The September quarter results have been full of surprises. But one thing that has not come as a surprise is that earnings growth has been the slowest in the past eight quarters. That was pretty much on expected lines.

While topline growth was somewhat better than in the June quarter, bottomline growth has deteriorated sharply. For the record, the aggregate sales of 1763 companies (excluding banks), which have declared results for this season have risen 18.82 per cent, year-on-year.

But don't rejoice yet - operating profits grew only by 15.13 per cent and net profits growth was even slower at 9.62 per cent during the period.

Compared to the September quarter, figures in the June look much better. In the June quarter, when sales for the same set of companies grew by 16.38 per cent, operating profits were up 12.72 per cent and net profits were up 25.07 per cent.

Sure, some of the largest companies by sales - read oil marketing companies - were not in the pink of health as they were not able to increase product prices to cover their costs and that dragged down profits in September quite a bit.

But even after stripping off the three oil marketing companies Hindustan Petroleum, Bharat Petroleum and Indian Oil Corporation [Get Quote] from the basket, the picture does not change dramatically.

Earnings growth for India Inc excluding both banks and oil marketing companies stood at 21 per cent on a sales growth of 17.22 per cent. Operating profits were up 13.38 per cent. Compare this with the June quarter when sales grew 15.43 per cent and net profits grew 43.86 per cent.

The numbers look comparatively poor even when measured against a sales growth of 24 per cent and a net profit growth of 35 per cent (y-o-y) in the September 2004 quarter. Simply put, the numbers confirm a trend. The message is loud and clear; India Inc. is slowing down.

While there is every reason to be bullish on the long term outlook for the Indian economy and the markets, there is little doubt that the going will be tougher in the coming few quarters.

"We are entering into a phase of slower earnings growth as well as a phase of earnings disappointments," says a recent report by Merrill Lynch.

According to another equity research firm, First Global, there is a high cyclical component to growth in the past three years. In a recent report, the firm's chief strategist Devina Mehra argues that the manufacturing sector has seen cyclical growth in three out of past ten years and the Nifty (excluding banks and financials) has seen earnings declines in two years and only a three per cent growth in another year.

The high growth in the past three years, thus, indicate that the current period represents a cyclical high, she says.

How the biggies fared?

Coming back to September quarter numbers, the performance of several large companies have been far ahead of expectations. Equally, quite a few companies, particularly smaller ones, have surprised on the downside too. Of the 30 companies constituting the Sensex, 24 of them posted positive growth while earnings fell in six companies.

Going sector wise, capital goods, information technology and autos exceeded Street expectations. But, quarterly numbers from cement, metals, banks and pharma companies were way below expectations.

Notably, raw material costs seem to have exerted pressure on bottomlines this quarter. Raw material costs as a proportion of sales stood at 47.78 per cent in the September quarter, compared to 45.29 per cent in the June quarter and 46.05 per cent in September, 2004.

One of the worst performers among Sensex companies was Gujarat Ambuja [Get Quote] Cement, which saw its net profits decline 17 per cent as monsoon and resultant floods affected both production and sales.

The other big cement manufacturer also suffered but for different reasons. ACC net profit was down sharply (60 per cent) due to higher raw material cost, freight costs and a higher tax outgo.

The best performer this quarter was mobile company Bharati Tele-Venture, which posted a y-o-y growth of 56per cent. Similarly, on the back of a surge in crude oil prices, ONGC [Get Quote] clocked good numbers.

Even as revenues grew at a lower rate of seven per cent owing to subsidy losses, net profits grew at a robust 22 per cent. Again Reliance Industries [Get Quote] saw profits go up a phenomenal 41 per cent buoyed by better refining margins and volume growth in petrochemicals while its sales also grew at a handsome 28 per cent.

IT services biggies also showed robust volume as well as earnings growth. Sequentially, Infy recorded earnings growth of 13.91 per cent while Wipro [Get Quote] grew its IT services earnings by 11.68 per cent. TCS [Get Quote] profits were up 7.33 per cent.

But Satyam [Get Quote] Computer emerged as the winner stunning the markets by posting a 25 per cent sequential growth in earnings powered by robust sales growth and improvement in margins.

Similarly, capital goods behemoths Larsen & Toubro and BHEL saw over 42 per cent and 65 per cent jump in bottomline respectively. And order order books still remain strong. Maruti Udyog [Get Quote] and M&M clocked over 30 per cent growth in net profits backed by decent volume growth and lower raw material costs.

In case of  Tata Motors [Get Quote], however, net profit grew at 9 per cent, trailing behind a sale growth at 15 per cent. Both Bajaj Auto [Get Quote] and Hero Honda showed splendid growth in sales - 32 per cent and 23 per cent respectively, better than in the June quarter - thanks to higher volumes. Operating margins were under pressure though bottomline growth was fairly decent.

Big pharma, steel disappoint

But that was pretty much all the good news. Now the bad ones. Domestic drug makers continued to disappoint. Ranbaxy [Get Quote] slipped into the red with earnings declining 90 per cent from Rs 200 crore (Rs 2 billion) to Rs 18 crore (Rs 180 million) primarily due to mounting pricing pressure in the US generics market and higher R&D expenditure.

Another casualty of the pricing pressure, this time in European statins market was Biocon [Get Quote], which posted a decline of 22 per cent in net profit.

Steel margins came under pressure due to rising raw material prices and lower realisations. As metal prices took a hit, Tata Steel [Get Quote] sales growth was flat at 3.39 per cent. Net profit growth stood at 12.46 per cent.

Public sector peer SAIL [Get Quote] saw more than 300 basis points drop in operating margins and clubbed with a higher tax outgo, the company saw its net profit decline 25 per cent.

Needless to say, oil marketing companies were among the biggest drags. Indian Oil Corporation recorded a 23 per cent decline in profits but both Hindustan Petroleum and Bharat Petroleum slipped into the red. The latter was particularly bad with its net plunging from a profit of Rs 321 crore (Rs 3.21 billion) in September 2004 to a loss of Rs 203 crore (Rs 2.03 billion) in the past quarter.

Growing divergence

The key takeaway from the September results is that not all companies will continue to post steady growth. The divergence in performance of companies across sectors and within the sectors and between smaller and larger companies is getting starker.

Going forward, both financial and stock performances are going to be even more divided. And companies with less capable managements will be on the receiving end as they face a higher execution risk.

Most analysts expect earnings growth to slow from 25 per cent in the past three years to around 15 per cent in fiscal 07. The number of earnings upgrades by broking houses have been less frequent, which itself is an indicator of the fundamental weakness and worries, analysts have.

There are solid reasons why earnings growth would slow. One reason is that large cyclical companies including commodity players contributed a disproportionate share of earnings growth over the past three years. And as commodity cycles appear to be turning, these companies may see slower growth and that could drag down overall numbers.

As repeated often, the higher base of the past years itself makes it difficult for companies to replicate their previous performance. Other levers, which propped up earnings in the past are disappearing too.

The worries

For one, there seems to be a reversal in the interest rate cycle already. Market experts feel that rising inflation coupled with a widening current account deficit and strong credit growth may make a further rise in interest rates inevitable.

Merrill Lynch expects inflation to peak around 6 per cent in the first quarter of CY2006 and interest rates to see a 50-75 basis points rise over the next one year.

While companies saw their net profit growth aided by continuous reduction in interests cost over the past three years, in a rising interest rate scenario, it could eat into bottomlines.

Similarly, driven by high capacity utilisation, depreciation costs as a percentage of sales were lower till now. With companies once against getting into capacity expansion mode, this situation is set to reverse.

Also, most corporates have already pruned their costs substantially and benefited from efficiency gains. Going forward, there may not be too much scope for margin improvements on that front. We have already seen operating margins stabilise around 20 per cent levels.

The consolation

On the plus side, with easing commodity prices, the pressure on margins may be less of a worry in the coming quarters. Even in this quarter lower steel prices have meant lesser pressure on margins for several companies, especially automobiles.

Rising steel prices have been affecting autos for the past few quarters and if metal prices continue to be weak, margins should remain stable going forward.

Also, topline growth seems to be intact with domestic demand still quite buoyant. Whether it be cars or bikes, mobile phones of consumer good, sales seems to be growing.

Though lower interest rates have been one of the important factors driving growth in the durables segment, no one is predicting yet that rising interest rates could impact demand significantly. One will have to wait a few quarters to see if demand slows due to escalating financing costs, especially if interest rates move up substantially.

The winners

Analysts expect IT services and capital goods companies to sustain their growth in the coming quarter. With the rupee depreciating against the dollar, software services is likely to remain a beneficiary.

But some companies with higher import content in their raw materials may see pressure on margins. Then again, despite the sharp drop in earnings this quarter, analysts feel that cement companies have a good chance of bouncing back as demand is looking up and supply is tight.

As for stock market performances, all the factors influencing stock valuation have been benevolent in the past three years with a potent combination of lower interest rates coupled with a structural shift in interest rates.

But these very factors that aided stock performance (apart from the foreign flows, of course) are now reversing. As First Global's Mehra points out in her report, cyclicals and a drop in interest rates have contributed almost entirely to earnings growth in the past three years.