The El Nino impact on southwest rains could complicate efforts to put the economy back on fast track
By Mohan Sule
After reaching a new closing high on 23 April, the market lost over a quarter of the 8% gain notched in the current calendar year in the next five trading sessions following an alert about the El Nino effect on southwest monsoon. Historical evidence suggests that below-average rainfall is losing its potency to dent growth, though it does affect agriculture output. A year after the global financial meltdown in September 2008, the economy grew 8.6% despite receiving just 78% of normal rainfall. FY 2010 was officially declared as a drought year. Two years later, the GDP rose just 6.7% even after 101% of normal rainfall. FY 2014 saw 106% of normal rains. Yet, output is expected to slump below 5%. Besides, the Indian Met has been off the mark about its forecast. Only in FY 2011 has the actual rainfall matched the predictions made since FY 2001. In a normal year, the warning would have caused a blip for a day or two, before the market returning to its preoccupation with inflows from foreign investors. 2014, however, is no ordinary year. Besides uncertainty about the formation of a stable Union government, withdrawal of stimulus in instalments by the US Federal Reserve since December 2013 and the slowdown in China are overhangs. Concerns that a coalition government will have less flexibility to carry out reforms have already led to foreign capital outflow. Foreign institutional investors were net sellers of debt in April, perhaps worried about the inability of the Reserve Bank of India to lower interest rates, and slowed down purchases of equity after their buying reached the highest level in March of this calendar year.
The immediate concern about scanty rainfall is the pressure on food prices. Food items have been the biggest contributor to the Consumer Price Index despite good rainfall in seven of the past 10 years. Slump in demand has stalled manufacturing growth. But consumption of food continues to be buoyant as the population coming out of poverty due to reforms and welfare schemes is increasing. Shortages, therefore, could lead to a spike in food inflation and nix the chances of the RBI beginning its interest rate reduction cycle soon. Cut in household expenses could affect discretionary usage. In fact, India is caught in a paradoxical situation. Both above average and less-than-normal rainfall bolster food prices. The government hikes prices of farm output to lend support during bumper production and to compensate for the fall in harvest during drought. Hence, consumers end up paying more year after year. Indication of scarcity of any agricultural produce leads to spurt in international prices. This is what happened when India wanted to import sugar for the October 2009-Sepetmebr 2010 season after the failure of sugarcane crop. Global sugar prices shot up more than 60% from end 2008 till August 2009. A glut in Indian production, on the other hand, saw a worldwide slump in global sugar prices and duty on sugar imports had to be raised to 15% in October 2013 from 10%.
What can be done? The economy could expand in FY 2010 despite drought due to fiscal stimulus of the earlier year. Standard excise on non-petroleum products was reduced to 8% from 14% to insulate India from the worldwide credit crunch. As a result, fiscal deficit ballooned to 6% of GDP in FY 2009 from 2.5% in the previous year. In contrast, GDP could grow just 3.8% in FY 2003, another drought year, with rainfall 81% below normal, in the absence of booster doses. These sops have not been rolled back fully. Excise duty remains at 12% now. The interim budget presented in February 2014 introduced more relief for automobiles. Any more reduction in domestic levies will have to be at the expense of personal and corporate taxes. Nonetheless, any stimulus would be a short-term measure. In the medium term, infrastructure proposals need to be given clearances quickly and irrigation and low-cost housing projects have to be initiated to increase offtake of commodities such as cement, aluminum and steel and to revive the manufacturing sector. The budget for 2012-13 had proposed setting up a financial holding company for PSU banks to meet their capital needs. The idea should be extended to other PSUs, too. The holding company could offer a mix of PSU shares to get better pricing instead of seeing the stock of a standalone entity poised to enter the market getting hammered. The CPSE exchange traded fund, comprising shares of 10 PSUs constituting the CPSE index, launched in March 2014 has met with good response and should embolden the government to undertake aggressive offloading of its shares to boost the market as well as to mop up funds for growth activities.
Wednesday, May 21, 2014
The shape of things
What Sun’s buy of Ranbaxy foretells about the the pharma industry and M&As
By Mohan Sule
The acquisition of Ranbaxy Laboratories by Sun Pharma is another milestone on Deal Street. On the surface, it is seen as a vindication of the trend of fluidity in the pharmaceutical sector. In no other indsutry is there such mobility of companies and uncertainty about future earning. Giants have beaten hasty retreats and small players scaled up to large caps. MNCs have sold off to local investors as well as snapped up promising outfits. No one symbolizes this flux better than the Ajay Piramal group, which bought Indian as well as foreign drug producers and in 2010 divested its branded generics domestic business in favor of a large global producer at bumper valuation of 10 times sales. Copycat producers pushing prices down, the wait for regulatory approvals and changes in government policies keep the industry on the edge. For all the unpredictability, the market has welcomed the Sun-Ranbaxy merger for three reasons. First, promoter Dilip Shanghavi has the tenacity to make his purchases pay off. The battle to control struggling Taro was long-drawn. Despite the Israeli pharma maker’s minority shareholders foiling a merger with Sun, the acquisition is a jewel in Shanghavi’s crown: He added a producer with significant global presence to his portfolio and also lured its CEO to manage the group going global. Second, there was no cash outflow. The share-swap makes Ranbaxy’s owner Daiichi the second largest shareholder of Sun. This has raised concern about future flexibility of the group. But that is a small price to pay to conserve cash, which will be needed to revamp Ranbaxy’s manufacturing processes and to take care of liabilities arising from the US FDA’s crackdown going forward.
Third, Sun’s product portfolio will expand. It can leverage its leadership position in certain niches to position itself as a producer of generics accross spectrum, boosting bulk buying by healthcare giants. In fact, the presence of Daiichi could be taken as a confirmation of the continuing potential of Indian generics, which in the first place prompted the Japanese global maker to snap up Ranbaxy in 2008. This is in contrast to the pessimism about the local industry’s health due to its conversion into a low-margin business because of pricing controls, pushing it to seek outsourcing and exports. The deal is also notable for confirming certain assumptions as well as exploding myths about takeovers. First, companies with global ambitions require footprints in markets across the board. This includes presence in different geographics as well as in a range of products. The US market may consume drugs to counter lifestyle diseases, while the emerging markets need to thwart life-threatening ailments. Besides, patents are going off at a faster pace than new drugs being discovered. This makes the generics market crowded and cost-effective players have a better chance of survival. Second, at two times revenue, the buy was at the lowest valuation in the pharma space, signalling that the industry’s margin might have peaked, even after discounting the seller’s immediate problems, which are repairable in the short to medium term.
Third, the merger throws a light on the blurring of the caste system in the Indian drug industry. During the pre-reform era of controlled capacity and pricing, entrepreneurs could enter the segment by obtaining licences of big players on loan. Now small-scale players are getting back by concentrating on overseas markets and competing in the trading ring with older and established players. For instance, the shift in focus of Ranbaxy from being a local leader to a significant player in the US market. Thus, the deal confirms that Indian players have to look overseas to grow. The downside is the turning of the spotlight on quality issues at production facilities. Fourth, the conventional investing wisdom of ignoring distressed companies in favor of those making profit has been turned on its head as predators would prefer cheap buys rather than load their balance sheet with debt. The fifth lesson is that a brute controlling stake such as over 60% held by Daiichi in Ranbaxy need not be a barrier to change in management control. Instead of exiting through an open offer, minority shareholders of the target company would want to be part of a growth story. But if innovative financial engineering can be a boon it can also be a bane. Piramal Healthcare received cash from the sale of the generics business and later announced a 300% special dividend. But the ordinary shareholders were left with a company devoid of a divison contributing nearly 70% of revenue. Last, concern of dilution of equity (Sun’s by nearly 14%) can be addressed by the earning potential of the target’s (Ranbaxy’s) basket of products. The Sun-Ranbaxy merger, thus, could be a trigger for more cashless consolidation.
By Mohan Sule
The acquisition of Ranbaxy Laboratories by Sun Pharma is another milestone on Deal Street. On the surface, it is seen as a vindication of the trend of fluidity in the pharmaceutical sector. In no other indsutry is there such mobility of companies and uncertainty about future earning. Giants have beaten hasty retreats and small players scaled up to large caps. MNCs have sold off to local investors as well as snapped up promising outfits. No one symbolizes this flux better than the Ajay Piramal group, which bought Indian as well as foreign drug producers and in 2010 divested its branded generics domestic business in favor of a large global producer at bumper valuation of 10 times sales. Copycat producers pushing prices down, the wait for regulatory approvals and changes in government policies keep the industry on the edge. For all the unpredictability, the market has welcomed the Sun-Ranbaxy merger for three reasons. First, promoter Dilip Shanghavi has the tenacity to make his purchases pay off. The battle to control struggling Taro was long-drawn. Despite the Israeli pharma maker’s minority shareholders foiling a merger with Sun, the acquisition is a jewel in Shanghavi’s crown: He added a producer with significant global presence to his portfolio and also lured its CEO to manage the group going global. Second, there was no cash outflow. The share-swap makes Ranbaxy’s owner Daiichi the second largest shareholder of Sun. This has raised concern about future flexibility of the group. But that is a small price to pay to conserve cash, which will be needed to revamp Ranbaxy’s manufacturing processes and to take care of liabilities arising from the US FDA’s crackdown going forward.
Third, Sun’s product portfolio will expand. It can leverage its leadership position in certain niches to position itself as a producer of generics accross spectrum, boosting bulk buying by healthcare giants. In fact, the presence of Daiichi could be taken as a confirmation of the continuing potential of Indian generics, which in the first place prompted the Japanese global maker to snap up Ranbaxy in 2008. This is in contrast to the pessimism about the local industry’s health due to its conversion into a low-margin business because of pricing controls, pushing it to seek outsourcing and exports. The deal is also notable for confirming certain assumptions as well as exploding myths about takeovers. First, companies with global ambitions require footprints in markets across the board. This includes presence in different geographics as well as in a range of products. The US market may consume drugs to counter lifestyle diseases, while the emerging markets need to thwart life-threatening ailments. Besides, patents are going off at a faster pace than new drugs being discovered. This makes the generics market crowded and cost-effective players have a better chance of survival. Second, at two times revenue, the buy was at the lowest valuation in the pharma space, signalling that the industry’s margin might have peaked, even after discounting the seller’s immediate problems, which are repairable in the short to medium term.
Third, the merger throws a light on the blurring of the caste system in the Indian drug industry. During the pre-reform era of controlled capacity and pricing, entrepreneurs could enter the segment by obtaining licences of big players on loan. Now small-scale players are getting back by concentrating on overseas markets and competing in the trading ring with older and established players. For instance, the shift in focus of Ranbaxy from being a local leader to a significant player in the US market. Thus, the deal confirms that Indian players have to look overseas to grow. The downside is the turning of the spotlight on quality issues at production facilities. Fourth, the conventional investing wisdom of ignoring distressed companies in favor of those making profit has been turned on its head as predators would prefer cheap buys rather than load their balance sheet with debt. The fifth lesson is that a brute controlling stake such as over 60% held by Daiichi in Ranbaxy need not be a barrier to change in management control. Instead of exiting through an open offer, minority shareholders of the target company would want to be part of a growth story. But if innovative financial engineering can be a boon it can also be a bane. Piramal Healthcare received cash from the sale of the generics business and later announced a 300% special dividend. But the ordinary shareholders were left with a company devoid of a divison contributing nearly 70% of revenue. Last, concern of dilution of equity (Sun’s by nearly 14%) can be addressed by the earning potential of the target’s (Ranbaxy’s) basket of products. The Sun-Ranbaxy merger, thus, could be a trigger for more cashless consolidation.
The big picture
Besides fiscal projections, the government should fix monetary targets, too, to eliminate conflict of interest
By Mohan Sule
With the biggest democracy in the world kickstarting its five-year cyclical ritual, the economy has come to occupy centerstage. Should the preoccupation with growth be a reason to cheer or is the pushing aside of crony capitalism as the most important issue facing the country a sign that more things appears to change the more they remain the same? As if overjoyed by the renewed sense of importance in the citizens’ mindspace, the broad market benchmarks are scaling new heights despite uncertainty about any political grouping getting a comfortable majority and the specter of an unstable government propped up by regional forces guided by opportunism rather than by ideology. Whatever might be the outcome, there are two inescapable conclusions. The first is the preference for prosperity rather than being bogged down by controversial issues. The second is corruption is not being viewed as a standalone problem though it is considered as a blockage to development. Increasingly, there is recognition of the need for a long-term vision for the country and a package of incentives to achieve the results. The Planning Commission is assigned the role to chart India’s roadmap for the next five years. The primary objective is to assess the current resources including human, raw material and machinery, and capital in meeting the desired objectives. This is a top-down approach, with the finance minister marshalling the tools at his disposal to allocate the necessary finances.
With the opening up of the economy, investment in roads, sea ports, airports, and power generation, clubbed under the sweeping label of infrastructure and till recently the responsibility of the government, is either undertaken as part of public-private initiative or by the private sector on its own. Developers do not have to depend on the treasury to meet their funding. With guidelines framed, land acquisition is to be negotiated by the investor and the owner. Even procurement of natural resources has been left to the discretion of users: some power generators imported coal from Indonesia due to shortages in local supply. The government now acts as a facilitator by expediting clearances and a regulator by monitoring adherence to environmental safeguards and ensuring a fair-playing field. Hence, there should be a rethink on the role of the Plan panel of assigning capacity requirement, particularly for infrastructure projects. Economic indicators should be used to determine if investments are in the right direction and if policy calibration is needed. Like in other industries, overcapacity and non-performing assets should result in consolidation and unlocking of shareholder value.
The Reserve Bank of India uses the benchmark of inflation to guage the health of the economy. Recently, it shifted from the WPI to a more relevant CPI to effect changes in lending rate. The central bank also spells out the comfort level for inflation, which signals impending rate revisions. The finance minister, too, forecasts a fiscal deficit level besides growth rate. These projections are necessary not only for imparting predictability about policies but also to give the market a sense about the indicative route the fiscal and monetary authorities are likely to take to meet them. For instance, it was understood that hiking of import duty on gold was going to be a temporary measure to puncture the ballooning current account deficit and not a reversal in policy. Similarly, the state of fiscal deficit gives a rough idea about the likely course that would be adopted by the government including aggressive PSU divestment, which would have a bearing on supply of paper in the market, and ramp-up in taxes, which would affect consumption. Spurt in government borrowings signals a widening revenue-expenditure gap and heating up of interest rates. What the value of the rupee should be is a debatable issue. Yet, a steep slide is a pointer to the unattractiveness of the country as an investment destination. This would call for dipping into reserves or control on capital outflows. However, the targeting as well as the authority to act to reach the goal posts are divided between the RBI (using interest rates to influence inflation and currency) and the government (using taxes for controlling deficits and growth), leading to conflict of interest. The central bank might want the rupee to finds its own level but the government might want to cap its movement on concerns of costly imports or uncompetitive exports. Hence, there is merit in the suggestion of RBI governor Raghuram Rajan that the government should take up plotting the trajectory for various economic parameters including inflation so that other agencies can accelerate or slow down their efforts to be in step with the big picture.
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