On the margins of recovery

Corporate profit margins have recovered handsomely but are likely to come under pressure in the face of both higher salary as well as increased raw material costs.

Corporate profit margins have recovered handsomely but are likely to come under pressure in the face of both higher salary as well as increased raw material costs.

The global environment that India’s corporate sector faces is without precedent in the post-reform era. Exports have contracted sharply while private consumption demand growth has decelerated. In this backdrop, it is pertinent to examine how badly corporate houses have been hit relative to the pre-crisis level and how far they have recovered.

 

Our analysis is based on the quarterly data for a balanced panel of 2,040 manufacturing and 425 non-financial services firms (excluding oil and gas companies), extracted from the Prowess database. To examine the impact of the economic crisis on the bottom line of companies, especially in the third quarter of 2008-09 when the crisis intensified, profit margin ratios have been indexed to the levels of the preceding year, that is, to the third quarter of 2007-08.

Indian corporations experienced considerable erosion in both gross and net profit margins in the third quarter of 2008-09, relative to the pre-crisis level. Indeed, the net profit margin of manufacturing companies shrank to less than half on a year-on-year basis in the third quarter of 2008-09. Margins had started to decline from the first quarter of 2008-09, but the situation worsened with the deepening global crisis.

The good news, however, is that profit margins in the manufacturing sector have started to recover in recent quarters and have nearly rebounded to pre-crisis levels in the second quarter of 2009-10.

The results reveal that a sharp decline in growth of sales in the third quarter of 2008-09 rendered the margins vulnerable since growth in costs could not be cut to the same extent. Although growth in fuel and power, and raw material costs, also came down in line with the steep fall in global commodity prices in the third quarter of 2008-09, their growth continued to be above the growth in sales. More critically, a large component of expenses — the wage bill which, by its very nature, cannot be reduced within a short period — continued to grow at a significantly higher rate than sales growth, leading to lower profit margins in the third quarter of 2008-09.

By the first quarter of 2009-10, due to higher decline in raw material and fuel bill relative to a fall in sales, firms witnessed an unanticipated positive impact on their bottom lines. The escalation in wage bills was also restrained around the pre-crisis level in the first quarter of this fiscal. Consequently, profit margins began to recover. However, the positive scenario on cost reductions will begin to reverse in the future. The wages and salaries component has already began to accelerate again and the expenditure on raw material has also increased due to a sharp upturn in the outlay on fuel and commodity inputs. For example, steel prices have risen nearly 45 per cent in the first half of this year.

At the dis-aggregated level, it is natural that companies in the tradable sector have been affected more than domestic market-centric, because the shock originated from abroad. The pharmaceutical and gems and jewellery (G&J) sectors were the worst hit. Although the dip in the pharmaceutical sector is somewhat counter-intuitive, given that the sector is expected to be resilient to macroeconomic changes. It was, however, affected due to the indirect effects of the crisis in terms of currency depreciation, which dented the profit margins of the sector.

The problem was not confined solely to the export sector. There has been a collapse in profit margins of four-wheelers (4Ws) and commercial vehicles (CVs). These sectors were hit due to the tight monetary regime that prevailed until August 2008-09 coupled with increased risk aversion from banks which led to a significant drop in retail credit growth.

Similar analysis carried out with the second quarter results of 2009-10, that is indexing the gross profit margins to pre-crisis levels, reveals that most sectors — domestically market-centric as well as those linked to global recovery — have seen profit margins recovering sharply compared to the lows of the third quarter of 2008-09. Two-wheelers (2Ws) and CVs have emerged as the leaders of the pack, with 2Ws improving their margins further.

For most sectors, the margins were hit in the third quarter of 2008-09 despite sales being higher on a y-o-y basis, because expenditure growth remained above sales growth. Subsequently, as the global crisis intensified, raw material and fuel costs came down and profit margins of domestically-linked sectors recovered to the pre-crisis level. In sectors such as textiles, the rise in profitability is largely the result of recovery in domestic demand drivers and improved operational efficiency. The bottom lines of export-linked sectors have also improved significantly; the only exception is the G&J industry, where increase in input costs surpassed the impressive growth in sales revenue.

As for sales, with the commencement of recovery, revenues of all sectors have crossed the pre-crisis levels, with 4Ws and G&J leading the pack. In the case of the textile sector, aggregate sales have recovered to the pre-crisis levels, but our analysis suggests the recovery is not broad-based with larger companies growing at the expense of the smaller ones by rationalising the vendor base.

Most sectors, even those closely linked to the global economy, seem to be recovering to the pre-crisis level in terms of both sales revenue and profit performance. However, the extent of global recovery cannot be ascertained accurately as yet, and considerable uncertainties continue to prevail. The Indian economy is expected to operate below capacity for a while. As a result, going forward, profit margins could come under pressure in the face of expected rise in expenses.

The authors are senior economist and economists at Crisil respectively