Q4FY07 Preview - Macquarie

Is earnings growth slowing?
Event
> Our earnings growth forecasts for the 56 companies in our universe suggest a slowdown in aggregate growth to 12% YoY in 4Q FY3/07 from the 83% achieved in 3Q FY3/07. Sequentially, we expect earnings to drop 6% QoQ. This poses the question of whether earnings growth is poised to slow down.
Impact
> Only a partial earnings slowdown. One-offs in two of the largest sectors, oil & gas, and banks, are likely to skew growth. The oil & gas sector typically witnesses violent unpredictable swings in subsidy allocations, especially in the 4Q of every financial year. Stripping out oil & gas, estimated PAT growth improves to 35% YoY and 2% QoQ. Similarly, the banks will make ~Rs 9bn of one-off general provisioning. Stripping this out, the banks’ PAT growth increases to 37% YoY and 7 % QoQ. Excluding both oil & gas profits and banks’ one-offs, PAT growth rises to a significant 41% YoY and 7% QoQ.
> EBITDA margin expansion, but PAT pressure. We expect strong top-line aggregate growth of 24% YoY and even stronger EBITDA growth of 29% suggesting margin expansion of 100bp. Nevertheless, aggregate PAT margins will be squeezed by 140bp, a trend generally evident in most sectors and primarily attributable to higher interest costs.
> Telecom, pharma and property likely to show high growth, albeit off a lower base. Robust subscriber growth of 70-100% should cushion telecom average revenue per user (ARPU) declines, while pharma growth should be driven by US generic launches by Dr Reddy’s. Similarly, property sector growth should come from better volumes and margins off a low base.
> Cement and IT sectors driven by volume growth, with PAT growth of 73% and 46%, respectively. Volume growth in cement should be 8-10% and for IT, 35-40%. A small loss expected for Arvind Mills should force a 50% fall in textile aggregate PAT growth. Ex-Arvind, textile growth should be 26% YoY.
Outlook
> Cautious on cyclicals given risk of hard landing. The latest CRR hike was a serious surprise to the market, raising the probability of a hard landing. We think the market will be cautious on cyclicals (where the cycle relates to the Indian economy) and rate sensitives for a little while.
> Focus on low-interest-rate-sensitive stocks. We are positive on companies whose earnings are relatively protected from rising interest rates or where topline growth is somewhat hedged against a hard landing. This is reflected in our top 5 stock picks - Bharti Airtel (BHARTI IN, Rs753, Outperform, TP: Rs1,025), TCS (TCS IN, Rs1,203, Outperform, TP: Rs1,672), Reliance Industries (RIL IN, Rs1,362, Outperform, TP: Rs1,590), Tata Steel (TATA IN, Rs467, Outperform, Target: Rs556) and Dr Reddy’s (DRRD IN, Rs738, Outperform, TP: Rs837.5).




Our top five stock picks
Bharti Airtel (BHARTI IN, Rs753, Outperform, TP: Rs1,025) – 36.1% upside
> Bharti delivers one of the lowest tariffs per minute in the world, but still generates attractive operating margins (41.5% in FY08E) and returns (ROE 40.9% in FY08E).
> Bharti’s low-cost position, driven by its scale, innovation and efficiency, should insulate it from competitive threats.
> Further EBITDA margin expansion in the next three years and better asset leverage will result in higher return ratios (ROE).
> Among Asia’s cheapest wireless stocks on valuation multiples adjusted for growth. On EV/EBITDA by EBITDA CAGR, it is at 0.43x, while on PEG, it trades at 0.67x.
> More sharing of passive infrastructure should increase margins.

TCS (TCS IN, Rs1,203, Outperform, TP: Rs1,672) – 39.0% upside
> Huge volume growth due to small base effect (combined market share of Indian IT <3%> Presence of margin expansion levers, like 0-3 years employee mix - ie, the percentage of employees with 0–3 years of experience - (TCS at 52% as against Infosys at 59%) and offshore mix (TCS at 46% as against Infosys at 51%), would lower the per capita employee cost. These should more than offset the effect of margin erosion arising from wage inflation. TCS also enjoys the industry’s lowest attrition rates.
>Lastly, focus on software products business (driving non-linear growth and therefore operational gearing), adoption of global delivery model (delivery centres spanning from China to Chennai and Chile providing near-shoring capabilities) and complementary inorganic growth (eight relatively small gap-filling acquisitions in the past three years) would squarely position TCS to translate the growth into shareholder value.

Reliance Industries (RIL IN, Rs1,362, Outperform, TP: Rs1,590) – 16.7% upside
> RIL recently embarked on a staggering capex plan of US$19bn over the next five years to fuel aggressive growth.
> Earnings poised to triple as expansion plans in refining, petchem, oil & gas and organised retail contribute over the next five years.
> Financing growth not a concern as free cashflow should be sufficient to fund capex.
> ROE is expected to rise consistently due to contribution from high-margin businesses such as oil & gas.
> Fall in gearing would enhance flexibility to raise debt for funding stepped-up capex.

Tata Steel (TATA IN, Rs467, Outperform, Target: Rs556) – 19.1% upside
> India's largest private sector steel manufacturer, and with the acquisition of Corus is now the fifth largest steel producer globally.
> Six-fold expansion planned over the next 10 years, to drive the synergy benefits with Corus.
> Highest operating leverage to steel prices and the best steel play to ride the upcycle in the sector,in our view.
> Highest EBITDA margins in steel globally, along with a rich resource base and investment book,not being factored into valuations.

Dr Reddy’s Labs (DRRD IN, Rs738, Outperform, TP: Rs837.5) – 13.5% upside
> Launch of generic Ondansetron towards the end of December 2006 is expected to drive quarterly earnings for 4Q FY07 and 1Q FY08.
> Overall structural improvement in business and earnings mix, robust outlook for all base businesses including Betapharm (excluding the impact of 180 days marketing exclusivities and authorised generic launches).
> Strong growth outlook for FY09.