Mumbai: The profitability of Indian manufacturing firms has dipped to their lowest in six years, hammered by the twin effects of capital expansion during the bull run between 2004 and early 2008, and an economic slowdown.
According to a Mint study, the collective return on equity, or RoE, of 807 firms for which data is available for at least a decade has declined to 15.39% for the fiscal year ended March, comparable with the 14.94% return in 2003. This metric reached a high of 24.79% in March 2007 and declined subsequently to 22.01% in 2008.
RoE is one of the key measures of a firm’s profitability, and shows how much profit a company generates with the money shareholders have invested in it.
To be sure, this measure alone may not reflect the true picture of profitability if a company has a large amount of debt. Therefore, Mint calculated the return on capital employed, or RoCE, as well for this sample.
Graphics: Sandeep Bhatnagar / Mint
RoCE measures the profit earned by a firm for every rupee of capital. This metric closely mirrors that of RoE for these 807 firms, with RoCE declining to 15.76% in 2008-09, again comparable to the 2003 figure of 15.64%.
It had reached a high of 22.53% in fiscal 2007 and dipped to 20.71% the following year.
Financial advisers and investment bankers say the decline reflects the downturn in the business cycle.
The decline in RoE and RoCE “has to do with the business cycle. Companies are not growing right now”, said Avinash Gupta, head of financial advisory services at consulting firm Deloitte Touche Tohmatsu India Pvt. Ltd. “The business cycle is affecting them since they don’t have a market now. Excess capacity is one of the reasons for low returns on capital employed.”
After touching a high of 9.7% in fiscal 2007, the second highest since the country’s independence in 1947, the rate of economic expansion slowed over the following two years after high prices and a global financial crisis crippled demand.
India’s gross domestic product, or GDP, grew 6.7% in the last fiscal year and this is reflected on company balance sheets too.
“Profits have come down because of the general slowdown in the environment,” said Sidharth Punshi, managing director of the local unit of American investment bank Jefferies and Co. Inc.
Also, “companies pushed for topline growth and thus, earnings was sacrificed.”
For instance, the collective profit of these 807 companies declined 14% in fiscal 2009. Sales for this sample grew 24% during this period.
However, the decline in profit presents one side of the picture.
After registering double-digit profit growth for the most part of 2003-2007, Indian companies started feeling the pinch of low capacity (one reason for the relatively high RoE during the preceding years), and started investing in more production capabilities.
“Companies went into an investment mode,” said Manoj Mohta, who heads the research unit of ratings firm Crisil Ltd. According to him, the pace of investment growth (during this period) was at 22-25%, as companies scrambled to put up more capacities anticipating a rise in purchasing power because of economic expansion.
As a result, there was a huge round of capital-raising activity, in both debt and equity. A rise in shareholder capital dilutes RoCE unless it is accompanied by a similar spurt in profits. But the economic slowdown put paid to those hopes and the resultant demand slowdown cut into the operating rates of these new capacities.
For instance, in the cement industry, the capacity utilization is around 80% now, compared with 95% a year ago, said Mohta. In the commercial vehicle industry, it is 45-50% now compared with 65% a couple of years ago.
Still, India has one of the higher profitability ratios in the region. RoE of 15% compares favourably with around 10.8% for Asian countries (except Japan), according to a 27 July note from Credit Suisse.
One reason for this is the relatively high cost of capital for Indian firms, according to Deloitte’s Gupta. The weighted average cost of capital for Indian firms is around 11-12% now, according to anecdotal estimates.
With returns lagging capital employed (provided there is demand growth), the outlook for these profitability measures is bright and equity analysts are announcing earnings upgrades.
Perhaps, this is one reason why investors are placing a premium on Indian stocks. The Sensex, India’s bellwether index, is now trading at 18 times estimated fiscal 2010 earnings. The index gained 387.92 points, or 2.55%, on Monday, to close at 15,628.75.