What to make of Q1 results • Sales are up 34%, the highest since Dec 2006 • But profit growth has slowed down to 16%, the lowest in two years • Valuations are low but there is no sign of recovery in the near future • Good time to buy select stocks with a two-year horizon • But if stocks don’t recover till mid-2009, there will be a short-term opportunity cost |
If a company announces an increase in sales over the previous year, it usually gets a thumbs-up from the market. But when NTPC announced its first-quarter results last fortnight, its 6% rise in turnover was greeted with a 10% fall in its stock price. That’s because while its sales had grown, the company’s net profit had declined 27% over the previous year. The public-sector power producer is not the only one with such a divergence. An analysis of the first-quarter results of 901 listed companies shows that while revenues have grown by 34%, the best since the December 2006 quarter, profits have risen by 16%, the worst in more than two years.
This drop in profit growth wasn’t entirely unexpected. The overall results have been in line with market expectations. This could also be because investors and analysts have toned down their expectations of corporate profits.
If there is one fundamental rule that the results have underlined, it is that investors are better off sticking to companies which offer clear earnings visibility. These are usually companies that provide clear earning estimates in the short and medium terms. This is mostly true for big, blue-chip companies. If you are keen on a stock, but its earnings visibility is low, use its PE ratio as a decider.
Revenues shot up
The rise in sales implies that despite the worsening macro indicators (especially rising inflation), there has been no slowdown in the demand for goods and services. Sales growth, which had dropped to about 15% in the June-September quarter of 2007-8, has now bounced back to over 34%.
However, analysts don’t expect this momentum to sustain. To a large extent, companies were able to sustain higher sales in value terms by passing on some of the increase in input costs to consumers. But with most banks having raised their prime lending rates (PLR) only from 1 July, the impact on demand will be seen in the next quarter. Analysts feel it is only time before rising product prices and higher interest rates affect consumer spending. “The deterioration in the business environment is yet to have its full impact on companies’ sales,” says Hitesh Agrawal, head of research at Angel Broking.
Profits were subdued
The profit growth continued on its downward trajectory, falling from 18.37% in the previous quarter to 16.04%. The cold comfort is that the drop was not as steep as in the previous quarter, when the growth rate had almost halved from 35.41% in the September-December quarter of 2007-8.
This was possible due to the increased efforts by companies to trim costs. Compared with the January-March quarter, which saw a 3.7 percentage point rise in total costs, the total costs rose by only 0.16% in the latest quarter. “Tremendous cost-cutting by corporates helped them cope with the increase in raw material prices. But the uncertainties in raw material prices and foreign exchange will remain the biggest challenge for the corporate world,” says Amitabh Charkraborty, president, equity, Religare Securities.
Also, one needs to watch how companies tackle the increase in interest rates, which poses a serious threat to their investment and expansion plans. If capital becomes costlier, some of these plans may need to be put on the backburner or shelved completely.
Profitability is dipping
Competitive pressures prevented companies from passing on the rise in input costs to customers fully, leading to a significant drop in profit margins. The pressure on margins is clearly visible in the steep rise in expenditure to total revenues. Total expenditure as a percentage of total sales rose by over 3 percentage points to 70.37% from 67.30% witnessed in the same period last year. As a result, profit margins have fallen from 13.1% in the April-June quarter of 2007-8 to 11.32% now. “Rising input costs are increasingly showing up in the form of lower EBIDTA margins and shrinking bottom lines. The cycle of negative operating leverage, slowing other income and profit growth, has started,” says Waqar Naqvi, CEO, Taurus Mutual Fund.
Despite the gloomy backdrop, this may not be a signal to sell after all. In fact, it may well be a good time to buy if you are planning to invest for more than two years. The slowdown in corporate sales and earnings has, to a large extent, been factored into stock prices. Analysts expect Indian companies to register a cumulative annual growth rate of 15% over the next couple of years.
“Investors can start accumulating stocks with a 12-18 month horizon,” says Agrawal. Any improvement on the margins and costs front in the next two quarters might help companies generate positive earnings surprises. The only risk in buying equities at current levels is the opportunity cost of investing when there is no possibility of a rebound in the stock markets till the first half of 2009.
