Market Outlook July 05, 2017

Market Outlook July 05, 2017 Index Litmus test ahead Visit us at www.sharekhan.com

Litmus test ahead Positives falling in place but the outlook on earnings revival is key to sustaining the rally Indian rally in equities accompanied by a global one: Indian markets are not alone, global markets too witness a rally in equities. If we compare the emerging market valuation to developed market, MSCI emerging market is trading at around 12.5x earnings, while the MSCI United States (28.4 ), MSCI Europe (14.2 ), MSCI Japan (13.6 ), and MSCI World (15.7 ) indices are trading at levels that are 10-50% richer in comparison. Indian market is on an economic and earning up cycle,which does not seem stretched looking at the global re-rating of equity as an asset class. GST - near term pain, long term gain: The NDA government s flagship big tax reform, Goods and Service Tax (GST), was successfully launched and was implemented from the 1st July, 2017. The GST reform is aimed at overhauling the entire indirect tax regime and will be win-win for all stakeholders. GST will subsume all the indirect taxes governed by state (VAT, Octroi, Entry tax) as well as the centre (Service Tax, Excise Duty) into a single tax levy that is uniform for each product and services category across the country. As a result, businesses will benefit with improved cost efficiencies and productivity by getting access to national market, cost optimization through uniform tax regime and better distribution system. On the other hand, the end consumer would benefit from lower product prices and availability of more options in the similar price range. However, any new reform will cause short term disruption in the system and the performance of the companies for short term. Corporate earnings rising risk to expectations: Given the potential teething issues, the implementation of GST could adversely impact corporate earnings in the first half of this fiscal. The consensus estimates, however, for the year remain at elevated level and suggest close to 18-20% surge in aggregate net profits of the Sensex companies in FY2018. Consequently, the Q1 results and the management commentary in post results interaction would be keenly watched and test the sustainability of consensus estimates in the forthcoming result season. Valuation earnings revival key to returns from now onwards: Post the smart rally in H1 of year 2017, the Sensex trades at ~18x one-year forward earnings estimates, which is at premium to long term average valuation multiples of close to 16x of Sensex. Though the macro scenario in terms of low interest rates, good monsoons and favourable global cues would support equities, we do not expect any meaningful expansion of valuation multiples from here. Thus, the returns would have to be supported by the much awaited revival in growth of the corporate earnings. Overall, we remain constructive on equities. We believe that investors would do better by focusing on structural growth themes along with careful chosen stocks through bottom up approach. Investment Themes: Affordable Housing, Government Infrastructure spending and Non Performing Assets (NPA) resolution by banks Sensex P/E (based on one-year forward earnings estimates) 25.0 22.0 19.0 16.0 13.0 10.0 7.0 Jun-09 Jun-11 Jun-13 Jun-15 +1 sd PER Avg PER -1 sd July 05, 2017 2

GST Positive reform for the long term growth GST implemented from 1st July: The Goods and Service Tax (GST) which was implemented from July 1, will subsume all the indirect taxes governed by state as well as the centre into a single tax levy that is uniform for each product and services category across the country. The four tax slabs which are applicable are:5%, 12%, 18% and 28%. Benefits in the long term: The implementation of GST is expected to be win-win situation for the government, companies and end consumers in the Market Outlook long run. However any new reform will cause short term disruption in the system and the performance of the companies. Corporate earnings weak Q1 and H1 results in this fiscal: Corporate earnings performance would be affected due to de-stocking of goods by various trade channels, including dealers and distributors and also by re-aligning of supply chain under the new regime; it will take two to three months for things to stabilise. However the sales are expected to recover from Q3FY2018 and will gradually improve in the subsequent quarters. Sector wise positive and negative impact of GST Sectors Tax Implications under GST Companies to benefit Auto -Commercial Vehicle (CV)/Two wheelers (2W) To marginally reduce by 1% compared to the existing tax structure. Sentimentally Positive Auto - Small cars Small cars < 4 meter length and < 1500 cc engine tax rates to reduce by 2-2.5% compared to the existing tax structure. Sentimentally Positive Auto - Mid sized cars and SUV Mid sized cars <1500 cc &<4 meters in length and SUV rates would come down by 8% and12% respectively. Sentimentally Positive Consumer goods - essential items Effective tax rate in essential goods (soaps, toothpaste, edible oil and hair oils) under various tax slabs - Positive Consumer goods - Cigarettes Effective tax under GST would be 28% along with additional Cess and other taxes. GST rate on cigarettes in line with existing rate would gradually increase over the next 5-6 years - Positive Consumer goods - Footwear Footwear tax rates (<Rs 500) to reduce to 5% from 9.5% and <Rs500 to reduce to 18% from 24-30% Positive Building Materials Organised players to benefit from higher tax rate in the long term, as they gain market share on reduced pricing spread between organised and unorganised players. However, higher tax rate may lead to tax evasion through loopholes, which is a concern from organised players. Logistics Im Consolidation of warehouses across the country with free movement of goods will lead to higher volumes for logistic companies. Execution of the same, however, might take some time as unorganised players will have to adapt to new systems under GST. Eicher Motors, Ashok Leyland, Tata Motors, Hero Motocorp, Bajaj Auto, TVS Motors, Eicher Motors Maruti Suzuki Maruti Suzuki, M&M and Tata Motors HUL, Marico, Godrej Consumer Products and ITC etc ITC and Godfrey Phillips Relaxo Footwear and Bata India etc Kajaria Ceramics, Cera Sanitaryware, HSIL, Century Plyboards, Greenply Industries among others Container Corporation, Gateway Distriparks, Allcargo Logistics July 05, 2017 3

Market Outlook Sector wise positive and negative impact of GST Sectors Tax Implications under GST Companies to be negatively impacted Hotel more than Rs5000 room rental Tax rate on fine dining restaurants increased to 28% from 15%. This will result in room rentals hikes, with consequent impact on hotel occupancies.- Negative Hotels, Hotel Leela Ventures, ITC s hotel business and Royal Orchid Restaurants & fine dinning Branded Apparels Tax increased to 18% from 15%. This tax revision will affect the fine dining restaurant industry which has already seen significant pressure on its sales due to macro environment slowdown. - Negative Garments >Rs 1000 will be taxed at 12% instead of 7%. This will adversely impact business as price hikes would lead to late recovery in sales. Speciality Restaurants and Sayaji Hotels Arvind, Kewal Kiran Clothing and Aditya Birla Fashion Favourable macros precursor to economic and earnings growth: Low interest rates and easing inflationary pressures will spur faster economic growth and be a precursor to uptake in consumer demand and earnings growth. This will lead to rerating and higher valuations at the beginning of economic cycle; since we are in a up cycle, we will witness double digits earnings growth over next few years with superior RoE, as compared to other EM. Low Inflation rates 8 6 4 2 0-2 -4-6 -8 7 6 5 4 3 2 1 0 Indian G-Sec Yield still low Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 7.6 WPI Inflation % CPI Inflation % (RHS) 7.4 7.2 Source: Bloomberg, RBI, Sharekhan Research 7.0 6.8 6.6 6.4 6.2 Further, with lower inflation, improving CAD situation, Oil prices staying on the lowerside; the rupee is showing strength as FII investors pour in to count on economic growth. 6.0 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Mar-17 10 Year Gsec Yield % Apr-17 May-17 Policy Measures: addressing issues in key Ssctors Banking Sector: NPA Ordinance aimed at NPA resolution Low interest rates, help bring down the cost of funds, which are beneficial for further as well as existing borrowers. Banks are the back bone of economy but so far publics sector banks and large banks with exposure to corporates have been hobbled by the huge NPA burden. RBI is taking steps to encourage and guide banks to take stricter measures to resolve stressed assets and effectively deal with defaulters. July 05, 2017 4

Banks with relatively high exposure to corporate loans has been sharply de-rated on the back of close to Rs7-7.5 trillion worth of sticky loans (bad or restructured) RBI has identified 12 accounts with 25% of bank bad loans and is pushing the case for fast-track resolution / bankruptcy proceedings against them. NPA resolution could result in re-rating of coprporate lending banks and reduce their valuation gap with retail focused peers. Power Sector: UDAY a new dawn Huge investments that were previously stuck are getting resolved by gas/coal pooling and reducing stress on State Electricity board ; the UDAY Scheme is showing results Roads and Railways: Hybrid model to drive new projects Another big roadblock in economic growth was the huge number of road projects stuck due to non availability of land or environment clearance or aggressive bidding by construction companies. However, resolution of old sticky projects and new projects under hybrid model with lower implementation risk has given the much needed boost to start the flow and execution of projects. Market Outlook Since ~60% of rural households depend on Agriculture and allied activities as their primary source of income, as a result, better monsoon is crucial for income levels, and maintaining rural demand. The government has increased budget allocation for rural, agriculture and allied activities, by 24% to Rs1872 billion from what it had allocated in FY2017. Aided by an increased rural spending plan and near normal monsoons, rural economy can receive a significant boost, which will be a positive for overall economy and as well as demand. Earnings Estimates and rising risk: From a fundamental perspective, it is earnings growth, which matters most. Importantly, the downgrade in earnings, factor in lot of negatives; the growth in FY2017-18 is expected to be healthy double-digit as per consensus estimates. With possible weakness in H1 due to implementation of GST, a lot would depend upon Q1 results and the management commentary on the outlook ahead. Consensus Estimates 2500 2300 2100 1900 1700 Normal monsoon forecast is a positive cue for overall economy: For FY17, IMD has forecast a NORMAL monsoon and upgraded its forecast to 98% from 96% of LPA. After 2 years of deficit rainfall in 2014 and 2015, India saw good monsoon in2016, which helped revive demand in country. 1500 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Sensex EPS consensus Estimates FY18 Sensex EPS consensus Estimates FY19 Monsoon in the country 120 100 80 60 40 20 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Monsoon forecast % LPA Actual Rainfall % LPA Average Source: IMD, Sharekhan Research Valuation earnings revival key to returns from here: Post the smart rally witnessed in H1 of 2017, the Sensex trades at ~18x one-year forward earnings estimates, which is at premium to long term average valuation multiples of close to 16x of Sensex. Though the macro scenario in terms of low interest rates, good monsoons and favourable global cues would support equities, we do not expect any meaningful expansion of valuation multiples from here. Thus, the returns would have to be supported by the much awaited revival in growth of corporate earnings. Overall, we remain constructive on equities. We believe that investors would do better by focusing on structural growth themes along with careful chosen stocks through bottom up approach. July 05, 2017 5

Sensex P/E (based on one-year forward earnings estimates) 25.0 22.0 19.0 16.0 13.0 10.0 7.0 Jun-09 Jun-11 Key Investment Themes 1. Banking NPA Resolution: Spurred by RBI initiatives, banks have started bankruptcy proceedings against 4 A/cs and also fast tracked proceedings against remaining 8 A/cs. Though NCLT and the resolution mechanism is yet largely untested, we believe that meaningful steps for resolution of NPA would result in rerating of corporate lending focused banks. In this backdrop, our preferred picks from private sector banks are ICICI Bank along with the evergreen HDFC Bank. While, in case of public sector banks, SBI and BOB are our preferred picks. 2. Push to affordable housing- a major investment theme in the works: India s economy is set for a $1.3 trillion bonanza from the 60 million new homes that are estimated to be added between 2018 and 2024. This will be a result of growing affordability, changing demographics and also aided by the push to affordable housing sector by the NDA government. We believe that there can be a significant positive rub off effect on industries like Cement, Steel, Paints, Housing finance, Tiles, Sanitaryware among other industries. The construction of homes will also help in creating over 2 million jobs annually and can potentially add up to 75 basis points to India s GDP. Jun-13 Positive levers in place for affordable housing play a) India has given infrastructure status to the affordable housing sector providing low cost funding opportunity for development. b) Central and state assistance in funding, subsidized interest rates from banks, usage of provident fund for buying and servicing EMIs among others are key steps towards pushing affordable housing Jun-15 +1 sd PER Avg PER -1 sd Sector Update c) Increasing transparency and focus on improving execution through Real Estate Act (RERA). Sectors/segments to benefit: Cement, Housing Finance Cos, Paints and construction companies etc. 3. Return of infra/construction companies: Due to low interest rates, rational biding environment and success of projects under hybrid annuity model, we believe can benefit infrastructure and construction companies in a significant manner. India s infrastructure investment is estimated to be around of Rs43 lakh crore ($646 billion) over the next 5 years, of which 70% will be utilised for rail, roads and urban infrastructure. The Road construction and award target is 15,000km (up 82% YoY) for FY2018. There are investments planned in urban development via AMRUT scheme, 12 airports capacity expansion, 100 smart cities, Irrigation etc over the next five years which augur well for the above mentioned sectors. Positive levers in place: a) Addressing funding issues: Offshore fund raising, infrastructure investment trusts, restructuring & refinancing loans from banks; and above all benefits from low interest rates. b) Fast tracking of projects through faster environmental clearances, replacement of concessionaires, re-bidding of projects, prior land acquisition, periodic monitoring etc. 4. However, we are cautious on Pharma (especially formulations) and Neutral on IT Services Conclusion: Recent market rally makes valuation of Indian equities at premium to long term average multiples and to its peers (other emerging markets). Valuation though at a premium, can be justified and sustainable, in our view. The present favourable macros like low interest rates, ample liquidity and benign inflation rates are positive and intuitively a precursor to economic growth. We also believe that positive policy measures like addressing structural issues in key areas like banks, power, roads etc are also positive. At present, the retail inflows are driven by lack of decent returns in other asset class, and the ample liquidity scenario continues. We also believe corporate earnings estimates are stabilizing and chances of a revival in FY2018 are bright. The Q4 results reaffirm our expectations to quite an extent. We opine investors to stick to our investment themes and use the market volatility to pick the quality stocks. July 05, 2017 6

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