Corporate earnings are the one and true indicator of stock market health. With the economy in dire straits, the markets have continuously surprised investors with the level of buoyancy. Since stock markets are forward-looking, current problems have been shrugged off. Markets are looking at the future earnings of companies and hoping things will only get better from here. But, for investors, who paid a good premium for quality companies, it is important to see whether those company managements are delivering results or not. With the September 2019 quarter earnings picture is now clear, in this article, we will look at the key highlights and takeaways from the Q2 scorecard.
A muted demand environment amid a general economic slowdown seems to have weighed on corporate earnings in Q2FY20. The BSE Sensex is a basket of the top-30 companies in the India Inc. So, let us take a look at how the Sensex firms performed. According to ICICI Direct research, the Sensex top line (excluding financials) declined by two per cent YoY (year on year). The operating margin profile was nevertheless stable YoY at 18.7 per cent amid raw material price decline (down 200 basis points YoY) and perils of negative operating leverage (up 200 bps YoY).
The Sensex Profit Before Tax (PBT), however, eased 12 per cent YoY primarily tracking an increase in interest and deprecation charge, which was partly compensated by higher other income.
In contrast, the Sensex Profit After Tax (PAT) in Q2FY20 was up nearly seven per cent YoY due to a new corporate tax rate regime with the blended tax rate for the quarter at 18 per cent vs. 32 per cent in the base quarter (Q2FY19).
While Sensex is an important benchmark, many investors track the wider Nifty-50 as well. The Nifty-50 has a larger number of stocks. Let us see if the Sensex picture finds a reflection in Nifty-50 Q2 numbers.
As per Motilal Oswal research, Nifty-50 sales declined 2.5 per cent YoY (versus an estimated decline of 2.1 per cent YoY). Nifty-50 EBITDA/PAT grew 2.1 per cent /8.3 per cent YoY (versus estimated decline of 2.4 per cent /8 per cent). Lower taxes drove the profit beat in the case of Nifty-50, a trend that we saw in the Sensex. PBT declined three per cent (versus estimated four per cent decline).
Excluding corporate banks, Nifty PBT declined 10.6 per cent (versus estimates of 11.8 per cent decline), dragged by metals, oil & gas and autos. PAT, however, was up 7.5 per cent YoY (versus an estimated decline of 7.5 per cent).
Nifty EBITDA margin (Ex-Financials, OMCs) contracted 50 basis points YoY to 20.2 per cent.
Aided by lower taxes, 42 of the 50 Nifty companies posted in-line/higher-than estimated PAT, while eight missed expectations. 16 of the 50 Nifty companies saw upgrades more than three per cent for FY20 EPS, while 12 companies saw downgrades of less than three per cent.
At the aggregate level, large caps continued to outperform midcap and small caps in these challenging times. Despite tax rate benefits, profitability was still muted in the midcap and small cap space. At the Nifty level, including banks and NBFCs, sales were largely flattish while bottom line grew (adjusted for Bharti Airtel) due to a recovery in earnings in banking space and overall tax-related benefits.
For the listed universe (~3,000 companies), top line de-grew 1.1 per cent YoY, while bottom line de-grew 16.6 per cent YoY. Large bottom line decline is owing to a one-time special charge at Bharti Airtel and Vodafone-Idea. Excluding this, the aggregate bottom line increased by 7.7 per cent YoY.
Going forward, incorporating the change in index constituents amid the government’s measures to overcome the economic sluggishness domestically, expectations are being moderated.
Modest quarter with tax cut led growth
A quick read of the above numbers tells us a few things. One, Q2 (July-September 2019 quarter) was a modest one. Two, the corporate tax cut helped companies post profit growth. Three, underlying business conditions on an aggregate basis have not really improved much. Four, the high expectations from corporate earnings have to be moderated i.e. earnings estimates need to be pruned to reflect realism.
According to Edelweiss, the weak growth momentum poses risks to FY20 Nifty estimate with Edelweiss FY19/FY20/21 estimate is INR480/580/730 versus the consensus forecast of INR480/550/690.
In light of this, the 22 per cent second half of 2019-20 financial year (H2FY20) Nifty asking rate looks a tad optimistic, although global growth tailwinds should help. Topdown, Edelweiss expects: i) global cyclicals (metals, export auto and industrials) to lead the earnings recovery; ii) domestic cyclicals (cement, utilities) earnings to slow owing to weak domestic demand and potential scale-back in government spending (while Street is factoring in a recovery). iii) Domestic consumption companies’ EBITDA growth to moderate as the deepening slowdown is now even hurting the organized sector, while lower input-price tailwind may fade. iv) The slowdown in bank loan growth to manifest in private banks too and a few pockets of retail lending. However, unsecured lending growth continues to be brisk (>30% YoY) with a higher share of incremental growth coming from sub-prime customers. Can this growth continue to defy the slowdown?
Overall, tax cuts are likely to aid PAT growth, but there are no wishing away operating challenges. And the prolonged slowdown is now weighing on the typically resilient companies. Global-oriented companies are better poised for recovery than domestic ones.
In this background, investors must tread with caution when it comes to completely believe what company managements say when it comes to future earnings. The façade of bravado, which saw companies maintaining guidance in Q1, has begun to peel off in Q2.
“We expect H2 to be better and this will not completely die out as a catchphrase for the majority. The stock market sails on hope, and so company managements will sell hope to justify current valuations.”
While the corporate tax rate cuts helped in arresting earnings downgrades, commentaries do not suggest any imminent recovery. Demand concerns in the economy are now coming to the fore, a continuation of which can raise the risk for earnings downgrades in FY21.
Hits and misses
One of the highlights of Q2 earnings picture is that 'beats' outpace 'misses' while forward earnings remain steady. This is a significant departure from recent trends. According to ICICI Securities, corporate earnings in the listed space have seen more beats than misses (146 beats; 117 misses and 57 neutral) while the forward earnings of the NIFTY50 index for FY21 and FY22 have been maintained without any downgrades.
Now, the momentum of positive earnings surprise holds the key. Despite the larger number of beats, the forward earnings have just been maintained, not upgraded. This could possibly allow the ‘positive earnings surprise’ to continue as it did in the US post the tax cuts. The bulk of the profit up-swing expected during FY19-FY22E is coming from: (a) banks which could further benefit from NCLT resolutions, credit growth revival, and tax cuts; and (b) industrials along with TAMO.
Let us take a look at sectoral trends provided by Edelweiss.
Domestic consumption: Weak domestic demand led to a broad-based revenue slowdown, although lower input prices boosted EBITDA growth. Going ahead, while demand may stabilize, fading input-price-tailwind could weigh on EBITDA growth.
Domestic investment: Industrial companies posted flat EBITDA growth (sharp moderation from FY19) while cement turned in a robust uptick. Going ahead, weak demand along with potential scale-back in government spending and the fading input-price-tailwind could weigh on cement earnings. That said, improving global growth could drive up industrial companies.
Global exporters: IT companies’ EBITDA growth slowed, while export auto EBITDA inched up. EBITDA growth for these two sectors is similar, but their paths are different. Going ahead, auto export growth could do better given their higher sensitivity to global growth.
Resources: A very subdued quarter with EBITDA contracting. However, given the expectations of an improving global economy and the stalling USD rally, earnings recovery prospects are bright.
Financials: In this quarter, aggregate loan growth slowed to seven per cent YoY (versus 11 per cent in Q1FY20) dragged by private banks, PSU banks, and NBFCs. Credit cost is moderating though. Unsecured lending is holding up, but can it continue to defy the downturn?
(The author is a journalist with 14 years of experience)