Citigroup - L&T, India Cement Sector, Indian IT Services, Reliance Industries

[Sunil]

L&T Summary

Downgrade to Hold — Downgrade L&T to Hold/Low Risk on account of (1) significant stock outperformance, (2) fair valuations, and (3) lower margin of error on operating performance. Our new target price of Rs1,733 (up from Rs1, 579.5) leaves limited upside potential, and hence we downgrade the stock. Significant outperformance — L&T has outperformed the BSE Sensex over the past year. The outperformance has been even more significant in the past 6 months, as the company has been consistently surprising analysts on EBITDA and earnings. But now the stock looks fairly valued. Fairly valued — Post 44% yoy earnings growth in FY07E, momentum should moderate to ~30% in FY08E-09E as high base effects on revenue growth and core EBITDA margins parameters are bound to catch up. The stock trades at an adjusted P/E (adjusted for value subsidiaries) of 22.7x FY08E, which in our view fairly captures the growth profile of the parent business. Lower margin of error — We expect L&T to end FY07E with a core EBITDA margin of 8.8%, a 231bp YoY increase. Although improvements of ~50bps from these levels cannot be ruled out, progressively this becomes tougher given the nature of the business. Further, at current valuations the margin of error in terms of sales growth and EBITDA margins is lower. Fairly priced — Although we think L&T remains the best E&C company from an operational point of view, the stock looks fairly priced.

Flash: Indian Cement Sector - Negative Budget Expectations

Summary

Reports of cement export ban, higher excise duty — Stock prices of Indian cement majors have come off 7-14% in the past week. Reasons behind this fall are media reports of (1) a possible ban on cement exports in the budget and (2) introduction of a differential excise duty for cement to control inflation. Export ban would be a potentially bigger negative — About 10mn tonnes of cement and clinker (6% of FY07E demand) are likely to be exported in FY07. Any ban would disproportionately affect the largest exporters, Gujarat Ambuja and UltraTech. The cement flowing back would then create oversupply in Gujarat (capacity 17m tpa, demand 9m tpa, more than 70% of cement exports). Differential excise duty regime — Expected to remain at Rs408/t (Rs20/bag) upto a certain price level and may be higher, reportedly Rs600/t (or Rs30/bag), if the price crosses a certain benchmark. While the industry would be able to pass on this hike, it would limit the price upside available to producers. New regime could be ambiguous and difficult to implement — Cement is largely billed ex-factory and a plant may have to pay a higher excise duty only because a higher freight cost means a higher price. The price differs in each locality is subject to various discounts and incentives and hence difficult to define. Fundamentally positive; Grasim top pick — The industry has considerable pricing power in the next 6-9 months. However, the direction of cement stock prices would be determined by the severity of measures announced in the budget. Our top pick remains Grasim, for its cheapness and defensiveness.

India IT Services

Summary

Demand remains very strong — Our interaction with Indian players (including Cognizant) highlighted that demand conditions remain very strong – particularly in US and Europe. A sharp US slowdown would likely be the only speed breaker. Offshoring is a key theme across the US and European players we met. However, Indian companies have a long way to go in Continental Europe. "Defend and Extend" strategy as MNC's turn aggressive — Accenture's "Defend and Extend" strategy highlights that MNC's are ready to take on Indian vendors in smaller contracts and at their price points to stop them from entering clients and ramping up. Domain knowledge and GDM appear to be the key differentiators — Domain knowledge and global delivery capabilities are becoming key differentiators – Tier I companies are investing more in subject matter expertise, global delivery and customer penetration. Supply and linearity cited as challenges — Supply in terms of hiring large numbers, training and retaining employees remains the top concern across the sector. With hiring requirements increasing as companies grow, companies are also trying to find ways to reduce linearity in the business model. We prefer Tier I; TCS and Infosys are our top picks — With deals getting bigger and complex and more services being bundled, Tier I companies appear better placed on demand. This coupled with better ability to manage supply should give them the winning edge.

Reliance Industries

Summary

Promoters infusing equity — RIL Board has approved preferential issue of 120m warrants to the promoter group ( 8.6% dilution), potentially taking promoters' stake to 54.5% (from 50.6%). Notwithstanding healthy internal accruals, under-leveraged balance sheet and treasury stock to fund capex plans (E&P, retail), we see this intent as positive for short-term sentiment. Though fundamentally difficult to attribute value to, it could also be a precursor to (1) increasing visibility and hence higher capex in E&P and (2) strategic sale in E&P assets. Warrants exercisable over 18 months — Promoters would make upfront payment of 10%, with remainder at the time of exercise. The pricing will be decided post the shareholder approval (which could take 30-60 days) based on SEBI formula – higher of two weeks and 26-weeks average closing price. At current market price, the equity infusion would be Rs169bn (US$3.8bn). New petrochemical unit at Jamnagar — RIL also announced a 2mtpa petrochemical unit at Jamnagar at a total cost of US$3bn, to be commissioned by 2010-11. The unit, which will produce ethylene/propylene from refinery off gases/byproducts is aimed at competing with the gas-based crackers coming up in the Middle East. Besides being super-sized, it improves RIL's feedstock mix and competitiveness in the long run. KGD6 update — RIL also disclosed two additional gas discoveries (AA-1 and Q-1) in a new seismic area besides reiterating its development time lines for gas and oil. While the two gas discoveries (partially included in our SOP) have been notified to DGH, there is no estimate of the prospective reserves as yet. Our valuation of E&P assets at Rs408/share includes Rs240/share for KGD6 based on ultimate recovery of 16.3tcf and a development capex of US$7.0bn. Retain Hold/Low Risk — We believe the current valuations factor in a large part of the core business fundamentals, value accretion from KG gas reserves, as well as the new initiative of organized retailing. We retain Hold/Low Risk (2L) rating with a target price of Rs1,450.

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