There is ample evidence of the economic environment being far from rosy. But that shouldn’t be a reason to stay away from markets.
Market pundits say successful investors look for opportunities during crises. They add now, opportunities are many, including picking companies that could gain from higher operating leverage once growth picks up.
The current situation is so grim that India Inc’s asset turnover ratio has fallen to a multi-year low. The ratio, which reflects how well assets are utilised relative to ability, is calculated by dividing total sales by total assets. The fall in this ratio may be partly explained by the pressure on realisations but a large part of this is to do with falling capacity utilisation across sectors, owing to demand issues. This is especially true of companies in core sectors such as cement, capital goods and steel and other cyclical sectors that aren’t able to operate at optimum capacity.
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In the steel sector, companies are operating at about 80 per cent utilisation, while cement companies are operating at a decade-low capacity utilisation rate of 70 per cent, against 99 per cent in 2007-08. Engineering, power and certain pockets of the automobile sector, too, are operating at low capacity utilisation rates. However, there is a positive to this — companies with healthy balance sheets operating at low capacity utilisation could do well when demand picks up and, therefore, these may be investment-worthy candidates.
“Overall, the benefit of operating leverage is yet to be seen. If demand improves, it may lead to substantial improvement in the earnings and cash flow of companies operating at low capacity utilisation,” said Pankaj Pandey, head (research), ICICI Securities.
On an aggregate level, BSE 200 companies’ data (excluding financials) showed the asset turnover ratio fell to 1.52 in FY13 from the peak 1.85 in FY07. Though low capacity utilisation may be bad news, a section of the market is looking for companies with low capacity utilization; these may benefit because of the improving operating leverage in ensuing years. Among the key reasons for this is the expectation of an economic recovery in the coming quarters.
“Our economists expect the Indian economy to bottom out in FY14 and slowly, resume a growth trajectory. While execution-related risks in corporate India remain elevated, a number of companies have already completed their capital spending programmes through recent years and are poised to see a recovery in cash flow,” says Jitendra Sriram, equity strategist and head of research (India), HSBC Securities and Capital Markets.
The benefits of operating leverage, however, can vary and accrue in different ways. For instance, capital goods companies such as Thermax, BHEL and Crompton Greaves are operating at low capacity utilisation. If demand recovers, it will have a huge impact on their earnings, given the large capacity and economies of scale. Besides, due to the under-utilisation of capacity, companies have cut prices to recover fixed cost and maintain a certain level of plant utilisation, leading to pressure on margins. Leading players in the power equipment space, including BHEL, have seen erosion in margins because of capacity under-utilisation and a cut in product prices due to competition.
One disadvantage of low capacity utilisation is during that phase, it hits operating margins significantly. “Cement is the classic case of companies making very low earnings before interest, tax, amortisation and amortisation per tonne because of under-utilisation. However, if demand recovers and the benefits of operating leverage start kicking in, this will have a huge impact on earnings,” says Pankaj Pandey of ICICI Securities.
Mid- and small-sized companies, which do not have sufficient strength in terms of balance sheets and operating costs, have been hit by the slowdown. An improvement in demand and the consequent benefits of operating leverage may help many of these come out of stress and generate higher cash flows, which may be used for managing day-to-day businesses.
This will also mean an improvement in their earnings and return ratios, such as return on capital and return on equity. This could act as an important catalyst in their stocks being re-rated.