Investor's Eye: Update - PTC India (Turning cautious with depreciating rupee; price target revised down to Rs75); Special - Q1FY2014 IT earnings preview (A mixed bag)

 

Investor's Eye [July 03, 2013]  Sharekhan www.sharekhan.com

Summary of Contents     STOCK UPDATE PTC India Recommendation: Buy Price target: Rs75 Current market price: Rs47 Turning cautious with depreciating rupee; price target revised down to Rs75  Key points Depreciation of rupee to weigh high on tolling margin: Apart from the short-term and long-term power trading, PTC India (PTC) also has a tolling arrangement with Madhucon Projects and Meenakshi Group. As per the arrangement, PTC imports coal and by paying a conversion charge to the two power generators, it sells power produced from these projects. This arrangement is considered to be high-risk high-gain proposition compared with its core trading business. In an environment where the international coal prices remained soft (during FY2013), PTC managed to earn an operating profit of around 80 paise per unit, which is significantly higher compared with its trading margin of around 4 paise per unit. Nevertheless, the model has its own share of risk. Though the international coal prices remained soft, the dollar has appreciated quite sharply against the rupee in the last three months. Eventually, the landed cost of imported coal would go up for PTC and adversely affect the margin of its tolling business, keeping other variables unchanged. Every one rupee depreciation to impact 4% earnings: On account of a weaker rupee against the dollar, we believe the operating profit of PTC's tolling business is likely to come down from 80 paise in FY2013 (when the dollar remained in the range of Rs50-55) to around 55-60 paise per unit in FY2014 (if the dollar remains around Rs58). In our existing model, we have already built-in the dollar rate at Rs58 for FY2014; however, the dollar is inching ahead and hovering around Rs60 for the last couple of days. Hence, we believe if the dollar remains around or above the level of Rs60 for the whole year, the tolling margin of PTC would be lower than our current estimate. We have run a sensitivity analysis to understand the potential impact (see the table below). Our sensitivity study indicates that with fall in every rupee (against the dollar), PTC will tend to loose around 6 paise margin per unit (tolling business), keeping the remaining things constant. Consequently, for every one rupee depreciation against the dollar, the earnings of PTC would be impacted by 4%. View and valuation: We have retained our earnings as of now building the dollar rate at Rs58 for FY2014, but we would closely watch the movement of the dollar. Nevertheless, the above mentioned unfavourable events are whispering higher risk for the company ahead; therefore, we have revised down our valuation multiple of trading business from 10x to 9x its earnings. Moreover, we have fine-tuned our valuation multiple of its subsidiary PTC India Financial Services also. Consequently, we have cut our price target by 15% to Rs75. We believe there could be potential earnings revision of ~10% if the dollar remains above Rs60 for FY2014 and the company gets tariff revision of 10 paise. In case, the company will not get a tariff revision and the dollar remains above 60 level, the earnings could slip by ~15-16% from the current estimate. However, the stock has corrected sharply (21% since April 2013 and 37% since January 2013) in the recent past and is trading at 0.6x its book value. Hence, though we have revised downwards the price target to Rs75 (based on sum-of-the-parts [SoTP]), we have retained our Buy rating on PTC. SHAREKHAN SPECIAL Q1FY2014 IT earnings preview A mixed bag Key points Performance equation unlikely to change: In the upcoming earnings season (ie Q1FY2014), we do not expect any major change in the performance equation among the top four information technology (IT) companies. Tata Consultancy Services (TCS) and HCL Technologies (HCL Tech) will continue to lead the pack, with a decent top line growth of 2.7-3.4% whereas Infosys and Wipro will lag with a muted top line growth. The reported revenues in dollar terms will show an impact of 70-80 basis points on account of cross-currency head wind. However, the recent steep depreciation in the rupee against the dollar will have a positive impact on the margin of these companies. Among the mid-cap companies under our coverage, we expect a soft performance from Persistent Systems Ltd (PSL) and NIIT Technologies (NIIT) whereas CMC is expected to report a decent performance on the net income front.  Currency tail wind will boost margins despite cost head wind: In the last three months the rupee has depreciated by close to 9.7% against the dollar. On an average, the rupee has depreciated by 5% since Q4FY2013. For the quarter under review, annual wage hikes coupled with visa application fees will affect the margins. TCS will show the impact of an annual wage hike cycle (effective from April 1, 2013) whereas Wipro's performance will show the impact of one month of wage hike for its offshore employees (effective from June 2013). Infosys' numbers too shall reflect the impact of one month of wage hike for its global sales force and the additional impact of the wage hike given to its onsite employees in Q4FY2013. Nevertheless, we expect the margin damage to be restricted on account of the steep rise in the local currency. We expect margin improvement in HCL Tech whereas TCS, Infosys and Wipro are expected to report stable margins for the quarter.  Management commentary on preparedness for new visa regime holds the key: The US immigration bill in the current form has the potential to disrupt the current business landscape of the Indian IT sector. Recently, the US Senate passed the bill, which will go to the House of Representatives by July 2013 for discussion or to be redrafted. The bill in its current form is severely damaging to the Indian IT sector. Though we hope that the most severe clause on outplacement in the current draft of the bill will get diluted in the final draft, but even without the outplacement clause the impact of the bill on the margin of the Indian IT companies will be severe, as it will lead to a higher visa cost, higher wage cost and higher cost of hiring the locals (which would affect the onsite utilisation too). Further, recently the Australian Lower house also passed an amendment bill on the 457 visa rules (the Lower House is likely to pass the bill on Friday, July 5, 2013). The bill will increase the visa cost and the wage bill for the Indian IT companies operating in Australia. Management commentary on the domestic IT companies' preparedness to face the upcoming new visa regime will be most sought-after in the upcoming quarterly results season.  Infosys' guidance not relevant any more: We do not think Infosys' guidance for FY2014 will be relevant any more to gauge the demand environment for the IT sector in FY2014. Though a downward revision in Infosys' current guidance (6-10%) and a weaker than expected quarterly performance will have a negative rub-off impact on the performance of the stocks in the IT sector on the day Infosys announces its results (ie July 12, 2013). Overall, given the weak performance from US IT companies Oracle and Accenture, we expect the management commentary of most of the domestic IT companies on discretionary spending to remain weak. Nevertheless, management commentary on the overall demand environment, the re-bid market engagements (HCL Tech's commentary will be particularly sought on this), deal flows, pricing environment (given the recent drop in the rupee) and reinvestment strategy for the currency gains will be closely tracked.  Valuation: We remain confident of the earnings predictability of our preferred IT picks. However, owing to the US immigration bill there will be a negative impact on their margin. At the current juncture, given the overhang of the US immigration bill and the continuous softness in discretionary spending, it has become imperative to remain selective about the IT companies rather than taking a secular call on the sector. In terms of earnings predictability and management delivery execution, we remain positive on TCS and HCL Tech among the large-cap stocks, and CMC and PSL among the mid-cap stocks. Click here to read report: Investor's Eye   Sharekhan Limited, its analyst or dependant(s) of the analyst might be holding or having a position in the companies mentioned in the article.

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