Risks to firms’ profit margins on the rise

Even as corporate sector recovery is yet to gather pace, risks to earnings are lurking. An analysis by Motilal Oswal Securities Ltd of Reserve Bank of India (RBI) data on the private sector shows that expenses grew at almost double the rate of sales growth in the December quarter. Compared to a 2.8% rise in aggregate sales, expenses which include raw material costs, grew 5% from a year ago.

Of course, although margins softened on a sequential basis, they are still at multi-year highs. But if the current trend of high raw material costs and faster growth in expenses prevail, the corporate sector’s profitability can come under pressure. The Thomson Reuters CRB Index, which captures the changes in commodity prices, is up 6.6% in the last one year. The Wholesale Price Index, which rose to a three-year high in February, surpassed the Consumer Price Index for the second consecutive month, indicating transmission challenges.

According to Emkay Global Financial Services Ltd, while output inflation remained largely unchanged, input inflation accelerated from 3.5% in December 2016 to 10.4% last month. “The latest (February) reading portrays that input inflation has gained pace in the last two months, indicating an increase in margin pressure in Q4FY17,” adds Emkay. Nikhil Gupta, vice-president (institutional research) at Motilal Oswal Securities, echoes the view. According to him, it is crucial that the increase in sales momentum sustains as it will help companies overcome cost pressures through economies of scale. “It’s evident that if sales growth momentum does not hold up or companies are not able to pass on the rising costs, then margins can soften further,” adds Gupta.