Monday 24 March 2008

Other income goes for a toss, so does profit

"What we learn from history, is that people don’t learn from history"
- Warren Buffett


India Inc. has been thriving on other income over the previous few quarters. The dependency has moved up so much that core profits have declined extensively. Other income to sales was pegged at some 8% and 40% to profit after tax. This is sizeable enough to ring the warnings bells. In percentage terms, growth in core profits for manufacturing businesses has moved down consistently since the previous five quarters. But, till the time other income was perking up, the profit after tax (PAT) growth looked all fine. Markets chose to ignore and euphemism continued. The APAT (adjusted for other income) growth however continued to provide with a clearer picture.

That was then. Now that the exposures to forex products are propping out from the books of India Inc. a gaping hole seems inevitable. How big and how soon are the key questions that suddenly have become the hot topic of debate everywhere – across early morning meetings at fund and brokerage houses or over a friendly beer with fund managers. So, the hole is for real and if things are to be believed a deep one too. Uncertainties loom large about how deep the problem is and how should India Inc. approach the issue to minimize the hit. Definitely, the market has far moved from risks to uncertainty. Having said that, here’s an estimate of how big India Inc.’s forex exposures could be. It snapped at our faces and we glared. Tough to believe at first, yet these could be just the tip of the ice berg.

To avoid mere speculation, it was a good idea to just look at the quarter ahead rather than over the few quarters. The other reason is perhaps more clarity may come to light only in the near future. The only question however is whether India Inc. will book losses in the March quarter or the next. Things would look like this, if India Inc. were to report it during the March quarter.

Sales

Profit

Other Income

APAT

Rs cr

Rs cr

Rs cr

Rs cr

Mar-07

439,467

28,321

11,624

16,697

Mar-08

527,360

23,207

3,280

19,927

Growth YoY

20%

-18%

-72%

19%

Dec-08

Rs cr

Other Income

14,059

Source: CNBC TV18 Analysis

Explaining the numbers may not be difficult at all. The above numbers are for 2000 odd companies ex oil and financials. Since the advance tax numbers have been robust, we keep the sales and the core profit growth rate at 20%. A safe assumption to make keeping in mind the trend over the previous few quarters. PAT will however decline due to a fall in other income. According to our calculations if India Inc. books losses during the current quarter a 72% fall in other income is evident. Here’s how?

Other income for the December 2007 quarter was at Rs 14,000 crore. Of these around two-thirds could be assigned as income arising through exotic mark to market and mark to models plays, trading/investment income, currency hedges and leveraged plays. In some cases, leverages could well be more than the export income – thanx to the complex bets that India Inc. has managed to get entrapped into. With these positions now getting ‘out-of-the-money’, other income could well be shaved off to that extent (provided India Inc. reports them in this quarter). That’s one element.

To top that actual booked loss could bring down the other income further. Since a few corporates have actually booked around 10% losses, we assume the general trend to be the same. With that we arrive at a PAT which could show a decline of around 18% y-o-y. The actual decline could be less or could be more. No one is certain about it. And since market respect PAT growth, suddenly the market could well look expensive again. The APAT growth however, inches up.

As William Jennings Bryan put it, “Destiny is not a matter of chance. It is a matter of choice: It is not a thing to be waited for, it is a thing to be achieved.” Knowing India Inc. much less could be brought forward at one go. If the problem persists into the new fiscal, things may well go out of hand, but at least, as of now the battle is won – the war however continues.

The same trend continued during the tech bust in 2000. India Inc. refrained from writing down huge losses. There were no tangible assets. There was no brick and mortar logic. It was all air. And the bubble had no option but to burst. History repeats itself. But, people have short memories. No wonder then, market guru Warren Buffet comments, "What we learn from history, is that people don’t learn from history". So very true.

Disclosure: The author is not permitted to trade and/or invest into the equity market directly or indirectly, apart from investing (long only) in mutual fund products.