Cutting profit targets

The global liquidity crisis, a slowdown in demand and high cost of funds have led to a sharp cut in earnings estimates for India Inc.

Till January 2008, analysts were seeing corporate earnings growing at their fastest pace. Between 2004 and 2008, all the earnings revisions that analysts put out were going in just one direction - up. But with economic weakness all around, the trend has reversed since August 2008 as analysts are now sharply cutting their earnings estimates for India Inc. At the same time, they are also lowering the valuations (such as the price-earnings and price-book value multiples), which together has led to lower stock prices. During this period, the Sensex has fallen by almost 40 per cent and 32 per cent since October 1, 2008.

Over the last three months, the earnings for BSE Sensex have been cut by 5-7 per cent for FY09 and by 14-15 per cent for FY10, to an average Rs 910 and Rs 1,040, respectively. “We were earlier expecting the Sensex earnings to grow at about 17-18 per cent in FY09, but this is now pegged at about 9-10 per cent,” says Aneesh Srivastava, CIO, IDBI Fortis Life Insurance.

Among the most pessimistic views is that of Jyotivardhan Jaipuria and Anand Kumar, analysts at DSP Merrill Lynch India. “After a 25 per cent compounded annual growth rate in earnings in the past six years, we expect zero growth in earnings in the second half of FY09 (full year FY09 growth at 6 per cent) and zero to negative in FY10 from a top-down perspective.”

During the last three months and specifically after Q2 results, analysts have aggressively started lowering their earnings estimates. Notably, they also indicate a possibility of further downgrades. The situation is equally worse for non-Sensex companies, including some of the large- and mid-cap companies, where the cuts have been sharp of up to 35 per cent. Mid-cap companies are more vulnerable to adverse economic conditions, which could see a further cut in their earnings estimates.

Broadly, the revised estimates factor in concerns pertaining to the slowdown in global and domestic economies, which has started to reflect in lower demand (in some cases, a fall in sales) and declining realisations. The liquidity crunch has meant that companies have a difficult time raising funds for their long-term capex plans. While banks have been reluctant to lend money, many companies have seen insufficient demand for their rights offers.

A majority of these factors are already reflecting in the revised earnings estimates. But, there are some factors that need to be watched, including the recent decline in interest rates and liquidity in the system. Since commodity prices (metals, oil and petrochemicals) are coming down, the pressure on margins for many companies will be lesser. While such developments could possibly have a positive rub-off on earnings going forward, the situation continues to be uncertain. Read on to know the most recent earnings estimates for key sectors and companies, as well as the reasons for the revision.

Among the biggest drag on Sensex earnings are commodities companies. The cumulative weightage of commodity-based companies in the Sensex is 22.78 per cent, which includes companies from the oil and gas, metals and cement sectors.

METALS: Melting
Analysts have aggressively cut earnings estimates for Sensex companies in the metal space by 40-60 per cent in FY09 and FY10. This is primarily on account of the gloomy outlook for ferrous and non-ferrous metals on the back of lower demand and falling commodity prices. The US, Europe and Japan are considered to be in recession and according to estimates, it will lead to a 5-20 per cent decline in consumption of metals. Even as emerging economies are expected to consume more, it will not offset the decline in consumption of metals by developed countries.

The LME prices of zinc, copper and aluminium are down by 40-60 per cent over the last six months. Thus, realisations of companies such as Sterlite Industries, Hindalco and Hindustan Zinc have fallen and are expected to be lower going forward. The price of domestic steel has come down by 30-40 per cent, which should hit the earnings of steel companies. Prasad Baji, analyst at Edelweiss Securities, has cut his FY10 consolidated earnings estimate for Tata Steel by 86 per cent due to the unfavourable price environment in Europe, which will hit the earnings of the company’s UK subsidiary Corus. The outlook is equally worse for non-Sensex metal companies like JSW Steel, Sail and others, as earnings estimates have been cut by up to 45 per cent.

CEMENT AND REALTY: On shaky ground
The cement sector is no exception and the earnings of Grasim Industries and ACC have also been cut by 5-12 per cent for FY09 and FY10. It’s equally bad for non-Sensex companies; Ambuja Cement and UltraTech Cement are expected to report a decline in earnings of 19.6 per cent and 4.6 per cent, respectively in FY10. The downgrade reflects lower cement offtake, fall in cement prices and slowdown in the construction and housing sectors. The latter has also impacted the outlook for real estate companies. The expected fall in real estate prices, lower demand, high interest rates and issues related to lack of funding avenues have dampened it’s outlook. DLF’s earnings estimates have been cut by 6-20 per cent for FY09-10. Experts suggest that further earnings downgrade for the sector is not ruled out.

OIL AND GAS: Slipping
This sector has the second largest weight in the Sensex; ONGC (4.49%) and Reliance Industries (14.34%). The expected decline in earnings of these companies will also have a major impact on the overall Sensex earnings. The falling crude oil prices and decline in gross refining margins (GRM) have prompted analysts to estimate lower GRM’s for RIL, which has already seen them drop from $15.7 a barrel in Q1FY09 to $13.4 per barrel in Q2FY09. Analysts estimate its margins to range $10-11 a barrel in FY10 and FY11. Thus, the company’s earnings estimates have been lowered by about 10-20 per cent for FY09 and FY10. Lower crude oil prices have also meant a 7.8 per cent earnings downgrade for ONGC for FY10.

BANKING: Cautious
The largest sector by weightage in the Sensex is banking and financial services, which includes HDFC Bank, HDFC, SBI and ICICI Bank, thus the visibly large impact on earnings for the Sensex. Analysts have cut down their sector’s earnings by 8 per cent in FY09 and 12 per cent in FY10. ICICI Bank, which has the largest weight among banks, has recently seen its earnings estimate cut by 11.3 per cent for FY09 and 18.2 per cent for FY10, thanks to the slowdown in retail loan growth, mark-to-market losses in its UK subsidiary and increasing pressure on the NPA front. On the other hand, HDFC Bank has seen the least amount of downgrade (just 2 per cent for FY10), largely due to expectations of lower NPA, better margins and high risk management systems.

AUTO: Bumpy road
Tata Motors has seen an aggressive cut in earnings estimate (by 45 per cent for FY10) on the back of falling domestic sales and worries over its international business, which includes Jaguar and Land Rover. Overall, the auto sector is facing the heat on account of shrinking consumer demand, which is partly due to high interest rates. About 70 per cent of car sales and 90 per cent of commercial vehicle sales are financed by credit.

Also, since the commercial vehicle sales are dependent on economic growth, the slowdown in the economy could further dent the commercial vehicle demand. On the flip side, M&M, a diversified player, looks relatively insulated due to the growth in tractor segment. Analysts, in fact, have revised upwards its earnings estimated for both, FY09 and FY10.

In case of Maruti, too, the downward revision is not significant, thanks to relatively decent domestic sales and expectations of higher export sales. In two and three wheeler segments, sales in October were down by 10 per cent on y-o-y basis. Bajaj Auto’s volumes were down the most – by 31 per cent on y-o-y basis. Analysts have lowered their EPS estimates for Bajaj Auto by 17-21 per cent for FY09 and FY10.

Among other non-Sensex companies, Ashok Leyland’s earnings estimates have been significantly cut by 40-55 per cent for FY09 and FY10, factoring in lower volumes and profit margins going forward. Put together, although there are near-term concerns, if interest rates fall and the fact that commodity prices (steel and oil) have already declined, there could be some positive earnings surprises for companies in this sector.

IT: Global woes
The IT sector, which has the third largest weightage in the Sensex, has not seen any significant cut in earnings estimate for FY09. However, for FY10, the earnings estimates were recently downgraded by about 7-8 per cent. This is largely due to concerns regarding the ongoing global financial crisis, slowdown in US and Europe, fear of lower billing rates and slow recruitments by companies. In this light, there are expectations of volumes declining by about 5-7 per cent in FY10.

The least impacted
Almost every sector that has representation in the Sensex has seen a downgrade in earnings estimate for the current fiscal and next. However, defensive sectors like FMCG (ITC and Hindustan Unilever) and power utilities (NTPC, Tata Power and Reliance Infrastructure) stand unscathed. ForTata Power, analysts have upgraded earnings estimates by 30 per cent for FY10 at Rs 99 per share, led by commissioning of new power generating capacities. For NTPC, too, there is a marginal improvement of 0.2 per cent in earnings estimate for FY09, and a 2.5 per cent downgrade for FY10. Likewise, there hasn’t been significant change in estimates for ITC and HUL, while the impact for companies in sectors like telecom (robust growth in subscriber numbers expected) and engineering (driven by strong order books and lower commodity prices), too, has been marginal.

The pharmaceutical sector, too, is relatively insulated, barring a few companies. Ranbaxy is the only company representing the sector in the Sensex and accounts for a marginal weightage of 0.59 per cent. Analysts have downgraded Ranbaxy’s FY09 earnings by 5.3 per cent followed by severe cuts of 34 per cent in FY10 earnings. Among non-Sensex companies, analysts have downgraded FY10 earnings by about 8-20 per cent for Glenmark and Sun Pharma. Beyond these companies, the outlook is stable for the sector.

The defensive nature of the sector has helped limit the damage on account of economic slowdown and global worries. While the investment case for pharma companies – low cost generics and formulation sales in the domestic and overseas markets – remains unchanged, drug majors such as Jubilant Organosys, which have significant expansions or repayment of FCCB loans, could be in a spot of bother.

But, for most pharma companies the repayments in the short term are too small or their cash flow quite robust to cover costs of expansion and repayments. With governments world over seeking to reduce healthcare costs, volume growth for generic as well as contract research and manufacturing players is assured, but there will be pressure on margins due to rising competition.