Will falling commodities help earnings?

Will falling commodities help earnings?

New Delhi: One positive ramification of the Federal Reserve’s ‘significant downside risks to the economic outlook’ statement is the sharp fall in commodity prices.

Fearing demand contraction, commodity prices have corrected sharply in international markets. Brent crude fell below $110 a barrel to $107. Copper, purported to be the barometer of the ‘world industrial production cycle,’ has technically entered the bear phase.

A preliminary gauge of China’s (the world’s commodities guzzler) manufacturing activity fell in September. The fall, if substantiated by final numbers, will mark the contraction in factory sector for third consecutive month. Read more...-

Going by the current economic climate, there are high chances that commodities will trail the flagging global economy. A sustained fall in commodity prices will do more good to the Indian companies.

Yes, a weak world economy is a bad omen for corporate India. But with demand holding up for most sectors (it is moderating now, at least according to the RBI) a sustained fall in commodity prices will help domestic firms improve margins.

Sandwiched between increasing competition and high costs, Indian companies have sacrificed margins in recent quarters to safeguard volumes and market shares.

High raw material costs alone, according to IDFC Securities, have led to 200 basis points contraction in Sensex companies EBITDA margins in the first quarter. Net sales of the Sensex companies grew by 25.9% in June quarter. But cost pressures weighed on bottom-lines, which registered a muted 7.9% rise on a year-on-year scale.

The June quarter numbers reflect a structural downtrend in margin environment. Morgan Stanley has done a broader analysis of 1,145 companies and found that gross margins of the domestic firms have fallen to the lowest level since 2002.

Morgan Stanley analysts led by Sheela Rathi note:

The gross margins (net sales–raw material costs) for the broader market (ex-services, energy and sugar sectors) has contracted to its lowest level since 2002 (since the quarterly data is available)……..The fall in margins have been the aftermath from rising costs (especially commodity prices) and intensifying competition (thus, lack of pricing power).

According to Morgan Stanley, gross margins on a year-on-year scale have fallen for six consecutive quarters till June this year. True, low raw material costs alone will not be sufficient to reverse the margin trend. But the other two cost heads–employee expenses and capital costs are not at alarming levels either.

Employee costs as a percentage of sales are at a favorable level. According to Morgan Stanley, employee costs to sales ratio has fallen to almost three year low (11 quarter low to be exact) during the June quarter.

Capital costs, however, are not that favorable. Capital costs of the 1,145 companies have risen due to high interest costs. It is debatable whether these costs would moderate in the near term. Nevertheless, with employee costs under control and raw materials prices showing signs of easing, Indian companies can look forward to better margins. The only caveat here is that the demand environment should hold up.