Rough weather ahead
Vikas Khemani March 3, 2011This earnings season has not fully reflected the changed environment but offers a lot of indicators on what is in store. Approximately 60 per cent of the companies that have declared results have either met or exceeded analysts' estimates and 40 per cent have negatively surprised the market. So, why then are the markets not cheering this earnings season? One of the main reasons could be that it does not fully reflect the changing macroeconomic conditions. Yet we get a sense of what to expect in the coming quarters.
The key takeaways are rising input costs and a slowdown in order book accretion. Although volumes have remained stable, margins have definitely come under pressure in many sectors. However, I feel that the full impact of rising input costs is not yet reflected because of inventory gains. Typically, companies keep two to four months of raw material inventory which helps them if prices go up in the short term.
This strategy fails if prices continue to climb and inventory has to be replaced, leading to higher input costs. The sudden change in the macroenvironment after October, when both inflation and inflationary expectations went up, squeezed margins only towards December. There is a high possibility that Q4 numbers will disappoint the street both on volume as well as margins.
Technology results are good with strong volume growth, though rising wages are a concern. Given the growth outlook of the sector, it will be able to absorb the hikes, and hence markets are not unduly worried about the rising cost pressure. For banking, Q3 was probably the best period in terms of margins, and one can expect pressure on the net interest margin, or NIM, to intensify due to the laggedeffect of re-pricing of deposits over advances. Also, there were signs of slippage in the asset quality. Banks with a strong CASA, or current account and savings account, franchise do well in a rising interest scenario. If a 10-year bond yield inches up beyond 8.15 per cent, Q4 numbers will have an impact on that as well.
Most fast-moving consumer goods, or FMCG, companies reported a 200-300 basis points drop in gross margins because of the steep rise in food prices and other input costs. However, most companies offset this with the help of the inventory effect and significant cost-cutting on discretionary spends like advertising and promotion. Even consumer durables companies were affected by rising commodity prices. This trend is likely to continue till we see inflationary pressures easing.
The auto sector also faced cost pressure due to rising prices of commodities such as steel, aluminium and rubber. The margins were impacted by 200 basis points, but this was partly offset by an increase in realisation. Volume growth is unlikely to continue since it is a ratesensitive sector. Rising cost of products with rising cost of interest and oil may impact the sector over the next three to four quarters.
We believe that most of the upsides have been factored in so far, and, surprisingly, one has still not seen significant downgrades in earnings by analysts. This leaves a lot of scope for negative surprises in the quarters to come. In my opinion, in the next quarter analysts could downgrade earnings estimates for FY 2012 as cost pressures intensify in terms of rising input and borrowing costs. India's relative valuation premium compared to other emerging markets has already come off a bit because of the recent underperformance.
In a nutshell, if cost pressures continue, we will see downgrades in earnings estimates, leading to a cycle of further de-rating of Indian equities.
The author is the Head (Institutional Equities), Edelweiss Securities