Metal headache: Commodity rally will put pressure on operating margins

The recent rally in metal prices would prove expensive for India Inc, which is still recovering from the demand shock and economic disruption caused by demonetisation and the roll-out of the goods and services tax.

Analysts expect cuts in corporate margins in the forthcoming quarters, given the negative correlation between metal prices and operating margins of domestic manufacturers.

Historically, domestic manufacturing companies (excluding energy, metals, and mining players) have reported higher core operating margins when commodity prices, including metals, have been low and vice versa (See adjoining charts).

The benchmark LME index on the London Metal Exchange (LME) is up 7.4 per cent during April so far and has rallied nearly 30 per cent since the beginning of 2017 calendar year. The LME index reflects the price movement of six base metals, namely aluminium, copper, zinc, lead, nickel, and tin. Aluminum, copper, and zinc have the highest weight on the index, together accounting for 89 per cent of the index.

There is a similar trend in steel, with the price of hot-rolled steel up 5.1 per cent in the Chinese spot market in the last one month. China is the world’s largest producer and consumer of steel and its spot prices are a benchmark for the global steel industry.

Historically, there is a negative correlation between commodity prices and corporate margins in India. 

For example, the core operating margin of listed companies (excluding financials, oil and gas, metals, and information technology) rose from a low of 19.7 per cent (of net sales) during the January-March 2015 quarter to a record high of 22.1 per cent during October-December 2016 quarter.

The margin expansion was preceded by a 43 per cent fall in prices of base metals such as aluminium, copper, and zinc between June 2014 and December 2015.
 

The trend in corporate margins reversed in the last one year as metal prices began to climb after hitting lows in December 2015. The core operating margin for domestic manufacturers is down 225 basis points (bps) during 12 months ended December 2017 quarter.

This, analysts say, will translate into higher raw material prices for Indian manufacturers, forcing companies to take a hit on their margins unless the costs are passed on to consumers, which looks unlikely. “In a booming economy, companies pass on the cost hike and even make mark-up margins, but demand conditions are soft right now, limiting manufacturers’ pricing power,” says G Chokkalingam, managing director, Equinomics Research & Advisory.

He sees at least a 200-bps decline in core operating margins of domestic manufacturers due to higher metal prices. Cuts would expand to 500 bps if there is a rally in crude oil prices as well. One basis point is one-hundredth of a per cent.

The maximum impact would be felt by companies in metal-intensive sectors such as automobiles, capital goods, and consumer durables. In comparison, companies in chemicals, plastics, paints, tyres, and synthetic fibres would bear the brunt of the recent spike in crude oil prices.

“Usually there is a three-four quarter lag between movement in commodity prices and corporate margins due to factors such as inventory of raw materials and resetting of prices by suppliers. The transmission could be faster this time as companies are sitting on a lower inventory due to poor demand in the last three years,” says Dhananjay Sinha, head of research, Emkay Global Financial Services.

This could wipe out most of the gains in corporate earnings that came after a sharp decline in metal and energy costs beginning in the second half of 2014, he says.
 

There has been some recovery in demand and top line growth in recent quarters, which could be negated. For example, the combined net sales of domestic manufacturers were up 5.5 per cent during the trailing 12 months ended December 2017, growing at the fastest pace in the last 11 quarters. This raised hopes of double-digit growth in corporate earnings (net profits) during the current fiscal year. “A sustained rise in commodity prices would jeopardise economic recovery in India due to its adverse impact on trade deficit and currency, besides corporate profitability,” says Sinha.

The blow, however, would soften if there is a strong demand recovery in the economy during the current fiscal year as anticipated by the markets. “Faster demand growth would allow companies to pass on the rise in input prices thus, protecting their margins and profitability,” adds Sinha.

There is also a sense that commodity prices may not rise beyond an extent due to the lower demand after the trade war between China and the US, and the surplus production capacity in most commodity-producing economies. “There has been a deceleration in export growth in major economies after tariff hikes in the US and China. In crude oil, producers in the US are adding rigs at a record pace, putting a check on prices,” says Chokkaligam.