The income pyramid is hard to dig into

Is high growth inevitable for companies operating in under-penetrated sectors? Many of us implicitly assume as much, particularly investors when they indiscriminately invest in such companies despite expensive valuations. The logic behind this appears robust: Any extra expenditure for a household would have a different spending pattern from its current pattern; basic needs having already been taken care of, they should spend the extra rupees on new categories on which they spent too little.

But there appears to be no free lunch — at least none so far. Over the last decade and a half, revenue growth in most corporatised sectors has been at or below nominal gross domestic product (GDP) growth. Let alone categories such as biscuits and soaps that were reasonably well-penetrated at the start of this period, gross sales of even sectors such as automobiles have struggled to beat nominal GDP growth meaningfully. Two-wheeler sales have grown slower than the overall consumption growth of about 13.5 per cent per year, and even car sales growth has annualised at just above 15 per cent. To be sure, on an absolute basis these are strong numbers over a long period, but not relative to implicit assumptions.

It appears that improvement in penetration came only when pricing was sacrificed. At one extreme were cigarettes, where an 11 per cent annualised growth in prices meant zero growth in volumes, and at the other was toothpaste, where almost no price growth supported a 10 per cent annualised growth in volumes. Most sectors fall between these two extremes, implying something like a growth ceiling: It is hard to get the sum of prices and volumes to exceed overall consumption growth.

Take motorcycles for example: At the turn of the century a motorcycle with a 100cc engine cost about Rs 40,000. Even today, despite significant inflation in the cost of inputs (like steel, aluminium, rubber, plastic and labour), and substantial feature enhancements (like better mileage), prices are barely higher in nominal terms, and down sharply in real terms (that is, adjusting for consumer price inflation). It is unlikely that the jump in motorcycle penetration from 4 per cent in 2000 to 22 per cent in 2012 could have been achieved without this. 

A more extreme example is of mobile telephony: Even before the recent fall in prices, average revenue per user (ARPU) had fallen by nearly three-fourths over the past decade, from Rs 320 to about Rs 80. This may have been essential to improve telecom penetration above 90 per cent, but annualised revenue growth for the industry was only 6 per cent during this period.

Companies across sectors continue to innovate, trimming costs and improving productivity to dig steadily deeper into the income pyramid while retaining profitability. However, it appears that without transformational innovation, or a substantial change in enablers, sustained revenue growth faster than nominal GDP growth is tough. Sachets, introduced in the 1990s, were an example of such innovation, bringing down the price point considerably — everyone could afford a Rs 1 hair wash, but very few could afford to pay for 60 washes upfront. It was a win-win for both companies and consumers.

Electrification is an enabler: Even if a household can afford to buy a Rs 1,000 mixer-grinder, in the absence of regular electricity, they would not buy one. But once the power situation improves, as it appears to have over the past five years, looking at some remarkable satellite pictures of night-time India published by NASA, demand for such appliances can accelerate.

Financial services are currently going through such a transition, enabled by the steep drop in transaction costs. If every transaction in a bank branch costs Rs 60, it drops to Rs 17 in an ATM, and nearly zero for mobile banking. Thus, in the era of branch visits, paper-heavy Know-Your-Customer (KYC) norms, cheque books and pass-books, banks were reluctant to open an account unless a customer could keep Rs 5,000-10,000 in it. Therefore, despite repeated prodding from the government over the decades (and bank nationalisation!), bank accounts were a luxury. Now, with Aadhaar as KYC and mobile-only services, an account can be viable only with a few hundred rupees in it, and banking penetration is now near-universal.

Lending costs, too, have fallen: Earlier, when a loan evaluation was done manually and disbursals and collections were cash-based, costs could add up to a Rs 1,000 or more per loan. This meant that a Rs 20,000 loan had a 5 per cent operational cost, making it unprofitable for the lender. Now, with database-based credit evaluation (not the panacea that many believe but a step jump nevertheless), and online disbursements and repayments, operational costs could be a fifth of what they were, making even a Rs 5,000 loan viable.

While there are some other sectors, particularly technology-affected ones, that are seeing changes of this magnitude, these are still only at the fringes. Businesses (and investors) would be best advised to target innovations that allow going deep into the income pyramid profitably: Super-normal growth is not inevitable.
 

The writer is India Equity Strategist for Credit Suisse