Interesting times

Most large companies are unlikely to be adversely impacted by the rising interest rates over the medium term.

Interest rates in India are moving up, and banks, unlike a year ago, are in no mood to pamper the Indian corporate by offering loans at sub-PLR (prime lending rates).

A slew of banks have gone for lending rate hikes of 25-50 basis points in the recent past, thanks to the hike in cash reserve ratios. Since April 2006, public sector banks on an average have hiked rates by 100-125 basis points.

Though corporates have no choice but to raise capital, they are not disturbed by rising interest rates as the demand for their products is robust. Many of them are also going for a never-seen-before capex boom.

While these are signs that all is hunky-dory with India Inc, what happens in the future? The RBI doesn't show any signal in pausing rate hikes, inflation has crossed its projected 5.5 per cent, credit growth is robust at 30 per cent despite the central bank's attempts to rein it.

Will we then see a situation sometime in the future where the current robust growth of profitability will be in danger when interest rates really start pricking corporates?

That doesn't seem to be a problem right now, and at least for the next two to three quarters if the interest to operating profit ratio of the 500-odd companies having a turnover of more than Rs 200 crore in the first half of this fiscal is anything to go by. And, surprisingly, half of these companies have seen this ratio fall y-o-y in the first half of FY07.

Obviously, if the interest-operating profit ratio is low, it indicates that operating profits are growing faster than interest costs. The companies which fall into this category belong to sectors like FMCG, pharmaceuticals, metals and mining, auto ancillaries and textiles.

Are these companies good bets, especially when the Sensex has peaked and touched another all-time high levels of 14325.9 points? Read on to find out what favoured the gainers and what went wrong with the losers, if they qualify for investments at current levels.

IMMUNITY PASS
While India Inc is booming and demand across sectors is buoyant, companies' operating profits have grown faster than the interest costs partly also due to benign interest rate regime for the past few years.

As a result, of the total 532 sample companies that have a turnover of Rs 200 crore in H1, about 72 per cent or 383 companies witnessed a marginal rise (upto 300 basis points) or a decline in the interest-operating profit (I-OP) ratio.

If you go deeper, then the finding is even more heartening. Of these 383 companies, nearly 68 per cent witnessed a decline in the ratio while the remaining 32 per cent saw an increase of up to 300 basis points. Reasons? As Vasudeo Joshi, head-institutional sales, Man Financials, rightly points out, "Strong operating leverage, upturn in business cycle for most industries and efficient use of debt are the prime reasons for the improvement in the ratio."

Adds Sandeep Nanda, head of research, Sharekhan, "Falling debt to equity ratio due to strong internal accruals and raising more of equity (mainly in the form of FCCBs which carries nominal interest if any), utilisation of the earlier unused capacity are some reasons."

Besides, while capex projects of many companies are still in the work in progress stage, the interest costs are added as capital costs and thus, they are not yet reflected in the profit and loss account, he further adds.

In FY06, about 60 per cent of the total 383 companies had debt-equity ratio of less than one as compared to 42 per cent in FY05. Partly, the reason could be high growth in reserves and rise in equity capital.

A whopping 90 per cent of the total companies witnessed growth in reserves. But that also means deploying internal accruals for future expansions or repayment of debt, which again means lower I-OP ratio.

About 39 per cent of the 383 companies raised equity capital with 17 per cent of them seeing an increase of over 25 per cent in equity capital. Besides this, about 68 per cent of the companies saw a growth in cash.

This helped many companies to reduce dependence on high cost debt. Thus, around 40 per cent of the high performers witnessed no change or decline in their debt while 60 per cent witnessed an increase in their debt in FY06. 
 

RISKY BETS
Companies	Debt- Equity*	Interest  expenses#	Operating  profit #	Net  profit#	P/E  (FY07E)	P/E  (FY08E)
JIndal stainless	2.20	248.00	50.00	34.00	5.60	NA
Jet Airways	2.10	4.50	-70.00	-161.00	Loss	Loss
MRPL	1.40	26.00	-24.00	-41.00	NA	NA
Arvind Mills	1.20	6.00	-31.00	-85.00	23.20	14.20
TVS Motors	0.50	138.00	-5.00	-19.00	13.60	10.40
NTPC	0.40	152.00	37.00	22.00	16.60	14.00
Zee Tele	0.30	178.00	-32.00	-50.00	NA	NA
Madhucon Projects	0.30	4061.00	133.00	206.00	24.20	14.50
Micro Inks	0.20	157.00	-84.00	-154.00	NA	NA
Matrix	0.20	137.00	-21.00	-31.00	14.50	10.30
* For FY06, # Percentage change year on year in H1FY07

Even in H1 FY07, over 60 per cent have been on an equity capital raising spree, which augurs well for the ratio.

Another factor for the fall in I-OP ratio is also strong business dynamics prevalent in the economy leading to robust demand and thus profitability growth.

While over 87 per cent of the companies reported increase in operating profits in H1 FY07 (up from 81 per cent in FY06), the proportion of companies witnessing a rise in interest costs lagged far behind at 63 per cent (60 per cent in FY06), thus improving the I-OP ratio for most of them.

LOW INTEREST
Surprisingly, most of the companies that have reduced their interest to operating profit ratio had a debt-equity of over one in FY06. However, their I-OP ratio is still low as their operating profits grew at a skyrocketing pace in H1 FY07 much faster than interest costs.

Cement (India Cements, JK Cement, Madras Cement, Gujarat Ambuja and UltraTech), construction and real estate (Patel Engineering, Gammon, Unitech and Ansal Properties) and retail and lifestyle related companies (Gitanjali Gems, Titan Industries, Rajesh Exports and Indian Hotels) figure among the top 100 companies.

Though these stocks have seen a significant run-up, market players are still positive about most of them.

Says Deepak Jasani, head of research, HDFC Securities, "Cement companies still look good for the next one or two quarters."

Many of the cement and construction companies like India Cements, Madras Cements, UltraTech, Unitech and Patel Engineering are attractively valued. Even lifestyle related companies, which are witnessing a huge unprecedented growth in their business thanks to growing purchasing power and aspiration of consumers are trading at reasonable valuations except Titan.

In all, the above companies are comparatively at lower risk due to greater visibility and better profitability prospects.

FEELING THE PINCH
The proportion of companies, that reported a higher I-OP ratio are less. Thus if you are invested in them, then you need to keep a watch on them because they will be more vulnerable to profit decline on account of higher interest rate scenario.

The remaining 28 per cent (or 149 companies) of the total sample of 532 companies witnessed an increase of over 300 basis points in the ratio in H1FY07.

The profitability of these companies was affected by higher interest costs either due to major capex funded by mostly debt or lower operating profit growth due to weak industry scenario.

About 64 per cent of these companies had a debt-equity ratio of over 1 in FY06. One obvious reason is the increase in debt on the books of these companies or lower growth in reserves and cash. Over 77 per cent of the total 149 companies witnessed a growth in their total debt in FY06, with over half of the total seeing a growth of over 25 per cent.

This is despite a good 48 per cent of the companies witnessing an increase in equity capital, and 90 per cent showing growth in reserves and 64 per cent of them seeing growth in cash. Even in H1 FY07, over 50 per cent of the companies went for capital raising.

Another reason is that the operating profit growth was lower as compared to that in interest costs. Though 62 per cent of the companies showed increase in operating profits, 89 per cent of the companies showed a rise in interest costs in FY06. The scenario even worsened in H1 FY07 with a whopping 93 per cent showing growth in interest costs.

ARE THEY RISKY?
Even if the I-OP has gone up, some of these companies may make investment sense. Micro Inks, Zee, Madhucon Projects, Matrix Laboratories, NTPC and TVS Motors figured among the top in terms of higher I-OP ratio despite a lower gearing.

This means that either these companies were facing problems in their business environment (Micro Inks, TVS Motors and Matrix) or their businesses are on a major expansion stage (Madhucon Projects).

On the other hand, there are companies like Jet Airways, Arvind Mills, MRPL and Jindal Stainless, which have higher I-OP ratio thanks to their higher gearing of over 1.25-2 times in FY06.

Moreover, their profitability in the last few quarters has not been that great and interest costs on the other hand have shown a rise. So analysts need to be cautious about them as the valuation of many of them look stretched except Madhucon, Matrix and NTPC.

Market analysts are cautiously positive on Micro Inks but the improvement in the I-OP ratio has to be closely watched. However, declining crude oil prices will lead to better profitability. 
 

SAFE N CHEAP BETS
Companies	Debt- Equity*	Interest  expenses#	Operating  profit #	Net  profit#	P/E  (FY07E)	P/E  (FY08E)
Rajesh Exports	5.70	58.00	178.00	310.00	NA	NA
Unitech	3.10	216.00	476.00	751.00	60.60	19.20
Patel Engineering	2.20	25.00	172.00	186.00	26.90	19.10
KEC International	1.80	28.00	73.00	117.00	19.00	14.00
Madras cement	1.50	-1.40	37.00	78.00	14.00	10.50
Ultratech	1.40	4.00	180.00	463.00	18.50	15.30
Jyoti Structures	1.30	-55.00	40.00	88.00	24.20	14.90
Titan Ind	1.20	-18.00	25.00	18.00	31.90	25.00
Mcnally bharat	1.00	-0.30	88.00	320.00	24.10	11.80
India cement	0.90	-14.00	147.00	1978.00	12.80	10.20
J K cement	0.90	-34.00	155.00	812.00	7.80	7.80
Ansal Properties	0.70	-27.00	24.00	36.00	NA	NA
Gitanjali Gems	0.70	-26.00	47.00	85.00	19.90	12.80
Gujarat Ambuja	0.50	-53.00	100.00	149.00	21.00	17.80
Indian hotels	0.30	-31.00	57.00	95.00	23.40	19.80
Gammon India	0.20	-66.00	-1.90	11.40	32.30	22.50
* For FY06, # Percentage change year on year in H1FY07

Analysts are not worried about Madhucon's high I-OP ratio as the construction company's prospects are strong and good profitability is quite predictable.

Moreover, the company has also proved its mettle by reporting a growth in the top line in the range of 50-80 per cent in last few quarters and has shown consistent improvement in performance.

So, even if interest rates rise a bit going forward, a large section of India Inc will not have a problem over the next two to three quarters. For the time being, investors needn't worry about the impact of rising interest rates on corporate profitability.