INDIAN MANUFACTURING: PROFIT POTENTIAL AND …

INDIAN MANUFACTURING: PROFIT POTENTIAL AND OPPORTUNITIES ACROSS THE VALUE CHAIN

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CONTENTS

1. SNAPSHOT OF INDIA'S MANUFACTURING SECTOR ......................................................... 5

2. INDUSTRY ANALYSIS .............................................................................................................. 7 2.1 Automotive and Auto Components....................................................................................... 7 2.2 Engineering goods................................................................................................................. 12 2.3 Oil and Gas ............................................................................................................................. 15 2.4 Chemicals .............................................................................................................................. 20 2.5 Textiles and Apparels............................................................................................................ 23

3. CONCLUSION ....................................................................................................................... 26

EXECUTIVE SUMMARY

Manufacturing sector accounts for nearly 16 per cent of India's GDP1. The government's NMCC2 envisages increasing the share of manufacturing to 25 per cent of the GDP by 2025. India's manufacturing sector consists of a number of industries. The major industries are engineering goods, automotive, oil and gas, chemicals, and textiles. Together these make up roughly 50 per cent of the sector. This report analyses the profitability of top players across the value chain and identifies opportunities for these five industries.

The value chain of auto sector consists of auto components and automotive manufacturers. The profitability, as measured by five-year average EBITDA3 margin of major companies in the sector stood at 15.1 per cent. The automotive segment enjoys higher profitability, with its average five-year EBITDA margin standing at 19.5 per cent compared with 15.9 per cent for auto-components sector. The major demand driver of growth in the auto sector has been the rising per capita income, especially in semi urban and rural areas.

The value chain of engineering goods sector consists of machine tools and heavy engineering. The extended value chain would have other manufacturing industries such as automotive, textiles and chemicals following the heavy engineering segment. The five-year average EBITDA margin of major companies in the sector stood at 12.9 per cent. The machine tool makers enjoy a higher profitability, with their average five-year EBITDA margin standing at 15.7 per cent compared with 10.6 per cent for heavy engineering companies. The government's emphasis on infrastructure development in recent years has been the major driver of growth for this sector.

The value chain of the oil and gas sector is divided into three components: upstream, midstream and downstream. Exploration and production are considered upstream activities, while storage and transportation are midstream. Downstream comprises refining, processing and marketing of oil and gas. The five-year average EBITDA margin of major companies in the overall sector stood at 27.1 per cent. There is a marked contrast in profitability across the value chain, as the average EBITDA margin of upstream players stands at 48.2 per cent compared with just 4 per cent for downstream players.

1 GDP is Gross Domestic Product 2 NMCC is National Manufacturing Competitiveness Council 3 EBITDA is Earnings Before Interest, Tax, Depreciation and Ammortisation

The value chain of the chemicals sector begins with petrochemicals, which are converted into basic chemicals. These basic chemicals are used for polymer production; this is further converted into special chemicals. The five-year average EBITDA margin of major companies in the sector stood at 20.9 per cent. The average profitability of the low value-add chemical producers was found to be 43.2 per cent, while that of integrated players varied from 15 per cent to 23 per cent.

The value chain of the textiles sector begins with fibre production, which is spun into yarn. The yarn is knit into fabrics, which are further used to manufacture garments. However, most of the large firms in the sector are integrated players operating on the entire value chain. The five-year average EBITDA margin of major companies in the sector stood at 16.4 per cent. Exports have been the major driver of growth in the sector.

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1. SNAPSHOT OF INDIAS MANUFACTURING SECTOR

Manufacturing holds a key position in the Indian economy, accounting for nearly 16 per cent of real GDP in FY12 and employing about 12.0 per cent of India's labour force. Growth in the sector has been matching the strong pace in overall GDP growth over the past few years. For example, while real GDP expanded at a CAGR of 8.4 per cent over FY05-FY12, growth in the manufacturing sector was marginally higher at around 8.5 per cent over the same period. Consequently, its share in the economy has marginally increased during this time ? to 15.4 per cent from 15.3 per cent.

Exhibit 1 Size of the manufacturing sector in India

9000

16.4

8000

16.2

7000

16.0

6000

15.8

5000

15.6 4000

3000

15.4

2000

15.2

1000

15.0

0

14.8

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12

Manufacturing sector (size in INR billion, constant prices)

Share in real GDP (%) Source: RBI, Aranca Research

Exhibit 2 Growth in real GDP and manufacturing in India (%)

15 13 11

9 7 5 3

FY06 FY07 FY08 FY09 FY10 FY11 FY12

GDP

Manufacturing

Services

Source: RBI, Aranca Research

Rapid growth in the manufacturing sector has been accompanied by the higher productivity and profitability of Indian manufacturing companies.

5 Indian Manufacturing: Profit Potential and Opportunities Across The Value Chain

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A study4 by the Reserve Bank of India (RBI) found that these companies' productivity was 24 per cent higher in 2005 compared to that in 2000. It also derived that Indian companies achieved higher profit growth during the period. Despite expected dips in profits during the 2009 downturn, manufacturing industries have been resilient and are back on the recovery path towards precrisis levels or even higher. An example of the latter is the automotive industry, which has been reporting strong growth in business activity owing to high domestic and export demand.

The rising competitiveness of India's manufacturing companies is reflected in the country's ranking as second in the world in terms of competitiveness as per the 2010 Global Manufacturing Competitiveness Index5 (GMCI) prepared by the US Council on Competitiveness and Deloitte. This index factors in market dynamics and policy issues that influence the sector. India is ahead of major developed and emerging economies such as the US, South Korea, Brazil and Japan. Going forward, the nation's competitiveness would increase further with its index score set to improve to 9.01 (out of 10) in the next five years from the 2010 figure of 8.15.

Exhibit 3 2010 Global Manufacturing Competitiveness Index

Current Rank

Country

Index Score

Rank in 2015

1

China

10.00

1

2

India

8.15

2

3

Republic of Korea

6.79

3

4

United States of America

5.84

5

5

Brazil

5.41

4

6

Japan

5.11

7

7

Mexico

4.84

6

8

Germany

4.80

8

9

Singapore

4.69

11

10

Poland

4.49

9

New add*

Thailand

-

10

Source: Deloitte and US Council on Competitiveness *New addition among the top-10 countries. Currently Thailand is ranked 12th with an Index Score of 4.17

All these developments have significantly boosted India's manufacturing prowess. After China, the country is currently the largest producer of textiles, chemical

4 "Profitability of Indian Corporate Sector: Productivity, Price or Growth?", Reserve Bank of India Occasional Papers, Vol. 28, No. 3 5 based on the views of more than 400 senior manufacturing executives worldwide

6 Indian Manufacturing: Profit Potential and Opportunities Across The Value Chain

................................................................................................................................................... products, pharmaceuticals, basic metals, general machinery and equipment, and electrical machinery, as per the United Nations Industrial Development Organisation (UNIDO). The sector's importance to the domestic and global economy is set to rise even further in FY12 as a combination of supply-side advantages, policy initiatives, and private sector efforts set India on the path to become a global manufacturing hub. 2. INDUSTRY ANALYSIS India's manufacturing sector consists of a number of industries. The major industries are engineering goods, automotive, oil and gas, chemicals, and textiles. Together these make up roughly 50 per cent of the manufacturing sector's weight in the IIP6. Some of the industries have pure play companies present only in one segment of the value chain, while others are characterised by presence of integrated players across the chain in order to achieve synergies associated with either backward or forward integration as the case maybe in a particular industry. The major industries listed above have been analysed in the research note. Porter's Five Forces Model7 is used to determine the attractiveness of the industries concerned. In the analysis below, we use a colour code to indicate attractiveness in our diagrammatic representations; green indicates a favourable scenario, yellow is neutral and red denotes an unfavourable scenario. For instance, if the threat of new entrants is green, it means that there is low threat from new entrants to the industry, hence enhancing the attractiveness quotient of that segment. Profitability of the top companies across the value chain is analysed for each of the sectors by considering their five-year average EBITDA margin values, and opportunities are identified for each of the sectors. 2.1 Automotive and Auto Components The Indian automobile industry is the seventh-largest in the world. It forms an important part of the country's manufacturing sector, accounting for nearly 22 per cent of the total manufacturing GDP. The automobile industry generated a gross turnover of USD58.68 billion in FY11; volumes more than trebled over the last decade (FY00-10). The auto components industry has been a high-growth industry in the last decade, generating USD39.9 billion in revenues during FY119. The auto sector's IIP10 (as indicated under motor vehicles, trailers & semi-trailers) expanded at a rate of 15.1 per cent during FY06?12*(Includes April ? Feb 2012) to reach 256.3 from the base year FY05. This classifies the auto sector into the highgrowth category (10?20 per cent).

6 The current IIP (with base year as 2004-05) 7 The forces of Porters model are ? threat of new entrants, threat of substitutes, competitive rivalry, bargaining power of suppliers and bargaining power of customers. Attractiveness in this context refers to the overall industry profitability, so an "attractive" industry is one in which the combination of these five forces acts to drive overall profitability levels. 8 Society of Indian Automobile Manufacturers (SIAM) 9 Automotive Component Manufacturers Association of India (ACMA) 10 IIP is the Index of Industrial Production

7 Indian Manufacturing: Profit Potential and Opportunities Across The Value Chain

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Exhibit 4 Growth in motor vehicles, trailers & semi-trailers (IIP)

35 30 25 20 15 10

5 0 -5 FY06 -10 -15

FY07 FY08 FY09 FY10 FY11 FY12* Motor vehicles, trailers & semi-trailers

Source: Central Statistical Organisation, Aranca Research; Note: *FY12 includes April ? Feb 2012

Sector Composition: Organised sector dominates in Automotives; Auto Components is highly unorganised

The automotive industry consists of well-established companies such as Maruti Suzuki, Tata Motors, Mahindra and Bajaj Auto, while the auto components industry is largely unorganised (accounts for over 90 per cent of the total companies). However, the smaller organised segment accounts for over 77 per cent of the overall production.

Major growth drivers

Demand fundamentals: The rising per capita income over the last decade has been a major driver for this industry, especially with rural incomes also increasing at a decent pace in the same time frame. Demand for commercial vehicles also received a boost in the last few years due to roadway development in urban and rural areas, which leads to greater market access. Easier access to credit has been another major facilitator of the industry's growth as private banks got into the business of auto financing and tapped into the huge and growing market.

Favourable policy: Favourable policy measures from the government have aided the sector's growth. These measures permit the automatic approval of foreign equity in the sector and encouraged R&D by offering rebates on auto companies' R&D expenditure. The Indian government also set up NATRiP11s at a cost of USD390 million to adapt and implement global performance standards. This initiative offers support to small car manufacturers as a reduction of excise duty on them was announced.

11 NATRiP is National Automotive Testing and R&D Infrastructure Project

8 Indian Manufacturing: Profit Potential and Opportunities Across The Value Chain

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