Strong earnings growth may provide downside protection

A major correction was always round the corner on the domestic bourses after a solid run up in share prices that was witnessed over the past few months. Excessive leveraging by traders and retail investors provided the trigger for correction when FIIs pressed heavy sales as global emerging markets witnessed a sell-off. As the weakness in the market triggered off a series of margin calls, brokers and banks were forced to liquidate positions of retail investors that could not meet margin payments.

Analysts feel that the fundamentals of the Indian corporate sector remain strong and strong corporate earnings growth would limit downside on the domestic bourses. The macro growth outlook for India remains strong, supported by structural factors like robust domestic consumption to a healthy take-off in the capital expenditure cycle. Favorable demographics with large young population will drive consumer demand.

In fact, Indian companies are better place than their Asian counterpart to weather global upheavals given that they don't rely excessively on external demand as a source of growth.

However, some more correction in near term may not be ruled out given that the rally has been quite steep over the past few months

Investmart:Tata Steel

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Banks: After an eventful FY06...

Better economic growth, relatively lower interest rates, capacity expansion by corporates, retail credit penetration and technological upgradation are factors that have facilitated the banking sector's 'dream run' so far. In the initial years of this decade, with the spiraling bond prices, banks could afford 'lazy banking'. Later on (2004 onwards), the highest credit growth in two decades, net interest margins and asset quality comparable to global standards and extended reach, more than made up for the treasury losses.

• Exponential growth: A consistent year on year growth in incremental credit disbursals of more than 30% persuaded banks to lighten their treasury portfolios and concentrate on the higher yielding advance book.
  
  

• Not just retail...The growth was not just in the retail segment (especially mortgage loans) but also in the corporate book (primarily SMEs). The corporates who initially borrowed only for working capital purposes, gradually sourced capital for capex also, as overseas borrowing became expensive.
  
  

• Margins at the zenith: Higher demand for credit coupled with low cost of deposits enabled banks to extract a very attractive spread (interest income less interest expended). The average NIMs of above 3% in FY06 are almost comparable to that of the banking sector in the developed countries.
  
  

• Marked improvement in quality: The asset quality of Indian banks has shown a remarkable improvement over the last 5 years, wherein average gross NPA levels have shrunk from the highs of 11% in FY02 to 3% in FY06. Also, banks that enjoyed high treasury gains, utilized the same to write off the stressed assets from their books. Of late, the secondary market for stressed assets has further facilitated banks to offload the bad assets.

Nevertheless, we reckon, that the route forward is not as rosy for the players in this sector.

Here on...
Going forward, we perceive certain encumbrances that may handicap the ability of the players in this sector to enhance their profitability.

• High base effect: With the larger banks in the sector now having attained a sizeable asset book, the growth hereon with be at a lower clip due to the high base effect. While we are not trying to negate the possibility of future credit growth being robust, the YoY growth in percentage terms (as against absolute terms) is expected to be lower. Also, the fact that interest rates charged across asset classes have seen an upward revision over the last couple of months, may discourage potential borrowers.
  
  

• Margin pressures inevitable: With interest rates headed northwards (impact of rising global interest rates weighing heavily), banks have been compelled to raise funds at higher interest rates to meet the incremental credit demand. However, the time lag for passing on the rate hike to the customers is typically 6 to 9 months. This has started squeezing the net interest margins for players across the sector and we see the margin pressure continuing, going forward.

Investors should look for...

• Attractive valuations: The valuation parameter typically used for banks is price to adjusted book value. Unlike other sectors, a bank's asset is cash and the ability to grow the topline (interest income) is therefore, largely dependent on the capital base (net worth in a broader sense). Therefore, rather than price to earnings ratio, the price to adjusted book value (book value less net NPA per share) is more relevant while valuing a banking stock.
  
  

  Besides this, investors could also look at some of the unconventional parameters such as net interest income per share and net NPA per share. While the former is to banking what sales per share is to manufacturing, net NPA per share could be considered as erosion from the book value per share. Similarly, the price to pre-provisioning profit (PPP) per share multiple would be similar to the price to EBIDTA valuation used for manufacturing companies.
  

  FY06	P*/ ABV (x)	P*/ PPP (x)	NII/ share (Rs)	Net NPA/share (Rs)
  HDFC Bank	4.8	12.0	81.3	4.9
  ICICI Bank	2.3	10.4	47.8	11.7
  UTI Bank	3.1	8.3	38.7	5.6
  SBI	2.1	4.1	297.1	89.5
  OBC **	1.1	5.9	64.1	5.7
  Corp Bank	1.3	3.9	85.5	10.0

  * Considering prices as on 25th May 2006
  ** For OBC the pre-provisioning profits are net of the extraordinary write-offs.

• Dividend yield: Investors must also look out for a regular dividend history and an attractive dividend yield that can provide them with a regular income stream at times when capital appreciation is not commensurate with expectations.

Not undermining the banking sector's ability to capitalise on the superior growth prospects of the Indian economy, what we would like to point out to investors, is the fact that the historic growth levels seen so far are not sustainable. Also, the future growth prospects will be subjective and dependent on a bank's scalability, operating efficiency and competitive edge, more so once the sector opens to foreign players in 2009. Investors, must therefore, take their decisions based on critical evaluation of the parameters as mentioned above.

Sharekhan Commodities Buzz

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Jain Irrigation & Bharat Bijlee

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Thanks Manish Chauhan

SSKI - Biocon

SSKI - Biocon - Outperformer - CMP >  405 Target > 558

SSKI - Sasken

Outperformer - Target - Rs. 426

SSKI - Vaibhav Gems

Outperformer - Target - Rs 585

Motilal Oswal - Titan Industries

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Thanks Ramesh - Keep them coming.

Sharekhan Investor's Eye

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Prime Focus Ltd

Solid growth prospects, but aggressive pricing

Prime Focus (PF) is one of India's techno-creative leading end-to-end post-production and visual effects services house. The company offers a comprehensive spectrum of services ranging from visual effects, digital film lab (digital intermediate, high-resolution film scanning and film recording), telecine, editing, and motion control to High Definition (HD) production. Currently, it holds 85% of all films undergoing process. PF caters to the commercials, features film and television segments.

Adlabs Films is a Strategic Partner, holding 482,000 shares (3.8% to 3.9% of the post equity capital) of Rs 10 each of PF. Incidentally the effective cost of acquisition for Adlabs Films was Rs 96.80 per share. Their relationship extends into business alliance agreement wherein the terms give PF a non-transferable, non-exclusive right and license to use the Name/Brand of Adlabs Films in consideration of royalty of Rs 12,80,000/- per annum.

PF operates at Santacruz, Mumbai, Royal Palms, Goregaon and Raghuvanshi Mills, Lower Parel, Adlabs premises at Goregaon, Mumbai & Vijaya Labs, Chennai. Most of the premises are owned by the company, some by its directors and couple of them by Adlabs. The company employs 273 personnel with 141 creative staff & 132 non-creative staff.

PF has acquired 55% of the share capital of VTR Plc, listed on the London Stock Exchange, totaling to 13,491,561 ordinary shares of 5 pence @ 35 pence per ordinary shares, amounting to a purchase price of GBP 4.7 million with GBP 4.2 million in cash & GBP 0.50 million in equipment. Currently, its shares are trading at 28.5 pence in London Stock Exchange, which is at about 19% discount to the PF's purchase price. VTR Plc provides services to the media industry with 20 years of post-production experience and is involved in post-production and graphic design for broadcast, commercials and promos sectors. The main focus on the acquisition is to enter in the UK market, London a key advertising market.

The Issue proceeds are to be utilized to finance the following: -

1. domestic expansion (service commencement April 2007)
2. acquire existing studio in Los Angeles, the main business center for film-based production (service commencement April 2007)
3. London studio (service commencement April 2007)
4. set up studio in Hyderabad to tap south market (service commencement September 2006)
5. fund long term working capital
6. set up studio in Dubai (service commencement July 2007)
7. issue expenses.

Strengths

• PF is the market leader in the post-production visual effects, especially for films, except in the Southern Region. Now the company also plans to enter the Southern region market as well, by setting up a studio in Hyderabad.

• The Indian Entertainment Industry stands at Rs 20,000 crore currently and is expected to grow at the rate of 18% per annum. The average budget for postproduction and visual effects is expected to be 15-25%. PF which provides a wide range of post production and visual effect services under one roof will be able to secure a sizeable piece of the pie with only 2-3 players offering such services under one roof.

• Setting up shop in Los Angeles, London & Dubai will enable the company to explore the international markets as also to explore the possibilities of outsourcing of services.

Weakness

• The collection period for PF is 90 days that gets stretched to 120 days that in turn leads to high receivables. Bad debt write off accounted for Rs 1.13 crore (5.61% of sales) as on March 31, 2004, Rs 0.89 crore (2.85% of sales) as on March 31, 2005 and Rs 0.84 crore (2.87% of sales) as on December 31, 2005. However, bad debts totaling to Rs 0.63 crore were recovered during the period ended December 31, 2005.

• On a consolidated basis, VTR Plc (subsidiary of PF), reported 18% fall in turnover to GBP 9.59 million in the six months ended February 2006. During this period, the performance deteriorated and the company reported loss after tax of GBP 0.52 million compared to a profit to GBP 0.30 million in corresponding previous period. The consolidated net worth of the company stood at GBP 4.66 million (GBP 6.15 million corresponding previous period).

• PF has to report consolidated numbers from the current fiscal. The losses of VTR Plc will eat into the profits of the stand-alone entity. The net profit for the nine months ended Dec'05 of PF is Rs 11.04 crore, while the net loss of VTR Plc for the six months ended Feb'06 is Rs 4.03 crore! Hence, much depends on the ability of PF to quickly turnaround VTR Plc and benefit from synergy in operations, which it believes to be immense.

• The mega expansion plans slated by the company will start realizing gains only in 2007-08 since the time frame for commencement of services in all location except the Hyderabad studio is proposed to be April 2007.

Valuation

The nine months annualized EPS of (stand alone) PF is Rs 10.43 / 10.22, which discounts the offer price by 48 times at the higher end and by 44 times at lower end. There is no other listed player for comparison, the biggest unlisted player being Prasad Studio. However, the Entertainment Industry PE taken as a basket is 54.3, but this again is not comparable taking into account the services rendered and the size of the company, which is at the moment mid-sized. Also, ballooning losses of VTR Plc will bring down the consolidated EPS.

The year end for both VTR and PF are different, and they have disclosed unaudited results for different periods, with the former having disclosed results for the six months ended February 2006 while the latter has disclosed the results for the nine months ended December 2005. Assuming steady stream of revenues and profits, based on the latest available financials of both the companies, we find that the consolidated P/E to be in the range of 65 to 74 times (depending on the offer price) the annualised consolidated earnings, which appears to be on a higher side.

On the positive side, the company has a basket of services covering the entire range of post-production and visual effects, and claims to be a market leader in India, except in South. With entertainment sector set to witness accelerated pace of growth, by virtue of its leadership and expansions, PF is ideally placed to optimally capitalise on the growth. But it is equally critical for the company to quickly turnaround VTR Plc and derive operational and business synergies therefrom, lest it's consolidated profits will not reveal its operational prowess. In this context, the offer price in the range of Rs 450 to 500 per share, appears stiff

Bangalore Maha Rally

Maha Rally on 28th May (Sunday)

Time: 9:30 AM
Venue: starts at Chiklalbagh (near Majestic), concludes at Banappa Park

This will be the BIGGEST rally so far in Bangalore with five to ten thousand protestors. We will make it peaceful and conclusive.

Contact persons:
Kumar Gaurav (IITK alumnus; 9341018993, kgaurav.iitk@gmail.com)
Subodh Kumar (IITKGP alumnus; 9342104597; subodh.kgp@gmail.com)
Anurag Arora (Bangalore Medical; 9844140125)