Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and joining me today to give his three stock picks, is Kunal Desai, Manager of the Neptune India Fund.
Kunal Desai: Hi Emma.
Wall: So, what's the first stock you'd like to highlight today.
Desai: So, the first stock which I think is very interesting is a company called Blue Star (BLUESTARCO). And what Blue Star do is they manufacture air conditioning units which they sell into commercial and corporate customers. But increasingly are now being a consumer products company and selling room air conditioning units to the millions of people across India. So really this company is one which has done well, is a mid-cap company, but we think can do even better.
Two sides of the business, the first side of the business is what they call projects. So, this is big central air conditioning systems for big corporate customers, industrial conglomerates. And this is quite a cyclical business. Typically, it’s the capex cycle which drives demand as creation of new commercial entities takes place. And this had been under pressure, really because it's been very competitive, bidding intensity has increased and when you look at their order book about 15% of their order book was at 0% margin. So, it was a business under stress.
We think this turns around though, India's economy is turning around. Commercial and corporate appetite for new capex is improving and this is a business which we think can sustainably grow at about 15% with margins moving from 3%, 4% up to 6%. But probably the more interesting element of this company is the consumer facing side. And what they do is they manufacture products such as room air conditioning units to the 250 million, 300 million households which exist in India and some of their export markets.
One of the most interesting areas of this company is they have by far in a way one of the strongest distribution networks across India. So really where I see a potential upside which is not implied by the valuation is they are able now to move into other products and push them through these distribution pipes which they have. They are a very service intensive company with an after sales network which is at par with the market leader. So, this is company which we see over 3, 5-year view a good degree of earnings visibility at about 20%, 25% and given what’s being implied by valuation I still think it represents good value here.
Wall: And what's the second stock today?
Desai: Second one is a bank, a new bank, a new age bank called Equitas (EQUITAS). And what Equitas do is they typically have lended to micro-finance and had lended a little bit towards micro and small businesses. What this company are now doing is changing they are looking to run down their micro-finance business because its very risky and it has all sorts of political problems and looking to focus on micro small businesses. Now this is an area which is severely underpenetrated.
When you look at micro small business, credit penetration it's less than 10% versus emerging market peers north of 30%, 40%. So, there is a big avenue for growth here. What they are doing which is interesting is they are looking to lend to rural areas where you get these micro small businesses and the yield on these loans are about 15% to 17%. At the same time, they are looking to get their deposits from liability rich urban centres. So, these deposits in terms of current account or savings account are only, they are only paying out 3%, 4%, 5% so they are earning a very healthy spread. But given the transformation in this company looking to expand their branch network, again, this is a company which we see very strong visibility of growth with ROEs hitting about 20% by 2020.
Wall: And banking is quite an interesting sector in India, isn’t it? Because its mostly dominated by state-owned enterprises. But you do have increasingly these disruptor companies coming through in the sector, don’t you?
Desai: I think that’s completely right. I think what India is trying in its financial system today is something no emerging market has tried. And really, they are using two reforms one being the ID system in India which is linked to your biometrics, your thumb print and your iris. And also, the GST network which now makes sure that every business has their cash flows uploaded for banks to see. So, when it comes down to underwriting quality of a bank it's the ability to price risk and with this huge improvement in data granularity which you are seeing at the moment, these challenger banks have been very aggressive in building their own algorithms to price risk far better than the old state-owned and private banks had done.
Wall: And what's the third and final pick?
Desai: The third one is more of a turnaround company and it's a company called Cognizant (CTSH). Who are one of the big IT services bellwether. Now the reason why we like this company is there is a change in strategy that this company are looking to employ. That sector is under all sorts of change, all sorts of disruption as essentially customers are demanding more they want their IT provider to offer them consultancy help about how to grow and become a better company, not just doing things for cheaper and keeping the lights on essentially.
What Cognizant have done a very, very focused on the front end. They have increased their consultancy business. Digital as a percentage of their revenue has grown from 15% now north of 30%. So, this is a very digital savvy company which are focused on social, mobile, analytics and cloud type systems. At the same time, they have investors on board who are demanding change. And what we are looking for is them to improve their operating margins which we believe they will and this is the digital profile which has a better margin and mix shift and also becoming far more shareholder friendly. And we'd expect now over the next three years about 8% of the market cap to be returned to shareholders. So, from our perspective this is a company in a sector under change which is trying to do something different.
Wall: Kunal thank you very much.
Desai: Thank you.
Wall: This is Emma Wall from Morningstar. Thank you for watching.
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