Q1FY2008 IT earnings preview
Against all possible odds
It couldn't have been worse for the information technology (IT) service companies. During the first quarter, the margins of the front-line IT companies are generally dented by the cumulative impact of the incremental cost of visa charges (the visa window opens only during Q1 every year), the inflow of fresh engineers (they are put under training and are non-billable) and the annual salary hikes. (The annual salary hikes are fully reflected in Q1 in case of Infosys Technologies [Infosys] and Tata Consultancy Services [TCS]; the other front-line IT companies provide for the same in either Q2 or spread it out over a number of quarters.) In addition to all this, the steep appreciation in the rupee against all major currencies in Q1 added to the pressure on the margins.
SECTOR UPDATE
Automobiles
June numbers—a mixed bag
Auto sales numbers continue to be a mixed bag. Two-wheeler sales continued to decline in June owing to higher interest rates and stringent checks by financiers. On the other hand, cars sales outperformed the sector in the same month despite it being the slack season on account of the monsoon. The growth in cars was largely led by a flurry of new launches in the recent times, such as SX4, Swift Diesel, Logan and Spark. The commercial vehicle (CV) sales continued to reel under the monsoon, hardening interest rates and tightened liquidity. Maruti Udyog Ltd (MUL) and Mahindra and Mahindra (M&M) were clear winners of June, as their growth was fuelled by their recent launches.
Ceat
Cluster: Ugly Duckling
Recommendation: Buy
Price target: Rs190
Current market price: Rs171
Still on a fast track
Key points
- The slowdown in the sales of commercial vehicles in the country has been greater than the company's expectations which is feared to take its toll on the company's original equipment manufacturer (OEM) sales. Consequently, Ceat's management expects the sales revenues from the OEM segment to be lower at Rs500 crore in FY2008 vs Rs600 crore in FY2007. However, to counter the situation the company is trying to realign its strategies and boost its replacement sales and exports.
- The company expects the slowdown to continue for the next few months and the demand to revive with the onset of the festive season, ie by September or October. For FY2008, the company expects a volume growth of about 10%, with the growth in the second half likely to be better than that in the first half.
- Some positive developments regarding the industry are also expected in the coming days. For instance, the government might tighten the anti-dumping laws. It might also raise the reference price for import of cross-ply tyres to $130 from $100 at present. Also, China is reducing the incentives on export of tyres and lowering the freight subsidy to India for cross-ply tyres by 5%. All this would be positive for the entire tyre industry and help it combat the cheaper Chinese tyre imports. However, the same would affect only the cross-ply imports. Hence, the radial tyre imports from China are expected to continue at the same speed in the medium term.
- The rubber prices have softened significantly in the past couple of weeks. The prices have come down to about Rs73 per kilogram levels from the average level of Rs95 per kilogram. The rubber prices are expected to remain soft in the coming months. At the same time, we believe there will be pressure from the OEM customers for price reductions. Even if the prices are lowered for the OEM customers, the replacement market may not see any price cuts. Since the replacement market constitutes about 65% of a tyre company's total sales, this is a huge positive for both Ceat and the industry.
- The company expects to improve its margins in the current year, mainly due to lower raw material prices and improved efficiencies.
- The land sale at their Bhandup plant site has got delayed due to a delay in obtaining certain legal approvals. The company expects to finalise the deal by the third quarter of the current fiscal.
- Spotting great potential in the off-the-road market, the company is raising its capacity in the segment from 25 tonne a day to 45 tonne a day by November 2007. The location for the greenfield plant is still under consideration and is expected to be finalised soon.
- The de-merger of its investment business into a separate investment and finance company in order to optimise the operational efficiencies and improve the performance of its core business is expected to take place in FY2008.
- The financial restructuring entails the conversion of one share of Ceat out of every four held into a share of the investment and finance company. Thus, the equity capital of Ceat (ie the core tyre business) will reduce by 25% which will improve the earnings per share.
- We maintain our positive outlook on the company in view of its smart turn-around and brilliant performance. At the current levels, the stock trades at 10.8x its FY2008E and an enterprise value/earnings before interest, depreciation, tax and amortisation of 5.0. We maintain our Buy recommendation on the stock with a price target of Rs190.
Nucleus Software Exports
Cluster: Emerging Star
Recommendation: Hold
Price target: Rs1,020
Current market price: Rs993
Annual report review
Key points
- Nucleus Software Exports has further built on the growth momentum of FY2006 and reported another year of robust performance. The quality of its revenues has also improved with the high-margin product business contributing 54% of the total turnover.
- It was an exceptionally good year in terms of order inflows as the company added 21 new clients for 74 modules of the FinnOne product suite. The order backlog of Rs330 crore provides strong growth visibility in the coming quarters.
- The balance sheet continues to be strong with Rs81.9 crore of cash and cash equivalents and healthy return ratios. However, the jump in the account receivables to 91 days is a worrying factor.
- The current valuations of the stock factor in most of the positives and any re-rating would depend on a higher than expected ramp-up in the business. We maintain Hold on the stock.