Strategy: Can we get back to FY2018 earnings please? - Kotak

Can we get back to FY2018 earnings please? 4QFY17 results suggest stabilization in underlying parameters (volumes and realizations) in certain sectors but risks of earnings downgrades to our FY2018 estimates have resurfaced in others from domestic (higher provisions in the banking sector, stronger INR and higher interest rates) and global (lower commodity prices) factors The Street has already moved to FY2019 (and even FY2020 in some cases) earnings but FY2018 earnings are looking rather shaky.

4QFY17 results: Some improvement in underlying trends but no major positive surprise

Underlying volume and realization data for the companies that have reported so far suggest some stabilization in volumes post the 'demonetization' quarter of 3QFY17. However, we have not seen any meaningful changes to our underlying volume and realization assumptions based on 4QFY17 results and recent economic data. 4QFY17 EBITDA of large-cap. companies show a modest 'beat' so far but this is entirely due to RIL; some have missed significantly. 4QFY17 net profits show large 'beats' or 'misses' for the financials depending on the extent of loan-loss provisioning and may be less relevant.

Risks to FY2018 earnings estimates have increased

We note that the risks of earnings downgrades have increased from (1) higher-than-estimated loan-loss provisions in the banking sector, (2) weaker-than-expected commodity prices (metals, oil & gas) and (3) stronger-than-expected exchange rate (IT, metals, oil & gas, pharmaceuticals). In fact, some of these sectors contribute to a large share of incremental profits for FY2018-19E. Thus, any disappointment in earnings in the aforementioned sectors will lead to significant earnings downgrades for the overall market. Also, we would watch for higher interest rates although we do not assume any change to policy rates through FY2018.

Government action may boost sentiment for certain sectors

Any government-backed plan to resolve the problem of stressed assets in the Indian banking system or resolutions by the banks will improve the sentiment for and multiples of the so-called corporate banks. Their large weightage in indices will support the market and also, may lead to some rotation among sectors as investors have been generally negative on corporate banks. The government recently passed an ordinance that will empower the RBI to "specify one or more authorities or committees with such members as the Reserve Bank may appoint or approve for appointment to advise banking companies on resolution of stressed assets."

Valuations versus liquidity

We find valuations of most sectors and stocks quite expensive even on FY2019E estimates even with our assumptions of strong recovery in volumes and profitability across sectors. We model the net profits of the Nifty-50 Index to grow 15% and 17% for FY2018 and FY2019 but note the aforementioned risks to earnings. Top-down valuations look expensive even though they are largely irrelevant given the wide dispersion in valuations across sectors and large share of net profits of 'low P/E' sectors. Lastly, we do not see any reason for value of stocks to change just because institutional investors may have more funds to invest. That may change the price of stocks (if investors feel more bullish), not their value.

Changes to Model Portfolio

We increase weight on GAIL (100 bps to 400 bps) and NTPC (100 bps to 300 bps) and remove TPWR (200 bps earlier) from our recommended large-cap. Model Portfolio. Our 'punt' on TPWR has not played out with the Indian Supreme Court ruling against the orders of the Central Electricity Regulatory Commission (CERC) and the Appellate Tribunal for Electricity (APTEL) to award compensator tariffs for TPWR's imported coal-based Mundra power plant.

We also remove AXSB (200 bps earlier) from the portfolio and allocate the same to HDFC (800 bps) and HDFCB (900 bps). We struggle with the valuations of other banks and NBFCs in the context of their business models and are happy just parking some money into stocks that will hold up better in the event of a market correction.

We expect AXSB's NPLs (5% as of FY2017) to rise further as we don't see any potential resolution for its power assets. 60% of AXSB's internal 'watch-list' comprises power assets now and AXSB's power assets in the 'watch-list' account for 29% of the bank's power sector exposure. We note that only 3.2% of AXSB's power sector exposure is recognized as NPLs.

Lastly, AXSB trades at 2.0X FY2019E ABVPS (Rs255), which is at a significant premium to ICICIBC's valuation. We note that 70% of AXSB's 'watch-list' (as of March 31, 2016) has slipped into NPLs in FY2017, which is quite discomforting. In the case of ICICIBC, the corresponding figure is lower at 45%.

Source : Equity Bulls

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