Japan)


CFO, 57.5%

Proceeds from

shares, 1.1%

Debt raised, 39.2%

Interest received,

1.5%

Dividend received,

0.8%

Net Capex, 67.5%

Purchase of investment,

17.4% Dividend

paid, 11.2%

Interest paid, 2.4%


cash equivalent,

1.5%

Lupin


Exhibit 8: Re-rating driven by product approvals in USA followed by decline in PE due to quality issues at Goa


Exhibit 9: Lupin’s share price performance v/s Sensex



Field Score Comments

Accounting AMBER

In our forensic analysis of 360 companies, Lupin scores above the pharma industry average (comprising 26 companies). Lupin scores high on ratios of: (a) CFO/EBITDA; (b) fixed asset turnover; (c) contingent liabilities; and (d) audit fees as a percentage of standalone revenues. However, Lupin has weaker scores on: (a) volatility in selling and distribution costs; and (b) cash yield.

Predictability AMBER Overall, the management made timely announcements in its earnings calls, meetings and interviews regarding product filings, acquisitions and business outlook. However, the unpredictability of unknown large filings in the USA, emerging markets and innovative projects makes us assign an AMBER flag on predictability.

Earnings momentum RED Consensus FY17E and FY18E EBITDA and EPS estimates have been downgraded by 3-9% over the past three months led by muted guidance for FY17E, increase in guidance for R&D spends to 12-15% of sales (vs 10% in FY16) and lack of clarity on remediation at it Goa facility.

Source: Ambit Capital research, Note: - Strong; - Relatively Strong; - Average; - Relatively weak





- 5.0

10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0

Mar

-05

Mar

-06

Mar

-07

Mar

-08

Mar

-09

Mar

-10

Mar

-11

Mar

-12

Mar

-13

Mar

-14

Mar

-15

Mar

-16

LPC - one-yr forward P/E chart

Five-year average PE = 22.1x

0

500

1000

1500

2000

2500

3000

3500

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

Jan-

15

Jan-

16

Lupin Sensex

Lupin


Balance sheet (consolidated)

Year to Mar (` mn) FY15 FY16 FY17E FY18E FY19E

Total assets 96,377 183,984 198,978 223,776 254,402

Fixed assets 32,961 86,379 95,231 103,107 105,171

Current assets (incl cash) 64,507 107,473 120,088 146,302 185,552

Cash 4,814 8,379 30,767 35,542 46,752

Investments 16,584 75 75 75 75

Total liabilities 96,377 183,984 198,978 223,776 254,402

Total networth 88,741 109,844 134,837 169,635 210,261

Total debt 5,371 71,775 61,775 51,775 41,775


Deferred tax liability 2,024 2,045 2,045 2,045 2,045

Source: Company, Ambit Capital research;

Income statement (consolidated)


Net revenues 127,700 142,085 175,355 220,382 278,723

Material costs 41,570 43,094 54,162 67,149 93,161

Employee costs 13,949 17,260 19,744 22,063 24,710

Other mfg. costs 35,985 44,196 54,501 68,636 87,553

Core EBITDA 36,196 37,535 46,948 62,534 73,299

Depreciation 4,347 4,635 6,149 7,124 7,936

Interest expense 98 446 1,669 1,419 1,169

Adjusted PBT 34,149 34,331 40,538 56,351 65,794

Tax 9,705 11,536 10,945 15,215 17,764

Net profit 24,032 22,707 29,367 40,886 47,733


Cash flow statement (consolidated)


PBT 34,149 34,331 40,538 56,351 65,794

Depreciation 4,347 4,635 6,149 7,124 7,936

Tax (9,436) (11,662) (10,945) (15,215) (17,764)

Net working capital (1,378) (22,946) 9,856 (12,317) (16,048)

Others (351) (8,047) 7,756 (124) (1,153)

CFO 27,331 (3,689) 53,354 35,819 38,765

Capital expenditure (14,970) (70,028) (15,000) (15,000) (10,000)

Investment and others 4,425 593 - - -

CFI (10,545) (69,435) (15,000) (15,000) (10,000)

Issuance of equity 413 536 - - -

Inc/Dec in borrowings (700) 62,081 (10,000) (10,000) (10,000)

Net dividends (1,573) (4,055) (4,071) (4,374) (6,088)

Interest paid (109) (436) (1,669) (1,419) (1,169)

Others - - (226) (250) (297)

CFF (1,969) 58,126 (15,966) (16,043) (17,554)

Net change in cash 14,817 (14,998) 22,387 4,776 11,210


FCFF 12,361 (73,717) 38,354 20,819 28,765


Lupin


Ratio analysis (consolidated)


Revenue growth 13.1 11.3 23.4 25.7 26.5

Core EBITDA growth 20.5 3.7 25.1 33.2 17.2

APAT growth 30.9 -5.5 29.3 39.2 16.7

EPS growth 31.1 -5.7 29.3 39.2 16.7

Core EBITDA margin 28.3 26.4 26.8 28.4 26.3

EBIT margin 24.9 23.2 23.3 25.1 23.5

Net profit margin 18.8 16.0 16.7 18.6 17.1

RoCE (%) 26.7 15.8 15.7 19.3 20.1

Reported RoE (%) 30.4 22.9 24.0 26.9 25.1

Debt-equity ratio (X) 0.1 0.7 0.5 0.3 0.2

Current ratio 1.8 2.7 2.6 2.6 2.8



CFO/EBITDA (x) 0.8 -0.1 1.1 0.6 0.5


Valuation parameters (consolidated)


EPS 53.5 50.4 65.2 90.7 105.9

Book value ( per share) 197.4 243.8 299.3 376.5 466.6

P/E (x) 28.1 29.8 23.0 16.5 14.2

P/BV (x) 7.6 6.2 5.0 4.0 3.2

EV/EBITDA(x) 18.6 19.7 15.1 11.1 9.2

EV/Sales (x) 5.3 5.2 4.0 3.1 2.4

EV/EBIT (x) 21.2 22.4 17.3 12.5 10.3



Inches make champions Cadila, a late bloomer, is finally displaying abilities in the US market and results from innovative pursuits (19% revenue CAGR over FY03-16). Cadila is building capabilities in complex generics and innovative pursuits inch by inch and moving up the value chain from plain vanilla oral solids to complex generics like transdermals and modified release, resulting in FY11-16 cumulative R&D spends of 7% of sales. Despite quality compliance issues, Cadila is best placed to reap the benefits of faster product approvals through GDUFA (~150 ANDAs pending approval). US business should normalise as issues get resolved, facility is cleared (Apr-17) and Cadila receives bunched up product approvals (US revenue CAGR of 26% over FY16-19E). Cadila ranks third on our IBAS framework led by realisation of novel products and biosimilars in India and EMs.


Catching up with peers

Cadila has missed opportunities that were leveraged by peers to create value for stakeholders. However, if we discount the initial 43 years of its relatively passive existence, Cadila seems to be a budding newbie. A deep dive into Cadila’s history suggests that the company has been proactive in acquiring capabilities and product-related assets through alliances, JVs and acquisitions. However, its financials suggest that the company is yet to extend these acquired assets beyond the domestic market. We believe the extension of these assets and capabilities beyond the home market would be a key trigger for value creation and revaluation of Cadila’s long-term growth prospects. Niche product launches in the USA to drive near-term margins/RoCE

Cadila has been guilty of quality issues in past (FY12 and FY16), but the management is closer to clearing its facility as majority remediation have been done with and Form 483 has been cleared. Cadila should receive bunched up product approvals and we build >75 product approvals for the USA in FY18/19; most would be complex generics (modified release, topicals, transdermal patches) implying lower competition and higher pricing. Over-dependence on Moraiya facility will end with Baddi and SEZ facilities gaining scale. Normalised margins (excluding one-off in HCQS revenues) should increase from ~18% in FY16 to 21.4% in FY19E led by ramp-up in US generics (40% share). Positive surprises can be from bolt-on acquisitions (in EMs) which are in gestation period (losses).

IBAS framework: Leads in innovative capabilities, India brand equity

Cadila is among the more successful innovation plays in Indian pharma. Whilst innovatives’ revenues would emanate only from India/EMs in the near term, success will set stage for regulated market forays. Its Indian business has a slow-growing acute heavy portfolio, yet revenues have grown faster than IPM due better execution (MR productivity at Rs6.5mn vs peers’ average of Rs4mn).

Valuations to recover as concerns abate

Quality compliance issues at the Moraiya facility have affected valuations in the past. The company is closer to clearing its facility, as per our analysis. Whilst well-entrenched promoters, high R&D productivity and excellence in execution lend comfort on valuations, earnings momentum is also likely to sustain (led by the unfolding of the ANDA pipeline in the USA). We use a DCF-based methodology to value Cadila with target price of Rs430/share, implying 19x FY18E P/E vs current P/E of 17.2x, material discount to 20-21x average for last 2 years and peers at ~20x. Remediation at Moraiya will drive re-rating.

STRATEGY NOTE CDH IN EQUITY November 17, 2016

Cadila

BUY

Healthcare

Recommendation Mcap (bn): `389/US$5.8 3M ADV (mn): `314/US$4.7 CMP: `380 TP (12 mths): `430 Upside (%): 13


Performance


Cadila’s forensic score analysis


Cadila’s greatness score analysis


708090

100110120

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

Cadila Health. Sensex

Research Analyst

Paresh Dave, CFA

+91 22 3043 3212

[email protected]

Cadila


Exhibit 1: Evolution of Cadila

Source: Company and Ambit Capital research. Note: RoCE is pre-tax RoCE


(Rs mn) FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Revenues 17,855 22,660 28,624 35,742 44,647 50,900 61,552 70,600 84,971 94,694

Revenue growth (%) 26.9% 26.3% 24.9% 24.9% 14.0% 20.9% 14.7% 20.4% 11.4%

Net profits 2,338 2,576 3,031 5,051 7,110 6,526 6,536 8,036 11,506 15,226

EPS 3.7 4.1 3.0 4.9 6.9 6.4 6.4 7.8 11.2 14.9

CFO 2,885 2,548 4,491 7,084 8,382 6,934 9,105 11,753 14,130 27,188

CFO (pre-tax)/EBITDA 78.9% 49.1% 44.1% 87.7% 73.2% 43.9% 62.1% 88.3% 78.6% 111.4%

FCF 645 -3074 -1,918 3050 1,464 -8881 -2,759 4,294 4,981 10,275

Debt equity (x) 0.5 0.8 1.0 0.7 0.5 0.9 1.0 0.8 0.6 0.5

RoE (%) 29.9% 26.7% 26.4% 35.3% 37.4% 27.5% 23.7% 25.2% 29.9% 31.7%

RoCE* (%) 26.8% 26.3% 22.4% 27.8% 31.9% 22.5% 17.8% 18.5% 25.9% 31.8%




FY05-FY07 Indian business drives growth

Cadila derived 60% of its revenues from the Indian business over FY05-07 comprising primarily of acute therapy (contributing >70% of Indian business).

The US business is at a nascent stage (8% of revenue), with focus on product development. As of FY07, the company had 23 ANDAs approved (but only 9 launched) and 37 ANDAs filed and pending approval.

Margins were at 20% (vs FY16 at 25%) due slow moving and lower margin acute therapy portfolio in India.

FY08-12 Focus shifts to US generics

Revenue growth accelerated (23% CAGR over FY08-12) led by higher revenue contribution from the US business (24% of overall revenues) led by launch of limited competition generics. Revenue per ANDA increased from <US$2mn to US$3.1mn.

The Indian business reported 12% CAGR over FY08-12 led by a gradual shift from acute therapy to chronic products (chronic contributing 52% in FY12 vs 30% in FY07). Also, improvement in sales force efficiency led by chronic therapy (MR productivity increases from Rs2mn in FY08 to Rs4.3mn in FY12). From FY09, the management expanded its presence in emerging markets (though acquisitions) leading to 16% revenue CAGR over FY07-12.

Led US business and chronic revenues in India, gross margins expanded from 64% in FY08 to 67% in FY12, however EBITDA margins remained flat at 20% due to increase in R&D spends from 6% of sales in FY07 to 8% in FY12.

FY13 – Current Quality issues at its facility stalls revenue partially

Cadila received warning for its Moraiya facility in FY12 and FY16 leading to slowdown in pace of product approvals in the US market. However, on the positive side, the launch of limited competition products (Depakote ER and HCQS) led to flat gross margin (67% in FY12 vs 65% in FY16).

Improvement in revenue growth in emerging markets (26% revenue CAGR over FY12-16) but continue to remain loss making for the company due to gestation period in establishing brand equity.

Increase in R&D spends (20% CAGR over FY12-16), losses in EM business and limited product approvals led to EBITDA margins at 18% in FY16 vs 21% in FY12. RoCE improved to 23% in FY16 from 19% in FY12. Quality issues raised at its Moraiya facility are expected to be cleared by the end of FY17.


0%

5%

10%

15%

20%

25%

30%

35%

0

20

40

60

80

100

120

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Revenue, LHS (Rs. Bn) RoCE

India business driven growth with >70% of revenue from slow-growing acute therapy

Focus on US generics with launch of limited competition products improving RoCEs

Quality issues at its facility hamper revenue growth though limited comeptition opportunity in US salvages RoCE

Cadila


Exhibit 4: Competitive mapping of Lupin, with other comparable generic pharma peers

Company Positioning FY16 revenue

Revenue CAGR

FY10-16

Revenue per ANDA

(US$mn)

EBITDA Margin

(median FY10-16)

Pre-tax RoCE

(median FY10-16)

Median Pre-tax CFO/

EBITDA (FY10-16)

Cumulative R&D as % of

Sales (FY10-16)

Sun Pharma #1 282,697 38% 5.1 34% 25% 91% 7%

Lupin #2 142,085 20% 7.3 24% 26% 86% 8%

Cadila #5 98,376 18% 6.5 21% 24% 82% 7%

Torrent #4 66,764 23% 2.2 22% 27% 91% 4%

Dr. Reddy’s #3 156,978 14% 7.0 23% 23% 85% 8%

Cipla #6 136,783 17% 1.9 21% 19% 92% 5%

Ipca #8 28,850 10% 1.4 18% 24% 92% 4%

Aurobindo #7 138,961 25% 4.1 22% 21% 65% 4%


Exhibit 5: Mapping Lupin and its peers on IBAS

Innovation Brand Architecture Strategic Asset

Overall Comments

Sun

Visionary management has built its business through acquisitions and fortified its moats through innovative pursuits like MK3222. The company has strong brand equity in India with base business reporting stellar growth over FY11-15.

Lupin

Marginally lower than Sun Pharma but has the ability to scale up in the US market through launch of complex generics. The company has focused on creating strategic assets through investment in Japan and maintaining low-cost structure.

Cadila

Need to look out for Cadila's innovative pursuits. Whilst the innovative revenues would be from India and EMs in the near term, success in these geographies would be incrementally positive for its regulated market expectations.

Torrent

Torrent Pharma’s biosimilar outlook coupled with improvement in productive MR in the Indian business help strengthen moats. However, the company has entered late in the US business and will have to use the inorganic route to improve its position. It continues to be best in class in the EM markets and expect EM revenues to cushion ventures in regulated markets.

Dr. Reddy’s

Best in class innovation profile as it leads the pack in biosimilar evolution. However, it falters on brands in India and EMs due to predominant presence in acute therapy in India and volatility in its EM business.

Cipla

Apart from inhalers, limited investment in innovation. Base business in India lags its peers implying lower brand equity for its excising portfolio. Senior management churn results in weak architecture.

Ipca

Serious compliance issues at its faculties hamper its prospects in the US market. Yet to prove capability in innovative pursuits. Low-cost structure is the only advantage for the company.

Aurobindo

Limited investment in innovation, no branded generic business and average cost structure despite presence in complex generics lead to lowest position on IBAS.


Exhibit 6: CFO and some marginal debt were key sources of funds over last decade (Rs112bn)


Exhibit 7: Capex and dividend were main uses of funds over last decade (Rs76bn)


CFO, 81.0%

Debt raised, 15.3%

Interest received,

3.3%

Dividend received,

0.3%

Net Capex, 62.6%

Purchase of investment,

1.4% Dividend paid, 20.7%

Interest paid, 6.7%


cash equivalent,

8.6%

Cadila


Exhibit 8: Re-rating in 2008 driven by entry in USA followed by de-rating in FY16 due to quality issues


Exhibit 9: Cadila’s share price performance v/s Sensex



Field Score Comments

Accounting GREEN

In our forensic analysis of 360 companies, Cadila scores in line with the average of the pharma industry (comprising 26 companies). Cadila scores high on ratios of: (a) gross block conversion; (b) change in depreciation rates; (c) audit fees; and (d) non-operating expenses. However, Cadila has weaker scores on: (a) cash yield; and (b) volatility in sales and distribution costs.

Predictability AMBER Overall, the management has made timely announcements in its earnings calls, meetings and interviews regarding product filings, acquisitions and business outlook. However, the unpredictability of unknown large filings in the USA, emerging markets and innovative projects makes us assign an AMBER flag on predictability.

Earnings momentum AMBER Consensus FY17E and FY18E EBITDA and EPS estimates have been flat over the past three months and have seen material downgrades in the six-month period led by concerns around remediation at Moraiya facility.






5

10

15

20

25

30

35

Mar

-05

Mar

-06

Mar

-07

Mar

-08

Mar

-09

Mar

-10

Mar

-11

Mar

-12

Mar

-13

Mar

-14

Mar

-15

Mar

-16

(P/E) CDH 1yr fwd P/E chart

Five yr PE average = 20.0x 0

200

400

600

800

1000

1200

1400

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

Jan-

15

Jan-

16

Cadila Sensex

Cadila



Year to Mar (Rs mn) FY15 FY16 FY17E FY18E FY19E

Total assets 71,304 79,904 93,094 110,238 128,277

Fixed assets 41,501 47,896 54,165 59,868 65,004

Current assets (incl cash) 47,426 49,604 63,529 80,705 96,360

Cash 6,699 6,953 15,651 22,892 32,973

Investments 1,544 2,663 2,663 2,663 2,663


Shareholders' equity 1,024 1,024 1,024 1,024 1,024

Reserves & surplus 41,492 52,495 65,685 82,829 100,868

Total networth 42,516 53,519 66,709 83,853 101,892

Total debt 26,513 24,420 24,420 24,420 24,420


Deferred tax liability 586 611 611 611 611

Source: Company, Ambit Capital research;


Year to March (Rs mn) FY15 FY16 FY17E FY18E FY19E

Net revenues 84,971 94,694 111,864 140,601 156,573

Material cost 31,966 32,770 40,790 53,200 59,824

General expenses 31,382 34,240 37,907 44,656 49,601

R&D expenses 5,608 7,537 9,421 12,530 15,663

Core EBITDA 17,557 23,829 25,617 32,555 34,054

Depreciation 2,873 3,022 3,731 4,297 4,864

Interest expense 679 486 661 661 661

Adjusted PBT 14,455 21,237 22,250 28,919 30,428

Tax 2,594 5,711 4,450 5,784 6,086

Reported net profit 11,506 15,226 17,800 23,135 24,342


Cadila




PBT 14,455 21,237 22,250 28,919 30,428

Depreciation 2,873 3,022 3,731 4,297 4,864

Tax 2,594 5,711 4,450 5,784 6,086

Net working capital (3,770) 2,656 (2,833) (5,582) (3,135)

CFO 9,936 19,938 18,698 21,851 26,072

Capital expenditure (4,955) (9,663) (10,000) (10,000) (10,000)

Investment 308 624 - - -

Other investments - - - - -

CFI (4,647) (9,039) (10,000) (10,000) (10,000)


Inc/Dec in borrowings (1,162) (2,558) - - -

Net dividends (2,349) (6,969) - (4,610) (5,991)

Other financing activities - - - - -

CFF (3,511) (9,527) - (4,610) (5,991)

Net change in cash 1,778 1,372 8,698 7,241 10,081


FCFF 4,981 10,275 8,698 11,851 16,072


Ratio analysis (consolidated)


Revenue growth 20.4 11.4 18.1 25.7 11.4

Core EBITDA growth 46.3 35.7 7.5 27.1 4.6

APAT growth 43.2 32.3 16.9 30.0 5.2

EPS growth 41.4 31.4 16.7 30.0 5.2

Core EBITDA margin 20.7 25.2 22.9 23.2 21.7

EBIT margin 17.3 22.0 19.6 20.1 18.6

Net profit margin 13.5 16.1 15.9 16.5 15.5

RoCE (%) 23.4 29.6 27.1 29.7 26.5

Reported RoE (%) 29.9 31.7 29.6 30.7 26.2

Debt equity ratio (X) 0.6 0.5 0.4 0.3 0.2

Net Debt Equity ratio (X) 0.5 0.3 0.1 0.0 (0.1)

CFO/EBITDA (x) 0.6 0.8 0.7 0.7 0.8



Current ratio 2.5 2.4 2.3 2.4 2.7


Valuation parameters (consolidated)


EPS 11.3 14.9 17.4 22.6 23.8

Book Value ( per share) 41.5 52.3 65.2 81.9 99.5

P/E (x) 34.4 26.2 22.4 17.3 16.4

P/BV (x) 9.4 7.5 6.0 4.8 3.9

EV/EBITDA(x) 23.9 17.5 15.9 12.3 11.5

EV/Sales (x) 4.9 4.4 3.6 2.9 2.5

EV/EBIT (x) 28.5 20.0 18.6 14.2 13.4



On a steady growth path Britannia is the value market leader in India’s biscuit market; delivered sales/PAT CAGR of 18%/19% over FY07-16. During the first half of the last decade, it faced intense competition from ITC resulting in market-share loss. Since FY13, under its new CEO Varun Berry, EBITDA margin expanded from 6.8% to 14.1% in FY16 and it regained market leadership. The company’s increased focus on systems and processes and a stronger diverse portfolio have made it more capable than a decade ago to weather key threats of input cost inflation and intense competitive action. With limited scope for margin expansion and market-share increase we value Britannia at 30x FY18E EPS, at lower end of FMCG average.


Biscuit market leader with legacy brands

Britannia derives ~76% of its sales from biscuits with remainder from cakes, rusk and dairy products. In the biscuit segment, Britannia derives majority of its revenues from the mid-to-premium segment with dominant market share in the cookies segment (~26% of the market) through the Good Day brand. It is a distant second in the mass market glucose segment (~19% of the market) and a close #3 in the creams segment (~23% of the market) which is dominated by ITC (#1) at the premium end and Parle (#2) in the mass end. Britannia has leveraged the brand equity of legacy brands like Good Day, Cream Treat and Tiger to maintain its dominance in the biscuit market. Renewed dominance since FY13 under the new CEO

During FY07-12, the company barely maintained its biscuit market share due to severe competition from ITC. The company did not have any successful product launches and its diversification attempts into the snacks and breakfast category failed. Over FY13-16, under Varun Berry the company focused on: a) widening and deepening its distribution; b) product innovation and renovation; and c) several cost cutting initiatives (Click here for detailed note_16Dec2014). This helped the company regain its market leadership from Parle in FY16. Along with input cost tailwinds, the cost cutting initiatives helped increase EBITDA margin from 5.7% in FY12 to 14% in FY16 with PAT growing at ~46% CAGR over FY13-16.

Leveraging strong brands and distribution to gain scale advantages

Biscuits sales in India is a low-margin commodity-like business as the category is mostly dominated by basic variants like glucose and cookies. Unlike its peers which have only 1-2 strong brands, Britannia has positioned itself in the mid and premium segment through bouquet of strong brands (Good Day, Tiger, Marie, Treat, 50-50, Milk Bikis and Nutri Choice) positioned across biscuit sub-categories. Britannia has the second largest distribution reach in the biscuits category which has been going deeper and wider in the last 5 years. These strengths have been leveraged to gain scale and drive investment in technology to further bring down costs and keep growing ahead of its peers.

Trades at a marginal premium

Our bullishness around gains in market share and EBITDA margin is capped by: (a) aggressive approach to product development by peers like ITC and Parle; and (b) increasing input prices, leaving lower potential for EBITDA margin expansion. We expect Britannia to deliver revenue/earnings CAGR of 14%/17% over FY16-20E. Our DCF-based fair value of `2,700 (12% downside) implies FY18P/E of 30x.

STRATEGY NOTE BRIT IN EQUITY November 17, 2016

Britannia

SELL

Consumer Staples

Recommendation Mcap (bn): `396/US$5.9 3M ADV (mn): `668/US$10.0 CMP: `3,080 TP (12 mths): `2,700 Downside (%): 12


Performance


Britannia’s forensic score analysis


Britannia’s greatness score analysis


8090

100110120130

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

Britannia Inds. Sensex

Research Analysts

Rakshit Ranjan, CFA

+91 22 3043 3201

[email protected]

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

http://reports.ambitcapital.com/reports/Ambit_Britannia_CompanyInsight_16Dec2014.pdf

Britannia


Exhibit 1: Tale of two halves over the last decade

Source: Ambit capital research


(` mn) FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Revenues 27,763 34,212 37,729 46,052 54,854 61,854 69,127 78,584 86,789

Revenue growth (%) 23% 23% 10% 22% 19% 13% 12% 14% 10%

Net profits 1,699 1,335 1,338 1,343 1,996 2,595 3,954 5,426 8,164

EPS 14.2 11.1 11.1 11.2 16.6 21.6 32.9 45.2 68.0

CFO 522 2,926 2,396 2,591 6,802 711 5,979 6,231 6,630

Pre-tax CFO-EBITDA 40% 145% 151% 133% 240% 40% 123% 102% 86%

FCF (4) 145 167 204 3 104 572 631 712

Debt equity (x) 0.4 (0.2) 0.9 0.5 (0.3) 0.2 (0.2) (0.5) (0.4)

RoE (%) 27% 19% 27% 44% 54% 54% 58% 53% 54%

Pre-tax RoCE (%) 27% 21% 17% 25% 40% 53% 62% 70% 75%




Pre 2003 Sunil Alagh era

Key brands like Good Day (1986), 50-50 and Little Hearts (1993), Milk Bikis (1996) was launched Entered into JV with Fonterra for dairy business In 1993, Danone and Wadia bought controlling stake in Britannia Industries. Strengthened ‘Brand Britannia’ through aggressive marketing campaign in late 1990s with ‘Eat Healthy,

Think Better’ and Cricket World Cup 1999 and 2003 campaign of ‘Britannia Khao, World Cup Jao’

2004-2013 Vinita Bali – Taking step backward

In 2005, Vinita Bali was appointed as new CEO Despite shift of focus from brand building to increasing operating efficiency, EBITDA margin decreased from

11.4% in FY04 to 6.8% in FY13 Market-share loss to Parle and ITC New product launches intensity decreased Wadia bought out Danone’s stake (25.5%) in the company Wadia bought out Fonterra’s stake in the Joint Venture entity Varun Berry was appointed VP and COO in 2013

Post 2013 Varun Berry – Biscuits back in focus

Vinita Bali quits; Varun Berry was appointed as MD Distribution efficiency was brought by: a) resolving supply chain inefficiencies to reduce damages; b)

implementing new IT infrastructure for better MIS; and c) restructuring of sales force by giving more decision making power to junior sales person

New product launch intensity increased in premium brands and superior/innovative packaging for existing premium brands

Increased advertising spends from 7.6% in FY12 to 8.5% in FY16 EBITDA margin improved from 6.8% in FY13 to 14% in FY16 by a) improving operating efficiency; b) in-

house manufacturing (increasing from 33% in FY13 to 50% in FY16; c) supply chain efficiency; and d) reducing trade promotions

Britannia became the market leader in biscuits by end of FY16


0%

20%

40%

60%

80%

-

20

40

60

80

100

FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Biscuits revenue (Rs bn, LHS) Other revenue (Rs bn, LHS) Pre-tax ROCE (RHS)

Varun Berry era - deepeing of distribution, product renovation driving share gains

Vinita Bali era – several failed product innovations and diversifications resulting in market share loss to ITC and Parle

Britannia


Exhibit 4: Competitive mapping of Britannia

Company Sub-segment Positioning

FY16 revenue (` bn)

Revenue CAGR

FY10-16

Industry market

share


Pre-tax RoCE

(FY16)

Pre-tax CFO/ EBITDA

(FY10-16)

Capex/CFO (FY10-16)

Britannia #1 86.8 15% ~29% 14% 40% 125% 35%

ITC – FMCG division #3 97.0 18% ~13% 3% NA NA NA

Parle Biscuits #2 ~83.0 19% ~28% 9% 26% 73% 41%

Source: Company, Ambit Capital research; Note: For ITC we have taken the FMCG segment revenues

Exhibit 5: Mapping Britannia and its peers on IBAS Britannia Parle ITC Comments

Innovation

Introduction of mini pack to increase penetration First to focus on nutrition biscuits with the launch of NutriChoice However, Britannia has poor track record of successful product innovation over the last

decade

Branding

Britannia has built strong brands across categories and price points through popular marketing campaigns like ‘Eat Healthy, Think Better’ in the last 1990s and the Cricket World Cup 1999 campaign with a tagline of ‘Britannia Khao, World Cup Jao’

ITC and Parle haven’t been able to create strong sub-brands

Architecture

Britannia has the second largest distribution outreach in the biscuit category next only to Parle

Britannia has increased its network of factories and brought them closer to the end market thus reducing the logistics cost. It has focused on bring manufacturing in-house to improve product quality and produce more value-added products.

Parle also has an extensive network of factories but these are mostly outsourced manufacturers.

Strategic assets

In a low profit margin category, Britannia’s scale is a key strategic asset Britannia has also successfully created strong sub-brands at different price points which

it has used to capture the current consumption trend. For e.g. it has used Good Day to ride the cookies wave and NutriChoice to tap into consumer demand for health biscuits

Overall

Amongst its peers, Britannia is best placed on the IBAS framework. However, the other two players are a close second to Britannia


Exhibit 6: Britannia’s sources of fund over the last decade


Exhibit 7: Britannia’s application of funds over the last decade


CFO 89%

Proceeds from

shares 0%

Decrease in cash

5%

Dividend received

6%

Debt repayment

15%

Dividend paid 28%

Interest paid 5%

Net Capex 29%

Purchase of

Investments

23%

Britannia


Exhibit 7: Most of the re-rating happened over last 2 years


Exhibit 8: After doing nothing, the stock performed with the change in the management


Exhibit 9: Explanation for our forensic accounting scores


Accounting GREEN Britannia has, in the past, reported high cash conversion and efficient management of working capital and it ranks in the top quartile of our forensic accounting checks for FMCG. Consequently, we give a high rating to the quality of its accounting.

Predictability AMBER Due to a combination of its presence across products, categories and SKUs, and predominant exposure to consumer-activity-led sector of the economy, revenues show stability. However, the current economic environment and volatility in raw material prices can lead to some volatility in earnings.

Earnings Momentum AMBER End of tailwinds around raw material cost has led to consensus downgrading its EPS forecast for Britannia by ~5% for both FY17 and FY18 over the past six months.






10

20

30

40

50

Oct

-11

Feb-

12

Jun-

12

Oct

-12

Feb-

13

Jun-

13

Oct

-13

Feb-

14

Jun-

14

Oct

-14

Feb-

15

Jun-

15

Oct

-15

Feb-

16

Jun-

16

Oct

-16

Britannia 1 year fwd P/E

Average of 5yr P/E

-

500

1,000

1,500

2,000

Oct

06

Oct

07

Oct

08

Oct

09

Oct

10

Oct

11

Oct

12

Oct

13

Oct

14

Oct

15

Oct

16

BRIT Sensex

Britannia


Balance sheet




Total networth 12,451 17,693 22,211 27,586 34,143


Debt 1,402 1,270 408 408 408

Deferred tax liability (234) (277) (277) (277) (277)


Gross block 15,989 18,067 21,067 24,067 25,567

Net block 7,334 8,343 9,876 11,183 10,822

CWIP 484 901 901 901 901

Goodwill 1,107 1,159 1,159 1,159 1,159

Investments 771 3,564 3,564 3,564 3,564

Cash & equivalents 6,672 4,841 6,975 11,055 17,989

Debtors 1,358 1,706 1,926 2,198 2,528

Inventory 4,040 4,407 4,974 5,677 6,530

Loans & advances 5,563 8,995 10,154 11,588 13,329

Other current assets 372 378 427 487 560

Total current assets 18,005 20,327 24,456 31,004 40,937


Provisions 4,228 5,092 5,748 6,560 7,546



Total assets 13,644 18,711 22,365 27,736 34,291


Income statement


Operating income 78,584 86,789 97,971 1,11,804 1,28,606

% growth 13.7% 10.4% 12.9% 14.1% 15.0%

Operating expenditure 69,945 74,523 84,186 95,363 1,09,317

EBITDA 8,639 12,265 13,786 16,441 19,289

% growth 37.7% 42.0% 12.4% 19.3% 17.3%

Depreciation 1,445 1,134 1,468 1,693 1,861

EBIT 7,194 11,131 12,318 14,749 17,428


Non-operating income 880 1,000 1,233 1,082 1,574

Adjusted PBT 8,035 12,082 13,500 15,806 18,989

Tax 2,611 3,920 4,380 5,128 6,160

Adjusted PAT/ Net profit 5,424 8,163 9,121 10,678 12,829

% growth 37.2% 50.5% 11.7% 17.1% 20.1%

Extraordinaries 1,461 (103) - - -


Minority Interest (2) (2) (2) (3) (4)

Share of associates - - - - -

Adjusted Consolidated net profit 3,965 8,268 9,123 10,681 12,832

Reported Consolidated net profit 3,965 8,268 9,123 10,681 12,832


Britannia


Cash flow statement


EBIT 8,074 12,131 13,551 15,830 19,002

Depreciation 1,445 1,134 1,468 1,693 1,861

Others (320) (42) (0) 0 (0)

Tax (2,611) (3,920) (4,380) (5,128) (6,160)

(Incr) / decr in net working capital (318) (2,626) 13 16 19

Cash flow from operations 6,231 6,630 10,601 12,386 14,709

Capex (786) (2,561) (3,000) (3,000) (1,500)

(Incr) / decr in investments (457) (2,846) - - -

Others - - - - -

Cash flow from investments -1,243 -5,406 -3,000 -3,000 -1,500

Net borrowings (80) (133) (861) - -


Interest paid (39) (49) (50) (24) (12)

Dividend paid (2,238) (2,888) (4,105) (4,806) (5,775)

Others 1,282 (34) (500) (500) (500)

Cash flow from financing (1,074) (3,103) (5,517) (5,331) (6,287)

Net change in cash 3,914 (1,880) 2,084 4,055 6,922


Free cash flow 5,446 4,069 7,601 9,386 13,209


Ratio analysis

Year to March FY15 FY16 FY17E FY18E FY19E

Gross margin (%) 40.3% 42.4% 42.4% 43.0% 43.3%

EBITDA margin (%) 11.0% 14.1% 14.1% 14.7% 15.0%

EBIT margin(%) 10.3% 14.0% 13.8% 14.2% 14.8%

Net profit margin(%) 6.9% 9.4% 9.3% 9.6% 10.0%

Dividend payout ratio(%) 41.2% 35.4% 45.0% 45.0% 45.0%

Net debt: equity (x) (0.4) (0.2) (0.3) (0.4) (0.5)

Working capital days (13) (0) (0) (0) (0)


RoCE(%) 47.0% 50.7% 44.6% 42.7% 41.4%

RoE(%) 53.1% 54.2% 45.7% 42.9% 41.6%




EPS (`) 45.2 68.0 76.0 89.0 106.9

Diluted EPS (`) 45.2 68.0 76.0 89.0 106.9



P/E (x) 68.1 45.3 40.5 34.6 28.8

P/BV (x) 29.5 20.8 16.6 13.3 10.8

EV/EBITDA (x) 42.2 29.8 26.3 21.8 18.2

Price/Sales (x) 4.7 4.3 3.8 3.3 2.9



The old lady of housing finance LICHF’s prolonged strong performance – 22% EPS CAGR, 24% AUM CAGR, and median RoE of 19% over FY06-16 – was supported by a decadal rally in real estate prices and its parent LIC’s support. LIC’s support ensures access to cheaper liabilities (no liquidity crunch even during Lehmann crisis) and ease in customer acquisition (access to LIC’s strong brand and 1mn agents). Going forward, declining real estate prices and rising competitive intensity should moderate its earnings growth and RoE; we estimate 12% EPS CAGR over FY16-19E (vs 18% CAGR over FY13-16) and 17.5% RoE, which should de-rate the multiples. Our TP of `420, implies 1.9x 1-year fwd P/B. Rapidly moderating cost of funds is a near-term risk.

Competitive position: MODERATE Changes to this position: NEGATIVE

Strong focus on the salaried and urban segments Promoted by state-owned life insurance giant, Life Insurance Corporation of India (LIC), LICHF is India’s second-biggest HFC with a `1.3tn loan book. LICHF focuses on home loans (88% of loan book) and more specifically on the salaried segment (84% of home loans) and metros (46% of home loans). Growth and RoE slowed despite realignment of assets and liabilities

LICHF’s strong growth and profitability during FY06-12 (27% AUM CAGR; median RoE of 23%) were driven by benign regulatory and moderate competitive environment. But from FY12, regulatory and competitive headwinds put intense pressure on LICHF’s growth and profitability. Growth moderated to 19% CAGR over FY12-16 and RoE slowed to 18% over FY12-16. This was despite a meaningful realignment in liability mix (share of cheaper bond borrowings rose from 58% in FY12 to 77% in FY16) and loan mix (share of higher yielding LAP rose from 0% in FY12 to 9% in FY16). Growth in line with RoE implied that dividend payout ratio was a reasonable ~21% over FY12-16.

Parent LIC’s support is the strategic asset

LIC’s support has helped LICHF get cheap and convenient access to wholesale markets. This was tested during the Lehman crisis, when LIC was able to access funds rather effortlessly and sustained growth even as other lenders struggled for funding. Moreover, beyond liabilities, LIC’s support has also driven customer acquisition for LICHF through: i) branding: LICHF’s approval on a home loan of a under-construction project is perceived by customers as having minimal legal and execution risks; and ii) origination: LICHF has access to ~1mn LIC agents, who currently contribute ~60% of its origination.

A turn in the decade-long dream run

A decadal surge in real estate prices combined with strong support from parent LIC drove LICHF’s earnings momentum of 22% CAGR over FY06-16. However, with declining real estate prices and high competitive intensity, LICHF’s already moderate loan growth and profitability should decelerate further (due to pressures on margins and asset quality). So, we estimate LICHF’s earnings growth to continue moderating from 18% CAGR over FY13-16 to 12% CAGR over FY16-19E. Moreover, HFCs are exposed to the looming regulatory risk of convergence of loan pricing to a more transparent and objectively calculated base rate (which is followed by banks). LICHF stock trades at 2.3x 1-year forward P/B, which is at a 27% premium to 5-year average.

STRATEGY NOTE LICHF IN EQUITY November 17, 2016

LIC Housing Finance

SELL

BFSI

Recommendation Mcap (bn): `242/US$3.6 3M ADV (mn): `1367/US$20 CMP: `511 TP (12 mths): `420 Downside (%): 18

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: GREEN

Performance


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

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

80

100

120

140

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

LIC Housing Fin. Sensex

LIC Housing Finance


Exhibit 1: LICHF’s growth has moderated due to increasing competition


Exhibit 2: LICHF – key financial parameters over the last decade


Interest Income 9.1% 10.2% 11.0% 10.0% 10.2% 10.8% 10.9% 11.0% 10.9% 10.9%

Interest Expense 6.7% 7.4% 8.1% 7.3% 7.1% 8.3% 8.6% 8.7% 8.6% 8.3%

Net Interest Income 2.4% 2.8% 2.9% 2.7% 3.1% 2.5% 2.2% 2.3% 2.3% 2.6%

Non-Interest Income 0.5% 0.7% 0.6% 0.6% 0.5% 0.4% 0.3% 0.3% 0.3% 0.2%

Total Income 2.9% 3.4% 3.6% 3.3% 3.7% 2.9% 2.5% 2.6% 2.6% 2.8%

Operating Expenses 0.6% 0.7% 0.62% 0.58% 0.49% 0.43% 0.41% 0.38% 0.39% 0.42%

Pre Provisioning Profit 2.2% 2.8% 2.9% 2.7% 3.2% 2.5% 2.1% 2.2% 2.2% 2.4%

Loan loss provisions 0.08% 0.12% 0.02% -0.09% 0.09% 0.20% 0.12% 0.03% 0.01% 0.13%

Profit Before tax (PBT) 2.1% 2.7% 2.9% 2.8% 3.1% 2.5% 2.0% 2.2% 2.2% 2.3%

Taxes 0.5% 0.7% 0.8% 0.8% 0.9% 0.7% 0.5% 0.6% 0.6% 0.8%

RoA 1.7% 1.9% 2.1% 2.0% 2.2% 1.6% 1.5% 1.6% 1.4% 1.5%

Leverage 11.3 11.7 12.1 11.5 11.5 11.3 11.3 11.8 12.6 13.2

RoE 19.3% 22.7% 25.8% 23.2% 25.5% 18.5% 16.8% 18.8% 18.1% 19.6%

AUM growth (%, YoY) 19% 21% 22% 34% 38% 28% 25% 18% 19% 15%

EPS growth (%, YoY) 35% 39% 37% 16% 40% -6% 5% 29% 5% 20%


Exhibit 3: LICHF’s growth and profitability has meaningfully moderated since FY12


Strong growth period FY06-12

LICHF’s robust growth (27% CAGR) during this period was driven by both increasing customer acquisition (due to benign competition in the small ticket segment and increasing ticket size per loan (due to rapid increase in real estate prices).

Regulatory and competitive environment remained benign. Consequently both growth and profitability remained high during this period (AUM CAGR of 27% and RoA of 1.9%).

Moderation in growth and profitability

FY12-Current

Regulatory headwinds emerged FY11 onwards such as introduction of base rate system (which led to increasing cost of funds) and removal of prepayment penalties (leading to higher churn in the loan book and reduction in fee-income).

Moreover, during this period, HFCs have seen hyper-competition from banks in home loans due to: i) lack of any opportunities in corporate loans due to slowdown; and ii) regulators incentivising affordable housing in FY15 by reduction of risk weights and exemption on SLR/CRR and PSL requirements. Decline in real estate prices have also let to moderation in ticket size growth (which used to drive 50-60% of growth of HFCs).

Consequently LICHF’s growth has moderated to 19% CAGR over FY12-16 versus 27% CAGR in FY06-12. However, LICHF was able to sustain such pressure on profitability and growth by: i) increasing the share of higher-yielding albeit risky LAP (from 0% in FY12 to ~9% in FY16); and ii) shift in liability mix towards cheaper bond borrowings (from 58% in FY12 to 77% in FY16). This somewhat offset the lower profitability from the business and enabled it to still deliver moderate RoAs of 1.5% during this period.

Source: Ambit Capital research.

10%

15%

20%

25%

30%

(100)

100

300

500

700

900

1,100

1,300

FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

AUM (Rs bn) RoEs (RHS, %)

Strong growth period AUM CAGR 27% RoAs 1.9%

Moderation in growth and profitability AUM Growth 19% RoAs 1.5%

LIC Housing Finance


Exhibit 4: Competitive mapping of HFCs – LICHF’s growth has moderated despite its small-ticket positioning Key metrics (FY16)

Avg. ticket size (` mn)

AUM (` bn)

AUM CAGR (FY13-16) NIMs Opex/

AUM Gross

NPA (%) RoA RoE Branches (#)

Employees (#)

LICHF 1.2 1,252 17% 2.6% 0.4% 0.45% 1.5% 19.6% 234 1,726

Repco 1.1 77 29% 4.9% 1.0% 1.30% 2.2% 17.0% 150 619

GRUH 0.5 111 27% 4.2% 0.8% 0.32% 2.3% 31.5% 179 618

HDFC 2.5 2,908 16% 3.1% 0.3% 0.70% 2.4% 21.8% 401 2,196

CANFIN 1.7 106 38% 3.1% 0.7% 0.19% 1.6% 19.0% 140 553

DEWAN 1.2 695 24% 3.0% 0.9% 0.93% 0.9% 11.9% 353 2,625

PNBHF 3.7 272 60% 3.8% 1.2% 0.22% 1.4% 17.6% 47 752


Exhibit 5: Mapping GRUH and its peers on IBAS

Particulars GRUH HDFC LICHF REPCO CNFIN DHFL PNBHF Comments

Innovation

Innovation in terms of ability to appraise a non-salaried borrower is key to gain penetration in the under-served low-income segment. GRUH scores best in the metric due to its innovative products and appraisal techniques. GRUH’s product innovation is exemplified from the fact that it structures customised EMIs to match the cash flows of the low-income borrowers and has flexible repayment plan as per daily, monthly or yearly amortising. Moreover, GRUH was the first HFC to introduce a formal credit score methodology for the low-income category of borrowers. Repco comes closest to GRUH in replicating this. Moreover Repco’s origination strategy is also innovative as it sources only through loan melas and referrals and avoids sourcing through DSAs unlike other HFCs.

Brand

Brand for the home loan borrower will depend on the perceived customer service and the perceived project financing abilities by the lender. Whilst HFCs score lower than banks on all these metrics, HDFC enjoys the best brand amongst the HFCs due to superior perception on the above metrics, followed closely by GRUH. LICHF, CNFIN and PNBHF also score high due to their PSU parentage.

Architecture

A robust branch network with decentralised decision making is the key to gain penetration in small ticket housing finance. HDFC with ~400 branches and a decentralised decision making has one of the best architectures amongst peers, closely followed by DHFL and GRUH. Whilst REPCO has marginally lower branches than GRUH, it also scores highly due to a decentralised decision making process.

Strategic asset

Support of the parent, strong credit rating and a granular retail deposit franchise are the key strategic assets for HFCs in times of liquidity crunch. LICHF is best placed in this metric due to strong support from its parent on the above mentioned metrics.

Overall rank

GRUH comes out as one the strongest HFCs versus its peers due to its strengths in innovation, brand, architecture and strategic assets.

Source: Company, Ambit Capital research Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

Exhibit 6: LICHF’s AUM is dominated by home loans


Exhibit 7: Salaried segment dominate LICHF’s home loans


88%

9%

3%

Home loans

LAP

Developer 84%

16%

LICHF's customer profile

Salaried

Self-employed& others

LIC Housing Finance


Exhibit 8: LICHF’s liability mix is tilted towards bonds


Exhibit 9: LICHF’s asset quality has remained in control


Exhibit 10: LICHF is trading at a 27% premium to its cross-cycle average P/B


Exhibit 11: LICHF’s share price performance versus Sensex




Accounting GREEN LICHF’s revenue and expense recognition policies are by far the most conservative amongst the peers. We do not come across any instance wherein the reported profitability of the company is materially different from its true profitability.

Predictability AMBER Volatile bond yields and frequent base rate cuts by banks have made it difficult to predict the earnings of LICHF. Moreover, the management guidance has been off-mark both in times of earnings decline and recovery.

Earnings momentum GREEN Consensus has marginally upgraded in FY17/18 estimates by 1% over the past 3-4 months


13%

80%

3%

3% 2%

Banks

NCD

NHB

Deposits

Others -0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Gross NPA Credit costs

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Mar-0

5

Mar-0

6

Mar-0

7

Mar-0

8

Mar-0

9

Mar-1

0

Mar-1

1

Mar-1

2

Mar-1

3

Mar-1

4

Mar-1

5

Mar-1

6

PB Avg. PB -1 SD +1 SD

-

500

1,000

1,500

2,000

2,500

Apr

-07

Apr

-08

Apr

-09

Apr

-10

Apr

-11

Apr

-12

Apr

-13

Apr

-14

Apr

-15

Apr

-16

SENSEX LICHF

LIC Housing Finance


Income statement

FY15 FY16 FY17E FY18E FY19E

Net Interest Income 22,364 29,441 33,730 35,663 40,692

Interest Income 105,467 122,508 139,409 155,950 177,080

Interest Expense 83,102 93,068 105,679 120,287 136,388

Non Interest Income 2,520 2,346 2,575 2,825 3,102

Total Income 24,884 31,787 36,305 38,487 43,794

Operating expenses 3,792 4,687 5,849 6,835 7,664

Pre Provisioning Profit 21,092 27,100 30,456 31,652 36,130

Provisions 73 1,465 2,087 1,405 1,556

PBT 21,020 25,635 28,369 30,247 34,574

Less:Tax 7,158 9,028 9,362 9,982 11,409

Net Profit 13,862 16,608 19,007 20,265 23,164


Balance sheet


Networth 78,184 91,460 106,666 122,878 141,410

Borrowings 965,470 1,109,360 1,265,452 1,437,619 1,627,282

Total Sources of funds 1,043,654 1,200,820 1,372,118 1,560,497 1,768,692

Loan Book 1,083,610 1,251,730 1,430,290 1,626,657 1,843,678

- Individual 1,056,300 1,217,310 1,390,186 1,579,252 1,787,224

- Developer 27,310 34,420 40,104 47,405 56,454

Other Assets (39,956) (50,910) (58,173) (66,159) (74,986)

Total Application of funds 1,043,654 1,200,820 1,372,118 1,560,497 1,768,692


LIC Housing Finance


Key ratios


AUM growth (%) 18.6 15.5 14.3 13.7 13.3

Dil Consol EPS growth (%) 5.2 19.8 14.4 6.6 14.3

Net interest margin (NIM) (%) 2.3 2.6 2.5 2.3 2.3

Cost to income (%) 15.2 14.7 16.1 17.8 17.5

Opex (% of AAUM) 0.39 0.41 0.44 0.45 0.44

Gross NPAs (%) 0.5 0.5 0.6 0.6 0.6

Credit costs (% of AAUM) 0.01 0.13 0.16 0.09 0.09

Provisioning Coverage 52.2 51.1 55.0 55.0 55.0

Capital adequacy (%) 16.5 17.0 17.0 17.0 17.0

Tier-1 (%) 12.5 13.9 13.9 13.9 13.9

Leverage (x) 12.6 13.2 13.0 12.8 12.6




BVPS (`) 155 181 211 243 280

Diluted EPS (`) 27.5 32.9 37.7 40.2 45.9

ROA (%) 1.6 1.5 1.5 1.4 1.4

ROE (%) 18.1 19.6 19.2 17.7 17.5

P/E 18.6 15.5 13.6 12.7 11.1

P/BV 3.3 2.8 2.4 2.1 1.8

Dividend yield (%) 1.0 1.1 1.3 1.3 1.5



‘Inner’ Strength With laser-like focus on innerwear and associated categories, the Genomals have leveraged their experience in the Philippines to fortify Page’s moats around: a) product differentiation given in-house manufacturing; b) aspirational brand recall; and c) tight control on the distribution channel. Hence, new entrants offering either international brand recall, or affordable price, struggle to break Jockey’s customer loyalty which is built on a combination of quality, affordability and brand. Weakness in revenue growth momentum in FY16 is temporary and macro-driven. We expect 28%/34% CAGR in revenue/earnings over FY16-21 with average RoE of 58% and a high dividend payout of >55%. Our DCF-based fair value of `16,400 implies 44x FY18E EPS.

Competitive position: STRONG Changes to this position: STABLE Page possesses strong and sustainable growth drivers

Page controls the master franchise of Jockey (innerwear) and Speedo (swimwear) in India. Over the past 10 years, Page has delivered 33%/34% revenue/earnings growth with 35% average RoCE. Longevity of Page’s growth is led by: (a) only ~50% penetration of mid-premium innerwear in SEC A/B households even in 2020; (b) sustainability of competitive advantages driving market-share gains in mid-to-premium innerwear to 38% overall (including 65% in men’s segment) by FY30; and (c) unexplored sub-segments in categories like kidswear and loungewear. Page has focused intently on Jockey/Speedo, and capital discipline

Page’s foundation is built on: a) 60-year association with Jockey and Speedo; b) strong focus on capital allocation and RoCE; and c) incentivisation and empowerment of professionals to achieve scale with operating efficiencies. Some of the key strategic decisions Page has implemented over the past decade include: a) extending Jockey’s product portfolio to leisurewear segments like thermals, loungewear, t-shirts, shapewear etc; b) maintaining capital allocation discipline with 0.5-0.7x debt/equity ratio, leveraging on benefits under Technology Upgradation Funds Scheme for textile sector, and ensuring payout of surplus capital each year as dividends to shareholders. Page has built a fortress with its competitive moats

Page’s competitive advantages are centered on: a) in-house manufacturing to deliver product differentiation in a labour-intensive industry; b) maintaining aspirational connect with consumers; and c) an entrenched distribution channel spanning hosiery stores to exclusive brand outlets through distributors. Threats to Page’s leadership are low given: a) incumbents like Rupa/Maxwell sell through the wholesale channels with outsourced manufacturing and hence lack control of both manufacturing and distribution; b) given lack of in-house manufacturing, new entrants like FCUK, USPA, CK or regional players can’t offer affordability with good product quality. Page deserves one of the highest P/E multiples in the consumer space

Besides overall macro improvement, Page’s growth revival will be driven by benefits from recent initiatives like: a) new products (kids innerwear, hoodies/lounge pants and towels); b) new IT platform aimed at improving working capital management, closer monitoring of the sales team and distributors’ performance; and c) expanding Speedo’s footprint in India. Exemplary financials (33% EPS CAGR over FY16-21E and ~57% RoCE) support the valuation premium to most consumer names. Key risk: Inability to manage growth given labour-intensive manufacturing and wide range of SKUs.

STRATEGY NOTE PAG IN EQUITY November 17, 2016

Page Industries

BUY

Consumer Discretionary

Recommendation Mcap (bn): `176/US$2.6 6M ADV (mn): `151/US$2.3 CMP: `14,177 TP (12 mths): `16,400 Upside (%): 16

Flags Accounting: GREEN Predictability: GREEN Greatness: GREEN

Performance (%)

Source: Bloomberg, Ambit Capital Research

Page’s forensic score analysis


Page’s greatness score analysis


70

90

110

130

150

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

Page Inds. Sensex

Research Analysts

Rakshit Ranjan, CFA


Dhiraj Mistry, CFA


Page Industries


Exhibit 1: Evolution of Page Industries

Source: Ambit Capital research, * Split of men and women innerwear is available since FY10.

Exhibit 2: Page’s key financial parameters over the last decade


Revenues 1,375 1,945 2,584 3,441 4,977 6,966 8,758 11,876 15,430 17,834

Revenue growth 35% 42% 33% 33% 45% 40% 26% 36% 30% 16%

Net profits 170 238 316 396 585 900 1,125 1,537 1,960 2,327

EPS (`) 15 21 28 36 52 81 101 138 176 209

CFO 91 112 315 298 (2) 1,226 871 740 1,670 2,165

CFO (pre-tax)/EBITDA 63% 58% 84% 70% 31% 113% 79% 59% 83% 85%

FCF (45) (90) 43 62 (275) 959 430 280 1,139 1,902

Debt equity (x) 0.4 0.5 0.5 0.6 0.9 0.5 0.5 0.6 0.3 0.1

RoE 42% 33% 39% 43% 53% 62% 59% 61% 58% 52%

Pre-tax RoCE 47% 36% 42% 44% 48% 60% 64% 65% 64% 65%


Exhibit 3: The key things to note from the evolution of Page

Time period Phase Key developments/ initiatives

1959-1992 Establishing Jockey’s leadership in the Philippines

Genomal Vehromal (father of Sunder Genomal) got the licence to manufacture Jockey in the Philippines in 1959

Genomals got the master franchise of brand Speedo in Philippines in 1988 Jockey entered India in 1962 with Associated Apparels, and exited in 1973 Several innerwear brands expanded during 1980s and 1990s in India – Rupa, Amul, Lux Cozi, Neva,

Bodycare, Softy, Lady Care, Little Lacy, Red Rose etc.

1993-1997 Jockey re-enters India through Page

Page Apparel Manufacturing was incorporated in Nov 1994 in Bengaluru Men’s innerwear products launched in November 1995 First exclusive brand outlet launched in Bengaluru’s Commercial Street in 1995 Between 1995 and 1997, core team was hired (incl. Vedji Tiku and Pius Thomas) Competition for Jockey included strong brands like Liberty, Libertina and Tantex

1997-2003 Gearing up for competition

Competition intensified – Rupa and VIP were 7-8x larger than Jockey in sales TTK Tantex and Associated Apparel (Liberty/Libertina) fell prey to labour strikes In FY03, Page crossed `500mn in sales with a retail network of 10,000 outlets

2004-2015 Beating the competition

Page delivered 35% sales CAGR with at least one new product launch every year Some key new product launches – sub-brand ‘Jockey Zone’ for men’s in 2004, brassieres in 2005, ‘No panty

line promise’ in 2006, sub-brand ‘USA Originals’ in 2014, Kids innerwear in 2015, Towels in 2016 In 2007, Page raised `1bn from an IPO Brand campaign launch - ‘Just Jockeying’ (2010) and ‘Jockey or Nothing’ (2015) Speedo’s licence for India signed up in 2011 UAE was added as a new territory in 2011

Source: Ambit Capital Research, Company

30%

40%

50%

60%

70%

80%

90%

-

5

10

15

20

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

in ` bn

Others Liesurewear Women Men *Innerwear (Men + Women) Pre-tax ROCE (RHS)

Phase III - Gearing up for competition

Phase IV - Beating the competition

Page Industries


Exhibit 4: Competitive mapping of the company with its key peers

Revenues of FY16 (` mn)

3 yr Revenue

CAGR

Avg 3 yr EBITDA margin

Avg 3 yr CFO /

EBITDA

Avg 3 yr CFO/

Capex

Avg 3yr ROCE

Distribution channel type Segment presence

Page 17,834 27% 21% 76% 5.0 43% Distributor-based only Men and women innerwear; leisurewear, sportswear, swim wear

Rupa 10,148 9% 15% 38% 1.3 26% Wholesale largely Men innerwear, men leisurewear, thermal wear

VIP 1,946 3% 10% 82% 0.9 11% Wholesale largely Men and women innerwear

Lovable 1,725 7% 19% 22% 5.4 15% Wholesale + Distributors Women innerwear, women sportswear


Exhibit 5: Mapping Page and its peers on IBAS

Page Rupa VIP Lovable Comments

Innovation

Jockey (Parent) provides technology related innovation Page has 20 member R&D team to understand local consumer preferences Whilst Page launches one new product every year, product portfolio of peers largely

remains unchanged for 3-5 years in a row

Brand

Jockey has maintained an aspirational recall as an international brand Page doesn’t allow price discounts on its products, unlike others Page maintains premium look and feel of its stores, display racks and packaging

Architecture

Page uses in-house manufacturing with strong labour relationships vs outsourced manufacturing for peers

Page sells through distributor channel vs wholesale for Rupa/VIP Page follows a process-oriented approach towards operations management Page's HR philosophy includes empowerment of professionals and attractive incentive

structures for senior managers

Strategic Asset

Page has over 60 years’ of experience in expanding Jockey in the Philippines Access to Jockey's international experience and technology is a key strategic asset

Overall

Source: Ambit Capital research; Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

Exhibit 6: Sources of funds over FY07-16


Exhibit 7: Application of funds over FY07-16


Cash flow from

operations, 71%

Proceeds from shares,

4%

Debt raised, 24%

Interest received,

1%

Debt repayment,

5%

Dividend paid, 45%

Interest paid, 7%

Net Capex, 30%


cash equivalents,

14%

Page Industries


Exhibit 8: Band chart of Page one-year forward P/E


Exhibit 9: Page’s share price performance vs Sensex

Source: Company, Ambit Capital research; Note: price are rebased to 100



Accounting GREEN Page Industries' cash conversion has remained healthy and this has resulted in cumulative CFO (pre-tax)/EBITDA of above 70% in FY07-16. Page has maintained effective control on the working capital cycle, and hence despite high sales growth, WC days have increased marginally from 63 days in FY09 to 71 days in FY16.

Predictability AMBER Since FY16, Page Industries has twice beaten or missed consensus revenue estimates by more than 4%. The company has twice missed consensus net profit estimates by more than 4% and beaten once by more than 4%.

Earnings momentum GREEN In the last six months, consensus earnings forecasts for Page have been upgraded by ~3.5% for FY17 and FY18


Exhibit 11: Page’s forensic score has remained in zone of safety over 2011-15


Exhibit 12: Page’s greatness score has improved from 40 in 2011 to 95 in 2015


20

30

40

50

60

70

80

Oct

-11

Feb-

12

Jun-

12

Oct

-12

Feb-

13

Jun-

13

Oct

-13

Feb-

14

Jun-

14

Oct

-14

Feb-

15

Jun-

15

Oct

-15

Feb-

16

Jun-

16

Oct

-16

Page 1 year fwd P/E Average of 5yr P/E

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Mar

07

Sep

07M

ar 0

8Se

p 08

Mar

09

Sep

09M

ar 1

0Se

p 10

Mar

11

Sep

11M

ar 1

2Se

p 12

Mar

13

Sep

13M

ar 1

4Se

p 14

Mar

15

Sep

15M

ar 1

6Se

p 16

Page Sensex

Page Industries


Abridged financial summary Balance sheet



Reserves & surplus 3,756 4,941 6,203 7,850 10,050

Total net worth 3,868 5,052 6,315 7,961 10,162

Loan funds 1,344 734 734 484 234



Gross block 3,059 3,251 3,941 4,672 5,446

Net block 2,173 2,132 2,555 2,968 3,368

CWIP 1 4 4 4 4

Investments 0 0 0 0 0

Inventories 4,435 5,393 4,939 6,182 8,063

Debtors 884 1,034 1,190 1,545 2,016

Cash and cash equivalents 44 86 1,145 1,358 1,649

Loans & Advances 509 705 595 773 1,008



Creditors 821 941 1,071 1,391 1,814

Deposits from Dealers 556 735 869 1,128 1,472

Other current liabilities 1,028 1,234 1,369 1,777 2,318

Provisions 504 640 357 464 605



Total assets 5,326 5,897 7,159 8,556 10,506


Income statement


Net Sales 15,430 17,834 21,718 28,204 36,788

% growth 29.9% 15.6% 21.8% 29.9% 30.4%

Raw materials Cost 7,121 8,133 10,230 13,397 17,474

Employees cost 2,585 3,130 3,670 4,231 5,564

Royalty expenses 846 994 1,210 1,571 2,050

Advertisement expenses 714 670 903 1,044 1,324

Other Admin, S&D expenses 974 1,137 1,387 1,713 2,108

Total operating expenses 12,240 14,063 17,400 21,956 28,520

EBITDA 3,190 3,771 4,318 6,248 8,267

% growth 27.0% 18.2% 14.5% 44.7% 32.3%

Depreciation 176 238 266 318 374

EBIT 3,014 3,533 4,052 5,930 7,893

Non-operating Income 86 62 130 169 221


PBT 2,933 3,443 4,125 6,055 8,089

Tax expenses 973 1,116 1,320 1,938 2,588

Adjusted PAT 1,960 2,327 2,805 4,117 5,500

% growth 27.5% 18.7% 20.6% 46.8% 33.6%

Extraordinary items - - - - -



Page Industries


Cash flow statement


PBT 2,933 3,443 4,125 6,055 8,089

Depreciation 176 238 266 318 374

Others 96 102 (73) (125) (196)

Tax (966) (1,046) (1,320) (1,938) (2,588)

(Increase)/Decrease in working capital (569) (572) 220 (772) (1,258)

Cash flow from operating activities 1,670 2,165 3,218 3,538 4,421

Capex (534) (263) (689) (731) (775)

(Increase)/Decrease in investments - 1 - - -

Interest income 3 4 - - -

Others 3 - 130 169 221

Cash flow from investing activities (531) (258) (559) (562) (554)

Net borrowings (59) (624) - (250) (250)

Interest paid (171) (152) (57) (44) (25)

Dividend paid (899) (1,087) (1,543) (2,470) (3,300)

Cash flow from financing activities (1,129) (1,864) (1,600) (2,765) (3,575)

Net change in cash 10 43 1,059 212 291

Closing cash balance 43 86 1,145 1,358 1,649

Free cash flow 1,139 1,902 2,659 2,977 3,867


Ratio analysis


Gross margin (%) 53.8 54.4 52.9 52.5 52.5

EBITDA margin (%) 20.7 21.1 19.9 22.2 22.5

EBIT margin (%) 19.5 19.8 18.7 21.0 21.5

Net profit margin (%) 12.7 13.0 12.9 14.6 15.0

Dividend payout ratio (%) 49 49 55 60 60

Net debt/equity (x) 0.3 0.1 (0.1) (0.1) (0.1)

Asset turnover excluding cash (x) 3.2 3.2 3.4 3.7 3.9



Post-tax RoCE (%) 42.6 44.2 44.3 53.5 58.6

Pre-tax RoCE (%) 63.7 65.4 65.2 78.7 86.1

ROE (%) 58.0 52.2 49.4 57.7 60.7




EPS (`) 175.7 208.6 251.5 369.1 493.1

Book value per share (`) 347 453 566 714 911


P/E (x) 79.8 67.2 55.8 38.0 28.4

P/BV (x) 40.4 31.0 24.8 19.6 15.4

EV/EBITDA (x) 49.4 41.6 36.1 24.9 18.7

Price/Sales (x) 10.1 8.8 7.2 5.5 4.3

Dividend yield (%) 0.5 0.6 0.8 1.4 1.8



Competitive edge under threat Amara Raja has made rapid market gains in automotive battery segments (4W and 2Ws) led by Johnson Controls (JCI) parentage (low-cost manufacturing knowledge; hence, competitive pricing vs Exide) and innovation surrounding products/advertising. We expect market share gains for AMRJ to slow as Exide attempts comeback through aggressive pricing/cost cutting. The current expensive valuation multiples (25x FY19E net earnings) do not appear sustainable as long-term RoCE will moderate due to rising capital intensity for investments in new technologies and changes to business model from Lithium-ion adoption.

Competitive position: STRONG Changes to this position: POSITIVE

Second-largest battery player in India

AMRJ is a JV between the Galla family and JCI (world’s largest lead acid battery player). AMRJ’s automotive segment (~56% of FY16 revenues) is a play on automotive volume recovery (at 18/1,000 people, India has among the lowest PV penetrations). The key growth drivers are market share gain from unorganised segment and market leader Exide. The Industrial segment is, however, very dependent on telecom segment (slowly shifting to lithium-ion) and recovery in industrial activity.

JCI provides strategic edge

AMRJ started as an Industrial battery player (in 1975), ventured into the Automotive battery segment, with a JV with JCI in 2000. Driven by competitive pricing, aggressive warranty terms and distribution expansion, it gained significant market share across both 4W OEM (30% market share) and replacement (41% market share). Despite late entry, it now commands 15% and 28% market share in 2W OEM and replacement. Over the last 10 years, AMRJ has grown its revenue and EBITDA by 26% and 29% CAGR respectively.

Market share gains to slow down

AMRJ’s tie-up with JCI imparts superior technology, lower production cost and competitive pricing over Exide. Further, it also scores over Exide on innovative advertisement/communication. As battery technologies such as lithium-ion evolve, strategic global partnerships and low-cost architecture will play a key role. However, AMRJ’s cost advantage is under threat from Exide’s growing focus on cost control. This should slow AMRJ’s market-share gains, particularly in the lucrative auto replacement segment (1,600bps over FY09-16).

Current valuation akin to a consumer company is unjustified

We are concerned about slowdown in: (1) the lucrative automotive replacement battery industry (30% of AMRJ’s revenue) given muted OEM volume across vehicle categories over FY12-16 and Exide’s increased focus on cost control/technology upgrade; and (2) telecom battery segment (24% of AMRJ’s revenue) due to lower tower addition over FY12-16. So, we expect revenue and EBITDA to grow at a slower pace of 12% and 11% CAGR respectively over the next 10 years. JCI’s parentage does provide better long-term visibility but technology changes (lithium-ion, advances in lead-acid) over the next decade could erode some key competitive advantages. Current multiples seem rich and akin to consumer stocks though battery business drivers are not as sustainable. We are SELLers of the stock with a target price of `763, implying 20x one-year forward net earnings. The stock currently trades at 27.4x FY18E net earnings.

STRATEGY NOTE AMRJ IN EQUITY November 17, 2016

Amara Raja Batteries

SELL

Auto & Auto ancillaries

Recommendation Mcap (bn): `165/US$2.4 3M ADV (mn): `406/US$6.1 CMP: `960 TP (12 mths): `763 Downside (%): 20


Performance


Amara Raja’s forensic score analysis


Amara Raja’s greatness score analysis


8090

100110120130

Nov

-15

Dec

-15

Jan-

16

Feb-

16M

ar-1

6A

pr-1

6M

ay-1

6Ju

n-16

Jul-

16A

ug-1

6Se

p-1

6O

ct-1

6

Amara Raja Batt. Sensex

Research Analyst Details Ashvin Shetty, CFA +91 22 3042 3285 [email protected]

Gaurav Khandelwal, CFA +91 22 3042 3132 [email protected]

Ritu Modi +91 22 3042 3292 [email protected]



Exhibit 1: Amara Raja has emerged as a formidable player in the automotive battery segment…


Exhibit 2: … through better quality products at a lower price…

Phase Time period Key developments

Phase-I FY1996-2000 Emerged as a major player in the industrial battery segment Won several prestigious contracts from industrial customers like DoT (for rural telecommunication programme)

and ONGC (power supplies on offshore platforms)

Phase-II FY01-08 Entry into automotive segment in 2000 through JV with Johnson Controls Started with the more lucrative 4W aftermarket segment Later won OEM contracts with key players like Maruti and Hyundai

Phase-III FY09-16

Gained significant share in automotive segment from Exide Amara Raja’s better technology, lower price, expanding distribution contributed to share gains Exide’s complacency (lack of capacities/shortage in replacement market)/capital allocation issues (foray into

insurance business) helped Amara Raja Source: Company, Ambit capital research

Exhibit 3: … allowing it to earn superior returns


Revenues 5,958 10,833 13,132 14,645 17,611 23,645 29,614 34,367 42,113 46,907

Revenue growth (%) 64% 82% 21% 12% 20% 34% 25% 16% 23% 11%

Net profits 479 909 1,115 1,550 1,479 2,024 2,898 3,621 4,125 4,768

EPS 4.2 8.0 6.5 9.1 8.7 11.8 17.0 21.2 24.1 27.9

CFO (pre-tax) (146) 328 2,776 2,927 1,638 4,011 4,721 4,394 5,872 7,729

CFO (pre-tax)/EBITDA -18% 18% 138% 101% 63% 118% 104% 78% 83% 95%

FCF (1,056) (1,333) 1,335 1,627 195 2,176 1,892 (943) (112) 643

Net-debt equity (x) 0.5 0.8 0.5 0.1 0.1 (0.2) (0.3) (0.2) (0.1) (0.0)

RoE (%) 19.6% 27.3% 27.5% 28.5% 22.9% 24.6% 27.3% 26.6% 24.3% 23.7%

ROCE* (%) 23.2% 31.9% 27.7% 40.7% 32.3% 40.4% 51.5% 49.3% 40.6% 36.4%


-20%

0%

20%

40%

60%

80%

100%

120%

(8)

2

12

22

32

42

52

FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

`. b

illi

on

AMRJ's Revenues (LHS) AMRJ's ROCE % (Pre-tax) (LHS)

Launched 4W battery

Launched CV and Tractor battery

Won OE orders from Maruti and Hyundai

Launched 2W battery

Phase I- Emergence as a strong industrial battery player

Phase II- Foray into automotive segment through JV with Johnson Controls

Phase III- Finding success across various automotive battery segments.

Revenue CAGR: 32% Median RoCE: 84.4%





Exhibit 4: Amara Raja has been able to gain the scale required to generate healthy returns

Particulars Amara Raja

Exide Industries Comments

Aftermarket network >30,000 38,500 Amara Raja has established a network size of more than 30,000 in 15 years as compared Exide’s 38,500 developed over decades.

Number of plants 2 7

Amara Raja's plants are relatively new and more efficient compared to Exide’s old plants which are operating with old equipment.

Amara Raja’s both plants are located in close vicinity of each other, as compared to Exide plants which are spread across India. This has helped Amara Raja operate its plant at lower overheads vs Exide.

Market share in four-wheeler OEM 31% 59% Amara Raja has gained significant market share across both 4W OEM and replacement driven by competitive pricing, aggressive warranty terms and distribution expansion.

Market share in four-wheeler replacement 41% 56%

Revenues (FY16 ` mn) 46,907 68,246 From FY11-16, Amara Raja has gained significant market share in both OE and aftermarket segments from Exide due to its better quality product and lower price (enabled by lower cost of manufacturing).

Shortage of capacity at Exide Industries also benefited Amara Raja. During 2009-10, automobile volumes picked up sharply and Exide took a strategic decision to cater to the full requirement of the OE customers thereby underplaying the more profitable aftermarket. This enabled Amara Raja to become a major player in the aftermarket through its ‘Amaron’ brand. Amara Raja’s market share in the 4W aftermarket segment improved to 41% in FY16, an increase of 1600 bps over FY09-16.

Revenue CAGR FY11-16 34% 16%

EBITDA margin (FY16) 17.4% 15.0% Amara Raja benefited from improving product mix with rising contribution from the higher-margin replacement segment, increasing utilisation levels and more cost efficient operations (deployed best manufacturing practices of Johnson Controls). As against this, Exide suffered market share loss in profitable 4W replacement market and rising overheads.

Change in EBITDA Margin (FY11-FY16) (+)290 bps (-)430bps

Pre-tax CFO/ EBITDA (Average FY11-16) 90% 96% Lower working capital levels have helped cash conversion for both the companies.

Capex to CFO (Average FY11-16) 79% 47% Amara Raja has been continuously investing over the years to expand its 4W and 2W capacities. It also invested in UPS capacities which were earlier sourced from outside.

Exide on the other part made significant investment in FY15/16 (`8bn) to upgrade their technology and plants & machinery. Apart from this, Exide also made significant investments in the insurance business which now represents 53% of its FY16-end capital employed.

Capex and Investments to CFO (Average FY11-16) 79% 63%

Post-tax RoCE (Average FY11-16) 28% 23% Higher margins and lower capex enabled Amara Raja to generate higher returns vs Exide.

Source: Company, Ambit Capital



Exhibit 5: Strong Innovation capabilities and Brand places Amara Raja on top in our IBAS framework

Parameters Amara Raja Exide Remarks

Innovation

A) Does the company have an agreement with a foreign partner for technology?

JV with Johnson Controls Inc.

Technological agreement

Hitachi, Japan

AMRJ brought zero maintenance batteries (Amaron Hi-Life) into the Indian market, which was a key differentiator from the batteries which required regular maintenance and top-ups. Similarly, it pioneered the introduction of VRLA batteries for the 2W segment (Amaron Pro-bike rider) in May 2008, which was suited for rising power needs of 2Ws due to adoption of self-start bikes.

AMRJ offered aggressive warranty terms; for instance, it introduced Amaron Pro-range of automotive batteries in FY2005 with a first of its kind 48 month warranty.

Rank

B) Was the company first to innovate and have competitors copy it? Yes Yes

Rank

Overall position in Innovation

Brands/Reputation

A) What is the ranking of the company in the industry?

Market Challenger in a Duopoly industry

Market Leader in a Duopoly industry

AMRJ has emerged as a strong challenger to Exide over the years and closed the difference in brand perception to a significant extent. However, build upon its decades of presence in India and a large number of installations in the existing car park, Exide still commands a greater brand recall.

Rank

B) Does the company spend more than industry level on advertising, sales promotion, publicity?

1.2% of sales 0.8% of sales

Rank

Overall position in Brands

Architecture

Does the company employ superior manufacturing practices?

AMRJ employs superior manufacturing practices through its business alliance with JCI. AMRJ commands low rejections/higher yield which is one of the reasons for its higher gross margin despite pricing its products cheaper than Exide.

AMRJ has had consistently low employee and overhead costs compared to that of Exide mainly because of its concentrated manufacturing plants.

Rank

Overall position in Architecture

Strategic Asset

A) Has the company demonstrated cost competitive edge over competition? Yes No JCI commands a much dominant position in the global lead-

acid battery industry with significantly higher R&D spends. JCI’s parentage provides an edge to AMRJ. It also helps that JCI owns 26% equity stake in AMRJ. On the other hand, while Exide has technical tie-ups with East Penn, Shin-Kobe (Hitachi) and Furukawa, there is no equity participation.

Captive smelters have historically lent significant cost advantage to Exide. However, recycling of lead has increased in India over the years and the price of the used batteries (that dealers pay to customers) has witnessed a spike, somewhat negating Exide’s cost advantage on this front.

Rank

B) Does the company have more

manufacturing facilities in India than its competition?

2 mfg. facilities 7 mfg. facilities

Rank

Overall position in Strategic Asset

Overall Score in IBAS

Strong Innovation capabilities, Improving brand perception and better cost control places Amara Raja ahead of Exide Industries in our IBAS framework.

Source: Company, Ambit Capital. Rank 1; Rank 2



Exhibit 6: Cash generated over the years...


Exhibit 7: ... has largely been used to fund expansion


Exhibit 8: Stock trades at 27.4x one-year forward net earnings, 50% premium to five-year average multiples


Exhibit 9: AMRJ has multiplied ~37x in the last 10 years as compared to ~2x by Sensex




Accounting GREEN AMRJ’s scores relatively well in our accounting and forensic framework. AMRJ’s key accounting ratios such as cash yield, CFO-EBITDA conversion, miscellaneous expenditure (as a % of sales) was much higher than other listed peers. On Ambit’s forensic accounting, AMRJ is categorised in the 3rd decile of the Auto ancillary universe.

Predictability AMBER

The OEM business (15% of the revenue) tends to be volatile. However, the replacement demand (35% of the revenue) is more stable as battery required replacement in 2-3 years. Industrial volumes (44% of the revenue) are also volatile and linked to telecom sector performance and industrial activity. Moreover, Lead (and lead alloys) which is a volatile commodity is the key raw material in battery manufacturing and constitutes 60-65% of the material cost (35%-40% of the sales revenue). However, Lead price is a pass-through for ~65% of the sales (auto OEM and Industrial).

Earnings momentum AMBER Bloomberg shows no significant upgrades/downgrades to consensus numbers in recent weeks.


CFO 96%

Interest & dividend received

4%

Capex 78%

Change in net debt

4% Dividends

17%

Finance charges

1%

0

5

10

15

20

25

30

35

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

1 yr forward P/E (x) 5 yr Average P/E

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Nov

-06

Jul-

07

Mar

-08

Nov

-08

Jul-

09

Mar

-10

Nov

-10

Jul-

11

Mar

-12

Nov

-12

Jul-

13

Mar

-14

Nov

-14

Jul-

15

Mar

-16

Retu

rn p

erc

en

tag

e

Amara Raja Sensex index



Exhibit 11: AMRJ scores high in our forensic framework...


Exhibit 12: …and greatness framework




Balance sheet (standalone)


Share capital 171 171 171 171 171

Reserves and surplus 16,825 19,974 24,283 29,209 34,857

Total Networth 16,996 20,145 24,453 29,380 35,027

Loans 759 741 678 615 552


Sources of funds 18,123 21,475 25,720 30,584 36,168

Net block (inc CWIP) 10,785 14,485 16,339 16,839 17,438

Investments 161 161 161 161 161

Cash and bank balances 2,221 1,498 3,173 6,839 11,021

Sundry debtors 5,541 5,921 6,664 7,458 8,373

Inventories 4,181 6,016 6,771 7,577 8,507

Loans and advances 992 1,002 1,127 1,262 1,416

Current assets 12,935 14,437 17,735 23,136 29,318

Current liabilities and provisions 5,757 7,608 8,514 9,552 10,749


Application of funds 18,123 21,475 25,720 30,584 36,168


Income statement (standalone)


Revenue 42,113 46,907 52,787 59,077 66,327

% growth 22.5% 11.4% 12.5% 11.9% 12.3%

Total expenses 35,005 38,738 43,594 48,789 54,776

% growth 21.8% 10.7% 12.5% 11.9% 12.3%

EBITDA 7,108 8,169 9,193 10,288 11,550

Net depreciation 1,260 1,399 1,746 2,000 2,222

EBIT 5,849 6,770 7,447 8,288 9,329

Interest 7 5 5 5 5

Other Income 273 330 358 531 779

PBT after EO 6,115 7,095 7,799 8,814 10,103

Provision for taxation 1,990 2,327 2,558 2,821 3,233

Adjusted PAT 4,125 4,768 5,241 5,994 6,870

% growth 13.9% 15.6% 9.9% 14.4% 14.6%

Reported PAT 4,104 4,894 5,241 5,994 6,870

Adjusted EPS diluted (`) 24.1 27.9 30.7 35.1 40.2




Cash flow statement (standalone)


EBIT 6,099 7,222 7,799 8,814 10,103

Depreciation 648 1,340 1,399 1,746 2,000

Others (305) (116) (215) (353) (526)

Direct taxes paid (1,606) (1,922) (2,181) (2,558) (2,821)

Change in working capital (1,315) (1,450) (677) (778) (832)

CFO 3,519 5,074 6,125 6,871 7,924

Capex (3,731) (4,062) (4,904) (3,600) (2,500)

Other expenses 282 182 190 358 531

CFI (3,448) (3,880) (4,714) (3,242) (1,969)

Proceeds from borrowings (27) (97) (18) (63) (63)

Interest paid (0) (2) (5) (5) (5)

Dividends paid (504) (645) (1,614) (871) (933)

CFF (531) (745) (1,637) (939) (1,001)

Change in cash (460) 448 (226) 2,690 4,955

Closing cash 746 1,498 3,173 6,839 11,021

Free cash flow (112) 643 2,257 4,136 4,538


Ratio analysis (standalone)


EBITDA margin 16.9% 17.4% 17.4% 17.4% 17.4%

EBIT margin 13.9% 14.4% 14.1% 14.0% 14.1%

Net profit margin 9.8% 10.2% 9.9% 10.1% 10.4%

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

RoCE (pre-tax) 40.6% 36.4% 33.8% 34.6% 36.7%

RoCE (post-tax) 27.4% 24.5% 22.7% 23.5% 24.9%

RoE 24.3% 23.7% 21.4% 20.4% 19.6%


Valuation parameters (standalone)


EPS (`.) 24.1 27.9 30.7 35.1 40.2

Diluted EPS (`.) 24.1 27.9 30.7 35.1 40.2

Book value per share (`.) 100 118 143 172 205

Dividend per share (`.) 3.6 4.3 4.6 5.2 6.0

P/E (x) 39.8 34.4 31.3 27.4 23.9

P/BV (x) 9.6 8.1 6.7 5.6 4.7

EV/EBITDA (x) 23.0 20.0 17.8 15.9 14.1

EV/EBIT (x) 27.9 24.1 21.9 19.7 17.5



Will it stand the test of time? GRUH has the strongest positioning in the affordable housing finance due to its innovative credit scoring (first to credit score low-income borrowers), strong local knowledge (well penetrated and decentralized branches) and backing of the behemoth HDFC. Combined with a decadal surge in real-estate prices, such strengths have driven GRUH’s superior profitability and growth over FY06-16 (avg. RoE of 30% and AUM CAGR of 26%). However, declining real estate prices and increasing competition in affordable housing finance have led to moderation in earnings growth (EPS growth of 20% in FY16 versus 28% CAGR over FY10-15). GRUH’s lofty valuations (10x 1-year fwd P/B, 100% premium to its peers) will be tested by such declining earnings momentum.

Competitive position: STRONG Changes to this position: NEGATIVE

Play on the rural mortgage opportunity

Set up in 1986, GRUH is a subsidiary of HDFC (owns 59%). It provides housing loans in rural and semi-urban areas, operating primarily in the Gujarat and Maharashtra, which account for ~70% of its loan book. With a modest loan book of ~`120bn, GRUH accounts for less than 1% market share in mortgages and has averaged loan growth of ~27% over FY06-16, making it a promising play on the rural mortgage opportunity in India. Strong focus in informal segment has driven robust growth and RoE

Since the stressful period of 1996-98, GRUH has moved away from the developer loan segment to individual home loans where asset quality and profitability were higher. Hence, share of individual home loans increased from 61% of loan book in FY97 to 97% by FY02, resulting in RoE improving from 3% in FY98 to 22% in FY04. Since then RoE has never dipped below 24% as it has single-mindedly focused on small-ticket home loans to informal segments. High RoE over the past ten years (average RoE of ~30%) implied that it didn’t need to raise capital despite growing at 27% CAGR and simultaneously sustaining a generous dividend payout of ~43% during the same period.

Innovation and architecture drive competitive advantages GRUH is one of the strongest HFCs on the IBAS framework due to: (i) its innovative products and appraisal techniques (first HFC to introduce credit scoring for low-income borrowers); ii) a well penetrated and decentralized branch architecture underpinning its strong local area knowledge and superior sourcing of low-ticket customers (despite low ticket sizes, credit costs have been minimal at average of ~20bps over past ten years); iii) HDFC’s parentage, which enables it to get a better cost of funding, credit appraisal process and management quality; and (iv) strong local reputation owing to its superior and transparent customer service relative to peers. However, regulatory and competitive headwinds pose risk to its earnings growth.

Valuations could be tested by declining earnings momentum

Mortgage financers have re-rated over the past two years at the cost of corporate lenders due to the latter’s shaky earnings trajectory due to asset quality concerns. A combination of such fundamental and sentimental factors underpins GRUH’s premium valuations. However, such peak valuations could be tested by a declining earnings momentum (EPS growth of 20% in FY16 versus 28% CAGR over FY10-15) due to slower growth (24% in FY16 versus 30% CAGR over FY10-15) caused by declining real estate prices and increasing competitive intensity in the small-ticket housing finance. Moreover, HFCs are exposed to the looming regulatory risk of convergence of loan pricing to a more transparent and objectively calculated base rate (which is followed by banks).

STRATEGY NOTE GRHF IN EQUITY November 17, 2016

GRUH Finance

NOT RATED

BFSI

Recommendation Mcap (bn): `103/US$1.5 3M ADV (mn): `143/US$2.1 CMP: `282 TP (12 mths): NA Downside (%): NA


Performance


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

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

80

100

120

140

160

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

GRUH Finance Sensex

GRUH Finance


Exhibit 1: Evolution of GRUH – good times have ended due to competitive and regulatory headwinds


Exhibit 2: GRUH – key financial parameters over the last decade


Interest Income 10.0% 10.8% 12.3% 11.1% 11.0% 12.3% 12.3% 12.2% 12.0% 11.4%




Total Income 4.2% 4.5% 4.0% 4.8% 5.0% 5.1% 4.7% 4.5% 4.5% 4.4%


Employee Expenses 0.4% 0.4% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.4% 0.4%

Admin Expenses 0.6% 0.5% 0.4% 0.5% 0.5% 0.5% 0.4% 0.4% 0.4% 0.4%


Loan loss provisions 0.5% 0.2% 0.1% 0.3% 0.1% 0.1% 0.1% 0.04% 0.2% 0.2%


Taxes 0.5% 1.0% 0.8% 1.0% 1.1% 1.1% 1.0% 1.0% 1.1% 1.1%

RoA 2.2% 2.3% 2.1% 2.6% 2.9% 3.0% 2.9% 2.7% 2.4% 2.3%

Leverage 11.0 10.2 11.4 11.0 10.8 11.5 11.8 12.1 12.9 13.9

RoE 23.9% 23.7% 24.3% 28.4% 31.4% 34.2% 34.2% 32.2% 30.9% 31.5%

AUM growth (%, YoY) 29% 29% 18% 18% 29% 28% 33% 29% 28% 24%

EPS growth (%, YoY) 16% 30% 19% 37% 31% 31% 20% 20% 14% 19%


Exhibit 3: Emerging regulatory & competitive headwinds led to slower growth and lower profitability recently


The good times FY05-14

GRUH’s robust growth (28% CAGR) during this period was driven by both increasing customer acquisition (due to benign competition) and increasing ticket size per loan (due to real estate prices).

Regulatory headwinds emerged FY11 onwards such as introduction of base rate system (which led to increasing cost of funds) and removal of prepayment penalties (leading to higher churn in the loan book and reduction in fee-income). However, GRUH was able to price in such increased costs to its customers due to benign competition and relatively small market share in key geographies. Its RoAs sustained at 2.5% during this period.

Headwinds emerge

FY14-Current

During this period, HFCs have seen hyper-competition from banks in home loans due to: i) lack of any opportunities in corporate loans due to slowdown; and ii) regulators incentivising affordable housing in FY15 by reduction of risk weights and exemption on SLR/CRR and PSL requirements. Moreover decline in real estate prices have also let to moderation in ticket size growth (which used to drive 50-60% of growth of HFCs).

Such headwinds mentioned above led to slowdown in growth as well as pressure in profitability for HFCs including GRUH. GRUH’s growth has slowed down to 24% YoY in FY16 (versus 28% CAGR in FY05-14) and RoAs moderating to 2.3% from an average of 2.5% in FY05-14.


20%

25%

30%

35%

40%

45%

- 20 40 60 80

100 120 140 160



The good times AUM CAGR 28% NIMs 4.5% RoAs 2.5%

Headwinds emerge AUM Growth 24% NIMs 4.2% RoAs 2.3%

GRUH Finance


Exhibit 4: Competitive mapping of HFCs – GRUH’s small-ticket positioning makes drives its superior profitability Key metrics (FY16)

Avg. ticket size (` mn) AUM (` bn) AUM CAGR

(FY13-16) NIMs Opex/AUM Gross NPA (%) RoA RoE Branches

(#) Employees

(#)

GRUH 0.5 111 27% 4.2% 0.8% 0.32% 2.3% 31.5% 179 618

HDFC 2.5 2,908 16% 3.1% 0.3% 0.70% 2.4% 21.8% 401 2,196

LICHF 1.2 1,252 17% 2.6% 0.4% 0.45% 1.5% 19.6% 234 1,726

REPCO 1.1 77 29% 4.9% 1.0% 1.30% 2.2% 17.0% 150 619

CANFIN 1.7 106 38% 3.1% 0.7% 0.19% 1.6% 19.0% 140 553

DEWAN 1.2 695 24% 3.0% 0.9% 0.93% 0.9% 11.9% 353 2,625

PNBHF 3.7 272 60% 3.8% 1.2% 0.22% 1.4% 17.6% 47 752




Innovation


Brand


Architecture


Strategic asset


Overall rank



Exhibit 6: AUM mix


Exhibit 7: Liability mix


52% 29%

11%

3% 4% Home loan - Salaried

Home loan - Selfemployed

LAP - Residential

LAP - Non Residential

Construction Loans

39%

38%

14%

9% NHB

Bank loans

Public deposits

Others

GRUH Finance


Exhibit 8: NIMs are declining due to competitive pressures


Exhibit 9: Asset quality is worsening


Exhibit 10: GRUH is trading at 60% premium to its cross-cycle average P/B


Exhibit 11: GRUH – share price performance versus sensex




Accounting GREEN GRUH’s revenue and expense recognition policies are by far the most conservative amongst the peers. We do not come across any instance wherein the reported profitability of the company is materially different from its true profitability.

Predictability GREEN GRUH’s earnings trajectory has been fairly predictable. It has delivered a clockwork 20% earnings growth for at least past 18 quarters.

Earnings momentum AMBER Pressure on AUM growth and profitability has led to GRUH’s earnings growth moderating from 30% PAT CAGR over FY07-14 to 20% PAT CAGR over FY14-16.


4.0%

4.2%

4.4%

4.6%

4.8%

5.0%

5.2%

5.4%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

NIM

0.0%

0.5%

1.0%

1.5%

2.0%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Gross NPA

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Apr

-10

Sep-

10

Feb-

11

Jul-

11

Dec

-11

May

-12

Oct

-12

Mar

-13

Aug

-13

Jan-

14

Jun-

14

Nov

-14

Apr

-15

Sep-

15

Feb-

16

Jul-

16


-

500

1,000

1,500

2,000

2,500

3,000

Apr

-07

Apr

-08

Apr

-09

Apr

-10

Apr

-11

Apr

-12

Apr

-13

Apr

-14

Apr

-15

Apr

-16

SENSEX GRUH

GRUH Finance


Income statement

Year to March (` mn) FY12 FY13 FY14 FY15 FY16

NII (inclu. Securitisation) 1,871 2,311 2,707 3,437 4,212

Other income 170 149 319 389 468

Total income 2,041 2,460 3,025 3,826 4,680

Operating expenditure 392 463 556 661 844

Pre-provisioning profit 1,649 1,997 2,469 3,165 3,836

Provisions 22 29 24 157 219

Profit before tax 1,627 1,968 2,445 3,008 3,617

Tax 424 509 675 970 1,181

Consol. PAT 1,202 1,500 1,770 2,038 2,436


Balance sheet


Net-worth 3,856 4,910 6,072 7,115 8,353

Borrowings - on balance sheet 38,330 49,145 64,475 67,453 102,444

Borrowings - off balance sheet 0 0 0 0 0


AUM 40,774 54,378 70,090 89,544 111,146

Cash and equivalents 1 652 530 798 1,429

Net Current Assets 1,410 (974) (73) (15,775) (350)

Total assets 28,134 36,990 46,431 59,165 74,927


Key ratios


NIM % (on AUM) 5.2% 4.9% 4.3% 4.3% 4.2%

AUM Growth 28% 33% 29% 28% 24%

Opex as % of AAUM 1.08% 0.97% 0.89% 0.83% 0.84%

Credit costs as a % of AUM 0.06% 0.06% 0.04% 0.20% 0.22%

CAR (%) 14.0% 14.6% 16.4% 15.4% 17.8%




Dil EPS – Consol (`) 3.4 8.2 4.9 5.6 6.7

BVPS (`.) 11 14 17 20 23

ROA (%) 3.0% 2.9% 2.7% 2.4% 2.3%

ROE (%) 34.2% 34.2% 32.2% 30.9% 31.5%

P/B (x) 25.8 20.6 16.7 14.4 12.3

P/E (x) 82.6 34.4 57.4 50.3 42.1


GRUH Finance


This page has been intentionally left blank


Long-term growth path Dr Lal PathLabs is the largest diagnostics chain in India by revenues; it recorded 35% sales CAGR and 78% PAT CAGR over FY07-16 driven by: 1) aggressive geographical expansion; 2) acquisition of smaller labs; 3) market-share gain from low-quality unorganised players (48% share now); and 4) acquiring customers through branding, not commission-based referrals by doctors. Sales growth of mid-to-high teens with steady margins and return ratios will continue given: 1) low penetration rate of healthcare; 2) socio-economic tailwinds; and 3) continued market-share gains from unorganised players. Valuation at 61x FY18E P/E is at a 100% premium to FMCG sector justified by potentially higher growth rates while delivering FMCG-like EBITDA margins and RoIC. Key risks: Price disruption and increased competition from other labs.


Sustained quality leadership in Indian diagnostics space

Dr Lal started operations in 1949 and is one of the pioneers in the diagnostics industry in India. It is highly focused on technology to provide high quality customer experience, faster turnaround time and wider array of tests with higher accuracy vs unorganised peers. More than 20 labs of Dr Lal are certified by National Accreditation Board. With `7.9bn in revenues (FY16), 175 labs, 1,500 patient service centres and annual throughput of 26mn+ samples, Dr Lal is the largest diagnostics chain in India. Dr Lal’s 35% sales CAGR (last 10 years) is unlikely to sustain given high base but a higher-than-industry growth rate of mid-to-high teens is possible. Focus on quality is helping to grow market share

Diagnostics in India is highly fragmented (unorganised hold 48% market share). Organised chains hold only 15% of revenues. Dr Lal, the largest player, has only 2% market share. Though globally, the industry is fragmented, market leaders tend to have 10-20% market share (e.g. Quest in USA has 10% share, Miraca in Japan has 21% share, DAAS in Brazil has 18% share, and Sonic in Australia has 43% market share). Dr Lal can continue to consolidate its market-leading due to: 1) shifting of sales from unorganised to organised; 2) geographical expansion beyond North and East; and 3) acquiring smaller/regional labs.

Investing for growth to ensure competitive advantage sustains We believe, given the high base and rising competition from national and regional chains, Dr Lal will have to continue investing in growth. Steps being taken to maintain market leadership in terms of growth and quality are: 1) setting up of two reference labs for capex of `1bn; 2) continuous expansion of an array of tests, including for latest epidemics like the Zika virus; 3) pricing discipline with annual hikes averaging 2-3%, which is much lower than inflation; 4) addition of satellite labs in new cities to enhance reach; and 5) acquisition of smaller/regional labs. While these steps will drive growth, RoIC will be hit. However, given high RoIC (50%+), we are not overly worried about this.

Valuation is rich as investors are focusing on long-term growth

Trading at 61x FY18 consensus P/E, Dr Lal appears rich. However, we believe Dr Lal combines the higher growth potential of the consumer discretionary sector but at the economics of the consumer staples sector. This combination of higher growth and healthy profitability, return ratios and cash generation is unique and justifies the 100% premium over consumer staples and 33% premium over the consumer discretionary basket.

STRATEGY NOTE DLPL IN EQUITY November 17, 2016

Dr Lal PathLabs

NOT RATED

Healthcare

Recommendation Mcap (bn): `93/US$1.4 3M ADV (mn): `188/US$2.8 CMP: `1,135 TP (12 mths): NA Downside (%): NA

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: GREEN

Performance


80

130

180

230

280

Dec

-15

Jan-

16

Feb-

16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-

16

Aug

-16

Sep-

16

Oct

-16

Dr Lal Pathlabs Sensex

Research Analyst

Anuj Bansal

+91 22 3043 3122

[email protected]

Dr Lal PathLabs


Exhibit 1: Tale of two halves over the last decade

Source: Ambit capital research


(` mn) FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Revenues 945 1,230 1,670 2,373 3,422 4,517 5,579 6,596 7,913

Revenue growth (%) 24% 30% 36% 42% 44% 32% 24% 18% 20%

Net profits 86 128 252 295 452 557 803 964 1,059

EPS 1.6 2.4 4.5 3.6 5.6 6.8 9.7 11.6 16.1

CFO 522 2,926 2,396 2,591 6,802 711 5,979 6,231 6,630

Pre-tax CFO-EBITDA 144% 105% 151% 135% 136% 95% 177% 111% 125%

FCF 63 103 234 438 559 380 974 700 904

Debt equity (x) 0.0 0.0 0.0 0.2 0.0 0.0 0.0 - -

RoE (%) 13% 16% 26% 32% 43% 40% 41% 34% 25%

Pre-tax RoCE (%) 31% 46% 83% 49% 73% 90% 127% 110% 92%




Pre 2005 Dr S.K Lal and Dr Arvind Lal run the company as a family business

Business started in 1949 by Dr Major S.K. Lal Dr Arvind Lal (son of Dr S.K. Lal) took over as the Chairman of Dr Lal PathLabs in 1977 Under his leadership the company modernised and adopted Information and Communication Technology

(ICT). The company also expanded beyond Delhi NCR. In 2004, Dr Lal PathLabs became first Indian Diagnostic chain to get into a Public Private Partnership with

Government of Tripura

2005-2014 Dr Om Manchanda joins as COO and promoted to CEO in 2008

Helped convert a family run business into a professional entity Revenues grew 11x in 10 years at a 30% CAGR mainly driven by rapid geographic expansion and

acquisition of smaller labs Profitability improved significantly, going up from `10mn to `1.8bn over FY06 to FY16

Post 2014 Growth is strong but at a higher cost

Level of investments set to rise to ensure growth levels are maintained. This should cap profitability and return ratios going forward

With two new reference labs coming up, quality of service should improve further Focus will be firmly on growing in North and East with West and South to be tapped either inorganically or

through selected clusters


15%

25%

35%

45%

10%

50%

90%

130%

FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Pre-tax ROCE (%) Revenue growth (RHS, %)

Phase 1: With penetration rates low, rapid geographic expansion, share gains and acquisition of smaller labs for lower price helped strong revenue growth while driving up RoCE

Phase 2: As base expanded, smaller players became organised, valuations for M&A moved up – scope for revenue growth moderated and incremental RoIC for this growth became lower

Dr Lal PathLabs


Exhibit 4: Competitive mapping of Britannia


FY16 revenue (` bn)

Revenue CAGR

FY11-16

Industry market

share


Pre-tax RoCE

(FY16)

Pre-tax CFO/ EBITDA

(FY11-16)

Capex/CFO (FY11-16)

Dr Lal #1 79.1 27% ~2% 23% 92% 130% 15%

SRL #2 77.4 14% ~2% 24% NA NA NA

Thyrocare #4 23.5 25% ~1% 40% 74% 108% 30%

Source: Company, Ambit Capital research; Note: For ITC we have taken the FMCG segment revenues

Exhibit 5: Mapping Dr Lal and its peers on IBAS

Dr Lal SRL Thyrocare Metropolis Comments

Innovation 4 3 1 3

In terms of back-end systems or sample collection and logistics, all four are fairly well placed.

Key difference is range of tests provided where Dr Lal leads (4,600) followed by SRL (3,500) and Metropolis (4,500).

Thyrocare has a limited test portfolio (200 tests) and focuses just on basics.

Branding 3 4 2 3

SRL has a well-established brand with presence across pan-India (revenue split is even).

Dr Lal (North and East) and Metropolis (West) are also strong brands but with limited geographic reach.

Thyrocare is better known for Thyroid tests and its Aarogyam brand for preventive health check-ups is still work in progress

Architecture 2 3 2 3

SRL through higher presence in hospitals, more accredited labs (37) and more doctors (700) has a better ecosystem.

Dr Lal is largely dependent on franchisees which have high churn rate of 15-20% and fewer certified labs (20) and doctors (175).

Thyrocare also has a weaker ecosystem which is completely dependent on franchisees which compromises customer experience and quality

Strategic Assets 4 4 3 3

High class reference lab for Dr Lal in Delhi. Synergies with Fortis Hospitals for SRL provide better branding and customer reach Thyrocare's reference lab is relatively limited in its ability due to limited number of

tests supported by it.

Overall 3 4 2 3 Dr Lal is a strongly competing player though SRL due to its parentage with Fortis

Hospitals has an edge. Thyrocare clearly needs to enhance focus on moving up the quality chain


Exhibit 6: CFO was the main source of funds


Exhibit 7: Post capex, large sums of money available for liquid investments


CFO 79%

Share Capital

17%

Debt 4%

Capex 57%

Investments 20%

Dividend 14%

Others 9%

Dr Lal PathLabs


Exhibit 8: Sharp re-rating since listing in Dec’15


Exhibit 9: Strong outperformance vs Sensex


Exhibit 10: Explanation for our forensic accounting scores


Accounting GREEN There are no significant issues with Dr Lal’s accounting policy. High CFO/EBITDA and steady working capital are positives. Historically ESOPs have been at an elevated level but have been accounted for fairly.

Predictability AMBER Earnings swing due to extent of onset of seasonal diseases is fairly high. While structural growth over medium term is fairly predictable, near-term volatility can be high. Actual performance has often beaten management guidance.

Earnings Momentum GREEN Earnings momentum has been positive for Dr Lal with consistent earnings beat vs expectations since listing.


40

50

60

70

80

Jan-

16

Feb-

16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-

16

Aug

-16

Sep-

16

Oct

-16

Nov

-16

Dr Lal 1- yr average

80 90

100 110 120 130 140 150 160

Dec

15

Jan

16

Feb

16

Mar

16

Apr

16

May

16

Jun

16

Jul 1

6

Aug

16

Sep

16

Oct

16

Dr Lal Sensex

Dr Lal PathLabs


Balance sheet


Shareholders' equity 163 164 803 1,108 1,243

Reserves & surpluses 996 1,457 1,512 2,303 3,831

Total networth 1,160 1,621 2,315 3,411 5,074


Debt 0 4 9 0 0

Deferred tax liability (27) (127) (196) (254) (121)


Gross block 1,245 1,466 1,676 1,995 2,340

Net block 1,145 1,271 1,400 1,510 1,697

Investments 48 548 86 379 643

Cash & equivalents 134 215 1,057 1,482 2,296

Debtors 143 198 252 310 363

Inventory 62 86 117 143 145

Loans & advances 180 203 347 597 882


Total current assets 415 528 776 1,128 1,495

Current liabilities 394 898 1,038 1,127 838

Provisions 204 150 135 192 312

Total current liabilities 598 1,048 1,173 1,319 1,150

Net current assets (183) (520) (397) (192) 345

Total assets 1,171 1,640 2,342 3,434 5,102


Income statement


Revenues 3,422 4,517 5,579 6,596 7,913

% growth 32% 24% 18% 20%

Operating expenditure 2,557 3,540 4,194 5,036 6,090

EBITDA 865 977 1,386 1,560 1,824

% growth 13% 42% 13% 17%

Depreciation 198 204 272 282 283

EBIT 667 773 1,113 1,278 1,541

Interest expenditure 11 (1) (56) (90) (142)

Non-operating income 8 28 22 29 50

Adjusted PBT 664 802 1,192 1,397 1,734

Tax 213 245 389 433 675

Adjusted PAT/ Net profit 452 557 803 964 1,059

% growth 23% 44% 20% 10%

Extraordinaries - - - - (274)


Reported PAT / Net profit 447 552 796 957 1,322


Dr Lal PathLabs


Cash flow statement


PAT 452 557 803 964 1,059

Depreciation 198 204 272 282 283

Others ESOPs 6 250 155 242 239

Tax 213 245 389 433 675

(Incr) / decr in net working capital 78 (337) 123 205 537

Cash flow from operations 947 919 1,743 2,126 2,792

Capex 194 368 400 372 400

Cash flow from investments 194 368 400 372 400

Net borrowings (183) 4 5 (9) -

Issuance of equity (66) 0 640 305 135

Dividend paid 150 91 100 150 196

Cash flow from financing (399) (87) 545 146 (61)

Closing cash balance 134 215 1,057 1,482 2,296

Free cash flow 380 974 700 904 907


Ratio analysis

Year to March FY12 FY13 FY14 FY15 FY16

Gross margin (%) 77.7% 78.5% 78.9% 78.9% 78.1%

EBITDA margin (%) 25.3% 21.6% 24.8% 23.6% 23.0%

EBIT margin (%) 19.5% 17.1% 20.0% 19.4% 19.5%

Net profit margin (%) 13.2% 12.3% 14.4% 14.6% 13.4%

Dividend payout ratio (%) 33.5% 16.4% 12.6% 15.7% 18.5%

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

Working capital days -20 -42 -26 -11 16


Post-tax RoCE(%) 49.3% 62.6% 85.5% 75.9% 56.0%

RoE(%) 43.3% 40.1% 40.8% 33.7% 25.0%




EPS (`) 5.6 6.8 9.7 11.6 12.9

Diluted EPS (`) 5.6 6.8 9.7 11.6 12.9



P/E (x) 198.6 162.3 113.3 94.7 68.6

P/BV (x) 76.6 55.3 38.9 26.6 14.3

EV/EBITDA (x) 102.5 90.9 64.2 56.9 48.1

Price/Sales (x) 26.0 19.8 16.2 13.7 9.2



No room for error eClerx has built formidable moats around its niche of low-volume, high-complexity BPO, reflected in high pre-tax median RoCE of 57% (FY06-16). Its internal processes, deep domain expertise and superior sales engine have helped it offset competition (from larger peers, offshore captives) to deliver 40%/30% revenue/operating cash flow CAGR (FY06-16). The promoters have also demonstrated an impeccable capital allocation track record over the past 10 years – 41% of profits have been returned to shareholders over the past 10 years and each of the three acquisitions has been successful. However, regulatory-driven challenges in BFSI (40% of revenue) and the rise of robotic process automation tools threaten its business model. Current valuation of 15x FY18E EPS (vs. 15x for Infosys) leave no room for error. We are SELLers with a TP of `1,425, implying 14x FY18E EPS.

Competitive position: STRONG Changes to this position: NEGATIVE

Specialises in low-volume, highly complex, offshore BPO

eClerx business has three segments: financial services (~40% of FY16 revenues), digital marketing (~40%) and cable & telecom (~20%). Examples of processes in each: handling documentation related to OTC derivatives for a global investment bank, optimising an e-commerce website catalog to boost sales and using analytics to improve customer-service for a large US-based cable company. Revenue and operating cash flow posted 40% and 30% CAGR over FY06-16. Impeccable capital allocation, exemplary growth

The founders have made no mistake in either strategy or execution since founding in 2000. eClerx has focused on large corporate customers, small & complex processes and annuity-like revenue. Its key competitive advantages have been its internal processes (knowledge management, training), deep domain expertise and superior sales engine (higher-quality talent). The capital allocation track record is also impeccable. 41% of profits were returned to shareholders over FY06-16. After examining hundreds of potential targets, eClerx has made just three niche acquisitions (in FY08, FY13 and FY15), each of which has been successful (EPS-accretive from day-1, continued to grow post deal).

Architecture built around domain expertise, talent and clients

eClerx scores most highly on the architecture aspect of the IBAS framework. The founders’ network (both were Wharton MBA graduates) and sales ability enabled marquee wins (e.g. Dell, Lehman Brothers). This, in turn, not only allowed eClerx attract and retain high-calibre employees (a generous ESOP and listing in 2007 also helped) but also resulted in significant growth headroom. Focus on low-volume and complex processes have resulted in better pricing (low competition) and also high utilisation (just-in-time hiring). All of these combine to deliver high customer satisfaction despite relying on low-cost, junior, offshore labour, which in turn generates high profitability (average EBIT margin of 35% over FY06-16).

Trading at par with Infosys; threats from regulation and automation

The regulatory-driven shift of trading OTC derivatives to the exchanges and the higher proportion of newer, smaller-duration projects are hurting eClerx’s competitive advantages in the financial services segment (~40% of revenues in FY14). Robotic process automation is another threat. Although the management has a good track record of overcoming challenges and it could potentially add new revenue streams, current valuations leave no room for error. eClerx trades at 15x FY18E EPS, on par with Infosys (15x) which is a better franchise (much larger scale, full-service offering).

STRATEGY NOTE ECLX IN EQUITY November 17, 2016

eClerx

SELL

Technology

Recommendation Mcap (bn): `57/US$0.8 3M ADV (mn): `77.8/US$1.2 CMP: `1,399 TP (12 mths): `1,425 Upside (%): 1.8%


Performance


eClerx’s forensic score analysis


eClerx’s greatness score analysis

A b AW A b l h

8090

100110120130

Nov

-15

Dec

-15

Jan-

16

Feb-

16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-

16

Aug

-16

Sep-

16

eClerx Services Sensex

Research Analysts

Sagar Rastogi

+91 22 3043 3291

[email protected]

Sudheer Guntupalli

+91 22 3043 3203

[email protected]

eClerx


Exhibit 1: eClerx has executed the same play book (mine customers, make sensible acquisitions…)




Revenues ($ mn) 20 31 42 55 76 98 122 138 154 199

Revenue growth (%) 91% 56% 39% 30% 37% 29% 25% 14% 11% 29%

Net profits 397 446 618 735 1,328 1,599 1,716 2,555 2,297 3,630

EPS 13.9 15.6 21.7 18.8 30.8 39.8 42.7 62.8 55.7 87.7

CFO 358 330 412 606 1,020 1,721 1,533 1,950 2,432 4,254

CFO-EBITDA 82% 67% 51% 60% 76% 91% 60% 55% 77% 87%

FCF 330 177 284 517 780 1,470 451 1,503 1,822 2,583

Debt equity (x) - - - - - - - - - 0.0

RoE (%) 135% 34% 37% 37% 56% 55% 44% 50% 35% 40%

RoCE* (%) 193% 61% 46% 45% 68% 69% 54% 65% 46% 53%


Exhibit 3: …since it was founded in 2000

Phase Time Period Key developments

Phase- I 2000-now

Founded by P D Mundhra and Anjan Malik, batch-mates at the Wharton MBA programme. After graduation, PD worked at Citibank and Anjan worked at Lehman Brothers. They founded the company in 2000.

Initially most of the revenues from the investment banking segment with also some revenues from retail and manufacturing segments.

It listed on the stock exchanges in 2007 through an IPO.

In 2007, it acquired Igentica which added clients in the digital marketing segment.

In 2008, Lehman Brothers, which was one of its top clients, went bankrupt but eventually revenues resumed from the successor entity.

In 2012, it acquired Agilyst, which added the cable and telecom segment.

In 2015, it acquired CLX, which added capabilities in content marketing.


20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

-

50

100

150

200

250FY

07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Pre

-Tax R

oC

E Reve

nu

e (

US$

mn

)

Revenue (US$mn) Pre-tax RoCE

Executing the same play book over last decade

eClerx


Exhibit 4: Competitive mapping of eClerx, HGS and WNS Global

Metric eClerx Hinduja Global Solutions (HGS) WNS Global

FY16 Revenues (US$mn) 199 507 562

Revenue growth (US$ terms, last 5 years) 21.0% 15.8% (2)%

FY16 EBIT Margin (%) 33.2% 9.0% 11.0%

Last 5 FY EBIT Margin (%) 34.0% 11.3% 9.9%

CFO/EBITDA 56.0% 50.7% 118%

CFO/CAPEX 1.23 0.63 3.8

RoE 36.0% 9.0% 15.0%

RoCE 53.0% 10.0% 15.0%

Client Metrics

US$5m+ clients 7 NA 16

US$1m+ clients 17 NA 57

Top 10 clients' revenue (%) 76.0% 60.6% 45.5%

Revenue per employee ('000 $) 22 12.7 17.3

EBIT per employee ('000 $) 7 1.1 2.0


Exhibit 5: Mapping eClerx and peers on our IBAS framework

Component eClerx HGS WNS Global Comment

Innovation

The ability of the management to identify sweet spots (high value work that can be done by relatively low-cost employees) is a key innovation. Though peers like HGS and WNS Global were quick to capitalise on the BPO opportunity which evolved as a logical extension to ITO, eClerx went a step ahead and started offering solutions which are more critical than a typical BPO. It kept moving up the value chain over a period of time, becoming a key strategic partner to its clients. The company’s average EBIT margin (35%) is significantly higher than that of peers (HGS - 9%, WNS Global – 19%) indicating the complexity of processes (pricing power) that eClerx executes.

Brand (Reputation)

eClerx occupies high mindshare of clients in its niche despite many competitors/captives now providing, such services. This reflects in the fact that it has not lost a single client so far despite intense competition from larger peers.

Architecture

eClerx focuses on low-volume, highly complex processes. This insulates the company from competition from its larger peers like TCS, Infosys etc. since BPO divisions of these companies prefer high volume and simple processes. Captives are not able to match its cost structure or its knowledge management and training processes. In fact, most of its clients use eClerx’s training material to train their own employees!

Strategic Assets

eClerx’s deep understanding of the client’s processes, and relationship with marquee customers are the key strategic assets.

Overall

The brand image, architecture and strategic assets that eClerx has built in its business makes it less vulnerable to upcoming technologies like robotic process automation when compared to peers like HGS and WNS Global which are into low-end BPO services. Clients can easily automate low-value offerings like claims and payroll processing, which is not the case with complex offerings (such as trade confirmations and settlements) that eClerx provides.

Source: Company, Ambit Capital research, Note: - Strong; - Relatively Strong; - Average; - Relatively weak

Exhibit 6: Cash generated over the years…


Exhibit 7: …largely used to fund dividends


CFO (ex-WC) 93%

Equity Issuance

7%

Total Outflow: `18bn

Capital Expenditure

15%

Dividends 37%

WC investments

34%

Acquistions 14%

Total Outflow: `17bn

eClerx


Exhibit 8: Valuations at premium to historic average


Exhibit 9: eClerx share price performance v/s Sensex




Accounting GREEN Our proprietary forensic accounting tool Hawk places eClerx in ‘Zone of safety’ (D2 in FY15) in terms of Accounting policies.

Predictability AMBER The management issues annual guidance and earnings surprises over past eight quarters have averaged more than 5%.

Earnings momentum AMBER Bloomberg shows downgrade to consensus numbers in last 8 weeks.






8

10

12

14

16

18

20

Apr

-11

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

Apr

-15

Oct

-15

Apr

-16

Oct

-16

1 year forward P/E (consensus)

P/E Avg

-

500

1,000

1,500

2,000

2,500

3,000

3,500

Nov

-08

May

-09

Oct

-09

Apr

-10

Oct

-10

Apr

-11

Sep-

11

Mar

-12

Sep-

12

Mar

-13

Sep-

13

Feb-

14

Aug

-14

Feb-

15

Aug

-15

Feb-

16

Aug

-16

SENSEX Eclerx

eClerx



(` mn) FY15 FY16 FY17E FY18E FY19E

Net worth 7,150 10,863 14,653 18,839 23,319

Other liabilities 122 300 182 182 182

Capital employed 7,272 11,163 14,835 19,021 23,501

Net block 1,693 968 4,277 5,208 6,226

Goodwill 857.5 2,429.4 2,429.4 2,429.4 2,429.4

Other non-current assets 720 579 614 694 805

Curr. assets 7,190 8,677 9,177 12,568 16,204

Debtors 1,261 1,861 1,953 2,205 2,513

Cash & bank balance 4,419 5,459 5,786 8,736 11,803

Other current assets 505 1,357 1,439 1,626 1,888

Current liab. & prov 2,319 1,456 1,662 1,878 2,164


Application of funds 7,272 11,163 14,835 19,021 23,501




Revenue (US$ mn) 154 199 207 234 266

Revenue 9,421 13,143 14,163 15,988 17,842

Cost of goods sold 3,964 5,514 6,040 7,017 8,129

SG&A expanses 2,801 3,268 3,469 3,712 4,104

EBITDA 3,156 4,868 5,177 5,909 6,393

Depreciation 500 507 524 649 783

EBIT 2,656 4,361 4,653 5,260 5,610

EBIT margin 28.2% 33.2% 32.9% 32.9% 31.4%

Other income 324 404 316 310 348

PBT 2,979 4,765 4,969 5,570 5,957

Tax 683 1,132 1,139 1,337 1,430

Rate (%) 0.2 0.2 0.2 0.2 0.2

Reported PAT 2,297 3,630 3,831 4,233 4,528

Diluted EPS 55.7 87.7 92.8 102.6 109.7


eClerx




PBT 2,979 4,765 4,969 5,570 5,957

Depreciation 500 507 524 649 783

CF from operations 3,272 5,179 5,216 5,909 6,393

Cash for working capital 121 (1,310) 32 (224) (283)

Taxes (683) (1,132) (1,139) (1,337) (1,430)

Net operating CF 2,710 2,738 4,110 4,349 4,679

Net purchase of FA (623) (2,223) (1,403) (1,581) (1,801)

Net cash from invest. (1,776) (3,562) (1,161) (1,350) (1,565)

Proceeds from equity & other 2 104 0 - -

Equity distributions (1,692) (49) (48) (48) (48)

Others 103 207 (147) - -

Cash flow from fin. (1,587) 263 (194) (48) (48)

Free cash flow 2,088 515 2,706 2,768 2,878

Net cash flow (652) (562) 2,754 2,951 3,067




Growth

Revenue (US$) 11% 29% 4% 13% 14%

EPS -11% 57% 6% 11% 7%

Valuation

P/E 29.5 18.7 17.7 16.0 15.0

EV/EBITDA 20.4 13.2 12.4 10.9 10.0

Price/Book value 9.5 6.2 4.6 3.6 2.9

Return ratios (%)

RoE 35% 40% 30% 25% 19%

RoCE 31% 36% 28% 24% 20%

Turnover ratios

Receivable days (Days) 48 51 51 51 51

Fixed asset turnover (x) 5.8 9.9 5.4 3.4 3.1



STRATEGY NOTE ASTRA IN EQUITY November 17, 2016

A ‘fanatic’ challenger Astral evolved from a niche pipe maker (CPVC) to a pan-India plastic pipe brand in less than a decade. Sales and EPS CAGR was 40% and median ROCE was 22% over FY06-16. Focus on innovation (products and processes) and strong relationships across ecosystem (suppliers, global innovators and intermediaries) will support growth of the plastic pipe business and building adhesives/construction chemicals business. Astral can transition into an ace building material franchise (akin to legends like Pidilite, Asian Paints) since: (a) both segments have significant room for innovation/re-investments; and (b) management is fanatic, frugal and focused. Valuations appear misleadingly expensive (25x FY18 EPS) and should be seen in light of high growth rates beyond the next decade. Consensus expects 39% EPS CAGR over FY16-18, higher than most other “new-age” building material names.


Pipes – a category with ample room for sustaining innovation

Despite a 16% 10-year revenue CAGR for top-5 companies, plastic pipes in India have a long path to chart through: (a) replacement of GI pipes, (b) increasing applications, and (c) innovation in plastic compounds and water management systems. Current deflation in input prices (CPVC/PVC resin) alongside scale and distribution ramp-up will support market share gains for organized players (40% industry is unorganized). Astral is the 3rd largest and one of the strongest plastic pipes brands and, hence, poised to gain share as the market expands. Increasing competition has led to management’s decision for reinvesting capital and leveraging its brand/reach architecture. From category creation to brand building to category extension

Astral created the CPVC pipes market in India through: (a) continuous launch of differentiated products, (b) innovative communication to the influencers (plumber trainings), and (c) branding (mass-media advertising in a seemingly commoditized product). Throughout the last decade, the company maintained focused capital allocation, with cash flows initially ploughed back to increase capacities and then to de-leverage (0.2x D/E in FY16 vs 1.5x in FY05). Establishment of Astral’s brand and prudent capital allocation manifested in 40% sales/EPS CAGR and average pre-tax RoCE of 22% over FY06-16.

Innovation flows into products, branding and processes Innovative, category-expanding product launches and processes set Astral apart from peers. Strong relationships with Lubrizol and global pipe majors (Wavin, Spears and IPSC) facilitated launch of differentiated products. Astral’s unique strategic assets are: (a) unparalleled CPVC/pipes brand (even without Lubrizol support now), (b) relationships with plumbers, and (c) management’s strong reputation amongst channel. Acquisitions of well-established adhesive brands in India/UK will add another leg to growth. Astral is slowly replicating its winning formula of quality products, impactful communication, intermediary connect and learning from leaders to build India’s 2nd largest adhesives franchise.

Headline valuations can often be misleading At 25x FY18 consensus EPS, Astral is one of the most expensive building material franchises in India. However, Astral’s valuation should be considered in light of: (a) focused capital allocation history, and (b) ability and intent to reinvest cash in RoCE-accretive products/segments to sustain the longevity of cash flow growth. The growth phase in such businesses is longer than a 10-year DCF model gives them credit for and, hence, a low terminal growth rate assumption leads to misleading exit multiples (akin to Asian, Berger and Pidilite).

Astral Poly

NOT RATED

Building Materials

Recommendation Mcap (bn): `50/US$0.8 3M ADV (mn): `28.2/US$0.4 CMP: `418 TP (12 mths): n.a. Downside (%): n.a.


Performance


Astral’s forensic score analysis


Astral’s greatness score analysis


Research Analysts Nitin Bhasin +91 22 3043 3241 [email protected]

Girisha Saraf +91 22 3043 3211 [email protected]

8090

100110120130

Nov

-15

Dec

-15

Jan-

16

Feb-

16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-

16

Aug

-16

Sep-

16

Astral Poly Sensex

Astral Poly Technik


Exhibit 1: Evolution of Astral Poly

Source: Company Ambit Capital research

Exhibit 2: Key financial parameters over the last decade (consolidated)


Revenues 969 1,358 1,924 2,888 4,113 5,827 8,252 10,796 14,299 17,190

Revenue growth (%) 80% 40% 42% 50% 42% 42% 42% 31% 32% 20%

Net profits 91 171 140 277 328 395 610 793 782 1,024

EPS 1 2 1 2 3 4 5 7 6 8

CFO 29 101 167 245 501 851 648 672 1,170 2,303

CFO (pre-tax)/EBITDA 31% 60% 84% 71% 106% 114% 64% 58% 85% 127%

FCF (72) (35) (316) 68 230 158 (42) (286) 315 944

Gross debt equity (x) 0.4 0.4 0.4 0.4 0.3 0.5 0.4 0.5 0.3 0.3

RoE (%) 13% 23% 16% 26% 25% 24% 29% 28% 17% 15%

ROCE* (%) 14% 21% 17% 26% 26% 31% 32% 33% 20% 18%

Source: Company, Ambit Capital research. Note: *This is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator;



FY03-07 Product Establishment

Established relationships with real-estate developers such as Rohan Lifescapes and Hiranandani and hotels in Mumbai and Bangalore, which was the first proof of acceptance of CPVC pipes

Expanded product portfolio through launch of lead-free PVC pipes

Began plumber training and certifications aggressively to build brand recall with the intermediaries

Set-up a fitting manufacturing capacity in Baddi, HP, which was a significant step towards increasing revenue scale and improving financial performance

FY08-12 Scale ramp-up

Raised `340mn through an IPO and re-invested spare cash flows to increased its capacities 7x in this phase

Enhanced product portfolio through launch of large diameter pipes and sound-proof pipes

Ventured into Kenya through acquisition of a 26% stake in a JV

Incurred significant forex losses due to unhedged forex exposure in FY09, which wiped out 40% of its FY09 PBT

Improved working capital cycle to 48 days in FY12 as against 84 days in FY07

FY13-17 Brand building and addition of new segments

Aggressively started brand building initiatives and hired Salman Khan as the brand ambassador. Brandex increased at a 50% CAGR in this phase

Expanded in South India and set-up a plant in Hosur in Feb-14. It also shut down its operations in Baddi

Expanded capacities in Gujarat. Installed capacities increased to ~120k tonnes as against 65k tonnes in FY12

Acquisitions – acquired Resinova in India and Seal-It in UK to establish its adhesive franchise. It raised `3bn through a QIP to fund this acquisition.

Ended ties with Lubrizol for CPVC compound and technology in October 2016; setting up own compounding facility and partnered with Japan’s Sekisui Chemical for CPVC resin.

Currently, bringing changes to Resinova (a) product packaging – appearance and longevity, (b) go-to-market strategy – channel engagement and product reach, and (c) pricing strategy – increasing prices and reducing cash discounts to distributors; expected to increase branding for the adhesives business


10

15

20

25

30

35

40

45

-

4,000

8,000

12,000

16,000

FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

(%) (` mn)

Revenue Pre-tax RoCE (RHS)

Product Establishment Sales CAGR: 65% Pre-tax RoCE: 29%

Scale ramp-up Sales CAGR: 43% Pre-tax RoCE: 24%

Brand Building; start of Adhesives Sales CAGR: 31% Pre-tax RoCE: 26%

Astral Poly Technik


Exhibit 4: Competitive mapping of Astral with its plastic piping peers

Company Capacity

FY16 (tonnes)

FY16 revenue (in `mn)

Revenue CAGR

FY10-16 Segments Plants


Pre-tax RoCE

(FY16)

Pre-tax CFO/

EBITDA (FY10-16)

Capex/CFO (FY10-16)

Supreme 4,00,000 23,069 18% Plumbing and Agri Maharashtra (3), UP (1), WB (1), MP (2), 14.50% 29% 94% 58%

Astral 1,27,762 12,855 28% Plumbing, Agri and Industrials Gujarat (2), HP (1), TN (1) 11.90% 22% 93% 75%

Ashirvad* 1,08,000 14,002 33% Plumbing, Agri and Industrials Karnataka (2) 12.90% 30% NA NA

Finolex 2,80,000 17,822 14% Largely Agri, now getting into plumbing

Maharashtra (2), Gujarat (1) 15.20% 29% 83% 28%

Prince* 90,000 9,572 21% Largely Agri, now getting into plumbing

Dadra (2), Uttarakhand (1), Maharashtra (1), Tamil Nadu (1)

5.70% 11.10% NA NA

Source: Company, Ambit Capital research;*Ashirwad & Prince numbers as of FY15

Exhibit 5: Mapping Astral and its peers on IBAS

Company Innovation Brand Architecture

Strategic asset


Rural Urban Mfg reach

Dstrbn reach

Supreme Industries

Continued innovation in plastic processing with unique products launches such as Silpaulin. The company has a strong brand with the plumbers for PVC pipes and farmers for agri pipes. Unmatched manufacturing and distribution architecture, with plants at 18 locations.

Astral PolyTechnik

Innovation in plastic pipes, first through creation of the CPVC market and then through launches of differentiated products of global majors in India. Strongest CPVC brand in India but weak in rural India. Relationship with real-estate developers and plumbers for retail pipes form its unique architecture. Now with Lubrizol relationship broken, Astral’s own brand is the strategic asset which is helping it maintain recall and also display strong bargaining power with new CPVC resin supplier

Finolex Industries

Has not displayed innovation and does not have differentiated products. A strong agri brand but still not very strong in urban markets

Ashirvad Pipes

Launched innovative products such as column pipes and is now a part of one of the most innovative plastic pipes company globally - Alliaxis. A strong brand, especially in urban markets. Ashirvad also has relationships with Lubrizol for raw material supply

Prince

No innovation of note in product launches or marketing. Brand is reasonably strong but largely an institutional seller

Jain Irrigation

One of the slowest growing pipes companies. Largely an agri pipe manufacturer but has been losing market share to more aggressive peers


Astral Poly Technik


Exhibit 6: CFO and equity were the primary sources of funds


Exhibit 7: Continuous capacity expansion and recent acquisitions to build upon brand were the main uses


Exhibit 8: After a strong re-rating valuations have corrected as the company absorbs the new acquisitions


Exhibit 9: Astral’s share price performance vs Sensex




Accounting GREEN Astral falls in the top most decile (D1) in Ambit’s accounting framework; the company’s (a) high cash yield (9%), (b) low contingent liabilities as a % of net worth (1%), (c) negligible misc. expenses as a % of total revenues, and (d) low volatility in non-operating income stand out.

Predictability GREEN Largely a predictable business. Management has been providing good indication of the progress of the business. Excepting the sales of newly acquired Seal IT and Kenyan operations operating metrics are fairly predictable

Earnings momentum AMBER Consensus EPS downgraded by 4.7% and revenue by 2.5% over the past three months


Exhibit 11: Astral’s forensic score evolution


Exhibit 12: Astral’s greatness score evolution


CFO, 59% Equity raises, 29%

Net borrowings

, 11%

Interest recd, 1%

Capex, 51%

Investments in sub/JV,

29%

Interest paid, 12%

Net change in cash, 5%

Dividend paid, 3%

010203040506070

Nov

-10

May

-11

Nov

-11

May

-12

Nov

-12

May

-13

Nov

-13

May

-14

Nov

-14

May

-15

Nov

-15

May

-16

Nov

-16

1-year forward P/E (x) 6 yr avg P/E

0

1,000

2,000

3,000

4,000

5,000

6,000

Mar

-07

Dec

-07

Sep-

08

Jun-

09

Mar

-10

Dec

-10

Sep-

11

Jun-

12

Mar

-13

Dec

-13

Sep-

14

Jun-

15

Mar

-16

Astral Sensex index

Astral Poly Technik


Balance sheet (consolidated)*

(` mn) FY12 FY13 FY14 FY15 FY16



Total networth 1,841 2,414 3,153 6,188 7,816


Debt 938 923 1,420 2,026 2,026



Gross block 2,119 2,808 3,766 4,826 6,159

Net block 1,640 2,150 2,888 3,424 4,364

CWIP 130 120 82 268 165

Cash & Cash equivalents 355 115 10 115 542

Debtors 1,032 1,063 1,451 2,327 2,308

Inventory 1,271 1,505 1,950 2,656 2,804

Loans & advances 368 486 554 702 759



Provisions 48 76 67 93 29


Net current assets 668 1,037 1,714 2,604 2,241

Total assets 2,793 3,422 4,698 8,556 10,185

Source: Company, Ambit Capital research; EPS adjusted for stock splits

Income statement (consolidated)*

(` mn) FY12 FY13 FY14 FY15 FY16

Net Sales 5,827 8,252 10,796 14,299 17,190

% growth 42% 42% 31% 32% 20%


EBITDA 827 1,153 1,551 1,683 2,051

% growth 50% 39% 35% 8% 22%

Depreciation 138 181 219 364 423

EBIT 689 971 1,332 1,319 1,628



Adjusted PBT 500 798 1,045 1,095 1,344

Tax 105 189 252 313 319 Adjusted PAT before minority interest 395 610 793 782 1,024

% growth 20% 55% 30% -1% 31%

Minority Interest 0 (4) (4) (23) (10) Adjusted PAT after minority interest 395 606 789 759 1,014

Reported PAT after minority interest 7% 7% 7% 5% 6%


Astral Poly Technik


Cashflow statement (consolidated)*

(` mn) FY12 FY13 FY14 FY15 FY16

Net Profit Before Tax 500 798 1,045 1,095 1,335

Depreciation 138 181 219 364 423

Others 228 199 301 281 328

Tax (91) (91) (229) (264) (292)

(Incr) / decr in net working capital 77 (440) (665) (306) 508

Cash flow from operations 851 648 672 1,170 2,303

Capex (net) (696) (681) (920) (854) (1,359)

(Incr) / decr in investments (2) - (7) (2,591) (696)

Other income (expenditure) 18 16 18 11 12

Cash flow from investments (680) (665) (909) (3,435) (2,043)

Net borrowings 278 (48) 476 313 (27)

Issuance/buyback of equity - - - 2,359 590

Interest paid (167) (145) (309) (255) (307)

Dividend paid (29) (29) (36) (47) (90)

Cash flow from financing 82 (223) 131 2,371 166

Net change in cash 253 (240) (106) 106 426

Closing cash balance 355 115 10 115 542

Free cash flow 155 (33) (248) 315 944



(` mn) FY12 FY13 FY14 FY15 FY16

EBITDA margin (%) 14% 14% 14% 12% 12%

EBIT margin (%) 12% 12% 12% 9% 9%

Net profit (bef min. int.) margin (%) 7% 7% 7% 5% 6%

Dividend payout ratio (%) 6% 5% 5% 6% 5%

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



RoCE (pre-tax) (%) 31% 32% 33% 20% 18%

RoIC (pre-tax) (%) 32% 34% 33% 20% 18%

RoE (%) 24% 29% 28% 17% 15%


Valuation parameters (consolidated)*

(` mn) FY12 FY13 FY14 FY15 FY16

EPS after minority interest (`) 3.5 5.4 7.0 6.4 8.4

Diluted EPS (`) 3.5 5.4 7.1 6.6 8.5



P/E (x) 121.6 78.7 60.5 64.7 50.3

P/BV (x) 26.1 19.9 15.2 8.2 6.5

EV/EBITDA (x) 63.6 45.7 33.9 31.3 25.6

EV/EBIT (x) 76.3 54.2 39.5 39.9 32.3

Source: Company, Ambit Capital research; EPS adjusted for stock splits


STRATEGY NOTE RLXF IN EQUITY November 17, 2016

The nimble footed giant Relaxo has grown at anything but a relaxing pace with FY05-16 revenue and PAT CAGR of 21% and 37%, respectively. It is a testament to brand creation; brandex equalled capex since FY11 with ad spends averaging 8% of sales over the decade. The consistency and focus have provided Relaxo pricing power (13% CAGR; FY05-16) in a value offering without compromising volume growth (8% CAGR). Segmented brands (Sparx, Flite, Bahamas, Schoolmate, Boston, etc.) and brand investments as against distribution (only 250 stores) have driven asset turns (from 2.2x in FY06 to 2.7x in FY16), driving RoE from 7% in FY06 to 28% in FY16. Relaxo with an average selling price of `170/pair (just 4% market share in volumes) could very well be the horse for the long haul. Relaxo trades at 23x FY18E EPS (consensus), which is at a discount to Bata despite superior RoCE/ improving brand equity.


Unique combination of value proposition, quality and branding

Relaxo is one of the largest footwear companies in India selling over 129mn pairs across its brands. It can sustain high growth as it is a leader in the largely unorganised footwear market (at lower price points) with unique proposition of value, durability and branding. Moreover, as the company expands its distribution outside its dominant geographies (North and East), it will gain market share. The company has room to premiumise its portfolio (realisation per pair has moved from `36 in FY05 to `132 in FY16) as it adds more offerings such as Sparx (35% of FY15 revenues) to the portfolio. From the humble Hawaii slippers to spring in the step

Relaxo has come a long way from a Hawaii slipper company to creating and selling brands like Flite, Sparx, Boston and Bahamas. It began brand additions in FY04 to give discerning customers premiumisation choices. In FY08, it identified exports as an important market and grew it from `15mn to `300mn in FY15 (stagnant since FY12). In FY12, Relaxo introduced four major brand ambassadors for four of its brands, which catapulted the brand perception of the seeming value offering of rubber and rubber lookalike slippers. A point to note is that unlike other parameters inventory days deteriorated from 67 days in FY10 to 138 days in FY16 – partly due to premiumisation (lower turns).

Brand equity extends from customers to distributors

The strategy of premiumisation, consistent branding (8% of sales since FY04) and brands across different price points (from `140 to `3,000) sets Relaxo apart. Moreover, the company has demonstrated strong control over manufacturing costs at its 8 plants by delivering 800bps improvement in EBITDA margins over FY05-16. The fact that debtor days stand only at 3 weeks (as against 12-week industry norm) indicate the strength of the brand and willingness of the distributors to pay in time.

Valuations - Package of brand, value and RoE, yet at a discount!

The stock trades at 23x consensus FY18E EPS, a discount to Bata India (Ambit - 29x FY18E EPS) despite superior RoE profile and brand-driven growth strategy as against Bata’s distribution-driven strategy (see our report dated 09th Dec 2015). The large opportunity at the bottom of the pyramid and a decade of brand investment make Relaxo one of the best positioned companies in the branded footwear category. FCF generation and maintaining value proposition of brands such as Sparx are the risks which investors should watch out for.

Relaxo Footwears

NOT RATED

Retail

Recommendation Mcap (bn): `48/US$0.7 3M ADV (mn): `7.2/US$0.1 CMP: `401 TP (12 mths): NA Downside (%): NA


Performance


Relaxo’s forensic score analysis


Relaxo’s greatness score analysis

708090

100110120

Nov

-15

Dec

-15

Jan-

16

Feb-

16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-

16

Aug

-16

Sep-

16

Relaxo Footwear Sensex

Research Analysts

Abhishek Ranganathan, CFA

+91 22 3043 3085

[email protected]

Mayank Porwal

+91 22 3043 3214

[email protected]

http://reports.ambitcapital.com/reports/Ambit_BataIndia_Initiation_DistributionhaslittlePowerleft_09Dec2015.pdf

Relaxo Footwears


Exhibit 1: Evolution of Relaxo Footwears – The “Flite” from Hawaii slippers to Sparx and Bahamas

Source: Company, Ambit Capital research Note: RoCE is pre-tax.

Exhibit 2: Key financial parameters over the last decade (Fig in ` mn) FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 Revenues 2,359 3,057 4,075 5,537 6,916 8,647 10,098 12,123 14,808 17,130 Revenue growth 17% 30% 33% 36% 25% 25% 17% 20% 22% 16% Net profits 61 105 142 377 268 399 448 656 1,031 1,203 EPS (`) 1 1 1 3 2 3 4 5 9 10 CFO (post-tax) 205 306 411 719 437 727 540 1,249 1,075 1,594 CFO (pre-tax)-EBITDA 97% 121% 116% 104% 72% 87% 68% 104% 72% 89% FCF (67) 38 (183) (206) (190) 239 (298) 538 (238) 246 Debt equity (x)* 1.1 1.1 1.4 1.3 1.3 1.0 0.9 0.7 0.6 0.5 RoE 13% 19% 21% 41% 22% 26% 23% 27% 32% 28% RoCE* 16% 20% 22% 30% 18% 22% 22% 26% 30% 30%

Source: Company, Ambit Capital research. Note: *This is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator. Debt:equity used is Net debt:equity

Exhibit 3: Relaxo’s evolution – calibrated and thoughtfully executed strategy


FY05-08 The quite period; new brand launches

Production capacity during the period of 0.25 mn pairs from across 6 plants. Revenues increased at a CAGR of 12% during this period and gross margins increased by 960bps; as a consequence EBIT

margins improved by 360bps. Sold 56mn pairs per annum on an average during the period wherein realisation per pair increased from `36.2 to 47.6

(CAGR of 10%). CFO (pre-tax) to EBITDA averaged 105%; net debt equity averaged 0.6. Launched brand ‘Sparx’ in 2005 and opened its first retail outlet by the name of ‘Relaxo Retail Shoppe’. Brandex on an average formed 8% of sales and averaged 87% of capex during the period.

FY09-12 Catapulting new brands with strong segmentation

Production capacity during the period increased from 0.29mn pairs to 0.38mn pairs across 7 plants. Own store network - 149 Revenues increased at a CAGR of 29% during this period and gross margins increased by 40bps. EBIT margins improved from

7.8% in FY09 to 11.1% in FY10 and dropped to 8.2% in FY12 due to pressure on raw material prices (natural rubber and EVA).

Identified exports as an important market and grew it from `15mn to `300mn in FY12 CFO (pre-tax) to EBITDA averaged 95%; net debt equity averaged 0.9. Sold 83 mn pairs per annum on an average during the period wherein realisation per pair increased from `58.9 to 92.5

(CAGR of 16%). Brandex on an average formed 8% of sales and averaged 81% of capex during the period.

FY13-16 Supply Chain initiatives and debt reduction

Production capacity was increased to close to 0.6mn pairs per day during the period across 8 plants. Own store network - 250 Opened regional warehouses across India to strengthen supply chain management. Revenues increased at a CAGR of 19% during this period and gross margins increased by 520bps. Raw material prices eased

during the period and as a consequence of the aforementioned and cost rationalisation, EBIT margins improved by 300bps. Revenues from exports remained stagnant at `300mn per annum during this period as focus shifted to domestic market. CFO (pre-tax) to EBITDA averaged 82%; net debt equity averaged 0.5. Signed heavyweight brand ambassadors for Hawaii, Flite and Sparx brands spending ` 800 mn in FY13 Sold close to 115mn pairs per annum on an average during the period wherein realisation per pair increased from `100.4 to

`132.4 (CAGR of 10%). Launched brand ‘Bahamas’ in FY15. Brandex on an average formed 8% of sales and averaged 100% of capex during the period.


0%

5%

10%

15%

20%

25%

30%

35%

-

2

4

6

8

10

12

14

16

18


Revenues (Rs bn) (LHS) RoCE (RHS)

The quiet period Revenue CAGR 12% Sold 56mn pairs p.a. (avg.)

Catapulting new brands Revenue CAGR 29% Sold 83mn pairs p.a. (avg.)

Undertook supply chain initiatives Revenue CAGR 19% Sold 115mn pairs p.a. (avg.)

Relaxo Footwears


Exhibit 4: Competitive mapping of Relaxo with other comparables


FY16 revenue

Revenue CAGR

FY10-16

EBITDA Margin

(FY16)

Pre-tax RoCE

(FY16)

Pre-tax CFO/ EBITDA

(FY10-16)

Capex/CFO (FY10-16)

Bata Mid premium (ASP ` 500) 24,254 14% 11% 18% 91% 92%

Relaxo Value (ASP ` 170) 17,130 21% 14% 29% 85% 66%

Liberty Value (ASP ` 450) 4,542 9% 8% 10% 75% 85%

Metro Premium (ASP ` 1,500) 7,020 24% 18% 46% 79% 59%

Source: Company, Ambit Capital research. Note: Metro Shoes data is available only till FY15.

Exhibit 5: Mapping Relaxo and its peers on IBAS

Relaxo

Footwears Metro shoes

Bata India

Liberty shoes Comments

Innovation

Innovation is not the key source of competitive advantage in footwear sub-segment. Innovation at best can be attributed to maintaining product quality and low cost – both of which can be replicated by peers.

Brands and reputation

While Bata is the oldest brand (in India for 85 years), Relaxo has a legacy of 40 years – it started out as a slipper brand. However, as the customer has moved up, Relaxo’s product launches and designs have kept pace along with consistent branding.

Relaxo is one of the few major footwear brands to have created sub-brands at price points (as low as `150), significantly lower than peers. So much so that original brands of Relaxo and Hawaii are no longer the core brands and its additions such as Flite, Sparx etc. have become part of the core brands.

It has backed these brands by consistent advertisement and brand ambassadors. The aggregate ad spend of `5bn over last decade with consistent messaging of style, quality and value is Relaxo's valued and strategic asset. Peers such as Bata have missed this strategy and in contrast have sacrificed volumes in the endeavour to premiumise.

Architecture

Relaxo enjoys strong terms of trade with distributors (a sign of popular brand) as is evident in 21 debtor days. Similarly, it enjoys creditor days of 52.

Relaxo controls manufacturing (has 8 plants) whereas most peers outsource a significant portion of their products.

Relaxo is available across 50,000 touch points (higher than Bata’s 30,000). While Metro has lower reach its store productivity is lot superior to that of Bata’s and hence in our framework scores as well as Bata and Relaxo.

Strategic Assets

Apart from Bata India, which has access to the know-how and designs of its parent, there are no major strategic assets for the players.

Overall Relaxo and Metro score highly given brand reputation and strong architecture driven

by distribution reach (Relaxo) and high throughput stores (`20,000 sales per sq ft).


Exhibit 6: Cash generated over the last 10 years…


Exhibit 7: …have been deployed to fund capex and service interest


CFO 78%

Sale of investments

1%

Loans taken 21%

Purchase of assets 78%

Dividend paid 3%

Interest paid 19%

Relaxo Footwears


Exhibit 8: Relaxo is trading at a 40% premium to its 5-yr average P/E


Exhibit 9: Relaxo’s share price performance v/s Sensex




Accounting GREEN Relaxo scores well on key accounting parameters like a low contingent liability proportion as a % of networth and steady auditor remuneration. On Ambit’s forensic accounting, Relaxo is categorised in the 1st decile of the consumer discretionary universe (comprising eleven companies).

Predictability AMBER The company does not provide any guidance on future estimates.







0

10

20

30

40

50

60

70

Oct

-11

Feb-

12

Jun-

12

Oct

-12

Feb-

13

Jun-

13

Oct

-13

Feb-

14

Jun-

14

Oct

-14

Feb-

15

Jun-

15

Oct

-15

Feb-

16

Jun-

16

Oct

-16

Relaxo's trailing P/E 5-yr avg. P/E

0

5,000

10,000

15,000

20,000

Oct

-06

Oct

-07

Oct

-08

Oct

-09

Oct

-10

Oct

-11

Oct

-12

Oct

-13

Oct

-14

Oct

-15

RLXF SENSEX

Relaxo Footwears






Total networth 1,724 2,144 2,766 3,678 4,800

Minority Interest - - - - -

Debt 1,455 2,049 1,627 2,110 2,026



Gross block 3,785 4,572 5,256 6,678 7,712

Net block 2,713 3,267 3,658 4,717 5,305

CWIP 202 237 242 21 282


Debtors 230 360 682 821 1,080

Inventory 1,285 1,594 1,640 2,487 2,858

Loans & advances 134 55 86 141 192



Provisions 142 50 168 221 312


Net current assets 417 865 708 1,271 1,468

Total assets 3,471 4,525 4,741 6,131 7,251


Income statement


Net Sales 8,647 10,098 12,123 14,808 17,130

% growth 25% 17% 20% 22% 16%


EBITDA 943 1,098 1,470 2,009 2,411

% growth 31% 16% 34% 37% 20%

Depreciation 231 255 312 399 471

EBIT 712 843 1,159 1,610 1,940



Adjusted PBT 535 677 955 1,426 1,776

Tax 136 229 299 396 573 Adjusted PAT before minority interest 399 448 656 1,031 1,203

% growth 49% 12% 46% 57% 17%

Minority Interest - - - - - Adjusted PAT after minority interest 399 448 656 1,031 1,203

Reported PAT after minority interest 399 448 656 1,031 1,203


Relaxo Footwears


Cashflow statement


Net Profit Before Tax 535 677 955 1,426 1,776

Depreciation 231 255 312 399 471

Others 192 176 227 191 192

Tax 89 209 276 376 543

(Incr) / decr in net working capital (142) (359) 31 (566) (302)

Cash flow from operations 727 540 1,249 1,075 1,594

Capex (net) (471) (827) (706) (1,302) (1,344)

(Incr) / decr in investments - - 0 2 39


Cash flow from investments -470 -825 -697 -1,298 -1,303

Net borrowings (67) 502 (270) 410 (30)

Issuance/buyback of equity - - - - 6

Interest paid (187) (177) (227) (164) (216)

Dividend paid (14) (18) (24) (30) (60)

Cash flow from financing (268) 294 (513) 211 (313)

Net change in cash -11 10 39 -12 -21


Free cash flow 257 -287 543 -227 250


Ratio analysis

Year to March (%) FY12 FY13 FY14 FY15 FY16

EBITDA margin (%) 11 11 12 14 14

EBIT margin (%) 8 8 10 11 11

Net profit (bef min. int.) margin (%) 5 4 5 7 7

Dividend payout ratio (%) 5 5 5 6 6

Net debt: equity (x) 1 1 1 1 0

Working capital turnover (x) 23 16 15 15 13

Gross block turnover (x) 2 2 2 2 2

RoCE (pre-tax) (%) 21 22 26 30 29

RoCE (post-tax) 16 15 18 22 20 RoIC (%) (post-tax) 18 15 19 23 21

RoE (%) 26 23 27 32 28




EPS after minority interest (`) 3 4 5 9 10

Diluted EPS (`) 3 4 5 9 10


Dividend per share (`) 2 2 1 1 1

P/E (x) 122 109 74 47 41

P/BV (x) 3 2 9 7 10

EV/EBITDA (x) 53 46 34 25 21

EV/EBIT (x) 71 60 44 32 26



Swimming against the tide Repco’s decade-long earnings momentum (23% EPS CAGR, 26% AUM CAGR, and average RoE of 22% over FY06-16) are underpinned by a decadal rally in real estate prices and its strong positioning in the informal segment. Its strengths are derived from strong local area knowledge (validated by low credit costs) and an innovative origination strategy (avoids sourcing through DSAs unlike other HFCs). Further rerating of Repco’s premium valuations (at 3.7x 1 year fwd P/B) depends on its ability to further extend its current earnings momentum, which seems doubtful in the light of declining real estate prices and pressures on the informal economy.

Competitive position: MODERATE Changes to this position: NEGATIVE

Play on the under-penetrated informal segment

Set up in 2000, Repco provides housing and LAP loans to the vastly underpenetrated informal segment (non-salaried; 59% of loan book), with focus on the four South Indian states (~90% of loan book). With a modest loan book of ~`80bn, the bulk of it home loans, Repco has delivered ~27% loan book CAGR of over FY06-16 with average RoE of 21%, making it a promising play on housing finance to the informal segment in India. Increasing LAP offset declining growth and profitability in home loans

Post capital infusion by Carlyle in FY08, Repco’s growth was led by strong growth in home loans (45% CAGR over FY08-12) driven by aggressive branch expansion (from 25 in FY08 to 73 in FY13). But FY12 onwards, growth in home loans moderated (26% CAGR over FY12-16) due to regulatory and competitive headwinds. However, shifting gears to LAP ensured Repco’s loan growth and profitability remained respectable despite moderation. This led to Repco posting at least 29% AUM CAGR and average RoA of 2.4% over FY12-16 (vs 45% AUM CAGR and average RoA of 3% over FY06-12) as LAP’s share in AUM increased from 14% to 20% during the period. Growth being higher than RoE implied that dividend payout ratio remained frugal at ~9% over FY12-16.

Local knowhow and decentralized architecture are key strengths

A well-penetrated and decentralized branch architecture underpins strong local area knowledge and superior sourcing of low-ticket customers (despite low ticket sizes, credit costs have been reasonable at ~34bps over the past ten years). Moreover, Repco’s strong positioning in the informal housing finance is also led by its innovative origination strategy (unlike other HFCs, it avoids sourcing through DSAs and instead sources only through loan melas and referrals). That said, a weak credit rating profile relative to its peers implies a weaker liability franchise, making it susceptible to margin pressure during a liquidity crunch.

Further rerating doubtful due to macro headwinds

A decadal surge in real-estate prices combined with strong local knowhow and decentralized decision making drove Repco’s earnings momentum of 23% CAGR over FY06-16. Simultaneously, mortgage financers have re-rated over the past 2 years at the cost of corporate lenders due to the latter’s shaky earnings trajectory due to asset quality concerns. The combination of such fundamental and sentimental factors underpins Repco’s premium valuations (3.7x 1-year fwd P/B, in line with peer average). Further re-rating hereon is doubtful as Repco could find it difficult to sustain its current earnings momentum in light of declining real estate prices and pressures on the informal economy due to clampdown on the black economy. Moreover, HFCs are exposed to the looming regulatory risk of convergence of loan pricing to a more transparent and objectively calculated base rate (which is followed by banks).

STRATEGY NOTE REPCO IN EQUITY November 17, 2016

REPCO Home Finance

NOT RATED

BFSI

Recommendation Mcap (bn): `33/US$0.5 3M ADV (mn): `98.9/US$1.5 CMP: `532 TP (12 mths): NA Downside (%): NA


Performance


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

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

80

100

120

140

Nov

-15

Dec

-15

Jan-

16

Feb-

16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-

16

Aug

-16

Sep-

16

Repco Home Fin. Sensex

REPCO Home Finance


Exhibit 1: Evolution of Repco – Repco’s growth has moderated as the base effect is now over


Exhibit 2: Repco – key financial parameters over the last decade


Interest Income 10.8% 10.9% 12.4% 12.3% 11.9% 12.4% 11.8% 12.1% 12.8% 12.7%




Total Income 5.0% 4.9% 5.1% 5.8% 5.5% 4.7% 4.2% 5.0% 4.8% 4.8%


Employee Expenses 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.5% 0.6% 0.6%

Admin Expenses 0.5% 0.8% 0.4% 0.4% 0.4% 0.3% 0.3% 0.4% 0.4% 0.4%


Loan loss provisions 0.3% 0.1% 0.3% 0.3% 0.3% 0.4% 0.3% 0.5% 0.4% 0.6%


Taxes 0.8% 1.0% 1.1% 1.3% 1.2% 0.8% 0.8% 0.9% 1.2% 1.2%

RoA 3.1% 2.6% 2.8% 3.5% 3.2% 2.7% 2.4% 2.6% 2.3% 2.2%

Leverage 9.8 6.6 6.2 7.4 8.3 9.1 7.1 6.2 6.9 7.8

RoE 30.1% 17.4% 17.7% 25.7% 26.2% 24.7% 17.1% 16.0% 15.8% 17.0%

AUM growth (%, YoY) 47% 50% 52% 41% 47% 35% 26% 32% 29% 28%

EPS growth (%, YoY) 83% 35% 61% 75% 29% 19% 19% 38% 12% 22%


10%

15%

20%

25%

30%

- 10 20 30 40 50 60 70 80 90

100

FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16


The honeymooon period AUM CAGR 45% Avg. RoA 3.0%

Growth moderation AUM Growth 29% Avg. RoA 2.4%

REPCO Home Finance


Exhibit 3: From a high growth phase of FY06-14, Repco is now going through a steady-state growth phase


The honeymoon period

FY06-12

Repco’s robust growth (45% CAGR) during this period was driven by both increasing customer acquisition (due to benign competition in the small ticket segment and rapid branch expansion from 25 in FY08 to 73 in FY13) and increasing ticket size per loan (due to rapid increase in real estate prices).

Such growth was supported by ~`1.1bn investment by Carlyle for a 49% stake in 2007. Such capital infusion helped Repco to further scale up their growth quickly.

Regulatory and competitive environment remained benign in the relevant sub-segment Repco was operating. Consequently both growth and profitability remained high during this period (AUM CAGR of 45% and RoA of 3%). Home-loans was the key growth and profitability driver, growing at 46% CAGR during this time period and accounting for 86% of the AUM mix in FY12.

Growth moderation

FY12-Current

Regulatory headwinds emerged FY11 onwards such as introduction of base rate system (which led to increasing cost of funds) and removal of prepayment penalties (leading to higher churn in the loan book and reduction in fee-income).

Moreover, during this period, HFCs have seen hyper-competition from banks in home loans due to: i) lack of any opportunities in corporate loans due to slowdown; and ii) regulators incentivising affordable housing in FY15 by reduction of risk weights and exemption on SLR/CRR and PSL requirements. Decline in real estate prices have also let to moderation in ticket size growth (which used to drive 50-60% of growth of HFCs).

Consequently Repco’s growth in the key segment of home loans moderated to 26% CAGR over FY12-16 versus 46% CAGR in FY06-12. However, Repco was able to sustain such pressure on profitability and growth by increasing the share of higher-yielding albeit risky LAP (from 14% in FY12 to 20% in FY16). This somewhat offset the lower profitability from the business and enabled it to still deliver a respectable RoA of 2.5% during this period.


Exhibit 4: Competitive mapping of HFCs – Repco’s small-ticket positioning drives its sustainable growth

Key metrics (FY16) Avg. ticket size (` mn)

AUM (` bn)

AUM CAGR (FY13-16) NIMs Opex/

AUM Gross

NPA (%) RoA RoE Branches (#)

Employees (#)

Repco 1.1 77 29% 4.9% 1.0% 1.30% 2.2% 17.0% 150 619

GRUH 0.5 111 27% 4.2% 0.8% 0.32% 2.3% 31.5% 179 618

HDFC 2.5 2,908 16% 3.1% 0.3% 0.70% 2.4% 21.8% 401 2,196

LICHF 1.2 1,252 17% 2.6% 0.4% 0.45% 1.5% 19.6% 234 1,726

CANFIN 1.7 106 38% 3.1% 0.7% 0.19% 1.6% 19.0% 140 553

DEWAN 1.2 695 24% 3.0% 0.9% 0.93% 0.9% 11.9% 353 2,625

PNBHF 3.7 272 60% 3.8% 1.2% 0.22% 1.4% 17.6% 47 752




Innovation


Brand


Architecture


Strategic asset


Overall rank


Source: Company, Ambit Capital research Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

REPCO Home Finance


Exhibit 6: Repco has delivered a robust loan book growth


Exhibit 7: Increasing share of LAP has sustained growth


Exhibit 8: Repco’s liability mix is tilted towards banks


Exhibit 9: Repco’s asset quality has remained in control


Exhibit 10: Repco is trading in line with its cross-cycle average P/B


Exhibit 11: Repco – share price performance versus sensex




Accounting GREEN Repco’s revenue and expense recognition policies are by far the most conservative amongst the peers. We do not come across any instance wherein the reported profitability of the company is materially different from its true profitability.

Predictability GREEN Repco’s earnings trajectory has been fairly predictable. It has delivered earnings growth of 16%+ for at least past 13 quarters.

Earnings momentum GREEN Repco’s recent earnings growth (20%+) has sustained at FY12-16 run-rate of 22% CAGR over FY12-16.


57%

14% 12%

47%

27% 31%

47%

35%

26% 32%

29%

28%

0%

10%

20%

30%

40%

50%

60%

70%

FY11 FY12 FY13 FY14 FY15 FY16

Disbursements growth AUM growth

84% 85% 86% 85% 81% 81% 80%

16% 15% 14% 15% 19% 19% 20%

0%

20%

40%

60%

80%

100%

FY10 FY11 FY12 FY13 FY14 FY15 FY16

AUM mix (%)

Mortgages LAP

14%

72%

8% 6%

NHBRefinancing

Banks

Repco Bank

NCDs

1.3%

1.0%

1.2% 1.2% 1.4%

1.5% 1.5% 1.3% 1.3%

0.1%

0.3% 0.3% 0.3% 0.4%

0.3%

0.6% 0.4%

0.6%

0.0%0.2%0.4%0.6%0.8%1.0%1.2%1.4%1.6%

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Gross NPA (%) Credit Costs as a % of AUM

0.00.51.01.52.02.53.03.54.04.55.0

Jun-13

Sep-13

Dec-1

3

Mar-1

4

Jun-14

Sep-14

Dec-1

4

Mar-1

5

Jun-15

Sep-15

Dec-1

5

Mar-1

6

Jun-16

Sep-16


-

100

200

300

400

500

600

Apr

-13

Jul-

13

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Oct

-16

SENSEX REPCO

REPCO Home Finance


Income statement


NII (inclu. Securitisation) 1,033 1,255 1,909 2,604 3,327

Other income 128 147 198 8 12

Total income 1,161 1,402 2,106 2,612 3,339

Operating expenditure 191 242 388 547 642

Pre-provisioning profit 970 1,160 1,718 2,065 2,698

Provisions 94 92 227 204 393

Profit before tax 875 1,068 1,491 1,861 2,304

Tax 201 268 390 632 800

Consol. PAT 674 801 1,101 1,229 1,505


Balance sheet


Net-worth 3,032 6,345 7,411 8,121 9,548 Borrowings - on balance sheet 25,102 30,645 39,020 51,044 65,379

Borrowings - off balance sheet - - - - -


AUM 28,022 35,447 46,619 60,129 76,912

Cash and equivalents 175 2,101 219 175 200

Net Current Assets (143) (639) (531) (1,263) (2,309)

Total assets 28,134 36,990 46,431 59,165 74,927


Key ratios


NIM % (on AUM) 4.2% 4.0% 4.7% 4.9% 4.9%

AUM Growth 35% 26% 32% 29% 28%

Opex as % of AAUM 0.78% 0.74% 0.93% 1.04% 0.96%

Credit costs as a % of AUM 0.39% 0.29% 0.55% 0.38% 0.57%

CAR (%) 16.5% 25.5% 25.5% 25.5% 20.7%




Dil EPS – Consol (`) 13.2 17.1 17.6 19.7 24.1

BVPS (`.) 66 102 119 130 153

ROA (%) 2.7% 2.4% 2.6% 2.3% 2.2%

ROE (%) 24.7% 17.1% 16.0% 15.8% 17.0%

P/B (x) 8.1 5.2 4.5 4.1 3.5

P/E (x) 40.3 31.2 30.2 27.0 22.1


REPCO Home Finance


This page has been intentionally left blank


A super-efficient Superbrand Cera ranks second in scale but is the best-run Indian sanitaryware company; it posted 27%/25% revenue/EBITDA CAGR and 24% median RoE over FY07-16, significantly beating closest peer HSIL and tiles players. Continuous capacity additions (first in sanitaryware, then faucets and now tiles) and industry leading brandex (~4% of sales; FY05-16) led to high growth and made it a Superbrand. Despite stellar history, our concern emanates from rising competition in sanitaryware/faucets from domestic tile manufacturers in low-mid range and global majors in premium category. Stock isn’t cheap at 22x FY18 EPS and value creation depends on ability to: (a) improve working capital intensity (78 days, highest among building materials) and gross block intensity (plateaued at 3.1X); (b) gain market share (seems difficult, hence entry into new segments); and (c) bring in further operating efficiencies.


Can rising competition clog Cera’s wheels?

In the last decade Indian sanitaryware industry expanded at ~12% CAGR and Cera posted 27% CAGR. Whilst poor sanitation quality/penetration in India leaves ample scope for top brands to grow, our key concerns are: (a) market is relatively small (`40bn vs `240bn for tiles), (b) organized players have sizable market share (~60%); (c) new entrants (tile players, global majors); hence, limited market share gains for Cera in future. Though tiles may get Cera incremental sales, it is hard for Cera to build significant market share in this segment; globally, we have not seen any sanitaryware brand succeed in tiles. A disciplined approach to usurp competition

A decade back, Cera was 1/3rd the size of main peer HSIL; by FY16, it was ~90% of HSIL’s revenues and a lot more profitable (21.6% RoE vs 8.6% for latter). Cera’s secret sauce: (a) focus on gradually growing scale and segments (lifestyle products, faucets, tiles) alongside maintaining strong balance sheet (D/E within 1x in the last decade though capacity tripled); (b) significant spending on brand (one of highest in building material space); (c) controlled overheads; (d) expanding distribution. Faucets are 1.3x sanitaryware market size at `52bn-55bn with 40% organised vs 60% in the case of sanitary ware.

Strong brand and low-cost manufacturing are key advantages

Cera has launched several differentiated products like twin-flush and 4-litre WC ahead of competition. Higher brandex than most peers has helped CERA increase premium sales mix to ~40% of sales. It has the second-largest sanitaryware manufacturing capacity (3mn units), strongest distribution network, and a team of 200 in-house technicians for after-service. It is the only frontline ceramic manufacturer with access to administered gas (30% cheaper than spot gas) for ~30% of its production, which is a unique strategic asset.

Sustenance of rich valuations require a lot playing out in Cera’s favor

Cera trades at 22x FY18 EPS, a marginal discount to Kajaria and at a premium to Somany. Whilst Cera deserves credit for disciplined growth and good capital allocation over the last decade, future free cash flows will depend on: (a) ability to garner further market share, (b) reduce working capital intensity (78 days now); and (c) discipline in deployment of capital in the tiles segment. Both of the above could be difficult given aggressive expansions by competitors which make us less comfortable on Cera given it rich valuations.

STRATEGY NOTE CRS IN EQUITY November 17, 2016

Cera Sanitaryware

NOT RATED

Building Materials

Recommendation Mcap (bn): `29/US$0.4 3M ADV (mn): `54.7/US$0.8 CMP: `2,193 TP (12 mths): n.a. Downside (%): n.a.


Performance


Cera’s forensic score analysis


Cera’s greatness score analysis


Research Analysts Nitin Bhasin +91 22 3043 3241 [email protected]

Girisha Saraf +91 22 3043 3211 [email protected]

80

100

120

140

160

Nov

-15

Dec

-15

Jan-

16

Feb-

16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-

16

Aug

-16

Sep-

16

Cera Sanitary. Sensex

Cera Sanitaryware


Exhibit 1: Evolution of Cera Sanitaryware

Source: Company, Ambit Capital research (RoCE for the above purpose implies Median RoCE for that period)



Revenues 1,067 1,281 1,595 1,914 2,430 3,194 4,879 6,637 8,217 9,337

Revenue growth (%) 33% 20% 25% 20% 27% 31% 53% 36% 24% 14%

Net profits 91 101 147 196 265 320 462 519 677 835

EPS 7 8 10 15 21 25 37 41 52 64

CFO 124 134 215 255 295 78 424 634 406 1,138

CFO (pre-tax)/ EBITDA 85% 79% 87% 97% 93% 44% 83% 91% 60% 102%

FCF (98) (86) 171 228 79 (166) 44 235 (426) 248

Gross debt/equity (x) 0.6 0.7 0.5 0.3 0.3 0.3 0.3 0.2 0.2 0.2

RoE (%) 19% 19% 23% 25% 27% 26% 29% 26% 24% 22%

ROCE* (%) 19% 19% 22% 26% 30% 29% 33% 32% 29% 27%




FY05-08 Setting the base

In this phase, the company was much smaller than the leader – HSIL. To plug the gap, the company added capacities (to 24,000 MT in FY08as against 16,000MT in FY05) and started expanding its distribution

Initial stages of building brand through adding Cera Bath studios (display centres) Improved plant level efficiencies (leading to 20% increase in production) and also increased capacity of its

power capacities by installing a 1.25MW wind turbine generator in Gujarat

FY08-12 Product extensions

Increased manufacturing capacity by 33% to 2.7mn pieces in FY11. Also, tied up with Italian wellness major Novellini, SPA for launching premium wellness products in India

Established a faucetware unit in FY11 to extend its products beyond sanitaryware. It further expanded its product portfolio by adding kitchen sinks, mirrors and sensor products to its range under Bathware

Began plumber and architect influencing programmes, through adding sales manpower to build its intermediary connect

Debt/Equity receded to 0.34x in FY12 as against 0.68x in FY08

FY13-17 Building premium brand

Aggressively stared investing in the brand – hired Bollywood celebrities (Sonam Kapoor and Dia Mirza) as brand ambassadors.

Entered into the tiles business, first through outsourcing and has recently entered into a JV with Anjani Tiles in Hyderabad. The tiles segment accounts for 13% of Cera revenue currently. The company also plans to enter into a JV in Rajasthan

The company trebled its faucetware capacity to 2.34mn pieces in FY15. This segment now accounts for 20% of the company’s overall revenue

D/E reduced to 0.16x in FY16 as against 0.34x in FY13. The company also raised `700mn from Lighthouse capital for capacity expansions

Entered the luxury sanitary ware segment through exclusive tie up with Italian luxury designer sanitary ware brand, ISVEA, to market their luxury range of sanitary ware in India


0%

5%

10%

15%

20%

25%

30%

35%

- 100 200 300 400 500 600 700 800 900

1,000

FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Revenues Rsbn (LHS) RoCE pre-tax (%)

Setting the base: Sales CAGR: 26% RoCE: 19%

Product extensions: Sales CAGR: 26% RoCE: 27%

Building premium brand: Sales CAGR: 26% RoCE: 31%

Cera Sanitaryware


Exhibit 4: Competitive mapping


FY16 revenue

CAGR FY10-16

Industry market share


Pre-tax RoCE

(FY16)

Pre-tax CFO/ EBITDA

(FY10-16)

Capex/CFO (FY10-16)

Kajaria #1 23,073 18% ~10% 19% 37% 89% 81%

Somany #2 14,975 31% ~7% 7% 20% 87% 94%

Berger #2 14,010 33% ~20% 14% 33% 102% 50%

Astral #2 16,938 15% ~7% 12% 16% 97% 71%

Cera #1 12,000 14% ~23% 15% 29% 83% 74%

Century Ply #1 11,628 2% ~9% 17% 26% 71% 69%


Exhibit 5: Mapping Cera Sanitaryware and its peers on IBAS

Company Innovation Brand Architecture

Strategic asset


Rural Urban Mfg reach

Dstrbn reach

Kajaria

Ahead of competition in launching and building premium tile brand (Glazed and Double charged polished vitrified tiles). It is the only tile Super-brand in India and has the highest scale, strong distribution and is now building a professional management team

Somany

Somany’s has innovated in products and launched differentiated by launching tiles such as abrasion resistant VC tiles. It has a strong ceramic brand and has significantly improved its vitrified brand in the last few years. The company is the third largest manufacturer and has been investing in improving distribution. It is still way behind Kajaria in professionalizing management

Berger

Promoter’s hands-off approach and flying under the radar differentiates Berger from most other paint manufacturers. Aggressive sub-brand creation such as Silk and Illusions. Unique employee work culture which empowers and helps improve execution. Widest network of manufacturing locations – 9 across the country

Astral

Innovation in plastic pipes, first through creation of the CPVC market and then through launches of differentiated products of global majors in India. Strongest CPVC brand in India but weak in rural India. Relationships with Lubrizol for raw materials and real-estate developers and plumbers for retail pipes are it's unique architecture

Cera

Innovation in limited to a few products. It has a mid-segment brand recall and manufacturing is centred on a single location. Its unique advantage is the access to administered gas, which is 30% cheaper than spot gas.

HSIL

We do not note any major innovation by HSIL which set it apart from competition. The company has a strong brand and manufacturing capability. We don’t notice any unique strategic assets which competitors do not enjoy.

Century Ply

Century has not displayed any major product innovation. It is the most premium ply brand in India and has a wide spread manufacturing reach (seven plants in India) and is strengthening distribution to reach micro-markets. Access to face veneer from Myanmar and Laos through its own capacities, is its unique strategic asset.


Cera Sanitaryware


Exhibit 6: Mostly CFO and a small equity issuance were the key sources (`4.7bn)


Exhibit 7: Funds were mostly expended on capex (`3.5bn)


Exhibit 8: Strengthening of franchise and high earnings growth led to sharp re-rating


Exhibit 9: Cera’s share price performance vs Sensex




Accounting GREEN

Cera falls into the 5th decile on the HAWK framework; in FY14 the forensic score evolved to ‘zone of safety’ from ‘zone of pain’. Whilst the company does well in terms of (a) low contingent liability as % of net worth (at 3%), (b) low volatility in depreciation rate, (c) reasonable auditors remuneration and (d) low volatility in non-operating income; we would like to flag that the company (a) does not provide for doubtful debts, and (b) has high miscellaneous expenses as % of total revenue (at 3.6%).

Predictability GREEN Largely the business is fairly predictable excepting the demand related issues emanating from category specific issues or overall discretionary consumption spending. Management has not surprised on guidance and discussed business progress in detail at regular intervals







CFO, 70%

Equity issuance,

19%

Net borrowings

, 8%

Interest recd, 3%

Capex, 65% Net

increase in cash, 11%

Investments, 9%

Interest paid, 8%

Dividend paid, 7%

0

10

20

30

40

50

Nov

-10

May

-11

Nov

-11

May

-12

Nov

-12

May

-13

Nov

-13

May

-14

Nov

-14

May

-15

Nov

-15

May

-16

Nov

-16

1-year forward P/E (x) 6 yr avg P/E

0500

1,0001,5002,0002,5003,0003,5004,000

Nov

-07

May

-08

Nov

-08

May

-09

Nov

-09

May

-10

Nov

-10

May

-11

Nov

-11

May

-12

Nov

-12

May

-13

Nov

-13

May

-14

Nov

-14

May

-15

Nov

-15

May

-16

Nov

-16

Cera Sensex index

Cera Sanitaryware


Balance sheet (consolidated* in FY16)

(` mn) FY12 FY13 FY14 FY15 FY16



Total networth 1,392 1,795 2,240 3,517 4,210

Minority Interest - - - - 164

Debt 476 610 483 682 667



Gross block 1,324 1,753 2,117 2,879 3,145

Net block 903 1,251 1,517 2,147 2,298

CWIP 109 43 52 77 651


Debtors 455 831 1,066 1,612 1,884

Inventory 918 940 1,046 1,259 1,357

Loans & advances 231 307 418 572 754


Current liabilities 671 897 1,158 1,489 1,962

Provisions 271 332 450 477 689

Total current liabilities 942 1,229 1,608 1,965 2,651

Net current assets 981 1,260 1,234 1,776 1,961

Total assets 2,004 2,568 2,924 4,477 5,384


Income statement (consolidated* in FY16)

(` mn) FY12 FY13 FY14 FY15 FY16

Net Sales 3,194 4,879 6,637 8,217 9,337

% growth 31% 53% 36% 24% 14%


EBITDA 534 753 949 1,175 1,413

% growth 27% 16% 41% 26% 24%

Depreciation 77 94 122 155 163

EBIT 525 749 888 1,087 1,349



Adjusted PBT 485 678 824 1,009 1,295

Tax 165 216 305 333 460 Adjusted PAT before minority interest 320 462 519 677 835

% growth 21% 44% 12% 30% 23%

Minority Interest - - - - - Adjusted PAT after minority interest 320 462 519 677 835

Reported PAT after minority interest 320 462 519 677 835


Cera Sanitaryware


Cashflow statement (consolidated* in FY16)

(` mn) FY12 FY13 FY14 FY15 FY16

Net Profit Before Tax 485 678 824 1,009 1,295

Depreciation 77 94 122 155 163

Others 11 45 38 72 (2)

Tax (155) (200) (233) (296) (300)

(Incr) / decr in net working capital (340) (194) (118) (535) (18)

Cash flow from operations 78 424 634 406 1,138

Capex (net) (244) (380) (399) (832) (890)

(Incr) / decr in investments 69 (2) (108) (356) 17


Cash flow from investments (150) (356) (481) (1,173) (832)

Net borrowings 98 134 (128) 199 (15)

Issuance/buyback of equity - - - 706 164

Interest paid (39) (68) (63) (76) (51)

Dividend paid (37) (44) (59) (74) (98)

Cash flow from financing 23 22 (250) 755 (1)

Net change in cash (49) 91 (96) (12) 305


Free cash flow (166) 44 235 (426) 248


Ratio analysis (consolidated* in FY16)

(` mn) FY12 FY13 FY14 FY15 FY16

EBITDA margin (%) 16.7% 15.4% 14.3% 14.3% 15.1%

EBIT margin (%) 16.4% 15.4% 13.4% 13.2% 14.5%

Net profit (bef min. int.) margin (%) 10.0% 9.5% 7.8% 8.2% 8.9%

Dividend payout ratio (%) 12% 11% 12% 12% 14%

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



RoCE (pre-tax) (%) 29% 33% 32% 29% 27%

RoIC (pre-tax) (%) 31% 34% 35% 30% 28%

RoE (%) 26% 29% 26% 24% 22%


Valuation parameters (consolidated* in FY16)

(` mn) FY12 FY13 FY14 FY15 FY16

EPS after minority interest (`) 25.3 36.5 41.0 52.0 64.2

Diluted EPS (`) 25.3 36.5 41.0 52.0 64.2



P/E (x) 106.4 73.7 65.7 51.8 42.0

P/BV (x) 24.5 19.0 15.2 10.0 8.3

EV/EBITDA (x) 65.7 46.5 36.9 29.8 24.8

EV/EBIT (x) 66.8 46.8 39.5 32.3 26.0


Cera Sanitaryware


Appendix 1: How the Coffee Can is different to our other portfolio constructs "Forever is a good holding period."

– Warren Buffett

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

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

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

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

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

Please click here for the latest G&C portfolio published on August 29, 2016.

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

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

Exhibit 13: The ‘greatness’ framework

Source: Ambit Capital Research

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

Percentage improvements in performance over FY13-15 vs FY10-12; and

Consistency in performance over FY10-15 i.e. improvements adjusted for underlying volatility in financial data

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

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

b. Conversion of investment to sales (asset

turnover, sales)

c. Pricing discipline (PBIT margin)

d. Balance sheet discipline (D/E, cash ratio)

a. Investment (gross block)

e. Cash generation (CFO)

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_Good&Clean11_29Aug2016.pdf

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_Tomorrow%E2%80%99stenbaggers_19Jan2012.pdf

Cera Sanitaryware


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

Exhibit 14: Factors used for quantifying greatness Head Criteria

1 Investments a. Above median gross block increase (FY13-15 over FY10-12)*

b. Above median gross block increase to standard deviation

2 Conversion to sales a. Improvement in asset turnover (FY13-15 over FY10-12)*

b. Positive improvement in asset turnover adjusted for standard deviation

c. Above median sales increase (FY13-15 over FY10-12)*

d. Above median sales increase to standard deviation

3 Pricing discipline a. Above median PBIT margin increase (FY13-15 over FY10-12)*

b. Above median PBIT margin increase to standard deviation

4 Balance sheet discipline a. Below median debt-equity decline (FY13-15 over FY10-12)*

b. Below median debt-equity decline to standard deviation

c. Above median cash ratio increase (FY13-15 over FY10-12)*

d. Above median cash ratio increase to standard deviation

5 Cash generation and PAT improvement a. Above median CFO increase (FY13-15 over FY10-12)*

b. Above median CFO increase to standard deviation

c. Above median adj. PAT increase (FY13-15 over FY10-12)*

d. Above median adj. PAT increase to standard deviation

6 Return ratio improvement a. Improvement in RoE (FY13-15 over FY10-12)*

b. Positive improvement in RoE adjusted for standard deviation

c. Improvement in RoCE (FY13-15 over FY10-12)*

d. Positive improvement in RoCE adjusted for standard deviation

Source: Ambit Capital research; Note: * Rather than comparing one annual endpoint to another annual endpoint (say, FY10 to FY15), we prefer to average the data out over FY10-12 and compare that to the averaged data from FY13-15. This gives a more consistent picture of performance (as opposed to simply comparing FY10 to FY15).

The ten-bagger portfolio focuses on structural plays that are financially strong firms (with credible management teams) and remain consistent performers on a cross-cyclical basis. Companies are identified based on their relentless improvement in financial performance over long periods of time (usually, six years). This portfolio is ideal for conventional buy-and-hold investors with a 1-3 year horizon.

Adding the Coffee Can for long-term investors with a ten-year outlook

To this suite of portfolios, we add the Coffee Can which is ideal for long-term investors with a ten-year outlook. In the table below, we summarise our portfolio recommendations for investors.

Exhibit 15: Our suite of Portfolios for investors looking to invest in India

Type of Investor Recommended Ambit Portfolio

Returns over recommended time period

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

The 16 instalments of our ‘Good & Clean’ portfolios over the last five years have delivered a staggering 4.1% alpha on a CAGR basis

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

The five iterations of our ten-bagger portfolios have generated over 10.2% alpha on a CAGR basis over the past five years

Long-term investor with ten-year outlook Coffee Can Portfolio Average alpha of 8.3% over seven ten-

year iterations using total returns Source: Ambit Capital Research

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

Cera Sanitaryware


Appendix 2: Performance of the 14 back-tested Coffee Can Portfolio Period 1: 2000-2010 (6.6% alpha relative to the Sensex; 22.6% per annum absolute returns) All-cap portfolio stocks: NIIT, Cipla, Hero MotoCorp, Swaraj Engines, HDFC

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

In the first iteration, both versions of the CCP outperformed the benchmark. Whilst the all-cap CCP delivered a 22.6% return (6.6% alpha to the Sensex), the large-cap portfolio delivered a 23.6% return (7.6% alpha to the Sensex). The maximum drawdown for both the portfolios in this period was also less than the maximum drawdown for the Sensex.

Exhibit 16: First iteration summary

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

CAGR returns 22.6% 23.6% 16.0%

Maximum drawdown** -35% -30% -56%

Excess returns 0.42 0.53 0.14

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2000. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to February 2009 for the all-cap CCP and Sensex and December 2007 to December 2008 for the large-cap CCP.

The five stocks that constituted the first iteration of the Coffee Can Portfolio consisted of one IT company, one pharma company, one BFSI company and two companies from the automobile/auto-ancillary sector. These were NIIT, Cipla, Hero MotoCorp HDFC Ltd and Swaraj Engines. The star performers during this period were Hero MotoCorp and HDFC which proved to be a ten-bagger whilst NIIT collapsed ~74% in this period.

Exhibit 17: Portfolio performance during the first iteration


Value at end (` bn) Total return

CAGR Date from/to 30-Jun-00 30-Jun-10

NIIT 100 26 -13%

Cipla 100 531 18%

Hero MotoCorp 100 1,499 31%

Swaraj Engines 100 493 17%

H D F C 100 1,283 29%

Portfolio 500 3,831 23%

Sensex 100 441 16%

Outperformance 6.6%

Source: Bloomberg, Ambit Capital research. Note: *Portfolio price at start of `500 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `500 at the start to `3,831 at the end.

Exhibit 18: Hero and HDFC rose exponentially whilst NIIT collapsed in 2000-2010

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of `100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from `500 at the start to `3,831 at the end.

-

1,000

2,000

3,000

4,000

5,000

Value at start Vaue at end

Swaraj Engines

Hero Motocorp

Cipla

NIIT

H D F C

Hero MotoCorp and HDFC were the star performers, whilst NIIT was the laggard in Period 1

Cera Sanitaryware


Period 2: 2001-2011 (11.7% alpha relative to the Sensex; 32.2% per annum absolute returns) All-cap portfolio stocks: Cipla, Hero MotoCorp, Apollo Hospitals, Roofit Inds, HDFC Ltd and LIC Housing Finance

Large-cap portfolio stocks: Cipla, Hero MotoCorp and HDFC

Both versions of the CCP performed well during the second iteration as well, beating the Sensex. The all-cap and large-cap CCP gave an impressive alpha of 11.7% and 7.8% respectively for this iteration. The portfolio was remarkably steady as compared to the maximum drawdown, delivering an excess return of 0.66-0.72x.

Exhibit 19: Second iteration summary


CAGR returns 32.2% 28.3% 20.5%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 29 June 2001. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to November 2008 for the all-cap CCP and the large-cap CCP and December 2007 to February 2009 for the Sensex.

During the second iteration, the Coffee Can Portfolio consisted of six stocks with three repeats (Cipla, Hero MotoCorp and HDFC from Period 1) and three new entries (Apollo Hospitals, Roofit Industries and LIC Housing Finance). During this period, note that one of the stocks in the portfolio, Roofit Industries, was delisted during 2001-2011. Despite this, the portfolio performed admirably. The star performer was LIC Housing Finance that delivered 46.7x returns whilst Cipla was a laggard at 3.0x.

Exhibit 20: Portfolio performance during the second iteration




Cipla 100 396 15%


Apollo Hospitals 100 1,409 30%

Roofit Inds. 100 4 -27%

H D F C 100 1,242 29%

LIC Housing Fin. 100 4,767 47%

Portfolio 600 9,802 32%

Sensex 100 646 20%



Exhibit 21: LIC Housing Finance was the stellar performer during 2001-2011


-

2,000

4,000

6,000

8,000

10,000

12,000


LIC Housing Fin.

H D F C

Roofit Inds.

Apollo Hospitals

Hero Motocorp

Cipla

LIC Housing Finance was the star performer delivering ~47x total returns in Period 2

Cera Sanitaryware


Period 3: 2002-2012 (5.1% alpha to the Sensex; 25.4% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Gujarat Gas, Aurobindo Pharma, HDFC and LIC Housing Finance Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, HDFC During the third iteration, the Coffee Can delivered an alpha of 5.1% whilst the large-cap Coffee Can delivered an alpha of 3.3%. Both versions of the Coffee Can performed well during maximum drawdown as well, delivering excess returns of 0.43x-0.49x.

Exhibit 22: Third iteration summary


CAGR returns 25.4% 23.7% 20.3%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 28 June 2002. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to November 2008 for the all-cap CCP, December 2007 to December 2008 for the large-cap CCP and December 2007 to February 2009 for the Sensex.

The number of stocks making it to the 2002 edition of the Coffee Can Portfolio was much higher than the previous two iterations. A total of eight stocks qualified to be part of the Coffee Can Portfolio in the third iteration. Cipla, Hero MotoCorp, HDFC Ltd and LIC Housing were repeated yet again whilst the other four stocks were Infosys, Container Corporation, Gujarat Gas and Aurobindo Pharma.

Exhibit 23: Portfolio performance during the third iteration




Infosys 100 706 22%


Cipla 100 461 16%

Container Corpn. 100 740 22%

Guj Gas Company 100 763 23%

Aurobindo Pharma 100 505 18%

H D F C 100 1,237 29%

LIC Housing Fin. 100 2,260 37%

Portfolio 800 7,709 25%

Sensex 100 637 20%

Outperformance 5.1%


Exhibit 24: Portfolio’s outperformance was led by LIC Housing Finance once again


-

2,000

4,000

6,000

8,000

10,000


LIC Housing Fin.

H D F C

Aurobindo Pharma

Guj Gas Company

Container Corpn.

Cipla

Hero Motocorp

Infosys

LIC Housing Finance continued to dominate portfolio returns in period 3

Cera Sanitaryware


Period 4: 2003-2013 (7.2% alpha to the Sensex; 27.4% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Sun Pharma, Container Corporation of India, Gujarat Gas, Aurobindo Pharma, HDFC, LIC Housing Finance

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

Whilst the all-cap version of the portfolio delivered a 7.2% alpha, the large-cap version gave a higher 9% alpha in the fourth iteration. In a maximum drawdown situation, both versions remained steady and beat the Sensex, delivering excess returns of 0.62-0.77x.

Exhibit 25: Fourth iteration summary


CAGR returns 27.4% 29.2% 20.2%




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

Exhibit 26: Portfolio performance during the fourth iteration



CAGR Date from/to 30-Jun-03 30-Jun-13 Infosys 100 713 22% Cipla 100 710 22% Hero MotoCorp 100 958 25% Sun Pharma 100 3,381 42% Container Corpn. 100 736 22% Aurobindo Pharma 100 528 18% Guj Gas Company 100 518 18% H D F C 100 1,292 29% LIC Housing Fin. 100 1,338 30% Portfolio 900 10,175 27% Sensex 100 631 20% Outperformance 7.2%


Exhibit 27: Sun Pharma delivered a stellar performance in Period 4


-

2,000

4,000

6,000

8,000

10,000

12,000


LIC Housing Fin.H D F CGuj Gas CompanyAurobindo PharmaContainer Corpn.Sun Pharma.Inds.Hero MotocorpCiplaInfosys

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

Cera Sanitaryware


Period 5: 2004-2014 (12.7% alpha to the Sensex; 32.6% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Gujarat Gas, Alok Industries, Munjal Showa and Havells India, HDFC and LIC Housing Finance

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

The fifth iteration of our Coffee Can Portfolio yielded a whopping 12.7% alpha over the Sensex. The portfolio was equally divided between large-caps and mid-caps/small-caps. The higher share of the mid-caps/small-caps vs earlier iterations was instrumental in delivering higher alpha during this period.

Exhibit 28: Fifth iteration summary 2004-2014* All-cap CCP Large-cap CCP Sensex CAGR returns 32.6% 22.1% 19.9% Maximum drawdown** -62% -31% -56% Excess returns 0.40 0.45 0.21


The performance amongst the mid-cap/small-cap stocks was extreme: Whilst Havells delivered ~96.7x returns, Alok Industries on the other hand delivered -60% by the end of the iteration. Given the phenomenal performance by Havells during the period, the performance of the large-cap portfolio (22.1% CAGR) lagged that of the all-cap portfolio (32.6% CAGR).

Exhibit 29: Portfolio performance during the fifth iteration



CAGR Date from/to 30-Jun-04 30-Jun-14 Infosys 100 547 19% Hero MotoCorp 100 710 22% Cipla 100 561 19% Container Corpn. 100 738 22% Guj Gas Company 100 1,199 28% Alok Inds. 100 40 -9% Munjal Showa 100 627 20% Havells India 100 9,764 58% H D F C 100 1,123 27% LIC Housing Fin. 100 1,540 31% Portfolio 1,000 16,849 33% Sensex 100 616 20% Outperformance 12.7%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1000 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `1000 at the start to `16,849 at the end.

Exhibit 30: Havells India was the star performer in Period 5


-

5,000

10,000

15,000

20,000


LIC Housing Fin.H D F CHavells IndiaMunjal ShowaAlok Inds.Guj Gas CompanyContainer Corpn.CiplaHero MotocorpInfosys

The CCP delivered a whopping 12.7% to the Sensex, in Period 5

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

Cera Sanitaryware


Period 6: 2005-2015 (6.0% alpha to the Sensex; 22.1% per annum absolute returns) All-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Geometric, Havells India, Ind-Swift, Munjal Showa and HDFC Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India and HDFC In the sixth iteration, our Coffee Can Portfolio again outperformed the Sensex with an alpha of 6.0%. The large-cap version also outperformed the Sensex with an alpha of 3.4%. In this period, while the all-cap version generated a higher alpha than the large-cap version on an absolute basis, on a risk-adjusted basis, large-cap version beat all-cap version mainly on account of lower maximum drawdown (excess return of 0.41x for large cap vs. 0.26x for all cap). Both versions, however, continued to perform better than Sensex on risk–adjusted basis as well. Exhibit 31: Sixth iteration summary


CAGR returns 22.1% 19.5% 16.1%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2005. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to February 2009 for the all-cap CCP and Sensex; and from December 2007 to December 2008 for the large-cap CCP.

The extreme price performance among mid-cap/small-cap stocks continued during this iteration as well: Havells’ delivered ~30.6x returns whilst Ind-Swift delivered -92% returns by the end of the iteration. Exhibit 32: Portfolio performance during the sixth iteration



CAGR Date from/to 30-Jun-05 30-Jun-15 Infosys 100 394 15% Hero MotoCorp 100 607 20% Cipla 100 529 18% Container Corpn. 100 612 20% Geometric 100 121 2% Havells India 100 3,155 41% Ind-Swift 100 8 -22% Munjal Showa 100 391 15% H D F C 100 827 24% Portfolio 900 6,643 22% Sensex 100 446 16% Outperformance 6.0%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `900 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `900 at the start to `6,643 at the end.

Exhibit 33: Havells India continued being star performer in sixth iteration as well


-

1,000

2,000

3,000

4,000

5,000

6,000

7,000


H D F C

Munjal Showa

Ind-Swift

Havells India

Geometric

Container Corpn.

Cipla

Hero Motocorp

Extreme price performance among mid-cap/small-cap stocks continued in period 6

Cera Sanitaryware


Period 7: 2006-2016 (8.9% alpha to the Sensex; 20.3% per annum absolute returns) All-cap portfolio stocks: Infosys, Cipla, Hero MotoCorp, Container Corporation of India, Geometric, Havells India, Suprajit Engineering, Munjal Showa, HDFC and HDFC Bank

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

In the seventh iteration, our Coffee Can Portfolio has again outperformed the Sensex with an alpha of 8.9%. The large-cap version has also outperformed the Sensex with an alpha of 5.7%. On a risk-adjusted basis, as well, both versions beat the Sensex with excess return of 0.25-0.28x vs. 0.06x for the Sensex.

Exhibit 34: Seventh iteration summary 2006-2016* All-cap CCP Large-cap CCP Sensex CAGR returns 20.3% 17.1% 11.4% Maximum drawdown** -49% -33% -56% Excess returns 0.25 0.28 0.06

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2006. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to February 2009 for the all-cap CCP and Sensex; and from December 2007 to November 2008 for the large-cap CCP.

Mid-cap/small-cap stocks again outperformed in this period with Havells and Suprajit Engineering delivering 13.4x and 11.9x returns respectively.

Exhibit 35: Portfolio performance during the seventh iteration



CAGR Date from/to 30-Jun-06 30-Jun-16 Infosys 100 361 14% Cipla 100 248 10% Hero MotoCorp 100 551 19% Container Corpn. 100 342 13% Havells India 100 1,441 31% Geometric 100 296 11% Munjal Showa 100 431 16% Suprajit Engg. 100 1,291 29% H D F C 100 622 20% HDFC Bank 100 794 23% Portfolio 1,000 6,376 20% Sensex 100 294 11% Outperformance 8.9%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,000 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `1,000 at the start to `6,376 at the end.

Exhibit 36: Mid-caps continued their outperformance in seventh iteration


-

1,000

2,000

3,000

4,000

5,000

6,000

7,000


HDFC Bank

H D F C

Suprajit Engg.

Munjal Showa

Geometric

Havells India

Container Corpn.

Hero Motocorp

Cipla

Infosys

Mid-caps continued their outperformance in the seventh iteration

Cera Sanitaryware


Period 8: 2007-Present (10.8% alpha to the Sensex; 19.5% per annum absolute returns) All-cap portfolio stocks: Infosys, Wipro, Cipla, Tech Mahindra, Hindalco, Hero MotoCorp, Container Corporation of India, Asian Paints, Havells India, Geometric, Aftek, Munjal Showa, Suprajit Engineering, HDFC and HDFC Bank

Large-cap portfolio stocks: Infosys, Wipro, Cipla, Tech Mahindra, Hindalco, Hero MotoCorp, Container Corporation of India, Asian Paints, HDFD and HDFC Bank

In the eighth iteration, our Coffee Can Portfolio continued its outperformance versus the Sensex both on an absolute and risk adjusted basis. The large-cap CCP beat the all-cap CCP on a risk adjusted basis (0.24x for large cap CCP vs. 0.22x for all-cap CCP).

Exhibit 37: Eighth iteration summary


CAGR returns 19.5% 17.4% 8.8%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2007. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2007 to February 2009 for the all-cap CCP, large-cap CCP and for the Sensex.

In this iteration, amongst large caps, Asian Paints lead the charge with almost 14.9x returns. Extreme movements were seen in mid-cap stocks again with stocks like Suprajit Engineering delivering almost 15.4x returns whereas Aftek delivered -96% returns.

Exhibit 38: Portfolio performance during the eighth iteration



CAGR Date from/to 30-Jun-07 30-Sep-16

Infosys 100 253 11%

Wipro 100 196 8%

Cipla 100 297 12%

Tech Mahindra 100 131 3%

Hindalco Inds. 100 116 2%

Hero MotoCorp 100 665 23%

Container Corpn. 100 202 8%

Asian Paints 100 1,587 35%

Havells India 100 952 28%

Geometric 100 221 9%

Aftek 100 4 -30%

Munjal Showa 100 591 21%

Suprajit Engg. 100 1,635 35%

H D F C 100 386 16%

HDFC Bank 100 592 21%

Portfolio 1,500 7,828 20%

Sensex 100 218 9%


Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,500 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `1500 at the start to `7,828 until Sep ‘16.

Suprajit Engineering and Asian Paints have proven to be the star performers in the eighth iteration so far

Cera Sanitaryware


Exhibit 39: Suprajit Engineering and Asian Paints have been the star performers in the eighth iteration

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of `100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from `1500 at the start to `7,828 until Sep ‘16. Period 9: 2008-Present (11.2% alpha to the Sensex; 22.1% per annum absolute returns) All-cap portfolio stocks: Infosys, Wipro, Cipla, Asian Paints, Tech Mahindra, Havells India, Automotive Axles, Geometric, HDFC, HDFC Bank and Punjab National Bank

Large-cap portfolio stocks: Infosys, Wipro, Cipla, Asian Paints, Tech Mahindra, HDFC, HDFC Bank and Punjab National Bank

Our ninth iteration that began in June 2008 is also outperforming the Sensex with an alpha of 11.2%. The large-cap version too continues to beat the Sensex with an alpha of 8.5%. The large-cap version on account of lower drawdown has the highest risk adjusted return at 0.30x vs. 0.29x for all-cap version and 0.07x for the Sensex.

Exhibit 40: Ninth iteration summary


CAGR returns 22.1% 19.3% 10.9%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2008. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from July 2008 to February 2009 for the all-cap CCP, large-cap CCP and for the Sensex.

Both large-caps and mid-caps shared the outperformance during this iteration with Asian Paints and HDFC Bank delivering 10x and 5.7x returns respectively whilst Havells India is continuing its dream run with 12.4x returns.

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000


HDFC BankH D F CSuprajit Engg.Munjal ShowaAftekGeometricHavells IndiaAsian PaintsContainer Corpn.Hero MotocorpHindalco Inds.Tech MahindraCiplaWiproInfosys

Both large-caps as well as mid-caps have shared the outperformance during the ninth iteration

Cera Sanitaryware


Exhibit 41: Portfolio performance during the ninth iteration




Infosys 100 277 13%

Wipro 100 228 10%

Cipla 100 290 14%

Asian Paints 100 1,103 34%

Tech Mahindra 100 256 12%

Havells India 100 1,339 37%

Automotive Axles 100 355 17%

Geometric 100 585 24%

H D F C 100 395 18%

HDFC Bank 100 671 26%

Punjab Natl. Bank 100 226 10%

Portfolio 1,100 5,724 22%

Sensex 100 235 11%


Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,100 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `1,100 at the start to `5,724 until Sep ‘16.

Exhibit 42: Large-caps and mid-caps shared outperformance in this iteration

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of `100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from `1,100 at the start to `5,724 until Sep ‘16.

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000


Punjab Natl.Bank

HDFC Bank

H D F C

Geometric

Automotive Axles

Havells India

Tech Mahindra

Asian Paints

Cipla

Wipro

Infosys

Cera Sanitaryware


Period 10: 2009-present (11.5% alpha to the Sensex; 22.7% per annum absolute returns) All-cap portfolio stocks: Infosys, Wipro, Jindal Steel, Cipla, Asian Paints, Oracle Financial Services, Tech Mahindra, Motherson Sumi, HDFC, HDFC Bank and Punjab National Bank Large-cap portfolio stocks: Infosys, Wipro, Jindal Steel, Cipla, Asian Paints, Oracle Financial Services, HDFC, HDFC Bank and Punjab National Bank In the iteration beginning in 2009, both all-cap and large-cap CCP beat the Sensex comprehensively again with alpha of 11.5% and 7.2% respectively. On a risk adjusted basis, they gave a stable performance as well with excess returns of 0.56-0.69x.

Exhibit 43: Tenth iteration summary


CAGR returns 22.7% 18.3% 11.1%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2009. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from July 2015 to February 2016 for the all-cap CCP; and December 2010 to December 2011 for the large-cap CCP and Sensex. Motherson Sumi has been the star performer in this iteration having delivered ~14.4x returns during this period.

Exhibit 44: Portfolio performance during the tenth iteration



CAGR Date from/to 30-Jun-09 30-Sep-16 Infosys 100 266 14% Wipro 100 262 14% Jindal Steel 100 19 -21% Cipla 100 239 13% Asian Paints 100 1,049 38% Oracle Fin. Serv. 100 317 17% Tech Mahindra 100 245 13% Motherson Sumi 100 1,544 46% HDFC Bank 100 450 23% H D F C 100 331 18% Punjab Natl. Bank 100 121 3% Portfolio 1,100 4,843 23% Sensex 100 215 11% Outperformance 11.5%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,100 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `1,100 at the start to `4,843 until Sep ‘16.

Exhibit 45: Motherson Sumi has been the star performer in this iteration


-

1,000

2,000

3,000

4,000

5,000

6,000


Punjab Natl.BankH D F CHDFC BankMotherson SumiTech MahindraOracle Fin.Serv.Asian PaintsCiplaJindal SteelWiproInfosys

The returns for the tenth iteration have largely been dominated by Motherson Sumi and Asian Paints

Cera Sanitaryware


Period 11: 2010-Present (9.5% alpha to the Sensex; 18.7% per annum absolute returns) All-cap portfolio stocks: Asian Paints, Amar Remedies, Motherson Sumi, Tulip Telecom, HDFC Bank, Punjab National Bank and Dewan Housing Finance

Large-cap portfolio stocks: Asian Paints, HDFC Bank and Punjab National Bank

This iteration of the Coffee Can Portfolio too continues to outperform the Sensex (with an alpha of 9.5%). The large-cap version beat both the Sensex and the all-cap version in this iteration with an outperformance of 11.2% and 1.8% respectively.

Exhibit 46: Eleventh iteration summary


CAGR returns 18.7% 20.4% 9.2%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2010. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from October 2010 to August 2013 for the all-cap CCP; June 2011 to December 2011 for the large-cap CCP and December 2010 to December 2011 for the Sensex.

The performance of the portfolio in this iteration continues to be led by Motherson Sumi and Asian Paints. In spite of suspension of trading in two of the constituent stocks through the period (Amar Remedies and Tulip Telecom), the portfolio continues to deliver a stellar performance with an 18.7% CAGR.

Exhibit 47: Portfolio performance during the eleventh iteration




Amar Remedies 100 8 -33%


Motherson Sumi 100 789 39%

Tulip Telecom 100 1 -53%

HDFC Bank 100 348 22%

Punjab Natl. Bank 100 77 -4%

Dewan Hsg. Fin. 100 284 18%

Portfolio 700 2,042 19%

Sensex 100 173 9%

Outperformance 9.5%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `700 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `700 at the start to `2,042 until Sep ‘16.

Exhibit 48: Motherson Sumi and Asian Paints continue to be the star performers in this iteration

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of `100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from `700 at the start to `2,042 until Sep ‘16.

-

500

1,000

1,500

2,000

2,500


Dewan Hsg. Fin.

Punjab Natl.Bank

HDFC Bank

Tulip Telecom

Motherson Sumi

Asian Paints

Amar Remedies

Even in the eleventh iteration Motherson Sumi and Asian Paints have dominated the portfolio returns

Cera Sanitaryware


Period 12: 2011-present (2.7% alpha to the Sensex; 12.1% per annum absolute returns) All-cap portfolio stocks: ITC, Asian Paints, Motherson Sumi, Ipca Labs, Tulip Telecom, Zylog Systems, Pratibha industries, Unity Infra, Amar Remedies, Setco Automotive, HDFC Bank, Punjab National Bank, Dewan Housing and City Union Bank

Large-cap portfolio stocks: ITC, Asian Paints, HDFC Bank and Punjab National Bank

This iteration gave the weakest result in terms of both the absolute performance of our Coffee Can Portfolio and the alpha generated versus the Sensex. The large-cap version continued its outperformance in this iteration as well beating both the all-cap version and the Sensex on both absolute and risk-adjusted return measures.

Exhibit 49: Twelfth iteration summary


CAGR returns 12.1% 17.0% 9.4%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2011. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from April 2012 to August 2013 for the all-cap CCP, July 2011 to December 2011 for the large-cap CCP and February 2015 to February 2016 for the Sensex.

Extreme price performance among mid-cap/small-cap stocks was seen during this iteration. Motherson Sumi delivered 4.0x returns during this period whilst Zylog Systems lost 99% of its value.

Exhibit 50: Portfolio performance during the twelfth iteration


Value at end (` bn)

Total return CAGR

5.26 Date from/to 30-Jun-11 30-Sep-16

ITC 100 196 14%


Motherson Sumi 100 505 36%

Ipca Labs. 100 179 12%

Tulip Telecom 100 1 -59%

Zylog Systems 100 1 -55%

Pratibha Inds. 100 34 -19%

Unity Infra. 100 18 -28%


Setco Automotive 100 222 16%

HDFC Bank 100 263 20%




Portfolio 1,400 2,550 12%

Sensex 100 161 9%

Outperformance 2.7%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,400 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `1,400 at the start to `2,550 until Sep ’16.

Extreme price performance amongst small/mid-caps can be seen in the twelfth iteration

Cera Sanitaryware


Exhibit 51: Extreme price performance was seen in mid/small-caps in this iteration

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of `100 in each stock at the start of the period. Value at end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from `1,400 at the start to `2,550 until Sep ’16.

Period 13: 2012- Present (9.9% alpha to the Sensex; 23.3% per annum absolute returns) All-cap portfolio stocks: ITC, Asian Paints, Marico, Opto Circuits, Ipca Labs, Berger Paints, Page Industries, Balkrishna Industries, Grindwell Norton, Zylog Systems, Tecpro Systems, Pratibha Industries, Astral Poly Technik, Amar Remedies, Unity Infra, Setco Automotive, HDFC Bank, Axis Bank, Punjab National Bank, Allahabad Bank, Dewan Housing and City Union Bank Large-cap portfolio stocks: ITC, Asian Paints, HDFC Bank, Axis Bank and Punjab National Bank In the iteration beginning June 2012, the all-cap version again came to the fore, beating both the Sensex and the large-cap CCP on both absolute basis and risk-adjusted basis.

Exhibit 52: Thirteenth iteration summary


CAGR returns 23.3% 19.5% 13.4%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2012. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2012 to August 2013 for the all-cap CCP, May 2013 to August 2013 for the large-cap CCP and from February 2015 to February 2016 for the Sensex.

With 22 companies making the cut in this iteration, this was the biggest Coffee Can Portfolio in terms of number of constituent companies. Astral Poly Technik was the star performer in this iteration with almost 9x returns. Zylog Systems and Tecpro Systems, on the other hand, lost almost their entire value with a drop of 99% and 97% respectively.

-

500

1,000

1,500

2,000

2,500

3,000


City Union BankDewan Hsg. Fin.Punjab Natl.BankHDFC BankSetco AutomotiveAmar RemediesUnity Infra.Pratibha Inds.Zylog SystemsTulip TelecomIpca Labs.Motherson SumiAsian PaintsITC

The thirteenth iteration has been the biggest CCP in terms of number of stocks in the portfolio

Cera Sanitaryware


Exhibit 53: Portfolio performance during the thirteenth iteration




ITC 100 151 10%


Marico 100 321 32%

Opto Circuits 100 8 -45%

Ipca Labs. 100 170 13%




Grindwell Norton 100 292 29%

Zylog Systems 100 1 -67%

Tecpro Systems 100 3 -57%





Setco Automotive 100 162 12%

HDFC Bank 100 233 22%

Axis Bank 100 278 27%


Allahabad Bank 100 56 -13%



Portfolio 2,200 5,356 23%

Sensex 100 171 13%

Outperformance 9.9%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `2,200 denotes an equal allocation of `100 in each stock at the start of the period. Thus, for this period, the value of the portfolio rose from `2,200 at the start to `5,356 until Sep ‘16.

Exhibit 54: Astral Poly Technik outperformed other stocks in this iteration


-

1,000

2,000

3,000

4,000

5,000

6,000


City Union BankDewan Hsg. Fin.Allahabad BankPunjab Natl.BankAxis BankHDFC BankSetco AutomotiveUnity Infra.Amar RemediesAstral PolyPratibha Inds.Tecpro SystemsZylog SystemsGrindwell NortonBalkrishna IndsPage IndustriesBerger PaintsIpca Labs.Opto CircuitsMaricoAsian PaintsITC

Cera Sanitaryware


Period 14: 2013-present (21.4% alpha to the Sensex; 34.8% per annum absolute returns) All-cap portfolio stocks: ITC, HCL Technologies, Asian Paints, Marico, Berger Paints, Ipca, Page Industries, Balkrishna Industries, Solar Industries, Astral Poly Technik, Pratibha Industries, Unity Infra, Sarla Performance Fibers, HDFC Bank, Axis Bank, Indian Bank, City Union Bank and Dewan Housing

Large-cap portfolio stocks: ITC, HCL Technologies, Asian Paints, Marico, HDFC Bank, Axis Bank

The June 2013 has given the best results thus far with a whopping return of 34.8% on a CAGR basis. Sensex over the same period generated a CAGR return of 13.5%, whereas the large-cap portfolio generated a CAGR return of 26.4%.

Exhibit 55: Fourteenth iteration summary


CAGR returns 34.8% 26.4% 13.5%



Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2013. Excess returns have been calculated as returns in excess of risk-free rate (assumed to be 8%) divided by absolute maximum drawdown. Maximum drawdown is defined as the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. ** Maximum drawdown took place from December 2015 to February 2016 for the all-cap CCP, from July 2015 to February 2016 for the large-cap CCP and from February 2015 to February 2016 for the Sensex.

Mid-cap stocks led the performance of the profile in this iteration with some of the stocks’ prices rising 3-4 times since the beginning of this portfolio in June 2013. These stocks included names like Astral Poly Technik, Balkrishna Industries, Page Industries, Sarla Performance Fibers and Solar Industries. Unity Infraprojects and Pratibha Industries on the other hand are amongst stocks that lost value in this period.

Exhibit 56: Portfolio performance during the fourteenth iteration




ITC 100 119 5%

HCL Technologies 100 220 27%


Marico 100 283 38%


Ipca Labs. 100 93 -2%



Solar Inds. 100 360 48%




Sarla Performance 100 467 61%

HDFC Bank 100 195 23%

Axis Bank 100 213 26%

Indian Bank 100 198 23%



Portfolio 1,800 4,762 35%

Sensex 100 151 13%


Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,800 denotes an equal allocation of `100 in each stock at the start of the period. Portfolio price at end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from `1,800 at the start to `4,762 until Sep ’16.

Mid-caps drove the outperformance for the fourteenth iteration

Cera Sanitaryware


Exhibit 57: Mid-caps led the charge in this iteration driving most of the portfolio returns


-

1,000

2,000

3,000

4,000

5,000

6,000


Dewan Hsg. Fin.City Union BankIndian BankAxis BankHDFC BankSarla PerformancUnity Infra.Pratibha Inds.Astral PolySolar Inds.Balkrishna IndsPage IndustriesIpca Labs.Berger PaintsMaricoAsian PaintsHCL TechnologiesITC

Cera Sanitaryware


Appendix 3: John Kay’s IBAS Framework “I don’t want an easy business for competitors. I want a business with a moat around it. I want a very valuable castle in the middle and I want the duke who is in charge of that castle to be very honest and hardworking and able. Then I want a moat around that castle. The moat can be various things. The moat around our auto insurance business, GEICO, is low cost.” – Warren Buffett

“I always try and spend the last few minutes… to touch on a competitor, or a company they do business with, such as a supplier or a customer. Although not all managements will talk about other companies, when they do, it can be very revealing. The ultimate commendation is when a company talks positively about a competitor. I always put a strong weight on such a view.”

– Anthony Bolton, the legendary fund manager who ran the Fidelity Special Situations fund

Sustainable competitive advantages allow firms to add more value than their rivals and to continue doing so over long periods of time. But where do these competitive advantages come from? And why is it that certain firms seem to have more of these advantages than others?

In his 1993 book, ‘Foundations of Corporate Success’, John Kay, the British economist and Financial Times columnist, wrote more comprehensibly and clearly about this than any other business guru. John states that “sustainable competitive advantage is what helps a firm ensure that the value that it adds cannot be competed away by its rivals”. He goes on to state that sustainable competitive advantages can come from two sources: distinctive capabilities or strategic assets. Whilst strategic assets can be in the form of intellectual property (patents and proprietary know-how), legal rights (licenses and concessions) or a natural monopoly, the distinctive capabilities are more intangible in nature.

Distinctive capabilities, says Kay, are those relationships that a firm has with its customers, suppliers or employees, which cannot be replicated by other competing firms and which allow the firm to generate more value additions than its competitors. He further divides distinctive capabilities into three categories:


Architecture

Innovation

Let us delve into these in more detail, as understanding them is at the core of understanding the strength of a company’s franchise.


"A product can be quickly outdated, but a successful brand is timeless." – Stephen King, American novelist, author & TV Producer

In many markets, product quality, in spite of being an important driver of the purchase decision, can only be ascertained by a long-term experience of using that product. Examples of such products are insurance policies and healthcare. In many other markets, the ticket price of the product is high; hence, consumers are only able to assess the quality of the product only after they have parted with their cash. A few examples of such products would be cars and high-end TVs.

In both these markets, customers use the strength of the company’s reputation as a proxy for the quality of the product or the service. For example, we gravitate towards the best hospital in town for critical surgery and we tend to prefer world-class brands whilst buying expensive home entertainment equipment. Since the reputation for such high-end services or expensive electronics takes many years to build, reputation tends to be difficult and costly to create. This in turn makes it a very powerful source for a competitive advantage.

Sustainable competitive advantages allow firms to add value and continue doing so over long periods

John Kay’s framework focusses on ‘Innovation’, ‘Brands’, ‘Architecture’ and ‘Strategic Assets’ as sources of sustainable competitive advantage

“A product can be quickly outdated, but a successful brand is timeless”

Cera Sanitaryware


For products that we use daily, we tend to be generally aware of the strength of a firm’s brand. In more niche products or B2B products (e.g. industrial cables, mining equipment, municipal water purification, and semiconductors), investors often do not have first-hand knowledge of the key brands in the relevant market. In such instances, to assess the strength of the brand, they turn to:

Brand recognition surveys conducted by the trade press.

The length of the warranties offered by the firm (the longer the warranties, the more unequivocal the statement it makes about the firm’s brand).

The amount of time the firm has been in that market (e.g. “Established 1905” is a fairly credible way of telling the world that since you have been in business for over a century, your product must have something distinctive about it).

How much the firm spends on its marketing and publicity (a large marketing spend figure, relative to the firm’s revenues, is usually a reassuring sign).

How much of a price premium the firm is able to charge vis-a-vis its peers.

One way to appreciate the power of brands and reputation to generate sustained profits and, hence, shareholder returns, is to look at how India’s most-trusted brands, according to an annual Economic Times survey, have fared over the last decade. As can be seen in the table below, over the past decade, the listed companies with the most powerful brands have comfortably beaten the most widely acknowledged frontline stock market index by a comfortable margin on revenues, earnings and share price movement.

Exhibit 58: Performance of listed companies with the most-trusted brands

# Company Trusted Brands* 10-year Growth (FY04-14) (% CAGR)**

Revenues EPS Share price***

1 Colgate-Palmolive Colgate (1) 14 17 27

2 Hindustan Unilever

Clinic Plus (4), Lifebuoy (10), Rin (12), Surf (13), Lux (14), Ponds, etc

10 8 15

3 Nestle Maggi (9), Nestle Milk Chocolate (62), etc 15 16 23

4 GSK Consumer Horlicks (16) 15 21 33

5 Bharti Airtel Airtel (18) 33 18 15

Average for the listed companies with the top 5 brands 18 16 22

For the index, Nifty 12 13 14

Source: Economic Times and Ambit Capital analysis using Bloomberg data. Note: * Figures in brackets indicate the rank in the 2012 Economic Times ‘brand equity’ survey to find the 100 most-trusted brands in India. ** The FY14 data is based on Bloomberg consensus as on 7 April 2014. *** Share price performance has been measured from Mar-04 to Mar-14

Architecture

“A dream you dream alone is only a dream. A dream you dream together is reality.” – John Lennon

‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers. Thus, architecture would include the formal employment contracts that a firm has with its employees and it would also include the more informal obligation it has to provide ongoing training to its employees. Similarly, architecture would include the firm’s legal obligation to pay its suppliers on time and its more informal obligation to warn its suppliers in advance if it were planning to cut production in three months.

Such architecture is most often found in firms with a distinctive organisational style or ethos, because such firms tend to have a well-organised and long-established set of processes or routines for doing business. So, for example, if you have ever taken a home loan in India, you will find a marked difference in the speed and professionalism with which HDFC processes a home loan application as compared to other lenders. The HDFC branch manager asks the applicant more specific questions than other lenders do and this home loan provider’s due diligence on the applicant and the property appears to be done more swiftly and thoroughly than most other lenders in India.

Listed companies with the most-trusted brands have beaten the benchmark index on revenues, earnings and share price performance

‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers

Cera Sanitaryware


So, how can an investor assess whether the firm they are scrutinising has architecture or not? In fact, whilst investors will often not know the exact processes or procedures of the firm in question, they can assess whether a firm has such processes and procedures by gauging the:

extent to which the employees of the firm co-operate with each other across various departments and locations.

rate of staff attrition (sometimes given in the Annual Report).

extent to which the staff in different parts of the firm give the same message when asked the same question.

extent to which the firm is able to generate innovations in its products or services or production processes on an ongoing basis.

At the core of successful architecture is co-operation (within teams, across various teams in a firm and between a firm and its suppliers) and sharing (of ideas, information, customer insights and, ultimately, rewards). Built properly, architecture allows a firm with ordinary people to produce extraordinary results.

Perhaps the most striking demonstration of architecture in India is the unlisted non-profit agricultural co-operative, Gujarat Cooperative Milk Marketing Federation Ltd (GCMMF), better known to millions of Indians as ‘Amul’.

With its roots stretching back to India’s freedom movement, GCMMF was founded by the legendary Verghese Kurien in 1973. This farmer’s co-operative generated revenues of `137bn (around US$2.1bn) in FY13, thus making it significantly larger than its main private sector competitor, Nestle (FY13 revenues of `91bn or around US$1.5bn). Furthermore, GCMMF’s revenues have grown over the past five years by 21% as opposed to Nestle’s 16% over the same period. In fact, GCMMF’s revenue growth is markedly superior to the vast majority of the top Indian brands shown in exhibit 58.

GCMMF’s daily milk procurement of 13 million litres from over 16,000 village milk co-operative societies (which include 3.2 million milk producer members) has become legendary. The way GCMMF aggregates the milk produced by over 3 million families into the village co-operative dairy and then further aggregates that into the district co-operative which in turn feeds into the mother dairy has been studied by numerous management experts.

Not only does the GCMMF possess impressive logistical skills, its marketing acumen is comparable to that of the multinational giants cited in the table shown above: In key FMCG product categories such as butter, cheese and packaged milk, Amul has been the longstanding market leader in the face of sustained efforts by the multinationals to break its dominance. GCMMF is also India’s largest exporter of dairy products.

So how does GCMMF do it? How does it give a fair deal to farmers, its management team (which includes the alumnus from India’s best business schools), its 5,000 dealers, its 1 million retailers and its hundreds of millions of customers? Although numerous case studies have been written on GCMMF, at the core of this co-operative’s success appears to be: (a) its 50-year old brand with its distinctive imagery of the little girl in the polka red dotted dress; (b) the idea of a fair deal for the small farmer and the linked idea of the disintermediation of the unfair middle man; and (c) the spirit of Indian nationalism in an industry dominated by globe girdling for-profit corporates.

Innovation

“Learning is not compulsory … neither is survival.” – W Edwards Deming, American statistician, professor, author. The world’s most

famous prize for manufacturing excellence is named after him. "Innovation distinguishes between a leader and a follower."

– Steve Jobs

HDFC and GCMMF are the most striking demonstrations of architecture in India

Cera Sanitaryware


Whilst innovation is often talked about as a source of competitive advantage, especially in the Technology and Pharmaceutical sectors, it is actually the most tenuous source of sustainable competitive advantage as:

Innovation is expensive.

Innovation is uncertain - the innovation process tends to be a ‘hit or miss’.

Innovation is hard to manage due to the random nature of the process.

Furthermore, even when the expensive innovation process yields a commercially useful result, the benefits can be competed away, as other firms replicate the innovator and/or employees who have driven the innovation process tend to extract the benefits of innovation through higher compensation.

In fact, innovation is more powerful when it is twinned with the two other distinctive capabilities we have described above – reputation and architecture. Apple is the most celebrated example of a contemporary firm which has clearly built a reputation for innovation (think of the slew of products from Apple over the past decade which first changed how we access music, then changed how we perceive our phones and finally, how we use our personal computers).

Strategic assets

In contrast to the three distinctive capabilities discussed above, strategic assets are easier to identify as sources of competitive advantages. Such assets can come in different guises:

Intellectual property i.e. patents or proprietary know-how (e.g. the recipe for Coke’s famous syrup which is a closely held secret and kept in the company’s museum in Atlanta, Georgia);

Licenses and regulatory permissions to provide a certain service to the public, e.g., telecom, power, gas or public transport;

Access to natural resources such as coal or iron-ore mines;

Political contacts either at the national, state or city level;

Sunk costs incurred by the first mover which result in other potential competitors deciding to stay away from that market; e.g. given that there already is a Mumbai-Pune highway operated by IRB, it does not make sense for anyone else to set up a competing road; and

Natural monopolies i.e. sectors or markets which accommodate only one or two firms; for example, the market for supplying power in Mumbai is restricted to one firm, Tata Power.

Whilst strategic assets can come in different forms, all of them result in a lower per unit cost of production for the firm owning the asset relative to its competitors. For example, Tata Steel’s decades-old access to coal and iron-ore from its captive mines allows it to make more money per tonne of steel produced than any other steel manufacturer in India. According to Ambit Capital’s analysts, on a tonne of steel produced, Tata Steel earns `45,000 vs `39,000 for SAIL and `38,000 for JSW Steel.

Unsurprisingly, therefore, among the top-50 companies by market cap in India since the Nifty was launched in 1995, there is only one conglomerate – Tata Sons - which has had three companies which have been in the index more or less throughout this period i.e., Tata Power, Tata Steel and Tata Motors.

Upon closer examination, the Tatas are an almost text book case of how to build businesses which, without being the most innovative players in town, combine architecture and brands to great effect, thereby creating robust sources of sustainable competitive advantages. The group seems to have created at least three specific mechanisms to ensure that these sources of competitive advantage endure:

Firstly, Tata Sons, an unlisted company (owned by several philanthropic trusts endowed by members of the Tata family), is the promoter of the major operating Tata companies and holds significant shareholdings in these companies. Tata Sons’ patient, long-term orientation in terms of building large and robust businesses gradually has played a major role in the stability of the listed Tata businesses.

Whilst most talked about, ‘Innovation’ is also the most tenuous source of sustainable competitive advantage…

…’strategic assets’ on the other hand are easier to identify

Access to captive coal and iron ore results in more money per tonne of steel for Tata Steel vs its competitors due to lower cost of production

The Tatas have combined architecture with brand to create robust sources of sustainable competitive advantages

Cera Sanitaryware


Secondly, Tata Quality Management Services (TQMS), a division of Tata Sons, assists Tata companies in their business excellence initiatives through the Tata Business Excellence Model, Management of Business Ethics and the Tata Code of Conduct. TQMS, quite literally, provides the architecture to harmonise practices in various parts of the Tata empire.

Thirdly, Tata Sons is also the owner of the Tata name and several Tata trademarks, which are registered in India and around the world. These are used by various Tata companies under a license from Tata Sons as part of their corporate name and/or in relation to their products and services. The terms of use of the group mark and logo by Tata companies are governed by the Brand Equity and Business Promotion Agreement entered into between Tata Sons and Tata companies.

Cera Sanitaryware


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected] Pramod Gubbi, CFA Head of Equities (022) 30433124 [email protected]

Research Analysts

Name Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected] Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected] Abhishek Ranganathan, CFA Retail (022) 30433085 [email protected] Anuj Bansal Mid-caps (022) 30433122 [email protected] Aditi Singh Economy / Strategy (022) 30433284 [email protected] Ashvin Shetty, CFA Automobile (022) 30433285 [email protected] Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected] Deepesh Agarwal, CFA Power Utilities / Capital Goods (022) 30433275 [email protected] Dhiraj Mistry, CFA Consumer (022) 30433264 [email protected] Gaurav Khandelwal, CFA Automobile (022) 30433132 [email protected] Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected] Karan Khanna, CFA Strategy (022) 30433251 [email protected] Mayank Porwal Retail (022) 30433214 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected] Paresh Dave, CFA Healthcare (022) 30433212 [email protected] Parita Ashar, CFA Metals & Mining / Aviation (022) 30433223 [email protected] Prashant Mittal, CFA Strategy / Derivatives (022) 30433218 [email protected] Rahil Shah Banking / Financial Services (022) 30433217 [email protected] Rakshit Ranjan, CFA Consumer (022) 30433201 [email protected] Ravi Singh Banking / Financial Services (022) 30433181 [email protected] Ritesh Gupta, CFA Oil & Gas / Chemicals / Agri Inputs (022) 30433242 [email protected] Ritesh Vaidya, CFA Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected] Ritu Modi Automobile (022) 30433292 [email protected] Sagar Rastogi Technology (022) 30433291 [email protected] Sudheer Guntupalli Technology (022) 30433203 [email protected] Sumit Shekhar Economy / Strategy (022) 30433229 [email protected] Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected] Vivekanand Subbaraman, CFA Media (022) 30433261 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7886 2740 [email protected] Dharmen Shah India / Asia (022) 30433289 [email protected] Dipti Mehta India (022) 30433053 [email protected] Krishnan V India / Asia (022) 30433295 [email protected] Nityam Shah, CFA Europe (022) 30433259 [email protected] Parees Purohit, CFA UK (022) 30433169 [email protected] Punitraj Mehra, CFA India / Asia (022) 30433198 [email protected] Shaleen Silori India (022) 30433256 [email protected]

Singapore

Praveena Pattabiraman Singapore +65 6536 0481 [email protected] Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola – CEO Americas +1(646) 793 6001 [email protected] Hitakshi Mehra Americas +1(646) 793 6002 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected] Sharoz G Hussain Production (022) 30433183 [email protected] Jestin George Editor (022) 30433272 [email protected] Richard Mugutmal Editor (022) 30433273 [email protected] Nikhil Pillai Database (022) 30433265 [email protected]

Cera Sanitaryware


Cadila Healthcare Ltd (CDH IN, BUY)


Lupin Ltd (LPC IN, BUY)


LIC Housing Finance Ltd (LICHF IN, SELL)


HDFC Bank Ltd (HDFCB IN, SELL)


HCL Technologies Ltd (HCLT IN, BUY)


Exhibit 59: eClerx Services Ltd (ECLX IN, SELL)


0

100

200

300

400

500

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Cadila Healthcare Ltd

0

500

1,000

1,500

2,000

2,500

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Lupin Ltd

0

100

200

300

400

500

600

700

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

LIC Housing Finance Ltd

0200400600800

1,0001,2001,400

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

HDFC Bank Ltd

0

200

400

600

800

1,000

1,200

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

HCL Technologies Ltd

0200400600800

1,0001,2001,4001,6001,800

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

eClerx Services Ltd

Cera Sanitaryware


Asian Paints Ltd (APNT IN, BUY)


Exhibit 60: Britannia Industries Ltd (BRIT IN, SELL)


Axis Bank Ltd (AXSB IN, BUY)


Exhibit 61: Page Industries Ltd (PAG IN, BUY)


Exhibit 62: Astral Poly Technik Ltd (ASTRA IN, NOT RATED)


Amara Raja Batteries Ltd (AMRJ IN, SELL)


0

200

400

600

800

1,000

1,200

1,400

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Asian Paints Ltd

0500

1,0001,5002,0002,5003,0003,5004,000

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Britannia Industries Ltd

0

100

200

300

400

500

600

700

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Axis Bank Ltd

02,0004,0006,0008,000

10,00012,00014,00016,00018,000

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Page Industries Ltd

0

100

200

300

400

500

600

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Astral Polytechnik Ltd

0

200

400

600

800

1,000

1,200

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

Aug

-16

Amara Raja Batteries Ltd

Cera Sanitaryware


GRUH Finance Ltd (GRHF IN, NOT RATED)


Dr Lal PathLabs Ltd (DLPL IN, NOT RATED)


Relaxo Footwears Ltd (RLXF IN, NOT RATED)


Repco Home Finance Ltd (REPCO IN, NOT RATED)


Cera Sanitaryware Ltd (CRS IN, NOT RATED)


050

100150200250300350400

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

Aug

-16

GRUH Finance Ltd

400500600700800900

1,0001,1001,2001,300

Dec

-15

Jan-

16

Feb-

16

Mar

-16

Apr

-16

May

-16

Jun-

16

Jul-

16

Aug

-16

Sep-

16

Oct

-16

Dr Lal PathLabs Ltd

0

100

200

300

400

500

600

700

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

Aug

-16

Relaxo Footwears Ltd

0

200

400

600

800

1,000

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

Aug

-16

Repco Home Finance Ltd

0

500

1,000

1,500

2,000

2,500

3,000

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

Aug

-16

Cera Sanitaryware Ltd

Cera Sanitaryware


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock POSITIVE We have a positive view on the sector and most of stocks under our coverage in the sector are BUYs

NEGATIVE We have a negative view on the sector and most of stocks under our coverage in the sector are SELLs

Disclaimer This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Ambit Capital. AMBIT Capital Research is disseminated and available primarily electronically, and, in some cases, in printed form.

Additional information on recommended securities is available on request.

Disclaimer

1. AMBIT Capital Private Limited (“AMBIT Capital”) and its affiliates are a full service, integrated investment banking, investment advisory and brokerage group. AMBIT Capital is a Stock Broker, Portfolio Manager and Depository Participant registered with Securities and Exchange Board of India Limited (SEBI) and is regulated by SEBI

2. AMBIT Capital makes best endeavours to ensure that the research analyst(s) use current, reliable, comprehensive information and obtain such information from sources which the analyst(s) believes to be reliable. However, such information has not been independently verified by AMBIT Capital and/or the analyst(s) and no representation or warranty, express or implied, is made as to the accuracy or completeness of any information obtained from third parties. The information, opinions, views expressed in this Research Report are those of the research analyst as at the date of this Research Report which are subject to change and do not represent to be an authority on the subject. AMBIT Capital may or may not subscribe to any and/ or all the views expressed herein.

3. This Research Report should be read and relied upon at the sole discretion and risk of the recipient. If you are dissatisfied with the contents of this complimentary Research Report or with the terms of this Disclaimer, your sole and exclusive remedy is to stop using this Research Report and AMBIT Capital or its affiliates shall not be responsible and/ or liable for any direct/consequential loss howsoever directly or indirectly, from any use of this Research Report.

4. If this Research Report is received by any client of AMBIT Capital or its affiliate, the relationship of AMBIT Capital/its affiliate with such client will continue to be governed by the terms and conditions in place between AMBIT Capital/ such affiliate and the client.

5. This Research Report is issued for information only and the 'Buy', 'Sell', or ‘Other Recommendation’ made in this Research Report such should not be construed as an investment advice to any recipient to acquire, subscribe, purchase, sell, dispose of, retain any securities and should not be intended or treated as a substitute for necessary review or validation or any professional advice. Recipients should consider this Research Report as only a single factor in making any investment decisions. This Research Report is not an offer to sell or the solicitation of an offer to purchase or subscribe for any investment or as an official endorsement of any investment.

6. This Research Report is being supplied to you solely for your information and may not be reproduced, redistributed or passed on, directly or indirectly, to any other person or published, copied in whole or in part, for any purpose. Neither this Research Report nor any copy of it may be taken or transmitted or distributed, directly or indirectly within India or into any other country including United States (to US Persons), Canada or Japan or to any resident thereof. The distribution of this Research Report in other jurisdictions may be strictly restricted and/ or prohibited by law or contract, and persons into whose possession this Research Report comes should inform themselves about such restriction and/ or prohibition, and observe any such restrictions and/ or prohibition.

7. Ambit Capital Private Limited is registered as a Research Entity under the SEBI (Research Analysts) Regulations, 2014. SEBI Reg.No.- INH000000313.

Conflict of Interests

8. In the normal course of AMBIT Capital’s business circumstances may arise that could result in the interests of AMBIT Capital conflicting with the interests of clients or one client’s interests conflicting with the interest of another client. AMBIT Capital makes best efforts to ensure that conflicts are identified and managed and that clients’ interests are protected. AMBIT Capital has policies and procedures in place to control the flow and use of non-public, price sensitive information and employees’ personal account trading. Where appropriate and reasonably achievable, AMBIT Capital segregates the activities of staff working in areas where conflicts of interest may arise. However, clients/potential clients of AMBIT Capital should be aware of these possible conflicts of interests and should make informed decisions in relation to AMBIT Capital’s services.

9. AMBIT Capital and/or its affiliates may from time to time have or solicit investment banking, investment advisory and other business relationships with companies covered in this Research Report and may receive compensation for the same.

Additional Disclaimer for U.S. Persons

10. The research report is solely a product of AMBIT Capital

11. AMBIT Capital is the employer of the research analyst(s) who has prepared the research report

12. Any subsequent transactions in securities discussed in the research reports should be effected through Enclave Capital LLC. (“Enclave”).

13. Enclave does not accept or receive any compensation of any kind for the dissemination of the AMBIT Capital research reports.

14. The research analyst(s) preparing the email / Research Report/ attachment is resident outside the United States and is/are not associated persons of any U.S. regulated broker-dealer and that therefore the analyst(s) is/are not subject to supervision by a U.S. broker-dealer, and is/are not required to satisfy the regulatory licensing requirements of FINRA or required to otherwise comply with U.S. rules or regulations regarding, among other things, communications with a subject company, public appearances and trading securities held by a research analyst account.

15. This report is prepared, approved, published and distributed by the Ambit Capital located outside of the United States (a non-US Group Company”). This report is distributed in the U.S.by Enclave Capital LLC, a U.S. registered broker dealer, on behalf of Ambit Capital only to major U.S. institutional investors (as defined in Rule 15a-6 under the U.S. Securities Exchange Act of 1934 (the “Exchange Act”)) pursuant to the exemption in Rule 15a-6 and any transaction effected by a U.S. customer in the securities described in this report must be effected through Enclave Capital LLC (19 West 44th Street, suite 1700, New York, NY 10036). In order to receive any additional information about or to effect a transaction in any security or financial instrument mentioned herein, please contact a registered representative of Enclave Capital LLC., by phone at 646 361 3107.

16. As of the publication of this report Enclave Capital LLC, does not make a market in the subject securities.

17. This document does not constitute an offer of, or an invitation by or on behalf of Ambit Capital or its affiliates or any other company to any person, to buy or sell any security. The information contained herein has been obtained from published information and other sources, which Ambit Capital or its Affiliates consider to be reliable. None of Ambit Capital accepts any liability or responsibility whatsoever for the accuracy or completeness of any such information. All estimates, expressions of opinion and other subjective judgments contained herein are made as of the date of this document. Emerging securities markets may be subject to risks significantly higher than more established markets. In particular, the political and economic environment, company practices and market prices and volumes may be subject to significant variations. The ability to assess such risks may also be limited due to significantly lower information quantity and quality. By accepting this document, you agree to be bound by all the foregoing provisions.

Additional Disclaimer for Canadian Persons

18. AMBIT Capital is not registered in the Province of Ontario and /or Province of Québec to trade in securities and/or to provide advice with respect to securities.

19. AMBIT Capital's head office or principal place of business is located in India.

20. All or substantially all of AMBIT Capital's assets may be situated outside of Canada.

21. It may be difficult for enforcing legal rights against AMBIT Capital because of the above.

22. Name and address of AMBIT Capital's agent for service of process in the Province of Ontario is: Torys LLP, 79 Wellington St. W., 30th Floor, Box 270, TD South Tower, Toronto, Ontario M5K 1N2 Canada.

23. Name and address of AMBIT Capital's agent for service of process in the Province of Montréal is Torys Law Firm LLP, 1 Place Ville Marie, Suite 1919 Montréal, Québec H3B 2C3 Canada.

Additional Disclaimer for Singapore Persons

24. This Report is prepared and distributed by Ambit Capital Private Limited and distributed as per the approved arrangement under Paragraph 9 of Third Schedule of Securities and Futures Act (CAP 289) and Paragraph 11 of the First Schedule to the Financial Advisors Act (CAP 110) provided to Ambit Singapore Pte. Limited by Monetary Authority of Singapore.

25. This Report is only available to persons in Singapore who are institutional investors (as defined in section 4A of the Securities and Futures Act (Cap. 289) of Singapore (the “SFA”).” Accordingly, if a Singapore Person is not or ceases to be such an institutional investor, such Singapore Person must immediately discontinue any use of this Report and inform Ambit Singapore Pte. Limited.

Cera Sanitaryware


Additional Disclaimer for UK Persons

26. All of the recommendations and views about the securities and companies in this report accurately reflect the personal views of the research analyst named on the cover. No part of this research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research report. This report may not be reproduced, redistributed or copied in whole or in part for any purpose.

27. This report is a marketing communication and has been prepared by Ambit Capital Pvt Ltd of Mumbai, India (“Ambit”) and has been approved in the UK by Ambit Capital (UK) Limited (“ACUK”) solely for the purposes of section 21 of the Financial Services and Markets Act 2000. Ambit is regulated by the Securities and Exchange Board of India and is registered as a Research Entity under the SEBI (Research Analysts) Regulations, 2014. ACUK is regulated by the UK Financial Services Authority and has registered office at C/o Panmure Gordon & Co PL, One New Change, London, EC4M9AF.

28. In the UK, this report is directed at and is for distribution only to persons who (i) fall within Article 19(1) (persons who have professional experience in matters relating to investments) or Article 49(2)(a) to (d) (high net worth companies, unincorporated associations etc) of the Financial Services and Markets Act 2000 (Financial Promotions) Order 2005 (as amended) or (ii) are professional customers or eligible counterparties of ACUK (all such persons together being referred to as "relevant persons"). This report must not be acted on or relied upon by persons in the UK who are not relevant persons.

29. Neither Ambit nor ACUK is a US registered broker-dealer. Transactions undertaken in the US in any security mentioned herein must be effected through a US-registered broker-dealer, in conformity with SEC Rule 15a-6.

30. Neither this report nor any copy or part thereof may be distributed in any other jurisdictions where its distribution may be restricted by law and persons into whose possession this report comes should inform themselves about, and observe, any such restrictions. Distribution of this report in any such other jurisdictions may constitute a violation of UK or US securities laws, or the law of any such other jurisdictions.

31. This report does not constitute an offer or solicitation to buy or sell any securities referred to herein. It should not be so construed, nor should it or any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever. The information in this report, or on which this report is based, has been obtained from publicly available sources that Ambit believes to be reliable and accurate. However, it has not been prepared in accordance with legal requirements designed to promote the independence of investment research. It has also not been independently verified and no representation or warranty, express or implied, is made as to the accuracy or completeness of any information obtained from third parties.

32. The information or opinions are provided as at the date of this report and are subject to change without notice. The information and opinions provided in this report take no account of the investors’ individual circumstances and should not be taken as specific advice on the merits of any investment decision. Investors should consider this report as only a single factor in making any investment decisions. Further information is available upon request. No member or employee of Ambit or ACUK accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of this report or its contents.

33. The value of any investment made at your discretion based on this Report, or income therefrom, maybe affected by changes in economic, financial and/or political factors and may go down as well as go up and you may not get back the original amount invested. Some securities and/or investments involve substantial risk and are not suitable for all investors.

34. Ambit and its affiliates and their respective officers directors and employees may hold positions in any securities mentioned in this Report (or in any related investment) and may from time to time add to or dispose of any such securities (or investment). Ambit and ACUK may from time to time render advisory and other services to companies referred to in this Report and may receive compensation for the same.

35. Ambit and its affiliates may act as a market maker or risk arbitrator or liquidity provider or may have assumed an underwriting commitment in the securities of companies discussed in this Report (or in related investments) or may sell them or buy them from clients on a principal to principal basis or may be involved in proprietary trading and may also perform or seek to perform investment banking or underwriting services for or relating to those companies.

36. Ambit and ACUK may sell or buy any securities or make any investment which may be contrary to or inconsistent with this Report and are not subject to any prohibition on dealing. By accepting this report you agree to be bound by the foregoing limitations. In the normal course of Ambit and its affiliates’ business, circumstances may arise that could result in the interests of Ambit conflicting with the interests of clients or one client’s interests conflicting with the interest of another client. Ambit makes best efforts to ensure that conflicts are identified, managed and clients’ interests are protected. However, clients/potential clients of Ambit should be aware of these possible conflicts of interests and should make informed decisions in relation to Ambit services.

Disclosures

37. The analyst (s) has/have not served as an officer, director or employee of the subject company.

38. There is no material disciplinary action that has been taken by any regulatory authority impacting equity research analysis activities. 39. All market data included in this report are dated as at the previous stock market closing day from the date of this report. 40. Ambit and/or its associates have received compensation for investment banking/merchant banking/brokering services from Astral Poly Technik in the past 12 months.

Analyst Certification

Each of the analysts identified in this report certifies, with respect to the companies or securities that the individual analyses, that (1) the views expressed in this report reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly dependent on the specific recommendations or views expressed in this report. © Copyright 2015 AMBIT Capital Private Limited. All rights reserved.

Ambit Capital Pvt. Ltd. Ambit House, 3rd Floor. 449, Senapati Bapat Marg, Lower Parel, Mumbai 400 013, India. Phone: +91-22-3043 3000 | Fax: +91-22-3043 3100 CIN: U74140MH1997PTC107598 www.ambitcapital.com

STRATEGY - Repco HomeSTRATEGY Research Analysts: November 2016 The Coffee Can Portfolio 2016 Karan Khanna, CFA [email protected] Tel: +91 22 3043 3251 ... Asian Paints · 2017-4-6

Documents