Ambit Coffee Can 2017

STRATEGY

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November 2017

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The Coffee Can Portfolio 2017 Research Analysts Prashant Mittal, CFA [email protected] Tel: +91 22 3043 3218

Aadesh Mehta, CFA [email protected] Tel: +91 22 3043 3239

Sudheer Guntupalli [email protected] Tel: +91 22 3043 3203

Pankaj Agarwal, CFA [email protected] [email protected] Tel: +91 22 3043 3206

Abhishek Ranganathan, CFA [email protected] Tel: +91 22 3043 3085

Ashvin Shetty, CFA [email protected] Tel: +91 22 3043 3285

Nikhil Pillai [email protected] Tel: +91 22 3043 3265

Strategy

CONTENTS The Coffee Can Portfolio 2017 ……………………………………………………3 Executive Summary ………………………………………………………………….4 The case for a Coffee Can Portfolio

…………………………………………….10

Framework and results from back-tests

………………………………………..14

Patience with Quality is the Holy Grail

…………………………………………19

Today’s Coffee Can for 2017-2027 …………………………………………….26 Performance of ‘live’ Coffee Can portfolios ……………………………………28 Appendix 1: How the Coffee Can is different to our ………………………….31 other portfolio constructs Appendix 2: Performance of last 14 back tested Coffee Can portfolios …….33 Appendix 3: John Kay’s IBAS framework ……………………………………….52 Appendix 4 ………………………………………………………………………….57

COMPANIES HDFC Bank (SELL)

…………………………………………………………………61

HCL Technologies (SELL) ………………………………………………………….67 Lupin (NOT RATED) ………………………………………………………………..73 LIC Housing Finance (SELL)

………………………………………………………81

Page Industries (BUY) ……………………………………………………………..87 GRUH Finance (NOT RATED)

…………………………………………………..101

Amara Raja (NOT RATED) ……………………………………………………….107 Abbott India (NOT RATED) Astral Poly (NOT RATED)

……………………………………………………..113 ………………………………………………………..121

Dr Lal PathLabs (NOT RATED) …………………………………………………..129 Cera Sanitaryware (NOT RATED) ………………………………………………135 REPCO Home Finance (NOT RATED) ………………………………………….141

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Page 2

Strategy THEMATIC

November 17, 2017

The Coffee Can Portfolio 2017

Coffee Can Portfolio 2017

In this year’s Coffee Can thematic, we highlight how combining ‘patience’ (of staying invested in Indian stocks) with ‘quality’ (offered by the Coffee Can companies) is the holy grail of investing. We show that holding a Coffee Can Portfolio (CCP) untouched for 10 years generates the best returns with minimal risk. The 2017 Coffee Can portfolio contains familiar names like HDFC Bank, HCL Tech., Lupin, Page, Astral, Cera and LIC Housing - with Abbott India being the new entrant this year. 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 transaction 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, 16 out of 17 iterations of the Coffee Can Portfolio have handsomely outperformed the Sensex as well as broader market indices, such as the BSE200 index. Further, for investors who seek deployment of fresh funds received every year, we showcase how the IRR achieved from investing fresh inflows in the subsequent year’s Coffee Can portfolio is almost 9% higher vis-à-vis the Sensex index. ‘Patience’ with ‘Quality’ is the holy grail of investing In last year’s (hyperlink) Coffee Can report we highlighted that even as Coffee Can Portfolios (CCP) beat the Sensex over a shorter duration of five years, the alpha is much higher if you stay put for a longer duration of 10 years. We analyze this point and highlight how combining the ‘patience’ of staying invested in Indian markets (which improves risk-adjusted returns as the holding period increases) with ‘quality’ of investments generates the best returns with least risk. Today’s Coffee Can for 2017-2027 Six stocks from the previous CCP do not make it to this year’s portfolio: Asian Paints, Britannia, Cadila, eClerx, Axis Bank & Relaxo. The fresh addition to this year’s portfolio is Abbott India. Whilst we do not advocate annual rebalancing of the portfolio, clients interested in 2017 CCP should refer to exhibit on the right.

Company Name

Ambit Stance

HDFC Bank

Our stance: SELL

Mcap (US$ bn): 72.6 ADV - 6m (US$ mn): 40.1 HCL Technologies

Our stance: SELL

Mcap (US$ bn): 19

ADV - 6m (US$ mn): 23.1

Lupin

Our stance: NR

Mcap (US$ bn): 5.9

ADV - 6m (US$ mn): 36.5

LIC Housing Fin.

Our stance: SELL

Mcap (US$ bn): 4.5

ADV - 6m (US$ mn): 19.3

Page Industries

Our stance: BUY

Mcap (US$ bn): 3.9

ADV - 6m (US$ mn): 4.4

GRUH Finance

Our stance: NR

Mcap (US$ bn): 2.7

ADV - 6m (US$ mn): 2

Amara Raja Batt.

Our stance: NR

Mcap (US$ bn): 1.9

ADV - 6m (US$ mn): 6.5

Abbott India

Our stance: NR

Mcap (US$ bn): 1.5

ADV - 6m (US$ mn): 0.3

Astral Poly

Our stance: NR

Mcap (US$ bn): 1.4

ADV - 6m (US$ mn): 0.9

Dr Lal Pathlabs

Our stance: NR

Mcap (US$ bn): 1.1

ADV - 6m (US$ mn): 1.9

Cera Sanitaryware Our stance: NR Mcap (US$ bn): 0.7

ADV - 6m (US$ mn): 0.4

Repco Home Fin

Our stance: NR

Mcap (US$ bn): 0.5

ADV - 6m (US$ mn): 2.4

Source: Bloomberg, Ambit Capital Research

Coffee Can Portfolios have consistently outperformed the Sensex 2000 2001

All-cap CCP (start) 500 600

All-cap CCP (end) 3,831 9,802

CAGR return 22.6% 32.2%

Outperformance relative to Sensex 6.6% 11.7%

2002 2003

800 900

7,709 10,175

25.4% 27.4%

5.1% 7.2%

2004 2005

1,000 900

16,849 6,643

32.6% 22.1%

12.7% 6.0%

2006 2007

1,000 1,500

6,376 9,027

20.4% 19.6%

9.0% 10.3%

2008 2009

1,100 1,100

6,759 6,510

21.4% 23.7%

9.6% 11.5%

2010 2011

700 1,400

3,167 3,558

22.8% 15.8%

12.1% 4.7%

2012 2013

2,200 1,800

7,502 6,608

25.7% 34.8%

11.1% 19.8%

2014 2015

1,600 2,000

2,902 2,841

22.1% 19.0%

14.6% 5.7%

2016

1,700

2,142

26.0%

-2.5%

Kick-off year

Source: Bloomberg, Ambit Capital research. Note: Full 10 year TSR (Total Shareholder Return) calculation is done for the periods from 2000 – 2007 (starting 30th June). For periods after 2007, TSR calculation is performed till 7th November 2017 ( this is excluding live portfolios for 2014, 2015 & 2016 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in Nov ’14, Nov'15 and Nov ’16 respectively).

Research Analyst Prashant Mittal, CFA +91 22 3043 3218 [email protected]

[email protected]

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.

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 January 2008 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 Page Industries’ 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. Note that research suggests a combination of superior RoCE and revenue growth has been a winner in the Indian context (see exhibit 1 below):

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Strategy Exhibit 1: A combination of superior RoCE and revenue growth is a winner in the Indian context* 12.0%

Average outperformance: 10-year CAGR 9.6%

10.0% 8.0%

6.7%

6.0% 4.1% 4.0% 2.0% 0.0% Superior on sales growth

Superior on RoCE

Superior on Both

Source: Bloomberg, Ambit Capital research. Note:*The universe is 2007’s BSE200 firms (ex-financials); performance relative to the BSE200 Index; the chart is based on price data from 31 March 2007 to 31 March 2017. The red bars denote the 10-year 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 17 years. Results from our back-test suggest that in 16 out of 17 iterations, the Coffee Can portfolios have 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, 16 out of 17 iterations of the Coffee Can portfolios still beat the benchmark BSE200 index quite comprehensively. Performance of the live Coffee Can Portfolio launched in form 2014-16 We launched our maiden 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 two more Coffee Can Portfolios in 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” and 17 November’16 thematic: “The Coffee Can Portfolio 2016” Since publication in November 2014, the first Coffee Can Portfolio has generated total returns of 22% (on a CAGR basis) vs total returns of 8% for the benchmark Sensex index since initiation. The Coffee Can Portfolio launched in 2015 has generated total returns (CAGR) of 19% vs total returns of 13% for the benchmark Sensex index since initiation. The Coffee Can Portfolio launched in 2016 has generated total returns (CAGR) of 26% vs total returns of 29% for the benchmark Sensex index since initiation. That said, from one CCP to the next, these portfolios have witnessed a churn of 3035%. With reasonably high levels of churn, the obvious question one would ask is whether to rebalance the 2014, 2015 and 2016 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 ~3.7% points (on a median basis; in CAGR terms, see exhibit below):

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Strategy Exhibit 2: Share price CAGR returns over 10-year periods for CCP with and without rebalancing 20002010

2001- 2002- 2003- 2004- 20052011 2012 2013 2014 2015

20062016

2007- Median 2017 CAGR

CCP without rebalancing

19.3%

28.5%

22.4%

25.4%

30.8%

20.5%

18.4%

18.9%

21.5%

CCP with rebalancing

18.5%

22.6%

22.0%

17.0%

18.7%

13.5%

11.2%

12.7%

17.8%

Difference (w/o minus 0.8% 5.9% 0.4% 8.4% 12.0% 6.9% 7.2% 6.2% 3.7% with rebalancing) 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-year period starting from June of the first year and ending with June of the last year.

Patience with Quality is the Holy Grail of investing While we have advocated a minimum holding period of ten years for the Coffee Can Portfolio to realize its true potential, 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 in 15 out of the last 17 iterations, the Coffee Can Portfolio handsomely outperformed the benchmark Sensex index over a shorter time horizon (i.e. five years). However, that does not imply that investors should shift to a duration of five years for their investments. Our analysis suggests for the Coffee Can construct to work its magic, the portfolio should be left untouched for a decade. A portfolio at the end of, say, 5 years (and rolling over funds from the exiting stocks to 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. We analyze this point further by combining analysis, covered in our 22 Dec’16 note ‘The peculiar distribution of equity returns in India’ and 25 Jan’17 note ‘The free lunch in Indian equities’ with the results for Coffee Can portfolios. In these notes we highlighted how the risk-adjusted returns pattern in India is clearly in favour holding on for periods of more than 5 years. However, once you combine patience with ‘quality’ – something that we proxy using our Coffee Can portfolios, the risk-adjusted returns are even better. The exhibits below highlight how the risk-adjusted returns improve for the market (median returns improves while standard deviation declines) as one moves towards longer holding horizons. Further, if one was to hold on to ‘quality’ companies (as in the CCP) the risk-adjusted profile improves further. Exhibit 3: Combining ‘Patience’ with ‘Quality’ of investing (using Sensex as proxy for market) is the holy grail 50% = 1 Yr

Standard Deviation

40%

Staying invested for longer period improves median returns for Sensex whilst reducing risk

30%

20%

Sensex Coffee Can Portfolios

1 Yr

Combining patience with quality (through CCP) further improves risk-adjusted returns

3 Yr

3 Yr

5 Yr 10%

5 Yr

10 Yr

10 Yr

0% 8% -10%

13%

18%

23%

28%

Returns (median)

Source: Bloomberg, Ambit Capital Research Note: The returns have been computed since Jan’86 for the Sensex and since Jun’00 for the CCP on a weekly rolling basis. For the CCP, every June we shift to the new portfolio being launched that year

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Page 6

Strategy Today’s Coffee Can Portfolio for 2017-27 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 summarized in the exhibit on the next page. 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.

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Page 7

Strategy Exhibit 4: Summary of the 2017 Coffee Can Portfolio Company

Ticker

Mcap ($mn)

HDFC Bank

HCL Technologies

Lupin

HDFCB IN

HCLT IN

LPC IN

LIC Housing Fin. LICHF IN

72,487

19,272

Free Float ADV-6m Greatness Mcap (Median) Accounting Score Ambit Decile Stance ($mn) ($mn) (%) 53,641

7,516

31.0

18.1

N/A

D2

N/A

92%

Comments

P/E

P/B

RoCE*

FY17

FY18E

FY17

FY18E

FY17

SELL

Credible execution track record driving consistent high earnings growth while maintaining asset quality

31.9

26.6

5.2

4.6

1.8

SELL

We see the competitive advantages built by the company in IMS & ES at risk because of its recent aggression into end of life IP products. In addition, service line oriented organization structure is a key negative

14.6

14.0

3.8

3.3

27.7

14.8

20.6

2.8

2.5

13.3

5,849

3,100

26.0

D9

92%

NR

Lupin has championed the art of business evolution (from plain oral solids to complex generics) without compromising on profitability and stakeholder interests. However, now the company is facing threats in US business because of quality issues at facilities delaying launches and channel consolidation in USA leading to base business erosion. India and Japan offer some support though

4,545

2,727

17.6

N/A

N/A

SELL

LIC’s support is key strategic asset. But earnings momentum would decline due to moderating real estate prices, competitive headwinds and asset quality risks

15.2

14.3

2.6

2.3

1.4

86.2

69.5

34.5

28.4

41.7

Page Industries

PAG IN

3,532

1,731

3.1

D1

79%

BUY

Page can grow at 24% CAGR over the next decade led by women’s innerwear, leisurewear and kidswear. Disciplined category selection (only knits), tough to displace shelf space and brand sweating will only boost dominance. Valuation of 55x FY19E EPS only partly captures blend of Hanes-like dominance and high/visible growth ramp

GRUH Finance

GRHF IN

2,684

1,101

1.7

N/A

N/A

NR

Best play in affordable housing due to innovative credit scoring, strong local knowledge and support of the parent HDFC

58.6

49.0

15.6

13.5

2.4

Amara Raja Batt. AMRJ IN

1,790

859

4.9

D4

67%

NR

Emerged as credible competitor to Exide driven by cost/technological advantages. However, market share gains to slow down as Exide wakes up from its complacent past

24.3

23.0

4.5

3.9

19.7

34.6

26.6

6.9

5.9

21.4

62.9

50.3

10.7

9.0

16.8

Abbott India

BOOT IN

1,471

368

0.2

D1

83%

NR

Abbott trading at a 10-15% discount to peers is justified due to no novel product launches, over dependence on legacy business and compromised minority interest. Excess cash on the books of the parent and lack of focus in building the business, we believe multiples signal a likely delisting candidate.

Astral Poly

ASTRA IN

1,400

560

0.5

D1

42%

NR

Over last decade Astral’s sales and EPS has grown at 35% and 31% CAGR and can grow at similar rate over the next decade as the company builds on its brand and architecture to become an ace building materials brand from a premium pipes brand

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Page 8

Strategy

Company

Ticker

Mcap ($mn)

Dr Lal Pathlabs

Cera Sanitwaryware

DLPL IN

CRS IN

REPCO Repco Home Fin IN

1,026

684

550

Free Float ADV-6m Greatness Mcap (Median) Accounting Score Ambit Decile Stance ($mn) ($mn) (%)

123

308

341

0.9

0.2

1.8

D2

D6

N/A

75%

54%

N/A

Comments

P/E

P/B

RoCE*

FY17

FY18E

FY17

FY18E

FY17

NR

Sales growth of mid-to-high teens with steady margins and return ratios will continue led by investment in growth in the form of reference and satellite labs, expanding the test palette and reasonable price hikes. Stock’s valuation at 35x FY19E consensus P/E is justified given that Dr Lal combines the higher growth potential of the consumer discretionary sector at the economics of the consumer staples sector.

43.0

38.6

10.1

8.3

26.5

NR

Cera’s high RoCE (Median FY13-FY17: 29%) despite increasing competition keeps its valuations elevated. Improving product portfolio, increasing presence in premium and mass market and the launch of home upgrade division can strengthen the brand and growth rates

45.7

37.7

8.6

7.2

18.4

NR

Strong positioning in affordable housing in South India due to local area knowledge and an innovative origination strategy. However a weak rating profile implies that competitive advantages are moderate

19.6

17.3

3.1

2.7

2.4

Source: Bloomberg, Capitaline, Ambit Capital Research. Note: *RoA for BFSI stocks. Market cap data as of 07 Nov’17.

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Page 9

Strategy

The case for a Coffee Can Portfolio The Coffee Can approach to portfolio construction We introduced our maiden 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 (ideally for ten years or more). To recap the origins of this 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’ likening the approach 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.

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

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: 

Four factors work in favour of the Coffee Can approach to portfolio Higher probability of returns over the long term: As is well understood, construction 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%.

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

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 5: Probability of gains from equity investing disproportionately with increase in holding horizon

in

India

increases

Probability of gains

100% 90% 80% 70% 60% 50% 1 Hour

1 Day

1 Week

1 Month Years

1 Year

10 Year 100 Years

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

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Page 10

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.

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

Exhibit 6: A hypothetical portfolio with 50% strike rate and symmetry around positive and negative returns 10-year CAGR

600 500

Stock A

26%

Stock B

-26%

Portfolio

17.6%

400 300 200 100 0 0

1

2

3

4

5

6

7

8

9

10

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.”

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

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Strategy As an example, we highlight how, over the long term, Page Industries’ stock price has withstood short-term disappointments to eventually compound at an impressive 30% CAGR since Mar’07. Exhibit 7: Page’s stock has compounded at an impressive 30% CAGR since Mar’07

Share price (in Rs)

25,000 20,000 CAGR 4.2%

CAGR 2.6%

15,000 10,000 5,000

CAGR 0.7%

Sep-17

Sep-16

Mar-17

Mar-16

Sep-15

Mar-15

Sep-14

Mar-14

Sep-13

Mar-13

Sep-12

Mar-12

Sep-11

Mar-11

Sep-10

Mar-10

Sep-09

Mar-09

Sep-08

Mar-08

Sep-07

Mar-07

-

Source: Bloomberg, Ambit Capital research.

However, the chart shown above also highlights that over the past 10 years, there have been several extended time periods when Page’s share price has not gone anywhere – such as from Mar’07 to Mar’09, Jan’15 to Jan’16 and May’16 to May’17. In spite of remaining flat over these periods, Page has performed so well in the remaining six years that the 10-year CAGR for the stock is 30%. 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) [email protected] November 17, 2017

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Page 12

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 2007. 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 18.6%. Left untouched, however, the same portfolio would have Finally, churn has a significant generated CAGR returns of 19.7%. This implies ~8.6% of the final corpus impact on overall portfolio (~US$52mn in value terms) is lost to churn over the ten-year period. Thus, a returns US$100mn portfolio that would have grown to US$602mn over the ten-year period (30 June 2007 - 30 June 2017) in effect grows to US$550mn 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.

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Strategy

Framework and results from back-tests In the world of investing, a number of quantitative (or rules based) approaches have been devised 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.] That said, whilst there are multiple rule-based approaches for portfolio construction, most of these rule-based approaches usually require a periodic rebalance of the portfolio. Thus, by virtue of limitations in their very construct they become less useful for making designing a Coffee Can portfolio. We, therefore, start with the basic principles of investing for our stock selection in a Coffee Can portfolio. 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 strong RoCE.

We start with the basic investing principles for our stock selection

Exhibit 8: A combination of superior RoCE and revenue growth is a winner in the Indian context* 12.0%

Average outperformance: 10-year CAGR 9.6%

10.0% 8.0%

6.7%

6.0% 4.1% 4.0% 2.0% 0.0% Superior on sales growth

Superior on RoCE

Superior on Both

Source: Bloomberg, Ambit Capital research. Note:*The universe is 2007’s BSE200 firms (ex-financials); performance relative to the BSE200 Index; the chart is based on price data from 31 March 2007 to 31 March 2017. 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.

The twin filters of Coffee Can We use RoCE (pre-tax) and revenue growth as the filters for selecting Coffee Can stocks. Details are given below:  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 Stocks with superior RoCE have exceed the cost of capital. RoCE, therefore, is of utmost importance in assessing a outperformed their peers over the firm’s performance. Our empirical work on the share price performance of Indian last ten-year period 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 FY07-17 outperformed the BSE200 Index by 4.1% on a CAGR basis. However, firms with a superior RoCE growth gave a higher outperformance of 6.7%. The best outperformance during this period was given by firms that were superior on both revenue growth and RoCE at 9.6%. [email protected]

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Page 14

Strategy Why 15%? The weighted average cost of capital (before taxes) for Indian 15% RoCE is the minimum return companies is around 13-14% (assuming an equal mix of debt and equity; ~11% required to beat the cost of capital cost of debt and ~15% cost of equity). Adding the risk-free rate (7.5-8% in India) in India and an equity risk premium of 6-6.5% too gives a cost of capital broadly in that 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 Very few listed companies manage nominal GDP growth rate has averaged 14% over the past ten years (FY07-17). A to achieve a sales growth that firm operating in India should, therefore, be able to deliver sales growth of at matches India’s nominal GDP least 14% per annum. However, very few listed companies (only 6 out of the growth rate of 15% ~1512 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. Note: Given the recent accounting standard change from Indian GAAP to IND-AS, to calculate the parameters above for FY16-17 we have used corresponding IND-AS numbers. 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 We use RoE of 16% and loan equity over return on assets because it is a fairer measure of the bank’s ability to growth of 15% as filters to screen generate higher income efficiently on a given equity capital base over time. BFSI stocks 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- We use a market-cap threshold of cap threshold of `1bn. India is the least liquid among the world’s 15 largest equity `1bn 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. Note that whilst these twin filters of revenue growth and RoCE may appear simplistic in nature, our approach consciously does not look for 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.

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Page 15

Strategy Results from back- testing the Coffee Can portfolios 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 seventeen years (i.e. portfolios initiated annually from 2000 to 2016), including eight portfolios that have run their entire course of ten-years (2000-2010, 2001-2011, 2002-2012, 2003-2013, 2004-2014, 2005-2015, 2006-2016 and 2007-2017) 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 17 portfolios and the Sensex/BSE200 index;  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 riskfree rate (assumed at 8%, comparable to the last ten year average 10-yr Government bond yield of 7.8%) divided by the absolute maximum drawdown.

We back-test the framework and the results are revealing

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 17 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 17 iterations in the table below. For details on the portfolio constituents, please refer to the Appendix 2.

Exhibit 9: Back-testing results of 17 iterations of the Coffee Can Portfolio (vs Sensex) using total shareholder returns Kick-off year*

All-cap CCP (start)

All-cap CCP (end)

CAGR return

Outperformance relative to Sensex

Large-cap CCP (start)

Large-cap CCP (end)

CAGR return

Outperformance relative to Sensex

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

9,027

19.6%

10.3%

1,000

4,690

16.7%

7.4%

2008

1,100

6,759

21.4%

9.6%

800

4,028

18.8%

7.0%

2009

1,100

6,510

23.7%

11.5%

900

3,534

17.8%

5.6%

2010

700

3,167

22.8%

12.1%

300

1,138

19.8%

9.2%

2011

1,400

3,558

15.8%

4.7%

400

1,076

16.8%

5.8%

2012

2,200

7,502

25.7%

11.1%

500

1,214

18.0%

3.4%

2013

1,800

6,608

34.8%

19.8%

600

1,451

22.5%

7.5%

2014

1,600

2,902

22.1%

14.6%

700

1,118

17.0%

9.5%

2015

2,000

2,841

19.0%

5.7%

1,200

1,460

10.2%

-3.1%

1,700 2,142 26.0% -2.5% 800 969 21.1% -7.4% 2016 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 2012 have been calculated until 07 Nov’17 (except for the live portfolios for the years 2014, 2015 and 2016 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in November each year).

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Page 16

Strategy The results are revealing and can be summarised as follows:  16 out of 17 CCPs 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 15 out of 17 occasions. 



On a risk-adjusted basis (where we define risk as maximum drawdown), 16 out of 17 iterations of the all-cap portfolio and 15 out of 17 iterations of the largecap portfolio have outperformed the Sensex. The large-cap versions of the CCP have outperformed the all-cap versions in 2000, 2003 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.

17 iterations of the CCP that we initiated from 2000 to 2016 prove the potential of the CCP to beat the Sensex and the BSE200

Performance of the previous Coffee Can portfolios vs BSE200 index using total shareholder returns In the exhibit 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 16 out of 17 all-cap Coffee Can portfolios and 15 out of 17 large-cap Coffee Can portfolios managing to beat the benchmark BSE200 index comprehensively. Exhibit 10: Back-testing results of 16 iterations of the Coffee Can Portfolio (vs BSE200 index) Kick-off year* 2000

All-cap CCP (start) 500

All-cap CCP (end) 3,831

CAGR return 22.6%

Outperformance relative to BSE200 5.1%

Large-cap CCP (start) 400

Large-cap CCP (end) 3,338

CAGR Outperformance return relative to BSE200 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

9,027

19.6%

9.4%

1,000

4,690

16.7%

6.5%

2008

1,100

6,759

21.4%

8.3%

800

4,028

18.8%

5.7%

2009

1,100

6,510

23.7%

10.1%

900

3,534

17.8%

4.1%

2010

700

3,167

22.8%

11.1%

300

1,138

19.8%

8.2%

2011

1,400

3,558

15.8%

2.9%

400

1,076

16.8%

4.0%

2012

2,200

7,502

25.7%

8.9%

500

1,214

18.0%

1.2%

2013

1,800

6,608

34.8%

16.4%

600

1,451

22.5%

4.1%

2014

1,600

2,902

22.1%

10.8%

700

1,118

17.0%

5.7%

2015

2,000

2,841

19.0%

2.0%

1,200

1,460

10.2%

-6.8%

1,700 2,142 26.0% -6.3% 800 969 21.1% -11.1% 2016 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 2012 have been calculated until 07 Nov’17 (except for the live portfolios for the years 2014, 2015 and 2016 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in November each year).

How should investors deploy fresh capital received every year? Given the long-term “buy and hold” approach advocated by the Coffee Can it is only natural that investors wonder about the approach to be followed for fresh fund deployment that are received every year. We discussed this point in detail in our last years’ Coffee Can report “The Coffee Can Portfolio 2016” dated 17 Nov’16. Specifically we took into account two scenarios: a) The fresh inflows every year are assumed to remain constant and are deployed in next year Coffee Can portfolio. So for instance, after starting a Coffee Can portfolio in Jun’00 with `100, when an investor receives `100 more in Jun ’01, 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. The results from the analysis have been summarised in exhibit below: [email protected]

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Strategy Exhibit 11: Portfolio returns assuming constant fund inflows every year Weight in the portfolio (%): Total stocks

Portfolio IRR

Sensex IRR

Alpha (Portfolio vs Sensex)

100.00

29.7%

21.4%

8.3%

17.79

100.00

29.5%

21.0%

8.5%

20.30

100.00

25.1%

16.9%

8.2%

24.29

21.05

100.00

23.3%

15.1%

8.1%

53.88

17.50

28.63

100.00

25.6%

15.7%

9.9%

49.15

18.10

32.76

100.00

21.6%

13.5%

8.1%

Top 5 stocks

Next 5 stocks

Remaining stocks

Overall

30

62.33

23.70

13.96

2001-11

31

57.78

24.44

2002-12

36

53.14

26.56

2003-13

46

54.65

2004-14

48

2005-15

50

2000-10

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%

Source: Bloomberg, Ambit Capital research. Note: In the exhibit above we have assumed that the fresh fund inflows every year remain constant (i.e. Rs100 each year). Exhibit reproduced without any changes from our 17 Nov’16 report “The Coffee Can Portfolio 2016”.

One can clearly gauge from the table above that not only has each of the 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%). b) The fresh fund inflows every year are assumed to grow at 20% each year over the 10-year life of a particular Coffee Can Portfolio. Here we assume that after starting Coffee Can portfolio in Jun’00 with `100, when an investor receives `100 more 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.

The exhibit below summarises the results from our analysis. Exhibit 12: Portfolio returns assuming fund inflows grow at 20% every year Total stocks

Weight in the portfolio (%): Top 5

Next 5

Others

Overall

Portfolio IRR

Sensex IRR

Alpha (Portfolio vs Sensex)

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%

Source: Bloomberg, Ambit Capital research Note: In the exhibit above we have assumed that the fresh fund inflows every year increase by 20% (i.e. Rs100 at the start of year 1, Rs120 at the start of year 2, and so on) Exhibit reproduced without any changes from our 17 Nov’16 report “The Coffee Can Portfolio 2016”.

In this case too, portfolio IRR remains healthy at ~24.2% (vs ~15.3% for the Sensex index). We believe the exhibits 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.

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

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November 17, 2017

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Page 18

Strategy

Patience with Quality is the Holy Grail In last years’ Coffee Can report, “The Coffee Can Portfolio 2016” dated 17 Nov’16, we’d also discussed briefly how the returns as well as risk profile for the Coffee Can Portfolio are over a shorter time horizon. In that context, we determined the performance of Coffee Can portfolios over shorter time horizon of five years and as the results in exhibit below showcase, even over shorter time horizons, 15 out of 17 CCPs has outperformed the benchmark Sensex index Exhibit 13: Performance of the previous 17 iterations of the Coffee Can Portfolio over a 5-year period Kick-off year*

All-cap CCP (start)

All-cap CCP (end)

CAGR return

Outperformance relative to Sensex

Large-cap CCP (start)

Large-cap CCP (end)

CAGR return

Outperformance relative to Sensex

2000

500

1,150

18.1%

4.1%

2001

600

2,409

32.1%

0.9%

400

925

18.2%

4.2%

300

1,320

34.5%

3.3%

2002

800

4,006

38.0%

-0.5%

500

2,667

39.8%

1.3%

2003

900

3,771

2004

1,000

3,904

33.2%

1.3%

600

3,089

38.8%

6.9%

31.3%

6.3%

500

1,769

28.8%

3.8%

2005

900

2006

1,000

2,525

22.9%

1.8%

500

1,606

26.3%

5.2%

2,029

15.2%

1.0%

600

1,458

19.4%

5.2%

2007

1,500

2,685

12.3%

7.5%

1,000

1,968

14.5%

9.7%

2008

1,100

2,670

19.4%

10.7%

800

1,875

18.6%

9.8%

2009

1,100

3,529

26.3%

12.5%

900

2,203

19.6%

5.8%

2010

700

1,764

20.3%

9.4%

300

708

18.7%

7.8%

2011

1,400

2,335

10.8%

0.4%

400

828

15.6%

5.2%

2012

2,200

6,651

24.8%

8.9%

500

1,165

18.4%

2.5%

2013

1,800

6,608

34.8%

16.4%

600

1,451

22.5%

4.1%

2014

1,600

2,902

22.1%

10.8%

700

1,118

17.0%

5.7%

2015

2,000

2,841

42.1%

4.8%

1,200

1,460

21.7%

-15.5%

2016

1,600

2,069

29.3%

-2.9%

800

969

21.1%

-11.1%

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 2012 have been calculated until 07 Nov’17 (except for the live portfolios for the years 2014, 2015 and 2016 for which CAGR returns and absolute returns have been calculated since these portfolios were launched in November each year).

While this result might lead investors to wonder why then should they keep their money locked in for 10 years instead of five, our subsequent analysis in the report pointed towards how results are materially better in the former case. Specifically, we compared two scenarios, Scenario 1- Each of the eight (2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007] completed Coffee Can portfolios are left untouched for a decade. Scenario 2- Each of these eight (2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007] 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, IndSwift and Munjal Showa). We repeat this exercise for the periods of 2001-11, 200212, 2003-13, 2004-14, 2005-15, 2006-16 and 2007-17. 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 below:

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Strategy Exhibit 14: Performance of the Coffee Can Portfolios under the two scenarios Scenario 1

Scenario 2

Growth of `99 CAGR returns for invested at the start the portfolio of the period* 22.6% 759

Phase 2000-10

Scenario 1 vs Scenario 2 Excess CAGR Loss of terminal returns under portfolio value Scenario 1 under Scenario 2 -0.2% 1%

Growth of `99 CAGR returns for invested at the start the portfolio of the period* 22.7% 769

2001-11

32.2%

1,617

24.9%

913

7.4%

-44%

2002-12

25.4%

954

23.3%

803

2.2%

-16%

2003-13

27.4%

1,119

25.7%

976

1.8%

-13%

2004-14

32.6%

1,668

28.5%

1,222

4.1%

-27%

2005-15

22.1%

731

21.3%

686

0.8%

-6%

2006-16

20.4%

631

13.3%

344

7.1%

-45%

2007-17

19.6%

596

17.5%

496

Average

25.3%

22.1%

2.2%

-17%

3.2%

-21%

Source: Bloomberg, Ambit Capital research. Note: *After considering Rs1 in terms of brokerage and price impact cost.

The results from our analysis showcase how in seven out of eight 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.

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

This analysis yet again brings 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. Combining patience with quality generates best risk-adjusted returns In this version of our annual Coffee Can thematic, we decided to further explore the point on why someone should stick to investing for the long term with Coffee Can companies. Tying up funds for 10 years is by no means an easy task and a large majority of investors need to showcase good returns over shorter duration too in light of extreme competition in the fund management industry. To analyze the performance of a typical Coffee Can portfolio over durations less than 10 years then, we first direct investors’ attention towards our 22 Dec’16 dated note ‘The peculiar distribution of equity returns in India’ and 25 Jan’17 dated note ‘To get the free lunch in Indian equities’ where we had highlighted how the risk-adjusted returns pattern in India is clearly in favour holding on for periods of more than 5 years. The exhibits below clearly showcase how patience with respect to investments serves investors the best. Exhibit 15: The BSE100’s returns over a 10-year investment horizon are most likely to beat the risk-free rate Avg : 13%

No. of observations

10 Yr investment horizon +1SD 120

80

40

-1SD

Avg :17%

-1SD

1 Yr investment horizon

+1SD

10 Yr horizon has a fat right tail

1 Yr horizon has a fat left tail

0 -50%

-30%

-10%

10%

30%

50%

70%

90%

110%

130%

150%

BSE100 returns (in %) Source: Bloomberg, Ambit Capital Research. Note: Period under consideration is from April 1991 – December 2016. Avg refers to the average. The red dotted lines represent the average, average +1standard deviation, and average -1standard deviation for the 1-year investment horizon and the black dotted lines represent the average, average +1standard deviation, and average -1standard deviation for the 10-year investment horizon.

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Strategy

Median

distributions

Standard deviation

14%

Sharpe (using median) 40%

2.5

11%

The region which showcases ‘free lunch’ – i.e. returns and risk move in favourable direction together

10% 9%

20% 15% 10%

Sharpe ratio

25%

1

3

5

7

9

11

13

15

17

35% 30% 25%

1.5

20% 1.0

15% 10%

0.5

5%

5%

0%

8%

40%

2.0 Standard Deviation

30% 12%

Standard deviation

The ‘sweet spot’ of investment horizon

35%

13% Returns (annualised)

Exhibit 17: For the Nifty, the sweet spot of risk-adjusted returns is reached around the fifteen-year mark

Standard deviation

Exhibit 16: For the Nifty, the returns ‘normalize’ as the time horizon increases

0%

-

19

1

Years Source: Bloomberg, Ambit Capital Research Note: The returns have been computed on a daily rolling basis for the Nifty50 index since July 1990

3

5

7

9

11 13 Years

15

17

19

Source: Bloomberg, Ambit Capital Research Note: The returns have been computed on a daily rolling basis for the Nifty50 index since July 1990

We take this analysis further and showcase that how once you combine patience with ‘quality’ – something that we proxy using our Coffee Can portfolios, the risk-adjusted returns are even better. The exhibits below highlight how the risk-adjusted returns improve for the market (median returns improves while standard deviation declines) as one moves towards longer holding horizons. Further, if one was to hold on to ‘quality’ companies (as in CCP) for the long term, the risk-adjusted profile improves even further. Exhibit 18: Combining ‘patience’ in investing with ‘quality’ of investing (using Sensex as proxy for market) is the holy grail 50% =

Standard Deviation

1 Yr

Staying invested for longer period improves median returns for Sensex whilst reducing risk

40%

30%

20%

Sensex Coffee Can Portfolios

1 Yr

Combining patience with quality (through CCP) further improves risk-adjusted returns

3 Yr

3 Yr

5 Yr 10%

5 Yr

10 Yr

10 Yr 0% 8% -10%

13%

18%

23%

28%

Returns (median)

Source: Bloomberg, Ambit Capital Research Note: The returns have been computed since Jan’86 for the Sensex and since Jun’00 for the CCP on a weekly rolling basis. For the CCP, every June we shift to the new portfolio being launched that year

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Strategy Exhibit 19: Combining ‘patience’ in investing with ‘quality’ of investing (using BSE200 as proxy for market) is the holy grail 50%

BSE200 index Staying invested for a longer period improves median returns for BSE200 whilst reducing risk

Standard Deviation

40%

Coffee Can Portfolios

1 Yr

1 Yr 30% Combining patience with quality (through CCP) further improves riskadjusted returns

3 Yr

20%

3 Yr

5 Yr

10%

5 Yr 10 Yr

10 Yr

0% 8% -10%

13%

18%

23%

28%

Returns (median)

Source: Bloomberg, Ambit Capital Research Note: The returns have been computed since Jun’94 and since Jun’00 for the CCP on a weekly rolling basis. For the CCP, every June we shift to the new portfolio being launched that year

These results are clearly spectacular and vindicate the rationale of long-term investing. However, any smart investor would think that these results are an ‘effect’ rather than a ‘cause’. In other words, these results are obtained by performing a critical task i.e. selecting quality companies and holding on to them for long term. So then how does one identify such quality companies? To capture that point we’d like to direct investors’ attention to our 02 Nov’15 dated note “The Coffee Can Portfolio.. the coffee works”, where we identified the common traits of those quality franchises that have made way to Coffee Can portfolios maximum number of times (referred to as “Winners amongst winners” in the note). Three traits in particular stood out with respect to such companies - (a) obsessive focus on the core franchise instead of being distracted by short-term gambles outside the core segment; (b) relentless deepening of competitive moats and; (c) sensible capital allocation i.e., refraining from large bets and returning excess cash to shareholders. These traits manifest themselves in the form of high and stable earnings growth trajectory for such companies. In the very same note mentioned in the paragraph above, we also compared the capital allocation profiles (i.e. sources and uses of cash) of the “Winners amongst winners” vs. the market (using Nifty as a proxy in that case). As can be clearly seen in the charts below, the propensity of using internal cash (i.e. cash from operations) is much higher for a typical CCP company vs. a typical company in the market index. This in turn implies lower use of debt and resultantly lower leverage for such companies.

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Strategy Exhibit 20: Nifty companies rely more on debt…

3%

Exhibit 21: ...as compared to “Winners amongst winners” 1%

5%

CFO

5%

CFO

5%

Debt Raised

5%

7% Debt Raised

Equity issued

Equity issued

53%

34%

Net cash used

Net cash used 82%

Dividend and Interest received

Dividend and Interest received

Source: AceEquity, Ambit Capital Research Note: Exhibit above reproduced from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” without changes. Data pertains to the FY05-15 period

Source: AceEquity, Ambit Capital Research Note: Exhibit above reproduced from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” without changes. Data pertains to the FY05-15 period

Exhibit 22: Nifty companies pay lower dividends…

Exhibit 23: ...while “Winners amongst winners” are more shareholder friendly on dividends

Net capex and investments

1% 9%

Net capex and investments

5% 5%

Debt Repayment

11%

Debt Repayment 48%

Interest paid

7% 54% 18%

Interest paid

37% Dividend paid

Dividend paid

Others

Others 2%

Source: AceEquity, Ambit Capital Research Note: Exhibit above reproduced from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” without changes. Data pertains to the FY05-15 period

3%

Source: AceEquity, Ambit Capital Research Note: Exhibit above reproduced from our 02 November 2015 thematic: “The Coffee Can Portfolio…the coffee works!” without changes. Data pertains to the FY05-15 period

Now for any Coffee Can company to keep growing at more than 10% year after year, it will need to find new ‘value accreting’ opportunities especially as it grows bigger in size. Given the sharp focus of such companies on maintaining their competitive moats, these companies do so (i.e. invest in new opportunities) without letting go of their return on capital. This characteristic allows a typical Coffee Can company to maintain a steady earnings growth trajectory. These two facets (lower use of leverage and growing whilst maintaining high RoCE), are what separates a typical Coffee Can firm from a typical firm in the market. Whilst the latter might make use of leverage to fund its growth aspirations (even if its value diluting in nature), a Coffee Can firm maintains a high benchmark for its capital allocation decisions. It achieves high growth but not at the cost of return on capital. Lower use of leverage in turn allows for lower earnings (and consequently stock) volatility during turn in credit cycles. The effect of such a focused business practice for these companies is visible in anecdotal evidence of impressive growth in earnings and lower stock price volatility. The exhibit below clearly showcases how the EPS CAGR of the CCP portfolios has beaten the EPS CAGR for BSE200 index in 14 out of 17 instances.

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Strategy Exhibit 24: The Coffee Can Portfolios have seen higher EPS growth versus the BSE200 index in 14 out of 17 instances 30% CCP

EPS growth (CAGR)

25%

BSE200

20% 15% 10% 5%

FY16-17

FY15-17

FY14-17

FY13-17

FY12-17

FY11-17

FY10-17

FY09-17

FY08-17

FY07-17

FY06-16

FY05-15

FY04-14

FY03-13

FY02-12

-5%

FY01-11

FY00-10

0%

-10% Source: Bloomberg, Capitaline, Ambit Capital research.

Also, a typical completed CCP (one that has run its entire course of 10 years) has seen much lower drawdown vs. the BSE 200 index. As an example, we present below the trajectory of Rs100 invested in BSE200 index and the Coffee Can portfolio beginning in Jun’00. The returns and drawdown profiles for rest of the completed Coffee Cans portfolios (i.e. the ones starting in 2001 to 2007) are given in Appendix 4. Exhibit 25: Coffee Can Portfolios suffer much lower drawdowns than the BSE200 index 70%

900

50%

500 30%

300 100

10%

-100

-10%

-300

-30%

-500 -50%

-700 -900

Maximum drawdown

Portfolio values (Rs)

700

CCP - Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Jun-10

Jan-10

Aug-09

Mar-09

Oct-08

May-08

Dec-07

Jul-07

Feb-07

Sep-06

Apr-06

Nov-05

Jun-05

Jan-05

Aug-04

Mar-04

Oct-03

May-03

Dec-02

Jul-02

Feb-02

Sep-01

Apr-01

Nov-00

Jun-00

-70%

Source: Bloomberg, Ambit Capital research. Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example, in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07

The importance of this point with respect to the relative performance of CCP vis-à-vis the aggregate market index can be gauged through a simple example. Let’s say you invest Rs100 in two stocks each – A and B. Investment in Stock A goes to Rs50 in a year while the one in stock B goes to Rs80 during a downturn. Now for Stock A to make back the initial investment of Rs100, it will need return of 100% (50* (1+ 100%) = 100) while stock B will need a return of 25% (80* (1+25%) = 100). What this essentially implies is that in any long enough holding horizon with intermittent periods of sharp correction, stock A will need to provide much better returns than stock B to be able to beat the latter in end. This extreme divergence in risk (captured through propensity of drawdown) is what allows quality companies with low drawdown (like Stock B in above example) to keep compounding robustly even with modest returns year after year and result in a substantial corpus at the end of ten years. At the same time, the aggregate market [email protected]

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Strategy index (like Stock A in the above example) on the back of a higher and more prolonged drawdown is unable to garner equivalent overall returns even with some intermittent periods of sharply high returns. This lesser ‘risk’ as captured by lower price correction and resultantly lesser required return to claw back initial investment is an important reason why the stocks in a typical CCP tend to outperform aggregate market indices on a long-term basis. Combining the lower drawdown aspect with higher EPS growth trajectory for CCP results in best of both worlds – a high stock price appreciation trajectory (on the back of high earnings growth which as we showed in our 29 Apr’15 note, “Can value investors make money in India”, is a primary determinant of long term returns) and lower stock price volatility on the back of lower leverage. These two factors in combination lead to Coffee Can portfolios outperforming the broader market year after year.

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Strategy

Today’s Coffee Can for 2017-2027 Introducing the Coffee Can candidates for 2017-2027 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 26: The shortlisted firms with superior RoCE (pre-tax) and sales growth over the last ten years (FY07-17) Share price performance (ten-year CAGR rel. to Sensex) (%)

Mcap (US$bn)

FY18 P/E

HCLT IN

20%

19.0

13.9

Lupin

LPC IN

28%

5.9

21.2

Page Industries

PAG IN

48%

3.9

76.5

Amara Raja Batteries

AMRJ IN

44%

1.9

25.1

Superior on both

Ticker

HCL Technologies

Abbott India

BOOT IN

25%

1.5

26.4

Astral Poly

ASTRA IN

52%

1.4

50.6

Dr Lal Pathlabs

DLPL IN

N/A

1.1

39.6

Cera Sanitary.

CRS IN

48%

0.7

37.7

Coffee Can 2017-2027 continues to feature some of India’s mostsuccessful franchises as well as the most-compelling investment themes

Source: Bloomberg, Capitaline, Ambit Capital research; Note: Share price performance has been measured over a ten-year period (i.e. 31 March 2007 to 31 March 2017). 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 7th November 2017. Dr. Lal PathLabs 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 our previous Coffee Can Portfolio, stocks like Asian Paints, Britannia, Cadila, eClerx, Axis Bank and Relaxo do not find a place in this year’s Coffee Can. The only new addition this year is Abbott India. 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 Only 5 BFSI stocks meet our screening filters for the past ten years. The firms clearing this filter are shown in the exhibit below. Exhibit 27: The very short list of the BFSI firms with superior RoE and loan book growth (over FY07-17)

HDFC Bank

HDFCB IN

Share price performance (Ten year CAGR rel. to Sensex) (%) 22%

72.6

26.7

LIC Housing Finance

LICHF IN

36%

4.5

14.3

GRUH Finance

GRHF IN

40%

2.7

50.1

Repco Home Finance

REPCO IN

15%

0.5

17.2

Muthoot Capital Serv

MTCS IN

25%

0.1

24.0

Superior on both

Ticker

Mcap US$bn)

FY18 P/E

Source: Bloomberg, Capitaline, Ambit Capital research; Note: Share price performance has been measured over a ten-year period (i.e. 31 March 2007 to 31 March 2017). 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 7th November 2017. 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 and liquidity. It is striking that this year we have a very short list of stocks that pass our filters – only 8 non-BFSI stocks and only 5 BFSI stocks. The last time the Coffee Can Portfolio had so few stocks was in 2011.

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Strategy Exhibit 28: Stocks that featured in the CCP last year but did not make it to this year’s iteration of the CCP Company

Reasons for exclusion

Asian Paints delivered a sales growth of 7.6% in FY17 (using IND-AS numbers for FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales growth in excess of 10% Britannia delivered a sales growth of 7.8% in FY17 (using IND-AS numbers for FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales Britannia Inds. growth in excess of 10% Cadila's sales have been flat in FY17 (using IND-AS numbers for FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales growth in excess of Cadila Health. 10% Relaxo Footwear delivered a sales growth of ~1.6% in FY17 (using IND-AS numbers for Relaxo Footwear FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales growth in excess of 10% eClerx delivered a sales growth of ~1.2% in FY17 (using IND-AS numbers for FY16 and FY17); hence does not clear the Coffee Can filter on ten consecutive years of sales eClerx Services growth in excess of 10% Axis Bank delivered a loan book growth of ~10.1% in FY17 (using IND-AS numbers for FY16 and FY17) and an RoE of ~6.8% (using IND-AS numbers for FY16 and FY17); Axis Bank hence does not clear the Coffee Can filter on ten consecutive years of loan book growth of 15% and RoE in excess of 16% .

Asian Paints

Source: Company filings, Ambit Capital research

Having identified the Coffee Can stocks for this year’s iteration of the Coffee Can In the ensuing sections we evaluate Portfolio, in the ensuing sections we will evaluate each of the companies forming part the stocks that feature in this year’s CCP using John Kay’s IBAS of our Coffee Can Portfolio using John Kay’s IBAS framework. framework John Kay’s IBAS framework has been discussed in greater details in Appendix 3: John Kay’s IBAS Framework.

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Strategy

Performance of ‘live’ Coffee Can portfolios We launched our maiden Coffee Can portfolio on 17 November 2014 titled “The Indian Coffee Can Portfolio”, We followed this up with two more portfolios revealed in 2015 and 2016 under notes titled “The Coffee Can Portfolio…the coffee works!” and “The Coffee Can Portfolio 2016” respectively.

We have launched three Coffee Can portfolios beginning Nov’14

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 two out of these three portfolios have done extremely well vs. the Sensex. Also, the pattern of returns in these three portfolios highlight that the benefit from Coffee Can portfolios is realized when you hold them for longer periods The Coffee Can Portfolio launched in 2014 has generated total returns of 22% (on a CAGR basis) vs total CAGR returns of 8% for the benchmark Sensex index since initiation. The Coffee Can Portfolio launched in 2015 has generated total CAGR returns of 19% vs total CAGR returns of 13% for the benchmark Sensex index since initiation. The Coffee Can Portfolio launched in 2016 has generated total CAGR returns of 26% vs total CAGR returns of 29% for the benchmark Sensex index since initiation.

The 2014 and 2015 portfolios have done extremely well vs the Sensex index

Exhibit 29: Performance of the 2014 Coffee Can Portfolio since initiation Company Date from/to

Value at start (`)

Value at end (`)

Total return CAGR

14-Nov-14

07 Nov 17

ITC

100

114

5%

Asian Paints

100

174

20%

Godrej Consumer

100

204

27%

Marico

100

195

25%

Ipca Labs.

100

81

-7%

Berger Paints

100

198

26%

Page Industries

100

217

30%

Balkrishna Inds

100

275

40%

eClerx Services

100

135

10%

Mayur Uniquote

100

113

4%

V-Guard Inds.

100

344

51%

HCL Technologies

100

117

5%

HDFC Bank

100

200

26%

Axis Bank

100

114

4%

City Union Bank

100

205

27%

GRUH Finance

100

218

30%

1,600

2,902

22%

100

124

8%

Portfolio* Sensex Outperformance

14.6% 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 the end is the value of the portfolio at the end of the period (07 Nov’17). Thus, for this period, the value of the portfolio rose from `1,600 at the start to `2,902 at the end.

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Strategy Exhibit 30: Performance of the 2015 Coffee Can Portfolio since initiation Company

Value at start (`)

Value at end (`)

01-Nov-15

07-Nov-17

HCL Technologies

100

106

3%

ITC

100

124

11%

Lupin

100

45

-33%

Asian Paints

100

140

18%

Cadila Health.

100

121

10%

Britannia Inds.

100

146

20%

Marico

100

166

28%

GlaxoSmith C H L

100

93

-4%

Colgate-Palm.

100

111

5%

Amara Raja Batt.

100

76

-13%

Page Industries

100

148

21%

Berger Paints

100

159

26%

eClerx Services

100

93

-3%

Astral Poly

100

185

36%

V-Guard Inds.

100

347

85%

Cera Sanitary.

100

176

32%

HDFC Bank

100

168

29%

Axis Bank

100

113

6%

LIC Housing Fin.

100

128

13%

GRUH Finance

100

197

40%

2,000

2,841

19%

100

129

13%

Date from/to

Portfolio* Sensex

Total return CAGR

Outperformance

5.7% 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 the end is the value of the portfolio at the end of the period (07 Nov’17). Thus, for this period, the value of the portfolio rose from `2,000 at the start to `2,841 at the end.

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Strategy Exhibit 31: Performance of the 2016 Coffee Can Portfolio since initiation Company

Value at start (`)

Value at end (`)

16-Nov-16

07-Nov-17

Total return CAGR

Asian Paints

100

123

23%

HCL Technologies

100

115

15%

Lupin

100

62

-38%

Britannia Inds.

100

156

56%

Cadila Health.

100

134

34%

Amara Raja Batt.

100

73

-27%

Page Industries

100

158

58%

eClerx Services

100

92

-8%

Astral Poly

100

192

92%

Cera Sanitary.

100

168

68%

Relaxo Footwear

100

141

41%

HDFC Bank

100

148

48%

Axis Bank

100

113

13%

LIC Housing Fin.

100

118

18%

GRUH Finance

100

170

70%

Dr Lal Pathlabs

100

73

-27%

Date from/to

Repco Home Fin Portfolio Sensex

100

107

7%

1,700

2,142

26%

100

129

29%

Outperformance

-2.5%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of `1,700 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 (07 Nov’17). Thus, for this period, the value of the portfolio rose from `1,700 at the start to `2,142 at the end.

Should investors rebalance the Coffee Can portfolios for the years 2014, 2015 and 2016? With 6 out of last year’s 17 stocks not featuring in this year’s Coffee Can Portfolio, the obvious question one would ask is whether to rebalance the earlier Coffee Can Portfolio (initiated in 2016) to include the stocks figuring in this year’s iteration. To answer that question, 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.

We advise investors to refrain from rebalancing the Coffee Can portfolios

The updated results from our analysis have been reproduced in exhibit below. Exhibit 32: Share price CAGR returns over 10-year periods for CCP with and without rebalancing 20002010

2001- 2002- 2003- 2004- 20052011 2012 2013 2014 2015

20062016

2007- Median 2017 CAGR

CCP without rebalancing

19.3%

28.5%

22.4%

25.4%

30.8%

20.5%

18.4%

18.9%

21.5%

CCP with rebalancing

18.5%

22.6%

22.0%

17.0%

18.7%

13.5%

11.2%

12.7%

17.8%

Difference (w/o minus 0.8% 5.9% 0.4% 8.4% 12.0% 6.9% 7.2% 6.2% 3.7% with rebalancing) 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.

As can be seen in the exhibit above, the Coffee Can approach without rebalancing has outperformed with rebalancing approach on all eight occasions. The median CAGR for CCP without rebalancing over these six iterations was 21.5% vs 17.8% for CCP with rebalancing. These results reaffirm the advantage of the “buy and hold” approach over an annual rebalancing approach. [email protected]

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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.

Our G&C portfolio is ideal for investors aiming to beat benchmarks over the short term

Please click here for the latest G&C portfolio published on September 02, 2015. 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 33: The ‘greatness’ framework a. Investment (gross block)

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)

e. Cash generation (CFO)

d. Balance sheet discipline (D/E, cash ratio)

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:

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Strategy 

Percentage improvements in performance over FY14-16 vs FY11-13; and



Consistency in performance over FY11-16 i.e. improvements adjusted for underlying volatility in financial data

A complete list of factors that are considered whilst quantifying greatness has been mentioned in Exhibit below. Exhibit 34: Factors used for quantifying greatness Head 1 Investments 2 Conversion to sales

3 Pricing discipline 4 Balance sheet discipline

5

Cash generation and PAT improvement

6 Return ratio improvement

Criteria a.

Above-median gross block increase (FY14-16 over FY11-13)*

b.

Above-median gross block increase to standard deviation

a. b. c.

Improvement in asset turnover (FY14-16 over FY11-13)* Positive improvement in asset turnover adjusted for standard deviation Above-median sales increase (FY14-16 over FY11-13)*

d.

Above-median sales increase to standard deviation

a.

Above-median PBIT margin increase FY14-16 over FY11-13)*

b.

Above-median PBIT margin increase to standard deviation

a.

Below-median debt-equity decline (FY14-16 over FY11-13)*

b.

Below-median debt-equity decline to standard deviation

c.

Above-median cash ratio increase (FY14-16 over FY11-13)*

d.

Above-median cash ratio increase to standard deviation

a.

Above-median CFO increase (FY14-16 over FY11-13)*

b.

Above-median CFO increase to standard deviation

c.

Above-median adj. PAT increase (FY14-16 over FY11-13)*

d.

Above-median adj. PAT increase to standard deviation

a.

Improvement in RoE (FY14-16 over FY11-13)*

b.

Positive improvement in RoE adjusted for standard deviation

c.

Improvement in RoCE (FY14-16 over FY11-13)*

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, FY11 to FY16), we prefer to average the data out over FY11-13 and compare that to the averaged data over FY14-16. This gives a more consistent picture of performance (as opposed to simply comparing FY11 to FY16).

The ten-bagger portfolio focuses on structural plays that are financially strong firms (with credible management teams) and remain consistent performers on a crosscyclical 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 now 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 35: Our suite of Portfolios for investors looking to invest in India Type of Investor

Recommended Ambit Portfolio

Short-term investor with quarterly performance focus

Good and Clean Portfolio

Conventional buy-and-hold investor with 1-3 year horizon

Ten-Bagger Portfolio

Long-term investor with ten-year outlook Source: Ambit Capital Research

Coffee Can Portfolio

Returns over recommended time period The 19 instalments of our ‘Good & Clean’ portfolios over the last six years have delivered a staggering 3.1% alpha on a CAGR basis The six iterations of our ten-baggers portfolios have generated over 10.7% alpha over the past six years Average alpha of 8.6% over eight- to ten-year iterations

The Coffee Can Portfolio is ideal for long-term investors with a tenyear outlook

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Appendix 2: Performance of last 14 back tested Coffee Can portfolios 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 20.6% 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 36: 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 December 2008 for the all-cap CCP, large-cap CCP and for the Sensex.

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 37: Portfolio performance during the first iteration Value at start (Rs)

Value at end (Rs)

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%

HDFC

100

1,283

29%

Portfolio

500

3,831

23%

Sensex

100

441

Company Date from/to

Outperformance

Total return CAGR

Hero Motocorp and HDFC were the star performers, whilst NIIT was the laggard in Period 1

16% 6.6%

Source: Bloomberg, Ambit Capital research. Note: *Portfolio price at the start of Rs500 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs500 at the start to Rs3,831 at the end.

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Strategy Exhibit 38: Hero and HDFC rose exponentially whilst NIIT collapsed in 2000-2010

Value of stock in portfolio (in Rs)

4,500 4,000 3,500 Swaraj Engines

3,000 2,500

Hero Motocorp

2,000

Cipla

1,500

NIIT

1,000

HDFC

500 Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs500 at the start to Rs3,831 at the end.

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 Industries, HDFC Ltd and LIC Housing Finance Large-cap portfolio stocks: Cipla, Hero MotoCorp and HDFC Ltd 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 39: Second iteration summary 2001-2011*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

32.2%

28.3%

20.5%

Maximum drawdown**

-34%

-31%

-56%

Excess returns

0.72

0.66

0.23

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 20012011. 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 40: Portfolio performance during the second iteration Company Date from/to Cipla Hero Motocorp Apollo Hospitals Roofit Inds. HDFC LIC Housing Fin. Portfolio Sensex Outperformance

Value at start (Rs) 30-Jun-01 100 100 100 100 100 100 600 100

Value at end (Rs) 30-Jun-11 396 1,985 1,409 4 1,242 4,767 9,802 646

Total return CAGR

LIC Housing Finance was the star performer delivering ~47x total returns in Period 2

15% 35% 30% -27% 29% 47% 32% 20% 11.7%

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of Rs100 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 Rs600 at the start to Rs9,802 at the end.

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Strategy Exhibit 41: LIC Housing Finance’s performance during 2001-2011 was stellar Value of stock in portfolio (in Rs)

12,000 10,000 LIC Housing Fin. 8,000

HDFC

6,000

Roofit Inds. Apollo Hospitals

4,000

Hero Motocorp

2,000

Cipla

Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs600 at the start to Rs9,802 at the end.

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 Ltd and LIC Housing Finance Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, HDFC Ltd 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 42: Third iteration summary 2002-2012*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

25.4%

23.7%

20.3%

Maximum drawdown**

-41%

-32%

-56%

Excess returns

0.43

0.49

0.22

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.

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Strategy Exhibit 43: Portfolio performance during the third iteration Value at start (Rs) 30-Jun-02

Company Date from/to

Value at end (Rs) 30-Jun-12

Total return CAGR

Infosys

100

706

22%

Hero Motocorp

100

1,038

26%

Cipla

100

461

16%

Container Corp.

100

740

22%

Guj Gas Company

100

763

23%

Aurobindo Pharma

100

505

18%

HDFC

100

1,237

29%

LIC Housing Fin.

100

2,260

37%

Portfolio

800

7,709

25%

Sensex

100

637

20%

Outperformance

5.1%

Source: Bloomberg, Ambit Capital research. Note: *Portfolio price at the start of Rs800 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs800 at the start to Rs7,709 at the end.

Exhibit 44: Portfolio’s outperformance was led by LIC Housing Finance once again Value of stock in portfolio (in Rs)

9,000 8,000

LIC Housing Fin.

7,000

HDFC

6,000

Aurobindo Pharma

5,000

Guj Gas Company

4,000

Container Corpn.

3,000

Cipla

2,000

Hero Motocorp

1,000

Infosys

Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs800 at the start to Rs7,709 at the end.

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 Ltd, LIC Housing Finance Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, Sun Pharma and HDFC Ltd 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, thereby delivering excess returns of 0.62-.0.77x. Exhibit 45: Fourth iteration summary 2003-2013*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

27.4%

29.2%

20.2%

Maximum drawdown**

-31%

-28%

-56%

Excess returns

0.62

0.77

0.22

Sun Pharma powered through to be the best-performing stock in Period 4

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2003. 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.

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Strategy 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 46: Portfolio performance during the fourth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-03

30-Jun-13

Infosys

100

713

22%

Cipla

100

710

22%

Hero Motocorp

100

958

25%

Sun Pharma.Inds.

100

3,381

42%

Container Corpn.

100

736

22%

Aurobindo Pharma

100

528

18%

Guj Gas Company

100

518

18%

HDFC

100

1,292

29%

LIC Housing Fin.

100

1,338

30%

Portfolio

900

10,175

27%

Sensex

100

631

Company Date from/to

Total return CAGR

Outperformance

20% 7.2%

Source: Bloomberg, Ambit Capital research. Note: *Portfolio price at the start of Rs900 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs900 at the start to Rs10,175 at the end.

Exhibit 47: Sun Pharma delivered a stellar performance in Period 4 Value of stock in portfolio (in Rs)

12,000

LIC Housing Fin.

10,000

HDFC Guj Gas Company

8,000

Aurobindo Pharma 6,000

Container Corpn.

4,000

Sun Pharma.Inds. Hero Motocorp

2,000

Cipla Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs900 at the start to Rs10,175 at the end.

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 Ltd and LIC Housing Finance Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India and HDFC Ltd 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 midcaps/small-caps. The higher share of the mid-caps/small-caps vs earlier iterations was instrumental in delivering higher alpha during this period.

The CCP delivered a whopping 12.7% to the Sensex, in Period 5

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Strategy Exhibit 48: 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

Source: Bloomberg, Ambit Capital research. Note: * Portfolio kicks off on 30 June 2004. 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 performance amongst the mid-cap/small-cap stocks was extreme: Whilst Havells delivered ~96.7x returns, Alok Industries 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 49: Portfolio performance during the fifth iteration Value at start (Rs)

Value at end (Rs)

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%

HDFC

100

1,123

27%

LIC Housing Fin.

100

1,540

31%

1,000

16,849

33%

100

616

Company Date from/to

Portfolio Sensex

Total return CAGR

Outperformance

Extreme price performance among mid-cap/small-cap stocks sets apart Period 5 from the earlier iterations of the CCP

20% 12.7%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,000 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,000 at the start to Rs16,849 at the end.

Exhibit 50: Havells India was the star performer in Period 5 Value of stock in portfolio (in Rs)

18,000

LIC Housing Fin.

16,000

HDFC

14,000

Havells India

12,000

Munjal Showa

10,000

Alok Inds.

8,000

Guj Gas Company

6,000 4,000

Container Corpn.

2,000

Cipla Hero Motocorp

Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,000 at the start to Rs16,849 at the end.

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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 Ltd Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India and HDFC Ltd 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 51: Sixth iteration summary 2005-2015*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

22.1%

19.5%

16.1%

Maximum drawdown**

-54%

-28%

-56%

Excess returns

0.26

0.41

0.15

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.

Extreme price performance among mid-cap/small-cap stocks continued in period 6

Exhibit 52: Portfolio performance during the sixth iteration Value at start (Rs)

Value at end (Rs)

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%

HDFC

100

827

24%

Portfolio

900

6,643

22%

Sensex

100

446

Company Date from/to

Outperformance

Total return CAGR

16% 6.0%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs900 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs900 at the start to Rs6,643 at the end.

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Strategy Exhibit 53: Havells India continued being the star performer in sixth iteration as well

Value of stock in portfolio (in Rs)

7,000 HDFC

6,000

Munjal Showa 5,000

Ind-Swift

4,000

Havells India Geometric

3,000

Container Corpn. 2,000

Cipla

1,000

Hero Motocorp Infosys

Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs900 at the start to Rs6,643 at the end.

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 Ltd and HDFC Bank Large-cap portfolio stocks: Infosys, Hero MotoCorp, Cipla, Container Corporation of India, HDFC Ltd 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 54: 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’s stock price rising by 13.4x and 11.9x respectively.

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Strategy Exhibit 55: Portfolio performance during the seventh iteration Value at start (Rs)

Value at end (Rs)

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%

HDFC

100

622

20%

Company Date from/to

HDFC Bank Portfolio Sensex

Total return CAGR

100

794

23%

1,000

6,376

20%

100

294

Outperformance

11% 8.9%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,000 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,000 at the start to Rs6,376 at the end

Exhibit 56: Mid-caps outperform the large-caps in the seventh iteration Value of stock in portfolio (in Rs)

7,000

HDFC Bank

6,000

HDFC

5,000

Suprajit Engg.

4,000

Munjal Showa Geometric

3,000

Havells India

2,000

Container Corpn.

1,000

Hero Motocorp Cipla

Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,000 at the start to Rs6,376 at the end.

Period 8: 2007-2017 (10.3% alpha to the Sensex; 19.6% 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 Ltd and HDFC Bank Large-cap portfolio stocks: Infosys, Wipro, Cipla, Tech Mahindra, Hindalco, Hero MotoCorp, Container Corporation of India, Asian Paints, HDFD Ltd 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.

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Strategy Exhibit 57: Eighth iteration summary 2007-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

19.6%

16.7%

9.3%

Maximum drawdown**

-53%

-39%

-56%

Excess returns

0.22

0.22

0.02

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 led the charge with almost 14.2x returns. Extreme movements were seen in mid-cap stocks again with stocks like Suprajit Engineering delivering almost 24x returns whereas Aftek delivered -96% returns. Exhibit 58: Portfolio performance during the eighth iteration Value at start (Rs) 30-Jun-07

Value at end (Rs) 30-Jun-17

Total return CAGR

Infosys

100

235

9%

Wipro

100

212

8%

Cipla

100

284

11%

Tech Mahindra

100

119

2%

Hindalco Inds.

100

145

4%

Hero Motocorp

100

739

22%

Container Corpn.

100

211

8%

Asian Paints

100

1,521

31%

Havells India

100

1,055

27%

Geometric

100

243

9%

Aftek

100

4

-28%

Munjal Showa

100

564

19%

Suprajit Engg.

100

2,472

38%

HDFC

100

449

16%

HDFC Bank

100

774

23%

1,500

9,027

20%

100

244

Company Date from/to

Portfolio Sensex Outperformance

9% 10.3%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at start of Rs1500 denotes an equal allocation of Rs100 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 Rs1500 at the start to Rs9,027 at the end

Exhibit 59: Asian Paints was the star performer in the eighth iteration

Value of stock in portfolio (in Rs)

10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Value at start

Vaue at end

HDFC Bank HDFC Suprajit Engg. Munjal Showa Aftek Geometric Havells India Asian Paints Container Corpn. Hero Motocorp Hindalco Inds. Tech Mahindra Cipla Wipro Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of Rs100 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 Rs1,500 at the start to Rs9,027 at the end.

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Strategy

Period 9: 2008-Present (9.6% alpha to the Sensex; 21.4% per annum absolute returns) All-cap portfolio stocks: Infosys, Wipro, Cipla, Asian Paints, Tech Mahindra, Havells India, Automotive Axles, Geometric, HDFC Ltd, HDFC Bank and Punjab National Bank Large-cap portfolio stocks: Infosys, Wipro, Cipla, Asian Paints, Tech Mahindra, HDFC Ltd, HDFC Bank and Punjab National Bank Our ninth iteration that begins in June 2008 is also outperforming the Sensex with an alpha of 9.6%. The large-cap version also beats the Sensex with an alpha of 7%. The large-cap version on account of lower drawdown has the higher risk-adjusted return at 0.29x vs. 0.28x for all-cap version and 0.10x for the Sensex. Exhibit 60: Ninth iteration summary 2008-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

21.4%

18.8%

11.8%

Maximum drawdown**

-48%

-38%

-39%

Excess returns

0.28

0.29

0.10

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 8.7x returns respectively whilst Havells India is continuing its dream run with 15.2x returns. Exhibit 61: Portfolio performance during the ninth iteration Company Date from/to

Value at start (Rs)

Value at end (Rs)

Total return CAGR

30-Jun-08

07-Nov-17

Infosys

100

265

11%

Wipro

100

289

12%

Cipla

100

305

13%

Asian Paints

100

1,097

29%

Tech Mahindra

100

293

12%

Havells India

100

1,621

35%

Automotive Axles

100

467

18%

Geometric

100

643

22%

HDFC

100

506

19%

HDFC Bank

100

967

27%

Punjab Natl.Bank

100

306

13%

1,100

6,759

21%

100

285

Portfolio Sensex Outperformance

12% 9.6%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,100 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,100 at the start to Rs6,759 until 7thNov’17.

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Strategy Exhibit 62: Large-caps and mid-caps shared outperformance in this iteration

Value of stock in portfolio (in Rs)

8,000

Punjab Natl.Bank

7,000

HDFC Bank

6,000

HDFC

5,000

Geometric Automotive Axles

4,000

Havells India

3,000

Tech Mahindra

2,000

Asian Paints

1,000

Cipla Wipro

Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,100 at the start to Rs6,759 until 7thNov’17.

Period 10: 2009-Present (11.5% alpha to the Sensex; 23.7% per annum absolute returns) All-cap portfolio stocks: Infosys, Wipro, Jindal Steel, Cipla, Asian Paints, Oracle Financial Services, Tech Mahindra, Motherson Sumi, HDFC Ltd, HDFC Bank and Punjab National Bank Large-cap portfolio stocks: Infosys, Wipro, Jindal Steel, Cipla, Asian Paints, Oracle Financial Services, HDFD Ltd, HDFC Bank and Punjab National Bank In the iteration beginning in 2009, both all-cap and large-cap CCP beat Sensex comprehensively again with alpha of 11.5% and 5.6% respectively. On a riskadjusted basis as well they gave a stable performance with excess returns of 0.53x0.74x. Exhibit 63: Tenth iteration summary 2009-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

23.7%

17.8%

12.2%

Maximum drawdown**

-21%

-19%

-24%

Excess returns

0.74

0.53

0.18

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.

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Strategy Motherson Sumi was the star performer in this iteration with the stock price rising ~26x during this period. Exhibit 64: Portfolio performance during the tenth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-09

07-Nov-17

Infosys

100

255

12%

Wipro

100

333

15%

Jindal Steel

100

40

-11%

Cipla

100

252

12%

Asian Paints

100

1,044

32%

Oracle Fin.Serv.

100

375

17%

Tech Mahindra

100

281

13%

Motherson Sumi

100

2,695

48%

HDFC Bank

100

648

25%

HDFC

100

424

19%

Company Date from/to

Punjab Natl.Bank Portfolio Sensex

Total return CAGR

100

164

6%

1,100

6,510

24%

100

261

Outperformance

12% 11.5%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,100 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,100 at the start to Rs6,510 until 7thNov’17.

Value of stock in portfolio (in Rs)

Exhibit 65: Motherson Sumi was the star performer in this iteration 7,000

Punjab Natl.Bank

6,000

HDFC HDFC Bank

5,000

Motherson Sumi Tech Mahindra

4,000

Oracle Fin.Serv.

3,000

Asian Paints

2,000

Cipla

1,000

Jindal Steel Wipro

Value at start

Vaue at end

Infosys

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,100 at the start to Rs6,510 until 7thNov’17.

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Strategy

Period 11: 2010-Present (12.1% alpha to the Sensex; 22.8% 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 In this iteration, our Coffee Can Portfolio outperformed the Sensex with an alpha of 12.1%. The large-cap version also beat the Sensex with an alpha of 9.2%, but on account of a lower maximum drawdown has the higher risk-adjusted return at 0.59x vs. 0.57x for all-cap version and 0.11x for the Sensex. Exhibit 66: Eleventh iteration summary 2010-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

22.8%

19.8%

10.6%

Maximum drawdown**

-26%

-20%

-24%

Excess returns

0.57

0.59

0.11

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 was led by Motherson Sumi (~12.7x returns). In spite of suspension of trading in two of the constituent stocks through the period (Amar Remedies and Tulip Telecom), the portfolio gave a stellar performance with ~23% CAGR returns. Exhibit 67: Portfolio performance during the eleventh iteration Company Date from/to

Value at start (Rs)

Value at end (Rs)

30-Jun-10

07-Nov-17

Total return CAGR

Amar Remedies

100

8

-29%

Asian Paints

100

532

25%

Motherson Sumi

100

1,378

43%

Tulip Telecom

100

1

-47%

HDFC Bank

100

501

24%

Punjab Natl.Bank

100

104

1%

Dewan Hsg. Fin.

100

643

29%

Portfolio

700

3,167

23%

Sensex

100

211

11%

Outperformance

12.1%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs700 denotes an equal allocation of Rs100 in each stock at the start of the period. Data for Amar Remedies and Tulip Telecom is not available because the companies were suspended during this period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs700 at the start to Rs3,167 until 7thNov’17.

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Strategy Exhibit 68: Motherson Sumi again was the star performer in this iteration

Value of stock in portfolio (in Rs)

3,500 3,000

Dewan Hsg. Fin.

2,500

Punjab Natl.Bank

2,000

HDFC Bank

1,500

Tulip Telecom Motherson Sumi

1,000

Asian Paints 500

Amar Remedies

Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs700 at the start to Rs3,167 until 7thNov’17. Data for Amar Remedies and Tulip Telecom is not available because the companies were delisted during this period.

Period 12: 2011-Present (4.7% alpha to the Sensex; 15.8% per annum absolute returns) All-cap portfolio stocks: ITC, Asian Paints, Motherson Sumi, Ipca, 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 In the twelfth iteration also the Coffee Can portfolio is outperforming the Sensex with an alpha of 4.7%. 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 riskadjusted return measures. Exhibit 69: Twelfth iteration summary 2011-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

15.8%

16.8%

11.1%

Maximum drawdown**

-27%

-16%

-21%

Excess returns

0.29

0.56

0.15

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’s stock price rose 7.8x during this period whilst Zylog Systems lost 98% of its value.

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Strategy Exhibit 70: Portfolio performance during the twelfth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-11

07-Nov-17

ITC

100

219

13%

Asian Paints

100

380

23%

Motherson Sumi

100

881

41%

Ipca Labs.

100

165

8%

Tulip Telecom

100

1

-52%

Zylog Systems

100

2

-46%

Pratibha Inds.

100

15

-26%

Unity Infra.

100

10

-30%

Amar Remedies

100

6

-36%

Setco Automotive

100

219

13%

HDFC Bank

100

380

23%

Punjab Natl.Bank

100

97

0%

Dewan Hsg. Fin.

100

669

35%

City Union Bank

100

514

29%

1,400

3,558

16%

100

195

11%

Company Date from/to

Portfolio Sensex Outperformance

Total return CAGR

4.7%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,400 denotes an equal allocation of Rs100 in each stock at the start of the period. Data for Amar Remedies and Tulip Telecom is not available because the companies were suspended during this period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,400 at the start to Rs3,558 until 7thNov’17. Data for Amar Remedies and Tulip Telecom is not available because the companies were suspended during this period.

Exhibit 71: Extreme price performance was seen in mid/small-caps in this iteration Value of stock in portfolio (in Rs)

4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 Value at start

Vaue at end

City Union Bank Dewan Hsg. Fin. Punjab Natl.Bank HDFC Bank Setco Automotive Amar Remedies Unity Infra. Pratibha Inds. Zylog Systems Tulip Telecom Ipca Labs. Motherson Sumi Asian Paints ITC

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,400 at the start to Rs3,558 until 7thNov’17. Data for Amar Remedies and Tulip Telecom is not available because the companies were suspended during this period

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Strategy

Period 13: 2012- Present (11.1% alpha to the Sensex; 25.7% 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 riskadjusted basis. Exhibit 72: Thirteenth iteration summary 2012-2017* CAGR returns Maximum drawdown** Excess returns

All-cap CCP 25.7% -21% 0.84

Large-cap CCP 18.0% -23% 0.43

Sensex 14.6% -21% 0.32

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 ~16.3x increase in the stock price. Zylog Systems and Tecpro Systems, on the other hand, lost almost their entire value with a drop of 99% and 97% in their stock price. Exhibit 73: Portfolio performance during the thirteenth iteration Company Date from/to ITC Asian Paints Marico Opto Circuits Ipca Labs. Berger Paints Page Industries Balkrishna Inds Grindwell Norton Zylog Systems Tecpro Systems Pratibha Inds. Astral Poly Amar Remedies Unity Infra. Setco Automotive HDFC Bank Axis Bank Punjab Natl.Bank Allahabad Bank Dewan Hsg. Fin. City Union Bank Portfolio Sensex Outperformance

Value at start (Rs) 30-Jun-12 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 2,200 100

Value at end (Rs) 07-Nov-17 169 308 368 5 156 530 747 762 416 1 3 17 1,729 5 14 160 336 273 128 58 885 432 7,502 208

Total return CAGR 10% 23% 28% -43% 9% 36% 46% 46% 30% -56% -49% -28% 70% -44% -30% 9% 25% 21% 5% -10% 50% 31% 26% 15% 11.1%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs2,200 denotes an equal allocation of Rs100 in each stock at the start of the period. Data for Amar Remedies is not available because the company was suspended during this period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs2,200 at the start to Rs7,502 until 7thNov’17.

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Strategy Exhibit 74: Astral Poly Technik outperformed other stocks in this iteration City Union Bank Dewan Hsg. Fin. Allahabad Bank Punjab Natl.Bank Axis Bank HDFC Bank Setco Automotive Unity Infra. Amar Remedies Astral Poly Pratibha Inds. Tecpro Systems Zylog Systems Grindwell Norton Balkrishna Inds Page Industries Berger Paints Ipca Labs. Opto Circuits Marico Asian Paints ITC

Value of stock in portfolio (in Rs)

8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Value at start

Vaue at end

Source: Bloomberg, Ambit Capital research. Note: Value at the start denotes an equal allocation of Rs100 in each stock at the start of the period. Value at the end is the value of each stock at the end of the period. Thus, for this period, the value of the portfolio rose from Rs2,200 at the start to Rs7,502 until 7thNov’17.

Period 14: 2013- Present (19.8% 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 Tech, Asian Paints, Marico, HDFC Bank, Axis Bank This iteration beginning in 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 has generated a CAGR of 14.9% whereas the large-cap portfolio has generated a CAGR of 22.5%. Exhibit 75: Fourteenth iteration summary 2013-2017*

All-cap CCP

Large-cap CCP

Sensex

CAGR returns

34.8%

22.5%

14.9%

Maximum drawdown**

-19%

-12%

-21%

Excess returns

1.40

1.21

0.34

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 Balkrishna Industries, Dewan Housing Finance, Astral Poly Technik, Solar Industries and Page Industries. Unity Infraprojects, Pratibha Industries and Ipca Labs on the other hand are amongst stocks that lost value in this period.

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Strategy Exhibit 76: Portfolio performance during the fourteenth iteration Value at start (Rs)

Value at end (Rs)

30-Jun-13

07-Nov-17

ITC

100

132

7%

HCL Technologies

100

248

23%

Asian Paints

100

256

24%

Marico

100

324

31%

Berger Paints

100

313

30%

Ipca Labs.

100

85

-4%

Page Industries

100

519

46%

Balkrishna Inds

100

935

67%

Solar Inds.

100

590

50%

Astral Poly

100

693

56%

Pratibha Inds.

100

28

-25%

Unity Infra.

100

25

-27%

Sarla Performance

100

394

37%

HDFC Bank

100

281

27%

Axis Bank

100

209

18%

Indian Bank

100

346

33%

City Union Bank

100

340

32%

Dewan Hsg. Fin.

100

889

65%

1,800

6,608

35%

100

183

Company Date from/to

Portfolio Sensex Outperformance

Total return CAGR

15% 19.8%

Source: Bloomberg, Ambit Capital research. Note: * Portfolio price at the start of Rs1,800 denotes an equal allocation of Rs100 in each stock at the start of the period. Portfolio price at the end is the value of the portfolio at the end of the period. Thus, for this period, the value of the portfolio rose from Rs1,800 at the start to Rs6,608 until 7thNov’17.

Exhibit 77: Mid-caps led the charge in this iteration generating most of portfolio value Value of stock in portfolio (in Rs)

7,000 6,000 5,000 4,000 3,000 2,000 1,000 Value at start

Vaue at end

Dewan Hsg. Fin. City Union Bank Indian Bank Axis Bank HDFC Bank Sarla Performanc Unity Infra. Pratibha Inds. Astral Poly Solar Inds. Balkrishna Inds Page Industries Ipca Labs. Berger Paints Marico Asian Paints HCL Technologies ITC

Source: Bloomberg, Ambit Capital research. Note: Value at start denotes an equal allocation of Rs100 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 Rs1,800 at the start to Rs6,608 until 7thNov’17.

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Strategy

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?

Sustainable competitive advantages allow firms to add value and continue doing so over long periods

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: 

Brands and reputation



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.

John Kay’s framework focusses on ‘Innovation’, ‘Brands’, ‘Architecture’ and ‘Strategic Assets’ as sources of sustainable competitive advantage

Brands and reputation "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.

“A product can be quickly outdated, but a successful brand is timeless”

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. [email protected]

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Strategy 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 (egg. “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 78: Performance of listed companies with the most-trusted brands #

Company

Trusted Brands*

1

ColgatePalmolive

Colgate (1)

2

Hindustan Unilever

3

Nestle

4 5

Clinic Plus (4), Lifebuoy (10), Rin (12), Surf (13), Lux (14), Ponds, etc Maggi (9), Nestle Milk Chocolate (62), etc

GSK Horlicks (16) Consumer Bharti Airtel Airtel (18) Average for the listed companies with the top 5 brands For the index, Nifty

10-year Growth (FY04-14) (% CAGR)** Revenues

EPS

Share price***

14

17

27

10

8

15

15

16

23

15

21

33

33

18

15

18

16

22

12

13

14

Listed companies with the mosttrusted brands have beaten the benchmark index on revenues, earnings and share price performance

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.

‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers

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. [email protected]

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Strategy 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.

HDFC and GCMMF are the most striking demonstrations of architecture in India

Perhaps the most striking demonstration of architecture in India is the unlisted nonprofit 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 92. 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 cooperative’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

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Strategy 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.

Whilst most talked about, ‘Innovation’ is also the most tenuous source of sustainable competitive advantage…

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: 

   



…’strategic assets’ on the other hand are easier to identify

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); Licences 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.

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

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:

The Tatas have combined architecture with brand to create robust sources of sustainable competitive advantages

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. [email protected]

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Strategy 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.

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Strategy

Appendix 4 The exhibits below highlight how the maximum drawdown for the completed Coffee Can portfolios (beginning every year from 2001 to 2007) has been lower than the BSE 200 index.

70%

1,500

50%

1,000

30%

500

10%

0 -10%

-500

-30%

-1,000

BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Jun-11

Jan-11

Aug-10

Mar-10

Oct-09

Dec-08

May-09

Jul-08

Feb-08

Sep-07

Apr-07

Nov-06

Jun-06

Jan-06

Aug-05

Mar-05

Oct-04

May-04

Dec-03

Jul-03

Feb-03

-70% Sep-02

-2,000 Apr-02

-50% Jun-01

-1,500

CCP- Max DD (RHS)

Maximum drawdown

2,000

Nov-01

Portfolio value (Rs)

Exhibit 79: Coffee Can Portfolio (2001) suffered much lower drawdowns than the BSE200 index

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07

Exhibit 80: Coffee Can Portfolio(2002) suffered much lower drawdowns than the BSE200 index

Portfolio value (Rs)

50%

750

30% 250

10%

-250

-10% -30%

-750

-50% -70% Jun-12

Jan-12

Aug-11

Mar-11

Oct-10

May-10

Dec-09

Jul-09

Feb-09

Sep-08

Apr-08

Nov-07

Jun-07

Jan-07

Aug-06

Mar-06

Oct-05

May-05

Dec-04

Jul-04

Feb-04

Sep-03

Apr-03

Nov-02

Jun-02

-1,250

Maximum drawdown

70%

1,250

CCP - Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

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Strategy

70%

1,000

50% 30%

500

10% 0 -10% -500

-30%

CCP - Max DD (RHS) BSE200 - Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Jun-13

Jan-13

Aug-12

Mar-12

Oct-11

May-11

Dec-10

Jul-10

Feb-10

Sep-09

Apr-09

Jun-08

Nov-08

Jan-08

Aug-07

Mar-07

Oct-06

Dec-05

May-06

Jul-05

Feb-05

-70% Apr-04

-1,500 Sep-04

-50% Nov-03

-1,000

Maximum drawdown

1,500

Jun-03

Portfolio value (Rs)

Exhibit 81: Coffee Can Portfolio(2003) suffered much lower drawdowns than the BSE200 index

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07

Jun-14

Jan-14

Aug-13

Mar-13

Oct-12

May-12

Dec-11

Jul-11

Feb-11

Maximum drawdown

-70% Apr-10

-1,800 Sep-10

-50% Nov-09

-1,300 Jun-09

-30%

Jan-09

-800

Aug-08

-10%

Oct-07

-300

Mar-08

10%

May-07

200

Jul-06

30%

Dec-06

700

Feb-06

50%

Apr-05

1,200

Sep-05

70%

Nov-04

1,700

Jun-04

Portfolio value (Rs)

Exhibit 82: Coffee Can Portfolio (2004) suffered equivalent drawdown to BSE200 index

CCPMax DD (RHS) BSE200 Max DD (RHS) CCP (LHS) BSE200 (LHS)

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

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Strategy Exhibit 83: Coffee Can Portfolio (2005) suffered lower drawdowns than the BSE200 index 70%

900

50%

500 30%

300 100

10%

-100

-10%

-300

-30%

-500

Maximum drawdown

Portfolio value (Rs)

700

-50%

-700

CCP - Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

-70% Jun-15

Jan-15

Aug-14

Mar-14

Oct-13

May-13

Dec-12

Jul-12

Feb-12

Sep-11

Apr-11

Nov-10

Jun-10

Jan-10

Aug-09

Mar-09

Oct-08

May-08

Dec-07

Jul-07

Feb-07

Sep-06

Apr-06

Jun-05

Nov-05

-900

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

70%

700

50%

500 30%

300 100

10%

-100

-10%

-300

-30%

-500

CCP- Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Jun-16

Jan-16

Aug-15

Mar-15

Oct-14

May-14

Dec-13

Jul-13

Feb-13

Sep-12

Apr-12

Nov-11

Jun-11

Jan-11

Aug-10

Mar-10

Oct-09

May-09

Dec-08

Jul-08

Feb-08

-70% Sep-07

-900 Apr-07

-50% Nov-06

-700

Maximum drawdown

900

Jun-06

Portfolio value (Rs)

Exhibit 84: Coffee Can Portfolio (2006) suffered much lower drawdowns than the BSE200 index

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

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Strategy

Jun-17

Jan-17

Aug-16

Mar-16

Oct-15

May-15

Dec-14

Jul-14

Feb-14

Maximum drawdown

-70% Sep-13

-700 Apr-13

-50% Nov-12

-500 Jun-12

-30%

Jan-12

-300

Aug-11

-10%

Mar-11

-100

Oct-10

10%

May-10

100

Dec-09

30%

Jul-09

300

Feb-09

50%

Sep-08

500

Apr-08

70%

Nov-07

700

Jun-07

Portfolio value (Rs)

Exhibit 85: Coffee Can Portfolio(2007) suffered much lower drawdowns than the BSE200 index

CCP- Max DD (RHS) BSE200 Max DD (RHS) CCP (LHS)

BSE200 (LHS)

Source: Bloomberg, Ambit Capital Research Note: The maximum drawdown is calculated as drop in value from the peak to the period concerned. For example in Nov’08 the maximum drawdown of 59.5% denotes a drop in value of 59.5% in BSE200 index from the peak achieved in Nov’07.

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HDFC Bank SELL HDFCB IN EQUITY

Sustainability is key

BFSI

Flags Accounting: Predictability: Earnings Momentum:

GREEN GREEN GREEN

Performance 155 130 105

HDFC Bank

Sensex

Strong execution is in its DNA 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 (e.g. technology-led capture of capital market floats). The bank has taken a long-term approach to protect margins and asset quality rather than aggressive, near-term growth (e.g. avoided project finance-led growth). Superior profitability has allowed HDFC Bank to sustain its capital position through internal profit generation without undue dilution of shareholders’ fund. The bank has made two acquisitions but its recent focus has been on organic growth through accelerated branch network expansion on a pan-India basis.

Source: Bloomberg, Ambit Capital research

Going beyond IBAS framework A risk-averse culture and ability to use technology (systems and processes) to create a unique offering have been key differentiators. Despite a relatively low advertising budget and lack of celebrity endorsements, a high brand recall is a testimony of the bank’s strengths. HDFC Bank is known for its focus on systems and processes, which has helped it in terms of business continuity. The bank’s key strategic asset is its low-cost funding franchise (cost of funds of 5.2% vs peer average of ~5.7%), which has helped it effectively compete with other banks without taking higher asset quality risks. Valuations leave little margin of safety Despite the weak macro environment, the bank has done well in terms of superior loan growth (currently at 22% vs ~7% for the banking system) and maintaining strong NIM (currently 4.3%). However, bank faced some asset quality hiccups in recent times. Thus, with our expectation of a slowdown in loan growth for private banks due to recapitalisation of PSU banks, pressure on NIM given weak CASA growth, and pick-up in delinquencies in retail/SME loans, we do not expect a pick-up in EPS growth from current levels. HDFC Bank is trading at 23.6x FY19E P/E and 4.1x FY19E P/B, ~50% premium to peers.

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]

[email protected] 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.

Nov-17

Sep-17

Aug-17

Jun-17

80 May-17

Established in 1994, HDFC Bank is India’s largest private sector bank in terms of assets with ~6.7% market share (in loans). HDFC Bank has differentiated itself from peers through strategic focus on retail assets and liabilities. Retail loans and retail deposits form ~68% and ~79% of loans and deposits respectively. This has helped the bank deliver superior NIM (5-year average of ~4.3%) compared to peers. Robust risk management and processes have helped the bank maintain its asset quality (average credit cost of 70bps in the past 5 years), helping deliver average RoE of ~19.4% in the last 5 years. A stable management team and use of technology since inception have facilitated the consistent performance.

`4,708/US$72.9 `2,969/US$46.0 `1,822 `1,330 27

Mar-17

Banking on retail bank and technology

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

Feb-17

Changes to this position: STABLE

Recommendation

Dec-16

HDFC Bank has since inception focused on building a granular retail franchise on both sides of the balance sheet. It has maintained a conservative approach to lending (gross NPA of 1.26%). With a stable management team at the helm, the bank was able to expand its retail offering on a pan-India basis and fill gaps in its corporate banking offering. However, despite EPS growth slowing to 19% in the last two years (vs a decade of >25% EPS growth), valuation multiples expanded. Valuations are at ~50% premium to peers. This leaves little margin of safety especially as the external environment is still not conducive for banks. Remain SELLers with TP of Rs1,330 (2.9x FY19E BVPS). Competitive position: STRONG

November 17, 2017

Nov-16

STRATEGY NOTE

HDFC Bank Exhibit 1: HDFC Bank loan book is diversifying towards retail Home

Vehicle

Other retail

Non-retail

RoE (RHS)

40%

10%

20%

5%

0%

0%

FY13

FY14

FY15

FY16

FY17

1HFY18*

792

989

1,258

1,600

1,954

2,397

3,030

3,655

4,646

5,546

6,049

FY14

FY12

FY13

FY11

FY12

FY10

FY11

FY09

FY10

FY08

FY09

1HFY18

15%

FY17

60%

FY16

20%

FY15

80%

FY08

25%

FY07

100%

Source: Company, Ambit Capital research

Exhibit 2: Key financial parameters over the last decade Loan book (Rs mn) Loan book growth (%)

36.1%

24.9%

27.3%

27.1%

22.2%

22.7%

26.4%

20.6%

27.1%

19.4%

22.3%

Operating profits (Rs mn)

41,975

51,790

64,297

77,254

93,906

114,276

143,601

174,045

213,635

257,324

153,379

Net profits (Rs mn)

17,221

22,449

29,487

39,264

51,671

67,263

84,784

102,159

122,962

145,496

80,449

EPS (Rs)

8.1

10.6

12.9

16.9

22.0

28.3

35.3

42.1

48.6

56.8

31.3

Gross NPAs (%)

1.81%

1.95%

1.43%

1.05%

1.01%

0.97%

0.98%

0.93%

0.94%

1.05%

1.26%

Net NPAs (%)

0.66%

0.63%

0.31%

0.19%

0.18%

0.20%

0.27%

0.25%

0.28%

0.33%

0.43%

Tier 1 (%)

10.2%

10.6%

13.3%

12.2%

11.6%

11.1%

11.8%

13.7%

13.2%

12.8%

13.3%

ROA (%)

1.28%

1.31%

1.45%

1.57%

1.68%

1.82%

1.90%

1.89%

1.85%

1.81%

1.79%

ROE (%)

16.7%

16.1%

16.1%

16.7%

18.7%

20.3%

21.3%

19.4%

18.3%

17.9%

17.3%

Source: Company, Ambit Capital research. Note: *1HFY18 operating profits, net profits and EPS numbers not annualized

Exhibit 3: The key things to note from evolution Time period

1994-1999

2000-2008

2009-Present

Phase

A corporate bank with a difference

Building the retail bank

Reaching the hinterland and taking on Silicon Valley

Key developments



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.



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.



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.

Source: Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

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

Loan CAGR (FY13-17)

CASA

NIMs

RoE

Net NPAs

Tier I

15,711

12.6%

44.6%

2.6%

7.0%

3.71%

10.4%

HDFC Bank

5,546

23.2%

48.0%

4.4%

17.9%

0.33%

12.8%

ICICI Bank

4,642

12.8%

50.4%

3.2%

10.3%

5.43%

14.4%

Axis Bank

3,731

17.1%

51.4%

3.5%

6.8%

2.31%

11.9%

Kotak Mahindra Bank

1,361

28.3%

44.0%

4.3%

13.2%

1.26%

15.9%

IndusInd Bank

1,131

26.4%

36.9%

4.0%

15.3%

0.39%

14.7%

Company (Rs bn, FY17) State Bank of India

Source: Company, Ambit Capital research

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 has impacted the 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 quasiPSU 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 (bestin-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, received 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 longterm relationship-based customer connect in vehicle finance); and strategic assets (unmatched differentiated vehicle finance franchise, structured midmarket 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.

[email protected] November 17, 2017

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HDFC Bank Exhibit 6: Loan book growth has been stable at ~22% with improvement in NIM Loan growth

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

Net interest margins (RHS)

RoA

4.8%

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

4.5%

RoE (RHS)

2.0%

25% 20%

1.5%

15%

1.0% 0.5%

0% 1HFY18

FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY07

FY17

5%

0.0%

1HFY18

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

4.0%

10%

FY08

4.3%

13.3% 1HFY18

12.8%

11.8% FY14

FY17

11.1% FY13

13.2%

11.6% FY12

12.2%

Tier 1

FY11

FY10

10.6% FY09

FY07

10.2%

16% 14% 12% 10% 8% 6% 4% 2% 0%

1HFY18

FY17

0% FY16

20%

0.0% FY15

0.5% FY14

40%

FY13

1.0%

FY12

60%

FY11

1.5%

FY10

80%

FY09

2.0%

FY08

100%

FY07

2.5%

FY08

Provision coverage ratio (RHS)

8.8%

Gross NPAs

FY16

Exhibit 9: Tier-1 ratio has been strong over the years 13.7%

Exhibit 8: Gross NPAs have increased in recent years

FY15

Source: Company, Ambit Capital research; Ratios are annualised for 1HFY18

13.3%

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 10: HDFC Bank is trading at a premium to its historical multiples

Exhibit 11: HDFC Bank has outperformed BSE Bankex by ~5x

6

600 500

5

400

4

300 200

3

100

2

Oct-17

Mar-17

Aug-16

Jan-16

Jun-15

Nov-14

Apr-14

Feb-13

Sep-13

Jul-12

Dec-11

May-11

Oct-10

Mar-10

Aug-09

HDFC Bank

Avg. PB

Source: Bloomberg, Company, Ambit Capital research

Jan-09

Jun-08

Oct-17

Jan-17

Apr-16

Jul-15

Oct-14

Jan-14

Apr-13

Jul-12

Oct-11

Jan-11

Apr-10

Jul-09

Oct-08

Jan-08

Apr-07

Jul-06

Oct-05

PB

Nov-07

0

Sensex Index

Source: Bloomberg, Company, Ambit Capital research

Exhibit 12: Explanation for our flags Segment

Score

Accounting

GREEN

Predictability

GREEN

Earnings momentum

GREEN

Comments 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 average ~8% over FY14-17. 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. Consensus EPS estimates for FY18 and FY19 have been reduced by 3% each in past one year. We expect 19% EPS CAGR over FY17-20E.

Source: Ambit Capital research [email protected]

November 17, 2017

Ambit Capital Pvt. Ltd.

Page 64

HDFC Bank Balance sheet Year to March (Rs mn) Networth Deposits

FY16

FY17

FY18E

FY19E

FY20E

726,778

894,624

1,027,228

1,185,413

1,376,621

5,464,242

6,436,397

7,723,676

9,268,411

11,122,093

Borrowings

849,690

740,289

838,150

950,031

1,078,003

Other Liabilities

367,251

567,093

652,157

749,981

862,478

7,407,961

8,638,402

10,241,211

12,153,837

14,439,195

389,188

489,521

583,968

696,921

832,028

Investments

1,958,363

2,144,633

2,564,538

3,067,475

3,669,912

Advances

4,645,940

5,545,682

6,644,634

7,964,685

9,550,659

Other Assets

414,470

458,566

448,071

424,756

386,596

Total Assets

7,407,961

8,638,402

10,241,211

12,153,837

14,439,195

Total Liabilities Cash & Balances with RBI & Banks

Source: Company, Ambit Capital research

Income statement Year to March (Rs mn)

FY16

FY17

FY18E

FY19E

FY20E

Interest Income

602,214

693,060

788,275

935,476

1,114,852

Interest Expense

326,299

361,667

397,194

473,570

564,879

Net Interest Income

275,915

331,392

391,081

461,907

549,974

Total Non-Interest Income

107,517

122,965

142,395

159,519

181,635

Total Income

383,432

454,357

533,476

621,426

731,609

Total Operating Expenses

169,797

197,033

221,542

253,025

288,873

57,022

64,837

69,515

78,195

87,818

Employees expenses Other Operating Expenses

112,775

132,197

152,026

174,830

201,055

Pre Provisioning Profits

213,635

257,324

311,934

368,401

442,736

Provisions

27,256

35,933

48,804

54,508

63,316

PBT

186,379

221,391

263,131

313,893

379,420

Tax

63,417

75,894

90,203

107,605

130,068

122,962

145,496

172,928

206,288

249,352

FY16

FY17

FY18E

FY19E

FY20E

85.0%

86.2%

86.0%

85.9%

85.9%

PAT Source: Company, Ambit Capital research

Key ratios Year to March (Rs mn) Credit-Deposit (%) Cost/Income ratio (%) Gross NPA (Rs mn) Gross NPA (%)

44.3%

43.4%

41.5%

40.7%

39.5%

43,928

58,857

87,002

97,483

111,688

0.94%

1.05%

1.30%

1.21%

1.16%

13,204

18,440

30,451

34,119

39,091

Net NPA (%)

0.28%

0.33%

0.46%

0.43%

0.41%

Provision coverage (%)

69.9%

68.7%

65.0%

65.0%

65.0%

NIMs (%)

4.40%

4.37%

4.35%

4.29%

4.27%

Tier-1 capital ratio (%)

13.2%

12.8%

12.5%

12.3%

12.2%

Net NPA (Rs mn)

Source: Company, Ambit Capital research

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HDFC Bank Du-pont analysis Year to March

FY16

FY17

FY18E

FY19E

FY20E

NII / Assets (%)

4.1%

4.1%

4.1%

4.1%

4.1%

Other income / Assets (%)

1.6%

1.5%

1.5%

1.4%

1.4%

Total Income / Assets (%)

5.8%

5.7%

5.7%

5.5%

5.5%

Cost to Assets (%)

2.6%

2.5%

2.3%

2.3%

2.2%

PPP / Assets (%)

3.2%

3.2%

3.3%

3.3%

3.3%

Provisions / Assets (%)

0.4%

0.4%

0.5%

0.5%

0.5%

PBT / Assets (%)

2.8%

2.8%

2.8%

2.8%

2.9%

Tax Rate (%)

34.0%

34.3%

34.3%

34.3%

34.3%

ROA (%)

1.85%

1.81%

1.83%

1.84%

1.88%

Leverage

9.9

9.9

9.8

10.1

10.4

18.3%

17.9%

18.0%

18.6%

19.5%

Year to March

FY16

FY17

FY18E

FY19E

FY20E

EPS (Rs)

48.6

56.8

67.0

79.3

95.1

EPS growth (%)

16%

17%

18%

18%

20%

ROE (%) Source: Company, Ambit Capital research

Valuation

BVPS (Rs)

287.5

349.1

397.8

455.5

524.9

P/E (x)

38.4

32.9

27.9

23.6

19.6

P/BV (x)

6.49

5.35

4.69

4.10

3.56

Source: Company, Ambit Capital research

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HCL Technologies SELL November 17, 2017

HCLT IN EQUITY

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

Flags Accounting: Predictability: Earnings Momentum:

GREEN GREEN AMBER

Performance

HCL Tech.

Sensex

Source: Bloomberg, Ambit Capital research

HCLT’s forensic score analysis

Second only to TCS on our IBAS framework HCLT has consistently innovated (3/4) to lower its cost structure. It has been able to deliver average EBIT margin of 19% (FY07-17) despite offering 30-40% cost savings to clients on each deal renewal and steady wage inflation though helped by depreciation of INR vs USD. HCLT scores well (3/4) on brand as it occupies a high client mind-share (source: third-party industry reports) as well as good reputation among employees, reflected in lower attrition (16% vs peer median of 18%). HCLT’s decent positioning on architecture (3/4) and strategic assets (3/4) reflects strong sales architecture built over years and client connect. Competitive positioning is dwindling with the IP acquisition spree Over the last two years, HCLT started aggressively investing in IP deals by partnering with global product majors like IBM. These deals relate to products approaching end of life, and we reckon their IRRs to be in low double digits. Besides the risk of continuous reinvestments on upgrade of these products, HCLT is also exposed to the risk of wasted management bandwidth. A service line centric organization structure adds to the risks. Valuations at 13x one-year forward P/E are not enticing enough given the above risks.

Source: Ambit ‘HAWK’, Ambit Capital research

HCLT’s greatness score analysis

S

A bit ‘HAWK’ A bit C

it l

h

Research Analyst Sudheer Guntupalli +91 22 3043 3203 [email protected]

[email protected] 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.

Nov-17

Sep-17

Aug-17

Jun-17

May-17

140 130 120 110 100 90 80

Rode the IMS wave, now well-positioned for IoT HCLT began as the R&D division of HCL Enterprise, which had 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 highvalue 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 (38% of FY17 revenues, no.2 globally after IBM) and acquired Axon in 2009 (gave it relationships with CXOs in large organizations). Its next big bet is IoT, which would require it to build on capabilities in IMS and engineering services.

Rs1,241/US$19 Rs1,377/US$21 Rs870 Rs750 14%

Mar-17

One of the better performing large Indian IT services companies Since the GFC, performance of top firms has diverged with capital allocation, portfolio mix, operational excellence and management quality. HCLT has been one of the better performers on these metrics driven by bold bets on IMS and Axon that have paid off, strong capabilities in IMS and an excellent sales effort driven by Vineet Nayar (CEO over 2007-13). Over the past 10 years, HCLT’s revenue has posted 19% CAGR (USD, vs 17% for larger peers) and 23% CAGR (INR, vs 21% for larger peers).

Recommendation

Feb-17

HCLT’s discerning bets on Infrastructure Management Services (IMS) and engineering services (ES) have enabled it to deliver FY07-17 revenue CAGR of 19% (USD) vs. 17% for larger peers. Strong capabilities in these segments also position it well for the upcoming Internet-of-Things era. The company has had a stellar capital allocation track record (FY07-17 average RoE of 26%, its large acquisition of Axon has been successful). However, with 13 acquisitions in the past 24 months, we are concerned about a potential value-destructive deal, especially given the string of IP deals related to end-of-life products and low double-digit estimated IRRs. Current valuation of 13x one-year forward P/E does not offer adequate margin of safety. HCLT remains our top SELL in IT services. Competitive position: STRONG Changes to this position: STABLE

Technology

Dec-16

On a slippery slope

Nov-16

STRATEGY NOTE

HCL Technologies Exhibit 1: Evolution of HCL Technologies

Cloud / IoT

Software services

Infrastructure services

Engineering and R&D services

ROCE* (RHS)

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% FY17

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

IMS & ES ramp up

FY16

6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500

BPO

Source: Ambit Capital research, company

Exhibit 2: Key financial parameters over the last decade (Rs mn)

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

1,763

2,078

2,574

3,320

4,035

4,539

5,180

5,822

6,235

6,975

39%

18%

24%

29%

22%

12%

14%

12%

7%

12%

13,732

9,787

12,156

14,361

21,014

36,313

57,138

73,209

73,365

84,325

Revenues ($ mn) Revenue growth (%) Net profits EPS CFO

13.4

7.3

8.9

10.3

15.0

25.8

40.4

51.9

51.9

59.7

15,282

21,272

11,811

14,584

18,493

27,096

63,481

55,422

71,067

94,010

CFO-EBITDA

1.1

1.0

0.5

0.6

0.5

0.5

0.8

0.6

0.8

0.9

8,786

17,507

6,864

7,353

10,021

22,490

57,527

44,110

61,310

60,988

-

0.70

0.42

0.31

0.20

0.11

0.05

0.02

0.03

0.02

RoE (%)

26%

18%

21%

19%

22%

29%

35%

35%

29%

27%

ROCE* (%)

26%

27%

20%

24%

31%

41%

46%

40%

38%

36%

FCF Debt equity (x)

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.

Exhibit 3: The key things to note from evolution Time period

Phase

Key developments

FY07-15

IMS and ES ramp up

FY15-

Cloud/IoT

 HCLT grew its revenues faster than peers because of IMS & ES  To remain insulated from cloud disruption and build on IoT capabilities

Source: Ambit Capital research, company

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

Sub-Segment positioning

FY17 revenue ($)

Revenue CAGR FY10-17

Industry market share

EBITDA margin (FY17)

Pre-tax ROCE (FY17)

Pre-tax CFO/EBITDA (FY10-17)

Capex/CFO (FY10-16)

TCS

2

17,575

12%

38%

27%

53%

93%

16%

Infosys

4

10,208

11%

22%

27%

35%

97%

31%

Wipro

3

7,705

8%

16%

21%

23%

94%

26%

HCLT

1

6,975

15%

15%

22%

38%

84%

20%

TechM

NA

4,351

24%

9%

14%

29%

67%

56%

Source: Company, Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 68

HCL Technologies Exhibit 5: Mapping HCLT and peers on our IBAS framework Company

Innovation

Reputation

Architecture

Strategic asset

Overall rank Comments

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%, FY17). 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%, FY17). 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 (24%, FY17). 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 (19.5%, FY17). 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%, FY17) and ROCE (22%, FY17) by keeping utilization (84%) 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 (11%, FY17), 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

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HCL Technologies Exhibit 6: Sources of cash over the last 10 years (FY07-17)

Exhibit 7: Uses of cash over the last 10 years (FY07-17)

4%

7%

16% 33% 60% 80%

CFO

Asset sale

Cash Flow from Financing

Dividend

Capex

Acquisitions

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 8: One year forward P/E evolution

Exhibit 9: HCLT’s share price performance vs Sensex

18

180 160

16

140 120

14

100

12

80

Avg

Source: Company, Ambit Capital research

HCLT IN

Oct-17

Sep-17

Aug-17

Jul-17

Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

Dec-16

Oct-17

Apr-17

Oct-16

Apr-16

Oct-15

Apr-15

Oct-14

Apr-14

Oct-13

Apr-13

Oct-12

Apr-12

Oct-11

P/E

Nov-16

60

10

SENSEX

Source: Company, Ambit Capital research

Exhibit 10: Explanation for our flags Segment Accounting Predictability Earnings momentum

Score

Comments

GREEN

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

GREEN

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

AMBER Bloomberg shows multiple downgrades to consensus numbers in last 8 weeks.

Source: Ambit Capital research

Exhibit 11: Forensic score evolution

Exhibit 12: Greatness score evolution

Source: Ambit ‘HAWK’, Ambit Capital research

Source: Ambit ‘HAWK’, Ambit Capital research

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HCL Technologies Balance sheet (consolidated)* Rs bn Net Worth Other Liabilities

FY16

FY17

FY18E

FY19E

FY20E

277

345

350

395

442

22

18

18

18

18

Capital Employed

300

363

368

414

460

Net Block

106

166

179

186

193

Other Non-current Assets

40

40

35

35

35

247

272

266

315

368

Debtors

76

85

93

101

112

Unbilled revenues

30

26

28

30

33

Cash & Bank Balance

117

131

114

149

184

Other Current Assets

24

31

31

34

38

Current Liab. & Prov

94

115

112

122

135

Curr. Assets

Net Current Assets

153

158

154

193

232

Application of Funds

300

363

368

414

460

FY16

FY17

FY18E

FY19E

FY20E

6,235

6,975

7,775

8,492

9,431

Growth

7.1%

11.9%

11.5%

9.2%

11.1%

Revenue

409

466

501

548

608

Cost of goods sold

Source: Company, Ambit Capital research

Income statement (consolidated)* Rs bn Revenue (US$ mn)

275

316

343

393

446

SG&A expanses

52

55

58

57

65

EBITDA

88

103

109

106

106

Depreciation EBIT EBIT Margin

6

8

9

8

9

82

94

100

98

97

20%

20%

20%

18%

16%

Other Income

10

9

10

10

12

PBT

92

104

110

108

109

Tax

19

19

22

22

22

Reported PAT

73

84

88

86

87

Diluted Adj EPS

52

60

61

60

61

Source: Company, Ambit Capital research

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HCL Technologies Cash flow statement (consolidated)* Rs bn

FY16

FY17

FY18E

FY19E

FY20E

Net Income

73.4

84.3

87.5

85.8

86.9

Depreciation

5.7

8.3

9.1

7.8

8.9

CF from Operations

73.5

93.8

96.6

93.6

95.8

Cash for Working Capital

(2.4)

0.2

(7.7)

(3.7)

(4.8)

Net Operating CF

71.1

94.0

88.9

89.9

91.0

Net Purchase of FA

(9.8)

(33.0)

(13.6)

(15.0)

(16.7)

Acquisitions

(179.2)

(144.2)

178.1

5.9

7.9

Others

(33.1)

(10.4)

11.5

0.4

0.5

Net Cash from Invest.

(42.8)

(43.4)

(2.2)

(14.6)

(16.1)

Proceeds from Equity & other

0.0

-

-

-

-

Dividend Payments

(33.7)

(40.6)

(33.8)

(40.3)

(40.3)

Cash Flow from Fin.

(28.4)

(44.4)

(67.7)

(40.3)

(40.3)

61.3

61.0

75.2

74.9

74.3

103.6

119.5

126.1

114.4

149.4

(0.1)

6.2

19.0

35.0

34.6

FY16

FY17

FY18E

FY19E

FY20E

P/E

17.5

15.2

14.9

15.2

15.0

EV/EBITDA

13.5

11.5

10.8

11.2

11.1

2.9

2.5

2.4

2.2

1.9

14.4

12.5

11.8

12.1

12.2

4.6

3.7

3.7

3.2

2.9

2.4%

2.6%

1.8%

2.6%

2.6%

RoE

29%

27%

25%

23%

21%

RoCE

24%

23%

22%

19%

17%

ROIC

39%

37%

33%

30%

28%

Receivable days (Days)

95

87

87

87

87

Fixed Asset Turnover (x)

4.3

3.4

2.9

3.0

3.2

Free Cash Flow Opening cash balance Net Cash Flow Source: Company, Ambit Capital research

Ratio analysis (consolidated)* Valuation (x)

EV/Sales EV/NOPAT Price/Book Value Dividend Yield (%) Return Ratios (%)

Turnover Ratios

Source: Company, Ambit Capital research

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Lupin NOT RATED LPC IN EQUITY

Legacy under threat?

Healthcare

From India to USA; journey from weak product portfolio to complex one Until FY07, Lupin had an India-heavy revenue profile with product portfolio in slow-growing acute therapies. Management realised changing trends in Indian pharma consumption and switched to lifestyle disease chronic products that grew faster than IPM. Similarly, in the US, management realised product-specific opportunities and capitalised during FY13-16 (US revenue CAGR of 23%). Lupin’s capability to adapt to changing environments has led to margin/RoCE expansion. While peers focused on acquisitions to grow, Lupin primarily grew organically. Early entry into the Japanese market is an advantage over peers. Ranks 2nd on sector framework; needs to improve on innovation Focus has been 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. Lupin has a 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 and higher investments in biosimilars, NCEs and NDDS (innovation) can improve comparative standing.

Flags Accounting: Predictability: Earnings Momentum:

RED AMBER RED

Performance 150 130 110 90 70

Lupin

Sensex

Source: Bloomberg, Ambit Capital research

Lupin’s forensic score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Lupin’s greatness score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Valuations will take time to rerate At current valuation of 17x FY19E consensus earnings, there is scope for a rerating emerging from: a) receding concerns in the USA (2HFY19E), b) wellentrenched management, c) strong balance sheet, and d) excellence in execution. However, the recent warning letter, uncertainty around launches and pricing in the US will delay a rerating. Near-term catalysts to watch for are: (a) gTobi and gTamiflu launches in 4QFY18; (b) Prevacid ODT, Coreg CR and gLialda launches in FY19; and (c) further cost efficiencies. [email protected] 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.

Nov-17

Sep-17

Aug-17

Jun-17

50 May-17

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 FY07-17. 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 the medium term, but this is now getting delayed because of the warning letter.

`374/US$5.7 `2,259/US$35 `827 n.a. n.a.

Mar-17

Vision to move from oral solids to complex generics materialises

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Upside (%):

Feb-17

Changes to this position: STABLE

Recommendation

Dec-16

Lupin transitioned from API to plain oral solids to complex generics due to management’s vision/agility in tapping the changing dynamics. We had considered Lupin as one of the biggest beneficiaries of GDUFA given presence in complex generics and pipeline of ~150 ANDAs. However, the US business is coming under pressure because of price pressure in the base business due to channel consolidation in the US and repetitive quality issues at its facilities delaying product approvals. However, India’s faster than IPM growth driven by higher composition of chronic therapies and first-mover advantage in Japan will provide support to earnings albeit with some margin decline. Reduction in R&D, underperformance of Gavis acquisition and limited investments in innovation are emerging structural challenges. Stock trades at 17x FY19 consensus earnings, which is at a marginal discount to peers. Competitive position: STRONG

November 17, 2016

Nov-16

STRATEGY NOTE

Lupin

` Bn

Exhibit 1: Evolution of Lupin

200 180 160 140 120 100 80 60 40 20 -

Making inroads in the US business led by launch of plain oral solids; enetering chronic space in India.

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

FY05

FY06

FY07

FY08

India

FY09

FY10

US generics

FY11

FY12

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

FY13

Others (RoW , API)

FY14

FY15

FY16

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

FY17

RoCE (RHS)

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

Exhibit 2: Strong growth and RoCE over the past decade but a sharp decline in RoCE in FY17 (Rs mn) Revenues Revenue growth (%)

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

28,917

38,666

48,708

58,190

70,829

96,413

112,866

127,700

142,555

174,943

44%

34%

26%

19%

22%

36%

17%

13%

12%

23%

4,083

5,015

6,816

8,626

8,677

13,142

18,364

24,032

22,607

25,575

9.9

12.1

15.3

19.3

19.4

29.4

41.0

53.5

50.2

56.6

2,585

4,695

6,764

7,980

5,600

12,510

20,039

27,331

(3,824)

41,148

59%

78%

86%

88%

60%

79%

92%

102%

21%

117%

FCF

241

1,308

72

7,990

549

7,097

14,787

18,655

(61,639)

15,141

Gross debt equity (x)

0.94

0.86

0.44

0.35

0.41

0.22

0.09

0.06

0.64

0.59

RoE (%)

38%

37%

34%

29%

24%

29%

30%

30%

23%

21%

ROCE* (%)

25%

24%

26%

24%

23%

31%

38%

37%

23%

18%

Net profits EPS CFO Pre tax CFO/EBITDA

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.

Exhibit 3: The key things to note from evolution Time period

Phase

Key developments

 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 Indian business drives FY05-FY07 EBITDA margins <20%). Its US business was negligible contributing ~15% of the overall revenues with growth products in plain vanilla oral solids and entering as follow-on generic player, garnering revenue per ANDA of
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Lupin Exhibit 4: Competitive mapping of Lupin with comparable generic pharma peers Company

Positioning

FY17 Revenue Revenue CAGR FY1117 (Rs bn)

EBITDA Margin (median FY11-17)

Pre-tax RoCE (median FY11-17)

Median Pre-tax CFO/ EBITDA (FY11-17)

Cumulative R&D as % of Sales (FY11-17)

Sun Pharma

#1

313

33%

34%

25%

94%

3%

Lupin

#2

175

20%

26%

24%

88%

11%

Cadila

#5

94

13%

20%

22%

83%

7%

Torrent

#4

59

18%

22%

24%

101%

5%

Dr. Reddys

#3

142

11%

23%

21%

85%

8%

Cipla

#6

144

15%

21%

16%

91%

5%

Ipca

#8

32

9%

18%

19%

92%

4%

Aurobindo

#7

149

23%

22%

24%

65%

3%

Source: Company, Ambit Capital research

Exhibit 5: Sun, Dr. Reddy’s and Cadila are building innovation pipelines while others have lagged on most parameters US business

Complex generics

Innovation

Bargaining power with customers

Compliance

De-risking US Overall revenues

Sun has best in class investment in innovation with higher percentage of ANDAs in complex generics. Whilst biosimilar portfolio is limited, it is developing NCEs and NDDS through partners and SPARC. Dr. Reddy’s is best placed to reap benefits of biosimilar opportunity globally. Whilst in India and EMs, the company is launching independently, in regulated market the company is rightly following a partner model. Cadila has second best complex generics portfolio with revenue per ANDA at Rs7mn. Though NCEs and NDDS opportunities are limited, we expect company to excel in biosimilars in the emerging markets. Lupin with its complex generics portfolio will be able to garner high quality revenue. However, limited investment in biosimilars and NCEs and NDDS would hurt longer opportunity in the innovation space. Torrent has limited ANDA filings in the complex generics in the US market. But the company, with its partner, is developing all available biosimilars. We believe management will have to make a bolt-on acquisition for enhancing its innovative capability. Baring inhaler, Cipla has limited investment in the innovation space. With inhaler launch delayed due to additional data requirements, we believe the company will have to re-invent its R&D set-up to catch up with its peers. Though Ipca has previously displayed green shoots of innovation, it largely remains restricted to India and EMs. Also, these novel products do not exactly fit in the bracket of innovation as products launched are with improved efficacy with no material differentiation. We credit Aurobindo for pipeline in complex injectables, peptides and microspheres. However, baring these, there are limited investment in innovation for branded products like NCEs and NDDS. Ajanta has primarily focused on Para III opportunities in the US. Though in India they have launched firstto-market products, they are not in the category of NCEs/NDDS

Sun

Dr. Reddy

Cadila

Lupin

Torrent

Cipla

Ipca

Aurobindo

Ajanta Source: Company, Ambit Capital research Note:

Comments

- Strong;

- Relatively Strong;

- Average;

- Relatively weak

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Lupin Exhibit 6: Sun and Lupin consistently outperform on most parameters MR productivity

India business

Lower Brand concentration

Base business growth

Overall score

Comments Sun has large portfolio of top ranked products. Best in class execution with MR productivity at ~Rs8mn per MR per month. Strategically propelled its branded business through acquisition of Ranbaxy. Lupin falls marginally short of the podium ranking due to low MR productivity. We believe the company has credible branded franchise with broad based product portfolio (Top 10 brands contribute only 20% of revenue). Dr. Reddy’s is an average joe in the branded generics space with base business report growth of 7.5% over FY11-15 implying subpar brand equity. Launch of biosimilars could provide impetus to the MR productivity but the company needs structural change in portfolio which is currently in slow growing acute therapy area. Though Cadila has launched innovative products in India and is one of the few companies to be in the market since inception, it continues to struggle in having large no. of credible brands. Management is overhauling its filed force with objective of improving its MR productivity. Whilst not impossible, we believe the improvement in MR productivity will have to be aided by credible launches in novel space and optimising the Elder portfolio. Cipla has built strong inhaler franchise and has launched first to market products in India. However base business lags its peers implying lower brand equity for its excising portfolio. Also, the company continues to lose market share in the inhaler franchise with raises concern on ability to retain consumers. Promising base business growth at 16.1% over FY11-17, but lacks in areas of MR productivity and concentrated portfolio. As company launches better efficacy products, we expect company to improve on these parameters. Aurobindo has limited revenue from branded business and hence fares lower than its peers. Excellent product portfolio but focused only in four therapies where growth opportunity is limited. Need to expand to newer therapies.

Sun

Lupin

Dr. Reddy

Cadila

Torrent

Cipla

Ipca Aurobindo Ajanta Source: Company, Ambit Capital research Note:

- Strong;

- Relatively Strong;

Exhibit 7: Increase in debt towards funding of Gavis acquisition in 2015

Net borrowings 33%

Interest and dividend received 1%

Source: Company, Ambit Capital research

- Relatively weak

Exhibit 8: Lupin focused on organic growth through capex in relevant markets (like Japan) Dividend paid incl. tax 10%

Others 4%

Interest paid 2% CFO 61%

Equity issues 1%

- Average;

Cash 14%

Investments and loans to subs/JV 13%

Capex 61%

Source: Company, Ambit Capital research

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Page 76

Lupin

Oct-17

Jan-17

May-17

Apr-16

Sep-16

Dec-15

Mar-15

Aug-15

Jun-14

Nov-14

Oct-13

Feb-14

Jan-13

May-13

Apr-12

Sep-12

Dec-11

Mar-11

460 410 360 310 260 210 160 110 60 Aug-11

12-Oct-17

12-Apr-17

12-Oct-16

12-Apr-16

12-Oct-15

12-Apr-15

12-Oct-14

12-Apr-14

12-Oct-13

12-Apr-13

12-Oct-12

35 30 25 20 15 10 5 0

Exhibit 10: Lupin’s share price performance vs Sensex; has given up all outperformance

Nov-10

Exhibit 9: Recent dip is due to invalidation of Ravicti patent and US FDA warning for Goa and Indore plant

1- year forward P/E (x) 5 year avg P/E (x) Source: Company, Ambit Capital research

Lupin

SENSEX

Source: Company, Ambit Capital research

Exhibit 11: Explanation for our flags Field Accounting

Predictability Earnings momentum

Score RED

AMBER RED

Comments In our forensic analysis of 360 companies, Lupin scores above the pharma industry average (comprising 26 companies). Lupin scores high on (a) volatility in other income; and (b) contingent liabilities as percentage of networth. However, Lupin has weaker scores on: (a) CFO-EBITDA; (b) cash yield; (c) change in depreciation rate; and (d) cumulative FCF to median revenues. Overall, 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. Consensus FY18E and FY19E EBITDA and EPS estimates have been downgraded by 4% and 11% respectively in the last six months.

Source: Ambit Capital research.

Exhibit 12: Forensic score evolution

Exhibit 13: Greatness score evolution

Source: Ambit ‘HAWK’, Ambit Capital research

Source: Ambit ‘HAWK’, Ambit Capital research

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Page 77

Lupin Balance sheet (consolidated) (Rs mn) Shareholders' equity

FY13

FY14

FY15

FY16

FY17

895

897

899

901

903

Reserves & surpluses

51,078

68,157

87,282

109,589

132,335

Total networth

51,973

69,053

88,181

110,490

133,238

Minority Interest

595

669

241

321

345

11,645

6,537

5,371

71,775

79,661

1,632

1,779

1,182

(92)

(1,128)

Sources of funds

65,845

78,039

94,975

182,494

212,116

Net block

30,002

33,556

43,682

87,170

110,329

2,497

2,660

4,956

9,812

7,150

21

1,785

16,584

164

21,361

4,349

7,975

4,814

8,218

6,994

Debt Deferred tax liability

CWIP Investments Cash & Cash equivalents Total current assets

55,305

62,970

64,510

108,533

107,975

Net current assets

32,784

39,919

29,509

69,281

60,833

Applications of funds

65,845

78,039

94,975

182,494

212,116

Source: Company, Ambit Capital research;

Income statement (consolidated) (Rs mn) Net Sales % growth

FY13

FY14

FY15

FY16

FY17

96,413

112,866

127,700

142,555

174,943

36%

17%

13%

12%

23%

Operating expenditure

73,714

82,838

91,504

105,702

130,012

EBITDA

22,699

30,028

36,196

36,854

44,931

% growth Depreciation EBIT

57%

32%

21%

2%

22%

3,322

2,610

4,347

4,871

9,122

19,377

27,418

31,849

31,982

35,809

Interest expenditure

410

267

98

595

1,525

Non-operating income

279

1,165

2,398

1,852

1,065

19,246

28,317

34,148

33,239

35,349

5,842

9,622

9,704

10,593

9,785

13,404

18,695

24,444

22,646

25,564

51%

39%

31%

-7%

13%

(263)

(331)

(412)

(88)

(72)

13,142

18,364

24,032

22,558

25,492

14%

16%

19%

16%

15%

Adjusted PBT Tax Adjusted PAT before MI % growth Minority Interest Adjusted PAT after MI PAT margin Source: Company, Ambit Capital research

Cash flow statement (consolidated) (Rs mn) Net Profit Before Tax Depreciation Others (Incr) / decr in net working capital

FY13

FY14

FY15

FY16

FY17

19,246

28,317

34,148

33,288

35,431

3,322

2,610

4,347

4,871

9,122

874

1,495

(780)

982

3,025

(5,494)

(4,663)

(949)

(31,264)

5,059

Tax

(5,439)

(7,719)

(9,436)

(11,701)

(11,490)

Cash flow from operations

12,510

20,039

27,331

(3,824)

41,148

Capex (net)

(5,412)

(5,252)

(8,676)

(57,815)

(26,007)

Cash flow from investments

(5,219)

(8,585)

(10,545)

(69,617)

(25,287)

Cash flow from financing

(6,628)

(8,571)

(1,969)

58,364

4,332

Net change in cash

663

2,883

14,817

(15,077)

20,193

Closing cash balance

3,109

6,066

21,084

7,802

27,995

Free cash flow

7,097

14,787

18,655

(61,639)

15,141

Source: Company, Ambit Capital research

[email protected]

November 17, 2016

Ambit Capital Pvt. Ltd.

Page 78

Lupin Ratio analysis (consolidated) (Rs mn)

FY13

FY14

FY15

FY16

FY17

EBITDA margin (%)

24%

27%

28%

26%

26%

EBIT margin (%)

20%

24%

25%

22%

20%

Net profit (bef. MI) margin (%)

14%

17%

19%

16%

15%

Net debt: equity (x)

0.14

(0.05)

(0.18)

0.57

0.38

Working capital turnover (x)

4.08

4.04

4.12

3.15

3.13

Gross block turnover (x)

2.17

2.26

2.14

1.80

1.62

RoCE (pre-tax) (%)

31%

38%

37%

23%

18%

RoIC (pre-tax) (%)

33%

42%

45%

26%

20%

RoE (%)

29%

30%

30%

23%

21%

FY14

FY15

FY16

FY17

Source: Company, Ambit Capital research

Valuation parameters (consolidated) (Rs mn) Diluted EPS (Rs) Book value per share (Rs)

FY13 29

41

53

50

57

116

154

196

245

295

P/E (x)

28

20

15

16

15

P/BV (x)

7.1

5.4

4.2

3.4

2.8

EV/EBITDA (x)

17

12

10

12

9

Source: Company, Ambit Capital research

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Lupin

This page has been intentionally left blank

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Page 80

LIC Housing Finance SELL LICHF IN EQUITY

GREEN AMBER AMBER

Performance 160 140 120 100

LIC Housing Fin.

Sensex

Source: Bloomberg, Ambit Capital research

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 decade-long surge in real estate prices combined with strong support from parent LIC drove LICHF’s earnings momentum of 21% CAGR over FY06-17. However, with declining real estate prices and high competitive intensity, LICHF’s already moderate loan growth and profitability should decelerate further as margin and asset quality pressures now start biting. So, we estimate LICHF’s earnings growth to continue moderating from 18% CAGR over FY13-17 to 8% CAGR over FY17-19E. Moreover, like other HFCs, LICHF is also 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’s stock trades at 2.2x 1-year forward P/B, which is at a 22% premium to 5-year average.

Research Analysts Pankaj Agarwal, CFA +91 22 3043 3206 [email protected] Aadesh Mehta, CFA +91 22 3043 3239 [email protected]

[email protected] 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.

Nov-17

80 Sep-17

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. Over FY12-17, AUM growth moderated to 18% CAGR and RoE declined to 19%. This was despite a meaningful realignment in liability mix (share of cheaper bond borrowings rose from 58% in FY12 to 79% in FY17) and loan mix (share of higher yielding LAP rose from 0% in FY12 to 12% in FY17). Growth in line with RoE implied that dividend payout ratio was a reasonable ~21% over FY12-17.

Accounting: Predictability: Earnings Momentum:

Aug-17

Growth and RoE slowed despite realignment of assets and liabilities

Flags

Jun-17

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 (85% of loan book) and more specifically on the salaried segment (83% of home loans) and metros (45% of home loans).

`292/US$4.5 `1263/US$19 `578 `499 14

May-17

Changes to this position: NEGATIVE

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

Mar-17

Competitive position: MODERATE

Recommendation

Feb-17

LICHF’s prolonged strong performance – 21% EPS CAGR, 23% AUM CAGR, and median RoE of 20% over FY06-17 – was supported by a decade-long rally in real estate prices, less hostile competition and parent LIC’s support. The latter ensured 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). Moderating real estate prices, hostile competition and worsening asset quality could moderate earnings growth and RoE. We estimate 8% EPS CAGR over FY17-19E vs 18% over FY13-16 and 17.7% RoE, which should de-rate multiples. Our TP of `499 implies 1.9x 1-year forward P/B. Increasing wholesale cost of funds is a near-term catalyst for our SELL stance.

BFSI

Dec-16

The old lady of housing finance

November 17, 2017

Nov-16

STRATEGY NOTE

LIC Housing Finance Exhibit 1: LICHF’s growth has moderated due to increasing competition Moderation in growth and profitability AUM CAGR 18% RoAs 1.5%

Strong growth period AUM CAGR 27% RoAs 1.9%

1,300 1,100

30% 25%

900 700

20%

500 300

15%

100 (100)

FY06

FY07

FY08

FY09

FY10

FY11

FY12

AUM (Rs bn)

FY13

FY14

FY15

FY16

10%

FY17

RoEs (RHS, %)

Source: Company, Ambit Capital research

Exhibit 2: LICHF – key financial parameters over the last decade (` mn) Interest Income

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

10.2%

11.0%

10.0%

10.2%

10.8%

10.9%

11.0%

10.9%

10.9%

10.7%

Interest Expense

7.4%

8.1%

7.3%

7.1%

8.3%

8.6%

8.7%

8.6%

8.3%

7.9%

Net Interest Income

2.8%

2.9%

2.7%

3.1%

2.5%

2.2%

2.3%

2.3%

2.6%

2.8%

Non-Interest Income

0.7%

0.6%

0.6%

0.5%

0.4%

0.3%

0.3%

0.3%

0.2%

0.2%

Total Income

3.4%

3.6%

3.3%

3.7%

2.9%

2.5%

2.6%

2.6%

2.8%

3.0%

Operating Expenses

0.7%

0.62%

0.58%

0.49%

0.43%

0.41%

0.38%

0.39%

0.42%

0.47%

Pre Provisioning Profit

2.8%

2.9%

2.7%

3.2%

2.5%

2.1%

2.2%

2.2%

2.4%

2.5%

Loan loss provisions

0.12%

0.02%

-0.09%

0.09%

0.20%

0.12%

0.03%

0.01%

0.13%

0.22%

Profit Before tax (PBT)

2.7%

2.9%

2.8%

3.1%

2.5%

2.0%

2.2%

2.2%

2.3%

2.3%

Taxes

0.7%

0.8%

0.8%

0.9%

0.7%

0.5%

0.6%

0.6%

0.8%

0.8%

RoA

1.9%

2.1%

2.0%

2.2%

1.6%

1.5%

1.6%

1.4%

1.5%

1.5%

Leverage

11.7

12.1

11.5

11.5

11.3

11.3

11.8

12.6

13.2

13.0

22.7%

25.8%

23.2%

25.5%

18.5%

16.8%

18.8%

18.1%

19.6%

19.5%

AUM growth (%, YoY)

21%

22%

34%

38%

28%

25%

18%

19%

15%

15%

EPS growth (%, YoY)

39%

37%

16%

40%

-6%

5%

29%

5%

20%

16%

RoE

Source: Company, Ambit Capital research.

Exhibit 3: LICHF’s growth and profitability has meaningfully moderated since FY12 Time period

Strong growth period

Moderation in growth and profitability

Phase

Key developments 

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%).



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 feeincome).



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 18% CAGR over FY12-17 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 ~12% in FY17); and ii) shift in liability mix towards cheaper bond borrowings (from 58% in FY12 to 79% in FY17). This somewhat offset the lower profitability from the business and enabled it to still deliver moderate RoA of 1.5% during this period.

FY06-12

FY12Current

Source: Ambit Capital research.

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LIC Housing Finance Exhibit 4: Competitive mapping of HFCs – LICHF’s growth has moderated despite its small-ticket positioning Key metrics (FY17)

Avg. ticket size (Rs mn)

AUM (Rs bn)

AUM CAGR (FY13-17)

NIMs

Opex/ AUM

Gross NPA (%)

RoA

RoE

Branches (#)

Employees (#)

LICHF

1.3

1,445

17%

2.7%

0.5%

0.43%

1.5%

19.5%

245

1,833

GRUH

0.6

132

25%

4.3%

0.8%

0.31%

2.5%

30.5%

185

661

HDFC

2.6

3,378

16%

3.0%

0.2%

0.79%

1.5%

19.1%

427

2,196

REPCO

1.4

89

26%

4.8%

0.8%

2.60%

2.2%

17.4%

157

625

CANFIN

1.8

133

35%

3.5%

0.7%

0.21%

1.9%

24.1%

170

578

DEWAN

1.4

836

23%

2.7%

0.8%

0.94%

3.6%

18.0%

352

2,881

PNBHF

3.7

415

58%

3.7%

1.0%

0.22%

1.4%

13.6%

63

999

Source: Company, Ambit Capital research

Exhibit 5: Mapping LICHF 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 ~427 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

LICHF 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;

Exhibit 6: LICHF’s AUM is dominated by home loans

- Average;

- Relatively weak.

Exhibit 7: Salaried segment dominate LICHF’s home loans LICHF's customer profile

4%

Salaried 13%

17%

Self-employed & others

Home loans LAP Developer 84%

Source: Company, Ambit Capital research

83%

Source: Company, Ambit Capital research

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Page 83

LIC Housing Finance Exhibit 8: LICHF’s liability mix is tilted towards bonds 2%

Gross NPA

3.0% 9%

Credit costs

2.5% Banks

2.0%

NCD

1.5%

NHB Deposits

1.0%

Others

0.5%

81%

FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

-0.5%

FY09

0.0% FY08

5%

FY07

3%

Exhibit 9: LICHF’s asset quality is worsening slightly

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 10: LICHF is trading at a 21% premium to its cross-cycle average P/B

Exhibit 11: LICHF’s share price performance versus Sensex

3.5

1,000

3.0 2.5

750

2.0

500

1.5

250

1.0

LIC Housing

+1 SD

Nov-17

Jul-16

Mar-17

Nov-15

Mar-15

Jul-14

Nov-13

Mar-13

Jul-12

Mar-11

Nov-11

Jul-10

Nov-09

Jul-08

Mar-17

Source: Bloomberg, Ambit Capital research

Mar-16

-1 SD

Mar-15

Mar-14

Mar-13

Avg. PB

Mar-12

Mar-11

Mar-10

Mar-09

Mar-08

Mar-07

Mar-06

Mar-05

PB

Mar-09

0.0

Nov-07

0

0.5

Sensex Index

Source: Bloomberg, Ambit Capital research

Exhibit 12: Explanation for our flags Segment

Score

Comments

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

AMBER

Consensus has downgraded in FY18/19 EPS estimates by 3-4% over the past 3-4 months

Source: Ambit Capital research

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Page 84

LIC Housing Finance Income statement Net Interest Income Interest Income Interest Expense

FY15

FY16

FY17

FY18E

FY19E

22,364

29,441

36,452

39,138

42,399

105,467

122,508

138,767

149,543

166,498

83,102

93,068

102,315

110,405

124,100

Non Interest Income Total Income

2,520

2,346

2,036

2,159

2,340

24,884

31,787

38,489

41,297

44,738

3,792

4,687

6,118

7,198

8,483

21,092

27,100

32,371

34,099

36,255

73

1,465

2,813

2,180

2,831

21,020

25,635

29,558

31,919

33,424

7,158

9,028

10,246

10,533

11,030

13,862

16,608

19,312

21,386

22,394

FY16

FY17

FY18E

FY19E

Operating expenses Pre Provisioning Profit Provisions PBT Less:Tax Net Profit

Source: Company, Ambit Capital research

Balance sheet FY15 Networth

78,184

91,460

106,909

124,018

141,933

965,470

1,109,360

1,263,350

1,462,703

1,655,375

Total Sources of funds

1,043,654

1,200,820

1,370,259

1,586,721

1,797,308

Loan Book

1,083,610

1,251,730

1,445,340

1,653,992

1,873,507

- Individual

1,056,300

1,217,310

1,390,240

1,568,177

1,757,727

Borrowings

- Developer

27,310

34,420

55,100

85,815

115,780

(39,956)

(50,910)

(58,785)

(67,271)

(76,199)

1,043,654

1,200,820

1,386,555

1,586,721

1,797,308

Other Assets Total Application of funds

Source: Company, Ambit Capital research

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Page 85

LIC Housing Finance Key ratios FY15

FY16

FY17

FY18E

FY19E

18.6

15.5

15.5

14.4

13.3

Dil Consol EPS growth (%)

5.2

19.8

16.3

10.7

4.7

Net interest margin (NIM) (%)

2.3

2.6

2.7

2.5

2.4

Cost to income (%)

15.2

14.7

15.9

17.4

19.0

Opex (% of AAUM)

0.39

0.41

0.45

0.46

0.48

0.5

0.5

0.4

0.5

0.6

Credit costs (% of AAUM)

0.01

0.13

0.21

0.14

0.16

Provisioning Coverage

52.2

51.1

67.4

66.0

65.0

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

12.9

12.7

FY15

FY16

FY17

FY18E

FY19E

AUM growth (%)

Gross NPAs (%)

Source: Company, Ambit Capital research

Valuation parameters BVPS (Rs)

155

181

212

246

281

Diluted EPS (Rs)

27.5

32.9

38.3

42.4

44.4

ROA (%)

1.6

1.5

1.5

1.4

1.3

ROE (%)

18.1

19.6

19.5

18.5

16.8

P/E

21.2

17.7

15.2

13.8

13.1

P/BV

3.8

3.2

2.8

2.4

2.1

Dividend yield (%)

0.9

0.9

1.1

1.2

1.3

Source: Company, Ambit Capital research

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Page 86

Page Industries BUY PAG IN EQUITY

Consumer Discretionary

With unparalleled 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. New entrants struggle to break Jockey’s customer loyalty which is built on a combination of quality and affordability. Lingerie will be a key growth driver as Page fills product gaps in fashion segment. Transition from men’s wear brand to family brand via US$2.4bn leisurewear market and US$8bn kidswear market supports growth visibility. Valuation of 50x FY19E EPS is punchy but attractive given expectations of strong momentum in the topline (26% CAGR over FY17-21E) led by streamlined focus on each category, high growth opportunities in women’s wear and leisurewear.

Recommendation

Competitive position: STRONG

Performance (%)

Page has focused on Jockey/Speedo and capital discipline Page’s foundation is built on: a) 60-year association with Jockey and Speedo; and b) strong focus on capital allocation and RoCE. Some of the key strategic decisions Page has implemented over the past decade are: a) extending Jockey’s product portfolio to leisurewear and women’s innerwear; b) maintaining capital allocation discipline with 0.3-0.5x debt/equity, leveraging benefits of Technology Upgradation Funds Scheme for the textile sector, and c) 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 channel with outsourced manufacturing and, hence, lack control on both manufacturing and distribution; b) new entrants like FCUK, USPA, CK and Van Heusen or regional players can’t offer affordable products given lack of in-house manufacturing. Page deserves one of the highest P/E multiples in the consumer space Page can record 24% CAGR over the next decade led by women’s innerwear, leisurewear and kidswear. Disciplined category selection (only knits), tough-todisplace shelf space and brand sweating will only boost dominance. Valuation of 50x FY19E EPS only partly captures blend of Hanes-like dominance and high/visible growth ramp. Key risks: Inadequate launches in women’s wear, allowing peers to grow bigger; impact of macro slowdown on leisurewear demand; and inability to manage growth given labour-intensive manufacturing.

GREEN AMBER GREEN

Page Inds.

Nov-17

Sep-17

Aug-17

Mar-17

200 180 160 140 120 100 80 Feb-17

Page controls the master franchise of Jockey (innerwear) and Speedo (swimwear) in India. Over the past 10 years, Page has delivered 31% revenue/earnings growth with 36% average RoCE. Longevity of Page’s growth is led by: (a) volumes of panties, which are just a fourth of men’s innerwear while the socioeconomic class that Page caters to in men’s and women’s wear is the same; (b) sustainability of competitive advantages driving market share gains in mid-to-premium innerwear; and (c) new launches in largely unorganized and unrivaled leisurewear and kidswear (US$ 8bn).

Accounting: Predictability: Greatness:

Dec-16

Page possesses strong and sustainable growth drivers

`206/US$3.6 `270/US$4.2 `20,400 `16,728 0

Flags

Nov-16

Changes to this position: STABLE

Mcap (bn): 6M ADV (mn): CMP: TP (12 mths): Upside (%):

Jun-17

One Page many stories

November 17, 2017

May-17

STRATEGY NOTE

Sensex

Source: Bloomberg, Ambit Capital Research

Page’s forensic score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Page’s greatness score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Research Analysts Abhishek Ranganathan, CFA +91 22 3043 3085 [email protected] Mayank Porwal +91 22 3043 3214 [email protected]

[email protected] 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.

Page Industries Exhibit 1: Evolution of Page Industries 25

0.6 Phase IIIGearing up for the competition

20 15

0.5 0.4 0.3

10

0.2

Mens innerwear revenues (LHS)

Leisurewear revenues (LHS)

Others (LHS)

Womens innerwear revenues (LHS)

Innerwear (Men + Women) revenues (LHS)

RoCE (post-tax) (RHS)

FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

FY06

FY05

0 FY04

0 FY03

0.1 FY02

5

FY01

Rs bn

Phase IV-Beating the competition

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 (Rs mn)

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

Revenues

1,945

2,584

3,441

4,977

6,966

8,758

11,876

15,430

17,955

21,301

Revenue growth (%)

42%

33%

33%

45%

40%

26%

36%

30%

14%

18%

Net profits

238

316

396

585

900

1,125

1,537

1,960

2,315

2,663

21

28

36

52

81

101

138

176

208

239

EPS CFO

112

315

298

(2)

1,226

871

740

1,670

2,192

2,736

CFO (pre-tax)/EBITDA (%)

58%

84%

70%

31%

113%

79%

59%

83%

86%

100%

FCF

(90)

43

62

(275)

959

430

280

1,139

1,929

2,122

Debt equity (x)

0.5

0.5

0.6

0.9

0.5

0.5

0.6

0.3

0.1

0.1

RoE (%)

33%

39%

43%

53%

62%

59%

61%

58%

51%

45%

Pre-tax ROCE (%)

36%

42%

44%

48%

60%

64%

65%

62%

59%

60%

Source: Company, Ambit Capital research

Exhibit 3: The key things to note from the evolution of Page Time period Phase

1959-1992

Establishing Jockey’s leadership in the Philippines

1993-1997

Jockey re-enters India through Page

1997-2003

Gearing up for competition

2004-2017

Beating the competition

Key developments/ initiatives  Genomal Vehromal (father of Sunder Genomal) got the license 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.  Page Apparel Manufacturing was incorporated in Nov 1994 in Bangalore  Men’s innerwear products launched in November 1995  First exclusive brand outlet launched in Bangalore’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  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 Rs500mn in sales with a retail network of 10,000 outlets  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 Rs1bn from an IPO  Brand campaign launch - ‘Just Jockeying’ (2010), ‘Jockey or Nothing’ (2015) and ‘There is Only One’ (2017)  Speedo’s licence for India signed up in 2011  UAE was added as a new territory in 2011

Source: Ambit Capital Research, Company

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Page Industries Exhibit 4: Competitive mapping of the company with its key peers Revenues of FY17 (Rs mn)

3 yr Revenue CAGR

Avg 3 yr EBITDA margin

Avg 3 yr CFO / EBITDA

Avg 3 yr Avg 3yr Distribution CFO/ ROCE channel type Capex

Page

21,301

22%

20%

90%

4.6

41% Distributor based only

Men and women innerwear; leisurewear, sportswear, swim wear

Rupa

Segment presence

10,927

7%

14%

100%

5.8

25% Wholesale largely

Men innerwear, men leisurewear, thermal wear

VIP

2,321

-3%

6%

NA

0.9

11% Wholesale largely

Men and women innerwear

Lovable

1,974

7%

13%

41%

0.5

13% Wholesale + Distributors

Women innerwear, women sportswear

Source: Company, Ambit Capital research

Exhibit 5: Mapping Page and its peers on IBAS Page

Rupa

VIP

Lovable

Comments  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  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  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  Page has over 60 years’ experience of expanding Jockey in the Philippines  Access to Jockey's international experience and technology is a key strategic asset

Innovation

Brand

Architecture

Strategic Asset Overall Source: Ambit Capital research

Exhibit 6: Uncanny similarities between Hanes and Page in terms of organisation and brand positioning Attributes

Hanes

Page

65% overall cost of goods sold is manufactured in-house; this includes activewear, T-shirts which are usually outsourced Diversified yet utility driven product Hanes has utility-driven yet diversified product mix ranging mix from innerwear (46%) to activewear (27%) Employs various types of inventory management techniques that include collaborative forecasting Demand forecasting and working and planning, supplier-managed inventory, key event Capital management management and various forms of replenishment management processes Positioning is that of a product offering comfort yet timeless Clear and consistent positioning and everyday utility Ensuring availability of innerwear styles through the years Processes aligned to positioning (after launch) as customers seldom change styles Maintained its position in various categories over years despite High Displacement quotient competition from existing players as well as new players and private labels of department stores Control over Manufacturing

Page controls over 85% of COGS, as currently they deal only in innerwear and leisurewear Page's product portfolio is diversified catering to innerwear (68%) and leisurewear (40%) Sales and marketing team forecasts demand a year in advance based on a MIS for each and every product. This helps create order pipeline for production team Positioning as mid-to-premium aspirational international brand Ensuring style availability and refreshing the same with new colours Page has leveraged on its success in men's wear by re-investing in women's wear and thus, utilising same distribution channel

Source: Company, Ambit Capital research

Exhibit 7: Market share analysis for the mid-premium innerwear segment of Page By value

By no. of customers

Value growth

2014

2020

2030

2014

2020

2030

FY16-20

FY20-30

Mid-premium segment as a % of Total Innerwear Market

41%

50%

62%

11%

15%

18%

17%

12%

Men's mid-premium segment as a % of Total Men's Innerwear market

42%

52%

61%

13%

16%

20%

16%

11%

Women's mid-premium segment as a % of Total Women's Innerwear market

40%

50%

62%

10%

14%

17%

18%

13%

Page Total Innerwear as a % of mid-premium market

17%

26%

38%

25%

30%

56%

28%

19%

Page Mens as a % of mid-premium Men's market

30%

46%

65%

34%

40%

64%

24%

17%

8%

13%

25%

12%

16%

46%

37%

23%

For mid-premium segment

For Page Industries

Page Women's as a % of mid-premium Women's market Source: Ambit Capital research

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Page Industries

500 450 400 350 300 250 200 150 100 50 0

Others Leisurewear revenues Mens innerwear revenues

FY34E

FY32E

FY30E

FY28E

FY26E

FY24E

FY22E

FY20E

FY18E

FY16

FY14

FY12

Panty revenues

FY10

Rs bn

Exhibit 8: Bras will drive women lingerie growth; leisurewear share is set to increase led by distribution

Bra revenues

Source: Company, Ambit Capital research

Exhibit 9: Page will maintain its RoCE trajectory even as outsourcing increases

Exhibit 10: Hanes’ RoCE outsourcing

30%

40%

25%

30%

20% 10%

15% 10%

5%

5% 0%

Exhibit 11: Sources of funds over FY07-16

FY16

Exhibit 12: Application of funds over FY07-16 Interest received, 0%

Increase in cash and cash equivalents, 5%

Debt repayment, 10%

Net Capex, 28%

Source: Company, Ambit Capital research

FY15

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Cash flow from operations, 89%

FY14

0% FY08

FY20E

FY19E

FY18E

FY17

0% FY16

0% FY15

10% FY14

5%

25%

15%

FY13

20%

Proceeds from shares, 0%

higher

20%

FY12

10%

35%

50%

FY11

15%

60%

FY10

20%

Debt raised, 10%

RoCE of Hanes (post-tax) (RHS)

40%

FY09

25%

despite

% of cost of goods outsourced by Hanes (LHS)

% of cost of goods outsourced by Page (LHS) RoCE of Page (post-tax) (RHS)

has increased

Dividend paid, 46%

Interest paid, 7% Source: Company, Ambit Capital research

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Page Industries Exhibit 13: One-year forward P/E

Exhibit 14: Share price performance vs Sensex

80

6,000

70

5,000

60

4,000

50 40

3,000

30

2,000

20

1,000

1 year fwd P/E

0 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Apr-17 Oct-17

Sep-17

May-17

Jan-17

Sep-16

Jan-16

May-16

Sep-15

Jan-15

May-15

Sep-14

Jan-14

May-14

Sep-13

Jan-13

May-13

Sep-12

Jan-12

May-12

10

5 yrs average PE

PAG IN

Source: Company, Ambit Capital research

SENSEX

Source: Company, Ambit Capital research; Note: price are rebased to 100

Exhibit 15: Explanation for our flags Segment

Score

Accounting

GREEN

Predictability

AMBER

Earnings momentum

GREEN

Comments Page Industries' cash conversion has remained healthy and this has resulted in cumulative CFO (pre-tax)/EBITDA of above 76% in FY08-17. 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 FY08 to 72 days in FY17. Since FY16, Page Industries has thrice beaten consensus revenue estimates by more than 6% and missed twice by less than 5%. It has thrice missed consensus EPS estimates by more than 3% and beaten twice by more than 4%. In the last six months, consensus earnings forecasts for Page have been downgraded by ~0.5% for FY18 and upgraded by ~0.5% for FY19

Source: Ambit Capital research

Exhibit 16: Page’s forensic score has remained in the “zone of safety” over 2011-16

Source: Ambit ‘HAWK’, Ambit Capital research

Exhibit 17: Page’s greatness score has improved from 50 in 2011 to 80 in 2016

Source: Ambit ‘HAWK’, Ambit Capital research

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Page Industries

Abridged Financial summary Balance Sheet Year to March Shareholders' equity

FY15

FY16

FY17

FY18E

FY19E

112

112

112

112

112

Reserves & surplus

3,756

5,187

6,546

7,754

9,595

Total net worth

3,868

5,299

6,658

7,866

9,707

Loan funds

1,573

949

877

699

449

Total liabilities

5,555

6,327

7,646

8,675

10,266

Gross block

3,059

2,408

2,764

4,672

5,446

Net block

2,173

2,167

2,361

3,007

3,432

Inventories

4,435

5,408

6,229

6,505

8,260

878

1,024

1,099

1,457

1,830

44

86

206

1,055

994

609

506

517

728

915

Debtors Cash and cash equivalents Loans & Advances Other current assets

95

70

164

465

560

Creditors

821

941

1,113

1,370

1,739

Deposits from Dealers

556

735

1,031

1,064

1,336

Other current liabilities

799

1,120

1,380

1,675

2,105

Provisions

504

143

169

437

549

Net current assets

3,381

4,156

4,522

5,665

6,830

Total assets

5,555

6,327

7,646

8,675

10,266

FY15

FY16

FY17

FY18E

FY19E

Net Sales

15,430

17,955

21,301

26,589

33,405

% growth

29.9%

14.2%

18.6%

24.7%

25.6%

Raw materials Cost

7,121

8,084

9,814

12,497

15,867

Employees cost

2,585

3,127

3,756

4,440

5,470

Royalty expenses

846

994

1,183

1,481

1,861

Advertisement expenses

714

670

875

1,010

1,203

Other Admin, S&D expenses

974

1,329

1,540

1,684

2,047

Total operating expenses

Source: Company, Ambit Capital research

Income statement Year to March

12,240

14,204

17,169

21,113

26,448

EBITDA

3,190

3,751

4,133

5,476

6,957

% growth

27.0%

17.6%

10.2%

32.5%

27.0%

Depreciation EBIT Non operating Income Interest expenditure PBT Tax expenses Adjusted PAT

176

241

247

297

349

3,014

3,510

3,886

5,179

6,608

86

98

243

160

200

167

178

180

60

40

2,933

3,430

3,949

5,279

6,768

973

1,116

1,285

1,689

2,166

1,960

2,315

2,663

3,590

4,603

Source: Company, Ambit Capital research

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Page Industries Cash flow statement Year to March PBT Depreciation

FY15

FY16

FY17

FY18E

FY19E

2,933

3,431

3,948

5,279

6,768

176

241

247

297

349

Tax

(966)

(1,046)

(1,397)

(1,689)

(2,166)

(Increase)/Decrease in working capital

(569)

(583)

(65)

(565)

(1,227)

Cash flow from operating activities

1,670

2,192

2,736

3,222

3,565

Capex

(534)

(263)

(613)

(731)

(775)

Cash flow from investing activities

(531)

(262)

(1,074)

(571)

(574)

(59)

(624)

(72)

(250)

(250)

(171)

(178)

(180)

(60)

(40)

Net borrowings Interest paid Dividend paid Cash flow from financing activities Free cash flow

(899)

(1,087)

(1,289)

(1,974)

(2,762)

(1,129)

(1,889)

(1,541)

(2,284)

(3,052)

1,139

1,929

2,122

2,651

2,991

Source: Company, Ambit Capital research

Ratio analysis Year to March

FY15

FY16

FY17

FY18E

FY19E

Gross margin (%)

53.8

55.0

53.9

53.0

52.5

EBITDA margin (%)

20.7

20.9

19.4

20.6

20.8

EBIT margin (%)

19.5

19.5

18.2

19.5

19.8

Net profit margin (%)

12.7

12.9

12.5

13.5

13.8

Dividend payout ratio (%)

49

49

36

55

60

Net debt/equity (x)

0.4

0.2

0.1

(0.0)

(0.1)

Gross block turnover (x)

5.6

6.6

8.2

6.2

6.6

RoCE (%)

41.6

41.7

40.4

46.1

49.5

ROE (%)

58.0

50.5

44.6

50.9

52.4

Source: Company, Ambit Capital research

Valuation parameters Year to March EPS (Rs) Book value per share (Rs) Dividend per share (Rs)

FY15

FY16

FY17

FY18E

FY19E

175.7

207.5

238.8

321.8

412.6

347

475

597

705

870

72.0

85.0

72.0

151.3

211.6

116.6

98.8

85.8

63.4

49.4

P/BV (x)

59.1

43.1

34.3

28.9

23.4

EV/EBITDA (x)

72.1

61.2

55.4

41.5

32.6

Price/Sales (x)

14.8

12.7

10.7

8.6

6.8

0.4

0.4

0.4

0.7

1.0

P/E (x)

Dividend yield (%) Source: Company, Ambit Capital research

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Page Industries

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GRUH Finance NOT RATED GRHF IN EQUITY

Performance 200 180 160 140 120 100 80

GRUH Finance

Sensex

Source: Bloomberg, Ambit Capital research

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 ~20bps over the 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 risks to earnings growth. Valuations could be tested by declining earnings momentum Mortgage financers are trading at premium valuations due to expectations of strong and sustained earnings growth led by the Government’s thrust on affordable housing. Whilst such ‘yet to reflect on-ground’ measures could benefit smaller HFCs like GRUH in the long term, peak valuations could be tested in the interim as moderating real estate prices, hostile competition and asset quality risks moderate earnings momentum (EPS CAGR of 21% in FY16-17 vs 28% over FY10-15). Moreover, all HFCs, including GRUH, 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).

Research Analysts Aadesh Mehta, CFA +91 22 3043 3239 [email protected] Pankaj Agarwal, CFA +91 22 3043 3206 [email protected]

[email protected] 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.

Nov-17

Since the stressful period of 1996-98, GRUH 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 GRUH single-mindedly focused on small-ticket home loans to informal segments. High RoE over the past ten years (average ~30%) implied that it didn’t need to raise capital despite growing at 26% CAGR and simultaneously sustaining a generous dividend payout of ~43% during the same period.

GREEN GREEN AMBER

Sep-17

Strong focus on the informal segment drives robust growth and RoE

Accounting: Predictability: Earnings Momentum:

Aug-17

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 Gujarat and Maharashtra, which account for ~70% of its loan book. With a modest loan book of ~`137bn, GRUH accounts for less than 1% market share in mortgages and averaged loan growth of ~26% over FY06-17, making it a promising play on the rural mortgage opportunity in India.

Flags

Jun-17

Play on the rural mortgage opportunity

`181/US$2.8 `149/US$2.3 `496 NA NA

May-17

Changes to this position: NEGATIVE

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

Mar-17

Competitive position: STRONG

Recommendation

Feb-17

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 decadelong surge in real estate prices, these strengths have driven GRUH’s superior profitability and growth over FY06-17 (avg. RoE of 30% and AUM CAGR of 26%). However, moderating real estate prices, hostile competition and moderately worsening asset quality have slowed earnings momentum (EPS growth of 21% in FY16-17 vs 28% over FY1015). GRUH’s lofty valuations (13x 1-year fwd P/B, ~130% premium to peers) will be tested by the declining earnings momentum.

BFSI

Dec-16

Will it become more expensive?

November 17, 2017

Nov-16

STRATEGY NOTE

GRUH Finance Exhibit 1: Evolution of GRUH – good times have ended due to competitive and regulatory headwinds Headwinds emerge AUM Growth 24% NIMs 4.3% RoAs 2.3%

The good times AUM CAGR 28% NIMs 4.5% RoAs 2.5%

160 140 120 100

45% 40% 35%

80

30%

60 40

25%

20

20%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

AUM (Rs bn)

FY12

FY13

FY14

FY15

FY16

FY17

RoEs (RHS, %)

Source: Company, Ambit Capital research

Exhibit 2: GRUH – key financial parameters over the last decade (Fig in ` mn) Interest Income

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

10.8%

12.3%

11.1%

11.0%

12.3%

12.3%

12.2%

12.0%

11.4%

11.3%

Interest Expense

6.7%

8.6%

6.7%

6.4%

7.7%

7.8%

8.2%

7.9%

7.5%

7.2%

Net Interest Income

4.1%

3.7%

4.3%

4.6%

4.6%

4.5%

4.1%

4.0%

3.9%

4.1%

Non-Interest Income

0.4%

0.3%

0.5%

0.4%

0.4%

0.3%

0.5%

0.5%

0.4%

0.3%

Total Income

4.5%

4.0%

4.8%

5.0%

5.1%

4.7%

4.5%

4.5%

4.4%

4.5%

Operating Expenses

1.0%

0.9%

0.9%

1.0%

1.0%

0.9%

0.8%

0.8%

0.8%

0.7%

Employee Expenses

0.4%

0.5%

0.5%

0.5%

0.5%

0.5%

0.5%

0.4%

0.4%

0.4%

Admin Expenses

0.5%

0.4%

0.5%

0.5%

0.5%

0.4%

0.4%

0.4%

0.4%

0.4%

Pre Provisioning Profit

3.5%

3.1%

3.8%

4.1%

4.1%

3.9%

3.7%

3.7%

3.6%

3.7%

Loan loss provisions

0.2%

0.1%

0.3%

0.1%

0.1%

0.1%

0.04%

0.2%

0.2%

0.3%

Profit Before tax (PBT)

3.3%

3.0%

3.5%

4.0%

4.0%

3.8%

3.7%

3.5%

3.4%

3.5%

Taxes

1.0%

0.8%

1.0%

1.1%

1.1%

1.0%

1.0%

1.1%

1.1%

1.1%

RoA

2.3%

2.1%

2.6%

2.9%

3.0%

2.9%

2.7%

2.4%

2.3%

2.3%

Leverage

10.2

11.4

11.0

10.8

11.5

11.8

12.1

12.9

13.9

13.1

23.7%

24.3%

28.4%

31.4%

34.2%

34.2%

32.2%

30.9%

31.5%

30.5%

AUM growth (%, YoY)

29%

18%

18%

29%

28%

33%

29%

28%

24%

19%

EPS growth (%, YoY)

30%

19%

37%

31%

31%

20%

20%

14%

19%

22%

RoE

Source: Company, Ambit Capital research.

Exhibit 3: Emerging regulatory & competitive headwinds led to slower growth and lower profitability recently Time period

Phase

The good times FY05-14

Headwinds emerge

Key developments



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 feeincome). 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 RoA sustained at 2.5% during this period.



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 also led to moderation in ticket size growth (which used to drive 50-60% of growth of HFCs). Demonetisation and advent of RERA have led to a further slowdown in growth.



Headwinds mentioned above led to a slowdown in growth as well as pressure in profitability for HFCs, including GRUH. GRUH’s growth has slowed to 22% AUM CAGR in FY16-17 (versus 28% CAGR in FY05-14) and RoA moderated to 2.3% from an average of 2.5% in FY05-14.

FY14Current

Source: Ambit Capital research.

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GRUH Finance Exhibit 4: Competitive mapping of HFCs – GRUH’s small-ticket positioning drives its superior profitability Key metrics (FY17)

Avg. ticket size (Rs mn)

AUM (Rs bn)

AUM CAGR (FY13-17)

NIMs

Opex/ AUM

Gross NPA (%)

RoA

RoE

Branches (#)

Employees (#)

GRUH

0.6

132

25%

4.3%

0.8%

0.31%

2.5%

30.5%

185

661

HDFC

2.6

3,378

16%

3.0%

0.2%

0.79%

1.5%

19.1%

427

2,196

LICHF

1.3

1,445

17%

2.7%

0.5%

0.43%

1.5%

19.5%

245

1,833

REPCO

1.4

89

26%

4.8%

0.8%

2.60%

2.2%

17.4%

157

625

CANFIN

1.8

133

35%

3.5%

0.7%

0.21%

1.9%

24.1%

170

578

DEWAN

1.4

836

23%

2.7%

0.8%

0.94%

3.6%

18.0%

352

2,881

PNBHF

3.7

415

58%

3.7%

1.0%

0.22%

1.4%

13.6%

63

999

Source: Company, Ambit Capital research

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 depends on the perceived customer service and the perceived project financing abilities of 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 ~427 branches and 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 is 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;

Exhibit 6: AUM mix

- Average;

- Relatively weak.

Exhibit 7: Liability mix

3%

Home loan - Salaried 4%

20% 31%

Home loan - Self employed

11%

LAP - Residential

Bank loans 13%

52% 29%

Public deposits

LAP - Non Residential 36%

Construction Loans Source: Company, Ambit Capital research

NHB

Others

Source: Company, Ambit Capital research

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GRUH Finance Exhibit 8: NIMs are declining due to competitive pressures

Exhibit 9: Asset quality is worsening 2.0%

5.4%

Gross NPAs (%)

NIMs (%)

5.2%

1.5%

5.0% 4.8%

1.0%

4.6% 4.4%

0.5%

4.2% FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

FY07

0.0%

4.0%

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 10: GRUH is trading at a 60% premium to its cross-cycle average P/B

Exhibit 11: GRUH – share price performance versus Sensex

16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0

3,500 3,000 2,500 2,000 1,500 1,000 500 Oct-17

Mar-17

Jan-16

Aug-16

Jun-15

Nov-14

Apr-14

Sep-13

Jul-12

Gruh

+1 SD

Feb-13

Dec-11

May-11

Oct-10

Mar-10

Aug-09

Jan-09

Jun-08

Oct-17

Apr-17

Oct-16

-1 SD

Apr-16

Oct-15

Apr-15

Avg. PB

Oct-14

Apr-14

Oct-13

Apr-13

Oct-12

Apr-12

Oct-11

Apr-11

Oct-10

Apr-10

PB

Nov-07

0

Sensex Index

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Exhibit 12: Explanation for our flags Segment

Score

Accounting

GREEN

Predictability

GREEN

Earnings momentum

AMBER

Comments 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. GRUH’s earnings trajectory has been fairly predictable. It has delivered a clockwork 20% earnings growth for at least 18 quarters. Pressure on AUM growth and profitability has led to GRUH’s earnings growth moderating from 30% PAT CAGR over FY07-14 to 19% PAT CAGR over FY14-17.

Source: Ambit Capital research

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GRUH Finance Income statement Year to March (Rs mn)

FY13

FY14

FY15

FY16

FY17

NII (inclu. Securitisation)

2,311

2,707

3,437

4,212

5,260

Other income

149

319

389

468

416

Total income

2,460

3,025

3,826

4,680

5,676

Operating expenditure Pre-provisioning profit Provisions Profit before tax Tax Consol. PAT

463

556

661

844

935

1,997

2,469

3,165

3,836

4,741

29

24

157

219

320

1,968

2,445

3,008

3,617

4,421

509

675

970

1,181

1,454

1,500

1,770

2,038

2,436

2,967

Source: Company, Ambit Capital research

Balance sheet Year to March (Rs mn)

FY13

FY14

FY15

FY16

FY17

4,910

6,072

7,115

8,353

11,132

49,145

64,475

67,453

102,444

120,182

Net-worth Borrowings - on balance sheet Borrowings - off balance sheet

0

0

0

0

0

Total liabilities

54,055

70,547

74,568

110,797

131,314

AUM

54,378

70,090

89,544

111,146

132,443

652

530

798

1,429

1,561

(974)

(73)

(15,775)

(1,778)

(2,691)

36,990

46,431

59,165

17

18

Cash and equivalents Net Current Assets Total assets

Source: Company, Ambit Capital research

Key ratios Year to March (Rs mn)

FY13

FY14

FY15

FY16

FY17

NIM % (on AUM)

4.9%

4.3%

4.3%

4.2%

4.3%

AUM Growth

33%

29%

28%

24%

19%

Opex as % of AAUM

0.97%

0.89%

0.83%

0.84%

0.77%

Credit costs as a % of AUM

0.06%

0.04%

0.20%

0.22%

0.26%

CAR (%)

14.6%

16.4%

15.4%

17.8%

18.3%

FY13

FY14

FY15

FY16

FY17

8.2

4.9

5.6

6.7

8.1

Source: Company, Ambit Capital research

Valuation parameters Year to March (Rs mn) Dil EPS – Consol (Rs) BVPS (Rs.)

14

17

20

23

31

ROA (%)

2.9%

2.7%

2.4%

2.3%

2.3%

ROE (%)

34.2%

32.2%

30.9%

31.5%

30.5%

P/B (x)

36.7

29.8

25.7

21.9

16.4

P/E (x)

61.3

102.3

89.7

75.1

61.7

Source: Company, Ambit Capital research

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GRUH Finance

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Amara Raja NOT RATED AMRJ IN EQUITY

Mcap (bn): 3M ADV (mn): CMP: TP (12 month): Downside (%):

`135/US$2.1 `558/US$8.5 `788 NA NA

Flags Accounting: Predictability: Earnings Momentum:

GREEN AMBER AMBER

Performance 150 130 110 90 70

Amara Raja

Sensex

Emerged as a strong automotive player over the last ten years AMRJ posted strong market share expansion in automotive over the last 10 years (at Exide’s expense) led by competitive pricing, aggressive warranty terms and distribution expansion. In telecom, it benefited from strong subscriber growth. Revenues/EBITDA saw 24%/26% CAGR over FY08-17 (much higher than Exide’s 15%/13% growth). This was supplemented by pre-tax RoCE expanding from 23.2% in FY07 to 29.3% in FY17. CFO (before tax) averaged 89% of EBITDA over FY08-17 (aggregate Rs42bn). CFO has been mainly invested in capex (81%) and payment of equity dividend (14%).

Source: Bloomberg, Ambit Capital research

AMRJ’s forensic score analysis

Johnson Controls provide strategic edge, but cost advantage waning AMRJ scores over Exide on innovation (products, advertising) and parentage that enables superior manufacturing (low cost) and products. As battery technologies like lithium-ion evolve, strategic global ties and low-cost architecture will play important roles. While JCI’s parentage will continue to provide an edge in strategic partnerships, AMRJ’s cost advantage is under threat from Exide’s growing focus on cost control and technology upgrade. This alongside industry growth challenges (auto replacement, telecom) would slow revenue/EBITDA CAGR to 13%/14% (consensus estimates) over FY17-20. Potential headwinds, but current valuation provide comfort JCI parentage does provide better long-term visibility but disruptions over the next decade could erode some key competitive advantages. Revenue/EBITDA growth over the next 10 years could be significantly lower than historical levels. However, AMRJ’s PE multiple has de-rated significantly (by 25%) in the past year and premium over Exide narrowed from 40% to ~18% now. The stock now trades at 20x FY19 net earnings, close to last five-year historical average. In the context of duopoly nature of the industry (involving strong entry barriers surrounding brand and distribution) and pre-tax RoCE of ~30%, the current earnings multiple provide some comfort.

Source: Ambit ‘HAWK’, Ambit Capital research

AMRJ’s greatness score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Research Analyst Ashvin Shetty, CFA +91 22 3043 3285 [email protected]

[email protected] 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.

Nov-17

Sep-17

Aug-17

Jun-17

May-17

50 Mar-17

Second-largest battery player powered by Johnson Controls Owned 26% each by Johnson Controls and the Galla family, AMRJ is a leading domestic automotive/industrial battery player. It has developed strongholds in industrial segments like telecom (>50% market share) and UPS (after Exide with ~33% market share). It is also the second-largest player in auto (OEM and replacement; 30-35% and 40-45% market share respectively). Auto OE segment growth (12% of total revenue) is dependent on new vehicle sales. The bigger auto replacement (30%) caters to existing vehicle base (replacement every 2-3 years) and benefits from shift from unorganised segment. Growth of telecom (25% of revenues) depends on tower additions/usage.

Recommendation

Feb-17

Amara Raja, the second-largest automotive/industrial battery player, has successfully challenged Exide and gained material market share (especially in 4W replacement) given: (i) cost and pricing advantages provided by JCI parentage; and (ii) innovation (products, advertising). Market share gain from Exide would continue albeit slowly as pricing gap has narrowed and Exide is awakening from recent complacence. adoption mean This and potential risks from lithium-ion revenue/EBITDA growth over the next 10 years could be significantly lower than historical levels (revenue/EBITDA CAGR of 24%/26%; FY0817). But recent correction in earnings multiple (25% over the past year; now trading close to last 5-year average) provides some comfort. Competitive position: STRONG Changes to this position: POSITIVE

Auto & Auto Ancillaries

Dec-16

Challenging the leader

November 17, 2017

Nov-16

STRATEGY NOTE

Amara Raja Exhibit 1: AMRJ has emerged as a formidable auto/industrial battery player over the last 10 years 62

Rs. billion

52

Phase II- Foray into automotive segment through JV with Johnson Controls

Phase I- Emergence as a strong industrial battery player

Phase IVSlowing industry growth and market share gains

Phase III- Finding success across various automotive battery segments

100% 80%

42 32 Launched 4W battery

22 12

60%

Launched CV and Tractor battery

Launched 2W battery

40%

Won OE orders from Maruti and Hyundai

20% 0%

2 (8)

120%

FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Revenue CAGR: 21% Avg RoCE: 40.4%

Revenue CAGR: 32% Avg RoCE: 13.5%

Revenue CAGR: 32% Avg RoCE: 72.9% AMRJ's Revenues (LHS)

-20%

AMRJ's ROCE % (Pre-tax) (LHS)

Source: Company, Ambit Capital research

Exhibit 2: Key financial parameters over the last 10 years (Rs mn)

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

Revenue

10,833

13,132

14,645

17,611

23,645

29,614

34,367

42,113

46,907

53,172

Revenue growth (%)

82%

21%

12%

20%

34%

25%

16%

23%

11%

13%

Net profit

909

1,115

1,550

1,479

2,024

2,898

3,621

4,125

4,768

4,794

EPS(Rs)

8.0

6.5

9.1

8.7

11.8

17.0

21.2

24.1

27.9

28.1

(167)

2,364

2,143

861

2,985

3,355

2,788

3,950

5,547

5,529

18%

138%

101%

63%

118%

104%

78%

83%

95%

89%

(1,333)

1,335

1,627

195

2,176

1,892

(943)

(112)

643

1,224

0.80

0.53

0.05

0.08

(0.17)

(0.30)

(0.15)

(0.09)

(0.04)

(0.09)

RoE (%)

27.3%

27.5%

28.5%

22.9%

24.6%

27.3%

26.6%

24.3%

23.7%

18.5%

RoCE (pre-tax) (%)

31.9%

27.7%

40.7%

32.3%

40.4%

51.5%

49.3%

40.6%

36.4%

29.3%

CFO post tax CFO-EBITDA * FCF Net Debt equity (x)

Source: Company, Ambit Capital research Note: * CFO before tax considered in this ratio

Exhibit 3: AMRJ witnessed strong market share expansion in the auto segment between FY09 and FY15 Phase Phase – I

Time period FY1996-2000

Key developments

 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

Phase – III

FY01-08

FY09-15

     

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 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

 Industry growth slows down across automotive segments (OE, replacement) and key industrial segments like Phase – IV

FY16-17

telecom

 Exide attempts comeback through cost cutting and competitive pricing which slows AMRJ's market share gains

Source: Company, Ambit Capital research

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Amara Raja Exhibit 4: AMRJ’s growth has been higher than Exide but the latter scores better on RoCE Company

Sub-segment Positioning

FY17 revenue

Revenue CAGR FY10-17

Industry market share

EBITDA Margin (FY17)

Pre-tax RoCE (FY17)

Pre-tax CFO/ EBITDA (FY10-17)

Capex/CFO (FY10-17)

Exide

#1

76,284

10%

4W replacement 55%; 4w OEM60-65%

14.2%

38.4%

92%

43%

Amara Raja

#2

53,172

20%

4W replacement 40-45%; 4w OEM-30-35%

16.0%

29.3%

90%

77%

Source: Company, Ambit Capital research Note: Replacement market share in organised segment

Exhibit 5: IBAS analysis Parameter

AMRJ

Exide

Comments AMRJ has an edge because of its innovation surrounding products, advertising. Some of the instances of product differentiation are:  Zero maintenance batteries (Amaron Hi-Life), a key differentiator from the batteries which required regular maintenance and top-ups;  Introduction of VRLA batteries for the 2W segment (Amaron Pro-bike rider) in May 2008;  Aggressive warranty terms with introduction of innovative 48 months warranty in 2005;  Differentiated product design like black body with fluorescent green logo; and  'Clutter-busting' advertising campaigns using claymation (clay models + animation) which helped create strong recall for the brand 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 several decades of presence in India and a large number of installations in the existing car population, Exide still has greater brand recall.

Innovation

Brands/ Reputation

 Architecture

  Strategic Assets



AMRJ employs superior manufacturing practices through its business alliance with Johnson Controls Inc., USA, reinforcing compliance with global best-practices and benchmark. AMRJ commands low rejections/higher yield – 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 helped by its concentrated manufacturing plants. Amara Raja's JV relationship with Johnson Controls (involving equity participation) enables better access to the best technology/best manufacturing practices which is otherwise not possible in a pure-play technology sharing tie-ups like that of Exide with Shin-Kobe (Hitachi), East Penn and Furukawa. Johnson Controls' R&D spends and size dwarf that of Exide's technological partners

Overall

While Exide still has the highest brand recall, AMRJ has emerged as a strong challenger

Source: Ambit Capital research

Exhibit 6: Healthy operational cash generation over the last 10 years

Exhibit 7: Mainly utilised dividend payment

for

Dividend paid 14%

Int/div recd 9%

capacity

expansion

and

Interest paid 2%

Debt repaid 3% Capex (net) 81% CFO 91%

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

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Amara Raja

500%

10

0%

5 0 Nov-12

Nov-13

Nov-14

1 yr forward P/E (x)

Nov-15

BSE Auto Index

5 yr Average P/E

25-Oct-17

15

25-Oct-16

1000%

25-Oct-15

20

25-Oct-14

1500%

25-Oct-13

25

25-Oct-12

2000%

25-Oct-11

30

25-Oct-10

2500%

25-Oct-07

35

25-Oct-09

Exhibit 9: ..resulting in the stock price trailing BSE Auto Index recently after several years of outperformance

25-Oct-08

Exhibit 8: AMRJ’s one-year forward P/E has witnessed significant correction in the last one year…

AMRJ

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Exhibit 10: Explanation for our flags Segment

Score

Accounting

GREEN

Predictability

AMBER

Earnings momentum

AMBER

Comments AMRJ scores relatively well in our accounting and forensic framework. AMRJ’s key accounting ratios, such as cash yield, CFO-EBITDA conversion and miscellaneous expenditure (as a % of sales) were much higher than other listed peers. On Ambit’s forensic accounting, AMRJ is categorised in the 4th decile of the auto ancillary universe. The OEM business (15% of the revenue) tends to be volatile. However, the replacement demand (35% of the revenue) is more stable as battery requires replacement in 2-3 years. Industrial volumes (44% of the revenue) are also volatile and linked to telecom sector’s 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) Bloomberg shows no significant upgrades/downgrades to consensus numbers in recent weeks.

Source: Ambit Capital research

Exhibit 11: AMRJ has witnessed some deterioration in forensic score but is still above average

Exhibit 12: AMRJ framework

scores

‘good’

Source: Ambit ‘HAWK’, Ambit Capital research

Source: Ambit ‘HAWK’, Ambit Capital research

in

Ambit’s

greatness

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Amara Raja Balance sheet (standalone) Year to March (` mn) Shareholders' equity

FY13

FY14

FY15

FY16

FY17

171

171

171

171

171

Reserves & surpluses

10,427

13,456

16,825

19,974

25,760

Total networth

10,598

13,627

16,996

20,145

25,931

881

857

759

741

725

Debt Deferred tax liability Total liabilities

195

301

368

588

815

11,674

14,785

18,124

21,475

27,471

Gross block

6,803

9,955

14,414

19,147

18,156

Net block

3,589

6,232

9,443

13,163

14,922

CWIP

1,185

1,835

1,342

1,322

2,403

Investments (non-current)

157

161

161

161

189

Cash & Cash equivalents

4,112

2,947

2,221

1,498

2,987

Debtors

3,807

4,528

5,541

5,921

5,705

Inventory

2,929

3,350

4,181

6,016

8,170

Loans & advances

1,927

783

992

1,002

1,472

Total current assets

12,774

11,608

12,935

14,437

18,333

Current liabilities

3,161

3,421

4,118

5,755

7,434

Provisions

2,870

1,629

1,639

1,854

941

Total current liabilities

6,030

5,050

5,757

7,608

8,375

Net current assets

6,744

6,558

7,178

6,829

9,958

11,674

14,785

18,124

21,475

27,471

Total assets Source: Company, Ambit Capital research

Income statement (standalone) Year to March (` mn) Net Sales % growth

FY13

FY14

FY15

FY16

FY17

29,614

34,367

42,113

46,907

53,172

25%

16%

23%

11%

13%

25,055

28,738

35,005

38,738

44,677

4,559

5,628

7,108

8,169

8,495

% growth

34%

23%

26%

15%

4%

Depreciation

661

646

1,260

1,399

1,912

3,898

4,982

5,849

6,770

6,583

10

2

7

5

58

360

333

273

330

506

Adjusted PBT

4,249

5,313

6,115

7,095

7,031

Tax

1,351

1,692

1,990

2,327

2,237

Adjusted PAT

2,898

3,621

4,125

4,768

4,794

43%

25%

14%

16%

1%

Operating expenditure EBITDA

EBIT Interest expenditure Non-operating income

% growth Source: Company, Ambit Capital research

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Amara Raja Cashflow statement (standalone) Year to March (` mn)

FY13

FY14

FY15

FY16

FY17

4,218

5,367

6,099

7,222

7,022

Depreciation

577

648

1,340

1,399

1,912

Interest paid

2

7

2

5

58

(94)

(1,315)

(1,450)

(677)

(1,137)

(1,366)

(1,606)

(1,922)

(2,181)

(2,024)

17

(312)

(118)

(219)

(302)

Net Profit Before Tax

(Incr)/decr in net working capital Direct taxes paid Others Cash flow from operations Capex (net)

3,355

2,788

3,950

5,547

5,529

(1,463)

(3,731)

(4,062)

(4,904)

(4,305)

-

-

34

89

(1,110)

(Incr) / decr in investments Other income (expenditure) Cash flow from investments

258

282

148

101

56

(1,205)

(3,448)

(3,880)

(4,714)

(5,359)

26

(27)

(97)

(18)

(17)

-

-

-

-

-

(0)

(0)

(2)

(5)

(3)

(375)

(504)

(645)

(1,614)

-

-

-

990

776

9

Net borrowings Issuance/buyback of equity Interest paid Dividend paid Others Cash flow from financing

(350)

(531)

244

(861)

(10)

Net change in cash

1,800

(1,192)

314

(28)

160

Closing cash balance

4,095

2,929

746

1,498

1,008

Free cash flow

1,892

(943)

(112)

643

1,224

FY13

FY14

FY15

FY16

FY17

25%

16%

23%

11%

13%

Source: Company, Ambit Capital research

Ratio analysis (standalone) Year to March (%) Revenue growth EPS norm (dil) growth EBITDA margin (%) Net profit margin (%)

43%

25%

14%

16%

1%

15.4%

16.4%

16.9%

17.4%

16.0%

9.8%

10.5%

9.8%

10.2%

9.0%

Dividend payout ratio (%)

18%

18%

18%

18%

0%

Net debt: equity (x)

(0.3)

(0.2)

(0.1)

(0.0)

(0.1)

Working capital turnover (x)

6.3

6.9

8.9

8.0

7.0

Gross block turnover (x)

4.6

4.1

3.5

2.8

2.9

RoCE (Pre-tax) (%)

51%

49%

41%

36%

29%

RoIC (%)

27%

27%

24%

23%

20%

RoE (%)

27%

27%

24%

24%

18%

Year to March

FY13

FY14

FY15

FY16

FY17

EPS (`)

17.0

21.2

24.1

27.9

28.1

Diluted EPS (`)

17.0

21.2

24.1

27.9

28.1

62

80

100

118

152

Source: Company, Ambit Capital research

Valuation parameters (standalone)

Book value per share (`) Dividend per share (`)

2.5

3.2

3.6

4.3

-

P/E (x)

46.6

37.3

32.8

28.3

28.2

P/BV (x)

12.8

9.9

8.0

6.7

5.2

EV/EBITDA (x)

29.1

23.6

18.7

16.3

15.6

EV/EBIT (x)

34.1

26.7

22.7

19.6

20.2

Source: Company, Ambit Capital research

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Abbott India NOT RATED BOOT IN EQUITY

How much more left to extract?

November 17, 2017 Pharmaceuticals

Abbott India’s business quality has declined due to (a) price controls by DPCO/NLEM and resultant stagnant EBITDA margin of 14%; and (b) lack of product launches and over-dependence on legacy business (top 50 products contribute 65% of revenue). Further, minority interest is compromised as global parent is launching most of its new products (75-80%) from an unlisted subsidiary; Abbot India primarily launches line extensions of existing products. With most production outsourced, the company has generated RoCE of 30-35%. No material capex and limited investment in working capital led to annual FCF generation of `2-3bn in the last three years. The stock trades at 29x FY18E, at a discount to MNC peers and premium to domestics despite weak innovation and no improvement to business, implying an embedded delisting premium supported by excess cash in the group.

Recommendation

Competitive position: MODERATE

Performance (%)

Changes to this position: STABLE

Mcap (bn): 6M ADV (mn): CMP: TP (12 mths): Downside (%):

`107/US$1.6 `16.3/US$0.2 `5,048 NA NA

Flags Accounting: Predictability: Greatness:

GREEN GREEN AMBER

No material product launches; minority interest compromised

135

New launches declined to below 10 p.a. over FY14-16 from ~20 earlier; there was some recovery to 10 in FY17! Most launches have been line extensions of existing products. We believe minority interest is compromised as the parent entity has used a privately held company (Abbott Healthcare Pvt. Ltd.) to launch new products; over FY11-15, 75-80% of new products introduced in India by parent were from the privately held company. Given lack of product launches, we expect Abbott India to at best mirror market growth of ~12%. Key risk would be ban on Fixed Dosage Combination (FDC) drugs, which could lead to 2-3% impact on sales for Abbott India.

115

Source: Bloomberg, Ambit Capital Research

From cash cow to average Joe; regulatory hurdles tame the tiger

Abbott’s forensic score analysis

Over FY06-10, Abbot reported 14% revenue CAGR with ~20% EBITDA margin led by product launch and presence in high-growth chronic space. RoCE was ~40% given: a) low asset base (most production was outsourced); and b) regular buyback to deploy surplus capital. But over FY11-13, regulatory hurdles in the form of price control led to decline in margins from 20% to 12%. After price control, focus shifted to lowering cost through introduction of technology for the supply chain and improving sales-force effectiveness. Hence, margin expanded from 12% in FY13 to 14% over FY15-17. Average ranking on IBAS: No innovation; strong brand equity Low score on innovation is because incremental products are being launched by parent entity through private firm. Abbott India has primarily launched line extensions of existing products. Stronger brand equity than peers is visible as base business reported healthy CAGR of 10.7% over FY12-16 vs 7% for peers. Above-average MR productivity (`8mn sales per MR vs peer average of `6mn) bodes well for architecture but over-dependence on legacy is a worry (top 50 products contribute ~65% of revenue). The company lacks strategic assets, with no presence in top 100 pharma brands vs 7-10 products for peers.

95

Abbott India

Sep-17

Aug-17

Jun-17

May-17

Mar-17

Feb-17

Dec-16

Nov-16

75 Nov-17

STRATEGY NOTE

Sensex

Source: Ambit ‘HAWK’, Ambit Capital research

Abbott’s greatness score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Justified discount to peers; delisting and consumer nature factored in The stock trades at 29x FY18 consensus EPS vs 32-35x for peers; we believe the discount is justified given: a) no novel product launches, b) high revenue concentration, and c) compromised minority interest. Current valuations can sustain due to: (a) consistent revenue growth of 12-15%; (b) asset-light balance sheet, leading to high RoCE (~30-35%); and (c) stable annual FCF generation of `3bn. Due to excess cash on the books of the parent and no focus in building the business, we believe multiples signal a likely delisting candidate. [email protected] 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.

Abbott India Exhibit 1: Evolution of Abbott India Cash cow phase with low double digit product laucnhes and increasing penetration of products and limited control on pricing

35

Regulatory headwinds Slovay pharma acquisition led to dip in ROCE. One time integration and sales force transformation expense led to decline in margins. Introduction of NPPP in 2012 led to price controls

` Bn

30 25 20

The new normal with high single digit product launch (majority being line extensions) and high focus on cost controls

40% 35% 30%

15

25%

10

20%

5

15%

CY05

CY06

CY07

CY08

CY09

CY10 Revenue

CY11 CY12 RoCE (RHS)

FY14

FY15

FY16

FY17

Source: Company, Ambit Capital research. Note: (a) RoCE is pre-tax; (b) CY10 was a 13month period; CY11 is after merger with Solvay Pharma and (c) FY14 is a 15 month period; for FY15 we find the revenue growth by considering 12month sales of FY15

Exhibit 2: Key financial parameters over the last decade (Fig in Rs mn)

CY07

CY08

CY09

CY10

CY11

CY12

FY14**

FY15

FY16

FY17

Revenues

6,224

6,953

7,946

10,369

14,902

16,527

22,759

22,893

26,145

29,026

Revenue growth (%)

17%

12%

14%

30%

44%

11%

38%

1%

14%

11%

Net profits

684

619

775

609

1,204

1,447

1,985

2,290

2,553

2,766

EPS

47.3

45.2

56.7

44.6

56.7

68.1

93.4

107.7

120.1

130.2

CFO

305

872

372

461

241

1,013

1,553

2,148

2,487

3,072

Pre-tax CFO/EBITDA

78%

163%

77%

137%

48%

82%

99%

106%

109%

118%

FCF

219

659

293

340

88

843

1,512

1,993

2,260

2,859

Gross debt equity (x)

0.00

0.00

-

-

-

-

-

-

-

-

RoE (%)

30%

28%

29%

20%

22%

22%

25%

24%

21%

20%

ROCE* (%)

31%

30%

35%

20%

38%

31%

34%

35%

33%

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. CY10 was a 13month period; CY11 is after merger with Solvay Pharma and **FY14 is a 15 month period; for FY15 we find the revenue growth by considering 12month sales of FY15

Exhibit 3: The key things to note from evolution Time period

Phase

Key developments

 High margins (~20%) provided by launch of products (~20 products) in the chronic space. Enjoyed benefits of changing demand environment due to higher instance of lifestyle diseases.

FY06-FY10

Cash cow

 Majority of manufacturing outsourced to third parties, leading to low asset base and RoCE of 40-50%. Regular buyback to deploy surplus capital led to increase in RoCE from 37% in FY07 to 48% in FY10.

 CFO to EBITDA at ~90% led to high FCF generation and therefore reduction in debt from `22mn (0.01x debt to equity) in FY05 to NIL in FY10.

 Purchase of Solvay Pharma by parent entity led to India business of Solvay Pharma being acquired by Abbott India in an all-equity deal with swap ratio of 2:3.

FY11-13

Regulatory hurdles led to change in strategy

 Government introduces National Pharmaceutical Pricing Policy (NPPP), 2012, to reduce prices of essential

drugs – 348 drugs came under price control. Biggest impact on MNC pharma companies (including Abbott) which price their products 1.5-2x higher than domestic players.

 Issuance of compulsory licensing policy by the Government weakened IP protection policy of India. This led to

change in parent strategy for launch of new products. Product launches declined from ~20 products annually to high single digits. Majority of these new launches were line extensions with no material innovative product introduced in India. Parent entity shifted focus of new product introduction through its privately held company.

 No material product launch in the innovative space and most new launches were line extensions. Focus was on strengthening presence in existing therapy areas with no new therapy products introduced.

 Focus on lowering the cost structure through introduction of integrated technology platform for supply chain FY14 – Current

The New Normal

and sales representatives. Lowered ad spends from 6-6.5% of sales prior to FY13 to 4% of sales in FY15. This led to margin expansion from 12% in FY13 to 14% in FY16.

 Launched 10 products in FY17, mostly line extensions with innovative campaigns supporting launches; most

of the last 12-24 months sales growth was driven by Women’s Health, Gastro Intestine, Gastroenterology and GI Prospera.

Source: Company, Ambit Capital research

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Abbott India Exhibit 4: Competitive mapping of the company with its key peers FY17 Revenue

Revenue CAGR FY11-17

Median EBITDA margins (FY11-17)

Median RoCE (FY11-17)

Cumulative CFO to EBITDA (FY11-17)

Asset turnover FY17 (x)

GSK

39,865

10%

18%

36%

119%

1.40

Abbott

29,026

19%

12%

33%

101%

2.27

Sanofi

23,686

14%

15%

14%

129%

1.32

Pfizer

19,663

8%

20%

18%

103%

0.85

Merck

9,963

12%

11%

14%

103%

1.66

Company

Source: Company, AIOCD and Ambit Capital research.

Exhibit 5: Mapping Abbott India and its peers on IBAS Abbott

Pfizer

Sanofi

Merck

GSK

Comments

 Pfizer is leveraging on parent entity by consistently launching of 10-15 products annually.

Innovation

 Abbott and Sanofi’s lack of focus on expanding product 

Brand



basket from parent’s portfolio (~5 products launched annually and majority line extensions). Merck and Abbott have strong brand equity with base business growth of 10-12% over FY12-16. Sanofi and GSK have weak brand equity with base business growth of less than 5% over FY12-16.

 Abbott has best in class MR productivity at `9mn per MR while others are at `6mn per MR.

Architecture

 Higher revenue per MR is due to strong brand equity further accentuated by effectiveness of sale force.

 Whilst GSK has average brand equity, with 11 products in

top 100 drugs in India, we expect new product launches to cover up on base business deficit.

Strategic assets

 Merck has no products in top 100 drugs with no new product launches implying fading business.

 GSK and Pfizer score high due to focus on launching new

products and leveraging on brand equity and MR strength.

 Abbott, Merck and Sanofi do not have India as key focus

Overall score

market; no incremental product launch. Further, high dependence (70-80%) on base business with limited number of products in Top 100 increases risk to revenues

Source: Company, Ambit Capital research Note:

- Strong;

- Relatively Strong;

- Average;

- Relatively weak.

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Abbott India Exhibit 6: Margins have stabilized at 14% for the past three years 35,000

15%

30,000

12%

175%

14

150%

12

4

25%

2

0%

0

-

Revenue

FY07

FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

0%

EBITDA Margin (RHS)

FY17

50%

FY16

3%

5,000

FY15

6

FY14

75%

FY13

6%

10,000

FY12

8

FY11

100%

15,000

FY10

20,000

FY09

10

FY08

125%

9%

25,000 ` Bn

Exhibit 7: Five-year average cash conversion ratio at 103%; working capital turnover at ~12x in FY17

Pre tax CFO to EBITDA (x) Working Capital T/O (RHS)

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 8: CFO has been the major source of capital in the last decade

Exhibit 9: Limited capex and high dividend paid out

Capex 17%

Interest Others -21% and dividend received 7% Equity issues -5%

Dividend paid incl. tax 54%

CFO 65%

Net Investmen ts 5%

Cash 24%

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 10: Median pre- tax RoCE in the last 8 years was 34%

Exhibit 11: Current P/E is at 11% to historical 3-year average

40%

50%

35%

40%

30%

30%

25%

20%

20%

10%

25

15%

0%

20

10%

-10%

15

5%

-20%

35

1 - year forward P/E (x)

Source: Company, Ambit Capital research. Note: RoCE refers to Pre-tax RoCE i.e. EBIT divided by average capital employed

Nov-17

Aug-17

May-17

Feb-17

Nov-16

Aug-16

May-16

Feb-16

Nov-15

Aug-15

May-15

30

Feb-15

-30% FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 RoCE EPS growth (RHS)

40

Nov-14

0%

45

3 year Avg. P/E (x)

Source: Company, Ambit Capital research

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Abbott India Exhibit 12: Explanation for our flags Field

Score

Accounting

GREEN

Predictability

GREEN

Earnings momentum

AMBER

Comments In our forensic analysis of 360 companies, Abbott scores above the pharma industry average (comprising 26 companies). Abbott scores high on (a) CWIP to gross block; and (b) contingent liabilities as percentage of networth; and (c) provision for debtors. However, Abbott has weaker scores on: (a) miscellaneous expenses as a % of revenues; and (b) change in depreciation rate. Overall, the management made timely announcements in its earnings calls, meetings and interviews regarding product filings, acquisitions and business outlook. Consensus FY18E EPS estimates have been downgraded by 4% in the last three months.

Source: Ambit Capital research.

Exhibit 13: Forensic score evolution

Exhibit 14: Greatness score evolution

Source: Ambit ‘HAWK’, Ambit Capital research

Source: Ambit ‘HAWK’, Ambit Capital research

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Abbott India

Abridged financial summary Income statement (Rs mn) Net Sales % growth Operating expenditure EBITDA

CY12

FY14**

FY15

FY16

FY17

16,527

22,759

22,893

26,145

29,026

11%

38%

1%

14%

11%

14,513

20,086

19,780

22,508

25,078

2,014

2,673

3,113

3,637

3,948

% growth

15%

33%

16%

17%

9%

Depreciation

195

219

149

144

164

1,819

2,453

2,964

3,493

3,784

0

1

5

25

20

EBIT Interest expenditure Non-operating income Adjusted PBT Tax Adjusted PAT % growth PAT margin

227

493

485

512

602

2,046

2,946

3,444

3,980

4,365

703

961

1,154

1,428

1,598

1,343

1,985

2,290

2,553

2,766

12%

48%

15%

11%

8%

8%

9%

10%

10%

10%

Source: Company, Ambit Capital research. **FY14 is a 15 month period; for FY15 we find the revenue growth by considering 12month sales of FY15.

Balance Sheet (Rs mn) Shareholders' equity

CY12

FY14**

FY15

FY16

FY17

212

212

212

212

212

Reserves & surpluses

6,256

7,666

9,163

11,743

13,657

Total networth

6,469

7,879

9,375

11,956

13,869

Debt

-

-

-

-

-

13

(13)

(65)

(94)

(124)

Sources of funds

6,481

7,866

9,310

11,862

13,746

Net block

1,087

983

960

1,085

1,096

5

5

30

19

51

Deferred tax liability

CWIP Investments

-

-

-

-

-

Cash & Cash equivalents

3,233

4,628

6,439

8,394

10,909

Total current assets

7,979

17,836

21,043

14,958

19,356

Net current assets

5,389

6,871

8,311

10,749

12,587

Applications of funds

6,481

7,866

9,310

11,862

13,746

Source: Company, Ambit Capital research. Note: **FY14 is a 15 month period; for FY15 we find the revenue growth by considering 12month sales of FY15.

Cash flow statement (Rs mn)

CY12

FY14**

FY15

FY16

FY17

Net Profit Before Tax

2,150

2,946

3,444

3,980

4,365

195

219

149

144

164

Others

(287)

(230)

(521)

(384)

(527)

(Incr) / decr in net working capital

(398)

(285)

235

218

658

Tax

(646)

(1,097)

(1,159)

(1,472)

(1,588)

Depreciation

1,013

1,553

2,148

2,487

3,072

Capex (net)

Cash flow from operations

(170)

(41)

(155)

(227)

(214)

Cash flow from investments

(585)

(1,439)

(1,867)

(772)

(1,554)

Cash flow from financing

(420)

(423)

(576)

(803)

(898)

8

(309)

(295)

912

620

1,095

785

490

1,402

2,022

843

1,512

1,993

2,260

2,859

Net change in cash Closing cash balance Free cash flow

Source: Company, Ambit Capital research. Note: **FY14 is a 15 month period; for FY15 we find the revenue growth by considering 12month sales of FY15.

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Abbott India Ratios (Rs mn)

CY12

FY14**

FY15

FY16

FY17

EBITDA margin (%)

12%

12%

14%

14%

14%

EBIT margin (%)

11%

11%

13%

13%

13%

9%

9%

10%

10%

10%

(0.50)

(0.59)

(0.69)

(0.70)

(0.79)

Net profit (bef MI) margin (%) Net debt: equity (x) Working capital turnover (x)

5.80

7.16

7.03

8.65

11.97

Gross block turnover (x)

8.36

11.02

10.78

15.45

22.11

RoCE (pre-tax) (%)

31%

34%

35%

33%

30%

RoIC (pre-tax) (%)

60%

76%

97%

110%

120%

RoE (%)

22%

25%

24%

21%

20%

Source: Company, Ambit Capital research. Note: **FY14 is a 15 month period; for FY15 we find the revenue growth by considering 12month sales of FY15.

Valuation parameters (Rs mn) Diluted EPS (Rs) Book value per share (Rs) P/E (x) P/BV (x) EV/EBITDA (x)

CY12

FY14**

FY15

FY16

FY17

68

93

108

120

130

304

371

441

563

653

74

54

47

42

39

16.6

13.6

11.4

9.0

7.7

52

38

32

27

24

Source: Company, Ambit Capital research. Note: **FY14 is a 15 month period; for FY15 we find the revenue growth by considering 12month sales of FY15.

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Abbott India

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Page 114

Astral Poly NOT RATED ASTRA IN EQUITY

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 (0.3x D/E in FY17 vs 1.5x in FY05). Establishment of Astral’s brand and prudent capital allocation manifested in 35%/31% sales/EPS CAGR and average pre-tax RoCE of 24% over FY07-17. Leading pipe manufacturer to a strong building materials brand With strong branding and promotions over the years, Astral has created a strong brand that does not need the backing of Lubrizol’s name to sell CPVC pipes. With CPVC becoming competitive, Astral took advantage of its brand and changed its raw material supplier from Lubrizol to Sekisui, thereby reducing costs and gaining pricing flexibility over competitors. Astral’s successful foray into adhesives (25% of FY17 revenue) and increase in EBITDA margin is a classic example of capitalizing on its brand. Increasing adhesives capacity, strong promotion of its adhesive brand and strengthened distribution network will provide the next leg of growth for Astral. Near-term valuations futile; challenge to estimate a challenger’s path At 40x FY19 consensus EPS, Astral is one of the most expensive building materials franchises in India. However, Astral’s valuation should be considered in light of: (a) prudent capital allocation history (both organic and inorganic), 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 (albeit non-linear) 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, Pidilite).

Accounting: Predictability: Earnings Momentum:

GREEN GREEN AMBER

Performance 230 180 130

Astral Poly.

Sensex

Source: Bloomberg, Ambit Capital research

Astral’s forensic score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Astral’s greatness score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Research Analysts Nitin Bhasin +91 22 3043 3241 [email protected] Prateek Maheshwari +91 22 3043 3234 [email protected]

[email protected] 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.

Nov-17

Sep-17

80 Aug-17

Despite a ~15% 10-year revenue CAGR for top-5 companies, organised plastic pipes players in India have a long path to chart through: (a) replacement of GI pipes, (b) increasing applications, (c) innovation in plastic compounds and water management systems, and (d) GST adoption. Astral is the 3rd largest and one of the strongest plastic pipes brands and, hence, poised to gain share. Increasing competition drives management’s decision to reinvest capital in business outside pipes and leveraging its brand/reach architecture.

Flags

Jun-17

Pipes – a category with ample room for sustaining innovation

`92/US$1.4 `52.5/US$0.8 `768 n.a. n.a.

May-17

Changes to this position: STABLE

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

Mar-17

Competitive position: STRONG

Recommendation

Feb-17

Astral is evolving from an innovative pipe manufacturing company to a respected pan-India building materials brand (for pipes, adhesives and building maintenance products). Sales/EPS CAGR was 35%/31% and median RoCE was 22% over FY07-17. Astral can grow at similar or marginally lower rates over the next decade as it builds on its brand and architecture (suppliers, channel, employees, plants) to become an ace building materials franchise (akin to legends like Pidilite, Asian Paints). Evolving house construction practices will lead to higher reinvestment opportunities for new-age building products (and brands), keeping growth of the industry and champion franchises high. Management’s challenger mindset (through organic or inorganic approach) keeps sources of growth unknown and hence risk of underestimating long-term growth high. Near-term valuations are futile for such emerging leaders as displayed by similar stories in the past.

Building Materials

Dec-16

Challenger to champion

November 17, 2017

Nov-16

STRATEGY NOTE

Astral Poly Technik Exhibit 1: Evolution of Astral Poly 20 15

35%

Acquisitionof adhesives and becoming a multiple product brand Sales CAGR: 31% Median Pre-tax RoCE: 22%

Scale ramp-up Sales CAGR: 43% Median Pre-tax RoCE: 26%

Product and brand establishment Sales CAGR: 65% Median Pre-tax RoCE: 22%

30% 25%

10 20% 5

15%

0

10% FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

Plastics Revenue (Rs bn) International adhesives revenues (Rs bn)

FY13

FY14

FY15

FY16

FY17

Domestic adhesives revenue (Rs bn) RoCE (pre tax) (RHS)

Source: Company Ambit Capital research. Note: RoCE for the above purpose implies median RoCE for that period

Exhibit 2: Key financial parameters over the last decade (consolidated) (` mn)

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

Revenues

969

1,358

1,924

2,888

4,113

5,827

8,252

10,796

14,299

16,778

18,888

Revenue growth (%)

80%

40%

42%

50%

42%

42%

42%

31%

32%

17%

13%

91

171

140

277

328

395

610

793

782

1,075

1,472

1

2

1

2

3

4

5

7

6

8

12

Net profits EPS (`) CFO

29

101

167

245

501

851

648

672

1,170

2,258

1,142

CFO/EBITDA

31%

60%

84%

71%

106%

114%

64%

58%

85%

123%

60%

FCF

(72)

(35)

(316)

68

230

158

(42)

(286)

315

914

(455)

Gross debt equity (x)

0.4

0.4

0.4

0.4

0.3

0.5

0.4

0.5

0.3

0.3

0.3

RoE (%)

21%

23%

16%

26%

25%

24%

29%

28%

17%

17%

19%

ROCE* (%)

19%

21%

17%

26%

26%

31%

32%

33%

20%

19%

22%

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

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Astral Poly Technik Exhibit 3: The key things to note from evolution Time period

Phase

Key developments

 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

FY04-07

Product and brand Establishment

 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

 Aggressively started brand building initiatives and hired Salman Khan as the brand ambassador. Brandex increased at a 50% CAGR in this phase

FY13-17

Acquisition of Adhesives and building a larger home building material brand

 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

 Launch of other home improvement products from Clean-X partnership Source: Company, Ambit Capital research

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Astral Poly Technik Exhibit 4: Mapping Astral and its piping peers on IBAS Brand Company

Innovation

Rural

Architecture

Urban

Mfg reach

Dstrbn reach

Strategic asset

Overall rank

Comments 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. 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 realestate 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 Has not displayed innovation and does not have differentiated products. A strong agri brand but still not very strong in urban markets; recently tied up with Lubrizol for CPVC pipes and launching its plumbing portfolio aggressively 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 but a leader in rural market for column pipes. Ashirvad also has relationships with Lubrizol for raw material supply No innovation of note in product launches or marketing. Brand is reasonably strong but largely an institutional seller One of the slowest growing pipes companies. Largely an agri pipe manufacturer but has been losing market share to more aggressive peers

Supreme Industries

Astral PolyTechnik

Finolex Industries

Ashirvad Pipes

Prince Jain Irrigation Source: Company, Ambit Capital research

Exhibit 5: Competitive mapping of Astral with its plastic piping peers Company

Piping Capacity FY17 (tons)

FY17 Pipe Pipes and and Fittings Fittings Revenue Revenue CAGR (` mn) FY10-17

Supreme

400,000

24,679

16%

Astral

137,708

14,103

25%

Ashirvad*

108,000

16,141

34%

Finolex

290,000

22,169

15%

Prince

210,646

12,626

19%

Segments

Plants

Overall revenues (FY17) (` mn)

EBITDA Margin (FY17)

Plumbing and Agri

Madhya Pradesh, Rajasthan, West Bengal, Assam, Gujarat, and TN

44,623

17.1%

30%

91%

54%

18,888

14.0%

22%

85%

88%

16,141

15.0%

22%

81%

63%

29,876

18.8%

25%

90%

28%

12,626

12.8%

24%

71%

79%

Plumbing, Agri Gujarat and TN and Industrials Plumbing, Agri Karnataka and Industrials Largely Agri and recently Maharashtra and Gujarat started plumbing Maharashtra, TN, Plumbing and Uttarakhand, Agri Dadra and Nagar Haveli

Pre-tax Pre-tax CapCFO/EBITD RoCE ex/CFO A (FY17) FY10-17 FY10-17

Source: Company, Ambit Capital research;*Ashirvad financials as of FY16 but channel checks suggest that Ashirvad revenues for FY17 were `24bn

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Astral Poly Technik Exhibit 6: Mapping Astral and its building material peers on IBAS Brand Company

Innovation

Rural

Urban

Architecture Mfg reach

Dstrbn reach

Strategic Overall asset rank

Comments

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. Plans to enter into new categories such as ply may not be prudent capital allocation

Somany

Somany 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 though the brand and new products (especially sanitaryware) are resonating with customers

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, though now strengthening. Relationships with Sekisui for raw materials and real-estate developers and plumbers for retail pipes are it's unique architecture; entry into adhesives can create a unique distribution architecture

Cera

Product innovation is 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. Secondly, capital allocation by the promoters, gradual entry into new products and adjacent price points is helping it become stronger than most home building brands

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. Its unique advantage of premium positioning is facing competition from global and some local brands (Jaquar and Cera)

Century Ply

Century has not displayed any major product innovation though the recent launches of WPC, Fibre board and MDF indicate improvement on this front; this product innovation is more like imitation. 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.

Source: Company, Ambit Capital research

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Astral Poly Technik Exhibit 7: CFO and equity were the primary sources of funds

Exhibit 8: Continuous capacity expansion and acquisitions to build on brand were the main uses

Interest recd, 1%

Net borrowings, 12%

Net change in cash, -2%

recent

Dividend paid, 3%

Interest paid, 13%

Equity raises, 24%

Investments in sub/JV, 27%

CFO, 63%

Source: Company, Ambit Capital research

Capex, 59%

Source: Company, Ambit Capital research

Exhibit 9: After stagnating, multiples acquisition performance improved

expanded

as

45 40 35 30 25 20 15 10 5 0

Exhibit 10: Astral’s share price performance vs Sensex; outperformance compounding with patience 2,560 2,060 1,560 1,060

1- year forward P/E (x)

60 Nov-10 Mar-11 Aug-11 Dec-11 Apr-12 Sep-12 Jan-13 May-13 Oct-13 Feb-14 Jun-14 Nov-14 Mar-15 Aug-15 Dec-15 Apr-16 Sep-16 Jan-17 May-17 Oct-17

11-Oct-17

11-Apr-17

11-Oct-16

11-Apr-16

11-Oct-15

11-Apr-15

11-Oct-14

11-Apr-14

11-Oct-13

11-Apr-13

11-Oct-12

560

5 year avg P/E (x)

Source: Company, Ambit Capital research

Astral

SENSEX

Source: Company, Ambit Capital research

Exhibit 11: Explanation for our flags Segment

Score

Accounting

GREEN

Predictability

GREEN

Earnings momentum

AMBER

Comments Astral falls in the top most decile (D1) in Ambit’s accounting framework; the company’s (a) high cash yield (8%), (b) low contingent liabilities as a % of net worth (1%), (c) negligible miscellaneous expenses as a % of total revenues, and (d) low volatility in non-operating income (24bps) stand out. Largely a predictable business. Management has been providing good indication of the progress of the business. Except the sales of newly acquired Seal IT and Kenyan operations, operating metrics are fairly predictable. Consensus EPS downgraded by 6.4% and revenue by 2.0% over the past three months.

Source: Ambit Capital research

Exhibit 12: Astral’ s forensic score evolution

Exhibit 13: Astral’s greatness score evolution; decline on account of acquisition and slowdown in pipes

Source: Ambit ‘HAWK’, Ambit Capital research

Source: Ambit ‘HAWK’, Ambit Capital research

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Astral Poly Technik Balance sheet (consolidated)* (` mn)

FY12

FY13

FY14

FY15

FY16

FY17

112

112

112

118

120

120

1,841

2,414

3,153

6,188

7,084

8,468

938

923

1,420

2,026

1,966

2,274

Total liabilities

2,793

3,422

4,698

8,556

9,388

11,128

Gross block

2,119

2,808

3,766

4,826

4,732

5,978

Net block

1,640

2,150

2,888

3,424

4,314

5,091

CWIP

130

120

82

268

149

250

Cash & Cash equivalents

355

115

10

115

499

166

Net current assets

668

1,037

1,714

2,604

2,289

3,300

2,793

3,422

4,698

8,556

9,388

11,128

Shareholders' equity Total networth Debt

Total assets

Source: Company, Ambit Capital research; EPS adjusted for stock splits

Income statement (consolidated)* (` mn)

FY12

FY13

FY14

FY15

FY16

FY17

5,827

8,252

10,796

14,299

16,778

18,888

EBITDA

827

1,153

1,551

1,683

2,076

2,638

Depreciation

138

181

219

364

418

502

EBIT

689

971

1,332

1,319

1,658

2,136

Adjusted PBT

500

798

1,045

1,095

1,379

2,043

Tax

105

189

252

313

296

562

Adjusted PAT before MI

395

610

793

782

1,083

1,482

Adjusted PAT after MI

395

606

789

759

1,093

1,481

7%

7%

7%

5%

6%

8%

FY12

FY13

FY14

FY15

FY16

FY17

500

798

1,045

1,095

1,315

2,007

77

(440)

(665)

(306)

428

(1,064)

Net Sales

PAT margin Source: Company, Ambit Capital research

Cash flow statement (consolidated)* (` mn) Net Profit Before Tax (Incr) / decr in net working capital Cash flow from operations

851

648

672

1,170

2,258

1,142

Capex (net)

(696)

(681)

(920)

(854)

(1,344)

(1,597)

Cash flow from investments

(680)

(665)

(909)

(3,435)

(2,029)

(1,580)

278

(48)

476

313

(39)

320

-

-

-

2,359

590

1

82

(223)

131

2,371

156

104

155

(33)

(248)

315

914

(455)

Net borrowings Issuance/buyback of equity Cash flow from financing Free cash flow Source: Company, Ambit Capital research

Ratio analysis and Valuation parameters (consolidated)* (` mn)

FY12

FY13

FY14

FY15

FY16

FY17

EBITDA margin (%)

14%

14%

14%

12%

12%

14%

EBIT margin (%)

12%

12%

12%

9%

10%

11%

Net profit (bef MI) margin (%)

7%

7%

7%

5%

6%

8%

Net debt: equity (x)

0.3

0.3

0.4

0.3

0.2

0.2

Gross block turnover (x)

3.3

3.4

3.3

3.3

3.5

3.7

RoCE (post-tax) (%)

24%

24%

25%

15%

15%

16%

RoE (%)

24%

29%

28%

17%

17%

19%

Diluted EPS (`)

3.5

5.4

7.1

6.6

8.7

12.1

Book value per share (`)

16

21

28

52

60

71

117.9

76.3

58.7

62.7

47.8

34.3

P/BV (x)

25.3

19.3

14.8

7.9

7.0

5.9

EV/EBITDA (x)

61.8

44.3

32.9

30.4

24.6

19.4

P/E (x)

Source: Company, Ambit Capital research

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Astral Poly Technik

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Dr Lal PathLabs NOT RATED STRATEGY NOTE

DLPL IN EQUITY

Ready steady grow

Healthcare

Dr Lal PathLabs is the largest diagnostics chain in India by revenues. It recorded 29% sales CAGR and 77% PAT CAGR over FY07-17 led 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 commissionbased referrals by doctors. Sales growth of mid-to-high teens with steady margins and return ratios will continue given low penetration rate of healthcare, socio-economic tailwinds and continued marketshare gains from unorganised players. Valuation of 35x FY19 consensus P/E is justified by potentially higher growth rates than FMCG companies while delivering FMCG-like EBITDA margins and RoIC. Key risks: Price disruption and increased competition from other labs.

Recommendation Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

`73/US$1.1 `109/US$1.7 `872 NA NA

Flags Accounting: Predictability: Earnings Momentum:

GREEN AMBER AMBER

Changes to this position: STABLE 150 130 110 90 70

Dr Lal PathLabs

Sensex

Focus on quality is helping grow market share Diagnostics in India is highly fragmented (unorganised hold 48% market share). Organised chains account for only 15% of revenues. Dr Lal, the largest player, has only 2% market share. Though even globally, the industry is fragmented, leaders 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 leadership led by: 1) shifting of sales from unorganised to organised; 2) geographical expansion beyond North and East; and 3) acquiring smaller/regional labs.

Source: Bloomberg, Ambit Capital research

Investing for growth to ensure competitive advantage sustains

Source: Ambit ‘HAWK’, Ambit Capital research

We believe that 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 more reference labs for capex of Rs1bn (apart from Delhi and Kolkata); 2) continuous expansion of the array of tests; 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 already high RoIC of over 50%, we are not overly concerned.

Dr Lal’s forensic score analysis

Dr Lal’s greatness score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Valuation is attractive as investors focus on long-term growth After the 3QFY17 results, Dr Lal lowered revenue growth guidance to match industry growth of 17-18%, growth potential is still higher than that offered by the consumer discretionary space. The stock de-rated from 43x FY19 consensus P/E to 35x; this valuation is justified as Dr Lal combines higher growth potential of consumer discretionary with the economics of consumer staples.

Research Analysts Abhishek Ranganathan, CFA [email protected] Tel: +91 22 3043 3085 Mayank Porwal [email protected] Tel: +91 22 3043 3214

[email protected] 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.

Nov-17

Sep-17

Aug-17

Jun-17

May-17

Mar-17

50 Feb-17

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 than unorganised peers. More than 20 labs of Dr Lal are certified by National Accreditation Board. With Rs9.1bn in revenues for FY17, 189 labs, 1,759 patient service centers and annual throughput of 29mn+ samples, Dr Lal is the largest diagnostics chain in India. Dr Lal’s 29% sales CAGR over the past 10 years is unlikely to sustain given the high base but a mid-to-high teen growth rate, in line with industry growth, is possible.

Performance

Dec-16

Sustained quality leadership in Indian diagnostics space

Nov-16

Competitive position: MODERATE

November 17, 2017

Dr Lal PathLabs Exhibit 1: Tale of two halves over the past decade 80% 70% 60%

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 the base expanded, smaller players became organised, valuations for M&A moved up, scope for revenue growth moderated and incremental RoCE for this growth declined

50% 45% 40% 35%

50%

30%

40%

25%

30%

20% 15%

20%

10%

10%

5% 0%

0% FY08

FY09

FY10

FY11

FY12

FY13

Pre-tax ROCE (LHS)

FY14

FY15

FY16

FY17

Revenue growth (RHS)

Source: Ambit capital research

Exhibit 2: Key financial parameters over the last decade (` mn)

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

Revenues

945

1,230

1,670

2,373

3,422

4,517

5,579

6,596

7,913

9,124

Revenue growth (%)

24%

30%

36%

42%

44%

32%

24%

18%

20%

27%

Net profits

86

128

252

295

452

557

803

964

1,332

1,552

EPS

1.6

2.4

4.5

3.6

5.6

6.8

9.7

11.6

16.0

18.6

CFO

97

219

317

418

681

881

980

1,218

1,585

1,716

108%

82%

98%

103%

102%

124%

107%

113%

109%

103%

11

80

30

72

346

681

652

865

1,144

1,200

Pre-tax CFO-EBITDA FCF 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%

31%

27%

Pre-tax RoCE (%)

15%

22%

42%

42%

60%

73%

61%

51%

47%

37%

Source: Company, Ambit Capital research.

Exhibit 3: The key things to note from the evolution Time period

Phase

Pre 2005

Dr S.K Lal and Dr Arvind Lal run the company as a family business

2005-2014

Dr Om Manchanda joins as COO and promoted to CEO in 2008

Post 2014

Growth is strong but at a higher cost

Key developments  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 the first Indian Diagnostic chain to get into a Public Private Partnership with the Government of Tripura.  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.  Profits improved significantly, going up from `10mn to `1.8bn over FY06 to FY16.  Level of investments set to rise to ensure growth levels are maintained. This should cap profitability and return ratios.  With two new reference labs coming up, quality of service should improve.  Focus will be firmly on growing in North and East with West and South to be tapped either inorganically or through selected clusters.

Source: Ambit Capital research

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Dr Lal PathLabs Exhibit 4: Competitive mapping of Dr Lal Company

Sub-segment Positioning

FY17 revenue (` bn)

Revenue CAGR FY11-17

Industry market share

EBITDA Margin (FY17)

Pre-tax RoIC (FY17)

Pre-tax CFO/ EBITDA (FY11-17)

Capex/CFO (FY11-17)

Dr Lal

#1

9.1

25%

~2%

27%

78%

109%

39%

SRL

#2

6.4

24%

~2%

18%

9%

98%

108%

Thyrocare

#4

3.1

25%

~1%

38%

35%

108%

30%

Source: Company, Ambit Capital research. Note: SRL nos. are standalone nos.

Exhibit 5: Mapping Dr Lal and its peers on IBAS Dr Lal

SRL

Thyrocare

Metropolis Comments 

Innovation

   

Branding

  

Architecture



Strategic Assets



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

- Relatively high;

Equity Capital 5%

- Average;

- Less

Exhibit 7: Post capex, large sums of money are available for liquid investments

Exhibit 6: CFO was the main source of funds

Dividend/ Interest income 8%

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 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.

 - Highest;

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

  

Overall Source: Company, Ambit Capital research Note:

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.

Debt repayment 1%

Sources of funds (FY08-17)

Interest paid 1%

CFO 87%

Source: Company, Ambit Capital research

Application of funds (FY08-17)

Others 21%

Capex 33%

Dividend 12% Investments 32%

Source: Company, Ambit Capital research

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Dr Lal PathLabs Exhibit 8: Sharp de-rating since November 2016…

Source: Company, Ambit Capital research

Dr Lal

Oct-17

Aug-17

Jun-17

Nov-17

Sep-17

Jul-17

May-17

Mar-17

Jan-17

Nov-16

Sep-16

Jul-16

May-16

Mar-16

0

Apr-17

10

Feb-17

20

Dec-16

30

Oct-16

40

Aug-16

50

Jun-16

60

Feb-16

70

Apr-16

240 220 200 180 160 140 120 100 80 60

Dr Lal's avg. P/E

Dec-15

Dr Lal's 1 yr fwd P/E

Exhibit 9: Dr. Lal has recently underperformed the Sensex…

SENSEX

Source: Company, Ambit Capital research

Exhibit 10: …due to decline in revenue growth trajectory; but RoIC remains high RoIC (LHS)

Revenue growth (RHS)

120%

50%

100%

40%

80%

30%

60% 20%

40%

10%

20% 0%

0% FY11

FY12

FY13

FY14

FY15

FY16

FY17

Source: Company, Ambit Capital research

Exhibit 11: Explanation for our forensic accounting scores Segment

Score

Comments

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 the medium term is fairly predictable, near-term volatility can be high.

Earnings Momentum

AMBER

After beating consensus estimates since listing, Dr Lal has missed consensus estimates constantly since 3QFY17.

Source: Ambit Capital research

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Dr Lal PathLabs Balance sheet Year to March Shareholders' equity

FY13

FY14

FY15

FY16

FY17

164

803

1,108

1,243

1,243

Reserves & surpluses

1,457

1,512

2,303

3,831

5,351

Total networth

1,621

2,315

3,411

5,074

6,595

Minority Interest

16

18

23

29

24

Debt

4

9

0

0

0

(127)

(196)

(254)

(121)

(160)

Total liabilities

1,640

2,342

3,434

5,102

6,619

Net block

1,271

1,400

1,510

1,697

2,078

Cash & equivalents

215

1,057

1,482

2,099

2,383

Debtors

198

252

310

363

418

86

117

143

145

179

Loans & advances

203

347

597

1,079

1,192

Provisions

150

135

192

312

69

1,048

1,173

1,319

1,150

1,020

Deferred tax liability

Inventory

Total current liabilities Net current assets

(520)

(397)

(192)

542

954

Total assets

1,640

2,342

3,434

5,102

6,619

FY13

FY14

FY15

FY16

FY17

4,517

5,579

6,596

7,913

9,124

32%

24%

18%

20%

15%

3,540

4,194

5,036

5,815

6,758

EBITDA

977

1,386

1,560

2,098

2,366

% growth

13%

42%

13%

35%

13%

Source: Company, Ambit Capital research

Income statement Year to March Revenues % growth Operating expenditure

Depreciation

204

272

282

283

282

EBIT

773

1,113

1,278

1,815

2,085

(1)

(56)

(90)

(142)

(187)

Interest expenditure Non-operating income

28

22

29

50

62

Adjusted PBT

802

1,192

1,397

2,008

2,334

Tax Adjusted PAT/ Net profit % growth

245

389

433

675

781

557

803

964

1,333

1,553

23%

44%

20%

38%

16%

Source: Company, Ambit Capital research

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Dr Lal PathLabs Cash flow statement Year to March

FY13

FY14

FY15

FY16

FY17

PBT

802

1,192

1,397

2,007

2,333

Depreciation

204

272

282

283

282

Others ESOPs

250

155

242

(35)

73

(334)

389

433

675

781

Tax (Incr) / decr in net working capital

(28)

(94)

(82)

185

(81)

Cash flow from operations

881

980

1,218

1,585

1,716

Capex

(196)

(328)

(353)

(441)

(516)

Cash flow from investments

(650)

(897)

(1,135)

(1,635)

(1,407)

4

-

(9)

-

-

Net borrowings Issuance of equity

0

-

105

161

36

Dividend paid

(150)

(97)

(104)

(156)

(378)

Cash flow from financing

(148)

(102)

(8)

4

(344)

Closing cash balance

173

158

233

187

152

Free cash flow

685

652

865

1,144

1,200

Source: Company, Ambit Capital research

Ratio analysis Year to March

FY13

FY14

FY15

FY16

FY17

Gross margin (%)

78.5%

78.9%

78.9%

78.1%

78.6%

EBITDA margin (%)

21.6%

24.8%

23.6%

26.5%

25.9%

EBIT margin(%)

17.1%

20.0%

19.4%

22.9%

22.8%

Net profit margin(%)

12.3%

14.4%

14.6%

16.8%

17.0%

-0.5

-0.5

-0.5

-0.5

-0.5

Net debt: equity (x) Gross block turnover (x)

3.08

3.33

3.31

3.32

3.38

Post-tax RoCE(%)

38.4%

37.8%

30.7%

28.3%

22.6%

RoE(%)

40.1%

40.8%

33.7%

31.4%

26.6%

FY13

FY14

FY15

FY16

FY17

6.8

9.7

11.6

16.2

18.9

20.0

28.3

41.5

61.7

80.2

1.1

1.2

1.8

1.9

4.6

132.4

92.4

77.3

55.9

48.0

P/BV (x)

45.1

31.8

21.7

14.7

11.3

EV/EBITDA (x)

74.0

52.3

46.2

34.0

29.8

Price/Sales (x)

16.2

13.2

11.2

9.4

8.2

Source: Company, Ambit Capital research

Valuation parameters Year to March EPS (Rs) Book value per share (Rs) Dividend per share (Rs) P/E (x)

Source: Company, Ambit Capital research

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Cera Sanitaryware NOT RATED STRATEGY NOTE

CRS IN EQUITY

Imitating one of the best Cera ranks second in scale but is the best-run Indian sanitaryware company. It posted 25% revenue and EBITDA CAGR and 24% median RoE over FY07-17, significantly beating closest peer HSIL and tiles players. Continuous capacity additions (first in sanitaryware then faucets and now tiles) and industry leading brandex (~5% of sales; FY07-17) led to high growth, making it a Superbrand. Our concerns over rising competition in sanitaryware/faucets from domestic tile manufacturers in low-mid range and global majors in premium have partly eased. Growth tapered in FY17. But industry leading RoCE remained intact and should improve in FY18 with launch of premium/luxury products and unique home-upgrade platform (imitating Asian Paints). Value creation depends on ability to: (a) increase market share, (b) improve working capital intensity (80 days, highest in building materials); and (c) improve operating efficiencies. Competitive position: MODERATE

Changes to this position: STRONG

Rising competition did not dent CERA’s high RoCE

November 17, 2017 Building Materials Recommendation Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

`43/US$0.7 `37/US$0.6 `3,322 n.a. n.a.

Flags Accounting: Predictability: Earnings Momentum:

GREEN GREEN AMBER

Performance 160

Indian sanitaryware industry posted ~12% CAGR in the past 10 years while Cera clocked 25%. Cera’s continued high RoCE (27% in FY17) partly eased our concern that new entrants (tiles players, global majors) will hit market share and profitability, imparting confidence that rich valuations will sustain. Key concerns: (a) market is relatively small (Rs40bn vs Rs240bn for tiles), (b) organized players have sizable market share (~60%). Though tiles may get Cera more sales, Cera will find it tough to gain significant market share in this segment; globally, few sanitaryware brands have succeeded in tiles and vice versa.

140

A disciplined approach to usurp competition

Source: Bloomberg, Ambit Capital research

120 100

Cera

Sep-16

Jul-16

May-16

Mar-16

Jan-16

Nov-15

80

SENSEX index

rd

A decade back, Cera was 1/3 the size of main peer HSIL. By FY17, Cera increased this to ~91% of HSIL’s building material revenues with much higher profitability (20.7% RoE vs 6.9% for HSIL). Cera’s secret sauce: (a) focus on gradually expanding scale and segments (lifestyle products, faucets, tiles and now home upgrades) 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 the building materials space); (c) controlled overheads; and (d) expanding distribution. Faucets are a 1.7x bigger market than sanitaryware, at Rs40bn-42bn. Faucets market is 40% organised vs 60% for sanitary ware. Strong brand and low-cost manufacturing are key advantages

Cera’s forensic score analysis

Source: Ambit ‘HAWK’, Ambit Capital research

Cera has launched several differentiated products like twin-flush and 4-litre WC ahead of competition. Higher brandex than most peers helped Cera increase premium sales mix to ~40%. It has the second-largest sanitaryware manufacturing capacity (3mn units), strong 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.

Cera’s greatness score analysis

Rich valuations to sustain due to high RoCE and improved portfolio

Source: Ambit ‘HAWK’, Ambit Capital research

Cera trades at 37x FY18 EPS, a marginal discount to Kajaria (39x) and premium to Somany (36x). Rich valuations can sustain; we have seen in the past that strong and stable RoCE keep valuations elevated even if growth decelerates. Despite increasing competition, Cera has been able to maintain RoCE at ~27%. Improvement in product portfolio, entry into premium and mass brand ‘JEET’, and successful entry into home upgrade can strengthen the brand and growth.

Research Analysts Nitin Bhasin +91 22 3043 3241 [email protected] Prateek Maheshwari +91 22 3043 3234 [email protected]

[email protected] 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.

Cera Sanitaryware Exhibit 1: Evolution of Cera Sanitaryware

12,000

Setting the base: Sales CAGR: 26% RoCE: 19%

Building premium brand: Sales CAGR: 26% RoCE: 29%

Product extensions: Sales CAGR: 26% RoCE: 27%

35% 30% 25% 20% 15% 10% 5% 0%

10,000 8,000 6,000 4,000 2,000 FY07

FY08

FY09

FY10

FY11

FY12

FY13

Revenues Rsmn (LHS)

FY14

FY15

FY16

FY17

RoCE pre-tax (%)

Source: Company, Ambit Capital research (RoCE for the above purpose implies Median RoCE for that period)

Exhibit 2: Key financial parameters over the last decade – a steady 25%+ RoCE for last 8 years! (Fig in Rs mn) Revenues Revenue growth (%)

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

1,067

1,281

1,595

1,914

2,430

3,194

4,879

6,637

8,217

9,172

10,066

33%

20%

25%

20%

27%

31%

53%

36%

24%

14%

10%

91

101

147

196

265

320

462

519

677

835

973

Net profits EPS (Rs)

7

8

10

15

21

25

37

41

52

64

76

CFO

124

134

215

255

295

78

424

634

406

1,138

993

CFO-EBITDA

85%

79%

87%

97%

93%

44%

83%

91%

60%

102%

88%

FCF

(98)

(86)

171

228

79

(166)

44

235

(426)

248

274

Debt equity (x)

0.6

0.66

0.50

0.31

0.34

0.34

0.34

0.22

0.19

0.16

0.16

RoE (%)

19%

19%

23%

25%

27%

26%

29%

26%

24%

22%

21%

RoCE* (%)

19%

19%

22%

26%

30%

29%

33%

32%

29%

27%

27%

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.

Exhibit 3: The key things to note from evolution Time period

Phase

Key developments

 In this phase, the company was much smaller than the leader – HSIL. To plug the gap, the company added FY05-08

Setting the base

capacities (to 24,000 MT in FY08 as 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

 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

FY08-12

Product extensions

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  Aggressively started 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 company also plans to enter into a JV in Rajasthan

FY13-17

Building premium brand

 The company trebled its faucetware capacity to 2.34mn pieces in FY15.  D/E reduced to 0.16x in FY17 as against 0.34x in FY13. The company also raised Rs700mn 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

 In FY18 Cera has launched JEET brand of sanitaryware for the mass market  Started new division – Home Upgrade in metros offering hassle-free renovation of bathroom within 5-6 days. Source: Company, Ambit Capital research

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Cera Sanitaryware Exhibit 4: Competitive mapping Sub-segment Positioning

FY17 Revenue

CAGR FY10-17

Industry Market Share

EBITDA Margin (FY17)

Pre-tax RoCE (FY17)

Pre-tax CFO/EBITDA (FY10-17)

Kajaria

#1

25,496

19%

~7-8%

19%

29%

84%

87%

Somany

#2

18,110

19%

~5%

11%

20%

77%

100%

Berger

#2

45,523

13%

~18%

16%

39%

84%

152%

Astral

#2

18,888

31%

~ 6%

14%

21%

78%

88%

Cera

#1

10,066

27%

~ 9%

21%

27%

82%

68%

Century Ply

#1

18,187

7%

~7-8%

17%

24%

78%

153%

Company

Cap-ex/CFO (FY10-17)

Source: Company, Ambit Capital research

Exhibit 5: Mapping Cera Sanitaryware and its peers on IBAS Brand Company

Innovation

Rural

Urban

Architecture Mfg reach

Dstrbn reach

Strategic Overall asset rank

Comments

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. Plans to enter into new categories such as ply may not be prudent capital allocation

Somany

Somany 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 though the brand and new products (especially Sanitaryware) are resonating with customers

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, though now strengthening. Relationships with Sekisui for raw materials and real-estate developers and plumbers for retail pipes are it's unique architecture; entry into adhesives can create a unique distribution architecture

Cera

Products innovation is 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. Secondly, capital allocation by the promoters, gradual entry into new products and adjacent price points is helping it become stronger than most home building brands

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. Its unique advantage of premium positioning is facing competition from global and some local brands (Jaquar and Cera)

Century Ply

Century has not displayed any major product innovation though the recent launches of WPC, Fibre board and MDF indicate improvement on this front; this product innovation is more like imitation. 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.

Source: Company, Ambit Capital research

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Cera Sanitaryware Exhibit 6: Over FY07-17, mostly CFO and a small equity issuance were the key sources of funds (Rs3.4bn)

Exhibit 7: Over FY07-17, funds were mostly expended on capex (Rs2.6bn)

Interest recd, 3%

Net borrowings, 11%

Interest paid, 10%

Dividend paid, 7%

Investments, 12%

Equity issuance, 21%

Net increase in cash, 7%

CFO, 64%

Capex, 65%

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 8: Maintained RoCE despite competition from tiles and international players hence, multiple maintained

Exhibit 9: Cera’s share price performance vs Sensex

1- year forward P/E (x) Source: Company, Ambit Capital research

2,060 1,860 1,660 1,460 1,260 1,060 860 660 460 260 60 Nov-10 Mar-11 Jul-11 Dec-11 Apr-12 Aug-12 Jan-13 May-13 Sep-13 Feb-14 Jun-14 Nov-14 Mar-15 Jul-15 Dec-15 Apr-16 Aug-16 Jan-17 May-17 Oct-17

Nov-17

May-17

Nov-16

May-16

Nov-15

May-15

Nov-14

May-14

Nov-13

May-13

Nov-12

60 50 40 30 20 10 0

5 year avg P/E (x)

Cera

SENSEX

Source: Company, Ambit Capital research

Exhibit 10: Explanation for our flags Segment

Score

Accounting

GREEN

Predictability

GREEN

Earnings momentum

AMBER

Comments Cera falls into the 6th decile on the HAWK framework; in FY14 the forensic score plunged to ‘zone of pain’ from ‘zone of safety’. Whilst the company does well in terms of (a) low contingent liability as % of net worth (at 4%), (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%). 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 Bloomberg shows no significant upgrades/downgrades to consensus numbers in recent weeks.

Source: Ambit Capital research

Exhibit 11: Forensic score evolution

Exhibit 12: Greatness score evolution

Source: Ambit ‘HAWK’, Ambit Capital research

Source: Ambit ‘HAWK’, Ambit Capital research

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Cera Sanitaryware Balance sheet (Rs mn) Shareholders' equity

FY13

FY14

FY15

FY16

FY17

63

63

65

65

65

Reserves & surpluses

1,732

2,176

3,452

4,145

5,159

Total networth

1,795

2,240

3,517

4,210

5,224

610

483

682

351

342

Debt Deferred tax liability Total liabilities

162

202

278

344

357

2,568

2,924

4,477

4,905

5,923

Gross block

1,753

2,117

2,879

3,105

3,682

Net block

1,251

1,517

2,147

2,258

2,664

43

52

77

42

2

CWIP Investments

14

121

478

671

1,151

Cash & Cash equivalents

404

307

295

594

554

Debtors

831

1,066

1,612

1,884

2,207

Inventory

940

1,046

1,259

1,322

1,292

Loans & advances

307

418

572

678

1,087

Other current assets

7

5

3

16

17

2,489

2,842

3,741

4,494

5,157

Current liabilities

897

1,158

1,489

1,872

2,345

Provisions

332

450

477

689

706

Total current liabilities

1,229

1,608

1,965

2,561

3,051

Net current assets

1,260

1,234

1,776

1,933

2,106

Total assets

2,568

2,924

4,477

4,905

5,923

Total current assets

Source: Company, Ambit Capital research. Note: Financials are on Standalone basis

Income statement (Rs mn) Net Sales % growth Operating expenditure

FY13

FY14

FY15

FY16

FY17

4,879

6,637

8,217

9,172

10,092

53%

36%

24%

12%

10%

4,125

5,688

7,041

7,760

8,422

EBITDA

753

949

1,175

1,413

1,670

% growth

41%

26%

24%

20%

18%

Depreciation EBIT Interest expenditure Non-operating income

94

122

155

163

181

659

827

1,021

1,250

1,488

71

64

77

55

34

90

62

66

100

104

Adjusted PBT

678

824

1,009

1,295

1,558

Tax

216

305

333

460

545

Adjusted PAT

462

519

677

835

1,013

Source: Company, Ambit Capital research. Note: Financials are on Standalone basis

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Cera Sanitaryware Cash flow statement (Rs mn)

FY13

FY14

FY15

FY16

FY17

678

824

1,009

1,295

1,558

Depreciation

94

122

155

163

181

Others

45

38

72

(2)

(34)

Tax

(200)

(233)

(296)

(300)

(524)

(Incr) / decr in net working capital

(194)

(118)

(535)

3

(79)

424

634

406

1,159

1,103

Net Profit Before Tax

Cash flow from operations Capex (net)

(380)

(399)

(832)

(241)

(543)

(Incr) / decr in investments

(2)

(108)

(356)

(180)

(465)

Other income (expenditure)

26

26

15

41

48

(356)

(481)

(1,173)

(380)

(960)

134

(128)

199

(331)

(9)

Cash flow from investments Net borrowings Issuance/buyback of equity

-

-

706

-

-

Interest paid

(68)

(63)

(76)

(51)

(33)

Dividend paid

(44)

(59)

(74)

(98)

(141)

Cash flow from financing

22

(250)

755

(480)

(183)

Net change in cash

91

(96)

(12)

299

(40)

Closing cash balance Free cash flow

404

307

295

594

554

44

235

(426)

917

560

Source: Company, Ambit Capital research. Note: Financials are on Standalone basis

Ratio analysis FY13

FY14

FY15

FY16

FY17

EBITDA margin (%)

15%

14%

14%

15%

17%

EBIT margin (%)

14%

12%

12%

14%

15%

9%

8%

8%

9%

10%

11%

12%

12%

14%

0%

0.1

0.0

(0.0)

(0.2)

(0.3)

12.1

12.4

9.1

9.5

11.6

Net profit margin (%) Dividend payout ratio (%) Net debt: equity (x) Working capital turnover (x) Gross block turnover (x)

3.2

3.4

3.3

3.1

3.0

RoCE (pre-tax) (%)

33%

32%

29%

29%

29%

RoIC (pre-tax) (%)

41%

39%

36%

36%

38%

RoE (%)

29%

26%

24%

22%

21%

Source: Company, Ambit Capital research. Note: Financials are on Standalone basis

Valuation parameters (Rs mn)

FY13

FY14

FY15

FY16

FY17

EPS (Rs)

36.5

41.0

52.0

64.2

77.9

Book value per share (Rs)

142

177

270

324

402

Dividend per share (Rs)

4.0

5.0

6.3

9.0

-

P/E (x)

95.32

84.86

66.91

54.24

44.68

P/BV (x)

24.54

19.67

12.87

10.75

8.67

EV/EBITDA (x)

60.4

47.7

38.4

31.5

26.5

EV/EBIT (x)

69.0

54.8

44.3

35.7

29.7

Source: Company, Ambit Capital research. Note: Financials are on Standalone basis

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REPCO Home Finance NOT RATED REPCO IN EQUITY

Performance 180 160 140 120 100 80

Repco Home Fin.

Sensex

Source: Bloomberg, Ambit Capital research

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 ~38bps 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. Can the stock rerate? Multiple pain-points of demonetization, RERA and non-registration of unapproved plots in Tamil Nadu (~62% of AUM) have driven sharp deterioration in Repco’s growth and asset quality over the past 5 quarters. Consequently, Repco’s EPS CAGR moderated to 18% in 1HFY18 versus 21% over FY16-17 and 28% over FY10-15. Consequently, valuations too de-rated sharply from 4.5x one-year forward P/B to 2.7x one-year forward P/B in past year. We believe that valuations will re-rate only on improving growth visibility – which is now lacking due to weak growth trends (disbursement decline of 14% YoY in 2QFY18). Moreover, the looming regulatory risk of convergence of loan pricing to a more transparent and objectively calculated base rate (which is followed by banks) can structurally impair the premium valuations of HFCs.

Research Analysts Aadesh Mehta, CFA +91 22 3043 3239 [email protected] Pankaj Agarwal, CFA +91 22 3043 3206 [email protected]

[email protected] 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.

Nov-17

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 (24% CAGR over FY12-17, 16% in FY17) due to regulatory and competitive headwinds. However, shifting gears to LAP ensured Repco’s loan growth and profitability remained respectable. This led to Repco posting at least 26% AUM CAGR and average RoA of 2.4% over FY12-17 (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 FY12-17.

GREEN AMBER AMBER

Sep-17

Increasing LAP offset declining growth and profitability in home loans

Accounting: Predictability: Earnings Momentum:

Aug-17

Set up in 2000, Repco provides housing and LAP loans to the vastly underpenetrated informal segment (non-salaried; 60% of loan book), with focus on the four South Indian states (~90% of loan book). With a modest loan book of ~`93bn, the bulk of it home loans, Repco delivered ~37% loan book CAGR of over FY06-17 with average RoE of 21%, making it a promising play on housing finance to the informal segment in India.

Flags

Jun-17

Play on the under-penetrated informal segment

`38/US$0.6 `187/US$2.9 `614 NA NA

May-17

Changes to this position: NEGATIVE

Mcap (bn): 3M ADV (mn): CMP: TP (12 mths): Downside (%):

Mar-17

Competitive position: MODERATE

Recommendation

Feb-17

Repco’s decade-long earnings momentum (24% EPS CAGR, 26% AUM CAGR, and average RoE of 22% over FY06-16) was 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 cost) and an innovative origination strategy (avoids sourcing through DSAs unlike other HFCs). We believe that valuations will re-rate (2.7x 1-year forward P/B) only on improving growth visibility – which is now lacking due to weak growth trends (disbursement decline of 14% YoY in 2QFY18).

BFSI

Dec-16

Swimming against the tide

November 17, 2017

Nov-16

STRATEGY NOTE

REPCO Home Finance Exhibit 1: Evolution of Repco – Repco’s growth has moderated as the base effect is now over Strong growth from a very low base AUM CAGR 45% RoAs 3.0%

100 80

Growth moderation AUM Growth 26% RoAs 2.3%

30% 25%

60

20%

40

15%

20

10%

FY06

FY07

FY08

FY09

FY10

FY11

FY12

AUM (Rs bn)

FY13

FY14

FY15

FY16

FY17

RoEs (RHS, %)

Source: Company, Ambit Capital research

Exhibit 2: Repco – key financial parameters over the last decade (Fig in ` mn)

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

Total NII

4.0%

4.3%

5.2%

4.9%

4.2%

3.9%

4.6%

4.5%

4.5%

4.9%

Other Income

1.0%

0.9%

0.8%

0.7%

0.5%

0.5%

0.5%

0.4%

0.4%

0.0%

Total Income

5.0%

5.2%

6.0%

5.6%

4.8%

4.3%

5.0%

4.9%

5.0%

4.9%

Opex

1.2%

0.8%

0.8%

0.8%

0.8%

0.7%

0.9%

1.0%

1.0%

0.8%

Operating Profit

3.8%

4.4%

5.2%

4.7%

4.0%

3.6%

4.1%

3.9%

4.0%

4.1%

Provisions and write-offs

0.1%

0.3%

0.3%

0.3%

0.4%

0.3%

0.5%

0.4%

0.6%

0.6%

PBT

3.7%

4.1%

5.0%

4.4%

3.6%

3.3%

3.6%

3.5%

3.4%

3.5%

Taxes

1.0%

1.2%

1.4%

1.2%

0.8%

0.8%

0.9%

1.2%

1.2%

1.2%

ROA

2.7%

2.9%

3.6%

3.2%

2.8%

2.5%

2.6%

2.3%

2.2%

2.2%

6.4

6.1

7.2

8.2

9.0

6.9

6.1

6.8

7.6

7.7

17.4%

17.7%

26.0%

26.2%

24.9%

17.1%

16.0%

15.8%

17.0%

17.4%

50%

52%

41%

47%

35%

26%

32%

29%

28%

16%

5%

61%

48%

27%

8%

29%

3%

12%

22%

21%

Leverage ROE AUM growth (%, YoY) EPS growth (%, YoY) Source: Company, Ambit Capital research.

Exhibit 3: From a high growth phase of FY06-12, Repco is now going through a steady-state growth phase Time period

Phase

Key developments 

The honeymoon period

FY06-12

 

  Growth moderation

FY12Current 

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 in. Consequently, both growth and profitability remained high during this period (AUM CAGR of 45% and RoA of 3%). Homeloans were the key growth and profitability driver, growing at 46% CAGR and accounting for 86% of the AUM mix in FY12. 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 faced 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 also led 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 24% CAGR over FY12-17 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 FY17). This somewhat offset the lower profitability from the business and enabled it to still deliver a respectable RoA of 2.5% during this period.

Source: Ambit Capital research

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REPCO Home Finance Exhibit 4: Competitive mapping of HFCs – Repco’s small-ticket positioning drives its sustainable growth Avg. ticket size (Rs mn)

AUM (Rs bn)

AUM CAGR (FY13-17)

NIMs

Opex/ AUM

Gross NPA (%)

RoA

RoE

REPCO

1.4

89

26%

4.8%

0.8%

2.60%

2.2%

17.4%

157

625

GRUH

0.6

132

25%

4.3%

0.8%

0.31%

2.5%

30.5%

185

661

HDFC

2.6

3,378

16%

3.0%

0.2%

0.79%

1.5%

19.1%

427

2,196

LICHF

1.3

1,445

17%

2.7%

0.5%

0.43%

1.5%

19.5%

245

1,833

CANFIN

1.8

133

35%

3.5%

0.7%

0.21%

1.9%

24.1%

170

578

DEWAN

1.4

836

23%

2.7%

0.8%

0.94%

3.6%

18.0%

352

2,881

PNBHF

3.7

415

58%

3.7%

1.0%

0.22%

1.4%

13.6%

63

999

Key metrics (FY17)

Branches (#)

Employees (#)

Source: Company, Ambit Capital research

Exhibit 5: Mapping Repco 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 ~427 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

REPCO comes out as a middle rung HFC owing to lack of a strong credit rating.

Source: Company, Ambit Capital research Note:

- Strong;

- Relatively Strong;

- Average;

- Relatively weak.

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Page 137

REPCO Home Finance Exhibit 6: Repco has delivered robust loan book growth 70% 60%

AUM mix (%) 100%

57% 47%

50%

47% 26%

30% 14%

20%

16% 15% 14% 15% 19% 19% 20% 20%

80%

29% 32% 27%

35%

40%

31% 28% 16%

60%

12%

84% 85% 86% 85% 81% 81% 80% 80%

40%

10% 0% -10%

Exhibit 7: Increasing share of LAP has sustained growth

20% -7% FY11 FY12 FY13 FY14 FY15 FY16 FY17 Disbursements growth

0% FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Mortgages LAP

AUM growth

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 8: Repco’s liability mix is tilted towards banks

Exhibit 9: Repco’s asset quality has worsened of late 3.0%

15%

15%

NHB Refinancing

2.5%

Banks

2.0%

7% Repco Bank

1.5%

1.3% 1.0%

1.0% 0.5%

NCDs

2.6%

0.1%

1.2% 1.2%

1.4%

1.5% 1.5%

0.3% 0.3% 0.3% 0.4% 0.3%

0.6%

1.3% 1.3%

0.4%

0.6% 0.6%

Gross NPA (%)

FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY08

63%

FY09

0.0%

Credit Costs as a % of AUM

2.0

0

1.5 Oct-17

Jun-17

Source: Bloomberg, Ambit Capital research

Feb-17

-1 SD

Oct-16

Jun-16

Avg. PB

Feb-16

Oct-15

Jun-15

Feb-15

Oct-14

Jun-14

Feb-14

Oct-13

Jun-13

PB

Repco

+1 SD

Jul-17

100 Mar-17

2.5

Nov-16

200

Jul-16

3.0

Mar-16

300

Nov-15

3.5

Jul-15

400

Mar-15

500

4.0

Nov-14

600

4.5

Mar-13

5.0

Jul-14

Exhibit 11: Repco – share price performance versus Sensex

Mar-14

Exhibit 10: Repco is trading at 25% discount to its crosscycle average P/B

Nov-13

Source: Company, Ambit Capital research

Jul-13

Source: Company, Ambit Capital research

Sensex Index

Source: Bloomberg, Ambit Capital research

Exhibit 12: Explanation for our flags Segment

Score

Comments

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

AMBER

Repco’s earnings trajectory has been difficult to predict of late as it asset quality trends have been highly volatile.

Earnings momentum

AMBER

Repco’s recent earnings growth in 1HFY18 (~18%) has moderated from FY12-17 run-rate of 22% CAGR.

Source: Ambit Capital research

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Page 138

REPCO Home Finance Income statement Year to March (Rs mn)

FY13

FY14

FY15

FY16

FY17

NII (inclu. Securitisation)

1,255

1,908

2,376

3,039

3,978

Other income

147

198

236

297

16

Total income

1,402

2,106

2,612

3,336

3,994

242

388

547

642

675

1,160

1,718

2,066

2,694

3,319

92

227

204

393

519

Operating expenditure Pre-provisioning profit Provisions Profit before tax

1,068

1,491

1,862

2,301

2,800

Tax

268

390

632

800

981

Consol. PAT

800

1,101

1,230

1,501

1,819

Source: Company, Ambit Capital research

Balance sheet Year to March (Rs mn)

FY13

Net-worth Borrowings - on balance sheet

FY14

FY15

FY16

FY17

6,345

7,411

8,121

9,548

11,372

30,645

39,020

51,044

65,379

75,604

Borrowings - off balance sheet

-

-

-

-

-

Total liabilities

36,990

46,431

59,165

74,927

86,976

AUM

35,447

46,619

60,129

76,912

89,399

Cash and equivalents

2,182

343

299

324

381

Net Current Assets

(639)

(531)

(1,263)

(2,309)

(2,804)

36,990

46,431

59,165

74,927

86,976

Total assets Source: Company, Ambit Capital research

Key ratios Year to March (Rs mn)

FY13

FY14

FY15

FY16

FY17

NIM % (on AUM)

4.0%

4.7%

4.5%

4.4%

4.8%

AUM Growth

26%

32%

29%

28%

16%

Opex as % of AAUM

0.76%

0.95%

1.02%

0.94%

0.81%

Credit costs as a % of AUM

0.29%

0.55%

0.38%

0.57%

0.62%

CAR (%)

25.5%

24.5%

20.3%

20.8%

20.8%

Source: Company, Ambit Capital research

Valuation parameters Year to March (Rs mn)

FY13

FY14

FY15

FY16

FY17

Dil EPS – Consol (Rs)

17.1

17.6

19.7

24.1

29.1

BVPS (Rs.)

135

119

130

153

182

ROA (%)

2.5%

2.6%

2.3%

2.2%

2.2%

ROE (%)

17.1%

16.0%

15.8%

17.0%

17.4%

P/B (x)

4.6

5.2

4.8

4.1

3.4

P/E (x)

36.5

35.3

31.6

25.9

21.4

Source: Company, Ambit Capital research

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Page 139

REPCO Home Finance

Institutional Equities Team Saurabh Mukherjea, CFA

CEO, Ambit Capital Private Limited

(022) 30433174

[email protected]

Pramod Gubbi, CFA

Head of Equities

(022) 30433124

[email protected]

Research Analysts Name

Industry Sectors

Nitin Bhasin - Head of Research

E&C / Infra / Cement / Home Building

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Desk-Phone

E-mail [email protected]

Aadesh Mehta, CFA

Banking / Financial Services

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Retail / Consumer Discretionary

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Economy / Strategy

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Anuj Bansal

Consumer

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Ariha Doshi

Consumer

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Automobiles / Auto Ancillaries

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Gaurav Kochar

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Strategy / Derivatives

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Banking / Financial Services

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Utsav Mehta, CFA

E&C / Infrastructure

(022) 30433209

[email protected]

Vivekanand Subbaraman, CFA

Media / Telecom

(022) 30433261

[email protected]

Sales Name

Regions

Sarojini Ramachandran - Head of Sales

UK

Desk-Phone

Anmol Arya

India

(022) 30433079

[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]

Punitraj Mehra, CFA

India / Asia

(022) 30433198

[email protected]

Shaleen Silori

India

(022) 30433256

[email protected]

Praveena Pattabiraman

Singapore

+65 6536 0481

[email protected]

Shashank Abhisheik

Singapore

+65 6536 1935

[email protected]

+44 (0) 20 7886 2740

E-mail [email protected]

Singapore

USA / Canada Hitakshi Mehra

Americas

+1(646) 793 6751

[email protected]

Achint Bhagat, CFA

Americas

+1(646) 793 6752

[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]

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 140

REPCO Home Finance HCL Technologies Ltd (HCLT IN, SELL)

HDFC Bank Ltd (HDFCB IN, SELL)

1,500

HCL Technologies Ltd

Aug-17

May-17

Feb-17

Nov-16

Aug-16

May-16

Feb-16

Nov-15

Nov-14

Aug-17

May-17

Feb-17

Nov-16

Aug-16

May-16

Feb-16

Nov-15

Aug-15

May-15

Feb-15

Nov-14

0

Aug-15

500

May-15

1,000

Feb-15

2,000 1,500 1,000 500 0

HDFC Bank Ltd

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Lupin Ltd (LPC IN,NOT RATED)

LIC Housing Finance Ltd (LICHF IN, SELL)

3,000 2,000 1,000 0

1,000 500

Lupin Ltd

Aug-17

May-17

Feb-17

Nov-16

Aug-16

May-16

Feb-16

Nov-15

Aug-15

May-15

Feb-15

Nov-14

Jul-17

Apr-17

Jan-17

Oct-16

Jul-16

Apr-16

Jan-16

Oct-15

Jul-15

Apr-15

Oct-14

Jan-15

0

LIC Housing Finance Ltd

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Page Industries Ltd (PAG IN, BUY)

GRUH Finance (GRHF IN, NOT RATED) 560

30,000 20,000 10,000 0

540

Oct-17

Sep-17

Aug-17

Jul-17

Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

Nov-16

Dec-16

500

Aug-17

May-17

Feb-17

Nov-16

Aug-16

May-16

Feb-16

Nov-15

Aug-15

May-15

Feb-15

Nov-14

520

Page Industries Ltd GRUH Finance Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Amara Raja (AMRJ IN, NOT RATED)

Abbott India (BOOT IN, NOT RATED)

1,100

6,500

900

4,500

700

2,500 Jul-17

Aug-17

Sep-17

Oct-17

Aug-17

Sep-17

Oct-17

Jun-17

May-17

Jul-17

Amara Raja

Apr-17

Mar-17

Feb-17

Jan-17

Dec-16

Oct-17

Sep-17

Aug-17

Jul-17

Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

Dec-16

Nov-16

Nov-16

500

500

Abbott India

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Astral Poly (ASTRA IN, NOT RATED)

Dr Lal PathLabs (DLPL IN, NOT RATED)

900

1,500

700

1,000 Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

Dr Lal PathLabs

Astral Poly. Source: Bloomberg, Ambit Capital research

Dec-16

Oct-17

Sep-17

Aug-17

Jul-17

Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

Dec-16

Nov-16

Nov-16

500

500

Source: Bloomberg, Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 141

REPCO Home Finance Muthoot Cap. Serv. (MTCS IN, NOT RATED)

Repco Home Fin.

Oct-17

Sep-17

Aug-17

Jul-17

Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

750 700 650 600 550 500 Dec-16

Oct-17

Sep-17

Aug-17

Jul-17

Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

Dec-16

Nov-16

1,000 900 800 700 600 500

Nov-16

Repco Home Fin. (REPCO IN, NOT RATED)

Muthoot Cap. Serv.

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Cera Sanitary. (CRS IN, NOT RATED) 4,500 2,500

Oct-17

Sep-17

Aug-17

Jul-17

Jun-17

May-17

Apr-17

Mar-17

Feb-17

Jan-17

Dec-16

Nov-16

500

Cera Sanitary. Source: Bloomberg, Ambit Capital research

[email protected] November 17, 2017

Ambit Capital Pvt. Ltd.

Page 142

REPCO Home Finance Explanation of Investment Rating Investment Rating

Expected return (over 12-month)

BUY

>10%

SELL NO STANCE

<10% 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

* In case the recommendation given by the Research Analyst becomes inconsistent with the rating legend, the Research Analyst shall within 28 days of the inconsistency, take appropriate measures (like change in stance/estimates) to make the recommendation consistent with the rating legend.

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, Merchant Banker 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 Canadian Persons 10. 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. 11. AMBIT Capital's head office or principal place of business is located in India. 12. All or substantially all of AMBIT Capital's assets may be situated outside of Canada. 13. It may be difficult for enforcing legal rights against AMBIT Capital because of the above. 14. 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. 15. Name and address of AMBIT Capital's agent for service of process in the Province of Québec is Torys Law Firm LLP, 1 Place Ville Marie, Suite 1919 Montréal, Québec H3B 2C3 Canada. Additional Disclaimer for Singapore Persons 16. 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. 17. 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. Additional Disclaimer for UK Persons 18. 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. 19. 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. 20. 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. 21. 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. 22. 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. 23. 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. 24. 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.

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Page 143

REPCO Home Finance 25. 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. 26. 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. 27. 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. 28. 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. Additional Disclaimer for U.S. Persons 29. 30. 31. 32. 33.

The research report is solely a product of AMBIT Capital AMBIT Capital is the employer of the research analyst(s) who has prepared the research report Any subsequent transactions in securities discussed in the research reports should be effected through Enclave Capital LLC. (“Enclave”). Enclave does not accept or receive any compensation of any kind for the dissemination of the AMBIT Capital research reports. 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.

34. 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. 35. As of the publication of this report Enclave Capital LLC, does not make a market in the subject securities. 36. 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. 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 HDFC Bank Ltd 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 2017 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

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