Long Live the Republic - Happy 60th Birthday

Happy Republic day India!!
Its been 60 long years and we are sure we all grew up reading a lot (or are growing up reading a lot) on how we went about changing as a country in these years. The transformation has been slow (to say the least) and we believe at an appropriate way. Think about it, we always think that we could have done what we acheived in as many years in half that time. Just look at China they seem to be getting everything right, they are working at twice the speed, executing projects at breakneck pace and they just transformed the country in less than 25 years from 1985 to today. We on the other hand haggle about petty things, seek mandates from all and sundry and lose precious time just for making it all inclusive development.

Over the long run, we believe, only time will tell which model is right and which one proved a little bit dangerous but the fact of the matter is; there is no right or wrong model. This game is a marathon and not a sprint and above all looks like in this game we are the tortiose and China the hare. And we all know that story by heart, don't we?

There are a few point why we should be able to get an home run in this game. First, as a model we should be able to broadbase the pyramid more than China. That means that the people at the bottom of the pyramid (the destitutes, home less & landless labourers) should be able to move up gradually as a result of combination of public-private initiatives that seem to be taking root over the past 20 years. The evidence is more pronounced right in the middle of the pyramid; the class dubbed as the great Indian middle class.

Second, the ability of individuals and corporations to have a free hand; ability of freedom of rights; journalism and expression will over time take care of the sections that were hitherto neglected for decades. This process will gain speed and accelerate.

Lastly all of the above lends larger role for its people for participation in discussion, growth and enrighment of lifestyles.

Therefore is this model ultimately prove right at the end of this marathon. Prima facie seems so. But lets not get overboard on this. Sticking to basics, making the right calls in terms of educating the masses, allowing for proliferation of media and encouraging entrepreneureship are key to success over the long term.

So is India the next US? The answer to that question is whether the US is the role model. We think not. There are far greater vices hidden in the US system that seems apparent. They are increasingly becoming visible over the last 15 years. Do we therefore need to morph into such a system? Clear no.

Therefore, we believe that the next decade will come with its set of challenges and our ability to grab its more firmly that the 2000's; take full advantage and move the next level in this marathon, which would be the key to our success. It is also important to 'Do our own thing'; believe that we are doing the right thing and the world will sit up and take notice. This is already happening.

Until 2020, which can be looked as the next milestone; we think that we should see a newer India, an India which has come a long way ahead and becoming slowly, very slowly the role model for the rest of the world.

Until that time, however, lets get our head down and start off to do what we aimed at finishing long time ago. Let's build a strong, resilient and wonderful India in the decade ahead.

Jai Hind.

The name is BOND !!!!!!!!!!!

While we continue to write on Indian equity markets (which are our forte) we have chosen a misnomer in the title nevertheless. In addition, we strongly believe in following what our mentors have preached. For instance, Peter Lynch maintained (albeit mockingly) that “people who trade bonds do not know what they are missing”.

This time, however, we are departing from writing about our favorite asset class – equities. We are writing about Indian BOND market. Also, we’ve not forgotten that over a “long term horizon and on average equities outperformed bonds most of the time”.

So why are we even thinking about them leave alone write and put forth a case. The point worthy of mention here is that equity markets outperform bonds on average and that there could be that occasional period where bonds outperform equities in the past and can happen in future as well.

Is this that time when bond markets will overtake the equities over a short time in the future?

Let us see. For starters, we know that these things do not happen only occasionally and the last time that happened in India was just 5 years ago. For records, Indian bond markets returned whopping 18% (this is not a typo) in 2003-2004 period as compared with 6-8% return from equities.

What could then be the ingredients of a bond market rally the?

1. Plateau experienced in the rate environment (monetary policy of the central bank) after a rate tightening environment as a result of many MACRO factors (inflation etc.).



2. View from the central bank that interest rate plateau is certainly choking growth (given inflation is under control) and there exists a scenario to decrease the rates to stimulate demand or growth.



3. Existing bond paper would be much sought after as bond prices would rally as effects on interest rate stimulus will be only seen 2-3 quarters down in line.
   
   

   Are we then saying that now is the time to invest in bond markets and bond funds in particular?

   
   
   1. It looks like some of the ingredients mentioned above certainly could come through over the next few quarters. What could be the factors that would make this possible? Let's see.
   
   
   2. For one, we are in an inflationary environment, with runaway prices on commodities (agro and otherwise), high fuel prices and resultant liquidity tightening by the central bank (the RBI).
   
   
   3. This would mean that if the situation continues for another couple of quarters then we could end up witnessing rate hikes, albeit modestly. This could in turn impact commercial lending rates and further slow down credit growth visibly(Banks are seeing these early omens - March 2008 Earnings). Another obvious impact of higher rate environment is on the corporate sector, by putting strain on the cash flows by way of higher interest bills each quarter(This could lead to rating agencies showing some concerns).
   
   

   What could be the impact on the GDP growth?

   Well, obviously pressurized corporate sector would borrow lower than before, postpone projects and concentrated on protecting the bottomline. This would visibly impact each one of us adversely. Slower GDP growth than witnessed over the past 3-5 years would not go down well with the government as well and this could be a trigger (There are sell side forecasts of low 6% range to optimistic 8% range).
   

   What would the government do?

   For starters, not much in an election year (2009) and therefore sacrifice growth over inflation control. But not for long, according to us. Which ever party heads the next government in 2009 will start to push reforms, provide more fiscal stimulus and look to push the GDP growth to same levels which we already saw, 9-10% real growth. The caveat in all this could be the government formation by a predominantly one party. Can that happen – lets see.
   

   So what?

   This means by mid-2009 we could witness the same situation we saw in late 2003. Rate cuts, loose monetary policy and ample liquidity. The impact of which will be favourable on the corporate sector and another equities rally. But not before late early 2010.
   

   Then what could be in store in the Bond markets by then?

   
   
   1. As a result of rate cuts, easy monetary policy in early-mid 2009 we could see bond market rally
   
   
   2. Investors would flock to Bond market as a result of weak prospects of performance in the equity markets in 2009 strengthening the rally
   
   
   3. Bond market could end up beating equities market by a whopping margin.
   
   

   Are there holes in this thesis?

Yes but not many.Firstly we could be wrong in purely timing the cycle (late 2008-2009).

Secondly, we do not know how the corporate sector could behave. For instance, if the corporate sector borrows from outside (ECB route- RBI may increase the limit of ECB) then the anticipated slow down will not pinch the GDP and equities would perform much better and RBI could increase rates further. We see this possibility unlikely, given the bottom of the rate cycle in the west.
And lastly, we could be very early on this prediction and therefore limit the returns from the bond markets.

However, the good part is that we have time on our side.


Until next time!

Caution: Sharp turn ahead!

When we started writing in late 2007, we had said that 2008 could be full of uncertainty (refer: Ab kya hoga?). At that moment we did not know and did not have an iota of conviction where we could end up after 2008. At this juncture, however, we believe that 2H 2008 could be far more correction oriented(bumpy ride) than most people think it will. The reason for this ‘pessimism’ could be in what we are seeing lately on the macro front and its effect on the corporate performance has still to show up, according to us.


What’s up with the Sensex?

There are umpteen articles published recently comparing our markets with those of the rest of the emerging markets. The BRIC economies which had a spectacular run in the last four years have all corrected recently, but the arguments put forth are that the Sensex is amongst the cheapest of the lot, in terms of valuations. For the record the Sensex trades at around 16-17x FY09 earnings compared with other emerging economies which trade more than this multiple.
For one, Sensex companies have had a spectacular run in the last four years making them from ultra cheap in 2003 to overvalued by early 2008. For instance, the erstwhile (consolidated) Reliance Industries Ltd. was trading around 16-17x 1yr forward earnings in 2004, while now it trades at around 22-23x 1yr forward earnings. Sure it has corrected from 28x it was trading in early 2008. But we believe that to make an entry into Reliance Industries, we still have time on our side, right through 2008. This is true for most of the Sensex companies.

Secondly, sector wise we think that it would be prudent to move away from high beta sectors (read; rate sensitives, high growth, high multipliers), to defensive yield oriented and low beta sectors.

Thirdly, we believe that the near term could throw up certain sectors which could end up gaining from the current slowdown. Counterintuitive you might say. We meant in terms of relative performance.

Slippery when wet!!

Its like running while wearing rubber gripped shoes on a concrete surface. When the surface is dry the rubber provides grip and powers us forward. But what if we hit a patch with water on the surface. Just can’t imagine that, can you? The same, we argue, is that case with rate sensitives, high capex sectors, and ultra growth movers. A little lower octane (capital) provided than before can slow these sectors more than a few percentage points.
As a result of the successive liquidity squeeze, which in all probability does not seem to be over, the octane for certain sectors suddenly has been cut.

Real estate, banking, capital goods, construction, autos and manufacturing in heavy industries are the ones which could have visible lack luster performance in FY09. This situation could get complex as a result of commodity inflation, resulting in another set of industries such as Metals, cement, transportation & logistics and processing companies getting margin squeeze.

We believe that it is indeed a time to get defensive, albeit move into a watch mode from here. This situation could persist for maybe a year before the next leg of performance by the heavyweights of capital consumption.

The formula (if we can call that) to get over this trying phase is to look back at those sectors which display a secular demand which is devoid of economic cycles. FMCG, F&B companies, Pharma, IT and related services and of course medical care.

These stocks will display continued growth, could be available cheaper than those stocks in the cyclical sectors and could assure you decent returns which may not be provided by cyclical or growth stocks in this period of pain.

One could therefore look at stock such as ITC, Indian Hotels, Apollo Hospitals, PVR, and TCS.

Therefore, if the hare is resting bet on the tortoise.

Picking beaten angels - Part II - LMW (BSE: 500252)

Amongst all the clutter and noise at present in the market, we believe that there are companies which are plugging away slowly, beaten down more than necessary due to market pessimism and worthy of mention as a result of attractive fundamental story. LMW or Lakshmi Machine Works, (BSE: 500252; NSE: LAXMIMACH), is one such name. Below, we present our case:

Investment Rationale:

Lakshmi Machine Works Ltd (LMW) is a Coimbatore, Tamil Nadu based textile machinery manufacturer. LMW is India’s largest and world’s third largest textile machinery manufacturer. LMW is a 40 years old company and sold almost 2.3mn spindles in 2007 with almost 60% of the domestic market. Swiss based Rieter is world’s largest textile machinery manufacturer and has a long association with LMW. LMW acquired the technology to manufacturer textile machines from Rieter’s only. In 1999, both the companies called off their collaboration, but Rieter still continues to hold 13% in LMW and has its own production unit in India as well. Before we start narrating the entire script, here are the following major pillars of our investment thesis:

1. Orders of Rs.4500 Crores in hand, leading to a sales visibility for next 2 years.
2. Gets 10% of the order as advance from the customer, leading to negative working capital
3. Debt free with a cash of ~ INR 600 Crores at FY 07 end
4. Gets 1.75% of the textile machinery bill amount as subsidy from GOI under the EPCG scheme. Sales of textile machinery to 100% textile EOU are considered to be deemed exports.
5. Stable OPM of 17-18% and PAT of 11-12%
6. Implementation of VAT in TamilNadu is saving Rs.2.5-3 Crores every month for the company
7. Exploring other major Asian textile manufacturing hubs like Pakistan and Bangladesh
8. Textile Up-gradation Fund Scheme (TUFS) has been extended till 2012 by GOI

9. No price change since June 2005 with iron & steel, aluminum, brass, copper and pig iron as the biggest raw materials
10. Invested ~Rs.400 Crores in last few years to double the production capacity to 3.5mn spindles in 2008 from 1.8mn spindles in 2006
11. No plans to expand the capacity going forward

One Immediate Trigger

Voltas provides presales, order booking and installation services to LMW. In its latest results announced by Voltas, the company has gone on record saying that “Textile Machinery division achieved 20% growth in equipment sales”. Applying the same logic to LMW, the company should post the same growth in its textile machinery business also leading to Rs.2000-2100 Crores of sales in FY08 with Rs.1682 Crores of sales in FY08.

LMW is scheduled to announce its results on May 19, 2008.

Indian Textile industry – Key Facts

1. Accounts for 14% of industrial production and 4% of GDP
2. Employs approx 35mn people, second largest after agriculture
3. India’s textile exports in 2006-07 - $17B. Target to export $50B by 2012
4. India’s expected domestic textile market in 2012 - $50-60B
5. Installation of 38.8mn spindles (21mn supplied by LMW) out of which:
1. 29.8mn are active
2. 10mn are waiting to be scrapped
3. 15mn are fit for modernization
6. 6. India’s textile machinery market (3.9mn pa) is second largest after China (7mn pa). Pakistan is third largest with 1.1mn spindles pa.
7. 7. India is expected to add 3.5mn – 4.8mn – 5.4mn spindles every year under worst, base and best case scenario till 2012 to reach its $50B export target.

Business Profile

1. More than 4 decades old
2. Sold 2.33 mn spindles in 2006-07, with ~60% of the Indian market
3. Third largest textile machinery manufacturer worldwide with Rieter of Switzerland and Schlafhorst of Germany bigger than LMW
4. Long-term association with Rieter has helped the company to learn the technology with 90% of raw material and components locally procured. Reiter holds 13% of LMW. Reiter has its own production unit in India.
5. Large localization helps the company to sell the products at 15-20% less than its global peers.
6. Invested Rs.410 Crores in last 2 years to increase the capacity from 1.8 mn spindles in 2006 to 3.5 mn in 2008.
7. Takes 10% of the order as advance, leading to negative working capital. Similar amount on Rieter BS seems to make this a worldwide phenomenon.
8. Increased capacity and improvements in production has helped the company to decrease the delivery period to 10 months from 18 months.
9. Worldwide textile machinery demand peaked in 1HFY07. LMW is expected to end FY08 with an order book of Rs.4500 Crores as against Rs.5400 at Q2FY08 end.
10. Plan the production at the beginning of the quarter by getting an approval from the customers.
11. Irrespective of the date of arrival of the order, the customer is charged at the time of delivery of the machinery.
12. The pricing is done as per the prices prevalent at the time of delivery, as per the competitor’s rates and the market conditions. Due to this practice, the margins are expected to remain stable going forward.
13. The company has been following the current pricing rules since last 40 years and has never faced any issue with any customer.
14. No price hikes since June 2005.
15. The company gets 1.75% of the bill value machinery sold as exports or to EOU’s as benefit under EPCG scheme from GOI. The company previously used to share (50:50) the benefits with the customers but now has stopped the practice.
16. Implementation of VAT in Tamil Nadu is helping the company to save Rs.2.5 Crores - 3 Crores every month.
17. Holds investments worth Rs.60 Crores. JV with Rieter had sales of Rs.121 Crores and PAT of Rs.9.85 Crores in 2006-07. LMW has invested Rs.12.5 Crores in the JV.

Product Profile

1. Textile Machinery Division – 90% of the sales
2. Machinery tools & Foundry Division – 10% of the sales.
3. As the technology in the machinery tools division is highly guarded by some of the world major’s, the sales mix is not expected to change dramatically going forward.

Shareholding Pattern

Association with Voltas is strategic as the same provides presales, order booking and installation services to LMW. Voltas charges 3%-4% of the bill amount as commission.

We would like to resist from giving any projections considering the uncertain economic environment we are in. Also as per our philosophy, is it what he have that matters and not the uncertain future.

Conclusion

LMW with its leading position and strong order book is a strong defensive investment available at cheap valuations. We expect the company to do well in future and the share price to mirror company’s financial performance.