See earnings downgrade for IT if rupee remains strong; like IOC, Aurobindo: Sanjeev Prasad

Among sectors, he said that some pockets of value was left in the market for oil and gas. He liked Indian Oil as the stock was trading at much cheaper valuations than its peers. In fact, he felt that the refining cycle could surprise positively going forward.

In the pharma space, his preferred pick is Aurobindo Pharma. The stock is reasonably valued and there is not too much concern on product portfolio concentration.

Meanwhile, he recommended being ‘very selective’ on midcaps. Moreover, non-banking financial companies (NBFCs) were getting more crowded. Corporate loans were not growing and this could lead to banks being more aggressive on the consumer side. They have a bigger advantage in terms of technology, he added. The business models of NBFCs could then start coming under pressure as well.

On Reliance Industries’ surge, Prasad said that the market was not ascribing a lot of value to the telecom business. Its current valuation seems reasonable, he told the channel.

Information technology (IT) sector had some value, but more triggers were needed. Prasad saw a topline growth of 7-10 percent for the current fiscal based on the rupee’s value at 68/USD. However, if it sustained at current level at 65, there could be further downgrades for IT sector.

Below is the verbatim transcript of his interview to CNBC-TV18's Latha Venkatesh, Anuj Singhal and Sonia Shenoy.

Anuj: The liquidity driving market even further from last time when we spoke. What is next? Do you think this market is now vulnerable to a correction or you think liquidity is strong enough to hold this market?

A: You never know what liquidity is. Everything will look good and suddenly it could change. Therefore, keep in mind the fact that what is driving liquidity is the events which are unfolding in the US, so you are seeing weakness in the US stocks and on the back of that very strong inflows into emerging market and India is also getting its fair share of money.

If you look at India alone, it has got about USD 9 billion in the month of March; if you combine the debt and equity, foreign portfolio investor (FPI) inflows into the Indian market which in-turn has pushed the rupee up significantly and rupee appreciation attracts its own set of money into the country. So we have to be careful about what is driving this market. However, some of the factors could change if there is change in narrative in the US.

However, for now the way I would look at the market on broader basis, the risk reward balance is not very favourable for all. Large part of market, depending on your comfort levels with individual names, if you think there is money to be made over here, you stay invested or you invest. Otherwise if in pockets where one believes that valuations are stretched, there is clearly doubt about earning numbers in some cases, business models are not strong enough to justify the valuations then you start booking profit in those names.

Latha: Where do you have valuation comfort now? Do you have it in Reliance Industries; do you have it in any of the private banks?

A: A few areas, we have held it consistently for the last few months now so we are still finding value in some of the corporate banks assuming resolutions going forward. I assume the government sees to the matter and come out with some plan whether it is some sort of overarching, oversight committee to approve resolution plans proposed by the banking system or it is in the form of some sort of asset resolution. We will have to wait and see, but as I assume something will take place over the next few days and I think many of the corporate banks seem to be reasonably inexpensively valued at this point of time assuming you see some more positive movement on resolutions.

However, in the same way if I look at oil and gas names, I still find value there and companies like Gail. It is trading at 11 times, if you adjust for the value of its investments in various businesses. It's 11 times on March 2019 basis. Indian Oil Corporation is at 9.5 times March 2019, so quite expensive. We continue to like the utilities and Power Grid is still available at 11 times on March 2019 basis. So there are pockets of value left in the market even though many of the stocks have performed well over the last two years or so but there is still money to be made in some of these names.

Sonia: The other space that interests me from your report is the pharmaceutical space because you have recently added Aurobindo Pharma into your list, tell us what the call is over there because it is hard now to separate out the wheat from the chaff in the pharma space because of so many US-FDA issues, why Aurobindo Pharama?

A: We have discussed this last time also. It is reasonably an expensive stock trading at about 13 times in the March 19 basis.

One of the few things where we do not have too much of concerns about product portfolio concentration unlike in some of the other pharma companies, which we are starting to see a lot of pressure on some of the generic products in the US and accordingly disappointments in revenues, if you look at something like Sun Pharma, the top 20 products in the US only account for 40 percent of its US revenues so fairly well diversified product and not running the risk of more competition in any single product which could hurt the overall company revenues.

Anuj: You have Indian Oil Corporation (IOC) as one of your top picks. The reason I want to discuss this is what is happening with oil marketing companies (OMCs), we saw big rally but that rally has stalled despite crude coming down and rupee appreciating because of all the concerns on getting merged with upstream companies. Do you think that is a fair risk to some of these oil marketing companies?

A: I do not know what kind of restructuring the government has in mind with respect to the sector. It is a simple case of let us say a downstream company may require when upstream company – I do not see much changes over there for example, one of the things which was doing the rounds was that government stake in Hindustan Petroleum Corporation Ltd (HPCL) being bought by Oil and Natural Gas Corporation (ONGC) and the two companies would pretty much continue to exist as they are with HPCL just being 51 percent subsidiary of ONGC.

So assuming nothing much changes over there. If it is a full blown merger presumably it will be at the fair price to both sets of shareholders, I do not think again much will change. From an immediate stand point, yes, there will be longer-term synergies but given the fact it is a public sector companies, we cannot remove a lot of employees and do fair amount of operational savings out there.

Coming specifically to IOC, do keep in mind the fact that it is much cheaper compared to both the HPCL and Bharat Petroleum Corporation Ltd (BPCL), the other two are trading at about 11-12 times March 2019 basis, IOCL is much cheaper. One of the things, which I am getting a lot more positive about is the refining cycle could surprise on the upside as we go forward.

So the fact that we aren't seeing too much of new refining capacities additions globally, particularly in Europe and North America and if that is the fact over the next two-five years, you could see refining becoming very tight. Even now if you see, let us look at 2017-2018 put together, we are looking at incremental oil demand of somewhere about 2.7 million barrels per day against that -- if everything goes right, we are seeing a new refining addition of about 2.3 million barrels per day. Having said that, none of these refiners ever come on time, they could get delayed and even now global capacity utilisation running north of 90 percent. So over the next two-three years, capacity utilisation levels could further move up which could result in refining margins being very strong compared to whatever the street is assuming at this point in time.

Latha: Let me speak a bit about midcaps, especially in the NBFC space. These have been the extraordinarily well performing stories of the last several months, even years I would say – Bajaj Finance, Capital First, and then you can add all the smaller banks to it, the RBLs -- any thoughts?

A: You have to be very selective in these names. I don’t think the generic principle will work anymore. One of my thought process, something which we have written also about is that incrementally the NBFC space is going to get a lot more crowded. Given the fact that if we look at what has happen to banking system, your corporate loan book is not growing, neither do I expect that loan book to grow over the next few years given the fact that that particular part of the market will get intimated by the bond market.

You have 40 percent of loans of the entire banking system in the form of corporate loans and that book is not growing and banks will necessarily start looking at the retail segment more aggressively. Remember, many of the private banks, also corporate banks, feel more or less vacated large chunks of the consumer financing space. I suspect many of them will re-enter the space, the likes of Axis, ICICI, even SBI, etc. who will become more aggressive on the consumer side which is where typically the NBFCs are present.

You could see the private retail banks which are already present over there becoming more aggressive over there and clearly banks have the advantage as far as cost of funds are concerned, distribution is no longer a challenge in the digital world so I think the business models of NBFCs will causally start coming under pressure as we go forward.

Sonia: I wanted your latest view on telecom as well. Is your positive stance there restricted only to Reliance Industries because of Reliance Jio’s aggression, or do you think that there could be a bit of a rebound in some of the other incumbent players as well?

Latha: Are you positive on Reliance Industries at this price?

A: First of all I have never had a positive on telecom for the last 15 years; full disclosures over there. As far as Reliance is concerned, our call at Rs 1,050 was that the market was being very negative as far as the telecom business was concerned and we had a positive call on Reliance then. Even now I think Reliance looks okay for the simple matter if I look at the core chemical refining business, it will do something like roughly Rs 120-125 adjusted EPS on a March 19 basis once all the full capacity from petrochemicals and the gas cracker are through.

So, if you take a 11-12 kind of a multiple on that kind of earnings, you are looking at the chemical and the refining business valued somewhere about Rs 1,300-1,350 or so which means that the market is still not ascribing a very large value to the telecom business which is a good thing I guess if there is any positive surprise on the number of subscribers which people are still skeptical about in a way that the numbers go up to about 100 million or so paid subscribers, then I think the market will start ascribing about Rs 200 to the telecom business, and a one-time price to book at least for Reliance’s investment in Reliance Jio. So, I think there is still some money to be left but that is now contingent on the telecom numbers playing out well.

Anuj: IT stocks trading below median valuations, especially the likes of Infosys, do you see value there, do you think they are good portfolio bets?

A: There is value but the problem is the earnings numbers still have to be cut on the street. It is not as if we are looking at very strong earning numbers, topline growth for most of the companies were looking at range of 7-10 percent for the current fiscal year now.

Given the fact were rupee is, our earnings estimates were based on Rs 68 per dollar average for fiscal 2018. Currently the rupee is at Rs 65 per dollar and if rupee stays where it is based on whatever is happening globally, I think you will see further earnings downgrade as far as IT sector is concerned and whether they have the levers to manage the kind of pressure which will come because of such a strong rupee I am not very sure given the demand and the pricing environment which is out there. So, yes, value is there but I need some more triggers over there.

Disclosure: Reliance Industries owns Network 18 that publishes moneycontrol.com.