Sector Round-up

The year began with ample optimism about growth and earnings. But broad-based market correction, regulatory and policy headwinds and demand slowdown have dampened sentiments. We look back to find out what’s in store for key sectors in 2019

Oil & Gas: Slipping up

 

Anand Kalyanaraman

 

All but one, they all fell down. Of the nine stocks in the S&P BSE Oil & Gas Index, only Reliance Industries has made money for investors this calendar year 2018, a neat 22 per cent. This was driven by a good show across its refining, petrochemicals, retail and digital businesses.

 

 

But for this silver lining, it has been a forgettable year for the the oil and gas pack. The PSU oil marketing companies (OMC) — Indian Oil, BPCL and HPCL — have lost 24-42 per cent; the PSU hydrocarbon explorers — ONGC and Oil India — are down 23 per cent; gas utilities GAIL and Indraprastha Gas have fallen 6-21 per cent and lubricant major Castrol India has slipped 20 per cent. This broad downside has dragged the BSE Oil & Gas Index down 15 per cent over the year, in contrast to the 7 per cent gain in the Sensex.

Exploring the fall

The oil stocks were walloped primarily by two factors — fickle crude oil prices that did the trapeze act and government interference in fuel pricing. Crude oil prices headed north for much of the year and Brent crossed $85 a barrel in October; along with this, petrol and diesel prices scaled all-time highs.

The PSU OMC stocks were already under pressure due to repeated go-slows on fuel pricing during the hectic election cycle.

But the knock-out punch came in early October, when the Centre forcibly co-opted them as part of the package to provide relief to customers from high fuel prices. The ₹1 per litre cut in petrol and diesel prices raised fears that fuel price deregulation was being given a burial.

Higher oil prices should ideally have benefited the stocks of hydrocarbon explorers ONGC and Oil India. But worries of their price realisations being capped due to the risk of sharing higher under-recoveries pummelled these stocks too.

From October, Brent oil prices declined sharply to about $55 a barrel now. While this has seen the OMC stocks recover some lost ground, the exploration stocks remain under pressure.

The negative sentiment rubbed off on the gas utility stocks GAIL and Indraprastha Gas too, which were also impacted by concerns about volume growth and margins. Castrol India was also pulled down by lacklustre volume growth and margin pressure due to high material costs.

Outlook

The fortunes of the sector in 2019 will depend, as always, to a large extent on crude oil prices. It’s difficult to predict the commodity’s movements but the current spectre of oversupply and subdued demand growth should keep prices capped.

Also, when the general election dust settles in the middle of 2019, true pricing freedom will hopefully be restored to the OMCs; this should help the sector, overall.

Auto: Bumpy ride

 

 

After the GST-related hiccups in early 2017-18, the auto sector was on a purple patch, with demand reviving and benign interest rates nudging consumers to take the plunge.

The sector ended the fiscal on a high note, with an overall volume growth of 14.2 per cent. The script was very much the same until the beginning of fiscal 2018-19 too. The sector recorded an overall volume growth of 18 per cent in April-June 2018, thanks to the low base of the previous year, due to the GST move.

Speed-breakers

Rural consumption, which was growing faster than urban, helped car and bike sales, while a pick-up in mining, road-building and haulage needs pushed commercial vehicle sales. However, as the year progressed, things took a turn for the worse.

Concerns over rise in fuel prices, higher insurance costs for vehicles due to mandatory long-term third-party cover, a slowdown in vehicle loans from finance companies due to liquidity issues in the NBFC space as well as a dip in rural demand dampened sentiments. As a result, overall volume growth in auto sales has predominantly been in single-digits since July 2018. The festival season too didn’t do much to lift customer spirits. Most companies are now liquidating the inventory built-up for the festival by offering huge discounts to customers before the 2019 models come in.

Apart from challenges on the demand front, auto manufacturers faced margin pressure from rise in input costs due to spike in metal prices. The depreciation of the rupee also made raw material imports costlier.

Thanks to all these headwinds, auto stocks took on the chin in 2018, losing 9-59 per cent so far this year. With global factors such as the Chinese slowdown, Brexit and the disfavour for diesel vehicles in Europe and the UK affecting Jaguar Land Rover, the Tata Motors stock fared the worst. Mahindra and Mahindra is the lone gainer in the pack, sporting a modest 4 per cent rise.

Outlook

Many of the above-mentioned factors may continue to bog down auto stocks into 2019. Growth forecasts for fiscal 2018-19 is down to about 9 per cent from the double-digit rise in volumes expected earlier. But the sector may not be headed for a cyclical slowdown yet.

For one, populist measures in the run-up to the elections, including farm loan waivers, may boost consumption in the first half of 2019.

Beyond that, pre-buying before the implementation of the BS-VI norms in April 2020 (which will make vehicles costlier) will aid higher offtake.

Both sector-specific concerns and volatility in the broader markets have ensured that stock valuations, which catapulted in 2017, came down to more reasonable levels in 2018.

For instance, market leader Maruti Suzuki now trades at a trailing 12-month PE of 30 times, from 39 times in the beginning of 2018. The upcoming launch of an SUV as well as refreshes of the Wagon R and Alto expected in 2019, will support volumes next year.

Recent launches such as the Marazzo, Alturas G4 and the upcoming compact UV, the XUV300 place Mahindra and Mahindra on a strong wicket. The stock trades at an attractive trailing PE of about 21 times now.

Banking: Stressed out

 

When the Centre first announced its massive recapitalisation plan of ₹88,000 crore last year, there was incredible optimism, as this was expected to ease up the constant issue of capital within PSBs. But the renewed enthusiasm soon fizzled out. The year began with one of the biggest scams breaking out in India’s second largest public sector bank — Punjab National Bank — that soured sentiments.

The next blow came from the RBI’s February circular that essentially did away with all the old restructuring schemes and forced banks to accelerate the NPA recognition exercise. Banks, in particular PSBs, took a hard knock in the March quarter; PSBs alone reported loss of ₹62,000 crore in the March quarter, and increase in NPAs of around ₹1.2 lakh crore. Overall, at the system level, GNPAs rose by about ₹3 lakh crore in FY18 over FY17. In the latest September quarter, while the pace of addition to bad loans has moderated considerably from the March quarter, banks are still not out of the woods.

Cause for concern

For one, the large bad loan book (of ₹10 lakh crore) will keep provisioning high in the coming quarters. Two, the slow progress on Insolvency and Bankruptcy Code (IBC) cases and the large haircuts that banks need to take on them, will continue to depress earnings. Three, while credit growth has moved up to 14 per cent levels in recent times, the growth is only in pockets (mainly unsecured retail loans), with modest recovery in corporate lending. Also, loan growth for PSBs (that are over two-third of the overall loans) still remains subdued at 4-5 per cent (in the September quarter). Four, deposit growth has slowed down considerably to 8-9 per cent.

Lastly, the February diktat also requires banks to report even one-day defaults and draw up resolution plans within 180 days. This has put ₹1.74 lakh crore of stressed power sector accounts in limbo. The appointment of Shaktikantha Das as the new RBI governor has kindled hopes of regulatory leeway on capital requirement and PCA norms for banks.

Also, the Centre’s recent decision to infuse additional capital may offer some interim relief to PSBs. These quick-fixes may, however, do little to iron out the structural challenges of growth, capital and governance.

Safe bets

Investors can continue to avoid PSBs. HDFC Bank, IndusInd and RBL Bank are safer bets in volatile markets. Investors can await for a clearer picture on asset quality trends at ICICI and Axis Bank before investing.

IT: Sound bytes

 

 

The IT pack had a fabulous run through much of 2018, after nearly two years of under-performance vis-à-vis the broader markets. The BSE IT index is up nearly 27 per cent so far this calendar year, while the Sensex delivered just about 7 per cent.

Top-tier stocks such as Infosys, TCS and Tech Mahindra rallied 30-40 per cent; several mid-cap/large IT players’ shares too rose at a similar pace. Valuations expanded from 13-20 times the trailing earnings at the start of year, to 20-28 times when the IT Index peaked in late September.

The subsequent correction, mostly as broader markets fell in October-November, and the pick-up in earnings over the FY19 fiscal have meant that price-earnings multiples are more reasonable now for most players.

Of course, on the revenue front, barring a few companies, most of the IT pack still grows in single-digits on the revenue front in dollar terms, though the picture looks better in rupee terms.

But rapidly increasing contribution of digital services to overall revenues, steady traction in key verticals such as BFSI (banking, financial services and insurance) and retail, and a generally weak rupee look set to aid growth for most IT firms in 2019.

Digital drive

For the likes of TCS, Infosys and Wipro, digital services now account for 28-31 per cent of revenues, as clients transition from traditional applications to newer technologies and platforms. These services generally deliver better margins for these companies and have been growing at 10-20 per cent annually. For large and mid-tier IT players such as L&T Infotech, Mindtree, NIIT Technologies and Zensar Technologies, digital offerings account for 28-40 per cent of the overall pie .

Key verticals such as BFSI and retail (accounting for 30-50 per cent of revenues) that were a bit weak in the previous years have returned to spending mode. Thanks to the surge in oil prices, the energy vertical too has been looking up for top and mid-tier IT firms.

The rupee’s weakness, especially in the second half of the calendar year, has been a key tailwind for these companies. Some have made use of the weakness and given better wage hikes to stem attrition, while others may have been asked by clients to rework pricing to pass on some of the benefits from a depreciating rupee. Thus, operating margins are still in the 20-26 per cent range for the top-tier firms, despite a 10 per cent fall in the rupee against the dollar.

Select bets

Few IT players are likely to deliver double-digit revenue growth in dollar terms for FY19, though the picture may improve in 2019-20. In this regard, looking at the segment for the next couple of years, especially given that 2019 is going to be an uncertain year, thanks to the election, conservative investors must ideally stick to prominent names. TCS, HCL Tech, L&T Infotech and Mphasis may be suitable for those with a modest risk, as theyhave solid prospects and trade at a comfortable 14-18 times the FY20 per share earnings.

 

Pharma: Slow recovery

 

 

The pharma sector has been reeling under multiple headwinds for the last few years. However, some pharma majors posted a good set of numbers in the last two quarters, thanks to recovery in the domestic business, coupled with higher sales volume in existing products in key markets.

With significant correction in share prices, many pharma stocks, including Sun, Dr Reddy’s, Lupin and Cipla, are attractive with a valuation of 19 to 22 times their estimated 2019-20 earnings.

Pick up in sales

However, revenues from the US are likely to remain subdued until sales from newly-launched products pick up. In the near term, higher sales from existing products and new approvals could partially offset the impact of loss of revenue due to price erosion. New approvals for products with limited competition, will further help mitigate price erosion in existing products.

Despite rising competition, supplier consolidation, and the resultant pricing pressure affecting exports to the US, Indian pharma players are likely to benefit from the significant R&D spend in creating a niche specialty pipeline. Further, fresh approvals in the US, which were stalled so far owing to regulatory tangles, can also help revenue.

The launch of Suboxone, Nuvaring, and Copaxone is expected to drive revenues and margin for Dr Reddy’s in FY19. The company expects favourable outcome from the ongoing court case against its Suboxone drug. Sun Pharma, despite facing pressure in the US, is confident of its higher sales from specialty products such as Ilumya and Odomzo.

Concerns linger

The recent concerns over corporate governance and blacklash, if any, by SEBI can keep Sun Pharma under pressure. The strong growth in injectables and ramp-up in over-the-counter (OTC) will provide a leg-up to Aurobindo. Ongoing capacity rebalancing, pressure on tender business and higher R&D spend are likely to weigh on the growth prospects of Cipla in FY19. Lupin’s revenue growth is likely to be boosted by the revival in branded sales in US.

While the Indian pharma companies appear to be adjusting to the new competitive landscape in the US, the risks of increasing competition in existing products, delays in approvals and slower ramp-up of recent launches may postpone the growth story.

Higher R&D cost due to focus on specialty and biosimilars, increasing operational costs due to launch of new generics in the US and branded generics in emerging markets are likely to weigh on margins in the medium term.

On the domestic side, many pharma companies registered mid-teen growth (Y-o-Y) in the last two quarters, post the GST disruption. In the last few years, the ban on various combinations and more inclusions under the NLEM list have taken a toll on growth in the domestic market. Going ahead, launches of in-licensed molecules from global partners will benefit companies such as Lupin, Sun, Cipla, Cadila and Dr Reddy’s.

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