STRATEGY August 26, 2020 Scouting for giants Head of Research Author / Consultant Nitin Bhasin Ritika Mankar Mukherjee, CFA [email protected] [email protected] Tel: +91 22 6623 3241 Tel: +91 98333 49668 Research Analyst Nikhil Pillai [email protected] Tel: +91 22 6623 3265 [email protected] 2020-12-07 Monday 13:17:41 Strategy CONTENTS Strategy: Scouting for giants ………………………………………………………………….3 Section1: India’s High GDP growth rate ≠ high revenue growth rates ………………..4 for listed firms! Section 2: Listed Indian firms’ susceptibility to dwarfism > EM peers ……………….11 Section 3: India’s High GDP growth rate ≠ high revenue growth for ………………..15 unlisted firms too Section 4: So why do Indian businesses suffer from scalability challenge? ………….20 Section 5: A deep-dive into five key sectors ……………………………………………..26 Section 5.1: Consumers – Market appears optically large! …………………………….27 Section 5.2: Pharma: High competition along with high capital intensity! …………..29 Section 5.3: IT - Only sector to present an organic scalability example! ……………..31 Section 5.4: Metals & Mining – High presence in the +1tn revenue club! ….33 Section 5.5: Oil & Gas – Maintaining leadership on ‘scale’ in India ………..35 for decades Section 5: Why check for scale? Scale quintiles persist but high ……………37 growth rarely Section 6: Highly probable scalable bets ……………………………………….42 COMPANIES Aarti Industries (BUY): Leader in the making …………………………………..47 Aavas Financiers (NOT RATED): Wired to play in big league ……………….57 Amber Enterprises (BUY): Ride the import substitution wave ……………….63 APL Apollo Tubes (BUY): A ‘Structural’ Story ………………………………….73 Dixon Technologies (BUY): Riding on the electronic wave ……………………83 Hatsun Agro (NOT RATED): Milking scale and pricing power ………………..93 ICICI Lombard (BUY): Good things come at a price! ……………………….101 L&T Infotech (NOT RATED): Balancing growth and profitability …………….109 Mahindra CIE (BUY): Growing on internal accruals ………………………..121 Minda Industries (BUY): Scaling up profitably …………………………………131 Pidilite Industries (NOT RATED): Portfolio of opportunities ………………….141 Prestige Estates (NOT RATED): Set the floor to rise higher ………………….151 SBI CARDS (NOT RATED): Moving to the Premier League …………………..163 SBI Life Insurance (SELL): A true marathon runner! …………………………..175 Torrent Pharmaceuticals (SELL): An enviable M&A track record …………..183 Whirlpool of India (NOT RATED): David’s fight with new Goliaths ………..193 August 26, 2020 Ambit Capital Pvt. Ltd. Page 2 Strategy THEMATIC August 26, 2020 Exhibit A: Majority of listed Indian Scouting for giants companies suffer from dwarfism India’s GDP growth rate will hit an unprecedented air-pocket this year. FY11 FY19 This should be doubly worrying for Indian listed companies. This is 55% 41% because, even as India’s real GDP grew at a spectacular 7% for three decades, this growth rate did not distil into high revenue growth for its 3.2% 0.4% companies. An overwhelming 28% of listed firms (ex-BFSI) even today have revenues of <Rs400mn. Then only 55% of firms fall in the Rs1- BFSI cos by Sales by cos BFSI Share Share of listed 100bn revenue range, a ratio that is distinctly higher in peer countries. - 1-6tn 0-1bn ex Given Indian companies’ inherent susceptibility to dwarfism and given 1-100bn that Covid-19 will disrupt business models in unimaginable ways, it 100bn-1tn Annual Sales (in Rs) becomes critical to identify companies that can overcome the scale challenge. We highlight 16 companies that in our view will able to Source: Capitaline, Ambit Capital research deliver consistent revenue growth over the next 5 years. Exhibit B: EM peers markedly less The mysterious malaise of dwarfism prone to this malaise Even as GDP growth in India will crash in CY20, average GDP growth over the India 6 EMs' Median last 3 decades has been spectacular (7% in real terms, 13% in nominal terms). It 64% would be logical to expect such a high growth economy to be characterized by 55% (1) a few small companies that are routinely scaling-up and (2) a rich eco-system of large companies. The reality however could not have been more contrasting. Of the 2,865 listed ex-BFSI companies in India as at FY19-end, (1) 28% were 28% BFSI cos. ultra-small i.e. had revenues of <Rs400mn, (2) only 55% of companies had - 13% 8% revenues in the range of Rs1-100bn and (3) only 0.4% of companies had ex 4% revenues +Rs1tn in a country whose nominal GDP is >Rs200tn (see exhibit A). listed inShare total Ultra Small Small Medium And the plot thickens - EM peers appear markedly healthier Is dwarfism a common ailment that most companies operating in EMs have to Source: Bloomberg, Ambit Capital research grapple with? Cross-country evidence again suggests otherwise. Data spanning Exhibit C: Ambit’s 16 scalability six large EMs suggests that only 8% of listed companies are Ultra-small in these candidates regions whilst the corresponding number for India is 3.6x this median ratio. Mid- Pidilite (NR) Dixon (Buy) sized companies account for 64% of the listed space in EMs which is significantly Torrent Pharma (Sell) Minda (Buy) higher than the 55% ratio in India (see exhibit B). At the top end, Large and LTI (NR) APL (Buy) Mature companies (i.e. +Rs100bn revenues) account for 14% of companies in Whirlpool (NR) MCIE (Buy) EMs as compared to only 4% of companies in India being in this top bracket. Aarti (Buy) SBI Life (Sell) So what’s wrong with Indian firms – is it nature or nurture? Both. Amber (Buy) SBI Cards (NR) Large Indian firms must deal with frequent changes in regulations or poorly Hatsun (NR) ICICI Lombard (Buy) defined policies that end–up in drastic judicial interventions (2G license Prestige (NR) Aavas (NR) cancellations in CY12 or coal block cancellations in CY14). Mid-sized firms then Source: Ambit Capital research, Note: Refer to need to battle the fact that the Indian market is deceivingly small. Whilst it is Investment Implications for details. vast, it is highly segmented lacking homogeneity of tastes & preferences. The fact that India lacks export competitiveness then further restricts the market size that Indian firms can address. Finally, smaller businesses also struggle to scale-up as Research Analyst (1) the shape of labour regulations creates a perverse incentive for firms to stay Nitin Bhasin small and (2) the cost of debt-capital facing smaller corporates is unusually high. +91 22 6623 3241 So how can investors circumvent Indian companies’ susceptibility to dwarfism? [email protected] Introducing Ambit’s top scalability candidates Author/Consultant It’s apparent that India’s high GDP growth rate fails to distil itself into consistently Ritika Mankar Mukherjee, CFA high revenue growth for its companies. Now with Covid-19 crisis wreaking +91 98333 49668 havoc, carefully identifying mid-sized companies of today that can overcome dwarfism tomorrow becomes all the more critical. We highlight 12 non-BFSI and [email protected] 4 BFSI companies (see exhibit C for details) as our top scalability candidates. Research Analyst These medium sized companies today clear our corporate governance filters and, Nikhil Pillai possess the ability to efficiently sweat their brand and successfully boost their +91 22 6623 3265 scale over the next quinquennium. [email protected] Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision. Strategy Section1: India’s High GDP growth rate ≠ high revenue growth rates for listed firms! Summary: GDP growth in India will sink to an unprecedented low in FY21. However, it is worth noting that India has maintained an impressive average real GDP growth of +6% for four consecutive decades now. It would then be logical to expect businesses to be able to scale up their revenue base with a high degree of success. However, sales data relating to the listed universe suggests exactly the contrary. Despite the high GDP growth that India has maintained for decades on end, this has failed to translate into high sales growth for listed businesses. At one end of the spectrum, Ultra-small firms (i.e. firms with annual sales of less than Rs400mn) have shown a distinct inability to break into higher revenue buckets – a dynamic which has notably been exacerbated in the noughties. Consequently, Ultra-small listed companies account for an eye-watering 28% of non-BFSI listed companies today. Besides suffering from an unusually wide-base of Ultra-small companies, the Indian corporate landscape is characterized by an even larger ‘middle’ and then a narrow ‘peak’. Medium-sized companies (i.e. firms with sales of Rs100bn-Rs1tn) account for 55% of total non-BFSI listed companies in India. And when it comes to the top category of the largest firms, only 12 listed ex-BFSI Indian companies today have a revenue base of +Rs1tn. To make matters worse, not only are companies of world-class revenue size rare in India, they also appear to be concentrated in sectors like Oil & Gas, Metals & Mining or Automobiles; i.e. sectors that are arguably past their heyday . The Indian listed space – A few mature adults but mostly dwarfs and midgets India has maintained a lead of 450bps and 150bps as against the real GDP growth rate of G7 economies and EM peers respectively over the last three decades (see exhibit below). Exhibit 1: India’s GDP growth rate has been materially Exhibit 2: Ultra-small companies’ share in total listed higher than that of peers for the last three decades companies is high and it stopped declining by FY11 G7 EMs FY91 FY01 FY11 FY19 6.2% 58% 5.1% 44% 3.0% 27% 28% 2.1% (%) Sales 22% 1.8% 20% 1.3% listed of Share 15% 13% excess of & excess G7 (%) EM companies* by annual by annual companies* India's real GDP growth in growth GDP real India's FY91-00 FY01-10 FY11-19 0-400mn (Ultra Small) 400mn-1bn (Small) Source: IMF, Ambit Capital research Source: Bloomberg, Ambit Capital research; Note: 1.