Expect 14% Sensex earnings growth for FY17: Citi

With India Inc's good earnings show in the March quarter in FY16, Citigroup has revised its Sensex target for FY17. The US-based brokerage now expects Sensex to touch 28,800 points by the end of FY17. In an interview to CNBC-TV18, Surendra Goyal, Head of Research at Citigroup India, said 47 of BSE100 companies have exceeded estimates in the fourth quarter of FY16. He added whenever earnings momentum has been positive, the market tends to trade at higher-than-mean valuations. He said, "If the momentum trajectory continues, higher multiples can not be ruled out."Goyal said the brokerage expects a 14 percent earnings growth on the Sensex for FY17. The brokerage is overweight on financial, cement and utilities segments and expects the auto sector to do well. It is also of the view that the pharma sector is one of the fastest-growing sectors. The US FDA overhang with regard to regulatory troubles seemingly lifting, the sector could expect good growth. The brokerage is underweight on consumer staples. Goyal said things are improving but we are yet to see a linear recovery.Below is the verbatim transcript of Surendra Goyal’s interview with CNBC-TV18's Latha Venkatesh.Q: What is your view on the market and how do you expect earnings to pan out in FY17?A: Earnings has been pretty decent for the fourth quarter. The overall headline earnings may look muted but if you kind of take out financials where we have seen a big impact or provisioning earnings have actually surprised positively. If you look at the BSE Sensex earnings ex-financials the growth is high teens versus our expectation of single digit. So, that is a material beat and if you kind of look at it in another way, if you look at the BSE 100 companies 47 of them have exceeded estimates. 41 of them have missed but 47:41 is a fairly decent ratio to have given the kind of trends we have in the last couple of years.Another metric if you look at is the downgrade, upgrade ratios. So, it is right now upgrade downgrade is 40:60 and this has been improving through the course of this year. So, if you put it all together we have had a decent earnings season and what is interesting is FY17 earnings are by and large unchanged which is interesting if you kind of consider that on the financial side we have had fairly significant downgrades. So, the rest of the sectors are kind of contributing and essentially offsetting the impact that we have seen on financials. So, at an aggregate levels we have seen decent earnings. From FY17 perspective our expectation is for 14 percent odd earnings growth on the Sensex.Q: What does that do to your index target in that case?A: Our index target we have revised it up from 27,000 to 28,800 and the change is primarily we are seeing good earnings momentum. Also on the multiple side we have raised a very small change but what is interesting in which we have highlighted in our note is whenever earnings momentum has been positive the market tends to trade at higher than mean kind of valuations. Right now the last 10 year mean is say 15-15.5 times our target is at 16 times. So, it is not a significantly higher multiple but if the momentum trajectory continues higher multiples cannot be ruled out.Q: So, this 28800-29000 Sensex which are the horses that lead from the front?A: From an earnings perspective if you look at it what we are expecting is some of the sectors which had a tough FY16 like financials, materials etc this year significant rebound and it is largely base effect and things seem to be improving little on the material side. Even on the financials the underlying is pretty decent. Autos and pharma etc these are the sectors which have been doing well. We expect the momentum to continue. So, it is a combination of a lot of these things coming together which should drive the 14 percent earnings growth next year.Q: Is there anything that you would avoid. You have got an underweight on some sectors like consumer?A: Consumer staples, we do have an underweight. There are few things to keep in mind here. Firstly if you look at volume growth for a lot of the players they are mid to high single digits and valuation multiples of these stocks are extremely rich. So, that is something which one needs to keep in mind that unless volume growth picks up significantly this multiples may not be easy to justify.The second thing is obviously the impact of Patanjali which we have highlighted in one of our reports as well. What it does to the sector is firstly they are taking some volume share in multiple categories. So, the volume growth of the incumbents is getting impacted and it impacts your pricing power. If there is so much competitive intensity you may not be able to take price increases and that is the reason why we have an underweight on consumer staples.Q: This earnings season what stood out was earnings before interest, taxes, depreciation and amortisation (EBITDA) growth and EBITDA margins. Not so much revenues and even less volumes. What would you think would be the trajectory for FY17? Will revenues take over and EBITDA decline?A: What we are expecting is that revenues see a significant uptick. This year is actually on the headline negative. It is a decline. So, we are expecting that that turn into positive and what also happens is that the moment you have revenue growing and this year was a year of contraction you will have some operating leverage kicking in. So, while I take the point and that is the question I get very often that this year was a year of commodity price benefits, next year they may not be there but operating leverage kicks in because your revenues are starting to grow.Secondly, corporates also are in cost control mode. Lot of sectors have gone through difficult times and people have been tightening belts. So, that impact should also come in. So, you will have a mix of revenue starting to grow faster and EBITDA margins kicking in.Q: What are the top sectoral bets if the economy recovers in a seminal way?A: There are quite a few sectors which are doing well and if you look at some of our overweight sectors like autos for example. We have seen autos being fairly robust and with a good monsoon as is being forecasted and expected as well as hopefully the pay commission hike as and when it kicks in you should see autos continuing to do well.The pharma sector there have been challenges around US Food and Drugs Administration (FDA) etc but the revenue momentum is still intact. It is one of the fastest growing sectors in India.Financials also as I said this quarter got impacted by non-performing loans (NPL) provisioning but if you look at some of the retail focussed banks they seemed to be doing well. But some of the - let us say IT services for example, there have been tailwinds on reported basis the rupee revenue always looked pretty decent.Q: What about say, capital goods for instance. If you are betting that the worst is over for financials you are obviously betting that the economy is turning in a very seminal way where would the Larsen & Toubros and the various midcap capital goods figure in your scheme of things?A: Let me answer it a little differently. What we are saying is that things are improving but it is not like a linear recovery. It is fairly uneven if you look at all the macro indicators you have two months of good data and third month it slips. But the good thing is if you kind of take a six month average or a three month average it is better than the prior three months or six months. So, the direction is positive but it will be a little uneven. So, that is something which one will need to keep in mind.Financials, the reason why we are positive is if you look at some of the sectors which have been the biggest challengers as far as NPLs are concerned. You could look at power, steel, construction. A lot of them actually are starting to see some kind of improvement. It could be because of various reasons. Steel prices have started going up, the government is also helping.Q: You are buying steel?A: Maybe sectorally I will come to it a little later. But at underlying level the stress on the balance sheet is easing a little. Similarly in construction we are seeing road activity pick up. So, again there the stress will ease a little bit. So, what we are saying is that at the margin things are bottoming out. It may not be a full steam recovery yet, but that is very helpful for the banks because this industry have been kind of going down and down for a while. So that is the reason why we are overweight on the financial sector. On the industrial side it's primarily the large cap plays where we are interested in, not so much really the midcaps.Q: Global flows they have been clement for now, but we all know that there are ambushes on the way. What kind of a downside can the Sensex touch if Brexit were to go badly, if the Fed hike is taken badly, if the Yuan depreciates again?A: That's a tough one and obviously they will play on the markets if and when they play out. Let's look at the Fed rate hike our global view is that it happens more likely in the latter part of this year, but having said the probability of a summer rate hike has inched up a little in the recent months. Our emerging markets (EM) strategist he put out an interesting note, where he has argued a couple of things firstly its rate hike is not necessarily such a bad thing because it kind of indicates that growth is coming back.Secondly in the last two instances of rake hikes EMs have done well and it's been a risk on trade even within the EMs rather than a risk off trades, so short term yes we could see an impact on flows. All of these issues can impact flows, but what I am more concerned about is the earnings trajectory and the macro. I think if both those things are intact you may see short term negative surprises, but finally you should see index make a decent return over the medium term.