Covid 2.0 will affect outlook, not Q4 results: Aditya Narain

The management commentaries in Q4 might get a little softer than what we have seen in Q3, says Aditya Narain, HoR, Edelweiss Securities.

How are you expecting the second Covid wave to impact Q4 earnings? Would it have an adverse impact for companies across the board or would it be in specific sectors?
In terms of the second wave and Q4, I do not think it makes too much of a difference because Q4 is past. So, I do not think it will make a difference to Q4 earnings. It could potentially start making an impact on earnings looking forward. That is where a fair amount of optimism has been built into the Street. But that is also where we may see a little bit of a challenge. The management commentaries might get a little softer than what we have seen in the last quarter.

There are two things to look at; one is of course that this is still very early in the ride and we have to be watchful of extrapolating too much too quickly. The second thing is the manufacturing and the industrial side should not suffer too much because the impact has been somewhat limited but the services side is where you could actually see much more weakness.

Those are the two things to look at; one is it is not about Q4 earnings, those are past. The commentaries could get a little bit more guarded than they have been and services are going to be a little bit more vulnerable at this point in time than necessarily manufacturing.

What are you pencilling across the board when it comes to the revenue trajectory as well as margins?
There are two elements to this; in terms of margins, there is a massive expansion on an year-on-year basis because at the end of the day, there was a shutdown base quarter that you are looking at. There is a massive expansion there. But on a quarter-on-quarter basis, we are seeing a drop of about 180 to 190 bps in margins. That is something that you need to keep in mind that relative to the feel good that was created in the third quarter, the fourth quarter might be a little weaker because the cost elements are coming through. Plus you would not have the same pent up demand that came through in the last quarter.

If we were to step back and see what the revenue side is, it is a little bit more modest. We are looking at revenue growth of about 5-6% which is unlike what you are seeing from a profit growth which will probably be about a 100% plus on a year-on-year basis. That is a reflection of two things that have continued to play out; one that demand at the end of the day has come back in some manner but it is not fully wholesome and the second is that there have been massive gains on costs.

That is something which will tend to sustain through this quarter or show up reasonably well. But as I said, on a quarter-on-quarter basis, one needs to be a little bit more watchful even though they are not necessarily comparable because there is a high level of seasonality between the third quarter and the fourth quarter.

The other thing that is important is one should keep in mind that year-on-year, there is a huge base effect. It is not that relevant. If one looks at the numbers on a two year CAGR basis, that is where some of the extra health is there in the system. We are looking for a two-year CAGR of about 16% for this quarter. That tells a much better story than the 100% plus that you will see on a year-on-year basis for the 12-month period but that is impacted by the shutdown that we had last time.

Even adjusting for the low base effect, the one problem that we have grappled with all through Q4 has been the sharp uptick in commodity prices. Which sectors do you think will suffer more when it comes to the margins?
It does not fully show because the commodity companies get a huge leg up but the offshoot will really start showing through a little bit in the auto and the consumer staples spaces. So those are the two sectors where you will see a margin impact. They have to be seen on a quarter-on-quarter basis but that is where the pain actually lies.

Do you think the tilt would remain in favour of cyclicals?
Absolutely. The bulk of these very strong numbers that you are seeing quite honestly both for this quarter and looking out are coming from the cyclical space. On the commodity side, commodity prices have sustained into the current quarter and look particularly robust. We almost overnight raised numbers there also.

The other is on the financial side where they have taken a lot of pain in terms of the provisioning cycle. It was very exaggerated in the last quarter-- in the corresponding quarter but in the last three, four years, the banks have had a high credit cycle and that is going to reverse sustainably over the next couple of quarters or a little longer. That is where the bulk of the earnings is actually coming from.

From our own portfolio perspective, our overweights are really in the commodity space and to some extent in industrials and the banking space, We believe the IT space is a more structural story space where you will also continue to get numbers.

Where is your momentum softening? What are the factors at play in pockets like an FMCG, cement or even domestic auto?
Typically those are the sectors which have taken a little bit of a cost hit and their margins are a little weaker. We spoke in terms of staples seeing a bit of a drop off in margins on a quarter-on-quarter basis. The auto space is going to see a fairly consistent drop off in terms of the margin side. More importantly, this element can very often be quantified. You can have a call on it and it tends to swing a little bit. Companies can do a little bit to address it.

The bigger issue is whether the price hikes that are put in place by a lot of these players to limit the margin damage starts impacting demand. In auto and staples space, there could be a little bit of pressure from a demand perspective but not the least because you have actually had the second wave coming and it is a much deeper wave. Also, it is spreading faster and it can bring in a certain amount of hesitancy both in people stepping out of their homes and equally in terms of the demand momentum that they are effectively seeing.

The second Covid wave in the US and in Europe has been much more painful on the economies in Europe, where the lockdowns have had to be a little stronger and the fiscal stimulus has been less compared to the US. So it is not just about commodity prices coming through and hurting some of the spaces, it is also the demand risk that they are running as a result of higher prices and potential shutdowns.