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If the Rate Cycle Reverses

Tanvi Varma/Money Today   Delhi     Print Edition: January 2012

The Reserve Bank of India's (RBI's) war on inflation has many victims, some more badly bruised than others. While 13 rate increases since March 2010 have hurt companies, and as a consequence, their stocks, the worst off have been shares that are collectively known as 'interest rate sensitives.'

"The continuous increase in interest rates has affected a large number of companies in automobile, power, real estate, textile, retail and construction sectors," says Kislay Kanth, senior director, research, MAPE Securities.

An analysis of 400 companies by Espirito Santo Securities shows that interest costs are up nearly 40% year-on-year (YoY). "This has contracted the overall net margins of companies from 10.5% in the September 2010 quarter to 8.2% in the September 2011 quarter," says Nick Paulson Ellis, country head, Espirito Santo Securities.

Banking woes

Rajesh Jain, executive vice president and head, retail research, Religare Securities
Among the worst hit is the banking sector, plagued by three concerns since rates started rising-slowing loan growth, a sharp deterioration in asset quality and margin compression. The Bombay Stock Exchange (BSE) Bankex, that is, the banking index, which outshined peers in the 2010 rally, has lost 25% value since its peak of 14,000 in September 2010.

"Banks' net interest income comes under pressure as they are unable to pass on the entire increase in cost to borrowers due to competition," says DR Dogra, MD & CEO, CARE Ratings. Loan offtake, as reflected in credit growth, is down to 18% from 22-23% last year, making banks fear that any further increase in interest rates may hurt demand for loans.

Banks reported a much lower profit after tax growth in the September 2011 quarter (See Banks Come Under Pressure).

Life In the Slow Lane
Life In the Slow Lane
Further, many large banks reported significantly higher non-performing assets (NPAs) compared to the September 2010 quarter. The NPAs of the country's largest bank, State Bank of India, rose 40% from the year-ago period. The NPAs of Bank of India and Union Bank of India doubled.

Dogra says bank NPAs are driven by the performance of the economy and the industrial sector. In a downturn, there is pressure on companies, which can impact their ability to service debt. This is reflected in bank NPAs. Power, infrastructure and real estate sectors, badly hit by the slowdown, have been the main contributors to bank NPAs.

Badly-bruised
Two sectors badly hit by rising interest rates are real estate and capital goods. "Rising rates have affected both developers and buyers. With each increase in the repo rate, interest rates on loans taken for projects increase. The rates on loans to buy houses also increase, affecting demand for houses and commercial multiplexes," says Rajesh Jain, executive vice president and head, retail research, Religare Securities.

With economy in a bad shape and stock markets volatile, the sentiment has turned cautious in recent months. Most real estate companies saw net sales dip in the September 2011 quarter compared to the same quarter a year ago. Sales of Anantraj Industries, HDIL and Indiabulls Real Estate fell more than 60-70% with profits falling 22%, 73% and 97%, respectively. (See High Rates Bite Realty Firms). HDIL and Indiabulls Real Estate have lost 66% and 55% value since the beginning of this year.

Banks Start Feeling the Heat
Banks Start Feeling the Heat
"The real estate sector has been hurt by a decline in margins. There is a huge build-up of inventory as well as debt on balance sheets," says Kanth of MAPE Securities. For instance, DLF reported sales growth, mainly on account of sale of land, though its operating cash flow was insufficient for the interest outflow of Rs 680 crore.

Analysts say the risk-averse must stay away from real estate stocks. Jain of Religare Securities says even though the RBI may have reached the end of the rate increase cycle, this may lead to only a slight revival. Real estate stocks can outperform only after interest rates start falling, he says. If real estate companies can curtail debt, it can be a positive. "It is better to be selective. One should avoid highly debt-ridden companies," he says.

Also, over the last 10 years, property prices have risen considerably, hitting demand. "From an investment perspective, return expectations are much lower as prices have already run up so much. There is a downside risk as demand slows," says Kanth of MAPE. "We could see a further downgrade of the sector due to the ongoing macroeconomic uncertainty," says Shanu Goel, senior research analyst, Bonanza Portfolio Ltd.

The capital goods sector has bled equally, if not more. The BSE Capital Goods Index has fallen 40% since its peak in September 2010. MAPE Securities' Kanth says it is the first sector to be hit by any fall in investment demand.

Nick Paulson Ellis, country head, Espirito Santo Securities
In addition, overall spending has slowed due to few government initiatives in last four-six quarters. There has been little addition to order books, thanks to higher cost of materials, labour and finance. According to the Centre for Monitoring Indian Economy, the capital goods sector contracted by 5.6% in the second quarter of 2011-12, while new project announcements shrunk by 50%. Voltas registered a 77% drop in profit in the September 2011 quarter compared to the year-ago period due to high input and interest costs. Larsen & Toubro's order inflows dipped 21% YoY.

Dogra of CARE Ratings says companies dealing with investment goods and consumer goods driven by borrowing have been hit. Rising interest rates have impacted investment in machinery in all sectors. Further, the infrastructure sector has been under pressure as any investment made at high interest rates today will have a high chance of becoming financially unviable.

So unless industry is convinced that interest rates have peaked, it will not go for long-term investments. "When revival comes, this sector will outperform, led by names such as L&T, BHEL and Siemens," says Kanth of MAPE.

Mixed bag
The demand for automobiles heavily depends on interest rates as most purchases are on loans. However, companies in the sector have shown mixed results in the last couple of quarters. Hero MotoCorp's sales rose 28% in the September 2011 quarter over the year-ago period while its profit after tax was up 19%. Mahindra & Mahindra's sales grew 37%, but its profit after tax growth was flat. Bajaj Auto increased sales and profit after tax but not as much as in the September 2010 quarter..

Kanth of MAPE says some segments, including two-wheelers and tractors, apart from value-for-money products, do not see a huge contraction in demand when interest rates rise. "The buyer segment for these vehicles is different. There is a lot of extra income in the hands of rural consumers which can keep demand steady," he says.

"The demand for cars, commercial vehicles and sports utility vehicles is falling due to economic uncertainty, lower credit availability and high interest rates and fuel prices," says Goel of Bonanza.

However, there has been some turnaround is this segment. According to a Credit Suisse report, after declining for four consecutive months, car sales (excluding Maruti) rose 34% YoY in November. The report suggests that given the slowdown in the broader economy and the gradually deteriorating job outlook, car sales will remain muted in the coming months.

What if rates turn?
However, there is a silver lining. The RBI has said its main concern, inflation, could start falling, indicating low likelihood of any rate increase. However, a fall in interest rates could be at least six-nine months away.

The inflationary trend has reversed in many parts of the world, including China. But in India, this has been delayed by the falling rupee, which has negated the positive impact of the fall in global commodity prices on inflation.

So, is it time to invest? Analysts say do not invest in rate-sensitive stocks right away. The reason is that in the current environment, there may be more trouble in the next four-six weeks, when the European debt crisis will worsen. "Combine it with the political crisis and slowing growth and you know it's not the time to take risky bets on rate-sensitive sectors," says Kanth of MAPE.

"We are still advising clients to remain defensively positioned in this market until there is more certainty on inflation and global issues," says Paulson-Ellis.

High Rates Bite Realty Firms
High Rates Bite Realty Firms
Within the rate sensitive sector, he prefers banks that are relatively more resilient. He recommends banks with robust loan books, negligible restructured assets, high return on assets (RoA should be more than 1.2%) and capital adequacy. He prefers Bank of Baroda (best in class underwriting and a diversified loan portfolio) in the public sector and HDFC Bank in the private sector due to their growth in less risky segments in the last two years. He believes PSU banks may gain more than private sector banks as rates soften with higher growth, positive surprises on the asset quality front and lower valuations. He says one must take a bank-specific approach as portfolios vary according to the priorities of each bank.

"For instance, a bank more inclined towards retail lending may face less pressure on NPAs than one with exposure to the SME segment, which is sensitive to rate shocks," says Dogra.

Religare Securities' Jain recommends stocks that are fundamentally strong and expected to show business growth rather than the risky rate-sensitive stocks.

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