From consumer goods to textile sectors: The great polarisation in India Inc

There is a clear divide between firms with record valuations but few assets, and those with substantial assets but low market capitalisation

No conversation on the Indian economy or earnings growth is complete without a complaint about the lack of investment by the corporate sector. Corporate spending on plant and equipment was up just 6.7 per cent in FY18, in line with the past four years’ compounded annual growth rate (CAGR) of seven per cent. In comparison, capital expenditure (capex) had grown at an annualised 16 per cent between FY10 and FY14. 

If two of India’s biggest non-financial firms — Reliance Industries and Tata Motors — are excluded from the sample, the numbers look worse. Excluding the two, capex was up just 4.9 per cent in FY18. Reliance Industries has made large investments in building its nationwide mobile network under its Jio subsidiary, while the bulk of the incremental capex by Tata Motors is accounted for by its British subsidiary, Jaguar Land Rover. Analysts say that slow growth in capex reduces the future growth potential for companies and the economy, and prolongs the financial and operational pain in the industrial and infrastructure sector. Companies, however, can’t be blamed for going slow on new investments, given that capacity utilisation remains at about 75 per cent. 

The market is now sharply polarised between firms with record valuations but fewer assets on one side, and those with large assets and low market capitalisation on the other. For example, Tata Motors — the single largest investor in the automotive space — has one of the lowest market capitalisations in the industry and the stock has been one of the worst performers over the past 12 months. In auto ancillaries, Motherson Sumi — the largest company by assets and revenues — has lost out to its much smaller peer, Bosch, in terms of market capitalisation. A similar polarisation can be seen in other sectors such as consumer goods, textiles and garments, airlines, hotels and logistics, among others.

 

At the end of September 2018, corporate India’s 10 biggest investors accounted for 35.1 per cent of the combined assets of the top 1,000 companies by revenues (BS1000 companies) but only 15.8 per cent of their combined market capitalisation. This ratio is the lowest in a decade. The corresponding ratios were 33.9 per cent and 32.1 per cent respectively at the end of March 2009. (See Chart 1) 

Excluding Reliance Industries, the top 10 investors accounted for only 10 per cent of the market capitalisation, against their 29.2 per cent share in assets. Only two out of the 10 biggest investors in corporate India — Reliance Industries and Oil and Natural Gas Corporation (ONGC) — are among the 10 most valuable firms in India.

Analysts attribute this growing mismatch between assets and value to the inability of companies to generate adequate returns on their big-ticket investments in the past. “Equity investors value profits and expected future cash flows that companies are likely to generate, rather than physical assets that companies may own. Many large manufacturing firms have failed to generate sufficient returns on their big-ticket investments, pushing down their valuations,” says Saurabh Mukherjea, founder, Marcellus Investment Managers.

This has left many firms with large assets and liabilities on their books but insufficient profits or cash flows to service them, creating a downward cycle of lower profitability, lower valuations and steadily growing liabilities.

In the Tata group for example, the bulk of the incremental capex in the last decade went to Tata Motors and Tata Steel, but most of the value has been created by asset-light companies such as Tata Consultancy Services, Titan Company and Voltas. At the end of September last year, Tata Motors and Tata Steel accounted for two-thirds of the group’s assets but accounted for only around one-tenth of the group companies’ combined market capitalisation. This makes it tough for these cash guzzlers to continue their spending spree. 

Saurabh Mukherjea, Founder, Marcellus Investment Managers

In the Aditya Birla group, most of the group assets are accounted for by Hindalco and Vodafone Idea, but most of the value resides in UltraTech Cement. The cement major accounts for a little over 40 per cent of the group companies’ combined market capitalisation, but has just 10 per cent of the group’s assets. Vodafone Idea, which reported a debt of around Rs 1.2 trillion at the end of September last year, has a market capitalisation of around Rs 28,000 crore. 

In the case of the Adani group, most the group’s assets are locked in its power business, but Adani Ports and Special Economic Zone is most valuable (in terms of market capitalisation) in the group. For example, Adani Power has a market capitalisation of around Rs 18,000 crore, against its total borrowings of around Rs 45,000 crore at the end of September 2018.

 

“Every passing year, interest or debt servicing eats away a larger portion of the incremental growth in corporate revenue and operating profit. This leaves little retained earnings for companies to share with their equity investors as dividends or fund new projects,” says Dhananjay Sinha, head of institutional equity, Emkay Global Financial Services. 

In the last five years, BS 1000 companies’ combined revenues and operating profit grew at a CAGR of 3.4 per cent and 7.1 per cent respectively. In the same period, the companies’ interest liabilities grew at an annualised rate of 10.8 per cent, leading to a gradual deterioration in their financial metrics. It’s worse for companies in sectors such as power, metals, infrastructure and telecom, which have been most affected by the demand slowdown. 

Rajesh Gopinathan, CEO, Tata Consultancy Services, India’s most valuable company

“At the end of the day, the stock market values a company’s equity or its net worth. If a company has too much debt relative to equity on its books, it will weigh on its market capitalisation, and this is the case with most asset-heavy companies in India currently,” says UR Bhat, managing director, Dalton Capital Advisors. 

Bhat argues that enterprise value, which is the sum of market capitalisation and net debt on a company’s books, is a more suitable measure of valuing manufacturing companies. “Assets are mostly created at the peak of the business cycle and largely funded through borrowings. This pushes down the market capitalisation even if the company is doing well financially,” he adds. 

Bhat has a point. The total borrowings of the country’s top 10 asset-heavy companies exceeded their net worth by around 30 per cent on average at the end of September 2018, pushing down their market capitalisation, even though they lead the charts on enterprise value. Some of the companies in our list include Reliance Industries, Oil and Natural Gas Corporation, NTPC, Tata Motors, Indian Oil, Vodafone Idea, Tata Steel, Power Grid Corporation, Bharti Airtel and Grasim Industries. 

In all, these companies reported combined gross debt of Rs 14.46 trillion at the end of September 2018, against a net worth of Rs 10.97 trillion and market capitalisation of Rs 17.8 trillion.

A poor show by BS 1000 toppers is, however, not due to lack of investor interest in equities. In the last five years, the combined market capitalisation of BS 1000 companies has nearly doubled to around Rs 104 trillion, now growing at an annualised rate of 14.7 per cent as equity markets absorbed a greater part of domestic financial savings. It has resulted in a sharp expansion in the valuation multiple on Dalal Street. For example, an average BS 1000 company is now trading at 29 times its net profit or earnings in FY18, up from 17.1 times in 2013. Investors are, thus, willing to give top valuations to companies they like. 

 

Analysts say that there has been a value migration from high-risk companies to those that offer fewer surprises to investors. “Investors turn risk-averse when economic growth slows down, making it tough for companies to generate faster earnings growth. This has meant record high valuations for asset-light companies which may be smaller in size but have better earnings visibility and offer few downside risks,” says G Chokkalingam, founder and MD, Equinomics Research & Advisory.

Not surprisingly, the list of the country’s top ten most valuable firms (in terms of market capitalisation) is dominated by asset-light and debt-free companies such as Tata Consultancy Services, Hindustan Unilever, ITC, Infosys, Maruti Suzuki, Wipro and HCL Technologies, among others. Reliance Industries is the only exception and it tops both the market capitalisation and assets list. 

Sanjiv Puri, CEO, ITC

Investors’ love for asset-light companies, however, makes it tough for companies in capital-intensive sectors such as power, telecom, infrastructure, and metals and mining to fund their growth plans, hitting the overall corporate capex cycle.

“It’s tough for companies to convince their shareholders or lenders to give them additional capital when they are struggling to service the existing liabilities on their books,” says Sinha. He points out that the cost of capital now exceeds the return on capital employed for many of the top companies in capital-intensive sectors, putting them in a financial bind. 

Many companies can’t raise fresh equity capital due to a sharp fall in their market capitalisation, while raising fresh loans from lenders is a challenge, given an already stretched balance sheet.  

Salil Parekh, CEO, Infosys

While top firms and those backed by deep-pocketed promoters with diversified business groups have somehow managed to fund their operations, the going has been tough for many independent and mid-sized firms in capital-intensive sectors.

In the Tata group for example, Tata Sons has used its dividend income from Tata Consultancy Services to support group cash guzzlers such as Tata Steel, Tata Motors and Indian Hotels. Reliance Industries is using free cash flows from its oil refining and petrochemical businesses to fund the multi-billion-dollar capex of its telecom business. 

But for companies in stressed sectors without access to a captive cash cow, it is a difficult time. A look at the growing list of corporate failures in recent years is proof of what this drought of capital means for corporate India.

According to Mukherjea, corporate India is caught in a financial trap with no immediate exit in sight. “What India Inc requires is two-three years of vigorous growth in corporate earnings, like we saw from 2003 to 2006. This will improve capacity utilisation, raise return on capital employed and provide companies with the firepower to fund a new cycle of growth and expansion,” he adds.

Kenichi Ayukawa, CEO, Maruti Suzuki

A period of rapid earnings growth will also allow companies to deleverage their balance sheets either through loan repayment or greatly increase their equity relative to debt on their books. 

The biggest question is where the incremental growth will come from, to start a new virtuous cycle of higher demand growth, higher profitability, stronger balance sheets and greater investments.