FY18 results must catch up to justify high valuation of Indian equities

Starting this week, India Inc would gear up for its busy earnings period yet again. The key question is if corporate India will match investors'expectations. Thanks to the passage of goods and services tax (GST) on July 1, the expectations are extremely toned down this June quarter (Q1). Analysts at Edelweiss expect a moderate 12 per cent revenue growth for 225 companies under its coverage, while net profit growth may dip by even two per cent on the back of a 262-basis point decline in operating margins.

However, it is essential that at least these lowered targets are met to keep India's position among global equities, especially emerging markets. This is particularly important at a time when foreign investors such as UBS, CLSA and Credit Suisse are asking if Indian equities justify their premium valuations, given that earnings growth has remained elusive for over four years in a row.

Sample this: in FY14 Nifty companies were poised to post earnings per share (EPS) of Rs 441 while the actuals were about Rs 386. The narrative was the same in FY15, FY16 and even FY17. With earnings growth failing to meet expectations, FY18 estimates have been cut to size. As per Bloomberg polls, FY18 EPS estimates now stand at Rs 523 as against Rs 539 as on March 31, 2017, indicating that analysts have marginally reduced their expectations perhaps to acknowledge the impact of GST. Nonetheless, at the current levels, the EPS estimates are much lower than the initially populated expectations of Rs 740 at the start of FY15. The Street usually computes its estimates on a two-year forward basis.

Table 1: Estimates vs Actuals (*1 year forward earnings per share estimates) Source: Bloomberg

Fiscal	Estimates	Actuals*	Shortfall(%)
FY14	441.1	386.8	-12.3
FY15	474.1	384.2	-19.0
FY16	537.4	425.5	-20.8
FY17	493.2	425.5	-13.7

Table 2: How FY18 expectations have been downgraded

As on	Estimates (Rs)
1-Apr-15	739.7
1-Apr-16	591.8
31-Mar-17	538.5
10-Jul-17	523,0

The constant downgrade of earnings has nudged foreign brokerages to take step back on Indian equities. In a recent report by Credit Suisse co-authored by Sakti Siva, she mentions that India which is a part of ‘Expensive 4’ among the Asia Pacific stocks has been an underperformer on a year-to-date basis. Therefore, the brokerage reiterates its ‘underweight’ call on India adding that there could be continued downgrades for the calendar year 2017 EPS consensus as well.  

Switzerland-based UBS was among the first to lower its ‘overweight’ rating on India to ‘neutral’ citing reasons of expensive market valuations. “On our models, India no longer looks so attractive, though much of this on the thematic side is down to the impact of demonetisation negatively impacting earnings in calendar 2018 versus this year's bounce back,” the report notes. “Unfortunately, the valuation expansion in India has taken the country back to looking less attractive on our fundamental framework. We take it back to neutral for now, though recognise that a big slowing in the rate of upgrades in the more cyclical parts of the region will inevitably draw attention back to India's better structural story,” it adds. 

CLSA’s Mahesh Nandurkar in his note also makes a similar observation. “As against the historical average multiple of 14.7x, the Nifty currently trades at 17.8x which is 20 per cent premium and well above one standard deviation”, he points out in his report. “Our starting price-earnings versus 12-month forward return analysis implies only low single-digit returns over the next 12 months and high probability of negative returns. Earnings growth trend also does not appear to be particularly attractive with earnings revisions still happening on the downside. Hence, valuation comes up as a key investor concern in most investor interactions,” the note warns. 

For now, Q1 expectations are watered-down, particularly for consumer-oriented sectors due to massive de-stocking prior to the introduction of GST. September quarter results may also be turbulent as businesses could take a while to readjust. What’s more, Vetri Subramanium, group president, UTI Mutual Fund says with the tax regime itself being complex it is not possible to price in its impact on earnings at the moment. 

Therefore, as the Street is not fully pricing in an earnings disruption, lower than anticipated EPS growth would be a drag on equities. Thus, with investors casting doubts on Indian valuations, particularly those overseas, it is extremely important for India Inc to meet its FY18 earnings target. Another year of failed earnings promise may not go down well with them.