Motilal Oswal: 2012

INDIA STRATEGY: Cradle of pessimism

Posted by Motilal Oswal | Posted on Wednesday, April 11, 2012

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Second successive quarter of sub-2% PAT growth

- MARKET: Indian equities end FY12 with a modest decline of 10%

- 4QFY12 PREVIEW: Another disappointing quarter; PAT up 6% YoY (1.6% ex SBI)

- FY14 ESTIMATES: Expect earnings CAGR of 14% over FY12-14

- ECONOMY: Growth should be the focus of RBI/government

- TOP PICKS: ICICI Bank / SBI, Maruti / Tata Motors, Wipro / Infosys, Coal India, UltraTech / JP, Lupin

MARKET: Indian equities end FY12 with a modest decline of 10%

The BSE Sensex declined 10% in FY12 and closed at 17,404. The decline would have been higher but for a 13% rally in 4QFY12. During FY12, all emerging markets, led by BRIC nations, faced headwinds on growth and inflation, leading to severe underperformance. India in particular faced additional headwinds of policy inaction. Considering the economic-political-corporate-global headwinds of FY12, a decline limited to 10% appears quite reasonable. As at the end of FY12, Indian markets traded at a P/E multiple of 13.8x, the global average. The P/B multiple, however, remains among the highest in the world, considering the strong RoE of 18%.

In line with the weak sentiment, FII flows plunged from USD25b in FY11 to USD8.5b in FY12, that too after huge inflows of over USD9b in 4QFY12 itself. Domestic mutual funds were net sellers for the third year in a row and insurance companies were net sellers for the first time in several years. While we expect domestic inflows to improve in FY13, the volatility in FII flows would remain the key catalyst for the trend in Indian equities.

4QFY12 PREVIEW: Another disappointing quarter; PAT up 6% YoY (1.6% ex SBI)

We expect MOSL Universe (ex RMs, oil refining and marketing companies) to report PAT growth of 6% YoY in 4QFY12. Here, 4.5 percentage points of growth would be single-handedly led by State Bank of India (SBI); ex-SBI, aggregate PAT growth would be just 1.6%. This would make 4QFY12 the second successive quarter of sub-2% PAT growth and the quarter of lowest PAT growth excluding the global crisis period.

The results would reflect the macroeconomic backdrop of persistent high inflation, high interest rates, and weak currency. Thus, as in the recent few quarters, aggregate revenue growth would be fairly robust at 19%. However, EBITDA margins are likely to be down over 200bp YoY; EBITDA growth would halve YoY to 9%. Further, high interest cost and forex-related losses would drag down PAT growth to 6% YoY.

- 63 out of 137 companies ex RMs (i.e. 46%) are likely to report PAT de-growth YoY. This is the highest ever in any quarter including the quarters of peak global crisis (3Q and 4QFY09). At the same time, the number of companies with expected PAT growth of over 30% is one of the lowest ever at 26 (19% of Universe).

- The top-5 PAT growth sectors are: Financials (36% YoY, led by SBI; ex-SBI: 10% YoY), Autos (32%), Consumer (17%), Technology (15%) and Healthcare (13%). The top-5 PAT de-growth sectors are: Infrastructure (-50% YoY), Media (-26%), Metals (-18%), Telecom (-18%), and Real Estate (-13%).

- Sensex PAT growth would be respectable at 15% YoY. But here too, the SBI factor comes into play; ex-SBI, PAT growth would be just 7% YoY. We expect Sensex sales growth of 21% YoY, EBITDA growth of 11% YoY, and PAT growth of 15% YoY.

FY14 ESTIMATES: Expect earnings CAGR of 14% over FY12-14

We estimate aggregate PAT growth at 14% for FY14, largely in line with 16% in FY13 and significantly above 6% in FY12. Likewise, based on a bottom-up PAT aggregation of Sensex constituents, we arrive at Sensex EPS of INR1,431 for FY14, up 14% (after 14% growth in FY13 and 7% growth in FY12). This is also in line with the 10-year/20-year Sensex earnings CAGR of 15%. Thus, post a moderation in FY12, growth rates in FY13 and FY14 would move towards the long-term average. The key reasons for this sustained growth momentum are 15%+ earnings growth in sectors like Financials, Consumer, Healthcare, Technology and Telecom (these sectors contribute 46% to MOSL Universe).

Earnings growth in FY13/FY14 would be fairly diversified, with key sectors like Financials, Oil & Gas, Autos and Technology contributing 67% / 76% of the earnings growth. The earnings contribution of these sectors to Sensex earnings stands at 70%; earnings growth would be in line with earnings contribution. This is unlike FY12, during which there were sharp swings across sectors, with Financials contributing 48% of earnings growth, while Metals and Telecom witnessed de-growth of 21% and 6%, respectively. We believe the expected diversity in FY13/FY14 earnings growth would provide stability.

Economy: Growth should be the focus of RBI/government

FY12 turned out to be a year of reckoning for most countries. India witnessed rapid slowdown in growth, coupled with near double-digit inflation. Accordingly, we also had to tone down many of our optimistic assumptions. With the uncertainties persisting, we now focus more closely on the coming quarter (1QFY13), while annual projections would remain a critical input for our forward-looking assessment.

- We estimate inflation at 6.5% for March 2012 and at 6.2% for 1QFY13. These estimates have seen some upward revision in the last couple of months, led by global crude prices, budget proposals, electricity tariff hikes and pending fuel price hikes. These factors have also led us to revise our average inflation estimate to 6.8% for FY13 from 5.6% earlier. We believe inflation would remain within the 6.5% level for a major part of FY13 and will inch above 7% only after December 2012. This presents a reasonable 8-month window of opportunity for the RBI to first ease rates and then pause, as inflation begins rising once again in December 2012. We expect the RBI to cut rates by 100bp in CY12.

- The liquidity deficit persisted through FY12, but became aggravated during 2HFY12. The government/RBI has also scheduled a larger part (65% of gross and 59% of net) of borrowing for 1HFY13. Some softening of the liquidity situation is likely in April-May 2012, but should firm up once again due to large net borrowings, slowing money supply growth and stress from the external situation. To tide over the liquidity problem, we expect the RBI to undertake open market operations (OMOs) totaling INR1.8t during FY13.

- The latest BoP data indicates significant stress on the external situation. While merchandise trade volume has declined in 3QFY12, invisibles have been failing to grow for some time. Trade and current account gaps are reaching their record levels at 10% and 4%, respectively. The scenario is unlikely to improve much in FY13 due to multiple headwinds, including weakness in the western economies, high oil prices, etc. Additionally, the INR is vulnerable to inflation. Considering these factors, the exchange rate should hover at INR50-52/USD barring unexpected developments in balance of payments (BoP) or inflation.

- Policy flip-flops in many key areas of reform coupled with the coming together of various macroeconomic risks have heightened uncertainties prevailing in the market. While many factors such as coalition politics, political bickering, strained relationship between the government and the judiciary and general lack of governance has been held responsible for this, the combined impact of these events has taken a toll on the investment cycle and attractiveness of India as a destination for foreign capital. We believe meaningful progress in some of these areas is necessary to restore investors’ confidence.

STRATEGY: Top picks – ICICI Bank / SBI, Maruti / Tata Motors, Wipro / Infosys, Coal India, UltraTech / JP, Lupin

Indian markets staged a good recovery in 4QFY12, which limited the decline in FY12 to 10%. There were significant headwinds (global, political, economic and monetary) during the year, which had impacted performance. Our earnings estimates witnessed a period of downgrades during 9MFY12. The two most keenly awaited events of 4QFY12 – the UP elections and the Union Budget also failed to cheer the markets.

Post this dismal performance, Indian market valuations have slipped below historical averages (rolling 12-month forward P/E of 13.8x v/s 10-year average of 14.6x). We believe that a bulk of the earnings downgrades (16% downgrade in FY13 earnings) and the entire rate tightening (13 rate hikes aggregating 375bp) is now behind. However, there is poor visibility of implementation of key reforms. While the monetary cycle has begun to ease (CRR cut by 125bp; rate cuts to follow), any meaningful re-rating of the Indian markets will be preceded either by confidence in the implementation of key reforms or significant correction in global crude prices. We see limited downside in the markets from here, but upsides would be a function of clarity on either of these catalysts. Our model portfolio has sectoral weights similar to the benchmarks, as there is some discomfort on either fundamentals or valuations of most sectors. There is significant divergence in stock weights within the sectors. Our top picks are ICICI Bank / SBI, Maruti / Tata Motors, Wipro / Infosys, Coal India, UltraTech / JP, and Lupin.

Get on track please!

Posted by Motilal Oswal | Posted on Thursday, January 12, 2012

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Assessing key trends in 2012

2011 has turned out to be at best a forgettable year for the Indian equity markets. India has been the worst performing markets globally with 25% negative returns; Given the sharp currency depreciation, performance in USD terms has been even worse at -37%, making India by-far the worst performing global market. Also, the Sensex returns in each quarter of 2011 have been negative, indicating a gradual build-up of the headwinds.

Besides the global headwinds, everything that could have gone wrong domestically has gone wrong. Policy paralysis, stubbornly high inflation, high interest rate scenario and ending the year with an unfavorable currency movement. All these had an impact in GDP growth, fiscal deficit and corporate profitability. While some of the domestic issues are cyclical (like interest rates, currency, etc) and will get corrected over a period of time; several of them are more structural like lack of reforms, fuel linkages and subsidy issues. And finally, the biggest issue at this point: When will the Policy engine start cranking?

Trend #1: GDP growth hard lands; finds its base at 6-7%

After six consecutive quarters of slowdown, India is staring at sub-7% growth for FY12 (8.6% in FY11), which could dip further to 6-6.5% levels in FY13. During the course of the year the several downgrades of high magnitude were effected giving it a semblance of ‘hard landing’. So far the agriculture and services have continued to perform with service sector displaying only moderate slowdown. Of much bigger concern, is the industrial downturn that crashed to -5.1% in Oct-11 from 7.5% in Jan-11.

In the last 15 years service sector has fallen below 8% only in four occasions. Given the strong resilience of the service sector, it is fair to assume 8-9% service sector growth going forward. In view of the continued weakness in the industrial sector we have cut our FY12 growth estimate to 6.8% from 7.2% estimated earlier. However, if industrial slowdown further aggravates affecting the service sector as well, it may take GDP growth closer to 6.5% level or even to 6% in the worst case. We think large part of FY13 would be spent in spillover effects of downturn in FY12. However, we expect things to improve in 2HFY13. Industrial growth may perform a notch higher on lower base while service sector might be affected over longer period of industrial downturn.

Trend #2: Monetary policy - from tight to loose

The biggest positive surprise may emanate from rapid decline in inflation in 4QFY12. Inflation is expected to come down within 7% by end-March 2012. However, because of an interplay of several factors including i) rather sharp decline in food prices, ii) expectation of oil price moderation, iii) international commodity prices remaining under pressure and iv) the base effect, inflation is expected to remain range-bound within 4.5-5.5% for large part of FY12. Thus there is every chance that inflation might surprise on the positive.

This gives enormous policy space to RBI to effect rate cuts in the backdrop of rapid slowdown of growth. Surely the growth inflation mix is changing in favor of growth and RBI may effect larger rate cuts than expected at present. We hold that the rate cut cycle would begin as early as Jan-12 now. We also expect RBI to continue with its series of open market operations (OMOs) aggregating INR860b for FY12, especially in the backdrop of currency intervention draining out liquidity. However, depending upon the prevailing liquidity situation a CRR cut may be effected too coinciding with rate cuts. In aggregate we expect RBI to ease rates at least by 150bp in FY13.

Trend #3: Fiscal policy - from loose to tight

In FY12 government the fiscal situation has slipped considerably and expected to clock a full 1% higher at 5.6% vs. 4.6% placed in the Union Budget FY12. Hence, market borrowing targets have already been announced to exceed by a steep INR930b, also reflecting unavailability of some alternate source of borrowing i.e. implying a reversal on the path of fiscal rectitude.

Any meaningful fiscal correction would remain a challenge in FY13 as well. Revenues would be affected by growth slowdown. With deferment of major tax reforms no major improvement in revenue buoyancy is expected in the near term either. On the other hand an expanding welfare net on account of possible implementation of the food securities bill would weigh on the expenditure. Thus there is no headroom left on fiscal front to come up with a counter-cyclical policy response. Given the sensitivity of sovereign debt crisis and its implications for financial market as also from reprioritization of domestic demand, a fiscal course correction seems imperative. However, a significant part of it may come from cutback on planned expenditure. Given that a FY12 fiscal slippage was partly on account of unanticipated growth slowdown, the FY13 budget calculations are expected to be conducted on more realistic assumption. While fiscal consolidation would still be a challenge, we expect government to announce a fiscal deficit ~5.0% of GDP in the Union Budget for FY13.

FY12 earnings muted; mild recovery in FY13; earnings downgrade risks persist given high uncertainty For full year FY12, we expect MOSL Universe (ex RMs) to report aggregate sales growth of 10% YoY and PAT growth of 9% YoY. In YTDFY12 (i.e. trailing three quarters), aggregate sales growth of 22% and PAT growth of 10% has already been achieved. Thus, the residual growth required in 4QFY12 is ~9%, which we believe, is achievable.

Likewise, YTDFY12, Sensex companies clocked sales growth of 23%, EBITDA growth of 13% and PAT growth of 12%. Residual 4Q PAT growth required is ~15%, which is expected to be led by SBI given its washout 4QFY11.

We expect FY13 Sensex EPS of 1,266, up a 15% over FY12, despite a 15% downgrade from 1,492 expected a year ago (i.e. in Dec-2010). This is because, over the same time, base FY12 EPS itself has seen an 18% downgrade from 1,263 expected in Dec-2010 to currently expected 1,105. In effect, FY11-13E EPS CAGR for the Sensex has gone down sharply from 19% to 11%. Interestingly, after a growth holiday of FY08-10, FY10-13E EPS CAGR works out to 15%, which is in line with Sensex’s long period EPS CAGR.

3QFY12: Lowest growth in last 23 quarters ex global crisis

We expect MOSL Universe (ex RMs, oil refining and marketing companies) to report PAT growth of 7% YoY in 3QFY12. This would be the lowest PAT growth in the last 23 quarters, excluding four quarters of global crisis (3QFY09-2QFY10), when YoY PAT growth was negative. The results would clearly reflect the macroeconomic backdrop of persistent high inflation, high interest rates, and weak currency.

We expect 51 out of 136 companies ex RMs (i.e. 38%) to report PAT de-growth YoY. This is the highest ever in any quarter excluding the four global crisis quarters. At the same time, the number of companies with expected PAT growth of over 30% is the lowest ever at 24 (18% of Universe).
Aggregate EBITDA margin (ex Financials) would be 14% - 200bp lower than FY05-12 average of quarterly margin, and 150bp lower than FY05-12 average of 3Q margin. Aggregate PAT margin (ex Financials) would be 7.3%, the lowest ever 3Q margin over FY05-12. It would be 220bp lower than the average quarterly margin and 170bp lower than the average 3Q margin.
Only four sectors are likely to see meaningful expansion in margins - Cement (230bp), Telecom (160bp), Technology (6bbp) and Healthcare (60bp). The worst margin hit would be seen in Oil & Gas ex RMs (-530bp), Real Estate (-470bp), Metals (-280bp), Infrastructure (-250bp) and Capital Goods (-250bp).
Top-5 PAT growth sectors would be: Cement (38% YoY), Utilities (29%), Private Banks (20%), Consumer (17%) and Technology (17%). The top-5 PAT de-growth sectors would be: Infrastructure (-64% YoY), Real Estate (-23%), Telecom (-17%), Metals (-13%) and Capital Goods (-8%).
Private Banks is the only sector where all companies are expected to report positive YoY PAT growth. In sharp contrast, Infrastructure is the only sector where all companies are expected to report YoY PAT de-growth.
Sensex PAT is expected to grow 9% YoY. The last 4-quarter average growth in Sensex PAT is 9%. This is the lowest ever 4-quarter average growth ex global crisis quarters.

Investment strategy

Post a dismal performance of 2011, Indian market valuations have slipped to below historical averages (rolling 12-month forward PE of 12.6x v/s 10-year average of 14.6x). We believe that a bulk of the earnings downgrades (15% downgrade in FY13 earnings) and the entire rate tightening (425bps rate hikes) is now behind. However, there is poor visibility of Implementation of key reforms. While the monetary cycle is expected to ease hereon, any meaningful re-rating of the Indian markets will have to be preceded either by confidence in implementation of key reforms or a turnaround in the cycle in earnings downgrades. The outcome of UP state elections and the Budget for 2012-13 will be two very significant events for the markets.