India Inc faces new challenges to maintain growth momentum in FY23

A strong double-digit recovery in revenue and profit in 2021-22 (FY22)   ended a three-year growth drought for India’s top 1,000 listed (BS1000) firms. Their combined revenue was up 33.9 per cent year-on-year (YoY) in FY22, while aggregate net profit was up 72.5 per cent.

In contrast, combined revenues had contracted for two successive years in 2020-21 (FY21) and 2019-20 (FY20). They grew at a compound annual growth rate (CAGR) of just 2.2 per cent from 2017-18 (FY18) to FY21.

Similarly, aggregate net profit was down 42.4 per cent YoY in FY20, followed by an earnings recovery in FY21 and FY22. However, net profit CAGR was just 7.5 per cent between FY18 and FY21.

Against this backdrop, a surge in BS1000 companies’ revenues and profits in FY22 created an expectation that India Inc might be on the cusp of a new cycle of growth after years of subpar growth.

It was expected at the beginning of 2022-23 (FY23) that consumer spending would see a post-Covid-19 uptick, export growth would pick up, and higher government capital expenditure (capex) would kick-start a boom in new projects by the corporate sector, ending its years-long capex famine.

“India’s earnings cycle has seen a turnaround after nearly a decade. Domestic earnings continue to remain healthy and provide a silver lining, notwithstanding the challenges faced on multiple fronts, such as the Russia-Ukraine war and rising interest rates. After 15 per cent and 35 per cent growth in Nifty earnings per share in FY21 and FY22, respectively, we are building in 18 per cent growth for FY23”, wrote analysts at Motilal Oswal Securities last June, after corporate results for the fourth quarter (Q4) of FY22 were declared. They expected the profit-to-GDP ratio to improve in both the short as well as medium term.

Other analysts also expected a revival in the corporate capex cycle in FY23.

“We believe the structural story is intact, led by information technology (IT) services with strong global demand, record hiring, and salary hikes; [and] expect gains from the China Plus One supply-chain realignment in pharmaceuticals, chemicals, textiles, among others, and private-sector capex to kick-start, led by cement, steel, oil and gas, textiles, data centres, etc,” wrote research analysts Amnish Aggarwal and Anushka Chhajed of Prabhudas Lilladher in their India Strategy report last April.

Slowing quarterly earnings growth in FY23 and a deterioration in the local and global macroeconomic environment, however, show that secular growth remains a challenge for India Inc.

Earnings slowdown

Corporate earnings have slowed in FY23, from the highs of the last quarter of FY22.

BS1000 companies’ revenue growth in the third quarter (Q3) of FY23 was the lowest in seven quarters. Combined revenues grew 17.2 per cent YoY in Q3FY23, down from 28.8 per cent in the second quarter (Q2) of FY23 and 34 per cent in FY22.

The trend in earnings has been worse. BS1000 companies’ combined net profit was down 15.6 per cent YoY in Q3FY23, following a 26.9 per cent YoY decline in Q2 — the worst showing for corporate earnings in the aftermath of the Covid-19 pandemic.

The rise in interest rates has also reduced the financial flexibility of firms. BS1000 companies’ interest coverage ratio fell to 5.5x in Q3FY23, from a decade-high 6.8x in FY22, as interest expenses surged while operating profits shrank.

Their total interest expenses rose 24.3 per cent in Q3FY23, while operating profit, or earnings before interest, tax, depreciation, and amortisation (Ebitda), was down 2.2 per cent in Q3. The sharp rise in interest expenses was a result of additional borrowing by many companies, especially in the manufacturing sector.

Analysts expect further deterioration in financial ratios, as interest rates have yet to peak and central banks, including the Reserve Bank of India (RBI), continue to fight inflation.

This analysis, based on quarterly results of a sample of 908 of the top 1,000 companies whose numbers are available for the last 16 quarters, casts doubt on their ability to grow at a fast clip in FY24 and beyond.

“The combination of a slowdown in revenue growth, contraction in earnings, and higher interest expenses will force many companies to scale back their growth targets to conserve cash. Poor profitability and a decline in the financial ratio will also force companies to defer or even cancel capex plans and new projects,” says Dhananjay Sinha, director and head of research and strategy at Systematix Institutional Equities.

Sinha expects corporate revenues to grow just 7-8 per cent YoY in Q4FY23, with similar single-digit growth in FY24. Lower-than-expected corporate earnings have also led to earnings downgrades by brokerages.

“Corporate earnings were below expectations during the (October-December) quarter, dragged (down) by commodities, while financials and auto held the fort. The broad-based slowdown in consumption, both staples and discretionary, also hit corporate earnings,” wrote research analysts Gautam Duggad, Deven Mistry, and Aanshul Agarawal of Motilal Oswal Financial Services, in their India Strategy report after Q3FY23 earnings were announced.

“Of the 222 companies under our coverage, 83 exceeded estimates, 96 recorded a miss, and 43 were in line on the profit-after-tax front,” they added.

The brokerage now expects the combined net profit of Nifty50 companies to grow 11.6 per cent YoY in FY23 — a sharp scale-down from the 19 per cent it expected at the start of FY23. This could translate into earnings contraction for companies in the non-financial space, as banks and non-banking financial companies (NBFCs) have accounted for most of the growth in corporate earnings in the first three quarters of FY23.

BS1000 is a listing of the 1,000 biggest non-financial companies ranked by their consolidated revenues in FY22/calendar year 2021. This excludes banks, NBFCs, insurers, and stockbrokers.

Macroeconomic headwinds

India’s growth also faces headwinds from worsening macroeconomic factors. GDP growth at constant prices came in at 4.4 per cent in Q3FY23 despite a relatively low base of 5.2 per cent YoY growth a year ago.

With this, GDP growth has been below 5 per cent in two of the past four quarters. Besides, in the past five years, India’s GDP at constant prices has grown at 4.5 per cent on average. This raises doubts about the country’s ability to grow at a sustained 7 per cent or higher rate over the longer term.

“We expect India’s GDP growth to decelerate 100 basis points to 6 per cent in FY24, from 7 per cent this financial year (FY23),” says Amish Mehta, managing director and chief executive officer, CRISIL. The rating agency attributed this to a slowdown in the global economy, monetary tightening, and higher inflation.

“One, a slowing world — stemming from elevated inflation and aggressive rate hikes by major central banks — will create downside risks to India’s growth. Domestic demand, therefore, will have to do the heavy-lifting next fiscal. Two, the full impact of rate hikes by the RBI will manifest next financial year. Monetary moves typically impact growth with a lag of three to four quarters. Three, the tricky geopolitical situation implies that India will continue to reckon with volatility in crude and commodity prices,” says CRISIL.

Elevated inflation coupled with higher interest rates is likely to hurt private discretionary consumption, squeezing demand for manufactured goods, such as consumer durables, two-wheelers, and passenger vehicles. The recent rise in interest rates on home loans is also expected to weigh on demand for new homes, which will be a negative for industries such as cement, steel, paint, tile, glass, consumer durables, electrical goods, and furnishing.

Sluggish GDP growth has traditionally translated into lower revenue and profit growth for corporate India, including BS1000 companies.

“The drivers of corporate growth may differ from those of nominal GDP, depending on the economic cycle, but at the overall level, they move in tandem,” says CRISIL’s Mehta.

A slowing of the global economy has already begun to impact India’s merchandise exports, which declined YoY for the sixth consecutive month in February. Ministry of Commerce data show merchandise exports down 8.8 per cent YoY in February 2023 to $33.9 billion, from $37.2 billion a year ago, and a monthly high of $42.2 in March 2022.

Exports account for a significant share of revenue for BS1000 companies in sectors like two-wheeler, auto component and ancillary, textile and garment, chemical, pharmaceutical, metal and mining, and gems and jewellery.

Manufacturing slowdown

The corporate sector’s growth plans also face challenges from a persistent slowdown in the country’s manufacturing and industrial sectors. According to the latest national income estimate for FY23 by the National Statistical Office, the manufacturing sector declined 1.1 per cent YoY at constant prices in Q3FY23, compared with 4.6 per cent YoY growth in gross value added (GVA) and 4.4 per cent YoY growth in GDP during the quarter.

The overall industrial sector, which includes mining, construction, electricity, and utilities, grew just 2.4 per cent YoY in Q3FY23. GVA is the total output of goods and services in the economy minus consumption of intermediate goods and services, including raw materials and inputs. GDP is calculated by adding indirect taxes minus subsidies to GVA.

Similarly, the manufacturing sector grew only 0.4 per cent YoY at constant prices in the first three quarters of FY23, while the overall industrial sector was up just 3.8 per cent during this period.

By comparison, the country’s overall GVA at constant prices was up 7.2 per cent YoY, and GDP was up 7.7 per cent during the period. Analysts attribute the poor showing by the manufacturing sector to a narrowing of the growth funnel in the industrial sector.

“India’s industrial production data is characterised by the co-existence of limited growth sectors and contraction at a broader level. The rise in the manufacturing industry is majorly coming from an increase in the production of food products and beverages, auto and auto parts, basic metals, and coke and refined petroleum products. All these contribute 12.8 per cent of the total manufacturing basket,” says Sinha.

The latest Index of Industrial Production data, he reckons, suggests a decline in the output of most basic consumer goods.

“There has been a major contraction in the production of textiles, upholstery, ready-made garments, and footwear in February 2023. Similarly, production of building material items has flattened as pent-up demand has fizzled out,” he adds.

Fiscal drag

India’s growth also faces headwinds from the country’s unusually high fiscal deficit and public debt-to-GDP ratio. According to the International Monetary Fund, India’s public debt-to-GDP ratio, at 84 per cent, is one of the highest among emerging markets outside Latin America. It improved in the past two years owing to faster growth in GDP at current prices. But it will once again rise in FY24 owing to a sharp dip in GDP growth at current prices and a faster rise in fresh borrowings by the government.

A World Bank Policy Research Working Paper published in 2010 says a long-term public debt-to-GDP ratio of 64 per cent is a tipping point, and hurts GDP growth if public debt exceeds this threshold for an extended period.

A rise in public debt has made interest payments the biggest and fastest-growing expense item in government finances. According to the latest Union Budget, interest on central government debt will account for nearly a quarter of its expenses in FY24, up from 21.2 per cent in FY22.

The government’s interest expenses are expected to grow 14.8 per cent in FY24, against a 7.5 per cent increase in overall government expenses and an expected 11.7 YoY growth in central government tax revenues. Interest on public debt will, as a result, soak up 46.3 per cent of total central government net tax revenues in FY24, compared with 44.6 per cent in FY22.

The interest burden on India’s public finances will be even bigger if the RBI hikes rates further to tame inflation. This may force the government to cut back revenue expenditure. “Total revenue expenditure, net of interest payments, is budgeted to contract 3.8 per cent YoY at Rs 24.2 trillion in FY24. This implies a negative multiplier effect, which may accentuate the extant demand drag if the crowding-in effect of a sustained expansion in capex continues to disappoint,” says Sinha.

The government has tried to compensate for the cut in revenue expenditure, such as subsidies, by announcing a 33 per cent YoY jump in capex in FY24. This is expected to boost demand for investment-related goods, such as capital goods, steel, and cement, and crowd in private sector investment.

But private capex growth has been elusive. “We are yet to see broad-based growth in private-sector capex. Fresh investment in new projects is restricted to a handful of sectors — chemical, FMCG, auto ancillary, and green energy,” says Madan Sabnavis, chief economist at Bank of Baroda.

Corporate India’s growth will largely depend on the services sector, especially IT services exports, a bright spot so far. On the demand side, the heavy lifting on the demand side is mostly expected to be done by households and public spending on infrastructure.

This is unlikely to compensate for the contraction in exports (of non-IT sectors), declining profit margins of non-financial companies, and the fiscal drag on rural consumption.