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Sowmya Sundar

April 10, 2003: Mastek declares earnings numbers for the year 2002-03. The market downgrades the stock and 50 per cent of its value is wiped off in a single trading session.

THE market had expected much higher numbers as Mastek had, only a couple of months ago, upped its earnings forecast for 2002-03.

The company made the announcement on the basis of the six-month performance for the period ended December 31, 2002. Subsequently, when it failed to meet the projections and reported much lower earnings than expected, the stock was dumped, resulting in chaos.

When the management, which has superior information, can go wrong in forecasting earnings based on half-yearly performance, investors with access to minimal information cannot obviously be expected to predict a company's earnings by extrapolating the quarterly or half-yearly performance for the full year.

Good reference, not a good guide: Stock prices react sharply to quarterly performance announcements. But quarterly numbers do not always indicate how a company will fare for the full financial year.

Quarterly earnings announcements do, however, serve to compress the time-frame in which key numbers remain in an insiders' domain. This is important as, otherwise, insider trading may become rampant. But to base investment decisions solely on these numbers may not be a good idea.

Mastek is not a one-off instance where quarterly earnings announcements failed to indicate the actual performance for the full year. Blips in quarterly earnings announcements are common across companies and industries. The reasons may be external or company-specific.

Blips galore: A look at the earnings performance for the 50 companies in the Nifty basket for 2002-03 indicates that most companies reported vast variations in their earnings performances across the four quarters.

The numbers for any particular quarter do not, in most cases, give a realistic picture of the sustainable performance for the full year.

One-time gains: In the fiscal year just ended (2002-03), banks, steel and oil and gas companies reported commendable performances, especially in the latter part of the year. Companies such as Tata Engineering, Tata Steel, ONGC, HPCL and Canara Bank reported robust sales and earnings growth.

The profitability of banks was primarily boosted by treasury income. As interest rates declined and bond prices rose, banks made windfall gains.

As a sharp reduction in interest rates from this level is limited, banks cannot piggyback on treasury income for growth and have to depend on core credit offtake.

The reliance on treasury income had decreased in the last two quarters, compared to the earlier quarters. The focus should be on core earnings growth and the effects of such unsustainable items should be eliminated while interpreting the numbers.

Commodity price fluctuations: Earnings of commodity businesses are highly volatile and most now track the international price movements. For instance, for 2002-03, a sharp rise in international crude prices because of the Iraq war magnified the performance of domestic oil companies.

Oil refining companies recorded exceptional earnings growth in the last quarter as crude prices breached the $30-per-barrel mark, raising,in turn, the product prices.

Higher refining margins and inventory gains resulted in an exceptional quarter of earnings growth in March 2003 for companies such as HPCL, Indian Oil and Reliance. As oil prices are now declining from their high levels, these companies may not make such gains in the first quarter of 2003-04.

This is the case with most other commodity companies too. For instance, most steel companies witnessed a sharp ramp-up in earnings in the latter half of 2002-03. Three price hikes during the period, coupled with lower interest costs, bolstered the earnings for these companies.

Tata Steel's last quarter earnings constituted 46 per cent of the total earnings reported for the year. SAIL turned around in the last quarter after reporting losses in the previous quarters. A similar trend in profits may not be sustainable. For commodity stocks, a fair idea of the direction of price movements would provide a better clue for an investment decision rather than the earnings announcements.

Following the international trends and monitoring the price movements would help in taking an investment decision in commodity stocks.

Declining interest costs: Declining interest costs is another factor that has had a significant impact on the earnings of quite a few companies on a quarter-on-quarter basis in the last couple of years.

A bulk of the savings may occur in the period when the company replaces a substantial chunk of its debt. As companies replace high-cost debt with low-cost debt, they report lower interest costs each quarter, improving margins in the process.

As the chances of a substantial decline in interest rates from this level are remote, the quantum of interest costs in the last quarter is a more appropriate indicator of the future savings and margin expansion, against the previous quarters.

For instance, Tata Steel's interest costs declined 30 per cent in the first quarter of 2002-03, against 8.5 per cent in the last quarter. Therefore, from this level, the magnitude of margin expansion due to interest cost savings would be limited.

Product mix: Product mix provides enough room for variations in the topline and bottomline figures of a company. This is because a company might have a portfolio of high-end and low-end products, with varying margins. For instance, in a typical engineering company, such as Cummins or ABB, services is a lucrative high-margin business.

If, in any quarter, a company gets more revenues from the services business, or if the product mix is tilted towards the high-end margin business, it would do exceptionally well. But a similar performance may not be sustained in the subsequent quarters.

Cummins India's operating margins were 200 basis points higher in the December quarter but remained stable in other quarters because of higher sales of HP engines in that quarter.

Similarly, project-based companies such as BHEL often report lower earnings for the first couple of quarters and a huge jump in the last quarter. It would be misleading to take a negative view based on the numbers of the first couple of quarters or positive view of the last quarter.

The fortunes of these companies depend on flow of orders and the pace of execution. There is a huge time-lag between project commencement and completion. Each company follows a different practice as to when and how the receipts and payments are recorded.

In such companies, the orderbook position and the growth in orders booked year-on-year or quarter on quarter is a good indicator of future growth. For instance, for BHEL, orders worth two years turnover is considered healthy.

Pressure on operating margins: Over the past few quarters, margins have been consistently declining for IT companies as a fallout of the drop in billing rates and pricing pressure. Business is more volume-led. For instance, operating margins for Infosys fell consistently in the last four quarters, from 39.8 per cent to 33.4 per cent.

Under these circumstances, earnings announced in the first two quarters might just not be representative of the full year earnings. Therefore, investors should provide for the decline in margins when arriving at the expected yearly earnings growth figure.

It would be better to take a conservative outlook than see your stock going down the drain.

This also makes a case for profit-booking when a stock starts moving up in anticipation of better earnings growth when the overall business environment does not appear too encouraging.

Turnaround stocks: It is usually difficult to forecast future earnings based on half-yearly or quarterly performances when the stock is in turnaround mode.

Stocks such as Thermax and Tata Engineering progressively reported higher earnings in the past few quarters.

Progressive margin expansion, quarter-on-quarter and also in the trailing quarters could be a better guide. Also, a sharp rise in turnover or orders booked might point to a recovery in such cases.

Seasonal businesses: Certain businesses such as sugar and agrochemicals are purely seasonal. For instance, for agrochemical companies, April-September and January-March are peak sales periods, while the remaining two quarters are lean periods.

The financials for the lean periods may not really provide any indication of the prospects for the year.

While evaluating such companies, the trailing twelve-month earnings per share could be a better measure to gauge sustainable performance.

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