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Holding the Fort!

Earnings growth in FY22 at the highest since FY04; margin headwinds persists

* The Nifty ended FY22 with gains of 19% YoY, marking another year of strong returns. Given the multitude of challenges (lockdowns announced due to the second COVID wave, rate hikes by the US Fed, withdrawal of excess global liquidity, Russia-Ukraine conflict, the relentless rise in commodity prices, disruption in supply chains, and weak rural demand), the fact that the Nifty is down barely 5% from its recent high underscores its resilience. The market never failsto surprise investors. If we had been foretold that: a) Brent Crude oil prices will be trading over USD100/bbl, b) a war will break out, and c) we will see FII outflows of USD18b in the last six months, many participants would have perh aps forecast that the market will be below Oct’21 levels. Yetthe Nifty is down barely 5% from its 52-week high. What has held it together? We believe three factors have driven thisresilience: 1] Strong undertone of corporate earnings(~35% earnings growth in FY22 – the highest since FY04); 2] Growing faith of domestic investors, with consistently higher equity allocation, as reflected in the USD20b of inflows since Oct’21, which more than matched FII outflows; and 3] The government’s clear intent to drive big reforms be it disinvestment (Air India),manufacturing (PLI schemes), or supporting those at the bottom-of-pyramid through targeted welfare schemes.

* Our outlook on corporate earnings and market performance in FY23 is positive. After a 15% growth in Nifty EPS in FY21 – the first double-digit growth in a decade, earnings are expected to grow by 35% in FY22. We are building in 19% growth for FY23, led by BFSI, O&G, and IT. Despite the frightening news emanating from the Russia-Ukraine warfront, US Fed rate hike, tightening liquidity, and supply chain disruptions, the market has remained resilient on the back of very strong corporate earnings, which matters the most to market returns in the long term. We, however, highlight two important concerns. First, if global inflation remains stubborn and central bankers accelerate the pace of rate hikes and tighten liquidity, it could pose a headwind to equity valuations. Second, there are clear pockets of slowdown in domestic rural consumption, which needs to be tackled with urgency. It is important for this piece of the equation to recover for earnings to stabilize in the medium term.

* A domestic economic recovery provides relief, with multiple indicators (like GST collections, power demand, e-invoice)suggesting a good pick-up. Average monthly GST collections rose 35.5% YoY to INR1.24t in FY22. With crude oil prices remaining above USD100/bbl, OMCs have started to pass on the increase to consumers. The ~INR10/liter hike in petrol and diesel prices is likely to raise freight costs for companies as well as impact consumer sentiment. The US Fed raised rates by 25bp at its meeting in Mar’22 and set expectations of further rate hikes at every meeting in CY22. This resulted in the US two-year Treasury yields topping the 10-year rate, leading to a yield inversion.

* The earnings growth trajectory for the MOFSL Universe continues to remain healthy, notwithstanding the challenges on multiple fronts. We expect a 4QFY22 earnings growth of 19% YoY, which is the lowest since 1QFY21, but comes on a high base of 100% growth in 4QFY21. While the aggregate growth is impressive, it is narrow and driven by three sectors: BFSI, O&G, and IT. More than half of the incremental growth is steered by BFSI, led by a modest revival in credit growth and improvement in asset quality trends. Upstream O&G companies are likely to benefit from the spike in crude oil prices in 4QFY22, driving aggregate earnings. The key drivers in 4QFY22 are: a) BFSI: The sectoris likely to report a 51% YoY growth in profit and contribute 55%/43% to incremental MOFSL/Nifty earnings growth; b) O&G: High Brent crude oil prices benefitted Upstream O&G companies, while rising GRM are likely to benefit OMCs, even though retail margins are likely to turn negative; and c) Technology: The strong demand environment continued and islikely to drive earnings. The key sectors, which are likely to drag earnings, are: a) Autos – A sharp increase in fuel and commodity prices are likely to delay a recovery in margin for OEMs, despite some improvement in supply-side constraints(semiconductor shortages); and b) Cement: Higher coal and petcoke prices are likely to lead to a fall in profitability for companies, despite the likely increase in blended realizations by 7% YoY.

* Nifty/MOFSL Universe to register 23%/19% YoY profit growth in 4QFY22E: We expect PBT/PAT to grow by 21%/19% for the MOFSL Universe in 4QFY22. O&G, Financials, and Technology are likely to contribute 88% of incremental earnings in 4QFY22E. Excluding Financials, we expect 4QFY22 earnings for the MOFSL Universe to record a modest 10% YoY growth. Sales for the MOFSL Universe is likely to grow by 32% YoY, led by higher commodity and energy prices. Excluding OMCs and Financials, the MOFSL Universe is likely to see a 150bp YoY decline in operating marginsto 20.6%. Sales/EBITDA/PBT/PAT for Nifty companies should grow by 28%/18%/28%/23% YoY in 4QFY22E. Excluding Financials, we expect profit to grow by 17% YoY for Nifty companies in 4QFY22. We expect a strong 54%/50% two-year earnings (4QFY20-4QFY22) CAGR for MOSL Universe/Nifty.

* Nifty FY22E/FY23E EPS has seen a minor downward tweak of 0.6%/0.8% to INR732/INR870. The cut in our FY23 earnings estimates for Autos (10%)/ Cement (10%)/Consumer (6%) is compensated by an increase in the estimates of Metals (13%) and O&G (7%). HNDL, ONGC, and TATA have recompensed for the entire cut in FY23 earnings for the rest of the Nifty pack. On a full year basis, Nifty FY22 EPS is estimated to grow by 35% YoY on a base of 15% EPS growth in FY21. Metals/O&G/BFSI have contributed 84% of incremental profit growth in Nifty companies in FY22. We estimate a Nifty EPS growth of 19% in FY23.

* While input cost pressures are impacting margins in Consumer, Autos, Cement, Specialty Chemicals, and Consumer Durables, BFSI, IT, Utilities, and Telecom have largely remained unaffected. The impact of rising commodity prices on earnings for the broader market and the economy is likely to be higher than that of Nifty companies, as the representation of these sectors in the index is small. Strong demand visibility in IT, pick up in credit growth, and normalization of asset quality should lend support to Nifty earnings. Deep cyclical sectors (Energy and Metals) continue to benefit from higher commodity prices, leading to strong aggregate earnings growth. Any disruption and demand destruction on account of higher prices will impact sales volumes for companies, leading to further pressure on operating margins. For the MOFSL Universe, we expect 39%/20%/ 16% YoY earnings growth for FY22/FY23/FY24.

* Key model portfolio changes: Our model portfolio positioning continues to focus on earnings visibility, economic recovery, pricing power, balance sheet strength and reasonable valuations. We maintain our OW stance on BFSI, IT, Consumer, Metals and Cement. We maintain our UW positions on Auto and Energy, albeit, with incremental 100bp addition in RIL. We raise Healthcare to OW and add Gland Pharma that remains on track for product development in complex areas of long-acting injectables, hormonal products, peptides and suspensions. We expect 27% earnings CAGR over FY22-24 for the company. In Financials, we are introducing Bank of Baroda where an expected revival in business trends along with improving asset quality will lead to strong earnings growth. We estimate its RoA/ RoE to touch 1.0%/13.7% by FY24. The stock is trading at an attractive valuation of 0.6x FY24E. In Metals, we are replacing SAIL with JSPL. SAIL is likely to report a very weak set of numbers for 1QFY23, weakest among all steel names. Conversely, JSPL is expected to report a better margin than SAIL. Volume growth for SAIL continues to be minimal v/s JSPL, where we also have the incremental advantage of captive coking coal mines.

* In Mid-Caps,we are adding: a) Macrotech: ~INR200b of completed and nearcompleted inventory thatwill drive strong sales on a sustained basis. Strong cash flows to reduce INR70b in leverage over the next two years. b) Dalmia Bharat: It is a tactical play and after the recent sharp correction, the stock factors in current negatives in our view. It should benefit from aggressive capacity expansion plans (to 48.5mtpa by FY24E from 33.7mtpa now) apart from its cost-saving strategies. The stock valuation is attractive at 10.2x FY24E EV/EBITDA. c) Gujarat Gas: We expect the company’s volume growth prospects to remain robust with the addition of over 60 new industrial units, undergoing expansions, and the emergence of a new ceramic cluster at Aniyari. Cooling of Spot LNG prices would also result in a quicker volume recovery for GUJGA. d) After the recent sharp rally, we are replacing Indian Hotels with Lemon Tree, whichwill benefit from the room additions carried outin the pre-pandemic phase, deleveraging in its balance sheet and addition of upscale brand Aurika Mumbai Hotel in CY23E. e) GR Infra: The company has a strong balance sheet and it is set to traverse the journey from being just a Roads player to a diversified EPC player. Its order book now stands at INR230b (2.9x FY22E revenue). With robust execution capabilities, GR Infra is very well placed to capitalize on the growth opportunities. f) Restaurant Brands Asia (formerly Burger King India) offers an opportunistic play on the economy opening up over the next few quarters, especially with around half of its stores being based in malls (much higher than peers). With the recent correction, RBA trades at an attractive valuation of 18.8x consolidated FY24E EV/EBITDA (pre-IND AS), which is at a 37% discount to that of market leader JUBI. Top picks

* Largecaps: ICICI Bank, SBI, Infosys, HCL Technologies, Reliance, Titan, Apollo Hospitals, Hindalco, Bharti Airtel, Ultratechand BoB.

* Midcaps: Ashok Leyland, Macrotech, APL Apollo Tubes, Chola Finance, Indigo Paints, Restaurant Brands, TCI, GR Infra, Dalmia Bharat, Lemon Tree and Angel One.

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