RIL to be rangebound; pick IndusInd Bank: Sanju Verma

Reliance Industries (RIL)'s net profit fell 5.7 percent to Rs 5376 crore,YoY owing to declining natural gas output from its KG-D6 fields and poor petrochemical margins. After the company declared its Q2 results, Sanju Verma of Violet Arch Capital Advisors expects the company's shared to remain rangbound in the near term adding that its performance is comforting on a sequential basis.

Verma further stated that Reliance's gross refining margins (GRM) may peak out in Q3FY13 and expects GRMs to moderate from current levels in 2013. She believes further rally in RIL is going to be event driven and gas price hike, volume ramp-up can be key triggers for the company. According to her, the company can catalyse growth through better cash usage.
India's third largest private sector lender Axis Bank on Monday reported 22% year-on-year rise in its second quarter (July-September) net profit to Rs 1,124 crore, boosted by growth in loans and other income. Verma however, does not consider the 15% NII growth encouraging. Although, its valuations are comfortable she thinks the bank's growth is weakening and therefore, would avoid Axis Bank at the moment.
From the banking space, Verma picks IndusInd Bank as a favourite and said the valuations for HDFC Bank are extremely stressed at this point.
As far as Infosys is concerned, Verma reiterated the fact that slowdown in discretionary spend key worry for Infosys and it needs to tweak its business model to drive growth. She also does not think that Infosys will be able to meet its dollar revenue guidance of 5%. Here is the edited transcript of the interview on CNBC-TV18. Q: Reliance at this level of Rs 825, how do you see it moving forward?
A: My sense is RIL is going to be pretty much rangebound. You are not going to see too many surprises either way, neither nasty nor pleasant ones. Don’t forget that in the first quarter of 2011 this was a company which at the bottom line was notching up growth of 28-30%. Now it has come a full circle.
Of course till about two quarters back the company was actually degrowing at a rate of 20% year on year (YoY). At that point when the March 2012 quarterly numbers were announced, I thought from its peak to trough, Reliance has come a full circle with the earnings having degrown from peak to trough by almost 50-60 percent. The company will not increasingly show incremental growth going forward.
However, clearly that does not seem to be the case. It is true that sequentially the numbers are very reassuring. At an EBITDA level, the company has notched up sequentially a growth of 14 percent or more. Even the bottomline sequentially has grown by 22 percent. But, if you look at the numbers YoY, I think there is a lot left to be desired with the profit still down 6 percent.
If we look beyond the numbers, first taking the positives that they have notched up revenues shy of Rs 5000 crore on the retail side is certainly welcome. But, this is just like a spec in the ocean for them. From revenue of something like Rs 93,000 crore, retail accounting for just about Rs 5000 crore doesn’t say much about the direction which this particular segment will take going forward. It will take a couple of quarters or maybe even a couple of years for this to be highly EPS accretive.
So coming back to the core business, it has been said and reiterated by most analysts and in my view it is the refinery outages in Asia, Indonesia, Japan, China etc which have led to gross refining margins (GRMs) coming at USD 9.5 per barrel. Maybe the Q3 of FY13 will see GRMs peaking out. I won’t be surprised if you see GRMs actually moving up even further closer to USD 11 per barrel in Q3 FY13.
But in Q4 of FY13, GRMs should settle at more sedate levels. In FY14 my sense is GRMs will settle down in a more sedate range of USD 7-7.5 per barrel. Clearly, USD 9.5 to USD 11 per barrel is a bullish scenario for RIL and that that will last only for another 3-4 months, maybe or a couple of months more.
The key point I want to highlight is that the only way RIL can now get into a secular bull run is if refining margins continue to be resilient but, it is not going to happen or if gas prices go up from UD 4.2 per mmbtu, which will certainly not happen before FY14, which is when their production sharing contract expires.
If gas volumes go up, which will also not happen given gas volumes are down some 30% from 40 mmscmd same quarter last year to just about 29 mmscmd this quarter. So the point I am trying to make is why would you want to pay 12.5-13 times price to earnings for a company which over the next two years will not grow compounded at more than 6-7 percent or more than 8-9 percent if you have to be really optimistic? And where the return ratios are not more than 10-11% given the huge cash pile of sub Rs 80,000 crore which they currently have at their disposal.
My sense is if I were a global or Asian Fund Manger, then the closest comparison to RIL would be Sinopec which is trading at 4-4.5 times EV to EBITDA and 7.5 times price to earnings. Why would I want to pay 8.5 times EV to EBITDA for RIL and about 12.5-13 times price to earnings for a company which will barely grow in pedestrian single digit?
For the next one and half or two years, unless there are big ticket announcements, which RIL has the wherewithal to do, each time the stock has rallied it has been an event driven rally. The last time it rallied handsomely was when BP took a 30 percent stake and everybody valued that for something like USD 15-16 billion though it is a different matter that six months back after the proven and probable reserves that estimate was brought down. People said the BP stake is not worth more than USD 6-7 billion.
In case of RIL, it is either the excellent financial engineering which the company keeps throwing at analysts can be the big surprise or if they really do something dramatic with their cash pile it would surprise. Other than that, purely from a results perspective, I don’t think you are in for too many surprises. And from a valuation perspective, if you are just a value driven investor it is better staying away because Rs 62-64 give or take a little bit is what the EPS will look like over the next one-one and half years.
_PAGEBREAK_ Q: What about Axis Bank, what did you take away from those results and relative to its peer set in the private banks given its valuations where would you place it?
A: I was pretty much surprised on the negative by Axis’ numbers. Too much of water has flown under the bridge with a lot of people saying that Axis have exposure to the more sickly state electricity board, NPAs will be a red-herring for this bank and will only incrementally get worst. Even if I take all that into context, what has surprised me is that here is a bank which was notching up net interest income growth in excess of 22-23 percent every quarter for the last so many quarters that I can recollect and the NII growth coming in at just about 15 percent this time around has been a bit of a nasty surprise.
More importantly, I think it is important to remember that do not get carried away by this net profit growth of Axis, which looks very handsome at 22 percent. I am quite taken aback by the fact that here is a bank which at the bottomline has shown in absolute numbers, a net profit number of just about Rs 1,100 crore or a little more than that but look at the other income, it has come in at Rs 1,600 crore.
Basically, a large part of the bottomline has been driven by other income, which is up some 30 percent year-on-year (YoY) with the capital markets having been flat. I am a bit circumspect about the stupendous 43 percent fee income which these guys have shown not to mention the fact that the gross NPA level is far from flattering.
At this point in time, while it is true that after Rs 112 EPS which is what our estimate is for FY13, Axis will notch up an EPS of something like Rs 136-137 for FY14 which over FY13 translates into more than a 40 percent growth. It is trading at barely less than 2 times price to book and 10-11 times price to earning. So great valuation story but the fact of the matter is that the core business has started slowing down dramatically and a large part of the growth is coming in from other income, which is not reassuring.
At this point in time, I think I would stay away from it. On the flip side, the numbers from IndusInd Bank were great. We have always known that IndusInd Bank will continue to have healthy margins because a large part of their portfolio is retail credit where the lending rates will not come down. What happens on the deposit side is a different game altogether but lending rates will be sticky and steady at 16-17 percent.
If deposit rates come down even a bit, the margins immediately shoot up and that is well reflected in the numbers with the margins having been pretty much steady at about 3.2-3.5 percent levels. If they can spruce up their capital adequacy, I think this is one bank which is increasingly looking interesting.
At this point, I would stay away from Axis Bank because the core business has certainly started slowing down. I think most of these banks, even HDFC Bank where NII growth was stupendous at 27 percent YoY, was very reassuring. Do not forget that the large part of the growth came in from the unsecured portfolio on the retail side. The unsecured portfolio on the retail side for HDFC Bank has grown by 38 percent. That tells you a lot, banks are pushing the envelope, NPAs do not seem to be on anyone’s radar at this point in time as long as they can get the growth coming in.
I would be wary of even that one, I would not want to pay 3.5 times price to book for a bank where the retail and the unsecured portfolio incidentally is growing close to 40 percent. If push comes to shove, it would have to be ICICI Bank, IndusInd and like. I have always maintained some of the smaller banks like an OBC or an Allahabad Bank, which have managed to check its NPAs are pretty much in favour. Q: The street seems to be divided on what to do with Infosys while more of the crowd is circumspect that there are some which are fairly aggressive by contrarion calls on that one, where do you stand?
A: I think we are certainly more bearish than some of the bears on Infosys. The consensus EPS for FY13 stands at something like Rs 161 or a notch higher than that. We are by far the most bearish at Rs 158 and I think our pessimism on Infosys stems from the fact that two years back this was a company, which always used to disappoint on the guidance front but they used to outperform as far as the deliverables were concerned.
Promise less but deliver more seemed to be their mantra. Somehow in the last three-four quarters they seem to have lost their track, so to speak. Every quarter this stock is hammered 7-10 percent down and I think it has less to do with numbers now. It has more to do with the constant churn at the top management level which does not certainly send out a flattering picture of the company, more so when competition is right up there.
From trading at a premium to TCS, today this is a company which is trading at a 20-30 percent discount to TCS. I do not think this discount will go away in a hurry.
The basic problem is their business model. Today for Infosys, 30-35 percent of their revenues come from discretionary spends and discretionary spends are the first to take a knock on the chin when global growth slows down. I think clearly it will take a while before Infosys rejigs its business model.
The reassuring part of its number this time was that infrastructure management services has never been their focus area. Over the last two quarters this has been going sequentially at a pretty healthy pace of 5-6 percent quarter-on-quarter (QoQ) but, this is just about 6-7 percent of their revenues. That is precisely the point I am trying to make.
Look at HCL Tech, why is it that global spends are coming down and HCL Tech always surprises you on the positive. It is because of the business model. 25-26 percent of HCL Tech revenues come from infrastructure management services.
Basically, the point I am trying to make is that companies which rely on discretionary spend will continue to face rough weather until global IT spends go up dramatically. Infosys being hugely reliant on discretionary spending is certainly not going to have it easy.
Also I think their business model is such that every appreciation in the rupee impacts them far more severely than it does to a lot of other people. For instance, a 5 percent appreciation in Infosys is likely to lead to something like a 8-9 percent decline in earnings via the negative multiplier effect on margins whereas that is not the case for HCL Tech or Wipro.
My point is that at this point in time, I would stay away from Infosys and I think while TCS has had a brilliant run, I would still stick my neck out and say that the pecking order would perhaps be HCL Tech, TCS and two midcaps in the form ofKPIT Cummins and Mindtree.
But, Infosys I do not think has too many positive surprises. In fact I do not think they will meet their dollar revenue guidance of 5 percent for FY13 because to do that their CQGR for the next couple of quarters in dollar terms has to be 3.5 percent and I do not think they will do that.
Just look at it this quarter, they notched up volume growth of 3.8 percent which I thought was very good. But that translated into revenue growth of just 2.6 percent when the market consensus was 3.4 percent. It is clear that they do not have any pricing pressure. I cannot understand why margins fell by 160 bps when they did not give any salary hikes. They say that it was because sub-contracting cost went up which means they do not have specialized personnel on board and they are subcontracting specialized work to people who are not on board because of paucity of skill set which I do not think augurs very well.
My sense is that at this point in time you are better off staying away from Infosys and you are better off being with the other biggie which is TCS.