DSIJ Mindshare

Q2FY12 - India Inc on a slippery path

We have seen India Inc. swimming against the tide quarter after quarter and emerging victorious by posting a good set of numbers on many an occasion. But sometimes, the tides get just too rough to handle and every attempt at swimming against them only tires you out without much success. The results for the September 2011 quarter seem to be echoing a similar story for India Inc. While rampant inflation, rising interest costs and weakening IIP numbers have already been playing spoilsport for quite a few quarters now, the situation has only been aggravated further with a new irritant entering the scene – mounting forex losses posted by the companies. These have only made matters worse for India Inc., whose bottomline seems to be weakening at its knees.

The September results season has almost ended, with the results of 2667 companies with us so far. With a consolidated topline growth of over 23%, India Inc. continued to show strong resilience in this quarter too. This is quite a relieving picture really, in an overall scenario like the one we are in presently. However, the excitement over a decent topline growth suddenly turns glum when you
look at the bottomline. The net profits have declined sharply by about 36% over the corresponding period! Can this really happen? There seems to be some kind of a disconnect here.

A deeper scrutiny of the data reveals that during September 2010 the net profits were skewed due to the onetime gain of Rs 16209.90 cr that Piramal Healthcare saw from the sale of its business to Abbott, while on the other hand, profits for the quarter ended September 2011 look stunted due to the highest-ever loss posted by Indian Oil Corporation during the quarter.

Thus, to get a clearer picture, we adjusted these aberrations and removed the numbers of PSU oil refinery companies, extraordinary items and the numbers of Piramal Healthcare. This brought in some rationality, with the topline growing at an even stronger rate of 23%, while the bottomline actually grew by close to four%.

Though this looks much better than the gross numbers, the adjusted numbers aren’t something to get hugely excited about. They are a clear reflection of the state in which the Indian economy currently is, in the light of unbridled inflation and rising interest costs. With inflation averaging at 9.6% on a fiscal-to-date basis, the five rate hikes since May 2011, the IIP falling consistently over the last quarter to a mere 1.81% as on September 2011 and the economy growing at 7.7% (the weakest in the last six quarters, not to forget the forex losses), it is indeed wishful thinking to expect India Inc. to perform well amongst these adversities.

While steep inflation has pushed the input costs up by a huge 31%, we would also like to bring to your notice the sharp rise in the interest cost. Even after adjusting the interest cost of banks and financial institutions, the interest cost for the September 2011 quarter has shot up by a massive 49% or Rs6797 cr. Now, this is quite huge for India Inc., as the rate hikes effected in quick succession have increased the interest burden on the existing debt.

A deeper look into the numbers suggests that the situation has only worsened. Out of the total of 2667 companies, the net profits of 1194 companies increased, those of 1329 companies declined while those of 144 companies remained stagnant on a YoY basis. In fact, the number of lossmaking companies increased by 26% to 695  companies in Q2 FY12. This is higher than the increase by 636 companies seen in Q1 FY12 and 538 companies seen during Q2 FY11. The only saving grace here is the sales figures, where out of the total of 2667 companies, the sales of 1648 companies increased, those of 774 companies declined and those of 245 companies remained stagnant.

In fact, if you go a little further and look at the numbers from the manufacturing and services point of view, it can be seen that while the adjusted topline growth for the manufacturing sector remains strong at 21%, the bottomline has managed to grow by five%. This is commendable, and shows the resilience of these companies despite the fact that manufacturing has been the worst affected by inflation and interest costs. What is even more shocking is that the adjusted bottomline for companies in the services sector increased by a mere 1.80%, though the topline increased by a strong 27%. Similarly, a comparative analysis between the PSUs and the private sector shows that while the PSUs (excluding oil marketing companies) managed to post almost a 20% bottomline growth, the private sector has let us down, with profits declining by almost 53%.

All in all, it is not a pretty picture to look at, and this may only deteriorate in the coming quarters. Rising inflation (already on a high base) and the lag effect of rate hikes will only increase the uneasiness for India Inc. going forward. The concerns have been only on the bottomline front till now, but going forward, these may creep up on the topline front too, as we expect the demand to weaken in the wake of the factors mentioned above. Already, with the demand taking a beating, interest rate-sensitive sectors are feeling the heat. This could only spiral downwards in the coming quarters, as customers are expected to postpone their purchases.

Besides, with the cost of funds going up sharply, India Inc. is not only going slow on investments, but may also stall projects altogether. Thus, with capacity additions expected to take their own sweet time, darkness looms over the future growth prospects of India Inc. Moreover, what will also act as a dampener in the next two quarters is the high base effect of the December 2010 and March 2011 quarter numbers. In these two quarters, the topline grew by 19% and 22%, while the bottomline growth grew by a strong 17% and 18% respectively. Thus, with such a high base effect and concerns looming large, it is highly unlikely for India Inc. to be able to sustain growth.

One also has to understand that while the September 2010 profit growth was in single digits too, its tax outgo was still higher, thus indicating better quarters ahead. In contrast, the tax outgo in September 2011 has declined by 10%, thus indicating a weaker quarter ahead. If these numbers are not expected to sustain then the Sensex at the 16700 levels and a trailing PE of 18x looks more expensive at the current levels. Hence, with the earnings expected to weaken in the coming quarters, the probability of the Sensex slipping even further cannot be ruled out. Read on to view our sectoral analysis.
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Auto

2&3 Wheelers

The two- and three-wheeler industry is passing through some challenging times, as on one hand the competition in the industry is increasing, while the demand is tapering off to some extent, especially in the domestic market. This is a big worry for the industry. Bajaj Auto, the second-largest player in two-wheelers, saw its domestic motorcycle sales growing by just eight% for the quarter ended September 2011 over the September 2010 quarter. At the same time, the company saw its three-wheeler volumes take a nine% beating in the domestic market.

We are of the opinion that a slowdown in the economy and the petrol price hike, coupled with increasing financing costs, would impact the demand for two-wheelers in the immediate future. Hence, we expect volume growth for the sector to be muted for the quarter ended December 2011. The effect of a slowdown is visible for the month of October 2011, in which Hero MotoCorp’s sales volumes grew by a mere 1.32% and those for Bajaj Auto grew by 6.46%. In the first half, the segment saw domestic sales growing by 14.36%, while exports were up by 32%.

On the financials, the top three players, Hero MotoCorp, Bajaj Auto  and TVS Motors, reported a topline growth of 24.5% over the same quarter previous year and a net profit growth of 13.16%. We believe that the YoY net profit growth for the December 2011 quarter would be in single digits. Hence, we advise our readers to keep their expectations low from this segment.

Passenger Cars

The industry is passing through a very peculiar situation, where petrol models are available at huge discounts with off-the-shelf delivery, while on the other hand, diesel cars have a huge waiting list (for new models). Overall, the scenario for the passenger cars industry is not very encouraging, and growth is hard to come by. In fact, the industry is heading towards lower sales volumes as compared to those in the last year. In the first half of the current year, sales in the domestic market grew at an anaemic rate of 1.84%, while exports grew at 21%.

The petrol price hike, higher financing costs and the slowdown in the economy have taken away the growth momentum of the sector. In the month of October 2011, India’s three leading car players, Maruti, Hyundai and Tata Motors, saw their sales volumes (including exports) take a beating by 34%. We expect the scenario to be more or less on the same lines for the next two months. 

On the financials front, Maruti reported one of its worst quarterly performances in the recent past, where its net profits plunged from Rs598 cr to Rs240 cr for the quarter ending September 2011. Besides lower demand, Maruti was impacted by the strike at its Manesar plant, which resulted in huge production losses. Looking at the October 2011 numbers for Maruti, we believe that the company would continue with its disappointing financials for the December 2011 quarter as well.

Commercial Vehicles

Despite a slowdown in the economy, the second quarter sales numbers for commercial vehicles are not bad. Tata Motors, India’s leading player in this segment, has performed well. Its domestic sales volumes have increased by 21.74%, mainly driven by LCVs, which grew by 30.61%. Ashok Leyland, another leading player, saw its volumes take a slight beating. Its sales declined to 20429 units, against 22239 sold during the same period last year. In the first six months of the current year, the domestic sales of commercial vehicles grew by 17.85%, while exports grew by 35.91%. However, the scenario is not looking very bright for the segment going forward, as a slowdown in the economy would impact the sector. This is despite the fact that Tata Motors did well for the month of October 2011, where its commercial vehicles sales volumes increased by 12.77%, again driven by LCVs.

Overall, we believe that the auto sector and the ancillary industries related to the sector would face speed breakers. Hence, one must be choosy while investing in this segment. 

Banking

The banking sector was recently in the news for two reasons – one bad and the other diametrically opposite.
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Two ratings agencies, Moody’s and S&P, rated the sector in opposite directions. While Moody’s downgraded the sector, S&P revised its ratings upward. Notwithstanding the rating agencies’ contradictory views, the banking sector is indeed staring at tough times.

The RBI, in its second quarter review of the monetary policy, lowered the GDP growth target by 40 basis points to 7.60%, while the baseline projection for WPI Inflation has been maintained at seven% for FY12. The central bank continued with its rate hikes during Q2 FY12, increasing the repo rate by 50 basis points in July 2011 and another 25 basis points in September 2011. Liquidity was tight during the quarter. The average Liquidity Adjustment Facility (LAF) injection dropped to around Rs47000 cr in Q2 FY12, against Rs49000 cr in the first quarter of 2011-12.

With banks offering higher interest rates, aggregate deposits increased by 16.7% on a YoY basis as on October 7, 2011. Time deposits increased by 19.7%, while demand deposits declined by 3.5%. Credit growth remained at 19.3% as on October 7, 2011, above the RBI’s projection of 18%. Demand from individuals, which include housing loans and education loans, remained strong, while the demand from industries like mining, power and roads was better.

The private sector banks (15 banks) posted healthy Q2 numbers as compared to the public sector banks (22 banks). The topline for private banking players increased by 39.50%, and the bottomline showed a healthy growth of 27.67% on a YoY basis.

On the other hand, public sector banks saw a marginal growth of seven% in their aggregate bottomline, despite the topline increasing by 35%. This was on the back of higher provisions by these banks, which increased by 34.62% to Rs12206 cr (where private sector banks saw a decline in provisions by 30% to Rs1380 cr).

On a YoY basis, the Net Interest Margin (NIM) of the banks has contracted. However, SBI witnessed an improvement in the margin by 40 basis points to 3.70% for the quarter ended September 2011. This was because its average cost of deposits is up by 58 basis points, while the yield on advances surged by 128 basis points.

At present, the banking sector is passing through tough times. On one hand, their lending growth would not be as robust as what it was before, and secondly, with a slowdown in the economy, their NPAs could rise. Also, the treasury income would take a beating when the rate of interest surges. In other words, banking stocks are likely to underperform, as they have been doing since July 2011.

Cement

Despite a negative outlook due to the monsoon as well as higher input costs, the cement sector has posted better-than-expected results for the September 2011 quarter on a YoY basis. Production and dispatches witnessed a growth of 5.4 and 4.4%  respectively, against a 3.5% growth in dispatches during the same period last year. Dispatches had declined by 0.6% during the previous quarter.
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The results reported by the 15 cement companies paint a similar picture with respect to the aggregate sales, which grew by 21%, and the operating profit, which was up 15.2% on a YoY basis. However, the growth in profits that exceeded expectations can be attributed to the low base effect, which had impacted margins during the same quarter in the previous year. If we look at the numbers for the corresponding period, the aggregate sales grew by a mere 1.69% and gross profit was down by 62%.

The July-September quarter is spread across the monsoon season, which typically witnesses a moderation in construction activity. Due to this, as is normally the case, cement prices all over India corrected by Rs5-15 per 50 kg bag. However, this was not the case in the southern region, where cement makers increased the prices in order to offset the higher input costs. Cement prices had plunged drastically in September 2010, which resulted in a lower realisation during that quarter. But realisations started improving subsequently from the lower levels, and went up significantly by March 2011. This was mainly on account of strict production discipline. Since May 2011, the prices have remained high and firm, mainly in the southern region. In other parts of the country, however, the prices came down sequentially.

The increase in prices in the southern region has helped players in those markets to improve  margins. UltraTech Cement and Madras Cements were major beneficiaries of this situation, and witnessed a steep improvement in margins by 300 and 800 bps respectively, despite an increase in the input costs on a yearly basis. On the other hand, companies like Ambuja Cements, Heidelberg Cement and Prism Cement witnessed a decline in margins due to a lack of exposure in the southern region.

Historically, the demand for cement has a propensity to get better post monsoon, and continues to be higher in the second half of the year due to construction activity picking up. This pickup may gain momentum in Q4 FY11. Therefore, we believe that the volume offtake in the coming quarters could be higher.

However, the pressure on margins may continue despite an increase in prices resulting from a shortage of coal in the country. Most of the coal requirement is diverted to the power sector, and higher import of coal may increase costs. Also, an increase in diesel prices will lead to further increase in the freight charges, which together constitute 50% of the total production cost. Moreover, the recent proposed mining tax would increase the limestone mining cost, which remains a potential risk in the forthcoming quarters.

FMCG

The raw material prices for FMCG companies have increased substantially, affecting the sector’s profitability. This is evident from the fact that the prices of key raw materials like palm oil (input for Hindustan Unilever and Godrej Consumer Products) increased by 17% and copra (a major input for Marico) went up by 31% from September 2010 to September 2011. However, some comforting news is that that these prices have started coming down, and this could offer some respite to the industry going forward.
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Another issue the industry had to grapple with was that of the rupee’s volatility, which pushed the cost of imported raw materials higher. The rupee’s depreciation majorly affected Godrej Consumer Products (GCPL), among other companies. The total mark-to-market impact at the consolidated level aggregates to Rs16.5 cr.

For the 10 FMCG companies which we analysed, sales grew by 22% on a YoY basis, while net profits increased by 15.71%. The raw material cost to sales ratio increased by 148 basis points to 43% during the quarter. However, to counter the same, the companies slashed their advertising and selling expenses. These expenses were down by 144 basis points to 9.89% of sales as compared to the same period last year, thereby reducing the impact on the EBIDTA margins.

Hindustan Unilever (HUL) posted robust Q2 FY12 numbers. Its topline witnessed a growth of 18% (less than 10% from volumes and the rest from prices), while the bottomline saw a growth of 21.69%. The company’s EBIDTA margins expanded by 116 basis points to 15% on the back of muted advertising and other expenses.

The FMCG sector will continue to enjoy a strong consumption-led demand growth, going ahead especially from the rural segment, where purchasing power is robust due to good monsoons and higher governmental spend on social sectors. Also, some relief from the decline in raw material prices should help the segment. The BSE FMCG Index has been strong, and one of the reasons is that many fund managers believe that this is a safe sector, especially when there is turmoil in the world economy. FMCG is a strong domestic consumption-led growth story, and hence, this sector is relatively immune from a slowdown. We expect the bottomline for the sector to grow by 15-17% for the next quarter.

Fertilisers

The fertilisers sector has been on the FIIs’ radar for quite some time now due to a few positive factors that have worked in its favour. The deregulation of complex and phosphatic fertilisers’ prices, followed by the positive impetus provided in the Union Budget of 2011-12, provided the initial thrust, which resulted in robust financial performance for companies in this space over the past one year. More recently, the much-coveted urea deregulation policy proposal, followed by the plan to set up a direct subsidy mechanism, provided the final thrust.
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In the September 2011 quarter, the fertilisers sector witnessed a less-than-impressive growth of 12% and five% in its topline and bottomline respectively on a YoY basis, despite a normal and well-spread monsoon. This was primarily on account of a sharp drop in sales volumes of complex fertilisers, driven by a drop in imports (imported DAP, MOP and imported NPK) and an increase in retail prices. The drop in imports can be attributed to the non-availability of raw materials, coupled with the deadlock between Indian importers and global suppliers
over pricing issues.

Consequently, the growth was fuelled by increased urea sales, owing to the significant price difference in comparison with complex fertilisers. DAP was sold at average price of Rs16500 per MT in Q2 FY12, against Rs5310 per MT for urea.

However, these sets of numbers should be largely viewed in the backdrop of a robust 40% and 68% growth seen in the topline and bottomline respectively in the September quarter of 2010. This growth was largely on the back of the NBS policy introduced for complex fertilisers at that point.

On the company front, the withdrawal of the proposal to de-merge the shipping business by Chambal Fertilisers came in as a disappointment. On account of the adverse environment seen in the shipping business, we expect the company’s earnings to come under some pressure.

Considering the successful implementation of the urea de-regulation policy, we believe that the performance of companies in the fertilisers sector will improve going forward. However, the government already faces the challenge of handling rising inflation and the risk of overshooting its fiscal deficit targets. On one hand, keeping in mind the subsidy burden, it is under pressure to address the urea policy issue. On the other hand, the de-regulation of urea prices may lead to a spurt in the retail prices of urea, fueling inflation further.

We believe that fertiliser companies, especially complex fertiliser players, would feel the heat in the coming quarters owing to the high raw material prices, a weak rupee, poor gas availability and the expectation of a fall in demand due to the cyclical nature of this sector.

IT

A cursory glance at the IT sector results that have come out so far would probably come as a shocker to many. While we can understand a fair topline growth of 19%, the even stronger bottomline growth of 26% certainly raises some eyebrows. In the backdrop of concerns over the US and Europe, rising unemployment and corporates feeling the heat of the economic slowdown, the numbers seem to be disconnected from reality. However, a deeper dive into the numbers revealed that they are skewed mainly due to the standalone ‘Other Income’ of TCS. Thus, if we are to adjust the TCS numbers, the sector’s overall bottomline growth drops to a mere five% on a YoY basis.
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While many would consider these as reasonable numbers, considering the tough global scenario that we are in, it clearly indicates that while the IT biggies continue to do well, their mid-sized counterparts are finding it a tad difficult to manage growth. If we adjust the numbers for biggies such as Infosys, TCS, Wipro, HCL Technologies, etc., the sector’s bottomline growth slips to 16%. 44% of the IT companies have reported a decline in their profitability in Q2 FY12. In fact, in our sectoral analysis for the previous quarters, we had mentioned that IT biggies are in a much better shape to manage this crisis than their other counterparts, and that is what seems to be happening now.

Having said that, the growth story of the IT giants is still intact, and they continue to see a good business pipeline. While Infosys sounded a bit subdued in its commentary, wherein it pointed towards a delay in decision-making and higher scrutiny for long term investments, a challenging environment, etc., on the other hand, TCS sounded very optimistic after its management recently interacted with many of its clients. They have made it clear during their commentary that their client’s budget cycles are as per the plans, with no reduction in budgets. In fact, TCS added 35 clients, while Infosys and Wipro added around 45 and 44 clients respectively during the quarter. Besides, the yearly hiring targets, deal wins and business pipeline of the bigger IT companies continue to remains strong.

Besides, the strong numbers posted by Accenture and Oracle further reiterate a stable demand scenario for the IT sector, despite global uncertainty. In fact, Accenture’s management has indicated a growing demand for outsourcing, while Oracle’s strong new license booking shows that discretionary spend continues to remain strong from clients.

TPI, which is one of the largest IT outsourcing advisory firms globally, has shared the view that companies are likely to refocus on cost  cutting-led restructuring of their IT needs, which will lead to higher numbers and value of restructuring deals in the coming quarters. The fact that these deals are expected to fetch a total contract value in the range of USD 25-200 million will only benefit Indian companies further.

As for the December 2011 quarter, we don’t expect the numbers to be very different from the September quarter, with lower working days due to the holiday season beginning in the US and other regions globally.

Infra and Realty

Slow order inflows, higher input costs and an uncertain global environment is hurting the infrastructure segment. With the governmental decision-making process in a comatose state, the entire segment is finding it tough to see its topline and bottomline grow. What is worse is that the impact of a higher interest cost is yet to be fully reflected in the segment’s performance. This means that the infrastructure segment is bracing for much tougher times in the months to come. This would be particularly evident in the performance of those companies that are into infra, or are generating revenues through infra.
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Our analysis of the September 2011 quarter for infra companies reveals that the segment’s topline grew by 17%, as compared to that in the same period last year, but profits before tax (adjusted for extraordinary items, but not for forex volatility) grew at an anaemic rate of just about one%.

In view of the current scenario, we are not ruling out the possibility of this segment reporting lower profits for the December 2011 quarter as well, as compared to the corresponding period. Even the order books are growing at a slower pace. L&T, which is among the bigger players in this segment, had its order book standing at Rs16096 cr in September 2011, against Rs20466 cr during the same period last year.

We would suggest that readers keep their expectations from this segment low till the government takes some concrete action to revive the sentiment with some bold steps. If the government continues to go slow on reforms, the infra segment would continue to be a laggard, and hence, may underperform the broader market.

Real Estate

The real estate sector has consistently been in the news for one reason or the other, especially over the past couple of years. The recent buzz around the sector was the government tinkering with the idea of regulating and monitoring its affairs. This would be a more-than-welcome step, which would help in garnering more long term funds, as lenders would see the higher degree of regulation and monitoring as a safety net. If there is proper regulation and monitoring in place for the sector, we could probably see more FDI flowing into the real estate sector in the same way that FIIs increased their exposure to the Indian stock market after the SEBI started regulating it. This would make the sector healthier, and would curb malpractices to a large extent.

Coming to the financial performance, the sector continues to face problems of a slowdown, as transactions have taken a beating, especially in the metros. There has been some activity in the smaller towns, but realisations are not robust. A slowdown in the economy has definitely impacted the sector, and rising EMIs are forcing buyers to postpone their home purchases. The sale of commercial real estate has also taken a beating due to a slowdown in the economic activity.

We believe that this kind of a scenario would continue in the December 2011 quarter too, and hence, investors should not expect better financials to show up in this sector. The sector has lost investors’ fancy, which means that it would continue to underperform on the bourses in the coming months.

Oil & Gas

The oil & gas sector, excluding OMCs, has managed to fuel India Inc.’s overall growth in an otherwise lacklustre and below par quarter. The 15 companies (excluding OMCs) that we tracked have posted a decent YoY topline and bottomline growth of 30% and 21% respectively. The aggregate net profit stood at Rs16250 cr, largely on the back of ONGC reporting a net profit of Rs 8642 cr.
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ONGC benefited from higher crude oil realisations and lower dry well expenditure, which gave a fillip to its profits. As expected, the company posted robust net realisations of USD 83.7 per barrel for Q2 FY12 compared to USD 62.75 per barrel in Q2 FY11, despite a higher subsidy discount of Rs5713 cr. The long-pending dispute of royalty payment between ONGC and Cairn India was also resolved during the quarter. Accordingly, ONGC expects to receive around Rs1900 cr on account of royalty from Cairn for its Rajasthan block. Cairn India’s profits halved to Rs763 cr as a result of a one-time charge for the same.

Going forward, a higher discount that upstream companies would have to give to OMCs will put their financials under pressure. OMCs have reported massive quarterly losses amounting to a total of Rs14000 cr due to lack of compensation from the government for under-recoveries. The main reasons for their losses were higher crude oil prices, forex losses, lower GRMs and an increase in interest expenses. The OMCs are currently incurring a daily loss of Rs271 cr, and are expected to incur an under-recovery of over Rs121000 cr during this financial year, compared to Rs78000 cr in 2010-11.

In fact, the recent spurt in crude oil prices sparked off by the Iranian nuclear threat, coupled with a depreciating rupee, will prove disastrous for the OMCs going forward. Though they have recently hiked petrol prices, they are still losing heavily on account of subsidised sale of diesel, kerosene and LPG. With four state assembly elections coming up over the next year, it is highly unlikely that the government would initiate any hikes in these prices, as such a move would severely affect their vote banks.

In the present scenario, the quarterly results for the public sector OMCs have become irrelevant, as their financial performance is mostly based on budgetary support by the government and upstream companies, which is decided only at the end of the year. On a consolidated basis, these OMCs have consistently reported a rise in net profits annually, and are expected to remain profitable. In the case of RIL, despite posting its highest-ever net profits, the stock failed to attract investor fancy and was beaten down heavily after its results were announced. On the global front, the International Energy Agency (IEA) has predicted that oil prices could reach around USD 150 per barrel in the near term if investments in the Middle Eastern regions fall significantly. In conclusion, the September 2011 quarter has seen a robust topline performance by all major oil & gas companies (minus that of OMCs), while the bottomline growth too has been decent enough. 

Pharmaceutical

The pharma sector has always been looked upon as a safe haven in uncertain and volatile market conditions. The latest results of companies in this sector do prove this point. The sector, as a whole, has reported a 15 and 17% YoY growth in its adjusted topline and bottomline respectively during the September 2011 quarter. Despite rising operational costs (particularly in raw material prices), it was actually a surge in the interest costs that limited the bottomline growth.
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On the domestic front, we have seen a rise in the generics business, as companies launched new products. Lifestyle diseases are on the rise in India, and chronic illnesses have also seen a spurt in recent times. Both these segments have performed well.

A weak rupee resulted in higher realisations in exports for some companies. In sharp contrast though, companies like Ranbaxy reported notional forex losses for the quarter ended September 30, 2011.

There were a few capacity additions in the CRAMs business. Divis Laboratories commissioned its Vizag manufacturing facility, which has helped the company outperform its peers, with a 43% growth in its revenues. Jubilant Life Sciences, which clocked a 119% growth in its generics business, has also commissioned a new manufacturing facility.

On the regulatory front, the Foreign Investment Promotion Board (FIPB) will now start scrutinising Brownfield investments by foreign players in the Indian pharma sector. Going ahead, we foresee some improvement in the mergers and acquisitions activity led by domestic companies. Sun Pharma is already looking at acquiring a 100% stake in its Israeli subsidiary Taro. Russia is a key country within emerging markets with a huge OTC market, and hence, there could be a lot of takeover opportunities in this region too.

Overall, the companies have witnessed a strong growth in the formulations and generics business. Even though exports have not yet faced headwinds, the current economic crisis may force developed nations to follow the tendering route for medical contracts as adopted by the German government. Such a move will increase competition as well as the pricing pressure on Indian companies. Even in the domestic market, we can see competition rising, as large companies enter the generics space.

Going ahead, we expect the pharma sector to keep up the momentum, with better performance in the cardiovascular, diabetology, chronic diseases and anti-depressants segments.

Power

This is the last year of the 11th Five Year Plan, which largely aimed at reforms in the power sector. However, the same set of problems has hurt the sector, and is expected to continue doing so even as the 12th Five Year Plan unfolds.
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In our second quarter analysis, we have looked at a total of 23 companies. Nine companies among these have reported a negative growth in profits, five grew at a rate of less than 10% and only eight have managed to grow at a rate of over 10%. Overall, the topline and bottomline growth for the sector stood at 23 and nine% respectively. However, the topline growth figure falls significantly to 17% when we adjust the results of Adani Power, which has grown due to capacity additions, and Reliance Infra, which derives a major income from the EPC and construction business.

When we compare these numbers with those for the previous quarters, it can be seen that the net profits have been consistently falling over the last three quarters, even though there is a significant growth in topline. The topline growth points towards the capacity addition, while the bottomline numbers reflect higher fuel prices, lower tariffs, etc. The total interest cost grew by 15%, while the power and fuel costs increased by 24% on a YoY basis, which put the profitability of companies in the power sector under pressure.

This quarter witnessed a severe coal deficit due to the monsoons, as also the long-standing political crisis in Andhra Pradesh and the day-long strike at Coal India. According to the data published on the website of the Central Electricity Authority, there was about 10 MT of coal shortfall, which affected many state-owned thermal power plants in Punjab, Haryana, Maharashtra and Andhra Pradesh. Generation in gas-fired power plants continues to be affected, as Reliance Industries reported lower gas production in its KG-D6 basin.

The total power generated during this period was 217493 MU, compared to 197517 MU in the same period last year. It must be noted that the share of thermal power has gone down from 77% in the same period last year to 73% this year, despite nearly 90% of new capacities being based on thermal power (coal and gas). The share of nuclear power has increased by three%, mainly on account of improved nuclear fuel availability. The storage position in water reservoirs has also improved the share of hydro power by one%.

Recently, the Power ministry has recommended the imposition of a 19% import duty on foreign power equipments. We believe that this will put the margins for companies like NTPC under pressure, as they have some exposure to foreign equipments for their new projects. Domestic  power equipment manufacturers like BHEL will, however, benefit from this development.

Power Grid, which posted a nine% growth in its net profit to Rs708 cr, is yet to spend 20% of its planned capex of Rs55000 cr as per the 11th Plan. The company wishes to spend the leftover portion in the remaining period, and has awarded several contracts for the same. It has also planned a capex of Rs100000 cr for the next plan period (2012-2017).

It is amply clear that capacity addition is not the only solution to the issues faced by the power sector. There is an urgent need to clear the bottlenecks created by some chronic problems. Also, the tariff hikes by some state boards are not enough to cover their losses, and will require courageous decisions on their part in
the future.

We have seen some cooling of coal prices in the international market. However, Coal India and SCCL have indicated a price hike in the domestic coal market in order to compensate for the new mining royalty law, losses incurred due to lower coal production as well as higher remuneration demanded by employees. This will keep the margins for power companies under pressure.

Steel

The steel sector, which is one of the most important sectors for a growing economy, has been languishing for quite some time now due to high input costs. The problems for the sector started somewhere in October 2009-10, when coking coal prices started moving in an upward direction and continued to do so till September 2011. However, bigger companies had managed to keep their heads well above the water by showing a decent topline performance at least till the previous quarter (June 2011).
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If we look at the aggregate results of 62 companies in the sector for the September 2011 quarter, it can be seen that the scenario has just became more challenging as compared to that in the previous quarter. Aggregate sales for the quarter have gone up by 15.9%, but net profits are down by a whopping 70% on a YoY basis. The depreciation of the rupee against the dollar has been one of the major reasons for a fall in the net profit, as most of the companies weren’t hedged against this sharp movement in the rupee over the last few months.

However, the key parameter to understand the actual performance is to look at the companies’ operating performance. The aggregate EBITDA margins have declined by 290 bps to 11.9% on a YoY basis. Most of the companies have seen their margins deteriorate due to higher raw material and power/fuel expenses, which were up by 24.3 and 17.6% on a YoY basis respectively. The decline in margins would have been higher if Indian steel makers had not increased the product prices during the quarter. It should be noted that at a time when steel prices were on a declining trend internationally, the prices in India were moving upwards due to a production cut in Karnataka.

For major steel companies, the September 2011 quarter results have been a mixed bag. The topline growth of TATA Steel and SAIL has been muted, and is at 15 and 2.2% respectively. However, JSW Steel has outperformed, with its sales growing at 33% due to higher volumes, up by 19%. Moreover, despite iron ore issues in the Bellary region, the EBITDA margins for JSW Steel went down by just around 1.1% as compared to that of TATA Steel and SAIL, which were down by 34 and 15% respectively. TATA Steel was largely affected by its European operations, which accounts for 52% of its total revenue.

The outlook for the industry doesn’t look any better, as steel consumption has slowed down in a weak economic environment, and may result in an inventory build-up for major companies. The consumption of steel in various sectors such as construction, automobiles
and consumer durables has seen a decline in the recent months. A slowdown in industrial production, coupled with successive hikes in interest rates, has resulted in a sluggish demand. However, there has been some relief on the raw material prices front – coking coal prices have come down in the last one month from USD 300/tonne to USD 285/tonne due to a global slowdown in demand.

We believe that steel companies may reduce the product prices in the coming quarter in view of the weak demand and lower raw material prices, which will impact the companies’ sales volumes and realisations.

Textiles

While many would have thought that the results of the textile companies in the first quarter could have been an aberration, and things could improve from the second quarter onwards, here’s a check. With the sector’s profits dipping for the second consecutive quarter, the textile story seems to be fading off, for there are clear signs of the sector heading for a deep downturn yet again.
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Profits took a hit and dipped by about 43% in Q2 FY12. It should be noted that these are the results of 140 companies, and with almost 50% of the results yet to come, the profitability numbers could deteriorate further. The topline however, showed some resilience, growing by about 19% during the same period.

However, the picture seems to be deteriorating with every passing quarter now. This is evident from the fact that of the total 140 companies whose results have been announced so far, the Textiles sales for 77 of them increased, while the sales of 49 companies dipped and 14 companies showed no growth. On the profits front, while 44 companies managed to post a growth in profits, a massive 89 companies’ (64%) profits declined and those for seven companies remained stagnant. The worst of this is the fact that 52 companies (37%) have posted losses, which is higher than the 33 companies that were in loss during Q2 FY11.

While the earlier quarters saw a sharp rise in the raw material costs as the main culprit, new factors such as rising interest costs, a slowdown in domestic and international demand, with stiff competition from Bangladesh, Vietnam and Cambodia, have only increased the sector’s discomfort further. In fact, the rising interest burden issue has been put forth to the government, which is now
working on a package to restructure loans to the tune of Rs4000-5000 cr. However, the government has ruled out any debt wavier scheme for the sector.

If such a package is indeed devised, it could bring some succour to the sector, though it surely isn’t a long-term solution. An area of concern is the slowing demand on the domestic and international fronts. If this does not pick up soon, then it is about time that the topline could start weakening too. Besides, it could take at least a quarter or more for the high-cost raw material inventory procured by companies a few quarters ago to move out of the system, following which we may see some respite on the input costs front.

All in all, it is certainly not a pretty picture. Considering the fact that there aren’t any major triggers for the market to sustain the current levels, it would be wishful thinking to expect returns from the ailing sector. Hence, it makes sense to stay away from it.

DSIJ MINDSHARE

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