Topline vs. bottomline

Profit growth due to input costs and not rising sales

Corporate results for the second quarter (July-September) are being announced this month. They will either confirm or cast doubt on the generally upbeat tone of other economic indicators and are, therefore, being watched with keen attention. The BS Research Bureau’s analysis of 139 early announcers’ numbers, while admittedly a small sample, provides some important indications of how the corporate sector is performing. The analysis throws up a rather mixed picture. For the sample as a whole, topline growth was rather muted, with sales growing by a modest 8 per cent year-on-year, slower than the 10.7 per cent achieved in the previous quarter. This is partially accounted for by low and even negative rates of change in prices in many sectors, so in real terms, output growth may look a little more impressive. But, compared to even that, the rate of growth of profits has been far more impressive. In the full sample, net profits grew by 30 per cent year-on-year. The financial sector accounted for a significant proportion of this, perhaps reflecting the positive impact of high interest rates on these companies, but even if that is accounted for, profits still rose by a healthy 22 per cent. If the wedge between sales growth and profit growth is representative of the larger set of companies that will announce results this month, it has important macroeconomic implications.

Low or negative changes in energy and commodity prices contributed to significant year-on-year improvements in operating margins in the first quarter. Although their impact has been diluted somewhat in the second quarter, they remain by far the most significant reason for the wedge. In other words, companies are making money because it has become much cheaper to produce a given volume of output. However, as the sales growth numbers indicate, volumes are yet to begin rising at rates that will allow profits to sustain growth when input prices stabilise. This situation is already upon us. Commodity prices have already begun rising and, consequently, input costs are likely to move up steadily over the next couple of quarters. For companies that are not able to achieve proportionate increases in sales, this will mean a compression of margins. Sustained profit performance is, ultimately, the key driver of both capital expenditure and market valuation. If aggregate profitability is under pressure, this will sooner or later translate into subdued investment activity and a correction in equity valuations.

Of course, these are yet early days for the recovery and it is inappropriate to view the current rates of sales growth as predictors of performance over the next few quarters. But, one thing that investors will have to keep in mind is that, even as the macroeconomic numbers bring relief, many companies will simply be too weak to take advantage of the situation. Over the next few months, “picking winners” is likely to be a more effective investment strategy than a “rising tide” view that assumes all companies will equally benefit from the economic turnaround.