How dependent is earnings growth on commodity prices?

How dependent is earnings growth on commodity prices?

Most brokers are predicting strong earnings growth for the June quarter. Earnings of Sensex companies, excluding energy firms, are expected to grow by 29% year-on-year, based on the estimates of Kotak Institutional Equities and Motilal Oswal Securities Ltd. At first look, this is heartening news for the markets, which have priced in earnings growth of 25% for the year.

But what gets hidden in the aggregate numbers is that just one company accounts for 70-80% of the incremental Sensex (ex-energy) earnings in the June quarter. Tata Steel Ltd had reported a huge loss of around Rs2,000 crore for its consolidated operations in the June quarter of the previous fiscal. Thanks to the recovery in steel prices, it is expected to report a profit of between Rs2,150 crore and Rs2,750 crore based on Kotak and Motilal’s estimates.

Also See Cyclical Influence (Graphic)

If one were to keep Tata Steel out, the growth in Sensex (ex-energy) earnings falls to 7.8%, based on Kotak’s estimates, and 4.4% based on Motilal’s estimates. There are a few more companies such as Hindalco Industries Ltd and Sterlite Industries (India) Ltd whose fortunes have changed dramatically in the past year, thanks to an increase in commodity prices. If one were to exclude these companies as well, growth estimates fall to 3.5% for Kotak and -0.4% for Motilal Oswal.

In other words, but for the large jump in profits of cyclical sectors, earnings are flat for Sensex companies. This is a worrying sign—if the global economic situation worsens, commodity prices could fall and Sensex earnings for this year and the next could be at risk.

The pertinent question is how much cyclical sectors contribute to earnings growth in fiscal 2011 and fiscal 2012. According to Motilal’s estimates, earnings of all companies under its coverage (excluding refining and marketing companies) are expected to grow at an annual average growth rate of 23% between fiscal 2010 and fiscal 2012. Cyclical sectors such as oil and gas and metals account for 42% of the incremental growth. But the good news is that even excluding these sectors, growth for the rest of the pack is healthy at 19%.

Similarly, earnings of all companies under Kotak’s coverage are estimated to grow at an annual average growth rate of 22% between fiscal 2010 and fiscal 2012. Excluding cyclical sectors, growth will be 20.5%.

So while growth rates will be lower, excluding cyclical sectors, they are still expected to be healthy at around 20%. Even so, it doesn’t really make a strong case for investment in Indian equities. The trailing price-earnings multiple for the market is in excess of 20 times, resulting in a PEG (price earnings/growth) ratio of around 1, indicating that growth prospects are already factored in.

Graphic by Naveen Kumar Saini/Mint

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