Nomura’s Take On Key Sectors After India’s Tax Bonanza
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Nomura’s Take On Key Sectors After India’s Tax Bonanza

Corporate-focused banks and infrastructure-construction companies will be among the first beneficiaries as India’s mid-year tax bonanza is expected to nudge private investments, according to Nomura.

The reduction in corporate tax rate by Finance Minister Nirmala Sitharaman will aid Nifty 50 earnings by 7 percent to 16.5 percent, according to Saion Mukherjee, managing director and head of research, Nomura. But the brokerage is a “bit more conservative” on the index target at 12,500 for this fiscal, factoring in a somewhat slower pace of recovery in the earnings growth, he told BloombergQuint on a special series—Navigating Through Uncertainty.

What will have a much bigger impact is the reduced 17 percent tax on new manufacturing units, according to Mukherjee. While corporates can avail the lower tax rate by commissioning facilities by March, Mukherjee said, “My sense is that in 12 months or so, we’ll start to see the initial phase of investment activity picking up.”

Sitharaman brought down India’s effective corporate tax rate to among the lowest in Asia as the Modi government looks revive the growth that has fallen to its lowest in six years because of slowing demand for staples and shampoos to cars. While analysts and economists are unanimous that the tax cuts will eventually help the economy, they don’t see an immediate boost to consumption.

Benefits will vary on how a company chooses to use tax savings, said Mukherjee said. Here’s his take on key sectors:

Financials

This is a sector that requires capital every time and the tax bonanza is a significant positive for them, according to Mukherjee. “It has a rub-off effect where your profitability goes up, your ROE (return on equity) goes up, your valuation goes up,” he said.

Citing “anaemic” credit growth so far, he said, “From a next two- or three-year perspective as this investment cycle picks up, your credit demand also goes higher. It kind of starts that cycle which was down and out for a long time. We feel the corporate banks would be a clear beneficiary of this step.”

Infrastructure

The infrastructure and construction space also stand to gain, he said. “The stocks may start reacting to order inflows and the initial pickup in the investment demand which we think could pick up in the next 12-18 months.”

Pharmaceuticals

Most pharmaceutical companies were availing deduction on research and development spends, and that benefit goes way from the next fiscal. The corporate tax cuts will cushion drugmakers from this impact, Mukherjee said, adding that a lower minimum alternate tax rate will also help as cash outflow will come down. “We don’t see earnings immediately for these companies but at the end of the day, they also stand to benefit from a medium- to long-term perspective.”

Consumption

Mukherjee is not comfortable with heady valuations. “I think, one needs to re-look at the assumption on really buying these names. These are no doubt quality companies. But the valuations have just kept moving higher,” he said. Citing the growth model that will play out after the tax cuts, he said Nomura would be underweight on consumption theme where the valuations are expensive.

Information Technology

Nomura is underweight on information technology given that the stocks have done well and valuations are high, and there’s an uncertainty around global growth, he said. According to Mukherjee, pharma makes more sense as an export play compared to IT services.

Watch the full conversation with Nomura’s Saion Mukherjee here:

Here are the edited excerpts from the interview:

Obviously this not only improves the competitiveness of Indian corporates, but it also gives that big push to investment-led growth.

Yes, I think the announcement is quite important. So the three things that I see here are first, as you mentioned, it’s a clear policy in an investment in an export-led growth. One of the things which we felt was quite interesting and important here is that corporates can avail a lower tax of 17 percent if they set up a new manufacturing facility and commission it before March 2023.

So, that’s something which I feel even though we have three-and-half years window, my sense is that in 12 months or so, we’ll start to see the initial phase of investment activity picking up. So that’s what I would look forward to. Importantly, it’s positive for corporate sentiment. If you look at the last four or five years, there has been a feeling of alienation among corporates. Most of the investments were driven by the government and so, we have come to a point where you start seeing financial and administrative constraints that the government faces, right?

So, it’s time when you want private sector corporates to kind of come in and start investing. So, that’s the first big objective that lays the foundation for a revival from a medium-term perspective. The second point is on corporate earnings. So, the bottom-up analysis that we have done, suggests that there can be an impact of around 7 percent on the Nifty earnings at an aggregate level. Now, of course, this assumes that most of the bonanza or tax cut benefits are retained by corporates, but we will see how this kind of plays out and definitely leaves the money out of the hands of corporates to make the decision going forward. Finally, of course, from a macro perspective, it doesn’t necessarily change our expectation on growth or inflation in the very near term.

So, we continue to believe that in the very near term, we could continue to see a significant monetary stimulus which could lead to a cyclical recovery in growth in the shorter term. But yes, more importantly, the story is what is going to happen one or two years down the line and what kind of profile India would have which would be very different from what we had seen in the past.

Based on the other points that you just mentioned, various brokerages have come out and revised their targets on the index at the upper end. But the earnings are great of about 7-8 percent in terms of the impact. That would be probably similar to what Nomura also has but what I want to know from you is, which sectors do you see having an immediate benefit of this and when you have that kind of money coming back onto your balance sheet; different sectors may use it differently. For example, companies may use it to bring down prices and pass on the benefits to consumers to score volumes, some other spaces may use it to set up manufacturing facilities and revive that CapEx plans. So, in light of all of these factors, how would you pinpoint the benefits of each sector?

In the near term, given that the demand is weak, I think we need to see, and we need to keep an eye on potential risk of some of these benefits getting passed on. Some of the assessments that I have heard from companies; particularly auto companies are that even if we were to pass on the full benefits, the question is, whether they are large enough to drive up the demand. So, you have to wait and see how various companies react to that.

Obviously, it’s kind of difficult to assess what is going to happen in the very near-term. But if I take a year’s view and the view that we will probably see an investment-led revival, I think the sectors which I think should benefit are corporate banks in the financial space. First of all, they are of course beneficiaries of the financial space because the tax rates are typically high for most of them and it leaves the capital with them which is quite critical for these banks. Also, the fact that the return ratios improve has a rub-off effect on the valuations for these companies, right? I mean, compared to let’s say a consumer company which is already having high return ratios and is valued quite richly. So, the sensitivity to valuation is a lot higher for financials.

The second space where we are constructive because of this development is the infrastructure and construction space. I think the stocks may start reacting to order inflows and the initial pickup in the investment demand which we think could pick up in the next 12 to 18 months.

Let’s talk a little more about the current situation. So, while we are talking about companies fast-tracking CapEx in order to take the benefit of having a manufacturing unit at an effect of a tax rate of about 17 odd percent. Is the demand enough? I mean, we’ve not seen most companies running to full capacity even now. They are still in terms of overall capacities; they are still falling short. So, with the push to make sure that they expand currently, isn’t that a little bit of a rush?

I agree with you. I think the investment cycle in India, the private sector investment has been weak because the demand was weak. Firstly, as you know, there has been a lot of relocation happening out of China and our economic steam did some analysis in the region and what came out was that; we saw many of this relocation happening in other Asian countries too, like Vietnam, etc. So, India needs to be present at this point with the right incentive for these companies to come and invest because this is just starting to happen. If this phase gets over, it would be a missed opportunity for India. So, that’s one part which is about India trying to participate in the relocation process which does not have much to do with the local demand.

The second point is that, I guess, the demand has been weak in India but the view that most companies had is that they’d still have a fairly constructive view from a longer-term perspective as far as demand is concerned. Also, for companies which are trying to set up or would like to set up manufacturing in India, one of the advantages that India provides is that it also has a large local market. If we were to choose between a smaller Asian country and India, I think one of the things which work in India’s favour is, a large local market. So, therefore by putting a timeline or putting these facilities by 2023, given that you still have a positive view on longer-term demand, it may bring forward the decision-making and the companies may decide to invest ahead of the demand which typically would have taken longer to revive. So, it’s kind of expedited the process and this is what we should start seeing - the initial science of it in the next twelve months.

You spoke about the financial space and I want to go back to the topic because with this tax saving does not only give them leeway in order to make sure that they address their NPA challenges but also with the push for manufacturing and the deadline coming to about 2023. Do you see this fast-track credit offtake as well?

So, we all are aware of the kind of challenges that financials face. So, this is a sector that requires capital every time, right? It’s a capital-intensive sector. So, for them, to be given this tax bonanza is a significant positive for them. It has a rub-off effect where your profitability goes up, your ROE goes up, your valuation goes up which means that you could raise more capital going forward because even from a credit growth perspective, the corporate credit growth which has been anaemic. You now have a case which you make that from the next two- or three-year perspective as this investment cycle picks up, your credit demand also goes higher. So, it kind of starts that cycle, right? Which was down and out for a long time. So that’s what we feel that corporate banks would be a clear beneficiary of this step.

Where do you think these measures put India with regards to a global perspective in terms of the emerging market picture and investments going into countries which are still going in a big way into countries like China which has opened up its market. Do you feel that this probably would divert some of the money back into India?

Yes, I think so because I mean, this is a clear and strong signal by the government as to what growth model they want to put in place. I think the macro parameters have been reasonably benign, right? If you look at the current account, oil is behaving well. Inflation is very much in check. So, it’s just about the demand and growth which was hurting in India. So, it kind of creates a reason to believe that we would see growth reviving and investment-led growth reviving without really hurting the near-term macros. So, I feel, it really makes the story a lot different, right? From what we’ve seen and you know, this I feel given all the trade issues that we are already seeing, we think that India kind of stands out and hopefully the macro and all, etc. remain within bounds at the margin. This changes things a lot. In the regional context at least, India is one of our over-width markets.

With regards to spaces which have anyway been slightly more expensive and heavier in terms of valuations, this move probably has made it that much more expensive; talking about consumer discretionary as well as the consumer staples here. When we talk about paying any price for quality, does this mean that valuations will most likely be headier from here on? And would it be then justified according to you?

We had a consumption-led growth and these companies have done very well. Lately, they have delivered on earnings but because of what’s all happening in the other parts of the market, we are also seeing very significant multiple valuations moving up for these companies. At this point in time, when we look forward in the next two-three years, and as we discussed, we are talking about the change in the growth model. I think one needs to re-look at the assumption on really buying; these are no doubt quality franchises, quality companies. But the valuations have just kept moving higher. So, I would, therefore, think that, with this change which is likely to play out, we would be underweight on all these names that you mentioned given where the valuations are.

So, while we were taking a look at the tax-saving benefits and the top ten Nifty 50 companies have, I think the top counter stacked up was ONGC. From the oil and gas pack, there is a lot that’s been happening with regards of a push from divestment, probably looking at privatisation to get more value out of this stake sale. What’s your take on what happens to this particular pocket now that you’re talking about oil prices stabilising?

We have a marginal overweight on oil and gas as a sector put together- more biased towards the gas names. But I think your question is a bit difficult to answer. I do expect a lot of activity on the strategic disinvestment side which is an outcome of let’s say, the kind of slippage that we are likely to see and it’s quite natural to expect that there would be an incremental push and the oil and gas space would get impacted. Frankly, it’s very difficult to assess as to what would be the nature of these; that it would be privatisation or a stake sale which could have an impact on the supply of papers in the market and can, therefore, have an adverse impact. I think it’s a difficult call to take there, but I feel definitely we will see actions on that space over the next 12 months.

Two particular pockets that have been quite difficult in nature; that’s been the IT and the pharma space. I mean the benefits from tax exemptions come from the production of SEZ units and the income that they earn from these SEZ units. So probably this kind of a corporate tax may not have a big material impact for these players. In light of that, do we still focus purely on the earnings potential of IT as well as pharma?

Yes, you’re right. From a tax cut perspective, given that they are already benefitting, but then the fact is that, these benefits are time-bound, right? So, as and when these benefits end, they are supposed to get back to higher tax rates. Now, to that extent, this is a positive. For instance, if you look at the pharma space, most of these companies were taking back benefits of higher deductions of the R&D spend. Now, that benefit goes away from the next fiscal year. Therefore, you would have seen the tax rates for pharma companies actually going up because of this reason. Now, with this tax benefit, the impact may not be that much.

In addition, all these companies which have these tax concessions, also have to pay a minimum alternate tax—the rate of also which has come down. So, the cash outflow on paying MAT has also come down here. We don’t see earnings immediately for these companies but at the end of the day, they also stand to benefit from a medium- to long-term perspective. Also, I feel that if India follows the policy of export-led growth, we have to keep our currency competitive. So my sense is that we may not see a significant appreciation in the Indian rupee and to that extent, I feel that you may see some support being provided on the currency front for these exporters. Within IT and pharma, we are underweight on IT services given that the stocks have done well, and valuations are high, and you have uncertainties around global growth which could hurt growth for these companies. On the other hand, on the pharma side, I think there has been a downturn for the last two-three years and the margins are very suppressed. So, you may see a non-linear increase in the earnings in the pharma space and that’s where we think pharma makes more sense as an export play compared to IT services.

I want to understand from you; not just the announcement on the corporate tax reductions but the whole host of measures that the finance minister has been announcing in the recent past. A special window for stalled projects for real estate, linking loans to an external benchmark for faster transmission, then you’ve got pushing back of MSME loans, not categorising them as NPA loans for March 2020 and a whole host of other factors that the finance minister has announced. Do you think all of this put together along with the corporate tax cut, you’ll see a recovery on the ground on a faster pace and earlier anticipated?

Most of the measures that you talked about till the announcement on the tax cut, most of them except the real estate one, if you think about it, it’s essentially an attempt to start the credit flow into the system. So, the RBI has been cutting rates but it’s not getting transmitted because of these issues that these financial intermediaries currently face. I think the efforts of the government- the measures that you mentioned which also includes capitalising the banks upfront, and giving them the capital upfront, there is a talk about NBFCs and banks so that they can figure out and lend and how to bring the synergies there. I think a lot of these measures essentially is an attempt to ensure that the kind of credit flow through the system happens. So that along with the RBIs stance, they have already cut interest rates quite a lot, we would see a lot of cuts in the near term with abundant liquidity being provided into the system. So, I think most of these attempts were largely towards ensuring that the credit flow happens through the system. The real estate beat is I think a bit different because it’s a real problem of unfinished apartments which they want to address and I think it can have a reasonably good impact on that particular sector and it has a trickle-down effect on the rest of the economy. So, I feel it’s a combination of now the fiscal push that we have now from the tax cuts plus all the other measures which I felt was largely an attempt to make credit flow through the system and the way that transmissions happen.

With everything that we’ve spoken about, your index target till March 2020 of 12,550 odd factors in everything?

What we have talked about earnings growth, it’s a bit more conservative this year. So, after the tax cut which has a 7 percent impact on earnings, we are talking about 16 and a half percent earnings growth percent this year in fiscal 2019-20. So, excluding the tax cut, we were at 9-10 percent earnings growth which was lower than what the general expectations on the street are.

We had a weak quarter where the Nifty earnings grew at about just 2-3 percent and also the fact that the high-frequency indicators on growth that we were tracking are still quite soft. So, I think we would see that play out in this quarter as well. The expectation is that largely we would have to go through a recovery by the third quarter that is the December quarter and the March quarter where the base effect also starts to play out. So, what our essentially index target is factoring in is somewhat slower pace of recovery in the earnings growth. Also, we have attributed 17 times one-year forward earnings. I think that’s what is supported by the lower yields and I think that in the current environment we continue to expect that the yields are getting lower, but we still have reasonably real high rates in the system. We expect the credit spread and term premiums to come down. So, those things would also support the valuations for the equity market so 12,550-odd that we have as a target is factoring 16.5 percent growth for this year, 19.5 percent for FY21.

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