A profitable Q1FY11 masks Aditya Birla Nuvo Ltd?s (ABNL) concerns with two of its biggest value contributors (Idea Cellular & life insurance) being dogged by competition and regulatory pressures, respectively. Erstwhile loss-makers like BPO have turned a corner and the stable manufacturing businesses continue to hold up well, but with little overall valuation significance. We expect the holding company discount to widen to 30% and downgrade to Add from Buy, while our new TP (target price) indicates 14% upside on a 12-month basis.

We believe that Irda?s recent restrictions on policy pricing (including cap on surrender charges), once enforced, will lead to significant erosion of margins, leading to cuts in the distribution apparatus which, in turn, will impact growth. Accordingly, we assume new business to decline 10% in FY11 and then be flat in FY12, while FY12 margins are assumed at 10% (from 19% earlier). The resultant cut in insurance valuation is 48.8% at Rs 70.1 bn, now comprising 30.7% of ABNL SOTP (sum-of-the-parts) valuation .

The new norms would lead to under-recovery of expenses on such policies and hence, would drag NBM (new business margins). BSLI (Birla Sun Life Insurance) reported 5% growth in Q1FY11 vis-?-vis 15.6% growth for all private insurers, as it rejigged its product portfolio comprising heavily of Ulips. The company has fallen significantly behind other private-sector life insurers in the first two quarters of FY10. The management said the slowdown was due to realignment of the product portfolio in keeping with the new Irda directive on distributors? commissions.

While the changes introduced by Irda will improve the operating efficiency of insurers, they are likely to have an adverse impact on the margins.

Idea ? strong traffic growth, but margins disappoint: Idea reported a stronger-than-expected traffic growth of 12.5% QoQ (quarter-on-quarter) (adjusting for spice consolidation) while Ebitda (earnings before interest, taxes, depreciation and amortisation) fell due to higher spectrum charge provisioning in the current quarter and write-backs in the previous quarter. Importantly, Rs 404m of interest cost attributable to 3G auction payout has been capitalised, leading to a higher Ebit (earnings before interest and taxes) . Network opex spiked in the quarter to 31.5% of revenues due to higher traffic growth. PAT (profit after tax) was boosted by a lower effective tax rate in the quarter (2.3%) and lower depreciation expenses.

The general belief that high payouts in the 3G and BWA auctions would preclude the possibility of price cuts neither accommodates the possibility of recapitalisation, as seems to be happening with RCom (and to some extent, with Tata), nor the correspondingly increased desperation of other pure 2G players to stay competitive. Uninor?s results suggest significant marketing spend (30% of what Bharti spends), suggesting that no one is yet throwing in the towel. Trai?s 2G recommendations, when implemented, will be negative for incumbents, and given Idea?s sub-10% net margin, pose a threat to earnings.

BPO turnaround picking up steam: The previously loss-making BPO business has turned a corner in FY10, and the Ebit margin in Q1FY11 shows a marked jump both YoY (year-on-year) and QoQ. With business again moving to the expansion mode (seats being added), it needs to be seen if profitability gains can be sustained.

Q1FY11 health: The insulator business registered a strong Q1FY11 in terms of both revenue growth (46% volume growth YoY) and profitability in line with our expectation that it would be the growth leader among ABNL?s manufacturing businesses. As a beneficiary of the large planned investments in the power T&D sector in India, the company is well-placed to maintain high growth in this business.

In the absence of a near-term trigger to value unlocking, the holding company discount applicable will be around 30% (10% more than earlier). Our new 12-month target price is Rs 883 against the Rs 1,239 earlier.