Portfolio Review – 2Q FY25

Reviewing Q2 FY25 at Itus (Sep 24 Earnings Quarter)

The second quarter of FY24-25 have shown characteristics of earnings as we had discussed in our previous commentary we had written earlier in the year. We had spoken about FY24 being a strong year of growth, which meant that FY25 would see a revenue growth, which would be muted due to the higher base. Around this, we wanted to ensure that our portfolio construct had characteristics of strong operating leverage (companies, who have the ability to translate the low base growth into stronger earnings and cash flows, which invariably comes from companies with strong pricing power and margin profile)

Our portfolio continues to show exactly the above characteristics (as represented in the table below). The quarter went by (September 24 – Q2FY25) saw strong annual growth in revenue and profitability across our portfolio. Growth on a YoY basis, our profitability margins grew along with robust revenue growth. There were a few interesting trends in our portfolio companies which we highlight in further detail below:

Note: For the year-on-year (YoY) measurements, we have taken a rolling 4 quarter format, i.e., Q2FY24 to Q2FY25, as compared to Q2FY23 to Q2FY24. This helps us track growth of our portfolio better, removing dependence on cyclicality in the quarter. Our portfolio companies continue to demonstrate healthy growth and profitability.

Exhibit 1: Gross Margins for Itus Portfolio over the last 8Q

We measure the health of the portfolio to give us a summary of the earning capability of our holdings. Our Portfolio has largely maintained healthy gross margins over time – which in turn has helped our businesses accrete margins with efficiencies of scale. Keep in mind, seasonality and portfolio changes may affect Gross Margins on a quarterly basis.

Exhibit 2: Top 10 sectors for Itus by weight against benchmarks

As we have mentioned in prior quarterly reviews, our portfolio is overweight Healthcare, Oil & Gas, and Power, while we have trimmed exposure in Auto & Auto components. We continue to see tailwinds for growth and monitor the trends on the ground for additional channel-checks to re-validate our thesis and translate this into our positioning.

Below we highlight a few key updates and themes worth monitoring:

Why did we trim our Auto exposure?

When you compare the Itus Portfolio last year Q2FY24 against the current Q2FY25, you would observe one quite contrast – our Auto & Auto components exposure has been trimmed down to 6.5% from 22.5% last year. In this section, we talk about how the data and trends made us trim our exposure during the course of the year.

Indian domestic vehicle sales in FY24 were 27.7 million units of which 76% is constituted by 2W’s, 12% by PV’s and remaining are CV’s & three-wheelers. Though the auto industry has been one of the bedrocks of growth of the Indian economy, being a discretionary purchase, its growth has been extremely cyclical. This has resulted in most funds avoiding the industry for most parts as the sector does not lend itself to structural margin expansion.

Exhibit 3: Comparison of Maruti’s volumes and realization vs. Industry

The sections highlighted in red, have been downcycles for the industry; the sections in black, where the auto cycle was positive. Broadly speaking, auto cycles have lasted 3 years (both defined as an upcycle or a downcycle). While volumes in the domestic markets have compounded by 6% in the 15-year period, there have been periods where growth has slowed or declined.

For instance, the FY12-14 period saw negative and single digit growth, as we were coming off a period of strong growth of +20% in FY10 and FY11. Similarly, growth started tapering off from higher single digits in FY19 and the next couple of years were tough for the industry.  However, post covid you saw a rebound in the industry, with the preference shifting in favour of SUVs. The last 3 years have been a strong upcycle for Auto with the industry seeing both volume and realization growth.

Exhibit 4: Auto & Auto Components – growth and margins

In FY24 industry volumes grew by 8% after double digit growth in the previous two years, hence we are in the third year where we are witnessing healthy volume growth. The average industry volume growth in FY11-24 period is 6%.  As we enter the 4^th year of the auto cycle, there are a few trends that are visible on the ground – rising inventory days in the hands of dealers, increasing competition, increased safety norms and insurance costs, alongside change in consumption patterns. The data also suggests that Auto & Auto components as a sector is clearing showing signs of revenue slow down which prompted us to trim our exposure over the course of the year in the PVs & ancillary stocks from Q4FY24 onwards.

Exhibit 5: PV domestic market share across OEMs highlighting increased competition

Exhibit 6: Rising inventory days for Maruti Suzuki over the last 3Y

Consumer Demand – Rural vs. Urban growth:

The common commentary from corporate India in the recent quarter is the slowdown that we are witnessing in consumer demand. This is more prominent in urban India as compared to the rural markets. The primary factors that are hampering demand are – food inflation, slowdown in wage growth and bank credit growth for personal loans.

Food inflation saw a spike in September to 9.24%; given food items account for 46% of the consumer price index (CPI) – it is hence an important driver for inflation. Vegetables such as Potato, Onion and Tomato contributed to 37% of the food inflation rate. Factors that have contributed to rising prices are short crop cycles and the perishable nature of these products. Measures that the government has taken to counter the price rise is building up buffer stocks and retail sales of onions and tomatoes at subsidized rates.

Real salary and wage expenditure growth of listed non-financial companies (a proxy for urban wages) has moderated to a YoY growth of 0.8% in Q2FY25 and 1.2% in Q1FY25 down from 2.5% in FY24 and 10.8% in FY23. While credit growth in unsecured loans has been higher than the average credit growth of 12-14% in the country, several measures by the RBI have been implemented to regulate consumer loans. As a result, growth in gross bank credit for personal loans is slowing down.

On the other hand, rural demand is better than urban. The primary reasons are – production of kharif food grains is estimated at 165 million tonnes for FY25, this is higher by 5.7% than the final estimates of FY24, this upward revision is on the back of strong monsoons. Rabi production is also expected to be strong on the back of monsoons and adequate reservoir levels. MSP for all 14 kharif crops have been increased by 5.3%-10.3% for the 2024-25 season and will lead to more money in the hand of farmers. A pickup in rural demand is seen in higher volume and sales for automobile and FMCG companies.

Exhibit 7: Rural growth outpaces Urban growth in Auto and FMCG.

At ITUS, we are positioned in 2W and FMCG companies with wide product basket to play the rural recovery theme. We do see these companies improve their revenue growth and maintain margins.

Why we choose to remain underweight in banking:

We are witnessing a deceleration in the system credit growth for banks, which has subsequently moderated the growth in the Net Interest Income (NII) and margins for the banks. This has been an outcome of a multiple factors – recent regulatory measures, such as encouraging banks to lower their CD ratio (loan-to-deposit), mandating a higher capital adequacy requirement in tandem with the risk weighted assets, and a proposed review of the LCR (liquidity coverage ratio) framework has led to tightening of liquidity in the system for banks.

Exhibit 8: Total credit growth has slowed for Banks in the last 1Y

While the regulatory body’s intention behind such measures is to ensure that the banks are better prepared to manage risks in the evolving financial landscape, this has come at the cost of growth tapering off for banks. The below graphic illustrates that the average NII growth % for the top dozen banks by market capitalization had started slowing down after peak seen during late 2023. Specifically, the last five quarters has been a tepid growth phase for banks across the public and the private space.

Exhibit 9: NII growth (YoY) for Private and Public-sector banks over the last 2Y

The need for caution on banking sector stems from factors like low-cost deposits growth tapering off (likely impact of financialization), stress in unsecured pockets like personal loans, credit card outstandings, micro finance, agriculture and more. These can lead to increase in slippages, bad loans, require increased provisioning and compress NIM and ROA of the banks. The impending guidelines on LCR and ECL migration may further lead to tightening the regulatory framework and impact the operating performance of underlying banks. Regulatory tightening coupled with concern on margins, asset quality deterioration, and moderation in loan growth for the banks, has led to the Nifty Banking Index underperform Nifty over the past year.

The ability of banks to attract deposits remains crucial for sustaining future credit growth. We are at a juncture in which the macro environment for banks is clearly not favourable at the sectoral level. As a result of above, it seems optimal in terms of risk and prudence to stick with high quality lenders which have maintained a balance of healthy asset quality and growth in this challenging environment.

Exhibit 10: ICICI Bank growth and asset quality over the last 5Q

Among banks, one such lender is ICICI Bank, which has been consistently outperforming peers and benchmark even as the macro environment changed considerably over the years looking at past cycles in history. The brief snapshot of the bank’s performance in the recent quarters clearly shows that in an environment where growth has been a challenge, ICICI bank has grown its NII % at 15% while ensuring the asset quality improvement continues.

To summarise, the below table gives an overview of the health of our portfolio as of Q2FY25 (with the snapshot as of October 2024)

Note: The sum of above weights would not total up to 100%; remaining would be our cash holdings.

Team Itus

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