India Inc has slowed down in the June 2007 quarter. A sectoral analysis of Q1 FY08 results and what to expect.

After running at a breakneck speed for several quarters, India Inc’s financials have taken a breather. In the June 2007 quarter, our universe of 942 companies, excluding banks, financial services, oil and gas companies, and with a turnover of more than Rs 25 crore have shown the slowest growth in terms of almost all parameters like net sales, operating profit and net profit.

Net sales and operating profit (excluding other income) have grown at 19.5 per cent and 18.8 per cent year-on-year respectively-the slowest since last four quarters starting June 2006 quarter.

As a result, operating profit margins declined marginally by 11 basis points year on year, thanks to a small rise in total expenditure. However, a growth of 32 per cent in net profit has been maintained on a year-on-year basis, thanks to higher other income, declining interest cost and lower increase in depreciation costs.

Companies in sectors like construction and real estate, media, telecom and lifestyle have been leaders in terms of the overall growth of the universe. On the other hand, companies in the sugar, textiles and auto spaces have been laggards.

CORPORATE SCORECARD
% chg (y-o-y)	Net sales	Operating profit	Net Profit
Overall	19.50	18.80	32.30
Cement	24.30	32.30	50.50
Construction	45.00	89.20	87.90
Engineering	30.40	26.00	44.80
Ferrous metals	21.20	17.40	44.00
FMCG and related	23.30	20.50	20.50
Income / Life style-based	28.70	50.90	49.20
IT	26.90	21.60	33.80
Media	32.70	81.80	95.70
Non-ferrous	11.80	-5.80	5.80
Pharma	12.90	10.00	34.00
Power and power equip	19.30	8.00	36.30
Telecom	31.10	47.10	90.60
Textiles	18.00	1.40	-7.00

So will this slowdown continue or is this just a blip? What is the outlook for the next few quarters and which sectors look positive? Market participants are unperturbed by the slight slowdown in the financial performance of Indian companies as they have been on the expected lines.

Both Prateek Agarwal, fund manager, ABN Amro Mutual Fund and Bharat Shah, CEO and managing partner, ASK Investment Managers, feel that the performance of Indian companies has been reasonable.

Going forward, investors can consider investments on declines in domestic growth stories like capital goods, construction, financial services (primarily public sector banks), media and telecom sectors.

However, with the global mayhem, market watchers feel that there may be more declines in the next few weeks, and some of these sectors and companies will become attractive.

Let’s go deeper to find out what factors affected the leaders and the laggards in the June 2007 quarter and what your investment strategy should be.

THE LEADERS

Construction and real estate
The construction and real estate sector has once again emerged as the star performer in terms of overall growth. The sector has reported highest growth of 45 per cent in net sales and about 88-89 per cent each in operating profit and net profit growth, thanks to robust performance by companies like Unitech, Punj Lloyd, Simplex Infrastructures, IVRCL Infrastructure and Parsvnath.

India’s infrastructure spending pegged at $350 billion for the next five years is leading to robust growth of over 50 per cent in order inflows of construction companies, whose order book to sales ratios now stand at a comfortable three times their FY07 sales. Further, skyrocketing growth in real estate prices, especially in last three years, has led to fantastic growth in the financials of real estate companies.

But despite the favourable macroeconomic factors, most of the construction and real stocks like Nagarjuna Construction, Simplex Infrastructures, Parsvnath and Akruti Nirman have remained underperformers since January 2007.

Hitesh Kuvelkar, associate director, First Global, is not that bullish on construction stocks as he thinks that companies are facing competition in the Indian market because of which margins are constrained. Agarwal of ABN Amro Mutual, is positive on the real estate sector and according to him, the peaking of interest rates will lead to a bounceback of sentiment.

Media

Higher economic activity led by robust growth in GDP is leading to higher spends on advertising benefiting media companies. The sector has recorded the next best growth of 32.7 per cent led by companies like UTV, TV Today, PVR, Deccan Chronicle and Zee Entertainment.

The operating profit and net profit have grown at a scorching pace of more than 80 per cent and 90 per cent respectively. Going forward, analysts expect advertising revenues of media companies to grow at 20 per cent a year over the next three years.

However, stock prices of media companies have ballooned over the last six months reflecting the positives. Almost all the media companies have outperformed the Sensex with a significant margin since January 2007. However, investors can consider investments in Jagran Prakashan and Deccan Chronicle on declines.

Telecom
Robust growth of more than 6 million subscribers to 181.1 million at the end of June 2007, rising teledensity and huge untapped potential in rural areas with teledensity as low as 2 per cent are driving skyrocketing growth of telecom companies.

While the sector’s revenues have grown by 31.1 per cent, operating profits have jumped by 47 per cent and net profits have almost doubled. Companies like Bharti, Reliance Communications, Idea Cellular and Spice have contributed to this scorching pace of growth.

Analysts have a positive outlook on the sector but don’t expect the stock performance to be as robust as in the past as ARPUs are falling and urban markets are saturating, leading to compressed margins. Kuvelkar of First Global feels that the growth expectation is already factored into the prices.

Lifestyle
In India, where approximately 50 per cent of population is under 25 years of age and 30-35 per cent of the total population is placed in the middle and upper middle class category, companies impacted by changes in lifestyle cannot be ignored.

Lifestyle companies are those whose revenue growth is driven by favourable changes in demographics skewed towards younger population, higher disposable incomes and rising aspiration levels. India is witnessing a boom in this business and the beneficiaries are sectors like retail, liquor, consumer durables, accessories, and jewellery.

Accordingly, the sector has seen a robust growth of 30 per cent in net sales and 50 per cent each in operating profit and net profit in this quarter led by robust growth in companies like Titan Industries, United Spirits and Gitanjali Gems. Though these stocks have had a sharp run-up since January 2007, the companies are expected to grab attention due to high earnings visibility.

Engineering
While the sector’s revenues have grown at a robust pace of 30 per cent, operating profit growth has lagged behind growing 26 per cent due to rising input costs.

However, net profit growth has shown a robust growth of 45 per cent due to stable interest, depreciation and taxation. Companies like Larsen & Toubro, Bharat Earth Movers and Alstom Projects have been major gainers.

Kuvelkar is bullish on the sector for the next one year as capital goods companies are expected to see significant margin expansion due to demand-supply mismatch for the companies’ products and services not only in the Indian market but also globally.

Cement
Cement companies have not reported a very robust top line growth like other infrastructure-related companies as increase in price realisations have happened the most only in the southern region. Net profit has grown at a robust pace of 50 per cent though operating profit has been subdued at 30 per cent.

The sector’s performance has been largely led by India Cements, Shree Cements and Madras Cement. Agarwal feels that large cap cement companies are fairly valued while investors can look for an upside in midcap and smaller rung companies. Moreover he feels that prices are likely to remain at the current levels.

THE LAGGARDS

Auto and ancillaries
A substantial increase in interest rates on auto loans in the last six months by banks and other financial institutions led to a slowdown in the demand for automobiles, especially two-wheeler companies like Bajaj Auto, Hero Honda and TVS Motor.

However, four-wheelers including commercial vehicles have fared better reporting a growth of 10-20 per cent. The only exceptions are Maruti Udyog and Eicher Motors, whose revenues grew over 20 per cent.

As a result, the markets have punished the auto sector and most of the market players ask you stay away from the sector though some of them do not mind taking a contrarian call on cars and commercial vehicles. However, two-wheeler stocks will under-perform.

Sugar

A surplus of 7 million tonnes, domestic prices falling over 20 per cent, less lucrative exports market due to declining international sugar prices, appreciating rupee and unfavourable government policies have hit sugar players hard. The sector’s revenues declined by 6.5 per cent led by companies like Balrampur Chini, Dhampur Sugars and Shree Renuka.

Almost all the big players have reported negative growth in operating profit and net profit caused by a double whammy of declining realisations and increase in expenditure. Analysts advice is to stay away from sugar stocks as the surplus production factor will continue for the next four-six quarters.

Textiles
The rupee appreciation of 8.7 per cent and 5.5 per cent against the dollar and euro respectively plus competitive global market conditions have taken a toll on the performance of textile companies.

While revenues have still grown by 18 per cent largely driven by volumes, operating profit inched up only 1.5 per cent and net profit declined by 7 per cent.

However companies like Bombay Rayon Fashions, Spentex Industries, JBF Industries, S Kumars are some of the few who have shown extraordinary performance and are good investment bets for those who want to have a textile company in their portfolio.

Non-ferrous metals
Companies in the non-ferrous metal space reported a lacklustre performance in Q1 FY08 led by a poor performance in the aluminium business of Hindalco and Nalco but supported by decent performance in copper and zinc players like Sterlite and Hindustan Zinc.

While the sector revenues grew 12 per cent, operating profit declined by 5.8 per cent. Aluminium prices were affected by rupee appreciation and customs duty cut, but TC/RC (treatment and refining costs) margins in the copper business did not grow substantially.

However, zinc prices rose 6 per cent. Net profits also increased by a similar magnitude as companies are on an expansionary mode. Investors need to be cautious about the sector as it is fraught with volatility and uncertainty due to the China factor. Analysts expect aluminium prices to decline and TC/RC margins to weaken in 2009.

Power and power equipment
Despite India being a power deficit country and the existence of a huge potential for power companies, especially in the generation space, the sector has not performed up to the mark barring exceptions in the transformer and distribution space.

Net sales grew only 19.3 per cent and operating profit was largely affected due to a decline witnessed by large companies such as Tata Power and CESC. Operating profit was lower at 8 per cent though net profit jumped 36 per cent due to higher other income.

Pharma
Pharma companies once again disappointed on the operational front due to poor performance by large companies like Ranbaxy, Cipla and Dr Reddy’s. The sector reported a growth of just 13 per cent and 10 per cent in net sales and operating profit respectively, net profits jumped 34 per cent, thanks to doubling of over 100 per cent in other income. Companies that have had huge forex borrowings have gained due to rupee’s appreciation.

Market participants feel that the stocks are under-owned but prefer to be stock specific as global generics and domestic business is competitive leading to pricing pressures. Companies in the CRAMs space are worth looking at if at all.

Allaying market fears of a reversal in fortunes, India Inc has put out a robust earnings card for the June quarter. Despite last year’s bigger base, Corporate India scored a 17 per cent increase in revenues, while earnings grew about 36 per cent, year-on-year (inclusive of the ‘other income’ component, which was up a substantial 39 per cent).

While there has been a perceptible slowdown in sales growth, largely due to base effect, growth in earnings has remained stable, thanks to the improving operating efficiencies of India Inc. On a sector-wise break-up, while usual high-performers — construction, telecom and banks — continued their winning streak, sectors such as automobiles and engineering and technology recorded a slowdown in earnings’ growth (because of the rupee effect).

Among other sectors, while power companies posted firm numbers, sugar companies slipped into the red. The findings in this article are based on the numbers reported by about 1,400 companies for the June 2007 quarter. Here is a brief overview of sector-wise performance for April-June.

Double-digit growth for banks: Banks had a good quarter, with public sector banks (PSB)faring better than their private counterparts. While PSBs reported a near 48 per cent growth in earnings, private banks witnessed a 35 per cent incr ease. Given the robust loan growth over the year, it was no surprise to see the interest income component of most banks swell.

While interest income grew 50 per cent for private banks, public banks, on an average, recorded a growth of about 34 per cent. Among the private banks, Yes Bank and South Indian Bank more than doubled their profits. Interestingly, while all the banks recorded double-digit growth in earnings, IDBI reported flat earnings growth.

State Bank of India, the country’s largest bank, reported 78 per cent earnings growth, backed by a 28 per cent increase in total income. While the impressive performance could be due to last year’s low base, the overall earnings card was marked by stable net interest margins and an improvement in asset quality. The write-back of provisions in the AFS (Available for Sale) category also spurred earnings.

ICICI Bank, on the other hand, reported a modest 16 per cent increase in net interest income, a result of the contraction in net interest margins. While the bank’s earnings were up 25 per cent, the increase in non-performing loans rekindled concerns on asset quality.

Margin pressures in engineering: Engineering and capital goods companies continued to chip in with firm revenue numbers on the back of buoyant demand trends from user industries, but margin pressures remained. The sector reported a 25 per cent growth in revenues, but higher input costs and the subsequent contraction in operating margins led to a slowdown in earnings growth. Future performance, however, may rest on the timely commissioning of capacity expansion plans by companies in this sector.

L&T reported 140 per cent growth in earnings (helped by forex gains on overseas loans) on the back of a 30 per cent growth in revenues. Among other companies that put up a laudable performance were Praj Industries, Bharat Bijlee, HEG and Texmaco.

Construction and realty companies, despite slower growth in revenues, almost doubled their earnings. The lower revenue growth could be attributed to a sharp increase in interest rates (for real estate companies). Most real estate companies recognise revenues on a percentage completion basis of their projects. Earnings, therefore, got a boost from the booking of revenues from projects sold in earlier quarters at higher prices. Earnings volatility for companies in this industry is inevitable given the accounting system followed. Positive signals from telecom: Led by strong subscriber growth, telecom companies yet again notched up a good score, despite pressure on realisations.

The last quarter was marked by cuts in international call rates and roaming charges, reduction in cost of pre-paid lifetime schemes and introduction of low-cost handsets; as mobile operators stepped up efforts to deepen the market.

These efforts translated into healthy monthly additions in customers. For June 2007 monthly additions reached a high of 7.6 million, with key players gaining significant market share.

Bharti Airtel, driven by 54 per cent increase in revenues, saw earnings surge by about 71 per cent. Reliance Communication, backed by a 33 per cent growth in revenue, more than doubled its profits.

Subscriber churn and declining average revenue per user (ARPU) marred the growth picture for MTNL.

Mixed bag from cement: Cement companies reported a lower level of earnings growth, at 50 per cent, on the back of a 25 per cent rise in revenues. On a sequential basis, however, earnings grew by about 30 per cent, with improved realis ations leading to a rise in growth percentage.

Mysore Cements, helped by a high ‘other income’ component and zero debt status, reported a seven-fold increase in earnings. India Cements and Ambuja Cements reported healthy growth in profits, while ACC witnessed a slowdown in earnings growth.

Going forward, while the short-term scenario appears promising, given the firming prices and buoyant demand, the outlook for the sector over a two-year time-frame is uncertain.

Incremental capacities being installed in the next three years create concerns about pricing power. This apart, with the MRTPC (Monopolies and Restrictive Trade Practices Commission) probing the sector for price collusion and cartelisation, regulatory risk may remain a key concern for the sector.

Tough quarter for software: Software companies disappointed as a sharp appreciation in the rupee trimmed revenues as well as margins. Contraction in operating margins dented earnings growth, which was up just about 30 per cent. This is almost half the growth rates of the industry last year.

Top-tier companies such as Infosys, TCS and Wipro saw their operating margins come down by about 2-4 percentage points, quarter-on-quarter. However, given that most companies are now actively hedging their forex exposures, other margin levers such as billing and utilisation rates could offset the rupee effect.

This apart, strength in demand, improving offshore revenue contribution and subsidiaries’ profitability may cushion the firms, to some extent, against any further impact from rupee appreciation. While profitability for Tier 2 companies was under pressure, companies such as KPIT Cummins, 3i Infotech and Rolta India registered impressive numbers.

Headwinds put brakes on automobiles: A hardening interest rate scenario trimmed sales for auto companies — the commercial vehicles and passenger vehicles segment witnessed a modest growth in domestic sales while three-wheeler sal es reported lower growth.

Maruti Udyog scored high, with about 26 per cent rise in revenues and 35 per cent growth in earnings, backed by higher realisations and stable margins. Tata Motors reported just about 5 per cent rise in revenues.

The two-wheeler industry, however, seemed to be hit hard by interest rate headwinds. Lower motorcycle volumes led to a decline in revenues of TVS Motor and Bajaj Auto.

Hero Honda, however, managed a revenue growth of about 4 per cent backed by higher realisation and improvement in its product mix.

Powering ahead: Companies in power generation and supply had an impressive first quarter, driven partly by higher tariffs, partly by an increase in power generation and consumption and to some extent by “other income”.

This apart, growth in earnings may also have been driven by increased load factors in the quarter, resulting in a higher contribution to earnings. The sector recorded 44 per cent increase in earnings on the back of a 20 per cent rise in revenues and a 39 per cent increase in other income.

Reliance Energy recorded a 41 per cent rise in revenues on the back of higher electricity tariffs. Earnings, however, got a lift from the 103 per cent rise in ‘other income’ component. Other companies, such as Tata Power, NTPC and CESC, also reported firm numbers.
The big picture

Despite areas of concern surrounding the rupee’s effect on technology companies and the impact of interest rate hikes on asset purchases, India Inc largely managed to better consensus expectations on earnings this quarter.

Import-intensive businesses received help on their margins from a rising rupee; but the three-month period also brought to light the ability of large and the emerging large-cap companies to build on a high base and actively manage challenges to their margins from firm input prices and interest costs.

The quarter was however, not without its grey areas. One, with a significant proportion of companies registering a surge in “other income” (in many cases, from forex gains), the quality of earnings witnessed some deterioration. Further, mid-cap companies witnessed a stark divergence in performance, even within the same sector.

All this underscores the increasing role that stock selection will play in the performance of individual portfolios in the days ahead.

It’s a good set of numbers because we have got a big earning surprise at Rs 1,079 crore. Those numbers are way above our expectations at Rs 975 crore but the revenue numbers are absolutely flat between quarters. There could be a lot of other income, which we were expecting in any case, because of the big hedges that were taken by Infosys.

The profit numbers are whole lot higher than our expectations but the sales numbers are lower than our expectations. The rupee has certainly hurt this quarter. They have managed to deliver Rs 1,079 crore this quarter as against Rs 1,020 crore in the corresponding previous quarter, if you take out the tax right back. Without the tax right back, there is actually been an about 4-5% jump in sequential profits.

If you take the reported numbers from Rs 1,144 crore including the tax right back, you will see a marginal slip in net profit sequentially. A 5% jump in sequential profits without the tax right back is a very impressive set of numbers. There will be a lot of hedging profits out there, which has boosted other income.

The topline number is not terribly encouraging. We were expecting about Rs 3,813 crore and they have kicked in at Rs 3,773 crore. They are about Rs 40 crore odd lower than our expectations. It is flattish or 1% down sequentially on the revenue side.

On the profit picture, they have done far better. If this is the case then they might actually not have to lower their full year guidance and that’s exactly what the market will be focused on. Profits at Rs 1,079 crore raise hopes that maybe Infosys will not need to lower their guidance for the full year. There is a surprise on the bottomline, there is no getting away from that.

I think you will see a lot of other income out there. I don’t think with a flat revenue picture between quarters, there is any great operating margin expansion or lower than expected operating margin dip, which could have resulted in this profit figure. So 1,079 crore is a big surprise and I think it adds about a rupee-and-a-half to earnings per share. This means that Infosys may not struggle to keep its full-year guidance of Rs 80-81.

There were fears that they could actually do between Rs 950 and Rs 975 crore because of that slippage of Rs 100-150 crore and you could see them going extremely conservative on the full year. They may still chose to do that but I think the chances are much higher now. They may not need to lower the guidance for the full year because these numbers have come in on the higher end of expectations.

There will be damage on margins and there is no of getting away from that. I think the street might have underestimated the other income and that might come in much higher than expectations. We were expecting just under Rs 150 crore in other income. I would not be surprised if we have more than Rs 200 crore of other income because of the high amount of hedging and hedging profits, which may have come in.

If you look at the revenue picture between quarters, it tells you that the picture has not been great in this quarter. In fact, Infosys has missed its guidance for revenues this quarter and that itself is a very telling comment. There were expectations that it would have clocked 8-9% volume growth. To have negated that entire volume growth because of the rupee, tells you that it has been not a good picture. We probably will see quite a bit of operating margin pressure, maybe more than 300 bps as well. We will wait and see if this is good enough for Infosys to hold its full year guidance of Rs 80-81.

Infy’s results have come at a time when the overall global markets’ pace is a little weak this morning. I am wondering how the pulls and pressures will work out because there is a big sell-off in the US and some lukewarm movements in the Asian markets. Yesterday, the markets did not close very well.

On global markets:

The Asian markets’ sell-off is not extremely acute this morning. Most markets are down between half a percent and two-thirds of a percent. I don't think that qualifies as a big 1.5-2% sell-off. The cues are not great but they are not too terrible.

Apar Industries Ltd.;

Tata Chemicals Ltd.;

Crompton Greaves Ltd.;

Madras Cements Ltd.;

Tata Power Company Ltd.;

Jost`s Engineering Company Ltd.;

Super Sales India Ltd.;

Valiant ommunications Ltd.;

Ramco Industries Ltd.;

Sahil Financial Services Ltd.;

Welcure Drugs & Pharmaceuticals Ltd.;

Easun Reyrolle Ltd ;

Shriram Transport Finance Company Ltd.;

Niyati Industries Ltd.;

Birla Corporation Ltd.;

NTPC Ltd; Excel Crop Care Ltd.;

Lloyds Metals & Engineers Ltd.;

Beeyu Overseas Ltd.;

Rama Petrochemicals Ltd.;

GTN Industries Ltd.;

Lakshmi Machine Works Ltd.;

Bell Ceramics Ltd.;

Mathew Easow Research Securities Ltd.;

Cybertech Systems & Software Ltd.;

Kamat Hotels (India) Ltd.;

Rain Calcining Ltd.;

Zyden Gentec Ltd.;

Ucal Fuel Systems Ltd.;

K Sera Sera Productions Ltd.;

Maruti Securities Ltd.;

Bombay Burmah Trading Corporation Ltd.;

NRC Ltd.;

South Asian Enterprises Ltd.;

Lloyds Steel Industries Ltd.;

PAE Ltd.;

Dhunseri Tea & Industries Ltd.;

Dollex Industries Ltd.;

International Combustion (India) Ltd.;

Woo Yong Electronics Ltd.;

Engineers India Ltd.;

Rasoi Ltd.;

Rainbow Denim Ltd.;

TRC Financial Services Ltd.;

National Mineral Dev.corp.Ltd.;

Mysore Paper Mills Ltd.;

Vertex Securities Ltd.;

Ramco Systems Ltd.;

Dhoot Industries Ltd.;

Jenson & Nicholson (India) Ltd.;

Praveen Properties Ltd.

On Infosys Result - Dalal & Broacha

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Infosys Result - ASK RJ

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