Sales still strong, margins still weak

Updated: Feb 27 2012, 06:20am hrs
For the Nifty companies, sales growth in Q3FY12 at 26% was at three-year highs, whereas operating margins excluding IT and Tata Motors were almost at Dec-08 levels. Sales beat CS (Credit Suisse) estimates again, but for the first time, profits were higher than expected, albeit marginally (0.4%). In our coverage, IT, Pharma and Autos saw earnings upgrades, while most others saw downgrades, which was the sharpest at Telecom. CS Nifty EPS fell 1.1%.

For the 50 companies comprising Nifty, sales growth at 26% was at a three-year high, reflecting the strong nominal GDP growth. While net margins improved 100 bps (basis points) to 10.9%, they were still at levels seen in March 2009, and the improvement was concentrated in the IT and pharma companies and Tata Motors. The combined operating margin for 45 companies out of the Nifty 50 was merely 9 bps from the December 2008 bottom. Some of the overall sequential improvement in net margin can be attributed to forex losses in Q2this quarter the change in accounting standards helped reduce such losses. Operating margins would have to improve meaningfully to drive earnings growth.

In our coverage universe, for several quarters running, companies have continued to beat CS sales estimates, and Q3 saw a continuation of the trend. However, for the first time, a large number of sectors beat CS profit estimates, including metal, telecom and construction/infrastructure companies. In total, 44% of companies beat estimates and 27% missed, while 29% were in line (i.e., within 5%).Higher-than-expected subsidies helped PSU oil companies and lower provisioning in the face of rising NPAs helped financials profits. Net profit excluding financials and PSU oil companies was marginally better than expected (0.4% higher): operating profits in IT, autos and utilities were better than expected.

In our coverage, IT, pharma and autos saw earnings upgrades, while most others saw downgrades, with telecom seeing the sharpest downgrade. This has not yet been because of reduced sales growth expectations, but margin reduction. Post-results, margins were cut for oil, financials, metals, telecom and construction/infrastructure companies for FY12e and FY13e.

Mean-reversion rally continues Q3 truly a backward-looking quarter for the market: In the sharp rally seen since December 20, 2011, with some basic macroeconomic assumptions having changed (e.g., no money printing in the EU replaced by the success of the LTROlong-term refinancing operation), stocks have gone up irrespective of the quality of results delivered for the December 2011 quarter. For understandable reasons, the market has assumed the quarter to be not representative of future prospects.

Amid a sharp rally with unprecedented mean-reverting tendencies, results were mostly ignored, with the market treating Q3 as not representative of prospects. While companies that beat CS estimates indeed performed the best, even those that missed (e.g. Bhel, Tata Steel, Reliance Communications, Adani Power) did better than the companies that reported in line results. Consensus estimates have continued to trend down (1%), though FY13e still shows 15% growth. We expect earnings estimates to continue to trend down.

The mean reversion trend continues to be a global onethe markets that fell the most in 2011 have risen the most as well. Even sectors that have done well regionally/globally are the ones that have done well in India thus far. That is not to say this rally may not continuegiven the expected quantitative easing measures in the coming months from most major central banks in the developed world, liquidity should continue to be easy.

On India-specific issues there is much optimism over various problems that had worried the market in 2011: the governments steps to resolve some of these have gained credence, e.g., the PMOs directive to Coal India on coal. This is partly due to the markets move up, and partly due to a renewed sense of purpose among policymakers in Delhi. We remain unenthused about these developments so far.

Mean-reverting rallies provide opportunities as well as risks. With a 22% plus move from the bottom over 64 days, the rally is already the second longest since 1995, and valuations (16x FY12e; 14x FY13e) are not attractive. Further, while easy liquidity affects fundamentals for some companies, there are several stocks that have run up sharply and do not benefit from it. We flag SBI, Bhel and JSW Steel as liquid names to take profit on. We still find stocks such as Axis Bank, Hindustan Zinc and KSK Energy attractive: they are also beneficiaries of continued easy liquidity.

Earnings estimates yet to bottom

Earnings continue to be revised down, and consensus numbers are down 0.6-1% since the market bottom. Earnings growth expectations for FY13e are also down 40 bps. Earnings estimates do trough a few months before the markets, but we do not expect a trough in business momentum yet.

Consensus estimates for FY13e Nifty EPS are down 12% since the start of CY11. As expected, it has been concentrated in a few sectors, with estimates for materials and telecom down by a quarter, versus a 5% increase for staples.

Despite the changes so far, estimates in FY13e seem very optimistic, with 15%-plus earnings growth expected across sectors. IT, Pharma and Auto estimates should move up in the coming weeks, as the recent upgrades are reflected in consensus data. But on the whole, estimates are likely to see downward revisions.

It is entirely possible that if the current rally sustains, some estimates may in fact move up, but we believe that is unlikely except for companies that are able to raise equity capital by issuing new shares at a high price. CS estimates are on average lower than consensus and materially so for several sectors.

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