Small rise in consumption will lead to a sharp increase in earnings

The second quarter results were top-heavy and lumpy in nature. Big companies have done better than small and medium-sized ones and a few sectors have done well. This is at least partly a consequence of the disruption caused by goods and services tax (GST) implementation. 

Three negative consequences of the implementation have impacted all businesses. One was predictable — the informal elements in every supply chain have been hit. The second is the need for more working capital, due to the upfront payment of taxes and the slow credit cycles and tax offsets. The third has been multiplication of paperwork due to higher compliance requirements.  

Big companies are in a better position to deal with all three. They have fewer informal elements in the supply chain and more internal resources. And, they can usually raise working capital more easily. They also have full-fledged accounting departments to do the paperwork. 

Business Standard recently looked at the results of 1,850 listed companies. Even allowing for GST, the results were not inspiring. Revenue grew 8.7 per cent year-on-year, which was reasonable, but net profit declined 2.6 per cent. 

The net profit of the Nifty 50 was up 12 per cent and those 50 companies accounted for about 80 per cent of the combined net profits of the entire sample. Even in this sample of ‘mega-caps’, 13 companies missed the consensus estimates and another 24 just about met these.  

As to lumpiness, the financial and energy sectors generated the lion’s share of revenue growth and profitability. If these two are excluded, net profits would have fallen by seven per cent for the rest of the sample, and revenue growth would have reduced to seven per cent. Other strong performances came in automobiles and metals. The latter was driven by higher global commodity prices, while the former saw a rebound after first quarter destocking. 

Several statistical quirks might have to be discounted. Results in the base period, July-September 2016, were tepid, creating a low base effect. Also, the festive season started early this year, which might have given a bump to September consumption. The low base effect will continue through the third and fourth quarters, since demonetisation hit the second half of 2016-17 hard. This is one reason why consensus estimates have not been cut across the board. However, Bloomberg’s data suggest there have been some cuts to consensus estimates even in large stocks. 

Many analysts tend to exclude financials and energy when considering market-wide results. These two sectors have volatile earnings. In energy, crude oil, coal and gas price movements impact earnings, both upstream and downstream. In financials, banks have a fair degree of latitude in terms of provisioning for non-performing assets (NPAs). 

For what it’s worth, crude oil prices are now hitting two-year highs, and this will have a negative impact across the energy sector if it is sustained. NPAs are still rising but at much slower rates and the market will accept the need for high provisioning and correspondingly low profits if it helps to clean up bank balance sheets prior to recapitalisation. However, interest rates are unlikely to be immediately cut again. So, banks won’t have capital gains on their bond portfolios to boost profits. 

The first half saw activity buoyed up by government spending. But, the government is unlikely to have a great deal of ammunition left for pump priming, since it has already hit over 95 per cent of the year’s targeted fiscal deficit. The best hope is that consumption does pick up. There are no really strong signs of this. Consumption will improve as GST settles down and the lingering impact of demonetisation has already more or less played out. 

As of now, valuations still seem unrealistically high. The Nifty’s price-to-earnings (PE) of 26 is over twice the rate of earnings growth. Mid-caps are running at unheard of valuations of 33 PE or more. The total market capitalisation to gross domestic product ratio is close to 100 per cent. That macro-indicator is, therefore, at a level that has only been matched in 2010 and exceeded only in 2007-08. 

Given a low base effect, even a small consumption pick-up could result in a sharp year-on-year earnings rebound.  It’s high time. The rally has been sustained on hope for the past six quarters, as growth has consistently disappointed.