Vijay Kumar Gaba

India’s digital neural networks are set to step into self-regulated, self-taught proliferation zone, led by the second largest digital consumer base globally (800mn+ internet users), massive government impetus and keen private innovation. Thus, reportedly, India’s digital economy is forecasted to snowball into USD 800bn by 2030, growing 2.4x faster than its economy in FY14-19 (source). And MSMEs, the key brace structure of the economy with 26%+ GDP contribution in FY22, have sharply stepped digitisation pace. MSME digital penetration should grow 6x in FY20-25, as per Redseer. Expect plays such as Indiamart (INMART IN)/Justdial (JUST IN) that offer direct play on MSME digitisation, to set the pace for such progress and in turn benefit.

MSME business dynamics are seeing a paradigm shift, led by nuanced policy support and post-Covid recovery. Improving MSME credit growth, manufacturing revival, supportive government/RBI policies and rural demand traction enable a prolific seedbed for MSMEs. Moreover, a crest emerging off of Covid was the fast MSME digital adoption, add to which the Open Network for Digital Commerce (ONDC) variable may hasten MSME digital adoption.

Chemicals: Testing times for non-contracted players (JM Financial)

Agrochemicals demand is likely to remain buoyant on account of robust growth in world oilseed production (as per USDA). At the same time ex-agrochemicals demand is likely to remain tepid over the next couple of months and is likely to recover with increase in global discretionary spend. The only silver lining for all chemicals players currently is the continued decline in freight rates and reintroduction of export incentives from mid-Dec’22. This could help improve margins in both 4QFY23 and 1QFY24.

Agrochemicals demand likely to remain buoyant: As per US Department of Agriculture (USDA) reports, world oilseed production in CY23 is likely to grow at a robust 4% YoY; this level of growth was last seen in CY21 on account of pandemic-led disruptions. At the same time, IGC expects world grain production to moderate only a little in CY23 and sees strong growth in CY24. Moreover, in case of India, oilseed production growth in CY23 is likely to taper to 1.2% vs. ~4-5% growth over the last 3-4 years. Hence, in our view, agrochemicals demand in the exports market is likely to remain buoyant while domestic agrochemicals demand could be flat compared to CY22. This bodes well specifically for contracted agrochemicals focused players such as Navin, PI, SRF, and Anupam.

Ex-agrochemicals demand weakness to persist over next couple of months: Basis our channel checks, demand for non-agrochemicals, especially personal care, flavours and fragrances, and cleaning chemicals remains weak. As a result, we believe non-agrochemicals focused players are likely to face challenges in volume off-take in 4QFY23.

In some cases, end-customers have excess inventories lying idle for these chemicals. In our view, demand recovery for these chemicals is contingent on inventory drawdowns, which is likely with the increase in global discretionary spend.

Increase in basic chemicals prices unlikely to dent margins: Over the last couple of months, prices of most basic chemicals have risen marginally after falling 20-30% over the last 12 months. In our view, this increase in basic chemicals prices is unlikely to hinder the margin for a majority of the specialty chemicals companies under our coverage given that all chemical companies will benefit from the revised export incentives scheme (~0.8-1.2% across different chemicals) that came into effect from 16^th Dec’22.

Freight rates continue their downward trajectory: On account of decongestion at major ports and waning demand, India–North America and India–Europe freight rates have been on a continuous decline since May’22. In our view, this downward trajectory is likely to continue as the current freight rates are still 50-60% higher compared to the stable pre-Covid levels. This decline in freight rates was one of the contributors for the margin improvement of Indian chemicals players in 3QFY23. We expect this trend to continue in 4QFY23 as well.

IT Sector: Sell; Customer health deteriorating (Nirmal Bang Institutional Equities)

We believe that the Nifty IT’s outperformance vs the Nifty by ~7ppts since 30th September 2022 till date has largely been driven by the ‘delayed landing’ narrative that has developed around resilience of the US economy along with better growth prospects for both Europe as well as China in 2023 compared to earlier expectations. However, the narrative has turned very fluid post the problems that have surfaced in the banking sector in both US as well as Europe in the last fortnight. Early signs of economic stress are beginning to emerge from the fastest increase in Fed funds rate in recent history. This in our view will lead to at least our base case of a shallow recession in the US, if not something worse playing out by 2H2023.

The potential impact of the recent banking stress in the developed markets has not been incorporated in our estimates, which broadly remain unchanged since 3QFY23 results season. Our USD revenue growth estimates for Tier-1 IT companies for FY24 are still in low to mid-single digits with downside risks while consensus is anticipating high single-digit growth, implying a belief in the ‘soft/no landing’ narrative. Our EPS estimates are lower than consensus for FY24/FY25 by 5-10% due to lower revenue as well as margin estimates.

We are also working with lower target PE multiples vis-à-vis consensus as we believe that the structural IT industry growth is not going to be materially higher than where it was pre-pandemic. Our target PE multiples are not pessimistic as they are 2-3x higher than what the IT industry had witnessed during the last major downcycle in 2008-2009 and are at the higher end of the pre-pandemic range.

While many verticals/sub-verticals have come under pressure over the last nine months, including Mortgage, Hi-tech, Capital Markets, Healthcare, Retail, P&C Insurance, Telecom, etc, the banking space in 2022 was generally resilient because of improved NIMs and low credit costs. However, with deposit costs likely to rise following the SVB episode, most US banks will see NIMs compress from current expectations. With likely higher credit costs, profits will be under pressure, leading to constrained spending on IT. Investment banks could suffer because of lower capital market and M&A activity in 2023 as was the case in 2022.

We expect somewhat similar pressure for the large European BFSI institutions. We think that the top 25 western BFSI firms will form an outsized chunk of the BFSI revenue base of Indian IT companies. Regional US banks (the hardest hit lately) are likely not big clients for the Indian IT industry, but their dislocation will likely not bode well for the US economy and could have an outsized negative indirect impact on IT spend. The S&P 500 Index earnings (including those of components, see Exhibit 5,6) deteriorated throughout CY22 and are set to worsen further in CY23.

The banking problems in both US as well as Europe may accentuate the weakness. We think that all these problems could mean at best a flat tech spending scenario in 2023 (our base case), if not worse. The Russell 2000 index (US small cap index) internals and the spike in bankruptcy filings are indicating signs of stress in the broader US economy (even before the SVB/CS collapse). In FY23, the Indian IT/ITES industry’s exports are 4x of what they were at the time of GFC and believe the adverse DM macros will have a larger impact than it did in FY2010 when industry grew by just mid-single digit rate. We especially are concerned about Tier-2 IT players where exposure beyond non-Global-500 set is likely larger. PE premium of Tier-2 vs Tier-1 seems unsustainable.

Indian economy: Activity normalization (Jefferies Research)

The Jefferies Economic Indicator (JEI) shows activity slowed in February. The fourth iteration of our economy tracker composite indicator, the JEI (based on 34 monthly data), shows MoM activity slowed somewhat. The Feb'23 JEI YoY growth is down 2ppt MoM to 7%, in-line with the 3-mma. The improving / stronger data points were nearly two-fifths of the group (14).

While Jan month activity JEI helped by a low base (COVID third wave); February is on a normalized activity base; and notably better than December.

Broad-based indicators broadly inline with 3mma. The e-way bill generation for Feb'23 was +18% YoY, -2ppt MoM, but inline with the 3mma. Railway freight traffic growth at 4% YoY was inline with 3mma while port traffic at 13% YoY was 1ppt above. Petrol / Diesel consumption growth at 9%/8% YoY was -1ppt each vs. the 3mma. Electricity consumption +8% YoY, was -2ppt vs. the 3mma, partly on weather effects (early summer).

Urban consumption trends normalizing. Feb'23 urban consumption trends were mixed, impacted by the low Jan'22 base / pent-up release in Feb'22. Auto registrations for Feb'23 of 2W/PVs were +18%/+10% YoY, +7ppt/-3ppt MoM. Spending at malls was +12% vs. Feb'20, flat MoM. Credit & debit card spending +20% YoY, was inline with the 3mma. Property registrations in Mumbai/Delhi declined YoY, but for Jan-Feb combined were +1%/+37% YoY.

Rural trends somewhat better. The employment demanded under the rural employment guarantee (NREGS) scheme was -12% YoY and 5% below the pre-COVID levels. Construction indicators seeing mixed trends with steel consumption (+11% YoY) strong though Jan cement production (+5% YoY), at a 3-mth low. Housing starts are at a 9 year high and should help drive construction employment / rural transfer economy. While winter crop production (wheat expected +4% YoY) is not impacted by early summer onset, our analysts have raised concerns on a possible drought in 2023.

Trade deficit declines further. Mixed inflation trend. The CPI declined by 0.1ppt to 6.4%, but was higher than ests and stayed above the RBI's 6% upper limit. WPI declined by 0.9ppt to a 25-mth low of 3.9%, a relief. Indeed, lower WPI is now reflecting (link) in slowing bank credit growth which at 15.5% is 2.4ppt below Oct'22 peak.

Feb trade data saw the second consecutive month of decline in trade deficit, which at US$17bn was -7% YoY. Exports continued their decline for the 3rd month, with the Non-oil exports -4% YoY. The domestic demand linked imports (ex-oil, ex-Gold) were -4% YoY. Despite lower goods deficit and sharp rising services net surplus (US$15bn, +76% YoY); FX reserves were -US$15bn. Import cover is comfortable at 9.4-months.

Pharma Sector: Risk-Reward Favourable (Nirmal Bang Institutional Equities)

Almost all Pharmaceuticals companies in our coverage universe are trading at deep discounts (average ~25% discount) vs the historical 5-year average forward multiples - even excluding Covid-19 period valuations.

FY23 has been a challenging year for the sector owing to slowdown in overall growth, margin contraction and enhanced regulatory concerns. Domestic growth has been impacted by a higher covid base while US generics business has been impacted by double-digit price erosion. Margins have also contracted due to US price erosion, elevated cost inflation and a higher covid base. Apart from these headwinds, enhanced regulatory concerns, which were absent during the covid period, have also resurfaced, affecting sentiment for the sector. As the base normalises, we believe that domestic growth is expected to be back in double digits in FY24 while price erosion in the US is expected to cool off from double-digit levels to single digit levels. On the margin front, cost inflation is normalizing, and companies have to a great extent passed on the burden of additional costs, largely in branded markets. On the flip side, we believe that the USFDA inspections are still on the lower side (330 in CY19 against 77 in CY22), but the same are expected to increase from here on. Hence, our focus remains on companies that are heavy on branded generics and have the least exposure to US generics.

We also expect mean reversion in brand-centric /heavy companies with recovery in growth amid margin improvement.

Quick Service Restaurant (Centrum Broking)

Notwithstanding the hype behind the high growth western Quick Service Restaurant category, we believe companies in this space will still be valued based on their margin strategy. Our in-depth study delves into the strategies of both i.e., the Indian companies and their global parents to understand how they are evolving and shape-shifting to win in the Indian market. We give little credence (though not ignored) to beaten to a pulp words like convenience, efficiencies, digital devices, disposable incomes, etc. as they disconcert you enough to believe the woods for the forest. Hence, instead look at margins and volumes, these will define the future prospects as the companies expand out of saturated metro and tier-1 markets, because they are still consumer companies!

Western QSRs to outperform as international brands perfect product basket right: Our in-depth study reveals the strategies followed by global parent i.e. (1) follow margin expansion in the developed markets, (2) while drive the store expansion in emerging markets due to expanding QSR market opportunity and penetration beyond metros. Further, while store growth is important, margins and volumes will define the future prospects as companies expand out of saturated metro and tier-1 markets. Our study pointed three significant developments in consumption, (1) consumer affinity towards western QSRs, (2) changing consumer habits – simplicity of ordering and delivery through time efficient digital platforms, and (3) easing of competition from local outfits. Though millennials are shaping up demand favouring the shift towards organised segment, QSRs have used recent crisis to optimise cost structures, and they are capturing market share.

Surge in QSR network to drive revenue: CAGR of 13% over FY20-25E We expect India’s organised food services market to grow at CAGR of ~10.5% to Rs1,684bn over FY20-25E capturing ~46% market share from current 40%. Given vast growth potential, organised segment chains to grow at 13% CAGR garnering 12% market share of food service market to Rs383bn. Industry estimates point out Informal Eating out (IEO) market at Rs3.2trn and expecting to grow CAGR 12% in next 5 years. Growth in total addressable market (TAM) to be driven by, (1) targeting millennials, (2) consumer centric palate and choices, (3) focusing on online, time efficient delivery models, and (4) strategic pricing and promotions offering value proposition. Further, established brand acceptance helped top-5 global QSRs to garner ~50% market share with high concentration in top 25 cities, nonetheless, the brand reputation helps smoother entry in Tier 2/3 markets providing huge runway for growth. Therefore, we believe top QSR players to add +2,000 stores over FY22-25E.

India infrastructure: Strong capex in railways for FYTD23 (Nomura Research)

Central government capex (ex-highways) for FYTD23 is up 14% y-y led largely by railways (+54% y-y), and by drinking water (+19% y-y) offset by weakness in defence (down 1% y-y). Ex-railways capex growth was modest at ~3% y-y (we are not considering road capex as FY23 is entirely budget funded, while FY22 included significant extra budget funding). We note that road construction has been weaker against corresponding periods in FY22 and FY21.

Pace of state capex lower, whereas cumulative capex increased 3.8% y-y . FYTD23 (until Jan) capex for 12 key states (70% of aggregate state capex) fell to 46.4% of budgeted spending (vs 53.3% for FYTD22). However, given elevated levels of inflation, the y-y increase in capex would be lower in real terms, in our assessment.

Indian Financials In a Dislocated World: Strong Liabilities, Reasonable Vals (Jefferies)

Indian financials have also borne rub-off effect of global dislocations. They are better placed with higher share of retail deposit, limited ALM gap & MTM, limited dependence on AT-1 bonds & lower exposure to riskier segments like promoter/ acquisition finance. While equities & global bonds saw pressure off late, local bond mkt is stable. Post correction, vals of some

are near/below Covid lows

Higher share of retail deposits and lower ALM gaps. The deposit profile of Indian banks is highly dependent on household/ retail deposits that form >60% of total sector deposits. Banks have also been increasing focus on this segment to granularise deposits. ALM gaps, as measured by share of <1yr liabilities vs. share of <1yr assets, are also limited. Even NBFCs have been watching this aspect much more closely post the debacle of IL&FS few years before Covid. Interestingly on the bond side, while the prices of overseas bonds (issued by Indian issuers) have seen correction our conversation with local bond experts/ corporates indicate that local market is fairly stable and price action will be function of rate actions.

AT-1 bond market has polarised towards large/ quality banks post Yes Bank. India had a Credit Suisse like AT-1 bond issue right around Covid when Yes Bank wrote-down AT-1 bonds and still there was some franchise value assigned to equity through capital infusion by leading banks/ NBFC. Since then, the issuances have been lower and market has become polarized towards larger/ quality banks. Among banks, top-3 issuers are SBI, HDFC Bank and Canara Bank with PSU banks having higher contribution from this. Interestingly, smaller banks have a lower contribution from AT-1 bonds. Local bond mkt investors aren't really seeing risks here for Indian stocks.

Lower risk from MTM and asset quality. As discussed in our recent note, The SVB Test On Indian Banks: Sector Holds-Up, Again!, on assets side of banks, loans form 65% & investments 25%. HTM is allowed on GSecs & forms 80% of that & 15% of assets. On 4-5yr duration, impact will be just 6% of capital for Pvt. BKs & 15% for PSUs. Asset quality trends were strong, with slippages during 3QFY23 at multiyear low of 1.6% & recoveries from past NPLs helping to keep credit costs low at 1% of avg. loans.

Valuations in some cases below Covid lows. While the global events, especially in the financial sector, have stirred confidence and increased COE, we also note that valuation of Indian banks is looking fairly attractive and in some cases stocks trade below the levels during the height of Covid risk. Stocks above US$5bn in mkt cap that are trading below the Covid-low valuations are Kotak Bank, IPru Life, ICICIGI and HDFC Life. Life insurers are also attractive (and below Covid lows) but clarity on taxation of insurance policies will be key to rerating.