Mumbai: Earnings of Indian companies rose faster in the December quarter than in the previous six months, driven largely by increased sales.

The impressive growth in profits, however, has failed to enthuse the market as expectations of downgrades in earnings in the next few quarters and governance issues weigh heavily on Street sentiment, experts say.

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Stand-alone earnings of 40 firms on the Nifty index on the National Stock Exchange that have declared their results so far rose by 24% over the year-ago period, the highest in 12 quarters. Sales growth at 18% was less than in the June and September quarters, but comes on a higher base.

“The results have largely been in line with expectations, but the worsening macro environment has led to a weak outlook on future earnings growth, leading to downgrades," said Apurva Shah, head of research at Prabhudas Lilladher Pvt. Ltd.

The profit growth of 23 manufacturing firms, excluding oil and gas companies, grew at a slower pace of 6.5%, but this rise is still higher than the earnings growth for this set of firms in the June and September quarters.

The trend in the broader market has been similar.

A Mint analysis of the earnings of 291 companies in the BSE-500 index of the Bombay Stock Exchange that have declared earnings and for which past data is available shows that profit growth at 24% is the highest in four quarters.

The Nifty comprises 50 most-liquid stocks traded on the bourse while the BSE-500 accounts for 93% of market capitalization on the exchange.

Rising cost pressures because of a spike in global commodity prices and an increase in interest rates to fight inflation might lead to lower growth in profits in the coming quarters, analysts say.

So far, the squeeze in margins is not evident in the reported results for the three months ended 31 December.

Both raw material costs and employee expenses as a proportion of net sales have shown a slight decline over the previous two quarters for 216 manufacturing firms in the BSE-500 while interest costs have risen marginally. Profits for this set of firms grew 8.3%, the highest in three quarters.

Although the official estimate of factory output growth in December fell to 1.6%, sales for the 216 manufacturing firms during the quarter showed robust growth at 22%.

In the case of 23 manufacturing firms in the Nifty, raw material costs as a proportion of net sales rose to 41% in the December quarter from 39% in the previous two months, but employee expenses and interest costs fell as a proportion of net sales.

“The cost pressures are not evident yet," said Tirthankar Patnaik, strategist at Religare Capital Markets Ltd. “But downgrades have dominated upgrades as we expect margins to be hit in the next few quarters."

An improved outlook on global growth has led to a rally in commodity prices that adds to concerns over domestic inflation. The Thomson Reuters/Jefferies CRB index, a widely tracked basket of commodity futures, is hovering near its 28-month high.

Rising prices of commodities such as copper and iron ore, which are trading at their lifetime highs, and crude oil, are expected to raise costs for Indian companies, which are net importers of these commodities.

Moreover, domestic food inflation has been in double digits for the past few weeks, prompting economists to predict interest rate hikes by the central bank, which, apart from raising borrowing costs for firms, can curb demand.

The Reserve Bank of India had hiked its policy rate by 25 basis points in the review of monetary policy on 25 January to counter persistently high inflation.

One basis point is one-hundredth of a percentage point.

“We expect policy rates to be hiked by another 100 basis points in this calendar year," said Singapore-based Leif Eskesen, chief economist for India and Asean (Association of Southeast Asian) countries at the Hongkong and Shanghai Banking Corp. Ltd.

Most firms hedge against the rise in commodity prices using forward contracts, which is why the impact of rising input costs is expected to be felt one or two quarters down the line.

Besides, if demand slows because of monetary tightening, companies would find it harder to pass on cost increases to consumers.

Also, a rise in policy rates typically affects profit margins with a lag.

Inflation tends to boost sales growth figures initially but hurts margins when there is a slack in demand, analysts say.

Even as developed markets have become more attractive because of higher growth and likely earnings upgrades, macro concerns have clouded the outlook on Indian markets, leading to a sell-off amounting to $1.6 billion (Rs7,328 crore) net of purchases, by foreign investors.

Consequently, the benchmark Sensex index has plunged 13.6% to 17,728.61 points and made India the worst performing equity market after Egypt.

Concerns on earnings downgrades however, may have been overdone, said a 9 February strategy note by Aditya Narain and Jitender Tokas, analysts at Citigroup Global Markets Inc.

“We see some earnings downgrade risks, but believe the market is overly pessimistic," the note said.

The 20% profit growth estimate for the 30-stock Sensex in the fiscal year ending 31 March looks likely to be met, but profit growth expectations for fiscal 2012 have moderated from 22% earlier to around 18% now, said Sudhakar Shanbhag, chief investment officer at Kotak Mahindra Old Mutual Life Insurance Ltd.

Earnings for Sensex firms should be above 15% in fiscal 2012, said Narain and Tokas of Citigroup.

While the broader market has performed in line with expectations, there are sectors which have seen margins eroding. “There are early signs of cost pressures, in the consumption sector, for instance," said Shanbhag.

“Earnings have missed consensus expectations for roughly half the sectors led by cement, pharma, property, media and automobiles," said a 8 February note by Prabhat Awasthi and Nipun Prem, analysts at Nomura Financial Advisory and Securities (India) Pvt. Ltd.

IT stocks were the positive surprise and so were bank stocks, since the expected compression in net interest margins was not seen.

“IT and banks posted better results although bank margins might be impacted adversely in the quarters ahead," said Shah.

Among Nifty firms, Tata Consultancy Services Ltd beat Street expectations with a 32% rise in profits.

So did another Tata group firm, Tata Motors Ltd, which saw a 2.8% rise in stand-alone earnings, but its consolidated profit rose three and a half times over the year-ago period.

Among banks, Axis Bank Ltd posted higher than anticipated earnings growth of 36%.

Graphic by Yogesh Kumar/Mint