Weak earnings forecast to weigh on valuations

With costs and interest rates on the rise, the trend of Sensex earnings downgrades is likely to continue.

With the profitability of India Inc under pressure, there are clear reasons for investors to be cautious, with analysts once again lowering their earnings estimate for companies. If the trend of earnings downgrade continues which seems likely and actual earnings slip to levels lower than expected, then there is a risk that market valuations, looking reasonable currently, could also suddenly appear expensive.

Since January, 20 of the 30 Sensex companies have seen their earnings estimates being downgraded by analysts. In the past month, analysts have cut their estimates for half of these. On an average, analysts now expect companies to report seven-eight per cent lower earnings in 2011-12, as compared to their estimates before the start of 2011. The impact would be larger on aggregate Sensex earnings, as these 20 companies together account for 65.4 per cent weight in the index.
 

DOWNSIDE RISK
	FY12

MSCI EM Forward PE10.8 10-years Sensex premium28% A) Fair Forward PE for Sensex13.8 Estimated Sensex EPS (Rs )1,257 Likely downgrades over 3 mth7% B) Post downgrade EPS (Rs )1,169 Fair value of Sensex (A x B)16,132 Note: 7% likely downgrade over the next three months is based on 2%, 3%, 2% 
downgrade on account of interest, raw material and fuel costs respectively
Source: Ambit Capital Research

The trend of downgrade of earnings’ estimates is expected to continue for some more time, say analysts. The impact of higher commodity prices, coupled with the rise in interest rates, will reflect on corporate profitability in the coming months.(Click here for table)

“We see 2011-12 as a year which will start shakily, with earnings downgrades led by higher commodity prices, higher interest rates and a weak industrial capex cycle,” says Pralay Das of Elara Capital in his recent note on India strategy.

The earnings season is on and many companies have seen their earnings estimate for the full year being cut. Among the larger ones, State Bank of India had a poor March quarter, after which analysts lowered their earnings estimates for the country’s largest lender by eight to 10 per cent. That apart, companies such as Reliance Communications (RCom), DLF, Bharti Airtel, Cipla, Hero Honda and JP Associates have also seen their earnings’ estimate being scaled lower. Indicating that the profit pressure due to higher commodity prices and interest rates or rising competition is across industries.

Notably, while there have been some earnings upgrades in the past month, the rate of increase has been less than one percentage point.

PRESSURE ON MARGINS
The pressure of the high input prices and interest cost is likely to continue in the coming quarters and impact operating margins of the companies. “Upward earnings revision in sectors like automobiles is unlikely but could see sharp downward revision in sectors like banking and financials, engineering & capital goods, power and real estate. These sectors contribute 47 per cent to the aggregate Sensex earnings,” says Ajay Parmar, head of research, Emkay Global. The Sensex, at 14.4 times its 2011-12 consensus estimated earnings of about Rs 1,255 per share, is trading close to its long-term average of about 15 times and is considered reasonably valued. However, if the Sensex EPS for 2011-12 comes lower than expectations, then the valuations are likely to turn expensive.

“So far, the assessment of the results shows more disappointments than surprises. The companies are under margin pressure, which we think will continue for the next two-three quarters,” says Mehraboon Irani, principal and head, private client group business, Nirmal Bang Securities. The downgrades will have their impact on index valuations. “People were talking Sensex EPS of Rs 1,325 in 2011-12, which now have been brought down to about Rs 1,275. We believe there is downside risk to about Rs 1,200 EPS in 2011-12,” adds Irani.

There is a classic example of this happening. In 2009-10, analysts expected the Sensex EPS to be Rs 1,300, which actually turned out to be Rs 833, almost 36 per cent lower than the initial estimates. Then, the Sensex P/E had touched its multi-year lows at below 10 times. In reality, even after two years, the Sensex is far from achieving that number. Meanwhile, the situation may not be that grim. However, the possibility of further downgrade in earnings surely exists. The only debate, if any, is by how much?

Ambit Capital estimates that there could be about seven per cent downgrades in Sensex EPS to Rs 1,169, which factors in a two per cent impact due to interest, three per cent due to higher raw material costs and another two per cent for higher fuel cost.

In an environment wherein earnings’ estimates are being downgraded, it is also likely that the markets’ PE multiple could also see some moderation from current levels.