Recent macro events raise risk to earnings recovery in 2HFY19
INR weakness driving earnings of IT, Global Cyclicals; Domestic businesses face growth headwinds
* 2018 is turning out to be a year of sharp volatility and across-the-board correction in Indian equities – Nifty-50 is down by 12%, Nifty mid-cap index by 26% and Nifty small-cap index by 40% from their yearly highs. While FIIs have been net sellers of USD3.6b in CY18YTD, DIIs have remained on buying spree with net flows of USD13.4b in CY18YTD after an inflow of USD14b in CY17. We, however, note that DII flows have moderated in recent months.
* Rising crude prices and sharp INR depreciation (-16% in CY18YTD – the worst since 2011) have impacted investor sentiment of late. Recently, the fear of tight liquidity and higher interest rates is adversely impacting several domesticoriented sectors, which were the key to FY19 earnings recovery. NBFCs, in particular, will see downgrades after many years of strong growth, in our view.
* The 2QFY19 earnings-report season is likely to mirror the trend of the previous quarter, albeit with a reduced impact of a favorable base. Global Cyclicals like Metals and Oil & Gas will continue leading from the front and contribute three fourths of incremental profits for the MOSL Universe.
* Rural Consumption recovery is expected to continue, with Consumer Staples (FMCG) likely to post fifth straight quarter of double-digit profit growth. NBFCs should report strong growth in 2QFY19, as most headwinds emerged only toward the quarter-end – the impact will be evident in 2HFY19 estimates (NBFCs now form 6% of MOSL Universe profit pool v/s 1.6% in FY08). IT appears set for multi-quarter-high profit growth, driven by a strong operational performance and currency tailwinds. We estimate PAT CAGR (FY18-20) of 13% for our IT Universe (v/s 5% over FY15-18). Although Corporate Lenders are likely to report another quarter of subdued earnings, the operational trends are improving.
* We expect MOSL Universe PAT to grow 9% YoY. Global Cyclicals are likely to drive performance for the second straight quarter (with 23% YoY profit growth) and account for 81% of incremental profits. Defensives are expected to post muted profit growth of 7%, aided by IT/Consumer but dragged by Healthcare. Profit growth for MOSL Universe excluding PSU Banks and Private Corporate Lenders is estimated at 13%. Auto, Telecom, PSU Banks, Healthcare and Cement are expected to report muted numbers.
* We expect Nifty sales, EBITDA and PAT to increase by 24%, 12% and 12% on a base of 12%, 17% and 15% growth, respectively.
* Our Nifty EPS estimates for FY19/20 have been cut by 1.5%/2% to INR539/INR674. We are building in Nifty EPS growth of 18%/25% for FY19/20. Recent headwinds pose a significant risk to the 2HFY19 estimates.
Top ideas in this correction
* LARGE-CAPS: HDFC, ICICI BANK, AXIS BANK, MARUTI, HINDALCO, ASHOK LEYLAND, TECH MAHINDRA, L&T, TITAN, BRITANNIA
* MID-CAPS: RBL, SHTF, MINDTREE, EXIDE, TEAMLEASE
Key sectoral trends/highlights
* Auto Universe is expected to report a 28% YoY PAT decline on a strong base (25% YoY growth in base quarter). Timing difference in the festive season is expected to have influenced volume growth momentum in 2QFY19. Excluding Tata Motors, the Auto Universe is expected to post flattish 2% PAT decline – the highest in nine quarters. We expect EBITDA margin to shrink 220bp YoY to 11.9%, impacted by high commodity costs, a weak INR, and heightened competitive intensity in 2Ws.
* Technology is expected to report its second consecutive double-digit PAT growth (18.4%), with Wipro (1.5% PAT growth) expected to post the most tepid numbers. The usual second-quarter seasonal strength, coupled with the benefits from a favorable currency, is likely to drive a continued recovery for the technology sector. Revenue for Tier-I vendors is likely to increase by 9.4% YoY in constant currency terms (compared to 7.8% in 1QFY19 and 6.8% in 2QFY18), taking further strides toward entering a double-digit growth trajectory.
* Private Banks are expected to report flat PAT growth (-0.1% YoY), dragged by ICICI Bank (-76% YoY). Excluding ICICI Bank, Private Banks’ profit growth is expected to come in at 19.4%.
* NBFCs are expected to continue their strong run and post another quarter of strong and broad-based growth (30% YoY). All NBFCs, barring Shriram City Union and Repco Home Finance, are expected to post double-digit growth.
* PSU Banks are expected to report profit of INR3b (base quarter 2QFY18 reported profit of INR29b), with BOB being the only bank amongst our Universe that is expected to post PAT growth of 2.4%. PNB is expected to post a loss of INR10b in 2QFY19.
* Consumer Universe is expected to deliver 15% YoY growth in profits – the fifth consecutive quarter of double-digit PAT growth. The entire Consumer Universe is expected to report a strong set of numbers, barring Future Consumer (expected to post a loss), Emami and P&G Hygiene (both expected to post PAT de-growth). United Spirits, Page and Jyothi Labs are expected to report 30%+ profit growth, while HUL and ITC are estimated to post 22% and 13% growth.
* Metals Universe is likely to post another quarter of strong performance, with EBITDA and PAT growth of 27% and 41% YoY, respectively. Tata Steel (148%), JSW Steel (121%) and Nalco (152%) are expected to post strong earnings growth, while JSPL is expected to report a loss. Earnings growth is expected to moderate further in FY19 due to a strong base (triple-digit growth).
* Oil & Gas is expected to report 17% YoY PAT growth off a strong base (Sep-17 quarter posted PAT growth of 22%), driven by ONGC. Within our MOSL Universe, RIL and ONGC account for 80% of the Oil & Gas (Ex OMCs) profit pool.
* Utilities Universe is expected to report 53% PAT growth, led by a strong performance from Coal India (10.8x PAT from Sep-18). Coal India alone will contribute roughly 95% of the PAT delta of Utilities Universe. Utilities ex Coal India are expected to post 3% PAT growth in 2QFY19.
* Telecom Universe is expected to report a loss. Vodafone Idea’s loss is expected to remain elevated.
* The correction in broader markets began in early-CY18, even though the Nifty hit an all-time high in August 2018. The Nifty has corrected 12% from its recent highs, and mid-and small-cap indices have corrected between 26-40%. This has moderated valuations for many high-quality businesses, presenting an opportunity to add names with strong earnings visibility at more reasonable valuations. Despite the correction, the Nifty trades at 19x FY19 EPS, off from the recent highs but still at a premium to its long-period averages. Rising bond yields continue posing challenges for equity valuations as bond-earnings yield spreads stay elevated at 2.8%. Against this backdrop, our model portfolio continues reflecting our bias for earnings visibility and growth. Overall, we continue favoring Private Financials, Consumer Discretionary, FMCG, IT and select quality Mid-caps.
* BFSI: We are replacing Yes Bank with Axis Bank, given the prevailing uncertainty in the former around management change. In Axis, the recent appointment of Mr Amitabh Chaudhry as MD & CEO has provided much-needed clarity on top management. We expect balance sheet clean-up to complete soon and earnings recovery to pick up by end-FY19. AXSB has already increased the PCR to 69% (NCLT-1 provisions of 83%), while net stressed assets have declined to 6.7%. AXSB guided for normalization in credit cost in 2HFY19. Within NBFCs, we are raising weights on HDFC after the recent correction. It is best placed in the NBFC space to navigate the rising interest rates environment (best-in-class liability structure, with 30% funding from public deposits) and now trades at reasonable valuations adjusted for subsidiaries with 16-17% RoE. We are adding Kotak Bank (KMB) in our model portfolio, as growth commentary remains strong with management guiding for 20%+ growth across key business verticals. We expect KMB to report 21% loan growth over FY18-20. With prudential provisioning made by the bank in 1QFY19, PCR has improved to ~60%. Subsidiaries have been performing well (contributing ~35% of total PAT). Promoter ownership remains a near-term overhang, though. However, the ~25% correction in the stock price makes KMB attractive from a medium- to long-term perspective.
* Consumer: We are replacing Emami and UNSP with HUL in our model portfolio. While Emami continues witnessing moderation in demand trends and rising RM headwinds, UNSP is impacted by rising raw material pressure and elevated competitive intensity in IMFL in an environment of meagre price hikes. On the other hand, HUVR offers a relatively more robust rural story and its guidance of modest margin expansion and continued premiumization provides relatively good earnings visibility.
* Autos: We are replacing Bajaj Auto with Ashok Leyland in our model portfolio. Domestic 2W industry volumes and profitability are facing headwinds from an increase in cost of ownership (led by safety regulations, new insurance norms, etc.) and intensifying competition. BJAUT's profitability would remain under pressure due to a weak mix and limited benefit of the INR in the near term due to hedges. Ashok Leyland's volumes remain strong with ~35% growth in 1HFY19, despite the noise around higher rated load. After gaining market share profitably over FY15-18, Ashok Leyland is now shifting its focus toward expanding and creating new revenue/profit pools. This should likely drive revenue/EBITDA/PAT CAGR of 12%/15%/16% over FY18-22.
* Information Technology: We have raised the weight for Infosys marginally, added Tech Mahindra and replaced Persistent with Mindtree. With deals bagged over the past few quarters, revenues from the Telecom vertical appear set for revival in Tech Mahindra. Softness in Enterprise expected in 2QFY19 is transient and that too should recover from 3QFY19. Also, the benefits from currency seem to be flowing down to TECHM’s profitability, driving expectation of 290bp EBITDA margin expansion over FY18-20 (to 18.2%). The stock remains undervalued relative to peers, providing an opportunity for earnings upgrade and re-rating. Performance for PSYS has been clouded by near-term issues, while growth has been accelerating for the rest of the pack. The recent turnaround of MTCL and also momentum visibility (driven by acceleration in top clients) make its growth highest in our coverage universe. Turnaround of its acquisitions and benefits of INR depreciation would favor margins, driving highdouble-digit earnings growth.
* Capital Goods: We have raised the weight of L&T further given the attractive valuations, improved capital allocation and good visibility on orders. Energy: HPCL moves out of the portfolio after our recent downgrade.
* Mid-caps: In mid-caps, the significant correction has given us an opportunity to add some new ideas at relatively more reasonable valuations. We are adding Mindtree, Crompton Consumer and TeamLease in our model portfolio. Rising share of premium fans (~20% in total fan sales vs 7% two years back) will drive market share gains for Crompton Consumer along with margin expansion. It trades at a 20% discount to Havells, despite RoE being 2x of Havells. TeamLease has seen a gradual recovery in volume growth, which should continue through the rest of the year, resulting in maintenance of ~25% revenue growth historical trend. After the recent correction, long-term opportunities and high growth offer a good entry opportunity.
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