When macro begins to matter
n A prolonged slowdown – longer than we had anticipated
The continuing slowdown, in both investment and consumption, of the Indian economy has recently
been aggravated by the RBI’s liquidity tightening as it attempts to stabilize the INR. The INR,
however, remains volatile, implying that tight liquidity will continue longer than we had anticipated.
These factors, coupled with a lack of bold fiscal policies in a pre-election year led, BNPP Chief Asia
Economist Richard Iley to cut his Indian GDP growth forecast to 3.7% in FY14 and 5.2% in FY15.
Also, BNPP analysts have reduced earnings estimates across various sectors, primarily financials,
engineering and capital goods, consumer staples and discretionaries. There are potential silver
linings for the economy in the form of abundant monsoons supporting rural consumption and a
‘natural’ narrowing of the trade gap due to currency depreciation.
December 2013 Sensex target reduced to 17,000 from 21,300 previously
We held onto our earlier Sensex target of 21,300 for quite a while because we had already factored
in earnings downgrades. What we had not anticipated was the extent and pace of INR depreciation,
which has not only raised the cost of capital but also portends sharper earnings cuts than we had
foreseen. We have cut our Sensex target 21%, of which 12% is due to lower valuation multiples and
9% due to earnings downgrades. Despite INR-induced tailwinds to exporters and forex earners
(c30% of earnings), our Sensex EPS estimates of INR1,300 in FY14 and INR1,477 in FY15, based
on BNPP analyst estimates, appear at risk.
Top REDUCE ideas – Maruti, HUL, Nestle, SBI & BHEL
Even the erstwhile ‘FII darlings’ in the consumer space are suffering from earnings downgrades, and
their rich valuations are becoming increasingly unsupportable. In conjunction with our analyst views,
we note importers like Maruti, asset-quality victims like SBI and competition victims like BHEL as the
riskiest shares in the present scenario. Since late August, FIIs’ sense of fatigue about the so-called
defensives is becoming apparent. We also highlight Cummins and M&M as victims of sustained
economic slowdown, though M&M has some support from tractor sales. DLF suffers from the double
whammy of high leverage and slow growth
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n A prolonged slowdown – longer than we had anticipated
The continuing slowdown, in both investment and consumption, of the Indian economy has recently
been aggravated by the RBI’s liquidity tightening as it attempts to stabilize the INR. The INR,
however, remains volatile, implying that tight liquidity will continue longer than we had anticipated.
These factors, coupled with a lack of bold fiscal policies in a pre-election year led, BNPP Chief Asia
Economist Richard Iley to cut his Indian GDP growth forecast to 3.7% in FY14 and 5.2% in FY15.
Also, BNPP analysts have reduced earnings estimates across various sectors, primarily financials,
engineering and capital goods, consumer staples and discretionaries. There are potential silver
linings for the economy in the form of abundant monsoons supporting rural consumption and a
‘natural’ narrowing of the trade gap due to currency depreciation.
December 2013 Sensex target reduced to 17,000 from 21,300 previously
We held onto our earlier Sensex target of 21,300 for quite a while because we had already factored
in earnings downgrades. What we had not anticipated was the extent and pace of INR depreciation,
which has not only raised the cost of capital but also portends sharper earnings cuts than we had
foreseen. We have cut our Sensex target 21%, of which 12% is due to lower valuation multiples and
9% due to earnings downgrades. Despite INR-induced tailwinds to exporters and forex earners
(c30% of earnings), our Sensex EPS estimates of INR1,300 in FY14 and INR1,477 in FY15, based
on BNPP analyst estimates, appear at risk.
Top REDUCE ideas – Maruti, HUL, Nestle, SBI & BHEL
Even the erstwhile ‘FII darlings’ in the consumer space are suffering from earnings downgrades, and
their rich valuations are becoming increasingly unsupportable. In conjunction with our analyst views,
we note importers like Maruti, asset-quality victims like SBI and competition victims like BHEL as the
riskiest shares in the present scenario. Since late August, FIIs’ sense of fatigue about the so-called
defensives is becoming apparent. We also highlight Cummins and M&M as victims of sustained
economic slowdown, though M&M has some support from tractor sales. DLF suffers from the double
whammy of high leverage and slow growth
Sectors and stocks views (in conjunction with BNPP analysts)
Auto
We believe the auto sector remains beset by multiple headwinds of high and rising
fuel costs, high interest rates, weak consumer confidence and a weak job market.
We expect four-wheeler companies to bear the brunt. Post the BNPP analyst
downgrade (see “Log jam”, 4 Sep 2013), we exclude Maruti from our model portfolio
as our analyst expects industry growth rates to decline and risk to margins because
of FX (company is a net importer) and inferior mix as growth will be driven by rural
markets. While tractor growth remains robust, our analyst believes that M&M’s auto
business growth and profitability will remain under pressure because of weak
demand. We increase weight to Tata Motors we believe the company’s product mix
(led by the premium Land Rover portfolio) remains strong and strike concerns have
moderated (see “Storm shelter”, 28 Aug 2013). Because the high proportion of
overseas revenues, Tata Motors benefits from INR depreciation.
Energy
Except for Reliance Industries and Cairn India, the Indian energy sector is negatively
affected by currency depreciation due to rising under-recoveries (for oil marketing
companies) and higher subsidy burden (for upstream companies). We add Reliance
Industries to our model portfolio as BNPP analyst Amit Shah expects it to benefit
from higher realizations due to a weak INR. In the medium term, its petchem
expansion project should drive earnings growth. We keep our faith in ONGC as our
analyst believes, despite the policy uncertainties, current valuations are unwarranted
as they factor a loss on sale of crude oil (
with a reduced weight as our analyst believes the recent decline in share price is
more than justified by INR depreciation. Valuation remain attractive at current prices
with the standalone business trading at 0.40x FY14E P/B vs its five-year average of
0.9x. Nonetheless, we expect the sector to remain challenged with high underrecoveries post the recent crude price increase and currency depreciation.
Financials
Post the BNPP downgrade of the financials’ sector outlook to DETERIORATING (see
“Victim of macro factors”, 4 Sep 2013), we reduce allocation to financials in the
portfolio. We believe the liquidity tightening measures of the RBI to stem INR
depreciation have significantly hampered the growth outlook for India. We do not
expect any near-term reversal and expect interest rates to remain elevated. We
reduce weight on both Axis Bank and Indusind Bank and exclude LIC Housing
Finance. We believe they are vulnerable to both tighter liquidity conditions and the
deteriorating economic outlook. Despite concerns on asset quality from its developer
loan portfolio (c35% of its total loan book), we retain HDFC Ltd because of its
management expertise and through-the-cycle track record of more than two decades
we do not expect a significant spike in NPAs. We also stick to Power Finance despite
its underperformance as BNPP analyst Avneesh Sukhija believes that the current
valuations more than discount asset quality deterioration and currency depreciation
(see “Adjusting to the new normal”, 3 Sep 2013).
Tech
Tech is the most obvious beneficiary of INR weakness. BNPP analyst Abhiram
Eleswarapu estimates that theoretically a 1% depreciation of the USD/INR tends to
lift the EBIT margin of our Indian IT services coverage by 20-40bp and EPS by 1-3%.
But in reality high competitive intensity in the sector means that EBIT margin
increases are lower as companies pass on some of the INR depreciation benefit to
their clients (see “Big forex beneficiaries”, 26 Aug 2013). He believes that the current
situation is more similar to the one in 2011-12 than 2008-2009, but with slightly better
industry demand conditions. As such, we believe IT stocks will continue as they did
then. We increase the allocation to IT sector in the BNPP India model portfolio by
adding weight to HCL Tech and Wipro. We also include Persistant Systems in our
model portfolio as our analyst believes the company will be one of the biggest
beneficiaries of FX weakness and the company stands to benefit from structural
changes that the software market towards cloud computing, mobility, analytics and
collaboration (which together account for 50% of the company’s revenue).
Capital goods
The capital goods sector will be adversely affected by our forecast prolonged
industrial slowdown in India. The multiple headwinds – policy paralysis in New Delhi,
deadlock over fuel supply, environmental clearances and land acquisition, weak
demand – afflicting the sector will continue for the foreseeable future, in our view.
Post the downgrade in our rating for Cummins India (see “Downside risks remain”,
26 Aug 2013), we exclude the stock from our model portfolio. BNPP analyst Girsh
Nair has cut both revenues and earnings estimates for Cummins India as he believes
that power genset demand has weakened significantly in South India and exports will
remain weak due to tepid mining capex activity.
Metals
With steel imports priced out of the market due to a weak INR and exports becoming
attractive, Indian steel prices are likely to remain firm. We therefore include Tata
Steel in our model portfolio as the company has shown effective cost control in a
weak industry environment. Moreover, Tata Steel, via its European subsidiary, is also
leveraged to European economic recovery.
Property
BNPP analyst Avneesh Sukhija’s channel checks suggest that both volumes and
prices have begun to soften. Tight liquidity has constrained developers’ funding,
pressuring their already-weak balance sheets. While the situation may not be as bad
as in 2009 as companies now have a healthy contracted sales book to provide
steady cash flows if they execute, our analyst believes that the sector will be
vulnerable to a deteriorating macro environment. We therefore exclude Oberoi from
the model portfolio.
Changes to the model portfolio
In keeping with the recent changes to earnings estimates and recommendations by
BNPP analysts we change our model portfolio. The obvious exclusions are Maruti
and Cummins – both downgraded to REDUCE. With record-high under-recoveries in
diesel, concerns about the government passing on a larger share of subsidies to
PSU oil companies is likely to persist. This leads us to reduce weight on BPCL. In a
tight liquidity environment the pressure on the property sector – in terms of both
sales volumes and prices – is likely to increase. We exclude both LICHF and Oberoi
Realty, playing the sector only through market leader HDFC.
Inclusions in the model portfolio are the currency depreciation beneficiaries
Persistent Systems, Reliance Industries and Tata Steel. The latter, apart from being a
beneficiary of potential European recovery, is displaying good cost control in a weak
industry environment. We also increase our exposure to exporters significantly
through an increase in weight on frontline IT stocks and Tata Motors.
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