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Aarati Krishnan

Gold bars stacked inside a vault _ Commodity prices have bolstered the profits of companies which produce metals, petrochemicals, chemicals and paper.

INDIA Inc. has churned out exhilarating numbers for the just-ended September quarter, stoking the recent flare-up in equity values. The aggregate profit for a universe of over a thousand listed companies has expanded by a robust 32 per cent, while sales grew 11 per cent. Is this a flash in the pan or the beginning of a sustained boom in corporate earnings? A difficult question to answer at any time, given the cocktail of factors that influence corporate financials. But what adds a rather large dash of unpredictability to the recent numbers is the big hand that commodity price swings have had in the performance.

Prices bolster commodity companies...

Commodity prices have influenced recent corporate earnings by bolstering the revenues and profits of companies which produce metals, petrochemicals, chemicals and paper. Break up the September earnings scorecard into its sectoral constituents and it shows that metals and commodity companies, which tripled their earnings in the September quarter, have been instrumental in lifting India Inc.'s profit growth to the reported 32 per cent.

Cost-cutting measures and lower interest costs may also have helped, but it is this upward spiral in commodity prices which has made the sharp ramp-up in profitability possible for companies such as Hindalco, SAIL, and Tata Steel in the recent times. Tata Steel, for instance, admits that steel price increases accounted for as much as 60 per cent of the rise in operating profits in the first half of 2003-04. And there have been some really big moves in commodity prices, over the last year (see table). .

...and stunt profit growth for others

The other side of the story is the manner in which the spike in commodity prices has dented the profit margins of companies churning out industrial and consumer goods. A spike in input prices is the reason why the aggregate operating profit margins of India Inc have slipped by 0.25 percentage points in the September 2003 quarter, after expanding steadily on the back of cost-cutting measures in the preceding quarters.

In the September quarter, companies in such sectors as tyres, oil refining, fast moving consumer goods and cement have faced shrinkage in their profit margins due to the escalation in the cost of their inputs. Going forward, if the commodity spiral continues, the impact could also be on sectors such as automobile components, engineering and construction.

True, continued strength in demand could help companies pass on part of their input price rises to their consumers, in some of the particularly buoyant sectors. But this pricing power is likely to be tested, if commodity prices continue to leap ahead at the pace they have set over the past year. On the other hand, the impact of commodity prices on profit margins may be particularly hard-hitting with consumer good companies, where volume growth in the recent times has been driven mainly by aggressive pricing.

A quandary for investors

For stock market investors, the real dilemma now lies in deciding how the commodity price spiral will play out over the next few quarters. If commodity prices are set to rise further, it may pay to shift allocations to stocks of commodity companies and pull out of those sectors which are heavy users of commodity inputs. On the other hand, if the commodity price cycle is set to reverse, it may pay to book profits on the commodity plays and bet on the latter set of stocks, which would then enjoy some relief from the pressure on profit margins.

Right now, the majority opinion seems to favour a continuing rise in commodity prices.

Analysts argue that since commodity prices are just coming off their all-time lows, with the demand-supply balance just beginning to tilt in favour of the former, the recent rise in prices represent a long-overdue correction in the cycle, which will last for some time to come. This is why industry watchers, such as the Economist Intelligence Unit, have predicted that prices of hard commodities, such as metals, will continue to rise, through the next two years.

The China factor

Nevertheless, investors betting on commodity companies at this juncture have to keep a couple of factors in mind. One, in the commodity markets, when prices of finished products move up, those of the inputs mirror this trend with very little time lag.

This trend may mute the impact of commodity price increases on the profit margins of the commodity processors. Secondly, commodity markets are notoriously fickle. Often, one sees a raging bull market in a commodity turning turtle in as short a time frame as a month. What makes this threat a particularly potent one in the current run-up in commodity prices, is the China factor.

Across commodities, be it paper, chemicals or metals, it is robust Chinese demand, stoked by its growing economy, which has provided a firm underpinning to the commodity price spiral.

Hard data about the sustainability of Chinese demand and its internal demand-supply position for various commodities, is not easy to come by.

Any sudden shift in China's import policies or a deceleration in the Chinese economy, holds the potential to deflate commodity prices in a trice. This may be the big risk that investors have to factor into their bets on commodity stocks.

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