The problems faced by IT services majors Infosys and Wipro may not be specific to those companies, feels Sanjeev Prasad, Executive Director, Kotak Securities. In an interview to CNBC-TV18, Prasad said that at some point, HCL Technologies and TCS too would be hit by the slowdown in IT spending by global companies.
Both HCL Technologies' and TCS' quarterly earnings have been matching or even beating market expectations consistently for the past few quarters.
On the macro economy, Prasad said that while the pace of inflation has been falling, the improvement in the Current Account Deficit (CAD) would be gradual despite declining crude oil prices. Wholesale Price Index (WPI)-based inflation for March fell to a 40-month low, raising hopes that the RBI will cut interest rates at its meeting on May 3.
Prasad says that India, which used to trade at premium valuations to other emerging markets, has lost its special status among investors. In general, investors are now more confident on developed markets than emerging markets, Prasad said.
He is bearish on the automobile sector as he does not expect a recovery anytime soon. Sales of two-wheeler and passenger cars have been falling for the past few months, due to a combination of high fuel prices, high interest rates and muted wage hikes.
Prasad is also bearish on the banking sector, as he sees smaller companies increasingly struggling to repay loans in time because of the slowing economy.
Prasad is bullish on pharmaceutical companies and says investors should focus on only those stocks trading at reasonable valuations.
Below is the verbatim transcript of Sanjeev Prasad's interview on CNBC-TV18.
Q: You don’t seem to be a big fan of IT. Did you not like the earnings this time?
A: There was not much to like. Fourth quarter numbers were anyway quite weak and the guidance that the companies are giving out, at least both Wipro and Infosys have given a pretty weak guidance. Wipro for the quarter, Infosys for the full year and the very fact that Infosys has backtracked on giving any guidance shows that how much uncertain the price environment is.
A section of the Street is still looking at the fact that this maybe more Infosys and Wipro specific problems, but we are not very sure about that, given the fact that two of the larger companies have disappointed. You have not seen very good statements by Cognizant, Accenture. So, it looks like this is more of a industry-wide phenomenon and at some point of time, will start affecting even the players who have been very good in terms of execution, like Tata Consultancy Services (TCS) and HCL Tech.
If Infosys and Wipro become more aggressive on pricing, and Infosys has pretty much thrown down the confidence that it is going to be more aggressive on pricing. In a demand environment which is not looking robust, if some players start getting aggressive on pricing, then you would have pressure across-the-board.
Q: The game changer through last week was what happened with commodities like crude. What have you made of that and what could be the ramifications for our market?
A: It is a good development. The issue is how long it can sustain. Good news is, at least globally, it looks that you will have a reasonably soft crude price environment, looking at the supply-demand balance. You have about 1.1 million barrels/day of incremental oil production coming from US. Libya is back to full production and so you have a lot of supply coming in. There have been question marks on demand, given China’s weak economic data for the first quarter. All that put together is resulting in some pressure on crude, so that is good news for India.
Every USD 1/barrel effectively saves us about a billion dollars in terms of crude oil imports on a net basis adjusted for the exports of products also resulting in a big improvement in the CAD and that India can certainly do with.
If you look at the current account numbers which has been a big concern for us and even now looks a bit of an issue, but at least it is improving, 2013 CAD would be in the range of around 5 percent. If we take oil at USD 105/barrel, which is our current base case then you are looking at CAD at about 4.1 percent of GDP. If we bring down oil to USD 100 which is where crude prices are at currently, then you are looking at CAD of around 3.7 percent which is a much more manageable number. Similarly you will have positive impact from the subsidies and fiscal deficit as well.
Q: How are you positioned on Wipro?
A: We continue to have a reduce rating with a revised target price of Rs 350. We have cut our earnings number by 5 percent for 2014 and continue to be negative on the stock as of now. Let us see how much more correction takes place and depending on valuation whether we need to review the call or not. As of now even if I look at 2015 numbers, we are still looking at about Rs 28 of EPS. It is not as if the stock has come down to very attractive levels for us to get excited about it. 14 times is still not cheap in the context of the kind of numbers we are going to see going forward.
Q: What about the overall view on the markets now? Is this still a pullback in an otherwise down trending market or do you think because of the macro situation improving the texture of our market has changed a bit?
A: The macro environment is certainly improving, but it is not translating into earning numbers. That is the problem. You are seeing some disconnect between the movement in stocks versus whatever improvement you are seeing in the earnings or lack of improvement in earnings. If you look at the macro environment, there is an improvement in last two weeks with crude prices coming down.
The inflation numbers were also good. If you look at the four broad parameters of macro economy whether it is growth, inflation, interest rates, current account and fiscal deficit, we are on improving trend, but the pace of improvement is going to be gradual. CAD is improving because of lower crude prices. Coal prices should also help in that context.
Inflation ratio has started coming down and Reserve Bank of India (RBI) is going to cut about 75 bps during the course of the year and all that is positive and starts providing some tailwind to the economy and at some point of time, the investment cycle in earnings. What we are not seeing now is its translation into investment.
For India, the most important factor as of now is to get the investment cycle going, because unless we fix that, job creation is going to be a big issue. Unless you have a job creation in economy, your consumption is not going to takeoff. So, there is some excitement in the stocks based on the improvement in macro economy or at least based on the short-term trends we have seen but as of now, we are still not seeing that transferring into earnings.
Our earnings numbers continue to go down and for 2013 we are down to 5 percent earnings growth. It is over, so it does not matter that much, but even if I looked at 2014 numbers, it has come down to about 10 percent earnings growth. Somewhere we have to kick-start the economy growing and the biggest thing which we need to fix is investment side and for that the government may not have the time to do all the things that are required to fix the investment cycle whether it is making land acquisition process simpler, allocation of resources more transparent, environment approvals faster. Those are the real things that we will have to focus on. Hope government can start focusing on that issue, because if it does not do that, consumption will decline and we have already seen that happening.
If you look at the auto numbers in the last five months, we have negative numbers for passenger cars and so it is becoming parented. Even consumption is slowing down.
Q: Last time, you were quite concerned about the exchange-traded fund (ETF) outflows from emerging markets like India. Has the case become any stronger for a market like India to prevent a big chunk of ETF outflows and what would your view be on the global money for the rest of the year?
A: It is hard to take a call. Big problem for India is that it is becoming just like any other emerging market. It no longer has any special status on the minds of investors. India is just another market. People are investing India on a top down basis, continue to focus on the consumption theme. Little bit excited about the reform process, but compared to excitement of October-November which was the reform and transformation of economy, those expectations have died down in the last four-five months.
India needs to do something special if they have to get back that status and for that ultimately we have to fix the investment climate in the country. Even if we have an improvement in the macroeconomic environment with CAD improving, even if you take 4 percent CAD to GDP, you are still looking at about USD 85 billion of CAD which means we require somewhere USD 80-90 billion of capital flows to balance the current account. To balance that, it is imperative that we have the right investment climate in the country whether it is for portfolio flows or for direct investment, whether it is domestic investment or foreign investment it does not really matter, but somewhere we have to get the investment side going.
ETFs are one part of the story, but even the active funds are not very hot on India at this point in time. The other emerging markets have done very well compared to India. Developed markets are doing far better, so why take the risk of putting money into an emerging market which has its own political issues. You have an impending election. You do not know what is the colour of the next government, whether you will continue to see reforms taking place in the country? So, people are just focused more on the developed market at this point in time. Japan is a big market. One fund told us that they are seeing money getting pulled out of emerging markets and going into Japan which will hurt India on the margin.
Q: Ultimately, it all boils down to earnings performance. One of your peers made a point that his estimates for FY14 earnings are somewhere around 8 percent, do you expect earnings to continue to be poor for an elongated period of time?
A: We have 10 percent, so we are not too different from that 8 percent. Earning numbers are not looking very good and if the trend of weakening consumption continues for the first four-five months, then a lot of numbers will have to be reviewed downwards. As of now, some people have still high numbers on recovery in automobiles but looking at the trends and discussions with dealers and car companies, it does not look like you are going to see recovery anytime soon. Also, many of the markets are seeing specific problems.
In the auto segment, we have new entrants getting aggressive; on the other hand if you look at two wheelers you have Honda getting very aggressive. Auto is one space which is ripe for disappointment compared to Street expectations. The other one which I am a bit worried about is banking. The Street is too bullish on the numbers over there. It is another matter that banks can report whatever earnings they feel like that is hardly relevant. But if you do not see an economic recovery and particularly some of the problems which are affecting the infrastructure and power companies, then I do not see how these companies can get away without getting to default at some point in time.
Most of the problems which we have seen in the banking space have come from the smaller companies in chemicals, textiles, pharma, steel, agriculture segment. So far, none of the larger companies barring Suzlon Energy have got into trouble, but when you look at the financial condition of most of these companies on paper, they all look like they are in deep trouble. How long can the banks continue to postpone this, I do not know. I find this whole market a bit of paradox where you are not positive on the entire infra and power sector.
Most people do not want to even touch them with the barge pole, but somewhere people are very excited about banks which have a lot of exposure to these companies. So, we have a funny situation where investors are betting on leveraged banks who in turn have lent to leveraged companies. Coming to other sectors, in IT we have seen a big correction. Earnings numbers, we are not building very strong numbers, so there is a scope for disappointment. We have been cutting numbers in metals but we have seen softer commodity prices.
I know how much of the market is on some of these factors and how much more they need to cut. On the other side, the sectors that could surprise little bit on the upside is the energy sector. Coal India could surprise a little bit if you find to see a price increase there. Expectations are not very high in those sectors so we could see some positive surprise. On the whole, the scope for earnings surprises looks very limited on the upside. We could see some downgrades coming through as we proceed through the year.
Q: Where does that leave this market? If your call is that quality of earnings is going to be this poor and even the traditional pillars like banking and consumers are going to start suffering, do you think we are going to go through a period of consecutive revenue degrowth, because right now more of the impact has been felt at the margin end than the bottom-line?
A: I am also surprised, but the overall revenue numbers do move a lot with competitive prices. I would focus more on the probability and margins and at this point of time there is no scope of improvement there barring in a few sectors that are more dependent on specific factors. Some reforms are happening in those sectors or regulated utilities are doing well because of the nature of their earnings. At this point of time, we have a rather funny model portfolio, we are light on the consumption theme, on investment theme, on banking.
Effectively, we are not very positive on the entire India recovery story at this point in time. It will recover at some point in time, but to some extent the market is still referring the problems to some other sectors and is still not accepting the fact that valuations, particularly in consumer staples are very expensive compared to the deterioration in fundamentals which we are seeing, big decline and volumes there. It is a great story in the medium-term, but in the last two years the stocks have got rerated significantly at time when the volume growth has started to come down, earning numbers have started to be a little bit soft compared to the market expectations. Banking is discussed.
We are more positive on the pharma space, good growth and defensive story. Some of the regulated utilities like Power Grid and National Thermal Power Corporation (NTPC) are also showing good earnings growth and given the nature of the earnings they look fine. Both of them are trading at 10 times on 2014 earnings and even cheaper than 2015 based on whatever growth they are showing. It could be about 8 times. Some of these government owned companies like Coal India in oil and gas look okay as of now, but oil and gas companies have run up in the last few weeks and now they require some trigger to move ahead.
You finally need to see some resolution on the subsidy issue or gas price increase to support Oil India and Oil and Natural Gas Corporation (ONGC) from hereon and is therefore, a little bit of a portfolio. We are trying to protect the portfolio from any disappointments in economic growth. On consumption investment side, IT, we have been underweight. A little more positive on stocks that are trading at reasonable valuations and give you some scope for earnings upgrades and rating based on either some government related action or specific developments in those sectors or stocks.