With the earnings season almost behind us, CLSA is one of the first to come out with a strategy report. It says India Inc is moving out of the early stage of the growth cycle and that with a sharp rise in working capital and pickup in capex, free cash flow is getting squeezed

In its report to clients dated 8 November 2010, independent brokerage firm CLSA says that with mid-year disclosure of balance sheets available for the first time, it analysed trends based on data for 75 companies that make up 85% of BSE 500 assets. "Over half these companies saw a rise in net working capital days in 1H. While this could be partly attributable to seasonality, even on a y-o-y basis, growth was 42%. As a result, cash flow from operations has fallen 26% y-o-y."

Another squeeze on cash flow seems to be a pick-up in investment. "Investment is turning up, with capex rising 20% y-o-y for our universe. As a result, free cash flow has been squeezed to just 25% of that in 1H FY10."

Not only has accretion to cash significantly lagged overall balance sheet growth, there is also strong evidence of re-leveraging too, says CLSA and points out that in the first half gross debt (of the 75 companies it analysed) rose 22%.

However, it is not time to worry yet. The brokerage believes that return on capital will remain healthy as asset turnover ratios have not peaked yet. Even so, the pressures on margins and the higher balance sheet growth show that the Indian growth cycle is moving out of the early phase of recovery.

In the second phase, says the report, which is near the top of the boom, profits begin to struggle. The labour market tightens, interest rates tend to move up and demand stagnates. This in turn leads to margins being squeezed and profits tumbling (stage 3). Eventually, firms reduce capital expenditures and a downturn begins.

CLSA believes that growth will moderate in the second half. "While we see +30% y-o-y in consolidated earnings for the Sensex in 1H FY11, growth will moderate in 2H (our full year forecast is c.27%) and FY12-13 (18-2% Sensex EPS growth)."

The report points out that in the quarter gone by, it saw strong performances from oil & gas, banks, and capital goods and that there was an even spread of positive surprises and disappointments. Rising wage costs were something that stood out in 2Q results. "One can see acceleration in employee cost (up 23% y-o-y in 2QFY11, versus 2%-3% during FY10)."

Zee, Bharat Forge, BEL and Dr Reddy's stand out on free cash generation, said the report. Companies where cash flow from operations has substantially lagged profit in the last 12 months include United Spirits, Godrej Consumer, Sterlite Industries, Voltas, Tech Mahindra, and Wipro. Companies with biggest increase in capital expenditure during 1HFY11 include Thermax, Grasim, Bharat Forge, Sun Pharma, Exide, TVS, and Sintex. Companies with biggest fall in capital expenditures during 1HFY11 include Sesa Goa, Asian Paints, DRL, Petronet LNG, Ashok Leyland, and Hindustan Unilever. Companies with negative FCF included SAIL, MRPL, Power Grid, Idea, United Spirits, Ultratech, and Indiabulls Real Estate. Companies where debt levels went up substantially were Hindustan Zinc, Sesa Goa, Godrej Consumer, Tata Chemicals, Sun Pharma, BHEL, Idea, and Jindal Steel. 

(This article is based on secondary research. The report is for information only. None of the stock information, data and company information presented herein constitutes a recommendation or solicitation of any offer to buy or sell any securities. Investors must do their own research and due diligence before acting on any security. Some of the opinions expressed in this article are the author's own and may not necessarily represent those of Moneylife).