Growth without profits

While net sales of non-oil and finance companies have grown the fastest in the last five quarters, net profit has declined by 11.2%; the picture looks worse if IT is excluded

When it's pitch dark, even the hint of a faint light often brings relief. That's what the second quarter results of companies that so far have done for the markets and investors. A much better-than-expected top line growth has sparked hopes of a turnaround in India Inc's fortunes, leading to rally in the stock markets, with the benchmark BSE Sensex scaling a new peak. The thrill of an acceleration in revenue growth after two years of deceleration has overshadowed concerns about decline in operating margins and net profit - adjusted for exceptional items, for the first time in at least eight quarters.

The combined net sales of 787 non-oil, non-financial companies in our sample is up 12.3 per cent over the corresponding quarter last year, growing at its fastest pace in the last five quarters. The top line growth is 13.6 per cent - the highest in the last three quarters - if the numbers of all 986 companies, including oil & gas majors and financial companies, is considered. (Click for chart)

The news on margins and profits is, however, sombre. Reported net profit that includes exceptional items such as forex losses has declined by 11.2 per cent, against a decline of 5.2 per cent in the first quarter and a rise of 30.6 per cent during the corresponding quarter last year. Excluding exceptional items, the combined net profit for these companies has declined by 1.6 per cent, a first in the last six quarters. This is due to a fall in operating margins and rise in interest burden and depreciation charge. The picture changes only marginally, if oil & gas and financials are included in the sample. (Click for tables)

The sample includes 36 of India's top 50 companies that are part of the Nifty 50 index. The trend is likely to change a bit once the results season ends by the middle of October, as some of the industry leaders such as Tata Steel, Tata Motors, Hindalco, Coal India, State Bank of India, ONGC, Sun Pharma, Cipla and Indian Oil Corporation, among others are still to declare their quarterly numbers.

Growth has been driven by inflation- allowing consumer companies to get price increase- and rupee depreciation that has allowed exporters to book higher rupee revenues, besides exporting more. The rupee impact is visible in the information technology (IT) sector with TCS, Infosys, HCL Tech and Wipro among others being the top performers in terms of top line and bottom line growth. Excluding IT, the revenue growth for the sample falls to 10 per cent, while net profit adjusted for exceptional items has contracted by 14.6 per cent - the worst in eight quarters.

"Export- led companies, especially in IT and pharma, have done well on all counts and their outlook remains bullish given that the rupee is down 20 per cent on a year-on-year basis and export volume is rising," says Rikesh Parikh, vice president, institutional corporate broking at Motilal Oswal Financial Services. In all, net sales for IT companies are up 29 per cent, while net profit is up 28.3 per cent and operating margins have improved 130 basis points over last year.

Analysts blame the divergence between the top line and bottomline growth on inflation. "Higher inflation allowed companies to get price hikes despite poor volume growth. It translated into faster revenue growth and even margin improvement for those with pricing power," says Dhananjay Sinha, co-head institutional equity, at Emkay Global Financial Services.

It is most clearly visible in the consumer space, where FMCG companies have reported higher revenue growth and margin improvement on sequential basis. For non-consumer companies, however, inflation has translated into higher operating cost, especially employee cost and overheads.

At 16.7 per cent of net sales, core operating profit margin has fallen to its lowest level in the last seven quarters. Three years ago, the operating margin for the same set of companies was around 20 per cent. Margin shrunk by 86 basis points sequentially and 140 basis points over the corresponding quarter last year, driven by rise in salaries & wages and higher spends on sales & marketing, as companies try to grow by grabbing market share from their rivals.

Salary and wages are up 21 per cent, growing at its fastest pace in six- quarters. Sales and administration expenses are up 18.6 per cent, a six quarter high. Employee expenses are now equivalent to 12.5 per cent of net sales - up from 11.2 per cent last year and 10.7 per cent three years ago. This is good news for consumer companies, but for others, it hints at a vicious cycle of wage-push inflation that raises operating costs.

Some economists link it to the high double-digit rise in government expenditure in the current financial year compared to last year. "Public expenditure has created a consumer-led growth but it can't be sustained without a corresponding rise in investment. Given the government's compulsion to bring down the fiscal deficit, there is a slim chance of the latter happening anytime soon," says Devendra Pant, chief economist and head public finance, at India Ratings & Research.