Positive on oil sector post recent reforms: Kotak Equities

Focusing on the recent spate of reforms in the oil sector implemented by the government, Sanjeev Prasad, executive director and company head, Kotak Institutional Equities, says sentiment impact of the reforms is far more than an immediate earnings impact.

The government partially deregulated diesel prices and BPCL and IOC recently hiked petrol prices by Rs 1.50/litre and diesel by 45 paise/litre. Prasad says he has been positive on the sector for sometime now. Justifying the optimism on the sector, "It is very important from market's perspective because one of the themes which people will be focusing on, for the next few weeks leading up to the Budget is fiscal consolidation. Clearly, the oil sector math is going to play a very big role in that," he opines. Below is the edited transcript of Prasad's interview to CNBC-TV18.

Q: There is another diesel price hike and that might be a talking point in your confidence this morning. What would you be telling your attending investors to do on the oil sector now?
A: We have been positive on the oil sector for some time. We have seen some progress as far as reforms are concerned in the sector. It is very important from market's perspective because one of the themes which people will be focusing on, for the next few weeks leading up to the Budget is fiscal consolidation. Clearly, the oil sector math is going to play a very big role in that.

People wanted to believe that reforms will eventually happen in the sector because this has been a pretty much a very tough sector to implement reforms in. The government had announced diesel price deregulation as far as bulk diesel is concerned on January 17. It also announced the plan to raise twice as much small amount every month.

We have atleast seen one more round of price increase, so that will give more confidence to investors that the government actually means business as far as diesel price deregulation is concerned. Hopefully, over the next few months we will see some more evidence of that. So, from both - the fiscal consolidation perspective and the reforms momentum, this is a very positive development. An immediate impact may not be much but I think the sentiment impact is a lot more compared to the immediate earnings impact.

Q: The last part of the rocky earnings season would have raised some concern on the part of your investors. What are you going to tell them about how earnings are picking up and whether the upgrade cycle has begun as people were expecting at the start of the year?

A: Unfortunately, I don't think there is much of good news as far as the economic recovery or the earnings upgrade cycle is concerned. We just put out a note over the weekend highlighting some of the trends in the third quarter results as far as analysis of the third quarter numbers. Unfortunately, the trends aren't very good.
If one looks at the volumes; whether it is consumer staples, consumer discretionary, cement, etc, volumes have been trending down which is clearly a sign that we are not seeing economic recovery anytime soon. Looking at the investment cycle and particularly, if one looks at the investment demand and the order booking for industrial companies, that is down 16 percent on a year-on-year basis.
This is was the third quarter of the previous financial year. So, clearly, there is no evidence of investment demand picking up. Lastly, as far as the banking sector non-performing loans (NPLs) are concerned, the trends were again quite erratic. Some banks started to see some improvement in terms of slippages. That was the broad trend but on an overall level, the gross NPL numbers still increased a little bit.
The problem there has been revenue growth is trending down for the banks which recover 16 percent loan growth only. The bottomline growth was only 8 percent. So, one can say the issue was for the banking sector as far as loan loss provisions are concerned. Underlying trends are not very good as far as volume, margins profitability or banking sector NPLs are concerned.
The results were disappointing. If one looks at the BSE 30 index, we were looking at 11 percent year-on-year growth for the third quarter that came at 7.4 percent, but that was about 3 percent lower versus our expectations. This is despite some companies actually doing very well. For example, IT companies and Reliance surprised on the upside. At the EBITDA level, things were actually okay. They were more or less in-line with expectations.
However, a lot more is needed for this market to rally. If we have weak underlying trends, like say the weak macro environment or the fiscal deficit, current account deficit , as far as the economy is concerned, this market will have to get some news from somewhere in terms of reforms or good Budget, whatever it maybe for the market to start performing. Q: Aside from the point that you have made about there being no scope for earnings upgrades yet, you have also raised concerns about the quality of earnings. Are you getting worried about what’s happening on the core earnings performance itself and whether or not there could be more damage through the course of this year?
A: On the quality of earnings, there are two-three things which bother me. One is clearly the fact that other income is becoming a very large component of the earnings of some of the largecap names, particularly if one looks at consumer sectors. It is a very large proportion of the overall earnings. In some cases, it is as high as 30 percent. For the Nifty, as a whole, that number has gone up to 25 percent. Particularly in case of consumer staples, at best I am going to give the earnings which are based on financial income not more than 15 multiples, which means that core earnings of these companies are trading at even much higher multiples than what the optical numbers would imply. For example, HUL, is trading at say about 28 times March 2014 earnings. However, 30 percent of the profit before tax (PBT) is now coming from financial other income and operating other income which would definitely set a lower multiple. This means that the core consumer staple earnings are being badgered at a much higher level compared to the overall composite earnings numbers. So, clearly that’s becoming one area of concern.
Secondly, I would worry about the rising tax rates in some of the companies in auto, consumers, etc because many of these companies are now running out of tax shelters. Over the next two-three years, you will see earnings numbers starting to go up. So clearly, these are two signs of not very good quality of earnings. We didn't get a lot of balance sheet this time around because that only comes on a six monthly basis. However, whatever numbers were disclosed by various companies as also the banking sector numbers, it does not look like one is seeing any great improvement as far as working capital or bad loans, etc are concerned. So, there are some things to watch out for. On an overall level, the earnings maybe still okay but I think the quality of numbers is clearly deteriorating at a pretty rapid rate. If you have seen the last three-four quarters in particular, the working capital issues are becoming pretty big across sectors. Q: Liquidity is the wildcard but based on what you saw in earnings season, would you say the case is being made for valuations to actually contract a little bit rather than expand?
A: One has already seen that happening in a big way. Forget about the market as a whole which is probably being held up by a few names. You have IT companies which have actually gone up during the course of the year anywhere from 10-20 percent. We have the oil sector which has had a nice rally. Reliance has held up reasonably well, ITC has gone up 8-10 percent and HDFC, HDFC Bank have again held up very well. So, if one leaves aside 10 largecap names, the rest of the market is actually down a lot over the course of the year because the market is now flat on a year to date basis.
If one looks at it in rupee terms, it is absolutely flat. If one looks at some of the names in the metal space, etc - they have come down 10-15 percent over the last one month without anybody actually noticing it because the broad markets are generally held. So, it is becoming a bit of a worry that one is seeing such sharp corrections across stocks. Clearly, it is showing that there is not much of confidence as far as earning numbers, etc are concerned. So, relating is looking extremely difficult in the context of not much of earnings momentum and underlying trends are reasonably weak. I would rule out the upgrades in that case as far as multiples are concerned.

Q: After looking at this quarter's earnings and going with your view that further PE re-rating on the way up may not happen, how would you change your portfolio around then for the rest of the year? Do you become less cyclical or aggressive stock-oriented and become more defensive?
A: In December itself we had cut some of our aggressive positions in the interest rate sensitive names. For example, we had a pretty large overweight in some of the auto names, that is also in case of Non-Banking Financial Companies (NBFCs), However,  towards December-end when I realised that the valuations are becoming quite expensive,  most of the NBFCs had gone to something like 2.2-2.3 times March 2014 book. We were also not seeing too much evidence as far as recovery is concerned in terms of volumes of auto companies. We decided to cut weights rates over there and move to a more defensive kind of a portfolio.
Also, keep in mind the fact that even defensives do not have much of hiding comfort, because valuations are still very expensive out there and in many of the defensives one is seeing one-off issues starting to come in. For example, Hindustan Unilever (HUL) volumes come down to 5 percent this quarter. Housing Development Finance Corporation's (HDFC) Q-o-Q growth was hardly there as far as the retail segment is concerned and LIC Housing Finance had bad numbers as far as the developer loan book is concerned, so I do not know whether that is going to impact HDFC eventually.
The good news is that there are some sectors which have started to emerge once again where one can start making some reasonable investment. For example, the oil sector can absorb reasonably large amounts of money and so far the government seems to be doing the right things over there.
I would think National Thermal Power Corporation (NTPC) and Power Grid both have become quite attractive at current levels. Both would be trading at about 10-10.5 times March 2014 earnings. So, that looks reasonably attractive. Some of the pharma companies of late have corrected in the last one month. Sun Pharma has held up recently well, but other than that one has seen Cipla, Cadila correcting significantly. Again one is seeing some opportunities over there.
One will have to have very specific bottom-up portfolio now, because I do not think a top-down view is going to work, given the fact that there really isn’t too much of a of a top-down story. If one had GDP growth below 6 percent even in 2014 financial year , which is what we are looking at and not much of recovery on the investment side and consumption side is slowing down. So, I do not think earning numbers are really going to surprise as a whole for the market.
One has to look at specific stories where you are either seeing some management comfort or some specific developments. For example, in the oil sector we are seeing some reforms taking place so accordingly build your portfolio. We have very clearly positioned towards the large caps. I have a bias against stocks which provide some amount of rupee hedge, because I am very, very worried on the rupee because of the vulnerable Balance of Payments (BoP) position. So, accordingly, you have some positions in pharma and technology and then you can again look at some large cap names in banking where valuations would not be that great, but atleast you have comfort on the asset book side. So, you know what you are paying for the book over there unlike in many of the PSU banks where I have honestly no idea what the book looks like as of now because of the amount of restructured loans and net non-performing loans (NPL) that some of these banks are sitting on. Q: Given this kind of a backdrop, weak earnings, weak economic recovery, what can the finance minister do to change the course of the market or to get it perked up in the near term?
A: We will get some idea in the Budget anyway, but I think there are two things. Firstly, clearly on the fiscal side, there will have to be some amount of fiscal consolidation. The government can't be very aggressive on that because anyway, consumption demand is slowing down, the GDP is slowing down. So, we can't have a very aggressive fiscal tightening at the same time. Maybe, some amount of loosening as far as the monetary side will help, but again one is constraining there because of the current account position and also high inflation, particularly on the CPI side. In January, the CPI inflation was 10.8 percent which is quite scary. So, one really doesn’t have a lot of scope to manoeuvre given the macro economic compulsions.
What the government will have to do is atleast lay down the framework for improvement in the next few months or 18 months, whatever it may take. So, these reforms will have to be followed through. For example, in the oil sector, the diesel price increase has to be done to give comfort to investors that the government means business.
These are reasonably sensible ways to approach the problem. One can't have one round of Rs 5 increase and then forget about it for 18 months which was what was happening previously. So, I think this is a much more sensible approach.
Secondly, what the government can focus is how to revive the investment cycle because that is becoming a real concern. At a time when consumption is slowing down, one needs some leg up from the investment cycle. Again, one really doesn’t have any readymade solutions. One will have to go back to fixing the basics of land acquisition, resource allocation and fast approvals. So, as long as you start making the right noises, I think it is still a positive.
Thirdly, what can be done is, on a capital market side, provide some incentives for investment sentiment to stay positive and that is very important from a current account deficit perspective because India needs capital flows - there is no question about it. We are running USD 20 billion plus of current account deficit per quarter. We require atleast USD 14-15 billion coming from portfolio flows which is equity, debt, NRI. So, give some incentives for capital market investment, maybe reduce STT to some extent, provide some investment schemes etc, try and increase savings rate which is becoming another big problem because savings rate in general have declined over the last three years. From a high of 38 percent in 2007-08, it has come down to actually 31 percent last year and maybe even lower in the current year.
Finally, government needs to try and curb gold consumption as much as possible and try and put a domestic transaction tax. The jewellery sector may not like it too much but the government will have to take tough decisions because we can’t have a situation where so much money is getting blocked in unproductive assets. Also, it is clearly hurting us as far as the current account deficit is concerned. So, even if it does some of these four-five things, not that it is going to change the course of India dramatically, but it can atleast stabilise economy, give the right signals to investors in terms of that. Yes, there is a problem as far as some of the macro economic challenges are concerned but we are taking control of the situation and trying to solve the issues. So, I think that is probably the best we can hope for in the Budget. Don’t expect anything dramatic, just a sensible Budget and I think we should be fine. Q: Given these two pillars though, what has happened with earnings performance and the expectations from the Budget what is the sense you are getting from the crowd gathered over there amongst the global investors? Do you think it is going to be a make or break kind of event in terms of determining where flows go? Are people waiting and watching to see what comes through on the Budget considering earnings are not great anymore.
A: Over the next two weeks, there are a lot of conferences in India and practically the entire global investment community will be in India at some point in time over the next two weeks. So, they will have a fairly good sense as to what is happening at the company level, what is happening on the ground level. The bad news will be there in the sense the companies will not be painting a very rosy picture that is pretty apparent looking at the quarterly numbers.
There is no denying that there are issues on the ground and companies will presumably present the right picture. So, that may put some amount of cautiousness among investors who have been generally quite positive so far. On other side, if we have a sensible Budget as we were discussing, some fiscal consultation but the right language and the tone then I suppose that is going to be a little bit of positive. We should continue all the small reforms which have been started. That gives the right signal again to the investors. So, I think the next two weeks are going to be fairly critical as people digest the news of the fact that ground level the changes have not be as dramatic as what the market believed could happen in September when the first round of reforms were announced. However,  as long as we get a sense that India is moving in right direction with respect to fiscal consolidation, some amount of loosening as far as monetary policy is concerned and doing the right things as far as investment cycle is concerned, I think maybe we could still sustain interest.
My bigger worry is as we head into the second half, that is where one starts seeing problems, because then unfortunately, the hands of the government will also be tied because of state elections. We have four major state elections in the months of October, November this year and then you probably get into the election mode after that. So, whatever the government needs to do probably needs to do in the next six to eight months. Global environment is reasonably supportive, liquidity is very strong. People are interested in putting money in India. So, we need to give the right signals.