Modi's decisive victory to catalyse investment cycle, accelerate reform

With the Bharatiya Janata Party alone winning 303 seats, and the BJP-led National Democratic Alliance (NDA) winning 353 seats (out of 542 seats in the Lower House) with an unprecedented 50% share of the votes cast, the Indian electorate’s messaging was unambiguous:

• This is only the second time an incumbent Indian government has been re-elected with an even larger majority — with BJP/NDA exceeding the 2014 tally of 282/336 seats;

• Sixty-seven per cent voter-turnout (603 million people actually voted) and the highest recorded participation of women mark the election as a vote for continuity, stability, security, further reforms, investments and job creation; and

• This was a vote for Modi, explicitly rewarding him for his unrelenting anti-corruption agenda, and the commitment to continued reforms — despite the significant near-term pain wrought by the messy implementation of both GST and demonetisation.

Having criss-crossed the country over the past three months, we did want to take a moment to reflect on the general election:

• The electorate voted decisively for stability and continuity at the centre and deserves an awful lot of credit for the sophistication shown in distinguishing between their vote for the BJP in the general election, and the checks and balances they achieved by voting for the Opposition in the state elections held in December in Karnataka, Madhya Pradesh, Rajasthan and Chattisgarh;

• Historically, BJP depended on India’s populous Hindi-speaking states in the north for its support base. Since Modi came to power five years ago, BJP has forged, in Modi’s image, a true national identity touting national security, an anti-corruption crusade, reforms, development and job creation, affirmed by the electoral gains in the Southern states, the Northeastern states, West Bengal, Maharashtra and Gujarat; and

• The parallels with Ronald Reagan and Margaret Thatcher are striking: Once the pariah, Modi is now “larger” than his party, thanks to his personal charisma, an aura of personal incorruptibility, an unmatched ability to communicate a heady “cocktail of development, targeted welfare schemes and nationalism” and, crucially, the complete absence of a credible alternative as the Opposition self-imploded amid petty regionalism, egos and arcane caste arithmetic.

New cabinet focuses on reform and development

Partly by default, and partly by design, Modi’s new cabinet reflects not just his call for continuous change and reform but a commitment to deliver on explicit development goals.

• The “inner circle” of Amit Shah (Home Minister), Rajnath Singh (Defence Minister), Nirmala Sitharaman (Finance Minister) and Subrahmanyam Jaishankar (Foreign Minister) does engender confidence, given their track record of being extremely capable, driven technocrats; and

• Even more encouraging is the continuity provided by universally well-regarded “performing ministers” continuing in their earlier ministries — Nitin Gadkari in Roads and Highways, Piyush Goyal in Railways (and, incrementally, Commerce and Industry), Dharmendra Pradhan in Petroleum and Natural Gas (and, incrementally, Steel), Ravi Shankar Prasad in Law and Justice, R K Singh in Power, Sadananda Gowda in Chemicals and Fertilisers and Hardeep Singh Puri in Housing and Urban Affairs.

The bottom line is, we went into the general election virtually fully invested: As we have frequently articulated over the last several months, our expectation was for a Modi victory, and we are genuinely pleased that the Modi mandate has so handily exceeded our expectations.

• We expect that Modi’s new mandate will: (1) accelerate his reform and development agenda, (2) catalyse a new investment cycle, and (3) deliver on sustained, inclusive growth and job creation. Modi’s focus priorities (investments, job creation, infrastructure, industrialisation and farm distress) and his new cabinet do inspire confidence in the ability to deliver on explicit development goals in a growth-challenged world, sustaining a tailwind for Indian equities; and

• Our significant convictions remain in financial services, consumer discretionary and real estate, while remaining significantly underexposed to the sectors most vulnerable to a global slowdown — IT services, energy and generic pharmaceuticals.

The key risks we continue to assess:

• Messy geopolitics, protracted trade conflicts and custom-union breakdowns negatively impacting global growth and risk appetite. Please note: With the US accounting for just about 15% of India’s total exports (pharma, agri-goods, plastic, leather, textile, marine products, gems and jewellery), we are not particularly concerned by US President Donald Trump’s recent rhetoric on terminating the preferential trade access extended to India; and

• Higher energy prices potentially weighing on the rupee, on the government’s ability to deliver counter-cyclical fiscal stimulus to catalyse a new capex cycle and on the Reserve Bank of India’s (RBI) instinct to further ease monetary policy.

The stock we would like to highlight this month is Chalet Hotels, the hospitality arm of the K Raheja Group, operating in the business and luxury hotel segments in the high-traffic/high-entry-barrier markets of Mumbai, Bangalore and Hyderabad. Given the demand/supply dynamics in Chalet’s micro-markets, we have strong conviction projecting rising occupancy levels and improving average room rates as India’s hotel industry inflects off a 10-year recession brought upon by overbuilding, excessive leverage, falling occupancy levels and falling room rates.

Chalet Hotels’ earnings growth to outperform market

We expect Chalet Hotels to deliver on organic revenues compounding at 15%+ annually over the next three years, versus the market projecting a more modest 12% CAGR.

• The Marriott and Hyatt brands and loyalty programmes (50% of current inventory is booked by international business and leisure tourists), and strategic locations in the growth markets of Mumbai, Bangalore and Hyderabad, are key to our assumptions on higher occupancy levels improving room rate realisations;

• Over the next two years, we expect the commercial launch of three new hotels (a Westin-branded property in Hyderabad, and a W as well as a Hyatt-branded property in Mumbai), and two new commercial developments in Mumbai and Bangalore; and

• We are currently not modelling any inorganic expansion. However, given the balance sheet strength, and the new intent and resolve behind India’s new bankruptcy code, we do expect several potential distressed acquisition opportunities in key new markets/locations.

We expect earnings compounding at 65% annually over the next three years, versus the market’s more modest expectations of a 20% compound annual growth rate (CAGR).

• On the back of scale (occupancy levels improving by 100bps annually) and improving mix (a combination of higher average room rates, the upselling of rebranded properties and higher F&B sales), we expect earnings before interest, taxes, depreciation and amortisation margins to expand by more than 800bps over the next three years to 45%; and

• Continued deleveraging of the balance sheet and, hence, significant interest cost savings.

Conclusion

We expect Modi’s decisive new mandate to accelerate a strong reform/development agenda to deliver on sustained, inclusive growth and job creation. In a growth-challenged world (underscored by recent price action in gold and US Treasuries), India’s structural reforms and domestic economy stand poised to deliver on sustained real GDP growth compounding at more than 7% annually over the next three to five years.

On the ground, we continue to renew our conviction in India’s idiosyncratic growth opportunity translating into sustained rural consumption, a nascent capex cycle, infrastructure development, industrialisation, urbanisation and the digitalisation of the real economy. We expect our portfolio companies to deliver on earnings and cash flows compounding at more than 15% annually over the next three years.

Valuations and the risk/reward are compelling (and especially in the small- and mid-cap space) given our expectations of sustained revenue and earnings growth, the likelihood of further easing by the RBI and improving systemic liquidity.

The Tantallon India Fund is a fundamental, long-biased, India-focused, total return opportunity fund registered in the Cayman Islands and Mauritius. The Fund invests with a three- to five-year horizon, in a concentrated portfolio (25 to 30 unlevered positions), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models, and in management’s ability to execute. Tantallon Capital Advisors, an advisory company, is a Singapore-based entity, set up in 2003, holding a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore