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ANALYSIS

Second-decile companies shine in margin spurt

by Mahesh Vyas

Net profit margin of non-finance companies increased during the March 2018 quarter. It had increased in the preceding two quarters as well.

As mentioned in an article dated June 12, 2018, net profit margin adjusted for prior period and extraordinary transactions (PAT net of P&E, and henceforth just net profit margin for brevity) grew from 5.2 per cent in the June 2017 quarter to 6.2 per cent in the September 2017 quarter, then 6.4 per cent in the December 2017 quarter and now 6.9 per cent in the March 2018 quarter.

Distribution of the net profit margin shows that in recent quarters, its median value and the higher percentile values have also been rising. Margins at these levels of its distribution have been higher than they were during any other quarter of recent times. The lower end of the distribution, however, did not show any improvement.

This implies that companies with higher margins in the recent past are now reporting even higher margins and those with lower margins in the past are reporting a worsening of profit margins. But, this distribution doesn’t tell us anything about the characteristics of the companies whose net profit margins have been increasing.

Here we study the distribution of net profit margin by size of companies. The full set of listed companies is divided into ten size groups. The group consisting of the top ten per cent companies by size is classified as Decile 1 companies, the next ten per cent of companies by size is classified as Decile 2 companies, and so on, till Decile 10, which comprises the smallest ten per cent of companies by size. Size is measured as the average of sales and assets of companies. Both, sales and assets are individually inadequate measures of size. Trading companies may have small assets but very large turnover and a company with very large assets maybe going through a rough patch with very low turnover. An average of the two therefore provides a reasonably robust measure of relative size of a company.

This size-wise distribution of listed companies shows that large companies have systematically earned significantly higher net profit margins than smaller companies. On an average (where the average is over the last 32 quarters or 8 years), the top decile companies have a net profit margin of 6.7 per cent. The margin falls to 3.3 per cent for the next decile and then to 2.4 per cent for the third decile. Margins keep falling as the size of companies fall.

The bottom four deciles (bottom 40 per cent companies by size) have no profit margins. They make losses.

Evidently, size is important to ensure profits and, growth delivers higher profit margin over higher sales.

This seems to be an empirical structural construct. But, we are interested in finding the source of the recent growth in net profit margin.

The rise seen in profit margins in recent quarters is emanating largely from the second-decile companies. The largest companies, who continue to remain more profitable than any other size group, have also seen an improvement in their net profit margin in recent quarters. But, the second-decile companies have improved their margins a lot more, an almost dramatic improvement in the last two quarters.

These companies had a net profit margin of only 1.3 per cent in the quarter of June 2017. This shot up to 3.5 per cent in the September 2017 quarter, 4.55 per cent in the December 2017 quarter and then to 6.7 per cent in the March 2018 quarter. This steep rise of 540 basis points in net profit margin in the last three quarters is in contrast to the performance of every other size-decile sets of companies. Top decile companies did see an increase in margins but, that was small - a rise of just 165 basis points from 6.1 per cent to 7.8 per cent. Every other size-decile saw a fall in net profit margins.

The second-decile companies therefore stand out in terms of a rapid increase in net profit margin in the last three quarters.

These are companies of a size between Rs.5.5 billion and Rs.14.5 billion, where size is the average of net sales and net assets during a three year period.

Net profit margin of second-decile companies was comparable with that of the top-decile companies during 2010 and 2011. Then, margins of the smaller companies fell till the gap between the two widened to over 800 basis points in 2016. The sharp improvement in margins of the second-decile companies has reduced the gap to just about 100 basis points in the quarter ended March 2018. These companies are on a roll.