India Inc's earnings recovery signals double-digit growth in next 2 years

It was never expected to play out like this, but the post-lockdown rebound in the economy and corporate earnings has rekindled hopes of a new cycle of growth for India Inc. The quarterly net profit of the top listed non-financial companies in the last two quarters has been among the highest-ever, with the recovery in earnings being quite broad-based.

BS1000 is the listing of the country’s top non-financial companies. The listing excludes banks, non-bank lenders, insurance firms, brokerages and credit rating agencies.

The latest trend is in sharp contrast to the sombre mood in corporate board rooms at the end of FY20, when India was in the middle of one of the world’s most draconian Covid-19 lockdowns. Even though fewer than 10 days of March were part of the lockdown period, its impact was reflected in the FY20 finances of BS1000 companies.

A deeper dig into corporate results suggests that the uptick in corporate profitability in FY21 has largely come from higher operating profit margins and cost savings, rather than higher revenues and sales volumes. It remains to be seen if higher profit growth momentum can be sustained once the favourable base effect has worn off in the second half of FY22.

Euphoria after disappointment

The combined net profit of BS1000 companies was down a record 45.8 per cent year-on-year (y-o-y) in the financial year ended March 2020 (FY20) to Rs 2.35 trillion, the lowest since FY08. The companies’ combined revenues were down 2.3 per cent over the previous year, the worst showing by BS1000 companies in at least two decades.

The pain and dismay of FY20 has, however, given way to euphoria, thanks to a steep V-shaped recovery in corporate earnings in the September and December quarters of 2020-21 (FY21). This has kindled hopes of strong double-digit growth in corporate earnings in FY22 and even FY23.

The change in India Inc’s earnings trajectory is most visible in the data on a trailing 12-month basis, which irons out the quarterly volatility in earnings that can create a lot of noise (see charts).

The top listed companies, excluding banks, non-banking financial companies (NBFCs), insurance firms and stock brokerages, reported a combined net profit of Rs 2.22 trillion for the trailing 12-months (TTM) ended December 2020. Though it is still down nearly 46 per cent from the all-time high net profit of Rs 4.1 trillion during the TTM ended September 2018, the figure is up nearly 3.5 times from the record low earnings of Rs 0.63 trillion (or Rs 63,000 crore) in the TTM ended June 2020.

This has raised hopes that India Inc may recoup most of the Covid-19-related losses by the March 2021 quarter and start FY22 on a clean slate.

“Q3 (December 2020 quarter) has been a historic quarter for us in many ways. Despite all odds, we delivered the highest daily production, highest monthly production, highest Q3 volume sales and highest-ever quarterly revenue,” Hero MotoCorp’s chief financial officer (CFO), Niranjan Gupta, said in an analyst call, describing the company’s third quarter results.

Ranked 40 in this year’s BS1000, Hero MotoCorp is India’s largest two-wheeler maker.

On the investment side, Larsen & Toubro (L&T), the industry bell-weather, announced large deal wins. “We registered strong growth in order inflows in the third quarter on the back of some very high order wins, most notably in the infrastructure and the hydrocarbon segment. Consequent to such wins, our order book reached a new high at the end of the quarter,” the company said in its earnings presentation.

Ranked 8th in this year’s BS1000, Larsen & Toubro is the country’s biggest independent company, with a large presence in construction and infrastructure, technology services, financial services, capital goods and defence manufacturing.

A better-than-expected surge in corporate earnings had led to an upward revision of forward estimates by the country’s top brokerages.

“The overall corporate profits in FY21 are now expected to be just 4-5 per cent lower than that in FY20, and far ahead of previous estimates. It will be followed by 25-30 per cent growth in earnings in FY22 and 15 per cent growth in FY23,” says Dhananjay Sinha, head of research at Systematix Institutional Equity.

Others are modelling the start of a private capex cycle, not heard of in many years. “We believe the government’s focus on fiscal expansion and capex spending augurs well for the revival of the long-anticipated private investment cycle,” says Gautam Duggad, Head of Research — Institutional Equities, Motilal Oswal Securities.

Revenues lack momentum

The optimism about future growth is at an all-time high. A break-up of the quarterly results, however, suggests that most of the gains in corporate profitability have so far come from margin improvement and cost savings rather than higher revenues, which were flat in Q3FY21. Sustained growth in earnings, though, will require robust demand and topline growth.

There is still some uncertainty about the future trajectory of consumer and industrial demand in the economy, in light of higher retail inflation, rising energy and commodity prices, and income shock from job losses during the lockdown.

Most economists expect a double-digit rise in India’s gross domestic product, or GDP, in FY22 after a contraction in FY21, when overall economic activity could still be lower than that in FY20.

“The output gap will remain negative throughout and actual economic activity will still be 8 per cent below the level had there been no pandemic. We expect GDP growth to moderate to 6 per cent in FY23 as domestic and global financial conditions begin to normalise, the debt overhang constrains government spending and labour market pressures affect demand and the savings and investment outlook,” said Tanvee Gupta Jain, chief India economist, UBS Securities India, in a recent report.

Not surprisingly, India’s largest carmaker, Maruti Suzuki, is cautiously optimistic about the demand situation in the forthcoming quarters. “We have seen a sharp fall in replacement buying demand. Post-pandemic, people are upgrading their vehicles a little less and holding on to their vehicles a little longer,” said the company’s CFO, Ajay Seth, in a conference call with analysts after the Q3 results.

Ranked 18th in this year’s BS1000, Maruti Suzuki is the largest foreign-owned company in India, with revenues of Rs 79,352 crore in FY20.

Commodity producers lead the profit surge 

The numbers also suggest that most of the incremental growth in earnings in the first nine months of FY21 came from commodity producers and companies in cycle sectors with high market concentration, such as metals, cement, tyres, petrochemicals, plastics and chemicals. Some analysts believe, however, that many leading companies in these sectors may be able to sustain their current profits, as a result of macroeconomic changes in the last few quarters.

“We believe that the recent rise in operating margins in many sectors is structural in nature, and could stay high by a minimum of 200 basis points for years to come,” says Shailendra Kumar, chief investment officer of Narnolia Securities.

For example, metal companies’ profits tripled during Q3FY21, while companies in cement, tyres, plastics and chemicals more than doubled their profits during this quarter.

The production and supply chain disruption that took place due to the pandemic boosted the pricing power of companies in these sectors, leading to a rise in their product prices and record high margins and profits.

Admittedly, there has been a consolidation in most of these industries in recent years, through a series of mergers and acquisitions. This, coupled with a rise in import duty protection and other trade barriers, has made it easier for the top companies in these sectors to raise prices and improve profitability.

Higher margins due to greater pricing power in the post-pandemic environment is good for these companies and their shareholders, but this raises operating costs for user-industries and consumers. This will cut into the operating profit margins of many large industries, such as automobiles, consumer durables, capital goods, and construction and engineering. Cost inflation is also likely to dampen overall consumer demand. In the medium to long-term, it could be a zero-sum game for India Inc.

Automakers are already feeling the pinch from higher metal prices. Maruti Suzuki reported an almost 300 basis-point y-o-y impact on its raw material costs, owing to higher commodity prices. Similarly, in the consumer goods industry, raw material costs for most companies grew much faster than the rise in their topline in Q3FY21.

Havells India, the country’s top durable maker — ranked 112 this year — reported a 60 per cent y-o-y rise in raw material costs in Q3FY21, while its net sales grew 39.5 per cent in this period. If this trend persists, it could weigh down India Inc’s overall profits in forthcoming quarters, as the universe of user-industries is much larger than commodity producers put together.

A break in earnings trajectory

The pandemic has, however, broken the earnings trajectory of India Inc and created a performance gap that may take years to fill, despite the recent surge in profits. This is visible in the charts, where profits are plotted on a trailing 12-month basis.

Corporate earnings have fallen into a lower orbit compared to their pre-pandemic level. Something similar had occurred after the 2008 Lehman crisis, and its financial impact had lingered for years.

This is crucial, because corporate India’s financial liabilities have risen during the pandemic. Total outstanding loans of listed non-financial companies were up 14 per cent y-o-y in the first half of FY21 (April-September 2020). And a break-up of balance sheets suggests that most of the incremental borrowings were used to fund working capital needs rather than create new capacity.

Companies’ fixed assets were up just 2.5 per cent y-o-y during the first half of FY21, which means they will need to generate additional cash-flows from existing operations to service this incremental debt. With interest rates and input costs rising, this could challenge the finances of many companies in FY22.

Companies will require a run of high profitability for many years in succession to reclaim the higher earnings trajectory of the past. This cannot be taken for granted, given the uncertainties the Indian economy now faces.