The earnings season is on. The first results have already started trickling in, and this trickle will become a flood in the coming weeks, as each of the 6,000-odd companies listed on the Indian stock market makes its mandatory announcement.
The weeks ahead will offer lots of good news to investors (and the taxman). Indian companies have been flying high in recent years thanks to strong tailwinds. Economic growth has averaged 8.5% in the past four years, and was 9.2% in the year that has just ended. Demand has been strong. Finance costs have been low. So, it is very likely that companies will report stellar performances yet again.
The more interesting question is what is likely to happen to corporate earnings in the new financial year. Macro-indicators suggest that earnings growth should slow down over the next few quarters. Economic growth could be closer to 8% this year. Interest rates have already moved up by around 3%, and there is no telling when the Reserve Bank of India (RBI) will stop its tightening. Growth in bank credit has already dropped. Wage and input costs have spiralled.
The tailwinds have not become headwinds as yet, but there is a clear shift in momentum. It is very unlikely that Indian companies can maintain the 30%-plus earnings growth that they have become accustomed to in recent years. There are already signs of stress in some sectors: Automobiles (where growth in decelerating); banks (where there are fears that credit quality could suffer); and cement (where the government has intervened to the detriment of companies).
The next few quarters are likely to test the ability of some of our best companies to manage growth and business risks in a slightly more difficult economic environment. As of now, it seems very unlikely that the corporate sector, as a whole, will stutter to a halt. But many analysts are expecting earnings growth to drop to 15% a year in 2007-08.
However, it would be wrong to assume that the slowdown in earnings growth is merely the result of a tighter economy. There is actually a touch of inevitability to it. Indian companies have grown since the recession of the late 1990s by sweating their assets. Investment in new capacity was minimal. Instead, companies focused on cost cutting and squeezing more output from existing assets. In other words, there were fewer interest and depreciation claims. Profits grew smartly, and far quicker than the growth in the underlying economy.
The capex cycle turned in 2004. Companies have started investing heavily in new factories. The first round of investments was financed using retained profits, but this money stocked up in company balance sheets is not going to last for long. It is only a matter of time before companies start raising more equity and debt from the markets, perhaps more of the latter. There are already signs that corporate leverage is increasing despite rising interest rates. Higher capital expenditure, depreciation, debt and interest payments could strain both free cash flows and earnings. Less money will flow into the pockets of investors, as companies spend to grow.
Indian companies are entering a new phase. The golden run they had between 2000 and 2007 is likely to draw to a close. That was a time when corporate profits grew at least twice as fast as the economy did (in nominal terms). We are now likely to revert to a more classical outcome, where corporate profits march in step with the rest of the economy.
In other words, the corporate slowdown could be more severe than the mild economic slowdown.
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