ANOTHER QUARTER has gone by and the results have hardly surprised anyone, least of all the stock market. The slowdown in India Inc’s profit growth, which had become visible after the first quarter (Q1) of ’07, continues unabated as we near the end of calendar year ’08. And there’s little hope that the tide will change in the near future. The globe’s worst financial crisis has pushed the world’s largest economies into recession with countries like the UK and US witnessing contraction of their economies. Consumer spending in the world’s largest economy — the US — has fallen sharply as a number of large retailers posted double-digit fall in sales during October ’08. Globally, a number of companies are cutting down operations and laying off employees. The unemployment rate has already reached a 14-year high of 6.5% in the US, which is likely to worsen. To ease the credit crunch, central banks across the world are resorting to interest rate cuts, besides injecting cash into the system. However, these attempts have hardly yielded positive results so far.
EXPANSION BINGE:
India Inc is not likely to escape the mayhem unscathed. Encouraged by the strong economic growth of the past five years, cheap and abundant credit, coupled with prevailing bullish sentiment, India Inc (here we are referring to non-financial companies) embarked upon perhaps the biggest-ever spend on capital expenditure (capex) in the country’s history. Companies across sectors either went for aggressive capex or acquired companies, especially outside India, to achieve a global scale and footprint. This spending binge was initially financed by strong internal accruals, but as their ambitions rose, most companies resorted to debt financing, including external commercial borrowings (ECBs). The chicken has now come home to roost and India’s profitability is now being hit by debt servicing and other recurring costs related to capex. Besides, companies with high level of outstanding ECBs are being haunted by mark-to-market losses on their dollar- or euro-denominated debt.
The difficulties have been further compounded by the economic slowdown and falling demand for goods and services across sectors. If two years ago, demand was ahead of supply, now companies are facing over-capacity across-the-board. This has adversely affected operating margins.
Even as their internal cash generation is on a downward spiral, companies are being forced to increase cash outlays in the form of interest payments and purchase of capital goods. For instance, during the past two years, leading companies such as Reliance Industries (RIL), Tata Steel, Tata Motors, Hindalco Industries, DLF, Suzlon Energy and Larsen & Toubro (L&T) had higher cash outflows on account of investment activity, compared to the cash they generated from operations. When a company has higher capex than its operating cash flow, it needs to either borrow or dip into its reserves or cut dividends. And in the current scenario, where interest rates have risen and access to credit is restricted, a high dependency on financial institutions adds to the risk. Again, the economic downturn may affect the existing cash flow of such companies, further adding to the woes.
THE QUARTER GONE BY:
The September ’08 quarter was a reflection of these trends as India Inc’s profit growth came to a halt. The net profit reported by 1,214 listed companies grew by just 3% on a year-on-year (y-o-y) basis — the slowest profit growth in the past 10 quarters. We excluded banking and finance companies from our calculations due to the different revenue recognition practices they follow, as well as four public sector oil majors — IndianOil, Bharat Petroleum (BPCL), Hindustan Petroleum (HPCL) and ONGC — whose profits depend on government-determined subsidies and their large size can influence the aggregate numbers. A fall in the operating margin of the sample, which came down to a 20-quarter low of 15.6%, was not totally unexpected due to high inflationary pressures. When inflation soars, raw material costs and sales revenues move up in tandem; then the same operating profit, when calculated as a percentage to net sales, results in a lower operating margin. In fact, to remove this inflationary effect and to make historical data comparable, we have calculated various cost components as a percentage of operating profit, rather than net sales, in the adjacent chart.
Other income, which was fuelling India Inc’s profit growth towards the end of ’07, has failed to prop up profits in the September ’08 quarter. As a result, the y-o-y growth in PBDIT slipped to 10% from 16% in the June ’08 quarter and around 25% in FY08.
HURTING INTEREST:
A spurt in global interest rates was one of the major outcomes of the unprecedented global credit crisis. At the same time, the rupee lost heavily due to an exodus of foreign investments. Both these factors increased the interest burden for domestic companies, which rose a whopping 86% y-o-y. The interest costs alone took away over 16% of India Inc’s operating profits in Q2 FY09, which was substantially higher than 10% in FY08. Besides a rise in interest costs, an increase in the proportion of depreciation in operating profits indicate that various projects, launched earlier, have commenced operations in the quarter. The resultant pre-tax profit grew just 1.4%. However, a fall in the effective rate of tax propped up the net profit growth to 3% y-o-y. The effective rate of tax dipped to a two-year low of 22.8%.
NOT JUST LOSERS:
Industries such as cement, automobiles, consumer durables, pharmaceuticals and chemicals had a particularly bad quarter. Telecom, hospitality, healthcare and logistics sectors, which were doing well in the past couple of quarters despite the slowdown, have also taken a hit in the current quarter.
No Silver Lining
DESPITE THE odds, a few industries have done better than the others. These include the information technology (IT) sector, where a number of mid-sized companies recorded a healthy profit growth, thanks to a weaker rupee.
The sugar industry gained from higher sugar prices, while changes in the government’s subsidy norms helped fertiliser companies. Even the metals industry posted a double-digit profit growth, as the recent crash in prices had a limited impact in the September ’08 quarter. Healthy profit growth of biggies such as GE Shipping, Shipping Corporation of India (SCI) and Container Corporation (Concor) helped the logistics sector to report double-digit growth.
The profit growth of the FMCG sector, although in single-digit, was better than that in the preceding quarter. Although these industries did well during the September ’08 quarter, the likelihood of a continued outperformance is limited.
WHERE TO GO:
Although the Indian economy is less dependent on exports, it is linked to the global economy in more ways than one. The number of troubled industries is growing steadily from just textiles and real estate to airlines, brokerages, gems & jewellery and NBFCs, which have been in the news for cutting salaries or laying off employees. Other sectors such as hospitality, steel, cement, shipping and automobiles are also facing a slowdown.
Most of the companies in the above mentioned sectors have been expanding capacities over the past couple of years.
Although conditions are tough for everyone, there still remain a few industries where investors can expect some growth. The much-touted FMCG sector is one such investment avenue. The natural gas transmission industry is also likely to defy the difficulties and prosper, thanks to the rising availability of natural gas in India.
Similarly, companies offering services to onshore and offshore petroleum exploration activities are likely to grow, largely due to the existing long contracts they hold. Also, considering the power deficit in the country, turnkey contractors for power plants will continue to see healthy performance. Investing in stocks to earn dividends can also be a good approach, since a number of good companies are available at healthy dividend yields. However, a careful research of the companies is a must.
WHAT NEXT?
While India Inc’s profit growth has hit the bottom, the overall economic environment continues to deteriorate. For the time being, liquidity problems are being well-addressed, but the financial system globally is expected to suffer for some more time from the aftershocks of the subprime crisis.
At the same time, the options available with the Indian government to support economic growth appear limited, thanks to burgeoning trade and fiscal deficits. All this indicates prolonged pain in the months to come. If the current trend continues, India Inc can very well expect its December ’08 profits to slump below the December ’07 levels.
EXPANSION BINGE:
India Inc is not likely to escape the mayhem unscathed. Encouraged by the strong economic growth of the past five years, cheap and abundant credit, coupled with prevailing bullish sentiment, India Inc (here we are referring to non-financial companies) embarked upon perhaps the biggest-ever spend on capital expenditure (capex) in the country’s history. Companies across sectors either went for aggressive capex or acquired companies, especially outside India, to achieve a global scale and footprint. This spending binge was initially financed by strong internal accruals, but as their ambitions rose, most companies resorted to debt financing, including external commercial borrowings (ECBs). The chicken has now come home to roost and India’s profitability is now being hit by debt servicing and other recurring costs related to capex. Besides, companies with high level of outstanding ECBs are being haunted by mark-to-market losses on their dollar- or euro-denominated debt.
The difficulties have been further compounded by the economic slowdown and falling demand for goods and services across sectors. If two years ago, demand was ahead of supply, now companies are facing over-capacity across-the-board. This has adversely affected operating margins.
Even as their internal cash generation is on a downward spiral, companies are being forced to increase cash outlays in the form of interest payments and purchase of capital goods. For instance, during the past two years, leading companies such as Reliance Industries (RIL), Tata Steel, Tata Motors, Hindalco Industries, DLF, Suzlon Energy and Larsen & Toubro (L&T) had higher cash outflows on account of investment activity, compared to the cash they generated from operations. When a company has higher capex than its operating cash flow, it needs to either borrow or dip into its reserves or cut dividends. And in the current scenario, where interest rates have risen and access to credit is restricted, a high dependency on financial institutions adds to the risk. Again, the economic downturn may affect the existing cash flow of such companies, further adding to the woes.
THE QUARTER GONE BY:
The September ’08 quarter was a reflection of these trends as India Inc’s profit growth came to a halt. The net profit reported by 1,214 listed companies grew by just 3% on a year-on-year (y-o-y) basis — the slowest profit growth in the past 10 quarters. We excluded banking and finance companies from our calculations due to the different revenue recognition practices they follow, as well as four public sector oil majors — IndianOil, Bharat Petroleum (BPCL), Hindustan Petroleum (HPCL) and ONGC — whose profits depend on government-determined subsidies and their large size can influence the aggregate numbers. A fall in the operating margin of the sample, which came down to a 20-quarter low of 15.6%, was not totally unexpected due to high inflationary pressures. When inflation soars, raw material costs and sales revenues move up in tandem; then the same operating profit, when calculated as a percentage to net sales, results in a lower operating margin. In fact, to remove this inflationary effect and to make historical data comparable, we have calculated various cost components as a percentage of operating profit, rather than net sales, in the adjacent chart.
Other income, which was fuelling India Inc’s profit growth towards the end of ’07, has failed to prop up profits in the September ’08 quarter. As a result, the y-o-y growth in PBDIT slipped to 10% from 16% in the June ’08 quarter and around 25% in FY08.
HURTING INTEREST:
A spurt in global interest rates was one of the major outcomes of the unprecedented global credit crisis. At the same time, the rupee lost heavily due to an exodus of foreign investments. Both these factors increased the interest burden for domestic companies, which rose a whopping 86% y-o-y. The interest costs alone took away over 16% of India Inc’s operating profits in Q2 FY09, which was substantially higher than 10% in FY08. Besides a rise in interest costs, an increase in the proportion of depreciation in operating profits indicate that various projects, launched earlier, have commenced operations in the quarter. The resultant pre-tax profit grew just 1.4%. However, a fall in the effective rate of tax propped up the net profit growth to 3% y-o-y. The effective rate of tax dipped to a two-year low of 22.8%.
NOT JUST LOSERS:
Industries such as cement, automobiles, consumer durables, pharmaceuticals and chemicals had a particularly bad quarter. Telecom, hospitality, healthcare and logistics sectors, which were doing well in the past couple of quarters despite the slowdown, have also taken a hit in the current quarter.
No Silver Lining
DESPITE THE odds, a few industries have done better than the others. These include the information technology (IT) sector, where a number of mid-sized companies recorded a healthy profit growth, thanks to a weaker rupee.
The sugar industry gained from higher sugar prices, while changes in the government’s subsidy norms helped fertiliser companies. Even the metals industry posted a double-digit profit growth, as the recent crash in prices had a limited impact in the September ’08 quarter. Healthy profit growth of biggies such as GE Shipping, Shipping Corporation of India (SCI) and Container Corporation (Concor) helped the logistics sector to report double-digit growth.
The profit growth of the FMCG sector, although in single-digit, was better than that in the preceding quarter. Although these industries did well during the September ’08 quarter, the likelihood of a continued outperformance is limited.
WHERE TO GO:
Although the Indian economy is less dependent on exports, it is linked to the global economy in more ways than one. The number of troubled industries is growing steadily from just textiles and real estate to airlines, brokerages, gems & jewellery and NBFCs, which have been in the news for cutting salaries or laying off employees. Other sectors such as hospitality, steel, cement, shipping and automobiles are also facing a slowdown.
Most of the companies in the above mentioned sectors have been expanding capacities over the past couple of years.
Although conditions are tough for everyone, there still remain a few industries where investors can expect some growth. The much-touted FMCG sector is one such investment avenue. The natural gas transmission industry is also likely to defy the difficulties and prosper, thanks to the rising availability of natural gas in India.
Similarly, companies offering services to onshore and offshore petroleum exploration activities are likely to grow, largely due to the existing long contracts they hold. Also, considering the power deficit in the country, turnkey contractors for power plants will continue to see healthy performance. Investing in stocks to earn dividends can also be a good approach, since a number of good companies are available at healthy dividend yields. However, a careful research of the companies is a must.
WHAT NEXT?
While India Inc’s profit growth has hit the bottom, the overall economic environment continues to deteriorate. For the time being, liquidity problems are being well-addressed, but the financial system globally is expected to suffer for some more time from the aftershocks of the subprime crisis.
At the same time, the options available with the Indian government to support economic growth appear limited, thanks to burgeoning trade and fiscal deficits. All this indicates prolonged pain in the months to come. If the current trend continues, India Inc can very well expect its December ’08 profits to slump below the December ’07 levels.
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