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.

Please refer to the Disclaimers at the end of this Report.

AMBIT INSIGHTS 17 June 2014

DAILY

Top export plays

Stock Rating FY15 P/E (x)

HCL Tech BUY 14.1

Bajaj Auto BUY 16.9

Dr. Reddy's UR 18.0

AIA Engineering BUY 19.9

Balkrishna Inds. BUY 12.3

TTK Prestige BUY 28.7

Elgi Equipments NR 26.3

Source: Bloomberg, Ambit Capital research

UR = Under Review

NR = Not Rated

Updates

Real Estate

Bangalore Diary Day 1

BFSI

PSU banks – A “Holdco” structure is all but inevitable

Derivatives

Alpha This Week

An alternative take on markets

(Click here for detailed note)

Analyst Notes: Capital Goods: Many “ifs and buts” before defence FDI creates private sector winners Tanuj Mukhija, CFA, +91 22 3043 3203

The Indian government allowed 26% FDI in defence in 2001 but the total FDI inflows into the defence sector have been a meagre USD5mn since 2001. In order to encourage domestic and foreign private participation, the impending increase in the defence FDI limit should be supported by changes in administrative policies and favourable manufacturing policies. The defence procurement process should reduce the preferential treatment given to defence PSUs and awards projects through competitive bidding. Further, the foreign companies with domestic manufacturing facilities should be allowed to: (a) participate in the ‘Buy India’ category; (b) considered as an Indian offset partner; and (c) export domestically manufactured products.

If the above measures are implemented then the most likely private sector beneficiaries could be L&T, Pipavav Defence and unlisted defence subsidiaries of the Tata Group. Whilst the lack of focus on R&D has led to the limited technical capabilities of most defence PSUs (including BEML), the star PSU - Bharat Electronics Limited (BEL) - has built semi-complex capabilities in manufacturing electronics for aircraft fighters, gun systems and combat vehicle systems. BEL appears to us as the best amongst an ordinary bunch of 9 defence PSUs. Source: Ambit Capital research

AMBIT INSIGHTS

Ambit Capital Pvt Ltd 17 June 2014

Real Estate Bangalore Diary Day 1 With office space absorption often acting as a lead indicator of potential employment generation, our discussion with a cross section of experts in the Bangalore office property market suggests continued buoyancy with 36msf (million square feet) of office space likely to be launched over the next three years. With lead indicators signalling a pick-up in office space absorption in Bangalore (http://goo.gl/zw0uoH), we expect spillover effects for Sobha Developers in terms of better sales velocity in its residential projects (given Sobha’s predominant exposure to Bangalore). We are likely to upgrade our FY16 residential real estate volume assumptions for Sobha. This is likely to result in a significant upgrade in our valuation (our last published valuation was Rs510).

With press reports suggesting that one of the Big 4 is looking to lease over 0.7msf in Bangalore, our discussion with local experts suggests that the office space market in this city remains extremely buoyant with 36msf (million square feet) of office space likely to be launched over the next three years. With lead indicators signalling a pick-up in office space absorption trends, we expect demand for housing to remain largely end-user driven, reasonably stable and relatively immune to demand-side shocks.

Demand for office space in Bangalore at 2-year high

Our discussions with leading property consultants suggest that demand for office space in Bangalore is at a 2-year high. To put this in context, Bangalore witnessed about 10msf of office space absorption during 2012 and 2013. Incremental demand during 2014 is largely being driven by IT/ITeS firms such as Accenture (incremental office space demand for 1.6msf), Flipkart (1.1msf), IBM, Capgemini and General Electric. This appears to be driven by: (a) companies looking to expand their existing operations in Bangalore; (b) new companies looking to enter Bangalore; and (c) more firms looking for large-ticket absorption (higher average sft absorption).

Average office space requirement by occupiers

Source: DTZ Research, Ambit Capital research

The office real estate market in Bangalore has been extremely active with overall absorption at ~4msf during Jan-May 2014 - YoY growth of over 80%. Our discussion with leading office space providers (listed and unlisted) suggests that each of the past three months (March, April and May continuing into June) has witnessed a minimum of three companies closing large deals in excess of 100,00sft across the city’s IT hubs of Outer Ring Road (ORR) and Whitefield. More than 30% of the office space absorption over the past four months has been driven by bulk occupiers (occupiers looking for space in excess of 100,000sft).

33%13%

25%

0%

20%

40%

60%

80%

100%

120%

2012 2013 2014

Less than 25,000sft 25,000sft - 100,000sft More than 100,000sft

NEUTRAL Quick Insight Analysis Meeting Note News Impact

Our expert meetings in Bangalore

Expert at one of India’s leading IPCs in commercial space

Top executive from the strategy team at one of India’s finest unlisted developers of office space

India’s largest aggregator of office space in Bangalore

CEO of one of the largest online portals catering to Bangalore residential real estate

Managing Director of one of India’s most reputed developers

Analyst

Krishnan ASV vkrishnan@ambitcapital.com Tel: +91 22 3043 3205

AMBIT INSIGHTS

Ambit Capital Pvt Ltd 17 June 2014

From an employment creation perspective, companies are increasingly looking to accommodate their employees in 80-100sft cubicles (with the exception of IT R&D companies such as Intel that continue to offer about 175-180sft per employee). As a result, 1msf of office space absorption is equivalent to 10,000 new jobs being created (assuming 100sft per employee on an average). Given that Bangalore has absorbed 10msf of office space each during 2012 and 2013, this would imply that Bangalore has been creating nearly 100,000 new jobs during the past couple of years.

South and West Bangalore - infrastructure bursting at the sides

With the density of population being significantly higher in South and West Bangalore, the existing infrastructure is evidently clogged, forcing employees to spend more hours in travel than at work. The Outer Ring Road (ORR) micro-market remains a favourite with potential occupiers of office space on account of easier availability of manpower and the presence of modern offices with large floor plates. However, the lack of availability of land has severely constrained the supply pipeline and future scope for expansion. With infrastructure in South Bangalore (Electronic City / Hosur) and West Bangalore being completely clogged and with lack of availability of ready-to-move buildings, 2013 saw a shift towards East Bangalore (Whitefield) resulting in higher rentals.

Rentals in key micro-markets at Bangalore

Infrastructure Land Supply Rentals (Rs/sft/mth)

South Bangalore (Electronic City) Clogged Not available Saturated 35-40

West Bangalore Clogged Not available Saturated 35-40

East Bangalore (Whitefield) Clogged Unoccupied Saturated 50-55

Source: DTZ, Ambit Capital research

Given the supply saturation across other parts of Bangalore, experts see a clear but gradual need for occupiers to migrate towards North Bangalore over the next 3-5 years. More importantly, with the new airport operational in North Bangalore, a lot of SEZs (special economic zones) and IT parks that were otherwise lying dormant are now beginning to get more active. The growing optimism around the economy is clearly reflected in expectations around increase in leasing activity.

Implications for residential real estate

This demand for office space is generating fresh employment opportunities, which in turn, is driving the demand for residential projects. Hence, higher volumes (sales velocity) are driving rising realization (price hikes) rather than mere speculation or artificial hoarding of residential supply. Our discussion with IPCs, online portals and local brokers suggests that the top 8-10 developers in Bangalore have typically faced no problems with absorption of residential projects (unless the project location is completely out of sync with reality).

Sobha - strong internal controls to leverage strong external environment

With the local economy beginning to reflect growing optimism around incremental job creation, we expect spillover effects for Sobha Developers in terms of better sales velocity in its residential projects (30% of its under-construction projects are coming up in North Bangalore). We are looking to upgrade our FY16 residential real estate volume assumptions for Sobha, which is likely to result in a 10-12% upgrade in our valuations (from our last published valuation of Rs510).

AMBIT INSIGHTS

Ambit Capital Pvt Ltd 17 June 2014

BFSI PSU banks – A “Holdco” structure is all but inevitable We had a long and highly fruitful discussion with a recently retired Secretary from the Department of Financial Services, Ministry of Finance. This expert has also served the Finance Ministry’s nominee on the RBI’s Board. As a result, he has had ringside view of the woes of India’s public sector (PSU) banks.

Key takeaways from our meeting: (i) Poor risk management practises are at the heart of the banking system’s asset quality troubles, and the actual NPAs of most banks, including private sector banks, are much higher than what they have been reporting; and (ii) A holding company (holdco) structure for PSU banks is all inevitable given their continuous need for heavy capital injections and the Exchequer’s inability to fund the same. Given the new PM’s track record of professionalising PSUs there is a high probability that the Government will announce such a structure in the forthcoming budget in July.

Our ongoing search for well-informed primary data experts who can give us intelligent and accurate commentary on the issues facing the RBI and the Finance Ministry lead to us meeting a recently retired IAS officer from the Ministry of Finance. The expert in question was until recently Secretary, Department of Financial Services, Ministry of Finance.

Here are the key takeaways from our meeting:

Systematically poor risk management practices are at the heart of the banking system’s asset quality troubles: The shortcomings in risk management practices have componded asset quality deterioration of the Indian banking system in recent years. For example, there is virtually no awareness amongst bankers about the leverage of projects at the holding company level, which has allowed multiple layers of leveraging by group entities. The banks also failed to carry out basic checks on how the loans that have been disbursed are being used. For example, in many infra projects, the asset developer uses his own EPC to create the asset and then siphons money out through overinvoicing by his EPC arm. The NPAs that such questionable practices create are not going to be resolved by an economic recovery. The expert’s view is that such siphoning of cash (often to bank accounts outside India) is frequent and well understood and yet does not result in any regulatory action.

Asset quality stress - more than what meets the eye: The under-reporting of NPAs prevails across the system. Even excluding restructured loans, a large share of loans (estimated to be almost equal to reported NPAs) is delinquent and they are regularised at the last moment through “unorthodox means”. These stressed accounts can be classified into three categories: (1) genuine cases impacted by the economic slowdown; (2) diversion of funds by the promoters to other ventures which have got impacted by the slowdown; and (3) siphoning off the funds by the promoters for personal use. The hope is that the banks will be able to make good of this money as the economy recovers. However, the money lent to the third category of stressed cases clearly is money lost with no assets backing it, even to allow recoveries. This segment probably accounts for as much as half of the stressed loan in the system.

The RBI’s measures to form Joint Lender Forums (JLF) to resolve stressed assets are reactive at best: The measures taken by the RBI since February 2014 to form JLFs to resolve stressed corporate loans are reactive measures and address issues arising once bad lending decisions have been made. For any structural improvement, a pro-active framework, which addresses pre-lending credit appraisal practices, is required. Until such a pro-active framework emerges, we will continue to see multiple banks lending for the same project with access to different sets of information and with different terms & conditions attached to the loan.

A “holdco” structure is the only lasting solution: The only lasting solution for PSU banks’ continuous need for capital injections is the holding company structure, where the Government transfers its stake in PSU banks to one holding company and then

NEGATIVE

Quick Insight Analysis Meeting Note News Impact

Analysts

Pankaj Agarwal, CFA Tel: +91 22 3043 3206 pankajagarwal@ambitcapital.com

Ravi Singh Tel: +91 22 3043 3181 ravisingh@ambitcapital.com

Aadesh Mehta Tel: +91 22 3043 3239 aadeshmehta@ambitcapital.com

AMBIT INSIGHTS

Ambit Capital Pvt Ltd 17 June 2014

transfers the responsibility for PSU banks’ governance and management to the holdco. As per the expert, it is worth breaking down the issues facing PSU banks into four distinct components:

1. Their continuous need for capital: Since the PSU banks almost always grow their loan book faster than their ROEs, their funding needs are extensive and will balloon as we approach Basel III. Since the Exchequer is in no position to finance these funding needs and since privatization is out of question (it will require multiple legislative amendments and the new PM is not known to favour privatization), the only option is create a holdco structure. Such a structure can be brought into law by adding a few paragraphs to the Finance Bill (i.e. the bill which is used to legislate the budget).

Once a Holdco structure is created, the Government can then allow the Holdco to raise capital to such an extent that the Government’s stake in the Holdco falls to 51%. The Holdco can then allow the PSU banks to raise fresh equity capital to such an extent so that the Holdco’s stake in PSUs falls to 51% thus allowing the Government’s direct economic interest in PSUs to fall to around 25%.

2. Their need to lower asset-liability mismatches (ALM): Over the past decade, PSU banks ALM has widened as they have built up their Infra and Real Estate exposures. As a result, even with more Tier 1, PSU banks’ incremental ability to finance India’s Infra requirements in doubtful unless these banks “selldown” their long dated assets to an entity like IIFCL which can raise 20 year funding.

3. Their need for better governance: At present the PSU banks suffer to poor quality Boards and poorly motivated management. The three basic reforms that a holdco can carry out on this front are: (1) replacing “appointed” independent governors at the Boards of PSU banks by professional directors; (2) providing longer and stable tenures for CMDs of PSU banks; and (3) liberalising the executive compensation structure.

4. Their need for consolidation: At present India has 21 PSU banks and often in the same neighbourhood half a dozen PSUs have competing branches (often with no differentiation in the offering). Furthermore, IT systems and back office staff also are needlessly replicated. These 21 PSUs can be rationalized in 5-6 large PSU banks. However, the integration of different work cultures is a key road-block. The Finance Ministry had, at one time, begun the process by clubbing PSU banks across seven groups, based upon the banks’ geographical spreads, size, etc. The plan was to allow frequent employee mobility across banks within the same group so that over the years these groups emerge as an entity with a uniform culture and pave the way for being merged into one bank. However, this was never implemented.

[The Ambit view: Whilst bullet 1 seems inevitable, bullets 2, 3 & 4 will be much harder to implement.]

The “bad bank” model seems impractical: The transfer of the banks’ stressed assets to a special entity appears to be a non-starter, as it offers the banks no direct route to realise benefits from the recovery of stressed assets after the transfer. Moreover, the Government would have to fund this asset transfer which is not possible given the Government’s fiscal position.

Political will is the key catalyst: Most of these reforms and proposed solutions have been in the public domain for long. In fact, longer tenure for PSU banking chiefs was proposed as early as 1991. However, political will to implement these reforms has been the key hindrance. That being said, the example that Narendra Modi set in Gujarat, where state PSUs performed better after being given more autonomy, is encouraging. Moreover, this expert echoed Dr PJ Nayak is saying that “due to the large capital needs of the PSU banks over the next five years, the Government has no choice but to implement these reforms.”

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.

Alpha This Week

Jun 17, 2014

Derivatives

Securities featured in this note

Company Near term

Medium term

Nifty () ()

INR () ()

BSE Metals () ()

BSE Oil&Gas () ()

CNX Pharma () ()

CNX IT () <->

BSE FMCG () ()

CNX Auto () ()

Bank Nifty <-> ()

LIC Housing Fin () ()

ONGC () ()

Tata Motors () ()

NMDC () ()

ICICI Bank () ()

Larsen & Toubro () ()

MSCI EM () ()

DXY () ()

() denotes positive view, () denotes negative view, <-> denotes no major view

Analyst Details

Gaurav Mehta, CFA +91 22 3043 3255 gauravmehta@ambitcapital.com

An alternative take on markets 17th Sept 2013 Last week, in line with our view, was marked by Tech stocks’ rebound; we stay positive on that space. On the Nifty, even as our near term targets of 7600 have been met, an overshoot towards the key technical resistance of 8000 looks likely. Structurally we continue to believe that these are only initial stages of a long term uptrend. LIC Housing Finance and ONGC are two stocks that look very attractive at these price points both from long as well as short term perspectives. That apart we stay positive on ICICI Bank, L&T, Tata Motors and NMDC to play the structural upmove in Indian equities. Sectorally, we stay positive on Metals, Oil&Gas, Autos and Banks in addition to Tech, and negative on Pharma and Consumer Staples.

Index: As we have maintained, the Nifty has been in a structural uptrend ever since the mega 6350 breakout. Last few weeks’ activity only reinforces our conviction in this long term Indian equity uptrend! From a near term perspective, even though our targets of 7600 have been met, we believe a move towards the technical resistance of 8000 is likely.

Stocks: We recommend fresh BUY on LIC Housing Finance; ONGC too looks very attractive at these price levels. In addition, we stay positive on L&T, ICICI Bank, Tata Motors and NMDC to play the structural upmove in Indian equities. We also like Mind Tree from the Technology space!

LIC Housing Finance- BUY

Source: Metastock; this is a plot of the CNXIT index

Sectors: We believe the rebound in Tech stocks should continue. We also stay positive on Metals, Oil & Gas, Autos and Banks while remaining negative on Pharma and Consumer Staples.

Currency: While the ‘golden cross’ in INR continues to point to a longer trend towards appreciation, the currency is likely to consolidate in the short term with 58.5 as the cap.

FIIs’ index futures longs still in the neutral zone: Even with the recent run-up in Indian equities, FIIs’ longs have inched lower in the index derivatives segment suggesting that positions remain in neutral region, away from levels denoting complacency.

AMBIT INSIGHTS

Ambit Capital Pvt Ltd 17 June 2014

Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 saurabhmukherjea@ambitcapital.com

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infrastructure / Cement (022) 30433241 nitinbhasin@ambitcapital.com

Aadesh Mehta Banking / Financial Services (022) 30433239 aadeshmehta@ambitcapital.com

Achint Bhagat Cement / Infrastructure (022) 30433178 achintbhagat@ambitcapital.com

Aditya Khemka Healthcare (022) 30433272 adityakhemka@ambitcapital.com

Akshay Wadhwa Banking & Financial Services (022) 30433005 akshaywadhwa@ambitcapital.com Ashvin Shetty, CFA Automobile (022) 30433285 ashvinshetty@ambitcapital.com

Bhargav Buddhadev Power / Capital Goods (022) 30433252 bhargavbuddhadev@ambitcapital.com

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 dayanandmittal@ambitcapital.com

Deepesh Agarwal Power / Capital Goods (022) 30433275 deepeshagarwal@ambitcapital.com Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 gauravmehta@ambitcapital.com

Karan Khanna Strategy (022) 30433251 karankhanna@ambitcapital.com

Krishnan ASV Real Estate (022) 30433205 vkrishnan@ambitcapital.com

Nitin Jain Technology (022) 30433291 nitinjain@ambitcapital.com

Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 pankajagarwal@ambitcapital.com

Paresh Dave Healthcare (022) 30433212 pareshdave@ambitcapital.com

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 paritaashar@ambitcapital.com

Pratik Singhania Retail (022) 30433264 pratiksinghania@ambitcapital.com

Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 rakshitranjan@ambitcapital.com

Ravi Singh Banking / Financial Services (022) 30433181 ravisingh@ambitcapital.com

Ritesh Vaidya Consumer (022) 30433246 riteshvaidya@ambitcapital.com Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 ritikamankar@ambitcapital.com

Ritu Modi Automobile (022) 30433292 ritumodi@ambitcapital.com

Tanuj Mukhija, CFA E&C / Infrastructure (022) 30433203 tanujmukhija@ambitcapital.com

Utsav Mehta Technology (022) 30433209 utsavmehta@ambitcapital.com

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 sarojini@panmure.com

Deepak Sawhney India / Asia (022) 30433295 deepaksawhney@ambitcapital.com

Dharmen Shah India / Asia (022) 30433289 dharmenshah@ambitcapital.com

Dipti Mehta India / USA (022) 30433053 diptimehta@ambitcapital.com

Nityam Shah, CFA USA / Europe (022) 30433259 nityamshah@ambitcapital.com

Parees Purohit, CFA UK / USA (022) 30433169 pareespurohit@ambitcapital.com

Praveena Pattabiraman India / Asia (022) 30433268 praveenapattabiraman@ambitcapital.com

Production

Sajid Merchant Production (022) 30433247 sajidmerchant@ambitcapital.com

Sharoz G Hussain Production (022) 30433183 sharozghussain@ambitcapital.com

Joel Pereira Editor (022) 30433284 joelpereira@ambitcapital.com

Nikhil Pillai Database (022) 30433265 nikhilpillai@ambitcapital.com

E&C = Engineering & Construction

AMBIT INSIGHTS

Ambit Capital Pvt Ltd 17 June 2014

Explanation of Investment Rating Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >5%

Sell <5%

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