The markets opened the week in spectacular fashion, helped by the better than expected quarterly numbers from TCS declared over the last weekend. Despite the weakness in super heavyweights ONGC and Reliance, the frontline indices closed the day with gains of over a per cent each.

Markets tried to consolidate for the next two days, with the indices moving within narrow ranges. Thursday saw the indices cracking in afternoon trades as there was not much buying support. This was the only day of the week when the indices closed with losses.

The markets closed the week with a huge rally on Friday. The Sensex posted its first 100 point gain in a single day for the first time since February. The strong closing helped the main indices to close the week with gains of over a per cent each.

The rally on Friday followed the revaluation of Chinese yuan on Thursday. This led to a decline in the US dollar which traders hope would attract more FII investments into India. The prospect of a further upward revision of Yuan against the dollar later in the year led to broad based buying in frontline stocks.

Mid-caps outperformed the frontline stocks by a handsome margin for the week. A new benchmark index, CNX Mid-Cap 100, was introduced for mid-caps during the week. The new index closed the first week of its life with a 4 per cent gain.

There are reports that many large domestic mutual funds have decided to suspend fresh subscriptions to their mid-cap focussed growth funds from August. These fund houses believe that most of the smaller stocks are over-valued and need to correct before they can look at fresh investments.

Domestic economic and regulatory action

• The astronomical prices quoted for the old mill land in Mumbai which were auctioned during the week surprised most analysts. The high prices quoted during earlier auctions were dismissed as one off transactions and the prices were expected to stabilize. The latest auction prices have far exceeded the earlier prices and questions are being raised about the viability of these projects.

  Though it is true that land availability in Mumbai is severely limited, the viability of most construction projects depends on their affordability to retailers. At these prices, it is very difficult to see any conventional retailer venturing into these projects.

  The mall building wave in and around Delhi has also come down significantly as most new complexes are struggling to attract customers. Rentals at most of the new properties are considerably lower than those prevailing as recently as a year before. Even residential property prices in Delhi suburbs are showing signs of topping out.

  Therefore, the high prices quoted for the Mumbai plots have raised the question whether we are seeing the last leg of a property bubble. The question is important as many industries depend on the residential and commercial construction sectors.

  While accepting that prices have gone up significantly and there are instances where it is way beyond justifiable limits, it is difficult to see property prices coming down across the country unless there is an economic slow down. If the economy is able to sustain the momentum, demand for housing and commercial space would sustain itself. The select pockets of price exuberance would correct themselves and would not have much of an impact.

• Inflation for the week ended 09 July increased marginally to 4.14 per cent from 4.09 per cent reported for the week before. Higher food prices were the main reason for the rise in inflation. The June hike in liquid petroleum fuel prices has surprisingly had no impact on price levels.

Industry update

• The first quarter results of the 4 large technology services companies have been mildly disappointing as they struggled to achieve growth. Operating margins of most of them also came under considerable pressure from currency fluctuations and higher employee costs.

  Among the top 4, TCS posted the best numbers for the quarter. Though the results of TCS should be viewed in the context of a weak previous quarter, the improvement in operating margins was impressive. The fact that the company managed to improve its margins even on fixed price contracts, which form a very high percentage for TCS, was commendable. It was able to improve the profitability in domestic business, mostly done through its subsidiary CMC, as well by reducing the proportion of low margin hardware business.

  On the positive side, all the companies said prices have stabilised and new customers are coming in at higher rates. Given the buoyancy in the US technology sector and economy in general, this trend may sustain for the rest of the year.

  The sustainability of the current high valuations enjoyed by the IT services stocks depends on their ability to post higher growth rates in the coming quarters. The three top companies TCS, Infosys and Wipro enjoys a forward price-earnings multiple of between 21 and 25, which is high considering their current growth rates. Another quarter of low growth would increase the risk of a downward adjustment in valuation of all these companies.

  There is hardly any doubt that Indian IT service companies would face considerable pressures in maintaining their high growth rates. First there is the high base effect with even the smallest of the 4, Satyam, expected to cross the $1 billion revenue mark this year. Achieving growth rates of 35 and 40 per cent on a base of $1 billion or more while maintaining the profit margin is not easy, whatever be the competitive advantages enjoyed by these companies.

  TCS, Infosys and Wipro are trying to expand into the consulting space in a big way. Consulting offers much better margins than services, but well established and large players like IBM and Accenture makes it a difficult nut to crack. The space may not offer much cost advantages to Indian companies unlike IT services, as consultants would come at a high cost and most of them would have to be based onsite. Building the competency and credibility would also take some time.

  The BPO operations of these companies are struggling to maintain margins, with some of them trying to migrate to more value added services from the commoditised business of voice based services. Here again, high employee attrition and rising costs would continue to put pressure on margins. Wipro saw a net reduction of over 2,000 employees in its BPO division during the first quarter.

  To make matters more difficult, US technology services companies like IBM and Accenture are expanding their presence in India in a major way. Accenture already has almost 20,000 employees in the country, which would double in the next couple of years. This large presence in India would help these companies to offer services at the same cost as Indian companies. The top management of these US companies have already stated that they have now started bidding for price-sensitive smaller projects, which form the bread and butter for most Indian companies.

• Indian sugar companies have been on a roll for the last one year as sugar prices jumped after a crop failure in many states last year, especially Maharashtra. The crop outlook for the current year is better than last year as the monsoons have been very healthy. Many of the larger companies are rushing to expand capacity before the new cane crushing season starts in September.

  Demand for sugar in India, the largest consumer globally, can only grow as the general economic growth pushes up the demand for packaged sweets, confectionery and beverages.

  The introduction of ethanol blending in liquid petroleum fuels has opened up a new revenue source for sugar companies. This is a very popular practice in Brazil, which is one of the largest producers of cane sugar in the world. With crude oil prices at record highs, blending of ethanol makes economic sense too.

  Many sugar companies have also set up co-generation power plants as well. Even smaller companies now have generation capacities of 20mw to 30mw which can add to the revenues. The efforts of Power Trading Corporation to buy electricity from small captive and co-generation power plants has reduced their dependence on state electricity boards, most of which are very bad when it comes to making payments to power producers.

  Though it is too early to assess the potential, the sugar industry may also be in a position to earn Certified Emission Reductions or carbon credits under the Kyoto Protocol. Some of the larger companies like Balrampur Chini have already initiated some projects which are in the process of being certified for carbon credit entitlements.

  More than any of the above, the one development which could change the fortunes of the sugar industry in a dramatic way is a total de-control. Sugar prices are still controlled by the government through monthly or quarterly sales quotas. Companies are also required to supply a fixed portion of the production at lower than market price for distribution through PDS. De-control would encourage capacity addition and consolidation in the industry and globally competitive players could emerge.

  If European governments remove the subsidies given to sugar beat farmers as promised, international prices would firm up further. This could open up significant export opportunities for the Indian sugar industry, provided they consolidate and become as competitive as the large Brazilian producers.

  However, the government continues to drag its feet on the issue of sugar de-control which is highly politically sensitive given the large number of sugar cane farmers. The issue has attracted a lot of attention ever since the government allowed the companies to sell a large portion of their production in the open market, even though the quantity was restricted through monthly quotas. This week also, the union agriculture minister stated that the industry will not be de-controlled even in 2006. The sooner it happens the better it is for the health of this industry which could emerge as a significant export earner and have a positive impact on millions of farmers.

• This week saw the largest ever acquisition in the country in the telecom space. BPL Mobile and Communications was taken over by the Essar group for an enterprise value of $1.1 billion. The Essar group is planning to merge BPL with Hutchison Essar at a future date, subject to regulatory approval.

  If it happens, the merged entity would emerge as a strong and equal size competitor to the private sector player Bharti and public sector major BSNL in GSM mobile telephony. More importantly, the merged Hutch-BPL combine would control two-thirds of the lucrative Mumbai market. The average revenues per customer of Hutch are already the highest in the country.

  After this deal, the only potential acquisition target of significant size in the mobile space is Aircel. Most other players are very small, with their area of operation limited to one or two circles. Therefore, for the telecom companies medium term growth would be more organic than through acquisitions.

US markets, economy and oil

The broader US indices like the Dow and S&P 500 closed the week on a flat note. NASDAQ performed better, closing with gains of a per cent for the week. US technology companies continue to report very strong earnings as the overall economic growth is robust.

US markets were helped this week by the positive statements from the US Fed chairman on the health of the economy. The Fed believes the economic growth momentum is sustained and inflation is well contained despite the sharp increase in fuel prices. The statement on inflation was well received by the market as it means less pressure to raise short term interest rates.

The big story in US markets during the week was the rebound in economic growth. After showing some signs of lethargy over the past couple of months, most analysts were expecting a short term slow down because of higher fuel prices. However, latest data suggests that economic momentum is intact which was further confirmed by the Fed Reserve and strong corporate earnings.

The continuing terrorist threats in London did have an impact on markets by Thursday, tempering the overall positive sentiment.

The much anticipated revaluation of the Chinese Yuan was received by the US markets with some circumspection. While the move would help improve the competitiveness of large industrial and engineering companies in overseas markets, retail chains and other large importers would be affected by a weaker US dollar. Higher prices for imported consumer goods would have a negative impact on consumer inflation in the US. The extent of revaluation was much lower than market expectations.

Crude prices remained subdued for most of the week in the absence of fresh triggers, despite periodic warnings about tropical storm in the Gulf of Mexico. Crude prices are not reacting much to storm warnings as the earlier storms which pushed crude prices to record highs did not cause much damage.

Crude prices recovered on Friday on expectations of higher Chinese demand following the yuan revaluation. The commodity gained over 2 per cent on Friday to close at $58.64 to a barrel. Traders waiting for a reason to push up prices capitalised on the appreciation in the Chinese currency which would make imports cheaper. It is hard to believe that a 2 per cent change in currency value would increase the Chinese demand for oil significantly.

*Disclaimer: The author doesn't have any position in the stocks specifically mentioned above at the time of writing this article. This analysis/report is only for the purpose of information and is not an investment advice. Readers are advised to consult a certified financial advisor before taking any investment decisions. While efforts have been made to ensure the accuracy of the information provided in the content the author or publisher shall not be held responsible for any loss caused to any person whatsoever.

Other articles by Rex Mathew

List of general reports on markets

List of general reports on finance