How Safe are Banks Assets. 20 Sectors in Focus

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1 How Safe are Banks Assets 2 Sectors in Focus June 216

2 216 SMERA Ratings Limited

3 How Safe are Banks Assets 2 Sectors in Focus 216 SMERA Ratings Limited

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5 SMERA Analysis: Stress in Banking Assets 2 Sectors in Focus Foreword India is one of the fastest growing economies in the world thanks to India s socio-economic evolution over the last five decades. The way business is done in India has evolved with the private sector playing a larger role. It is evident even from Budget that the government is focussed and committed to fuelling the growth of India s private sector. The government has mobilised a massive amount of public finances (15% and 9% increase in Plan and Non-Plan Expenditure respectively) to boost the economy and stabilise the private sector. According to data by the World Bank, the domestic credit to India s private sector increased to 52% of GDP in , as against 25% in the 198s. However, relentless growth has also led to huge quantum of debt going bad and banks declaring significant portions of their assets stressed. Currently, India Inc. doesn t wish to invest in capacity creation on account of excess capacity and at the same time the outlook for demand is not very encouraging until current inventories clear and capacity utilisation levels stabilise. This is evident from the fact that the Gross Fixed Capital Formation (GFCF), the very basic indicator of Capex has been constantly declining over the years and currently contributes to only 29.4% of GDP. Interestingly, during India s growth phase (2-21), the same metric averaged nearly 35%. The average capacity utilisation is less than 7 resulting in a weak GFCF hence the private sector isn t planning further expansion. This is apparent from the negative growth (-2.2% YoY) recorded by the Capital Goods category in the IIP classification. Furthermore, as per the recent IIP data, there exists double digit decline in capital goods category, which is a cause for worry. The global economic crisis and the resultant fall in demand have led to subdued returns from these hefty investments, made to augment capacity. This has resulted in companies struggling to repay debt. The introduction of Asset Quality Review (AQR), has created an ecosystem where high and timely disclosures have become the norm. As on March 216, Gross NPA levels crossed 11% of advances. Considering restructured accounts, which are increasing substantially, the stressed assets amount to over 18% of advances. 216 SMERA Ratings Limited

6 With banks now being extra cautious in lending, credit offtake has fallen below 1 (excluding personal loans), which is one of the lowest growth rates recorded in the last decade. To understand the impact of these regulations on the overall economy, an understanding of the composition of the GDP of a nation is important. Therefore, SMERA has dissected the debt pool and identified 2 sectors that are pacifiers as well as instigators of this adverse situation. These have maximum influence over India s directional growth. The funding to these sectors collectively represent 4 of total credit outstanding (including corporate bonds and other facilities), estimated to be nearly Rs.7,3, cr. In the following pages, SMERA analyses the identified sectors to provide a holistic approach of assessing stress in banking assets. Sankar Chakraborti Chief Executive Officer SMERA Ratings Limited 216 SMERA Ratings Limited

7 Contents Executive Summary... 1 Methodology: Report on Stressed Assets... 3 SMERA Sector Perspectives... 5 Agro and Allied Sector... 6 Auto Ancillary... 8 Auto OEM... 1 Cement Chemicals Electronics Engineering Fertiliser... 2 Gems and Jewellery Healthcare Hospitality Infrastructure Metal & Alloys... 3 Pharmaceuticals Power Generation Real Estate Sugar Steel... 4 Telecommunications Textiles SMERA Ratings Limited

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9 Executive Summary SMERA s Sector Stress score reflects the impact of industry variables on cash flows and credit profiles of companies over the short to medium term (2-3 years). The broad parameters considered to arrive at the score are industry characteristic and structure, present demand supply situation and outlook, cost structures, competitive forces, government policies and regulation and financial performance of sizeable players in the industry. SMERA has analysed 2 key sectors as listed below, out of which six were categorised in the High risk category, while two were in low risk. With expected improvement in consumer spending on the back of a normal monsoon and healthy pace of infrastructure spending to continue, SMERA believes that stress levels in most of the key industries will subside to an extent. The key highlights of the sector specific stress levels are given below. Sr No Sectors Current Expected 1 Agro & Allied 2 Auto - OEM 3 Auto Ancillary 4 Cement 5 Chemicals 6 Electronics 7 Engineering 8 Fertilisers 9 Gems & Jewellery 1 Healthcare 11 Hospitality 12 Infra 13 Metals & Alloys 14 Pharmaceuticals 15 Power Generation 16 Real Estate 17 Steel 18 Sugar 19 Telecommunication 2 Textiles Stress Level (Points between 7.1-1): Red symbolises high stress Stress Level (Points between 4.1-7): Amber symbolises moderate stress Stress Level (Points between 1-4): Green symbolises low stress Stress Zone Current Expected High 6 2 Moderate Low SMERA Ratings Limited 1

10 Highlights Overall stress score for 2 sectors in consideration is expected to reduce from 6.1 to 5.5 Auto OEM only sector to move from moderate stress level to low stress level Telecommunication and Pharma will see marginal increase in stress level score, however will continue to remain in low stress zone Agro and Allied product and Sugar will see maximum improvement in stress level score on account of good monsoon forecasted. Sugar industry, which is currently reeling under low margins will move from high stress zone to moderate stress zone Heavyweights such as Steel and Sugar are unquestionably important sectors for the Indian economy but currently remain risky as far as bankability is concerned Steel, Textile, Gems and Jewellery and Hospitality are expected to see reduction in stress level going forward. However, it will continue to remain between moderate and high stress zone Sectors such as Infrastructure and Power Generation will register reduction in stress levels with hefty budget allocations in FY affirming the Government s agenda to support these sectors SMERA Ratings Limited

11 Methodology: Report on Stressed Assets To analyse current stress levels in the Indian banking sector, SMERA selected entities having debt of over Rs. 1 cr. Based on the above criteria, the sample comprised 3,424 entities that had cumulative borrowings of Rs. 36 lakh cr. - over half of the total advances given by the Indian Banking Sector. SMERA believes, the sample adequately represents major borrowing trends and can provide a snapshot of the stress situation. Further, SMERA has also segregated the identified entities among India s primary sectors choosing the 2 most significant ones as per outstanding debt level. The outstanding ratings of the entities, industry scenario and aggregate financial position of the sector have been considered in order to understand where the stress levels exist. In the following pages, each of the chosen sectors includes: Sector specific rating distribution Changing trends over the previous quarters, each sector s Modified Credit Ratio - MCR {[Upgraded ratings + Re-affirmed ratings]/[downgraded Ratings + Re-affirmed ratings]} ) Analysis of key financial ratios and parameters such as capital structure, Interest coverage ratio (ICR) and return indicators Comparison between Net Sales and PAT over the past four years Equity Returns as compared to BSE5 SMERA has classified each of the 2 sectors on the basis of a colour coded 1 point scale with 1 being the highest Stress Level grading assigned. Stress Level (Points between 7.1-1): Red symbolises high stress Stress Level (Points between 4.1-7): Amber symbolises moderate stress Stress Level (Points between 1-4): Green symbolises low stress The report also covers rating drivers for each of the sectors. Ratings SMERA AAA SMERA AA SMERA A SMERA BBB SMERA BB SMERA B SMERA C SMERA D Interpretation Highest Safety, Lowest Credit Risk High Safety, Very Low Credit Risk Adequate Safety, Low Credit Risk Moderate Safety, Moderate Credit Risk Moderate Risk, Moderate Risk of Default High Risk, High Risk of Default Very High Risk, Very High Risk of Default Default / Expected to be in Default soon 216 SMERA Ratings Limited 3

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13 SMERA Sector Perspectives 216 SMERA Ratings Limited

14 Agro and Allied Sector Sector Statistics 74% of portfolio with rating of BBB and above Portfolio Highlights Agro & Allied Overall* BBB and above 74% 71% Downgrade rate 11% 1 In default 8% 9% Upgrade rate 16% 15% MCR Debt coverage (ICR in times) 2.8 Leverage (D/E in times) 1.2 Profitability (RoCE in %) 14. Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 5 45% 4 35% 3 25% 2 15% 1 5% 45% 2 16% 8% 7% 2% 1% D C B BB BBB A AA AAA Robust growth in Profitability and Net Revenue High Volatility in Equity Market Returns Rs Cr % 9.3% 9.8% 9.1% Revenue PAT% (RHS) Agro & Allied BSE 5 The per capita yield at an aggregate level improved significantly on account of improvement in agro-infrastructure, access to fertilisers, agricultural tools and superior varieties of other agricultural inputs. This significantly reduced procurement costs for agro-allied industries and improved the per unit productivity of the inputs Improvement in storage and warehousing infrastructure also increased the supply chain efficiency apart from providing a boost to vertical integration in the industry Good rainfall is expected to further reduce input costs for the industry High dependence on externalities (rainfall) results in excess volatility in the equity market returns for the sector Though a good expected monsoon will reduce the procurement prices, SMERA estimates that the government s decision to increase the Minimum Support Price on Kharif crops is expected to have a slight impact on cost at the aggregate level. Relatively low export demand may also weigh down on the equity market returns on account of both lower sales volumes and downward pressure on finished goods prices Increased investment in storage, transportation and distribution infrastructure for agricultural products is expected to further build in supply chain efficiencies and result in significant economies of scale SMERA Ratings Limited

15 SMERA Perspective Agro Allied sector expected to remain in the medium stress zone over the medium term Falling agricultural prices world-wide with healthy production domestically has enabled the sector to maintain healthy cash accruals as a result of which the industry is known to report healthy profitability indicators and coverage ratios. Further, the presence of substantial internal accruals limits the dependence on external borrowings resulting in a limited degree of financial leverage. Current Expected Healthy monsoon with significant investment in agri-infrastructure is expected to improve operating margins and enhance the cash accruals for the sector. This is expected to yield better coverage indicators and add further buoyancy to the profitability indicators. As a result, the credit risk profile for the sector is expected to improve slightly from current level Parameters Reason Stress level Demand-supply Net sales for the sector has grown by Compounded Annual Growth Rate (CAGR) of over 16% apart from maintaining a healthy fixed asset turnover ratio. Moreover, rising household incomes along with improvement in distribution channels is expected to further stimulate demand. At the same time, a healthy monsoon with increased investment in Agri-infrastructure is expected to limit the supply-side bottlenecks currently encountered by the industry. Profitability The profitability of the industry at an aggregate level has improved substantially over the last three years and its Return on Capital Employed stood at over 14% in FY215. Further, an improving Net Profit Margin that stood at 9.5% along with significant growth in operating profits has resulted in healthy cash accruals for the sector. Debt protection Healthy cash accruals have not only enabled firms to maintain robust coverage ratios but also reduce the aggregate quantum of debt by generating sufficient internal accruals for the industry. As a result, the degree of financial leverage has significantly reduced over the last three years. Sector Monitorables: Timeliness, adequacy and distribution of rainfall Minimum Support Price for key agricultural products Utilisation of funds allocated towards agri-infrastructure development Agricultural yield in the global markets and their aggregate traded price Consumer demand and household incomes 216 SMERA Ratings Limited 7

16 Auto Ancillary Sector Statistics 87% of portfolio with rating of BBB and above Portfolio Highlights Auto Ancillary Overall* BBB and above 87% 71% Downgrade rate 11% 1 In default 3% 9% Upgrade rate 12% 15% MCR Debt coverage (ICR in times) 2.3 Leverage (D/E in times).6 Profitability (RoCE in %) 12.3 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 4 35% 3 25% 2 15% 1 5% 35% 33% 15% 7% 3% 4% 1% 1% D C B BB BBB A AA AAA Slow growth in Auto sales but demand to pick up Sector (equity return) to underperform peers % 4.1% 5. 1 Rs Cr % 3.3% Revenue PAT% (RHS) Auto Ancillary BSE 5 The auto ancillary sector has been battling slow down in demand along with margin pressures. The margin expansion for FY is largely on account of softening of raw material prices Auto ancillary players to witness heathy growth which will be supported by higher demand from OEMs, government focus on infrastructure development and strong replacement market. Domestic demand to remain bullish due to expected softening of interest rates, low inflation (SMERA estimated CPI, 4.8%) and healthy GDP growth The 7th Pay Commission may act as a multiplier of demand for the Automotive sector whose complement product is automobile components SMERA Ratings Limited

17 SMERA Perspective Auto Ancillary is expected to remain in the medium stress zone Profitability has increased over the last financial year perhaps with steel being available at cheap rates (excessive dumping by China). However, with anti-dumping duty imposed by the Indian government, the same may not continue to be so in the next financial year. A growing working population and an expanding middle-class are expected to remain key demand drivers for the auto segment in India, driving auto component demand. Further, emergence of India as an auto hub for small and medium passenger vehicles will also fuel demand for deemed exports. Current Expected Parameters Reason Stress level Demand-supply Sales grew at a healthy pace during , with moderation in the past two years. Going forward, SMERA expects revenue growth to be higher, driven by domestic demand. Profitability Profitability indicators moderated in the recent past on account of stagnant demand. However margins were supported by softening of raw material prices. SMERA expects EBITDA margins to improve from the current levels with increase in utilisation level and weak raw material prices in the medium term. Debt protection Given the comfortable capital structure of the industry, debt protection metrics were not impacted despite moderation in profitability. In the future, with expected improvement in margins, SMERA believes that debt protection metrics will strengthen further. Sector Monitorables: Product expansion Raw material price volatility Export competiveness 216 SMERA Ratings Limited 9

18 Auto OEM Sector Statistics 94% of portfolio with rating of BBB and above Portfolio Highlights Auto - OEM Overall* BBB and above 94% 71% Downgrade rate 3% 1 In default 9% Upgrade rate 6% 15% MCR Debt coverage (ICR in times) 6.5 Leverage (D/E in times).4 Profitability (RoCE in %) 15.3 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 35% 3 25% 2 15% 1 5% 29% 29% 26% 1 3% 3% D C B BB BBB A AA AAA Auto sales growth slow, but demand to pick up Sector equity returns to outperform peers 6 7.4% % 6.3% 5.5% Rs Cr Revenue PAT% (RHS) Auto - OEM BSE 5 As domestic sales rise and product portfolios are expanded, demand for debt expected to increase in the coming time. Around 94% of the portfolio is BBB and above rating grade,the only sector to have more than 9 of its portfolio in the BBB and above rating category Nil Default has occurred in the studied period West and South regions combined host 84% of the OEMs. Domestic demand to remain bullish due to continued expectations of falling interest rates, low inflation (SMERA estimated CPI, 4.8%) and healthy GDP growth The 7th Pay Commission may act as a multiplier of demand for the Automotive sector Demand for Indian Auto exports has been hit by poor demand in commodity trading nations in Latin America and Africa SMERA Ratings Limited

19 SMERA Perspective Auto OEM is expected to remain in the low stress zone Stagnant sales and volatile trend in pat margin can be witnessed for last three years. This is in particular for Commercial Vehicle segment. Owing to same, the sector is operating on low capacity utilisation and high inventory. SMERA believes that the stress level will subside with healthy growth in Consumer Goods Category of IIP. Auto OEM is a heavy weight sector, directly or indirectly influencing nearly 19% of IIP. The economic growth momentum is also picking up. Regulatory issues (e.g: Delhi and Kerala diesel vehicle ban) has negatively impacted the sales of Passenger Vehicle. Current Expected Parameters Reason Stress level Demand-supply The sector has grown at over 1 during the last decade. Sales slowed down but better economic conditions have given the much needed fillip as Indian industry recovers. Overall, the industry declined in but recovered since then, albeit slowly. Profitability Though PAT has been declining due to increased competition, but given the month on month increase in sales volume in recent period will lead to better capacity utilization resulting in improved margins. Debt protection ICR is at a healthy 6.5 times, while leverage is recorded at.4. Sector record - 94% Investment Grade Portfolio with 88% Stability Sector Monitorables: Dependence on monsoon for rural demand to pick up Implementation of the 7th Pay Commission New model launches and portfolio expansion Commodity price movement Sustainable export market growth (Africa and South America) 216 SMERA Ratings Limited 11

20 Cement Sector Statistics 73% of portfolio with rating of BBB and above Portfolio Highlights Cement Overall* BBB and above 73% 71% Downgrade rate 2% 1 In default 8% 9% Upgrade rate 1 15% MCR Debt coverage (ICR in times) 1.9 Leverage (D/E in times).9 Profitability (RoCE in %) 1.1 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 3 25% 2 15% 1 5% 24% 24% 16% 16% 8% 8% 2% D C B BB BBB A AA AAA Revenue increase due to massive investment in infrastructure creation Sector (Equity) is driven by government expenditure and capacity augmentation % 7.6% Rs Cr % 4.3% Revenue PAT% (RHS) Cement BSE 5 The infrastructure sector is the primary driver of growth and expansion Revenue of the industry has been increasing at a slow rate on account of weak demand in real sector and stalled projects in infrastructure sector. Low price realization has subdued the margins. The sector remains attractive destination for FDI inflow marked by large number of M&A deals. Stocks have returned 4% as compared to negative returns offered by the BSE 5. The Index of Cement is one of the better growing segments among Core Industries and averaged a growth of 4.5% during the last year Higher government investment in infrastructure projects will augment the sector s capacity and drive further demand for cement SMERA Ratings Limited

21 SMERA Perspective Cement sector to record adequate growth rates in the near term The cement industry is performing moderately. Increased government expenditure on infrastructure projects causes the sector to grow around 1. Lower power and fuel cost and freight charges keep the sector profitable. On-going capacity expansion in the power generation sector and cheaper crude oil prices will continue to keep the operational cost for the cement industry low in the near future. Similarly, the central and state governments have initiated various infrastructure schemes, which will also increase demand for this industry. Current Expected Parameters Reason Stress level Demand-supply SMERA foresees capacity expansion and greater profitability in the cement industry. For, the central government has already allocated Rs.2,2, cr to construct roads and railways. Besides, the 1 smart cities and Housing-for-all schemes will push demand further not to mention the several irrigation and road projects initiated by state and central governments that will provide further impetus. Profitability Profitability is expected to increase on account of higher capacity utilisation due to better infrastructure spending by the Government in particular for the southern region. Debt protection In the last couple of years, even though most metrics including, leverage, EBITDA margins, RoCE have been declining but given the higher revenues and profits, SMERA expects the debt protection metrics to stabilise Sector Monitorables: Government focus on Infrastructure Capacity augmentation Export demand 216 SMERA Ratings Limited 13

22 Chemicals Sector Statistics 78% of portfolio with rating of BBB and above Portfolio Highlights Chemicals Overall* BBB and above 78% 71% Downgrade rate 12% 1 In default 8% 9% Upgrade rate 17% 15% MCR Debt coverage (ICR in times) 3.2 Leverage (D/E in times).7 Profitability (RoCE in %) 13.3 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 35% 3 25% 2 15% 1 5% 31% 27% 16% 8% 9% 4% 2% 2% D C B BB BBB A AA AAA Revenue to increase due to import substitution and high demand for agro chemicals Sector (Equity) returns are healthy due to fall in crude and other basic good prices Rs Cr 7, 6, 5, 4, 3, 2, 1, 6.8% 6.2% % Revenue PAT% (RHS) Chemicals BSE 5 Strong demand for agro related chemical products and higher import duty on imports from China have helped increase revenue over the past four years The sector remained attractive for investors and received higher FDI inflows than most peers, improving to the seventh position in cumulative FDI inflows between 2 and 215. There has been higher government support on technological upgradation and research and development. Stocks have performed better than the overall market due to higher investment and capacity augmentation The sector recorded nearly 17% growth in FDI inflows from Rs.4,668 crore in FY to Rs.9,664 crore in FY Lower petroleum prices in the past months have increased the profitability of the industry SMERA Ratings Limited

23 SMERA Perspective Chemicals industry is expected to remain in the moderate risk category The Chemical industry is one of the oldest industries in India contributing around 2% to the overal GDP and 9% to exports. Chinese dumping is perhaps the biggest threat to this industry s performance. However, the govenrnment has extended anti-dumping duty on import from China for another five years to protect the industry s interest. With high FDI inflows, the chemicals industry has greater scope for technology upgradation and capacity expansion. However, some sections in the sector are reserved for small scale industries and therefore lack technology upgradation as investment on R&D is low. The policy and support by the government is thus critical for this sector growth in the foreseeable future Current Expected Parameters Reason Stress level Demand-supply The Chemicals industry is expected to augment capacity in order to meet domestic demand and increase competitiveness in the global market. Modernisation in the agricultural sector will push demand for agro-related chemical products. However SMERA believes that the threat from cheaper Chinese imports will impact the growth prospects of the industry. Profitability EBITDA margins as well as RoCE have been under pressure largely on account of underutilization of capacity. However, SMERA believes that this pressure is expected to continue going forward mainly on account of demand supply uncertainties and strengthening crude oil prices Debt protection Debt to Equity has remained at less than.74 times. ICR also remains at a healthy 3.2 times. SMERA expects the debt protection matrix to remain at this level Sector Monitorables: Significant increase in FDI inflows Government support available on technology upgradation Strong domestic demand and competitiveness in the global market Creation of incremental capacity 216 SMERA Ratings Limited 15

24 Electronics Sector Statistics 88% of portfolio with rating of BBB and above Portfolio Highlights Electronics Overall* BBB and above 88% 71% Downgrade rate 8% 1 In default 4% 9% Upgrade rate 8% 15% MCR Debt coverage (ICR in times) 1.4 Leverage (D/E in times).3 Profitability (RoCE in %) 4.4 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 4 35% 3 25% 2 15% 1 5% 38% 27% 23% 6% 4% 2% D C B BB BBB A AA AAA The Electronics industry has been experiencing declining revenue due to cheaper imports Sectorial equity index return in line with the benchmark index 1,55, 1,5, 6.6% Rs Cr 1,45, 1,4, 1,35, 1,3, % -3.5% ,25, -4. 1,2, Revenue PAT% (RHS) Electronics BSE 5 Revenue of the industry has fallen over the last two years due to cheaper and higher quality imports. Margins are thus severely impacted The Indian government has received proposals worth around Rs.17, cr in the last four quarters With subscriber numbers increasing, there s much thrust on mobile manufacturing. Chinese and Taiwanese companies have invest over Rs.2, cr in the sector Stocks have underperformed the market lately but expected to rebound given the strong pent up demand for consumer durables The Make in India initiative is expected to expand capacity and bring about import substitution Dedicated Industrial Parks for the Electronics industry are expected to create over 1, job opportunities The Ministry of Electronics and IT aims envisages an annual sectoral output of $4 billion by SMERA Ratings Limited

25 SMERA Perspective Electronics sector expected to remain moderately risky With a debt quantum of nearly Rs.74, cr, the electronics industry is definitely a heavy weight in the economy but overall the portfolio has been only moderately risky. Current declines in sales can be attributed to dumping and cheaper imports but overall growth in consumer durables is expected to neutralise the situation SMERA believes that as an important part of the Make in India initiative, the Electronics Industry has a lot riding on it. Consumer Electronics, Complex electronics and Defence equipment will drive the sector. Innovation and adequate supply chains will however hold the key to this optimism. Overall the sector will remain in the moderate stress zone Current Expected Parameters Reason Stress level Demand-supply Creation of incremental capacity and buoyed by healthy FDI equity, the sector is in a strong position to meet domestic demand. Dedicated and focussed initiatives and advent of global supply chains will help the sector scale new heights Profitability Thin margins have resulted in a continuous fall in EBITDA as well as RoCE. Falling top lines have impacted profitability, which is a cause for concern. However, continued investment and rise in household consumption over the next few years are expected to improve the situation Debt protection Even though leverage is healthy, an ICR of just 1.38 times as well as RoCE of 4% is a cause for concern Sector Monitorables: Continuous flow of FDI Equity Government s focus through the Make in India policy Consumer demand and export opportunity 216 SMERA Ratings Limited 17

26 Engineering Sector Statistics 78% of portfolio with rating of BBB and above Portfolio Highlights Engineering Overall* BBB and above 78% 71% Downgrade rate 14% 1 In default 4% 9% Upgrade rate 13% 15% MCR Debt coverage (ICR in times) 3.8 Leverage (D/E in times).4 Profitability (RoCE in %) 15.1 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 45% 4 35% 3 25% 2 15% 1 5% 38% 2 18% 12% 4% 4% 2% 1% D C B BB BBB A AA AAA Stagnancy in revenue and uneven profitability due to poor demand for capital goods Sector (Equity) low until capacity augmentation becomes a reality Rs Cr 15, 14,8 14,6 14,4 14,2 14, 13,8 13,6 5.1% 6.8% 4.9% 4.9% , Revenue PAT% (RHS) Engineering BSE 5 About 14% of the portfolio has been downgraded while 4% is in default Poor performance of the capital goods category explains moderate growth in the industry Revenue of the sector remains stable as capacity augmentation is slow due to low investment Global slowdown has impacted Engineering exports Government initiatives are expected to drive demand for engineering goods The stock has given a negative return of nearly 15% in the last financial year as compared to negative return of 7.6% offered by BSE 5. This indicates the sector has inherent industry specific risk. Heavyweights such as BHEL have recorded a net loss in FY216 The outcome of the ongoing negotiations with other members of Regional Comprehensive Economic Partnership (RCEP) will also majorly impact margins and profitability SMERA Ratings Limited

27 SMERA Perspective Engineering sector to be in the moderate stress zone The sector experiences adequate domestic demand as investment in infrastructure and growth in the automobile sector are correlated with this segment. There is however, weak global demand accompanied by underpowered exports performance Low labour costs and weaker growth momentum in the Chinese economy will create huge potential for this sector to grow. The Engineering Export Promotion council (EEPC) is expected to promote India s engineering goods exports and find new opportunities. Besides, the Make in India initiative is likely to draw more FDI equities Current Expected Parameters Reason Stress level Demand-supply The government aims at being self-reliant in engineering products by 22 with zero imports. While there exists adequate domestic demand, the poor performance of exports is a major risk for the sector Profitability The PAT, even though positive is on a declining trend and so is EBITDA margin. Cheaper imports as well as poor capacity creation in the domestic market can take a toll on the sectoral profitability Debt protection Debt equity is about.4 while the ICR is at a comfortable 3.7 times. Overall, the sector remains capable of meeting its debt obligations Sector Monitorables: Continuous flow of FDI equity Performance of Capital Goods category included in the IIP Government s focus through the Make in India policy Consumer demand and export opportunity Expansion in the domestic defence sector Creation of incremental capacity 216 SMERA Ratings Limited 19

28 Fertiliser Sector Statistics 69% of portfolio with rating of BBB and above Portfolio Highlights Fertilisers Overall* BBB and above 69% 71% Downgrade rate 23% 1 In default 15% 9% Upgrade rate 8% 15% MCR Debt coverage (ICR in times) 1.7 Leverage (D/E in times) 1.1 Profitability (RoCE in %) 7.6 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 35% 3 25% 2 15% 1 5% 31% 31% 15% 8% 8% 8% D C B BB BBB A AA AAA Steady growth in turnover coupled with rising competition Complex regulatory structures and low profitability weigh downs the equity market returns 12 91, 9, 89, 88, 87, 4.8% Rs Cr 86, 85, 84, 1.2% , 82,.6% 1. 81, Revenue PAT% (RHS) Fertilisers BSE 5 Robust growth in agricultural acreage on account of a healthy monsoon is expected to significantly increase demand Increased MSP for key agri-products by the government will stimulate acreage in the medium term With implementation of the New Pricing Scheme (NPS), prices of DAP and MOP have doubled. As a result, the usage of Urea has increased (which has always been priced lower than DAP and MOP). Further, on account of competition from rising imports, margins have declined significantly Implementation of the Direct Benefit Scheme for transfer of subsidies is expected to reduce demand for Urea for non-agricultural purposes and thus affect revenue growth The fertiliser sector has underperformed the market on account of weak inflow of foreign capital. Additionally, the high degree of regulatory controls have adversely affected the growth prospects. As a result, the sector underperformed the market by generating % returns over the last one year. Further, fertiliser prices in India are the lowest across the world. As a result, private investment in the sector has grown extremely slowly. An indirect Retention Pricing-based policy has restricted investment in the sector despite the introduction of a revamped form of the Urea Investment Policy (UIP). Weak confidence of investors in the sector has restricted the quantum of equity infusion. However, the degree of financial leverage for the industry remains stable on account of a healthy rise in revenues and deferral of capital expenditure plans SMERA Ratings Limited

29 SMERA Perspective Stress level in the Fertilisers Industry is expected to remain moderate SMERA believes that stress level in the sector will continue to be moderate on account of a complex policy environment and lack of significant rise in per unit revenues. This is on account of stringent price controls, distribution and production regulations. Further, limited equity infusion on account of low investment attractiveness of the industry is also expected to weigh down in the medium term. SMERA expects the stress level in the industry to marginally improve in the medium term due to rationalisation of capital expenditure plans apart from a robust growth in the overall revenues for the sector due to a healthy agricultural acreage in the coming crop seasons. Moreover, marginal improvement in profitability may be expected due to rise in petroleum prices and the Wholesale Price Index. Current Expected Parameters Reason Stress level Demand-supply The sector is expected to record an approximately 5-6% rise in turnover. However, the low capacity addition in the recent past is expected to result in higher imports and thus increase competition for the industry. Profitability Debt protection As a direct consequence of the stringent price controls, the operating profit margin for the industry has significantly declined from over 11% in FY212 to below 8.5% in FY215. This is accompanied by a 4.5% fall in the return on capital employed from over 12% in FY212 to approximately 7.6% in FY215. As a result, the return on marginal capital employed will reduce and has thus inhibit significant capacity addition in the recent years. While, the interest coverage ratio has declined on account of lower profitability, it continues to remain above 1.6 times. Further, an aggregate debt-equity ratio of approximately 1.8 times further supports the credit risk profile for the sector. The sector is expected to experience higher equity based funding once the compliance process for the new UIP gets simplified. Sector Monitorables: Government pricing and investment policy for the fertiliser sector Import tariffs and SPS and TBT for both finished fertiliser products and inputs Acreage and area under cultivation Capacity expansion and capital expenditure in the sector 216 SMERA Ratings Limited 21

30 Gems and Jewellery Sector Statistics Highest concentration at BBB rating level Portfolio Highlights Gems & Jewell Overall* BBB and above 84% 71% Downgrade rate 1 1 In default 1 9% Upgrade rate 21% 15% MCR Debt coverage (ICR in times) 1.8 Leverage (D/E in times) 1.5 Profitability (RoCE in %) 9.8 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors % 24% 1 2% 4% 1% D C B BB BBB A AA AAA Profitability expected to improve in future Sector equity return remains negative for FY16 1,4, 1,2, 3.2% 2.8% 3.5% ,, 2.5% 8 Rs Cr 8, 6,.9% % 6 4 4, 2,.6% 1..5% Revenue PAT% (RHS) Gems & Jewellery BSE 5 Revenue growth in FY16 is expected to be 6-8% lower across the sector reflecting weak industry demand throughout the year (domestic + export). The month long jewellers strike after introduction of excise duty in Feb 216 has also taken a toll. Industry players are expected to report flat (as compared to previous year) to negative net profitability. Sector equity return has remained negative at 14.6% as compared to negative return of 8.5% delivered by BSE 5. Barring few players in the sector, all companies across retailing, manufacturing and diamond processing have posted negative returns. Weak demand and changes in government regulations are the main reasons for below average corporate profitability SMERA Ratings Limited

31 SMERA Perspective Gem and Jewellery sector stress level expected to decline marginally Overall, the gems and jewellery sector is under high stress due to weak export demand and moderation in domestic demand over the past month period. Stress levels in the diamond processing segment is higher as compared to jewellery on account of low value addition and elongated working capital cycle leading to weaker profitability. Current Expected SMERA believes that the overall stress levels in the industry will reduce marginally on account of expected improvement in demand in both, the domestic as also export market. Diamond processors will continue to face weak profitability trends with marginal reduction in working capital cycle. Jewellery manufacturers and retailers on the other hand are likely to witness better profitability as compared to the previous year on account of better prospects of demand and lower cost of funds. Parameters Reason Stress level Demand-supply Profitability Debt protection Overall, the domestic demand for jewellery (plain gold and studded jewellery) has been growing at a moderate pace of 5-6% during the period Export of gems and jewellery has grown by around 3% in FY216 (Rupee terms) to Rs.2.5 lakh crore. The growth has been largely driven by export of gold medallions and coins, while cut and polished diamond exports saw decline of 8% over FY215. SMERA believes that with expected improvement in macroeconomic factors domestically, expectation of above average monsoon will drive rural demand for gold in the form of jewellery and investment. Investment forms 3 of total gold demand. However, given the current high domestic gold prices and global factors such as Brexit, the interest rate policy and oil prices of developed economies will keep gold prices volatile, impacting domestic investment demand. Profitability indicators of Cut and Polished diamond players will continue to remain weak on account of weak export demand and stretched working capital cycle. Return indicators of domestic jewellery manufacturers and retailers have remained healthy till FY214. However, with changes in government regulations, decline in gold prices and increasing competition, return indicators have remained depressed in the last two years. Going forward, profitability of jewellers is likely to improve marginally as rural demand will improve on account of a favourable monsoon. Debt protection indicators have weakened over the last two year period with interest coverage ratio declining from above 2.5x to less than 1.8x on account of dip in profitability, higher interest cost and increased debt due to long working capital cycle. Going forward, SMERA believes debt protection metrics will improve marginally for players engaged in integrated jewellery business (manufacturing + retailing), while standalone players in jewellery manufacturing and diamond processing will continue to have below average debt protection indicators. Sector Monitorables: Price movements in Gold and Diamond Working capital management Export competitiveness diamond processing (exchange rate and government policies) 216 SMERA Ratings Limited 23

32 Healthcare Sector Statistics 71% of portfolio with rating of BBB and above Portfolio Highlights Healthcare Overall* BBB and above 71% 71% Downgrade rate 4% 1 In default 1 9% Upgrade rate 22% 15% MCR Debt coverage (ICR in times) 4. Leverage (D/E in times).4 Profitability (RoCE in %) 8.5 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 35% 3 25% 2 15% 1 5% 33% 33% 12% 1 6% 6% D C B BB BBB A AA AAA Capacity augmentation in Healthcare; revenue growth to be in double digits Equity returns maintain decent convergence from the mean Rs Cr 16, 14, 12, 1, 8, 6, 4, 2, 5.2% 8.1% 1.9% 2.9% Revenue PAT% (RHS) Healthcare BSE 5 The sector records an upgrade rate of of 22% Healthcare is roughly.4% of the Indian GDP Primary growth drivers of the sector includes the independent diagnostic industry as well as medical tourism Budget allocation to the health sector has shrunk due to the centre s ongoing fiscal prudence & devolution of finances (14th Finance Commission recommendations) with the states now increasingly becoming the custodians of public health Healthcare equity has been constantly over performing the market over last year As per IBEF/ PwC estimates, India requires 7, additional beds by the year 22; this is driven further by rapid growth in foreign FDI equity Government programs such as Rashtriya Swasth Bima Yojana will spread the healthcare led insurance service thereby increasing demand for organized medical facilities in terms of both quality and quantity The sector is showing promising growth due rising per capita spending on healthcare as well high interest of global investors SMERA expects the sector to provide healthy returns going forward (medium to long term) due to state funded projects, which are accentuating the investment cycle SMERA Ratings Limited

33 SMERA Perspective Healthcare has received a tremendous push from the Government; will sustain growth through increased private participation and encouraging FDI flows Performance of the sector is moderate at this time due to the ongoing investment cycle. Not to mention, the sector is an attractive destination for foreign investment. Government to Government schemes have been highlights of the sector especially the case of the Japanese Official Development Assistance s offer of Rs 1,548 crores loan with an interest rate of.3% for 4 year to develop urban health care in Tamil Nadu. Central as well as State schemes such as National Dialysis & National Health Assurance have had substantial impact on the sector Current Expected Emerging healthcare sectors such as mental health, Diagnostics, Yoga and traditional healthcare will significantly drive the Indian healthcare space. With per capita GDP growing above 7%, demand for health care will increase. The sector is likely to attract more FDI equity in the near future and performance is likely to improve. SMERA also believes that smaller players will witness increased M&A activity in the near future. Rural healthcare is likely to be the new focus area of the Government while the private sector will augment the urban multispecialty space further Parameters Reason Stress level Demand-supply Even though 7 of the sector is driven by private players, the role of the government will be the focal point. India is likely to roll out the National Health Assurance Mission (NHAM) at a cost of Rs.1.6 lakh cr and a lot more investment can be expected in the coming years. These schemes will significantly increase the consumption power of citizens and determine demand. Profitability Debt protection Given the high competiveness and unorganised nature small private players have struggled lately, however the branded players in the multispecialty space has been the performers Averaging over 5% lately, PAT has however been uneven. SMERA expects moderation in the medium term An ICR of 4 times and a leverage of less than.4 is encouraging and offers good debt protection for the sector Sector Monitorables: Preferred Medical tourism destination Government s focus through National Health Assurance Mission Strong consumer demand /higher per capita GDP 216 SMERA Ratings Limited 25

34 Hospitality Sector Statistics 54% of portfolio with rating of BBB and above Portfolio Highlights Hospitality Overall* BBB and above 54% 71% Downgrade rate 11% 1 In default 14% 9% Upgrade rate 9% 15% MCR Debt coverage (ICR in times).7 Leverage (D/E in times) 2. Profitability (RoCE in %) 2.5 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 35% 3 25% 2 15% 1 5% 32% 16% 16% 14% 14% 7% 1% D C B BB BBB A AA AAA Revenue to increase with rise in disposable income Sector equity returns remain positive in FY16 16, -.3%. 14 Rs Cr 14, 12, 1, 8, 6, 4, 2, -6.5% % Revenue PAT% (RHS) Hospitality BSE 5 The gloomy global economic outlook is expected to affect the foreign tourist inflow resulting in low occupancy rates Increasing dependency on a relatively price sensitive domestic tourist along with the need to stimulate demand shall adversely affect the Average Room Rent (ARR) and thus prevent significant improvement in the operating margins. Occupancy rate have remained below 55% for the sector thereby impacting the margins and debt repaying capacity. Growth in e-commerce engagement for the hospitality sector is also expected to reduce marketing costs and enhance the Net Revenue per unit marketing outlay. This will further compliment the multi-fold growth in tourist arrivals using the E-Visa facility besides the massive rise in online bookings over the last 3 years. The increase in both foreign and domestic investment has led to a significant degree of rationalization in the degree of financial leverage along with the onset of economies of scale for individual players SMERA Ratings Limited

35 SMERA Perspective Hospitality sector expected to remain in the high stress zone The current stress level of the industry continues to be high on account of low net cash accruals as a result of weak profitability indicators. However, market consolidation and improvement in leverage indicators have partially offset the stress-level in the sector. SMERA believes that the continued global economic slowdown will negatively weigh on the industry over the medium term. As a result, it is unlikely that the healthy policy support from the government will significantly improve the risk profile of the firms in the sector. The average occupancy rate is unlikely to rationalize over the medium term. Current Expected Parameters Reason Stress level Demand-supply The average occupancy rate in the second half of FY216 increased to over 61% from 6.3 in FY215. However, this was accompanied by decline in the Average Room Rate (ARR) from Rs.6,489 in FY21 to Rs.5,51 in FY215 in order to penetrate the price sensitive market. Further, the industry continues to face changing customer preferences along with weak demand from foreign tourists. Profitability On account of significant decline in the ARR, the Revenue Per Available Room declined from Rs.3,861 in FY21 to Rs.3,324 in FY215. As a result, the operating and net profit margins for the industry declined significantly over the last five years. This has resulted in a low return on capital employed that persistently stayed below 5% over the last three years. Debt protection With an average Debt Equity Ratio of 1.37 times in FY215 and an interest coverage ratio under one, the decline in profitability indicators has substantially increased the delinquency risk in the hospitality sector. Sector Monitorables: Growth in Real Disposable Income both domestic and global Expansion and Implementation of government policies including Tourism Sector MoUs, Regional Connectivity Scheme under the Aviation Policy Foreign Tourist Arrival Rate Average Room Rent and Average Occupancy Rate Development of the transportation infrastructure rail, road and aviation Development of new hospitality sector products 216 SMERA Ratings Limited 27

36 Infrastructure Sector Statistics 67% of portfolio with rating of BBB and above Portfolio Highlights Infrastructu Overall* BBB and above 67% 71% Downgrade rate 12% 1 In default 13% 9% Upgrade rate 16% 15% MCR Debt coverage (ICR in times) 1.2 Leverage (D/E in times) 2. Profitability (RoCE in %) 8.7 Source: SMERA Research; ACE Equity * Aggregate median of 2 sectors 45% 4 35% 3 25% 2 15% 1 5% 42% 17% 13% 13% 6% 6% 1% 2% D C B BB BBB A AA AAA Revenue of Infra companies has been increasing but profitability perhaps not so much Sector (Equity) has been a consistent underperformer and returns have been poor 2,2, 2,15, 2,1, 2,5, 3.1% 2.3% Rs Cr 2,, 1,95, 1,9, 1,85, 1,8, 1,75, -.4% -2.4% ,7, Revenue PAT% (RHS) Infrastructure BSE 5 Nearly 12% of the portfolio has been downgraded while 13% has been in default category Quantum of debt issued is almost Rs.7, cr Primary reason for poor performance has been the sheer magnitude of debt as well as uncertain regulations and clearance issues India needs to invest an estimated Rs.135, cr in infrastructure by the year 22 Returns have been below par. However, the sector is yet to receive a major fillip via government expenditure. The budgetary allocation for FY217 is over Rs.22, cr Indian Railway is expected to further increase its capital expenditure to Rs.12, cr, primarily to improve its infrastructure Creation of the National Infrastructure Fund will further augment this thrust by accessing capital from foreign avenues that include sovereign wealth funds SMERA Ratings Limited