Metals and mining may underperform in the second half

Metals and mining was the best performing sector in the September quarter. The global commodity cycle was up strongly for non-precious metals, and for energy. In addition, tariff protections added to the margins for metals and helped benefit local steel manufacturers, while the bullish global trends benefited Coal India and NMDC; also, to some extent, Oil & Natural Gas Corporation and Oil India.

The reversal in crude oil prices has been highlighted but the reversal in industrial metals is also worth noting. Steel hit a record high earlier in the year but prices have moderated. Ditto for copper, whose prices collapsed in June. Aluminium prices started falling in April-May. Manganese is still strong.

The price movements have been driven to a large extent by perceptions that global growth will get slower in 2019. This will result in lower demand. If true, the second half of this financial year (ending March 31) will be much less exciting for commodity manufacturers and this should reflect in share prices across a wide range of companies.

The other side of the story is that high metal and energy prices have impacted the margins of downstream industries. Construction costs, for example, have been hit by high steel prices; cement has been impacted by high energy prices. The automobile industry has also suffered from higher input costs. Manufacturers have not been able to pass these on to consumers. We've seen that in terms of margin pressure in the September quarter (second or Q2 of 2018-19) and it's also visible at the macro level, if you look at the Wholesale Price Index (WPI) versus the Consumer Price Index (CPI). The WPI has been consistently trending about 100-150 basis points higher than the CPI, indicating the margin issue for manufacturers.

A study by the BS Research Bureau shows that in Q2, the combined net profit of 1,889 companies, across sectors, was up 16.2 per cent year-on-year (YoY), the fastest in seven quarters. Base effects caused by the Goods and Services Tax have to be accounted for, with earnings down 11 per cent in Q2 of 2017-18. Even so, the net profit for this sample, was up by three to four per cent on Q2 of 2016-17.

Combined revenues were up 19.6 per cent YoY, the best in three years. But, 60 per cent of top-line growth was accounted for by oil & gas and metals & mining. Net sales of energy companies, including Reliance Industries, were up 48 per cent YoY, while metals and mining net sales were up 23 per cent. Metals and mining also topped in earnings growth, with 151 per cent growth in net profit. The best performances were from Coal India and Tata Steel.

In contrast, companies which disappointed were cement, automobile makers, auto ancillaries, consumer durables makers, airlines and in media & entertainment, with lower than expected growth in earnings per share. The operating margins of domestic manufacturers (excluding other income) was down 150 basis points YoY, due to rising materials and energy costs.

All that might have changed with the shift in the cycle. A fair basket of industrial commodities is now trading lower than a year before, although the drawdowns are uneven. Oil is down, YoY, copper is down, aluminium, zinc, nickel are all down. Steel and coal are still up.

The lack of demand is a worrying factor but lower metal and energy prices should help boost margins for users. Volumes for manufacturers might remain stagnant if demand does not pick up but that could still mean higher earnings, on flat revenues.

Given commodities are cyclical and the cycle appears to have changed for the worse, there is a case for investors to start moving out of metals and mining, and to look at downstream manufacturers. The pattern of returns across the second half of the year could be different from the first half.