INDIA STRATEGY: Get on track please! | 3QFY12 Earnings Preview: Motilal Oswal

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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 ~6.5% levels in FY13. During the course of the year, 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. Our FY13 GDP growth estimate is 6.6%. 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 worst case.

Trend #2: Monetary policy - from tight to loose

The biggest positive surprise may emanate from rapid decline in inflation in 4QFY12. Inflation will come down within 7% by end-March 2012. However, because of an interplay of several factors, inflation is expected to remain range-bound within 5-6% for large part of FY13. 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. 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. 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 by 150bp over CY12 / FY13.

In 2012, inflation could spring a positive surprise

Trend #3: Fiscal policy - from loose to tight

In FY12, 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.

Any meaningful fiscal correction would remain a challenge in FY13 as well. Revenues would be affected by growth slowdown. 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. 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

For full year FY12, we expect MOSL Universe (ex RMs) to report aggregate sales growth of 22% 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 been estimated. Thus, the residual growth required in 4QFY12 is ~9%, which we believe, is achievable.

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, base FY12 EPS itself saw an 18% downgrade from 1,263 expected in Dec-2010 to current 1,105. In effect, FY11-13E EPS CAGR for the Sensex has gone down sharply from 19% to 11%.

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.-         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 would be 7.3%, lowest ever 3Q margin over FY05-12.
-         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%).
-         Sensex PAT will grow 9% YoY. The last 4-quarter average growth in Sensex PAT is 9%. This is the lowest 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 (FY13 PE of 12x vs 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.

Our Model Portfolio has Overweight positions in Private Banks, Technology, Autos, HealthCare and Telecom sectors and Underweight positions in Oil & Gas, Infrastructure & Related sectors and Consumer sectors. Our top bets for 2012 are: ICICI Bank/SBI, Infosys/HCL Tech, Bharti, Maruti/Tata Motors, Coal India and Cipla.