India on the cusp of significant new capex cycle

• Prime Minister Narendra Modi’s government continues to implement structural reforms without compromising the country’s fiscal position.
• Infrastructure investments, industrialisation, China+1, urbanisation, financials and domestic consumption remain long-term investment thematics.
• Pools of domestic savings continue to underpin market valuations.
• As the US dollar starts to look “top-pish”, Asia and India in particular, will likely benefit disproportionately from asset allocation flows, thanks to the visibility on growth and corporate earnings. It is noted that after having net sold US$29 billion ($39.2 billion) in the first half of 2022, foreign institutional investors have turned net buyers to the tune of US$10 billion over the last three months.

That said, the third significant attempt this year by global risk markets to rally off their “lows” failed. This is a warning that we should expect global equity markets to remain super volatile.

• Given the commitment of the Fed to ratchet back inflationary expectations and the persistent strength in the jobs and industrial manufacturing reports with business activity hitting an 11-month high, the odds of continued Fed tightening in 2023 have risen, virtually ensuring a US recession.
• In contrast, given the dire economic data out of China and sharply rising unemployment levels feeding social unrest, we expect China to ease monetary and fiscal policy counter-cyclically while simultaneously starting to ease zero-Covid restrictions to stimulate the domestic economy.
• Geopolitics remain fraught. The war in Ukraine and simmering tensions in the South China Sea have negative implications on global risk appetite.

Expect interest rate to peak in 1Q

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Having just spent several days visiting companies in multiple cities, here are some of our observations:

• The correction in energy prices and the policy decisions grounded in fiscal prudence do anchor lower inflationary expectations and will likely allow the Reserve Bank of India (RBI) to signal a near-term peak in interest rates, perhaps as early as the first quarter of 2023.
• Thanks to the government’s focus on industrialisation and job creation and its commitment towards infrastructure building, we are seeing domestic capital as well as foreign direct investment trickle into manufacturing capacity which is supporting a nascent private sector capex cycle and sustaining new-job creation.
• In our estimates, combined capital expenditure (government spending plus private sector investments) is on track to exceed an all-time high of US$250 billion in the current fiscal year ending March 2023, alongside a robust real estate and credit cycle.
• We are seeing a sustained boost in industrial employment and corporate profitability. As operating leverage kicks in and with commodity prices correcting sharply off their peaks in the first half of the year, earnings, free cash flow, balance sheet de-leveraging and re-investments are likely to surprise the market on the upside.
• The high-frequency data that we track validates an economy in recovery: GST collections in November are tracking above the INR1.4 trillion ($23 billion) mark for the ninth consecutive month; manufacturing PMI is steady at 55.7; credit growth remains strong at +17.2% y-o-y; both power demand and rail freight gained pace, y-o-y and m-o-m; passenger vehicle sales moderated slightly on a high base while two-wheeler sales have picked up, in line with the recovery in services PMI rising to a three-month high of 56.4 in November.
• Weakening external demand remains the key risk.
• Growth will be domestic demand-driven and will likely continue to surprise on the upside on the back of pent-up demand, healthy labour markets and strong consumer confidence.
• We are especially encouraged by the sustained recovery in real estate markets across the country, both residential and commercial.

Heading into the new year, as we reflect on our portfolio convictions, it is clear that we remain more constructive than consensus and are looking to take advantage of volatility to build our exposure to Indian equities.

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Anchored by Modi’s reforms and the digital and physical infrastructure that has been built, India is on the cusp of a significant new capex cycle that will sustain GDP growth in the 6%–7% range over the next five years.

We continue to build a position in the highest quality financials, capital goods and consumer-facing companies where we have a conviction on earnings and cash flow visibility and where the recent market action has provided us with a compelling valuation reset.

Stock highlight of the month

The company we would like to highlight this month is MTAR Technologies (MTAR), a non-government privately-owned precision tooling and fabrication company designing and manufacturing components for the clean energy (hydrogen and hydro), nuclear energy, space, and defence and aerospace industries.

MTAR’s order book is underpinned by long-standing relationships and committed orders from Indian public sector companies focused on aerospace, defence, satellite launches and nuclear power.

There are also significant but under-appreciated growth possibilities that sit in the clean energy business which was set up in partnership with Bloom Energy to produce hot boxes for hydrogen fuel cells.

We conservatively expect MTAR to deliver on revenues compounding at 65%+ annually over the next three years and expect consensus to continue to “upgrade” their numbers on the back of sustained order book accretion.

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We are genuinely excited about the potential of scaling the Bloom Energy business and expect Bloom orders alone for the US and South Korean markets to deliver on revenues compounding at a 55%+ CAGR over the next three years. MTAR has invested in the capacity required for both hydro and solar segments and is poised to ramp up deliveries meaningfully over the next three to five years.

Given current geopolitical realities, it feels like our current projection of MTAR’s defence order book compounding revenues at 12%+ annually is too conservative and we are likely to increase our current estimates.

Given the Covid backlog, the Indian Space Research Organisation’s satellite launch schedule is packed over the next three years, underpinning our expectation of an order book compounding revenues in the 7%– 10% range over the next three years.

Given inherent delays in securing the clearance for a new nuclear reactor, we have not yet factored in expectations for new nuclear power reactor orders. However, given India’s stated intent to commission eight to 10 new reactors over the next two decades, we expect the nuclear energy vertical to contribute meaningfully to the top and bottom line over the next three to five years.

We expect MTAR to deliver on earnings compounding at 70%+ CAGR over the next three years; consensus, quite frankly, is several orders of magnitude “light” in their estimates.

Improving mix (higher margin nuclear and aerospace and defence orders), higher localisation, scale benefits and significant operating leverage as utilisation rates increase will drive sustained margin accretion to the tune of about 150 bps annually over each of the next three years.

As port congestion eases and payment terms improve on the new orders, we expect a significant reduction in net working capital requirements, which will help to offset higher depreciation charges as new capacity is commissioned.

We anticipate MTAR to conservatively double ROCE over the next three years to 30%+, providing self-sustaining growth capital and higher dividend payouts.

The Tantallon India Fund is a fundamental, long-biased, India-focused, total return opportunity fund, registered in the Cayman Islands and Mauritius. The fund invests with a three-to-five-year horizon, in a portfolio (25 to 30 positions without leverage), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models and management’s ability to execute. Tantallon Capital Advisors, the advisory company, is a Singapore-based entity, set up in 2003, and holds a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore