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INDIA STRATEGY | 2QFY20 PREVIEW: The wait gets longer!; Weak underlying demand delaying earnings recovery
More of the same; 2QFY20 earnings to be tepid and uneventful
- It has been a year since the IL&FS crisis erupted and the repercussions of the same are still being felt, especially in Financials. Besides NBFCs, banks too have started facing asset quality concerns now. Underlying economic momentum has decelerated sharply, as reflected in 1QFY20 real GDP growth of 5% and the RBI's latest downward revision in the FY20 GDP growth forecast to 6.1% (from 6.9%). Thus, earnings downgrades have remained a key feature of Corporate India.
- The government and the RBI have been taking steps to revive growth. The central bank has cut the repo rate by 135bp since Feb'19 (although the transmission is still very limited), while the government has taken the historic step of a big corporate tax rate cut and also other measures for specific sectors. Fiscal and monetary stimulus are trying to work in tandem to boost growth, the impact of which will be visible only with a lag. High frequency data and our team's interactions with managements spanning sectors suggest that the 2019 corporate earnings will be a washout and any normalcy will only return in 2020.
- The second-quarter earnings-report season will be more of the same - tepid and uneventful. Underlying demand slowdown in the domestic economy and weak global commodities prices are expected to take a toll on earnings with very few bright spots, if any. However, it is important to look at this quarter's numbers from a PBT perspective, as the reduction in the corporate tax rate cuts will result in several adjustments in this quarter's tax numbers (e.g. large corporate banks will make deferred tax adjustments).
- We expect MOFSL Universe's PBT to grow 2% YoY but PAT to decline 6% YoY, dragged by Automobiles and Metals. The difference between PBT and PAT is exaggerated because of the deferred tax adjustments in Financials. Ex-Financials, we expect MOFSL Universe's PBT/PAT to decline 14%/8% YoY. Private Banks, Consumer, Cement and Capital Goods, however, will provide some respite. Our FY20 Nifty EPS estimate has been cut by 3.8% to INR539 (prior: INR560). We now build in EPS growth of 12% for FY20. Ex-corporate banks, we expect 3% profit growth for the Nifty in FY20.
- Markets have remained weak in 2QFY20, despite the sharp bounce back post tax cut. Nifty's divergence with the broader markets has expanded significantly, as discussed in detail in our recent note. Earnings risks continue to be tilted to the downside on account of the underlying weak demand scenario in the domestic economy, the uneven asset quality trends in financials and the deflationary trends in commodity prices. At this point, tax rate cuts will largely limit the downgrades rather than driving big upgrades on the earnings front.
Key sectoral trends/highlights
- Auto Universe’s PAT is expected to decline 37% YoY in 2QFY20 off a weak base (down 25% YoY in 2QFY19) – a sixth consecutive quarter of double-digit PAT decline. Ex-Tata Motors, Auto Universe’s PAT is expected to be down 24% YoY. We expect the EBITDA margin to shrink 270bp YoY to 9.2%, impacted by weak operating leverage and higher discounts. 12/16 companies are expected to report a PAT decline, while Tata Motors is expected to post a loss.
- Technology Universe's revenue/EBITDA/PAT is estimated to grow 8%/4%/(1.8)% in 2QFY20. We expect EBITDA margin contraction across Tier-I by 160-360bp YoY, barring Wipro.
- Private Banks are expected to report a healthy quarter (26% PPoP and 9% PAT growth), despite factoring in DTA adjustments for corporate banks in 2QFY20 itself. Kotak Mahindra Bank, IndusInd, AU and Federal are expected to deliver strong YoY PAT growth.
- NBFCs are likely to post healthy 20% YoY growth, led by HDFC and Bajaj Finance. Ex-HDFC and Bajaj Finance, profit growth is expected at 7%. Bajaj Finance is expected to post another strong quarter, with 39% profit growth. HDFC (37%), MAS Financial (41%) and PNB Housing (46%) are expected to deliver healthy profit growth, while LTFH, Muthoot Finance, Shriram Transport, CIFC and Repco are expected to deliver subdued growth in profitability.
- PSU Banks are expected to post losses of INR39b, led by sluggish loan growth, higher credit costs and DTA reversals, while Telecom is expected to report a loss for the ninth straight quarter.
- Consumer Universe profits are expected to increase 7.1% YoY after eight consecutive quarters of double-digit profit growth. Pidilite (+31% YoY), Marico (17%), GCPL (15%) and GSK Consumer (14%) are expected to exhibit a strong performance, while Britannia, Colgate, Dabur, Emami, Page and PGHH are expected to show a flattish performance. HUL and ITC are likely to report 6% and 8% YoY growth, while both the liquor companies – UNSP and UBBL – should report a double-digit YoY profit decline.
- Metals are expected to post a decline of 29% YoY in EBITDA and 61% YoY in PAT. Within our coverage universe, barring NMDC and HZAL, every other company is expected to report a sharp earnings decline YoY, with Tata Steel, JSW Steel and Hindalco’s profits estimated to decline by 80%, 72% and 25% YoY, respectively.
- Oil & Gas is expected to report a marginal decline (-2% YoY), driven by a significant moderation at OMCs (BPCL, IOCL). ONGC is expected to report a 17% PAT decline, while Reliance Industries is expected to post 13% growth. Ex-OMCs, we expect YoY flat profits for O&G.
- Cement is expected to post 26% YoY EBITDA and 24% YoY profit growth on a flat base, after delivering 34% profit growth in 1QFY20, largely led by Ultratech (profits to expand 2x YoY) and Shree Cements (11% growth).
- Capital Goods are expected to report sales/EBITDA/PAT growth of 9%/9%/13%, with L&T/Crompton Consumer/Bluestar/Siemens/Thermax expected to lead the pack delivering 13%/49%/77%/46%/35% growth. Bharat Electronics (-6%), BHEL (-23%) and Voltas (5%) are expected to drag the sector’s performance.
- Utilities sector’s PAT is expected to decline 1% YoY, dragged by Coal India (-25% YoY). Power Grid (8%) and NTPC (12%) are expected to lead the performance.
- Healthcare is expected to deliver growth of 11% in EBITDA and 1% in PAT off a low base (+3% YoY in 2QFY19). Key large-cap names like Lupin, Sun and Cipla are expected to post 10%, 4% and 36% YoY growth, respectively, while Aurobindo and Dr. Reddy’s profits are expected to decline by 6% and 18%, respectively.
Model portfolio
- The construction of our model portfolio remains premised on the twin factors of earnings visibility, structural themes and tactical opportunities presented by valuation mismatches. We maintain our overweight stance on Financials owing to expectations of asset quality normalization over the next two years. Given the sharp underperformance of mid-caps and relative valuation discounts, we are adding more mid-caps in the model portfolio.
- BFSI: We stay overweight on corporate banks. We have increased weights in SBI ICICI and Axis after the recent correction. ICICIBC has delivered a steady performance at the PPoP level and is showing healthy signs of earnings normalization. It trades at 1.7x FY21E ABV adjusted for subsidiaries. SBIN remains the best play on a recovery among corporate banks with one of the lowest NSLs at ~3.6%. The bank trades at 0.7x FY21E ABV adjusted for subsidiaries.
- In NBFC, we raise our weights in HDFC, as the market share shift in both retail and corporate businesses will be toward well-established players in this tough operating environment.
- Consumer: We retain HUL, MARICO and Titan in the model portfolio, given our structural positive view on these names. We have maintained weights in ITC, given the attractive valuations and the significant EPS upgrade post the recent tax cuts.
- Information Technology & Telecom: In IT, we raise our weights marginally in Infosys while maintain weights in Tech Mahindra. IT offers a quality defensive bastion in volatile markets. We remain overweight on Bharti Airtel.
- In Oil & Gas, we have raised weights in Reliance Industries post the recent upgrade in rating by our O&G team. We are adding IOCL in the portfolio. Its quality of earnings will improve with the commissioning of the polypropylene plant at Paradeep and the ramp-up of the Ennore LNG terminal. Despite capex of ~INR200b annually, FCF is expected to be ~7% of market cap annually for the next 2-3 years.
- In Cement, we are replacing ACC with Ultratech as it is moving down the cost curve and offers better operating leverage.
- Mid-caps: We are adding Colgate, JK Cements, Alkem Labs, Crompton Consumer and Ashok Leyland. Colgate’s new MD Mr Ram Raghavan has already shown aggression on share gain and volumes. Also, valuations are at a discount to peers. We like JK Cement’s positioning in the key markets of north and central India – it derives ~70% of volumes from these regions. In our view, the north and central regions will have >85% utilization levels over the next two years, supporting pricing and margins there. Alkem is best fit to the theme of higher exposure to domestic formulation (67% of sales), limited price erosion in the US business due to a low base (USD270m), sound compliance record, and attractive valuation. We find Crompton’s valuations attractive and had recently raised our earnings estimates by 12%/14% for FY20/21. Ashok Leyland’s EV/EBITDA multiple has corrected substantially from the recent peak and is trading at the bottom end of the range on FY21 downcycle earnings – at ~25% discount to LPA despite a marked improvement in business positioning and capital allocation.
Top Picks
- Large-Caps: ICICI Bank, SBI, HDFC, Bharti Airtel, L&T, Infosys, Maruti, HUL, Titan, NTPC.
- Mid-Caps: Indian Hotels, Federal Bank, MMFS, Ashok Leyland, ABFRL, JK Cement, Oberoi Realty, Colgate, Alkem Labs.
- The government and the RBI have been taking steps to revive growth. The central bank has cut the repo rate by 135bp since Feb'19 (although the transmission is still very limited), while the government has taken the historic step of a big corporate tax rate cut and also other measures for specific sectors. Fiscal and monetary stimulus are trying to work in tandem to boost growth, the impact of which will be visible only with a lag. High frequency data and our team's interactions with managements spanning sectors suggest that the 2019 corporate earnings will be a washout and any normalcy will only return in 2020.
- The second-quarter earnings-report season will be more of the same - tepid and uneventful. Underlying demand slowdown in the domestic economy and weak global commodities prices are expected to take a toll on earnings with very few bright spots, if any. However, it is important to look at this quarter's numbers from a PBT perspective, as the reduction in the corporate tax rate cuts will result in several adjustments in this quarter's tax numbers (e.g. large corporate banks will make deferred tax adjustments).
- We expect MOFSL Universe's PBT to grow 2% YoY but PAT to decline 6% YoY, dragged by Automobiles and Metals. The difference between PBT and PAT is exaggerated because of the deferred tax adjustments in Financials. Ex-Financials, we expect MOFSL Universe's PBT/PAT to decline 14%/8% YoY. Private Banks, Consumer, Cement and Capital Goods, however, will provide some respite. Our FY20 Nifty EPS estimate has been cut by 3.8% to INR539 (prior: INR560). We now build in EPS growth of 12% for FY20. Ex-corporate banks, we expect 3% profit growth for the Nifty in FY20.
- Markets have remained weak in 2QFY20, despite the sharp bounce back post tax cut. Nifty's divergence with the broader markets has expanded significantly, as discussed in detail in our recent note. Earnings risks continue to be tilted to the downside on account of the underlying weak demand scenario in the domestic economy, the uneven asset quality trends in financials and the deflationary trends in commodity prices. At this point, tax rate cuts will largely limit the downgrades rather than driving big upgrades on the earnings front.
Key sectoral trends/highlights
- Auto Universe’s PAT is expected to decline 37% YoY in 2QFY20 off a weak base (down 25% YoY in 2QFY19) – a sixth consecutive quarter of double-digit PAT decline. Ex-Tata Motors, Auto Universe’s PAT is expected to be down 24% YoY. We expect the EBITDA margin to shrink 270bp YoY to 9.2%, impacted by weak operating leverage and higher discounts. 12/16 companies are expected to report a PAT decline, while Tata Motors is expected to post a loss.
- Technology Universe's revenue/EBITDA/PAT is estimated to grow 8%/4%/(1.8)% in 2QFY20. We expect EBITDA margin contraction across Tier-I by 160-360bp YoY, barring Wipro.
- Private Banks are expected to report a healthy quarter (26% PPoP and 9% PAT growth), despite factoring in DTA adjustments for corporate banks in 2QFY20 itself. Kotak Mahindra Bank, IndusInd, AU and Federal are expected to deliver strong YoY PAT growth.
- NBFCs are likely to post healthy 20% YoY growth, led by HDFC and Bajaj Finance. Ex-HDFC and Bajaj Finance, profit growth is expected at 7%. Bajaj Finance is expected to post another strong quarter, with 39% profit growth. HDFC (37%), MAS Financial (41%) and PNB Housing (46%) are expected to deliver healthy profit growth, while LTFH, Muthoot Finance, Shriram Transport, CIFC and Repco are expected to deliver subdued growth in profitability.
- PSU Banks are expected to post losses of INR39b, led by sluggish loan growth, higher credit costs and DTA reversals, while Telecom is expected to report a loss for the ninth straight quarter.
- Consumer Universe profits are expected to increase 7.1% YoY after eight consecutive quarters of double-digit profit growth. Pidilite (+31% YoY), Marico (17%), GCPL (15%) and GSK Consumer (14%) are expected to exhibit a strong performance, while Britannia, Colgate, Dabur, Emami, Page and PGHH are expected to show a flattish performance. HUL and ITC are likely to report 6% and 8% YoY growth, while both the liquor companies – UNSP and UBBL – should report a double-digit YoY profit decline.
- Metals are expected to post a decline of 29% YoY in EBITDA and 61% YoY in PAT. Within our coverage universe, barring NMDC and HZAL, every other company is expected to report a sharp earnings decline YoY, with Tata Steel, JSW Steel and Hindalco’s profits estimated to decline by 80%, 72% and 25% YoY, respectively.
- Oil & Gas is expected to report a marginal decline (-2% YoY), driven by a significant moderation at OMCs (BPCL, IOCL). ONGC is expected to report a 17% PAT decline, while Reliance Industries is expected to post 13% growth. Ex-OMCs, we expect YoY flat profits for O&G.
- Cement is expected to post 26% YoY EBITDA and 24% YoY profit growth on a flat base, after delivering 34% profit growth in 1QFY20, largely led by Ultratech (profits to expand 2x YoY) and Shree Cements (11% growth).
- Capital Goods are expected to report sales/EBITDA/PAT growth of 9%/9%/13%, with L&T/Crompton Consumer/Bluestar/Siemens/Thermax expected to lead the pack delivering 13%/49%/77%/46%/35% growth. Bharat Electronics (-6%), BHEL (-23%) and Voltas (5%) are expected to drag the sector’s performance.
- Utilities sector’s PAT is expected to decline 1% YoY, dragged by Coal India (-25% YoY). Power Grid (8%) and NTPC (12%) are expected to lead the performance.
- Healthcare is expected to deliver growth of 11% in EBITDA and 1% in PAT off a low base (+3% YoY in 2QFY19). Key large-cap names like Lupin, Sun and Cipla are expected to post 10%, 4% and 36% YoY growth, respectively, while Aurobindo and Dr. Reddy’s profits are expected to decline by 6% and 18%, respectively.
Model portfolio
- The construction of our model portfolio remains premised on the twin factors of earnings visibility, structural themes and tactical opportunities presented by valuation mismatches. We maintain our overweight stance on Financials owing to expectations of asset quality normalization over the next two years. Given the sharp underperformance of mid-caps and relative valuation discounts, we are adding more mid-caps in the model portfolio.
- BFSI: We stay overweight on corporate banks. We have increased weights in SBI ICICI and Axis after the recent correction. ICICIBC has delivered a steady performance at the PPoP level and is showing healthy signs of earnings normalization. It trades at 1.7x FY21E ABV adjusted for subsidiaries. SBIN remains the best play on a recovery among corporate banks with one of the lowest NSLs at ~3.6%. The bank trades at 0.7x FY21E ABV adjusted for subsidiaries.
- In NBFC, we raise our weights in HDFC, as the market share shift in both retail and corporate businesses will be toward well-established players in this tough operating environment.
- Consumer: We retain HUL, MARICO and Titan in the model portfolio, given our structural positive view on these names. We have maintained weights in ITC, given the attractive valuations and the significant EPS upgrade post the recent tax cuts.
- Information Technology & Telecom: In IT, we raise our weights marginally in Infosys while maintain weights in Tech Mahindra. IT offers a quality defensive bastion in volatile markets. We remain overweight on Bharti Airtel.
- In Oil & Gas, we have raised weights in Reliance Industries post the recent upgrade in rating by our O&G team. We are adding IOCL in the portfolio. Its quality of earnings will improve with the commissioning of the polypropylene plant at Paradeep and the ramp-up of the Ennore LNG terminal. Despite capex of ~INR200b annually, FCF is expected to be ~7% of market cap annually for the next 2-3 years.
- In Cement, we are replacing ACC with Ultratech as it is moving down the cost curve and offers better operating leverage.
- Mid-caps: We are adding Colgate, JK Cements, Alkem Labs, Crompton Consumer and Ashok Leyland. Colgate’s new MD Mr Ram Raghavan has already shown aggression on share gain and volumes. Also, valuations are at a discount to peers. We like JK Cement’s positioning in the key markets of north and central India – it derives ~70% of volumes from these regions. In our view, the north and central regions will have >85% utilization levels over the next two years, supporting pricing and margins there. Alkem is best fit to the theme of higher exposure to domestic formulation (67% of sales), limited price erosion in the US business due to a low base (USD270m), sound compliance record, and attractive valuation. We find Crompton’s valuations attractive and had recently raised our earnings estimates by 12%/14% for FY20/21. Ashok Leyland’s EV/EBITDA multiple has corrected substantially from the recent peak and is trading at the bottom end of the range on FY21 downcycle earnings – at ~25% discount to LPA despite a marked improvement in business positioning and capital allocation.
Top Picks
- Large-Caps: ICICI Bank, SBI, HDFC, Bharti Airtel, L&T, Infosys, Maruti, HUL, Titan, NTPC.
- Mid-Caps: Indian Hotels, Federal Bank, MMFS, Ashok Leyland, ABFRL, JK Cement, Oberoi Realty, Colgate, Alkem Labs.
Akash