Commodity price rise, bond yields could weigh on India Inc's earnings

The recent spike in interest rates and commodity prices not only raises questions on the Nifty50’s sky-high valuation but could also weigh on the profitability of India’s top companies. 

The bump-up in corporate earnings in the last few quarters largely came from higher margins due to lower operating and finance cost rather than higher revenues and sales volume.

The Nifty50 companies’ operating profit (EBITDA) margins were up nearly 240 basis points year-on-year (YoY) while profit before tax (PBT) margins were up nearly 200 basis points in Q3 of FY21 YoY as companies saved on raw materials, energy and interest cost.

Higher margins more than compensated for flat revenues during the quarter. Index companies’ combined operating profit was up 9.7 per cent while their PBT and profit after tax (PAT) were up 25.7 per cent and 24.5 per cent, respectively, during the quarter.

For comparison, index companies’ raw materials and energy cost was down 6.7 per cent YoY, on an average, during the third quarter while their interest cost was down 4.3 per cent in the same quarter. Commercial banks and non-bank lenders such as Housing Development & Finance Corporation (HDFC) were the biggest beneficiaries of the sharp decline in interest cost, post the pandemic. 

The combined finance cost of the country’s top eight lenders, which are part of the Nifty50 index, was down 8.2 per cent YoY in the third quarter against 4.5 per cent decline in Q2 of FY21 and 6.6 per cent growth in the October-December quarter of 2020.

In comparison, lenders’ total interest income was up 6.1 per cent YoY while their total revenues, including fee income, were up 6.9 per cent YoY during the quarter. Savings on finance cost allowed lenders to report 8.9 per cent growth in net profit despite double-digit growth in employee and other costs.

Banks and non-finance companies are the single biggest component of the Nifty50 and accounted for nearly a quarter of index companies net profit in Q3 of FY21.

The recent development in the bond and commodity markets threatens to reverse these gains and hurt India Inc’s earnings in the forthcoming quarter.

“Higher bond yields are expected to have only a small impact on corporate borrowings cost but I expect a bigger impact from higher commodity prices. The recent rally in industrial commodities and crude oil price may bring down corporate margins in the next few quarters,” said Shailendra Kumar, chief investment officer (CIO) of Narnolia Securities. Higher yields may also force banks to book mark-to-market (MTM) losses on their bonds portfolio, thus hitting their bottom line.

Over the long term, there seems to be an inverse relationship between India Inc’s top line growth and profit margins. This comes out clearly in the chart below. Both ratios are on trailing 12-month basis, in a bid to wrinkle out quarterly volatility. For example, index companies have reported a steady improvement in operating margins since the October-December 2018 quarter despite a considerable slowdown in revenue growth during the period. 

The improvement in margins has been driven by a steady decline in raw material and energy cost besides the recent softening of interest rates.

Others, however, said rise in bond yields and commodity prices signal better demand that will allow India Inc to grow faster. “Higher commodity prices and interest rates mean a much faster growth in corporate revenues in the forthcoming quarters. This will more than compensate for any adverse impact on operating margins and overall corporate earnings will only rise from here,” said Dhananajay Sinha, head of research at Systematix Institutional Equities.

If this the case, it may require investors to rejig their portfolio in favour of commodity and energy producers and away from consumer goods companies that have been driving corporate earnings and equity markets for close to five years now.