The Hindu Business Line : Does the IIP offer clues to corporate growth?

The stock market appears to be watching macro-economic indicators such as the Index of Industrial Production (IIP), closer than ever before. For instance, on March 12, the Sensex declined by about 600 points intra-day after the IIP numbers for January 2008 unexpectedly showed a dip. But detractors point out that indices such as the IIP are outdated, their constituents no longer reflecting the real fortunes of India Inc.

But how closely do the IIP numbers really track the earnings prospects of corporate India? Has corporate sales performance corresponded to trends flagged off by the IIP in the past? Do the IIP numbers really matter to a person investing in the stock market?

Business Line traced the movement of the sales growth of S&P CNX 500 relative to the IIP over the past six yearsand looked at how other factors such as lending rates and capital investments may have influenced both the growth numbers. The analysis suggests that investors should take note of IIP numbers to gauge how Indian companies may perform.

Closely linked

There is a discernible link between trends in IIP and the growth in revenues of the CNX-500 companies over the past six years. The two parameters were positively correlated with a correlation co-efficient of close to 0.79 (the coefficient measures the strength and direction of a linear relationship between two variables).

A similar correlation arises even if one excludes “services” companies from the CNX 500. This suggests a couple of possibilities. One, manufacturing growth (rather than services) may be playing a dominant role in determining the overall revenue growth of the listed universe.

Two, growth in service sector may also be moving in line with manufacturing as suggested by the high correlation reflected even after including the service industries.

Whichever is true, the correlation indicates that if the IIP numbers point to a possible slowdown, then corporate earnings numbers may well be headed the same way, unless higher agricultural growth or a far superior performance from the services sector offsets such a slowdown.

The growth in sales of CNX 500 companies (over same period last year) and the IIP have been considered at quarterly intervals, for calculating the above correlation. The CNX 500 is a good representative for India Inc’s performance, as the index captures 86 per cent of the total market capitalisation and 78 per cent of the total turnover of NSE (as on January 31, 2008). Sector weights in the index also closely reflect industry weights for the market as a whole.

As part of the exercise, service sectors such as software, banking, finance, hotels and entertainment were removed from the CNX 500 basket, to make it more comparable to the IIP, which captures output of goods alone. Sectors such as engineering services that are closely linked to the capital goods sector were, however, retained.

The index of industrial production captures the country’s industrial growth divided into manufacturing, mining and electricity segments. An additional use-based classification sorts the index into basic and intermediate goods, capital goods, consumer durables and non-durables. The index seeks to reflect the growth in the country’s industrial activity and excludes all kinds of services. The base year for the index over the period of the analysis is 1993-94.

The trend

Over the period of analysis, IIP and revenue growth have moved mostly in tandem, with only a few quarters of divergence. From a period of slow growth in early 2001, both the parameters have made a sharp comeback, accelerating sharply since 2005; the latest numbers once again bring the hint of a slowdown in the economy. Macro-economic factors such as inflation and interest rates also appear to have influenced the growth in both these variables.

In 2001-02, both IIP and corporate revenue growth remained modest, with India Inc’s growth just about matching the IIP readings. A high base and a spike in inflation numbers the preceding year appear to have contributed to this challenging period. By 2002-03 however, both industrial production and corporate India’s sales were firmly on the recovery path. This was probably aided by newly commissioned capacities. There was a 15 per cent addition to the gross block (indicating commissioning of new capacities) by the CNX 500 companies (other than service sectors) in 2002-03.

Over the next couple of years, sales growth for corporate India began to accelerate and comfortably outpace the growth in IIP. By June 2004, the CNX 500 revenue growth was almost four times the IIP growth number. The increasing role of service industries such as construction, engineering services and IT, not captured in the IIP, could have aided corporate earnings in this period.

Growth in corporate sales clearly responded to interest rate trends. Overall interest rates in the economy, captured by the Prime Lending Rate, softened during this period and remained steady in the 10.25-10.75 per cent range until the end of 2004-05.

Glorious years

The economy’s boom phase, starting 2005, was reflected in all the key indicators. By the quarter ended September 2006 GDP grew by 10.1 per cent over the previous year, IIP jumped to a 12 per cent growth and revenues of CNX 500 companies surged by 33 per cent for this quarter.

Large capital inflows from foreign institutions as well as availability of low-cost funding options overseas (external commercial borrowings and foreign currency convertible borrowings) probably helped capex investments. A 15 per cent addition was made to the gross block of assets in each of these two years, the highest since 2002, suggesting that easy access to funds may have aided the investment cycle, helping sales growth.

The above trends clearly suggest that boom phases in the IIP have corresponded with those in corporate earnings, while slow phases have been reflected in a sales slowdown. In this context, the recent slowdown in IIP is a cause for concern on the pace of growth likely in India Inc.

What now?

With a relatively high base the previous year, the IIP has shown signs of weakness in recent quarters, especially after October 2007. From 12.2 per cent growth in October 2007, the recent IIP numbers (January 2008) stood at 5.3 per cent. India Inc’s sales growth has also seen a slowdown in recent quarters. From a 26 percent YoY growth in December 2006, sales growth declined to 16 per cent in December 2007.

Interestingly, interest rates, which have climbed sharply since mid-2006, could partly explain this trend. The prime lending rate, which was below the 11 per cent mark until April 2006 has since climbed to the 12.75-13.25 per cent range. Manufacturing sectors that constitute the IIP are typically more sensitive to interest rates, given the high working capital requirements and the need to expand capacities, than services.

The recent slowdown in IIP numbers has to be seen in the context of higher interest rates and higher inflation, both of which have flagged off slower phases in the economy, in the past. The investment cycle, which has underpinned previous high growth phases in India Inc, may also be impacted on the funding side, given the higher cost of domestic borrowings and restricted access to overseas options.

Recent global credit market developments may also make it tougher for foreign institutions to invest in India. All this suggests that Indian investors may well have to brace for a period of slower sales (and thus earnings) growth from India Inc. This would call for lower PE multiples and more modest return expectations from stocks.

But does the picture look entirely bleak? Not necessarily. The February index for six core infrastructure industries has grown by 8.7 per cent. As this is a good lead indicator on the IIP, the revival in this number offers some hope on better IIP numbers in the month ahead.

Superior performance from the services sector (which accounts for close to 40 per cent of the CNX 500) and improved agricultural growth also hold the potential to boost India Inc’s show.

Further, increased spending power arising out of the Pay Commission’s recommendation and a more liberal tax slab may also bolster the consumption story in the coming year.

More Stories on : Economy | Insight | Performance

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Madras Cements: Buy

Does the IIP offer clues to corporate growth?

Templeton India Equity Income Fund: Invest

DBS Chola Opportunities Fund: Invest

Graphite India: Buy

Amtek Auto: Buy

Index Outlook

Diversification or Di-worse-ification?