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Profits and profitability under pressure

Rising costs of raw materials and limited pricing power have led to a significant shrink in operating margins on sales

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India Inc’s performance is expected to be listless in the third quarter of 2011-12, considerably weakened by the government’s price control in the oil and gas sector and recession-laden sectors, such as automobiles, auto ancillaries, steel and non-ferrous metals.

Although the depreciation of the rupee by around 9 per cent has increased input costs and hurt profitability of sectors importing raw materials, it is proving to be beneficial for the net exporters like software services and pharmaceuticals.

So far, results available from cement, capital goods and fast moving consumer goods (FMCG) sectors have been healthy. The results of construction, infrastructure and telecom sectors have been in line with expectations. (Click here for detailed table)

Lack of pricing power
The review of 312 companies that declared their third quarter results till January 25 showed a robust growth in net sales, at 25.4 per cent, thanks to the figures reported by petrochemicals giant Reliance Industries and gas distributor Gail.

The recessionary trend has been seen in manufacturing companies (ex-oil) that use to produce goods. For these companies, the cost of raw materials increased 19.5 per cent, as a result of which, the rate of net sales growth slipped below 20 per cent to 17.6 per cent, suggesting a decline in price realisations.

The revenue growth of the software services sector has been strong, thanks to depreciation of the rupee. The weak currency helped HCL Tech, Infosys Technologies, TCS and Wipro post export revenue growth of more than 30 per cent. So far as other sectors are concerned, Larsen & Toubro helped the capital goods sector post sales growth of more than 22 per cent, while higher price realisation helped cement companies grow at a healthy 22 per cent.

High costs squeeze margins
of raw materials and limited led to a significant shrink in operating margins on sales. The operating margins of 292 companies (ex-banks and finance) declined 357 basis points (bps), as the net sales of these companies rose at a slower pace of 26.1 per cent, compared to a rise of 36.3 per cent in the cost of raw materials.

The margin contraction was a hefty 600 bps for the oil and gas sector, led by a 52.4 per cent rise in costs of raw materials and drop in profits of industry leader Reliance Industries. The manufacturing companies have recorded 219 bps decline in margins, as a result of costs of raw materials rising 186 bps higher than the net sales growth.

Quarterly growth in % Net Sales Net Profit
Jun’11 Sep’11 Dec’11 Jun’11 Sep’11 Dec’11
Total (312 companies) 31.37 24.14 25.43 30.50 0.46 3.72
Manufacturing(214)* 26.18 20.34 17.63 23.57 -15.29 -4.65
Automobiles 15.50 5.58 1.31 17.81 -12.94 -4.13
Banks 15.20 10.85 15.69 26.38 23.77 23.94
Capital goods 21.76 17.99 22.27 21.62 2.48 15.84
Cement NC 24.07 32.71 NC 74.30 116.25
Oil and gas 41.03 34.93 39.33 18.24 11.32 -12.10
Pharmaceuticals 16.65 20.53 20.01 12.89 15.84 0.63
Software services 25.79 22.08 32.92 17.07 10.38 25.00
*companies with RM/Sales over 25% each, NC, not comparable due to merger in UltraTech

Margins have risen 100 bps for software exporters and 368 bps for cement manufactures. Capital goods, pharma and auto ancillaries companies reported a drop of more than 100 bps, wile services posted a decline of 100 bps in margins. The decline in prices of steel and high fuel and coal costs have severely impacted margins of steel makers, with 13 steel companies together reporting a fall of 600 bps in margins in the last three quarters.

Sluggish net profit growth
The profit growth for the sample of 312 companies remained sluggish, at 3.7 per cent, on account of poor show from oil & gas, steel, automobiles and auto ancillaries companies. A strong profit growth has been seen in sectors like banks, cement and software. The breadth of negative earnings is clear bad news, with 21 per cent of manufacturing and services companies (ex-banks) reporting net losses and 35 per cent of the 292 such companies studied here posting declines in net profit in the quarter under review.

The oil & gas sector is heading for a sharp reversal in profit this quarter, as the net profit of three companies studied here has decline 14 per cent, led by Reliance Industries and MRPL. The 14 banks studied here have done well, reporting a 27 per cent rise in net profit, led by new private banks. The net profit of software companies rose 25 per cent, significantly higher than that reported by these companies in the first two quarters of the current financial year.

Capital goods and engineering companies have managed to do well, with a net profit growth of 16 per cent.

The results of cement companies have shown a strong profit growth, of over 100 per cent, led by Shree Cement and UltraTech, and a turnaround by Prism Cement. Sectors such as steel and automobile have, on the other hand, seen a decline in net profits.

Brokerages’ Q3 expectations
The third quarter results preview by 14 brokerages hinted at an 18 per cent growth in net sales for the corporate sector (sample of 352 companies), excluding oil marketing companies. The rate of growth of the sample companies would be much slower than the 23.6 per cent reported in the second quarter and 29 per cent in the first quarter of this financial year. The net profit growth of the total sample is expected to be 4-5 per cent, marginally higher than in the second quarter (down 1.4 per cent), but significantly weak when compared to the first quarter (up 19.7 per cent).

Sectoral analysis
Software services Infosys’ flat revenue guidance for the quarter ending March 2012 was the single biggest scare in the recent results season, a Morgan Stanley analyst says. Most of the companies confirmed the Infosys management’s view of no material budget cuts but delays in deal starts. However, the Q4 revenue growth expectation for most other companies is slightly more optimistic than Infosys’.

The continued growth in Europe, despite the ongoing sovereign debt crisis, and resilient pricing trends were the key bullish data points supporting the large Indian IT services companies. The possibility of delays continuing and extending into coming quarters has emerged as the key concern. Outlook on budgets has been favourable, with 60-70 per cent of clients likely to have stable to higher 2012 budgets, according to TCS, Infotech and MindTree.

Higher capacity utilisation and a double-digit quarter-on-quarter (QoQ) rise in cement prices has succoured the sales and profit growth of the cement industry in the third quarter. The cement analyst at Motilal Oswal expects higher realisations, of about Rs 300 a tonne, and positive operating leverage to dilute the impact of cost inflation of higher energy and rail freight increase.

Cement demand, after growing moderately by 3.1 per cent in the first half of 2012, have shown some signs of improvement, growing at a decent 8.8 per cent in the third quarter, aided by low base of last year. Capacity utilisation for the quarter is expected to be 72-75 per cent, up from 68-70 per cent, assuming a year-on-year demand growth of more than 10 per cent.

Cost pressure increased further during the quarter, mainly on account of an increase in power & fuel and freight costs. The shortage of domestic linkage coal led to a shift towards purchase from e-auctions and imports. Though the international coal prices have declined 7 per cent sequentially, the impact of coal price correction was negated by an 11 per cent QoQ depreciation of the rupee.

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