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India Strategy - FM unleashes a fiscal booster

Today’s corporate tax rate cut announcement is expected to bring a massive boost to the economy. The magnitude of Rs 1.44tn corporate tax revenue foregone amounts to 0.7% of GDP. Along with the earlier announced measures towards improving conditions for MSME sector, NBFC, housing, unclogging pending government payments, GST refunds and expediting rate cuts by banks, the latest measures indicate a decisive intent to turn the negative sentiment in the economy to a positive narrative.

The Government is also overriding concerns on the lack of fiscal space by potentially adding 70bp to the fiscal deficit target of 3.3%. Importantly, all these moves corroborate our thesis contained in our India Strategy report “”, Aug 3, 2019. As we have maintained, the expansionary fiscal response, we believe this will also neutralize negative shock from global trade conflicts. Today’s move also adds to the fiscal space impetus that can get created from the Rs 1.48tn transfer resources (in FY20) from the RBI, announced earlier. Hence, we fortify our outlook for a better H2FY20 as we believe that the multiplier impact will roll out over the next 4-6 quarters.

Specific to the FM’s announcement today, the Rs 1.45 tn corporate tax revenue foregone by the GoI is a bold move, approximately to the tune of 20% of corporate tax collection target for FY20. We believe a  significant portion (more than 50%) of this benefit will go to unlisted companies.

As per our calculation, the reduction in effective tax rate from 34% to 25% will boost profit by nearly 14% in FY20 itself, assuming that it will apply for the full year. Assuming a conservative average profit growth of 5% in FY20, prior to the announcement, post the announcement profit growth can rise to 15-20%, broadly.

It is difficult to predict how the foregone tax revenue of Rs 1.47tn will impact different layers of economy. We believe it will have multiple benefits including:

• Enhancement of RoE of Indian companies and along with lower bank lending rate can create condition for better investment environment.
• Improvement in cash flows, i.e cash from operation, due to lower tax payoff. This can reinforce the measures already taken by the government to address the cash crunch.
• Improved profitability can prompt higher deployment of resources, including labor, resuscitative consumption demand.
• Improved market sentiment through measures like removal of surcharge on secondary market transaction in the equity markets, exempting equity buy-back by companies.

Portfolio view-Adding cyclicals: We believe that current corporate tax rate cut will support the EPS growth for NIFTY by 10% and wider set of companies by 13%. This will also have a positively spill over effect on multiples. Hence, we see NIFTY level rising up to 12000 over the next 12 months. We increase our Overweight exposure in consumption space to include discretionary stocks (Berger Paints & Voltas). We move from underweight to Overweight in Automobile sector (Maruti, Eicher & Hero Motors).  We also move to Equal Weight from under-weight position in banks while maintaining our preference from private banks (Axis banks & ICICI Bank, maintain UW in SBI). Improved cash flows in the system will positively impact NPAs, but gains will be neutralized by margin pressure emanating from benchmarking of lending rate to repo rate and losses on trading portfolio due to hardening in Gsec yield. We see 10 year breaching our estimated fair value of 7% sooner. We also increase our position in capital goods from Equal Weigh (L&T). We hold an Overweight position in Metals.

Following are the IDFC top picks on account of announcement of lower corporate tax:

HUL, Titan, Berger, United Breweries, HDFC Bank, ICICI Bank, Axis, Shriram Transport Finance, Eicher, Maruti, Tata Steel, JSPL, Ultratech, Crompton Consumer, L&T, Adani Ports, PVR, Kajaria Ceramics and Supreme Industries

Summary of announcements

• Corporate income tax rate for domestic players is slashed down to 22% from 30% earlier. Along with surcharges and cess the effective tax rate would settle at 25.17%. Domestic companies can avail this provided they let go of any other exemptions

o   Impact: Any company with effective tax rate above 25.2% would benefit with maximum benefits accruing to players with >30% effective corporate income tax rate. This will support ongoing weak corporate profits spree along with an improvement in RoE and RoA. Our analysis of aggregated P&L for key indices components (sourced from capitaline) indicates an effective tax rate of 33.7% for BSE500 and 31.3% Nifty 50 in FY19. Also, the effective for IDFC coverage universe stood at 27% for FY19, indicating a reasonably strong earnings fillip in FY20.

• New domestic companies which would be incorporated after 1st October 2019 – can pay a further discounted corporate income tax at 17.01%, if a) they will be making fresh investment in manufacturing sector, b) and they will be commencing production by 31st March 2023.

o   Impact: This is a very positive announcement pertaining to investments in the manufacturing, which has been a major contributor in dealing with capex lull experienced by Indian economy in the decade gone by. We believe this will also be positive for credit off take (owing to capex pick up) and thus corporate banks. This announcement will also have a positive rub off impact on employment as well.

• Companies will have a choice of moving to the new stream with 25.2% effective tax rate by forgoing existing exemptions. Once companies decide to forgo the exemptions, they can’t avail them again
• Minimum alternate tax (MAT) has been reduced from 18.5% earlier to 15%.

o   Impact: This will be positive for export oriented players like IT, Pharma and other companies operating out of SEZ’s (Special economic zone), thus providing relevant fillip to EPS growth

• Enhanced surcharge applied on capital gains of equity shares or other securities liable for securities transaction tax (STT) to be rolled back. This was announced with Finance bill, 2019. This will apply to FPIs as well as individuals.

o   Impact: Marginally positive from the flows point of view

• Tax relief on companies which announced buy back before 5^th July 2019.

o   Impact: It would impact a very small number of companies, who announced the buy backs on said dates. Within our universe Wipro and Infosys will be the beneficiaries.

·         Expanding the scope of CSR fund: 2% of the CSR funds can now be spent on incubators funded by government agencies