Vijay Kumar Gaba

Indian IT: Precariously Placed (Jefferies Research)

An unexpected decline in revenues: During 4QFY23, aggregate revenues for Top-5 IT firms declined by 0.8% QoQcc - first QoQ decline in 11 quarters - the key disappointment. While revenues in 4Q were especially impacted by sequential decline in Communication and Tech verticals, growth across verticals moderated sequentially. In local currency terms, Americas and Europe both witnessed de-growth, indicating weakness in both regions. Aggregate growth for mid-sized firms was a bit better than large IT firms though they all disappointed in 4Q. TCS and Coforge disappointed the least while Infosys' reported the weakest results.

... derails margin recovery: Aggregate margins for our coverage universe contracted by 20bps QoQ and were 40bps below our expectation, mainly due to revenue miss. Employee cost (-120bps) weighed on margins due to muted growth, while Subcontracting costs (+50bps) and others overheads (+40bps) supported margins. Margin contraction was due to a 40bps compression in margins for large sized firms, partly offset by 100bps margin expansion for mid-sized firms. All large IT firms disappointed on margins, with TechM and Infosys being the weakest. LTIM drove aggregate margin expansion for mid-sized firms.

Intensifying pain in the sector: IT firms continued with cautious commentary on demand environment, highlighting a cut in discretionary IT spends. While bookings were supported by cost takeout and efficiency deals, revenue growth is being impacted by project deferrals, delayed ramp-ups and project cancellations. While Europe seems to be holding better than muted expectations, the worsening sentiment in America (~60% of aggregate revenues) was the key negative. Furthermore, IT firms have turned more cautious on the pricing environment.

Among verticals, IT firms highlighted weakness in Communication, Tech, BFSI, Retail and Mfg verticals.

Slower growth remains a risk: Aggregate headcount for IT firms declined by 8k in 4Q – the second straight quarter of decline - similar to the decline seen in 2020 during Covid. Declining headcount along with a pricing outlook suggests sharp moderation in FY24 - also evident from the FY24 revenue growth guidance given by Infosys/HCL Tech/LTIM. Additionally, IT firms expect a soft 1H, also evident from Wipro's guidance for 1QFY24 of -3 to -1% QoQcc.

A weak exit and a soft 1H implies a tougher ask for 2HFY24, which would necessitate large deal wins/ramp-ups - the absence of which could drive disappointments to consensus US$ revenue growth expectations of 7% in FY24. Our aggregate FY24 revenue growth is 110bps below consensus.

Stay Selective: A weak 4Q and heightened caution led to a 1-6% cut in FY24/25 consensus EPS estimates. The back-ended growth implies further risks to consensus estimates, which could drive further derating. Our FY24/25 EPS estimates are 1-11% below consensus and with the sector still trading at 8% premium to its 10-yr average and 13% premium to Nifty, we remain selective 

Three make-or-break crises impacting the US (ING Bank)

There is a thread running between the three crises being felt in the US right now. The inflation crisis was borne from the pandemic, a politically toxic one. The looming debt ceiling crisis stems from politicking that is more aggravated than ever. And the third crisis is a banking one, in part brought on by a Fed reacting to the inflation crisis. Where now?

Banking crisis development as measured by the Regional Bank Index and FRA / OIS – risky but tolerable

There are a number of indicators that we can track to help assess where we are and where we are likely to get to. Let’s start with the banking story, and the small and regional bank stress on deposits in particular. Here the US Regional Bank Index tracks sentiment. It was at 120 a couple of months back. It’s now at 80. In the rear view mirror the pandemic took it down to 60. Before that, the Great Financial Crisis saw it dip to 40. That’s the potential doom leap, from 80 to 40 ahead. The question is, will it?

So far the answer is probably not. We look here at the 3mth FRA / OIS spread for guidance. It essentially measures the premium that banks impliedly need to pay over risk free rates in forward space. Currently the 3mth FRA / OIS spread is at about 40bp. It spiked to 60bp when Silicon Valley Bank went down. Having journeyed back down to the low 20’s bp, the crescendo in the First Republic story saw it re-edge higher. As the Great Financial Crisis broke some 15 year ago the FRA/OIS spread quickly got up to 70bp, and then gapped to over 150bp.

We’re nowhere near that. The simple reference of neutrality would be the 20’s bp. We are practically double this right now. Troubling, but not discounting a collapse of the system or anything like that.

Inflation crisis resolution as measure by market breakeven inflation rates – reasonably optimistic

The genesis of bank stresses in part reflects the switch in the stance of Fed policy to tightening on mounting inflation concern. Such concern has eased but has not gone away – latest core PCE readings still identify the US as a “5% inflation” economy.

But there is some good news coming from market inflation break-evens, as derived from the difference between conventional Treasury yields and real yields on inflation protected securities. These inflation break-evens not only have 2% handles right along the curve, but moreover are far closer to a big figure 2% than 3%.

In fact, the 2yr breakeven has just this week dipped below 2%. If that’s what gets delivered, the Fed’s hiking job is done and dusted, and indeed the ground is laid to rationalise future cuts. While interest rate cuts likely coincide with higher consumer delinquencies and corporate defaults, and there is a feedback loop to the stresses in the banking system, where pressure in the commercial real estate sector remains under immediate scrutiny. This would become further acute should these inflation expectations not be realised, making in more difficult for the Fed to execute those cushioning cuts.

Debt ceiling crisis as measure by US sovereign Credit Default Swaps – Concerning but fixable

And as we navigate this course, we face into a debt ceiling dilemma laced with political menace that is so intense as to risk a default. Just one missed interest rate payment would imply a default. Market concern on this front is quite elevated, with 5yr Credit Default Swaps now in the 75bp area. This is the highest since the Great Financial Crisis, and is at the widest spread over core eurozone, ever. While there is no cross default in Treasuries, where one defaulted bond pulls the rest into a defaulted state, there would still be a material tarnishing of the Treasury product even if just one interest payment were missed.

Many players would not want to take on the risk of having a defaulted bond on  their books, and the collateral value of Treasuries would come under scrutiny. One default should not take down the system if holders are immediately made whole through a swift resolution of the debt ceiling. But at this same time things could unravel quite quickly and uncontrollably. In essence the entire global financial system is at threat. Note though that while US CDS is indeed elevated, it’s also far from discounting an actual default, it’s just playing the (mild) probability of default.

India strategy: Improved macro, unchanged micro (Kotak Securities)

The market has lapped up the recent improvement in India’s macro—(1) peaking interest rates and (2) better external position (BoP). We hope that the improved macro percolates into better micro over the next few months. 4QFY23 results and management commentary underscored subdued domestic demand in consumption and weak global demand in the outsourcing (IT) sectors. We expect a gradual recovery in domestic consumption over the next 2-4 quarters. Valuations are at risk without a quick recovery.

Improving outlook on global inflation, but muted growth outlook: The global inflation outlook has improved in recent months, as a result of monetary tightening across major DMs, although core inflation has stayed high (see Exhibits 1-2). The progress on inflation has allowed the US Fed to pause its rate hike cycle, but bond markets are pricing in cuts after a brief pause.

We believe the growth outlook may weaken as DM central banks will likely keep rates at peak levels for an extended period of time. Economic conditions are still fairly strong in most DMs.

India’s macroeconomic outlook has improved: India’s macroeconomic outlook has improved with (1) peaking inflation and comfortable inflation trajectory and (2) an improving external sector outlook.

The country’s interest rates may have peaked in the current cycle, which may address concerns about the negative impact of higher interest rates on housing demand. The RBI had already paused its rate hike cycle at its April meeting on expectations of moderation in inflation.

Micro outlook remains muted: Domestic micro remains subdued, with 4QFY23 earnings slightly ahead of our muted expectations. The beat is largely because of lower-than-expected tax rate in the case of RIL. In fact, both consumer and IT companies reported weak results.

We note continued weakness across most consumption categories in 4QFY23), although lending remained robust. Outsourcing companies were impacted by a weak global demand environment.

We expect moderate earnings growth over FY2024-25 (see Exhibit 13), with low scope for earnings upgrades across sectors. We would not rule out earnings downgrades in the consumer discretionary space, as the underlying factors for the current spell of weak demand may sustain for another 2-3 quarters.

‘Rich’ valuations of ‘growth’ stocks may result in further de-rating: The Indian market is trading at reasonable valuations compared with recent history and bond yields after lackluster returns over the past 18-20 months. However, most ‘growth’ stocks, especially in the consumption, investment and outsourcing space, are trading at expensive valuations, despite increasing near-term demand issues and medium-term risks of disruption. Financials remain reasonably valued and appear attractive in the context of a likely healthy credit cycle over the next 1-2 years.

India: Credit offtake remains robust in April’23

Credit offtake rose by 15.9% year on year (y-o-y) for the fortnight ending April 21, 2023. In absolute terms, credit offtake expanded by Rs.19 lakh crore to Rs.138.6 lakh as of April 21, 2023. The growth has continued to be driven by personal loans, NBFCs, and higher working capital requirements.

•      Deposit witnessed a slower growth at 10.2% y-o-y compared to credit for the fortnight ended April 21, 2023. The short-term Weighted Average Call Rate (WACR) has reached 6.70% (as of April 28, 2023) from 3.63% as of April 29, 2022, due to a rise in policy rates and lower liquidity in the system.

•      The Credit to Deposit (CD) Ratio as of April 21, 2023, rose sequentially to 75.7% from 75.0% in the previous fortnight due to incremental credit offtake at Rs 0.1 lakh crore compared to a fall in incremental deposit at Rs 1.4 lakh crore.

India Steel: Healthy spreads despite recent price cut (ICICI Securities)

Major steel companies have pruned their HRC list price by Rs2,000-3,000/te in order to restore the parity wrt imports. Traders were anticipating a price cut in May23’ over the last few weeks, resulting in domestic HRC price progressively reducing by Rs1,000/te in the month of Apr23’. HRC export price from India was down sharply by US$40/te last week, tracking China’s FOB price. Spot HRC spread, however, continues to remain healthy. Factoring in the latest price cut, it is still at Rs33,000/te (Q4FY23: 26,375/te). Hence, we expect profitability of steel companies to improve in Q2FY24.

In China, the focus is shifting from demand revival to possible production cuts in H2CY23 which might undermine global iron ore prices further, but may lead to lower exports. That said, in their respective Q1CY23 result commentaries, global players have indicated an improving demand environment with higher margins in Q2CY23. We maintain our positive outlook on ferrous space led by higher spot spreads; we would keep a close tab on exports from China.

India Chemical: Export witnessing revival, demand stability maintained (SMIFS)

Our chemical channel checks suggest that pickup of demand is gathering with most factories operating at 60-65% utilization up from 35% and expect it to gather pace because supply channel inventory is minimum & demand is witnessing uptick. Majority of commodity chemical prices are witnessing a rebound from the bottom on anticipation of strong demand in the coming months.

Despite global headwinds, India remains on a strong footing in chemicals led by increasing interest of global companies to source from India to de-risk their supply chain, increasing share of speciality chemicals in overall product mix and robust capex aligned by chemical companies to capture future growth. For Indian chemical companies, the coming quarter i.e Q4FY23 is witnessing improvement in margins sequentially owing to rebound in exports volumes and domestic demand firming up. The full recovery in margins should be visible in Q1FY24.

Pharma segment is witnessing rebound in demand & correction of major API prices seems to be over. Agrochemicals demand is steady owing to higher crop prices, though high channel inventory could impact sales in the near term. Shipping rates and container availability have reached pre covid levels. Currently, crude oil prices are trading in a narrow band which will provide stability in downstream chemical prices of basic chemicals which will aide margins in the coming quarters. Valuations of most chemical companies seems reasonable factoring in largely the pain gone by & seems ripe for bottom fishing opportunities for those investors who wish to play on the recovery cycle going ahead. The cautious approach in chemicals is the impact of the global slowdown amid lingering recession worries which remains a watchful factor.

India Building Materials: A stampede to paint the town? (Investec)

Building material proxies have sought to widen Total Addressable Market (TAM) citing variety of reasons. We highlight moat for each category is different and often beyond demand push vs. brand pull. Bundling, store economics and business to applicator to take centre stage going forward and only few winners to emerge. Our new trademark / ROC database highlights more entrants into attractive paints category and concur with house view on increasing competitive intensity here.

Chasing TAM – push or pull: BM names have sought to widen TAM by venturing into multiple categories and have cited rationale of a) growth optionality, b) channel synergies, c) connect with influencers, d) connect with applicators, e) better capital deployment (vs higher pay-outs) and e) incremental RoCE. Based on our checks with channel/ influencers, the mantra is simple, brand pull works where products are visible post installation (faucetware, paints, even tanks); if not, applicator/ store economics (bundling) dictate push. We cite companies with healthy B/S have resorted to cash burn or chase volumes at cost of quality, not the best proposition.

TAM isn’t enough, need enablers to execute same: While cumulative TAM for BM categories (paints, construction chemicals, adhesives, consumer durables, bathware, ceramics, plumbing, wood+) is at $30b+ and headline growth rates/economics attractive, we find underlying enablers often lagging. For e.g., we cite ceramic plays who forayed into bathware ~7-8years back, and despite strong brand/distribution have achieved little (<Rs3b revenues p.a.).

We cite multiple reasons for disappointment in above case: a) Applicator: mason doesn’t fix a faucet, it’s a plumber (i.e., mason isn’t a plumber and DIY is still some time away), b) Ceramics is a dead product vs. faucet, a live product. Hence, after-sales is key, c) Channel’s willingness to cross-sell: Despite bathware potentially offering better margins and return ratios, selling bathware implies more hassle (vs. ceramics), given after-sales and number of parts.

Trademark/ROC checks: Based on our new proprietary database, we find several new players ready to foray into paints as a category, which is large attractive segment with incrementally high competitive intensity. We find Pidilite (brand: Haisha), Adani (into TiO2), Hyderabad Industries (HIL IN, NR), Wonder Cement as potential entrants, besides, known ones like Grasim.

Few winners: Several coverage plays have ventured into the paints category, and we expect only a few to thrive.