The economic recovery needs more demand, revenue growth

Profits grow, but not because of recovering demand

A broad-based economic recovery still seems some distance away, judging by corporate results in the July-September quarter (Q2, 2014-15). Lower costs enabled India Inc to show higher profitability. But sales grew slowly, indicating weak demand. Operating margins have also reduced a little compared to April-June 2014 (Q1, 2014-15). Net profits for a set of 2,432 companies (excluding banking and other financial companies, and also excluding those in the oil and gas sector) rose 41.8 per cent over Q2, 2013-14. This was a sharp improvement over the 29.9 per cent year-on-year growth rate of net profits, registered in Q1, 2014-15. But year-on-year sales growth dropped to 5.9 per cent in Q2, the lowest growth rate in five quarters and well below the 10.1 per cent sales growth of Q1. This is crucial: without robust top-line growth, it is impossible to declare that a recovery is broad-based or sustainable.

Operating profits also grew at a slower rate of 12.6 per cent, which was much lower than the 20.1 per cent growth registered in Q1. Operating margins, which were at 15.6 per cent in Q1, declined to 15.1 per cent. The rise in net profits could be attributed to lower costs and to base effects, not a demand recovery. In Q2, 2013-14, net profits fell by 21.9 per cent year-on-year, while interest costs rose by an extraordinary 36.9 per cent. In Q2, 2014-15, interest costs rose by a moderate 7.9 per cent year-on-year. That is enough to account for the 42 per cent rise in year-on-year net profits. Companies have also benefited from lower commodity prices. The rupee has stabilised, reducing the cost of imported raw materials. Interest rates have stabilised at slightly lower levels. Domestic inflation is also down.

But the lack of demand is worrying, given consumption demand contributes to over 60 per cent of gross domestic product or GDP. These results also gel with the 1.2 per cent lower excise duty collections by the Centre across April-October 2014 compared to the same period of 2013. The net profits of fast-moving consumer goods companies grew at 7.8 per cent, the slowest pace in 12 quarters. Sales growth slumped to the lowest in four quarters. Sales of another big-ticket consumption item, automobiles including commercial vehicles, were negative in September and October. Rupee stability has meant that exporters, such as information technology and pharmaceutical companies, showed moderating growth. Earnings growth for information technology companies fell to 15.9 per cent year-on-year in Q2, the slowest pace in 10 quarters. The year-on-year net profit of pharma companies grew at 30.3 per cent, down from 35.2 per cent in Q1. Sales growth for capital goods makers fell to 1.4 per cent from 2.9 per cent in Q1, which doesn't suggest a strong investment cycle either.

Companies are also braced for a cutback in government spending in the second half, so that it can meet fiscal deficit targets. Lower government spending would directly have an impact on construction and infrastructure, and also reduce rural disposable income. But if inflation trends down and the rupee is stable, margins may stay protected to some extent. In the circumstances, the stock market may be jumping the gun. An earnings recovery is creditable, but the sustainability of this is questionable until it is backed by revenue growth.