First Global: India Equity Strategy: Vertigo Justified?

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India Equity Strategy: Vertigo Justified?

There has been a benign cycle in the drivers of P/E, viz. Earnings growth, RoE & Cost of Capital... ... but the analysis of the past itself shows that the seeds of disquiet have already been sown Earnings Growth & Return ratios have expanded over the last few years but this has been almost entirely driven by cyclical earnings & interest cost reduction both of which are reversing now Free cashflows have already started contracting in FY05, with higher capex & working capital signs of tougher times ahead
Risks far higher for the Midcaps
October 15, 2005

Chief Strategist: Devina Mehra
With Sri Raghunandhan N. L.
Email: devinam@fglobal.com
Email: sriraghu@fglobal.com
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Research Note issued by First Global Securities Ltd., India FG Markets, Inc. is a member of NASD/SIPC and is regulated by the Securities & Exchange Commission (SEC), US First Global (UK) Ltd. is a member of London Stock Exchange and is regulated by Financial Services Authority (FSA), UK
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Table of Contents
Particulars
n The Short Story... n Headlines n Guide to terms & Indices used
Page Nos.
1-2 3-7 8-9 10-11 12-15 12 13-15 16-19
Current Values of & trends in Indices

n The 'Fair' P/E l The large cap indices are still not extraordinarily high in
P/E terms... compared to averages

l but Midcaps are expensiverelative to history & large caps n Markets are way above average on P/S & P/B n The Drivers of the P/E have all moved in a positive direction over the
last few years

l The Cost of Capital has fallen l The Returns on Equity/ Returns on Capital Employed expanded l Earnings Growth has accelerated n Earnings Growth has had a heavy cyclical component n Earnings growth was driven by lower interest & depreciation
20-25 20 21-22 22-25 26-28
which is reversing now

n The margin expansion has all been below the EBIDTA line n The RoE expansion has also been driven by cyclical sectors n RoCE expansion has also been driven by cyclicals n What has driven the return expansion?
29-30 31-32 33-35 36-38
PAT/EBIDTA & Asset Turnover

n Free Cash Flow analysis n What does the future hold? l All P/E drivers are taking a turn for the worse l RoE contraction is also on the cards l Cost of capital is inching up Page 63
39-44 45-53 54-56 54-55 55-56 56 56 57 58-61
l All these effects will be magnified for the MidCap universe n Conclusions n
Annexure A
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Terrell Biggs, Heavyweight Contender, in pre-fight conference: I have got the strategy to beat Mike Tyson Mike Tyson, Heavyweight Champion of the world: Everybody's got a strategy till they get hit
The Short Story...

Lets settle this debate, once and for all is India overvalued or not? For the only sensible answer from the sell-side on this issue, look no further than this piece of ours. For here is where we present the definitive answer to this question. And the answer is It depends!! Jokes apart, this is true, guys. The large caps are not terribly expensive...at least relative to their history & relative to the midcaps. The mid-caps are carrying reasonable sticker shock. So whether India is cheap or not, depends on where you are looking. But more than the cheap vs. expensive question, it's illustrative to see a bit of history All the determinants of the P/E ratio have had a benign cycle last couple of years. Earnings growth has been great for the last 3 years, but it has been almost entirely driven by cyclicals and a drop in interest expenses. (EBIDTA Earnings growth has been great for the last 3 margin for the market has remained years, but it has been almost entirely driven by stagnant, even in these go-go years). cyclicals and a drop in interest expenses. (EBIDTA These very factors and a rising Asset Turnover boosted RoE, as slack capacity margin for the market has remained stagnant, even got taken up. Believe it or not, Cyclical in these go-go years). These very factors and a rising sectors contributed more than 100% of Asset Turnover boosted RoE, as slack capacity got the RoE expansion! taken up. Believe it or not, Cyclical sectors Sadly, in the grand tradition of Indian Romantic tales, like Mughal-e-Azam, the ...Sadly, in the grand tradition of Indian Romantic villains are coming back in strength to tales, like Mughal-e-Azam, the villains are coming break up this romantic bull-market...for a back in strength to break up this romantic bullwhile, anyway. Earnings growth is market...for a while, anyway likely to decline as the uptrend for cyclicals flattens out... or reverses. Plus, the easy gains from fall in interest expenses will disappear, as interest rates creep up. For exactly the same reasons, as well as higher capex & massive capital dilutions, the RoE will be squeezed for market aggregates.
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contributed more than 100% of the RoE expansion!...
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The future is already here: Interest costs have started creeping up (long-term rates are up nearly 200 bp from the bottom), capex cycles are starting in industries like steel & capital goods, earnings growth is slowing. Most important, Free Cash flow for the market aggregate, has already declined even in the YE March 2005 (FY05), as investment in working capital & capex went up. This to Most important, Free Cash flow us is the first red flag. FY06 earnings growth & RoE will for the market aggregate, has already show significant declines. declined even in the YE March 2005
(FY05), as investment in working capital & capex went up. This to us is the first red flag. FY06 earnings growth & RoE will show significant declines.
What concerns us most is the upcoming uptick in capital expenditures by Indian companies. This will be a double whammy hit on free cash and RoCE. Both will contract valuations quite significantly. Save for capital goods companies (a sector we like), increased capex is bad news for the market. Even for interest rates.
All these effects will be magnified for the Midcap universe. Given that large caps are still not very expensive relative to their history; correction is more likely via time (slow drift), rather than a sharp crash. Even so, the Sensex could head down to 7500-8000. MidCaps have a much worse outlook due to greater earnings cyclicality/ volatility & vulnerability to interest costs plus the higher (relative to Balance Sheet size) capital dilutionsnot to mention the way-above average valuation ratios the danger signs there are clear.
What concerns us most is the upcoming uptick in capital expenditures by Indian companies. This will be a double whammy hit on free cash and RoCE. Both will contract valuations quite significantly.
Most importantly, the key sign of bearishness we see is that the markets have become non-discriminating: just look at the demand for mid-cap paper, and crazily priced IPOs. We are seeing mid-caps routinely raising 50-100% of their capital employed in the GDR/FCCB market. Deals are being sold on the specious basis that because valuations MidCaps have a much worse are high, earnings dilutions will be low. Stuff and nonsense. outlook due to greater earnings Markets value high RoCEs. You hit that ratio, your cyclicality/ volatility & vulnerability to valuation gets hit. And stays hit. For a long, long interest costs plus the higher (relative to period of time. There's no escaping that. And we Balance Sheet size) capital fear the mid-caps are headed that way.
dilutionsnot to mention the way-above average valuation ratios the danger signs there are clear
Recommendation: Stick to the Large caps. Avoid, generally speaking, the mid-caps. It's as simple as that. Detailed strategy piece follows shortly.
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Note: If you're interested in any of the earlier FG reports mentioned in this piece, do email us for copies.
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Headlines
First, the good news
As everyone, from the Finance Minister downwards is fond of pointing out, the market P/E ratios not too highat least for the large caps (see Page no. 13)
l l
Sensex P/E (ttm) is only 23.1% above its 10-year average The P/E for the Manufacturing (Mfg) subset of First Global's own Large Cap & Junior Large Cap Index FG iTotal # is at the decade's average. Of course, the FG iMidcap # P/E is 52.8% over its decade's average, at 18.1x, as against 18.1x and 16.4x multiple for the Sensex and Nifty respectively.
# For details & composition of FG iTotal & FG iMidcap see pages 58 & 60.
Last 2-3 years have seen a benign cycle for the 3 drivers of P/E: Growth, Return on Equity & Cost of Capital (See Page 20)
l
Earnings growth accelerated: The NSE-50 index (Nifty) saw a 3-year Net Profit CAGR (FY02-FY05)# of 37.2%, against a 17.6% 10-year CAGR FG iMidcap Index saw a Net Profit CAGR of 103.3% for FY02-FY05, against a 10-year CAGR of 9.9% RoE jumped: from 13.1% in FY99 to nearly 24.8% for the Nifty in FY05 Cost of Capital fell as the 10-year government bond yields fell from 12.0% in FY98 to 5.4% in FY04(10-year Bond yields are up to around 7.5% now)
l l
# Throughout the report, FY05 stands for the year ending March 2005, or the closest financial year thereto
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That was the good news The bad news

Other valuation ratios are much higher than the averages. P/sales has broadly doubled from the bottom for large cap indices. (See Page 16). For FG iMidcap P/S has more than quadrupled from the bottom of 0.3x to 1.3x and is at double the long-term averagesimilar trends for Price/ Book.
Most important, all the P/E drivers are taking a turn for the worse
Earnings Growth has had a heavy cyclical component

(See Page 26)
l
FG iMidcap has had earnings declines in 5 out of the last 10 years. Nifty (excl. banking) has had negative or marginal earnings growth in 3, out of the last 10-years. The recent high growth appears to be a cyclical high. The earnings growth contribution has been the highest from commodity stocks and other cyclicals (contributing 89% of thetotal increase in profits), especially for the Midcap index. Even for FG iTotal , about 7-8 cyclical sectors (steel, oil, petrochem, capital goods etc) contributed over 80% of the earnings growth. Add banking, and the percentage goes to 90%. The FY2000 'high' P/E was because of the worldwide boom in TMT stocks. For manufacturing companies, that high was on cyclically low earnings; with high/ negative (due to losses) P/E for sectors like steel, textiles, commercial vehicles, computer hardware etc. The present 'not so high' P/E is on cyclically high earnings. The Top-10 stocks contributing 67.7% of the Nifty's earnings growth in FY06 have a heavy weighting of commodity cyclicals, like petrochemicals & steel.
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l l
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Earnings growth was driven by lower interest costs & depreciation which is reversing now (See Page 29)
l
For Nifty (excl. Bkg), PAT compounded at 37.2% for the last 3 years (FY02-FY05), as against a mere 24.0% for EBIDTA. For FG iMidcap, the divergence was even more: EBIDTA compounded at 19.4%PAT at 103.3%! That means that almost the entire Net Profit growth was driven by a decline in interest, depreciation & taxes (mainly lower interest expenses) Another way of looking at it: PAT went from 10% of EBIDTA in FY02 to 38.3% of EBIDTA in FY05 for the FG iMidcap. Thus, in spite of the cyclical tailwind, EBIDTA margins did not move significantly above averagesthe story was really of improved asset utilisation, and even more so, of lowered interest rates. The effect was much more visible in the Midcap stocks, which tend to be more highly leveraged than the large caps.
RoE expansion was driven by increasing Asset turnover & the expansion in the PAT/EBIDTA ratio
(See Page 39)
l
For the FG iMidcap Index, the expansion in PAT/EBIDTA contributed 72.5% of the RoE expansion, with Asset Turnover expansion contributing another 19.9%. The EBIDTA margin expansion contributed a mere 11.5%. Trends were similar for even the Large Cap indices. Now the capex cycle is starting again in capital-intensive industries, like steel. Interest rates have also begun to riseboth will have adverse impact on the return ratios. Add the impact of the huge fund-raisings by companies, especially in the Midcap universeand the RoE picture looks bleaker. Midcap companies have been routinely increasing Capital Employed by 50-100% through dilutionsnever a good idea, as history has shown
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Cyclicals drove the Return ratios expansion as well(See Page 33)

l
For FG iMidcap Index, cyclical sectors with 46.8% weight in the index contributed more than 100% of the return expansion. The aggregate RoE expanded by 9 percent points from the bottom, whereas sectors like steel, mining etc. contributed 13.8 percent points of the rise. Now with the threat of the commodity cycle reversing (due, in no small part, due to the 'surprise' rally in the US Dollar - in which most commodities are quoted); these sectors are likely to see Returns slip from their highs driving down aggregate return ratios for the Indices
The most important indication: The pressure is already visible on the cashflows (See Page 45)
l
In FY05, Sensex companies showed a decline in Free Cash Flows of 7.8%, in spite of a NOPLAT growth of 46.5% - due to higher Working capital & capital investments. A similar trend was seen for the Nifty companies. (The Aggregates for the broader & Midcap Indices are not available, as not all Annual Reports have been released - but are likely to have worse numbers). In our view, cashflow strains normally precede pressures on the Income Statement.
All P/E drivers are taking a turn for the worse (See Pg 54)
l Earnings growth is likely to decline:

As the uptrend for cyclicals flattens out... or reverses The easy gains from fall in interest expenses disappear, as interest rates creep up
l The same reasons, plus the peaking of the improvement in asset
Turnover plus the capital dilutions will drive down Return on Capital/ return on Equity
l
Long-term interest rates are already up over 150 bp from the bottom & we expect to see further increases. Page 6
l All these effects will be magnified for the MidCap universe

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The Conclusions (See Page 57)

l l
Overweight Large Caps, relative to the Midcaps

All the P/E drivers; viz., earnings growth, Return on equity & Cost of capital are taking a turn for the worse, making P/E expansion very tough. However, given that large caps are still not very expensive relative to their history; correction is more likely via time (slow drift), rather than a sharp crash. Even so, the Sensex could head down to 7500-8000.
MidCaps have a much worse outlook due to greater earnings cyclicality/ volatility & vulnerability to interest costs plus the higher (relative to Balance Sheet size) capital dilutionsnot to mention the way-above average valuation ratios the danger signs there are clear.
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Guide to terms & Indices used

FG iTotal Index
This index is First Globals own index of stocks, consisting of 151 companies spanning across 31 sectors essentially a Large Cap & Junior Large Cap Index. It is split up into Sectoral Indices. The Index composition is given in Appendix A. FGs iTotal index (excluding banking) refers to the same index exclusive of all banking companies. Manufacturing Index (FG iTotal), as the name suggests, contains only the manufacturing companies in FG iTotal. This index has 107 companies spanning 23 sectors. Service Index (FG iTotal) is similarly that part of FG iTotal that contains companies in service sector. This index has 44 companies spanning 8 sectors. Service Index excluding banking (FG iTotal) is an extension of service sector index, which eliminates banking companies.
BSE-30 Sensitive Index (Sensex) and NSE-50 (Nifty)

BSEs Sensex and Nifty Indices have been used, Sensex (excluding banking) and Nifty (excluding banking) represent these indices exclusive of banking companies.
FG iMidcap Index
FG iMidcap has been used to show the trend of midcaps. FG iMidcap Index largely mirrors the CNX Midcap index, with the important distinction that it is split into the 26 sectoral indices. The composition of FG iMidcap is given in Appendix A. It currently has 150 companies. FG iMidcap (excluding banking) index is the FG iMidcap exclusive of banking companies. Manufacturing Index (FG iMidcap) consists of only manufacturing companies in FG iMidcap Index spanning 20 sectors. Service Index (FG iMidcap) contains only the service companies spanning 6 sectors. Service Index excluding banking index (FG iMidcap) is an extension of service sector index, which eliminates banking companies.
l Guide to the formulae & notations used

1. Throughout the report, FY05 stands for the year ending March 2005, or the closest financial year thereof. Thus for companies where the financial year is the calendar year, data for Year ending Dec. 2004 has been clubbed with FY05 data.
2. Averages referred to in the report, particularly for valuation ratios, are usually those calculated for the last 10-years (FY96-FY05), excluding the FY00 peak; though the averages including the peak values have also been given in the tables. 3. The Price based ratios for prior years are based on average prices for the last month of fiscal year. 4. Valuation ratios are historical, calculated for earnings of the fiscal year. Oct. 2005 valuation ratios are on ttm earnings/revenues, except P/BV, where FY05 book value has been used.
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5. The reason, for giving ratios & trends for various indices excluding banking & finance companies, in certain places, is that otherwise the ratios are somewhat distorted. For example, EBIDTA margins have a different meaning for the banking sector. 6. Everywhere in the report, the term Limited /Ltd. Companies refers to the subset of the Index for which the FY05 Annual Report/ Balance Sheet is available. For the Nifty, it is 49 out of 50 companies. For FG iTotal , it is 138 out of 151for FG iMidcap, it is 129, out of 150 companies. FY05 Annual reports were available for all Sensex companies. 7. All calculations are based on Reported Accounting Earnings, not Proforma/Adjusted earnings, in order to retain consistency. 8. Our data sources are Capitalline, Bloomberg and FG Estimates 9. We have calculated the valuation ratios in the following manner: 10. All ratios have been calculated for the same companies (the current index composition going back in time) rather than the actual index composition as on that date. P/E = Market Capitalisation/ Net Income to common stockholder P/S= Market Capitalisation / Net Revenues P/BV= Market Capitalisation/(Net Worth after excluding Preference Capital and Revaluation Reserve, if any) ROE= Net Income to common stockholder/ Net Worth after excluding Preference Capital and Revaluation Reserve, if any ROCE= [PAT + Interest Expense (1-t)] / Capital Employed (including short term debt)
The sectoral aggregates of these ratios have been computed by aggregating the items for all companies/ stocks in the numerator and denominator. For example, the P/E for the Sensex companies has been calculated by aggregating the Market capitalisation for all the Sensex stocks, and dividing by the Net Profits for all the Sensex stocks. Another possible way of calculating the same would taking a sum of (weight in the Index x P/E of the stock). The reason why this method was not used was due to distortions in historical ratios in years where several companies made losses. A sample calculation for the Sensex shows that there are significant differences in calculations under the 2 methods, though the expansion trend is similar: Calculation of P/E for Sensex companies
Aggregate Mkt Cap/Aggregate Profits Weights x P/E FY04 14.89 20.01 FY05 13.76 20.69 Oct 05 17.88 28.80
The second method would have resulted in higher P/Es, due higher weightage of companies like Infosys, which trade at a higher P/E, as against stocks in old economy sectors, like steel, oil, banks etc.
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Current Values of & trends in Indices

Table 1: Current Levels and Market Capitalisation of Indices
Current Levels of Indices Last Price 8540.6 2589.6 3786.0 Market Capitalisation of Indices Large cap Indices Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg Midcap Indices Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap FG iMidcap excl. Bkg INR in bn 10950 9595 12001 10431 9205 3856 1949 13061 11154 1103 340 227 1443 1329 USD in mn 244 214 267 232 205 86 43 291 249 25 8 5 32 30
Sensex Nifty CNX Index
Note: USD exchange price at 44.61 as on Oct 11, 2005 The last price and market capitalisation are as on Oct 11, 2005
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Chart 1: Trends in Market Capitalisation (Marcap) for Large Cap indices

Trend in Marcap
14000 12000 Marcap (Rs. bn) 10000 8000 6000 4000 2000 0 FY96 FY97 FY98 FY99 FY01 FY02 Years Services (FG itotal) FG itotal excl. Bkg Nifty FY00 FY03 FY04 FY05 Oct05
Mfg (FG itotal) FG itotal Sensex excl. Bkg
Services (excl. Bkg) Sensex Nifty excl. Bkg
Chart 2: Trends in Market Capitalisation (Marcap) for midcap indices

Trends in Marcap 1600 1400 Marcap (Rs. bn) 1200 1000 800 600 400 200 0 FY96 FY97 FY98 FY99 FY00 FY01 Years Mfg (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap excl. Bkg Services (FG iMidcap) FG iMidcap FY02 FY03 FY04 FY05 Oct05
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The 'Fair' P/E

Virtually everyone talking about the Indian Market loves to say: Its really not that expensive on a P/E basis. But, what is expensive & what is cheap in P/E terms? Can 10x be too expensive or 20x too cheap? Sure. Then again, is it all about sentiment, or are there objective criteria too to determine whats the fair value P/E for a stock, a sector or a company? To answer this Is it all about sentiment, or are question, one has to look at the drivers of P/E. A rough there objective criteria too to mapping of Discounted Cash flows onto accounting earnings determine whats the fair value P/E gets us to: 1-g/r for a stock, a sector or a company? P/E = k-g To answer this question, one has to Where g = growth in earnings r = return on incremental equity capital k = cost of equity
look at the drivers of P/E.
First, on P/E basis, the Indian markets currently look high, but certainly not extraordinarily so
l The large cap indices are still not extraordinarily high
in P/E terms... compared to averages

n n
P/E (ttm) is about 17.9x for Sensex, against an average of 14.1x for the 10-year period excluding FY00 P/E for Sensex, excluding Banking & Finance companies, is 18.2x, as against average of 14.7x for period excl FY00. For Nifty, the differential is less. Nifty, excl. Banking & Finance, P/E is 16.5x, against 14.4x for period excluding FY00. At first glance, the manufacturing sector P/Es dont appear too high 13.7x for Manufacturing (FG iTotal) against average of 13.7x for the period excluding FY00. The Manufacturing (FG iTotal) P/E grew from 8.3x in FY03 to 13.7x, whereas Nifty (excl bkg.) P/E grew from 10.4x in FY03 to 16.5x, revealing comparable growth rates. FG iTotal (net of Banking & Finance) P/E is 15.2x against average of 14.2x for the period excluding FY00.
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At first glance, the manufacturing sector P/Es dont appear too high 13.7x for Manufacturing (FG iTotal) against average of 13.7x for the period excluding FY00.
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l but Midcaps are expensiverelative to history &
large caps
n
Taking a peek at the midcaps, these are now more expensive than the large caps and are trading way above their historical multiples. Last 2 years, P/E for FG iMidcap (excl bkg.) has been above its average of 11.9x... it is currently at an all time high of 18.1x The midcaps, these are now more - 52.8% above its historical average. expensive than the large caps and are trading way above their historical multiples... n The P/Es are 24.6x and 16.6x for the FG iMidcap Service and manufacturing sectors ... Last 2 years, P/E for FG iMidcap (excl respectively against averages of 7.9x and 12.3x. bkg.) has been above its average of 11.9x... it is currently at an all time high of 18.1x 52.8% above its historical average
Table 2: Trends in Price/Earnings ratio

Price/ Earnings 10-year Avg excl Avg FY00 15.1 15.9 14.9 15.9 14.2 14 24.1 14.1 15.5 14.1 14.7 13.6 14.4 13.7 11.7 18 13.1 14.2
Oct '05 Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg 17.9 18.2 16.3 16.5 13.7 21.6 30.9 15.3 15.2 FG iMidcap P/E Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap FG iMidcap excl. Bkg 16.6 24.6 31.0 18.0 18.1
FY03 FY00 9.4 9.9 9.7 10.4 8.3 9.3 17.8 8.5 9.2 24.1 26.5 26.2 29.7 18.2 34.7 78.5 23.5 27.5
11.7 4.5 7.4 8.3 10.6
29.5 30.7 58.6 30.1 37.8
14.2 10.4 16.8 12.7 14.7
12.3 7.9 11.5 10.5 11.8
Note: FY03 & FY00 have been chosen to approximate the lows & highs in these ratios respectively Page 13
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Chart 3: P/E Trends in Large Cap indices

Trends in P/E
36 31 P/E Ratio 26 21 16 11 6 FY96 FY97 FY98 FY99 FY00 FY01 Years FY02 FY03 FY04 FY05 Oct05
Services (FG itotal) FG itotal excl. Bkg Nifty
Note: Services excl. Bkg (FG iTotal) P/E for FY00 was 78.5x, as India participated in the worldwide tech boom
Chart 4: P/E Trends in Midcap Indices

Trends in P/E
55 45 P/E Ratio 35 25 15 5 -5 FY96 FY97 FY98 FY99 FY00 FY01 Years FY02 FY03 FY04 FY05 Oct05
Mfg (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap excl. Bkg
Services (FG iMidcap) FG iMidcap
Note: Manufacturing (FG iMidcap) P/E for FY02 was 187.8x, due to extraordinarily low aggregate earnings (several sectors like steel, industrial machinery & cement saw significant losses) Page 14
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During the period that P/E has expanded, lets see what has happened to the drivers of P/E. All three drivers have moved in a direction conducive to P/E expansion, ie earnings growth has accelerated, returns have expanded & cost of capital has reduced. While the details come in a little later, the broad trend is captured in these headline numbers: All three drivers have moved
in a direction conducive to P/E expansion, ie earnings growth has accelerated, returns have expanded & cost of capital has reduced
All drivers were conducive for a P/E expansion

n
Earnings growth accelerated: The NSE-50 index (Nifty) saw a 3-year Net Profit CAGR (FY02-FY05) of 37.2%, against a 17.6% 10-year CAGR, Sensex saw a 3-year Net profit CAGR of 30.7%, against a 22.2% 10-year CAGR, FG iMidcap Index saw a CAGR of 103.3% for FY02-FY05, against a 10-year CAGR of 9.9% RoE jumped: from 13.1% in FY99 to nearly 24.8% for the Nifty in FY05... and similar trends were noted in other indices Cost of Capital fell as the 10-year government bond yields fell from 12.0% in FY98 to 5.4% in FY0410-year bond yields are up to 7% plus now.
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Markets are way above average on P/S & P/B

Hence, market P/Es are not too high, at least for the Large Caps, relative to their history & the P/E drivers have all moved in the right direction an expansionso far, so good.
n
The easy sense of comfort vanishes once one goes beyond the P/E into other valuation ratios. On P/BV & P/Sales, markets are much higher than their historical averages
The easy sense of comfort vanishes once one goes beyond the P/ E into other valuation ratios. On P/BV & P/Sales, markets are much higher than their historical averages
Table 3: Trends in Price/Sales ratio

Price/ Sales Oct '05 Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap FG iMidcap excl. Bkg 3.0 3.1 2.1 2.1 1.3 2.9 5.2 1.6 1.5 FG iMidcap P/S 1.2 1.8 2.4 1.3 1.3 FY03 1.3 1.5 1.0 1.1 0.7 1.2 2.9 0.8 0.8 0.3 0.4 0.7 0.3 0.3 FY00 3 3.5 2.1 2.4 1.0 4.2 12.5 1.5 1.7 0.8 2.9 7.4 1.2 1.3 10-year Avg 1.9 2.15 1.5 1.6 1.0 1.8 4.1 1.2 1.2 0.5 0.9 1.8 0.6 0.6 Avg excl FY00 1.8 2.0 1.4 1.5 1.0 1.6 3.1 1.1 1.2 0.5 0.7 1.2 0.55 0.6
Note: FY03 & FY00 have been chosen to approximate the lows & highs in these ratios respectively Page 16
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Thus P/S ratios have broadly doubled (or more) from the bottom for the large cap indices. Though these appear lower than the FY00 peak, thats solely because of TMT companies, which have not reached their FY00 peaks. Sensex P/S is 3.0x, against a low of 1.3x & average (excl. FY00) P/S ratios have broadly of 1.8x. Manufacturing (FG iTotal ) P/S is already at doubled (or more) from the bottom peak levels (excl. FY96 when it was 1.4). This is in for the large cap indices. Though contrast to the P/E for this sub-index, which remains these appear lower than the FY00 around historical averages.
peak, thats solely because of TMT companies, which have not reached their FY00 peaks
In the midcap space, the P/S for FG iMidcap has witnessed a massive growth from FY03, roughly swelling four times from the low of 0.33. The current P/S of 1.3 is also double the average (excl. FY00) of 0.6. It was also backed by Market capitalisation rise of 600% since FY03.
The P/S for FG iMidcap has witnessed a massive growth from FY03, roughly swelling four times from the low of 0.33. The current P/S of 1.3 is also double the average of 0.6
Chart 5: P/S Trends in Large Cap indices

Trends in P/S 5.0 4.5 4.0 3.5 P/S Ratio 3.0 2.5 2.0 1.5 1.0 0.5 0.0 FY96 FY97 FY98 FY99 FY00 FY01 Years Mfg (FG itotal) FG itotal Sensex excl. Bkg Services (FG itotal) FG itotal excl. Bkg Nifty Services (excl. Bkg) Sensex Nifty excl. Bkg FY02 FY03 FY04 FY05 Oct05
Note: Services excl. Bkg (FG iTotal) P/S for FY00 was 12.5x Page 17
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Chart 6: P/S Trends in FG iMidcap

Trends in P/S 3.5 3.0 2.5 P/S Ratio 2.0 1.5 1.0 0.5 0.0 FY96 FY97 FY98 FY99 FY00 FY01 Years Mfg (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap excl. Bkg Services (FG iMidcap) FG iMidcap FY02 FY03 FY04 FY05 Oct05
Note: Services excl. Bkg (FG iMidcap) P/S for FY00 was 7.4x
Table 4: Trends in Price/Book ratio

Price/ Book Oct '05 FY03 FY00 Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg 4.1 4.4 3.9 4.2 3.3 3.5 5.3 3.3 3.5 FG iMidcap P/BV Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap FG iMidcap excl. Bkg 3.0 2.2 3.4 2.8 3.1 0.7 0.6 0.6 0.6 0.7 1.5 4.5 8.3 2.2 2.4 1.1 1.5 2.3 1.2 1.2 1.1 1.1 1.7 1.1 1.1 1.8 1.9 1.8 1.9 1.7 1.5 2.4 1.6 1.8 3.7 4 3.6 3.9 2.1 4.9 11.1 2.9 3.3 10-yr Avg excl Avg FY00 2.5 2.6 2.5 2.6 2.1 2.2 4.2 2.2 2.4 2.4 2.5 2.3 2.5 2.1 1.9 3.5 2.1 2.3
Note: FY05 and Oct. 2005 ratios are for limited companies whose annual reports are released. Oct '05 P/ BV has also been calculated based on the Book Value as in the FY05 Annual Report as mid-year Balance Sheet numbers are not available.
Page 18 Note: FY03 & FY00 have been chosen to approximate the lows & highs in these ratios respectively Page 18
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With P/BV at or close to their peak and about doubling from the bottom, even for the large caps; the question is how much of the return expansion and growth story is already in the price. Taking a closer look at midcaps, manufacturing has led the growth story from forefront; its P/BV is more than double compared to the 10 year average.
Chart 7: P/BV Trends in Large Cap indices

Trends in P/BV 6.0 5.5 5.0 P/BV Ratio 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 FY96 FY97 FY98 FY99 FY00 FY01 Years Mfg (FG itotal) FG itotal Sensex excl. Bkg Services (FG itotal) FG itotal excl. Bkg Nifty Services (excl. Bkg) Sensex Nifty excl. Bkg FY02 FY03 FY04 FY05 Oct05
Note: Services excl. Bkg (FG iTotal) P/BV for FY00 was 11.1x
Chart 8: P/BV Trends in FG iMidcap

Trends in P/BV 8 7 6 P/BV Ratio 5 4 3 2 1 0 FY96 FY97 FY98 FY99 FY00 FY01 Years FY02 FY03 FY04 FY05 Oct05
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The Drivers of the P/E have all moved in an expansionary direction over the last few years
l The Cost of Capital has fallen
n
Cost of capital has fallen at the same time that returns were expanding. The risk-free 10-year bond rate has fallen from around 12.0% in FY98 and FY99 to 11.4% in FY00 and FY01; 6.9% in FY03 to 5.4% in FY04, before rising by a percent point to 6.3% in FY05 and 7.15% presently. Assuming a 7% risk premium, the average cost of equity dropped from 18.4% in FY00 and FY01 to 13.3% in March 05. The interest cost dropping had a two-fold effect one, the cost of capital declined. Two, the Net Profit was boosted due to lower interest costs. The differential between RoE and Cost of Equity went from a negative 2.3% to a positive 10-11% as returns expanded at the same time. That has had an explosive impact on valuations.
Cost of capital has fallen at the same time that returns were expanding. The risk-free 10-year bond rate has fallen from around 12.0% in FY98 and FY99 to 11.4% in FY00 and FY01; 6.9% in FY03 to 5.4% in FY04, before rising by a percent point to 6.3% in FY05 and 7.15% presently.
Chart 9: Risk free rate

Risk Free Rate - Benchmark 10 yr Bond Yield 16% 14% 12% Bond Yied 10% 8% 6% 4% 2% 0% FY97 FY98 FY99 FY00 FY01 Years FY02 FY03 FY04 FY05
`
Risk Free Rate
Average
Benchmark 10-yr Bond yield is 7.15% as on Oct 11, 2005 Page 20
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l The Return on Equity (RoE)/ Return on Capital
Employed (RoCE) expanded

n
RoE has moved up from a low of 14.0% in FY99 and 15-16% for 3 years thereafter to 19.1% in FY04 (Sensex excl. Banking & Finance). RoE has further moved up to 22.8% for FY05. For Nifty, excl. Banking & Finance, expansion in RoE has been from 13.1% in FY00 to 20.9% in FY04 (24.8% for Ltd. Companies in FY05) For FG iTotal companies (excl Bkg.), RoE touched a bottom of 12.0% in FY99, but has grown to 21.0% in FY04 (22.9% for Ltd. Companies in FY05) For FG iMidcap (excl bkg.), after consistent declines during FY96-02, RoE has expanded from 2.4% in FY02 to 8.5% in FY04 (16.9% for Ltd. Companies in FY05)
For Nifty, excl. Banking & Finance, expansion in RoE has been from 13.1% in FY00 to 20.9% in FY04 For FG iTotal companies (excl Bkg.), RoE touched a bottom of 12.0% in FY99, but has grown to 21.0% in FY04 (22.9% for Ltd. Companies in FY05)
Chart 10: RoE Trends in Large Cap indices

Trends in RoE 28% 26% 24% 22% RoE 20% 18% 16% 14% 12% 10% FY96 FY97 FY98 FY99 FY00 Years Mfg (FG itotal) FG itotal Sensex excl. Bkg Services (FG itotal) FG itotal excl. Bkg Nifty Services (excl. Bkg) Sensex Nifty excl. Bkg FY01 FY02 FY03 FY04 FY05
Note: FY05 numbers are only for Limited companies for which FY05 Annual Reports are available Page 21
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Chart 11: RoE Trends in FG iMidcap & its components

Trends in RoE 25% 20% 15% 10% 5% 0% FY96 FY97 FY98 FY99 FY00 FY01 Years FY02 FY03 FY04 FY05
RoE
Note: FY05 numbers are only for Limited companies for which FY05 Annual Reports are available
l Earnings Growth has accelerated

During the last few years, growth rates in sales & earnings have accelerated. The sales growth has been slightly higher in FG iTotal (3 year CAGR growth 17.5%) against FG iMidcap (3 year CAGR growth of 16.2%), whereas the earnings growth has seen a steep rise in midcaps (3 year CAGR growth of 103.3%), against FG iTotal earnings The sales growth has been slightly growth of 37.5% (3 year CAGR growth). higher in FG iTotal (3 year CAGR
growth 17.5%) against FG iMidcap (3 year CAGR growth of 16.2%), whereas the earnings growth has seen a steep rise in midcaps (3 year CAGR growth of 103.3%), against FG iTotal earnings growth of 37.5% (3 year CAGR growth).
The major contributor to such extraordinary growth has been declining interest rates, slightly helped by lower depreciation, as a percentage of sales indicating better capacity utilisation.
The major contributor to such extraordinary growth has been declining interest rates, slightly helped by lower depreciation, as a percentage of sales indicating better capacity utilisation.
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Chart 12: Annual Sales trends growth Trends in Largecap indices

Trends in annual volatility of sales in Indices 35% 30% 25% sales growth 20% 15% 10% 5% 0% FY97 -5% Years Mfg (FG itotal) FG itotal Sensex excl. Bkg Services (FG itotal) FG itotal excl. Bkg Nifty Services (excl. Bkg) Sensex Nifty excl. Bkg FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05
Chart 13: Annual Sales trends growth Trends in FG iMidcap

Trends in annual volatility of sales in Indices 50% 40% sales growth 30% 20% 10% 0% FY97 -10% Years Mfg (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap excl. Bkg Services (FG iMidcap) FG iMidcap FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05
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Chart 14: Annual earnings growth Trends in Largecap indices

Trends in annual volatility of earnings in Indices 100% 80% earnings growth 60% 40% 20% 0% FY97 -20% -40% Years Mfg (FG itotal) FG itotal Sensex excl. Bkg Services (FG itotal) FG itotal excl. Bkg Nifty Services (excl. Bkg) Sensex Nifty excl. Bkg FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05
Chart 15: Annual earnings growth Trends in FG iMidcap

Trends in annual volatility of earnings in Indices 200% 150% earnings growth 100% 50% 0 % FY97 -50% -100% Years Mfg (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap excl. Bkg Services (FG iMidcap) FG iMidcap FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05
Note: Manufacturing (FG iMidcap) earnings growth for FY03 was 1288.6%, as it was coming off the extraordinarily low base of FY02, when several cyclical sectors (Steel, Capital Goods etc.) saw losses Page 24
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Growth rate of earning has also accelerated oflate, Manufacturing sectors saw earnings growth of 78.6% in FY03, 26.1% in FY04 and 30.4% in FY05, against FG iTotal (excl Bkg) earnings growth was 59.7%, 24.9% and 30.3% for those years as against Nifty earnings growth was 44.6%, 26.3% and 39.0% for those years.
Table 5: 3&10 year CAGR of Net Profits

PAT Growth
CAGR 10 yr Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG IMIDCAP FG iMidcap excl. Bkg FY96-05 22.6% 22.2% 18.6% 17.6% 16.8% 15.8% 16.1% 16.6% 16.7% CAGR 10 yr 9.7% 11.2% 12.0% 10.0% 9.9% CAGR 3 yr FY02-05 30.7% 30.7% 36.4% 37.2% 43.2% 13.9% 5.4% 34.6% 37.5% CAGR 3 yr 270.2% 2.1% -0.9% 70.2% 103.3%
# The lower 3-year CAGR for this segment is mainly due to banking companies
All looks good. There have been good fundamental underpinnings to the bull run so wheres the dark lining to this silver cloud? Its roots lie in the very good news that we have been celebrating. Remember the equation: P/E = 1-g/r k-g Where g = growth in earnings r = return on incremental equity capital k = cost of equity The drivers here are not one-time or historical values, but what the future trends are. And here, the analysis of the past itself indicates that the seeds of disquiet have already been sown.
Wheres the dark lining to this silver cloud? Its roots lie in the very good news that we have been celebrating
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Earnings Growth has had a heavy cyclical component

n
If one analyses the tables & graphs in the previous section, The interesting thing is that Mfg. (FG iTotal) and even FG iTotal (excl Bkg) have seen earnings declines in 3 out of the previous 10 years. Nifty (excl. Banking & Finance) has seen earnings declines in 2 years and only 3% growth in another year; vs. a CAGR of 37.2% in the last three years. In midcaps (FG iMidcap excl. bkg), the earnings growth The interesting thing is that Mfg. (FG has been negative in 5 of 10 years; only during last 3 years, has growth been seen. The iTotal) and even FG iTotal (excl Bkg) growth has been phenomenal with 103.3% have seen earnings declines in 3 out of the and 270.2% (3 year CAGR growth) in FG previous 10 years. Nifty (excl. Banking & iMidcap and manufacturing (FG Finance) has seen earnings declines in 2 iMidcap) sectors respectively. years and only 3% growth in another year; vs. Thus, there is clearly a cyclical component to the growth. 3 years of very high earnings growth, particularly for manufacturing, means that the current period represents a cyclical high. This is also evident from the improvement in Working Capital ratios, which shows that conditions have lately been conducive for most cyclical industries.
a CAGR of 37.2% in the last three years... ... In midcaps (FG iMidcap excl. bkg), the earnings growth has been negative in 5 of 10 years; only during last 3 years, has growth been seen.
Another way to look at it is that the high P/Es in around FY2000 for manufacturing sectors were on cyclically low earnings unlike now. During FY00 & FY01 that period negative/ high P/E sectors were: Steel, CV, textiles, Pharma, Computer Hardware, FMCG, Food. Therefore P/E was high then around cyclical low in earnings unlike now.
Another way to look at it is that the high P/Es in around FY2000 for manufacturing sectors were on cyclically low earnings unlike now.
Of course, the major reason for the yo-yo days of 2000 was the worldwide Tech boom, in which the Indian TMT stocks participated gleefully. This time round, P/E is high for services sectors: Retail Sector, Construction Sector, Hotel Sector, Telecom Sector, and Banking/Finance Sector. Of course, some of which may be secular stories. Even media & software, while below the peak are still high compared to last 3 years.
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Table 6: Sectoral PAT contribution to earnings growth (FY02-FY05) in FG iTotal

Standalone Aggregates Industry Nature PAT Growth (Rs mn) Contribution Cumulative Contribution to Cumulative to FG iTotal contribution mfg(FG iTotal) contribution profit growth growth
28.5% 17.8% 10.8% 5.6% 5.3% 5.3% 3.4% 3.4% 2.0% 1.2% 0.9% 0.9% 0.4% 0.3% 0.3% 0.1% -0.3% -0.4% 1.1% 1.0% 1.0% 0.4% 28.5% 46.3% 57.2% 62.7% 68.0% 73.3% 76.6% 80.0% 82.0% 83.2% 84.1% 85.0% 85.4% 85.8% 86.0% 86.2% 85.9% 85.5% 86.6% 87.7% 88.6% 89.0% 88.7% 32.1% 20.1% 12.2% 6.3% 6.0% 5.9% 3.8% 3.8% 2.3% 1.3% 1.0% 1.0% 0.5% 0.4% 0.3% 0.1% -0.3% -0.4% 1.3% 1.2% 1.1% 0.4% -0.4% 32.1% 52.2% 64.5% 70.8% 76.7% 82.6% 86.4% 90.2% 92.5% 93.8% 94.8% 95.8% 96.3% 96.7% 97.0% 97.2% 96.9% 96.4% 97.7% 98.9% 100.0% 100.4% 100.0%
MANUFACTURING SECTORS Steel Sector Oil Sector Petrochemicals Industry Oil Refineries Sector CV & PV Sector Metals Sector Shipping Sector Industrial Machinery Sector Cement Sector Auto Ancillary Sector 2W Sector Fertilizer Sector Chemicals Sector Textile Sector Paints Industry Oil Exploration Computer Hardware Sector Equipment Sector FMCG Sector Pharmaceuticals Sector Power Sector Food Sector Consumer Durable Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Non-Cyclical Non-Cyclical Non-Cyclical Non-Cyclical Non-Cyclical 141423 88456 53789 27696 26240 26064 16663 16661 10085 5836 4459 4371 2176 1665 1415 649 -1417 -1915 5663 5136 4824 1891
-1776 -0.4% SERVICE SECTORS
Standalone Aggregates
Industry Nature
PAT Growth (Rs mn)

44397 18411 2674 1396 1126 973 435 -13176 440055 56235 9164 496290 449219 320707 276722 440237 383374
Contribution Cumulative Contribution to Cumulative to FG iTotal contribution service(FG contribution profit growth iTotal) growth
8.9% 3.7% 0.5% 0.3% 0.2% 0.2% 0.1% -2.7% 88.7% 11.3% 1.8% 100.0% 90.5% 97.6% 101.3% 101.9% 102.1% 102.4% 102.6% 102.7% 100.0% 78.9% 32.7% 4.8% 2.5% 2.0% 1.7% 0.8% -23.4% 78.9% 111.7% 116.4% 118.9% 120.9% 122.7% 123.4% 100.0%
Banking Sector Software Sector Finance and Investment Sector Construction Sector Hotel Sector Media Sector Retail Sector Telecom Sector Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg
Considering the increase in profits in FG iTotalTM during FY02-05, the cyclicals have emerged as the clear winners with a contribution of 85.5% to earnings growth. Yet, another way of looking at cyclicals is from viewpoint of manufacturing (FG Page iTotalTM) growth, where they comprise 97.7% of earnings growth.27 The top 7 sectors have contributed a whopping 82.2% of earnings growth, with steel leading the pack at 28.5%. Oil, oil refineries and petrochemicals together form 34.2% of earnings growth, followed by commercial & passenger vehicles, metals and banking (all are cyclicals sectors to varying degrees, including banking, which played a commendable role by contributing 8.9% to earnings growth).
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Table 7: Sectoral Sectoral PAT contribution to earnings growth (FY02-FY05) in FG iMidcap

Standalone Aggregates Industry Nature PAT Growth Contribution Cumulative Contribution to Cumulative (Rs mn) to FG iMidcap contribution mfg (FG contribution profit growth iMidcap) growth
MANUFACTURING SECTORS Steel Sector Mining Sector Industrial Machinary Sector Chemicals Sector Fertilizer Sector Auto Ancillary Sector Cement Sector Textile Sector Sugar Sector Metals Sector Paints Sector Oil Exploration Sector Petrochemicals Sector Tyres Sector Computer Hardware Sector Auto Sector Equipment Sector Power Sector Pharamceuticals Sector Plastic Sector Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Cyclical Non-Cyclical Non-Cyclical Non-Cyclical 28141 4821 4453 3751 3595 3343 2269 2181 1543 1489 1015 890 824 398 -179 -950 -5256 3348 869 457 47.8% 8.2% 7.6% 6.4% 6.1% 5.7% 3.9% 3.7% 2.6% 2.5% 1.7% 1.5% 1.4% 0.7% -0.3% -1.6% -8.9% 5.7% 1.5% 0.8% 47.8% 55.9% 63.5% 69.9% 76.0% 81.7% 85.5% 89.2% 91.8% 94.4% 96.1% 97.6% 99.0% 99.7% 99.4% 97.7% 88.8% 94.5% 96.0% 96.8% 49.4% 8.5% 7.8% 6.6% 6.3% 5.9% 4.0% 3.8% 2.7% 2.6% 1.8% 1.6% 1.4% 0.7% -0.3% -1.7% -9.2% 5.9% 1.5% 0.8% 49.4% 57.8% 65.6% 72.2% 78.5% 84.4% 88.4% 92.2% 94.9% 97.5% 99.3% 100.9% 102.3% 103.0% 102.7% 101.0% 91.8% 97.7% 99.2% 100.0%
SERVICE SECTORS
Standalone Aggregates
Industry Nature
PAT Growth Contribution Cumulative Contribution to Cumulative (Rs mn) to FG iMidcap contribution services (FG contribution profit growth iMidcap) growth
1372 821 378 240 -344 -555 57002 1911 883 58913 57885 2.3% 1.4% 0.6% 0.4% -0.6% -0.9% 99.1% 100.5% 101.1% 101.5% 100.9% 100.0% 71.8% 42.9% 19.8% 12.6% -18.0% -29.0% 71.8% 114.7% 134.5% 147.0% 129.0% 100.0%
Banking Sector Retail Sector Construction Sector Hotel Sector Finance & Investment Sector Software Sector Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap FG iMidcap excl. Bkg
Similarly, the profit growth in midcaps has also been led by cyclicals (forming 88.8% of earnings growth, a tad higher than that for the largecaps). The twist in the story was that the Top 7 sectors (accounting for 87.3% of earnings growth) driving the largecaps and the midcaps are completely different, with the exception of steel (steel once again led the pack in midcaps by contributing 47.8% to earnings growth). Mining, industrial machinery, chemicals, fertilizers, auto ancillary and power sectors have come into the limelight (power being the only noncyclical sector). Page 28
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Earnings growth was driven by lower interest & depreciationwhich is reversing now
The lower interest rates have helped not only on the Cost of capital front, but also boosted Net Profit growth through lower interest costs, for both large caps and midcaps. In fact, in spite of the cyclical tailwind, EBIDTA margins did not move significantly above averagesthe story was really of improved asset utilisation and even more so, of lowered interest rates. The effect was much more visible in the midcap stocks, which tend to be more highly leveraged than the large caps. Depreciation and Tax costs, as percentage of sales, have remained at around the same levels. Interest costs have declined over the years. The interest expenses, as percentage of sales, have been 1.7%, 1.0% and 0.8% in FY05 for Sensex (excl Bkg), Nifty (excl Bkg) and FG iTotal (excl Bkg) respectively, against FY02 ratios of 3.2%, 2.8% and 3.1% in Sensex (excl Bkg), Nifty (excl Bkg) and FG iTotal (excl Bkg) respectively. The contrast is even sharper vis--vis the interest expenses in FY97 (see Table below). Clearly declining interest rates have been the major force, driving PAT higher. 3 year CAGR (FY02-FY05) PAT growth has been 30.7%, 37.2% and 37.5% for Sensex (excl Bkg), Nifty (excl Bkg) and FG iTotal (excl Bkg) respectively against at CAGR EBIDTA growth of 23.7%, 24.0% and 21.8% in 3 year CAGR (FY02-FY05) PAT growth has been Sensex (excl Bkg), Nifty (excl Bkg) and 30.7%, 37.2% and 37.5% for Sensex (excl Bkg), Nifty FG iTotal (excl Bkg) respectivelythus (excl Bkg) and FG iTotal (excl Bkg) respectively Net profit growth has compounded at a against at CAGR EBIDTA growth of 23.7%, 24.0% and rate roughly 10 percent points higher than 21.8% in Sensex (excl Bkg), Nifty (excl Bkg) and FG the EBIDTA growth for Nifty & FG iTotal (excl Bkg) respectivelythus Net profit growth iTotal companies has compounded at a rate roughly 10 percent points higher than the EBIDTA growth for Nifty & FG For FG iMidcap, the divergence was iTotal companies... even more: EBIDTA compounded at 19.4%PAT at 103.3%! That means ... For FG iMidcap, the divergence was even more: that the extraordinary compounding of EBIDTA compounded at 19.4%PAT at 103.3%! Net Profits was because of proportionately lower interest, depreciation & tax charges (mainly lower interest costs) Page 29
In spite of the cyclical tailwind, EBIDTA margins did not move significantly above averagesthe story was really of improved asset utilisation and even more so, of lowered interest rates. The effect was much more visible in the midcap stocks, which tend to be more highly leveraged than the large caps.
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www.first-global.us Table 8: Interest rate as percentage of Sales

Interest as %age of Sales Sensex excl. Bkg Nifty excl. Bkg Mfg (FG iTotal) Services (excl. Bkg) FG iTotal excl. Bkg FG iMidcap Mfg (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap excl. Bkg 4.1% 3.0% 4.0% 9.0% 4.4% 8.6% FY05 1.7% 1.0% 0.8% 0.8% 0.8% FY02 3.2% 2.8% 3.2% 1.6% 3.1%
Decline in interest rates has proved more fruitful in midcaps, as from 8.6% of turnover in FY02, interest expenses declined to 4.6% of turnover in FY05. Interest cost decline has led to higher PAT growth - 3 year CAGR PAT growth for FG iMidcap excl bkg was 103.3%, as against 19.4% for EBIDTA.Another way to look at it: Net Profits Decline in interest rates has proved more went up from 10% of EBIDTA in FY02 to fruitful in midcaps, as from 8.6% of turnover in FY02, 38.3% of EBIDTA in FY05 for the FG interest expenses declined to 4.6% of turnover in FY05. Interest cost decline has led to higher PAT growth... iMidcap Index. This has been the single most important component of the Earnings ... Net Profits went up from 10% of EBIDTA in FY02 to Growth & RoE expansion. Basically, the 38.3% of EBIDTA in FY05 for the FG iMidcap Index. positive impact of operating & financial This has been the single most important component of the Earnings Growth & RoE expansion... leverage kicked in, as a cyclical upturn coincided with lowered interest costs.
Table 9: Common Size Statements for FG iTotal and FG iMidcap

FG iTotal (excl bkg) EBIDTA Interest Depreciation Tax PAT EBIDTA Interest Depreciation Tax PAT FY02 100.0% 18.8% 24.0% 16.9% 40.3% FY03 100.0% 11.9% 20.0% 19.3% 48.7% FY04 100.0% 8.5% 18.5% 19.9% 53.1% FY05 100.0% 4.3% 16.5% 20.0% 59.2% 100.0% 21.8% 26.2% 13.7% 38.3%
FG iMidcap (excl bkg) 100.0% 100.0% 100.0% 51.2% 39.3% -0.5% 38.0% 33.7% 33.3% 33.7% 9.2% 23.8%
8.8% Page 30 10.0% 19.4%
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The margin expansion has all been below the EBIDTA line
The lower interest rates have also helped Net Profit Margins. EBIDTA Margin expansion has been very little, especially beyond the large cap companies represented by the Sensex & Nifty. The FG iMidcap EBIDTA margins remain at 10-year averages. For the FG iMidcap Index, EBIDTA margins are actually below the decade's averages. The entire margin expansion has come below the EBIDTA line.
Table 10: Trends in EBIDTA margin

EBIDTA MARGIN
FY05 Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap FG iMidcap excl. Bkg 35.1% 28.4% 28.5% 22.4% 17.8% 57.1% 28.2% 23.9% FY04 37.1% 29.0% 28.5% 21.0% 17.9% 69.0% 26.8% 25.7% FY99 35.4% 27.1% 28.3% 20.9% 17.0% 69.2% 33.3% 27.2% 18.1% 19.4% 57.8% 23.1% 26.6% 19.7% 10-year % points above Avg average (FY05) 35.3% 26.7% 28.7% 21.3% 17.0% 69.0% 31.1% 26.1% 17.8% 18.6% 54.7% 25.1% 25.0% 19.1% -0.2% 1.8% -0.2% 1.1% 0.8% -11.9% -2.9% -2.2% 0.5% 0.0% -14.3% -10.5% -2.8% -0.9%
18.3% 18.3% FG iMidcap 18.6% 40.3% 14.7% 22.2% 18.2% 15.9% 48.9% 18.5% 22.4% 16.2%
Whatever EBIDTA margin expansion is there has also come in manufacturing that too, mainly in cyclical sectors like Steel, Shipping, Autos, Oil exploration. Interestingly, services margins have contracted
Whatever EBIDTA margin expansion is there has also come in manufacturing that too, mainly in cyclical sectors like Steel, Shipping, Autos, Oil exploration. Interestingly, services margins have contracted mainly due to pressure on Infotech and construction companies' margins.
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Table 11: Trends in PAT margin

PAT margin
FY05 FY04 FY99 10-year Avg % points above average (FY05) 3.3% 3.0% 3.0% 2.7% 2.4% 0.5% 0.0% 2.0% 2.2% 2.4% -1.8% -4.0% 1.6% 1.9%
Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap FG iMidcap excl. Bkg
16.1% 16.6% 13.0% 12.9% 9.8% 13.7% 17.4% 10.4% 10.2% 6.4% 7.9% 7.3% 6.6% 6.5%
14.7% 15.4% 11.6% 11.5% 9.4% 16.0% 15.9% 10.4% 9.8% 3.4% 10.9% 6.9% 4.9% 3.7%
11.5% 12.8% 8.4% 8.7% 6.0% 12.1% 18.6% 7.2% 6.9% 3.7% 8.0% 11.5% 4.5% 4.3%
12.7% 13.6% 10.0% 10.2% 7.4% 13.3% 17.4% 8.4% 8.0% 4.0% 9.7% 11.3% 5.0% 4.6%
PAT margin
Decline in interest rates have been fruitful for midcaps, aiding PAT margin to almost double from the bottom.
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The RoE expansion has also been driven by cyclical sectors

As weve mentioned earlier, all indices have seen RoE expansion: For Sensex excl. Banking & Finance, from a low of 14.0% in FY99 to 22.8% in FY05. For FG iMidcap (excl bkg.), after consistent declines during FY96-02, RoE has expanded from 2.4% in FY02 to 8.5% in FY04 (16.9% for Ltd. Companies in FY05)
n
However, whats key is that cyclical sectors have been huge contributors to the RoE expansion. For example, for FG iTotal:
Table 12: RoE contribution of cyclicals in FG iTotal

RoE
Sector
Mkt. Cap wt in FG iTotal FY04 FY05 (Ltd. Cos.) Lo 10-yr Avg % pts % pts Contribution Contribution above Lo above avg. in percent pts in percent pts FY04 FY04 (above low) (above avg)
Steel Oil Auto: CVs & PVs Ind. M/C Cement Auto Ancillaries Auto: 2W Metals Shipping Textiles Fertilizers Total (these sectors) Total (All sectors)
3.7% 15.7% 2.5% 7.1% 2.5% 1.7% 2.4% 3.9% 0.8% 0.6% 0.6% 41.4% 100.0%
42.9% 24.1% 21.8% 17.2% 18.2% 28.0% 26.3% 16.9% 22.8% 8.6% 13.1%
58.8% 23.9% 24.3% 19.6% 21.1% 29.0% 23.8% 20.2% 30.4% 7.7% 15.9%
-17.1% 11.6% -4.3% 11.0% 6.6% 13.2% 16.4% 11.2% 7.7% -5.7% 4.1%
8.4% 18.3% 11.7% 14.9% 13.7% 19.7% 23.6% 14.4% 15.7% 4.6% 9.5%
60.0% 12.5% 26.1% 6.3% 11.6% 14.8% 9.9% 5.7% 15.1% 14.3% 8.9%
34.5% 5.8% 10.1% 2.4% 4.5% 8.3% 2.7% 2.5% 7.1% 4.0% 3.5%
2.2% 2.0% 0.6% 0.4% 0.3% 0.2% 0.2% 0.2% 0.1% 0.1% 0.0% 6.5%
1.3% 0.9% 0.2% 0.2% 0.1% 0.1% 0.1% 0.1% 0.1% 0.0% 0.0% 3.1% 4.7%
21.0%
22.9%
12.0%
16.4%
9.1%
4.7%
9.1%
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Table 13: RoE contribution of cyclicals in FG iMidcap

RoE
Sector
Mkt. FY04 Cap wt in FG iMidcap FY05 (Ltd. Cos.) Lo 10-yr Avg % pts above Lo FY04 % pts above avg. FY04 Contribution in percent p ts (above low) Contribution in percent p ts (above avg)
Steel Sector
3.7% 13.0% 33.8% -135.4% -10.0% 148.3% 22.9%
5.5% 1.8% 1.1% 1.0% 0.6% 0.6% 0.4% 0.3% 0.2% 0.1% 0.0% 0.0% 11.7%
0.9% 0.6% 0.5% 0.2% -0.1% 0.1% -0.1% 0.1% 0.1% 0.0% -0.1% -1.7% 0.6% -0.6%
Industrial Machinary Sector 9.4% 14.4% 19.9% -4.6% 7.8% 19.0% 6.6% Auto Ancillary Sector Computer Hardware Sector Cement Sector Fertilizer Sector Mining Sector Textile Sector Petrochemicals Sector Metals Sector Tyres Sector Equipment Sector Total (these sectors) Total (All sectors) 8.9% 26.5% 24.6% 14.3% 20.4% 12.2% 6.1% 1.3% 26.6% 12.3% -51.7% 8.5% 78.2% 18.1% 4.8% 0.4% 4.9% -13.0% 2.0% 13.4% -1.5% 19.9% 11.6% -1.9% 8.5% 5.5% 1.8%
3.3% 13.6% 14.1% -4.8% 11.6% 18.4% 2.0% 3.6% 18.0% 63.8% 6.4% 5.8% 10.3% 8.8% 4.9%
2.9% 17.3% 15.6% 10.7% 13.8% 6.6% 3.6% 1.3% 21.0% 24.8% 16.7% 20.7% 4.3% 0.3% 1.7% 10.9% 8.3% 8.0% 14.7% 2.9% -3.8%
2.7% -71.2% -8.2% -71.2% -7.7% 0.0% -63.5% 46.8% 100.0% 8.5% 16.9% 2.4% 9.1% 6.1% -0.6%
6.1%
Quite clearly the big gains in returns have come from sectors, which are deeply cyclical from Steel to Oil to Shipping to Capital Goods. While some gains may be somewhat permanent eg. through the export orientation of auto ancillaries, or a permanent improvement in working While some gains may be somewhat capital through better inventory and debtor control.; higher permanent eg. through the export commodity prices & a good demand cycle have been big orientation of auto ancillaries, or a contributors too. permanent improvement in working capital through better inventory and n For FG iMidcap Index, cyclical sectors with 46.8% weight in the index contributed more than 100% of debtor control.; higher commodity prices & a good demand cycle have been big the return expansion. The aggregate RoE expanded contributors too. by 6 percent points from the bottom, whereas sectors like steel, mining etc. contributed 11.7 percent points of the rise. Even for FG iTotal , cyclical sectors with a 41.4% weightage contributed 3.1 percent points, of the 4.7 percent point return For FG iMidcap Index, cyclical expansion. sectors with 46.8% weight in the index contributed more than 100% of the return n Now with the threat of the commodity cycle expansion. The aggregate RoE expanded by reversing (due, in no small part, due to the surprise 6 percent points from the bottom, whereas rally in the US Dollar in which most commodities sectors like steel, mining etc. contributed are quoted); these sectors are likely to see Returns 11.7 percent points of the rise. slip from their highs driving down aggregate return ratios for the Indices
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Also anecdotal evidence suggests that taking up of slack capacity also contributed to the return expansion. In Cement, for instance, companies are still using up capacities set up 5-7 years ago. For Manufacturing (FG iTotal) Companies Sales/ Net Fixed Assets has gone up from 1.94 in FY98 to 2.9 in FY04. Sensex (excl. Banking & Finance) Fixed Asset Taking up of slack capacity also turnover went up from 1.51x in FY99 to 2.08 in contributed to the return expansion. In FY04. For Nifty (excl. Banking & Finance) Sales/ Cement, for instance, companies are still Fixed Assets went up from 1.7 in FY98 to 2.6 in using up capacities set up 5-7 years ago. FY04. More details on this in our next section. The biggest gainers in this area were also cyclicals Companies Sales/ Net Fixed Assets has Fixed Asset turnover for steel companies in FY05 gone up from 1.94 in FY98 to 2.9 in FY04. was 1.5-2x as against 0.7-0.8x 6-7 years ago. For the Industrial Machinery sector, the ratio has almost tripled. The expansion has to do with stock price escalation, better commodity prices and increased capacity utilisation.
For Manufacturing (FG iTotal)
The biggest gainers in this area were also cyclicals Fixed Asset turnover for steel companies in FY05 was 1.5-2x as against 0.70.8x 6-7 years ago. For the Industrial Machinery sector, the ratio has almost tripled
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RoCE expansion has also been driven by cyclicals

Chart 16: Trends in RoCE
Trends in RoCE
24%
19% RoCE
14%
9%
4% FY96 FY97 FY98 FY99 FY00 FY01 Years FY02 FY03 FY04 FY05
Services (FG itotal) FG itotal excl. Bkg Nifty
Chart 17: Trends in RoCE of FG iMidcap

Trends in RoCE 37% 32% 27% RoCE 22% 17% 12% 7% 2% FY96 FY97 FY98 FY99 FY00 Years Mfg (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap excl. Bkg Services (FG iMidcap) FG iMidcap FY01 FY02 FY03 FY04 FY05
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Bearing in mind the 10-year trend in RoCE, last two years have seen steep growth. FY05 witnessed 3.4%, 2.6% and 10.4% ROCE growth in Nifty (excl bkg.), sensex (excl bkg.) and FG iTotal (excl bkg.) respectively. FY05 has seen good bottomline growth, coupled with minute fall in leverage, percolating down to robust RoCE growth.
Table 14: Trends in RoCE and RoCE drivers

ROCE YoY Growth (FY 05 on FY 04) Sector FY04 (Ltd. Cos.) 17.6% 15.2% 15.7% 16.1% 15.5% 23.5% 14.3% 18.2% 15.3% FY05 (Ltd. Cos.) 18.1% 17.8% 16.6% 19.5% 17.1% 20.3% 15.5% 18.2% 17.0% RoCE % point growth 0.5% 2.6% 0.8% 3.4% 1.7% -3.2% 1.2% 0.1% 1.7% Debt Capital Employed Debt/Equity Ratio FY04 (Ltd. Cos.) 0.7 0.4 1.0 0.4 0.5 1.2 0.1 0.7 0.5 FY05 (Ltd. Cos.) 0.6 0.4 0.9 0.3 0.5 1.7 0.1 0.8 0.4 Change
Sensex Sensex excl. Bkg Nifty Nifty excl. Bkg Mfg (FG iTotal) Services (FG iTotal) Services (excl. Bkg) FG iTotal FG iTotal excl. Bkg
15.1% 4.8% 15.0% 1.5% 5.1% 90.9% -0.7% 43.4% 4.9%
18.8% 15.3% 18.9% 15.2% 14.4% 24.5% 17.4% 17.8% 14.7%
0.0 -0.1 -0.1 -0.1 -0.1 0.5 0.0 0.1 -0.1
CNX Midcap RoCE Mfg (FG iMidcap) Services (FG iMidcap) Services excl Bkg (FG iMidcap) FG iMidcap FG iMidcap excl. Bkg 8.1% 27.4% 8.5% 12.3% 8.1% 10.4% 22.5% 9.6% 13.0% 10.4% 2.4% -4.9% 1.1% 0.7% 2.3% 1.1% -4.7% 18.7% 0.0% 1.7% 9.9% 5.8% 15.2% 9.0% 10.3% 1.4 0.8 0.4 1.3 1.3 1.2 0.7 0.4 1.1 1.1 -0.2 -0.1 0.0 -0.2 -0.2
Note: For comparative reasons, FY04 numbers have been included only for companies where FY05 Annual reports are available. Parallel to RoE growth, cyclicals have triggered growth in RoCE as well. At the outset sectors like steel, auto and auto ancillaries seem to be the biggest contributors, followed by all other cyclical sectors. In midcap space again, cyclicals are having their say with Mining and computer hardware leading the expansion.
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Table 15: RoCE trend of cyclicals in FG iTotal

Sector Mkt. Cap wt in FG itotal 3.7% 15.7% 7.1% 1.7% 3.9% 2.5% 2.4% 0.6% 0.6% 0.8% 2.5% 41.4% Total (All sectors) 100.0% 15.3% 17.0% 9.3% 12.1% 6.0% 3.2% FY04 FY05 (Ltd. Cos.) Lo ROCE Avg % pts above Lo FY04 24.6% 8.2% 4.6% 10.6% 4.1% 16.3% 6.7% 5.0% 6.1% 8.3% 5.9% % pts above avg. FY04 11.0% 3.5% 1.7% 6.0% 2.2% 7.1% 1.3% 1.7% 1.0% 3.5% 2.3% Contribution (above low) Contribution (above avg)
Steel Oil Ind. M/C Auto Ancillaries Metals Auto: CVs & PVs Auto: 2W Fertilizers Textiles Shipping Cement
20.2% 16.9% 14.3% 21.3% 14.0% 18.1% 20.7% 10.8% 7.0% 14.3% 12.7%
36.6% -4.4% 17.1% 17.3% 8.7% 9.6%
9.3% 13.5% 12.6%
0.92% 1.29% 0.33% 0.18% 0.16% 0.40% 0.16% 0.03% 0.04% 0.07% 0.15% 3.71% 6.01%
0.41% 0.54% 0.12% 0.10% 0.09% 0.18% 0.03% 0.01% 0.01% 0.03% 0.06% 1.56% 3.24%
21.5% 10.7% 15.3% 16.7% 18.4% 9.9% 1.7% 11.8% 10.9%
18.3% 13.9% 19.4% 13.6% 6.0% 19.3% 14.6% 5.8% 0.9% 5.9% 6.8% 9.1% 6.0% 10.8% 10.4%
Table 16: RoCE trend of cyclicals in FG iMidcap

Sector Mkt. Cap wt in CNX Midcap 9.36% 8.93% 5.84% 4.81% 3.73% 3.59% 3.31% 2.71% 2.85% 1.68% 1.26% 1.29% 49.4% Total (All sectors) 100% 6.9% 10.4% 5.5% 7.7% 1.4% -0.8% FY04 FY05 (Ltd. Cos.) 15.3% 14.7% 6.4% 3.6% 12.1% 62.9% 8.4% -3.1% 9.7% 6.6% 16.1% 10.5% ROCE Lo Avg % pts above Lo FY04 9.8% 6.0% 1.7% 1.7% 9.8% 3.8% 6.2% 0.0% 4.2% 0.0% 1.7% 31.6% % pts above avg. FY04 3.7% 3.2% -0.1% -2.0% 2.5% -7.3% 0.3% -18.5% 1.2% -3.1% -0.1% 9.3% Contribution Contribution (above low) (above avg)
Industrial Machinary Sector Auto Ancillary Sector Textile Sector Cement Sector Steel Sector Mining Sector Fertilizer Sector Equipment Sector Petrochemicals Sector Tyres Sector Metals Sector Computer Hardware Sector
12.2% 16.8% 7.9% 3.1% 5.9% 9.9% 9.8% -16.7% 10.9% 8.6% 14.0% 22.4%
2.4% 10.8% 6.1% 1.4% -4.0% 6.1% 3.6% -16.7% 6.7% 8.6% 12.3% -9.2%
8.5% 13.6% 8.0% 5.1% 3.4% 17.2% 9.6% 1.8% 9.8% 11.7% 14.1% 13.1%
0.91% 0.54% 0.10% 0.08% 0.37% 0.14% 0.21% 0.00% 0.12% 0.00% 0.02% 0.41% 2.90% 1.39%
0.34% 0.28% 0.00% -0.10% 0.09% -0.26% 0.01% -0.50% 0.03% -0.05% 0.00% 0.12% -0.03% -0.80%
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What has driven the RoE expansion? PAT/EBIDTA & Asset Turnover
If one looks at the drivers of return ratios:
Table 17: RoE drivers
EBIDTA/Sales Sales/Net Assets EBIDTA/Net Assets Net Assets/Networth PAT/EBIDTA
In this context, if one looks at the following tables, one thing is clear the 2 components driving the return expansion have been Asset Turnover & PAT/EBIDTA. The EBIDTA margin expansion has already tapered off. This means that the two major underlying factors driving the return expansion have been better capacity utilisation (manifested in both higher asset turnover The 2 components driving the return & lower depreciation growth) & lower interest costs. For the Nifty, for instance, the asset Turnover in FY04 & FY05 was 1.34 and 1.56 respectively, against average of 1.18. The PAT/EBIDTA ratio in FY04 & FY05 was 54.5% and 57.6% respectively against average of 47.6%. For the FG iMidcap Index, (excl. banking), the expansion in PAT/EBIDTA contributed 72.5% of the RoE expansion from FY02 to FY05, with Asset Turnover expansion contributing another 19.9%. The EBIDTA margin expansion contributed a mere 11.5%. For the Nifty too, the PAT/EBIDTA & Asset Turnover, in that order, have contributed almost the entire expansion.
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expansion have been Asset Turnover & PAT/ EBIDTA. The EBIDTA margin expansion has already tapered off. This means that the two major underlying factors driving the return expansion have been better capacity utilisation (manifested in both higher asset turnover & lower depreciation growth) & lower interest costs.
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Table 18: RoE change and change contributors (change over FY02 to FY05)
Sensex, Nifty and FG iTotal Indices Contribution to RoE change (% of total) FG Mfg Services Services iTotal Sensex (FG (FG (excl. FG excl. excl. Nifty iTotal) iTotal) Bkg) iTotal Bkg Sensex Bkg EBIDTA/Sales Sales/Net Assets Services FG Nifty Services excl Bkg iMidcap excl. Mfg (FG (FG (FG FG excl. Bkg iMidcap) iMidcap) iMidcap) iMidcap Bkg 14.3% 16.4% 95.4 % 231.8% -0.1% 11.5% 19.9% Midcap Indices
31.6% -1455.3% 208.6% -18.0% 26.3% -3.5% 26.3% 4.1% 27.5% 52.1% -315.6% 35.7% 43.3% 54.4% 58.4% 77.6% 40.9% 57.4%
25.1% -123.2% 18.0%
EBIDTA/Net Assets 83.7% -1642.5% 244.3% 25.3% 80.6% 54.8% 103.9% 45.0% 84.9%
30.7% 120.5% 108.6% 17.9% -12.0% -18.0% -5.3% -8.5% 9.4% 87.5%
31.4% -3.9% 72.5%
Net Assets/Networth -61.5% 192.8% -102.9% -42.2% -56.1% -42.8% -53.8% -33.9% -45.5% -7.0% PAT/EBIDTA 77.7% 1549.7% -41.4% 116.9% 75.4% 87.9% 49.9% 88.9% 60.6% 76.3%
RoE
100.0% 100.0% 100.0% 100.0% 100.0% 100.0%100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
RoE change (FY02 - FY05) in percent points (contribution from various components)
FG Mfg Services Services iTotal Sensex (FG (FG (excl. FG excl. excl. iTotal) iTotal) Bkg) iTotal Bkg Sensex Bkg Nifty EBIDTA/Sales Sales/Net Assets 2.6% 41.9% -14.9% -1.5% -5.7% -2.9% -1.4% 2.0% -0.4% 2.3% 0.5% Services FG Nifty Services excl Bkg iMidcap excl. Mfg (FG (FG (FG FG excl. Bkg iMidcap) iMidcap) iMidcap) iMidcap Bkg 2.7% 3.5% -11.3% -10.6% -2.3% 43.2% 0.0% 2.5%
13.5% 37.1% 11.9% 28.6% 13.6% 38.7% 23.1%
12.0% 24.7%
EBIDTA/Net Assets 10.9% Net Assets/Networth -37.6% PAT/EBIDTA 19.5%
-5.1% 4.8% 6.0%
-5.8%
2.1%
9.4%
4.0% 10.2% 4.2% 11.8%
7.7%
-5.2% 12.8% 0.4%
-1.4% 6.2% -1.3%
2.8%
6.9%
11.1% -30.1% -30.1% -24.1% -18.7% -27.7% -24.4% -20.3% 2.4% 16.8% 17.0% 11.7% 8.9% 15.7% 15.1% 34.5%
-12.0% -9.3% 21.7% 29.2%
RoE
10.8%
0.3%
-1.3%
7.8%
9.3%
6.5%
7.0%
9.1% 10.3% 17.3%
-2.9%
-0.5%
11.9% 14.5%
Please note that FY05 figures are not comparable to prior year numbers for FG iTotal & FG iMidcap, as these have been calculated only for companies where FY05 Annual Reports are available (called Limited Companies elsewhere in report)
l Drivers of Return Ratios for various Indices

Table 19: Sensex
FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 Avg. From 96-05 35.3% 0.64 22.7% 2.06 36.0% 16.8%
EBIDTA/Sales Sales/Net Assets EBIDTA/Net Assets Net Assets/Networth PAT/EBIDTA RoE
32.4% 0.74 23.9% 1.86 35.8% 15.9%
33.3% 0.75 24.9% 1.83 33.3% 15.2%
34.1% 0.54 18.3% 2.49 35.2% 16.0%
35.4% 0.64 22.6% 1.87 32.4% 13.7%
37.2% 0.64 23.7% 1.97 33.1% 15.4%
36.2% 0.62 22.5% 2.10 34.1% 16.1%
35.5% 0.58 20.7% 2.18 34.1% 15.4%
36.9% 0.61 22.7% 2.23 37.0% 18.7%
37.1% 0.61 22.7% 2.13 39.6% 19.2%
35.1% 0.70 24.6% 1.94 45.8% 21.9%
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Table 20: Sensex (excl Bkg)

FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 Avg. From 96-05 26.6% 0.95 25.3% 1.31 51.1% 16.8%
24.8% 1.00 24.9% 1.23 52.5% 16.1%
23.8% 0.98 23.4% 1.30 49.2% 15.0%
24.4% 0.77 18.6% 1.63 50.9% 15.5%
27.1% 0.84 22.8% 1.30 47.4% 14.0%
28.3% 0.87 24.6% 1.34 46.4% 15.2%
27.6% 0.91 25.0% 1.32 49.0% 16.2%
26.1% 0.92 24.0% 1.32 49.5% 15.8%
27.0% 0.98 26.4% 1.31 54.4% 18.8%
29.0% 1.01 29.2% 1.24 53.0% 19.1%
28.4% 1.20 34.2% 1.14 58.4% 22.8%
Table 21: Nifty

FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 Ltd.Co. FY05 Avg. From 96-05 28.7% 0.78 22.2% 2.19 34.9% 17.0%
29.3% 0.85 24.9% 1.89 37.2% 17.6%
29.9% 0.81 24.2% 1.91 34.1% 15.8%
30.8% 0.60 18.7% 2.43 35.7% 16.2%
28.3% 0.76 21.6% 2.06 29.5% 13.2%
27.6% 0.78 21.6% 2.14 29.5% 13.6%
26.6% 0.82 21.9% 2.22 32.1% 15.6%
28.0% 0.72 20.3% 2.39 29.9% 14.5%
29.2% 0.76 22.2% 2.43 34.8% 18.7%
28.5% 0.77 22.0% 2.33 40.5% 20.8%
28.5% 0.86 24.5% 2.11 45.6% 23.6%
Table 22: Nifty (excl Bkg)

23.7% 1.15 27.3% 1.32 50.2% 18.1%
22.7% 1.05 23.8% 1.41 46.2% 15.5%
23.4% 0.81 18.9% 1.74 47.5% 15.6%
20.9% 1.07 22.3% 1.41 41.7% 13.1%
19.5% 1.13 22.1% 1.44 41.1% 13.1%
19.2% 1.28 24.5% 1.40 45.5% 15.6%
19.7% 1.17 23.1% 1.48 42.5% 14.5%
20.5% 1.26 25.8% 1.46 49.8% 18.7%
21.0% 1.34 28.1% 1.36 54.5% 20.9%
22.4% 1.56 34.9% 1.24 57.6% 24.8%
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Table 23: FG iTotal Index

27.1% 0.90 24.5% 1.88 35.2% 16.3%
27.0% 0.89 24.0% 1.93 31.0% 14.3%
28.6% 0.68 19.4% 2.36 31.4% 14.4%
27.2% 0.81 22.0% 2.07 26.5% 12.1%
25.4% 0.86 21.9% 2.16 26.1% 12.3%
23.7% 0.93 22.0% 2.23 28.5% 13.9%
25.5% 0.81 20.6% 2.46 26.7% 13.6%
27.1% 0.83 22.4% 2.47 34.0% 18.8%
25.7% 0.86 22.0% 2.34 40.5% 20.9%
24.1% 0.94 22.7% 2.16 43.5% 21.4%
Table 24: FG iTotal Index (excl Bkg.)

19.6% 1.22 23.8% 1.43 47.8% 16.3%
18.5% 1.15 21.2% 1.55 42.5% 14.0%
19.4% 0.91 17.6% 1.84 42.3% 13.7%
18.1% 1.17 21.1% 1.49 38.1% 12.0%
16.4% 1.27 20.8% 1.55 37.1% 11.9%
15.6% 1.42 22.1% 1.55 41.7% 14.2%
16.4% 1.31 21.5% 1.63 38.7% 13.6%
17.9% 1.38 24.6% 1.60 48.9% 19.2%
18.3% 1.48 27.1% 1.46 53.2% 21.0%
18.4% 1.68 30.9% 1.33 55.8% 22.9%
Table 25: Manufacturing Sector (FG iTotal)

18.8% 1.21 22.8% 1.43 48.2% 15.7%
17.7% 1.15 20.3% 1.57 41.8% 13.4%
18.5% 0.93 17.2% 1.84 40.9% 12.9%
17.0% 1.17 19.9% 1.54 35.6% 10.9%
15.7% 1.30 20.4% 1.63 34.8% 11.6%
14.4% 1.45 20.9% 1.66 38.4% 13.3%
15.3% 1.36 20.7% 1.73 35.8% 12.8%
17.3% 1.44 24.9% 1.67 48.3% 20.1%
17.9% 1.55 27.6% 1.50 52.7% 21.8%
17.8% 1.78 31.7% 1.35 55.3% 23.6%
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Table 26: Service Sector (FG iTotal)

65.1% 0.42 27.3% 3.75 18.0% 18.4%
69.9% 0.44 30.4% 3.20 18.3% 17.8%
72.0% 0.31 22.7% 4.02 21.1% 19.2%
69.2% 0.36 24.7% 3.66 17.4% 15.8%
70.9% 0.34 23.8% 3.53 17.0% 14.3%
70.0% 0.33 23.1% 3.66 18.2% 15.4%
72.4% 0.28 20.6% 4.15 17.9% 15.3%
74.8% 0.27 20.1% 4.38 18.0% 15.8%
69.0% 0.25 17.1% 4.63 23.1% 18.3%
57.5% 0.27 15.5% 4.20 24.0% 15.6%
Table 27: Service Sector excl Bkg. (FG iTotal)

31.8% 1.33 42.3% 1.41 44.5% 26.5%
30.7% 1.18 36.3% 1.24 48.8% 21.9%
32.4% 0.66 21.4% 1.91 53.9% 22.0%
33.3% 1.10 36.8% 1.05 55.8% 21.5%
28.0% 0.90 25.1% 0.99 57.1% 14.2%
35.6% 1.00 35.5% 0.88 63.7% 20.0%
34.5% 0.87 29.9% 1.03 59.5% 18.2%
29.4% 0.75 21.9% 1.12 55.4% 13.6%
26.8% 0.81 21.8% 1.19 59.3% 15.4%
28.8% 0.84 24.1% 1.14 61.9% 17.0%
Table 28: FG iMidcap

26.0% 0.79 20.6% 2.20 32.0% 14.5%
27.1% 0.79 21.4% 2.26 24.8% 12.0%
27.0% 0.73 19.7% 2.42 22.2% 10.6%
26.6% 0.71 18.8% 2.50 16.8% 7.9%
26.1% 0.70 18.4% 2.53 15.9% 7.4%
25.2% 0.70 17.6% 2.54 13.4% 6.0%
23.6% 0.70 16.4% 2.85 8.6% 4.0%
24.2% 0.70 16.8% 2.92 16.1% 7.9%
22.4% 0.72 16.2% 3.02 21.7% 10.6%
23.5% 0.82 19.2% 2.73 30.2% 15.9%
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Table 29: FG iMidcap (excl Bkg)

22.0% 0.89 19.4% 1.96 36.7% 14.0%
21.5% 0.93 20.1% 1.89 29.1% 11.1%
20.3% 0.88 17.9% 1.99 26.6% 9.5%
19.7% 0.88 17.3% 1.99 21.8% 7.5%
19.3% 0.89 17.1% 1.98 18.9% 6.4%
19.7% 0.87 17.1% 2.00 17.9% 6.1%
16.8% 0.88 14.7% 2.24 7.2% 2.4%
17.4% 0.90 15.6% 2.27 17.9% 6.3%
16.2% 0.97 15.8% 2.35 23.0% 8.5%
19.3% 1.12 21.6% 2.15 36.4% 16.9%
Table 30: Manufacturing Sector (FG iMidcap)

21.5% 0.88 18.8% 1.97 36.4% 13.5%
21.3% 0.93 19.8% 1.90 27.9% 10.5%
19.8% 0.87 17.3% 2.01 25.3% 8.8%
19.4% 0.86 16.6% 2.04 18.9% 6.4%
18.4% 0.88 16.2% 2.10 15.4% 5.3%
18.5% 0.86 16.0% 2.20 12.1% 4.3%
16.0% 0.89 14.2% 2.48 1.2% 0.4%
16.9% 0.91 15.3% 2.52 15.2% 5.9%
15.9% 0.97 15.5% 2.56 21.3% 8.5%
19.5% 1.12 21.8% 2.28 35.7% 17.7%
Table 31: Service Sector (FG iMidcap)

56.5% 0.48 27.1% 3.89 20.5% 21.6%
59.5% 0.43 25.4% 4.39 18.8% 20.9%
61.8% 0.41 25.1% 4.54 17.4% 19.8%
57.8% 0.40 23.3% 4.68 13.8% 15.1%
59.4% 0.38 22.4% 4.06 16.5% 15.0%
53.3% 0.39 20.7% 3.60 15.2% 11.3%
55.5% 0.37 20.3% 3.85 17.5% 13.7%
53.5% 0.36 19.3% 3.89 17.2% 12.9%
48.9% 0.35 17.3% 4.12 22.3% 15.9%
44.2% 0.34 15.1% 3.98 17.9% 10.8%
Table 32: Service Sector excl Bkg. (FG iMidcap)

30.4% 1.11 33.7% 1.67 40.0% 22.5%
25.8% 0.98 25.2% 1.79 45.2% 20.4%
27.6% 1.02 28.3% 1.76 40.7% 20.3%
23.1% 1.16 26.9% 1.46 49.9% 19.6%
29.3% 0.99 29.0% 1.13 43.8% 14.3%
32.2% 0.92 29.6% 0.98 53.9% 15.6%
26.4% 0.78 20.5% 1.12 49.3% 11.3%
23.0% 0.79 18.3% 1.17 39.5% 8.5%
18.5% 1.00 18.4% 1.26 37.6% 8.7%
15.8% 1.21 19.1% 1.18 47.9% 10.8%
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Free Cash Flow analysis

Weve always believed that the true pulse of a company always comes through in its cashflows, rather than a bland analysis of the Income Statement. This is also the place where problems and turning points show up, long before they do elsewhere in the financial statements. The same holds for market aggregates. And this is where the strain is already beginning to show. The true pulse of a company always
comes through in its cashflows, rather than a bland analysis of the Income Statement. This is also the place where problems and turning points show up, long before they do elsewhere in the financial statements. The same holds for market aggregates. And this is where the strain is already beginning to show.
In FY05, Sensex (excl. Banking) companies showed a decline in Free CashFlows of 7.8%, in spite of a NOPLAT growth of 46.5% - due to higher Working capital & capital investments. A similar trend was seen for the Nifty companies. Thus the peaking of the Asset Turnover cycle is clearly over working capital investments bottomed out in FY04, and are now creeping
upcapacity slack has also been used up & investments are picking up. The FY05 Aggregates for the Midcap Indices are not available, as not all Annual Reports have been released but are likely to have worse numbers.
In FY05, Sensex (excl. Banking) companies showed a decline in Free CashFlows of 7.8%, in spite of a NOPLAT growth of 46.5% - due to higher Working capital & capital investments. A similar trend was seen for the Nifty companies.
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Sensex excl banking companies

n
After expanding every year from FY02, the FCF from operations declined in FY05 with higher capex (YoY growth of 33.7%) & higher investment in Working Capital (shift from decrease in working capital in FY04, followed by an After expanding every year from FY02, increase). This was in spite of a Net Operating the FCF from operations declined in FY05 Profit less Adjusted Taxes (NOPLAT) growth with higher capex (YoY growth of 33.7%) & of 46.5% This indicates that the easier gains are already in. Asset turnover is likely to decline from hereon. The Working Capital increase showed up in Capital-intensive sectors like Oil, Steel and Capital goods.
higher investment in Working Capital (shift from decrease in working capital in FY04, followed by an increase). This was in spite of a Net Operating Profit less Adjusted Taxes (NOPLAT) growth of 46.5%
Table 34: Sensex excl banking companies

(Rs. in mn) Operating Profit Operating Profit Growth Less Adjusted Taxes Add Net Deferred Liabilities Add Provision For Taxes NOPLAT NOPLAT Growth Add Dec/(Inc) in Wrkg Cap Wrkg Capital Growth Operating Cash Flow Operating Cash Flow Growth Less Capex Capex Growth Add Depreciation Less Inc/(Dec) in Cons Invsts Free Cash Flow From Operations FCF from Operations Growth 31364 3542 5404 125271 102853 49150 2100 0 7597 152003 FY97 146507 FY98 162483 10.9% -868 0 150749 314101 106.6% 176644 259.4% 137457 33.6% 143150 14.3% 36968 38029 -6754 N.A FY99 213118 31.2% -8106 0 -95665 125559 -60.0% -53627 N.A 179186 30.4% 434993 203.9% 61897 11778 -205688 N.A FY00 265251 24.5% 2907 0 27035 289379 130.5% 91491 N.A 197888 10.4% 141599 -67.4% 80635 15506 121419 N.A FY01 309420 16.7% 16763 0 21808 314466 8.7% 74329 -18.8% 240137 21.3% 136022 -3.9% 85580 64455 125239 3.1% FY02 361253 16.8% 29601 18714 17946 368313 17.1% 74751 0.6% 293562 22.2% 384845 182.9% 92498 -64406 65621 -47.6% FY03 455940 26.2% 58829 6127 64844 468081 27.1% 47560 -36.4% 420521 43.2% 177613 -53.8% 99485 20327 322066 390.8% FY04 552912 21.3% 44150 17972 -28064 498670 6.5% -201665 N.A 700335 66.5% 221313 24.6% 112109 108095 483036 50.0% FY05 732746 32.5% 103826 9668 91954 730542 46.5% 98328 N.A 632214 -9.7% 295950 33.7% 125460 16514 445210 -7.8%
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Nifty excl banking companies

n
Operating profit has grown at 3 year CAGR of 27.7% against 23.9% for NOPLAT, indicating a higher growth in operating profit (due to increase in tax and tax provisions). There was a swing in trend with a higher NOPLAT growth in FY05 (53.1% growth in NOPLAT against 39.0% in operating profit) Increase in working capital as percentage of operating profit has grown in FY05 to 18.3%, against average of 12-13% during FY02-FY03. Capex has risen by 27.1% in FY05, but is still below the FY02 peak.
Table 35: Nifty excl banking companies

(Rs. in mn) Operating Profit Operating Profit Growth Less Adjusted Taxes Add Net Deferred Liabilities Add Provision For Taxes NOPLAT NOPLAT Growth Add Dec/(Inc) in Wrkg Cap Wrkg Capital Growth Operating Cash Flow Operating Cash Flow Growth Less Capex Capex Growth Add Depreciation Less Inc/(Dec) in Cons Invsts Free Cash Flow From Operations FCF from Operations Growth 60503 5369 12307 213263 170436 90912 7264 0 16387 261348 FY97 252225 FY98 278846 10.6% 78 0 168606 447375 71.2% 333402 266.7% 113972 -33.1% 239981 12.5% 72217 43564 -97356 N.A FY99 284613 2.1% -2972 0 -124596 162989 -63.6% -310587 N.A 472388 314.5% 225217 -6.2% 83809 16170 314645 N.A FY00 321040 12.8% 4725 0 26915 343230 110.6% 112710 N.A 230520 -51.2% 146884 -34.8% 105711 50708 138639 -55.9% FY01 402574 25.4% 19633 -7 16972 399905 16.5% 96737 -14.2% 303168 31.5% 178864 21.8% 113396 4252 233448 68.4% FY02 438815 9.0% 38167 22839 41453 464940 16.3% 60783 -37.2% 404157 33.3% 401472 124.5% 130258 -59729 192671 -17.5% FY03 558580 27.3% 80191 9311 82750 570450 22.7% 71819 18.2% 498630 23.4% 191560 -52.3% 138286 43635 401722 108.5% FY04 658097 17.8% 101971 22919 -1444 577601 1.3% -101443 N.A 679044 36.2% 238627 24.6% 145449 -21761 607627 51.3% FY05 914810 39.0% 155685 28271 97025 884421 53.1% 167796 N.A 716625 5.5% 303177 27.1% 164793 9210 569031 -6.4%
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Manufacturing Sector (FG iTotal)

n
Cyclicals have seen high inflows into capex (37.1% of operating profit), but this is lower than the FY02 peak. Increase in working capital and capex expenditure have led to lower operating cash flow and lower free cash flow in FY05. (Free cash flow declining for the first time after FY00). However, trends may be modified as the balance Annual reports come in.
Table 36: Manufacturing Sector (FG iTotal)

(Rs. in mn) Operating Profit Operating Profit Growth Less Adjusted Taxes Add Net Deferred Liabilities Add Provision For Taxes NOPLAT NOPLAT Growth Add Dec/(Inc) in Wrkg Cap Wrkg Capital Growth Operating Cash Flow Operating Cash Flow Growth Less Capex Capex Growth Add Depreciation Less Inc/(Dec) in Cons Invsts Free Cash Flow From Operations FCF from Operations Growth 81077 5805 -49037 283020 159394 173174 -13396 0 9624 333568 FY97 310549 FY98 335520 8.0% -24371 0 210755 570646 71.1% 254116 46.7% 316530 98.6% 327812 15.8% 97315 47167 38865 -179.3% FY99 339501 1.2% -27706 0 -172483 194724 -65.9% -291476 N.A 486200 53.6% 329606 0.5% 110037 10164 256467 559.9% FY00 385211 13.5% -14640 0 17972 417823 114.6% 135900 N.A 281923 -42.0% 248523 -24.6% 142288 41961 133726 -47.9% FY01 454659 18.0% -11045 175 27625 493503 18.1% 133592 -1.7% 359912 27.7% 229884 -7.5% 142844 53977 218894 63.7% FY02 481147 5.8% 13057 19946 39746 527781 6.9% -64751 -148.5% 592532 64.6% 404543 76.0% 160895 -1393 350276 60.0% FY03 677997 40.9% 76437 11077 92337 704974 33.6% 157963 -344.0% 547011 -7.7% 248119 -38.7% 169172 11811 456253 30.3% FY04 798903 17.8% 106246 28886 11373 732916 4.0% -101975 N.A 834891 52.6% 291388 17.4% 183951 282 727173 59.4% FY05 1004356 25.7% 157115 29721 93667 970630 32.4% 195134 N.A 775495 -7.1% 372279 27.8% 194832 -1641 599689 -17.5%
Note: In FY05, results of 101 out of 107 companies are available
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Service Sector (FG iTotal)

n n
Unlike cyclicals there is no divergence among operating profit and NOPLAT, the tax and tax provisions FY04 witnessed a decrease in working capital, followed by an increase in FY05. Overall, cashflows have begun to decline in FY05, due to higher investment in Fixed Assets & Working Capital. Operating cash flows and free cash flows has been at historical lows, standing at 104.9% and 98.3% as percentage of operating profit.
Table 37: Service Sector (FG iTotal)

(Rs. in mn) Operating Profit Operating Profit Growth Less Adjusted Taxes Add Net Deferred Liabilities Add Provision For Taxes NOPLAT NOPLAT Growth Add Dec/(Inc) in Wrkg Cap Wrkg Capital Growth Operating Cash Flow Operating Cash Flow Growth Less Capex Capex Growth Add Depreciation Less Inc/(Dec) in Cons Invsts Free Cash Flow From Operations FCF from Operations Growth 11908 3563 355742 33551 381012 3305 -67611 0 6327 389334 FY97 315396 FY98 367094 16.4% -82960 0 9980 460034 18.2% 395286 11859.1% 64746 -83.0% 36832 9.8% 15430 6811 36533 FY99 416224 13.4% -109580 0 1402 527207 14.6% -262515 N.A 789722 1119.7% 42618 15.7% 19550 3545 763109 FY00 480349 15.4% -130230 0 2374 612952 16.3% -94550 N.A 707503 -10.4% 36234 -15.0% 22040 41715 651594 -14.6% FY01 553259 15.2% -148141 0 -14424 686976 12.1% -84781 -10.3% 771756 9.1% 49897 37.7% 26053 -43887 791799 21.5% FY02 627171 13.4% -161744 -4059 6596 791453 15.2% -51125 -39.7% 842578 9.2% 67134 34.5% 28797 2347 801893 1.3% FY03 714270 13.9% -194925 -6322 4248 907121 14.6% 81025 -258.5% 826095 -2.0% 36891 -45.0% 35664 1339 823528 2.7% FY04 645166 -9.7% -165412 -2807 4167 811939 -10.5% -27734 N.A 839673 1.6% 29877 -19.0% 33962 4393 839365 1.9% FY05 683988 6.0% -167232 1360 3312 855892 5.4% 138574 N.A 717318 -14.6% 83169 178.4% 37844 -652 672645 -19.9%
-89.7% 1988.8%
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FG iTotal Index (excl Bkg.)

n
The trend of growth in NOPLAT and operating profit reveals that NOPLAT has risen at a higher rate. This shows tax and tax provisions coming into play. The increase in working capital and capex in FY05 over FY04 has led to lower free cash flow from operations. (Free cash flow, as percentage of operating profit, was 57.8% in FY05 against 68.1% in FY02)
Table 38: FG iTotal Index (excl Bkg.)

(Rs. in mn) Operating Profit Operating Profit Growth Less Adjusted Taxes Add Net Deferred Liabilities Add Provision For Taxes NOPLAT NOPLAT Growth Add Dec/(Inc) in Wrkg Cap Wrkg Capital Growth Operating Cash Flow Operating Cash Flow Growth Less Capex Capex Growth Add Depreciation Less Inc/(Dec) in Cons Invsts Free Cash Flow From Operations FCF from Operations Growth 88285 6884 -40675 304081 182746 183250 -6605 0 15950 367251 FY97 344696 FY98 378084 9.7% -17354 0 220735 616172 67.8% 368427 101.1% 247743 35.6% 350307 15.2% 106272 48245 -44537 N.A FY99 390930 3.4% -18687 0 -171081 238536 -61.3% -377511 N.A 616046 148.7% 354992 1.3% 120917 10820 371151 N.A FY00 431111 10.3% -9220 0 20346 460677 93.1% 154607 N.A 306070 -50.3% 268662 -24.3% 154389 82280 109516 -70.5% FY01 528834 22.7% -5644 175 13201 547854 18.9% 133474 -13.7% 414381 35.4% 264938 -1.4% 157408 21337 285513 160.7% FY02 554545 4.9% 21764 20690 46342 599813 9.5% -27958 -120.9% 627771 51.5% 427494 61.4% 177623 340 377561 32.2% FY03 737775 33.0% 84487 12052 96585 761924 27.0% 186274 -766.3% 575651 -8.3% 271505 -36.5% 186654 11312 479488 27.0% FY04 865482 17.3% 113522 30352 15495 797807 4.7% -102638 N.A 900446 56.4% 303069 11.6% 199457 3293 793541 65.5% FY05 1087936 25.7% 163745 30867 97023 1052081 31.9% 226664 N.A 825417 -8.3% 410143 35.3% 211272 -2248 628794 -20.8%
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FG iMidcap (excl Bkg)

n
The divergence between operating profit and NOPLAT is more underlined than largecaps, with tax and tax provisions growing more than proportionately. The capex plans in value terms for FY05 are more than that of FY02, FY05 capex plans stood at 47.5% Higher capex and working capital expenditure resulted in lower operating and free cash flows in FY05 (Free cash flow as percentage of operating profit is 50.7% which has been the lowest excluding FY97-98)
n n
Table 39: FG iMidcap (excl Bkg)

(Rs. in mn) Operating Profit Operating Profit Growth Less Adjusted Taxes Add Net Deferred Liabilities Add Provision For Taxes NOPLAT NOPLAT Growth Add Dec/(Inc) in Wrkg Cap Wrkg Capital Growth Operating Cash Flow Operating Cash Flow Growth Less Capex Capex Growth Add Depreciation Less Inc/(Dec) in Cons Invsts Free Cash Flow From Operations FCF from Operations Growth 18633 655 -11990 97378 65712 16574 -13090 0 918 82670 FY97 68586 FY98 70338 2.6% -15115 0 1085 86538 4.7% 4869 -70.6% 80246 22.1% 79478 -18.4% 20983 706 20705 N.A FY99 70842 0.7% -16583 0 1421 88845 2.7% 16901 247.1% 71725 -10.6% 54719 -31.2% 26584 2800 40683 96.5% FY00 78743 11.2% -18540 0 -800 96482 8.6% 14014 -17.1% 82468 15.0% 54084 -1.2% 30050 9408 49026 20.5% FY01 86860 10.3% -21805 1 1482 110147 14.2% 11480 -18.1% 98667 19.6% 48992 -9.4% 35618 1763 83530 70.4% FY02 64996 -25.2% -29280 -7593 1537 88220 -19.9% -2529 N.A 90749 -8.0% 51083 4.3% 42048 353 81360 -2.6% FY03 78394 20.6% -15450 846 3419 98109 11.2% 24714 N.A 73395 -19.1% 47751 -6.5% 39908 857 64694 -20.5% FY04 87021 11.0% -14257 -1082 2949 103145 5.1% 7486 -69.7% 95659 30.3% 57547 20.5% 44271 2295 80089 23.8% FY05 124220 42.7% 1434 7679 2243 132709 28.7% 26121 248.9% 106588 11.4% 84865 47.5% 42715 1413 63025 -21.3%
Note: In FY05, results of 21 companies are unavailable
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Manufacturing Sector (FG iMidcap)

n
Manufacturing especially cyclical sectors have witnessed a major change in tax and tax provisions crystallising into discrepancies between operating profit and NOPLAT Increase in working capital has resulted in lower operating cash flow, standing at a historical low of 86.3% as percentage of operating profit. More outflows into capex has dictated lower free cash flows.
Table 40: Manufacturing Sector (FG iMidcap)

(Rs. in mn) Operating Profit Operating Profit Growth Less Adjusted Taxes Add Net Deferred Liabilities Add Provision For Taxes NOPLAT NOPLAT Growth Add Dec/(Inc) in Wrkg Cap Wrkg Capital Growth Operating Cash Flow Operating Cash Flow Growth Less Capex Capex Growth Add Depreciation Less Inc/(Dec) in Cons Invsts Free Cash Flow From Operations FCF from Operations Growth 17843 185 -11014 93806 63426 13274 -12584 0 903 77037 FY97 63473 FY98 63785 0.5% -14307 0 805 78897 2.4% 4537 -65.8% 72937 15.0% 74911 -20.1% 19684 668 16703 N.A FY99 63515 -0.4% -15933 0 1148 80596 2.2% 13979 208.1% 66398 -9.0% 49763 -33.6% 24815 2737 38605 131.1% FY00 67888 6.9% -17316 0 -941 84263 4.6% 11401 -18.4% 72862 9.7% 50158 0.8% 27669 3541 46831 21.3% FY01 72980 7.5% -20548 1 1066 94595 12.3% 9362 -17.9% 85234 17.0% 37787 -24.7% 32470 74 79842 70.5% FY02 55271 -24.3% -28581 -7817 1229 77264 -18.3% -8362 N.A 85626 0.5% 41612 10.1% 38509 3194 79330 -0.6% FY03 69735 26.2% -14859 518 3574 88686 14.8% 23586 N.A 65100 -24.0% 38521 -7.4% 35194 1381 60391 -23.9% FY04 77660 11.4% -13536 -1357 2791 92631 4.4% 7008 -70.3% 85623 31.5% 59243 53.8% 39885 1979 64286 6.4% FY05 117230 51.0% 1973 7499 2170 124925 34.9% 23723 238.5% 101202 18.2% 82087 38.6% 39866 -777 59759 -7.0%
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Service Sector (FG iMidcap)

n
Similar to services sector in FG iTotal, there has been no divergence between operating profit and NOPLAT. The ratio of NOPLAT to operating profit has been the same roughly around 130.0% throughout the stint. FY05 saw an increase in working capital and increase in Capex leading to decrease in free cash flow.
Table 41: Service Sector (FG iMidcap)

(Rs. in mn) Operating Profit Operating Profit Growth Less Adjusted Taxes Add Net Deferred Liabilities Add Provision For Taxes NOPLAT NOPLAT Growth Add (Dec)/Inc in Wrkg Cap Wrkg Capital Growth Operating Cash Flow Operating Cash Flow Growth Less Capex Capex Growth Add Depreciation Less Inc/(Dec) in Cons Invsts Free Cash Flow From Operations FCF from Operations Growth 2564 888 27743 9195 34869 10953 -10664 0 150 49661 FY97 38848 FY98 50212 29.3% -13944 0 807 64963 30.8% 5344 -51.2% 59618 71.0% 9359 1.8% 3425 -829 54513 96.5% FY99 56576 12.7% -17884 0 539 74999 15.4% 12369 131.4% 62630 5.1% 9337 -0.2% 4241 65 57468 5.4% FY00 66451 17.5% -19797 0 220 86467 15.3% 10004 -19.1% 76463 22.1% 9168 -1.8% 5225 6679 65841 14.6% FY01 64778 -2.5% -20439 0 726 85943 -0.6% 100 FY02 70848 9.4% -21226 -745 1127 92456 7.6% 2621 FY03 74497 5.2% -21194 -138 542 96094 3.9% -5519 N.A 101612 13.1% 8138 -19.1% 8585 668 101392 17.4% FY04 80255 7.7% -21493 -134 1146 102760 6.9% -831 N.A 103591 1.9% 1584 -80.5% 7639 -176 109822 8.3% FY05 63597 -20.8% -20791 -422 -1448 82518 -19.7% -1479 N.A 83997 -18.9% 5203 228.5% 5685 2805 81674 -25.6%
-99.0% 2531.9% 85844 12.3% 13536 47.6% 6746 1067 77988 18.4% 89835 4.6% 10060 -25.7% 6606 12 86368 10.7%
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What does the future hold?

n n
Now for the future trends in Earnings growth (g), Return on Incremental Net Worth (r) & Cost of Equity (k)
Of course, all these values are supposed to be not one-time, but sustainable values.
l All P/E drivers are taking a turn for the worse

u
n
Earnings growth is likely to decline

As the uptrend for cyclicals reverses, or even flattens out, the cyclical part of the earnings growth will disappear. This is likely to happen as the bull run in commodities, which was part fuelled by the weakening US Dollar (See First Globals report Strategic U-turn on the dollar, Europe, small caps, large caps, commodities , dated 5th January 2005) tapers off; in no small measure, due to the US dollar rally. Even for aggregates, the 3-year growth trajectory has clearly been unusual. The Midcaps have seen earnings declines in half of the last 10-years, against the 100% plus net Profit compounding for the last 3 years. The growth slope is likely to turn down. The easy gains from fall in interest expenses disappear, as interest rates creep up
As the uptrend for cyclicals reverses, or even flattens out, the cyclical part of the earnings growth will disappear.
Net Profit growth for the Nifty is slowing down from 26.3% and 39.1% in FY04 and FY05 respectively to 13.5% in FY06, as per consensus estimates. However, these consensus estimates dont take into account the losses likely in oil marketing companies. Factor these in and growth rates slip to single digits. Net Profit growth for the Nifty is slowing The contribution in profits is also skewed towards a few stocks out of which about half are cyclicals, in areas like petrochemicals, steel etc. The Top10 stocks are expected to contribute 68% of Nifty's profit growth. Of these, only cyclicals like Oil, Petrochemicals & Steel contribute about half. Add banking, and just 6 stocks
The easy gains from fall in interest expenses disappear, as interest rates creep up
down from 26.3% and 39.1% in FY04 and FY05 respectively to 13.5% in FY06, as per consensus estimates. However, these consensus estimates dont take into account the losses likely in oil marketing companies. Factor these in and growth rates slip to single digits.
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from cyclical sectors will contribute about half of the total profit growth for the NSE-50 (Nifty). The secular growth stories like Infosys & TCS have a much lower contribution to profits. All these points towards threat to earnings growth in the coming years. Just 6 stocks from cyclical sectors
will contribute about half of the total profit growth for the NSE-50 (Nifty). The secular growth stories like Infosys & TCS have a much lower contribution to profits. All these points towards threat to earnings growth in the coming years.
Table 42: Top 10 FY06 PAT contributors in Nifty

(Rs in mn) ONGC Reliance Inds. St Bk of India SAIL TISCO TCS Infosys Tech. ICICI Bank Bharti Tele-Vent ITC Total of Top 10 Total Nifty Net Profit FY05 FY06E 129885 75397 43050 68217 35095 20029 18598 20069 11836 18096 440272 726514 170465 80222 65209 63831 41555 29099 25166 23485 23247 22526 544805 880919 Increase in Net Profit FY06E FY06 Contribution 40580 4825 22158 -4386 6460 9070 6568 3417 11410 4430 104533 154405 26.3% 3.1% 14.4% -2.8% 4.2% 5.9% 4.3% 2.2% 7.4% 2.9% 67.7% 100.0%
Sources: Company Annual Reports, Bloomberg consensus estimats
l RoE contraction is also on the cards

n
The same reasons that will drive down earnings growth plus the peaking of the improvement in asset Turnover plus the capital dilutions will drive down Return on Capital/ Return on Equity. Now the capex cycle is starting again in capital-intensive industries, like steel. Interest rates have also begun to riseboth will have adverse impact on the return ratios.
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n
www.first-global.us
Add the impact of the huge fund-raisings by companies, especially in the Midcap universeand the RoE picture looks bleaker. Midcap companies have been routinely increasing Capital Employed by 50-100% through dilutionsnever a good idea, as history has shown. We expect the RoE trends to dip southwards FY06 onwards. Add the impact of the huge fundraisings by companies, especially in the Midcap universeand the RoE picture looks bleaker... ... We expect the RoE trends to dip southwards FY06 onwards.
l Cost of capital is inching up

n
Long-term risk-free rates have been inching up from 5.4% in March 04 to 6.3% in March 05 to about 7.5% now. With the soaring fiscal deficit, these are likely to rise further if not immediately, then in another 6-8 months. For details of our interest rate view, please refer to First Globals report Where are interest rates headed...and why it should concern you, dated 26th September 2005.
l All these effects will be magnified for the MidCap
universe
This is the segment with the higher concentration of cyclicals, greater financial leverage and proportionately higher capital dilutions. Therefore, the returns & earnings growth contraction will be more pronounced here.
This is the segment with the higher concentration of cyclicals, greater financial leverage and proportionately higher capital dilutions.
Plus, the Midcaps are also trading far above their historical P/E & P/S ranges, and are now more expensive than the large capsall signs are flashing Red.
The Midcaps are also trading far above their historical P/E & P/S ranges, and are now more expensive than the large capsall signs are flashing Red.
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Conclusions
n n
Overweight Large Caps, relative to the Midcaps All the P/E drivers; viz., earnings growth, Return on equity & Cost of capital are taking a turn for the worse, making P/E expansion very tough. However, given that large caps are still not very expensive relative to their history; correction is more likely via time (slow drift), rather than a sharp crash. Even so, the sensex could be easily headed towards 7500-8000. MidCaps have a much worse outlook due to greater earnings cyclicality/ volatility & vulnerability to interest costs plus the higher (relative to Balance Sheet size) capital dilutionsnot to mention the way-above average valuation ratios the danger signs there are clear. As for the sectoral views & weighting, await our forthcoming piece.
Overweight Large Caps, relative to the Midcaps
Even so, the sensex could be easily headed towards 7500-8000.
MidCaps have a much worse outlook due to greater earnings cyclicality/ volatility & vulnerability to interest costs plus the higher (relative to Balance Sheet size) capital dilutionsnot to mention the wayabove average valuation ratios the danger signs there are clear.
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Annexure A
FG iTotal Composition
FG iTotal Index MANUFACTURING SECTORS Fertilizer Sector Power Sector Metals Sector RCF Tata Power Co. Hindalco Inds. Monsanto India CESC Natl. Aluminium GNFC Reliance Energy Neyveli Lignite Natl. Fertilizer NTPC Hind.Zinc Hind.Copper Industrial Machinary Sector Equipment Sector Shipping Sector Larsen & Toubro GTL Ship. Corp. (I) BHEL Himachal Futuris GE Shipping Co Sterlite Inds. Finolex Cables Essar Shipping Bharat Electron Sterlite Optical Varun Ship. Co. Siemens ABB Cummins India Engineers India Alfa Laval (I) Bharat EarthMove Jindal Saw 2W Sector Auto Ancillary Sector Oil Sector Bajaj Auto MICO ONGC Hero Honda Motor Bharat Forge Indian Oil LML Sundaram Clayton Essar Oil Kinetic Motor Co Sundram Fasten. TVS Motor Co. SKF India Motherson Sumi Steel Sector TISCO Essar Steel SAIL Jindal Steel CV & PV Sector Tata Motors Maruti Udyog M&M Ashok Leyland
Oil Exploration Aban Loyd Chiles Hind.Oil Explor. Oil Country
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Oil Refineries Sector BPCL HPCL Mangalore Ref. Kochi Refineries
www.first-global.us
Petrochemicals Industry Chemicals SectorPharmaceuticals Sector Reliance Inds. Tata Chemicals Ranbaxy Labs. IPCL ICI (India) Sun Pharma. Shasun Chemicals Cipla Dr Reddy's Labs. Glaxosmithkline Nicholas Piramal Lupin Matrix Labs. Novartis India Pfizer Aurobindo Pharma Wyeth Wockhardt Cadila Health Computer Hardware SectorPaints Industry Textile Sector Consumer Durable HCL Infosystems Asian Paints Arvind Mills Videocon Intl. Moser Baer (I) Goodlass Nerolac Raymond MIRC Electronics Tata Infotech Berger Paints Bombay Dyeing BPL Himatsing. Seide Nahar Spinning Indo Rama Text. FMCG Sector Food Sector Cement Sector GAS Sector ITC Nestle India Grasim Inds. GAIL (India) Hind. Lever Tata Tea Guj. Ambuja Cem Dabur India Britannia Inds. ACC Nirma Madras Cement Colgate Palmoliv Marico
Retail Sector Titan Inds. Trent Pantaloon Retail Banking Sector St Bk of India ICICI Bank HDFC Bank Bank of Baroda UTI Bank Bank of India Oriental Bank Corporation Bank J & K Bank ING Vysya Bank Pun. Natl. Bank
FG iTotal Index SERVICE SECTORS Construction Sector Hotel Sector Gammon India Indian Hotels Hind.Construct. EIH IVRCL Infrastruc Hotel Leela Ven. Nag. Constructn. Finance and Investment Sector Media Sector HDFC Zee Telefilms IDBI TV 18 India Reliance Capital Balaji Telefilms LIC Housing Fin
Telecom Sector Bharti Tele-Vent MTNL VSNL Software Sector Infosys Tech. Wipro Satyam Computer CMC Tata Elxsi SSI Pentamedia Graph Flextronics Polaris Software HCL Technologies TCS
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FG iMidcap Composition
FG iMidcap MANUFACTURING SECTORS Power Sector Mining Sector CESC Sesa Goa Guj. Inds. Power Guj. Mineral Dev
Fertilizer Sector Chambal Fert. GSFC Nag. Fert & Chem Coromandel Fert. Deepak Fert. Indo Gulf Fert. Godavari Fert. Steel Sector Essar Steel Ispat Inds. Bhushan Steel Jindal Stainless Mah. Seamless Uttam Galva
Metals Sector Electrost.Cast. L G Balakrishnan Tata Sponge Iron NavaBharat Ferro
Tyres Sector MRF Apollo Tyres
Industrial Machinary Sector Bharat EarthMove Crompton Greaves Thermax Lak. Mach. Works Honeywell Auto HEG BOC India KSB Pumps Elgi Equipment Auto Ancillary Sector Sundram Fasten. Amtek Auto Exide Inds. Motherson Sumi SKF India Rico Auto Inds Automotive Axles PRICOL Wheels India India Nipp.Elec. Omax Autos Munjal Showa Ucal Fuel Sys. Rane Engine Val. Fag Bearings
Equipment Sector Finolex Cables Himachal Futuris Shyam Telecom ITI
Auto Sector Eicher Motors Escorts Swaraj Mazda LML
Oil Exploration Sector Aban Loyd Chiles Hind.Oil Explor. S E Asia Marine
Chemicals Sector Pidilite Inds. Guj. Alkalies BASF India Godrej Indus. Aarti Inds. Clariant (India) Colour-Chem Rallis India Hind.Organ.Chem. GHCL Hikal
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Computer Hardware Sector CMC Tata Elxsi Zensar Technolgs Paints Sector Goodlass Nerolac Berger Paints ICI (India)
Petrochemicals Sector Pharamceuticals Sector Jubilant Organ. Glenmark Pharma Finolex Inds Torrent Pharma. T N Petro Prod. Orchid Chemicals Ipca Labs. FDC Alembic Merck Unichem Labs. J B Chem & Pharm Morepen Labs. Strides Arcolab Textile Sector Sugar Sector Bombay Dyeing Balrampur Chini Mahavir Spinning Bajaj Hindustan SRF Bannari Amman Himatsing. Seide Abhishek Inds. Vardhman Spg. Century Enka Nahar Spinning Garden Silk Mill Nahar Exports Alok Inds.
Plastic Sector Supreme Inds. Sintex Inds. Jain Irrigation Polyplex Corpn
Cement Sector Birla Corp. Shree Cement India Cements Dalmia Cement Ramco Inds. Everest Inds. Prism Cement
FG iMidcap SERVICE SECTORS Construction Sector Gammon India Hind.Construct. ITD Cem IVRCL Infrastruc Hotel Sector Asian Hotels Oriental Hotels Retail Sector Pantaloon Retail Titan Inds. Trent Banking Sector Allahabad Bank IndusInd Bank Federal Bank Karnataka Bank Karur Vysya Bank Dena Bank Bank of Rajasth. Bank of Punjab South Ind.Bank City Union Bank Finance & Investment Sector Tata Invest.Corp Sundaram Finance Tata Finance PNB Gilts Software Sector Infotech Enterpr GTL Geometric Soft. Rolta India Mastek Aftek Infosys Sonata Software VisualSoft Tech. Hexaware Page SSI
61
Pentamedia Graph iGate Global Sol Ramco Systems
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First Global: India Equity Strategy: Vertigo Justified?

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FIRST GLOBAL

FIRST GLO BAL

India Equity Strategy: Vertigo Justified?

Risks far higher for the Midcaps

October 15, 2005

Tel. No: 1-212-227 6611

Email: us@fglobal.com Email: uk@fglobal.com

UK & Europe Sales:

Tel.: 44-207-959 5300

Current Values of & trends in Indices

P/E terms... compared to averages

last few years

20-25 20 21-22 22-25 26-28

which is reversing now

29-30 31-32 33-35 36-38

PAT/EBIDTA & Asset Turnover

39-44 45-53 54-56 54-55 55-56 56 56 57 58-61

The Short Story...

contributed more than 100% of the RoE expansion!...

That was the good news The bad news

Earnings Growth has had a heavy cyclical component

Cyclicals drove the Return ratios expansion as well(See Page 33)

l The same reasons, plus the peaking of the improvement in asset

l All these effects will be magnified for the MidCap universe

The Conclusions (See Page 57)

Overweight Large Caps, relative to the Midcaps

Guide to terms & Indices used

BSE-30 Sensitive Index (Sensex) and NSE-50 (Nifty)

l Guide to the formulae & notations used

Current Values of & trends in Indices

Sensex Nifty CNX Index

Chart 1: Trends in Market Capitalisation (Marcap) for Large Cap indices

Mfg (FG itotal) FG itotal Sensex excl. Bkg

Services (excl. Bkg) Sensex Nifty excl. Bkg

Chart 2: Trends in Market Capitalisation (Marcap) for midcap indices

The 'Fair' P/E

look at the drivers of P/E.

l The large cap indices are still not extraordinarily high

in P/E terms... compared to averages

l but Midcaps are expensiverelative to history &

Table 2: Trends in Price/Earnings ratio

11.7 4.5 7.4 8.3 10.6

29.5 30.7 58.6 30.1 37.8

14.2 10.4 16.8 12.7 14.7

12.3 7.9 11.5 10.5 11.8

Chart 3: P/E Trends in Large Cap indices

Mfg (FG itotal) FG itotal Sensex excl. Bkg

Services (FG itotal) FG itotal excl. Bkg Nifty

Services (excl. Bkg) Sensex Nifty excl. Bkg

Chart 4: P/E Trends in Midcap Indices

Services (FG iMidcap) FG iMidcap

All drivers were conducive for a P/E expansion

Markets are way above average on P/S & P/B

Table 3: Trends in Price/Sales ratio

Chart 5: P/S Trends in Large Cap indices

Chart 6: P/S Trends in FG iMidcap

Table 4: Trends in Price/Book ratio

Chart 7: P/BV Trends in Large Cap indices

Chart 8: P/BV Trends in FG iMidcap

Services (FG iMidcap) FG iMidcap

Chart 9: Risk free rate

Risk Free Rate