India Strategy - Emkay

We revisit our rural underweight theme (Rural steroid is ebbing - Underweight rural exhilarants, Dec 2011) in the wake of the recent hikes in support prices, developments in food grain management, crop price movements and industry impact. While the recent hikes in support prices is seen by many as a turning point, we believe it may not address the structural issues plaguing the sector, leaving scope for disappointment. Our analysis summarized below reinforces our theme.

MSP hikes in response to declining margins; but excess supply dominates:

Renewed optimism following the recent MSP hikes need to be grounded to the fact that realized prices for the farm sector have continued to soften despite MSP hikes in the past. The intended benefits is getting eroded as margins for the sector have contracted due to excess supply and rising cost of cultivation. The excess supply manifests in the record foodgrain production at 252mt, monumental rise in food grain buffer to 82mt (May'12) and declining effectiveness of MSPs. Average prices for 10 crops have remained stagnant since Dec 2009 (declined 6.5% for 10 crops excluding cotton & soyabean). The spreads between market prices and MSPs have narrowed from 27% to 16% during May 2011-Mar 2012 and 3-5% currently. For several major foodgrain producing states the market prices have remained below MSP for the past 6-12 months.

Agri sector cash flow shrank 35% in FY12; could decline by 39% in FY13E:

Based on the latest indicators on cost and realization we estimate that in FY12 the average cash cost of cultivation has gone up by 15.1% while net cash realization (for marketable surplus) declined by 10.04%. Hence, the net cash flow declined by nearly 35% in FY12. Assuming overall cost of cultivation rising by 6.5% in FY13E and decline in cash realization by 10% could imply a further 39% decline in cash flow in FY13E.

Rural demand ebbing; Moderation is visible:

In our view a) two consecutive years of declining cash flows and b) limited policy support is likely to impair fundamentals of rural demand at large. The impact is already visible as indicated by: a) Domestic tractor sales slowed significantly to -5.1% yoy in Apr-2012 and has averaged at -1.4% for the past 6 months, b) Decontrolled fertilisers sales declined by 14% yoy during Apr-May 2012 while urea sales declined by 1%. Increase in prices of complex fertilisers by 25-30% and insecticides by 10-15% is likely to impact cost of cultivation and consumption, c)3-month sales volume growth for 75-124cc motorcycle segments declined to -6.5% yoy in May'12 vs 16.3% a year back, d) additions in GSM connections in Circle B&C contracted 23% yoy in Q4FY12 and 18% over Q3FY12 and e) SBI's agri NPA at Rs78bn jumped 72% jump in FY12 and comprised 6.7% of agri-loans.

Policy response: Higher PDS allocation, sell below MSP, encourage export:

In addition to the usual 55-60mt of offtake, the government has decided to sell additional 8mt of foodgrain this year, at price below the procurement cost for wheat. Hence, we estimate the food subsidy bill for GoI to rise to ~Rs 900bn in FY13E (20% higher than the budgeted Rs750bn). In the context of record production, decline in procurement/production ratio, rise in offtake/procurement & allocation/offtake ratios, higher allocation will only contribute to the prevailing over supply and thereby depress market prices further. The government is also considering encouraging exports to address domestic over supply. But softening global foodgrain prices could pose constrain.

Constraints intensify in terms of storage capacity, fiscal and financial:

Constraints are getting more glaring with food grain buffer rising to a historical high of 82mt. The key concern is that the total covered storage capacity is only around 50mt implying that nearly 32mt of foodgrain can be exposed to damage. In addition, schedule commercial banks food credit exposures at Rs 1.12tn (52% yoy), is currently at 43 times FCI's networth. This reflects accumulated losses of the FCI and procurement agencies and the embedded food subsidy which governments will need to eventually absorb. These constraints are forcing greater allocation through PDS.

Excess supply conditions a culmination of misaligned policies:

Excess supply conditions in foodgrain sector have prevailed since 2010 and comprehensively disputes earlier official position that rise in food prices is caused by structural shortages. Even if we consider that the rise in procurement to 60-82mt was done to meet the objectives of Food Security Bill, the eventual decision to sell food grains at 25-32% below economic cost of procurement and encouraging exports symbolizes lack of a coherent policy and defeats the basic logic of food security.

In our view, such misalignments have implied huge fiscal commitment and burden to both consumers and tax payers. While rise in cost of cultivation can be seen as the justification for increase in procurement prices, excessive reliance on hikes in procurement prices has become counter productive as it is causing unsustainable feedback loop between price and input costs.

A more tenable response to counter rise in cost would have been reallocation of fiscal and banking sector resources from unproductive allocations towards more productive activities like irrigation and market infrastructure.

Themes to play - We maintain our Underweight rural exhilarants theme

Emerging data since our Dec 2011 Rural Underweight theme have been broadly in line with our prognosis and is corroborated by industry level indicators. We see our theme sustaining going forward and expect stress in sectors like durables, passenger vehicles, two wheelers and tractors to accentuate further. Our theme is playing out on Agri input sectors-seeds, fertilizers and agro chemicals as well. FMCG companies dependent on foodgrain inputs should benefit from lower cost. But farm income demand led FMCG companies are expected to see moderation sales. Agri sector indebtedness poses credit risk concerns for PSU banks over the medium term.

Source : Equity Bulls

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