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Strategy
India
Hang in there; second half will likely be better. We have made a few minor
changes to our Model Portfolio to take advantage of severe volatility in stock prices and
large correction in certain high quality stocks. We continue to be overweight banking,
metals and technology sectors—(1) banking in light of inexpensive valuations and NIMs
likely surprising on the upside compared to Street expectations and (2) metals and
technology given their exposure to global economic recovery. We continue to avoid
infrastructure owners, high-debt companies and domestic consumption companies with
low pricing power. Our BSE-30 Index fair valuation based on FY2012E and FY2013E
estimates remains 21,000 (6-9 months target) and 24,000 (15-18 months target).
Tweaking the portfolio a bit
We have increased the weight on private banks (HDFC Bank and ICICI Bank) to take advantage of
the recent correction in their stock prices and reduced weight on HDFC and some infrastructure
and utilities stocks (already quite underweight) and Grasim (strong outperformance over the past
few months). We continue to be overweight on PSU banks. We believe that banks have strong
pricing power in the current tight-liquidity environment and banks with high CASA will be able to
defend their NIMs; we also note that CASA as a proportion of total incremental deposits has gone
up significantly in the past six quarters for the banking system. Among other major changes, we
have included Wipro in place of GAIL and ICICI Bank instead of Jaiprakash Industries (admittedly a
big disappointment) in the Top-10 List.
2HCY11E—earnings, government action, crude oil prices key triggers for the Indian market
We currently model 21% earnings growth for FY2012E for the BSE-30 but see downside risks to
earnings of several sectors, particularly sectors with (1) high exposure to global commodities as
inputs such as automobiles, consumers and energy and (2) high debt such as infrastructure
(owners), real estate, telecom and utilities. We are underweight all these sectors. We rule out
meaningful government action without lower inflation, which in turn would depend on softer
commodity (particularly crude oil) prices. We see inflation turning more benign over the next few
months (more due to base effects than price declines) and crude prices declining from current high
levels; large QE2-led speculation has pushed up commodity prices well above fundamental levels,
in our view.
1HCY11E—budget may be key but unlikely to be a big event
Current high inflation, an inflamed political environment and the government’s weak fiscal
position may preclude any radical policy changes in the FY2012 Union Budget. The government’s
resolve, if any, to tackle burgeoning fertilizer, food and fuel subsidies may be a good indicator of
its attitude towards fiscal consolidation; the latter will be construed positively by the market.
Reduction of taxes on crude (import duty) and diesel and gasoline (excise duty) may reduce the
under-recoveries on selling fuels at a discount to global prices but also lead to lower tax revenues.
Revised portfolio slightly but basic theme remains the same
Exhibit 1 gives our revised Model Portfolio. Our last changes were on November 16,
2010 when we had over-weighted metals and cut positions in infrastructure and utilities
sectors. We have been overweight on the banking and technology sectors for the past 15
months. Our basic thesis is unchanged but we have made a few changes to our Model
Portfolio to take advantage of the recent correction in stock prices of certain high quality
stocks and divergent movement in some others.
We avoid stocks that have downside risks to earnings from high input costs (automobiles),
high interest rates (infrastructure owners, real estate and utilities), limited pricing power
accompanied by expensive valuations (certain consumer stocks) and companies with poor
corporate governance (the lesser said, the better); this approach precludes a large section
of the investible universe currently.
We focus on stocks that will benefit from ongoing global economic recovery (metals,
technology) or have pricing power (banks and few select stocks).
Among the key changes to our Model Portfolio, we have increased weight on private
banks such as HDFC Bank and ICICI Bank at the expense of certain stocks in the banking
sector (HDFC), cement (Grasim), infrastructure and utilities sectors. We were already quite
underweight the latter two sectors in our portfolio. Among other changes, we have
replaced (1) GAIL with Wipro on increasing concerns about lower-than-expected gas
transmission volumes from lower-than-expected gas production from RIL’s KG D-6 block
and (2) Jaiprakash Associates with ICICI Bank. Exhibit 2 is our revised Top-10 List.
Earnings—risks have increased from continued high inflation, interest rates
Our portfolio reflects our concerns about earnings for several sectors. We currently model
22.7% and 20.9% net profit growth for the BSE-30 Index for FY2011E and FY2012E
(translating into unadjusted ‘EPS’ of `1,100 and `1,331 and adjusted (free-float basis) ‘EPS’
of `1,041 and `1,258). Exhibit 3 gives the earnings growth broken down by sectors for the
BSE-30 Index and their corresponding valuation parameters.
We discuss earnings drivers and risks for a few sectors (1) where our views on earnings may
differ from consensus such as banking (positive versus Street view) and consumer (negative
versus Street view) and (2) whose earnings are relevant for the market (energy and metals)
but can be quite volatile depending on global and domestic issues. Exhibit 4 gives the
breakdown of net profits and incremental net profits by sectors for the BSE-30 Index.
Banking. We expect banks’ NIMs to hold up quite well given their strong pricing power
in a tight-liquidity environment and their high CASA deposits. (1) We note that banks
have raised lending rates (see Exhibit 5) to match the increase in deposit rates (see Exhibit
6) over the past few months. We would clarify that revised deposit rates apply to new
deposits only while revised lending rates apply to the entire lending book. Thus, there
need not be a one-to-one correspondence in changes in deposit and lending rates. (2)
Banks’ CASA deposits have increased significantly over the past six quarters; rates on
CASA (SA rate is unchanged at 3.5% for the past several years; CA is anyway at 0%) will
not move up to the same extent as fixed deposits’ rates. Exhibit 7 shows that CASA
deposits have contributed to 57% of the increase in total deposits of the banks under our
coverage over the past six quarters. Thus, we are not overly perturbed by the increase in
interest rates even though we expect credit growth to slow down from the scorching
24% currently and current tight liquidity conditions to ease once government expenditure
increases over the next few weeks.
Consumers. We see earnings pressures from (1) high raw material costs and pressure on
profitability given limited pricing power in some cases (HUL, Jyothy, Marico and Tata
Global Beverages), (2) higher spending on food given high food inflation for the urban
poor that may lead to some amount of down-trading in consumer products; the urban
poor segments accounts for about 25% of the total consumption of consumer staples
and (3) increased competition from MNC players in the more profitable segments
(personal products) and diversification of Indian players into new segments. Also, we do
not see the sector offering its historical defensive characteristics at 24.8X FY2012E
earnings (average for KIE coverage universe) and in light of potential downside risks to
earnings.
Energy. We see downside risks to earnings of RIL from lower-than-expected gas
production. Our FY2012E EPS will decline by 7.6% to `67 if gas production from KG D-6
block is 52 mcm/d versus 70 mcm/d assumed by us currently. Also, in case income tax
exemption is not available on gas production, our FY2012E EPS will decline by 8.8% to
`66. We see limited scope for positive earnings surprises for the chemical and refining
segments since we model very strong chemical margins and US$9.3/bbl refining margin
for FY2012E (compared to US$7.7/bbl in 1HFY11) and US$8.2/bbl in FY2011E.
In the case of ONGC, we see downside risks from higher-than-expected subsidy
burden. Our base-case earnings scenario assumes US$85/bbl (Dated Brent) crude
price for FY2012E and diesel deregulation from October 1, 2012, which results in a
net realized price of US$62.3/bbl for crude oil for FY2012E versus US$55.7/bbl in
1HFY11. We note that oil companies would need to increase diesel prices by
`3.8/liter (quite manageable given the current average selling price is `40/liter in
the four major metros) to earn reasonable marketing margins at US$85/bbl crude
oil price. ONGC’s FY2012E EPS could decline to `119, if we assume US$56/bbl net
crude oil price realization. We note that ONGC had reported an EPS of `93 in
FY2009 when gross under-recoveries had gone up to `1.06 tn compared to our
estimated `656 bn for FY2012E. The government has deregulated APM gas price
since then, which has added about `20 to ONGC’s earnings on a full-year basis.
We would clarify that ONGC also benefits from higher crude oil prices although
its net realization will be stable at US$54-57/bbl range if the government does not
change domestic selling prices of diesel, kerosene and LPG in FY2012E and crude
prices stay in the range of US$90-100/bbl. This scenario, of course, assumes that
the upstream companies will bear one-third of gross under-recoveries.
Metals. This is one of the few sectors where we see upside risks to our earnings
estimates currently. Exhibit 8 shows that our FY2012E price and margin assumptions for
most metals are quite conservative compared to current spot prices. We expect the metals
sector to contribute to 11% of FY2012E net profits of the BSE-30 Index and 10% of
incremental profits for FY2012E.
High interest rates, fuel prices pose additional risks to earnings
We also highlight risks to earnings for the market from high interest rates. High debt
companies in the infrastructure, real estate, telecom and utilities sectors may face additional
earnings risks other than those from weaker-than-expected operating conditions. Interest
rates have gone up significantly over the past 3-4 months and can surprise negatively, if
inflation turns out to be stickier versus our expectations.
Exhibit 9 shows the risks to interest expenses for companies under our coverage. We assume
200 bps higher interest rates for FY2012E versus in FY2011E for this exercise. We note that
this is a hypothetical exercise and several companies have overseas borrowings, where rates
may not go up significantly. Nonetheless, many of these companies face related risks of
depreciation in the value of the Indian Rupee versus the currency of the foreign loans, which
would impact earnings negatively (through increase in their foreign currency loans) even if
their LIBOR-linked borrowing costs do not change meaningfully.
We expect inflation to average
6.5% in FY2012E assuming crude oil prices revert to more reasonable levels of US$85/bbl
(Dated Brent) and the government does not have to increase domestic fuel prices to levels
corresponding to current crude price levels (US$98/bbl). We take comfort from the fact the
crude oil fundamentals look reasonable with a significant amount of ‘OPEC’ spare capacity
in CY2011E (see Exhibit 11). It would seem that high speculation (see Exhibit 12) has pushed
up crude prices well above fundamental levels. However, it is hard to predict commodity
prices given so many divergent factors. If crude prices stay above US$95/bbl, India will have
no option but to increase diesel prices during the course of the year. This will result in higher
freight costs and impact earnings negatively for companies in the cement sector. We do not
rule out negative impact on automobile volumes also given high cost of ownership of cars in
a high-interest rate environment.
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