The quality of earnings is a factor often overlooked in the quest to meet consensus estimates. Poor earnings quality, or unsustainable earnings, changes the perspective even when things look good at first glance.
Often, net profit is inflated by non-operating income or a one-time profit item. Another common situation is when a company with multiple subsidiaries produces good standalone results. Check the consolidated numbers to see if there are any surprises pigeonholed among subsidiaries.
The difference between consolidated and standalone results is a persistent issue in calculating Sensex and Nifty earnings. Exchanges tend to use standalone results in their calculations, which are often misleading. Also, this could go both ways: The consolidated numbers could be better or worse than standalone ones.
For the September quarter, the earnings quality of two blue-chip companies has taken a hit. Airtel's consolidated results show an annual 10 per cent rise in net profit for the September quarter. For the second quarter of 2015, the company logged Rs 1, 523 crore of net profit, against Rs 1,383 crore a year earlier.
However, the net profit was down compared to Rs 1,554 crore in the June quarter this year. As such, the net profit deteriorated sequentially in the latest quarter. Operating profits, or earnings before interest, tax, depreciation & amortisation (Ebitda) is up 6.6 per cent at Rs 8,265 crore, against Rs 7,749 crore a year earlier, but barely up compared to Rs 8,249 crore for the June quarter. Ebitda growth is very low.
There is an exceptional gain of Rs 660 crore on sale of assets (towers) in Africa. Exclude that and the profit would fall sharply against the second quarter of 2014. There was an exceptional gain of Rs 1,430 crore in the first quarter of 2015 and an exceptional loss of Rs 175 crore in the second quarter of 2014. All this makes results hard to compare but the earnings quality seems poor.
Airtel's standalone India operations have seen net profit fall about 50 per cent, while Africa operations continue to see net losses. Average revenue per user (ARPU) in India is down for voice, compared to the first quarter of 2015, though up for data. Overall, ARPU for voice and data fell three per cent year-on-year in the second quarter. More, interest costs have almost doubled (up 90 per cent) for the consolidated entity. Airtel has the largest telecom subscriber base in India. But, this is a crowded, highly competitive market; every service provider has to spend huge sums to stay in the game.
The second blue-chip is HDFC. The housing finance major saw standalone net profit rise 18 per cent to Rs 1,605 crore in the September quarter this year from Rs 1,358 crore in the year-ago period. Standalone income increased 12.5 per cent to Rs 7,466 crore. In the September quarter, HDFC received a dividend of Rs 315 crore from HDFC Bank. It had received equal dividend in the June quarter last year, too. If adjustments are made for the dividend income, the net profit declines annually. The net interest margin, a key metric for any lender, has declined marginally year-on-year. Non-performing assets have also risen marginally year-on-year. Standalone results suggest a flat or marginally negative trend.
The consolidated results (which include results from insurance operations) of HDFC show growth has been poor for the insurance sector, too. Consolidated net profit increased two per cent to Rs 2,106 crore, while total consolidated income rose eight per cent to Rs 12,521 crore year-on-year.
The Reserve Bank of India's rate cut of 50 basis points in September should help reduce interest costs for HDFC. But, these results will not enthuse anyone. Though HDFC is undoubtedly the best and biggest entity in the mortgage segment, it faces challenges on the growth front.
Both companies are reasonably well managed, with long track records. Both hold large market shares in their respective sectors. Both segments are customer-facing, with business activity correlated to consumption demand.
If you assume HDFC is a proxy for home loans and Airtel for telecom, in each case, the overall sector is struggling. As such, consumption might still be below par in the overall economy.
Some will see this weakness as an opportunity to invest in these two blue-chips for the long term. Others will see it as a warning to get out of those sectors. It's up to an individual investor to decide on how long the sentiment could last and see whether that fits his preferred timeframe for investments.
