Hong Kong strategy:Darkness before dawn


Though we remain optimistic that a new business cycle is rolling back around, we believe now is thetime to take profit on cyclical sector investments, and await new opportunities to reinvest in thecyclical sector, as we are concerned over the potential for a retreat in cyclical stock valuations in thecoming two quarters.

We invited Mr. Chen Ran, Deputy General Manager of Gongkong (a well-knownthird-party consulting firm specializing in China’s IA market) to be present at ourAccess China Conference 2018on 10January in Beijing. We summarize belowour key takeaways:

We met TCS CFO Mr V Ramakrishnan and discussed demand and margin trends indetail. He reiterated that the sector is grappling with slower IT spend, evident inmoderating growth rates, but that this could still reverse in the coming quarters. Manystructural headwinds have pulled down sector growth, but macro weakness is a bigcontributor to the sector slowdown as well. Some of this spend may come back withimprovement in the macro environment and the business outlook of IT clients.

    August macro figures. Many argue August macro data came in much lower than expectation, wefind out that infrastructure plays a large role, and real estate and industrial investment are bothquite weak. With both supply side (manufacturing investment) and demand side (fixed assetinvestment) show weakness in August, we are a little bit concern about the future, as the higherbase effect and weak infrastructure would gradually harm the looking of the macro figures in thecoming quarter.

    2017ended on a strong note; 4Q beats expectations

    Banking recovery – the centre of the discussion storm. As shown in chart 1, TCS’sgrowth has been pulled down by the banking, hi-tech and retail sectors while othersectors have done well. The CFO believes that slower banking growth is not linked toTCS’s high market or wallet share at some of the large US banks. Rather, banks aresimply cautious to increase spending at this stage – although, with regulatory pressureexpected to lessen and a continued pick-up in business, spending should grow in thecoming quarters. TCS is strong in digital spend and has not lost market share. Topbanks in the US report decent revenue growth (chart 2) and, if this recovery is sustained,management expects IT spend to pick up as well.

    Price hike not sustainable. As we have communicated with investors, price hike supported bysupply-side reform and environmental regulation is the major driver for the cyclical sector rally, forthe market believes that price hike both reflect demand to be better than expectation, and betterearning for up-stream manufacturers. However, in reality, to keep price hike sustainable, theremust be stricter environmental regulation among industries. Moreover, as per our analysis on priceand investment, price hike in 2017 has become negative to manufacturing investment. Therefore,for the future, there are two possible scenarios: material price stop rising, or material pricecontinue to hike, further harming the demand, leading to a price halt or price drop. For eitherscenario, the price hike is not sustainable, thus the cyclical sector rally of this round is notsustainable.

    Preliminary data from Gongkong shows that China’s IA market demand was up15-16% YoY, with strong growth in 3Q sustained in 4Q. Such robust demand, inour view, beats expectations as the market previously expected 4Q growth to slowdown on high comparison base. Also, Gongkong noted that due to already betterthan-expected order intakes in 9M17, some industry players intentionally pushedsome 4Q orders to 2018, leaving enough room for growth in the coming quarters.Therefore, strong demand growth will likely be sustained at least in 1H18.

    Retail slowdown may be more structural. The CFO clarified that retail weakness isled by few small retailers who, unable to cope with the online attack, are losingbusiness. While the base will become favourable at some stage, the online impact onthe bricks-and-mortar business is structural and may continue to impact IT spend.

    Market misunderstanding the driver. As we have mentioned in out September outlook, Juneoutlook, and May outlook, the driver for continuing recovery comes from market clearance, supplyshortfall, and industrial investment demand improvement. While the market believe in price hikeand margin expansion driven by supply-side reform, which would eventually lead to the temporaryfall of both supply and demand, a negative sign for recovery. It might take time before the marketrealize that the clearance and recovery of investment demand to be the major driver for cyclicalrally in the coming new cycle.

    Demand driver has shifted to industry upgrade...Gongkong believes the key drivers for the strong IA demand in 2017include: 1)industry upgrades in low-to-mid-end manufacturing sectors; 2) rising labor costs;and 3) improvement in end-customers’ profitability. In the past, new capacityexpansion used to be the key driver for China’s IA demand but now industryupgrade has become and will continue to be the predominant driver.

    Traditional vs digital. Though the pricing pressure the traditional business faces maybe a little more than the historical average, the CFO believes higher realizations inthe digital segment more than offset this impact. Clients value quality and certainty ofdelivery and do not focus only on pricing; companies such as TCS, with scale acrosstechnologies, can therefore withstand some pricing pressure in the market.

    No further support before 2018Q2. Our accumulating depreciation fixed-asset model introduced inSeptember outlook suggest that the new cycle might start in 2Q2018, due to strong marginalimprovement of utilisation rate in 3Q2017 (utilisation rate leads investment for 3Q in China). Before2Q2018, however, our model do not suggest any upside potential from industrial investmentdemand, which can become a pressure upon sentiment.

    ...which means it’s structural and the cycle may last longerAlthough China introduced automation products 30years ago, the realautomation upgrade cycle in fact only started since 2014. Experiences fromdeveloped countries suggest it typically takes 10-15years to complete anautomation upgrade cycle but in China the cycle may last longer. This is mainlybecause China has a much more diversified and complicated manufacturingsector compared to most of the other developed economies. For example,automobile and electronic manufacturing, the two dominant verticals for IAdemand in other developed countries, only drive 30-40% of China’s total IAdemand. Sectors like textile machinery, metallurgy, public facilities, etc. used tobe China’s manufacturing foundation and they will lead this round of automationupgrade. In fact, such a trend is really taking place in these verticals.

    Margin outlook remains tricky. TCS reported a 23.4% margin in 1Q18. In the comingquarters, most of the wage impact of c. 150bp in 1Q should recover. However, thatstill means margin guidance of 26-28% may remain a challenge. Also, INR strength isa serious headwind in our view. It’s fair to assume the business model requires 3-4%INR depreciation every year to absorb wage inflation. Even a stable INR is a headwindfor margins in the medium to long term (2-5 years). Please refer to charts 3 and 4.

    Take profit on cyclical names. We suggest investors to take profit on cyclical sector investments,and, accordingly, we lower the pro-cyclical exposure of our Conviction BUY portfolio. We cut ourweighting of Sinotruk (3808:HK - BUY) by 7ppts, Nine Dragons Paper (2689:HK - BUY) by 5ppts, CIMCEnric (3899:HK – BUY) by 2ppts and Anhui Conch (914:HK - BUY) by 1ppt. We add to our portfolioCSPC Pharmaceutical (1093:HK – O-PF) with a 3% weighting and Yongda Auto (3669:HK – BUY) witha 4% weighting, and raise our weighting on ENN Energy (2688:HK - BUY), New Oriental Education &Technology (EDU:US – BUY) and Huaneng Renewables (958:HK - BUY) by over 3ppts each.

    Overall, we continue to believe sector growth in the recent quarters has beenled by both structural and cyclical factors. Structural factors are unlikely to recede;but the impact of cyclical factors may abate, driving acceleration from the current 6-7%sector growth rate. We like TCS’s ability to drive through tech cycles, but a high baseand valuations limit share price upside – Hold (TP of INR2,380).

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