Raw material costs to remain low in FY16, to aid operating margins

Raw material cost at 12-year low; prices of crude oil, coal, iron ore might stay weak

Indian companies’ earnings remained weak in 2014-15, particularly in the March quarter. But the overall performance might have been much worse if India Inc had not got some relief on raw material costs in the January-March quarter of the year. Raw material costs as a percentage of sales in the quarter fell to 46.6 per cent — the lowest since the 45.3 per cent seen in December 2002.

Analysts expect raw material prices to remain subdued in the current financial year, too. This will help companies keep input costs under control, thereby improving their operating margins.

One of the main reasons for companies’ savings on input costs was a steep fall in prices of crude oil and its derivatives. In the March quarter, Brent crude oil averaged $53.9 a barrel, a level seen after several years.

The prices of coal, copper, iron ore, steel, rubber, cotton and many other industrial commodities and fuels were low, too.

This was some comfort for Indian companies, which were facing a major problem because of demand staying low, new projects not taking off and revenues, therefore, remaining muted.

Raw material costs are widely expected to remain weak. And this, with finance costs beginning to come down, could lead to an improvement in operating margins.

Mahesh Nandurkar, India strategist, CLSA, said: “India Inc’s Ebitda (earnings before interest, tax, depreciation and amortisation) margins have seen some improvement in the past few quarters, due to falling input costs. Decline in raw material costs has more than offset the adverse impact of operating leverage because of revenue growth coming down. Going forward, the benefits of falling raw material costs are expected to continue, and the potential improvement in revenue growth will likely drive operating margins. Further, the expected fall in interest costs should boost net profit margins, and return on equity (RoE) should go up.”

Commodities other than crude oil, copper and zinc have continued to slide in the June quarter.

Nic Brown, head of commodities research at Natixis, a London-based research house, says: “Crude oil, coal and iron ore are expected to remain weak. Fundamentals have improved for metals like copper and zinc, which might strengthen.”

According to Brown, crude oil will remain oversupplied. Natixis estimates the Brent price to remain in mid-$60s a barrel, in the second half of 2015, as well as through 2016.

As structural changes in China continue to depress global coal prices, there will be surplus of both coking coal and metallurgical coal. In India, coal prices will also be affected by the availability (and auction price) of blocks. A similar story will keep iron ore prices depressed.

For metals, Nic says: “Nickel and aluminium exhibit excessive supply at present, and hence the recent decline in prices. However, with the price of refined metals now trading below the cost of production for many higher-cost producers globally, a mild rebound in nickel and aluminium prices would not be surprising. In contrast, fundamentals are robust for copper and zinc, suggesting their prices might rise over the coming year.”

The benefits of lower raw material costs might get somewhat diluted if the rupee continues to weaken. But Brown says even this might not be an issue, as “with fall in gold imports and low crude oil prices, the country’s current account deficit will come under control and cap the rupee’s weakness”.

Ajay Srinivasan, director, CRISIL Research, says: “With prices of most commodities likely to remain subdued, we expect Indian companies to continue to profit from lower raw material costs in 2015-16. For example, we expect crude oil prices (Brent) to average around $60 a barrel in 2015. That will benefit the companies whose raw material costs are linked to crude oil supply chain. Similarly, companies consuming steel will gain from tepid prices. Average international steel prices are forecast to be in the range of $380-400 a tonne in 2015. However, demand growth and a competitive scenario will influence the extent to which these gains on the raw material front will flow to the bottom line.”
 

Continued lower demand and poor monsoon can, however, upset India Inc's margins. If monsoon remains poor as per the IMD forecast, rural demand may be low for sometime. 

Several industries have also seen cheaper Chinese imports flooding Indian markets, which include manmade fibers, paper and steel among others. While cheap imports keep domestic prices under control, it hurts the pricing power of Indian companies. The steel industry is an example. 

With the RBI signalling a pause to further rate cuts and banks not passing on the cuts, the profitability of India Inc may be impacted. 

“It is clear that given the RBI’s stance on monetary policy, it does not look as if the cost of borrowing will fall further in FY16. However we focus on operating margins which in the the medium to long run will be driven not so much by raw material prices but by the competitive position of the companies concerned. I reckon that if you look at operating margins for the Sensex over long periods of time, you will not find them to be correlated to raw material prices,” said Saurabh Mukherjea, CEO, Institutional Equities, Ambit Capital.