The worst is yet to come

The worst is yet to come

The third quarter of 2008-09 has been one of the weakest in recent times, but profits could decline further.

Profit growth has been on the decline
1. Large-cap companies were not as badly affected by the slowdown. Some reported a healthy profit growth
2. Mid-cap and small-cap companies reported a 39% drop in Q3 profits compared with the previous financial year
3. Analysts expect that things will start looking up only in the second half of 2009-10

Let's begin with some good news. Large companies with proven track records haven't disappointed the market. In fact, the third-quarter results of Reliance Industries, Infosys, ITC and ICICI Bank have been either along expected lines, or better than the Street's estimates. But that's not true for the rest of India Inc. The earnings of most mid- and small-cap companies have deteriorated alarmingly.

The net sales of 450 firms, which declared Q3 results till 23 January, have grown at a healthy 19.34% compared with the same quarter in the previous fiscal. But their net profits have fallen by 22.15% during the same period. The steep drop in profits is worrying because these companies registered a robust 40.29% growth in profits in the third quarter of 2007-8. The real problem is with the small and mid-sized firms, whose net profits in Q3 2008-9 have fallen by a massive 39%.

"Most large corporates haven't really disappointed us. The stress is more pronounced in case of midcap firms, where some of the results were worse than the already toneddown expectations," says Gaurav Dua, head of research, Sharekhan.

So, should you invest across stocks as the indices fall to attractive levels? Or should you look only at blue chips? To answer these questions, one needs to figure out what is likely to happen in the next few quarters.

The third quarter of 2008-9 was expected to be one of the weakest in recent years. By November 2008, analysts had scaled down their expectations and the markets had discounted the prices of most stocks. Profit margins were under pressure during Q2 due to inventory losses as most companies were saddled with raw materials purchased at the peak of the commodity cycle in July-August 2008.

Profit growth in third quarter %
Going strong  
Dr Reddy’s Labs-41.04155.64
State Bank of India55.1152.06
3i Infotech24.2140.58
Bharti Airtel38.6839.61
Slowing down  
Reliance Capital28.1813.05
Tech Mahindra 19.611.58
Marico61.51 10.94
Reliance Comm 50.89 3.54
On slippery slope  
Zee Entertainment8.42-26
Asian Paints65.74-47.87
India Infoline265-48
Kotak Mah. Bank117.04 -62.77
Bharat Forge-7.80 -151.52
• The profits of Dr Reddy's Labs and State Bank of India surpassed expectations.
• Ancillary maker Bharat Forge suffered a loss. Kotak Bank’s profits dipped sharply.

Sadly, there may not be any respite in Q4. Reasons Dua: "Though some of the companies will begin to show relief on margins due to lower raw material costs, the demand environment will remain muted." This will happen because of several factors. Fragile sentiments, cash crunch and falling exports will take their toll on the Indian companies. As firms curtail investments, cut costs and reduce production, it will lead to a slump in economic activity.

"Industrial growth will slow down to 2.5% this year, against 9% in the previous fiscal. Given that the business confidence will remain low, the slowdown will spill over to 2009-10," predicts Anubhuti Sahay, associate economist at the Standard Chartered Bank.

In such a scenario, even sectors such as IT and banking, which were insulated from the drop in demand so far, can face problems. Commenting on the Q3 results, Wipro chairman Azim Premji said, "We are living in tough times; the macro-economic challenges are impacting businesses across segments." Both Infosys and Wipro have cut their annual guidance.

"The revenue visibility across companies appears to be, at best, limited to a quarter," says Abhiram Eleswarapu, analyst at BNP Paribas. Therefore, in the case of IT stocks, existing and potential investors need to wait and watch before taking investment decisions.

The same is true for banks, which posted an amazing profit growth of over 30% in Q3. But this is not likely to sustain. Moderate credit growth, lower interest rates on government bonds and rising NPAs will put pressure on earnings. "We foresee a slowdown in banks' earnings over the next few quarters as the G-Sec gains become muted," says Sonam Udasi, vice-president of research at Brics Securities.

Analysts say that despite low interest rates and the government's intention to trigger a demand-led growth cycle, the situation might improve only in the second half of 2009-10. "Once the impact of the interest rate cycle is passed on and firms begin to reduce their working capital requirement, the bottom line growth is expected to improve," says Sankaran Naren, CIO, equity, ICICI Prudential AMC.

Among sectors, while realty and commodities might slip, FMCG and pharma may continue with their growth story. Cash-rich companies with low or negligible debt are likely to outperform. "Investors should avoid aggressive or leveraged sectors, and focus on companies with excellent financial and operational management," concludes Naren.