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Rising interest costs to hit India Inc

| 11/7/2011 10:46 AM Monday

The RBI has left no stone unturned in its fight against inflation. It went ahead with a 25 basis point hike in the repo and the reverse repo rates yet again on October 25, 2011. A total of 13 rate hikes since March 2010, amounting to an overall hike of 3.50 per cent in the repo and 4 per cent in reverse repo rates, with seven of these effected in the year 2011, itself says a lot. While we understand the RBI’s upright intentions in trying to bring down inflation to manageable levels, its efforts are actually ending up denting growth, with India Inc. feeling the heat of these rising interest rates on both its topline as well as its bottomline.

While profitability is taking a beating due to the rising costs of the existing funds, a slowdown in demand from interest-sensitive sectors, such as auto, real estate, etc., is creating a double whammy for the companies. Future growth also seems to be hampered on account of a slowdown in the investment cycle, with the cost of raising new funds going up. In fact, in the case of 600-odd companies whose results for the quarter ended September 2011 have already come in, we have observed profits decline by about 20 per cent. With more results pouring in, the picture could deteriorate further.

Thus, in the current scenario, an important consideration from an investor’s point of view is to learn about companies that could face the heat of these rising interest rates. It makes sense to raise a red flag against those companies that would be more vulnerable to rising interest costs.

To gauge this, we have looked at the interest coverage ratio of ‘A’ group and ‘B’ group companies , as listed on the BSE. Also denoted by EBIDTA/interest, the interest coverage ratio tells you about a company’s financial durability. It measures whether the company is profitable enough to pay off its interest outgo. For the purpose of our analysis, we are focussing on companies whose EBDITA/interest is more than 1x but less than or equal to 2x, as such companies are likely to report deteriorating financial numbers going forward. In fact, to get a more realistic picture, we have considered the EBIDTA and the interest for the trailing four quarters, and these have led to some startling results.

As far as the ‘A’ group companies are concerned, there are currently four companies – namely Jaiprakash Power Ventures, Jet Airways, Pipavav Defence & Offshore Engineering Company and Reliance Communications – which, we believe, would be affected the most from the rising interest rate scenario, and may see their profits straining under pressure in the coming quarters. The EBIDTA/interest of these four companies stood at 1.79x, 1.82x, 1.89x and 1.90x, respectively. On a trailing 12-month basis, Jet Airways is already showing a loss of Rs 116.99 crore, and with interest rates rising further, these numbers could plunge to lower levels.

As for the ‘B’ group companies, nearly 200 of them are more vulnerable, as their EBIDTA/interest ranges between 1-2x. What is worse, is that as many as 77 companies are already reporting losses at the net level, and these losses could increase further.

A Negative Lag Effect

We went a step further and carried out a sensitivity analysis, wherein we included the impact of the lag effect of rate hikes from May 2011 onwards. We calculated the average cost of debt and added a 200 basis points’ rate hike for the expected lag effect, which gave us the new increased interest cost and finally, the new EBIDTA/interest. For the purpose of this study, we have assumed that the EBIDTA remains the same (this is unlikely, and may deteriorate due to a slowdown in the economy). After this analysis, we found that ‘A’ group companies in the red flag list have increased to nine, where earlier there were only three. The red flag list now includes counters like Jaiprakash Associates, DLF, Essar Oil and Lanco Infratech, among others.

As for the ‘B’ group companies, out of the initial 197 companies, the EBIDTA/interest ratio of 26 companies falls below 1x, thus indicating that these companies could find it difficult to cover their interest payments in the coming quarters. What is worse is that a total of 130 companies were added to the existing list, with their EBIDTA/interest ratio ranging between 1-2x, thus taking the total number of companies in the red flag list to about 300.The purpose of this study is to warn the investing fraternity that while parking funds in these companies, it is important to keep in mind the fact that these counters are likely to face tough times ahead in the face of the rising interest costs. Hence, their financials may turn red, and eventually, their market cap would take a beating. Therefore, do your homework properly before you take a step further.

 

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