| Hurdles to cross |
|
| Vishal Chhabria & Ram Prasad Sahu / Mumbai August 18, 2008, 3:15 IST |
|
The going gets tough for banking, auto and realty sectors in the next six months. Invest, but with a long-term perspective.
Inflation and interest rates, typically, go hand-in-hand, except for some short-term divergence. Central bankers the world over use ‘interest rates’ as a tool to keep a tab on the country’s inflation rate.
This is exactly what India has seen—the Reserve Bank of India has at different time intervals (more frequently in the last 12-15 months) hiked the repo rate (at which it lends to banks) as well as the cash reserve ratio (CRR; the portion of interest free balance that banks are mandated to keep with RBI.)
While these moves increase the cost of funds for banks, it also means higher costs for corporate and retail customers. Higher rates mean lower affordability and, thus the impact on demand for goods and services, as well as profitability of companies and banks.
With inflation rate on an upward trend (now at its 13-year high of 12.44 per cent) and expected to rise to over 13 per cent over the next two months, experts (economists and analysts) believe that the RBI may hike rates further.
On the other hand, sectors that tend to get impacted more when interest rates move up have seen stock values inch up faster recently.
The BSE Bankex and BSE Realty indices are up 27.8 per cent and 22.4 per cent, respectively in the last one month (since July 16), as compared to the 17.1 per cent rise in the value of the BSE Sensex. Even the BSE Auto index is up by 15.9 per cent in the last one month.
Although these sectors had also underperformed since January 2008, some argue that the market is reading beyond two quarters, wherein it expects inflation (and interest rates) to bottom out by December 2008 and start declining from early 2009. But, whether that happens or not will depend on various factors including global commodity prices among other things.
In the light of various developments, The Smart Investor takes a look at the three interest rate sensitive sectors viz. auto, banking and real-estate, and provides an insight into the current state of affair and their fortunes going forward.
BANKING
Pain to continue in the short-term
Banking stocks have seen significant underperformance as well as outperformance vis-à-vis the popular indices in different time periods during the last seven months.
The earlier underperformance (January 2008 to mid-July) is due to known factors like rising interest rates and inflation, slowing credit growth, pressure on net interest margins (NIMs) and potential threat of rising non-performing assets (NPAs), which is also visible in the performance for Q1 FY09 (ended June).
However, their outperformance (Bank Nifty up 34.8 per cent; Nifty up 18.7 per cent since July 16) in the last one month is not backed by an improvement in fundamentals.
Explains a banking analyst, “The change in sentiment is consequent to the softening in commodity prices (including crude oil) globally, marginal decline in domestic bond yields and, hopes of acceleration in banking reforms and moderation in inflation.”
But, the ground reality hasn’t changed much, especially inflation, which is only expected to remain high till December 2008.
Says Manish Karwa, senior vice president, research, Motilal Oswal Securities, “Inflation is likely to remain high for some time, and we don’t expect any softening in interest rates till then. We may possibly see some more tightening by RBI.”
Given the low base of inflation during second half of last year, inflation is only expected to inch up to beyond 13 per cent. And, the recent tightening (CRR and repo rates) by RBI would also have a lag effect on economic growth rates.
All these only suggest that the performance of the banking sector is likely to remain under pressure and this euphoria is thus likely to be short-lived. No wonder, many analysts echo the same view, “there is some more pain left, before things improve for banks.”
They are not excited about the short-term (4-6 months) prospects of the banking sector with some suggesting that the RBI is likely to tighten the noose further, by raising repo rates and CRR.
This anticipated move is expected to further increase the cost of funds for banks. Should that happen, banks could see further pressure on margins, perhaps higher customer defaults, higher losses on trading (bond) portfolio and a slowdown in business itself. The silver lining is that the prospects for the sector look good in the long run.
Margins: Under pressure
The RBI has raised the repo rate (125 bps in last 12 months) and CRR, both of which are currently around 9 per cent levels. These moves have increased the cost of funds for banks.
Since interest rates on deposits have also moved up to 10 per cent (one-year deposits), the highest in nearly over five years, there are high chances of customers moving their surplus current and savings (CASA) deposits to fixed (term) deposits, thereby further increasing the cost of funds for banks.
Analysts say that in a rising interest rate scenario, banks with a high CASA ratio are better placed vis-à-vis those with a lower CASA metric. That’s because, CASA deposits attract low interest rates (interest on current account balance is nil, while on savings account it is 3.5 per cent per annum).
They estimate that an increase of 100 basis points in CASA can improve NIMs by 10 basis points; as cost of CASA deposits remains constant even as lending rate charged to customers rises.
On the other hand, while the banks have resorted to hiking their respective prime lending rates (PLR), analysts expect the pressure (though not significant) on the NIMs to continue in Q2 FY09.
Thereafter, NIMs could stablise and perhaps improve from Q1FY10. Some of this pressure could also be offset considering that some banks have increased their deposit rates by a lower margin, and thus provide a surprise (beat estimates).
| KEY NUMBERS |
| Rs crore | TTM ended June 2008 | Price
(Rs) | P/BV (x) | NIM
(%) | CASA
(%) |
Net
Interest
Income | % Chg | Net
Profit | % Chg |
| Axis Bank | 2,975 | 81.2 | 1,226 | 71.8 | 700 | 2.86 | 3.4 | 39.8 |
| HDFC Bank | 5,966 | 61.4 | 1,733 | 41.7 | 1,175 | 3.62 | 4.1 | 44.9 |
| ICICI Bank | 7,915 | 28.9 | 4,527 | 24.1 | 673 | 1.61 | 2.4 | 27.6 |
| Indian Bank | 2,080 | 9.0 | 1,014 | 28.1 | 111 | 1.05 | 3.2 | 33.8 |
| PNB | 5,698 | 4.4 | 2,156 | 28.7 | 466 | 1.36 | 3.3 | 41.3 |
| SBI | 17,638 | 4.3 | 6,944 | 25.3 | 1,458 | 1.88 | 3.0 | 41.2 |
| Union Bank | 3,105 | 7.4 | 1,281 | 41.7 | 138 | 1.24 | 2.7 | 34.8 |
| Source: BS Research, Analyst report |
Asset quality & treasury income: Under stress?
The other area of apprehension is the threat of rising NPAs, which though will vary depending on the portfolio quality of individual banks.
Says an economist, “In any downturn, the asset quality tends to deteriorate. But, unlike in the past, the recovery systems for banks (including debt recovery tribunal, implementation of SARFESI Act, etc) are much stronger.”
Adds Tridib Pathak, CIO, Lotus AMC, “In a slowdown, NPAs can increase, which is a cyclical risk. But, are there signs of any secular deterioration? Certainly not!”
Economists explain that defaults are largely seen in non-collateral areas (mainly retail) like credit cards, personal loans, etc. Out of the retail assets, which form about 25 per cent (average) of total advances, about 18 per cent comprises housing loans, which are backed by assets.
And, the remaining seven per cent comprises of auto loans (backed by vehicle as a security), credit cards, personal loans, etc. Thus, in a worse case scenario, the defaults will be within manageable limits.
On the other hand, with interest rates on the rise and a good chance of RBI hiking rates further, banks may have to provide for the fall in bond values (held in available for sale (AFS) category), thus impacting profits over the next one-two quarters. But, the same would get reversed (since it is a book entry) thereafter, as interest rates decline.
Growth rates: Seen slowing down
Higher interest rates mean lower affordability and hence, are expected to lead to slower growth in retail and corporate advance, which is already happening. Banks, too, have deliberately put some brakes on providing credit to the retail segment to keep a tab on credit quality.
With access to foreign funds (ECB, etc) not coming easily, and equity markets in the doldrums, demand from corporate India has however been healthy.
Says Tridib, “Due to various reasons (including the fall in stock markets), the corporate finance activities have improved. This is on account of critical projects, including infrastructure and capex, where demand for credit is unlike to wane.”
Thus, overall credit growth is expected to slow down from over 25 per cent currently to around 18-20 per cent. Regards the fee-income, this too is likely to slow down over the next few quarters but still remain healthy between 15-25 per cent. Nonetheless, the overall income and profit growth for the industry should be at a respectable 15-25 per cent.
The silver lining
Even as the outlook for the next six months remains subdued led by rising costs, asset quality concerns and higher provisions, the sector’s medium-to long-term prospects continue to look good. Explains Tridib, “If you look at the last 15 years, the NIMs of banks have averaged around 3 per cent, which is across interest rate cycles.
This is because banks are a classic ‘pass-through’ mechanism. If you look at the recent hikes, banks have passed on the cost increase through PLR hikes. So, any pressure on margins will be temporary and over a period margins will remain stable and possibly inch up.”
Adds Karwa, “Margins should not correct from current levels, and are likely to be maintained as banks are also increasing lending rates.”
So, while it may take time for the clouds to clear off completely, the sector (stocks) is expected to see range bound trading. For instance, if the RBI hikes repo rates or CRR further then expect banking stocks to be hit in the interim. Likewise, in the current situation, any further upside is unlikely.
Meanwhile, watch out for any surprises that could come up in the form of significant losses on account of forex exposure (arising from exposure to credit derivatives, as yields have hardened in international markets) and, on account of asset quality and NIMs over the next two quarters.
Any spike in prices of crude oil or commodities to recent peaks (low probability as per experts) could prove to be dampeners, and cast their ominous shadow on the prospects of the banking sector.
Thus, any downward swing in market sentiments could be used as an opportunity to selectively buy banking stocks. Experts prefer banks with high CASA ratio, strong management and good liability (loan) profile.
Among preferred picks include Axis Bank, HDFC Bank, Union Bank of India, Indian Bank, Federal Bank, South Indian Bank, PNB, SBI and ICICI Bank.
REALTY
Grappling with low demand
“Some of the real estate players are land bank rich, but cash poor,” said a CEO of a large Bangalore-based realty firm referring to the liquidity problems being faced by real estate players.
While the real estate players The Smart Investor spoke to believe that the liquidity crunch and rising costs are a short-term phenomenon, analysts are of the view that the pain is going to last for at least two quarters if not more going ahead.
The rise in interest rates, the spike in input costs and drying up of funding options has led to a dip in prices, drop in profit margins and slowdown in development of construction projects.
The high three digit year-on-year growth in sales, EBIDTA and net profit registered in every quarter over the last few quarters is passé and this is reflected in the June quarter results of the companies that constitute the BSE Realty index.
Though some of it is due to a high base, the slowdown in demand has had its impact with sales and profit margins registering lower double digit growth. Unless the situation related to the high cost of capital, input costs and most importantly demand changes for the better, the sector could see worse days over the next three months.
Input costs
Construction costs for realty players have gone up by about 20-40 per cent over last one year. While cement prices are stable after inching up over the last four years, prices of steel shot up 26 per cent over the last one year with the spike coming in towards the end of 2007.
While most developers are passing on the cost to consumers or partially absorbing them, some such as DLF have been able to save about 15 per cent of the cost of steel by importing prefabricated steel from China and value engineering their processes.
Funding issues
Over the last one year, realtors have seen their debt cost go up by 300 bps to around 14 per cent. With banks being circumspect about giving loans to realtors and insisting on necessary clearances from local authorities before approving loans, some realty players are forced to look towards NBFCs and in some cases private parties to fund their expansions.
Such infusion of funds, however comes at a price of higher lending rates and thus adds to the interest burden.
Says Sahel Pramendra, managing director – North, Jones Lang LaSalle Meghraj, a real estate consulting firm, “Due to rising cost of funding and high real estate cost there is a significant pressure on margins. Alternatives such as private equity or mezzanine funding are becoming popular. Public markets are not an easy option considering the unfavourable market conditions and due to the prevalent guidelines, external debt is not possible.”
With cheaper sources of funding closed on them, realtors are hoping that the waning consumer demand picks up. Though there is latent demand, analysts argue that unless prices correct by 10-15 per cent there is no incentive for the real estate buyer to look at property purchase in the current high interest scenario.
Demand
Higher interest rates are having an impact both on the realty players as well home loan seekers. Says Angshuman Magazine, managing director of real estate consulting firm, C B Richard Ellis for South Asia, “High interest rates may force realty players to scale down the size of their projects and offer sops to attract investors.”
Housing loan disbursals by the country’s top home loan providers are down sharply as buyers postpone purchases due to the high costs and in the hope that prices and interest rates will come down going forward.
Commercial property prices which were resilient especially in tier 1 cities could start to weaken as the biggest catalyst in the form of IT/ITES expansion could see a slowdown on the back of lower y-o-y employee editions by the IT majors.
Incremental demand in commercial realty is likely to come from SEZs. Residential prices have corrected sharply in some metros and analysts expect some more correction to set in. While the current quarter is traditionally a muted one in terms of sales, the festival season and a dip in property prices could entice the buyer (actual user) to come back, higher EMIs not withstanding.
Battered stocks
While shares of listed real estate players have recovered over the last one month with BSE Realty gaining 22.4 per cent, over the year the Realty index is still down by a third.
Going forward, analysts believe that net asset values (a valuation metric) is likely to move down on the back of lower property prices, higher costs and slow pace of execution.
Analysts say that a 20 per cent reduction in price of property results in about 33 per cent drop in their NAVs and a 30 per cent price drop lops off half of the NAV, thus putting pressure on profits and valuations.
Given the current situation, analysts believe that DLF (execution track record, experience, land bank and project profile) and HDIL (attractive valuations) are the best bets in the current scenario, and can be looked at on declines.
| LONG TERM BETS |
| FY09E in Rs crore | M&M* | Maruti Suzuki | Hero Honda | Bajaj Auto* | DLF | HDIL |
| Sales | 12,893.70 | 21,348.60 | 11,313.32 | 9,356.36 | 15,367.00 | 3,808.00 |
| % change | 14.00 | 19.00 | 9.50 | 8.00 | 8.00 | 60.00 |
| EBIDTA | 1,291.50 | 2,270.00 | 1,376.35 | 1,201.80 | 10,326.62 | 2,419.56 |
| Net profit | 882.60 | 1,713.49 | 1,025.95 | 793.70 | 6,915.15 | 1,690.75 |
| Price | 583.00 | 650.55 | 785.10 | 561.85 | 501.00 | 431.00 |
| P/E | 16.78 | 10.97 | 15.30 | 10.26 | 12.35 | 7.02 |
| *Standalone Source: Analyst reports |
AUTO
Knocked out by interest rates
The automobiles sector is inextricably linked with economic activity in the country. While the sector is divided into two wheelers, passenger and commercial vehicles, it is the latter two which bear the brunt of any slowdown in the economy or high interest rates.
A slowdown in industrial activity invariably puts the brakes on the goods moved into different parts of the country and therefore the medium of transport--commercial vehicles.
Increase in input costs has forced the country’s biggest commercial vehicle companies to hike the price of their products, making it that much more difficult for truckers to offset their high investment cost despite the discounts and attractive finance schemes.
Tepid sales
Auto sales in July which saw muted passenger and commercial vehicle sales due high cost of fuel and interest rates are an indication of the sluggish nature of customer demand. While sales of passenger and utility vehicles are down by 2 and 7 per cent year-on-year in the domestic market, medium and heavy commercial vehicles are down by 1 per cent in the same period. It was not just the demand side that pinched.
Thanks to the high raw material, employee and other overhead costs, EBIDTA margins for the major manufacturers, with the exception of TVS Motors and Hero Honda, are down by a minimum of 100 bps.
Two wheelers/Passenger vehicles
Analysts believe that the passenger vehicle segment which has seen a 11 per cent increase in year-to-date sales could see a spurt as companies get ready to launch a slew of new cars and variants over the next two quarters.
In expectation, buyers tend to postpone their purchase decisions as they believe they will get a better car, hopefully, at an attractive price. As lenders finance 70 per cent of the cars procured in the country, a rise in interest rates and subsequent hike in EMI instalments makes this an expensive affair.
Says an analyst, “Cars are a discretionary spend and the increase in interest rates will force the buyer to rethink on the decision.” To improve their spreads, auto financiers such as HDFC Bank and Kotak Bank are now approaching customers directly instead of routing the proposals through dealers.
This not only helps in cutting costs but also allows them to verify customer records first hand and control their NPAs.
Two wheelers, due to their low unit price have not had the interest rate problems which have beset sales of larger vehicles. This is one of the reasons in addition to a low base which helped two wheelers buck the trend in the July quarter and grow by 20 per cent y-o-y.
Commercial vehicles
While commercial vehicle majors such as Tata Motors and Ashok Leyland have passed on some of the increase in input costs, they have not been able to achieve volume growth due to high interest rates.
In addition to high rates that causes an additional burden on truckers, slowing down of industrial production as compared to last year is a cause for concern. Unless interest rates come down (unlikely) or manufacturing activity picks up, CV manufacturers will have to contend with the triple whammy of high input costs, high interest rates and sluggish manufacturing activity.
While auto scrips have jumped 16 per cent over the month on the back of a drop in fuel prices globally, the short to medium term outlook for the sector, especially the commercial vehicles is rather bleak.
Experts recommend that investors pick stocks which have shown strong domestic volume growth (Hero Honda), Maruti (launch of A-Star and Splash), M&M (investment portfolio) and Bajaj Auto (diversifying into four wheelers and LCVs).
Primary market reforms have been on top of the agenda of Securities and Exchange Board of India (Sebi) Chairman Chandrasekhar Bhaskar Bhave, who completes six months in the hot seat today.
