Lower profits, uneasy market

April 13, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

On April 11, the CSO announced a further dip in industrial growth to 3.6 percent, bringing the Sensex down 189 points. That index was for February, the expectation about March is no better — which leaves the market a little cold.

Bombay Stock ExchangeThe reasons for the dip are not all dismal. Possibly, the dip is mostly caused by what is generally called the base effect. Last year in February, growth had climbed to an unsustainable 15 percent. Even a good increase in production would have brought down y-o-y growth. The market is not unaware of this statistical illusion though a higher growth would have given greater comfort.

What is of concern is inflation. It pushed up cost more than price, putting pressure on margins.  First, prices of industrial raw material (including agricultural raw materials, metals and petroleum products) were up in the Jan-March quarter by more than 20 percent y-o-y. These cost increases could not be wholly passed on. Surely, prices of manufacturers also increased. But that was less than the cost. Second, the sharp increase in interest payments which were about 15 percent of operating profits sliced off net profit.

What is surprising, industrial growth dipped in spite of the steep rise in exports. In February, exports were up 49 percent with import growth lagging behind at 21 percent. On average, industry exports more than 11 percent of production which should have stimulated industrial growth.

Not all corporates have been equally hit by cost inflation and interest rate. The impact has been more in manufacturing and mining than in services; and in manufacturing more in capital goods than FMCG. Capital goods production was actually down more than 18 percent.

Production was drastically cut because investment must have been on hold possibly in response to the increase in interest rate.

Demand continues to be fairly strong for consumer goods. Auto sales are increasing at more than 20 percent. There is no demand crunch in white goods and FMCG. But in all these industries, margins have been under pressure. IT has recovered with industrial revival in the U.S. and Europe.

It is the banking sector that should be in a very comfortable position. Credit has been expanding much faster than deposits and credit/deposit ratio has shot up from 70 to 74 percent. With the increase in interest rates, profit margins should be higher.

While there will be differences in performance in different sectors, for the corporate sector as a whole the margins will be under pressure. By and large, there may be a dip in net profitability by about 400 bps. That is bound to inflate P/E making the market overpriced.

The April-June quarter, however, is likely to show significant improvement with industrial growth picking up and inflation dropping further if the monsoon is good. The market therefore should be on the run before the end of June though some sectors will get going before that.

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