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Asset utilisation: Of peaks and troughs! - Views on News from Equitymaster
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  • May 9, 2006

    Asset utilisation: Of peaks and troughs!

    With indices at all time high levels and valuations across the boards not being cheap, stock selection becomes one of the most importance criteria of investment. In this article, we shall look at the performance of different sectors over last five years on the asset utilisation front and see how this performance metric has impacted their return on equity.

    Asset utilisation is key to the success of any company. In the most basic sense, an improving asset utilisation indicates that the incremental sales generated by the company are more than adequate to compensate for the rising depreciation charge. Lower utilisation indicates two things. One, the company is not able to utilise its assets efficiently (for company specific to industry specific reasons). Alternatively, lower asset utilisation could also be the result of the fact that company is not investing efficiently. In either case, there is likely to be an adverse impact on the performance of the company.

    For the purpose of this article, we have considered the financial of the companies under our coverage.

    Asset utilisation: How have they performed?
      FY01 FY05
      Sales/GFA RONW Sales/GFA RONW
    Steel 0.7 -2.2% 1.5 61.1%
    Cement 0.8 10.4% 0.9 19.3%
    Auto 1.7 -0.9% 2.6 23.0%
    Pharma 2.2 19.0% 2.0 21.7%
    Engineering 2.2 9.7% 3.3 19.8%
    Software 2.3 29.1% 3.9 31.9%
    Energy 2.8 17.0% 2.7 21.9%
    FMCG 3.1 28.7% 2.4 30.4%

    The above table indicates the asset utilisation (Sales/GFA) and return on equity of different sectors in two different time periods in the current business cycle - FY01 being the bottom and FY05 being on the higher side of the cycle. At the outset, we would like to clarify that our intention is not to compare the asset utilisations of different sectors. In fact, such a comparison would mean comparing 'apples with oranges', as each sector is governed by its dynamics, which are different from the other sectors. To give a perspective, while steel companies have seen significant expansion in their margins during the current upturn (mainly led by the leverage factor), software and engineering companies have witnessed margin pressure due to rising competition, volume based growth pattern and rising input costs (manpower in case of software companies).

    As can be seen from the above table, across all the sectors, the star performers have been steel and automobile sectors, as evident from the performance on the return on net worth (RONW) front. The performance on the RONW front has been led by the overall improvement in economic fundamentals, rising demand and consumption activities and business process restructuring. Incidentally, both automobile and steel stocks are cyclical in nature and highly capital intensive. On the other hand, sectors like FMCG and pharma are defensive plays and thus have been stable in their performances.

    Asset utilisation: Why have they performed?
    5 Year CAGR Sales GFA PAT
    Steel 19.5% 0.6% *
    Auto 18.6% 6.4% *
    Engineering 18.6% 6.8% 36.8%
    Cement 12.0% 7.9% 29.6%
    Energy 10.5% 11.9% 21.9%
    FMCG 6.9% 13.8% 9.4%
    Pharma 20.1% 22.4% 27.7%
    Software 44.7% 26.6% 35.9%
    * Loss in FY01

    So, where to invest - steel or auto?
    The first impression of looking at the first table is that investment in the two sectors can be a sound proposition considering the strong improvement in key performance metrics of RONW and asset turnover. However, we have a different view on that. We believe that a large part of the improvement in asset utilisation and consequently the return for these two sectors has been due to 'full' utilisation of existing capacities on the back of rising demand in the domestic economy. As the second table shows, both the auto and steel sectors have been laggards in ramping up capacities, something that they are in the process of doing now. As a matter of fact, in the next 2 to 3 years, the steel and automobile sectors are expected to invest around Rs 450 bn and Rs 100 bn respectively towards building up additional capacities.

    As such, we believe that the right time to invest in both these sectors was when the asset-turn was at the lowest. This is because, in general, cyclical sectors are outperformers both in an upturn as well as downturn. However, investors should note that we are not writing off these sectors completely considering that they are at the peak of their utilisations levels and that capacity utilisation in the future shall impact profitability. What we intend to say is that investors need to be reasonably selective while making their investment decisions with respect to stocks from these sectors.



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