There is economic slowdown – especially in the quarter ending Sep-19; but seeing the profitability of KSE100 companies, one may get the feeling that the mantra of slowdown is perhaps overplayed. The combined profitability, of hundred companies in KSE100, declined by 4.9 percent in 9MCY19 to stand at Rs462 billion.

It is pertinent to mention that companies listed on stock exchange are not the truest reflection of economy, and the other point is that decline is profitability does not mean that products offtake is proportionately slow – such as in cement where profitability is reduced to one third, but cement volumetric sales are resilient.

It is also important to note that some big sectors are somehow discontented to general sector conditions– for instance, banks' profitability is up by 10.1 percent year-on-year in 9MCY19, while the higher rates are resulting in higher NPLs and low private credit offtake.

Globally, commercial banks usually underperform in rising interest rate scenario. Since in Pakistan, they are just by name ‘commercial', but profitability is mainly driven from treasury business –mainly in government papers. Plus, big banks have sticky cost of deposits – heavily tilted towards CASA, mark up cost does not go up proportionately with increase in interest rates, but mark-up revenues move hand with hand with interest rates.  The increase in profitability during 3QCY19, when interest rates peaked at multiyear level amid economic activities are deemed to be at its lowest ebb, is manifestation of disconnect of banking to the real economic demand.

Oil and Gas Exploration companies in terms of profitability have the highest weight in KSE100 – its profitability is up by 28 percent. The profitability is linked to international oil prices in dollars – since rupee fell, the profitability of E&P companies went up. The presence is stronger in KSE100 index than in terms of economic contribution and job creation.

The other important factor is to bifurcate profitability from cash flows. –Since the infamous circular debt has increased companies' receivables – the dividend paying capacity diminished – dividend payout ratio declined from 44 percent in FY18 to 30 percent in FY19. Now with allowance of sovereign guarantee on pending issue of Rs200 billion Sukuk on circular debt, the cash flows and payment capacity may improve.

The case of power generation and distribution companies is no different where the profitability is up, but cash flows are under stress. In the downstream, oil and gas marketing companies' profitability is adversely affected – due to currency depreciation and falling margins – net income is down by 76 percent to Rs4.6billion.

In remaining few sectors, which are more connected to economic ground realities, there is significant dip in profitability. In case of fertilizer, the profits are down mainly due to margin compression as the gas prices- main raw material, moved north and were not immediately passed on. The important variable to see from economic performance lens is to see the offtake of fertilizer – urea is the main product and its volumetric sales are up 2 percent year-on-year.

KSE100 Sector Profitability
(PKR mn)9MCY199MCY18YoY3QCY193QCY18YoY
KSE100 Index   420,701   427,873-4.9%   140,748   137,731-1.5%
Commercial Banks   124,202   112,80210.1%      44,916      30,71346.2%
Fertilizer      48,841      53,950-9.5%      18,081      17,9190.9%
Oil & Gas Exploration Companies   167,499   130,84328.0%      53,025      49,9336.2%
Power Generation & Distribution      26,245      22,55716.3%      12,713        7,39671.9%
Cement      10,844      33,003-67.1%      (1,297)        7,774nm
Oil & Gas Marketing Companies        4,618      18,958-75.6%        2,615        6,542-60.0%
Food & Personal Care-Pruducts        6,314      11,247-43.9%        1,093        3,101-64.7%
Pharmaceuticals        6,257        7,714-18.9%        2,337        2,748-14.9%
Chemicals      14,249      13,1648.2%        5,671        5,10311.1%
Automobile Assembler      11,632      23,635-50.8%        1,594        6,503-75.5%

Fertilizer, and a few other sectors historically have prints of cartelization, undue protection, and transfer pricing – in short, rent seeking. If the profitability of these has come down while the products offtake is resilient, it's a healthy sign for economy where there is no strong body or lobby to protect consumer's interest while the producers usually spend a chunk of their economic rents on lobbying government and regulators – creating deadweight loss.

The classic case is of cement where the profitability in 9MCY19 is down by 67 percent to Rs10.8 billion, but the offtake is up by 1 percent in volumes in the same period. Cement's cartel of the past is no secret, and now with expansions coming in, the cartel is breaking for the good of consumer. The EBITDA margins of cement companies averaged 37 percent between 2012-16 – which is unheard of in peer economies. The domestic demand was upbeat and there were 20 percent protection on import of cement, and the companies milked it. There were no or little exports, and now exports volume are slightly building up – exports sales are up by 21 percent while domestic offtake is down by 2 percent. The reasons for profitability decline is breakdown of cartel due to capacity expansion and no more tax benefit on expansion, margin decline due to higher coal prices in rupee terms, high interest rates and lately higher distribution cost due to axle load implementation.

In case of automobile, profitability is down by 51 percent to Rs11.6 billion, and the car volume sales are down by 18 percent in the same period – it's the only sector where consumer demand is hit by higher rates. In case of FMGC business, the profitability plummeted by 44 percent to Rs6.3 billion – the cost is high, and the cost increase could not be passed fully to consumers. The profits are down significantly for Nestle, where not only competition is increasing, but also its network of small dairy farmer collection is hurting. The story of pharma is similar as high cost could not be passed on to the consumer. In automobile and pharma, there are prints of transfer pricing as well – with margins falling, the incidence of transfer pricing could be low – good for economy.

In short, the economy is not as bad as being depicted by the fall in profits of a few sectors– there might be case of low producer surplus and enhanced competition which is good for the economy. If market movement is of any guide, it seems the worst is over.