Prepare to get margin-alised

Consensus earnings estimates for FY12 may be downgraded if margin pressure mounts.

The pain of shrinking margins is not yet over for corporate India. While the optimists believe that margins will rebound in FY12 magically, the realists believe that operating expenses of corporate India have been rising since 2009-end and this will only continue. So far, most companies have managed the margin squeeze by undertaking price increases, as demand remained strong all through FY11. However, the passthrough has been incremental and not complete.

Strategists believe that margins have bottomed out for most sectors, and any further pressure will result in an earnings downgrade. Growth in expenses has now surpassed that of sales, and companies that were able to maintain margins over the past three quarters would now begin to feel the pressure. Operating expense trends of companies show that overall expenses have picked up substantially since the end of 2009, partly due to rising commodity prices and partly due to strong domestic economic activity.

Several market participants and analysts believe that margins will turn around in FY12. But this is a highly optimistic view. For one, margins have not only been falling since the last few quarters due to rising input prices, but also due to steadily falling import tariffs. Coal India’s recent price increases and the government’s partial de-regulation of oil prices clearly signal the end of subsidised energy in India. Evidently, operating margins are likely to continue their fall rather than rise as cost of energy, capital and other raw materials rises. Higher interest costs and larger working capital requirements will also start pinching from this financial year. The more realistic lot are estimating a 12-15 per cent growth in the EPS of Sensex, against consensus estimates of 19 per cent.

In its India strategy report, Macquarie says: “Consensus earnings estimates for FY12 could be downgraded if our expectation of a further margin squeeze turns out to be correct. Earnings estimates are highly sensitive to changes in margin assumptions; we estimate that a 50-basis-point decline in margins results in about 400-basis-point decline in earnings per share growth estimates. We expect earnings growth to be around 12-15 per cent in FY12 on the assumption that margins may squeeze in the range of 50-100 basis points.”