Will 2019 be the year of earnings revival?

One of the great frustrations of the past five years has been the abysmal performance of corporate earnings in India. Earnings have compounded at only about 5 per cent in these last five years, significantly undershooting consensus estimates, and frustrating investors. Every investor is tired of hearing how low the ratio of corporate profits to gross domestic product (GDP) has fallen and how much below the mean Indian corporate profitability currently is. One has seen too many strategy presentations regressing profitability back to the long-term mean over a five year period, and hence forecasting a 20 per cent earnings growth CAGR (compounded annual growth rate) for the broad market. These projections have been made every year for the last five years, and needless to say have not come to pass. Every single year, earnings estimates have had to be reduced, and consensus numbers cut, in many cases quite savagely. Fatigue has set in for many investors, with some saying that they will now believe in the earnings revival only after they see it. Indian market valuations only look reasonable if you believe in the earnings revival and profit margin normalisation, hence the criticality.

There is, to my mind, a real chance that the financial year 2019-20 (FY20) will be different. Consensus estimates are for earnings growth in the region of 20- 25 per cent, and I think we may actually achieve these numbers for once. A refreshing and much-needed change.

Illustration by Binay Sinha

The bedrock of the earnings revival in FY20 is the revival in profitability of the corporate banks. About 50-60 per cent of the incremental earnings growth for the broader market in FY20 will come from the revival in fortunes of the corporate banks, both private and public sector. As these banks will have largely completed both the recognition and provisioning for credit losses by the end of the current financial year, there will be a huge swing in profitability as credit costs simply normalise. Given the slowdown in incremental credit slippages, determination of most banks to take coverage ratios to near 60-65 per cent in FY19 itself and resolution of many large non-performing assets (NPAs) through the Insolvency and Bankruptcy Code process, this profit swing looks to be on track for FY20. Confidence comes from the fact that one does not have to assume large growth in credit or net interest margin (NIM) expansion, to deliver the consensus profit numbers, just a very reasonable assumption that credit costs drop from about 300 basis points to a more normalised mean of about 100 basis points.

Beyond the corporate banks, other diversified financials will also deliver about 5-7 per cent of the incremental profit growth expected in FY20. Given the hit many of these financials have taken in the second half of FY19, due to the liquidity crisis caused by the Infrastructure Leasing & Financial Services (IL&FS) default, FY 20 should see an improvement, as liquidity conditions normalise and one-off credit charges runoff.

The rupee has weakened by about 10 per cent in the last few months. The benefits of this depreciation will come through fully in the earnings for FY20. In the current year, hedges have prevented a full realisation of the improved profitability, and changed competitive position. The rupee benefits will accrue not just to exporters, but also to companies competing against imports more broadly. Big sectoral gainers will be IT (information technology) services, generic pharmaceuticals exporters and manufactured goods exporters. IT services companies, in particular, should deliver mid double digits earnings growth as their competitive position in digital continues to improve, IT spends continue to grow globally and company-specific margins/ capital allocation show improvement. They will deliver almost 10 per cent of the incremental growth in profits, we expect, for the broad markets. 

Another sector that will deliver strong growth in FY20 will be autos, as it experiences a significant pre-buy linked to a very significant change in emission norms in FY21. From commercial vehicles to diesel cars and utility vehicles (UVs), even two-wheelers, there will be a very significant increase in costs as India is forced to move to BS-6 norms. There will be a very aggressive pre-buy in commercial vehicles for sure, but this may extend to other segments also. A surge in volumes will benefit the whole chain — from original equipment manufacturers (OEMs) to component players and even the financiers. 

Beyond the above, there are also signs that the private sector investment cycle is slowly coming back, as capacity utilisation figures across industry continue to slowly creep up. A pickup in investments will front load profitability. 

Given that most expect the economy to gradually accelerate in FY20, and most macro variables to remain stable, with rates possibly declining, underlying profit growth in most consumption-oriented sectors should track their underlying trend of the last few years. 

Thus, FY20 can be the year when earnings finally break out, deliver on consensus expectations, and enthuse investors. In a world of slowing growth, few markets will show 20 per cent earnings. 

If we do get this earnings acceleration in FY20, it will help our markets stabilise and hopefully deliver positive performance in the calendar year 2019, as earnings growth will compensate for any multiple compression.

The broadening of earnings growth will also help to reduce the extreme valuation divergences we have in our market today. A bunch of the high quality, consumer-oriented names trade at multiples of 50-60 times forward earnings. Apart from the quality of management and superb business metrics, these companies have delivered stable, consistent earnings of 15-20 per cent, through the earnings recession of the last five years, when the market struggled to deliver even 5 per cent growth. As earnings growth broadens, and the market, as a whole, starts delivering 20-25 per cent growth, the valuation premium that investors are willing to pay for predictability of earnings should reduce. We may see a rotation away from some of these very highly valued consumer names, towards other more cheaply valued companies delivering similar 15-20 per cent earnings but trading at one third the valuations. 

Let’s hope that FY20 will finally be the year that earnings come through. In a tough, volatile and slowing global scenario, India will really stand out if it can deliver. 

The writer is with Amansa Capital