India's second Covid-19 wave upends GDP

Tantallon Fund
Tantallon Fund5/28/2021 06:31 AM GMT+08  • 6 min read
India's second Covid-19 wave upends GDP
"We have strong conviction in the recovery in the commercial vehicle cycle in India."
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The Tantallon India Fund closed up 2.34% higher in April with India’s second Covid wave casting a pall over a robust earnings season that significantly exceeded market expectations. The scale of human tragedy would suggest a harsh inevitability to a second national lockdown.

The markets, however, would seem to have found good support levels, with an investment calculus framed around new Covid-19 cases in India peaking in the middle of June, allowing for the current localised lockdowns to be lifted, restoring a more constructive stance on demand recovery, industrialisation and infrastructure spending.

A year ago, Covid infections centred around the slums, daily commuters compelled to use public transportation, and the pools of migrant labour and daily wage earners. This second wave has blind-sided the middle class and the affluent given the unfortunate confluence of political and bureaucratic ineptitude, recklessness prompted by lockdown “fatigue” and fatal vaccine complacency.

We are not discounting the risk of extended localised lockdowns and mobility restrictions impairing the nascent recovery off the 2020 nadir. The vaccination programme is inching along and only 4% of the eligible population is fully vaccinated.

At the risk of sounding tonedeaf, based upon the pattern of super-spreader events we have tracked over the past six weeks, we anticipate the localised lockdowns and an improving vaccination profile will translate into a peak in new Covid infections in early to mid-June. The current localised restrictions are primarily placed on the contact-intensive services sector.

At this point, the agricultural and manufacturing sectors have been minimally impacted by the new mobility restrictions, minimising the potential economic drag.

We expect the markets to be volatile in the short term given the expectations of a speedy “return to normal”. We remain focused on the structural reforms underpinning the growth runway over the next three to five years.

Strength in earnings

By the strength of reported earnings over the last six months, we have focused our virtual outreach over the last several weeks on a number of unlisted, smaller companies looking to create product/service differentiation relative to their peer groups.

We would highlight that the health crisis has not spilt over into a financial crisis. Evidence of this includes liquid credit markets, stable bond yields and borrowing rates, intentional increases in delinquency buffers by banks and finance companies without any meaningful deterioration in asset quality, and stable government finances bolstered by record GST collections.

The high-frequency indicators that we track have been mixed with the exports sector, PMI-manufacturing and GST collections showing impressive strength. However, weak mobility data and poor auto and jewellery sales would suggest an imminent slowdown in the real economy.

On a sector view, IT, pharmaceutical and auto exports, materials like cement, chemicals and metals as well as staples have been resilient.

However, discretionary consumption including auto sales, travel, retail, leisure and entertainment, is lagging. Rising input cost pressures are an overhang, given the sharp increase in commodity prices globally. But again, we have been surprised by mix/margin uplift, structural cost rationalisation measures that have been put in place last year and strong balance sheet discipline.

Robust construction and manufacturing activity also stood out, borne out by 23% y-o-y volume growth in steel, 32.5% y-o-y volume growth in cement and 21.6% higher y-o-y electricity production. Digital channels and organised sectors also continue to gain market share at the expense of the unorganised sector.

Highlight of the month

The stock we would like to highlight this month is Tata Motors, India’s largest commercial vehicle (CV) manufacturer, with significant ambitions to electrify its passenger vehicle (PV) offerings from the premium Jaguar-Land Rover (JLR) platforms, to the domestic variants that have quietly re-asserted a strong brand/ product presence.

Given the sharp cyclical rebound in the domestic CV business, and a long-heralded turnaround at JLR, we are extremely positive on Tata Motors’ earnings/free cash flow profile over the next two to three years driving the deleveraging of the balance sheet, and a stock multiple re-rating.

We expect Tata Motors to compound revenues at 15% CAGR over the next three years versus the market tentatively pencilling in a sub-10% run-rate. We have strong conviction in the recovery in the CV cycle in India on the back of infrastructure spending, industrialisation, a recovery in freight rates, a strong replacement cycle kickstarted by the new emissions norms and the government’s new scrappage policies.

We are excited by the new product/segment offerings and the model refreshes for both the domestic PV line-up, and importantly, the electrification ambitions at JLR, with management projecting a 100% electric portfolio for Jaguar by 2025.

Given pent-up demand and supply-side bottlenecks for the global OEMs, our sense is that we are likely to be surprised positively by both the mix improvement as well as the uplift in realised pricing for the luxury vehicle segment globally. We expect Tata Motors’ operating profits to compound at a higher than 45% CAGR over the next three years, with consensus pegged to a more pedestrian 25% run-rate.

We believe that the market is underestimating both the mix upside as well as the structural margin uplift opportunities at JLR and in the domestic PV business — thanks to the consolidation of the vendor base — and the focus on modularisation, uniformity of auto parts across the platforms and economies of scale.

With peak capex behind us, we anticipate that strong operating leverage will translate to robust free cash flow generation and a net cash balance sheet over the next two years.

In summary

Mindful of the potential economic drag from a prolonged resurgence in new Covid-19 infections and localised lockdowns, we would expect markets to be volatile in the short-to-medium term as India ramps up its vaccination programme from the current three million-plus vaccinations/day run-rate. India on the cusp of a sustained private sector capex cycle and re-establishing a sustainable 7%-plus GDP growth path thanks to accommodative monetary policy, growth-supportive labour, manufacturing, exports, infrastructure, and tax reforms, the recent budgetary fillip, and healthy private sector corporate balance sheets.

We have a strong conviction in industrialisation, infrastructure development, urbanisation, and the consumer and digital economies. We believe our portfolio holdings will deliver on earnings and cash flows compounding at 15%-plus annually over the next three to five years on the back of sector consolidation and sustained market share gains, operating leverage, and mix/margin improvement.

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 concentrated portfolio, market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models and in management’s ability to execute. Tantallon Capital Advisors, the advisory company, is a table Singapore-based entity, set up in 2003, and holds a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore.

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