Dec-17 Sensex target up 10% to 33,000 to reflect such possibility
We have been arguing for an M&A cycle over the past few months and lift our Sensex target by 10% to reflect the same. Potential key sector beneficiaries include Financials, Telecoms, Materials, and Infrastructure.
Demand for capacity or assets going up: Private capex has been depressed since 2009. With growth looking up, utilisation rate is likely to rise and, therefore, there should be demand for capacity.
Willingness to sell: Note that for most sectors it takes 3-4 years to set up new capacity and acquisitions are a faster way to build capacity at the turn of the growth cycle. Assuming there are enough distressed companies ready to shed assets for buying companies.
Ability to buy: Free cash flow on aggregate is at all-time highs in India, creating room to buy capacity within debt-ridden companies. Over the past 12 months, in the absence of clear growth signals, companies have used their rising free cash flows to hike payouts but we think this is likely to change into acquisitions. Banks are flush with liquidity and are likely to provide further impetus to such activity.
Cycle in favour: With adequate sellers and willing buyers, this sets up the potential for M&As. Indeed, as M&A is at multi-year lows, FDI is strong and equity valuations look reasonable, the possibility of this occurring is boosted. If history is a guide, M&A deals could scale $100 bn in the next 12-18 months.
Implications: Strong demand for stocks and a potential valuation overshoot, particularly if we add domestic demand from households. We lift our base case Dec-17 BSE Sensex target by 10% to 33,000. Consolidation leads to better margins. We lift our FY2019 earnings growth expectation for the Sensex from 15% to 24%. Financials, including property, steel, infrastructure, cement and telecoms are likely to lead the consolidation wave and are among the sectors to buy in India. We add Reliance Industries to our Focus List at the expense of Sun Pharma and close our underweight in Telecoms by going underweight Healthcare and further cutting Consumer Staples.
Risks: If banks are unwilling to take haircuts, transactions could be delayed. A slowdown in global growth could falter the Indian growth recovery. A sharp rise in commodity prices could similarly upset the growth trajectory.
Implications of a potential new M&A cycle
*Net demand for Indian equities is rising rapidly, implying the potential for a valuation overshoot.
*Domestic investors are already significant buyers of equities and corporate buying is adding to this demand. Our bull case for the Sensex could come into play by 2018. Our bull and bear cases are unchanged at 39000 and 24000.
*At a sector level, we think those with least pricing power and/or most distress will be the most favoured for M&A. These include banks, steel, infrastructure, cement, property and telecoms.
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*Consolidation should lead to better margins and, eventually, better earnings growth. Our FY2019 margin forecast rises from 19% to 20% for BSE Sensex. We lift our earnings growth expectation for Sensex FY2019 from 15% to 24%, as we embed higher margins for corporate India going into an upcycle. Our broad market earnings CAGR for the next two years is at 17%.