Q4 results point to earnings risks in some crucial sectors
After the wobble in the December quarter owing to demonetisation, Indian companies did well to report stable growth in volume and realizations in the March quarter.
Operating profit of companies that constitute the Nifty 50 index also rose by a decent 10% year-on-year (y-o-y), even though a large part of the increase was on account of favourable commodity prices.
But there are signs of trouble at five major industries which together account for the bulk of incremental earnings estimated for the next two years. If the recent troubles in these sectors end up hurting their profitability, the markets may well be in for a rude shock as far as earnings estimates are concerned, especially given where valuations are.
“We note that the risks of earnings downgrades have increased from (a) higher-than-estimated loan-loss provisions in the banking sector, (b) weaker-than-expected commodity prices (which can hit the metals and oil and gas sectors), and (c) a stronger-than-expected exchange rate (expected to hit earnings of IT, metals, oil and gas, pharmaceuticals companies),” analysts at Kotak Institutional Equities wrote in a note to clients.
Put together, these sectors are expected to contribute more than 70% of incremental earnings estimated for the next two years, according to the broker. As such, there may be large earnings downgrades ahead for the broader market. And valuations are at record highs of more than 23 times trailing earnings. While earnings for the constituents of the Nifty 50 index have risen at a glacial pace of 3% in the past four years, investors are betting on a revival in earnings growth in the coming two years.
In the past quarter, growth in earnings before interest, taxes, depreciation and amortization (Ebitda) was decent at around 10% (for Nifty 50 companies), which prima facie appears a sign of better things in the future. But note that this was because of favourable commodity prices, and a relatively low base on that front in the year-ago period.
Analysts at ICICI Securities Ltd estimate that excluding profit of companies whose fortunes depend on commodity prices, the rise in profit is restricted to a mere 4%.
“The sustainability of a rise in commodity prices appears untenable, given the global excess supply, neutral effect of Opec (Organization of Petroleum Exporting Countries) production cuts and China’s muted GDP (gross domestic product) growth, while the promised boost to infrastructure spend by the Trump administration appears unlikely”, ICICI Securities’s analysts wrote in a 5 June note.
Without this boost, it remains to be seen how earnings growth pans out in the coming quarters.
One of the heartening signs in the March quarter was decent volume growth in a number of sectors such as passenger vehicles, cement and so-called fast-moving consumer goods (FMCG).
“Companies have been focusing on volume growth, which resulted in improved year-on-year volume growth for cement (~6%), FMCG (~4%) , paints (~11%) and passenger vehicles (11%). Among other indicators of consumption volume growth in the economy, same-store sales growth (SSSG) of retail companies was a mixed bag with discretionary consumption faltering, while value retailers showed relatively stronger growth,” the analysts wrote in their note.
On the other hand, the worrisome bit was that among the Nifty 50 stocks, earnings estimates were downgraded for 32 stocks.
And it still remains to be seen how the implementation of the goods and securities tax (GST) impacts companies’ profitability in the coming quarters.
With the markets riding on high valuations, there is hardly any room for error as far as earnings go. But who knows, investors have been patiently waiting for earnings growth to return for a few years now. They may well be willing to wait it out for some more time.