Gloomy days ahead for cement and auto

2008-09 SECOND QUARTER RESULTS PREVIEW

* FMCG has price revision cushion
* Capital goods to ride high on buoyant order books 
* Pharma, IT firms to gain from rupee depreciation.

CEMENT
Cement companies reported 11 per cent growth in their revenues, while their net profit declined by 21 per cent on compression of margins. All the cement companies under our coverage continued to face margin pressures on account of an increase in their overall production costs.

Operating profit margins (OPMs) of major cement companies declined by 892 basis points (bps) to 33.55 per cent during the quarter due to a sharp increase in power, fuel and freight costs (on account of soaring prices of crude oil, imported coal and met coke).

 

The volume growth for most companies at around 2 to 4 per cent remained subdued due to capacity constraints, early arrival of the monsoon in some regions and the higher base of last year. UltraTech Cement has reported flat volumes due to a ban on cement exports in the western region.

Cement realisations grew between 9 and 16 per cent with south-based players such as India Cements and Madras Cement witnessing a strong growth due to firm cement prices in South India. On the other hand, UltraTech Cement reported a good growth in its blended realisations due to a lower proportion of clinker sales during the quarter ended June 2008.

After growing by over 10 per cent in the last two years, cement demand has slowed down to 9 per cent now. This decline stems from the slowdown in end-user industries like housing, real estate, and infrastructure sectors. Rising interest rates are likely to further delay the expansion plans of corporates, leading to lower off-take in the industrial segment.

Despite a weak sentiment in the medium-term, cement analysts expect a strong 7-9 per cent GDP growth will increase demand for cement in the near future. The government's renewed focus on infrastructure development, irrigation projects and the housing sector is likely to revive cement demand.

However, cement prices are likely to be affected on account of capacity addition in the coming years. Analysts indicate that capacity additions are running late by eight to 10 months, translating into a stable pricing environment for the next few months.

As per the announcements made by various cement companies, capacity additions during the next one year would mainly be in Rajasthan and the southern parts of the country. Therefore, cement prices in these regions are likely to come under pressure after the third quarter of the current financial year.

What is hurting the cement industry the most is the coal prices, which have increased by over 100 per cent in the last one year. Coal, which accounts for almost 35-40 per cent of the cost of production of cement, is in short supply.

The proportion of linkage coal from Coal India at notified prices and at a discount is constantly declining. The industry is forced to buy local coal from the open market at a 30-60 per cent premium, says a cement analyst at Enam Securities.

AUTOMOBILES
The automobile sector has fared badly in the first quarter of the current financial year. Revenues from all segments such as two-wheelers, passenger cars and commercial vehicles were ahead of expectations as automakers passed on the input cost hikes to consumers. However, their profit margins were lower due to higher than expected cost pressures and provisions on account of forex losses. Rising raw material prices affected their performance for the quarter, though the price hikes were effective only for a part of the quarter.

This affected the profitability of the automobile companies to a great extent. Their employee cost also increased due to rising inflation. There was a similar increase in power, fuel and transportation costs. The OPMs declined for all the companies in the sector.

The automakers reported weaker than expected Q1 profits on margin compression. Their operating margins declined across the board. Hero Honda did well and reported 120 bps increase in margins. Mahindra & Mahindra, Tata Motors, Maruti Suzuki, Bajaj Auto and Ashok Leyland reported margin compression.

According to auto analysts, the outlook is also muted. The firming up of interest rates is expected to affect the demand and volume growth across segments. In terms of company-specific performance, Tata Motors has reported a very high dividend income for the quarter, thereby a higher profit after tax (PAT).

This kind of income may not be recurring in nature. Maruti Suzuki has reported a sharp decline in its margins with concerns related to volume growth in the current financial year. Mahindra & Mahindra has outperformed the sector in terms of volume growth and decline in profit margins.

Auto sales continued to rise at a slower pace with Tata Motors and Maruti Suzuki reporting declines in August 2008. Mahindra & Mahindra did well with the sales in its utility vehicles segment increasing 5.2 per cent and tractor segment recording a rise of 15.6 per cent.

The two-wheeler companies, however, registered a minor growth on the back of new models. Hero Honda, the largest player in the two-wheeler industry, registered a growth of 27 per cent, while Bajaj Auto and TVS posted growths of 5 per cent and 11 per cent respectively.

FMCG
The first quarter results of fast moving consumer goods (FMCG) companies were below expectations on account of a steep rise in raw material costs.

FMCG players registered robust sales growth, driven by strong volume growth and price hikes implemented during the quarter ended June 2008. However, the steep input cost hike coupled with an increase in advertisement and promotional spends to maintain market shares affected their profit margins.

The surge in the prices of foodgrain and edible oils primarily on account of supply constraints in the domestic market and inflation in commodity prices at the global level was the highlight of the first quarter results. The high prices of foodgrain and edible oils significantly affected the growth of the FMCG companies at the operating level.

Strong sales growth was led by price increases by around 5 to 7 per cent and volume growth of 13-15 per cent. Except for categories like soaps and detergents, there were no signs of volume slowdown despite consistent price increases undertaken by most FMCG companies.

Pressure on margins was apparent as most of the price increases were either not sufficient to cover the input cost hikes, or were yet to reflect in the financials. However, for most companies, margin decline was limited to around 100 bps.

Hindustan Unilever (HUL), the industry leader, registered a robust revenue growth of 21.1 per cent in the first quarter, driven by the strong performance of its FMCG business that grew by 19.1 per cent during the period. The home and personal care segment grew by 20 per cent, while growth in the foods segment was satisfactory at 14.7 per cent.

ITC's cigarette business recorded a 5.7 per cent growth, while FMCG business registered a revenue growth of 27.9 per cent. The company's profitability was affected by increased brand-building and promotional expenses for the new launches in the personal care segment and a steep hike in raw material costs.

Tata Tea felt the pinch of the increase in the auction tea prices that led to a 4.2 per cent decline in its operating profit during the first quarter. A huge demand for Indian tea in the international market coupled with the ongoing unrest in Darjeeling could lead to a further increase in the auction tea prices in India.

Marico recorded a growth of 28.1 per cent in net sales, while its net profit grew by 15.1 per cent. The company's decision to increase prices across brands during the last 12 months prevented a steeper decline in its OPM.

Any further increase in input costs would put severe pressure on the margins of the FMCG companies, which could find it difficult to pass on the price hike to their consumers without affecting their volume growth.

CAPITAL GOODS
Revenue growth continues to remain robust in the capital goods sector, which comprises construction, engineering and power equipment manufacturing. The sector recorded 36 per cent growth in revenues and a 26.4 per cent rise in net profit.

Construction companies reported a 40 per cent increase in revenues on the back of huge order backlogs. The robust growth in revenues reflects the project execution strength of construction companies and their efforts in scaling up capabilities in line with the growth in order backlogs and revenues.

Power equipment companies posted a revenue growth of 25.8 per cent with Bhel reporting a 33.9 per cent rise. Crompton also reported better than estimated revenues. ABB came in lower than estimated on the back of change in the order backlog mix towards projects.

Engineering firms posted a strong 48.2 per cent growth, led by the pick-up in execution and on the back of robust order backlogs. Larsen & Toubro outperformed the sector with 53 per cent revenue growth, while the growth for Thermax was a modest 8 per cent.

Construction and power equipment companies saw sustained momentum in order inflows from power, industrial structures, irrigation, water supply and urban infrastructure. Power equipment firms witnessed the increase in order flows because of rising capex across power generation, transmission and distribution.

Order inflows momentum is likely to continue over the next 12 months. Analysts at IDFC-SSKI India expect no significant slowdown in order flows for construction companies as orders from segments such as power, urban infrastructure, irrigation and other government-led infrastructure projects are expected to maintain the current pace of growth.

Moreover, with NHAI stepping up awarding of highway build, operate and transfer (BOT) contracts, analysts see a spate of road construction orders over the next three to six months. Power capacity additions are likely to drive order inflow momentum for equipment companies with 69,294MW of power generation capacity expected to be added in the 11th Plan.

PHARMACEUTICALS
Pharmaceutical companies did well in the first quarter ended June 2008, posting a net sales growth of over 25 per cent, led by contract manufacturing companies.

Sales growth for the quarter was strong for many companies, driven mainly by acquisitions, double-digit growth in emerging markets (including India), an expanding product portfolio in the US and strong outsourcing by MNCs. Contract research and manufacturing services (CRAMS) players are, in fact, reaping the benefits of increased outsourcing from India.

Most of the companies being exporters had booked significant forward covers in 2007-08 in anticipation of a further appreciation of the rupee against the US dollar. These forward covers were taken at approximately Rs 39-41, while the closing rate for the quarter was around Rs 43, thus forcing the companies to book mark-to-market (MTM) forex losses on such covers.

Many companies have resorted to cheaper foreign currency loans and foreign currency convertible bonds (FCCBs), and hence they were required to provide for MTM losses on such borrowings. The companies that were hugely impacted due to such loans include Ranbaxy, Jubilant Organosys and Cipla.

Pharma analysts at Motilal Oswal are selectively bullish on the sector. According to them, the key determinants of future success will be broad generic product portfolios, including a mix of normal, low-competition and patent challenge products.

The topline growth for pharma companies was in line with estimates. Key trends visible include strong growth in emerging markets and the bottoming out of pricing pressures in the US.

Most of the Indian generic companies had commenced aggressive filings for the US market some years ago. Those filings have started yielding results in the form of a higher number of product approvals, leading to incremental growth.

Also, the price erosion has stabilised at 95-97 per cent for highly-competitive products and at lower levels for the low-competition products. Hence, a combination of new approvals and arresting of the decline in price erosions has resulted in higher topline growth in the US for most of these companies.

For CRAMS players, the topline growth continues its upward march with the increase in outsourcing by MNC pharma companies from Asia. However, their operations in Western Europe (acquired companies) have recorded single-digit topline growth.

INFOTECH
A falling Indian rupee — which has crossed a 17-month low to rise above Rs 44 against the greenback — appears to be spelling good news for Indian information technology (IT) firms. Every percentage point fall in the rupee adds between 30 and 50 bps to the operating margins of IT firms, and the fact is not lost on investors.

The stocks of major IT firms such as Tata Consultancy Services (TCS), Satyam Computer Services, Wipro and HCL Technologies have shown a steady rise, except when overall markets are down, on the Bombay Stock Exchange (BSE).

Analysts feel the depreciating rupee will have a positive impact on the second quarter results of the IT firms. "This will certainly have a positive impact on the revenues. But these firms should rethink their hedging strategy," says a market expert. Firms like HCL Technologies that have hedged a greater part of their exposure may not get the full benefit of a falling rupee.

The software giants could not take advantage of the rupee depreciation in the first quarter as the top IT companies had hedged their export receivables much in advance, anticipating appreciation of the rupee. No wonder, the top four reported combined MTM losses of Rs 261 crore in the first quarter.

The technology stocks are trading at an all-time low price to earnings (P/Es) following low investor confidence. The first quarter results did not signal any demand recovery for the IT giants. The slowdown in new deals and hiring during the first quarter had an impact on the IT stocks.

TCS reported a net forex loss of Rs 81 crore and calculated MTM losses of Rs 408 crore if the rupee weakens to around 45. However, if the domestic currency sustains at Rs 43, the MTM loss would be Rs 168 crore over the next eight to 10 quarters. TCS' year-on-year (y-o-y) revenue growth was the slowest among its peers and it was the only company among the top four to show a decline in operating margins.

Infosys Technology guides the growth acceleration in the second quarter and expects to do well in the full year. It posted a revenue growth of 28.7 per cent quarter on quarter (q-o-q), but the contribution of its top five clients declined 8.5 per cent. The operating margins rose by 174 bps y-o-y, but declined by 207 bps on a q-o-q basis.

Wipro posted sound revenue growth due to increased revenues from its top five clients. The company saw good profit growth due to non-implementation of a wage hike and reduction in hiring activities. Wipro has hedged export revenues of $3.1 billion at a rupee rate of 41 till FY09 and 44 for 2010.