Demonetization – Decoding Earnings Impact Report By Motilal Oswal

Demonetization – decoding earnings impact

Operating deleverage coming to the fore; B2C sectors impacted more

Demonetization is an unprecedented reform undertaken by the Government of India with significant implications for the Indian economy and markets. This is going to have a bearing on the investment frameworks in the near term and could drive several changes in the portfolios. In this report we try to assess the earnings impact for our MOSL Universe.

Demonetization; an unprecedented reform

We believe demonetization announced by the Government of India is an unprecedented reform that should have far-reaching implications for the Indian economy and in turn the corporate sector. We believe demonetization will cause some short-term pain (moderation in economic growth, disruption of trade, lower activity in informal sector, disturbance in supply chain and sundry other business activities, etc.), but long-term gain (better tax compliance across sectors, higher share of organized trade, enhanced transparency will benefit the corporate sector). Our research team has been continually interacting with many companies, channel partners, industry experts and business heads over the past three weeks. We have already released a report highlighting detailed ground zero feedback after the first week of demonetization.

In this note, we have tried to assess the prima facie impact on our coverage universe based on our discussions/meetings with stakeholders across sectors. As we write this report, the situation on ground is still fluid, and the government, regulators and corporates have been taking a number of initiatives to adapt to the tides of change this event has brought in. Our numbers thus have both upside/downside risks. We may have to make more adjustments to our numbers towards the end of the quarter.

Operating deleverage impact coming to the fore

Demonetization-driven sales moderation will bring to fore operating leverage/deleverage of the business model. We believe cost levers available to manage the adverse impact of revenue moderation are limited (cut in advertising/promotion expenses, shutdown of production lines). Thus, volume moderation or reduction in footfalls, as the case maybe, will cause disproportionate impact on EBITDA. We expect sectors like auto, cement and retail to bear the maximum brunt of operating deleverage, given inherent fixed costs residing in their respective P&L. For example, in auto, our 2HFY17 EBITDA estimates are cut by 6% for a 3% cut in sales. Similarly, in cement, our 2HFY17 EBITDA estimates are cut by 12% for a 10% cut in sales. In FMCG, our EBITDA estimates are cut by 9% for a 6% cut in sales, and in retail, we cut our EBITDA by 15% for a 6% cut in sales. Operating deleverage impact is also expected in mid-caps like Bata, Arvind, TTK, PVR and Inox Leisure, where we are building in sharper earnings cuts.