Sharekhan

International Combustion (India)    
Cluster: Cannonball
Recommendation: Buy
Price target: Rs519
Current market price: Rs391

Sharp increase in margins

Result highlights

• The revenues of International Combustion India Ltd (ICIL) grew by 27.2% year on year (yoy) to Rs20.2 crore in Q1FY2008. The revenue growth was in line with our estimates. 
• The revenues of the Heavy Engineering Division (HED) of the company grew by 18.9% yoy to Rs16.5 crore. The Geared Motor and Geared Box Division's (GMGBD) revenues rose by an impressive 78.9% yoy to Rs3.8 crore.
• The operating profit margin (OPM) expanded by 560 basis point yoy to 24%. The OPM rise was due to a reduced raw material cost to sales ratio, which declined by 380 basis points to 46.8% in Q1FY2008. The staff cost to sales ratio and the other expenses to sales ratio both saw a decline of 90 basis points yoy.
• The HED reported a profit before interest and tax (PBIT) margin of 38.4%, which was up 670 basis points yoy. The GMGBD, which incurred a loss in the corresponding quarter last year reported a PBIT margin of 1.3% for this quarter. 
• The net profit jumped by a whopping 104.4% yoy to Rs2.8 crore led by a higher other income and robust expansion of margins. The profit after tax (PAT) margin for the quarter was 13.9%.
• The outstanding order book of the company at the end of July 2007 was Rs64 crore. The HED has an order backlog of Rs52 crore while the GMGBD has pending orders worth Rs12 crore.
• The company plans a capital expenditure (capex) of Rs8 crore in FY2008 towards capacity addition in the HED and the GMGBD to meet the rising demand for its products.

India Mini Conference - London 2007

31 August 2007

Citigroup Global Markets | Equity Research

Infosys Technologies (INFY.BO)

Offshore Bellwether

 Impact of "subprime" issues — The impact of "sub-prime" issue remains the most important investor focus at this point in time. Infosys's exposure to the mortgage/subprime space and the likely impact on revenues/profits is a key focus area.

 Outlook on IT budgets for next year — IT budgets could suffer if the situation in the US mortgage market worsens and spreads to other financial services.What is Infosys's view based on its discussion with customers.

 Margin outlook and impact of INR — The INR has appreciated ~8% YTD against the US dollar. What is Infosys doing to mitigate this, and what are the other margin levers?

Tax rates post 2009 — With the STPI benefits ending (as per current regulations) in FY09 and SEZ's still taking time to ramp up, the impact on tax rates post 2009 is another area worth focusing on.

 Pricing trends — Infosys has witnessed a strong improvement of ~5-6% in revenue per employee on a YoY basis in 1Q FY08. Going forward, the trends in pricing should be a key focus area as pricing remains one of the key margin levers for the sector.

India Mini Conference - London 2007

Company description

Infosys is the second-largest IT services company in India with more than 66,000 professionals. It also is among the fastest-growing IT services organization in the world, and is a leader in the offshore services space. Infosys provides business consulting, application development and maintenance and engineering services to more than 475 active clients across verticals such as Banking, Financial Services, Insurance, Retail, Manufacturing, and Utilities in the Americas, Europe and Asia Pacific. Infosys sells a core banking application, Finacle, which is used by leading banks in India, the Middle East, Africa and Europe. Its subsidiary, Infosys BPO (formerly Progeon), which employs more than 11,000 people, is a provider of BPO services. It launched a subsidiary in April 2004, Infosys Consulting, which provides high-end IT consulting services.

Recent developments

Industry trends: Indian IT companies have seen strong volume growth of 30-35% yoy over past few years. Last year saw improving trends in pricing, led by industry leaders Infosys and TCS. However, a sharp INR appreciation has led to a decline in operating margins, though partly recovered by forex gains at the net

level. The subprime crisis in US has led to a few mortgage companies shutting down, leading to loss of business for some Indian IT companies – First Magnus for WNS, GreenPoint for Infosys BPO, etc. However, most offshore IT companies have said that their subprime exposure has been less than 1% of revenue.

Results: Revenue of US$928m (up 7.5% qoq) and EBITDA of Rs10.8bn (margins down ~300bp) were in line with expectations. Higher other income (driven by better forex gains and higher cash yields) and tax write-backs saw net profit at Rs10.8bn — better than expectations. Realization per employee was up 6.7% yoy onsite and 5.3% qoq offshore. In QoQ terms, it was 1%+. Management has reiterated their view of 3-4% pricing increase for renegotiations. The US$ revenue guidance was raised ~1% while INR EPS guidance was revised down 3% to factor in stronger revenue visibility and the appreciation in the INR. Upward revenue revision was below expectations, while INR EPS revision was broadly in-line. News flow and development: Infosys has announced a seven-year BPO contract with Royal Philips Electronics where Infosys BPO would provide Finance & Accounting (F&A) and Procurement processing services. As part of this contract, it will acquire three centers with employees in Poland (755 employees), India (445), and Thailand (190) and would pay US$28m as consideration for this takeover. Green Point Mortgage, a client of Infosys BPO, has shut shop due to the subprime crisis in the US. Infosys received US$1.2m (~0.1% of its revenue) from this client in the recent quarter and had net receivables of ~US$0.4m.

Investment thesis

We rate Infosys as Buy/Low Risk (1L). We are positive on the stock from a fundamental 12-month view. Offshore IT outsourcing has now become a mainstream option, and we think scale and scalability, along with an ability to move up the value chain, are key criteria for successful offshore IT vendors. In this respect, Infosys appears well positioned and continues to gain ground given its strong branding and industry-leading sales force. Infosys should see above industry average volume growth along with modest pricing improvement. We expect Infosys to deliver a revenue CAGR of 24.5% and EPS CAGR of 19.1% for FY07-10. Unlike many other high-growth firms in other industries, Infosys continues to generate solid FCF, and its RoE of 40%+ continues to be well above its cost of capital.

Valuation

Our target price of Rs2,440 is based on 25x FY09E EPS. This is close to the midpoint of the last one-year trading band of 20-28x 1-year forward earnings and factors in some deceleration in growth. We are now forecasting 19% earnings growth (on a high base of FY07) with some upside potential from pricing improvement and/or rupee depreciation. This is also supported by comparing it with global peers and the broader Indian market. The 25x multiple was also derived from a P/E band analysis of Infosys' trading pattern. During slowdowns in tech and offshore IT services, Infosys has traded at an average one-year rolling P/E of 25.1x with a low of 13x. Our estimates continue to assume a certain P/E premium to the market; this is justified, in our view, given the strong FCF, ROIC and growth rates for Infosys vs. the overall market. We believe P/E remains the most appropriate valuation measure given Infosys' profitable record and high earnings visibility.

Risks

We rate Infosys shares as Low Risk, which is consistent with our quantitative risk-rating system that tracks historical share price volatility. The key downside risks to the shares reaching our target price include:

(1) any significant appreciation of the rupee against the US dollar/euro/pound;

(2) pressure on billing rates (as Infosys continues to enjoy a 10-15% premium in its billing rates);

(3) a sharp slowdown in the US economy; and

(4) limited H1B visa quotas.

India Mini Conference - London 2007

31 August 2007

 Citigroup Global Markets | Equity Research

Reliance Industries (RELI.BO)

Valuing Sustained Exploration Success

 Life beyond KG-D6 — Reliance has confirmed exploration success in CYDWN-2001/2 (100% interest), first deepwater discovery in Cauvery basin. Presence of gas and oil in this 14,325 sq. km block has been termed as “good”, though any comparison with the flagship KG-D6 block is very premature. This was one of the three blocks awarded to RIL in the Cauvery basin in NELP-III. Recent media reports also suggest that the company has struck oil in the D4 block in the KG Basin (100% interest).

Discoveries provide sustainability of cash flows — Cauvery discovery and further potential in D9, D3 (with Hardy Oil), and D4 (with Niko), for which drilling is planned over 6-18 months, does two things:

 i) sustains oil/gas production when D6 goes into decline and, more importantly,

 ii) sustains RIL’s share of cash flows especially when D6 investment multiple becomes >2.5x. Though rig shortage and pre-occupation with D6 will stagger exploratory drilling activity, the recently  contracted drillship (Neptune Explorer) will come in handy.

 Low global refining supply — Growing risks to refinery expansions in the Middle East due to cost inflation should bode well for RIL’s margins in FY08-10E. Besides, RIL’s differentials over benchmarks have expanded to US$5- 8/bbl over the last five quarters. RPL’s green field capacity addition in FY09 would leverage it further.

 Petrochemicals: Stable FY08E, but expect pressure in FY09E — Tightness in naphtha supplies and commissioning of ME projects (ex. Iran) in 2H08-2009 imply increased possibility of cycle downturn beyond 2008. However, stable to improving trends in PX and PVC should partially offset the impact.

Company description

Reliance Industries is a conglomerate with interests in upstream oil & gas (E&P), refining, and petrochemicals. It is building a super-size refinery project through its 75% subsidiary (RPL) and is now undertaking development of a large gas find in KG basin. RIL is foraying into organized retailing and has plans to undertake SEZ projects over the medium to long term. In FY07, RIL derived 53% o f its EBITDA from refining, 37% from petrochemicals, and the rest from its E&P business. The promoter group led by Mr. Mukesh Ambani holds a 51% stake in the company, FIIs hold 20%, while domestic FIs and public hold the

remaining.

Recent developments

Industry trends: Delayed refining capacity expansions (esp. Middle Eastern and North African greenfield expansions), sustained strength in product spreads, and light-heavy crude spreads bode well for RIL's refining profitability over FY08-10E. In addition, RIL has continued to deliver strong differentials over

regional margins in recent times, with differentials over Singapore GRMs in excess of US$6/bbl over the last 3 quarters. While petrochem should remain stable in FY08E, we anticipate a downcycle beyond 2008, especially given RIL's exposure to PE/PP spreads where we forecast declining spreads. On the E&P

side, RIL continues to sustain its exploration success, with the Cauvery discovery and further potential in D9, D3, and D4, for which drilling is planned over the next 6-18 months. Results: RIL’s 1Q FY08 net profit of Rs32.6bn (up 28% yoy and 14% qoq) beat estimates driven by robust polyester margins, forex gains (Rs1.8bn on WC loans) and the absence of one-off payments incurred in 4Q FY07. Polyesters had a strong quarter (EBIT margins up 8-15% yoy) plus volume growth across the petchem chain negated the QoQ decline in PE/PP deltas. In addition, oneoff PX royalty expense in 4Q FY07 drove a sharp 310bp qoq improvement in petchem EBIT.

Refining performance was par for the course as RIL's GRM rose in line with global trends. Refining margins at US$15.4/bbl implied differentials over Singapore benchmark (adjusted for marketing losses) remained steady on a qoq basis at ~US$6.5/bbl.

News flow & developments: RIL has submitted FDPs for NEC-25 (plateau 6.5mmscmd, first gas FY12) and CBM (5mmscmd, FY10), indicating progress on blocks other than D6. Reliance has confirmed  exploration success in CY-DWN-2001/2 (100% interest), the first deepwater discovery in Cauvery basin. RIL will undertake appraisal wells in this block over the next 8-12 months. Management has also indicated 3 more deep water rigs to be mobilized in 2H

FY08 (from existing 3) to drill exploratory wells in 11 out of the 26 blocks (incl.D9, D3, and D4).

In organized retail, RIL's total investment went up by Rs12bn in 1Q FY08 to Rs60bn, with a total of 201 stores.

India Mini Conference - London 2007

31 August 2007

Investment thesis

We rate RIL Buy/Low Risk with a target price of Rs2,005. We expect regional refining margins to remain robust due to project delays in the Middle East, with RIL enjoying an enhanced premium for its superior complexity. E&P business has delivered positive surprise and looks set to become more meaningful in the

next 3-4 years as KG D6 field commences production and new discoveries are brought on stream. Upgrade of reserves in KG basin adds to the value, although the NAV of the gas find depends on development capex and the demand profile from anchor customers. Given the track record of exploratory success and the

evolving portfolio (much beyond KG D6), RIL's E&P business needs to be valued as a going concern rather than a combination of assets. We have therefore valued E&P business (Rs631/share) on a more traditional EV/FCF multiple rather than the consensus NAV approach. While petrochemicals will likely face pressure in FY09E, this will be offset by diversity of products to some extent.

Factors such as diversity of revenues, integration across product chains, and volume growth should help RIL tide over downturns in product cycles.

Valuation

Our target price of Rs2,005 is based on a sum-of-the-parts value:

1) RIL's core petrochem and downstream oil business is valued on an EV/EBITDA of 6.5x mid-FY09E, in line with the regional chemicals and refining peers;

 2) Total E&P assets including oil & gas prospects and other blocks are valued at Rs631/share based on 10x steady state (FY11E) FCF;

 3) Investment in IPCL and RPL valued at 8x profit contribution to consolidated profits;

4) Organized retail business is factored in at Rs125/share; and

5) Treasury stock is valued at RIL's target price.

Risks

We rate RIL Low Risk, as opposed to the Medium Risk suggested by our quantitative risk-rating system, which tracks 260-day historical share-price volatility. Diversified earnings and significant value contribution from the emerging E&P business and investment in listed subsidiaries have led to qualitative changes in the value constituents of the stock. Risks that could impede the stock from reaching our target price are: RIL's margins are exposed to the global petrochemical and refining cycles; the group could be asked to offer larger discounts on products sold to oil public sector units; delays in the key KG-D6 gas development and RPL refinery project; delays in the drilling programme for the new blocks (D9, D3, D4); and the organized retail business would call for significant investment in non-core areas.