Thematic: QARP Report

Quality at Reasonable Price

Mid- and small-cap indices had a dream run from January 2017 to January 2018—had zoomed 48%
and 56%, respectively—fuelled by easy liquidity and strong flows in mutual funds. However, post
January 2018, these indices slipped into correction mode due to the China–US trade dispute,
introduction of LTCG, NBFC crisis, among others. We believe, the tide is about to turn and expect
the small- and mid-cap space to outperform. Our conviction is anchored by: a) attractive valuations;
b) improving macro data; and c) uptick in sectoral trends. These, we believe, point to an imminent
bounce back.

I. Some pain before gain

Correction in small- and mid-cap indices not commensurate with fundamental performance
Over the past one year, Nifty and mid-cap & small-cap indices have seen higher correction versus
the large-cap Nifty index despite registering higher profit growth. While Nifty has returned 4% over
the past one year despite clocking 7% overall PAT growth, mid-cap and small-cap indices have
corrected 15% and 24% despite posting 50% and 27% PAT growth, respectively. The mid-cap index’s
PAT is expected to grow significantly in the ensuing one year led by improvement in performance
of PSU banks, amongst other factors (Source : Bloomberg).

PAT vs. Market return

47.6%

26.3%

3.9% 6.7%

-15%
-24%
Nifty NSE Midcap Index BSE Small Cap Index
Price Growth PAT Growth
Source: Edelweiss Professional Investor Research
Mid cap Adjusted for PSU Banks
Small cap adjusted for PSU and Reliance Communications

Quality outperforms during market corrections

• Generally, during periods of market correction, quality small-cap companies with better return
ratios bear less brunt of market correction compared to rest of the lot.
• This was evident during both market corrections—2008/09 and 2013/14—where companies
with RoCE in excess of 15% had experienced a drawdown of 46% and 10%, respectively,
compared to 68% and 33% average drawdown, respectively, from peak for rest of the
companies.
• Rebounds in quality stocks are also significantly stronger—while companies with 15% plus RoCE
had more than tripled from the bottom hit in 2008/09, the overall mid-cap universe had
catapulted 179% over a year.

Date: 28th February 2019

Edelweiss Professional Investor Research 1

 All companies painted with the same brush this time
• This time around, the correction has been more broad based—companies with RoCE in excess
of 15% slipped by 35% from peak and rest of the pack also corrected by 35%. This, we believe,
is an excellent opportunity to BUY quality mid- and small-cap companies at reasonable
valuations.

Correction has been broad based compared to past corrections

2008/09 2013 2018/19

-10%

-33% -35%
-37%
-46%

-68%
Stocks with RoCE below 15% in Nifty Midcap Stocks with RoCE above 15% in Nifty Midcap

Market has given considerable return post correction

173.3
156.6

124.7
100 100 100 100
90
75.6
66
54

28

2008/09 2013 2008/09 2013

Stocks < 15% ROCE Stocks > 15% ROCE

Invested Value at Bottom Value after 1 year from bottom

Source: Edelweiss Professional Investor Research

Edelweiss Professional Investor Research 2

 II. Why buy now?
A. Attractive valuations
Improvement in overall sentiments had spurred a revaluation of the mid-cap index in 2014.
However, due to the recent correction, one-year forward PE for the NSE Mid-Cap Index has
contracted 40%—to 15x in February 2019 from 26x in December 2017. With the recent
correction in the index, mid-cap valuation saw mean reversion and fell below long-term
average of 16x. Historical evidence indicates that post mean reversion, revaluation happens at
a significant pace. Hence, we anticipate history to repeat itself in case of the mid-cap index in
the near to medium term.

Nifty Midcap P/E Chart

30

25

20

15

10

5
Dec-06

Jun-09
Nov-09

Dec-11

Jun-14
Nov-14

Dec-16
Jul-06

Oct-07

Jul-11

Jul-16
Sep-05
Feb-06

Sep-10
Feb-11

Oct-12

Sep-15
Feb-16

Oct-17
Aug-08

Apr-10

Aug-13

Apr-15

Aug-18
May-07

Mar-08

Jan-09

May-12

Mar-13

Jan-14

May-17

Mar-18

Jan-19
Nifty Midcap 1 yr Fwd PE Average PE

Source: Edelweiss Professional Investor Research

Mid caps trading at a discount to Nifty: A multi-year low

Moreover, valuations for the mid-cap index are now trading at a discount to Nifty. The current ratio
is near a decade’s low, indicating minuscule downside in the mid-cap index from the current level,
unless Nifty’s valuations get suppressed further.

Nifty Midcap Ratio Chart

1.5 1.5
1.4

1.3

1.2
1.2
1.1 1.1

1.0
1.0 1.0
0.9

0.8
Jun-11

Nov-11

Jun-16

Nov-16
Dec-13

Dec-18
Jul-13

Oct-14

Sep-17

Jul-18
Apr-12

Sep-12

Feb-13

May-14

Apr-17

Feb-18
Mar-10

Aug-10

Mar-15

Aug-15
Jan-11

Jan-16

Nifty Midcap to Nifty PE Low Average

Source: Edelweiss Professional Investor Research

Edelweiss Professional Investor Research 3

 B). Macro economy trend indicates demand uptick
a) Nominal GDP on the rise
One of the drags on corporate profitability has been sub-optimal revenue growth. We believe,
nominal growth is a key underlying factor which propels revenue growth and thus could be ‘a pull’
to higher volume growth as well. India has gone through one of the worst disinflationary phases
recently and its nominal growth has contracted 400bps over the past five years in comparison to
the previous decade.

However, in Q1FY19, nominal GDP has been on an uptick and we expect the momentum to sustain.
We envisage enhanced money supply and reversal of low inflationary trend to induce significant
buoyancy.

Nominal GDP Expected to Rise Low Inflation Closing the Gap

25

19
20
17
15.3
15 15
% YoY
% YoY

13
10.9
11 10

9
5
7

5 0
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
2018-19

1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
2018-19
Nominal GDP Nominal GDP Average Nominal GDP Real GDP

Source: Edelweiss Professional Investor Research

India’s real interest rates are one of the highest in the world. However, RBI’s monetary policy stance
has changed recently to more accommodative, evident from the recent cut in the repo rate. This is
also likely to fuel liquidity and reinflate the economy, boosting nominal growth.

Repo Rate Coming Down

6.6
6.5
6.4
6.3
6.2
%

6.1
6.0
5.9
5.8
5.7
Jul-18
Jun-18
Apr-18

May-18

Nov-18
Feb-18

Mar-18

Jan-19
Aug-18

Sep-18

Dec-18

Feb-19
Oct-18

Source: Edelweiss Professional Investor Research

Edelweiss Professional Investor Research 4

 b) Populist budget boost to consumption
Union Budget 2019 has ensured that the government’s revenue expenditure continues to grow at
a rapid pace. In addition to announcement of higher MSP prices, increase in dearness allowance,
income support schemes and sustained focus on MGNERGA, the central government has focused
on efficiently transferring funds via direct benefit transfers (DBT).

We believe, this makes every incremental expenditure more impactful on India’s consumption
economy. The Income Support Scheme announced in the interim budget is a significant measure to
support rural consumption recovery. The support of INR6,000 p.a. to 12crore small and marginal
farmers is likely to fuel low-ticket consumption items. This boost can enhance India’s nominal GDP
by 15-20bps. Overall, spending on social scheme has been raised 42% to INR1.9tn.

Cumulative Govt Schemes ( Trn)

1.9

1.4

FY19 FY20

Source: Edelweiss Professional Investor Research

Edelweiss Professional Investor Research 5

 C. Sectoral trends reinforce macro trends
Moreover, sectoral data indicates palpable improvement in pivotal sectors—Banking,
Consumption, Infra and Cement.

a) Banking sector on the mend: The banking sector has seen 2 mega trends: a) credit growth is
making a comeback post sliding for 2 years. System-wide loans & advances have clocked the
highest growth in the past 18 quarters aided by rebound in the industry and service sector
growth; and b) gross NPLs have dipped by INR578bn over Q4FY18-Q3FY19 and from 12.52% to
10.76% of the system-wide loans & advances.

We expect the asset quality pain to remain moderate on account of: a) overall reduction in watch
list & drill down loans; and b) recognition of majority of stressed sector loans.

System wide Gross NPA trending down (INR bn) Credit growth highest in 18 quarters
25%
Credit Growth Industry loans growth
Gross NPA
20%
10,245
9,667 13%
15%
11% 10%
9%
10%
7,117 4%
4%
5%

0%
Q4FY17

Q1FY18

Q2FY18

Q3FY18

Q4FY18

Q1FY19

Q2FY19

Q3FY19

-5% -4%

Dec-17
Dec-14

Jun-15

Dec-15

Jun-16

Dec-16

Jun-17

Jun-18

Dec-18
Sep-14

Sep-15

Sep-16

Sep-17

Sep-18
Mar-15

Mar-16

Mar-17

Mar-18
Source: Edelweiss Professional Investor Research

Edelweiss Professional Investor Research 6

 b) Robust growth in staples and discretionary consumption likely: The FMCG sector continues
to thrive, fuelled by robust volume performance. Q3FY19 numbers further reinforce this with
our overall FMCG basket (of 7 stocks) posting 12.3% YoY growth. They have clocked double digit
growth over the past 5 quarters. This is a testimony to improving macro scenario and strong
pick up in rural growth led by the government's potent initiatives—announcements made
under interim budget will definitely spur volume off take, especially in rural markets.

We believe, staples as well as discretionary companies are in a sweet spot with price hikes in
the offing and government sops reflating the rural economy, in turn, ensuring sustenance of
volume spurt. Moreover, brown goods too have been clocking decent growth over the past few
quarters.

Brown Goods- Revenue growth trending

FMCG - Strong Revenue Growth
upward
14.2%
13.1% 12.4% 12.3% 21.9%
10.9%
17.4% 16.8%
7.3%
11.1% 10.9%
5.4%
2.5%
0.6%

Q1FY18 Q2FY18 Q3FY18 Q4FY18 Q1FY19 Q2FY19 Q3FY19 1QFY18 2QFY18 3QFY18 4QFY18 Q1FY19 Q2FY19 Q3FY19

Source: Edelweiss Professional Investor Research

c) Infrastructure sector maintaining momentum: Our coverage universe of 7 stocks in India’s

infrastructure sector has maintained momentum over the past few quarters. After registering
13% CAGR over FY13-18, the industry maintained healthy growth in 9mFY19. Average YoY
industry revenue growth over the past three quarters was a whopping 28%.

The biggest changes in the infrastructure space over the past 2 years were disciplined bidding,
timely execution and focus on deleveraging. Hence, not only have revenue and order books
expanded, but growth has percolated to margin as well. Over the past two years, Q3 operating
margins have improved 153bps to 10.5% and PAT margins have jumped 172bps to 5.7%.

Third quarter revenue grew at 17% CAGR over last two

3rd quarter EBITDA grew at 27% CAGR over last two years
years

60000 6000 5249 12%

50197 30%
50000 40408 25% 5000 11%
36605 24% 3961
40000 20% 4000 3268 10%
9.8% 10.5%
30000 15%
(INR Cr)

3000 9%
(INR Cr)

20000 10% 8.9%

10% 2000 8%
10000 5% 5%
0 0% 1000 7%
3QFY17

4QFY17

1QFY18

2QFY18

3QFY18

4QFY18

1QFY19

2QFY19

Q3FY19

0 6%
3QFY17

4QFY17

1QFY18

2QFY18

3QFY18

4QFY18

1QFY19

2QFY19

Q3FY19

Revenue YoY Growth (%) EBITDA EBITDA Margin

Edelweiss Professional Investor Research 7

 d). Strong cement demand
Strong ongoing construction activities in roads, irrigation and other infrastructure projects have led
to healthy recovery in cement demand since the past five-six quarters. Although over the past few
quarters, several cost saving measures helped prune overall expenses, compressed realisation
continued to strain profitability.

Nevertheless, since the start of the current calendar year, buoyancy in demand has enabled
companies to hike prices by INR35-40/bag, which we believe will revive profitability to some extent.

Cement Demand Growth YoY (%)

18.5
16.3
12.5 12.9
10.6

0.6
(3.3)
Q1FY18

Q2FY18

Q3FY18

Q4FY18

Q1FY19

Q2FY19

Q3FY19
Improving EBITDA/tn
4,800
4,600
4,400
4,200
4,000 696 750
790
3,800
3,600
3,400
3,200
3,000
Q1FY18 Q2FY18 Q3FY18 Q4FY18 Q1FY19 Q2FY19 Q3FY19 FY20E

Realisation (Rs/tn) Operating Cost (Rs/tn)

Source: Edelweiss Professional Investor Research

Edelweiss Professional Investor Research 8

 III. Investment avenues
While we expect overall recovery in the small- and mid-cap space, we have identified a few stocks
in our coverage universe for reasonable medium term upside. These have been shortlisted based
on the quality of business, balance sheet health, cyclical lows in their margins, return ratios trend,
corporate governance and valuation attractiveness.

Why these companies?

We believe, stock price reaction has been severe compared to actual change in business
fundamentals or any possible business disruption in the future. We find valuations of these stocks
also much below their historical averages and lower than peers as well.

We foresee maximum wealth creation opportunity over the next 12-18 months. Generally, if one
buys a stock at < 1x PEG, it can generate alpha of 19%. Moreover, if one buys it at 10x P/E, it will
generate even higher returns.

This portfolio will see revenue growth of 17%, CFO growth of 25% and PAT growth of 23%, while
maintaining RoCE at ~21-23% for the next 2 years.

Revenue is expected to grow 17E CAGR PAT is expected to grow at 23% CAGR
FY15-18 CAGR 15% FY15-18 CAGR 17%
FY18-21 CAGR 17% 3016 FY18-21 CAGR 23% 3016

2551 2551

1902 1902
1638 1638
1485 1485
1196 1196
1024 1024

FY15 FY16 FY17 FY18 FY19E FY20E FY21E FY15 FY16 FY17 FY18 FY19E FY20E FY21E

Cash Flow from Operations is expected to grow at 25% CAGR ROCE is expected to improve by 200bps
3246 FY15-18 Avg, ROCE 21%
FY15-18 CAGR 20% FY18-21 Avg. ROCE 21%
FY18-21 CAGR 25% 2792
23 23
2185 22 21 22
18
1665 17

1322
1173
967

FY15 FY16 FY17 FY18 FY19E FY20E FY21E FY15 FY16 FY17 FY18 FY19E FY20E FY21E

Source: Edelweiss Professional Investor Research

Edelweiss Professional Investor Research 9

 Valuation: The portfolio’s valuation too has corrected significantly—now at 17x 1-year forward
from 20-22x.

P/E Band
30.9

22.5 21.9
19.6
16.8

FY16 FY17 FY18 FY19E FY20E

Though the portfolio has declined 38% from the top, the profit pool has expanded 56% during the
same period.

Market Cap Vs Profit Ratio

Up 56%
156

100 Down 38% 100

62

Peak M.Cap of the Current M.Cap of PAT FY18 PAT FY20

Portfolio the portfolio

Source: Edelweiss Professional Investor Research

10

Edelweiss Professional Investor Research 10

 Last 3 year Last 3 year Avg Last 3 year Avg Last 3 year Avg Last 3 years Avg
Name of company CAGR EBIDTA margins NPM RoCE PE
(FY15-18) (FY16-18) (FY16-18) (FY16-18) (FY16-18)
Revenue Company Company Company Company
Avanti Feeds* 24% 14.6% 9.7% 59.3% 17.7
Crompton Consumers 7% 12.0% 7.0% 40.1% 46.7
Deepak Nitrite* 8% 11.3% 5.5% 8.9% 19.2
Finolex Industries 3% 17.8% 10.9% 19.3% 22.2
Heritage Foods** 14.6% 7.2% 2.4% 20.8% 26.9
KNR Constructions 30% 17.0% 14.0% 16.0% 15.0
Lumax Industries 13% 7.6% 5.0% 16.0% 26.0
PSP Projects 38% 12.0% 8.0% 30% 16.0
Sagar Cement* 16% 13.0% NA NA NA
Ujjivan Financial^ 42% 45.1% 25.3% 2.2% 18.4
^RoA & PPOP for Ujjivan Financial
** For Heritage Foods, the revenue and EBITDA nos are for dairy business, as the retail business was sold in FY18.

EPS
M.Cap P/E P/E
Name of Company CMP 52week High/Low P/E FY20E Growth PEG Ratio
(INR cr) High Low
FY19-21E
1 Avanti Feeds* 335 842 / 306 4534 37 4 12.1 23.4* 0.6
2 Crompton Consumers 210 273 / 190 13,143 46 27 27.3 19.3 1.2
3 Deepak Nitrite* 232 305/205 3171 26 9 9.6 100.2 0.2
4 Finolex Industries 475 679 / 437 6,194 25 4 14.8 13.8 1.2
5 Heritage Foods 457 7870/419 2119 46 10 20 24.0 1.0
6 KNR Constructions 200 340/165 2,826 17 9 11.1 15.5 0.9
7 Lumax Industries 1,660 2,580/1,405 1,550 26 11 11.2 30.3 0.5
8 PSP Projects 402 595/358 1,447 19 11 10.8 31.0 0.5
9 Sagar Cement* 570 1,074 / 528 1211 45 9 28.4 230.9 0.1
10 Ujjivan Financial 277 435/167 3360 28 15 11.4 48.9 0.4

EPS P/E ROCE/ROE

EPS Growth
FY20 FY21 FY20E FY21E FY20E FY21E
FY19-21
Avanti Feeds* 27.6 – 23.4 12.1 NA 27.3 NA
Crompton Consumers 7.7 8.9 19.3 27.3 23.6 45.3 46.3
Deepak Nitrite* 24.2 – 100.2 9.6 NA 24.3 NA
Finolex Industries 32.2 36.9 13.8 14.8 12.9 16.5 17.9
Heritage Foods 22.8 28.0 24 20 16.3 15 16.5
KNR Constructions 18.0 20.0 15.5 11.1 10 16 21
Lumax Industries 147.9 196.7 30.3 11.2 8.4 31.7 36.6
PSP Projects 37.3 43.9 31 10.8 9.2 34 30
Sagar Cement* 20.1 66.5 230.9 28.4 8.6 8.5 14.8
Ujjivan Financial 24.4 33.9 48.9 11.4 8.2 15 17.9
* EPS growth for Deepak Nitrite and Avanti Feeds considered between FY19-20 and for Sagar Cements considered between FY20-21

11

Edelweiss Professional Investor Research 11

 Risks
 Geopolitical risk.
 Global recession: Expectation of economy slowdown in US and Europe.

12

Edelweiss Professional Investor Research 12

Avanti Feeds Ltd
Edelweiss Broking Limited, 1st Floor, Tower 3, Wing B, Kohinoor City Mall, Kohinoor City, Kirol Road, Kurla(W)
Board: (91-22) 4272 2200

VINAY
Digitally signed by VINAY KHATTAR
Vinay Khattar DN: c=IN, o=Personal, postalCode=400072,
st=Maharashtra,
2.5.4.20=87db74ffb17a70c89e8519a4d13e40e93c4bc
Head Research aba1a64d00f3c841d2fee3fa678,

KHATTAR
serialNumber=cd5737057831c416d2a5f7064cb6931
83887e7ff342c50bd877e00c00e2e82a1, cn=VINAY

vinay.khattar@edelweissfin.com KHATTAR
Date: 2019.03.15 10:36:36 +05'30'

13

Edelweiss Professional Investor Research 13

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Edelweiss Professional Investor Research 14

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Edelweiss Professional Investor Research 15