Surreal Expectations

While markets seem to be betting on a better-than expected earnings season, the numbers tell a different story

While macroeconomic indicators tell a different story, what with the GDP growing at 5.7% in the June quarter — the economy’s slowest pace of growth in the past three years, and the CPI inflation in August rising to 3.36%, the markets seem to remain on solid ground. During the Q2 earnings season, by the looks of it, the market expects the earnings cycle to be more positive than negative. What else can be keeping them buoyant at this point, when macroeconomic indicators are far from rosy. 

In contrast to the market’s optimism, analysts and market experts remain concerned. “Barring domestic auto, commodity companies and private sector banks, growth is likely to be in mid-low single digits,” says Prateek Parekh, analyst at Edelweiss Securities. “The weakness is fairly broad-based and is a function of slackening demand as well as rise in input costs. By this time, earnings should have benefited from pent-up demand in the economy given that the effect of one-off disruptions, such GST-induced destocking and demonetisation, is ebbing. This lacklustre performance is a little disappointing,” adds Parekh. Consensus estimates peg the revenue growth for Nifty companies to be around 15% but a mutued earnings growth of just 5% as margins come under pressure in Q2FY18.    

Kamlesh Kotak, director (equity research), Asian Market Securities, says that there could be some downgrades owing to weak operating margins now that commodity prices have firmed up. This, combined with subdued demand, can put the end-user industries of commodities under pressure. For instance, “capital goods and engineering companies with a high exposure to commodities, such as ABB, Siemens, Cummins and sanitaryware players such as Kajaria Ceramics and Somany Ceramics, could see their margins come under pressure,” he says. 

However, most sectors that have done well in the recent past should carry on their positive performance in the coming quarter. The auto segment had a strong Q1 with 13% volume growth. Key segments such as tractors and commercial vehicles have done well recently, as can be seen from the commercial vehicle dispatches in September, which grew 28% on a YoY basis. “We are expecting the double-digit growth in auto to continue in this quarter as well,” says Pankaj Pandey, head of research at ICICI Securities. According to Kotak, tractor, commercial vehicles and car companies would continue to drive the growth, followed by two-wheelers. This growth momentum could continue even till the end of FY19, given the low base effect from FY17 and FY18 on account of sudden disruptions created in the system by demonetisation and the introduction of GST. According to analysts at Kotak Institutional Equities, auto companies should see revenue growth of 21%. Against this healthy topline growth, operating margins may slip by 200 basis points (bps) owing to higher commodity prices. 

While high commodity prices may not be good news for auto companies, it augurs well for commodity-related companies. “Metals and oil & gas are likely to continue with their strong performance, as pricing remains favourable for these sectors. The gross refining margins have gone up due to the shutdown of refining capacity in hurricane-hit US. Oil & gas companies should also see inventory gains as a result of this,” says Pandey. Besides this, the government is also letting energy companies to pass on the price rise to consumers. 

Kunj Bansal, CIO (equities) at Centrum Wealth, also expects housing finance companies and pharma to report good earnings. “In the case of pharma, domestic demand will pick up pace even as exports remain under the clouds owing to pricing pressure in the US,” he says. Ranjit Kapadia, analyst at Centrum Broking also doesn’t expect concerns around pharma, one of the worst-hit in Q1, to last for long. “The issues caused by GST’s roll-out in the domestic market and the current pricing pressure in the US market are not going to persist beyond a quarter or two. After destocking in anticipation of GST, the supply side is restocking again. USFDA’s approvals for Indian pharma companies’ plants and new product launches are coming thick and fast, and that should only improve the operating margins and earnings going ahead,” he says. The likes of Cipla, Sun Pharma, Cadila, Torrent Pharma and Lupin are likely to benefit from improvement in domestic demand. 

On the other hand, capital goods and IT are sectors that most market watchers expect to remain under the weather. Both Kotak and Bansal feel that capital goods companies will continue to struggle with their sluggish order books. Both also agree that IT will report subdued numbers in Q2. “Owing to weak global demand, IT earnings will remain lacklustre. They might even see downgrades. Fresh order wins and additions to the deal pipeline have been moderate; the much-anticipated acceleration in BFSI demand is yet to materialise,” says Bansal. 

In a research note, analysts at PhillipCapital state that all large-cap companies (except HCL Technologies) will report constant currency organic revenue growth of less than 2% QoQ, with 100-160 bps positive cross-currency impact. Even though higher, HCL Technologies’ growth at 2.6% is nothing to write home about.

Another sector that has recently faced headwinds is FMCG. However, analysts believe those challenges could ease going ahead. “Sales growth for most major FMCG companies should be better than Q1FY18. Revenue growth drivers will include inventory restocking post GST, new product launches and continued price growth. We expect sales and PAT of our FMCG universe (ex-ITC) to grow by 9% and 5% YoY and with ITC the sales and PAT to grow by 8% and 4% YoY,” add analysts at PhillipCapital. 

Weak credit growth remains another area of concern on the Street. As private capex is yet to revive, credit growth remains elusive. This has hurt the core profitability of the banking sector. “We expect tepid core earnings for banks in Q2FY18 with pre-provisioning profit falling 11% YoY (flat QoQ), owing to modest credit growth along with low NII (net interest income) and fees,” says Clyton Fernandes, analyst at BOB Capital. 

Private banks are expected to perform better than PSU banks. “We expect private banks to report NII growth of 25% YoY, while public banks could report a decline of 65% YoY,” analysts at Kotak Institutional Equities say in a note. Pandey and Kunj also expect PSU banks to have a muted earnings season. Private banks have been gaining market share at the expense of PSU banks and also boast of better asset quality than their PSU counterparts. 

Apart from earnings, market watchers have other concerns playing on their mind. Jigar Shah, CEO, Maybank Kim Eng Securities says that macroeconomic factors can pose downside risk to earning estimates. “The recent GDP number has prompted many to cut down their growth forecasts for the economy, which is a worrying sign. One also wonders how long will the economy take to transition from old tax structure to GST.” The RBI recently lowered its growth projection for FY18 from 7.3% to 6.7%. Credit rating agency Fitch has also lowered India’s growth forecast for 2017-2018 from 7.4% to 6.9%. 

Analysts expect the overall net earnings for the Nifty to increase 13.2% in FY18  and 20% in FY19. “The market is pricing in a sharp second-half recovery and expects the momentum to sustain in FY19, both of which are unlikely. We expect further cuts to Nifty consensus earnings even as Nifty earnings forecasts for the year have already come down by 10%,” feels Gautam Chhaochharia, head of India research, UBS. As earnings growth continue to disappoint, markets could be on a rollar-coaster ride.