April 11, 2012

Economy & Strategy

UPDATE

This could be heaven for stock pickers

The old India story (+8% growth, heavy investment in infra, a concerted macro thrust delivered to a powerful economy) is dead. The new India could be heaven for the diligent stock picker who is prepared to go to the smaller cities, visit the workshops of smallmidcap companies and see the vitality of Indias million mutinies (without worrying about whether the 3-month ADV of the stock in question is above US$3mn). It is in these new power centres that India will continue to buzz even as the old India story dies. The immediate term picture: Limited repo rate cuts, economic growth in line with the new normal
Factoring in the impact of two sets of developments that have unfolded over the past month namely: (1) A significant jump in the INR price of Brent, and (2) The administration of a 2% point increase in central excise duty rates leads us to shift our expected trajectory of inflation higher by ~50bps (see exhibit A on the right). Feeding this inflation dynamic into our Taylor Model reconfirms our view of limited repo rate cuts being administered in FY13 (cumulatively 50bps). Whilst repo rate cuts are likely to be limited, the RBI is likely to undertake meaningful intervention to counter the tight liquidity situation in the form of CRR rate cuts and liquidity infusions over the course of FY13. We expect GDP growth in FY13 to be recorded at 7.3% YoY, a 10bps downgrade v/s our previous estimate on account of lower than expected repo rate cuts (see pg 6 for details). With GDP growth in line with the subdued new normal of 7%, with structurally high cost of capital, with rising demand for liquidity and a clear diffusion of power away from the Centre, stock selection skills will come to the fore in FY13.

Analyst contacts
Saurabh Mukherjea, CFA
Tel: +91 22 3043 3174 ritikamankar@ambitcapital.com

Ritika Mankar Mukherjee

Tel: +91 22 3043 3175 ritikamankar@ambitcapital.com

Exhibit A: Expected inflation trajectory* shifts higher on account of (1) higher INR prices of crude and (2) excise duty hikes
Avg Qtrly WPI Inflation (YoY, in %) 8% 7% 6% 5% 4% 1QFY13 2QFY13 3QFY13 4QFY13 New Estimate Old Estimate

Source: CEIC, Ambit Capital research

Exhibit B: The rise of well managed states

5% Fiscal deficit (in FY12, as a % of GDP)

The big picture: Is India imploding?

The contours of the political and economic changes currently underway in India can be viewed through the lens of three long term trends that have been in play over the past 50 years: (1) The relentless demise of national parties, (2) The ascendancy of formerly suppressed communities and parties that champion their cause, and (3) The relentless rise of individual aspirations. The three key implications of these historical trends are likely to be: (1) The fragmentation of political power ultimately leading to the Third Front (of nonCongress and non-BJP parties) triggering a mid-term General Elections next year; (2) The creation of new wealth and power centres in cities such as Lucknow, Kolkata and Patna; and (3) The continued absence of national macroeconomic thrust as the two national parties lose their grip on power whilst the ascendant regional and caste based parties lack any national economic agenda.

4%

Punjab Kerala UP AP WB MP Tamil Nadu CG Orissa Haryana Rajasthan Gujarat Maharashtra

3%

Jharkhand

Bihar

Karnataka 2%

1% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% Real GDP growth (CAGR, in % over FY09-12)

Source: CEIC, Ambit Capital research (Refer to pg 11 for more details)

Investment implications: Bet on aspirations and management teams

The fragmentation of political power is likely to manifest itself in the form of continued underperformance of Heavy / Infra related sectors (see exhibit C on the right). Simultaneously this is likely to be accompanied by the rise of well managed states such as Bihar, Maharashtra and Gujarat (see exhibit B on the right). Even as Indias GDP growth rate settles at the new normal of 7% YoY, the rise of individual aspirations is likely to mean the continued outperformance of stocks focused on aspirational consumption (see exhibit C on the right). More generally, well managed, cash generative companies with brands, distribution, some innovative technology and demand underpinned by aspirational consumption will thrive in the new India even as the Power, Infra, Heavy Engineering sectors and the Banks who lent to them, flounder.

Exhibit C: Aspirational consumption plays have outperformed over the past decade
35% 30% Median CAGR (in %) 25% 20% 15% 10% 5% 0% Sales Aspirational PAT Essentials Stock Price BSE 500

Source: CEIC, Ambit Capital research (Refer to pg 12 for details)

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 consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.

Economy & Strategy

CONTENTS
In the immediate term: Limited repo rate cuts, economic growth in line with the new normal 3

The big picture: Is India imploding? 9 Investment implications .11 Appendix I 13 Appendix II ..14

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In the immediate term: Limited repo rate cuts, economic growth in line with the new normal
Summary: Factoring in the impact of two sets of developments that have unfolded over the past month namely: (1) A significant jump in the INR price of Brent (currently at INR6,400/barrel v/s our initial base case of INR5,500/barrel for FY13: see exhibit 1 on the next page); and (2) The administration of a 2% increase in central excise duty rates leads us to shift our expected trajectory of inflation higher by ~50bps (see exhibit 2 on the next page). Feeding this inflation dynamic into our Taylor Model reconfirms our view of limited repo rate cuts being administered in FY13. We expect the total quantum of repo rate cuts in India to be limited to 50bps in FY13 with the first rate cut likely to be administered on April 17, 2012. Just like the RBIs monetary policy tightening agenda over CY10 saw the RBI administer repo rate hikes whilst actively working to generate a deficit liquidity situation, we expect the RBI to pursue the reciprocal of this strategy in FY13. Whilst repo rate cuts are likely to be limited, the RBI is likely to undertake meaningful intervention to counter the tight liquidity situation in the form of CRR rate cuts and liquidity infusions over the course of FY13. The lower-than-expected cut in policy rates in turn leads us to trim our GDP growth forecast marginally by 10bps to 7.3% YoY. We re-iterate our expectation of marginally higher GDP growth in FY13 (v/s the 6.9% that the Indian economy is likely to deliver in FY12) in view of an incrementally supportive global macroeconomic environment. With GDP growth in line with the new subdued normal of 7%, with structurally high cost of capital, rising demands on liquidity and a clear diffusion of power away from the Centre, investors stock selection skills will come to the fore (refer to page 9 of this note for details).

The higher rupee prices of crude to drive inflation higher

The past month has been witness to a phenomenal rise in the INR price of crude (12% QoQ increase over 4QFY12: see exhibit 1 on the next page). Closer home, the announcement of the Union Budget on March 16, 2012 saw the central excise and service tax rates being hiked by 2% points for FY13.

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Economy & Strategy Exhibit 1: The run up in the INR prices of crude over the past quarter
6500 Avg Qtrly WPI Inflation (YoY, in %) INR prices of crude (INR/barrel)

Exhibit 2: Our expected inflation trajectory* shifts higher on account of: (1) higher INR prices of crude; and (2) excise duty hikes
8% 7% 6% 5% 4% 1QFY13 2QFY13 3QFY13 4QFY13 New Estimate Old Estimate

6000

5500

5000 03-01-12 17-01-12 31-01-12 14-02-12 28-02-12 13-03-12 27-03-12

Source: CEIC, Ambit Capital research

Source: CEIC, Ambit Capital research *Assumptions made: (1) Petrol prices are increased by INR 4/litre and diesel prices are increased by INR 1/litre in 1QFY13. Diesel prices are increased by INR2/litre in 2QFY13. (2) INR prices of crude average out at INR6000 per barrel in 1HFY13 and at INR5500 per barrel in 2HFY13.

Factoring in the impact of these two sets of developments into our inflation model (refer to the Appendix I for details) leads us to raise our expected inflation trajectory in FY13 by ~50bps (see exhibit 2). Whilst we expect the INR to remain under pressure in FY13 (in view of the widening current account deficit and weakening capital flows), our Oil & Gas analyst Dayanand Mittal, highlights that the current dollar crude price is building in significant geo-political risk premium of US$15-US$20/barrel (i.e. 15% of the current price of crude). He expects this geo-political risk premium to halve in 2HFY13 given: (a) The weakness in global oil demand; and (b) The improvement in supply from Libya, traditionally a major supplier of Brent. Consequently, we build in an average INR price of crude at 6,000 INR/barrel for 1HFY13 and 5,500 INR/barrel for 2HFY13 in our inflation model. Moving on to the impact of higher indirect tax rates, given that the WPI basket focuses on goods versus services the impact of the increase on the WPI gauge is likely to be more on account of the excise duty hike. Given those categories where the increase in excise duty rates is likely to be passed through fully amounts to 10% of the WPI basket (Dairy Products: 0.6% , Canning and processing food: 0.4%, Bakery products: 0.4% , Beverage & Tobacco: 1.8% , Metal Products: 1.7% and Transport Equipment: 5.2%), we build in an additional layer of 20bps (200bps excise duty increase x 10% weightage = 20bps) on account of excise duty rate hike.

leaving limited scope for repo rate cuts in FY13

Feeding our higher inflation expectation into our Taylor Model reconfirms our view of limited repo rate cuts being administered in FY13. We expect the total quantum of repo rate cuts in India to be limited to 50bps in FY13 with the first rate cut likely to be administered on April 17, 2012 (see exhibit 3 below). The rate cuts are likely to be motivated by the need to revive economic growth but will be capped by the extent of inflation. Inflation in turn is likely to reflect a downward trajectory in 1HFY13 but rise incrementally in 3QFY13 (see exhibit 2 above for details) as the second round impact of fuel and food inflation begins affecting the core gauge.

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Exhibit 3: We expect the RBI to cut policy rates by 50bps in FY13

9.0 Repo rate (in % p.a.) 8.5 8.0 7.5 7.0 6.5 6.0 04-2011 06-2011 08-2011 10-2011 12-2011 02-2012 04-2012 06-2012 08-2012 10-2012 12-2012 02-2013

Exhibit 4: The RBI actively created a deficit liquidity situation whilst tightening the repo rate in CY10
Liquidity in banking system / Net OMO injections (as a % of deposits) 8% 7% 6% 5% 4% 04-2008 07-2008 10-2008 01-2009 04-2009 07-2009 10-2009 01-2010 04-2010 07-2010 10-2010 01-2011 04-2011 07-2011 10-2011 Repo rate (in % p.a.) 4% 3% 2% 1% 0% -1% -2% -3% 9%

Liquidity in banking system (Left Scale : Net surplus , as a % of deposits) Net liquidity injections (Left Scale : Net OMO purchases, as a % of deposits) Repo Rate ( Right Scale)

Source: CEIC, Ambit Capital research

Source: CEIC, Ambit Capital research

However, an analysis of the broader monetary policy stance assumed by the RBI over the last tightening phase suggests that the initiation of the RBIs monetary policy tightening over CY10 saw the RBI actively working to generate a deficit liquidity situation (see exhibit 4 above), in a bid to expedite monetary policy transmission. Exhibit 5: The consistently rising demands on liquidity in India since CY11 . . .
Current a/c & fiscal deficit (as a % of GDP) -8% -7% -6% -5% -4% -3% -2% -1% 0% 03-2005 09-2005 03-2006 09-2006 03-2007 09-2007 03-2008 09-2008 03-2009 09-2009 03-2010 09-2010 03-2011 09-2011

Exhibit 6: . . . and the declining financial savings of Indian households

30% Gross Household Savings (as a % of GDP) 25% 20% 15% 10% 5% 0% FY10 HH : Financial HH: Physical FY11 Household 13% 12% 13% 10% 25%

23%

Current Account (4QMA , as a % of GDP) Fiscal Deficit (4QMA , as a % of GDP)

Source: CEIC, Ambit Capital research

Source: CEIC, Ambit Capital research

Given the rising demands on liquidity in India imposed by the twin deficits (see exhibit 5 above) and the concomitant decline in the internal sources of liquidity in the form of household financial savings (see exhibit 6 above), the liquidity situation in India is likely to remain vulnerable to the quantum of capital inflows into India. Much like the RBI forced a deficit liquidity situation on the banking system in India in CY10 to expedite the transmission of monetary policy tightening; the RBI is likely to intervene to counter the tight liquidity situation in the economy in FY13 as it cuts repo rates marginally. RBIs measures aimed at liquidity augmentation in FY13 are likely to assume the form of both explicit CRR cuts and as well as liquidity infusions.

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We trim our GDP growth forecast by 10bps

Feeding the lower-than-expected cut in policy rates into our GDP growth model (refer to the Appendix II of this note for details) leads to lower investment growth for FY13 and hence lower industrial sector growth (given that industrial sector growth is a function of the extent of capacity creation in an economy). Exhibit 7: We trim our investment growth forecast by 30bps in view of limited
repo rate cuts in FY13
(%) GDP Agriculture Industry Services Investment demand FY11 FY12 (actuals) (CSO estimates) 8.4% 7.0% 7.2% 9.3% 7.5% 6.9% 2.5% 3.9% 9.4% 5.6% FY13 (our old estimate) 7.4% 2.9% 6.2% 9.0% 7.3% FY13 (our new estimate) 7.3% 2.9% 6.0% 8.9% 7.0% Difference -10bps 0bps -20bps -10bps -30bps

Source: CEIC, Ambit Capital research

Whilst a subset of services in India (called Community Social and Personal Services) is driven by Government expenditure, more than 75% of the services sector growth is driven by the pace of activity in the industrial sector. Consequently, the lower industrial sector growth number leads to a 10bps reduction in services sector growth as well. The cumulative impact of a lower-than-expected policy rate cuts in India translates to a 10bps reduction in our projected GDP growth rate for FY13 (see exhibit 7 above).

Marginal improvement in GDP growth in FY13 (v/s FY12) to be driven by sectors with improved access to capital
Given that the Indian economy is in many ways like a small company that is working capital deficient, historically an increase in global risk aversion levels is accompanied by a sharp V shaped dip in Indias investment growth (see exhibit 8 below). In our note dated February 27, 2012 we made the point that, with France, Germany and USA headed towards presidential elections, comprehensive QE is likely to be administered on both sides of the Atlantic in FY13. Since then, following the administration of LTRO by the ECB (in 3Q & 4Q FY12), there has been a clear uptick in equity flows into India (see exhibit 9 below).

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Exhibit 8: Investment growth in India suffers in years that are characterized by a financial crisis
Investment demand growth (yoy, in %) 20% 15% 10% 5% 0% -5% FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13

Exhibit 9: Clear uptick in FII flows into India in 4QFY12

Net FII flows (in INR bn) 800 700 600 500 400 300 200 100 0 -100 06-2010 08-2010 10-2010 12-2010 02-2011 04-2011 06-2011 08-2011 10-2011 12-2011
Cement

FII : Total
Source: EPFR Global, Ambit Capital research

FII: Equity

Source: CEIC, Ambit Capital research

Given that our macro model points to incrementally higher investment growth in India in FY13 on account of an incrementally supportive global risk environment, we proceed to identify sectors within the economy that are likely to drive the incrementally higher investment growth in India due to improved access to capital. Whilst Financial Services-dominated new capital raised in FY12 recording a 221% YoY jump; Power, Non-ferrous metals and Roads are three sectors that have recorded above system-average credit growth rates. From a Government support perspective, Power, Civil Aviation and Roads are likely to be beneficiaries of improved Government capex. Exhibit 10: Financial Services recorded a 221% YoY increase in new capital raised in FY12 YTD
600 New Capital Raised (in INR bn) 500 400 300 200 100 0 Total FY10* Banks FY11* Financials FY12*

Exhibit 11: Sectors such as Power, Non-ferrous metals and Roads have recorded an increase in share in total bank credit over FY12 YTD
Increase in share of bank credit (in %) 0.5% 0.4% 0.3% 0.2% 0.1% 0.0% Non-ferrous metals Roads Iron & Steel Power Mining
7

0.4% 0.2% 0.2% 0.1% 0.1% 0.1%

Source: Bloomberg, Ambit Capital research Note : Data available till Jan 2012

Source: CEIC, Ambit Capital research

New capital raised: Financial Services dominate new capital raised Whilst the overall quantum of new capital raised in FY12 YTD (SEBI data available until Jan 2012) was recorded at INR280bn i.e. a 46% YoY contraction, a sectoral analysis of the data suggests that Financial Services dominated capital raises in FY12 YTD. Whilst capital raised by banks recorded

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Economy & Strategy a 186% YoY jump in FY12 YTD, Financial Services recorded a 333% increase in new capital raised over the same period (see exhibit 10 above).

Bank credit: Power , Non-ferrous metals and Roads experience aboveaverage bank credit growth Whilst bank credit growth has decelerated from 21% YoY in FY11 end to 16% YoY as at February 2012, credit growth to sectors such as Mining (40% YoY) , Non-ferrous Metals (38% YoY), Roads (26% YoY) as well Power (23% YoY) continues to grow at an above average pace. An analysis of the constitution of bank credit over FY12 year to date (i.e. from end-FY11until February 2012) suggests that the share of Power in total bank credit has increased by 40bps over this period whilst that of Non-ferrous metals and Roads has increased by 20bps each (see exhibit 11 above for details).

Government capex : Power, Civil Aviation and Roads emerge as Government capex focus areas Whilst the Central Government failed to deliver on fiscal consolidation, the Union Budget envisages a shift in expenditure in favour of capital expenditure. The Central Government envisages a 31% YoY increase in capex as against flat growth in FY12 as per the Union Budget for FY13. Making the assumption that the Indian states budget for the same extent of capex growth in FY13 as was the case in FY12, then State and Central capex together is likely to record a YoY growth of 24% YoY thus pushing Government (State + Centre) capex as a percentage of nominal GDP to 4.2% of GDP the highest in 5 years. A sectoral break-up of Central Government capex suggests that three key ministries namely Power (66% YoY), Civil Aviation (231% YoY) and Road Transport & Highways (18% YoY) are budgeted to record a meaningful increase in Central Government capex (see exhibit 13 below).

Exhibit 12: Central Government capex in FY13 is budgeted to expand at 31% YoY
50% Growth in Capex (YoY, in %) 40% 30% 20% 10% 0% FY11 Central : Capex All States : Developmental Capex Total Govt. Capex
Source: CEIC, Ambit Capital research

Exhibit 13: The Union Budget envisages a meaningful

increase in spends on Power, Civil aviation and Road Transport & Highway Ministries

39% 31% 24% 12% 0% FY12 FY13 (BE) 18% 9% 24% 18%

Central Capital Exp by Ministry (INR bn)

120 100 80 60 40 20 0 Power Civil Aviation Road Transport & Highways

FY12
Source: CEIC, Ambit Capital research

FY13

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The big picture: Is India imploding?

As major FIIs unwind their positions in India in the wake of the uncertainty caused by the notification of a new set of General Anti Avoidance Rules (GAAR), as domestic retail investors prefer to invest their money in gold rather than in the stock market and as rumours of a military coup make it to page 1 of the major national dailies, it is easy to feel despondent about India. Seasoned FIIs say that India is an uninvestable imploding democracy. So, is it all over for India? Will the country now go to sleep for another decade or two?

Viewing the past in proper perspective

To get a sense of Indias future at this despondency filled hour, it is worth looking at a longer sweep of its history, rather than the few wretched years of the current UPA regime. When you look at that longer sweep of Indian history, a few features stand out:

The demise of national parties: In almost every decade post Independence, the largest party in the Lok Sabha (the Congress for the most part and the BJP in some years over the past 20 years) has systematically lost vote share indicative of the demise of national parties and the concomitant rise of regional parties. The percentage of Lok Sabha seats won by the largest party in Lok Sabha has trended down systematically from 74% in the 1st Lok Sabha to 38% in the 15th Lok Sabha (current governing body). The relentless demise of the national parties is arguably driven by the rise of more regional, more working class, non-Brahmin, non-English speaking elites. Hence regardless of how the national parties perform vis--vis the KPIs that investors focus on (growth, inflation, interest rates, exchange rates), they are operating against the tides of social change in India.

The ascendancy of the suppressed: The adoption by the national parties, particularly the UPA, of an explicit pro-poor agenda (aimed at wooing disadvantaged castes and classes) shows how powerfully democracy has swung the balance of power in favour of economically disempowered groups. Not only is their cause represented by regional parties like the TMC, BSP, DMK parties whose raison detre is to lift the disadvantaged - their cause is now represented by every party as it is the only cause which matters at the ballot box. Once again, the simplistic KPIs of growth and inflation are no longer too relevant to Indian politics, which is now largely about the rise of groups who have never wielded power in India.

The relentless rise of individual aspirations: At the level of the individual, the analogue of the previous bullet is a relentless rise in aspirations. As V.S. Naipaul memorably put it in his 1989 masterwork, India: A Million Mutinies Now, The book was dedicated to a further idea: that India was, in the simplest way, on the move, that all over the vast country men and women had moved out of the cramped ways and expectations of their parents and grandparents and were expecting more. These men and women want their children to be well educated and healthy. They want to live in pucca homes and purchase products which signal to the community around them that they are moving up in the world. This dynamic, which we have analysed in detail in annual Megathemes notes, predates Indias 1991 economic reforms and has a life of its own, unrelated to the incompetence of our administrators.

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So what will the future bring for us?

Three key implications of the weakening of national parties, the rise of powerful states and the rise of individuals and their aspirations is likely to be: (1) The fragmentation of political power, (2) The concomitant creation of new wealth centres and (3) The continued absence of national macroeconomic thrust as national parties are overwhelmed by coalition management and as regional parties lack national focus. The fragmentation of political power A highlighted in our previous emails, power in India is migrating away from the Congress in New Delhi to the States, to regional parties, to the regulators (TRAI, SEBI, RBI etc.), to the watchdogs (CVC, CAG, Competition Commission, Election Commission etc.) and the Courts. Focusing specifically on the political fragmentation of power, we expect two key developments over the next 18 months:

The rise of the Third Front: Why should I just be a kingmaker if I can become the King myself? that is the question that at least half a dozen regional Indian political leaders (including members of the UPA and NDA coalitions) are asking themselves today. Having seen the demise of the national parties, they can sense that there is a power vacuum in Delhi. Obviously, they want to fill this vacuum themselves. To do so they have to cooperate with each other and agree to the outline of a power sharing agreement. These discussions are under way and will reach a climax over the next year at which point.. .Mid-term General Elections: will become a plausible event. At present, neither of the two main political parties have the will to trigger another election. A year hence, with critical State elections lined up in BJP strongholds of Gujarat, Madhya Pradesh and Chattisgarh over the next 18 months, the BJP will be more predisposed to vote with the Third Front and bring down the UPA.

The creation of new power and wealth centres As political and policymaking power migrates from Delhi to the States, we expect the previously unassuming State Capitals like Lucknow (UP accounts for 15% of Lok Sabha seats), Kolkata (Bengal accounts for 8% of Lok Sabha seats), Patna (7%) and Gandhinagar (5%) to become important power centres. And as we all know, in India with great power comes not great responsibility but great wealth. The continued absence of national macroeconomic thrust The new political elite does not have any political and economic ideology as such (beyond cornering rents for the specific group that they represent). To be fair, for Indian regional and caste based parties, their ascension to a position of power, after centuries of suppression by foreign and local elites, has been so rapid that they cannot be realistically expected to do anything else other than to grab power and use it for their narrow self-interested ends. Whilst it is likely to take a decade for such parties to have any view on what should be Indias economic policy, this does not mean that Indias democracy is a failure. In fact in all likelihood, this is another stage in the countrys evolution from a feudal, and then colonial, society to one which seeks to accommodate the aspirations of dozens of castes, religions and ethnicities. The old guard schooled in posh schools and elite colleges claimed to represent India. The new elite does not believe in this old guard but is yet to find its own intellectuals who can articulate how India should be run.

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Investment implications
For those looking for a grand India story to back (8%-9% growth, heavy investment in infra, the smooth administration of a powerful economy by capable politicians), there wont be such a story any more. In a country as diverse as India, as evolutionary and as irreverent as India, to expect this sort of China-type story to be sustained was/is unrealistic. Instead, the new India story will be focused on the micro rather than macro: A few well managed states As India becomes a more federal country, the more able state level Chief Ministers will be able to distinguish themselves even as the Centre crumbles. As Nitish Kumar has shown in Bihar, even in a state known for serial economic and social failure, an able Chief Minister can independently drive growth. The scorching 3-year CAGR of real economic growth in three states of Bihar (12.8% p.a.), Maharashtra (11.8% p.a.) and Gujarat (10.2% p.a.) is indicative of the rise of the economic might of States even as the national economy falls prey to economic rudderlessness (see exhibit 14 below). States such as these will continue to grow in economic and hence political significance in sharp contrast to the nation. Exhibit 14: The rise of economically and fiscally powerful States such as Bihar,
Maharashtra and Gujarat is likely to continue as the nation stumbles
5% Fiscal deficit (in FY12, as a % of GDP) 4% 3% 2% 1% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% Real GDP growth (CAGR, in % over FY09-12)
Source: CEIC, Ambit Capital research

Punjab Kerala MP Jharkhand CG Orissa Haryana Karnataka Rajasthan UP WB AP

Tamil Nadu Gujarat

Bihar

Maharashtra

Note: (1) Empty bubbles indicate states run by non-Congress Governments. Red dots indicate states run by a Congress majority whilst the mild coloured bubbles indicate States where the Congress is a part of the ruling Government in combination with an ally. (2) Real GDP growth CAGR for Maharashtra, Gujarat, Madhya Pradesh & Rajasthan refer to the CAGR over FY09-FY11 in the absence of updated data for FY12. Over the course of the next few months, we will provide clients with clarity on how to benefit from the efficiency of well managed States. The continued rise of individual aspirations The aspiration which seeps out of almost every aspect of the Indian underclass existence is and will continue to be a powerful driver for this country. Such aspirations have already meant that a basket of aspirational stocks (with no particular regard to quality) has outperformed essential stocks by 7% CAGR and the BSE100 by twice as much over the past decade (see exhibits 15 & 16 below; refer to our note Megathemes 2.0 dated November 9, 2012 for details). In fact the inability of heavy sectors to outperform is also a direct corollary of the absence of a powerful central macroeconomic thrust.

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Exhibit 15: Stocks focused on aspirational consumption have outperformed over the past decade
35%

Exhibit 16: B2C sectors have been clear outperformers

over FY08-11

70 60 FY08-11 share price CAGR 50 40 30 20 10 Realty -10% IT Banks FMCG Metals PSUs Oil & Gas R2 = 0.476

Cons Durables Auto

30% Median CAGR (in %) 25% 20% 15% 10% 5% 0% Sales Aspirational PAT Essentials Stock Price BSE 500

Healthcare TMT Capital Goods Power 30% 40%

-20%

0% 10% 20% (10) FY08-11 revenue CAGR

Source: CEIC, Ambit Capital research. Note: Period under study- FY01-FY11. Both Aspirational stocks and Essential stocks are a subset of BSE 500.Refer to pg30-31of out note Megathemes 2.0 for an exhaustive list.

Source: CEIC, Ambit Capital research.

Exhibit 17: Cash generative companies deliver superior share price performance
CAGR in stock price (in % p.a.) 25% 21% 20% 15% 10% 6% 5% 0% FY09-11 BSE 500
Source: CEIC, Ambit Capital research.

have

Exhibit 18: Cash generative sectors are likely to

continue to outperform the broader market
70 y = 26.051x + 22.669 60 R2 = 0.0747 50 40 30 BSE100 3 yr CAGR 20 10 Realty -40% -20% 0%

Consumer Durables Auto IT FMCG Capital Goods PSUs Power 20% Oil & Gas 40% 60% Banks Healthcare

18% 14%

FY06-11 Cash Generators

Op Cashflows (FY08-11 CAGR)

Source: CEIC, Ambit Capital research

Note: Cash generators are defined as BSE500 ex-financials with CFO greater than NP for the period spanning FY05-11as well as a positive CFO in FY05 as well as FY11.

Well managed, capital efficient small-mid cap companies As highlighted over the past year, Indian companies which dont generate free cashflow and dont have sustainable competitive advantages other than political connectivity will struggle in the new dispensation. A corollary of this is that the Banks which have lent to these companies will also struggle in FY12. On the other hand, well managed, cash generative companies with brands, distribution, some innovative technology and demand underpinned by aspirational consumption will thrive in the new India (see exhibits 17 and 18 above). Examples of such plays are Exide, Eicher, Cummins India, Kirloskar Oil Engines, Agrotech, Greaves Cotton, Elgi Equipment and Voltas.

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Shareholder returns in % (FY08-11 CAGR)

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Appendix I
Exhibit 19: The structure and assumptions underlying our inflation model for FY13
WPI Constituents Core Weightage* Definition Modeling technique Key assumption(s) made Regression analysis using the Manufacturing excluding following explanatory variables: GDP growth in FY13 is recorded at chemicals, metals and food output gap, food inflation and 7.3% regulated fuel price inflation (1) Petrol prices are increased by INR Regression analysis using the Diesel, Petrol , LPG and 4 per litre in 1QFY13 (2) Diesel retail prices of fuels as Kerosene prices are increased by INR 3 litre explanatory variables over 1HFY13 Fuel excluding regulated fuel, metals (both from Regression analysis using global Global crude oil prices average INR primary articles and crude oil prices in INR terms as 6,000 per barrel over 1HFY13 and manufacturing) and explanatory variables INR 5,500 per barrel over 2HFY13 chemicals. Primary articles excluding India receives normal rainfall and minerals and the food Historical seasonality trends historical seasonality trends are component of adjusted for deviations repeated in FY13. manufacturing. Historical trends are repeated in Historical trends FY13

32%

Regulated fuel

7%

Fuel floaters

26%

Food Coal & electricity WPI

29%

6% 100%

Source: CEIC, Ambit Capital research Note: The weightages used are as per the WPIs specification only the combinations used by our model are unique.

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Appendix II
Ambits supply-side GDP growth model
Our supply-side GDP forecasting framework rests on four interdependent models (see exhibit 20 below for details) with a model dedicated to forecasting 1) farm sector growth, 2) investment demand growth, 3) industrial sector growth and 4) services sector growth. The combined output from each of these 4 models is used to predict GDP growth. Exhibit 20: The structure of Ambits GDP growth model

Agriculture

Investment

Services

Industry

GDP
Source: Ambit Capital research

Each of the above highlighted four constituents of GDP is predicted using a set of macroeconomic variables (see exhibit 21 below for details) with each coefficient in our partial-equilibrium GDP framework being significant at a 95% degree of confidence. Further, each model is characterized by an adjusted R square (a statistical parameter indicative of the explanatory power of the model) of 55% or more. Exhibit 21: Explanatory variables used to predict GDP constituents
Significance at 95% degree of confidence 1. Farm Sector Growth Model Drivers Rainfall adjustment factor Increase in Minimum Support Prices Lagged farm sector growth 2. Industrial Sector Growth Model Drivers GFCF Growth 3. Investment Demand Growth Model Drivers Economic Crisis Factor Policy Rate Lagged GFCF growth GDP growth 4. Services Sector Growth Model Drivers Industrial sector growth Union Government expenditure
Source: Ambit Capital research

Adjusted R square

73%

55%

63%

60%

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Institutional Equities Team

Saurabh Mukherjea, CFA Research Analysts Aadesh Mehta Anand Mour Ankur Rudra, CFA Ashvin Shetty Bhargav Buddhadev Chhavi Agarwal Dayanand Mittal Gaurav Mehta Hardik Shah Jatin Kotian Krishnan ASV Nitin Bhasin Pankaj Agarwal, CFA Parita Ashar Rakshit Ranjan, CFA Ritika Mankar Mukherjee Ritu Modi Shariq Merchant Sales Name Deepak Sawhney Dharmen Shah Dipti Mehta Pramod Gubbi, CFA Sarojini Ramachandran Production Sajid Merchant Kausalya Vijapurkar Production Editor (022) 30433247 (022) 30433284 sajidmerchant@ambitcapital.com kausalyavijapurkar@ambitcapital.com Regions India / Asia India / Asia India / Europe India / Asia UK Desk-Phone (022) 30433295 (022) 30433289 (022) 30433053 (022) 30433228 +44 (0) 20 7614 8374 E-mail deepaksawhney@ambitcapital.com dharmenshah@ambitcapital.com diptimehta@ambitcapital.com pramodgubbi@ambitcapital.com sarojini@panmure.com Industry Sectors Banking / NBFCs FMCG Technology / Telecom / Education Automobile Power / Capital Goods Construction / Infrastructure Oil & Gas Derivatives Research Technology / Education Services Metals & Mining / Healthcare Banking Construction / Infrastructure / Cement NBFCs Metals & Mining / Media / Telecom Mid-Cap Economy Cement Consumer Desk-Phone (022) 30433239 (022) 30433169 (022) 30433211 (022) 30433285 (022) 30433252 (022) 30433203 (022) 30433202 (022) 30433255 (022) 30433291 (022) 30433261 (022) 30433205 (022) 30433241 (022) 30433206 (022) 30433223 (022) 30433201 (022) 30433175 (022) 30433292 (022) 30433246 E-mail aadeshmehta@ambitcapital.com anandmour@ambitcapital.com ankurrudra@ambitcapital.com ashvinshetty@ambitcapital.com bhargavbuddhadev@ambitcapital.com chhaviagarwal@ambitcapital.com dayanandmittal@ambitcapital.com gauravmehta@ambitcapital.com hardikshah@ambitcapital.com jatinkotian@ambitcapital.com vkrishnan@ambitcapital.com nitinbhasin@ambitcapital.com pankajagarwal@ambitcapital.com paritaashar@ambitcapital.com rakshitranjan@ambitcapital.com ritikamankar@ambitcapital.com ritumodi@ambitcapital.com shariqmerchant@ambitcapital.com Head of Equities (022) 30433174 saurabhmukherjea@ambitcapital.com

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Explanation of Investment Rating

Investment Rating Expected return (over 12-month period from date of initial rating) >5% <5%

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