Rising commodity prices may squeeze India Inc margins

After a 500-basis point gain over the past six quarters, India Inc's Ebitda margins will be under pressure on rising metal and energy costs

A rally in international commodity prices would deal a double blow to Corporate India, which is already suffering from demand slowdown after demonetisation. The recent spike in crude oil and metals prices could put a stop to the profit bonanza that corporate India has enjoyed over the past six quarters. 

The Ebitda (earnings before interest, taxes, depreciation and amortisation) margin for BSE 500 companies, excluding banks, and oil & gas, is up nearly 500 basis points (bps) in the past one-and-a-half years from their lows in the March 2015 quarter, driven by lower commodity prices. This has resulted in a 28 per cent cumulative rise in Corporate India’s combined net profit (adjusted for exceptional gains and losses) despite a stagnant revenue in the past 18 months. This is now under threat due to the continued rise in metal and energy prices. One bp is one-hundredth of a per cent. 

Thomson Reuters CRB Commodity Index, which tracks the prices of 19 widely used commodities, including agri-products, metals and energy, fell by a little over 40 per cent between the June 2014 quarter and March 2016 quarter. This translated into a lower input cost for Indian manufacturing companies, pushing up margins across manufacturing sectors. The biggest gainers were companies making paints, tyres, automobiles, auto components, cement, consumer durables and chemicals, among others. 

Commodity prices impact corporate profitability with a lag of a few quarters. For example, while the CRB Commodity Index made its near-term high in the June 2014 quarter, the operating margins for BSE 500 companies, ex-financials and energy bottomed out after nine months in the March 2015 quarter. 

The commodity cycle is once again on an upswing with non-ferrous metals prices as tracked by London Metal Exchange Index up 27 per cent from its quarterly lows in December last year. Crude oil prices are up 56 per cent during the period. 

Overall, the CRB Commodity Index is 13 per cent from its lows in the March 2016 quarter. 

Analysts say this will start eating into corporate profitability from the September-December 2016 quarter. The pain for Corporate India would be exacerbated by the currency demonetisation and its negative impact on revenue growth. 

According to estimates by Emkay Global, a decline in sales growth with even a modest 50-bp decline in operating profit margin can lead to a 20 per cent decline in profits of non-finance companies. 

“Historical data suggest that pricing power is a bigger determinant of operating margins than commodity prices. We can have high commodity prices and high margins, if demand growth is high, allowing companies to pass on high input costs. Demonetisation has severely weakened companies’ pricing power and is forcing them to absorb most of the recent rise in commodity prices,” says Dhananjay Sinha, co-head (institutional equities) at Emkay Global Financial Services. 

The biggest impact would be felt by paint companies, tyremakers and companies in energy-intensive industries such as cement and tiles. Incidentally, companies in these sectors are among the worst-hit by the demand slowdown after demonetisation. For example, cement prices have corrected by an average of Rs 4 a bag on all-India basis with dealers reporting up to 50 per cent decline in sales. 

“The recent rally in crude oil prices would pull down the record high margins that companies in sectors such as paints, tyres and chemicals are enjoying right now. However, margins could still settle at comfortable levels, if crude oil prices stabilise at $60-65 per barrel. Things would become problematic only if oil prices cross $70 a barrel, which looks unlikely right now,” says G Chokkalingam, founder and chief executive officer, Equinomics Research & Advisory. 

Economists also expect commodity prices to put upward pressure on wholesale inflation, leading to higher input cost for companies. “A large part of the gains that accrued to the economy from lower commodity prices in the past two years will now be reversed by way of higher inflation, potentially higher current account deficit and downward pressure on the rupee. Its exact impact on corporate profitability will depend on companies pricing power,” says Madan Sabnavis, head economist, CARE Ratings. 

The recent fall in the rupee means that commodity prices are much higher in rupee terms than their dollar prices suggest. A fiscal-induced demand boost during the second half of the next calendar year is something India Inc would need if the demand slowdown continues.