Crony banking and cowboy capitalism will end soon, predicts Vinayak Chatterjee, chairman and managing director of Delhi-based Feedback Infra, a consultancy that specialises in infrastructure projects. We are sitting in his 15th floor office in Gurgaon, looking down at some of the marquee names in global business, talking of the dramatic fall in the fortunes of India Inc. over the past five years or so. Chatterjee is talking mainly of the infrastructure sector’s slide, since this was the sector hardest hit, but what he says is equally true of the manufacturing and services sectors.
Between 2003 and 2008, corporate India rode the wave of GDP growth (an average of 8.8%) supported by huge capital inflows and a booming global economy. But then came the slowdown with its high and persistent price inflation, sub-5% growth, and high interest rate regime.
On the face of it, this is just another problem of the slowdown. Except that it goes far deeper. In the go-go years, companies went on an expansion binge, which banks were only too willing to fund. Both companies and banks believed that the growth would never slow, let alone stop, so they were totally unprepared for the impact of such a slowdown. Few corporates can claim to be as percipient as the then Ford CEO Alan Mulally in the mid-2000s. Mulally foresaw the big fall, and so borrowed heavily when funds were still easily available. This saw the company through a bad patch which stalled other American auto companies. Indian businesses, however, over-leveraged, banking on their profits to repay loans, assuming that the good days were there to stay. Except, of course, that demand fell and revenue took a beating, and loans simply piled up.
Companies, says Subir V. Gokarn, director of research at Brookings Institute India, and a former deputy governor of the Reserve Bank of India, underestimated “the obstacles of policy logjam, the impact of a high interest rate regime, and a depreciating rupee”. Equally, these companies overestimated demand, he adds. The result: corporate profitability fell; and corporate savings slipped from 9.4% in 2007-08 to 7.1% in 2012-13, while corporate investments fell from 17.3% to 9.2% in the same period.
Infrastructure, manufacturing, and pharmaceuticals companies have felt the pain of over-leveraging the most. The return on capital employed, a good indication of the state of a company’s health, has been falling between 2008-09 and 2012-13 for infrastructure and manufacturing companies on the BSE 500. Interest cost has also gone up by 14% for infrastructure companies and real estate firms, and 11% for manufacturing companies. Revenue, meanwhile, grew at 7% for infrastructure companies; 5.4% for real estate; and 11.4% for manufacturing.
This kind of fall in a company’s profitability means a fall in its “internal accruals, and hence, its fundraising capacity”, which then impacts all investing decisions, explains economist Amirullah Khan, policy consultant at the Bill & Melinda Gates Foundation. And things are unlikely to improve in a hurry, given that the economy is going to take some time getting back to the 9% growth mark. “India’s economy will grow at an average of 6.7% over the next 10 years, taking its nominal GDP from $1.9 trillion (Rs 114.2 lakh crore) to $5 trillion,” predicts Chetan Ahya, executive director and the India & Southeast Asia economist at Morgan Stanley.
The message is clear: Despite the recent surge of optimism in the markets, companies are not going to see a return to the hectic growth of 2003-08. Many of these companies had created business models based on a high rate of economic growth, and are now forced to redraw these models. As Feedback Infra’s Chatterjee notes, there’ll be no more cowboy capitalism—that is, ungoverned growth, risky fundraising, etc. Instead, there’s been perforce a move to more traditional ways of doing business, coupled with some of the positives of the era of unfettered growth—innovations in doing business, new routes for funding, and the like.
For infrastructure and real estate players, a business model based on long gestation, high capex, minimal profitability (because of the low-paying capacities of users as evident in most road projects) and negative cash generation, was good only as long as the economy was ticking along. Now, with no money coming in for long-term projects, these debt-laden companies are forced to sell off assets to trim some of the debt.
In 2012, India’s largest realtor DLF had to sell 17 acres of prime land in the heart of Mumbai to Lodha Developers for Rs 2,700 crore to pare its high debt. Then, in early 2013, infrastructure major GMR had to shed a 74% stake in the 58 km Jadcherla Expressway for Rs 206 crore, and sell its gas-based power plant in Singapore for Rs 2,640 crore.
It’s the same with hotels too. To meet its debt obligations, Leela Venture, for instance, had to sell off its Kovalam luxury hotel to Travancore Enterprises for Rs 500 crore in 2011, while Mumbai-based Kamat Hotels and Gujarat-based Neesa Leisure have been forced to restructure their debts. In retail, Kishore Biyani’s Future Group sold its profitable Pantaloon retail business to Aditya Birla Nuvo for an undisclosed sum, a stake in the financial services business to private equity player Warbug Pincus for Rs 463 crore, and a 22.5% stake in its life insurance venture with Italy’s Generali for Rs 300 crore. Real estate player Unitech exited its telecom joint venture with Telenor in October 2012. (To read what happened next, turn to page 96.)
The new breed of infrastructure players (Ashoka Buildcon, IRB Infrastructure, Sadbhav Engineering, etc.) has learnt from the failures of the old. Rather than depending on banks for funding, they have come in with private equity from investors such as Norwest Venture Partners and the Xander Group. More important, unlike companies such as GMR and GVK, which had diverse interests, these new companies focus on specific areas. Ashoka Buildcon, for instance, has restricted itself mainly to construction and maintenance of road projects and bridges across India, while IRB Infrastructure has stuck to roads and airport building.
The other big change is in financing infrastructure projects. The equity and debt markets are staying away from the sector, as are private banks. “Banks will remain tight-fisted and the covenants of loans will be stringent, which corporates were not accustomed to,” says Srinivasan Varadarajan, executive director, corporate banking, Axis Bank. Meanwhile, public sector banks are in no position to bail out India Inc., shackled as they are with high levels of non-performing assets and capitalisation woes. With more than Rs 57,233 crore of assets tied up in corporate debt restructuring schemes in 2013-14—a jump of nearly 241% over two years—and Rs 8.39 lakh crore in infrastructure funding, they will find it extremely difficult to loosen their purse strings in the near future.
So, what’s left? Foreign debt was a possibility, but currency volatility makes this a risky proposition especially for companies that earn in rupees. Many companies like Suzlon Energy, Aban Offshore, and Lanco Infratech, which had loaded up on dollar-denominated bonds, found their balance sheets awash in red when the rupee dived to 68 to a dollar last August. Not many companies (outside of those in IT and related sectors) have a hedging policy robust enough to deal with such sharp currency swings.
Infrastructure companies could now be looking at long-term global pension and insurance funds, sovereign wealth funds, private equity investors, strategic investors, and external commercial borrowings. The Jaypee Group, which planned to sell its hydel power projects to Abu Dhabi National Energy Co. (known as TAQA) for $1.5 billion, recently suffered a setback when TAQA announced it would not honour its commitment to buy. (Reliance CleanGen, an arm of Anil Ambani’s Reliance Power, recently acquired three Jaypee projects for Rs 12,000 crore.)
With the new government clearing the way for setting up infrastructure investment trusts similar to real estate investment trusts, cash-strapped infrastructure and real estate players now have an additional source of long-term funds. Funded by long- and short-term players, these trusts will be allowed to list on the bourses, providing an exit route for short-term players.
But such funding will come at a cost. There will be far greater scrutiny and stringent conditions laid down for borrowing, constant monitoring, and much higher accountability of the promoters of these companies. “Businesses will be far more cautious and the country is unlikely to see a capital-intensive growth wave as witnessed earlier,” says Guru Malladi, partner and leader, government advisory service at consulting firm EY. That, he adds, will be most helpful in these times of low growth rates and capital.
Banks, while unwilling to lend, are still keeping all options open. “When the growth cycle kickstarts, you want to be there and be ready to participate,” says Varadarajan of Axis Bank. That’s why there are still banks willing to fund new or early-stage projects; it’s the stalled work-in-progress projects that are having a hard time getting off the ground. With money so difficult to come by, infrastructure companies are bound to get more cautious when bidding for projects, instead of winning projects at ridiculously low rates as has been the practice so far. For instance, in the case of highway projects, some companies were even willing to give up a part of the toll collected on highways constructed by them, to become the lowest-cost bidders.
Meanwhile, the new government’s policies are also forcing infrastructure companies to change. There’s been a renewed emphasis on public-private partnerships (PPPs), and the latest Budget has also underlined the importance of these partnerships. These PPP deals, once seen as the saviours of Indian infrastructure, had broken down because of the faulty nature of the concession agreements—where most of the financial risks of the projects were loaded on the private player—as well as a complete breakdown of trust between the two partners.
Chatterjee says this is set to change. “The new PPP contracts will see a far greater balancing of risks—sovereign risks will have to be tackled by the government, while implementation risks will remain with the private sector.” Gokarn adds that government money will come through for these new projects, but “whether it will continue with the same promoters is still to be seen”.
The new Land Acquisition Act makes it near impossible for real estate players to buy huge tracts of land and thereby increase their valuations, a standard practice till now. This means land banks will no longer be the biggest determinant of valuation, says Utkarsh Palnitkar, partner and head of advisory and life science at consulting firm KPMG. The new model has to be driven by cash flows, and what a project can realistically achieve.
Binaifer Jehani, director, Crisil Research, says the increased cost will have a serious impact on affordable housing. “Land prices, which constituted 25% to 30% of the total project cost in affordable housing projects, will now account for 50% to 70% depending on location, making many projects unviable.”
New developers, or older ones that have seen the writing on the wall, are looking at an asset-light strategy by entering joint development agreements with landowners. This model has already started to yield results. Gurgaon-based Orris Infrastructure has tied up with Noida-based real estate developer 3C Company for a 47-acre parcel of land in Gurgaon. Since Orris already had the approvals and the permissions to build a group housing project on the land, the partner is saved of all the problems of land acquisition.
Real estate developers are also looking at mixed-use development models to pare risks of a downturn. For instance, the Oberoi Garden City in Mumbai has three residential blocks, a 32-storey office building, 550,000 sq. ft. of retail space, a hotel, and an international school spread over 80 acres, in a bid to spread risks.
The manufacturing sector has been facing problems of a different nature—more regulatory and less financial. The new model for manufacturing, says Khan of the Bill & Melinda Gates Foundation, must be “more enterprising, innovative, cost efficient, and entrepreneurial”. The big challenges for the sector revolve around labour laws and their implementation, weak domestic demand, and high taxes. Morgan Stanley’s Ahya says exports should help these companies “improve capacity utilisation and improve profitability”, given that demand from the U.S. and Europe are likely to pick up in the near term.
But a certain set of manufacturers is unlikely to get away so easily. The domestic pharmaceuticals industry faces a crisis as more and more countries, including the U.S., large parts of Africa and Southeast Asia, as well as Europe ban Indian generics. For instance, the U.S. Food and Drug Administration has banned imports of drugs from various factories of Ranbaxy, Wockhardt, Sun Pharma, and Strides Arcolab in the last one year.
The larger generics players (Sun Pharma, Dr. Reddy’s, and Lupin) derive some 60% of their revenue from exports, and the continuation of such bans could seriously damage them. That will not only push up their compliance costs but also put their export targets at risk. Domestic players claim that these bans have been initiated by global pharma giants as a form of protest against certain Indian policies, such as compulsory licensing. The MNCs are especially unhappy after the government allowed Natco to sell the copied version of Nexavar at a much cheaper price. While Nexavar’s treatment of patients afflicted with kidney cancer costs nearly Rs 2.8 lakh for a month, Natco’s drug costs Rs 8,800. Then, India’s position on not allowing patents on new versions of old drugs, where changes are just cosmetic, has already created much bitterness among global pharma biggies. Pfizer had to bear the brunt of the country’s stringent rules when its patent for cancer drug Sutent was revoked by India’s patent office; it was seen as being not inventive.
The commoditised part of the pharma value chain—bulk drugs and intermediaries that go into the making of bulk drugs—has already been taken over by Chinese players because of their cost competitiveness, says Prasad Koparkar, senior director, Crisil Research. So, Indian players need to continuously scan “the patented drugs landscape to see which one is falling off the cliff and can be readily challenged, have a legal process in place because of the challenge from the patent holder, and have a drug of similar bioequivalence and absorption capacity”, he says.
All this means that these companies will have to spend far more on modernising their R&D facilities and labs. “Without product differentiation and value addition, going up the value chain is a mirage, both in the pharmaceutical industry and IT. There is always the danger of obsolescence,” says Khan. Essentially, this means that companies will have to develop better manufacturing practices as well as a new growth strategy.
The services sector, while not so hard hit as the rest, is also looking at a new reality where money is relatively more difficult to come by. Plagued by a host of factors, the telecom sector has been struggling to survive for the past couple of years. Limited spectrum allocation, cancellation of 22 licences by the Supreme Court, the high cost of spectrum, and a high tax rate—close to 34%—have not only forced many telecom companies to shut shop, but also ensured that the remaining players have a huge debt overhang. Compounding the problem is that revenue growth (the increase in additional subscribers) has not kept pace with costs. Increasing revenue through higher rural penetration will come at a price because it will require setting up new telecom towers. The fate of 4G is still uncertain because of regulatory issues, and 3G itself has seen limited success.
“Telecommunications can no longer be a dumb pipe,” says Hemant Joshi, partner at Deloitte Haskins & Sells. “It will [have to] become an intelligent one, providing mobile solutions in different areas like money transfer, education, health care, logistics, water, and energy. These are huge opportunities waiting to be tapped.” For instance, he says, telecom companies can provide online data to power distribution companies operating smart grids so that they can efficiently manage demand and supply. They can play an important role where online real-time data is required. The second area of focus for these companies is likely to be the “Internet of things”, or machine-to-machine communication; that’s a $4.3 trillion opportunity, says Doshi.
And what about India Inc.’s erstwhile wunderkind, the IT industry? Its strong offshore delivery model that worked so well for so many years is in danger of obsolescence in the longer term. Intellectual property is still predominantly held by non-Indian companies and the demand for Indian services comes mainly from outside the country. “Rising relative labour costs could take activity elsewhere; technological developments may make the sector location-neutral, or the world has to learn to live with a higher-cost model, with implications for global demand,” says Gokarn.
The 14% CAGR rise in salaries among the IT companies within the BSE 500 also point out that India does not any longer necessarily provide low labour-cost arbitrage. But that’s a decade-old story, say those in the industry. Indian IT companies “offer a far more diversified portfolio of services in different categories and are planning to tap into new revenue streams such as mobility, analytics, cloud computing, social media”, says Rama Vedashree, vice-president, Nasscom. Top companies such as TCS, Wipro, and Infosys are providing turnkey solutions to many Fortune 500 companies and promising them outcome-based charges rather than on time spent and material used, while lower-rung companies like Persistent Systems are chasing niche, but promising, areas like mobility and analytics.
The problem is that of talent. It is no longer enough to have software engineers writing code. What’s needed today are user-experience designers, who bring to the table completely different skill sets. So, managers may have to learn to deal with a completely new set of employees, who may come from liberal arts backgrounds.
Even those in the business of fundraising are being forced to change strategy. IPOs, once the darlings of the stock market ($18.5 billion raised in 2007 and $16.5 billion in 2010) have lost sheen today. Overseas convertible offerings, the popular foreign currency convertible bonds, have also lost appeal after an unprecedented $7.7 billion raised in 2007. Private equity, which enjoyed a bull run between 2007 and 2009, has become conservative, while rights issues, non-convertible debentures (NCDs), and corporate bonds have registered a comeback after a long period of hibernation. From a four-year average issuance of $22.8 billion between 2004 and 2008, it has gone up to an average $52.5 billion in the four years between 2009 and 2013.
Rashesh Shah, chairman and CEO of Edelweiss Group, is a real-life example of the changes in funding. At the peak of the bull market in 2007, Shah launched Edelweiss Capital’s IPO. It turned out to be a hit, which not only saw the IPO being oversubscribed 110.96 times, but also list at Rs 825 per share. In mid-June, Shah was back in the market to raise finances for ECL Finance, a non-banking financial arm of the Edelweiss group, but not through the IPO route. ECL Finance raised Rs 400 crore in total, as the Rs 200 crore issue had a greenshoe option of equal amount, through unsecured NCDs for a 70-month tenure at a coupon rate of 12%. The June issue, which got oversubscribed 1.74 times in just two days, was Shah’s second such NCD issue after mobilising Rs 500 crore in January this year at a coupon rate of 11.85%.
“India is coming back on the investors’ map, both global and domestic, with sentiment and liquidity improving in the past six months, but improvements in corporate earnings is still two quarters away,” says Shah. He expects some $25 billion worth of investments to come from the FIIs.
The strong belief that the new government can help companies through this process of transition is growing. The decisive mandate given to the BJP-led NDA government means that reforms can be pushed through faster. “Such reforms will improve business sentiment, lift profitability of the corporate sector, incentivise a revival in private investment, and also bring down fiscal deficit by containing the less effective redistribution policies,” says Ahya.
It may well be that the new government has such a magic wand, but as Rajat Kathuria, director and chief executive at the New Delhi-based think tank Indian Council for Research on International Economic Relations points out, the real problems will come when creating new capacities. “The easy part is executing the existing plans, but to implement big-ticket, high-profile projects like the Delhi-Mumbai Industrial Corridor, creation of 100 smart cities, and cleaning the Ganges, the government will face a host of problems such as environmental clearances, Centre-state coordination, logistics, and institutional and capital-raising issues. That will call for tough choices.”
