 "Sajjid Z Chinoy: Something's gotta give")
With the continuing disconnect between the new gross domestic product (GDP) series and high-frequency indicators on the ground, corporate earnings have become an increasingly important barometer, not just for equity analysts to track sectors and firms, but for macroeconomists, too, to track the state of the business cycle.
Against this backdrop, earnings surprised positively in the January to March quarter after several quarters of disappointment. As markets await results for the April to June quarter, the question is what macro learnings can we glean from the last quarter and, indeed, the last year? What are the implications for the future? Is the recent performance replicable? Or will something have to give? We try and make sense of these issues in the lead up to earnings season.
Our universe of firms comprises the BSE 200. Furthermore, as is standard, we exclude financial and energy firms because the latter are significantly influenced by government policies (taxes, subsidies) that make their quarterly performance volatile and often unrepresentative of conditions on the ground.
So what trends can we glean from the earnings results over the last year? First, as Figure 1 shows, earnings growth has picked up smartly over the last four quarters, even as sales growth has remained tepid. The latest quarter is an exception, but we specifically address that later.
Second, the lift in earnings has been largely underpinned by the increase in EBITDA margins (Figure 2). To be sure, EBITDA margins are not completely devoid of volume implications, because they include fixed costs that need to be amortised over volumes. We, therefore, also construct gross operating margins (defined as sales minus raw material costs), which essentially capture the dynamics between input and output prices, and are independent of volume growth. We find that both indicators tell the same story: of margin expansion driving earnings over the last four quarters. Interestingly, even in the latest quarter (January to March) when earnings growth rose sharply and sales growth finally turned positive, EBITDA and gross operating margins jumped, and underpinned the positive earnings surprise.
Third, the margin expansion, in turn, was underpinned by the collapse in commodity and other input prices. Raw material costs started falling year-on-year from Q1 2015 (calendar year), with the pace of decline peaking in the second half of the year (Figure 2). Raw material costs declined more than eight per cent, on average, in 2015 versus an eight per cent increase in 2014 - a 16- percentage-point swing. During these quarters, EBITDA margins rose sharply, indicating that only a fraction of the sharp input cost declines was passed on as final price cuts. For example, EBITDA margins had declined to 19.8 per cent of sales in December 2014, but averaged 23.8 per cent of sales over the next five quarters, as oil and commodity prices collapsed.
Fourth, sales growth weakened over those quarters, likely reflecting a combination of output price declines and weak volume growth. Despite this trend, however, earnings picked up.
So the sequence of events for most of 2015 seems quite straightforward: a collapse in raw material costs boosting margins and earnings.
However, there was an interesting shift in dynamics in the January to March quarter. The boost from falling input prices began to fade, with raw material prices declining only 5.4 per cent one year ago (oya) - the lowest in five quarters - compared to the nine per cent contraction in the previous two quarters. Ordinarily, diminishing input price declines should have squeezed margins, and therefore, earnings last quarter. But exactly the opposite happened: EBITDA and operating margins jumped to their highest level in more than four years, underpinning the earnings surprise! Our only explanation for the sharp rise in margins when the boost from lower raw material costs actually faded is that output prices increased. This suggests the first signs of pricing power on the part of firms, which raised prices to offset slowing input price declines.
Consistent with this interpretation, both wholesale and retail core inflation have accelerated over the last few months. While Consumer Price Index core momentum (seasonally-adjusted, quarterly, annualised) has been tracking above six per cent since the start of 2016, core Wholesale Price Index momentum has also crept up from minus 1.8 per cent q/q, seasonally adjusted annual rate at the start of the year, to 2.9 per cent in June - a swing of almost five percentage points.
Could volume growth have powered the Q1 2016 increase in earnings, instead? This is unlikely given that sales growth, while finally positive, was just three per cent. Theoretically, sales growth could be weak but volume growth very strong, if output prices were declining. But that won't square with the observed margin increase. Also, it is unlikely output prices would decline if input costs and commodity prices were firming, and volume growth was strong!
So what does all this mean? India benefited from a large positive terms of trade shock in 2015, on the back of the collapse of oil and commodities. At the firm level, input costs collapsed, boosting margins and earnings amid weak demand and falling sales. In other words, lower commodities allowed us to have our cake and eat it, too: low inflation in tandem with higher corporate profits.
But those benefits began to wane in Q1 2016 and will likely fade further, or start to reverse. If oil prices remain at current levels, there will no year-on-year benefit for the rest of this year. Margins and earnings increased in January to March quarter, nevertheless, because firms began to raise output prices. But is demand strong enough to allow further price increases to preserve margins and earnings as the input cost relief fades further?
One thing seems certain: the free lunch from lower prices of commodities will soon be over. Against this backdrop, either firms will need to raise output prices to protect margins and earnings, with implications for inflation and monetary policy; or lacking pricing power, firms will have to accept a margin and earnings squeeze that could hurt investment down the line. Unless commodity prices fall further or volumes quickly pick up, something will have to give.
The author is chief India economist, J P Morgan
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
