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3Q FY11 earnings preview
c Summary
3Q FY11 earnings growth is expected to be slow: We expect earnings of stocks
under our coverage, ex-oil & gas and banks, to rise 10.4% y-y and 3.7% q-q in 3Q
FY11. We expect net sales to increase 17.7% y-y and 3.8% q-q. The average y-y/q-q
increase in 3Q earnings since FY02 for BSE100 ex-oil & gas and banks is 36.8%
y-y/3.5% q-q. For sales, 3Q averages are 23.6% y-y/7.1% q-q. In addition to a tough
macro backdrop for earnings, annual comparisons are expected to suffer because of
an unfavourable base effect, while quarterly growth rates in the Dec qtr are typically
weaker because of seasonally stronger Sep qtr.
Sector-wise: Higher oil and petchem prices and improving refining margins are
reflected in our expectations of strong earnings for oil & gas companies, although
uncertainty surrounding the subsidy sharing mechanism persists for oil PSUs. Flat
volumes q-q and weak steel prices are expected to hold back profits for steel makers,
but stronger non-ferrous metal prices should boost earnings for non-ferrous players.
For cement companies, average pricing underwent a sharp correction in 2Q FY11 and
although prices have recovered in this quarter they still remain down on a y-y basis. As
a result, we expect earnings growth to be strong q-q but weak y-y. Tight systemic
liquidity, higher interest rates and input costs are likely to affect profits of mid-cap
companies more than their larger counterparts. Order inflows for construction and infra
companies should be of particular importance given our concerns on the investment
cycle and the risk of near-term slippages in orders, especially since the order booking
rate in 1H FY11 has largely been below company guidance in the sector. We expect
results for banks to be boosted by the pick-up of credit growth in the Dec qtr, resulting
in high incremental credit-deposit ratios and a weak base. Higher-than-expected
provisioning for pension liabilities could negatively surprise earnings of PSU banks.
For IT majors, we expect sequential US$ revenue growth to be good this quarter, but
margins will likely moderate on a stronger rupee and higher employee and SG&A
expenses.
Tight liquidity and waning growth momentum an overhang on profits: On an
overall basis, we see downside risk to earnings revisions this year. The consequences
of exceptionally tight liquidity have yet to flow fully through the system. We expect
growth momentum to wane over the coming months, which along with higher input
costs, will likely act as a drag on corporate profitability in FY12F. Industrial production
growth has a strong bearing on revenue and earnings growth. We find that real activity
(as proxied by industrial production) lags domestic systemic liquidity conditions (as
proxied by banks’ net lending to/borrowing from the central bank) by 4-6 months. As
can be seen in the following exhibit, industrial production as a barometer of domestic
industrial activity in turn strongly influences sales and profits of companies
contemporaneously. Given the lagged relationship between IIP and liquidity and the
adverse base effects at play, we think industrial production will remain weak until the
middle of this year and prove to be a drag on corporate top and bottom lines.
Margin pressure from rising commodity prices: Rising commodity and oil prices will
likely help the top lines of commodity producers (26% weight in Sensex in terms of
market capitalisation, unadjusted for free-float) while increasing the input cost burden
of the larger manufacturing sector. As can be seen in the exhibit below, rising
commodity prices typically put pressure on COGS of the larger manufacturing sector
with a lag of one quarter.
Rising inflation and the wage-price spiral: We find that change in employee costs
as a ratio of sales lags WPI inflation by about three quarters (following exhibit).
Persistently high inflation then risks throwing the wage-price spiral into a higher orbit
and proving to be another source of margin pressure, in addition to system-wide labour
shortages. We think there will be little refuge for companies in operating and fiscal
leverage — there are system-wide capacity constraints and interest rates are not likely
to fall from here, in our view — and rising labour costs should become more of a drag
than in the past.
Net profit: Manufacturing companies +27.4% y-y / -8.4% q-q (vs. +44.6% y-y / +63.1%
q-q actual in 2Q FY11); Manufacturing ex-oil and gas +10.4% y-y / +3.7% q-q (vs.
+15.7% y-y / +2.9% q-q actual in 2Q FY11); Banks +21.3% y-y / +13.7% q-q (vs.
+14.3% y-y / -4.6% q-q actual in 2Q FY11).
Net sales: Manufacturing companies +18.4% y-y / +5.7% q-q (vs. +21.8% y-y / +8.4%
q-q actual in 2Q FY11); Manufacturing ex-oil and gas +17.7% y-y / +3.8% q-q (vs.
+17.8% y-y / +9.7% q-q actual in 2Q FY11).
Core EBITDA: Manufacturing companies +23.4% y-y / -0.5% q-q (vs. +32.2% y-y /
+34.2% q-q actual in 2Q FY11); Manufacturing ex-oil and gas +11.0% y-y / +8.4% q-q
(vs. +6.8% y-y / +0.8% q-q actual in 2Q FY11).
EBITDA margin: Manufacturing companies 16.8% (vs. 17.9% actual in 2Q FY11);
Manufacturing ex-oil and gas 21.0% (vs. 20.1% actual in 2Q FY11).
PAT margin: Manufacturing companies 9.4% (vs. 10.8% actual in 2Q FY11);
Manufacturing ex-oil and gas 11.8% (vs. 11.8% actual in 2Q FY11).
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