Margin pressure: Who will come out unscathed?

1QFY07 has passed us by and record numbers achieved by India Inc must have definitely soothed a lot of frayed nerves out there. However, bygones will be bygones and everyone is now focusing on what the coming quarters will bring with them. Uppermost on their minds would be the input cost pressures that were being witnessed during 1QFY07 and which is further likely to intensify, apart from the threat of a hike in interest rates. The impact of these two factors, however, is not going to be uniform across-the-board. In this write-up, we examine as to which sectors are in a better position to tackle these twin demons in the coming quarters.

What happens if all other things remain constant during 2QFY07 but input as well as interest costs both increase by 100 basis points (assuming the companies are equally funded by debt and equity). Let us see by how much the profit decreases due to the above-mentioned factors if the profit levels of all the sectors are assumed to be at 100.

As seen from the chart above, commodities like cement, steel and aluminium have emerged as the sectors which will be hurt the least in case of hike in input and interest costs on the basis of performance in 1QFY07. It should be noted that the magnitude of impact is inversely related to the kind of margins the companies enjoy. In other words, higher the margins the lesser the impact. Hence, what could also be concluded from the above charts is the fact that among all the sectors featured above; cement, steel and aluminium are the ones with the highest profit margins. On the other hand, sectors like textiles, auto and engineering have witnessed the lowest margins.

However, we would like to point out that arriving at a proper conclusion on the basis of just one quarterly set of numbers would be akin to aiming at a dartboard. All the sectors should be evaluated on the basis of their performance over a long-term period, a minimum of three to five years. If this criterion is taken into account, then is the same picture going to emerge? We are of the view that the top three sectors in the above chart are unlikely to find a place under the new criteria. This is because these sectors are cyclical in nature and at present they are going through a cyclical upturn and hence the buoyant margins.

It should be remembered that these sectors have been benefiting from high prices of their products in recent times and as a consequence, have been generating record revenues as well as cash flows that enable them to clean up their balance sheets. Thus, on account of their higher margins, they are currently less vulnerable to input price pressures. But if the realisations cool off a bit, which is not unusual, it does not take the margins long to take a U-turn. Therefore, it is advisable to stick to companies in those sectors where debt funding is kept to a bare minimum and where tight control is being exercised over costs.

Now, what about the other sectors in the pecking order, viz. software and FMCG. These sectors are characterised by consistently high operating margins and virtually debt-free balance sheets. As mentioned above, since the impact of cost escalation is inversely related to margins, these sectors are likely to come out of the period of cost inflation with minimum damage. Also, since the levels of debt are at a bare minimum, a rise in interest expenses is not likely to affect these companies much, as compared to companies with substantial debt on their books.

To sum up, we would advise investors to ask two basic questions before taking their investment decisions - does the sector/companies has/have a track record of consistently high margins and virtually debt-free balance sheets? If the answer to both these questions is yes, then you have got before you an attractive investment proposition. Everything however, will come to nought if the price-value equation is not in your favour.