20 July 2015 Asia Pacific/India Equity Research Investment Strategy

India Market Strategy Research Analysts STRATEGY

Neelkanth Mishra 91 22 6777 3716 [email protected] The surge of the states Prateek Singh 91 22 6777 3894 Figure 1: State governments enable private investment and were too small [email protected] Ravi Shankar 91 22 6777 3869 [email protected]

Other contributors Anantha Narayan 91 22 6777 3730 [email protected]

Arnab Mitra 91 22 6777 3806 [email protected] Jatin Chawla 91 22 6777 3719 [email protected] Lokesh Garg 91 22 6777 3743 Source: Credit Suisse research [email protected] Sunil Tirumalai ■ Indian “state” too small, but growing. Government services for citizens 91 22 6777 3714 and businesses are primarily provided by state governments. They employ [email protected] 12 mn people, supporting more than a fifth of India’s middle class. We Nitin Jain disagree with the popular opinion that it is wasteful. States with more govt 91 22 6777 3851 [email protected] employees have higher per capita GDP; e.g., Bihar has a third of the police force vs. the national average, and the worst per capita GDP. A “state” must Rohit Kadam, CFA 91 22 6777 3824 enable/facilitate the private sector to operate: a stunted state fails in that [email protected] role. This is changing now (e.g. education, police) as states get more funds. Vaibhav Jain 91 22 6777 3968 ■ States’ fiscal size growing rapidly. Combined (centre + state) spending is [email protected] budgeted to rise 13.4% YoY, in line with recent years, but the mix of Akshay Saxena spending has changed sharply: states together are to spend 65% more than 91 22 6777 3825 the centre in FY16 vs. just 6% more in FY11. Nearly half of the increase in [email protected] spending comes from their own revenues, as tax collection efficiency is

improving across states helped by VAT/computers, and GST should help.

■ Consumption stays supported; fiscal stress may emerge. With government services finally improving, so does India’s medium-term growth outlook, and the market P/E multiple. Near term, over the next two years implementation of 7th Pay Commission could increase the states’ combined salary bill by Rs2 tn. States’ pension bill is also rising (Rs2.2 tn), as is “social welfare” spend (5x NREGA at Rs1.6 tn), up 1.9x since FY12. These could stress state fiscal deficits, as well as inflation. From the market’s perspective, consumption should be boosted. We recommend Voltas, Maruti Suzuki, HUL, LIC Housing Finance, Zee TV, Havells and Kajaria Ceramics.

DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION® Client-Driven Solutions, Insights, and Access

20 July 2015 Focus charts

Figure 2: Slight pickup in total govt expenditure in FY16b Figure 3: States to spend 65% more than Centre in FY16 30% 24 1.7x Rs tn Central + State Govt. Receipts & Expenditure Growth 21 1.6x 25% 18 1.5x 20% 15 1.4x 15% 12 1.3x 9 1.2x 10% 6 1.1x 5% 3 1.0x 0% 0 0.9x 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016b 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015r Receipts YoY Expenditure YoY State Centre (net) Ratio (RHS) Source: RBI, Budget documents, Credit Suisse estimates Source: RBI, Budget documents, Credit Suisse estimates

Figure 4: State governments' capex split (FY15b) Figure 5: State governments’ revenue expenses (FY15b) Medical Others Urban Power Others Agriculture Education 4% 6% Development 4% 6% General 23% 20% Services 5% Rural 7% Interest Development Payment Welfare 10% 9% 11% Roads & Health Bridges Energy 6% 19% Pensions 9% Welfare Rural Urban 10% Development 8% Development Agriculture 10% Administration 13% 9% 11% Split for FY15b; FY16b States' Capital Expenditure: Rs 3.4tn Split for FY15b; FY16b States' Revenue Expenditure: Rs 18tn

Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates

Figure 6: High state govt. employment drives high GDP Figure 7: State spend on salaries to shoot up post 7th CPC

40 200 8 50% INR tn 35 7 An increase of Rs 2tn if all states 40% 30 150 6 implement 7th CPC recommendations 25 5 30% 20 100 4 15 3 20% 10 50 2 10% 5 1 0 0 0 0% HP UT DL TN PU KA KE HA MH AS RA AP OR GU MP JH CH WB UP BI 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 State Empl. Per '000 People (incl. Quasi) GSDP Per Capita (Rs '000) Total state spend on salaries (INR tn) YoY (RHS)

Source: MOSPI, Census 2011, Credit Suisse estimates Source: 6th CPC Report, Credit Suisse estimates

Figure 8: Share of increased net transfers in FY16b Figure 9: Incremental spending to boost consumption AR TR Others UP Urban Dev Roads Others 3% 2% 9% 20% 2% 2% 1% HP Water Education BI 3% 3% 3% Health 24% KE 6% Police RJ 4% CG 6% WB 4% 4% 14% Pay Comm. GU 7% Rural Dev 4% 7% Pension MP JH 18% 12% 5% Welfare OR Interest AS 8% 16% 6% 7% Categories of states' incremental spend in FY16: Rs 3.3tn Beneficiaries of Rs 1.6tn increase in net transfers in FY16 Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates

India Market Strategy 2 20 July 2015 The surge of the states States’ fiscal size growing rapidly Despite combined (state + centre) FY16 fiscal deficit target being the fourth lowest since Share of states spend up 1980, combined spending is budgeted to rise 13.4% YoY. Growth is only marginally above sharply since FY11… the recent trends, but the mix of spending has changed sharply: states together are to spend 65% more than the Centre in FY16, vs. just 6% more in FY11. Nearly half of the rise in state spending comes from states’ own revenue sources, a sixth …with nearly half the rise from a small rise in fiscal deficits from a low 2.1% in FY11. Around 37% of the increase coming from their own comes from higher central transfers: in FY15 a number of schemes were shifted from revenue sources Central Plan to State Plan, and in FY16 direct tax sharing was increased from 32% to 42%. There is limited scope for central transfers to increase further, though there could be some Tax collection efficiency more discretion given to state governments on fund allocation between and within schemes. improving in states; could But states’ own revenue sources are likely to improve further. VAT adoption as well as improve further with GST computerisation has improved the tax collection efficiency of states, with 1 pp of GDP improvement in collections since 2010. GST implementation could provide another boost. Indian “state” too small, but growing Government services that citizens and businesses need are primarily provided by state State governments support governments: education, police, urban administration, utilities, public works, and the like. more than a fifth of India’s They therefore together are ~60% of total government employment, and support more middle class than a fifth of India’s middle class families. Not surprisingly, states spend 20-25% of their budgets on salaries, and only 15% of their spending is capex. The commonly-held view that states’ high revenue expenditure is wasteful is incorrect, in States with more our view. We find that states that have more government employees have higher per government employees capita GDP. A possible reason for this: the government’s role is to enable the private have higher per capita GDP sector to operate, by providing law and order, educated workforce, urban amenities, etc. For example, against the national average of 1.38 police per ’000 population (among the lowest globally), Bihar has 0.55, and lags on GSDP per capita too. But this is changing as states get more funding: employment in education and police, the two largest categories of state workers, is rising steadily. Poorer states are also spending more on rural development. A concern is the rising pension bill (Rs2.2 in FY16b), and high “social welfare” spend (5x NREGA), up 1.9x since FY12 Consumption stays supported We see three key implications of the above changes for the market: (1) A larger “state” is A larger “state” is good for necessary for medium-term growth prospects and good for the broader market multiple. medium-term growth There is visible catch up with the world on measurable metrics like school enrolment and prospects policing, even though weak educational outcomes suggest quality needs improvement. (2) Given high employment, implementation of the 7th Pay Commission recommendations 7th Pay Commission could could increase the combined salary bill of states by Rs2 tn (1.3% of GDP) if all states raise the salary bill of states implemented it in FY17. This clearly affects consumption and likely inflation too. by Rs2 tn (more, including pensions) (3) FY16b state spending should be up 16% YoY (Rs3.3 tn), with nearly two-thirds in directly consumption boosting areas like education (teacher salaries), pensions, and social welfare: the productivity impact could take longer to show up. Slippage on targets should be lower this year, as budgeted central transfers don’t seem overstated. Kerala, Chhattisgarh, Odisha, MP and UP are the states likely to see the fastest growth. While the impact of these changes should be market-wide, a short-list of beneficiaries: Maruti Suzuki, HUL, LIC Housing Finance, Zee TV, Voltas, Havells and Kajaria Ceramics.

India Market Strategy 3 20 July 2015 Financial summary

Figure 10: A list of key stocks that benefit Stock Rating CMP Target price Upside Market cap P/E (x) EPS growth (%) (Rs) (Rs) (US$ bn) FY16 FY17 FY16 FY17 Hindustan Unilever Ltd OUTPERFORM 936 975 4% 32 41 34 18.6 20.7 Maruti Suzuki India Ltd OUTPERFORM 4,180 5,100 22% 20 22 15 52.4 44.6 Zee Entertainment OUTPERFORM 382 440 15% 5.8 34 26 11.3 28 LIC Housing Finance Ltd OUTPERFORM 463 540 17% 3.7 13 10 29.6 32.8 Havells India Ltd OUTPERFORM 301 340 13% 3.0 32 26 19.9 24 Voltas OUTPERFORM 315 380 21% 1.7 26 20 20.6 27.4 Kajaria Ceramics Limited OUTPERFORM 783 950 21% 1.0 30 24 14.1 24.7 Source: Company data, Credit Suisse estimates

Figure 11: States’ share of population and GDP State code State name Share of population (%) Share of GDP (%) UP Uttar Pradesh 16.5% 8.7% MP Madhya Pradesh 6.0% 4.4% GU Gujarat 5.0% 7.5% WB West Bengal 7.5% 6.8% KA Karnataka 5.1% 5.7% AP Andhra Pradesh 4.1% 4.5% TL Telangana 2.9% 3.8% MH Maharashtra 9.3% 14.4% BI Bihar 8.6% 3.3% TN Tamil Nadu 6.0% 8.3% RJ Rajasthan 5.7% 5.0% KE Kerala 2.8% 3.9% OR Odisha 3.5% 2.8% JH Jharkhand 2.7% 1.7% CG Chhattisgarh 2.1% 1.8% JK Jammu & Kashmir 1.0% 0.9% UT Uttarakhand 0.8% 1.2% TR Tripura 0.3% 0.3% HA Haryana 2.1% 3.7% PU Punjab 2.3% 3.1% HP Himachal Pradesh 0.6% 0.8% AS Assam 2.6% 1.6% AR Arunachal Pradesh 0.1% 0.1% MN Manipur 0.2% 0.1% MZ Mizoram 0.1% 0.1% NA Nagaland 0.2% 0.2% ME Meghalaya 0.2% 0.2% SI Sikkim 0.1% 0.1% GO Goa 0.1% 0.5% Source:Planning Commission, Census 2011

India Market Strategy 4 20 July 2015 States' fiscal size growing rapidly Changing seasonality of government expenditure has created volatility in economic momentum: it slows the economy down in the March quarter but revives it in the June quarter. But on a full year basis, the growth in combined expenditure of central and state governments has remained in the 11-13% YoY bracket for the last five years, with the 13.4% YoY budgeted in FY16b being the highest (Figure 12).

Figure 12: Slight pickup in total govt expenditure in FY16b Figure 13: FY16b total deficit target 4th lowest since 1980

30% 12% as % of GDP

25% 10%

20% 8%

15% 6%

10% 4%

5% 2%

0% 0% 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016b 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016e Receipts YoY Expenditure YoY Union Fiscal Deficit State Fiscal Deficit

Source: RBI, budget documents, Credit Suisse estimates Source: RBI, budget documents, Credit Suisse estimates State expenditure growing faster than at Centre While total fiscal deficit has remained unchanged since FY11 (Figure 13), the mix has changed as there has been an unprecedented sharp divergence in the pace at which spending by state governments is growing, and the rate of growth of central government expenditure (Figure 14). State governments together are budgeted to spend 65% more than the Centre in FY16 (Figure 15), substantially higher than five years back.

Figure 14: State expenditure growing faster than Centre Figure 15: States to spend 65% more than Centre in FY16

25% Rs tn 24 1.7x 20% 21 1.6x

15% 18 1.5x

10% 15 1.4x 12 1.3x 5% 9 1.2x 0% 6 1.1x

-5% 3 1.0x

-10% 0 0.9x 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016b 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015r

Central Exp. (Net) Y/Y (%) State Exp. Y/Y (%) State Centre (net) Ratio (RHS)

Source: RBI, budget documents, Credit Suisse estimates Source: RBI, budget documents, Credit Suisse estimates

India Market Strategy 5 20 July 2015

This increase in expenditure by state governments has not been due to a rise in deficits. Even though deficit ratios have risen from the low levels seen in FY11, they are still below levels seen in most of the last 35 years (Figure 16). FY16 deficit ratio is budgeted to be 2.6% (this is for a sample of 15 states that together constitute 88% of total state expenditure)—a 50 bp drop on the revised deficit of 3.1% in FY15 (2.2% was budgeted). The final deficit in FY15 too is likely to be lower than the revised number, as has generally been seen in prior years. Deficits’ contribution to the rise in spending has been minimal; instead, states' spending has been supported by a rise in their own revenue sources (37% of FY11-16 increase, Figure 17) as well as central transfers.

Figure 16: State deficits up from lows, but under control Figure 17: Source of funds for rise in expenditure FY11-16 5.0% Deficit 18% 4.5%

4.0% Own Tax 37% 3.5%

3.0%

2.5%

2.0% Central Transfers Own non-Tax 1.5% 37% 8% 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 States' fiscal deficit to GDP Increase in spend FY11-16: Rs12.9tn (2016 data for 15 states) Source: RBI, budget documents, Credit Suisse estimates Source: RBI, budget documents, Credit Suisse estimates States' improving tax collections: Better compliance States' own tax collections shot up between 2010 and 2013 (Figure 18) and after a slowdown in FY14, when they grew only 9%, picked up again in FY15, and are expected to grow robustly in FY16b as well. While high inflation does boost states' tax collections, as most state taxes are ad-valorem, state taxes as a % of GDP have risen sharply since FY10 (Figure 19), suggesting that tax collection efficiency has improved.

Figure 18: Tax collection growth shot up in 2010-13 Figure 19: States' own tax collection efficiency improving

25% 6.8% Standout increase in states' own tax growth 6.6% 20% 6.4%

6.2% 15% 6.0%

10% 5.8% 5.6%

5% 5.4%

5.2% 0% 1986- 1989- 1992- 1995- 1998- 2001- 2004- 2007- 2010- 2013- 5.0% 89 92 95 98 01 04 07 10 13 16 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016b

States' Tax Revenue CAGR Own Tax as % of GDP

Source: RBI, budget documents, Credit Suisse estimates Source: RBI, budget documents, Credit Suisse estimates

India Market Strategy 6 20 July 2015

Many incorrectly attribute this increase in efficiency to just higher property taxes (booming real-estate markets in many large cities) and to rising revenues from alcohol (i.e., state excise). Sales taxes have driven nearly two-thirds of the increase (Figure 20) in states' own tax collections. Among other things this has been driven by a steady increase in the number of entities registered to pay sales taxes (Figure 21 shows data for 18 states): this has helped taxes grow in excess of nominal GDP growth.

Figure 20: Sales taxes have driven two-thirds of increase Figure 21: No. of sales tax assessees rising at 5-7% p.a.

Others 5.6 8% 11% # of Sales Tax Assessees in 18 states (some assumptions) 5.4 7%

Property Taxes 5.2 6% 13% 5.0 5%

4.8 4%

State Excise 4.6 3% 10% Sales Tax 4.4 2% 66% 4.2 1%

4.0 0% 2010 2011 2012 2013

# of Assessees (mn) Y/Y (%) Sources of increase in states' own taxes (FY10-15b): Rs 4.8tn

Source: RBI, budget documents, Credit Suisse estimates Source: CAG State Audit Reports, Credit Suisse estimates Improving enforcement is being driven by computerisation (i.e., better information management), lagged effects of VAT implementation, as well as transfers of best practices between states. In our view, states should continue to grow tax collection faster than GDP, given the large number of enterprises that are NOT still in the tax net (Figure 22), the expected widening of the tax base with GST implementation, and also the significant catch-up that can happen for states that still have low sales tax to GDP (Figure 23).

Figure 22: Only a fraction of enterprises pay sales tax Figure 23: Sales tax as % of GDP could rise in many states Mn 58.5 60 7%

6% 50 5% 40 4%

30 3%

20 2%

1% 10 5.4 1.7 1.1 0% 0 WB BI MH OR JH MP CG RJ UP GU KA AP* KE TN # of enterprises in Sales Tax Service Tax Regd. companies India Assessees Assessees Sales tax as % of GSDP (2010) Increase during 2010-15 (pp)

Source: CAG Reports, Economic Census, Credit Suisse estimates Source: RBI, Budget documents, Credit Suisse estimates

India Market Strategy 7 20 July 2015

The surge in central transfers is likely behind us… As per the constitution most of tax collection responsibilities (income tax, corporation tax, customs duties, service tax, etc.) lie with the central government (as it should from an efficiency perspective), but most tasks of dispensing government services (law and order, healthcare, education, civic amenities, rural roads, electrification, etc.) are with state governments. This necessitates significant transfers of taxes from the centre to the state. These transfers are of four types: (1) Direct tax sharing/devolution: a fixed share of all taxes collected by the centre automatically go to the states—every five years the Finance Commission, a constitutional body, revises this ratio; (2) Grants: the Finance Commission also recommends some grants to weaker states, though the centre can choose to provide grants to specific states for disaster relief, repair of roads, etc; (3) Contribution to state plan: for schemes like education and health; and (4) Assistance for Centrally Sponsored Schemes (CSS): the centre can choose to spend on areas that are state subjects, and route funds through the state budget. Transfers to the states have risen at 18% CAGR from FY10-16b, and particularly sharply in the past two years (Figure 24): in FY15 all the central schemes on state subjects where the centre by-passed state governments and provided funds directly to autonomous bodies, were converted to schemes under state plans. This was just an accounting change and total spending in the economy did not rise: just control moved to the states. Then in FY16, as per the recommendations of the Fourteenth Finance Commission (FFC), there was a sharp increase in states’ direct share of tax revenues: from 32% to 42%, though this was offset by a Rs745 bn drop in Central Assistance for State Plan: untied funds and funds for eight small schemes were discontinued.

Figure 24: Rise in % of Central taxes transferred to states Figure 25: More increase in transfer to states is unlikely Rs Tn Others 9 60% Central Plan 2% 18% CAGR FY10-16b 16% 8 Interest 7 Central schemes 55% 32% 6 transferred to State Plan

5 50% Salaries 4 16% 3 45% 2

1 Defence Subsidies 0 40% 17% 2010 2011 2012 2013 2014 2015r 2016b 17%

Tax Sharing Grants State Plan CSS % of Taxes FY16 Central Expenditure ex-state transfers: Rs 14.4tn

Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates Going forward, a further increase in transfers is unlikely, given that the remaining expenditure at the central level is primarily on interest payments, defence, centrally administered subsidies and salaries (Figure 25). Much of Central Plan expenditure is also on central subjects like roads and railways (Figure 26), and areas that are constitutionally state subjects are much smaller. …though there could be more discretion for states In FY16b, most funds are to be transferred to states via direct tax transfers and contribution to 66 schemes under the state plan (Figure 27). While states have full autonomy to spend on these schemes as they wish, they do not have the freedom to use these funds elsewhere, i.e., the funds are still “tied” to these specific schemes. Recently a panel of chief ministers recommended that the government delink 46 of these schemes, letting the states choose which schemes they want to participate in.

India Market Strategy 8 20 July 2015

Given the significant diversity in infrastructure and social requirements between states (e.g., UP needs roads whereas Karnataka needs irrigation; TN and Kerala need old-age homes given the high average age whereas UP and Bihar need kindergartens and more primary schools given low literacy rates and a high fertility rate), more freedom would improve the productivity of this expenditure.

Figure 26: Most Central Plan spend is on central subjects Figure 27: Most transfers via direct sharing + State plans Others CSS Urban Dev 3% 3% 5% Energy Roads 6% 23% North East Welfare State Plan 7% 24%

Industry 7%

Tax Sharing Education Railways Grants 61% 8% 20% 12%

Economic Services Social Services 10% 11% Total FY16b Transfer to States: Rs 8.6 Tn FY16 Central Plan Outlay ex-state transfers: Rs 2.4tn

Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates Discretion for states necessary Given the size of India’s population (a sixth of humanity), each of the states is as large as most countries (Figure 28): this necessitates a federal system of governance, as it is near impossible for the centre to manage all changes in every state.

Figure 28: States in India are country-sized Figure 29: Low development level/Wide income disparity

Source: Census 2011, IMF World Economic Outlook Source: Census 2011, IMF World Economic Outlook

India Market Strategy 9 20 July 2015

Not only are the states large, they also have very disparate productivity levels (Figure 29), and are very poor. The richest state in India is Goa, which in per capita GDP (not PPP adjusted) is at the same level as Paraguay. The second richest, Delhi, is like Indonesia, and the third richest, Sikkim, is like Egypt. The rest of the country is more like sub-Saharan Africa. To rise from such low levels, ground level productivity drivers must improve.

Figure 30: Connections & availability–different challenges Figure 31: Some need kindergartens, other old age homes

Source: Census 2011 Source: Census 2011 The states also have very different infrastructure requirements: some states need to invest in electrifying their households (Figure 30), as the share of households that are electrified is abysmally low, whereas those that have gone through that process need to prioritise investments in capex to bring down distribution losses (e.g. Gujarat). Similarly, while the northern states, given higher fertility rates need more primary schools, the southern states, with average age in the early to mid-thirties, need more old-age homes. This adjustment to physical and social infrastructure necessitates planning and expenditure by state governments: their improving ability to spend is thus very positive for India’s medium-term growth prospects.

India Market Strategy 10 20 July 2015 Indian “state” too small, but growing Governance mainly provided by state governments The nature of spending by state governments is very different from that of the central government. As seen in the previous section (Figure 25 on Page 8) excluding interest costs, the central government by itself primarily spends only on defence, salaries of non- military defence services, and subsidies on food, fertiliser and fuel. The government services that citizens and businesses need from the government are primarily the responsibilities of state governments (Figure 32). Most of the times that a citizen or a business interacts with the government (s)he/it interacts with the state government.

Figure 32: Division of responsibilities between the centre and the states as per the Indian Constitution Central State Concurrent (State and Centre) Defence, atomic energy, foreign affairs Law and order (police, prisons, adm. of justice) Education Currency, foreign trade Local government Drugs and poisons Transportation (rail, air, national highways, major ports) Public health and sanitation Economic and social planning Telecommunication Agriculture, forests, fisheries, irrigation, etc Electricity Financial services (banking and insurance) Transportation (state and local highways, ports) Labour welfare Control of industries, mines, etc Land revenue, taxes on vehicles, luxuries, etc. Newspapers, books, etc. Income tax, customs and excise duties, etc. Ports Source: Constitution of India Of the 3.1 mn employees of the central government, nearly 90% are in the Railways (which is still a central government department), non-military security forces like the BSF (Border Security Force), CRPF (Central Reserve Police Force), and the like; civilian defence like Home Guards, and the department of Posts & Telegraph (Figure 33).

Figure 33: Ex-Railways and Defence, central govt. is small Figure 34: States provide most of government services Atomic Energy Health & Family Others Agri & Forestry Others 1% Welfare 5% 3% Audit 1% 9% Education 2% Community 22% Services Revenue 5% 3% Post & Transportation Telegraph Railways 6% 7% Defence 43% (Civilian) Public Works 12% 6% Police Utilities 15% 6%

Administration Urban Non-military Health 7% Administration Security Forces 11% 10% 26% Total Central Government Employment: 3.1mn State Government Employment: 12mn

Source: Brochure on Pay and Allowances, 2012, CS estimates Source: MOSPI Statistical Yearbook, Credit Suisse estimates State government employment on the other hand is focused on education, police, urban administration (including traffic police), healthcare services, utilities, public works, (Figure 34) etc. These services are essential for the day-to-day functioning of the economy. Bulk of state spending is revenue expenditure Given the large number of governance services they provide, states’ spending is revenue/salary heavy; only about 14% is capital expenditure (Figure 35): this rose from 9% to 17% between FY02 and FY08, as interest costs dropped with falling interest rates in the economy. But post the pay commission recommendations in FY09, as the salary bill and pension liabilities ballooned, the ratio declined again. Over the last 3-4 years, capital expenditure has grown only marginally faster than overall spending growth (Figure 36).

India Market Strategy 11 20 July 2015

Figure 35: Capex is ~14% of state govt. expenditure Figure 36: Capital and Revenue spend rising in sync now Rs Tn 25% 25 Staff costs + pensions 19% Dropping interest increased post 6th 20% 20 17% costs created Pay Commission room for capex 15% 15% 15 13%

10 11% 10%

9% 5 5% 7%

0 5% 0% 2002 2004 2006 2008 2010 2012 2014 2016b FY02-08 FY08-13 FY13-16b

Revenue Expenditure Capital Expenditure Capex % of Total Total Expenditure Revenue Capex

Source: RBI, budget documents, Credit Suisse estimates Source: RBI, budget documents, Credit Suisse estimates States' capex is mostly (Figure 37) on agriculture (irrigation canals), roads (state highways), urban development (metro rail projects, sanitation, water supply projects, etc.), rural development (rural roads, rural electrification, NREGA, etc.), and on power (mainly distribution, though some spend on generation as well). The share of agriculture/irrigation has come down meaningfully over the past decade. With a total capital expenditure of US$53 bn the states spend nearly 3x on capex as compared to the centre (ex-defence), but at 8% of GFCF they do not play a major role in the overall capex in the economy.

Figure 37: State governments' capex split (FY15b) Figure 38: State governments’ revenue expenses (FY15b) Others Power Others Medical General 6% Urban 4% 6% Education 4% Agriculture Services Development 20% 23% 7% 5%

Rural Interest Development Payment Welfare 10% 11% 9%

Health Energy 6% 9% Roads & Bridges 19% Welfare Pensions 8% 10% Rural Urban Development Development Agriculture Administration 10% 13% 9% 11%

Split for FY15b; FY16b States' Capital Expenditure: Rs 3.4tn Split for FY15b; FY16b States' Revenue Expenditure: Rs 18tn

Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates Revenue expenditure seems to be very productive As more than 85% of expenditure is revenue expenditure, its efficacy becomes important, particularly as much of it is on salaries and pensions (Figure 38). Conventional wisdom, mostly inherited from the developed world, frowns on high revenue expenditure. However, economic evidence in India suggests otherwise: there is a strong positive correlation between a state’s employee strength (per capita) and its productivity (Figure 39). That is, states that have more employees have higher per capita GDP. Poorer states of MP, Jharkhand, Chhattisgarh, West Bengal, UP and Bihar bring up the rear, while richer states like Delhi, Tamil Nadu, Punjab, Karnataka, etc. all have large employee strength.

India Market Strategy 12 20 July 2015

Figure 39: High state govt. employment drives high GDP Figure 40: Split of state government employment (2012)

40 200 Agri & Forestry Others 3% 9% Education 180 35 Community 22% Services 160 30 5% 140 Transportation 6% 25 120

20 100 Public Works 80 6% 15 Police 60 Utilities 15% 10 40 6% 5 20 Administration Urban 0 0 Health 7% Administration HP UT DL TN PU KA KE HA MH AS RA AP OR GU MP JH CH WB UP BI 11% 10% State Empl. Per '000 People (incl. Quasi) GSDP Per Capita (Rs '000) State Government Employment: 12mn

Source: MOSPI, Census 2011, Credit Suisse estimates Source: MOSPI Statistical Yearbook, Credit Suisse estimates Causality is from employees to productivity It is important then to figure out the direction of causality: do richer states have more employees because they can afford/need them or are they rich because they have more employees? It seems to be the latter. Given that police is the second largest area of employment (Figure 40), we looked at the correlation of police penetration (i.e., number of police people per '000 population) with per capita GDP of a state (Figure 41). A likely explanation behind Figure 41 below is that the private sector does most of the capex and for it to work a number of basic services like law and order must be provided.

Figure 41: Police employment vs. per capita GDP of states Figure 42: Police employment vs. per country capita GDP

5 200 6 60

5 50 4 160 4 40 3 120 3 30

2 80 2 20

1 10 1 40

0 0

UK

Italy USA

0 0 India

Brazil

Spain

Japan

Kenya

Russia

Poland France

Mexico Nigeria

DL PU HP HA UT AS CH JH MH KE TN KA GU RA OR AP MP UP WB BI Canada

Germany

Indonesia Philippines Police Personnel per 1000 People GSDP Per Capita (Rs '000, RHS) Police Personnel per 1000 population GDP Per Capita, PPP Adj (US$ '000, RHS)

Source: MOSPI, Credit Suisse estimates Source: UNODC, IMF, Credit Suisse estimates This is also visible when one compares India’s police employment to that of the rest of the world (Figure 42): India’s police force relative to its population is much smaller than in most countries. The correlation with per capita GDP across countries is not as high, a possible explanation being that productivity of a policeman/woman is not the same everywhere. Whereas within various states of India variations would be much lower, and hence the correlation is better. Further, beyond a threshold, the necessity for more policemen drops as well: likely, countries such as Spain, Italy and Russia are beyond that threshold.

India Market Strategy 13 20 July 2015

The Indian "state" is too small, but growing Thus, we continue to believe that the problem in India is that the Indian "state" (i.e. all forms of government) is too small, and with the states discharging most government responsibilities, employee additions need to happen at the state level. This is contrary to conventional wisdom which suggests revenue expenditure by governments is wasteful. Education: Rapid growth in expenditure to continue in FY16b

Figure 43: Steady increase in state spending on education Figure 44: No. of government teachers rising steadily

4,000 Fifth Pay 2.9% 4.8 37 Commission 3,500 2.8% Scheme 4.5 35 transferred to 2.7% 3,000 state budget 2.6% 4.2 33 2,500 Sixth Pay Commission 2.5% 2,000 3.9 31 2.4% 1,500 2.3% 3.6 29 1,000 2.2% 3.3 27 500 2.1%

0 2.0% 3.0 25 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2006 2007 2008 2009 2010 2011 2012 2013 2014

Education Spend (Rs bn) as % of GDP No. of Govt. teachers (mn) PTR in Govt. Schools (RHS)

Source: CEIC, Credit Suisse estimates Source: DISE Flash Statistics on Education, Credit Suisse estimates State government spending on education has been rising steadily (Figure 43). Implementation of the 5th and 6th Pay Commission recommendations, in FY97-99 and FY09-10 respectively, boosted spending sharply, as did the movement of key schemes like the Sarva Shiksha Abhiyaan (SSA; translates to "Education for All Campaign") from the central plan to the state plan in FY15 (just a change in classification). In FY16b the states have budgeted for another 14% increase in spending.

Figure 45: Most new govt. teachers where need is high Figure 46: Y/Y increase in spending in FY16b

WB 24% OTH WB AP 24% 16% 19% KE 23% DL BI 22% MP 3% UP 21% 3% JH 21% JK RJ 16% 3% MP 14% BI GU AS 14% 12% 3% HA 13% HA PU 11% 3% OR 10% TN MH 10% 4% OR CG 9% 4% UP GU 9% 11% PU TN 5% 5% AS RA 7% 7% 0% 5% 10% 15% 20% 25% Share of rise in govt. teachers from 3.2mn in FY06 to 4.6mn in FY14 Y/Y in FY16

Source: DISE Flash Statistics on Education, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates This increase in expenditure is however not all salary hikes and reclassification: between 2006 and 2014, the number of teachers on state government rolls increased by 1.4mn (Figure 44). Encouragingly, less developed states like West Bengal as well as those with low average age/high fertility rates like Bihar, UP, Rajasthan and Assam are together

India Market Strategy 14 20 July 2015 nearly 60% of new teacher hiring between 2006 and 2014 (Figure 45). In FY16b as well most of these states are budgeting for a substantial increase in spending (Figure 46).

Figure 47: Share of private teachers increasing as well Figure 48: Split of increase in private teachers by state 3.5 42% UP OTH 17% 17% 3.0 40%

2.5 BI 38% OR 3% RA 2.0 4% 9% 36% KA 1.5 4% 34% GU MA 1.0 4% 8% AP 0.5 32% 4% KE HA 0.0 30% PU 8% 5% 5% MP TN 2006 2007 2008 2009 2010 2011 2012 2013 2014 5% 7% Private Teachers (mn) Private Teachers as % of Total (%) Share of rise in Pvt school teachers 1.4mn to 3.1mn over FY06-FY14

Source: DISE Flash Statistics on Education, Credit Suisse estimates Source: DISE Flash Statistics on Education, Credit Suisse estimates That's not to say that more teachers are only needed in the less developed states or that the states are doing enough. Reflecting the rising demand for education, the increase in number of private teachers has exceeded that of government teachers (Figure 47), pushing the share of private sector from ~30% six years back to 40% now. The split of this increase by states shows a mixed picture: the large increase in UP in our view is reflective of a failure of the state, whereas in states like Kerala and Tamil Nadu, where citizens can afford private education, the state is likely taking a back seat (Figure 48). Police: Hiring of new police personnel continues

Figure 49: Police spending rising even after 6th Pay comm Figure 50: Police personnel as % of population increasing

1,000 0.80% 1.8 1.40 900 Fifth Pay Commission 0.75% 1.7 1.35 800 700 0.70% 1.6 1.30 600 Sixth Pay Commission 500 0.65% 1.5 1.25 400 0.60% 1.4 1.20 300 200 0.55% 1.3 1.15 100 0 0.50% 1.2 1.10 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Police Spend (Rs bn) as % of GDP No. of Police Personnel (mn) Police per 1000 People (RHS)

Source: CEIC, Credit Suisse estimates Source: MOSPI Statistical Yearbook, Credit Suisse estimates While absolute expenditure on police has been rising consistently, as a % of GDP it declined from 1999 to 2008, i.e., between the two pay commissions (Figure 49). Even after the surge in spending caused by the Sixth Pay Commission however, expenditure has been rising steadily, and we estimate the ~3% CAGR increase in police personnel seen over the past decade (Figure 50) has continued past the last 2013 data point available on headcount. With immediate needs for police force expansion varying from state to state,

India Market Strategy 15 20 July 2015 particularly given local imperatives (e.g. growth in insurgencies like Naxalism or their subsequent decline), the pace of growth of police forces is not necessarily mean-reverting (Figure 51). States with an already larger base also contribute the most to incremental spending, with Maharashtra and UP leading (Figure 52).

Figure 51: Hiring of police personnel not driven by base Figure 52: Split of incremental police spending (FY12-16)

3.0 7% Others OR MH 12% 14% 6% KA 3% 2.5 3% 5% GU 3% 2.0 4% AS UP 3% 13% 3% 1.5 KE 2% 3% HA 1.0 1% 4% AP 0% WB 9% 0.5 4% TN -1% 4% RJ MP 0.0 -2% 6% 4% PU JK BI UT JH BI GU CH OR KE TN PU RA WB UP MH MP HP AS KA HA AP 4% 5% 6% Police Personnel/'000 People (2013) CAGR (FY09-13) Contribution to rise in states' police spend: Rs 379bn FY12-16b

Source: MOSPI Statistical Yearbook, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates Social Welfare: 5x the spend on NREGA, up 1.9x in four years (FY12-16) The “state” is also increasing social welfare spending (Figure 53). This has two important parts: spending on upliftment of backward castes such as SC/ST/OBCs (through welfare programmes and special spend on education), and social security, i.e., spending on scholarships for economically weaker sections, the handicapped, disaster relief, etc. While this is an important role of any government, for most investors that are more focused on the fiscal multiplier of government expenditure, this would count as unproductive. There is a third component on labour welfare which is much smaller, and not growing.

Figure 53: Social Welfare spending up 1.9x since FY12 Figure 54: A few states dominate welfare spending

1,600 1.20% Others 10% AP GU HA 19% 1,400 1.10% 3% 3% 1,200 1.00% WB 3% 1,000 OR 0.90% 4% 800 UP KE 11% 0.80% 5% 600 0.70% BI 400 5% TN 200 0.60% RJ 9% 6% MP 0 0.50% KA MH 6% 9% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 7% Welfare Spend (Rs Bn) as % of GDP (RHS) Contribution to rise in states' welfare spend: Rs 906bn FY11-16b

Source: CEIC, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates More interestingly, expenditure on social welfare would be Rs1.6 tn in FY16b nearly 5x the budgeted spend on NREGA (National Rural Employment Guarantee Act)—the scheme much reviled publicly. And while NREGA spending has not changed much in the last five years, spending on social welfare has increased Rs906 bn to Rs1.6 tn, up 2.3x (18.4% CAGR) over the same period,

India Market Strategy 16 20 July 2015

A few states dominate incremental spending on social welfare between FY11-16b: (unified) Andhra Pradesh (AP), Uttar Pradesh (UP), Tamil Nadu (TN), Maharashtra (MH) and Karnataka (KA). With the exception of UP, which is just too large, welfare spending is larger in the states considered more developed. In this case there is indeed a possibility of the causality moving from the states’ prosperity to higher spending. Pensions burden to continue to rise State governments together spend Rs2.2 tn on pensions, nearly 1.6% of GDP (Figure 55), and pensions are the second largest component of incremental spending in FY16b after Education (Figure 79). Like at the centre in 2004, some state governments stopped fresh enrolments into defined benefit plans from 2006 onwards, but some like Kerala (KE) adopted it only in 2013, and West Bengal (WB) hasn’t as yet. For most however, all employees are on defined contribution plans. However, the retirees on defined benefit plans are likely to keep rising for quite a while, particularly as life expectancy continues to improve. There is generally a sharp surge when pay commission recommendations are implemented, and one should be expected starting FY17, as the 7th Pay Commission implementation starts.

Figure 55: Pension burden up steadily; 7th PC spike likely Figure 56: State-wise split of FY11-16 pensions increase

2,200 1.6% CG PU Others UP 2% 2% 9% 2,000 1.5% JH 18% 2% 1,800 1.4% GU 1,600 1.3% HA 3% 3% 1,400 1.2% MP AP 1,200 1.1% 4% 10% 1,000 1.0% OR 4% 800 0.9% WB TN 600 0.8% 5% 7% 400 0.7% RJ 200 0.6% 5% MH KA 7% KE 0 0.5% 6% BI 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 6% 7% Pension Spend (Rs bn) as % of GDP (RHS) Contribution to rise in states' pension spend: Rs 1.1tn FY11-16b

Source: CEIC, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates Over the past five years states’ spending on pensions has doubled, i.e., increased by Rs1.1 tn. Most of this increase as expected has come in the more developed states of (unified) AP, TN, MH and KE (Figure 56). However, pension spending in UP and Bihar has gone up meaningfully as well, in the latter case likely because of a delayed implementation of pay commission recommendations. Rural development: Central schemes shifted to state With per capita GDP in many Indian states at sub-Saharan African levels, the improvement in productivity has to be driven by provision of basic infrastructure, in the form of access to roads, electricity, phones and better quality houses. This spending took off in about 2000 with the centre launching its scheme for rural roads construction (Pradhan Mantri Gram Sadak Yojana, or the Prime Minister’s Rural Roads Programme), and then around 2007, schemes for rural housing (Indira Awas Yojana) and for other local infrastructure construction in the form of a job-guarantee scheme (the much discussed National Rural Employment Guarantee or NREGA) added to this pile. In FY15 these schemes were moved from the central government’s budget to the state government (Figure 57). Put together about Rs1.5 tn is budgeted for FY16b, mostly in the rural less developed states of India like UP, Bihar, MP, Rajasthan and West Bengal, though Maharashtra, Tamil Nadu and the unified AP also spend a significant amount (Figure 58).

India Market Strategy 17 20 July 2015

Figure 57: In FY15 rural development moved to state plan Figure 58: Most of spending in less developed states

1.6 1.3% Others MH KA 11% Central schemes transferred to states post FY14 KE 13% 3% 1.4 1.2% 2% INR tn 1.2 GU UP 1.1% 3% 9% 1.0 CG 1.0% 3% 0.8 AP BI 0.9% 4% 9% 0.6 OR 0.8% 4% 0.4 JH 4% MP 0.2 0.7% TL 9% 5% 0.0 0.6% TN RJ WB 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 6% 8% 6% States' Spend Centre's Spend as % of GDP (RHS) Split of Rural Development spending by states in FY16 of Rs 1.6tn

Source: CEIC, Min. of rural development, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates This spending is mostly on rural roads (some states have their own schemes as well), housing, NREGA, and a large amount is transferred to local bodies (gram panchayats, i.e. the village councils) (Figure 59).

Figure 59: Split of rural development spending Figure 60: States spend 0.9-1.0% of GDP on health

PMGSY 1.4 1.1% Central schemes transferred to Others 9% INR tn states post FY14 21% 1.2 1.0%

1.0 0.9% NREGA 22% 0.8 0.8%

0.6 0.7%

0.4 0.6%

IAY 0.2 0.5% Grants to local 8% bodies 40% 0.0 0.4% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Split of Rs 1.6tn FY16b Staes' Rural Dev. Spending by categories States' Spend (Rs Tn) NRHM Spend (Rs Tn) as % of GDP (RHS)

Source: Budget documents, Credit Suisse estimates Source: CEIC, Min of health, Credit Suisse estimates Health: Range-bound spending State government spending on health totals Rs1.3 tn and has been rising steadily over the past several years, but as a share of GDP, at 0.9%, has stayed range-bound (Figure 60). State governments generally seem to lack the ability to undertake large capital investment projects and therefore hospital construction by state governments is not common, even if it is a big need. Given the low cost of generic medicines in India, public backlash to private spending (~85% of healthcare spending in India is out of pocket) has been limited. In FY15, the government transferred its National Rural Health Mission (provides reproductive, neo-natal and infant care, and funds for research and education) to the state plan.

India Market Strategy 18 20 July 2015

Power: Still very low; capex needed Put together, states spend Rs1.2 tn on power, and as a share of GDP this spending has stayed below 1% (Figure 61). Given state governments’ monopoly on power distribution, this is far too low, particularly as only Rs339 bn is spent on capex. Revenue expenditure is mostly in the form of explicit subsidies or bailouts for broken State Electricity Boards: the recent bailout of some SEBs has increased provisions in state budgets. This explains why Rajasthan spends the most among states on power (Figure 62).

Figure 61: Power spending too low given state monopoly Figure 62: Split of revenue expenditure on power

1.4 1.6% Others RJ INR tn CG JH 10% 12% 2% 1.2 1.4% 2% PU 1.2% 3% UP 1.0 BI 11% 1.0% 5% 0.8 0.8% AP 0.6 5% KA 0.6% GU 10% 0.4 0.4% 6%

0.2 0.2% TN MH 6% 7% 0.0 0.0% HA TL MP 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 7% 7% 7% Power (Revenue Spend) Power (Capex) as % of GDP (RHS) Split of FY16b Power Revenue Expenditure : Rs 843bn

Source: CEIC, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates

India Market Strategy 19 20 July 2015 Consumption stays supported Some improvement in social indicators For India the most important measures of socio-economic development are at low levels, and, while there is visible improvement, that is so for most under-developed economies. So is this increase in spending by state governments having any impact? As education and police are the two largest areas of employment for state governments, we compare changes in India to those elsewhere. That on both literacy levels (Figure 63) and on the enrolment ratio in primary schools (Figure 64) India is faring better than even other developing countries suggests that some of these changes are having an impact.

Figure 63: Literacy growth better even if on a low base Figure 64: Enrolment has improved dramatically

Adult Literacy Net Primary Enrolment Rate 100% 1.6% 100% 2.5% 1.4% 95% 90% 2.0% 1.2% 90% 1.5% 80% 1.0% 85% 0.8% 80% 1.0% 70% 0.6% 75% 0.5% 0.4% 70% 60% 0.0% 0.2% 65% 50% 0.0% 60% -0.5%

2005 2015e 10yr CAGR (RHS) 2002 2012 10yr CAGR (RHS)

Source: UNESCO, Credit Suisse estimates Source: UNESCO, Credit Suisse estimates In particular the enrolment ratio is now in a range prevalent in most countries globally, even the developed ones, and the growth is much faster than in other developing markets even though current ratios are higher, suggesting a low base is not the only reason.

Figure 65: Educational outcomes weak across states Figure 66: India’s police-to-people growth among fastest

80% 30% 7.0 10.0% Police per '000 people 6.0 8.0% 70% 20% 5.0 6.0% 60% 10% 4.0 4.0%

50% 0% 3.0 2.0%

40% -10% 2.0 0.0%

1.0 -2.0% 30% -20% 0.0 -4.0% 20% -30% HP KE PU AP HA UT WBMHOR TN CG KA BI GU IN RJ JH MP UP

Std V Reading Levels in Dec. 2014 Change 2010-14 (% points, RHS) 2008 2013 5-yr CAGR (RHS)

Source: ASER 2014 (Pratham), Credit Suisse estimates Source: UNODC, Credit Suisse estimates

India Market Strategy 20 20 July 2015

However, this is not yet showing up in educational outcomes, suggesting that while states have rapidly expanded schools and teachers, the quality and processes may have suffered. Most states seem to have seen a sharp drop in reading and arithmetic proficiency (Standards III and V): very likely that the new schools and teachers are part of the student base, but aren’t learning as much as they should. Worryingly, this problem exists even in the developed states. This clearly will be the next challenge for states. Similarly, the improvement in the police-to-people ratio in India has been among the fastest in the world (in Figure 66, Brazil is an outlier), even though a 2% p.a. pace may seem slow given the large gap that needs to be bridged. High salary burden: Big 7th Pay Commission impact

Figure 67: States employ the bulk of government staff Figure 68: State spending on salaries to shoot up

State employees (57%) 8 50% INR tn 45% 7 An increase of Rs 2tn if all states Quasi (Central) State 25% implement 7th CPC recommendations 40% 25% 6 35% 5 30% 4 25%

3 20% Quasi (State) 15% 17% 2 Central 10% 18% 1 5% Local Bodies 15% 0 0% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Split of all India government employees in 2012 Total state spend on salaries (INR tn) YoY (RHS)

Source: MOSPI Statistical Yearbook, Credit Suisse estimates Source: RBI, budget documents, Credit Suisse estimates While the economic impact of changes to state governments’ administrative services may be longer term, their large staff strength has a significant regular presence in the economy. Given that most of the government services are provided by state governments, they also have the bulk of government staff on their rolls (Figure 67), with total employment at 12 mn and rising. Including quasi-state and local government employment (e.g. state transport corporations), they employ more than a fifth of the urban middle class.

Figure 69: Salaries may rise by 29% post 7th CPC Figure 70: State govt salary spend growth tracks centre’s

Change in pay post 7th CPC for lowest pay band 50%

50,000 40%

40,000 30%

30,000 20%

20,000 10%

10,000 0%

0 -10% Pre 7th CPC in 2016 Post 7th CPC in 2016 1998 2000 2002 2004 2006 2008 2010 2012

Basic Pay Grade Pay Other Allowances DA Central Govt Spend (2-yr CAGR) State Govt Spend (2-yr CAGR)

Source: 6th CPC Report, Credit Suisse estimates Source: RBI, Brochure on Pay and Allowances , CS research

India Market Strategy 21 20 July 2015

Not surprisingly, states spend 20-25% of their budget on salaries, with their FY16b salary bill likely to add up to Rs5.2n (Figure 68), nearly 3.6% of GDP. At the time of implementation of the once-in-a-decade pay revisions for government employees, this proportion shoots up, and then trends down in the intervening years as salary increases lag overall spending growth. The 7th Pay Commission is effective 01-Jan-2016, and the Central Pay Commission’s (CPC) report is expected by October 2015. Given the near-formulaic nature of increases seen thus far, it seems likely that the recommended increase would be 29% (Figure 69). States have their own pay commissions, but these generally adopt the central pay commission’s recommendations, as seen in the near-synchronous changes in the salary burden of the centre and the states (Figure 70): we use a two-year CAGR to smoothen out the impact of arrears. This pay commission is likely to submit its recommendations well in advance (unlike the 6th CPC that was accepted nearly 2.7 years after it became effective on 01-Jan-2006), and some of the states like MP have already started provisioning for the increases, as arrears create significant pressures on state budgets. It is clear from Figure 67 that generally all states do not implement the pay commission recommendations at the same time, else the increase in the overall salary bill would have been ~40% in any one year. It is very likely that this time as well not all of the Rs2 tn increase would be seen in the same year. Fiscal stresses and election calendar affect timing While the salary increase is to be effective 01-Jan-2016, only two states (Madhya Pradesh and Gujarat) have provisioned for an increase in FY16b. All others, like the centre, have not. The state-wise timing would be driven by two main factors: the state’s fiscal ability to absorb the cost, and when state elections are due. A sharp jump in compensation helps gather votes, and given the large number of employees, this voter base becomes important (some believe that the 2009 victor for the UPA in the general elections was affected by the 6th CPC). Some states are less well prepared fiscally to absorb the pay commission impact Given stringent fiscal targets, states with stretched finances (Figure 71) or those where these increases are a meaningful part of spending (Figure 72) are likely to delay the increase until they can: employee agitations would then be necessary to trigger the implementation of the pay commission.

Figure 71: States with high impact on deficits Figure 72: Impact of salary increases varies across states

5.0% 12%

4.5% 11% 4.0% 10% 3.5% 9% 3.0% 2.5% 8%

2.0% 7% 1.5% 6% 1.0% 0.5% 5% 0.0% 4% TL AP PU OR CG KE MP BI RJ UP HA TN KA JH GU WB MH PU MH AP WB KE HA OR TN RJ MP JH TL KA BI CG GU UP

FY17 Fiscal Deficit/GSDP FY17 Salary Spend increase as % of FY17 GSDP FY17-16 Salary spend increase as % of FY16 Spending

Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates

India Market Strategy 22 20 July 2015

Impact of state elections calendar: TN, KE, WB, AS, GU, PB & UP may see it early We use probable dates for next state elections to assess potential implementation dates. For Bihar (elections later this year), the elections pre-date the 7th PC findings. On the other hand, among major states, for Tamil Nadu, Kerala, West Bengal and Assam, where elections are due in the middle of 2016, and in Gujarat, Punjab and UP (mid/end-2017) an early implementation is likely. Other states may want to time it better depending on fiscal preparedness or impact on elections. Broad impact on the economy: Impact on inflation and possibly growth A sudden 30-40% increase in compensation for more than a fifth of the urban middle class is likely to show up in macroeconomic statistics. Particularly as the total quantum, once all states have implemented it, would be more than 1% of GDP. While it is difficult to isolate the impact of the pay commission, surges in inflation in 1998 and 2009 are noticeable (Figure 73): the episode after the 5th PC was shorter, while that after the 6th PC was much longer, though likely other factors played a role as well. There is likely to be some growth impact, even if the fiscal multiplier of such spending is generally low; the final impact would depend on the changes in fiscal deficits, i.e., how states go about funding this increase. Looking back at external balances, a noticeable change is not discernible.

Figure 73: Inflation impact of pay commissions Figure 74: State governments’ liabilities

40% 6th PC likely played a WB PU role in this surge UP 30% KE 5th PC: Inflation impact GO hard to isolate AP RJ 20% UT BI GU KA 10% JH MP MH 0% TN OR HA AS -10% CG Jan-61 Feb-67 Mar-73 Apr-79 May-85 Jun-91 Jul-97 Aug-03 Sep-09 10% 15% 20% 25% 30% 35% CPI (% YoY) Outstanding Liabilities as % of FY15 GSDP (as of FY15 end)

Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates Fiscal health of states Given that high inflation supports high nominal GDP growth, solvency stresses are uncommon among Indian states (Figure 74): only Punjab and WB were considered stressed 1-2 years back. Yet, a large increase in the salary burden can potentially create stresses on state government balance sheets. In particular as they also extend guarantees (effectively off-balance sheet funding) in various sectors like power and irrigation, and sometimes to State Finance Corporations as well.

FY16b impact: Spending up 16% In this financial year, the impact of larger or improved administration, or even the 7th PC recommendations would not matter. Instead, for investors the important factor is a 16% increase in total state spending (Figure 14 on Page 5). It is widely believed that state governments lack the institutional capacity to spend quickly, and generally miss their spending targets meaningfully. This fear is higher for some states than for others.

India Market Strategy 23 20 July 2015

Looking back at history, one finds that there is indeed a slippage in spending (Figure 75), but it was generally in the ~2% range till FY11. This is not insignificant, but not large enough to derail the growth impact. Since FY12 however, the slippage on FY targets has increased sharply, and the root cause for this, in our view, has been the uncertainty on receipts as the central government’s fiscal mismanagement drove very large slippages on transfers to states (Figure 76). This suggests the constraint is not the states’ ability to spend quickly. This year, as budgeted estimates of central revenue are credible, if not conservative, slippages against budgeted targets are likely to be insignificant.

Figure 75: Spending slippages are generally 2% of target Figure 76: High slippage since FY12 due to the centre

6% 1.0 1.0% INR tn 4% Slippage has been worse than expected in last 0.8 0.8% 4 years because of fiscal troubles at the centre 2%

0.6 0.6% 0%

-2% 0.4 0.4%

-4% 0.2 0.2% -6%

-8% 0.0 0.0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015e 2012 2013 2014 2015

States' Spending Slippage actual vs budgeted Revised vs Budgeted Transfers (INR tn) as % of GDP

Source: RBI, Budget documents, Credit Suisse estimates Source: Company data, Credit Suisse estimates Over and above the growth in their own tax revenues, the big change for state governments this year has been the change in transfers (see link). We estimate that UP, WB, MP and Orissa are together more than half of the increase (Figure 77). Not surprisingly, Orissa, MP and UP are the states likely to see the highest increases in spending (Figure 78).

Figure 77: Share of increased net transfers in FY16 Figure 78: Growth in states’ total expenditure in FY16 Others TR 9% KE 27% AR UP CG 26% 3% 2% 20% OR 21% HP MP 18% 3% UP 18% BI BI 17% 3% GU 16% KE RJ 16% 4% TN 16% AS 15% CG HP 15% 4% WB PU 15% 14% HA 15% RJ AP 15% 4% JK 14% GU JH 14% 4% WB 14% KA 13% JH MP MH 12% 5% AS 12% UT 4% OR 6% 7% 0% 5% 10% 15% 20% 25% 30% Beneficiaries of Rs 1.6tn increase in net transfers in FY16 YoY Increase in FY16/FY15

Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates The YoY comparisons seem high given that the FY15 actual spending was curtailed by the nearly Rs850 bn in slippages in transfers that the states did not know with just 1-2 months left to go in the year (see link). Moreover, as state budgets are presented without getting details of the significant central budget changes, many have not incorporated the higher central transfers. To this extent there could be some slippage on spending targets.

India Market Strategy 24 20 July 2015

Headline seems consumption boosting, but underlying more broad-based Of the Rs3.3 tn in additional spending in FY16b, the near-term effects of nearly two-thirds of it would just be to boost consumption (Figure 79). Spending on education and police are budgeted to continue growth. For some discretionary categories like roads, rural development and urban development, the growth could be higher than what official numbers show (Figure 80). This is because due to the Rs850 bn shortage in central transfers the final spend on these categories in FY15 would have been much lower than even the revised FY15 numbers the states presented in their FY16 budget.

Figure 79: Incremental spending to boost consumption Figure 80: Y/Y growth in spending for each category Urban Dev Roads Others Water 2% 2% 1% Pension 3% Education Interest Health 24% 6% Police Police Education 6% Water Pay Comm. Health 7% Rural Dev Welfare Rural Dev Roads 7% Urban Dev Pension 18% Admin Welfare Agri 8% Power Interest -5% 0% 5% 10% 15% 20% 16% Categories of states' incremental spend in FY16: Rs 3.3tn Budgeted Spending Increase (FY16b over FY15r)

Source: Budget documents, Credit Suisse estimates Source: Budget documents, Credit Suisse estimates Supportive of longer-term economy/market growth Changes of this magnitude: improving ground-level governance, 30-40% increase in compensation for 12 mn people, or a 16% growth in spending, can all have meaningful implications for the broader market. We shortlist seven stocks from the larger basket, using (1) sector; (2) geographical (i.e. state-wise) presence (it seems better to not have one!); and (3) ongoing company/management strategy level changes. In the following pages we cover implications for HUL, Maruti, LIC Housing Finance, Havells, Zee TV, Voltas and Kajaria Ceramics.

India Market Strategy 25 20 July 2015

Asia Pacific / India Personal Products

Hindustan Unilever Ltd

(HLL.BO / HUVR IN) Rating OUTPERFORM*

Price (16 Jul 15, Rs) 936.00 Target price (Rs) 975.00¹ Upside/downside (%) 4.2 Mkt cap (Rs bn) 2.02 (US$31,900 mn) Best play for premiumisation, Enterprise value (Rs mn) 1,990,512 Number of shares (mn) 2,163.81 ■ Surge of the states. The fiscal power of state governments in India is Free float (%) 33.0 improving rapidly: they now spend 65% more than the centre. They spend 52-week price range 974.3-622.0 ADTO - 6M (US$ mn) 24.1 mainly on essential government services (police, education) that are

manpower heavy. They employ 12 mn, supporting a fifth of India’s middle *Stock ratings are relative to the coverage universe in each class. Near-term, the 7th Pay Commission adoption could boost state wage analyst's or each team's respective sector. bills by Rs2 tn. In FY16 as well, two-thirds of the Rs3.3 tn in additional ¹Target price is for 12 months. spending is supportive of consumption. Research Analysts ■ HUL best positioned to gain from premiumisation, which should Arnab Mitra 91 22 6777 3806 accelerate in FY17. The sharp increase in government expenditure and the [email protected] pay commission revisions would support a strong recovery in premiumisation Rohit Kadam, CFA within home and personal care. HUL’s market share in premium segments is 91 22 6777 3824 significantly higher than its average market shares in many categories which [email protected] makes it very well positioned to gain.

■ HUL gains from its parent strategy, margin expansion from lower input costs. HUL is a direct beneficiary of its parent Unilever’s clear focus on personal care, with investments in innovations and global acquisitions. Also Unilever is willing to empower local managements more, which gives HUL leeway to tap local opportunities in India better. For FY16, HUL’s earnings have tailwinds as we expect ~180 bp EBITDA margin expansion from lower crude linked input costs. ■ Rich valuations will sustain, HUL in one of its best phases in 20 years. HUL is operationally in one of its best phases any time in the past 20 years. The stock has historically traded in a band of 25-45x one-year forward P/E. We expect the stock to sustain valuations at the higher end of this band in this phase of strong earnings growth. Share price performance Financial and valuation metrics

Year 3/14A 3/15E 3/16E 3/17E Price (LHS) Rebased Rel (RHS) Revenue (Rs mn) 274,082.9 301,969.5 332,337.5 376,225.8 1000 120 EBITDA (Rs mn) 44,752.6 51,834.2 63,807.5 75,242.3 800 100 EBIT (Rs mn) 42,147.1 49,134.5 61,018.2 72,363.4 600 80 Net profit (Rs mn) 38,674.9 41,464.8 49,187.6 59,364.1 EPS (CS adj.) (Rs) 17.88 19.17 22.74 27.45 400 60 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Change from previous EPS (%) n.a. 0.0 0.0 0.0 Consensus EPS (Rs) n.a. 16.9 22.0 24.7 The price relative chart measures performance against the S&P EPS growth (%) 1.9 7.2 18.6 20.7 BSE SENSEX IDX which closed at 28474.08 on 16/07/15 P/E (x) 52.3 48.8 41.2 34.1 On 16/07/15 the spot exchange rate was Rs63.49/US$1 Dividend yield (%) 1.6 1.5 1.8 2.1 EV/EBITDA (x) 44.8 38.4 31.0 26.0 Performance over 1M 3M 12M P/B (x) 61.8 51.9 43.7 36.7 Absolute (%) 8.7 -0.1 49.7 — ROE (%) 130.0 115.6 115.3 117.0

Relative (%) 2.6 -0.2 38.3 —

Net debt/equity (%) Net cash Net cash Net cash Net cash Source: IBES, CS RAVE, company data, Credit Suisse estimates.

India Market Strategy 26 20 July 2015

Asia Pacific / India Automobile Manufacturers

Maruti Suzuki India Ltd

(MRTI.BO / MSIL IN) Rating OUTPERFORM

Price (16 Jul 15, Rs) 4,180.40 Target price (Rs) 5,100.00¹ Upside/downside (%) 22.0 Mkt cap (Rs bn) 1.26 (US$19,890 mn) Higher volumes to continue to drive upgrades Enterprise value (Rs mn) 1,072,022 ■ Surge of the states. The fiscal power of state governments in India is Number of shares (mn) 302.08 Free float (%) 43.8 improving rapidly: they now spend 65% more than the centre. They spend 52-week price range 4,180.4-2,489.1 mainly on essential government services (police, education) that are ADTO - 6M (US$ mn) 20.9 manpower heavy. They employ 12 mn, supporting a fifth of India’s middle

class. Near-term, the 7th Pay Commission adoption could boost state wage *Stock ratings are relative to the coverage universe in each bills by Rs2 tn. In FY16 as well, two-thirds of the Rs3.3 tn in additional analyst's or each team's respective sector. spending is supportive of consumption. ¹Target price is for 12 months. ■ Industry growth can surprise positively. While consensus is largely Research Analysts expecting industry to grow in the 12-15% range, we expect it to surprise on Jatin Chawla the upside and grow at 20%+ in both FY17 and FY18. In our view, 91 22 6777 3719 implementation of 7th Pay Commission and GST will be big drivers of [email protected] industry growth in the next two years and cause the pent-up demand (given four subdued years) to come to the fore. The 6th Pay Commission resulted in almost an ~10x increase in sales to government employees for Maruti; this time impact could be even greater given improving vehicle affordability. GST should lead to a lowering of vehicle prices by ~10%, increasing demand. ■ Maruti with strong launch pipeline well placed to capitalise. Maruti (which has already gained ~600 bp share in the last two years) has a very strong product cycle over two years whereby it will enter new segments like SUVs, LCVs, super-premium hatchbacks, expanding the diesel market with the smallest diesel engine. We expect the company to outperform the industry in FY16 and largely maintain its share in FY17 and FY18. ■ ~50% earnings CAGR over FY15-17E. Despite margins already reaching 16% in 4Q FY15; Maruti still has margin tailwinds—improving capacity utilisation, further discount reduction, platform consolidation benefits, etc. We expect earnings to grow at ~50% CAGR over FY15-17E. Our FY17 estimates are ~20% higher than consensus. As in FY16 (when consensus estimates were upgraded on better margins), we expect FY17 numbers will see upgrades on higher volumes. The stock is trading at ~15x FY17 earnings which is in line with its historic average. However, when the market starts expecting 20%+ volume growth the multiples will expand. Share price performance Financial and valuation metrics

Year 3/14A 3/15E 3/16E 3/17E Price (LHS) Rebased Rel (RHS) Revenue (Rs mn) 437,006.0 498,806.1 587,277.7 735,227.7 6000 400 EBITDA (Rs mn) 50,959.0 65,883.6 91,745.4 125,665.2 4000 300 EBIT (Rs mn) 30,115.0 41,270.4 65,449.1 97,335.8 200 2000 Net profit (Rs mn) 27,830.0 37,161.8 56,635.7 81,869.2 100 EPS (CS adj.) (Rs) 92.15 123.05 187.54 271.09 0 0 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Change from previous EPS (%) n.a. 0 0 0 Consensus EPS (Rs) n.a. 123 175 226 The price relative chart measures performance against the S&P EPS growth (%) 16.3 33.5 52.4 44.6 BSE SENSEX IDX which closed at 28474.08 on 16/07/15 P/E (x) 45.4 34.0 22.3 15.4 On 16/07/15 the spot exchange rate was Rs63.49/US$1 Dividend yield (%) 0.3 0.6 1.0 1.2 EV/EBITDA (x) 22.0 16.3 10.9 6.9 Performance over 1M 3M 12M P/B (x) 6.0 5.3 4.5 3.7 Absolute (%) 9.8 14.8 63.2 — ROE (%) 14.1 16.6 21.8 26.2 Relative (%) 3.7 14.7 51.9 — Net debt/equity (%) Net cash Net cash Net cash Net cash

Source: IBES, CS RAVE, company data, Credit Suisse estimates.

India Market Strategy 27 20 July 2015

Asia Pacific / India Radio & TV Broadcasting

Zee Entertainment Enterprise

(ZEE.BO / Z IN) Rating OUTPERFORM

Price (16 Jul 15, Rs) 381.90 Target price (Rs) 440.00¹ Upside/downside (%) 15.2 Mkt cap (Rs mn) 366,795 (US$5,777 mn) Entering period of strong earnings upcycle Enterprise value (Rs mn) 346,819 ■ Surge of the states. The fiscal power of state governments in India is Number of shares (mn) 960.45 improving rapidly: they now spend 65% more than the centre. They spend Free float (%) 57.0 52-week price range 391.4-268.5 mainly on essential government services (police, education) that are ADTO - 6M (US$ mn) 14.3 manpower heavy. They employ 12 mn, supporting a fifth of India’s middle

class. Near-term, the 7th Pay Commission adoption could boost state wage *Stock ratings are relative to the coverage universe in each bills by Rs2 tn. In FY16 as well, two-thirds of the Rs3.3 tn in additional analyst's or each team's respective sector. spending is supportive of consumption. ¹Target price is for 12 months. ■ Advertising growth to remain robust. Zee’s ad revenues grew 25% YoY in Research Analysts 1Q FY16 (much ahead of industry) and we expect the 20%+ growth rate to Jatin Chawla continue. Industry growth should pick up from the low teens with economic 91 22 6777 3719 [email protected] recovery and also higher ad spends by FMCG companies. Zee should continue to do better on contribution from new GECs and also higher growth Akshay Saxena 91 22 6777 3825 in regional channels. Regional is now starting to emerge as a strong driver [email protected] as Zee is already among the top-two players in Marathi, Telugu, Bengali and Kannada genre and has also acquired a leading network in Odiya. ■ Subscription growth to accelerate. After ~25% CAGR in subscription revenues in FY12 to FY14, when digitisation was being implemented and hence growth was coming from volumes (under declaration going away), growth slowed down to ~10% in FY15-16 with only pricing growth. Once phase- 3 digitisation kicks in, volume growth will resume again and, to add to the pricing growth in phase-1 and 2, subscription growth can pick up again to ~25% from FY17. With more money in consumers’ hands post Pay Commission and government spending, digitisation acceptance should be easier. ■ Strong earnings momentum with ~25% growth CAGR. Even with higher sports losses and losses on new GEC, Zee expects FY16 margins to be similar to FY17. After a 300 bp QoQ margin expansion in 1Q16 as launch costs on the new GEC came down, we expect margins to continue to trend upwards gradually. With ~20% ad growth, ~25% subscription growth along with margin improvement we see a period of strong earnings momentum for the company and expect earnings CAGR of ~25% over FY16-18E. Share price performance Financial and valuation metrics

Year 3/15A 3/16E 3/17E 3/18E Price (LHS) Rebased Rel (RHS) Revenue (Rs mn) 48,837.0 56,940.3 67,130.5 77,044.2 400 140 EBITDA (Rs mn) 12,538.0 14,351.3 18,488.9 21,907.3 350 120 EBIT (Rs mn) 11,865.0 13,611.1 17,616.2 20,905.7 300 Net profit (Rs mn) 9,775.0 10,882.0 13,931.7 16,575.2 250 100 EPS (CS adj.) (Rs) 10.18 11.34 14.51 17.27 200 80 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Change from previous EPS (%) n.a. 0.0 0.0 0.0 Consensus EPS (Rs) n.a. 10.3 13.1 16.7 The price relative chart measures performance against the S&P EPS growth (%) 9.6 11.3 28.0 19.0 BSE SENSEX IDX which closed at 28474.08 on 16/07/15 P/E (x) 37.5 33.7 26.3 22.1 On 16/07/15 the spot exchange rate was Rs63.49/US$1 Dividend yield (%) 0.59 0.65 0.72 0.79 EV/EBITDA (x) 28.0 24.2 18.4 15.1 Performance over 1M 3M 12M P/B (x) 10.4 8.4 6.8 5.4 Absolute (%) 8.9 13.6 27.0 — ROE (%) 31.3 27.7 28.5 27.2 Relative (%) 2.7 13.4 15.6 — Net debt/equity (%) Net cash Net cash Net cash Net cash

Source: IBES, CS RAVE, company data, Credit Suisse estimates.

India Market Strategy 28 20 July 2015

Asia Pacific / India Mortgage Finance

LIC Housing Finance Ltd

(LICH.BO / LICHF IN) Rating OUTPERFORM

Price (16 Jul 15, Rs) 463.15 Target price (Rs) 540.00¹ Upside/downside (%) 16.6 Mkt cap (Rs mn) 233,735 (US$3,681 mn) Beneficiary of rising government staff spend Number of shares (mn) 504.66 Free float (%) 59.7 ■ Surge of the states. The fiscal power of state governments in India is 52-week price range 496.9-279.1 improving rapidly: they now spend 65% more than the centre. They spend ADTO - 6M (US$ mn) 19.5 mainly on essential government services (police, education) that are manpower heavy. They employ 12 mn, supporting a fifth of India’s middle *Stock ratings are relative to the coverage universe in each analyst's or each team's respective sector. class. Near-term, the 7th Pay Commission adoption could boost state wage ¹Target price is for 12 months. bills by Rs2 tn. In FY16 as well, two-thirds of the Rs3.3 tn in additional

Research Analysts spending is supportive of consumption. Sunil Tirumalai ■ Middle-class housing purchases should benefit. We believe the 91 22 6777 3714 [email protected] upcoming surge in government expenditure and pay commission revisions Rohit Kadam, CFA could help spur middle class home purchases. We believe LICHF will be a 91 22 6777 3824 direct beneficiary of the same. LICHF has an 88% salaried customer base, [email protected] half of which are government employees. It works in the Rs2 mn ticket size home loan segment. ■ Growth to remain healthy. We expect LICHF to sustain 20-22% loan growth over the coming years due to: (1) continued support from an army of 13,000+ agents of parent LIC, who create a unique differentiator, and (2) underlying secular growth in the underpenetrated mortgage segment. Given LICHF LTV of 51% and low share of risky LAP/developer segments (sub- 5%), we expect credit costs to remain low. ■ Attractive valuations. We find LICHF’s stock attractively priced at 9.7x and 2.1x FY17 P/E and P/B for 30%/20+% earnings growth/ROE respectively. LICHF remains one of our top picks in the NBFC segment with an Outperform rating and a Rs540 target price. Share price performance Financial and valuation metrics

Year 3/15A 3/16E 3/17E 3/18E Price (LHS) Rebased Rel (RHS) Pre-prov op profit (Rs mn) 21,265.6 28,794.0 38,285.7 48,365.4 600 180 Pre -tax profit (Rs mn) 21,193.1 27,453.7 36,489.3 46,115.3 400 Net attributable profit (Rs mn) 14,016.5 18,159.4 24,122.8 30,476.0 130 200 EPS (CS adj.) (Rs) 27.77 35.98 47.80 60.39 Change from previous EPS (%) n.a. 0 0 0 0 80 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Consensus EPS (Rs) n.a. 34.0 41.8 48.4 EPS growth (%) 6.0 29.6 32.8 26.3 The price relative chart measures performance against the S&P P/E (x) 16.7 12.9 9.7 7.7 BSE SENSEX IDX which closed at 28474.08 on 16/07/15 Dividend yield (%) 1.1 1.4 1.9 2.3 On 16/07/15 the spot exchange rate was Rs63.49/US$1 CS adj. BVPS (Rs) 156.5 184.9 222.7 270.3 P/B (x) 2.96 2.50 2.08 1.71 Performance over 1M 3M 12M ROE (%) 18.1 21.1 23.5 24.5 Absolute (%) 11.4 5.9 49.9 ROA (%) 1.3 1.5 1.6 1.7

Relative (%) 5.3 5.7 38.5

Tier 1 ratio (%) 12.5 12.3 12.2 12.1 Source: IBES, CS RAVE, company data, Credit Suisse estimates.

India Market Strategy 29 20 July 2015

Asia Pacific / India Multi-Industry-3

Havells India Ltd

(HVEL.BO / HAVL IN) Rating OUTPERFORM

Price (16 Jul 15, Rs) 301.45 Target price (Rs) 340.00¹ Upside/downside (%) 12.8 Mkt cap (Rs mn) 188,313 (US$2,966 mn) Levered to a pick-up in home improvement, Enterprise value (Rs mn) 186,741 Number of shares (mn) 624.69 many growth levers Free float (%) 38.3 52-week price range 333.2-231.5 ■ Surge of the states. The fiscal power of state governments in India is ADTO - 6M (US$ mn) 6.8 improving rapidly: they now spend 65% more than the centre. They spend mainly on essential government services (police, education) that are *Stock ratings are relative to the coverage universe in each manpower heavy. They employ 12 mn, supporting a fifth of India’s middle analyst's or each team's respective sector. ¹Target price is for 12 months. class. Near-term, the 7th Pay Commission adoption could boost state wage bills by Rs2 tn. In FY16 as well, two-thirds of the Rs3.3 tn in additional Research Analysts spending is supportive of consumption. Arnab Mitra 91 22 6777 3806 ■ Havells the strongest play on urban home improvement recovery. The [email protected] sharp increase in government expenditure and the pay commission revisions Rohit Kadam, CFA 91 22 6777 3824 should support a strong recovery in discretionary consumption, including [email protected] home improvement. The switchgear and cables business is highly levered to own home construction, and the bulk of sales come from urban India, which is where the pay commission impact will be the highest. ■ Havells entering white goods spaces, expanding distribution. Havells is expanding in its appliances division in relatively new categories like air coolers and water heaters while also focusing on its second brand Standard. The company is also expanding distribution into smaller towns and starting to explore the rural opportunity. ■ Valuations. Havells trades at ~26x FY17 earnings which is in-line with peers in home improvement. We expect a 21% earnings CAGR over FY15-17, which will be a significant acceleration over the FY13-15 pre-exceptional earnings growth of ~12%.

Share price performance Financial and valuation metrics

Year 3/14A 3/15E 3/16E 3/17E Price (LHS) Rebased Rel (RHS) Revenue (Rs mn) 81,858.0 84,290.2 90,369.0 98,707.1 400 160 EBITDA (Rs mn) 7,424.9 8,336.5 9,427.8 11,080.8 300 140 EBIT (Rs mn) 6,269.5 6,949.9 7,988.0 9,587.7 200 120 Net profit (Rs mn) 4,463.3 4,907.2 5,882.2 7,293.4 100 100 EPS (CS adj.) (Rs) 7.15 7.86 9.42 11.68 0 80 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Change from previous EPS (%) n.a. 0 0 0 Consensus EPS (Rs) n.a. 6.2 9.5 11.8 The price relative chart measures performance against the S&P EPS growth (%) 15.3 9.8 19.9 24.0 BSE SENSEX IDX which closed at 28474.08 on 16/07/15 P/E (x) 42.1 38.4 32.0 25.8 On 16/07/15 the spot exchange rate was Rs63.49/US$1 Dividend yield (%) 0.8 1.0 1.2 1.5 EV/EBITDA (x) 25.6 22.4 19.3 16.0 Performance over 1M 3M 12M P/B (x) 11.3 10.3 8.8 7.5 Absolute (%) 11.6 5.4 17.7 — ROE (%) 28.7 28.2 29.8 31.4

Relative (%) 5.5 5.3 6.3 —

Net debt/equity (%) 10.1 Net cash Net cash Net cash Source: IBES, CS RAVE, company data, Credit Suisse estimates.

India Market Strategy 30 20 July 2015

Asia Pacific / India Electrical Equipment

Voltas

(VOLT.BO / VOLT IN) Rating OUTPERFORM

Price (16 Jul 15, Rs) 314.60 Target price (Rs) 380.00¹ Upside/downside (%) 20.8 Mkt cap (Rs mn) 104,096 (US$1,640 mn) Market leader in an underpenetrated segment Enterprise value (Rs mn) 94,202 Number of shares (mn) 330.88 driven by purchasing power Free float (%) 69.7 ■ Surge of the states. The fiscal power of state governments in India is 52-week price range 358.1-188.2 improving rapidly: they now spend 65% more than the centre. They spend ADTO - 6M (US$ mn) 11.9 mainly on essential government services (police, education) that are manpower heavy. They employ 12 mn, supporting a fifth of India’s middle *Stock ratings are relative to the coverage universe in each analyst's or each team's respective sector. class. Near-term, the 7th Pay Commission adoption could boost state wage ¹Target price is for 12 months. bills by Rs2 tn. In FY16 as well, two-thirds of the Rs3.3 tn in additional [V] = Stock considered volatile (see Disclosure Appendix). spending is supportive of consumption.

Research Analysts ■ Well placed to leverage growth in purchasing power. We like Voltas as Lokesh Garg its provides preferable exposure to consumer durable demand and short 91 22 6777 3743 cycle projects in commercial real estate. Voltas’ consumer business will [email protected] benefit from growth in purchasing power from higher spending by states as Vaibhav Jain well as 7th Pay Commission-related salary and pension increases. We 91 22 6777 3968 believe that penetration of ACs will pick up on this purchasing power boost [email protected] driving strong overall market growth. As a market leader, Voltas is well placed in terms of distribution reach, and product shelf to leverage this increase in purchasing power. ■ Consumer AC as well project business can deliver: We believe that room AC business will drive growth based on (1) strong and durable growth in the under-penetrated room ACs segment and (2) strong execution, reflected in market share gains and steady margins. Further we believe that project business profitability has bottomed with (1) completion of legacy orders, and (2) improvement in inflow environment in both domestic and international market, leading to faster execution and gradual margin improvement. ■ Strong cash generation justifies valuations. The inherent value in Voltas is also supported by very strong cash generation (limited fixed and working capital investments), cash balance (Rs12 bn and ~10% of market cap.) and valuable real estate holdings. Strong corporate governance and management focus on cash flows, instead of revenue line accretion, add stability. Voltas trades at ~20x FY17 P/E; however, that is supported by free cash flows, growth opportunity and strong RoEs of about 20%? Share price performance Financial and valuation metrics

Year 3/15A 3/16E 3/17E 3/18E Price (LHS) Rebased Rel (RHS) Revenue (Rs mn) 51,442.9 61,765.5 74,886.5 — 400 400 EBITDA (Rs mn) 3,712.4 5,165.9 6,727.4 — 300 300 EBIT (Rs mn) 3,432.0 4,901.2 6,441.8 — 200 200 Net profit (Rs mn) 3,381.2 4,079.0 5,198.4 — 100 100 EPS (CS adj.) (Rs) 10.22 12.33 15.71 0 0 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Change from previous EPS (%) n.a. 0 0 Consensus EPS (Rs) n.a. 11.9 14.9 18.6 The price relative chart measures performance against the S&P EPS growth (%) 51.1 20.6 27.4 n.a. BSE SENSEX IDX which closed at 28474.08 on 16/07/15 P/E (x) 30.8 25.5 20.0 — On 16/07/15 the spot exchange rate was Rs63.49/US$1 Dividend yield (%) 1.1 1.2 1.5 EV/EBITDA (x) 25.6 18.2 13.8 — Performance over 1M 3M 12M P/B (x) 5.0 4.5 3.9 — Absolute (%) -6.9 6.5 49.1 — ROE (%) 17.4 18.5 20.8 —

Relative (%) -13.0 6.4 37.7 —

Net debt/equity (%) Net cash Net cash Net cash — Source: IBES, CS RAVE, company data, Credit Suisse estimates.

India Market Strategy 31 20 July 2015

Asia Pacific / India Building Products

Kajaria Ceramics Limited

(KAJR.BO / KJC IN) Rating OUTPERFORM

Price (16 Jul 15, Rs) 782.75 Target price (Rs) 950.00¹ Upside/downside (%) 21.4 Mkt cap (Rs mn) 62,204.4 (US$979.8 mn) Leader in a structurally robust category Enterprise value (Rs mn) 64,523 ■ Surge of the states. The fiscal power of state governments in India is Number of shares (mn) 79.47 Free float (%) 46.5 improving rapidly: they now spend 65% more than the centre. They spend 52-week price range 850.1-544.0 mainly on essential government services (police, education) that are ADTO - 6M (US$ mn) 1.3 manpower heavy. They employ 12 mn, supporting a fifth of India’s middle

class. Near-term, the 7th Pay Commission adoption could boost state wage *Stock ratings are relative to the coverage universe in each bills by Rs2 tn. In FY16 as well, two-thirds of the Rs3.3 tn in additional analyst's or each team's respective sector. spending is supportive of consumption. ¹Target price is for 12 months. ■ Leader in a structurally robust category. Low incidence of tiled houses in Research Analysts India, rising consumer aspirations, the ability of consumers to pay more, and Anantha Narayan the shift from the unorganised to the organised sector make ceramic tiles a 91 22 6777 3730 structurally robust category. Kajaria is a leader in the segment and has [email protected] among the highest growth over the past several years (25%, 38% revenue, Nitin Jain earnings CAGR over the past five years) with industry-leading operational 91 22 6777 3851 and balance sheet metrics. While the current discretionary demand [email protected] environment is weak, we anticipate the weak environment to bottom out soon and, even in this environment, we expect revenue growth to remain relatively resilient with a low double digit top line growth during 1H FY16. Kajaria also has 24% capacity being added in FY16. ■ Margins can gradually inch up. We believe improving demand can help margins due to some scale benefits as well as a more favourable pricing environment. Continuous improvement in the revenue mix (higher value- added tiles and lesser outsourcing) could be another driver. Also, we expect landed Rasgas prices to be down 6% in each of FY16 and FY17, and that helps margins by 100 bp in each year, although some benefits may be passed on. We are factoring in 50 bp margin expansion over FY15-17E. ■ Valuations likely to sustain. While the stock is up 150% over the last 18 months and current valuations appear rich as compared to history, we believe that the structural growth story is strong and valuations are reasonable as compared with many peers in consumer discretionary sectors and strong financial metrics are likely to support rich valuations. We have an O/P rating on the stock with a target price of Rs950 based on 29x FY17 EPS. Share price performance Financial and valuation metrics

Year 3/14A 3/15E 3/16E 3/17E Price (LHS) Rebased Rel (RHS) Revenue (Rs mn) 18,400.3 21,870.2 25,188.4 29,708.6 1000 400 EBITDA (Rs mn) 2,807.1 3,519.8 4,164.2 4,929.1 800 300 EBIT (Rs mn) 2,337.1 2,961.0 3,494.4 4,199.4 600 200 Net profit (Rs mn) 1,242.2 1,813.5 2,069.3 2,579.4 400 100 EPS (CS adj.) (Rs) 16.69 22.82 26.04 32.46 200 0 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Change from previous EPS (%) n.a. 0.0 0.0 0.0 Consensus EPS (Rs) n.a. 23.5 28.1 35.8 The price relative chart measures performance against the S&P EPS growth (%) 17.6 36.7 14.1 24.7 BSE SENSEX IDX which closed at 28474.08 on 16/07/15 P/E (x) 46.9 34.3 30.1 24.1 On 16/07/15 the spot exchange rate was Rs63.49/US$1 Dividend yield (%) 0.45 0.51 0.64 0.77 EV/EBITDA (x) 23.0 18.3 15.4 12.6 Performance over 1M 3M 12M P/B (x) 11.0 8.4 6.9 5.6 Absolute (%) 3.0 2.4 42.0 — ROE (%) 27.9 28.5 25.2 25.7 Relative (%) -3.1 2.3 30.7 — Net debt/equity (%) 40.4 28.9 19.9 0.4

Source: IBES, CS RAVE, company data, Credit Suisse estimates.

India Market Strategy 32 20 July 2015

Companies Mentioned (Price as of 17-Jul-2015) Havells India Ltd (HVEL.BO, Rs306.85, OUTPERFORM, TP Rs340.0) Hindustan Unilever Ltd (HLL.BO, Rs924.4, OUTPERFORM, TP Rs975.0) Kajaria Ceramics Limited (KAJR.BO, Rs787.05, OUTPERFORM, TP Rs950.0) LIC Housing Finance Ltd (LICH.BO, Rs475.25, OUTPERFORM, TP Rs540.0) Maruti Suzuki India Ltd (MRTI.BO, Rs4194.05, OUTPERFORM, TP Rs5100.0) Voltas (VOLT.BO, Rs314.1, OUTPERFORM[V], TP Rs380.0) Zee Entertainment Enterprise (ZEE.BO, Rs377.3, OUTPERFORM, TP Rs440.0)

Disclosure Appendix Important Global Disclosures Neelkanth Mishra, Ravi Shankar, Prateek Singh and Lokesh Garg each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.

3-Year Price and Rating History for Havells India Ltd (HVEL.BO)

HVEL.BO Closing Price Target Price Date (Rs) (Rs) Rating 28-Oct-13 138.62 NR 06-Oct-14 259.75 325.00 O * 27-Oct-14 269.80 320.00 05-Dec-14 321.30 380.00 15-Dec-14 267.75 365.00 16-Feb-15 267.20 340.00 * Asterisk signifies initiation or assumption of coverage.

N O T RAT ED OUTPERFORM

3-Year Price and Rating History for Hindustan Unilever Ltd (HLL.BO)

HLL.BO Closing Price Target Price Date (Rs) (Rs) Rating 22-Aug-12 511.55 564.00 O * 26-Oct-12 551.75 573.00 22-Jan-13 481.55 485.00 N 29-Apr-13 497.60 500.00 25-Jun-13 587.60 541.00 29-Jul-13 638.70 595.00 28-Oct-13 589.35 605.00 28-Apr-14 580.60 616.00 28-Jul-14 686.45 675.00 15-Sep-14 754.80 770.00 OUTPERFORM NEUTRAL 01-Dec-14 808.25 800.00 06-Jan-15 775.15 915.00 O 19-Jan-15 892.80 955.00 08-May-15 894.60 975.00 * Asterisk signifies initiation or assumption of coverage.

India Market Strategy 33 20 July 2015

3-Year Price and Rating History for Kajaria Ceramics Limited (KAJR.BO)

KAJR.BO Closing Price Target Price Date (Rs) (Rs) Rating 29-Nov-12 249.20 360.00 O * 09-May-14 490.30 560.00 24-Jun-14 520.15 600.00 04-Aug-14 632.85 750.00 14-Jan-15 637.80 785.00 23-Mar-15 781.20 950.00 * Asterisk signifies initiation or assumption of coverage.

OUTPERFORM

3-Year Price and Rating History for LIC Housing Finance Ltd (LICH.BO)

LICH.BO Closing Price Target Price Date (Rs) (Rs) Rating 20-May-13 274.83 364.38 O * 19-Aug-13 161.67 199.66 31-Oct-13 224.27 279.52 22-Apr-14 277.82 324.44 19-May-14 334.03 359.38 20-Oct-14 323.40 400.00 05-Dec-14 431.90 500.00 13-Jan-15 462.70 540.00 * Asterisk signifies initiation or assumption of coverage.

3-Year Price and Rating History for Maruti Suzuki India Ltd (MRTI.BO)

MRTI.BO Closing Price Target Price Date (Rs) (Rs) Rating 30-Jul-12 1120.15 1341.00 O 15-Oct-12 1338.20 1551.00 30-Oct-12 1394.55 1565.00 08-Jan-13 1574.50 1632.00 N 25-Jan-13 1600.20 1694.00 04-Mar-13 1393.05 1687.00 03-Apr-13 1305.60 1619.00 29-Apr-13 1680.70 2163.25 O 25-Jul-13 1414.20 1820.00 03-Sep-13 1273.20 1540.00 OUTPERFORM NEUTRAL 28-Oct-13 1513.00 1760.00 25-Nov-13 1679.75 1960.00 28-Jan-14 1563.20 2080.00 15-Mar-14 1737.10 2220.00 22-Apr-14 1974.25 2340.00 19-May-14 2214.25 2700.00 01-Jul-14 2584.85 3020.00 25-Aug-14 2802.40 3500.00 01-Dec-14 3389.65 4000.00 27-Jan-15 3685.20 4300.00 27-Apr-15 3646.70 4370.00 14-Jul-15 4048.70 5100.00 * Asterisk signifies initiation or assumption of coverage.

India Market Strategy 34 20 July 2015

3-Year Price and Rating History for Voltas (VOLT.BO)

VOLT.BO Closing Price Target Price Date (Rs) (Rs) Rating 26-Sep-12 134.49 82.90 U 13-Feb-13 93.09 81.90 13-Aug-13 76.36 75.91 13-Nov-13 85.70 83.90 04-Feb-14 108.02 91.89 19-May-14 205.00 191.77 N 24-Jul-14 193.57 NR 20-Nov-14 263.95 315.00 O * 16-Feb-15 249.60 300.00

25-May-15 323.70 380.00 UNDERPERFORM * Asterisk signifies initiation or assumption of coverage. NEUTRAL N O T RA T ED OUTPERFORM

3-Year Price and Rating History for Zee Entertainment Enterprise (ZEE.BO)

ZEE.BO Closing Price Target Price Date (Rs) (Rs) Rating 16-Apr-13 200.15 242.00 O * 22-May-13 241.35 263.00 04-Jun-13 238.95 255.00 26-Jul-13 251.90 290.00 18-Sep-13 227.00 280.00 21-Oct-13 267.10 290.00 22-Jan-14 284.45 320.00 18-Jul-14 294.65 340.00 17-Oct-14 322.55 340.00 N 10-Dec-14 371.50 400.00 OUTPERFORM NEUTRAL 21-Jan-15 381.60 380.00 21-May-15 316.90 400.00 O 15-Jul-15 375.75 440.00 * Asterisk signifies initiation or assumption of coverage. The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities As of December 10, 2012 Analysts’ stock rating are defined as follows: Outperform (O) : The stock’s total return is expected to outperform the relevant benchmark*over the next 12 months. Neutral (N) : The stock’s total return is expected to be in line with the relevant benchmark* over the next 12 months. Underperform (U) : The stock’s total return is expected to underperform the relevant benchmark* over the next 12 months. *Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ra tings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin American and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock’s absolute total return potential to its current share price and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe. For Australian and New Zealand stocks, the expected total return (ETR) calculation includes 12-month rolling dividend yield. An Outperform rating is assigned where an ETR is greater than or equal to 7.5%; Underperform where an ETR less than or equal to 5%. A Neutral may be assigned where the ETR is between -5% and 15%. The overlapping rating range allows analysts to assign a rating that puts ETR in the context of associated risks. Prio r to 18 May 2015, ETR ranges for Outperform and Underperform ratings did not overlap with Neutral thresholds between 15% and 7.5%, which was in operation from 7 July 2011. Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances.

India Market Strategy 35 20 July 2015

Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward.

Analysts’ sector weightings are distinct from analysts’ stock ratings and are based on the analyst’s expectations for the fundamentals and/or valuation of the sector* relative to the group’s historic fundamentals and/or valuation: Overweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is favorable over the next 12 months. Market Weight : The analyst’s expectation for the sector’s fundamentals and/or valuation is neutral over the next 12 months. Underweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is cautious over the next 12 months. *An analyst’s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cover multiple sectors.

Credit Suisse's distribution of stock ratings (and banking clients) is:

Global Ratings Distribution Rating Versus universe (%) Of which banking clients (%) Outperform/Buy* 49% (27% banking clients) Neutral/Hold* 36% (44% banking clients) Underperform/Sell* 13% (38% banking clients) Restricted 2% *For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, and Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdings, and other individual factors.

Credit Suisse’s policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein. Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: http://www.csfb.com/research-and- analytics/disclaimer/managing_conflicts_disclaimer.html Credit Suisse does not provide any tax advice. Any statement herein regarding any US federal tax is not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding any penalties.

Price Target: (12 months) for Havells India Ltd (HVEL.BO) Method: Our target price of Rs340 for Havells India Ltd is based on an SOTP (sum-of-the-parts) valuation. We value the India business at 28x Mar- 17 earnings, which is at the average of Indian home improvement stocks. We value Sylvania at 6x EV/EBITDA (enterprise value-to- earnings before interest, tax, depreciation and amortisation). Risk: Risks that could impede achievement of our Rs340 target price for Havells India Ltd include: (1) weakness in consumer spend in India, driven by weak economic growth; (2) recession in Europe impacting Sylvania numbers; and (3) new products failing to gain traction.

Price Target: (12 months) for Hindustan Unilever Ltd (HLL.BO) Method: Our Rs975 target price for Hindustan Unilever Ltd is based on 35x Mar-17 earnings forecast (in line with the three-year average multiple). Risk: Key risks to our Rs975 target price for Hindustan Unilever Ltd (HUL) include a significant slowdown in consumer income growth leading to down trading in HUL's key categories, increased competitive intensity on account of a fall in input prices and a sharp rise in key raw materials such as crude.

Price Target: (12 months) for Kajaria Ceramics Limited (KAJR.BO) Method: Our 12-month target price of Rs950 for Kajaria Ceramics Limited assumes the stock trades at 29x 12-month estimated earnings at that point of time. Risk: Risks that could impede the achievement of our target price of Rs950 for Kajaria Ceramics Limited include: (1) significant demand slowdown, and (2) significant INR depreciation and crude price increase which will increase gas prices for the company and will hurt margins.

Price Target: (12 months) for LIC Housing Finance Ltd (LICH.BO) Method: Our target price of Rs540 for LIC Housing Finance Ltd is based on a P/E (price-to-earnings) multiple of 11.3x on our 24M forward EPS (earnings per share) of Rs48.

India Market Strategy 36 20 July 2015

Risk: Risks to our target price of Rs540 for LIC Housing Finance Ltd include: (1) a slowdown in mortgages; (2) a reversal of the declining interest rate scenario; and (3) frequent management changes.

Price Target: (12 months) for Maruti Suzuki India Ltd (MRTI.BO)

Method: We value Maruti Suzuki India Ltd at a multiple of 18x our Jun-17 EPS (earnings per share) forecast, giving us a target price of Rs5,100. Our multiple of 18x is a 10% premium to its historic average mutliple; which we believe is justified given that we are currently in a downcycle for passenger vehicles in India. Risk: Risks that could impede achievement of our Rs5,100 target price for Maruti Suzuki include INR depreciation vs JPY, discounts staying high and car demand in India being weaker than expected.

Price Target: (12 months) for Voltas (VOLT.BO)

Method: Our target price of Rs380 for Voltas is based on 24x FY17E consolidated earnings. This is at 35% premium to five year average of one year forward PE multiple, which takes into account (1) strong market position that the company enjoys in room AC business, (2) low penetration levels in India, which makes Voltas a structural growth story, and (3) expectation of an economic recovery v/s past five years. Risk: Key downside risks to our target price of Rs380 for Voltas include slower than expected recovery in commercial and infrastructure construction activity in both India as well as Middle East, sharp drop in AC business market share or profitability.

Price Target: (12 months) for Zee Entertainment Enterprise (ZEE.BO)

Method: We value Zee Entertainment Enterprise at 30x Jun-17earnings (20% premium to historic valuations which is justified given the more optimistic outlook on subscription revenues) to arrive at our Rs440 target price. Risk: Risks that could cause the share price to diverge from our Rs440 target price for Zee Entertainment Enterprise include failure of digitisation with respect to full technical implementation, which would have a major impact on revenue and earnings growth.

Please refer to the firm's disclosure website at https://rave.credit-suisse.com/disclosures for the definitions of abbreviations typically used in the target price method and risk sections.

See the Companies Mentioned section for full company names The subject company (ZEE.BO, HLL.BO) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse. Credit Suisse provided investment banking services to the subject company (ZEE.BO) within the past 12 months. Credit Suisse has received investment banking related compensation from the subject company (ZEE.BO) within the past 12 months Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (LICH.BO, MRTI.BO, ZEE.BO, HLL.BO) within the next 3 months. Please visit https://credit-suisse.com/in/researchdisclosure for additional disclosures mandated vide Securities And Exchange Board of India (Research Analysts) Regulations, 2014 Credit Suisse may have interest in (HVEL.BO, LICH.BO, VOLT.BO, MRTI.BO, KAJR.BO, ZEE.BO, HLL.BO) Arnab Mitra worked as an employee in Hindustan Unilever. Important Regional Disclosures Singapore recipients should contact Credit Suisse AG, Singapore Branch for any matters arising from this research report. The analyst(s) involved in the preparation of this report have not visited the material operations of the subject company (HVEL.BO, LICH.BO, VOLT.BO, MRTI.BO, KAJR.BO, ZEE.BO, HLL.BO) within the past 12 months Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares. Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report. For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit https://www.credit- suisse.com/sites/disclaimers-ib/en/canada-research-policy.html. As of the date of this report, Credit Suisse acts as a market maker or liquidity provider in the equities securities that are the subject of this report. Principal is not guaranteed in the case of equities because equity prices are variable. Commission is the commission rate or the amount agreed with a customer when setting up an account or at any time after that. To the extent this is a report authored in whole or in part by a non-U.S. analyst and is made available in the U.S., the following are important disclosures regarding any non-U.S. analyst contributors: The non-U.S. research analysts listed below (if any) are not registered/qualified as research

India Market Strategy 37 20 July 2015 analysts with FINRA. The non-U.S. research analysts listed below may not be associated persons of CSSU and therefore may not be subject to the NASD Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Credit Suisse Securities (India) Private LimitedNeelkanth Mishra ; Ravi Shankar ; Prateek Singh ; Anantha Narayan ; Nitin Jain ; Lokesh Garg ; Vaibhav Jain ; Arnab Mitra ; Rohit Kadam, CFA ; Sunil Tirumalai ; Jatin Chawla ; Akshay Saxena

For Credit Suisse disclosure information on other companies mentioned in this report, please visit the website at https://rave.credit- suisse.com/disclosures or call +1 (877) 291-2683.

India Market Strategy 38 20 July 2015

References in this report to Credit Suisse include all of the subsidiaries and affiliates of Credit Suisse operating under its investment banking division. For more information on our structure, please use the following link: https://www.credit-suisse.com/who-we-are This report may contain material that is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Credit Suisse AG or its affiliates ("CS") to any registration or licensing requirement within such jurisdiction. All material presented in this report, unless specifically indicated otherwise, is under copyright to CS. None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of CS. All trademarks, service marks and logos used in this report are trademarks or service marks or registered trademarks or service marks of CS or its affiliates. The information, tools and material presented in this report are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities or other financial instruments. CS may not have taken any steps to ensure that the securities referred to in this report are suitable for any particular investor. CS will not treat recipients of this report as its customers by virtue of their receiving this report. The investments and services contained or referred to in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about such investments or investment services. Nothing in this report constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to your individual circumstances, or otherwise constitutes a personal recommendation to you. CS does not advise on the tax consequences of investments and you are advised to contact an independent tax adviser. Please note in particular that the bases and levels of taxation may change. Information and opinions presented in this report have been obtained or derived from sources believed by CS to be reliable, but CS makes no representation as to their accuracy or completeness. CS accepts no liability for loss arising from the use of the material presented in this report, except that this exclusion of liability does not apply to the extent that such liability arises under specific statutes or regulations applicable to CS. This report is not to be relied upon in substitution for the exercise of independent judgment. CS may have issued, and may in the future issue, other communications that are inconsistent with, and reach different conclusions from, the information presented in this report. Those communications reflect the different assumptions, views and analytical methods of the analysts who prepared them and CS is under no obligation to ensure that such other communications are brought to the attention of any recipient of this report. Some investments referred to in this report will be offered solely by a single entity and in the case of some investments solely by CS, or an associate of CS or CS may be the only market maker in such investments. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Information, opinions and estimates contained in this report reflect a judgment at its original date of publication by CS and are subject to change without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. The value of securities and financial instruments is subject to exchange rate fluctuation that may have a positive or adverse effect on the price or income of such securities or financial instruments. Investors in securities such as ADR's, the values of which are influenced by currency volatility, effectively assume this risk. Structured securities are complex instruments, typically involve a high degree of risk and are intended for sale only to sophisticated investors who are capable of understanding and assuming the risks involved. The market value of any structured security may be affected by changes in economic, financial and political factors (including, but not limited to, spot and forward interest and exchange rates), time to maturity, market conditions and volatility, and the credit quality of any issuer or reference issuer. Any investor interested in purchasing a structured product should conduct their own investigation and analysis of the product and consult with their own professional advisers as to the risks involved in making such a purchase. Some investments discussed in this report may have a high level of volatility. High volatility investments may experience sudden and large falls in their value causing losses when that investment is realised. Those losses may equal your original investment. Indeed, in the case of some investments the potential losses may exceed the amount of initial investment and, in such circumstances, you may be required to pay more money to support those losses. Income yields from investments may fluctuate and, in consequence, initial capital paid to make the investment may be used as part of that income yield. Some investments may not be readily realisable and it may be difficult to sell or realise those investments, similarly it may prove difficult for you to obtain reliable information about the value, or risks, to which such an investment is exposed. This report may provide the addresses of, or contain hyperlinks to, websites. Except to the extent to which the report refers to website material of CS, CS has not reviewed any such site and takes no responsibility for the content contained therein. Such address or hyperlink (including addresses or hyperlinks to CS's own website material) is provided solely for your convenience and information and the content of any such website does not in any way form part of this document. Accessing such website or following such link through this report or CS's website shall be at your own risk. This report is issued and distributed in Europe (except Switzerland) by Credit Suisse Securities (Europe) Limited, One Cabot Square, London E14 4QJ, England, which is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. This report is being distributed in Germany by Credit Suisse Securities (Europe) Limited Niederlassung Frankfurt am Main regulated by the Bundesanstalt fuer Finanzdienstleistungsaufsicht ("BaFin"). This report is being distributed in the United States and Canada by Credit Suisse Securities (USA) LLC; in Switzerland by Credit Suisse AG; in Brazil by Banco de Investimentos Credit Suisse (Brasil) S.A or its affiliates; in Mexico by Banco Credit Suisse (México), S.A. (transactions related to the securities mentioned in this report will only be effected in compliance with applicable regulation); in Japan by Credit Suisse Securities (Japan) Limited, Financial Instruments Firm, Director-General of Kanto Local Finance Bureau (Kinsho) No. 66, a member of Japan Securities Dealers Association, The Financial Futures Association of Japan, Japan Investment Advisers Association, Type II Financial Instruments Firms Association; elsewhere in Asia/ Pacific by whichever of the following is the appropriately authorised entity in the relevant jurisdiction: Credit Suisse (Hong Kong) Limited, Credit Suisse Equities (Australia) Limited, Credit Suisse Securities (Thailand) Limited, regulated by the Office of the Securities and Exchange Commission, Thailand, having registered address at 990 Abdulrahim Place, 27th Floor, Unit 2701, Rama IV Road, Silom, Bangrak, Bangkok 10500, Thailand, Tel. +66 2614 6000, Credit Suisse Securities (Malaysia) Sdn Bhd, Credit Suisse AG, Singapore Branch, Credit Suisse Securities (India) Private Limited (CIN no. U67120MH1996PTC104392) regulated by the Securities and Exchange Board of India (registration Nos. INB230970637; INF230970637; INB010970631; INF010970631), having registered address at 9th Floor, Ceejay House, Dr.A.B. Road, Worli, Mumbai - 18, India, T- +91-22 6777 3777, Credit Suisse Securities (Europe) Limited, Seoul Branch, Credit Suisse AG, Taipei Securities Branch, PT Credit Suisse Securities Indonesia, Credit Suisse Securities (Philippines ) Inc., and elsewhere in the world by the relevant authorised affiliate of the above. Research on Taiwanese securities produced by Credit Suisse AG, Taipei Securities Branch has been prepared by a registered Senior Business Person. Research provided to residents of Malaysia is authorised by the Head of Research for Credit Suisse Securities (Malaysia) Sdn Bhd, to whom they should direct any queries on +603 2723 2020. This report has been prepared and issued for distribution in Singapore to institutional investors, accredited investors and expert investors (each as defined under the Financial Advisers Regulations) only, and is also distributed by Credit Suisse AG, Singapore branch to overseas investors (as defined under the Financial Advisers Regulations). By virtue of your status as an institutional investor, accredited investor, expert investor or overseas investor, Credit Suisse AG, Singapore branch is exempted from complying with certain compliance requirements under the Financial Advisers Act, Chapter 110 of Singapore (the "FAA"), the Financial Advisers Regulations and the relevant Notices and Guidelines issued thereunder, in respect of any financial advisory service which Credit Suisse AG, Singapore branch may provide to you. This information is being distributed by Credit Suisse AG, Dubai Branch, duly licensed and regulated by the Dubai Financial Services Authority (DFSA), and is directed at Professional Clients or Market Counterparties only, as defined by the DFSA. The financial products or financial services to which the information relates will only be made available to a client who meets the regulatory criteria to be a Professional Client or Market Counterparty only, as defined by the DFSA, and is not intended for any other person. This research may not conform to Canadian disclosure requirements. In jurisdictions where CS is not already registered or licensed to trade in securities, transactions will only be effected in accordance with applicable securities legislation, which will vary from jurisdiction to jurisdiction and may require that the trade be made in accordance with applicable exemptions from registration or licensing requirements. Non-U.S. customers wishing to effect a transaction should contact a CS entity in their local jurisdiction unless governing law permits otherwise. U.S. customers wishing to effect a transaction should do so only by contacting a representative at Credit Suisse Securities (USA) LLC in the U.S. Please note that this research was originally prepared and issued by CS for distribution to their market professional and institutional investor customers. Recipients who are not market professional or institutional investor customers of CS should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents. This research may relate to investments or services of a person outside of the UK or to other matters which are not authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority or in respect of which the protections of the Prudential Regulation Authority and Financial Conduct Authority for private customers and/or the UK compensation scheme may not be available, and further details as to where this may be the case are available upon request in respect of this report. CS may provide various services to US municipal entities or obligated persons ("municipalities"), including suggesting individual transactions or trades and entering into such transactions. Any services CS provides to municipalities are not viewed as "advice" within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. CS is providing any such services and related information solely on an arm's length basis and not as an advisor or fiduciary to the municipality. In connection with the provision of the any such services, there is no agreement, direct or indirect, between any municipality (including the officials, management, employees or agents thereof) and CS for CS to provide advice to the municipality. Municipalities should consult with their financial, accounting and legal advisors regarding any such services provided by CS. In addition, CS is not acting for direct or indirect compensation to solicit the municipality on behalf of an unaffiliated broker, dealer, municipal securities dealer, municipal advisor, or investment adviser for the purpose of obtaining or retaining an engagement by the municipality for or in connection with Municipal Financial Products, the issuance of municipal securities, or of an investment adviser to provide investment advisory services to or on behalf of the municipality. If this report is being distributed by a financial institution other than Credit Suisse AG, or its affiliates, that financial institution is solely responsible for distribution. Clients of that institution should contact that institution to effect a transaction in the securities mentioned in this report or require further information. This report does not constitute investment advice by Credit Suisse to the clients of the distributing financial institution, and neither Credit Suisse AG, its affiliates, and their respective officers, directors and employees accept any liability whatsoever for any direct or consequential loss arising from their use of this report or its content. Principal is not guaranteed. Commission is the commission rate or the amount agreed with a customer when setting up an account or at any time after that. Copyright © 2015 CREDIT SUISSE AG and/or its affiliates. All rights reserved. Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments. When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from CS as a seller, you will be requested to pay the purchase price only.

India Market Strategy IA0184.doc39