Enthusiastic earnings upgrades may require a relook

The latest earning season (3QFY21) has been one of the best in recent times. Companies across sectors reported encouraging revenue growth. The margins also improved on the back of lower input cost and wage rationalization. Accumulated demand (due to two quarters of lockdown) and festive season may have a significant role to play in the demand growth during 3QFY21. It is anticipated that as the economy continues to open up further as vaccination drive accelerates and mobility restrictions are eased further, the demand growth may sustain for few more quarters. The demand environment is also supported by the counter cyclical fiscal policy and continued accommodative stance of monetary policy.

The quarterly earnings surprised many analysts on both EBIDTA and PAT level; while on top line the surprises were lesser in number. For Nifty companies, on aggregate basis, EBIDTA margins and PAT margins were flat. However, after adjusting for exceptional losses in Bharti Airtel and Tata Motors, picture does not looks that disappointing.

In 3QFY21, double digit top line growth in metals, mining, cement, construction and manufacturing also augurs well for the macro growth. In fact, the cement industry reported third consecutive quarter of good results with EBITDA/mt for the whole industry coming in at Rs1,000+. It was due to continuation of strong pricing and lower operating costs as witnessed during the first two quarters of FY21. The industry witnessed volume growth of 5.6% YoY after 2 quarters of decline. This these trends support the view that Indian economy may recover to a normalized 5%+ growth trajectory in FY23. Of course it is not something to celebrate, but it does provide a whiff of relief that the fears of a deeper recession have been alleviated completely.

The markets however appear to be discounting an all clear blue sky scenario, which might be little over optimistic. Cost advantages available in 3QFY21 are dissipating fast with sharp rise in raw material & energy prices and normalizing wages. Considering that EBIDTA margins in 3QFY21 may already have reached close to their all-time high in case of many large companies like Hindustan Lever, the earnings growth expectations from the current level may some room for disappointment.

After a spate of highly optimistic commentary oover past three months, some voices of caution have started to emerge. Analysts at BofA see rising commodity prices and bond yields as key risk for Indian equities in near term. A recent note from BofA research read, “With the Nifty already at our year-end target of 15,000, continuation of a broad-based market rally appears unlikely.” The research notes that steel, cement, crude, coal, copper, aluminium, iron ore, palm oil and caustic soda are the key commodities relevant for the Nifty companies and prices of these commodities are up by up to 75% since June 2020.

Similarly, Nomura analyst sees ‘rising number of Covid cases, higher commodity prices, rising in trade and current account deficit and rising bond yields as key risks to Nifty rally in the near term.

At CLSA, while earnings estimates for for over 2/3rd of coverage stocks have been raised after 3QFY21 earnings, recommendation downgrades by analysts are about 3x the number of recommendation upgrades; with valuation.

A note from ICICI Securities also notes that “Margins largely augmented by ‘cost control’ and product mix even as input prices continued to put pressure on gross margins in general. This phenomenon is continuing in Q4FY21 as evidenced by further rise in ‘manufacturing inflation’ component within WPI to 5% largely driven by metal prices.”. The note also cautions that rise in credit cost may surprise negatively for some financials.

A note from IIFL Securities notes that, “The steady margin improvement up to the previous quarter, driven by aggressive cost-cutting measures and benign input costs, has paused for now. Normalising activity and rising input costs are putting pressure on EBITDA margins.”

After the upgrades, the Nifty earnings is now expected to grow @20% CAGR over FY20-FY23 period, with FY22 EPS growth estimated to be over 33% yoy. Obviously, the current earnings estimates do not leave any room for disappointment. 4QFY21 and 1QFY22 earnings seasons must therefore be keenly watched. Any sign of disappointment on either revenue growth or EBIDTA margins may cause significant volatility in the market.

Chart of the day

Author: Midas Finserve

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