The severe bout of global risk aversion, triggered by the yuan’s devaluation a couple of weeks ago, has significantly affected global commodity prices, equities and EM (emerging market) currencies, and India has not been an exception. The fall in markets has been rather indiscriminate across sectors. We look at stocks which have corrected enough to become fundamentally attractive, and have earnings upside were current macro conditions to stay. The key variables used for earnings sensitivities are currency and commodity prices.
The correction that has happened across the board means that even companies that are potential beneficiaries of lower commodity prices and currency have seen price corrections. While it is difficult to predict a stable level of commodity prices, currency and other macro variables, current levels of these variables can be used to judge potential upsides to earnings. We note that India tends to benefit from cheaper commodity prices which improve balance of payments and lead to lower inflation. Earnings may not react symmetrically depending on whether a company is a consumer or producer of commodities.
We come up with a list of five stocks: Asian Paints, Hindustan Unilever (HUL), HCL Tech, Mahindra & Mahindra, and Ultratech Cement.
Following the recent price correction, the Sensex P/E (price-to-earnings) multiple has corrected to 14.8x (times) one-year forward earnings, which is at a 10% discount to its five-year average.
Asian Paints—Margins to see a sharp upswing: We believe Asian Paints remains a solid ‘buy’ for long-term investors.
The company should be one of the foremost beneficiaries of the fall in global commodity prices, especially given that almost 70-75% of the company’s input cost basket is linked directly to crude prices. If we were to build in the current crude price of $45 per barrel into our earnings model, the earnings for Asian Paints would be higher by 7%, thus pegging the FY17F EPS (earnings per share) at Rs 30.5.
As GDP growth picks up, we expect volume growth to also improve, which will help drive higher top-line growth over the next two years. We are currently building in steady double-digit volume growth for the company over the next couple of years. At current rates, the stock trades at 29.9x on FY17F(forecast) EPS of R28.5. The company’s top-line growth is strongly linked to GDP growth. In FY13/14, Asian Paints delivered average revenue growth of 14.5%, versus a long-term average of 20%.
HUL-Strong margin expansion likely: We believe the current commodity price decline will be a big positive for the consumer sector in general, and HUL in particular. A large part of the input cost basket for the company like packaging materials and palm oil is directly or indirectly linked to crude prices. This essentially means that if current prices were to be built into our estimates, there would be an upside risk to our earnings forecasts. We are building in 19% earnings growth for FY16F and FY17F, and believe that there would be upside risk of 5% to both at crude estimates of $45 per barrel.
On the business front, we are seeing some signs of demand revival in the urban sector, which augurs well for HUL. In the current cycle, this coincides with the company’s efforts to focus on the premium segment. A major chunk of HUL’s innovation pipeline focuses on the premium segment, along with higher spend on the category. At current rates, the stock trades at a P/E multiple of 35x FY17F EPS of R24.12, which is largely in line with the sector average. Given HUL’s strong earnings growth and business transformation, the risk-reward seems favourable. We maintain our ‘buy’ rating.
HCL Technologies-Reiterate top pick status: IMS (infrastructure management services), BPO and Engineering Services would continue to drive growth for Tier-1 IT, and HCL Technologies (HCL) benefits from having the best skew versus peers with 60% of revenues coming from these segments. In IMS and Engineering Services, HCL is among the largest players, while it is growing the fastest among Tier-1 IT in BPO. So we expect better-than-peer group dollar revenue CAGR of 14% for HCL over FY15-17F. We expect Ebit margins to improve towards the middle of the guided range of 21-22% over FY15-17F on (i) reallocation or rationalisation of rebadged employees; (ii) the large engineering services deals signed last year reaching steady-state margins (after initial dilutive impacts), and (iii) increased off-shoring.
We believe HCL’s investments in SG&A (selling, general and administrative expenses)—12.8% in Q4FY15, up 100 bps y-o-y—should provide opportunity for G&A rationalisation. Current USD-INR rates provide increased comfort to our Ebit margin expectations. At 14x FY17F EPS of Rs65, we find valuations reasonable. We retain our Buy rating and top pick status. Our target price of R1,110 is based on 17x FY17F EPS of Rs 65.
M&M-Falling material costs further positive: The recent fall in commodity prices will benefit auto companies’ Ebitda margins in the coming quarter. By our calculations, the cost of car index is down 100 bps since March-15. Not all of this benefit has been reflected in the Q1FY16 results as it takes at least one quarter for material cost benefits to flow through fully. We factor in Ebitda margins at 13.6% for FY16F and 14.1% for FY 17F, vs 14.3% reported in Q1 FY16.
M&M may retain this benefit in the farm equipment segment, given the lower competitive intensity. If we build in 50 bps higher Ebitda margins for M&M plus MVML (Mahindra Vehicle Manufacturers Ltd), our EPS estimates would move up by 4%. The fall in diesel prices is also positive for auto sector. With new SUV launches planned from September 2015 and a likely farm segment revival post the normal monsoons, we believe the worst is behind for M&M. At current prices the core auto business M&M + MVML trades at 10.7x FY17F EPS, which is very attractive. We value M&M on SOTP to arrive at our target of Rs 1,618.
UltraTech Cements remains our top pick: Since the June quarter, prices of coal and crude oil, which are key inputs for cement, have softened further. Prices of imported coal (Richards Bay as the benchmark), retail diesel, and polypropylene have declined 9%, 6%, and 13% sequentially from the June 2015 quarter (average prices in rupee terms). If we price in the current prices of these inputs into our estimates (assuming they remain at these levels for the next two years), our full-year FY16F and FY17F Ebitda estimates will see an increase by 6% and 10%, respectively. The fall in input costs and benefits from efficiency-improving initiatives should provide tailwind to our earnings estimates for UltraTech over FY16F-FY18F. We are positive on UltraTech as we believe the management’s focus remains on delivering superior growth. We expect UltraTech to deliver strong earnings growth over FY15-17F. Our target price of R3,416 offers implied upside of 18%.
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