1Q preview: Earnings growth gathering momentum

Disclosures & Disclaimer This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it. Issuer of report: HSBC Securities and Capital Markets (India) Private Limited View HSBC Global Research at: https://www.research.hsbc.com ✔VoteinAsiamoneyBrokersPoll20164July-12AugustIf youvalueourserviceandinsight,voteforHSBCClickheretovote  Government spending has slowed, though we believe this is temporary; we remain bullish on infrastructure plays  Earnings growth acceleration should continue (+20% y/y in 1Q17), helped by an improving execution pace  L&T and IRB are our preferred plays, while CCRI and BHEL are our Reduce rated stocks Government spending has slowed recently, yet should pick up through the year: Recent data suggest central government capital spending, which was very strong during FY16 (up 26% y/y), has cooled off (down 12% during April/May 2016). A similar slowdown is also visible in MHCV, Steel and Cement volumes, while Electricity demand remains a bright spot. However, we argue that such bouts of spending volatility are not uncommon, and we expect spending to pick up once again as the government looks to meet its growth targets (Roads c.40% y/y, Railways c.29% y/y during FY17). Earnings should give 1Q17 a strong start: We forecast the capital good sector (ex. Wind players) to report strong 20% y/y earnings growth during 1Q, driven by 11% y/y growth in revenue and 60bp y/y EBITDA margin expansion. L&T, ABB, Havells and Voltas are expected to post strong earnings growth, while earnings for BHEL, Thermax and Cummins India should be weak. Wind players (Suzlon and Inox Wind) are expected to post strong 25% growth in EBITDA (combined) led by volume pick-ups. Logistics companies (CCRI and VRL) are likely to post disappointing earnings during the quarter as modest 11% growth in revenue will be offset by a high cost base resulting in a 5% earnings decline. Capital Goods valuations are still rich; we prefer infrastructure plays: While earnings outlooks gather momentum, capital goods players are expected to report strong growth on a low base. Stocks continue to trade meaningfully above their long-term averages, while earnings quality remains weak (lower EBITDA margins and ROE relative to history). We remain sceptical of valuations being sustained as the industrial capex recovery remains delayed. Infrastructure players remain the only bright spots as they benefit from improving execution pace and anticipation of new order inflow recovery. Most preferred plays: We remain bullish on L&T (Buy) as it benefits from improving execution growth and a diversified presence helps grow order base during a selective recovery. IRB (Buy), with a quality asset portfolio and comfortable leverage, is our preferred road sector play. We also like Suzlon (Buy) as it benefits from operational and balance sheet restructuring, helped by growing market share and industry volume revival. Our least preferred plays: We continue to avoid power equipment value chain players like BHEL (Reduce) and Cummins India (Reduce). We remain negative on CCRI (Reduce) as the DFC growth catalysts are c2 years away while valuations remain full. 14 July 2016 Ashutosh Narkar* Analyst HSBC Securities and Capital Markets (India) Private Limited ashutoshnarkar@hsbc.co.in +91 22 2268 1474 Shrinidhi Karlekar* Analyst HSBC Securities and Capital Markets (India) Private Limited shrinidhi.karlekar@hsbc.co.in +91 22 6164 0689 * Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations India Industrials EQUITIES INDUSTRIALS India 1Q preview: Earnings growth gathering momentum  EQUITIES  INDUSTRIALS 14 July 2016 2 Summary of target price changes Company Ticker Price* ____ Rating _____ ____ TP (INR) ____ Upside/ Change (INR) New Old New Old (Downside) % in TP Target price change rationale Larsen & Toubro LT IN 1,551 Buy Buy 1,723 1,508 11% 14% Valuations roll over from June-17 to Sept-17. Core EPC business target PE increased to 25.4x (1.5 standard deviation above mean) from 23.1x (1.0 standard deviation above mean earlier). Increase in target multiple reflects our belief that L&T will be one of the biggest beneficiaries of Government’s public infrastructure focus and improving outlook on Middle East projects. Suzlon Energy SUEL IN 18 Buy Buy 25 25 37% 0% Valuations roll over from June-17 to Sept-17, though no change in target price due to rounding. Inox Wind INXW IN 231 Hold Hold 267 260 15% 3% Valuations roll over from June-17 to Sept-17. BHEL BHEL IN 142 Reduce Reduce 105 104 -26% 1% Valuations roll over from June-17 to Sept-17. Increase in target price due to valuation roll over is largely offset by cut in earnings estimates. Cummins (I) KKC IN 820 Reduce Reduce 706 681 -14% 4% Valuations roll over from June-17 to Sept-17. Siemens (I) SIEM IN 1,301 Reduce Reduce 828 796