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Brighter horizons for India Inc?

Kripa Mahalingam and Gaurav Dua | February 24, 2003

Corporate India looks  in good shape. Falling interest rates, coupled with healthy price and volume increases have helped companies across sectors turn out a creditable performance in the third quarter of fiscal 2003.

The aggregate profits of 967 companies across sectors grew a healthy 40 per cent on a sales growth of around 14 per cent.(For our study, we have only considered companies with sales of over Rs 10 lakh -- Rs 1 million -- and whose stock price is over Rs 10).

The increase in efficiencies of these companies is evident as operating profits surged 21 per cent. Operating margins have seen a healthy improvement, moving up from 15.29 per cent to 16.33 per cent in the last quarter, on a year-on-year basis.

As most companies took advantage of the favourable interest rate scenario and reduced their cost of borrowings, growth in net profit margins was even more impressive.

Net profit margins increased 138 basis points to touch 7.38 per cent at the end of December 2002. Falling interest rates have helped companies to make a huge saving on their interest costs.

However only larger corporates have been able to take advantage of the favourable interest rates.

"There are many companies that still have high-cost borrowings in their balance sheets and will benefit over time as these liabilities are replaced with lower cost borrowings," says R Sukumar, chief investment officer- equities, Franklin Templeton Investments.

For instance, if you look at the top 100 companies which account for about 65 per cent of the total sales and profits of corporate India, their interest costs have declined by around 15 per cent in the last quarter.

However, if you were to consider the whole universe of 1000-odd companies, interest costs have increased marginally by 3.50 per cent indicating there is room for smaller and mid-cap companies to reduce their interest costs.

Market experts expect the trend of decreasing interest costs to continue. However, on a quarter-on-quarter basis, the savings interest costs could decline in the future, they say.

"The trend of falling interest costs should continue through the next few quarters. However we could see a decline on a sequential basis," says Jyothivardhan Jaipuria, head of research, DSP Merrill Lynch.

In this article, we take a peek into the future to see what lies in store for companies in the fourth quarter (Jan-Mar 2003).

What is heartening to note is that this performance has been on account of volume growth and better price realisations. Volume growth has been significant on account of domestic demand in sectors like automobiles, cement, and exports in case of software and pharmaceutical industries.

Says Raamdeo Agrawal, joint managing director, Motilal Oswal Securities: "Indian companies which have found viable export markets have done well and will continue to do so in the future."

Though the strong rupee has impacted IT companies to some extent, it has not done too much damage.

"While the rupee has been appreciating against the US dollar, currencies of other countries that export to the US are also appreciating against the dollar. On a relative basis, Indian companies may not become uncompetitive," points out Franklin Templeton's Sukumar.

A beneficiary of both rising domestic demand and the increasing exports market, the steel sector is having its best years ever.

Rising demand coupled with hefty increases in global steel prices has helped Indian manufacturers to clock a higher volume growth and higher realisations.

Global prices have increased by around 60 per cent, and depending on the category are ruling at around $300-330 per tonne.

Following the trend in global prices, domestic prices have also seen a massive 50 per cent hike.

Exports have been driven by a spurt in demand from China, thanks to huge infrastructure investments it is making to prepare for the Olympics in 2007.

China's imports have gone up 37 per cent and exports have declined 30 per cent. Given the buoyant global prices and increasing demand, steel companies have been pushing their exports.

The increasing demand in the domestic sector from 1.5 per cent to around 6.5 per cent also helped in improving the pricing power of steel manufacturers. The outlook for the fourth quarter still looks bright.

Jindal Iron and Steel Company is expected to turn around this year and make a profit of Rs 74 crore (Rs 740 million) as against the loss of Rs 68 crore (Rs 680 million) last year.

Tata Steel is also expected to turn in a stellar performance by recording a profit of around Rs 1,200 crore (Rs 12 billion) as against a profit of Rs 400 crore (Rs 4 billion) last year.

However, analysts expect prices to start declining in the second quarter of the next fiscal, when they feel that the demand from China may start slacking. The possible softening in the prices could result in a slowdown in the sector.

Also given the huge growth rates clocked by steel companies in the second and third quarter of FY03, it will be quite a task to grow the large base at the same rate next fiscal.

The golden quadrilateral project has been instrumental in driving up demand in core sectors like cement, steel and automobiles. Cheaper home loans and sluggish real estate prices have led to a boom in the housing sector.

Most housing finance companies are reporting a healthy 25 per cent plus growth in housing loans. The boom in housing has led to increased demand for cement and steel, besides creating more employment opportunities.

"The backward linkage between these sectors is strong so an increase in demand in one sector has a rub-on effect on the other sectors as well," explains the chief investment officer of a mutual fund.

Though cement dispatches grew 7.70 per cent in the third quarter and 9.20 per cent in the first nine months, there have been no significant improvement in prices.

The industry is highly fragmented with the top four players accounting for 40 per cent, and the smaller players making up for the balance, so pricing arrangements are hard to sustain.

Opinion is divided on the outlook for the cement sector. While some feel the worst is over, there are some who claim there's still no reason for cheer in the sector.

Those who are bullish say that cement prices will firm up in the coming quarters given that there is no capacity expansion planned during the year (apart from the 2.61million tonne Sanghi plant which will be commissioned before the end of the current fiscal) and demand will remain buoyant, thanks to the golden quadrilateral project.

Those who are bearish argue that the excess capacity coupled with increasing efficiency of cement plants can easily meet the increasing demand and will limit the pricing power of cement players.

Traditionally, the first six months of the calendar year are the peak season for the cement sector and the volumes are bound to surge during the pre-monsoon season. But it remains to be seen if the players are able to sustain the price hikes for a longer period.

There are other concerns as well. Analysts feel if the forthcoming Budget introduces a value added tax, then the profitability of cement companies could take a hit as the tax exemptions they enjoy currently will no longer exist.

Says Urmik Chaya, analyst at Karvy Stock Broking: "The introduction of value added tax will result in existing sales tax exemptions getting converted into deferrals and this will lead to lower realisations and margins."

Coming to the auto sector, market experts expect it to continue the good show in the fourth quarter.

Fuelled by easier availability of consumer credit and an array of new product launches, the motorcycles segment grew an impressive 38.66 per cent this quarter.

However, since the base is larger now, it will be difficult to maintain the current growth rates. Experts concur that the segment will grow at 15-20 per cent.

Commercial vehicles too have done well thanks to strong exports and replacement demand.

However, like in the motorcycles, sustaining growth could be a problem.

Treasury gains

Falling interest rates have not only helped banks make windfall gains on their treasury portfolio but also helped them grow their retail loan portfolio. Public sector banks, especially, have made handsome gains as most of them still hold high interest bonds.

Though the recent volatility in the bond market could have knocked off some treasury gains, the banking sector is expected to continue its good performance in the fourth quarter.

With most banks having a nine per cent plus yield on treasury portfolios, they can continue to book profits and should do well in the fourth quarter. The passing of the Securitisation Bill was a major plus for the banking sector.

The bill empowers lenders to deal effectively with large defaulters and even allows them to seize the defaulter's assets. This could result in higher recoveries and lower non-performing assets.

"The banking sector should continue to do well. The foreclosure norms should help banks reduce their non-performing assets, thereby improving their overall profitability," says Jaipuria.

Subisidised profits

Oil refining companies clocked impressive numbers in the third quarter on account of the revision of government subsidy on LPG and kerosene.

Based on the interim subsidy scheme finalised by the government in December 2002, BPCL received Rs 500 crore (Rs 5 billion) as LPG/SKO subsidies during the third quarter.

HPCL received Rs 590 crore (Rs 5. 90 billion) as LPG/SKO subsidies during the quarter. The amount booked included the arrears as per the new subsidy formula for the previous quarters also.

As a result, other income of BPCL and HPCL saw a hefty rise of about 100 per cent and 79 per cent respectively. The hefty increase in other income helped BPCL post a 224 per cent rise in profits.

In case of HPCL, both the rise in other income and a 51 per cent decline in interest costs helped the company post a spectacular 440 per cent increase in profits during the third quarter.

A low base effect and deregulation of the oil sector are also the other reasons for impressive performance. Going forward, the performance of the oil sector in the fourth quarter would depend on crude oil prices.

However from a stock market perspective, the valuations of oil companies are more likely to be determined by their impending divestment rather than performance.

Under pressure

One sector that couldn't capitalise on its strong volume growth was information technology.

While the topline of infotech companies grew about 29 per cent, thanks to increasing volume growth and relatively stable billing rates, they could barely manage a five per cent growth in profits.

Rupee appreciation and the phasing of tax exemptions lowered the other income component and increased the tax rate resulting in lower profits.

However, severe pressure on operating margins of these companies is a more disturbing trend, analysts say. Operating margins have come under severe pressure due to an increase in marketing spend and rupee appreciation.

Since 70-90 per cent of the revenues are dollar denominated, a one per cent rupee appreciation could impact margins by 30-40 bps depending on the geographical exposure and the onshore-offshore mix.

Analysts expect the fourth quarter to remain flat. Margins could continue to be a problem area. Analysts say margins will continue to be under pressure as the share of the low margin services business increases in the overall business mix and pricing pressure.

A mixed bag

The performance of the pharma sector has been a mixed bag. While companies depending mainly on domestic markets such as Unichem Labs found the going difficult, those which thrived on exports are seeing impressive gains.

While Ranbaxy posted a huge 212 per cent jump in profits last year, Unichem Labs saw its profits decline 29 per cent. And this trend is likely to continue in the fourth quarter.

Says Jamshed Desai, head of research at Taib Securities: "Pharma companies such as Torrent Pharma and Unichem Labs that mainly depend on the domestic market should find the going tough in the next quarter. Smaller contract manufacturing companies like IPCA Labs, which has seen an impressive 115 per cent jump in profits in the third quarter, and Matrix Labs are tipped to do well in the coming few quarters."

No signs of revival

One sector which has disappointed is the FMCG sector. The sector was severely impacted by poor monsoons, intense competition from regional players and the presence of too many me-too products in the shampoos, soaps and toothpastes segments leading to severe pricing pressures.

The aggregate sales of the sector grew a meagre 2.18 per cent during the third quarter.

"Since the penetration levels of FMCG products is high and there has been no increase in the usage of these products, topline growth remains elusive," explains a fund manager.

But cost cutting measures and interest cost savings helped the sector to record a respectable 10 per cent profit growth.

However, with topline growth hard to come by, sustaining the current level of profitability seems to be an uphill task. Given the bleak outlook on the agricultural sector, analysts contend that it will be another quarter of lacklustre performance by FMCG companies.

Future perfect

Going forward experts feel that India Inc will become more profitable. Barring FMCG and infotech, there is still some scope for improvement in profit margins.

Operating margins, could stabilise at around current levels as most corporates are not making substantial capital investments.

Explains Aggarwal: "Corporates are likely to sweat their assets and improve efficiency rather than increase capital expenditure. In fact, in industries like cement, textiles and steel, which have plants operating at 80 per cent capacity, the additional annual demand of 6-7 per cent can be easily met by improving efficiency."

Even as the stock markets are worried about the imminent war between US and Iraq, market experts say that even if it happens, the war will have little bearing on corporate India's performance in the fourth quarter barring some sensitive sectors like software and hospitality.

The software sector could be impacted as companies tend to postpone decisions on IT spends in uncertain times. The hospitality sector will also be affected due to a drop in tourism.

Says Anand Radhakrishnan, fund manager at Sundaram Mutual Fund: "The US-Iraq tension will have no material significance on the fourth quarter performance of most Indian companies barring companies that significantly depend on sea freight and oil."

Even the rise in oil prices is not too much of a concern given that the country has hefty reserves. On the contrary, there can be quite a few gainers if war breaks out.

Says Prateek Agarwal, head of research at SBI Capital Markets: "Commodity companies are likely to gain if the war breaks out as there could be supply disruptions and the prices tend to increase."

The consensus among fund managers and analysts is that the fourth quarter should be a good one for corporate India.

Dileep Madgavkar, chief investment officer, Prudential ICICI Mutual Fund says: "We expect across-the-board strong performance from sectors in the fourth quarter."

Summing up, it looks as if sectors such as automobiles, banks and steel are likely to continue their good performance while there will be no reversal in the fortunes of FMCG and telecom companies whose performance hasn't been too inspiring. We'll only have to wait and see if these expectations are met.

Software companies: Hard on margins

Robust volume growth continued to drive the topline growth of software services companies. The top 10 companies reported an annual growth of 29 per cent in revenues during the last quarter.

This is much better than annual topline growth of 19.9 per cent and 24.5 per cent reported in the first and second quarters, respectively.

Even on a sequential basis, on the back of over a 10 per cent jump in volumes, revenues of the top 10 grew 7.8 per cent in the last quarter.

What's more, the sharp uptrend in hiring indicates that domestic players expect the strong growth in volumes to continue in the future.

Frontline companies like Infosys and Wipro added 2,754 and 2054 employees in the last two quarters -- more than the net employee additions in the previous five quarters.

Apart from volumes, easing pricing pressure has been another encouraging trend for software companies. The average billing rate too has remained stable in the last two quarters as compared to across-the-board rate cuts last fiscal.

But all is not well. The topline growth of these companies doesn't seem to percolate down to the bottomline. Despite strong growth in revenues, net profits of the top 10 software companies showed a tepid 4.6 per cent growth in the last quarter.

This can be attributed to factors like lower 'other income' and a sharp increase in tax rates. Thanks to rupee appreciation (forex fluctuation losses) the 'other income' component declined 22 per cent (YoY) and the tax rate vaulted 73 per cent (YoY) with the gradual phasing out of exemptions under Section 10A/10B for the software industry.

However, severe pressure on operating margins has emerged as an important factor which has dented growth in the bottomline.

Given the steep increase in marketing and selling expenses, the EBITDA of top 10 companies, at 15.4 per cent, is almost half of the 29 per cent growth in topline.

Worse still, there is a general consensus among industry experts that the margins will continue to be under pressure despite stable billing rates.

"Instead of the topline, markets are more concerned about the sustainability of operating margins and profitability of the infotech companies now," says Feroz Kudrolli, research analyst, HDFC Securities.

And rightly so, as the cost of customer acquisition has gone up considerably in the recent past. With increased focus on large-sized outsourcing projects, domestic companies have to compete with global majors like IBM Global, Accenture and EDS, among others.

Consequently, they are compelled to increase their sales and marketing expenses. In addition to this, large-sized projects generally require sufficient amount of skilled manpower in diverse technology platforms.

So to fill the gap, top-rung companies are compelled to subcontract some work to other domestic companies which tends to adversely impact margins.

For instance, the increase in sub-contracting charges depressed Infosys' operating margins by 0.4 per cent in the third quarter this year.

So unless there is a substantial increase in IT spend, margins of software companies are expected to remain under pressure, especially, in case of mid-cap companies which are offering huge price discounts to garner business.

Though there are certain mid-cap players like I-flex Solutions and Mastek which bucked the general trend, the way ahead seems to be on concentrating upon moving up the value chain.

In future, it will become increasingly difficult to just rely on cost advantages. Unless domestic companies gain a presence in system architecture and high-end consultancy work, profitability of software services sector could continue to move downwards.


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