Profit margins remain under siege
Premium- For the auto sector, rise in prices of retail fuel, aluminium, and precious metals makes road rougher
- Higher petcoke and coal prices pose a risk to earnings of cement companies in the near future
MUMBAI : Companies were just about recovering in the aftermath of the third covid wave, when the Russia-Ukraine conflict started. The crisis has led to a spike in prices of many commodities, including oil, aluminium and coal. This has added to the already-elevated inflationary pressures, weighing on the profitability of companies across sectors.
“Rising input prices are a cause for concern for seven sectors (autos, consumer staples, discretionary, industrials, pharma, cement and chemicals), which together account for 24% of Nifty weight," said analysts from Jefferies India Pvt. Ltd in a report on 3 March. Jefferies’ analysts build in 50-250 basis points (bps) Ebitda margin expansion in these sectors in FY23. This may see cuts, according to the brokerage firm. Ebitda is earnings before interest, taxes, depreciation, and amortization. One basis point is 0.01%.
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The longer the conflict lasts, the more devastation and economic pain is in store. Against this backdrop, incremental risks to global supply chain disruption persist. In addition, the lengthy shipping delivery timelines would add to the cost of importing raw material. As such, companies that raised prices in the December quarter can be expected to have some near-term cushion to their margins.
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Understandably, the stock markets are anxious. Since Russia invaded Ukraine in the early hours of 24 February, the Nifty50 index has lost 4.8%. Among sectoral indices, the Nifty Auto index has been the biggest loser, falling by 12.5%. Simultaneously, the Nifty Metal index has gained 7% because of an anticipated boost to price realizations.
For the auto sector, the road has become rougher. Kotak Institutional Equities’ analysis shows automotive OEMs’ (original equipment manufacturers’) raw material basket prices increased by 90-160 bps in Q4FYTD22 and 170-360 bps on current spot prices from Q3FY22 levels because of the sharp jump in aluminium and precious metal prices. Kotak expects Maruti Suzuki India Ltd and two-wheeler makers’ gross margins to be the most impacted.
Already, price hikes by OEMs to battle cost inflation and higher retail fuel prices have increased the cost of ownership for consumers. “Total cost of ownership for two-wheeler consumers increased by 15-16% year-on-year (y-o-y) in FY2022," said Kotak’s analysts.
Moreover, retail fuel prices are expected to be increased after the Assembly elections, which may further impact demand. However, the extent to which retail fuel prices are increased remains to be seen, with some expecting the government to also cut excise duties to soften the blow on consumers. On Friday, Brent crude prices closed at $123.5 per barrel.
For the fast-moving consumer goods sector, higher crude prices raise packaging costs. The sharp rise in palm oil prices does not bode well for many consumer firms.
International coal prices have also spiked. Crude-derived petroleum coke (petcoke) and coal are key inputs for manufacturing cement, which is not good news for the sector. “Imported coal/ petcoke prices are up 40% from the exit of December 2021 because of the current geopolitical tension, while domestic petcoke prices also increased by about 24% month-on-month in March 2022," ICICI Securities Ltd pointed out. Power and fuel costs are estimated to account for 25-30% of the sector’s total operating cost.
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Meanwhile, Coal India Ltd (CIL) is expected to benefit from rising e-auction premiums over the fuel supply agreement (FSA) prices. Also, FSA price hikes are expected. However, overall rising coal prices would weigh on the power sector. “India is already battling a coal shortage as CIL’s supplies are below demand because of a pickup in industrial activity. Plus, higher global coal prices make imports inaccessible to many power companies. This is a tough situation as we head into the peak summer season power demand," said Rohit Natarajan, an analyst at Antique Stock Broking Ltd.
Further, rising global gas prices are expected to lead to an upward revision in domestic gas prices in FY23. This would squeeze margins of city gas distribution companies and may also hurt volumes. Plus, high spot liquefied natural gas prices would make imports costlier.
True, companies can raise prices and pass on the burden of increased operating costs to end-consumers, but the subdued demand environment makes it challenging to do so.
Companies in the cement sector have attempted to hike prices several times in the past two quarters, but on most occasions, they had to be rolled back on poor demand.
As such, the overall surge in energy prices is a pressing concern. “We struggle to see prices settle and sustain at those levels (Newcastle coal at $260/t, spot LNG at +$25MMBtu or Brent at +$110/bb) as eventually, end demand would come off the longer the prices sustain at such levels," Pinakin Parekh, an analyst at J.P. Morgan India Pvt. Ltd, wrote in a report on 2 March, He added, “The issue, however, that we see is that energy prices are unlikely to collapse from here very quickly and the new normal could be for prices to be in a range near current levels. The issue for Indian policymakers is not only limited to oil and retail fuel prices, though this gets the most investor attention but applies to gas and coal as well."
Oil prices had risen 50% in 12 months until 23 February, even before Russia invaded Ukraine. The outlook is firm. “Even if the Russia-Ukraine conflict eases soon, higher oil prices are here to stay. The thrust towards decarbonization and clean energy has meant that companies have underinvested in capex to boost production since 2019. This would cap supply in the global market in a world that is slowly recovering from the covid-19 pandemic, creating upward pressure on prices." said Ritesh Jain, a global macro investor and a former executive at BNP Paribas Asset Management India Pvt. Ltd.
For now, the uncertainty in global geopolitics makes it difficult to ascertain for how long commodity prices will continue to rise.
However, the near-term outlook would largely be driven by news flow arising from the ongoing conflict. Some developments to watch out for are the kind of sanctions imposed on Russia, whether the Organization of the Petroleum Exporting Countries ramps up oil production, and whether China comes to Russia’s aid.
That said, the fears of eroding profitability and increased uncertainty have dampened investors’ sentiment. “We have recently cut our Dec’22 Nifty target to 17,500. The rising threat of a twin deficit, rising rates and lower global liquidity suggest that returns are likely to stay subdued near term," the Jefferies report pointed out.
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