PSU stock rally: Modi ki guarantee but Kotak has different view

Strong ordering, profitability and the Prime Minister Narendra Modi's light-hearted commentary on PSU stocks, a couple of months ago, where he pitched for 'Invest in PSUs', sent dozens of PSU shares soaring of late. But post the recent sharp rally, Kotak Institutional Equities says investors are paying too much heed to short-term triggers and ignoring large downside risks to medium-term profitability, business model challenges and disruptions.

PM Modi had last year in a debate in Parliament said that the stock market investors could buy PSU stocks that are being ridiculed by others (opposition leaders). "Share market vale logo ke liye yeh mantra hai ki jis bhi sarkari company ko yeh gaali dem usme daanv laga do, acha hi hone vala hai," he quipped.

PSU stocks have rallied up to 443 per cent over the past 12 months, with stocks from capital goods, electric utilities, financials and oil & gas leading the return charts.  "We find certain assumptions, surrounding the medium-to-long-term growth and profitability of these sectors, to be highly optimistic. We doubt much has changed in most sectors," Kotak said.

In a strategy note "Private pricy, public priceless", Kotak said it finds it hard to subscribe to the market’s new narrative of PSUs that may have contributed to the sharp rally in PSU stocks in recent months. 

It broadly gave example of three sectors.

PSUs in the capital goods sector, Kotak said, have seen a sharp rerating in their multiples over the past year, driven by a sharp increase in order books and elevated profitability and returns.

Kotak said it agrees with the brighter prospects of the companies, but believe that the market is underestimating the downside risks in assuming large order inflows for an extended period of time; sectors such as thermal electricity generation will have a finite quantum of orders. Besides, it said, it does not see  perpetually elevated margin or return profile.

"In our view, the government’s three-in-one role of buyer, owner and policy-maker/regulator creates uncertainty regarding the companies’ future earnings and returns," it said.

Besides, it said PSUs in the electric utilities sector have seen a sharp rerating in their multiples over the past year and NTPC’s current valuations at almost 2 tomes book value is meaningfully higher than the logical 1.25-1.50 times book value for extant coal-based assets based on regulated return and cost of equity, even assuming the generation assets exist in perpetuity. This is even if one ignores NTPC's likely lower return profile in the longer term, given the eventual transition to solar electricity, which will also consume operating cash flow of the extant coal-based plants.

"Meanwhile, the Street seems to be overestimating the growth opportunity in Power Grid versus its own growth targets and underestimating the risks to Power Grid's RoE profile from competitive TBCB projects," it said.

Lastly, Kotak said OMCs are at risk of high volatility in marketing margins and long-term disruption. Kotak said it is puzzled by the market’s confidence in the same, given large volatility in marketing margins in the recent past and high sensitivity of EPS to the same.

"Our profitability assumptions are much higher than historic levels, with limited visibility on the government’s pricing policy. Lastly, the low FCF-to-PAT ratios of the OMCs make P/E-based valuations irrelevant while ignoring the large downside risks to medium-term profitability,  business model challenges and disruption risks," it said.

 

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