Profit buzz back at India Inc

Finally, Lady Luck appears to be smiling on Corporate India. Return on equity (RoE), a key gauge of profitability, is in revival mode following a continuous decline for 5 years.

An India Strategy report from Morgan Stanley India Company titled ‘RoE: The Secret Sauce Could Turn Sweet Soon’ is proof that the RoE seems to have completed its cyclical of correction over the past 12 months. “We believe that with margins likely to find a floor in coming 12 months, it is possible that India’s RoE gap with emerging markets resumes an uptrend after falling for the past 5 years,” stated the report dated September 13 and authored by Ridham Desai, Sheela Rathi, Amruta Pabalkar and Utkarsh Khandelwal.

RoE, in simple terms, is a measure of profit a company generates as a percentage of the money shareholders have invested in it and is calculated by dividing the net profit by the shareholder’s equity. Minimum capex obligations and the likelihood of a fall in rates, the Morgan Stanley quartet believes, may be the root factors behind the reversal. “The tailwind for RoE comes from the fact that capex is at six-year lows and that interest rates may have peaked.

Indeed, asset turn has picked up to a 3-year high, even as interest expense to revenues rose to a 10-year high,” stated the report. Asset turn is sales generated as a proportion of a company’s assets. The greater the asset turn, the higher the RoE.

According to a DNA Money analysis, the average RoE for BSE 100 companies stood at 19.77% for 2012, the lowest since 2003, when it came in at 18.72%. The RoE has shown a declining trend ever since it hit 30.38% in 2007, registering 28.49%, 23.30%, 23.18% and 21.72% before slipping below the 20% mark to touch 19.77% in 2012.

Over the past 12 months, consumer discretionary and technology RoEs have stood out by improving the most, according to Morgan Stanley. Over the longer term, the most compression in RoE gap is in healthcare followed by materials and industrials. In the past 12 months, industrials have contributed the most to India’s RoE under performance. “At the sector level, cyclicals hold the key to RoE improvement, but the key takeaway is RoEs for these sectors are well below average, so a mean reversion is the likely scenario,” said the report.

Saibal Ghosh, chief investment officer at Aegon Religare Life Insurance Company, has a slightly different take, who is of the view that a further fall in RoE seems unlikely, but an immediate improvement is not on the cards either. “Interest rates are expected to improve, commodity prices are not higher than they were a year ago. The economy too shows signs of improvement, thanks to the PMI numbers. But a pick-up may take at least another two quarters,” he said. The August HSBC PMI or Purchasing Managers’ Index for services,  which makes up around 60% of India’s economy, offered much relief, which came in at a 6-month high.

Manish Bhandari, managing partner and chief executive officer of Vallum Capital, concurred, who said the wait for a turnaround in RoE may be longer. “A cut in interest rates may not immediately galvanise growth... there are bigger issues that the government needs to resolve... there is a need for big-bang reforms such as those concerning land acquisition and GST (Goods and Services Tax). Margins may see some respite if there is a fall in commodity prices and there are economic problems in China. But I do not see things changing over the next year,” he said.

A fund manager with a large mutual fund house sounded more optimistic, who does not see any further downside in RoE. “We are at the bottom of the cycle in terms of growth and interest rates are at a peak,” he reasoned.

While India’s RoE gap with emerging markets is set for some improvement, the spectre of additional debt may pose a big stumbling block. One can ignore it at its own peril, given the fact that debt-equity ratio of Indian companies compared to the emerging market peers is at a 15-year high.