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Who gains when commodities wane?
ƒ Declining commodity prices favourably impact Indian economy
ƒ Gain to equity market unclear; commodity makers contribute 33% of Sensex profit
ƒ HMCL, BJAUT, APNT and GCPL gained in the previous cycle
ƒ Profits decline for MSIL, TTMT, AL and MM, due to revenue slowdown
We seem to be approaching the era of declining commodity prices again – a usual offshoot
of global economic slowdown and consumer retrenchment. We believe there are interesting
ways of playing a downturn in the commodity cycle.
Economy gains, but do stock markets?
It is well known that the Indian economy tends to benefit when commodity prices decline.
Benefits accrue through a decline in imported inflation, and through a decline in fiscal and
current account deficits. But since 33% of Sensex free-float earnings are contributed by
commodity manufacturers (metals, oil, petrochemicals), it’s not very clear whether the Indian
equity market benefits from a commodity price decline.
Commodity users are gainers, but not all of them…
About 33% of Sensex free-float earnings come from commodity users (auto, engineering,
consumer staples). It may appear that investing in these sectors is an easy way to make
money during a commodity downturn, but it’s not so simple. During an economic slowdown,
consumer retrenchment leads to a decline in demand for consumer staples and
discretionaries – more so for the latter. The consequent increase in SG&A and working
capital and pressure on top-line may more than negate the benefit to gross margins –
leading to a decline in earnings. So, only commodity users with stable demand generate
super-normal returns.
…and sometimes there’s a time lag
In cases where the manufacturing company’s raw material procurement is on fixed time
contracts, margin benefit may come well after raw material prices begin to decline. For
instance, our analysis shows that auto ancillaries’ margins begin to improve one quarter
after metal prices begin to decline and auto (OEM) companies have a two-quarter time lag.
Gainers in last cycle: Hero MotoCorp, Bajaj Auto, Asian Paints, Godrej
Consumer Products
These companies have the benefit of stable demand from their products. Hero MotoCorp
(HMCL IN, Not rated) and Bajaj Auto (BJAUT IN) benefit from declines in aluminium and
steel prices, while Asian Paints’ (APNT IN, Not rated) raw material price is linked to crude
oil. Godrej Consumers (GCPL IN, Not rated) is a significant user of soft commodities like
palm oil.
Losers in last cycle: Maruti, Tata Motors, Ashok Leyland, M&M
In general, the profitability of companies that depend on discretionary spending suffers as
margin benefit from lower commodity prices is more than offset by declining revenues.
Maruti (MSIL IN), Tata Motors (TTMT IN), Ashok Leyland (AL IN) and Mahindra & Mahindra
(MM IN) are examples where profits declined sharply during the commodity downturn phase.
Similarly, auto ancillaries, such as Amtek Auto (AMTK IN, Not rated), Bharat Forge (BHFC
IN, Not rated), which derive significant proportion of their revenues from exports, also
suffered a decline in profitability despite improving gross margins.
Oil companies also gain due to regulatory paradox
Due to the subsidy structure in the Indian oil sector, both oil marketing companies (OMCs)
and E&P companies tend to gain when crude oil price declines. OMCs – BPCL (BPCL IN),
HPCL (HPCL IN), IOC (IOC IN, Not rated) – are direct gainers of reduced subsidies. For
ONGC, a sweet spot is when oil is between USD55/bbl and USD85/bbl.
The dichotomy of falling commodity prices
It is well known that the Indian economy tends to benefit when commodity prices
decline. Benefits accrue through a decline in imported inflation – commodity prices are
a strong lead indicator of manufactured product inflation (refer to, Defence is the best
offence, 20 June 2011) – and through a decline in fiscal and current account deficits.
But it’s not very clear whether the Indian equity markets benefit from a commodity price
decline.
After all, 31% of Sensex’s free-float earnings are contributed by commodity
manufacturers (metals, oil, petrochemicals). Out of that around 5% comes from oil,
where, because of India’s subsidy structure, earnings tend to be upgraded if global oil
prices decline. On the other hand, 26-27% of Sensex’s free-float earnings come from
commodity users (auto, engineering, consumer staples). It would seem that commodity
producers and commodity users are evenly matched in terms of their contributions to
market earnings. In reality, the sensitivity of earnings of commodity producers to
commodity price declines is far higher than that of commodity users. So, in times of a
commodity price collapse, Indian earnings usually decline.
Commodity price collapse a good time for stock selection
The discussion above clearly tells us how money can be made during phases of
commodity price decline – by investing in commodity users. However, we must be
slightly careful here. During times of a global economic slowdown, consumer
retrenchment leads to pressure on top-lines of consumer staples and consumer
discretionaries – more so for the latter. Hence, for some of these commodity users, the
benefits to margins may be more than neutralised by declines in revenue – leading to a
decline in earnings estimates despite benefits to gross margins. Besides, the benefits to
gross margins may not be immediate. In cases where the manufacturing company’s
raw material procurement is on fixed time contracts, margin benefit may come well after
raw material prices begin to decline.
In this note we try to answer three key questions:
1 Which are the companies and sectors that benefit the most due to commodity price
declines?
2 Is there a time lag between commodity prices declining and the positive effect?
3 Which are the companies and sectors where commodity price benefit leads to
earnings upgrades?
How to play the commodity price decline?
The recent sell off in risk assets has opened up opportunities for investors to pick
stocks that benefit from a benign commodity price environment. It is of course intuitive
that commodity users, like autos and auto ancillaries, consumer staples and industrials,
enjoy margin benefits from lower commodity prices.
However, as Exhibits 1 and 2 demonstrate, there is a 1-2 quarter lag between a decline
in commodity prices and an improvement in companies’ gross margins. Most
manufacturing companies’ raw-material contracts run for a fixed time. As such, the
benefit of lower input costs accrues only after 1-2 quarters when legacy procurement
contracts expire. For instance, HRC steel prices topped out in 1QFY09 whereas gross
margins of auto ancillary sector bottomed out at 36.4% in 2QFY09. Similarly, the 46%
q-q fall in HRC prices in 3QFY09 translated into a 13.6ppt gross margin expansion of
auto companies only in 4QFY09.
Gainers during the last cycle
The experience of the last down-cycle for commodity prices in FY09 suggests that
commodity consumers, such as two-wheelers and consumer staples, benefit from
declining commodity prices, particularly as their revenues are insulated from the
slowdown. For instance, Bajaj Auto’s gross margins expanded 750bp due to falling
aluminium prices in 1QFY10, contributing to a 67% y-y increase in PAT.
Similarly, consumer staple stocks, such as Godrej Consumer Products, or Asian Paints
were able to boost profitability due to falling commodity prices, particularly as revenue
growth remained stable.
However, slight caution is warranted. While the benefits of lower input costs lead to
higher gross margins, its impact on profitability may get neutralised by lower revenues
due to a slowdown in economic growth. In general, the profitability of companies that
depend on discretionary spending, such as passenger cars or capital goods, suffers as
margin benefit because of lower commodity prices is more than offset by declining
revenues. The example of Amtek Auto during the 2008-09 slowdown is salutary –
despite a 230bp q-q increase gross margin in 3QFY09, Amtek Auto’s PAT declined
69% y-y because of a sharp decline in revenues. Similarly, a 340bp increase in
Thermax’s gross margin in 1QFY10 could not prevent a 27% y-y decline in profits as
revenues declined 26% y-y.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Who gains when commodities wane?
ƒ Declining commodity prices favourably impact Indian economy
ƒ Gain to equity market unclear; commodity makers contribute 33% of Sensex profit
ƒ HMCL, BJAUT, APNT and GCPL gained in the previous cycle
ƒ Profits decline for MSIL, TTMT, AL and MM, due to revenue slowdown
We seem to be approaching the era of declining commodity prices again – a usual offshoot
of global economic slowdown and consumer retrenchment. We believe there are interesting
ways of playing a downturn in the commodity cycle.
Economy gains, but do stock markets?
It is well known that the Indian economy tends to benefit when commodity prices decline.
Benefits accrue through a decline in imported inflation, and through a decline in fiscal and
current account deficits. But since 33% of Sensex free-float earnings are contributed by
commodity manufacturers (metals, oil, petrochemicals), it’s not very clear whether the Indian
equity market benefits from a commodity price decline.
Commodity users are gainers, but not all of them…
About 33% of Sensex free-float earnings come from commodity users (auto, engineering,
consumer staples). It may appear that investing in these sectors is an easy way to make
money during a commodity downturn, but it’s not so simple. During an economic slowdown,
consumer retrenchment leads to a decline in demand for consumer staples and
discretionaries – more so for the latter. The consequent increase in SG&A and working
capital and pressure on top-line may more than negate the benefit to gross margins –
leading to a decline in earnings. So, only commodity users with stable demand generate
super-normal returns.
…and sometimes there’s a time lag
In cases where the manufacturing company’s raw material procurement is on fixed time
contracts, margin benefit may come well after raw material prices begin to decline. For
instance, our analysis shows that auto ancillaries’ margins begin to improve one quarter
after metal prices begin to decline and auto (OEM) companies have a two-quarter time lag.
Gainers in last cycle: Hero MotoCorp, Bajaj Auto, Asian Paints, Godrej
Consumer Products
These companies have the benefit of stable demand from their products. Hero MotoCorp
(HMCL IN, Not rated) and Bajaj Auto (BJAUT IN) benefit from declines in aluminium and
steel prices, while Asian Paints’ (APNT IN, Not rated) raw material price is linked to crude
oil. Godrej Consumers (GCPL IN, Not rated) is a significant user of soft commodities like
palm oil.
Losers in last cycle: Maruti, Tata Motors, Ashok Leyland, M&M
In general, the profitability of companies that depend on discretionary spending suffers as
margin benefit from lower commodity prices is more than offset by declining revenues.
Maruti (MSIL IN), Tata Motors (TTMT IN), Ashok Leyland (AL IN) and Mahindra & Mahindra
(MM IN) are examples where profits declined sharply during the commodity downturn phase.
Similarly, auto ancillaries, such as Amtek Auto (AMTK IN, Not rated), Bharat Forge (BHFC
IN, Not rated), which derive significant proportion of their revenues from exports, also
suffered a decline in profitability despite improving gross margins.
Oil companies also gain due to regulatory paradox
Due to the subsidy structure in the Indian oil sector, both oil marketing companies (OMCs)
and E&P companies tend to gain when crude oil price declines. OMCs – BPCL (BPCL IN),
HPCL (HPCL IN), IOC (IOC IN, Not rated) – are direct gainers of reduced subsidies. For
ONGC, a sweet spot is when oil is between USD55/bbl and USD85/bbl.
The dichotomy of falling commodity prices
It is well known that the Indian economy tends to benefit when commodity prices
decline. Benefits accrue through a decline in imported inflation – commodity prices are
a strong lead indicator of manufactured product inflation (refer to, Defence is the best
offence, 20 June 2011) – and through a decline in fiscal and current account deficits.
But it’s not very clear whether the Indian equity markets benefit from a commodity price
decline.
After all, 31% of Sensex’s free-float earnings are contributed by commodity
manufacturers (metals, oil, petrochemicals). Out of that around 5% comes from oil,
where, because of India’s subsidy structure, earnings tend to be upgraded if global oil
prices decline. On the other hand, 26-27% of Sensex’s free-float earnings come from
commodity users (auto, engineering, consumer staples). It would seem that commodity
producers and commodity users are evenly matched in terms of their contributions to
market earnings. In reality, the sensitivity of earnings of commodity producers to
commodity price declines is far higher than that of commodity users. So, in times of a
commodity price collapse, Indian earnings usually decline.
Commodity price collapse a good time for stock selection
The discussion above clearly tells us how money can be made during phases of
commodity price decline – by investing in commodity users. However, we must be
slightly careful here. During times of a global economic slowdown, consumer
retrenchment leads to pressure on top-lines of consumer staples and consumer
discretionaries – more so for the latter. Hence, for some of these commodity users, the
benefits to margins may be more than neutralised by declines in revenue – leading to a
decline in earnings estimates despite benefits to gross margins. Besides, the benefits to
gross margins may not be immediate. In cases where the manufacturing company’s
raw material procurement is on fixed time contracts, margin benefit may come well after
raw material prices begin to decline.
In this note we try to answer three key questions:
1 Which are the companies and sectors that benefit the most due to commodity price
declines?
2 Is there a time lag between commodity prices declining and the positive effect?
3 Which are the companies and sectors where commodity price benefit leads to
earnings upgrades?
How to play the commodity price decline?
The recent sell off in risk assets has opened up opportunities for investors to pick
stocks that benefit from a benign commodity price environment. It is of course intuitive
that commodity users, like autos and auto ancillaries, consumer staples and industrials,
enjoy margin benefits from lower commodity prices.
However, as Exhibits 1 and 2 demonstrate, there is a 1-2 quarter lag between a decline
in commodity prices and an improvement in companies’ gross margins. Most
manufacturing companies’ raw-material contracts run for a fixed time. As such, the
benefit of lower input costs accrues only after 1-2 quarters when legacy procurement
contracts expire. For instance, HRC steel prices topped out in 1QFY09 whereas gross
margins of auto ancillary sector bottomed out at 36.4% in 2QFY09. Similarly, the 46%
q-q fall in HRC prices in 3QFY09 translated into a 13.6ppt gross margin expansion of
auto companies only in 4QFY09.
Gainers during the last cycle
The experience of the last down-cycle for commodity prices in FY09 suggests that
commodity consumers, such as two-wheelers and consumer staples, benefit from
declining commodity prices, particularly as their revenues are insulated from the
slowdown. For instance, Bajaj Auto’s gross margins expanded 750bp due to falling
aluminium prices in 1QFY10, contributing to a 67% y-y increase in PAT.
Similarly, consumer staple stocks, such as Godrej Consumer Products, or Asian Paints
were able to boost profitability due to falling commodity prices, particularly as revenue
growth remained stable.
However, slight caution is warranted. While the benefits of lower input costs lead to
higher gross margins, its impact on profitability may get neutralised by lower revenues
due to a slowdown in economic growth. In general, the profitability of companies that
depend on discretionary spending, such as passenger cars or capital goods, suffers as
margin benefit because of lower commodity prices is more than offset by declining
revenues. The example of Amtek Auto during the 2008-09 slowdown is salutary –
despite a 230bp q-q increase gross margin in 3QFY09, Amtek Auto’s PAT declined
69% y-y because of a sharp decline in revenues. Similarly, a 340bp increase in
Thermax’s gross margin in 1QFY10 could not prevent a 27% y-y decline in profits as
revenues declined 26% y-y.
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