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India Strategy
Can’t see ‘I’ to ‘I’
Inflows and Inflation indicating contrary trends
Indian markets have rebounded strongly in the last few weeks driven by a return
of FII inflows. However, the macro environment continues to be challenging,
inflation is showing no signs of slowing down, and an investment cycle recovery
remains doubtful with interest rates rising further. A good harvest expected this
April may reduce concerns on food inflation, but oil prices are spiking and the
recent increase in coal prices by Coal India is likely to keep core inflation at
elevated levels. Hopes for an investment cycle recovery are seeing headwinds,
with corporate capex lagging due to increased concern about a consumption
slowdown.
Earnings estimate too optimistic on margins
Margins have been on a declining trend for the last few years driven by reducing
import tariffs. Coal India’s recent price increases and partial de-regulation of oil
prices have signalled the end of subsidised energy in our view and this means
that operating margins will likely continue to decline. However, consensus
estimates are forecasting strong margins into FY12, which seems to us even
more unreasonable given the cost inflation. The impact of rising interest costs
and larger working capital requirements also seems to be underestimated. Our
top-down approach to calculate the Sensex EPS suggests a growth of 12-15%
as compared to 19% suggested by consensus estimates.
Investment cycle – alive but not kicking
While some activity has been recorded in the infra space and awards of road
projects have picked up, we see no recovery in private capex. Order inflows
remain weak and we expect L&T, one of India’s best engineering companies, to
disappoint on order inflows. While we do hope for some pick-up later in the year,
rising interest rates, increasing commodity prices and regulatory hurdles do not
paint a perfect picture for improvement to occur in the short term. Among the
large capex heavy sectors like metals, cement, oil refinery and fertilisers, we
estimate very limited new capacity expansions.
Valuations – oil prices can lead to de-rating
Fair value for Sensex based on 2 stage dividend discount model comes to
around 20500 which implies a 16x PER on our top down earnings estimates.
Also comparing earnings yield to real return for debt clearly supports cause for
investment into equity. However, in the near term given the concerns on oil we
expect Sensex to trade below fair value. Historically, we have seen a strong
negative correlation between the Sensex’s 12mth forward PER and the oil price.
The de-rating has already started and if oil prices increase further, we see more
downside risk. India is trading at a 35% premium to Emerging Markets against a
10yr average of 26%. Add to this the downside risk to earnings and larger
sensitivity of EPS estimates to changes in margin assumptions, recommend
booking profits in this rally.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India Strategy
Can’t see ‘I’ to ‘I’
Inflows and Inflation indicating contrary trends
Indian markets have rebounded strongly in the last few weeks driven by a return
of FII inflows. However, the macro environment continues to be challenging,
inflation is showing no signs of slowing down, and an investment cycle recovery
remains doubtful with interest rates rising further. A good harvest expected this
April may reduce concerns on food inflation, but oil prices are spiking and the
recent increase in coal prices by Coal India is likely to keep core inflation at
elevated levels. Hopes for an investment cycle recovery are seeing headwinds,
with corporate capex lagging due to increased concern about a consumption
slowdown.
Earnings estimate too optimistic on margins
Margins have been on a declining trend for the last few years driven by reducing
import tariffs. Coal India’s recent price increases and partial de-regulation of oil
prices have signalled the end of subsidised energy in our view and this means
that operating margins will likely continue to decline. However, consensus
estimates are forecasting strong margins into FY12, which seems to us even
more unreasonable given the cost inflation. The impact of rising interest costs
and larger working capital requirements also seems to be underestimated. Our
top-down approach to calculate the Sensex EPS suggests a growth of 12-15%
as compared to 19% suggested by consensus estimates.
Investment cycle – alive but not kicking
While some activity has been recorded in the infra space and awards of road
projects have picked up, we see no recovery in private capex. Order inflows
remain weak and we expect L&T, one of India’s best engineering companies, to
disappoint on order inflows. While we do hope for some pick-up later in the year,
rising interest rates, increasing commodity prices and regulatory hurdles do not
paint a perfect picture for improvement to occur in the short term. Among the
large capex heavy sectors like metals, cement, oil refinery and fertilisers, we
estimate very limited new capacity expansions.
Valuations – oil prices can lead to de-rating
Fair value for Sensex based on 2 stage dividend discount model comes to
around 20500 which implies a 16x PER on our top down earnings estimates.
Also comparing earnings yield to real return for debt clearly supports cause for
investment into equity. However, in the near term given the concerns on oil we
expect Sensex to trade below fair value. Historically, we have seen a strong
negative correlation between the Sensex’s 12mth forward PER and the oil price.
The de-rating has already started and if oil prices increase further, we see more
downside risk. India is trading at a 35% premium to Emerging Markets against a
10yr average of 26%. Add to this the downside risk to earnings and larger
sensitivity of EPS estimates to changes in margin assumptions, recommend
booking profits in this rally.
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