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How vulnerable are earnings?
Our base view has been that earnings could see some margin pressure arising
from rising costs. In an attempt to put this in a historic context, we looked at RoEs
and their Du Pont composition since FY04. On a broad market level, we think
while cost pressures will make earnings vulnerable, there could be some buffer
for companies by raising asset turnover which is low relative to history. Hence,
earnings for the domestic economy companies, at least, are unlikely to see major
downgrades.
Key points from the RoE cycle
1. RoEs are still lower than FY04 levels and of course much lower than those
seen in the peak years of FY07 (led by easy liquidity conditions which we
think wont get repeated).
2. Margins, however, are getting similar to FY04 levels though again well
below the peak of FY07. We think margins are likely to get tougher as costs
in India are structurally rising and competition intensifying.
3. Lastly, lower leverage and lower asset turnover are the main reasons for
lower RoEs even relative to FY04.
Stocks & sectors: who is more vulnerable?
1. Maruti (low vulnerability): RoEs are close to the lows as are margins. While
royalty and enhanced competition are partly responsible, we think earnings
downside may be limited. The one point to watch is that asset turnover is
close to peak. So the company’s ability to ramp up capacity utilization may be
key to future RoE.
2. Consumers – ITC and HUL (RoEs peaking: limited surprise): RoEs as
well as margins in the consumer sector are close to peak, probably the only
sector with this phenomenon. HUL has used other levers of higher gearing
and increase in asset turnover too to boost RoE. We think RoEs in the sector
are peaking and are unlikely to surprise.
3. Industrials - BHEL and L&T (structural shift in RoEs): RoEs in Bhel are
close to peak as while margins are near there. L&T is seeing peak margins
though RoEs have fluctuated with falling asset turnover as the business mix
keeps changing. We are positive on the sector but recognize that if the infra
spend in the economy lags, earnings are highly vulnerable in this secto
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