Quarterly Review - Aug 2008

Quarterly Review - Aug 2008

The importance of a quarter

If you are an avid watcher of the business channels on television, you could not have missed the frenetic activity that accompanies the quarterly “earnings season” — the period when listed companies unveil their results for the latest quarter. In fact, the actual earnings announcement is often drowned by a veritable flood of analyst comments, Q&A sessions with the management and sound bytes from market players. All this is usually accompanied by sharp gyrations in the stock price of the company being discussed. Indeed, to find a stock battered by 5-10 per cent in a single day after ‘disappointing’ results is not an unusual occurrence.

Quarters as milestones

But if stock prices really capture a company’s earnings prospects over the next two-three years, why do results for a single quarter cause so much mayhem? Well, this exuberance is not entirely irrational. Here is why quarterly results influence stock prices.

Though the stock market typically values a company based on its estimated earnings over the next few years, the quarterly earnings announcements are milestones that help investors evaluate if a company is really on track to meet those expectations.

Failure to meet the market’s expectations for a particular quarter naturally means higher targets for the rest of the year. Numbers that are better than what the majority of players in the market expected drive the stock prices up, as that may warrant an upward revision in the earnings expectations.

In fact, stock price gains for the Sensex companies over the past three years have been driven, to a large extent, by them repeatedly delivering earnings that are higher than analyst expectations.

Cues to future

Another reason why the earnings season is such an action-packed one for the stock markets is that they often provide cues to future earnings, from the company’s management.

With disclosures improving, several companies use the earnings season to touch base with analysts and investors and update them on business developments.

Conference calls with analysts and the public appearances made by the company management, often give investors new insights about unfolding trends in the business as well as the outlook for it, over the next few quarters. The new information helps the stock market “reset” earnings expectations, triggering stock price moves.

Finally, the quarterly earnings season also helps to turn the spotlight on the earnings potential of the less-known mid-size and smaller companies. Remember; there is still a large cross-section of small and mid-cap stocks that are not yet tracked by an army of analysts. Stock prices for such under-researched stocks are often not shaped by formal “earnings estimates” or “consensus expectations” as in the case of the high profile companies.

Under the circumstances, the quarterly earnings announcement often serves as the only reference point for investors looking to evaluate such stocks. This is why the quarterly earnings season is often marked by frenetic activity in the mid-cap and small-cap space, with sharp jumps in stock prices shortly after a company’s results announcement. For some of the low-profile members of India Inc, the earnings season is the time to bask in a few moments of glory, fleeting though the stock markets’ attentions may be.

Earnings Strength Comparison - Q4FY07

Earnings Strength Comparison - Q4FY07

Quarterly Surprise ?

Buoyancy returned to Indian markets as equities rallied across all major sectors, other than software, on fresh buying by funds and traders. There were liquidity concerns because of public issues by DLF Ltd and ICICI Bank Ltd. But fresh buying by funds in the secondary market eased such concerns. Also, heavy oversubscription of the ICICI Bank share sale was another comforting factor. Inflation, which has been haunting the markets for quite some time, has now fallen to an acceptable, and rather unexpected, level. On the domestic front, there are no big concerns on the horizon.

But the situation is just the reverse on the global front. The resurfacing of concern over subprime contagion is a new challenge that global stock markets may face in days to come. Friday’s sharp fall on Wall Street was on fears that trouble at two Bear Stearns hedge funds may signal bigger problems for credit markets. Inflation and rising interest rates were already worrying markets across the globe and rising US bond yields had triggered a fall on global bourses. If the subprime problem spreads to more hedge funds, it could rattle all major global markets. The US markets are already under pressure as the yield on the benchmark 10-year treasury note has been approaching the 5.25% level. This may put pressure on the interest rates in the US.

This week, the US Federal Reserve meeting is scheduled on Wednesday and Thursday. The Fed has held the target for overnight interest rates steady at 5.25% since last June. Although only minor changes are expected in the meeting, the Fed may decide to hike interest rates, creating problems for global stock markets as it would put pressure on all major economies to review their own interest rates. But going by recent US economic data, chances of upward revision of interest rates are remote.

Other important data that will be released in the US this week includes home sales data on Monday and new home sales data on Tuesday. The new home sales are likely to be lower, compared with May. This may not impact markets substantially, but any positive surprises will boost the US markets. On Wednesday, the US commerce department reports on durable goods orders for May. This data is also likely to show a fall of 1% after a 0.8% rise in April—this has already been factored in by the markets. On Thursday, the revised figures of the first quarter GDP will be made available. This number is likely to be revised upwards to 0.8% from 0.6%.

Indian scenario

This week is going to be important for the domestic bourses as the derivatives contracts for June will expire on Thursday. Since the global markets are likely to be volatile and at present there are no major positive triggers on domestic bourses, the market will be quite volatile ahead of this expiry. The rollover thus far has been smooth and because of this, high open interest rates should not pose any problem. However, the creation of fresh short positions in the wake of uncertainty on global bourses could see some selling pressure building up. Also, the market may now start pondering over the earnings of the first quarter, as these will start arriving from the second week of July. The market’s expectations of first quarter earnings are not very encouraging. But given the strong growth in direct tax collections, the results may
spring some positive surprises.

Technical signs

This week is also going to be driven by a lot of uncertainties. It will start on a negative note and equities may register a fall initially. But no big-ticket selling is likely as the technical indicators are still bullish. Unless selling becomes a global phenomenon, uncertainty-led selling will be temporary.

Purely on a technical basis, the charts show that the market will be back on track from Wednesday. Stocks such as HDFC Bank Ltd, Suzlon Energy Ltd and Unitech Ltd look good on charts. However, readers should note that since some initial weakness is expected this week, it would be better to consider these stocks only after the market consolidates. HDFC Bank, at its current market price of Rs1,101, has the potential to move up to Rs1,064, with a stop-loss of Rs1,064. Suzlon Energy is currently northbound, but is likely to see a lot of volatility; however, with a medium-term perspective, the stock is a good buy. The stock, which is currently trading at Rs1,378, has a short-term target of Rs1,424 and a medium-term target of Rs1,467 with a stop-loss of Rs1,337. Unitech, at the current rate of Rs524.50, has a potential to move up to Rs547 in the short-term, with a stop-loss of Rs492.

From our last week’s recommendation, Century Textiles & Industries Ltd, recommended at Rs604, touched a high of Rs672, gaining 11.26% during the week, well above its target. IVRCL Infrastructures & Projects Ltd, recommended at Rs335, touched a high of Rs379, gaining 13.13%. And Punjab National Bank Ltd, recommended at Rs488, hit a high of Rs532.40, gaining 9.1% during the week.

Via Mint

Cost cuts, higher prices spur profit

Profit growth was much sharper than sales growth in the 3 quarters of FY07

Massive cost cuts, buoyant sales and improved price realisations accelerated Corporate India’s profit growth in the first three quarters of 2006-07.

A study of 808 companies (excluding oil & gas, software, banks and non-banking financial companies) shows that profit growth in these quarters was much sharper than sales growth. Further, the growth in bottom line was much higher in those quarters in which sales outpaced the rise in the cost of production.

While sales increased 28.24 per cent during the quarter ended December 2006, the total cost of production rose 25.79 per cent, indicating that the latter rate is 284 basis points (bps) lower than the former. As a result, net profit jumped 53.66 per cent.

In the second quarter, while sales rose 27.9 per cent, the increase in production cost was lower by 112 basis points at 26.8 per cent. Thus, net profit surged 35.7 per cent.

In the first quarter, sales were up 27.39 per cent, while cost of production rose 26.59 per cent, 80 bps lower than the former. Profit shot up 40 per cent. A Business Standard Research Bureau study shows that the share of cost-cutting in bottom line was 16.6 per cent in the first quarter, 25.74 per cent in the second quarter and 40 per cent in the third quarter.

In other words, while net profit, in absolute terms, increased by Rs 7,752 crore in Q3, the total cost of production was lower by Rs 3,100 crore (See ‘Methodology’). In Q2, savings on account of lower growth in the cost of production stood at Rs 1,329 crore compared with Rs 5,163 crore increase in net profit. In Q1, savings amounted to Rs 844 crore vis-a-vis the absolute rise of Rs 5,099 crore in net profit.

The study also attributes the rise in profit to savings in other costs, which include salaries and wages, interest and general administrative expenditures. However, raw material costs, which galloped past the sales growth, remained a major concern.

The increase in input costs was higher by 161 bps compared with the sales growth in the third quarter, 338 bps in the second quarter and 48 bps in the first quarter. As a result, raw material costs were higher by Rs 3,283 crore, Rs 3,340 crore and Rs 879 crore in the first quarter, the second quarter and the third quarter respectively.

The corporate sector saw a rise in tax provision in all the three quarters as profits surged. The tax provision was higher by Rs 210 crore in the third quarter, Rs 172 crore in the second quarter and Rs 194 crore in the first quarter.

More than half of the 808 companies studied managed to save on total costs during all the three quarters. Over 60 per cent of them made saving on other expenditure. And, about 50 per cent firms effected saving on interest and salaries/wages. Only 40 per cent of the companies saved on raw material tax provision.

One-fourth of the sample or 197 companies registered decline in net profits largely because of higher cost of production. Of this, the total cost of production was lower for 38 firms, while for 88 companies raw material costs were lower. However, 103 firms managed to save on other expenditure, and another 132 outfits showed a growth in sales income.

Further, of the 45 sectors studied, the sales growth rate of 29 per cent was higher compared with the growth in the total cost of production in the third quarter. The sales growth rate of 24 sectors was higher in the second quarter and of 28 sectors in the first quarter. However, the growth in raw material costs was higher than the sales growth for 26 sectors in the third quarter, for 30 sectors in the second quarter and 22 sectors in the first quarter.

Cement has done well in all the three quarters with net profit growth of 264 per cent in the third quarter, 145 per cent in the second quarter and 244 per cent in the first quarter.

The sales growth rates ranged between 40 per cent and 53 per cent, while cost of production moved between 20 per cent and 25 per cent in the three quarters. This shows that cement companies benefited from cost-cutting and higher price realisations.

Sugar companies suffered a severe setback on account of lower prices with 8 per cent decline in sales in the third quarter and a modest 4 per cent sales growth in the second quarter. However, raw material costs rose 14.5 per cent in the third quarter and 2.08 per cent in the second quarter. The result was obvious: bottom lines of sugar companies declined 17 per cent in the second quarter and slumped 53 per cent in the third quarter.

The first quarter offered a different picture. Net profits of sugar companies zoomed 113 per cent on the back of 33 per cent surge in sales, though there was 30 per cent rise in raw material costs as well. This was because there was buoyancy in prices in that quarter.

Methodology

The study is based on a sample of 808 companies that have posted profits in the last six quarters.

The study excludes the finance, software and services sectors, which do not use raw materials for production purpose. Oil & gas companies have also been excluded as the government controls the pricing power for oil marketing companies. In the third quarter, profits of state-run oil companies increased largely on account of oil bonds.

Savings on cost of production were calculated by applying the cost-to-sales ratio of the previous corresponding quarter to the current quarter. This was done to find out the cost of production for the current quarter based on the cost-to-sales ratio for the previous corresponding quarter. The study shows that the ratio was higher in all the previous quarters and lower in the quarters under review.

Had the cost-to-sales ratio during the quarters under review been higher or the same as the year-ago quarters, the cost of production would have been higher. In such case, bottom lines of these firms would have risen 27.3 per cent in the third quarter, 24.9 per cent in the second and 31.5 per cent in the first. However, they posted net profit growth of 53.7 per cent in the third, 35.7 per cent in the second quarter and 40.1 per cent in the first.

The total cost of production-to-sales ratio was lower at 82.51 per cent (84.11 per cent) in the third quarter, 83.03 per cent (83.76 per cent) in the second and 82.35 per cent (82.87 per cent) in the first.

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Source: Dreamgains