THE BIG STORY. 5 stocks to exit

Oriental Bank of Commerce: Don't bank on it just yet

Banking stocks, particularly those of public sector banks, have been on a roll over the past year. Two key factors have driven the euphoria. Expectations of a turnaround in the economy that has led the broader market rally in cyclical stocks, is one. After the RBI’s asset quality review — pegged as a major clean-up exercise of banks’ balance sheets — the market also assumed that the worst was behind for the sector.

But, sadly, earnings over the past year have failed to deliver on expectations. Oriental Bank of Commerce (OBC) is one such stock that has rallied over 80 per cent over the past year, but with little fundamentals to show.

Core performance Consider the core performance first. Despite the 8.3 per cent y-o-y growth in loans in FY17, continuing pressure on margins has dampened performance. Net interest income for the bank has fallen 8.6 per cent y-o-y in FY17, after a muted 5 per cent growth in FY16.

But for the near trebling of treasury gains that boosted other income, the already muted operating profit would have been much lower in FY17.

Operating profit for FY17 that stood at ₹4,170 crore was inadequate to absorb the 75 per cent y-o-y increase in bad loan provisioning, which stood at ₹6,315 crore.

The bank’s asset quality continues to be under pressure. After slippages more than doubled in FY16, they rose further by around 18 per cent in FY17.

As a result, OBC’s gross NPAs — that went up from 5 per cent in FY15 to 9.6 per cent in FY16 — shot up to 13.7 per cent in FY17. With no let-up in asset quality, the bank reported a loss of about ₹1,090 crore in FY17.

Corrective action Based on the recently tightened PCA (prompt corrective action) framework for banks, the RBI could also impose a corrective action plan for OBC, owing to high net NPA levels.

Banks that have a net NPA of 9 per cent or more but less than 12 per cent fall under the second risk threshold level.

The RBI’s mandatory action plan could include restriction on dividend distribution, restriction on branch expansion and higher provisions. OBC’s net NPA as of March 2017 is just short of the 9 per cent mark (8.96 per cent).

Its weak capital position also offers little buffer to absorb a sharp rise in bad loan provisioning in the coming quarters. The bank’s tier I capital and total capital stood at 8.8 per cent and 11.6 per cent respectively as of March 2017.

In terms of valuation, the stock may still appear cheap, trading at 0.4 times one year forward book.

But valuations based on banks’ book value can be misleading. Accounting for net NPAs and restructured book (assuming 30 per cent slippages), the stock trades at over one time its forward adjusted book (adjusted), which can correct substantially if earnings continue to remain under pressure.

Escorts: Sky-high valuations

A revival in domestic tractor sales, better product mix aided by launches and a pick-up in the construction equipment business saw Escorts turn a darling of the markets over the last year. In this period, the stock value quadrupled, shooting up by a whopping 300 per cent! With net sales growing by 21.6 per cent to ₹4,093 crore and profits, by 66 per cent to ₹157.7 crore in 2016-17 (over the previous year), the price rise has, to an extent, been backed by earnings. Nevertheless, the gallop has resulted in Escorts trading at rich valuations. This mid-cap stock now trades at over 50 times its trailing twelve-month earnings, at a huge premium to peers such as Mahindra and Mahindra, which trades at about 22 times. With the market touching new highs, the possibility of corrections especially in the over-heated mid-cap segment, cannot be ruled out. Investors can, hence, book profits in Escorts.

Sunny days Two years of bad monsoons in 2014-15 and 2015-16 pulled down domestic tractor sales sharply. Escorts, which derives about 80 per cent of its revenues from tractors, saw domestic sales volumes decline by 15 per cent and 12 per cent respectively in each of these years. But favourable monsoons last year, and good hikes in the minimum support prices, coupled with the effect of a low base, helped tractor sales chug along briskly in 2016-17.

Despite a temporary blip due to demonetisation, Escorts ended the year with a volume growth of 23.7 per cent in tractors, selling 62,699 units domestically. The company’s market share improved by 50 basis points to 10.8 per cent last fiscal. Launches in the 41-50 HP segment over the last couple of years to fill gaps in its product portfolio, along with separation of dealerships for its premium (Farmtrac) and economy (Powertrac) brands also worked well for the company. Operating margins in this segment moved up by 212 basis points to 10.3 per cent in 2016-17. Budget measures to boost the rural economy, good kharif sowing and a normal monsoon outlook will help tractors sales sustain the momentum.

Other business On the construction equipment side (about 15 per cent of revenue), Escorts notched up volume growth of 30 per cent in the year ended March 2017. Thanks to improving infrastructure spends, the business turned profitable at the operating level in the fourth quarter.

The Railway segment (about 5 per cent of revenues) has an order book of ₹155 crore to be executed over the next six to seven months and is expected to grow in double digits in the near to medium term.

Considering that the prospects remain bright, the stock can be reconsidered at lower levels.

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BHEL: Running out of power

Investors can sell the stock of BHEL at the current market price of ₹138. Even after the 23 per cent correction from its recent peak, valuations are at a substantial premium to its historical average.

The company’s order flows slowed down in 2016-17 with uncertainty around the realisation of a chunk of its order book. Moreover, regulatory hassles, poor demand and excess power equipment manufacturing capacity don’t augur well for its business.

The background BHEL’s power segment, which constitutes 78 per cent of overall revenues, largely supplies equipment to thermal, gas, hydro and nuclear power generators. It currently leads the domestic power equipment manufacturing industry with a 57 per cent market share.

Its industrial division manufactures a variety of industrial systems and products while also providing complete solutions for transportation, renewable energy, water management and defence projects.

Order flow slowdown Over the past few years, the power industry has been facing multiple issues such as delays in land acquisition and environmental clearance, and problems in procuring coal as well as project finance.

In FY17, BHEL’s order inflows from the power sector were down 47 per cent y-o-y to ₹23,300 crore. This translated to 6,800 MW of power-related orders. The company has 20,000 MW of power plant equipment manufacturing capacity, and the management expects to clock in new orders of about 12,000 MW annually over the next two years. However, achieving it will be a stretch, given the poor demand from power generators and surplus capacity in the industry.

Moreover, a large part of the order backlog is stuck in myriad regulatory and legal hassles. Of the total order backlog of ₹1,05,000 crore, 37 per cent is slow-moving, and orders worth just ₹66,000 crore are actually ‘executable’. While the management is concentrating on the latter, the risk is that its key client NTPC might shelve greenfield projects and go for retrofits and replacement instead. Big orders are therefore likely to remain elusive.

High valuation Even after the recent price correction, the stock looks expensive. It is quoting at a price-to-earnings ratio of 74 against its three-year average of 32. In FY17, the company turned the corner. It reported a profit after tax (PAT) of ₹455 crore, against a loss of ₹705 crore in the previous year. Moreover, its revenues were up 11 per cent at ₹27,618 crore.

However, the Q4 results were a big disappointment, with PAT declining 57 per cent, with one-time provision for gratuity and leave liability.

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Jet Airways: Flying in cloudy skies

The year gone by has been rather harsh to airlines in India. Traffic grew at a sizzling pace but high costs and low fares due to intense competition walloped their bottomlines.

Among the listed players, Jet Airways took the worst hit. Its profit crashed nearly 95 per cent y-o-y in the March 2017 quarter, and was down almost 64 per cent for the full year 2016-17 compared with 2015-16.

Meanwhile, like its peers, the Jet stock, after falling for much of last year, has run up smartly (nearly 40 per cent) since December. This is thanks to the dip in global oil price and a stronger rupee that should moderate the cost of aviation turbine fuel, the major expense for airline companies.

Oil, rupee volatility Weak earnings along with the market rally have made the Jet stock quite pricey — it now trades at more than 12 times its trailing 12-month earnings, double the average of about six times in the past three years. Investors can sell the stock, given its high valuation and likelihood of earnings staying weak.

One, the cost benefits are not a given. Oil and rupee movements are unpredictable. Oil, now about $50 a barrel, could move in the $45-60 range, given global demand-supply dynamics. The rupee too, currently about 64 to a dollar, could keep swinging between 60 and 70, as it has the past few years. Next, even if costs stay subdued, the ability of domestic airlines to make the most of it is doubtful.

Low average fares, which contributed to much of the pain last year, are likely to continue. This is primarily because most airlines, Jet included, are on a capacity expansion spree that will add to fleet sizes significantly. This will likely add to competitive intensity and keep fares subdued.

Passenger numbers In FY17, Jet Airways’ overall passenger numbers grew about 5 per cent, but average fare per passenger was down more than 3 per cent; the airline’s revenue per available seat kilometre (RASK) dipped about 5 per cent, while cost per available seat kilometre (CASK) was up marginally.

This not-so-nice state of affairs could continue with big sector capacity addition putting pressure on fares across airlines. Especially given that the passenger growth rate has been moderating — from over 23 per cent y-o-y in calendar 2016 to less than 18 per cent in January-April 2017. Seat supply growing faster than demand is a key risk for the sector.

Aggressive expansion by low-cost carriers such as IndiGo has seen Jet cede domestic market share — from more than 22.5 per cent in calendar 2015 to 19 per cent in calendar 2016. The possible entry of new deep-pocketed players such as Qatar Airways in the domestic skies could queer the pitch further.

Unlike peers, more than half the revenue and profit of Jet Airways comes from its international operations.

But this has not helped — the international segment did worse than the domestic business last year with a sharper fall in operating profit. Also, despite some reduction in debt levels, the airline’s interest cost still remains formidable and a drag on the bottomline.

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MEP Infrastructure: Potholes ahead

The stock price of MEP Infrastructure (MEP), a major road player, has seen a full cycle in its stock price. The stock, after its listing at ₹ 63 in May 2015, plunged to a low of ₹34 in November 2016.

However, following improving prospects for the road sector after the 2017 Budget, the stock price has run up to ₹72, a surge not entirely backed by fundamentals.

The company recorded a drop in consolidated revenue in FY17 compared to the previous year. Even if the impact of drop in toll collection due to demonetisation is factored in, revenue growth last fiscal year would have been flat.

Also, with MEP getting a nod from SEBI to float an infrastructure investment trust (Inv-IT), we can expect some of the mature and stable revenue generating projects from the company getting transferred to this investment vehicle. So, despite a strong outlook for the road sector and the company, the increased level of risk in MEP’s project portfolio and a slow top-line growth can pull the stock price lower. At the present elevated prices, investors who hold the stock can book profit.

Project Portfolio Besides MEP’s core expertise in handling short-term tolling (less than or equal to one year), long-term tolling (more than one year) and OMT (operate, maintain and transfer) projects, the company has one build, operate and transfer (BOT) project and six under-construction hybrid annuity model (HAM) projects in its portfolio.

Over the years, the revenue collection from long-term projects — tolling, OMT and BOT — has increased considerably from 39 per cent to 67 per cent between FY12 and FY16. Of the total revenue, Mumbai entry point OMT project contributes more than 20 per cent of the total revenue.

With this project expected to be transferred to the Inv-IT, we can expect a sharp dip in revenue. Also, once the Inv-IT gets operational, the residual risk — both construction and revenue generation — from the remaining portfolio of projects will increase. These factors should take the stock price lower over the medium term.

However, with all the six HAM projects bid by the company reaching successful financial closure, we can expect a stable flow of annuity revenue starting around 2.5 years from now. Besides, the company’s strength in toll projects should help it win long-term toll-operate-transfer projects, boosting its long-term prospects.

Financials MEP’s consolidated revenue for 2016-17 was ₹1,815 crore, about 8 per cent lower than for the same period a year earlier.

But, a 23 and 14 per cent respective fall in interest and depreciation expense for 2016-17 compared to the year earlier proved helpful. Profit before tax without considering exceptional items for 2016-17 stood at about ₹14 crore compared to a loss of ₹48 crore for the same period a year earlier.

The changes in Ind-AS accounting standard helped MEP book a net profit of ₹108 crore, a sizeable increase compared to a loss of ₹37 crore in the year ago period. The company’s net worth at the end of March 2016-17 was a negative ₹7.9 crore.