The Hindu Business Line : India Inc holds on to margins

An analysis of Q2 earnings suggests that the slowdown in terms of sales and net profits may be more pronounced in the large companies than in the smaller ones.

Vidya Bala

The curtains are now down on India Inc.’s September quarter results season. The final set of numbers only endorses the initial picture — Corporate India’s earnings growth pace has slowed. Our analysis of 2,380 listed companies (on a standalone basis) reveals that sales and net profits for the quarter ended September 2007 grew by 12.6 per cent and 23 per cent respectively compared to the corresponding quarter last year. Whereas the September 2006 quarter ( over September 2005) saw sales growing by 32 per cent with net profits expanding by 48 per cent.

The numbers indicate that while India Inc. appears to have braved the macro-economic challenges of a rising rupee, a spike in interest costs and restricted access to funding, it has not been completely unscathed.

However, the good news is that barring companies in a few sectors, most corporates either improved their profit margins or kept them intact, indicating that better cost management has helped maintain revenue and earnings grow at a comfortable pace. Here is a look at some of the key result indicators and how various sectors have fared on those parameters.

Sales growth still strong for some

Sales growth in several segments witnessed a slowdown in the quarter. Cement, real estate, auto and textiles saw a significant slowdown, while banks, media and engineering companies bucked the trend with a good showing. That the market expected improved performance in the engineering space was reflected in the rally in engineering stocks over the past few quarters. The average growth in sales for this segment stood at 28 per cent (for September 2007 over the same quarter in 2006) as against just 18 per cent for September 2006 on a Y-o-Y basis.

However, power equipment, which could be classified under capital goods, has not shown as much strength as other engineering peers. The prominent players in this segment, including BHEL, ABB, Crompton Greaves, Emco and Havells India, contributed to slower sales growth from this segment.

A few, such as Suzlon Energy, Areva T&D and Indo Tech Transformers, however were the exceptions. For large players, such as BHEL or ABB, capacity constraints or varying product mix, resulting in longer execution cycles, may be behind the slowdown.

In the banking segment, the results showed a divergence between the public and private banks. While the latter witnessed strong growth in net interest income, the former managed profit growth through ‘other income’ from sources such as sale of investment and bond and forex treasury gains.

The slowdown in loan growth seen by public sector banks could be the reason for their flat net interest income. The next few quarters may be critical for PSBs to revive their loan book and notch up steady and sustainable growth.

Subdued earnings

With a slowdown in sales growth, operating and net profit growth too decelerated in most sectors. Domestic textile and pharma companies were amongst the worst hit at the operating and net profit level.

Exports, which formed a big chunk of revenues for both these sectors, were affected by poor realisations on the back of an appreciating rupee. Among the interest-sensitive sectors, automobile players such as Ashok Leyland, Mahindra & Mahindra and Tata Motors registered a decline in net profits, adjusted for extraordinary items.

In the media space, increased advertisement revenues for broadcasters and new channel launches for content providers may have accelerated earnings growth at the operating level.

Oil exploration and allied service providers proved to be exceptions to the subdued growth. While revenue growth remained unchanged, profits grew in double digits, against flat or negative growth in September 2006. Companies such as Alphageo and Hindustan Oil Exploration recorded a turnaround at the operating level.

Significant increase in other income (which may have come about from borrowing in dollars or sale of land/investment book), buttressed net profit growth for the universe, to a large extent. Many companies may have reported lower profits but for this component.

Revival on Q-o-Q basis

While profit growth did slow in relation to last year, quarter-on-quarter earnings, however, showcased some signs of revival as revenue and profits grew faster in September than in the June 2007 quarter. For the entire universe too, July-September quarter earnings gained momentum with double-digit growth as against a flat trend/decline in the June quarter.

Recent weeks have seen several key changes in the macro environment, with interest rates peaking and the rupee stabilising to some extent. A continued improvement in sequential growth numbers by India Inc, could signal that the trough in earnings growth had already been reached in the June quarter.

Software, which had one of the worst quarters in June 2007, aggravated by abnormally high rupee appreciation over April-June, showed signs of earnings revival in September.

This is not entirely surprising, as July-September quarter is considered among the best for the sector. After a slide in earnings growth in the June 2007 quarter, the sector picked up steam with an average growth of 15 per cent in operating profits and 10 per cent in net profits for the last quarter.

Interest cost management

Interest cost as a percentage of sales stood at 9.8 for September 2007, against 7.8 for the same quarter a year ago — clear evidence that the series of rate hikes since last April has pegged up borrowing costs for India Inc. Surprisingly, the sectors that were dented by higher borrowing costs were not the ones that were expected. While entertainment, textiles and infrastructure saw a notable increase in the above metric, engineering, realty and cement companies fared well as interest/sales ratio underwent a decline.

Interestingly, real estate companies, often perceived to be among the most rate-sensitive, saw overall interest costs fall nearly 30 per cent. It appears that even as this sector’s funding options have been limited on the ECB/FCCB side, huge private equity investments and capital market funding has enabled it to limit high-cost borrowing.

Margins remained the bright spot in the otherwise dull picture presented by India Inc this quarter.

Margins remain stable

Both operating and net profit margins for the universe expanded by over one percentage point each, to 23.5 per cent and 11.2 per cent respectively, compared to last year. These margins have been reckoned excluding “other income”.

Higher margins in the face of slowing sales growth have, in fact, been instrumental in helping companies report a still healthy rate of earnings growth this quarter. Pricing power in consumption-driven sectors and better cost management may have helped companies improve margins.

The media space was among the most prominent in terms of improved OPMs for the reasons mentioned earlier. Companies in the cement segment rode purely on the back of strong realisation while construction and realty took a mild knock due to increased raw material costs.

A good number of companies in the realty space have been riding on the back of a ‘low-cost’ land bank to achieve abnormally high OPMs over the past few quarters. As they exhaust the old land bank and replenish at higher prices, OPMs could continue to see some decline.

Bigger size not necessarily better

The overall numbers, however, hide that a good proportion of the companies have indeed bettered their previous growth rates. Of the 2,380 companies analysed, 1,345, or 56 per cent, showed improved growth in sales and net profits in the September quarter, relative to last year. However, these companies were not big enough to influence the overall picture. Hence, the universe was split into companies with market capitalisation of over Rs 5000 crore (large-caps) and those below this cut-off (others), to get a better picture of growth rates.

An analysis after this breakdown suggests that the slowdown in the current quarter in terms of sales and net profits may be more pronounced in the large companies than in the smaller ones.

Sample this: Year-on-year, sales for large-caps grew 6.6 per cent in the September 2007 quarter as against 19.9 per cent in September 2006. However, smaller companies managed a sales growth of 7.3 per cent (September 2007), compared to 9.4 per cent (September 2006).

These numbers suggest that growth in the larger companies of India Inc may be reverting to mean, especially given their high base.

After the focused rally in stock prices of large-caps over the past year or so, they are now trading at significantly higher valuations than mid- and small-caps.

This is largely driven by investors willing to pay stiff prices for the higher growth recorded by larger companies. Should the growth divide between large-caps and mid-caps narrow, the mid- and small-caps could once again regain stock market favour. However, trends over several quarters need to be observed to arrive at this conclusion.

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