Corporate results should look up from Q1 FY10

Written by Sanjay Kr Singh | Updated: Nov 10 2008, 19:10pm hrs
So far the most noticeable aspect of corporate results in Q2 FY09 has been that expenses are up and margins have shrunk. Over the next couple of quarters, revenue growth is likely to fall as the economic slowdown hits home. Global cues, and how quickly corporates respond to the slowdown in revenue growth with cost-cutting measures, will determine the direction of the stock markets, says Anup Bagchi, executive director, ICICI Securities in an interview with our correspondent.

What has been the impact of the global economic crisis on Indian corporates
Broadly there are two types of impact on the market. Firstly, liquidity demand of FIIs in their own markets is leading them to sell their holdings here. Whenever there is liquidity pressure, selling can start defying valuations. This in turn leads to price correction. Rapid repatriation puts pressure on the exchange rate also. The impact on corporates is that outstanding overseas borrowings have become expensive. In addition, global liquidity is extremely tight for corporates because of the current global financial crisis.
The other impact is that it is becoming difficult for corporates to raise capital to support growth. And high interest rates are making borrowing expensive. Overall the cost of supporting growth is increasing rapidly.

What has been the impact of inflation
During the last one year, inflationary pressure within the Indian economy was very high because of the high price of crude and food grains. So the central bank had to tighten monetary policy to moderate demand. As interest rates began to rise, capital-intensive industries steel, cement, infrastructure and real estate started having problems. Due to the rapid economic growth of the last three years, wages and rentals have gone up. So input costs of both capital- and labour-intensive industries have risen.

During the last three years, when the economy was growing rapidly, this did not matter as companies could pass on costs to customers. Though expenses grew, income also grew, and profits were maintained. Then the global crisis happened. This has resulted in a contraction in topline demand. With interest rates so high, demand for big-ticket items like cars and housing has been hit. And since the EMI burden of households has gone up, they have reduced all types of discretionary spending. This is going to impact the topline of corporates. This impact on topline growth is not visible yet. It will show up more in corporate results of Q3 and Q4 of FY09.

How do you expect corporate results to be in the next few quarters
Corporates face a situation where their expenses have gone up, which is nothing but a high sensitivity to operating leverage, and income will begin to dip. The increase in expenses has shown up in the results of almost all sectors this quarter. Healthcare and FMCG are not so capital-intensive, so their costs have not gone up much. The IT sector has benefited from the depreciation of the rupee. In the auto sector the impact of higher raw material costs is quite evident.
But there is a silver lining. Due to moderation in demand, expenses have begun to fall. With the RBI cutting the repo rate, interest rates may start coming down. Commodity prices have already started falling.

The equation that is set to emerge is that while input costs remain high, revenue growth is set to decline. This state of increased expenses and decreased income is a state of disequilibrium that cannot last. Over the next couple of quarters, corporates will adjust to a new state of equilibrium and that is, reduced income and reduced expenses.
Q3 will be a period of adjustment, and pressures will be there. By Q4, a lot of corporates will cut costs and the equilibrium will return to low expenses, low income, which will protect their margins. The faster interest rates are cut, more rapid will be the adjustment. We expect the situation to start improving from Q1FY10 as corporates fine tune their business model according to the prevailing demand-supply scenario.

What is your view of corporate results so far Have they been below or above par, or in line with expectations
Many analysts had written the obituary of corporate results in this quarter. By that yardstick the results arent so bad. In sectors like banking the results are quite good. Its true that the days of 40 per cent growth in earnings have gone, but then prices have also corrected significantly. It is not a situation where prices have not corrected and there is negative earnings surprise.

What do you think of valuations in the market Are they attractive or are prices still too high because there could be significant earnings downgrade in future
The market has declined from the 21,000 level to the 10,000 level an above 50 per cent fall. Earnings growth over the next couple of years is likely to be moderate. On a pure valuation basis the Sensex is trading at 10-11x its FY10E earnings. Thus a large part of earnings downgrade is adjusted in the price.

Going forward, as the macro scenario in terms of global cues and domestic factors get clear how much slowdown will occur and how badly earnings will get impacted the market will be able to take a more appropriate call on growth in earnings. At this point, the markets are fairly valued and will try to consolidate from hereon until more clarity emerges.

Commodity inflation is behind us. What do you see as a continuing risk to the economy and stock markets
The economy is definitely witnessing a slowdown in terms of consumption and investment, but one feels that this slowdown is cyclical and not structural, as interest rates have been heading north.
The recent monetary measures by the RBI are a welcome move. But these actions will bear fruit with a lag effect. Very soon credit at an appropriate price will start flowing in the real economy, giving macro support to the market.
The other important variable to be tracked closely is the exchange rate. India being a net importer, the fiscal pressure on the government from oil and fertilisers will only be reduced with an appreciating rupee. Due to the overall global scenario, the dollar price of most commodities is already declining.

What steps can the RBI take to stem the decline of the rupee
Flows on account of NRI deposits may act as a balancing force. The recent steps by RBI to inject liquidity are a welcome step. I think there is an opportunity to incentivise NRI deposits a bit more and make India a safe haven for dollar deposits of NRIs.

Which sectors are likely to do well in the near future
Sectors that have low gearing i.e., low debt to equity ratio and are dependent on input costs of commodities whose prices are already falling will do well. Next, one should look at companies/sectors where the operating cash flows are reasonable so that the growth momentum does not get impacted. Sectors whose topline is protected because demand for their goods is inelastic, say FMCG and pharma, are also likely to do well.

And which will fare poorly
Sectors and companies that are highly capital intensive and highly leveraged may face difficulty as capital has become scare. Even if they arrange it, the internal rate of return (IRR) of the project might become unattractive because of the high cost of capital. Moreover, companies that are in the commodity space may face challenges going forward due to lower demand. They may have to cut production. This could impact their profitability and cash flows.