'Servicing' corporate profits could be a problem

The productivity-hike picture implies continued healthy profits for the manufacturing sector, but the outlook for the financial sector doesn't look as good.

Corporate profitability not only conveys information about the current state of the economy, but also indicates its future prospects. This is because profits are a key determinant of investment and employment in the medium-term. Analysis of Indian corporate profitability reveals that profit numbers bode well for the current growth scenario but also reveals constraints on investment and on growth in the future.

Corporate results for the first quarter of 2006-07 based on 2,224 manufacturing and 649 non-financial service firms indicate that profit margins have remained steady during the last three years (see table). This implies that profit growth and sales growth have moved hand-in-hand despite significant cost pressures such as escalating raw material prices and interest rates. Interest rate hikes over the past two years have not dented the liquidity position of the corporate sector. Sectoral liquidity measured by the ratio of interest payments to gross profits declined from 18 per cent in Q1FY05 to 14.5 per cent in Q1FY07 for the manufacturing sector. For non-financial services too, this ratio declined from 10 per cent to 7 per cent during the same period.

While manufacturing except transport recorded an increase in profitability in Q1FY07 compared to the same quarter last year, sectoral results continued to suggest a wide variation in profit margins. Profitability in the non-metallic mineral sector (15.5 per cent) was almost four times that of textiles (3.8 per cent), which is the least profitable sector.

Profit margins in non-metallic minerals as well as metal and metal products reflect higher relative prices "" due to supply bottlenecks "" rather than growth in underlying productivity. Over time these imbalances would be corrected through increased capacity expansion which is likely to ease pressure on prices, thereby making profit growth more dependent on productive efficiency.

In sectors such as transport, high profitability levels are likely to be more systemic in nature since profit margins have grown more because of a trend increase in output rather than a rise in prices. This fundamental increase in profitability is likely to see more investments from new entrants as well as existing players and is likely to keep sectoral investment levels high.

Two of the least profitable sectors, namely textiles and chemicals, witnessed low profit growth because of lower relative prices and inflexibility. Output prices have not been rising in line with increasing input costs and have caused a deterioration in sectoral terms of trade. Fragmentation and lack of economies of scale has prevented these sectors from expanding output at a level fast enough to meet growing international demand.

From the longer term perspective (based on an eight-quarter moving average for the period Q1FY02 to Q1FY07) it appears that the manufacturing sector has witnessed a trend increase in net profit margins. This rise has been both due to a trend increase in operating surplus (gross profits/sales) and a trend improvement in sectoral liquidity (interest cost/sales). Although profitability in the non-financial service sector does not reflect a similar trend during the same period, it has nevertheless begun to rise from Q1FY05. Sustaining this increase in profitability is critical for the service sector since retained earnings have been an important driver of growth and expansion of services in recent years. If profit margins do not keep pace, the commitment of extra resources for capacity additions would suffer.

What is the likelihood that profit margins in non-financial services and manufacturing would be sustained? To explore this issue further, we divide profit margin (profit/sales) into two components "" a profit share component (profits/value added) and a productivity component (value added/sales). Increasing profit margin in manufacturing reflects a significant increase in the share of profit in value added since unlimited supply of labour in manufacturing and relatively low labour demand have kept a lid on wage growth.

In contrast, in non-financial services profit share has declined significantly over the same period. This decline has been partly offset by an increase in overall productivity. However, shortage of skilled manpower which has become increasingly hard to hire and retain has raised labour cost in recent years. If the wage growth continues unabated and labour productivity fails to keep pace, profits margins may take a hit.

To conclude, it is clear that the corporate sector as a whole has held its own amidst rising cost pressures. Manufacturing has witnessed a secular growth in profitability bolstered by unlimited supply of labour which has helped moderate wage growth. Comparatively, the services sector has been unable to keep a lid on wage costs due to limited supply of skilled labour, a factor which may hamper investment and growth going forward. Thus, sustaining the current trend in profitability requires continuing improvement on productivity front.

The authors are economists at Crisil Ltd