Mumbai: Profits of Sensex and Nifty companies expanded the most in four quarters year-on-year (y-o-y) in the three months ended June as they reduced costs and benefited from lower raw material prices, countering the first sales decline in three years.

A Mint analysis of the earnings of 28 of the 30 Sensex companies, which had comparable numbers for the past 12 quarters, shows that these companies increased profits by an average of 9.8% y-o-y in the quarter. Their sales declined by 1%. The Nifty sample, which consisted of 43 of 50 firms with comparable numbers, also recorded the highest average earnings growth in four quarters at 9.9% despite a 7.76% fall in sales, the steepest in three years.

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Sensex and Nifty are the bellwether indices of the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), respectively.

Lower raw material prices, cost-control measures put in place by companies in the face of slowing economic growth and, in some cases, lower interest charges contributed to the profit growth despite the fall in revenue.

However, analysts caution that while optimism may have returned to the economy,raising hopes of higher sales in the coming quarters, rising commodity prices could cause margins to shrink.

The sales of both the Sensex and Nifty samples analysed by Mint were also dragged down by oil companies, which posted a steep decline in revenue because of a fall in crude oil prices.

Excluding Reliance Industries Ltd, the country’s most valuable company, and Oil and Natural Gas Corp. Ltd, the biggest explorer, the Sensex group posted sales growth of 12%, better than the 10.8% sales growth they recorded in the March quarter. Profits for the non-oil pack of companies grew 22.8%, the highest in seven quarters.

The Nifty group of non-oil firms, which consisted of 39 companies, also posted the sharpest rise in profits in seven quarters at 18%, though sales grew at a more modest 6.7%.

Cairn India Ltd, an arm of UK-based oil explorer Cairn Plc, DLF Ltd, India’s biggest realty firm by market value, mobile phone operators Idea Cellular Ltd and Reliance Communications Ltd, electricity transmitter Power Grid Corp. of India Ltd, and energy firm Reliance Power Ltd did not have comparable numbers going back 12 quarters.

Computer services provider HCL Technologies Ltd has not yet declared its June quarter numbers.

According to Morgan Stanley India Co. Pvt. Ltd analysts Ridham Desai and Sheela Rathi, earnings for the quarter ended June—the first of fiscal 2010—have exceeded analysts’ expectations.

However, they say that the broader market has outperformed the Sensex companies in earnings growth.

According to data available with Mint, 1,974 firms have until now announced their June quarter results.

On an aggregate, their net profit has grown by 19.64%, while sales fell 7.5%.

“At the sector level, consumer discretionary (spending) and energy are the key positive surprises while healthcare is the key negative surprise. So far, the best performing sector in terms of profit growth is financials, followed by energy, while materials is the worst performing sector," Desai and Rathi wrote in a 30 July strategy report.

“The risk is in execution. The challenge is how we grow profitability from now on," said Kenneth Andrade, vice-president, equity, IDFC Asset Management Co. Ltd. “We have done well this quarter. But what is absent is sales growth."

Experts say the earnings story will be even better if demand picks up and results in higher sales growth for companies.

“While there is likely a commodity price component to modest demand, we believe this is a worrying trend (of poor sales but good profits). Businesses have clearly taken advantage of raw material costs (50% of expenses), but also appear to have cut other operating costs, collectively driving up margins. We believe rising margin is good, but rising demand/sales would probably be better," Citigroup Global Markets India Ltd analysts Aditya Narain and Tirthankar Patnaik wrote in a report last week.

Andrade also says sales growth will be key going ahead. “We saw one of the weakest top line growth (rates). We need to see how top line behaves going ahead," he said.

Signals from the economy have been positive, economists say. The Index of Industrial Production numbers, a key measure of productivity, saw 2.7% growth in May. This was the second consecutive month the index registered growth after a 1.2% increase in April.

“Economic growth outlook is likely to improve, although there continue to be near-term concerns over the impact of the shortfall in monsoon season rainfall," Rajeev Malik, head of India and Asean (Association of Southeast Asian Nations) Economics at Macquarie Securities Ltd, said in a 28 July report.

Macquarie is maintaining its gross domestic product growth forecast of 7% for the current fiscal and 7.5% for the next.

Malik added that the rate easing cycle was over, and that the Reserve Bank of India appeared to have signalled a shift to a neutral stance. “We believe liquidity will be easy and policy rates will remain at their current low levels for several months," he added.

While easy and cheap credit is good news for companies, it also could mean higher raw material prices due to commodity price inflation, some analysts warn.

“With the stimulus from governments across the world, things are looking better for the economy. While there is hope for revival in revenue growth, there is a concern about rising commodity prices," said Dipen Shah, vice-president (private client group research) at Kotak Securities Ltd. “Hopefully, revenue growth exceeds the rise in commodity prices so that we can see margins expand in coming quarters."

Analysts say that without further earnings growth, valuations will become a cause for concern.

Consensus estimates by analysts, said Shah, put earnings per share of Sensex companies at Rs875 for fiscal 2010.

At Friday’s Sensex close of 15,670 points, the price-earnings, or P-E, multiples work out to 17.9 times, significantly higher than the long-term mean P-E of 15 times.

“We look fully priced at current levels. We need to look at FY11 earnings and possible upgrades. Only if that happens can the market move up on a substantial basis," said Shah of Kotak Securities.

Graphics by Sandeep Bhatnagar / Mint