Demonetisation aftershocks may short-circuit Q2 earnings recovery of firms
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Mumbai: After several quarters of disappointments, the September quarter results of Indian companies were slightly ahead of expectations. Net profit of companies on BSE Ltd’s benchmark Sensex index rose 8.3% year-on-year, ahead of expectations of growth of around 5%. This excludes Coal India Ltd, which was yet to report its second-quarter results when this article was written. Earnings before interest, taxes, depreciation and amortization (Ebitda), an indicator of operating profitability, grew by over 10% for these companies.
But before investors could celebrate the improvement in the overall performance of Indian companies, they were hit by the double whammy of a Donald Trump presidency and the Indian government’s demonetisation of high-value currency notes.
The fact that the valuations of Indian stocks had risen to expensive levels has led to a sharp correction in the markets. But more importantly, the aftershocks of the demonetisation move have made it clear that the performance of Indian companies will remain sluggish. Besides, there is some uncertainty relating to the introduction of the goods and services tax (GST). Sales volumes of a number of industries such as automobiles have been hit by the liquidity shortage post demonetisation, and it’s not yet clear when the situation will return to normal.
Even before this, while the overall September quarter results were slightly ahead of expectations, things weren’t buoyant all around. Analysts at Kotak Institutional Equities pointed out in a note to clients, “We note that economic recovery is still quite patchy, with only parts of urban discretionary consumption holding up well. The ongoing results season has not provided any signs of an incipient economic recovery, and management outlook on demand for the next two-to-three quarters is generally subdued. We note that 2QFY17 volume data was muted for a number of cement and consumer staple companies. We believe volume growth will become very relevant as a driver of profits as the gross margin expansion-led earnings growth is largely over.”
Thanks to the downturn in commodity prices in the past few years, Indian companies were able to grow margins fairly easily. But they no longer have this advantage. In fact, after the recent decision by the Organization of the Petroleum Exporting Countries (Opec) to cut production, Brent crude futures rallied by 15% in the week till 2 December, posting their biggest weekly gain in over five years. In this backdrop, the recent hit to sales volumes due to demonetisation couldn’t have come at a worse time for Indian companies.
Even as Indian companies grapple with these new difficult realities, a sharp rise in developed market bond yields after the Trump election has also led to large outflows from emerging markets. Listed funds tracked by Emerging Portfolio Fund Research that have India exposure have withdrawn $1.4 billion in the past four weeks. Since Indian stocks enjoyed relatively higher valuations, they have fallen at a higher rate in the past month, underperforming the other emerging markets.
Kotak’s analysts add, “In our view, the ‘yield compression’ and ‘gross margin expansion’ drivers of stock performance are over. We note the fortuitous nature of two biggest drivers of stock performance in the past few years—(1) re-rating of multiples from ‘yield compression’ or gradual decline in global yields due to extremely loose monetary policies of the global central banks and (2) gross margin expansion arising from sharp correction in commodity prices over the past two years.”
In the near-term, these factors can be expected to impact both financial performance and valuations.