The sector has been hit by a rise in raw material prices. As Motilal Oswal’s preview of first quarter earnings puts it, “The extent of impact would be a function of five factors: (1) steel as a percentage of raw material cost, since it has witnessed an exponential price increase, (2) fixed price contracts in the order backlog, (3) procurement strategy (in terms of long-term contracts with suppliers), (4) execution cycle (long/short), and (5) pricing power.” These metrics will need to be watched carefully and their impact on operating margins gauged. A recent survey of project developers (the clients of contractors and equipment makers) by Emkay Global Financial Services Ltd shows only 50% of those surveyed had price variation clauses, of which only 18% had a 100% pass-through clause. According to Emkay Research, the survey “highlights the risk of further scope for downward revision of Ebitda (earnings before interest, taxes, depreciation and amortization) margins”. Simply put, investors need to follow conference calls where managements are usually asked about what percentage of their billing is covered by price variation clauses, which tells you how much of the rise in input prices they can pass on to clients. Finally, we need to make sure companies continue to bag new orders. The proximity of the elections could hamper the inflow of orders from the government. Construction firms often have to raise resources frequently for new projects, which puts them at a disadvantage in the current environment. Interest costs also will have to be watched closely. And finally, the commodity hedging strategies will have to be monitored, to find out whether there’s a risk of such bets going wrong.
FMCG
The consumer goods sector has been in the enviable position of passing on raw material cost pressures to consumers, through price increases in some cases, and by reducing the pack size of some others where prices were kept constant. As a result, margins of most firms can be expected to improve.
But it needs to be seen whether volume growth has been affected as a result. Also one needs to monitor if the entire increase in raw material expenses has been absorbed by price increases or whether companies have relied more on reducing overheads such as advertising and promotion expenses.
If raw material costs as a percentage of sales come down, it means that firms have been rather aggressive about taking price increases. This could affect volume growth or may result in a shift to cheaper products. In this regard, one needs to watch out for management comments on the impact of price increases taken so far on volume growth.
Banking
The environment of slowing credit growth and rising interest rates is very challenging. Investors will do well to see to what extent banks have been hit by the slowdown in credit growth, or whether growth has been achieved at the cost of too high a price paid for deposits. Growth in net interest income (interest earned less interest expended) will therefore need to be watched— while banks have raised lending rates, they have not been able to pass on the entire rise in their cost of funds. Net interest margins will show whether higher interest rates are squeezing profitability. Banks with a higher proportion of CASA (current and savings accounts) should do well, because they are low-cost deposits. Lower interest income and lower fee income usually go together, but fees and treasury income from capital market-related activities will see much lower growth. Another negative factor is higher mark-to-market provisions for their bond portfolio as a result of significantly higher bond yields. Public sector banks will also be hit by higher wage costs.
Investors will also look for signs that the slowdown in the economy is having an impact on asset quality, such as a rise in gross non-performing assets (NPAs). Banks may be forced to raise provisions for NPAs, which will keep net NPA ratios low but hurt earnings. The impact of the farm waiver must also be kept in mind. With the tighter Basel-II norms on capital adequacy coming into force and with the environment for raising capital deteriorating, the capital adequacy position needs to be monitored. Mark-to-market losses on credit derivatives and legal complications arising out of forex derivatives losses of clients also need to be tracked.
Cement