HITTING A RAW NERVE

HITTING A RAW NERVE

With commodity prices hitting their all-time highs, margins of manufacturing companies are under pressure. Though companies use a variety of measures to protect their bottom lines from rising raw material prices, these are not enough to mitigate the risk. ET Intelligence Group analyse the impact of rising input costs on companies

THE commodities cycle has yet again turned bullish. Although better placed than their retail counterparts, manufacturing companies are not insulated from the impact of rising raw material prices. There is little relief from the rising wholesale price inflation. The inflation index has moved up to 8.4% in December from 7.5% in November. If these numbers are any indication, prices of most basic items of consumption have shot up (see the table). Prima facie, this indicates an inflated raw material bill for manufacturing companies but it is not bad news for all.
Companies use variety of means to protect their bottom lines from escalating input costs. Some enter into forward contracts by booking the price of a key commodity in advance for the next few quarters. There are others, which hedge their commodity exposure by taking a position in the futures market equivalent to their physical market requirement. Some other companies ensure supply of raw materials at competitive prices through contracts with farmers or producers. While all these measures do help in mitigating the risk of input prices, none of these is enough to ensure a complete insulation. Though companies from almost all sectors are impacted, some sectors bear the brunt more so than others. Even within a sector, some companies end up getting severely impacted than others due to their distinct product profiles. To understand this better, ET Intelligence Group studied the impact of rising costs on a sample of companies that feature in the BSE 500 index.
We analysed the impact of increasing input costs on companies, which spend more than 40% of their revenues to cover raw material costs. We excluded corporate producers of commodities. Read on to know more about the impact of higher costs on these companies and which of them could still be able to maintain their profitability.

CAPITAL GOODS: These companies typically spend 60-70% of their revenues on sourcing raw materials like ferrous and non-ferrous metals. Capital goods players such as ABB, Siemens, Thermax, Voltas, Cummins India, Crompton Greaves, Havells India, BEML and Bhel figure in our study. Rise in input costs has a negative impact on capital goods companies. But the companies that command a premium on products would be in a position to pass on higher input prices to customers. Also, those who enjoy flexibility in contracts with their clients could reduce the impact of cost escalation by revising the contract prices upwards. Companies such as ABB, Siemens, Thermax and Suzlon that have fixed price contracts are likely to adversely impact due to a rise in input prices. On the other hand, Bhel, which mostly has long-term projects in its order book, is likely to be less impacted. Cummins is also not likely to have a significant impact because of its high pricing power due to superior product profile. Voltas, with high pricing power in selected markets, will also be among the less affected ones.

AUTO: Input costs constitute 65-75% of total revenues of automobile manufacturers. These include Maruti Suzuki, Ashok Leyland, Bajaj Auto, Hero Honda, M&M and Tata Motors. Despite firm input costs, Tata Motors (on a consolidated basis) has been able to withstand a difficult operating environment over the past few quarters. This is largely due to revival in sales volumes in emerging markets for its Jaguar Land Rover brands. In addition, the company’s earlier cost-cutting plans have paid off. This trend is expected to continue in the coming quarters. In contrast, Maruti Suzuki’s operating profit margins have been under pressure as it has not been able to fully pass on higher input costs to customers. Its margins for the December quarter are expected to fall by 350 to 400 basis points.

CONSUMER GOODS: Inflationary environ ment is conducive for the growth of the consumer-oriented sector. It is partly due to a rise in consumer buying during a period of high inflation. The other key reason is companies with branded products can afford to increase prices without impacting sales. The only concern is that rise in the product price may not be proportionate to the increase in input costs. Asian Paints, HUL, Castrol, Nestle, Godrej Consumer Products, Dabur, Tata Global Beverages and Marico are the companies that figure in our list. While these companies may register contraction in their profit margins on account of high input costs, they will also report higher revenue growth. HUL, the industry leader, is likely to gain the most.

BEARING THE BRUNT
TYRES
Leading tyre companies, MRF and Apollo Tyres, have reported shrinking operating margins due to higher rubber prices. To meet the rising cost of production, these companies have increased prices of their products by 15-20% last year. But the measure has proved inadequate. Though toplines may show some buoyancy, these companies are expected to report further contraction in profitability.

OIL REFINING
Petroleum refineries use crude oil as input for producing a range of petroleum products, such as LPG, petrol, diesel and kerosene. It is a case of producing a chunk of heavy products that command a price lower to that of the raw material itself. In such a situation, rising crude oil prices may impact the refining business.
However, that is not the case always. Just like crude oil, refined products are independently traded commodities in the international markets.
If prices of refined products gain in line with the crude oil prices, refining margins are safeguarded. For instance, during the December quarter, the crude oil prices hit their $75-85 per barrel range and moved past $90. In spite of that domestic refiners are expected to post strong refining margins as demand for refined products improved.
In the coming quarters, the profitability of the oil refiners will depend mainly on the demand-supply forces rather than movement in the crude oil prices. A number of economists expects the global economic growth to slow down in 2011 as the impact of economic stimulus packages in various countries wane off. This could result in a slower growth in demand for oil products.
Refiners’ margins, hence, are expected to remain at modest levels. Reliance Industries, Indian Oil, HPCL and BPCL are the oil refiners in our sample.
Companies are better prepared to manage bottom lines during the period of a steady rise in commodity prices rather than the time of volatility in prices. In the long run, almost all companies pass on the cost rise to consumers. However, when prices increase sporadically, it’s impossible for companies to pass it on to customers.