Early signals

Early signals
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First Published: Mon, Aug 06 2007. 12 03 AM IST
Updated: Mon, Aug 06 2007. 12 03 AM IST
One of the commonly held assumptions among investors right now is that strong profit growth in Indian companies will be a buffer to protect local markets against any selling gales in the global financial markets. A recent analysis by Mint blows a hole through this comforting assumption.
It is quite clear that the headline numbers that are used to justify a sanguine view on valuations are misleading. Though the profits of the 30 large companies whose share prices make up the benchmark Bombay Stock Exchange Sensex were 30.65% higher in the first quarter of 2007-08 than they were a year ago, these profits have been pumped up by a one-time gain in the price of the rupee. Take these away, and some sheen falls off the new earnings numbers.
A new accounting norm that came into effect this July has encouraged the spread of a rather odd and questionable practice. Companies with lots of dollar loans in their balance sheet have unexpectedly benefited from the strength of the rupee. The rupee value of their debts has dropped because of the appreciation of the rupee. The new accounting norm allows them to shift these notional profits to the profit and loss account, and take credit for it. Companies such as Tata Steel, Ranbaxy Laboratories, Jet Airways and Larsen & Toubro have thus been able to show even higher profits because of foreign exchange gains. Jet Airways, for example, would have been in the red but for the Rs128.99 crore of forex profits.
Shorn of these and other similar one-time gains, company performance looks far more modest than the headlines suggest. For the 30 Sensex companies, profits in core operations grew by 15.88% in the first quarter, almost half of the reported net profit growth of 30.65%. The Mint analysis shows that operating profit growth in 1,290 non-oil and non-finance companies grew at 18.7%. This is far lower than what we have been used to over the past five years. These are perhaps early signs of a slowdown in corporate profitability.
One would have expected rising wage and input costs to chisel away at corporate profits. But there seems to be more to the slowdown than just these factors. Sales growth, too, has been sluggish, growing at 15% over the year. There were already several lead indicators of a sales slowdown—the deceleration in the index of industrial production (IIP) and bank credit, for example. While most industries continue to do well, some such as two-wheelers and consumer durables are in a spot of bother.
There are few signs that the industrial boom is unwinding. Perhaps even the slowdown in sales is temporary. But there are very clear cost pressures building up in the economy right now, which will translate into either lower profit margins or higher inflation (in case the companies have the power to pass extra costs to consumers). The huge investment in new projects is also likely to eat into cash flows, leaving less on the table for investors.
None of these are intractable problems. Productivity gains and even better financial management can help companies overcome these hurdles. Sustained economic growth in excess of 8% over the next few years will ensure that the business environment for Indian companies is very helpful. But rising wage and input costs as well as large bills for capital expenditures could muddy the waters. True, investments in new capacity lay the ground for further growth. But the intervening period could throw up new pressures on profits.
It is very likely that Indian companies will overcome these obstacles. But investors should not be blind to the recent indications of an incipient slowdown in corporate earnings. After all, slower profits growth and higher interest rates usually have a sobering effect on equity prices.
Are corporate profits under pressure? Write to us at views@livemint.com
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First Published: Mon, Aug 06 2007. 12 03 AM IST