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Our three key assumptions

Sep 21, 2004

The <>Indian stock market has never had it so good. In the last two years, while economic growth gathered pace, corporate profits grew at a faster pace owing to margin expansion (due to higher capacity utilization) as well as lower interest expenses (due to lower interest rates). Considering the fact that stock prices were also depressed as compared to the expected growth in net profits, valuations witnessed a correction. But will the buoyancy continue? If one were to look at whatever is quoted in the pink newspapers or in the business channels, it is taken for granted that the Indian corporates are in a much better position to grow their bottomline than ever before. The reasoning is simple and is well understood from the table below.

The Quantum Universe performance...
ParameterFY00FY01FY02FY03FY04
Operating ratios
EBDITA margin16.4%17.1%18.7%19.2%18.6%
Net profit margin6.0%5.6%5.6%7.0%8.4%
Working capital to sales56.9%43.6%46.8%41.6%51.4%
Interest/Gross profit56.3%51.0%49.7%41.2%34.4%
Sales/NFA2.6 3.0 2.7 2.9 3.1
Return ratios         
RONW15.4%15.8%15.1%18.9%21.5%
ROA3.2%3.2%3.0%3.8%4.4%
ROIC10.4%10.4%9.7%12.6%14.9%
(Source: Equitymaster, excluding banks)

The table above indicates the consolidated performance of companies (excluding banks) from our Quantum Universe (around 187 companies). As is evident, as compared to FY00, there has been a significant improvement in both operating as well as balance sheet ratios of these companies. While EBDITA margin or operating margin has expanded by 2.1% since FY00, the expansion at the net level is marginally higher at 2.4%. This could be attributed to the fact that both working capital requirements have fallen and so have interest costs. The result of the aforesaid positives is clearly reflected in the return ratios as well. To understand what the outlook is for the future, it is important to understand the factors that led to the improvement in the first place.

Since 1995, corporates have restructured their operations. First of all, while employee headcounts have reduced significantly, the topline has grown at a CAGR of 11% since FY00 for the aforesaid universe. This means that productivity has improved. Due to the economic slowdown, while inventory and debtor days were reduced, the suppliers were squeezed for more credit leading to a reduction in working capital requirements. A combination of aforesaid measures boosted operating profit margins and cash flow. Consequently, corporates were able to reduce the debt burden. Falling interest rates further helped in the reduction of the debt burden.

But will this trend continue? We do not think so. In our estimates of earnings in the research report section, we have factored in three key assumptions. Those are as follows:

  1. Capex recovery in sight and debt will rise: While net sales of the universe has grown at a CAGR of 11% over the last five years, growth in net fixed assets stood at just 6%. This means that without adding to capacities in a big way, corporates have been able to utilise their assets efficiently in the last five years. We believe that capital expenditure from corporates is likely to gather pace. To fund these expansion plans, corporate borrowing is likely to rise.

  2. Cash reserves are healthy now but working capital cycle will reverse: We believe that corporates have build up significant cash reserves (as is evident in the table from the rise in working capital to sales ratio. When current assets rise at a faster rate (of which cash is a component) than current liabilities, working capital to sales ratio increases. This is considering a sales growth of 11% in FY04, which is the denominator. But during an economic upturn or expansion phase, working capital requirements tend to rise. Barring few companies, on a broader basis, we have increased the working capital requirements of companies under our research coverage.

  3. Average interest costs have bottomed out: Barring few companies that are either debt free or have further scope of debt retirement, we have assumed a higher interest cost for companies under coverage beyond FY05 (around 100 to 200 basis points). There are two reasons. Firstly, working capital requirements are mostly met by short-term borrowings and secondly, the incremental cost of borrowings beyond FY05 is likely to be at a higher rate. Having said that, we do not expect average interest cost to increase very dramatically.

Why have been conservative in our estimate? For the simple reason that any economy operate in cycles. During a downturn, it is natural for corporates to tighten their belt to safeguard margins and vice versa. While it is not necessary that all companies are likely to witness the impact of the aforesaid factors in the future, we believe that the scope for operating margin expansion and further savings in interest costs is limited, provided the company has significant expansion plans. Not so asset intensive sectors like FMCG may continue to be less affected by these factors.

Unlike the last five years, when the CAGR in net profit was higher at 21% as compared to the sales growth of 11%, we believe that net profit growth is likely to be in line with sales growth or lower on a broader basis. Of course, it depends on company to company.

As an investor, we believe that it is better to be conservative and be worried more about the downside than the upside when it comes to investing in stocks.


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