Leverage to Drive Two-Track Recovery in Corporates; Restrict Overall EBITDA Growth to Single Digits in FY17

Leveraged borrowers are likely to report a higher degree of deterioration in financial performance than non-leveraged borrowers in the next 18 months, restricting the overall improvement in profitability to single digits in FY17 (FY16: 2% yoy, FY15: 8.6% yoy), says India Ratings and Research (Ind-Ra). This would be significantly below the 25% growth seen during FY11 when the last wave of investments was initiated.

Companies having strong cash flow generation ability and low debt levels are likely to benefit from a gradual revival in the economy as nominal gross domestic product (GDP) growth picks up during the course of FY17 (FY16 provisional: 8.7%). The agency believes FY17 growth would be supported largely by consumption demand especially urban consumption with improvement in rural consumption likely during 4Q assuming normal monsoons. Other pillars of growth such as private investment, exports and government expenditure are likely to remain marginal contributors in FY17 as highlighted in Ind-Ra's Corporate Risk Radar Report.

On the other hand, corporates having weak credit profiles, significant leverage and low pricing power are likely to lose market share and show further deterioration or limited improvements in cash flow generation. As demand picks up, borrowing conditions would continue to be difficult for these corporates due to their stretched balance sheets especially given their sole reliance on Indian banks.

Ind-Ra analysed 366 of the 500 listed corporate borrowers (excluding banks and financial services, public sector units) in its reportRefinancing Risk: Top 500 Corporate Borrowers, dated 21 June 2016. 60% of the companies analysed showed a 20% yoy improvement in cumulative operating profitability in FY16 (median growth: 22.1%), while 40% posted a 25% yoy decline (median decline: 25%) with overall cumulative growth of 2% yoy. EBITDA margin remained stable at 14.6% in FY16 compared with 14.3% in FY15 on the back of flat top line growth (0.2% yoy) and lower input prices. As highlighted in the refinancing report, EBITDA of the entities in the high ease of refinancing and medium ease of refinancing categories grew at an average 13.3% and 10.5%, respectively, in FY16, while EBITDA of the entities in the elevated risk of refinancing category declined 5.1% yoy. Stressed corporates witnessed a decline of 8.1% yoy in EBITDA in FY16.

For FY17, Ind-Ra expects consumption-linked sectors to fare better than the investment-linked sectors as the latter would be affected by the issues of high leverage and continued low capacity utilisation amid improving-but-tepid demand conditions. Also, revenue in some of the investment-linked sectors could pick up in FY17 on the back of an improvement in demand and continuous spending by the government such as those in roads and railways through the engineering, procurement, and construction route. However, benefits of input cost would fade away keeping a check on profitability.

Eight sectors account for 75% of the total debt of 500 corporate borrowers. Of these, positive EBITDA growth for FY16 was reported in auto & automotive supplier (11%yoy), cement (9%), real estate (4%), telecom (7.5%), infrastructure and construction (20%) and power (23%). High growth in infrastructure in FY16 was driven by lower input prices. Power sector companies benefitted from an improved plant load factor on the back of an increase in coal supply by Coal India Limited. However, significant pressure on merchant prices and limited interest from the state electricity boards to sign new power purchase agreements could limit further improvements during FY17.

Sectors such as metal & mining and oil & gas reported an EBITDA decline of 21% and 13%, respectively, in FY16 due to a fall in crude and metal prices amid a slowing demand. Within these two sectors, the number of corporates which reported deterioration in the EBITDA levels was more than the number of corporates showing an improvement. Ind-Ra believes a combination of an improvement in commodity prices and operating leverage could provide some fillip to margins especially in sectors with high fixed costs. However, import threats would keep a lid on a significant improvement in capacity utilisations in FY17, impacting overall profitability growth for corporates.

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