Table of Contents

Indian Pharmaceutical Industry (Shuchi Nahar) ................................................... 2

Indian Banking Sector (Shuchi Nahar and Keval Shah) ......................................... 26
Indian Tyre Industry (Akshay Satija) ............................................................... 75
Indian Steel Industry (Zain Iqbal) ................................................................... 85
Indian Cement Industry (Ashwini Damani) ..................................................... 103
Indian Sugar and Ethanol Industry (Keval Shah) .............................................. 119
Global & Indian Coffee Industry (Zain Iqbal) .................................................... 139

Owner: Chetan Phalke

Content owner: Chetan Kothari

Compiled by: Abhishek Murarka

Indian Pharmaceutical Industry
(Shuchi Nahar)
Understanding How The Indian Pharmaceutical
Industry Works
Posted on May 15, 2018 Author Shuchi Nahar

Following article is first in the series of articles on the Indian Pharmaceutical Industry, the first article is
written to familiarize ourselves with the terminology or the jargon’s of the pharmaceutical industry.
We will briefly touch upon terms like API, Intermediates, Formulations, Innovator drug, Generic drugs,
life cycle development etc.

The Indian Pharmaceutical industry is about $ 17 bn industry (2016) with as many as 20,000 registered
companies (includes MNC’s and small scale units) directly or indirectly involved in the business of
selling medicines. India has the distinction of being the lowest cost producer of medicine in the world.
India also has the feather of being the largest exporter of generic drugs in the world, we have some
great franchises like Lupin, Sun Pharma etc.

Terminologies

API-Active Pharmaceutical Ingredient – It is the basic drug itself with the desired medicinal
pharmaceutical properties, also known as bulk drug.

Intermediates – Most chemical reaction are step wise, that is they take more than one elementary
step to complete and the intermediary formed in the process of making an API is called an
intermediate.

Finished Dosage or Formulation – It is the form in which the drug is consumed by us. A dosage form
of a drug is usually composed of two things: The API, which is the drug itself; and an excipient, which
is the substance of the tablet, or the liquid the API is suspended in.

Pharma Supply Chain from Intermediates to API maker to Formulations maker.

Oncology – Oncology deals with the prevention, diagnosis, and treatment of cancer.
Tentative Approval – Tentative Approval is granted prior to patent exclusivity expiry for a
blockbuster drug, however companies getting tentative approval cannot market the drugs in USA until
they receive final approval.

Blockbuster Drug – A blockbuster drug is an extremely popular drug that generates annual sales of
at least $1 billion for the company that sells it. Blockbuster drugs are commonly used to treat
common medical problems like high cholesterol, diabetes, high blood pressure, asthma and cancer.

DMF- Drug Master File – API manufacturers need to file a document known as Drug master File
(DMF) with regulatory bodies. A Drug Master File (DMF) is a submission to the FDA that may be used
to provide confidential detailed information about facilities, processes, or articles used in the
manufacturing, processing, packaging, and storing of one or more human drugs.

New Drug Application – The final step formally taken by a drug sponsor, wherein it applies to the
Food and Drug Administration (FDA) for the approval required to market a new drug in theU.S. An
NDA is a comprehensive document with 15 sections that includes data and analyses on animal and
human studies, the drug’s pharmacology, toxicology and dosage, and the process to manufacture it.
When an NDA is submitted, the FDA has 60 days to decide whether to file it for review, or reject it
because some required information is missing. The goal of the FDA’s Center for Drug Evaluation and
Research (CDER) is to review and act on at least 90% of NDAs for standard drugs within 10 months
after the applications are received, and six months for priority drugs.

ANDA (Abbreviated New Drug Application) – Abbreviated New Drug Applications are
“abbreviated” since they do not require the applicant to conduct clinical trials and require less
information than a New Drug Application. If an ANDA is approved, the generic drug will be listed in
the Orange Book, which lists all medicines the FDA has found to be safe and effective. An ANDA
contains all the information the it needs to evaluate on how safe and effective a proposed generic
drug is compared with its brand-name equivalent. The FDA will not approve the generic unless it is
equally safe and effective.

Bio Similars – Bio similar is an approved drug that it is highly similar to an FDA-approved biologic
product, and has no clinically meaningful difference in safety or effectiveness from the originally
approved product. However, bio similar is not chemically identical to the drug they refer, and may
include slight differences. Medical practitioners or pharmacists don’t have the liberty to give a bio
similar drug in place of the biologic.

PARA 1 – A Para 1 filing is made during the launch of a generic drug when the innovator has not
provided the required information in the orange book.

PARA 2 – Para 2 filing is made when the drug is already off patent.

PARA 3 – Para 3 filing is made when the applicant does not have any plans to sell the generic drug
until the original drug is off patent.

PARA 4 – A Para IV filing for the launch of generic drug is made when the applicant believes its
product or the use of its product does not infringe on the innovator patents or where the applicant
believes such patents are not valid or enforceable.
Acute Disease – An acute disease is a disease with a rapid onset and/or a short course.

Chronic Disease – A chronic condition is a human health condition or disease that is persistent or
otherwise long-lasting in its effects. The term chronic is usually applied when the course of the disease
lasts for more than three months.

CRAMS – Contract Research and Manufacturing – One of the fastest growing segments in the
pharmaceutical and biotechnology industry. It pertains to outsourcing research services/
manufacturing products to low-cost providers with world class standards.

Generic Drug – A generic drug is a drug that is not branded but is similar to a branded or reference
listed drug in terms of dosage, administration and performance.

505 (b)(2) – The 505(b)(2) new drug application (NDA) is one of three U.S. Food and Drug
Administration (FDA) drug approval pathways and represents an appealing regulatory strategy for
many clients.A 505(b)(2) NDA contains full safety and effectiveness reports but allows at least some of
the information required for NDA approval, such as safety and efficacy information on the active
ingredient, to come from studies not conducted by or for the applicant.

Biologics – A biologic is manufactured in a living system such as a microorganism, or plant or animal

cells. Most biologics are very large, complex molecules or mixtures of molecules. Many biologics are
produced using recombinant DNA technology.

Exclusivity Period – Exclusivity period refers to certain delays and prohibitions on approval
of competitor drugs available under the statute that attach upon approval of a drug or of certain
supplements. Exclusivity period was designed to promote a balance between new drug innovation
and greater public access to drugs that result from generic drug competition.

Orange Book – The publication Approved Drug Products with Therapeutic Equivalence Evaluations
(commonly known as the Orange Book) identifies drug products approved on the basis of safety and
effectiveness by the Food and Drug Administration (FDA) under the Federal Food, Drug, and Cosmetic
Act (the Act) and related patent and exclusivity information.

Purple Book – The “Purple Book” lists biological products, including any biosimilar and
interchangeable biological products, licensed by FDA under the Public Health Service Act (the PHS
Act). The Purple Book includes the date a biological product was licensed under 351(a) of the PHS Act
and whether FDA evaluated the biological product for reference product exclusivity under section
351(k)(7) of the PHS Act.

CCS (Custom Chemical Synthesis) – Custom Chemical synthesis is a purposeful execution of

chemical reactions to obtain a product, or several products. This happens by physical and chemical
manipulations usually involving one or more reactions. In modern laboratory usage, this tends to
imply that the process is reproducible, reliable, and established to work in multiple laboratories.

FTF (First to File) – First to file is another category where even before the first five years are over a
company can challenge the drug if approved that company gets an 180 days exclusive approval to
market its generic version of the Innovator drug. This can prove very lucrative for the challenger if
granted. On the other hand there are Litigation Risks where the Innovator tries to prove that the
challenger has infringed on its patent/process while developing the generic version.

Innovator Drugs – A generic drug is bioequivalent to a drug that has a brand name, also called an
innovator drug. It will have a different name and will look different from its innovator counterpart, but
the active ingredients will be the same.

Dispensing – Selling out properly on a lawful prescription. A prescription can only be filled by a
registered pharmacist, veterinarian, dentist or member of the medical profession. The law requires that
a prescription be written only for patients that are under doctor’s care.

CFA (Clearing and forwarding agents) – These organizations are primarily responsible for
maintaining storage (stock) of the company’s products and forwarding SKUs to the stockist on
request. Most companies keep 1–3 CFAs in each Indian state. On an average, a company may work
with a total of 25–35 CFAs. The CFAs are paid by the company yearly, once or twice, on a basis of
the percentage of total turnover of products.

Stockist – He is the distributor, who can simultaneously handle more than one company (usually, 5–
15 depending on the city area), and may go up to even 30–50 different. They pay for the products
directly in the name of the pharmaceutical company after 30 to 45 days.

Bio-equivalence – Bio-equivalence is the similarity between two drugs which essentially means that
they both have the same effect on the patient. Bio equivalence means that two drugs release their
active ingredient into the bloodstream in the same amounts and at the same rate. When assessing
how well a generic drug works, scientists evaluate its bio equivalence to the name-brand version.

CGMP – Current Good Manufacturing Practice, CGMP is to follow the current guidelines to produce
the best quality pharmaceutical products.

Pediatric Exclusivity – 6 more months added to existing patent exclusivity.

Orphan Drug Exclusivity – To treat a disease that affects fewer than 200,000 people in the United
States.The orphan drug law offers tax breaks and a seven-year monopoly on drug sales to induce
companies to undertake the development and manufacturing of such drugs, which otherwise might
not be profitable because of the small potential market.
Para-Filings

Drug Types

There are two types of drug:

1. Innovator drug
2. Generic drug

Manufacturing stages of a medicine.

1. Innovator drug

Drug is build up from the scratch, thus a much rigorous process and even the patent is filled which
leads into huge prices of drug in its patent life as there is no competitor. And when a drug goes off
patent at that time price crashes roughly 70%. Usually the player who gets the 180 days exclusivity
corners 60% of this market as his brand gets established.

Drug Development Life Cycle

Drug Development Life Cycle is a complex and a very long process which lasts 10-15 years. 1000 of
tests are conducted on the drug across the country. Research teams from various labs work hard day
and night to analyze the disease. When any new drug is launched there are clinical trials done with
first to file. We have drug development phases which are regulated by the authority like FDA, these
phases are phase 1, phase 2, phase 3 etc.

The video embedded will explain the whole process of Drug Discover.

Discovery

 Represents first stage. It is the process by which drugs are discovered and/or designed. We identify
cellular and genetic factors that play a role in specific diseases and it can take 10-15 years for drug
approval.

Development

 It is a phase where promising compound is transformed into a marketable product. It is a process

of taking a new chemical through various stages necessary to allow it to be tested in human
clinical trials.

Pre-Clinical Tests

 The beginning of the drug approval process. To see the potential effects on humans, tests are
performed on: Isolated tissues, Cell Cultures and Animals. Company decides whether to put the
drug into the human testing process, based on the marketability of the product and their financial
situation. On average, only one compound in a thousand will actually make it to human testing

IND Filings

 The goal is to provide pre-clinical data of high quality to justify the testing of the drug on humans.
FDA has 30 days to review the Investigational New Drug (IND) application. It must be filed annually
until the completion of clinical testing. During this time patents are applied; patents last generally
for 20 years. About 85% of all IND applications move on to begin clinical trials. If they succeed,
there is a 20% chance of the product making it to the market.
NDA Filing

Upon desirable results from Phase III, New Drug Application (NDA) will be submitted. NDA contains
data supporting the efficacy and safety of the drug. Approval can take 2 month to several years, but
on average, it takes around 18 to 24 months. Drugs are subject to ongoing review, making sure no
adverse side effects appear. After FDA’s approval, the drug can be marketed and distributed.

Patent

Generally lasts for 20 years. Since most companies file for patent during pre-clinical trials, usually the
patent is only good for another 10 years or so after it gains FDA approval. What can be patented –
product, method and use.

2. Generic Drug

A generic drug is a medication created to be the same as an already marketed brand name drug in
dosage form, safety, strength, route of administration, quality, performance characteristics and
intended use. These similarities help to demonstrate bio equivalence which means that a generic
medicine works in the same way and provides the same clinical benefits as its brand name version. In
other words, it can be treated as an equal substitute for its brand name counterpart.
Different Business Segments Of Pharma Company

1) API- Active Pharmaceutical Ingredient

To understand the pharmaceutical business model, it is worth understanding the price relationship
between the API, the tablet, and the drug market price. The main ingredient in Pharmaceutical is API
[Active Pharmaceutical Ingredient]. It is the main drug which cures the disease. There are many
companies which produce and are specialist in only producing APIs. In producing APIs the companies
either purchase intermediates from different players and mix them to produce a final API or they
themselves produce all the intermediates and mix at their own place. These are the companies which
deal only in API. They sell their produced APIs to different formulation players who then further
process it to make it a consumable drug. The companies who produce and sell APIs need their
product to get registered with US FDA by filling a Drug Master File [DMF] which makes sure that the
facilities of the API manufacturing company are in proper shape and are safe. The companies in this
business do not attract high profit margins because there are many players who produce a single
chemical and even if they try to charge high price from their customers then they can lose their
revenue because of high competition in the market. However, such business work in bulk deals as the
formulation players purchase finished API from them in bulk due to which even if they lose a single
customer a good amount of revenue is lost. Generally, the size of the market of the API used in a
formulation is 10% of the total formulation market. The great expense that goes into a patent
challenge means that API suppliers working in support of such challenges must be extremely reliable,
sophisticated and capable of working on a highly confidential and exclusive basis. DMFs are filed with
USFDA, MHRA UK, Japan and other country specific bodies for receiving a marketing authorization
grant. A DMF provides the regulatory authority with confidential, detailed information about facilities,
processes, or articles used in the manufacturing, processing, packaging, and storing of one or more
drugs. There are basically three streams of API’s sold by the companies : Oncology, Hormones &
Steroids. Major revenue is earned from oncology segment. This is basically because it costs a lot to
put up manufacturing facilities for these streams, usually 5-6x than normal, as these drugs require
specialized handling. These facilities require stringent entry procedures and isolation
chambers/procedures to reduce risks of product contamination, cross-contamination and also
protecting people from hazards and toxicity. These are as mandated by the regulatory Authorities.
Scaling up proves very costly and barriers to entry are strong.

2) Formulations

Pharmaceutical formulation, in pharmaceutics, is the process in which different chemical substances,

including the active drug, are combined to produce a final medicinal product. The word formulation is
often used in a way that includes dosage form. There are two types or classifications for
Pharmaceutical Formulation, these types are the following:
Oral formulation – The most important characteristic for oral formulation it must be overcome the
problems which associated with oral administration. The most critical problem is rate of drug solubility
i.e., the active ingredient of the drug must be soluble in aqueous solution in a constant rate. This point
can be controlled through some factors like particle size and crystal form. The oral formulation divided
in two parts which are: A- Tablet form & B- Capsule form.

Topical medication forms – This type include several parts as the following: A-Cream, B-
Ointment, C- Gel, D- Paste, and E- Powder.

Within the Domestic formulations market the major therapeutic categories are ‐
Antinfective, gastrointestinal, cardiac, gynecology and dermatology.The leading drug classes were C
ephalosporin, Antipepticulcerants, oral antidiabetic and Ampicillin / Amoxycillin, etc.
The top ten drug classes contributed 35% of total domestic market. Formulations are the end-
products of the medicine manufacturing process, and can take the form of tablets, capsules,
injectables or syrups, and can be administered directly to patients. The production of formulations in
India increased at a CAGR of 17% during the period FY1991-2001. The exports of formulations from
India increased at a CAGR of 29% during FY1991-2000. The strong growth in formulation exports
during the 1990s can be attributed to exports made to the developing markets and the access gained
by Indian players to the generics markets of developed countries. Formulations account for over 50%
of the total pharmaceutical exports from India. A series of mergers and acquisitions in the
pharmaceutical industry has resulted in the concentration of market share among the leading players
in the formulations segment. Also, over a period of time, the incumbent players in the formulations
market have been able to set up extensive distribution networks, thus driving sales of their brands and
increasing market share.

3) CRAMS-Contract Research and Manufacturing

Pharmaceutical companies are increasingly outsourcing research activities to academic and private
contract research organizations (CROs) as a strategy to stay competitive and flexible in a world of
exponentially growing knowledge, increasingly sophisticated technologies and an unstable economic
environment. It has been widely recognized that the global pharmaceutical industry is currently
experiencing dynamic change. Under high pressure to contain fixed costs, all drug companies are
currently reducing their internal capacities in R&D, manufacturing, and even marketing and, instead,
increasing their outsourcing. To a significant extent, the drug companies, large or small, now rely on
outsourcing service providers more than ever to fulfil their tasks, solve their problems, and improve
their efficiency and productivity. The worldwide outsourcing demand for preclinical research and
development is, however, still soft at present. Almost all major pharma companies have publicly
announced that their current and near future R&D focus will be on the late-stage drug candidates.
Meanwhile, many drug companies also are shifting their research methodologies for toxicology (tox)
studies to include molecular biomarkers, imaging, and companion diagnostics, as these innovative
technologies are able to provide better safety profiles of trial compounds. There are three broad
outsourcing opportunities available to India – Custom Chemical Synthesis or CCS, clinical trials and
contract manufacturing or CRAMS. The most scalable business opportunity for Indian players would
be contract manufacturing or CRAMS. This is because: CCS would typically involve supply of material
at gram or kilogram level, while CRAMS involves supplies in tons. CCS supplies are linked to the
success of the partner’s R&D pipeline and are, hence, volatile. CRAMS supplies, on the other hand, are
linked to the success of a product post commercialization and can provide relatively stable revenues
(since probability of success post commercialization is higher than that at the R&D level). However,
custom synthesis or CCS skills are important from the following perspective: CCS assignments give
Indian players an opportunity to lock-in into MNC relationships very early in the product lifecycle. This
augurs well for the partnership approach that lays the foundation of the outsourcing business. CCS
projects demonstrate a company’s ability in process innovation. CCS skills can help a company to
graduate from only a ‘supplier’ to a ‘preferred strategic partner’. CCS projects are characterized by
high margins but low scale, but CRAMS projects offer scale plus reasonable margins. Hence, a proper
mix of CCS and CRAMS projects is a prerequisite for success in the outsourcing space. It can be
observed that CRAMS player who is also a substantial API player can enjoy very good profitability.

The key factors that help win outsourcing (CRAMS) contracts:

 Time and quality: Time and quality are of extreme importance to the innovator companies. In
R&D, time is very important to save on the limited patent life, and in manufacturing, it is a matter
of reputation for innovator companies to market the drugs during the entire patented period. Also,
high quality products are essential to win contracts. Due to the nature of pharmaceuticals, threat of
product contamination or excess impurities is enough to scare the potential customer. Also, the
drug quality has significant implication on the reputation of the innovator and financial liabilities of
the company.
 Availability of manufacturing capacity: Just as timeliness of supply is critical, sufficient capacity
is key to the new business especially for contract manufacturing. Innovative companies generally
request rapid turnaround time. Existing manufacturing capacity is critical for time-sensitive
projects. However, where supply relationships already exist, the ability to plan for projected new
capital needs can be jointly accomplished.
 Reputation and track record: If the CRAMS player was the service provider for the innovator
company in the past, and had delivered satisfactory services, the customer will most likely opt for
the same CRAMS player for similar or new projects on the basis of the trust that has been built.
Also, innovator companies will generally prefer big CROs and CMOs due to available infrastructure
and service quality.
 Array of services offered : Generally, innovators like to get maximum possible services from same
contract research company due to ease in administration and effective communication regarding
requirements. For example, if a company has synthesized a chemical, it might be a good choice for
other services such as process chemistry too.
 Reliability and flexibility : Suppliers should be reliable in terms of dedicated management team,
financial stability, strong track record of supply, manufacturing, logistics, etc. Flexibility is also
extremely important to innovators, as CMOs often collaborate with them to develop a new drug. In
particular, the ability to adjust manufacturing schedules to meet deadlines, adjust manufacturing
processes, and meet critical timelines is very important.
 Scalability: Pharmaceutical customers prefer suppliers who have the ability to increase their scale
of production, as products move from early stages to later stages of drug development. In general,
this means suppliers should have ready availability of CGMP capacity as products pass through
FDA hurdles, or the means to rapidly build additional capacity in conjunction with the anticipated
product launch. In addition, it requires a scalable process used to manufacture the molecule. In
other words, the contract manufacturer must develop a process that can effectively and
affordably manufacture commercial quantities of the molecule. This ties closely to contract-
manufacturing process chemistry skills. We believe that these skills are critical, yet very difficult to
assess (other than increased contract wins).

4) Biosimilars

Biosimilar are medicines made from living cells through highly complex manufacturing processes and
must be handled and administered under carefully monitored conditions. Biosimilar are used to
prevent, treat, diagnose, or cure a variety of diseases including cancer, chronic kidney disease,
autoimmune disorders, and infectious diseases. A biosimilar is exactly what its name implies — it is a
biologic that is “similar” to another biologic drug already approved by the FDA. The clinical trials
carried out on a potential biosimilar are designed differently to those for approval of a novel biologic.
When assessing a potential biosimilar, the aim is to confirm that there are no clinically meaningful
differences in its efficacy and safety compared to the reference product. Biosimilar approval is based
on the totality of data demonstrating similarity between the biosimilar and the reference product,
including quality characteristics, biological activity, safety, and efficacy. Because of this complexity,
there is a significant difference between the development of a generic drug and a biosimilar: on
average, a generic drug takes 3-5 years to develop at a cost of USD $1-5 million; a biosimilar, on the
other hand, takes on average 7-8 years to develop at a cost of USD $100-250 million. It’s worth
highlighting that the technology involved in manufacturing and characterisation of biologics has
advanced significantly. Manufacturers are now able to develop highly detailed characterisations of the
molecular and functional attributes of products, including tracing potential product impurities,
uniformity, and concentration. This allows for a multi-level assessment of the purity, safety, and
potency of biological products. The biologics market is predicted to continue to grow faster than the
total pharma market and is expected to account for almost 30% of global prescription sales by 2020.
Interestingly, according to some analysts, by 2020 biosimilars will comprise between 4% and 10% of
the total biologics market, with their market value expected to exceed $25 billion.

5) Export/Import Business:

The Indian pharmaceutical industry is the largest supplier of cost effective generic medicines to the
developed world. With the widest range of medicines available for exports and with the availability of
the largest number of approved pharmaceutical manufacturing facilities, India is all set to become the
leader of pharmaceutical exports to the world. The domestic Indian pharmaceutical industry is
estimated to be $ 26 billion in 2014 growing at nearly 20 percent and is expected to reach nearly $ 50
billion in 2020. It is evident that a lot of internal factors are responsible for the growing
Indian pharmaceutical industry. The year on year growth has taken a promising growth since 2008
with an incremental increase in the range of $ 1-1.5 billion each year. The US is the largest consumer
of Indian pharmaceutical exported medicines followed by the UK. Many of the top 50 domestic Indian
pharmaceutical companies contribute to this growth both in value and volume. The size of Pharma
industry in India is expected to increase to USD 48 billion by 2017-18, growing at a CAGR of 14%. The
industry has a large part of its revenues coming from exports. India exports pharmaceutical products
to more than 200 countries. The Government of India has come out with its policy document –
‘Pharma Vision 2020’, which aims to make India a global leader in end-to-end drug manufacture. Both
the domestic and export market are set to witness high growth.

Export Through API (Bulk Drugs)

API’s exports are likely to grow at a CAGR of 12-14 % over 2013-14 to 2018-19, driven largely by
exports to regulated markets as well as continued growth in the semi-regulated markets. Exports to
the regulated markets would be driven primarily by three factors:

 A large value of drugs going off-patent in the next 5 years

 The expected rise in penetration of Indian API players in regulated markets
 The need of global pharmaceutical players to outsource API manufacturing to cut costs.

We expect that major global innovators will not only extend existing deals with Indian players but will
also look to increase sourcing of bulk drugs from Indian companies. The exports in the year 2008-09
was 43% which increased to 49% in the year 2013-14 and is expected to rise by 51% in the
forthcoming years 2018-19.

Export Through Formulations (Domestic)

The growth story of the domestic formulations market is expected to remain strong, led by a rise in
life-related diseases, better healthcare diagnostic infrastructure adding to increasing disease detection
rate, new product introductions, volume growth driven by increasing penetration, and better access to
healthcare. Domestic formulation sales are set to grow at a CAGR of 12-14% between 2013-14 and
2018-19, with the market size crossing USD 20 billion.

Export Through Formulations (International)

India’s formulation exports are expected to grow at a CAGR of 14-16% between 2013-14 and 2018-19.
Steady growth is expected in exports to both regulated and semi-regulated markets over the next 5
years. During the period between 2012 and 2018, drugs generating annual sales of about USD 130
billion are likely to lose patent protection and will be exposed to generic competition. We therefore
expect sales of generics to grow at a CAGR of 7-9% over the next 5 years, outperforming the overall
global pharmaceutical market, whose growth is expected to be limited to 3-5%.

6) Pipelines In Biotech Companies:

The word pipelines in biotech companies generally refers to the stages of clinical trials. In the
pharmaceutical industry, pipelines are frequently used when describing and evaluating a
biotechnology company’s activities, research and development progress and overall potential for
success and growth. The status of a drug in the pipeline refers to the stages of clinical trials that it is
at (or must pass through) before being approved for sale and/or public use. The pipeline overall is the
group of unique products or processes reported or in development by a company. Drugs that have
entered into clinical trials and are pending approval by the U.S. Food and Drug Administration (FDA)
are said to be “in the pipeline”. A company that has several drugs in various stages of development
has multiple products in the pipeline. Likewise, a product in the pipeline is one that we can anticipate
hearing more about and, possibly using, in the future. However, the value of each individual pipeline
drug depends upon its progress through clinical trials and, ultimately, approval. When evaluating a
company pipeline, each drug is assigned a weighted value which increases as it progresses through
these trials.
7) Biotech Industry:

The Indian Biotechnology sector is presently divided into five segments based on the products and
services offered. These segments are Bio-Pharmaceuticals, Bio-Services, Bio- Agriculture, Bio-Industrial
and Bio-Informatics. Bio-Pharma is the largest sector contributing to 62% of the total revenue
followed by Bio-Services (18%)Bio-Agri(15%) and Bio-Industrial(4%). Bio-Informatics is still at a
nascent stage contributing to only 1% of the total revenue.

Growth Drivers Of Biotech Industry: Increasing cost of bringing a new drug to the market: India can
play a key role in reducing cost and time to market for new drug development through outsourcing of
various components of the drug development process. Top pharma companies spend a large part of
their research for in licensing new modules: There is an opportunity for R&D focused Indian biotech
companies to enter into such alliances through collaborative development projects. Inflammatory &
Infectious disease segment high on agenda: In the Indian context these are the two of the strongest
disease segments with a huge domestic market. Early stage deals are more common compared to the
middle and late stage deals: Indian companies with limited financial resources can optimize business
models by partnering with larger companies for product development and licensing at an early stage.

How pharmaceutical companies make money?

1. Research And Development

Research and development factors plays a vital role in pharmaceutical industry, as major part of
revenue is dependent on research and development. Company spends its major revenue in R&D
spending as once research of a new formulation is done profit can be booked for future.
Pharmaceutical markets, however, are extremely complex in many respects. Large public-sector
investments in basic biomedical R&D influence private companies’ choices about what to work on and
how intensively to invest in research and development. The returns on private-sector R&D are
attractive, on average, but they vary considerably from one drug to the next. Consumer demand for
prescription drugs is often indirect, mediated by doctors and health insurers. New drugs must
undergo costly and time-consuming testing before they can be sold. Moreover, it may cost hundreds
of millions of dollars to develop an innovative new drug that then will cost only a few cents per dose
to manufacture—and the price of the drug will have no obvious connection to either cost. Research
and development costs vary widely from one new drug to the next. Those costs depend on the type of
drug being developed, the likelihood of failure, and whether the drug is based on a molecule not used
before in any pharmaceutical product (a new molecular entity, or NME) or instead is an incremental
modification of an existing drug. Research and development spending per NME has grown
significantly in recent years, for various reasons.

 First, failure rates in clinical trials have increased, possibly because of greater research challenges
or a willingness to test riskier drugs in such trials.
 Second, larger drug firms are said to have shifted the focus of their development efforts away
from drugs for acute illnesses and toward drugs for chronic illnesses. Drugs that treat chronic
illnesses can be more expensive to develop because they often require larger and longer clinical
trials.
 Third, greater technological complexity in drug development and greater specificity in disease
targets have helped to raise average R&D costs, as firms now identify drugs with particular
molecular characteristics rather than using trial-and-error methods to find compounds that work in
some desired way.
The research and development process of a drug is as follows:

2. Marketing

Marketing always starts with the customer and ends with the customer as they are the valuable assets
for the country. Marketing is a business activity by which it means the flow of goods and products
from the manufacturer to the customer (End user). Pharmaceutical marketing is a well organized
information system. It helps the physicians to update about accessibility safety, effectiveness and
techniques of consuming the medicine. The Indian pharmaceutical industry has been gaining
momentum in the recent years and is expected to move towards an upward trend. Pharmaceutical
marketing costs are phenomenal. The end users must have awareness about these high technology
industries. Complex information must be communicated to customers properly.

What are the needs for Pharmaceutical Marketing?

India is emerging as the global hub for contract research and manufacturing services due to its low
cost advantage and world class quality standards. The introduction of product patent in India has
brought some fundamental changes in strategies of Indian pharmaceutical companies, with focus
shifting more towards Research and Development. The major revenue to the Indian pharmaceutical
industry has been gained through exports. India pharmaceutical products are exporting to more than
200 countries around the world. Therefore Pharmaceutical marketing helps:

 To have a healthy competition

 To increase the customer knowledge
 To have a better customer relationship
 To reduce the initial development costs.
3. Distribution

Drug distribution in India has witnessed a paradigm shift. Before 1990, pharmaceutical companies
established their own depots and warehouses. Now they have been replaced by clearing and
forwarding agents (CFAs). Recording of what has been consumed at various supply chain nodes and
replenishing it at the front end by the previous supply chain node. It is an end-to-end solution
involving the front end distribution system, operations and procurement as well. It enables the
company to be more agile in meeting market demands and helps to meet the two major
challenges: Excess Inventory & Shortages in system. In pharmaceutical industry selling and
distribution plays key role. If the product manufactured in the unit doesn’t reaches to its end customer
on time it becomes use less and companies start losing there brand name.

In pharma industry selling and distribution channels flow in the below manner.

The distribution of medicines in most markets is carried out by importers and wholesalers, which act
as a link between manufacturers and retailers to ensure the continuous supply of medicine, regardless
of the geographical location and portfolio of medicine required. For those medicines which are
imported, there is often an additional step from the importer who organises the logistics of bringing
the medicine into the country which are then transferred to the wholesaler for domestic distribution.
In some cases the two entities are vertically integrated, decreasing the number of steps in the
distribution stage of the value chain. Pharmaceutical distribution needs to meet the logistical
challenge of serving a large number of pharmacies with products sourced from many manufacturers
and often in a short period of time.

4. Dispensing
This step includes the transportation and handling of the medicine from the manufacturer to the end
user, whether this is a retail pharmacy (retailer), hospital or dispensing doctor. The complexity of this
journey will differ depending on manufacturer location, the need for importation of the medicine, the
nature of special handling requirements, and the geographic location of the end user which will vary
between large urban centres and remote rural villages. Providing the correct medicine dosage and
form, to the right patient, in a convenient and timely manner is the final step in the value chain. This
step can also involve a number of additional activities, including checking for potential interactions,
providing advice, and processing reimbursement claims, each of which is intended to ensure the
patient receives the full benefit and value from the medicines they receive. In some markets, retailers
make a loss from selling prescription medicine, profit is instead generated from additional over-the-
counter and health and beauty sales. An alternative business model finds other retailers which are very
much focused on prescription drug dispensing to drive their business profitability.

At the time of dispensing There are various types of products produced in pharmaceutical industry, such
as:

1) Prescription drugs are the main pharmaceutical industry products. These products are generating
high revenue amounts but there are also other types of products that make up the whole
pharmaceutical industry.

2) Biologics are composed of a variety of products that include vaccines, antibodies, blood, blood
components, therapeutic proteins, tissues, allergenics and somatic cells. They are used for variety of
medicinal, pharmaceutical and other important purposes.

3) Generic drugs are used interchangeably with branded drugs in the market. Basically, a generic
drug is quickly approved in the market. Regulators of drugs would not necessarily require detailed
testing and clinical trials for generic drugs. What the manufacturer of generic drugs needs to do is
show evidence of the generic drugs’ equivalence to the original and branded version.

4) OTC or Over-the-counter drugs are those medicines that one can buy from pharmacies and drug
stores even without prescriptions from physicians or doctors. There are many types of over the
counter drugs in the market. There are those which relieve pains, itches and aches. Others may also be
used in curing ailments and diseases like athlete’s foot and tooth decay. Migraines and other recurring
problems may also be treated using OTC drugs.

After various types of products that are dispensed in the market there company start building its
brand and after company becomes the famous brand in all the markets globally that’s the time when
revenue flow becomes easy.

5.Making A Brand

Pharma Companies define a Mega Brand as a drug with the annual sale of more than $ 1billion. Many
a times to make a brand pharma companies indulge themselves to partnership with foreign players.
When any company wants to make itself a global brand at that time company goes for Merger &
Acquisitions(M&A) with foreign reputed player which gives them a good edge in market and helps
them to become a big brand. Pharma companies have mastered various product launch strategies to
build the next billion dollar brand.

Some of these strategies include:

1) Involving key opinion leaders in the clinical trials.

2) Designing the trials based on payers needs.

3) Educating providers on new disease and usage under the garb of continuing medical education.

4) Working with the healthcare organisations to create disease protocols.

5) Providing grants to healthcare advocacy groups.

6) Educating the general population on why they should get themselves treated for the advertised
disease.

6. Government Tarrifs, Taxes And Charges

Taxes have been shown to be one of the larger components contributing to the price build-up of
medicines. To take careful steps which are in favour of customers as well as the manufacturer ,
Government is of the opinion that to streamline and simplify the procedure and to bring about a
greater degree of transparency as well as objectivity, an expert body should be constituted with the
powers, interalia, to fix prices and notify the changes therein, if any, of bulk drugs and formulations,
from time to time, under the Drugs (Prices Control) Order. Government have now decided to establish
an independent body of experts to be called as the National Pharmaceutical Pricing Authority. The
National Pharmaceutical Pricing Authority shall be empowered to take final decisions, which shall be
subject to review by the Central Government as and when considered necessary. The Authority shall
also monitor the prices of decontrolled drugs and formulations and oversee the implementation of
the provisions of the Drugs (Prices Control) Order. There are various orders that have been passed by
(N.P.P.A) such orders are as follows: To implement and enforce the provisions of the Drugs (Prices
Control) Order in accordance with the powers delegated to it. To deal with all legal matters arising out
of the decisions of the Authority. To monitor the availability of drugs, identify shortages, if any, and to
take remedial steps. To collect/maintain data on production, exports and imports, market share of
individual companies, profitability of companies etc. for bulk drugs and formulations. To undertake
and/or sponsor relevant studies in respect of pricing of drugs/pharmaceuticals. To recruit/appoint the
officers and other staff members of the Authority, as per rules and procedures laid down by the
Government. To render advice to the Central Government on changes/revisions in the drug policy. To
render assistance to the Central Government in the parliamentary matters relating to the drug pricing.
(link: http://nppaindia.nic.in/index1.html) The most prominent of these in certain markets is the import
tariff, which is a customs duty imposed by importing countries on the value of goods brought in from
other countries. Import duties are used to raise government revenues and help domestic producers by
providing a price advantage versus international competitors. It is expected that GST would have a
constructive effect on the Healthcare Industry particularly the Pharma sector. It would help the
industries by streamlining the taxation structure since 8 different types of taxes are imposed on the
Pharmaceutical Industry today. An amalgamation of all the taxes into one uniform tax will ease the
way of doing business in the country, as well as minimizing the cascading effects of manifold taxes
that is applied to one product. Moreover, GST would also improve the operational efficiency by
rationalizing the supply chain that could alone add 2 percent to the country’s Pharmaceutical industry.
GST would help the Pharmaceutical companies in rationalizing their supply chain the companies
would need to review their strategy and distribution networks. Furthermore, GST implementation
would also enable a flow of seamless tax credit, improvement the overall compliance create an equal
level playing field for the Pharmaceutical companies in the country. The biggest advantage for the
companies would be the reduction in the overall transaction costs with the withdrawal of CST (Central
Sales Tax). GST is also expected to lower the manufacturing cost.

7. Margins
 In India, under the Drugs Price Control Order 2013, both the wholesaler and retailer margins are
differentially regulated based on essential drug classification, with maximum margin for
distributors at 8% for scheduled drugs and 10% for non-scheduled drugs. Retailer remuneration is
determined by two key factors.
 Firstly the level of discounts negotiated from the wholesaler, which determines the acquisition cost
of the medicine. Secondly, the margin made on the acquisition cost of the medicine paid by the
end user.
 Importer margin : applied by the importer who is tasked with procuring and receiving delivery of
imported goods.
 Distributor margin : applied by wholesalers and sub-wholesalers to perform the logistical role of
storing and subsequently transporting medicine to point of sale.
 Retailer margin : applied by retailers in the final step of the distribution chain, the point at which
medicines are dispensed to patients.

Key Performance Indicators Pharmaceutical Sector

Sales & Marketing

Marketing always starts with the customer and ends with the customer as they are the valuable assets
for the country. Marketing is a business activity by which it means that the flow of goods and products
will flow from the manufacturer to the customer (End user). Pharmaceutical marketing is a well
organized information system. It helps the physicians to update about accessibility safety,
effectiveness and techniques of consuming the medicine. The Indian pharmaceutical industry has
been gaining momentum in the recent years and is expected to move towards an upward trend. The
end users must have awareness about these high technology industries. Complex information must be
communicated properly. Proper use of medicines will enable the companies to cut down their costs
which in turn help to increase their profits. This post gives an insight about the evolution of Indian
pharmaceutical markets, its need and characteristics. It also highlights the present scenario, future
prospects, challenges and the strategies to be adopted by the Indian pharmaceutical companies.

Current Scenario Of Indian Pharmaceutical Market

The Indian Pharmaceutical industry has been witnessing phenomenal growth in recent years, driven by
rising consumption levels in the country and strong demand from export markets. The Indian
pharmaceutical industry is the most progressive and advanced among all the developed and
developing countries. Today, India is among the top five pharmaceutical emerging markets in the
world. Demand from the exports market has been growing rapidly due to the capability of Indian
players to produce cost-effective drugs with world class manufacturing facilities. Pharmaceutical
Marketing helps to raise awareness about treatments for Chronic Diseases, the leading driver of health
care spending. India is also expected to become a pharmaceutical research and development (R&D)
hub in the next decade with the Department of Pharmaceuticals planning a road map for India to be a
global player in the industry by 2020. A recent survey indicates that the Indian Pharmaceutical sector
has given employment to approximately 2.86 million people, through 20, 053 units. It is estimated that
by the year 2020, India’s potential in Research & Development will reach between US$ 8 billion to US$
10 billion. In order to combat the growth slowdown, Pharmaceutical companies need to join hands
with Governmental agencies and other stakeholders to redness the challenges and grievances.

Research & Development

The pharmaceutical industry is characterized by heavy R&D expenditure. It is only the large
pharmaceutical companies who can allocate significant resources for R&D to introduce new products.
As the products are an outcome of significant R&D expenditures incurred by these companies, they
have their products patented. The patent allows the companies concerned to wield immense pricing
power for their new products. The pharmaceutical industry is one of the most research intensive
industries. Pharmaceutical firms invest as much as five times more in research and development,
relative to their sales, than the average manufacturing firm. Because increases in spending on drug
R&D have been nearly matched by increases in revenue from drug sales, the industry’s R&D intensity,
the ratio of research and development spending to total sales revenue, has not risen to the extent that
R&D expenditures have. Over the past 25 years, R&D intensity has grown by about 50 percent. Most
of that growth occurred in the 1980s; since then, the industry’s R&D intensity has hovered around 19
percent. A relatively close relationship exists between drug firms’ current R&D spending and current
sales revenue for two reasons. First, successful new drugs generate large cash flows that can be
invested in R&D (their manufacturing costs are usually very low relative to their price). Second,
alternative sources of investment capital from the bond and stock markets are not perfect substitutes
for cash flow financing. Those alternative sources of capital are more expensive because lenders and
prospective new shareholders require compensation (in the form of higher returns) for the additional
risk they bear compared with the firm, which has more information about the drug under
development, its current status, and its ultimate chance of success. The relative stability of the
relationship between pharmaceutical R&D and sales revenue suggests that firms find it most
profitable to invest any additional dollar of sales revenue in their own drug research. However,
changes in real drug prices can affect companies’ R&D intensity or their propensity to invest in R&D
from their revenue.

ANDA Filings

A generic company is rewarded for a Para IV filing. The first applicant to submit a substantially
completed ANDA (Abbreviated New Drug Application) is given marketing exclusivity for 180 days.
Exclusivity means that no company is allowed to launch its product during this period. As a result,
there isn’t any competition. As the first mover, this helps the manufacturer have an advantage. It can
give a boost to market share. This is a valuable opportunity to maximize profit margins without any
competition. A branded company can file a case of violation against a generic manufacturer within 45
days of receiving notification from the generic manufacturer. If a case is filed on time, then the stay
order for 30 months is given to a brand company. Also, the FDA suspends the approval of the ANDA
for the next 30 months. If the court finds that the patent isn’t valid or wouldn’t be trespassed, then the
FDA can approve the ANDA. Otherwise, it won’t be approved.

Operating Segment

It is to be seen that the company basically operates in which segment for e.g : acute or chronic.
Reason behind this is that due to present conditions it is observed that people are more reliable on
medications. Changes in lifestyle and food habits, aided by higher disposable income, have caused an
unprecedented rise in chronic diseases such as cardiovascular (CVS), diabetes, oncology and central
nervous system (CNS), according to experts. The middle class has been growing in both the emerging
and developed markets. People in these markets have more disposable income and expect better
healthcare solutions. Chronic disease cases have risen in number. This has made people become more
dependent on medications and health supplements. chronic segments, are increasing rapidly due to
the many changes that the country has witnessed over the past few years. These changes could be
classified as lifestyle changes, driven by rapid urbanisation, rising incomes of households,
westernisation of dietary habits, lack of physical efforts due to improved transportation facilities.

Product Pipeline
A drug pipeline is the set of drug candidates that a pharmaceutical company has under discovery or
development at any given point in time. This involves various phases that can broadly be grouped in 4
stages: discovery, pre-clinical, clinical trials and marketing. A Pipeline product is a series of products,
either in a state of development, preparation, or production, developed and sold by a company, and
ideally in different stages of their life cycle. A product pipeline is an assortment of products and
services at various stages of development. At any given time, a company typically has many items in
the pipeline. Some of them will make it all the way to production and begin to generate income for
the company. One end of the product pipeline is the finished result. At the other end is the
brainstorming that leads to a new product. Sometimes company personnel may meet to discuss a new
invention, while in other cases, they may engage in discovery activity with the goal of finding
potentially new compounds, as seen in the chemical and pharmaceutical industries.

Patent Filing

Patents are a vital aspect of the global pharma industry. Patent protection is essential to spur basic
R&D and make it commercially viable. Patents protect drugs from copycat versions for 20 years after
the drug is invented. This is a bitter pill for pharmaceutical companies because it can take eight years
or more after invention to accumulate enough data to get a drug pass the U.S. Food and Drug
Administration. Since initial investment in pharmaceutical R&D is costly, strong patent protection is an
important step to provide the opportunity to recoup investments in new products. Patents are the
legal protection for inventions, including new medicines discovered by research-based pharmaceutical
companies. This protection allows a company time to recoup their significant investment in research
and development. For a patent to have any commercial value there must be a market for the invention
embodied in the patent, which will support the cost of development of the invention and return a
profit. In return for such protection, a patent-holder discloses to the world patented research and
science underlying the invention. Thus, important scientific information behind a new cancer drug
becomes available immediately to researchers worldwide. The market exclusivity and higher prices are
made possible by the patent rights function as a reward for the risk undertaken by those who financed
the research and development leading to the new technologies.

Prescription Market

The prescription drug market is divided into two categories:

1. Branded, or patented
2. Generics, or off-patented

 Branded drugs are patented drugs. When a pharmaceutical company discovers a new drug, it files
for a patent. Then, the company is awarded a license for 20 years to exclusively sell the drug.
Exclusivity is provided to recoup research and development expenses incurred during the
development of a drug.
 Generics are off-patented drugs. They’re bioequivalent—in terms of dosage, form, strength,
quality, effect, intended use, side effects, and route of administration—to the branded drugs. A
route of administration is a way the medication is introduced to a site in a patient. This could be
oral, intravenous, intramuscular, nebulizer, and topical. A few of the leading generic drugs are:
Acetaminophen, or Paracetamol, Alprazolam, Amoxicillin, Asprin, or Acetylsalicylic Acid,
Azithromycin, Diclofenac
 A Drug Generally Has Two Names
 Generic name – a molecular formula
 Brand name – the company’s proprietary trademark used for marketing
 Patented drugs are patented by an innovator company.
 Generics are off-patented drugs with a generic name.
 Branded drugs are either patented or generics marketed under a company’s specific name.
Patented and branded drugs are used interchangeably across the industry.

Key Financial Metrics Used In Pharmaceutical Industry

To understand the pharma business the most important trackable financial metrics are as follow:

Research And Development Expense As A Percent Of Revenue

Analysing expenses as a percent of revenue is also useful when evaluating pharma companies. Most
pharma companies have very high research and development (R&D) budgets because they can only
survive and grow by discovering and developing new drugs. Knowing the R&D budget as a percent of
revenue helps understand if the company is creating a strong pipeline of future drugs to come on the
market. Compare the percent of R&D to revenues to industry standards and also to the company’s
own spending in past years. Declining R&D ratios can be an indication of a declining pipeline for a
company which is a negative signal. R&D as a of revenue in an increasing trend portrays that company
has a strong pipeline of drugs which is going to be launched in future and will lead to increase in
revenue.

Profit Margin

Profit margin is another vital metric. Operating profit margin lets the investor understand the impact
from R&D to see if the program is bringing successful candidates to the market, whether the
marketing and selling costs are having a positive impact on revenues (market share gains), and
whether external factors are negatively impacting the company. It is not uncommon for new, novel
drugs to have high profit margins, while the overall company margins are much lower.

Selling Cost As A Percentage Of Revenue

Selling cost as a percentage of revenue in an decreasing trend portrays that company is able to sell its
product in the market without expensing much on advertisement as well as on selling and distribution
cost and that clearly states that demand for that product is prevailing in the market.

Employee cost as percentage of revenue

Employee cost as percentage of revenue says that company is spending more and more revenue on
employee expenditure which can be concluded as company is employing more no. of people to meet
the future demand and there fore it can be said that company is able to see a good future for the
company in coming few years.

Dividend to earnings

Dividend to earnings in a pharma company is an important ratio because as major pharma companies
are cash rich companies , investors expects these company to redeploy capital back to shareholders in
form of dividends or any other capital structure programme.

Porter’s Five Force Analysis

One model for examining an industry and a company’s strategic position within its industry is Porter’s
Five Forces analysis.

1) Barriers To Entry

The big payoffs available in the pharmaceutical industry lead to a steady flow of new companies being
created. A team of researchers with an innovative idea or newly granted patents can find venture
capital funds eager to provide millions of dollars in startup funding. These smaller companies pose no
serious threat to big pharma. In fact, one of a startup investor’s main exit strategies is to sell out to a
big pharma firm when new products are through the initial development phase.

2) Supplier Power

Suppliers have very little power in the pharmaceutical industry. The raw materials for manufacturing
drugs are commodity products in the chemical industry, which are available from numerous sources.
Most of the equipment used in manufacturing and research is available from multiple manufacturers.
Suppliers usually offer multiple products to the manufacturer, which moderates pricing on rarer
materials and unique equipment.

3) Buyer Power

Pharma is unique among industries because the medical patient has an absolute lack of power
regarding pricing. The prescriber of the drugs, the physician, ethically is not allowed to profit from the
sale of drugs. The entity that pays for the drugs, the insurance company, only has a say in how much it
will pay to the distributor of the drugs, meaning it has little power with the drug manufacturers. The
insurer can refuse to pay for treatments it believes are overpriced. The only entities with any
negotiating power are the pharmacies and medical institutions that fulfill the medical patients’
prescriptions. Even these entities have little power over newer drugs under patent or drugs with only
one manufacturer. Pharmacies focus on their profit margins and have little incentive to provide
patients with the lowest possible pricing.

4) Threat Of Substitute And Compliments

The effect of substitutes is dependent on the individual drug. A new FDA-approved blockbuster drug
that has patent protection, treats a major health condition and is first to market in its category has a
license to print billions of dollars. The development of a new drug that cures a major disease could be
worth tens of billions of dollars per year. Once a drug loses its patents, generic drug manufacturers
start selling copycat versions at substantially lower prices. A drug that netted $100 million a year in
profit could become one that earns only $1 million a year in profit overnight. Additionally, there is a
major international problem with counterfeit drugs. The best of these counterfeits duplicates a real
drug’s formula and sells it at a lower price, which hurts corporate profits. The worst counterfeits are
made with low-grade materials and can destroy the reputations of the legitimate products.

5) Competition

With more than $1 trillion in global sales, pharmaceutical business can be cutthroat. The huge
importance of intellectual property results in strong competition for high-level workers and leading
researchers. Even strong non-disclosure and non-compete clauses cannot prevent the leaking of
competitive information. Any potential new drug has its public information analysed for the possibility
of creating a similar drug to market as a substitute. The industry exhibits a pattern of firms merging
and larger firms buying smaller firms that have promising research or new drugs.
Indian Banking Sector
(Shuchi Nahar and Keval Shah)
Understanding The Indian Banking Sector – Part
One : Basic Terminologies
Posted on August 5, 2018 Author Shuchi Nahar

Key Terminologies To Understand The Banking Sector

Indian banking sector, dodged the global financial meltdown in 2008. But they promptly embarked on
a frenzy of lending to big companies, sowing the seeds of a home-made crisis. The PSBs
gleefully funded infrastructure projects that never got the required permits, mines with an output
made much less valuable by slumping commodity prices, PSBs have tried to gloss over the problem for
years, but the RBI is now forcing them to admit the true extent of the damage.

We will be publishing 3 articles on the Indian Banking sector, starting with the first article we will cover
banking related terms and definitions like what are the different types of banks, Basel accords,
performance related metrics (CASA ratio, ROA & ROE of banks) and various solvency (capital
adequacy), and liquidity ratios.

Commercial Banks – Commercial Banks are profit making financial institutions that accept deposits,
make loans, and offer funds transfer (including transaction banking) services. Commercial banks usually
provide short-to-medium term credit as they gather funds from general public that could be withdrawn
at a short notice.

Public Sector Commercial Banks – Public sector banks constitute the majority of commercial banking
space in India both in terms of credit outreach and asset size. These are the banks in which government
is a majority shareholder. These banks comprise the 19 nationalized banks plus the State Bank of India
Group.

Private Sector Commercial Banks – India started giving licenses to private sector banks in 1990s. A
bank having its majority shareholding in private hands is called a private bank. These banks are
companies registered with limited liability and regulated by the RBI. Private Banks that have operating
even before the liberalization started are known as Old private banks whereas those which came into
existence are termed as New private banks.

Regional Rural Banks (RRBs) – RRBs were established in 1975 in India as local level banks. These are
structured as commercial banks and have the primary objective of providing credit and promoting
growth in rural economy. However they accumulated huge amount of non-performing assets (NPAs)
and due to their high cost of operation many were shut down.

Foreign Banks- By the end 2015, 46 foreign banks had branch office presence whereas 39 had
representative office presence in India. Standard Chartered Bank (SCB) had the highest 102 branches in
the country whereas HSBC and Citi had 50 and 45 branches, respectively. Foreign banks are present in
India since eighteenth century with HSBC and earlier versions of BNP Paribas, and Standard Chartered
banks having their offices in Kolkata. These banks provide Indian corporations the access to global stock
and bond markets. On the other hand, these banks bring global practices and technology to Indian
banking sector.

Foreign banks in India operate as either as Wholly Owned Subsidiary (WOS) or in branch mode.
Payments Banks – In 2014-15 RBI decided to give licenses to specialized banks known as payment
banks. These banks can take small deposits (up to 1Lakh currently). However, these banks can’t issue
credit cards or make loans.

Small Finance Banks – Along with payments banks a new type of banks Small Finance Banks were also
issued licenses recently. Their objective is to promote financial inclusion in the society.

Post-Office Savings Banks (POSB) – Post offices have widespread presence in India. They complement
rural banks in terms of providing deposit taking and money transfer facilities. However, they do not
make loans or provide credit. Recently these banks were also granted payments bank’s licenses.

Wholesale and Long-Term Finance Banks (WLTFB) – RBI has recently finalized guide-lines to issue
licenses to another type of new banks to known as Wholesale and Long-term Finance Banks. These
banks are being set-up to provide long-term funding to infrastructure projects.

Non-banking Financial Companies (NBFCs) – NBFCs are companies registered under the Companies
Act of 1956 or 2013, that carry out the businesses of loans and advances, advances, acquisition of shares,
stock-bonds hire-purchase, insurance business or chit business. They are regulated by RBI.

– NBFCs cannot accept demand deposits

– NBFCs do not form the part of the payment and settlement system and cannot issue cheques drawn
on themselves

– The Deposit Insurance and Credit Guarantee Corporation (DICGC) insurance is not available to them.

Basel 1 – The first set of Basel Accords, known as Basel I, was issued in 1988 with the primary focus on
credit risk. It proposed creation of a banking asset classification system on the basis of the inherent risk
of the asset.

Features Of Basel 1 – The Basel I Accord attempted to create a cushion against credit risk. The norm
comprised of four pillars, namely Constituents of Capital, Risk Weighting, Target Standard Ratio, and
Transitional and implementing arrangements.

Tier 1 – Tier I capital or Core Capital consists of elements that are more permanent in nature and as a
result, have high capacity to absorb losses. This comprises of equity capital and disclosed reserves.
Equity Capital includes fully paid ordinary equity/common shares and non-cumulative perpetual
preference capital, while disclosed/published reserves include post-tax retained earnings. However,
given the quality and permanent nature of Tier I capital, the accord requires Tier I capital to constitute
at least 50 percent of the total capital base of the banking institution.

Tier 2 – Tier II capital is more ambiguously defined, as it may also arise from difference in accounting
treatment in different countries. In principal, it includes, revaluation reserves, general provisions and
provisions against non-performing assets, hybrid debt capital instruments, and subordinated term debt

Basel 2 – Basel II, the second set of Basel Accords, was published in June 2004 – in order to control
misuse of the Basel I norms, most notably through regulatory arbitrage. The Basel II norms were
intended to create a uniform international standard on the amount of capital that banks need to guard
themselves against financial and operational risks. This again would be achieved through maintaining
adequate capital proportional to the risk the bank exposes itself to (through its lending and investment
practices). It also laid increased focus on disclosure requirements.

Limitations of Basel 2

The financial crisis of 2007 and 2008 exposed the limitations of Basel II, wherein certain risks were not
under the purview of this regulation. Amendments were made to the Basel II in 2009 to make it more
robust.

The revisions were as under:

Augmenting the value-at-risk based trading book framework with an additional charge for risk capital,
including mitigation risk and default risk.

Addition of stressed value-at-risk condition. This condition takes into account probability of significant
losses over a period of one year.

Basel 3 – The issues surrounding Basel II together contributed to the emergence of the Basel III accord.
The essence of Basel III revolves around two sets of compliance: i. Capital ii. Liquidity

While good quality of capital will ensure stable long term sustenance, compliance with liquidity covers
will increase ability to withstand short term economic and financial stress.

Liquidity Rules : One of the objectives of Basel III accord is to strengthen the liquidity profile of the
banking industry. This is because despite having adequate capital levels, banks still experienced
difficulties in the recent financial crisis. Hence, two standards of liquidity were introduced.

Liquidity Coverage Ratio (LCR) – LCR was introduced with the objective of promoting efficacy of short
term liquidity risk profile of the banks. This is ensured by making sufficient investment in short term
unencumbered high quality liquid assets, which can be quickly and easily converted into cash, such that
it enables the financial institution to withstand sustained financial stress for 30 days period. It is assumed,
within 30 days, the management of the bank shall take corrective actions to deal with the adverse
situation.

Net Stable Funding Ratio (NSFR) – Long term stability of financial liquidity risk profile is an important
objective to be achieved. The Net Stable Funding Ratio incentivizes banks to obtain financing through
stable sources on an ongoing basis. More specifically, the standard requires that a minimum quantum
of stable and risk less liabilities are utilized to acquire long term assets. The objective is to determine
reliance on short term means of finance, especially during favourable market periods.

Capital Adequacy Ratio (CAR) – The Capital Adequacy Ratio (CAR) is a measure of a bank’s available
capital expressed as a percentage of a bank’s risk-weighted credit exposures. The Capital Adequacy
Ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and
promote the stability and efficiency of financial systems around the world.

Two Types Of Capital Are Measured: tier one capital, which can absorb losses without a bank being
required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up
and so provides a lesser degree of protection to depositors.

Once the asset base is adjusted based on credit risk, and reserves in respect of operational risk and
market risk are computed, a bank can readily calculate its reserve requirements to meet the capital
adequacy norms of Basel II. As in the case of Basel I, a bank must maintain equal amounts of Tier 1 and
Tier 2 capital reserves. Further, the reserve requirement continued at 8 percent.

SLR – SLR stands for Statutory Liquidity Ratio. This term is used by bankers and indicates the minimum
percentage of deposits that the bank has to maintain in form of gold, cash or other approved securities.
Thus, we can say that it is ratio of cash and some other approved securities to liabilities (deposits) It
regulates the credit growth in India.

CRR – CRR means Cash Reserve Ratio. Banks in India are required to hold a certain proportion of their
deposits in the form of cash. However, actually Banks don’t hold these as cash with themselves, but
deposit such case with Reserve Bank of India (RBI) / currency chests, which is considered as equivalent
to holding cash with RBI. This minimum ratio (that is the part of the total deposits to be held as cash) is
stipulated by the RBI and is known as the CRR or Cash Reserve Ratio.

Repo Rate – Repo (Repurchase) rate is the rate at which the RBI lends short-term money to the banks
against securities. When the repo rate increases borrowing from RBI becomes more expensive.
Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money,
it increases the repo rate similarly, if it wants to make it cheaper for banks to borrow money, it reduces
the repo rate.

Reverse Repo Rate – Reverse Repo rate is the rate at which banks park their short-term excess liquidity
with the RBI. The banks use this tool when they feel that they are stuck with excess funds and are not
able to invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI
is ready to borrow money from the banks at a higher rate of interest. As a result, banks would prefer to
keep more and more surplus funds with RBI.

N.P.A – Non Performing Asset – A non-performing asset (NPA) refers to a classification for loans or
advances that are in default or are in arrears on scheduled payments of principal or interest. In most
cases, debt is classified as nonperforming when loan payments have not been made for a period of 90
days. While 90 days of non -payment is the standard, the amount of elapsed time may be shorter or
longer depending on the terms and conditions of each loan.
Where The NPA Is Coming From?

CASA – Current Account And Savings Account – CASA is a commonly used parameter that is used to
understand the amount of liabilities that the bank pays relatively less interest on. The higher the amount
of CASA as a percentage of total liabilities, the lesser will be the interest paid by the bank. Investors
should look at the CASA numbers carefully, as CASA is a source of strength for the bank. For example,
ICICI Bank is considered to have a comparatively healthy CASA percentage.

‘Out of Order’ status – An account should be treated as ‘out of order’ if the outstanding balance
remains continuously in excess of the sanctioned limit/drawing power. In cases where the outstanding
balance in the principal operating account is less than the sanctioned limit/drawing power, but there
are no credits continuously for 90 days as on the date of Balance Sheet or credits are not enough to
cover the interest debited during the same period, these accounts should be treated as ‘out of order’.

POS Machine- Point of sale – A POS, or Point of Sale System, machine is simply a way for business
owners to conduct financial transactions. Sometimes a POS machine is an interactive device that allows
consumers to make financial transactions themselves.
CDM – Cash Deposit Machine – Cash Deposit Machine (CDM) is self-service machine terminal that
enables you to deposit cash without any manual intervention of a bank officer. In a cash deposit
machine, you can deposit cash with or without using the ATM cum debit card. CDM has inbuilt
intelligence to identify fake notes and to sort cash deposited by customers into different denominations.

MCLR- Marginal Cost Of Funds – Marginal Cost of fund-based Lending Rate (MCLR) is a methodology
by the Reserve Bank of India (RBI) for setting lending rate on loans by commercial banks. (MCLR) refers
to the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the
RBI. It is an internal benchmark or reference rate for the bank. MCLR actually describes the method by
which the minimum interest rate for loans is determined by a bank – on the basis of marginal cost or
the additional or incremental cost of arranging one more rupee to the prospective borrower.

LIBOR- London Inter Bank Offered Rate – The London Inter-bank Offered Rate is the average of
interest rates estimated by each of the leading banks in London that it would be charged were it to
borrow from other banks. It is usually abbreviated to Libor or LIBOR

MIBOR – Mumbai Inter Bank Offer Rate – The Mumbai Inter-Bank Offer Rate (MIBOR) is one iteration
of an interbank rate, which is the rate of interest charged by a bank on a short-term loan to another
bank. Banks borrow and lend money to one another on the interbank market in order to maintain
appropriate, legal liquidity levels, and meet reserve requirements placed on them by regulators.
Interbank rates are made available only to the largest and most creditworthy financial institutions.

Interbank Rate – The interbank rate is the rate of interest charged on short-term loans made between
banks. Banks borrow and lend money between each other in the interbank market in order to manage
liquidity and meet the reserve requirements placed on them by regulators, the rate depends on maturity,
market conditions and credit ratings. The interbank rate can also refer to the price at which banks
conduct wholesale foreign exchange transactions in both the spot and forward market; spreads are
tighter than for smaller retail transactions.

Mumbai Interbank Bid Rate – The Mumbai Interbank Bid Rate (MIBID) is the interest rate that a bank
participating in the Indian interbank market would be willing to pay to attract a deposit from another
participant bank. The MIBID used to be calculated every day by the National Stock Exchange of India
(NSEIL) as a weighted average of interest rates of a group of banks, on funds deposited by first-class
depositors.

Prime Lending Rate (PLR) – The interest rate charged by banks to their largest, most secure, and most
creditworthy customers on short-term loans. This rate is used as a guide for computing interest rates
for other borrowers.

RWA- Risk Weighted Asset – Risk-weighted asset (also referred to as RWA) is a bank’s assets or off-
balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining
the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution.

CRWA – Credit Risk Weighted Asset – A bank’s assets weighted according to credit risk. Some assets,
such as debentures, are assigned a higher risk than others, such as cash. This sort of asset calculation is
used in determining the capital requirement for a financial institution and is regulated by the Federal
Reserve Board.

CRAR (Capital to Risk Weighted Assets Ratio) – Capital to risk weighted assets ratio is arrived at by
dividing the capital of the bank with aggregated risk weighted assets for credit risk, market risk and
operational risk. The higher the CRAR of a bank the better capitalized it is.
Leverage Ratio

The Tier 1 leverage ratio is the relationship between a banking organization’s core capital and its total
assets. The Tier 1 leverage ratio is calculated by dividing Tier 1 capital by a bank’s average total
consolidated assets and certain off-balance sheet exposures. RBI also calculates Coverage Ratio =
(Equity-Net NPA)/(Total Assets – Intangible Assets). This is almost like leverage ratio above and tells
about the amount of common equity available to support Net Assets.

CET1 Ratio (Core equity tier 1)- It is a capital measure that was introduced in 2014 as a precautionary
measure to protect the economy from a financial crisis. It is expected that all banks should meet the
minimum required CET1 ratio of 4.50% by 2019. A bank’s capital structure consists of Lower Tier 2,
Upper Tier 1, AT1, and CET1. CET1 is at the bottom of the capital structure, which means that in the event
of a crisis, any losses incurred are first deducted from this tier. CET1 is a measure of bank solvency that
gauges a bank’s capital strength. This measure is better captured by the CET1 ratio which measures a
bank’s capital against its assets. Since not all assets have the same risk, the assets acquired by a bank
are weighted based on the credit risk and market risk that each asset presents.

Additional Tier 1 – AT1 consists of capital instruments that are continuous, in that there is no fixed
maturity including: Preferred shares, High contingent convertible securities. Contingent convertible
securities (often referred to as CoCos) are a major component of AT1 and their structure is shaped by
their primary purpose as a readily available source of capital for a firm in times of crisis. CoCos can
absorb losses either by: Converting into common equity; or Suffering a principal write-down.

Hybrid Debt Capital Instruments – In this category, fall a number of capital instruments, which
combine certain characteristics of equity and certain characteristics of debt. Each has a particular feature,
which can be considered to affect its quality as capital. Where these instruments have close similarities
to equity, in particular when they are able to support losses on an ongoing basis without triggering
liquidation, they may be included in Tier II capital.

Hybrid Security – A hybrid security is a single financial security that combines two or more different
financial instruments. Hybrid securities, often referred to as “hybrids,” generally combine both debt and
equity characteristics. The most common type of hybrid security is a convertible bond that has features
of an ordinary bond but is heavily influenced by the price movements of the stock into which it is
convertible.

Held Till Maturity (HTM) – The securities acquired by the banks with the intention to hold them up to
maturity.

Held for Trading (HFT) – Securities where the intention is to trade by taking advantage of short-term
price / interest rate movements.

Available for Sale (AFS) – The securities available for sale are those securities where the intention of
the bank is neither to trade nor to hold till maturity. These securities are valued at the fair value which
is determined by reference to the best available source of current market quotations or other data
relative to current value.

Yield to maturity (YTM) or Yield – The Yield to maturity (YTM) is the yield promised to the bondholder
on the assumption that the bond will be held to maturity and coupon payments will be reinvested at
the YTM. It is a measure of the return of the bond.
Slippage ratio – (Fresh accretion of NPAs during the year/Total standard assets at the beginning of the
year) *100

RAROC (risk-adjusted return on capital) – This is the expected result over economic capital) allows
banks to allocate capital to individual business units according to their individual business risk. As a
performance evaluation tool, it then assigns capital to business units based on their anticipated
economic value added.

The theoretical RAROC can be extracted from the one-factor CAPM as the excess return on the market
per unit of market risk (the market price of risk)

RARoC = Adjusted Income .

Risk Based Capital Requirement

= Adjusted Income

Value at Risk (VaR)

Adjusted Income = [Spread (Direct Income on Loan) + Fees directly attributable to loans – Expected
Loss (P(D)*LGD) – Operating Cost] * (1- Marginal tax rate)

Asset Quality

Sub-standard Assets – a sub-standard asset would be one, which has remained NPA for a period less
than or equal to 12 months. Such an asset will have well defined credit weaknesses that jeopardise the
liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some
loss if deficiencies are not corrected.

Doubtful Assets – an asset would be classified as doubtful if it has remained in the sub-standard
category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in
assets that were classified as sub-standard, with the added characteristic that the weaknesses make
collection or liquidation in full, – on the basis of currently known facts, conditions and values – highly
questionable and improbable.

Loss Assets – A loss asset is one where loss has been identified by the bank or internal or external
auditors or the RBI inspection but the amount has not been written off wholly. In other words, such an
asset is considered uncollectible and of such little value that its continuance as a bankable asset is not
warranted although there may be some salvage or recovery value.

Total Loan and Advances – Loan is the definite money given to the borrower for a specific purpose
and for a specific period of time.

Advance is a credit facility granted by the bank for short-term purpose such as meeting working capital
requirements or short-term trading liabilities. There is a sense of debt in loan, whereas an advance is a
facility being availed of by the borrower. However, like loans, advances are also to be repaid.
Thus a credit facility- repayable in instalments over a period is termed as loan while a credit facility
repayable within one year may be known as advances. However, in our discussion here these two terms
are used interchangeably.

Gross Non-performing Asset (GNPA%) – An asset, including a leased asset, becomes non-performing
when it ceases to generate income for the bank. Any loan or advance on which interest is missed for
more than 90 days in India is classified as non-performing loan.

Gross NPA is defined as “Principal dues of NPAs plus Funded Interest Term Loan (FITL) where the
corresponding contra credit is parked in Sundries Account (Interest Capitalization – Restructured
Accounts), in respect of NPA Accounts.”

Net Non-performing Assets (NNPA%)-

It is calculated as:

Gross NPA – (Balance in Interest Suspense account + DICGC/ECGC claims received and held pending
adjustment + Part payment received and kept in suspense account + Total provisions held).

*Interest Suspense Account holds the interest payments obtained on non-performing assets.

Restructured Asset – A restructured asset is one where the bank, grants to the borrower concessions
that the bank would not otherwise consider. Restructuring would normally involve modification of terms
of the advances/securities, which would generally include, among others, alteration of repayment
period/ repayable amount/ the amount of instalments and rate of interest. It is a mechanism to nurture
an otherwise viable unit, which has been adversely impacted, back to health.

Restructured Loan – Restructured asset or loan are that assets which got an extended repayment
period, reduced interest rate, converting a part of the loan into equity, providing additional financing,
or some combination of these measures. Hence, under restructuring a bad loan is modified as a new
loan. A restructured loan also indicates bad asset quality of banks. This is because a restructured loan
was a past NPA or it has been modified into a new loan. Whether the borrower will repay it in future
remains a risky element. Corporate Debt Restructuring Mechanism (CDM) allows restructuring of loans.

Stressed Advances – Defined as GNPAs plus restructured + standard advances

Maturity Profile of Assets – Banks maintain the maturity profile of their loan assets to match it with
that off the liabilities as a part of asset liability management (ALM) exercise.

Off-balance Sheet Assets – Assets (liabilities) that are not on the balance sheet of the bank but
effectively form the part of its assets (liabilities). Securitised loans and operating leases are such type of
assets.

While analysing the company such assets should be added back to the balance sheet with their risk
characteristics. For example, collateralized debt obligations (CDOs) are off balance sheet liabilities. If
loans that underlie the CDO turn toxic then the CDO liability falls directly on the issuer.
Provisioning Coverage Ratio (PCR) – is essentially the ratio of provisioning to gross non-performing
assets and indicates the extent of funds a bank has kept aside to cover loan losses.

From a macro-prudential perspective, banks should build up provisioning and capital buffers in good
times when the profits are good, which can be used for absorbing losses in a downturn. This will enhance
the soundness of individual banks, as also the stability of the financial sector. It was, therefore, decided
that banks should augment their provisioning cushions consisting of specific provisions against NPAs
as well as floating provisions, and ensure that their total provisioning coverage ratio, including floating
provisions, is not less than 70 per cent.

Majority of the banks had achieved PCR of 70 percent and had represented to RBI whether the
prescribed PCR is required to be maintained on an ongoing basis. The matter was examined and till
such time RBI introduces a more comprehensive methodology of countercyclical provisioning taking
into account the international standards as are being currently developed by Basel Committee on
Banking Supervision (BCBS) and other provisioning norms, banks were advised that:

1) The PCR of 70 percent may be with reference to the gross NPA position in banks as on September
30, 2010;

2) The surplus of the provision under PCR vis-a-vis as required as per prudential norms should be
segregated into an account styled as “countercyclical provisioning buffer”.

3) This buffer will be allowed to be used by banks for making specific provisions for NPAs during periods
of system wide downturn, with the prior approval of RBI.

4) The PCR of the bank should be disclosed in the Notes to Accounts to the Balance Sheet.

TReDS (Trade Receivable Discounting System) – It is an electronic platform that allows auctioning of
trade receivable. The process is also commonly known as ‘bills discounting’, a financier (typically a bank)
buying a bill (trade receivable) from a seller of goods before it’s due or before the buyer credits the
value of the bill. In other words, a seller gets credit against a bill which is due to him at a later date. The
discount is the interest paid to the financier.

AUCA – Advance Under Collection Account (AUCA) is an account to hold the portion of a Non-
Performing Asset (NPA) accounts. AUCA is an NPA reduction strategy that allows the bank to take the
bad debt off their balance sheet but will have the option of recovering the amount from its promoter.
By writing-off bad and doubtful assets, bank can improve its NPA ratio.

Capital Conservation Buffer – The Capital Conservation Buffer is intended to ensure that firms build
up buffers of capital outside any periods of stress and is designed to avoid breaches of minimum capital
requirements. This capital buffer can then be drawn upon in times when losses are incurred. As Per Basel
III requirements, a firm must calculate a capital conservation buffer of CET1 capital equal to 2.5% of its
total risk exposure amount.

Countercyclical Capital Buffer – The Countercyclical Capital Buffer is an amount of capital a firm will
have to set aside in relation to a firm’s exposure in other jurisdictions, the aim of which is to avoid a
breach of minimum capital requirements.

SMA (Special Mention Accounts) – Banks will categorise accounts as SMA when the money remains
outstanding for 30-90 days after due payment date. There will not be any provisioning for SMA category
loans. This is step before account gets classified as NPA.
Cost Of Funds – Cost of funds is the interest rate paid by financial institutions for the funds that they
deploy in their business. The cost of funds is one of the most important input costs for a financial
institution, since a lower cost will generate better returns when the funds are used for short-term and
long-term loans to borrowers.

Capital Asset Pricing Model (CAPM)- A model that attempts to describe the relationship between the
risk and the expected return on an investment that is used to determine an investment’s appropriate
price. The assumption behind the CAPM is that money has two values: a time value and a risk value.
Thus, any risky asset or investment must compensate the investor for both the time his/her money is
tied up in the investment and the investment’s relative riskiness.

Z – Score Analysis – The Z-score is the output of a credit-strength test that gauges a publicly traded
manufacturing company’s likelihood of bankruptcy. The Z-score is based on five financial ratios that can
be calculated by using ratios like profitability, leverage, liquidity, solvency and activity to predict whether
a company has a high degree of probability of being insolvent.

Understanding The Indian Banking Sector – Part

Two : How The Bank Makes Money
Continuing our study on Banks we have come up with part 2 of the series where we will understand
various line items in a banks financial statement. We have defined and discussed definitions like
wholesale deposits, shareholders equity, interchange fee on POS transaction (debit & credit card) etc.
We have also discussed various risks like market risk, interest rate risk, forex risk etc faced by banks.

Depositors & Borrowers

The depositors and borrowers can be segmented into Retail and Corporate customers. Retail customers
are individual consumers, whereas corporate customers can be segmented to small companies, mid-
size enterprises, and large corporate.

Banks offer different value propositions to different customer segments.

To retail customers, banks offer Home loans, Education loans, Auto loans, and Personal loans. And for
Corporate customers in different industries have different loan requirements. For example, Power sector
companies need money to fund power projects. Airline companies need money to purchase airplanes.
Construction companies need money for building projects.

Before offering them money in form of loans, one critical exercise that banks do is the risk assessment.
This is to ensure that they will get back the money, along with the interest, they are lending.

Banks have two key revenue streams. First is the interest income from lenders. Second is the fee that
they charge for different kinds of operations. Banks also make money through Credit cards business.
Channel costs are the key component of the cost structure of a bank. The interest paid by the bank to
the depositors is also one of the important cost structure components.
How Banks Make Money?

Deposit – The largest source by far of funds for banks is deposits money that account holders entrust
to the bank for safekeeping and use in future transactions, as well as modest amounts of interest.
Generally referred to as “core deposits,” these are typically the checking and savings accounts that so
many people currently have. In most cases, these deposits have very short terms.

While people will typically maintain accounts for years at a time with a particular bank, the customer
reserves the right to withdraw the full amount at any time. Customers have the option to withdraw
money upon demand and the balances are fully insured.

Many banks pay no interest at all on checking account balances, or at least pay very little, and pay
minimal interest rates for savings accounts. By lending on high rates to borrower’s banks make money
through deposits. Eg. This graph represents CASA% and cost of deposit % for the year 2018 for all the
banks.
Key Metrics That Can Be Used To Track Banking Companies

Net Interest Margin

We should look for high net interest margin. If not high already, there should be an increasing trend.

Net interest margin is a parameter that is of great interest to a bank stock investor. It is the net interest
income divided by the interest earning assets.

NIM tells you about the profitability of the core lending business of the bank. It is evident that the higher
the proportion of CASA deposits in the total deposits, the lower will be the interest expense. A bank can
choose to lend at attractive rates (lower than competitors) and still maintain a healthy NIM if its interest
expenses paid to depositors are low.

Bank can contain the risk through innovative structuring or by taking adequate security, they can take
this business which others have rejected. They can earn a high interest rate on loans which others are
not in a position to make. This will give them a relatively high NIM even with roughly the same cost of
funding as other banks.

Spread Is A Slightly Different Way To Look At The Interest Numbers.

 Divide interest income by interest earning assets

 Divide interest expense by interest bearing liabilities
 The difference between the two figures is the interest spread.

Increasing Loan Growth

Loan growth means more interest income but might not mean more net interest income. This is because
a bank needs to garner enough deposits at a reasonable cost to back the loan growth. There are some
banks which grow their deposits with wholesale deposits instead of lower cost current account, saving
account deposits (CASA).
Analysts also look at credit to deposit ratios. In a nutshell, credit deposit ratios tell you whether credit /
loan growth is sustainable. For a bank to make incremental loans, it also has to grow deposits.

Decreasing Cost To Income Ratio

As operations become more efficient or loans outstanding per branch increase, operational costs
decrease relative to income. Recall the profit and loss statement of a bank. Operational costs are
deducted from net interest margin plus fee income.

Decreasing Non Performing Assets

We can track non-performing assets on an absolute basis in Rs. cr or in percentage form (NPAs divided
by advances) respectively.

Decreasing NPAs on absolute basis are always good to see. Gross NPAs less provisions give you net
NPAs. It is not a good sign if net NPAs stay relatively static and gross NPAs increase. This implies higher
provisions which reduce profit after tax.

In the short run, one might be misled by NPAs on a percentage basis because NPAs can stay the same
or even grow on an absolute basis while advances may grow relatively more, yielding a lower percentage
NPA number.

Loan To Deposit Ratio

The loan/deposit ratio helps assess a bank’s liquidity, and by extension, the aggressiveness of the bank’s
management. If the loan/deposit ratio is too high, the bank could be vulnerable to any sudden adverse
changes in its deposit base. Conversely, if the loan/deposit ratio is too low, the bank is holding on to
unproductive capital and earning less than it should.

Fee Income To Operating Income

Features like multi-branch banking, internet banking, and credit cards were not as widely used as they
are today. Banks have more interactions with customers across multiple banking product lines and
services that enable them to earn more in the form of fees. This is a parameter that many analysts track
since fee income has been seen to grow at a fast clip in most banks as compared to the “traditional”
net interest income.

Operating Expenses And Cost To Income

The biggest operating expense is usually salaries to employees. Other big expense heads are Rent, taxes
and lighting , repairs etc. The cost to income ratio is the ratio of operating expenses to the net operating
income As an investor, you want the cost to income ratio to be declining over time. This would signal
efficiency in operations. It means that the banks is spending less on operations relatively to do more
business (lending + fee income).

Provisions

Provisions are mandatory as per RBI guidelines. They force the bank to keep aside some of their income
even if all is good (provisions on standard assets). They also force the bank to recognize bad loans and
deduct appropriate amounts when there are signs that loans are going bad or have gone bad
(provisions on substandard assets and NPAs). The better the credit process, the better will be the quality
of the loan book. In bad times, lesser loans will go bad. Correspondingly, lesser provisions will need to
be deducted from income.

Let’s See Where a PSU Bank stands against A Pvt Bank –

Wholesale Deposits – If a bank cannot attract a sufficient level of core deposits, that bank can turn to
wholesale sources of funds. In many respects these wholesale funds are much like interbank CDs. There
is nothing necessarily wrong with wholesale funds, but investors should consider what it says about a
bank when it relies on this funding source.

While some banks de-emphasize the branch-based deposit-gathering model, in favor of wholesale
funding, heavy reliance on this source of capital can be a warning that a bank is not as competitive as
its peers.

Investors should also note that the higher cost of wholesale funding means that a bank either has to
settle for a narrower interest spread, and lower profits, or pursue higher yields from its lending and
investing, which usually means taking on greater risk.

Shareholders Equity – While deposits are the primary source of loanable funds for almost every bank,
shareholder equity is an important part of a bank’s capital. Several important regulatory ratios are based
upon the amount of shareholder capital a bank has and shareholder capital is, in many cases, the only
capital that a bank knows will not disappear.

Common equity is straight forward. This is capital that the bank has raised by selling shares to outside
investors. While banks, especially larger banks, do often pay dividends on their common shares, there
is no requirement for them to do so. Banks often issue preferred shares to raise capital. As this capital
is expensive, and generally issued only in times of trouble, or to facilitate an acquisition, banks will often
make these shares callable.
This gives the bank the right to buy back the shares at a time when the capital position is stronger, and
the bank no longer needs such expensive capital. Equity capital is expensive, therefore, banks generally
only issue shares when they need to raise funds for an acquisition, or when they need to repair their
capital position, typically after a period of elevated bad loans.

Apart from the initial capital raised to fund a new bank, banks do not typically issue equity in order to
fund loans.

Interchange Fee – Interchange is the money banks make from processing credit and debit transactions.
Each time you swipe your card at a store, the store, or merchant, pays an interchange fee. The majority
of money from interchange goes to your bank–the consumer’s bank–and a little goes to the merchant’s
bank. Because merchants have no control over interchange fees, there’s been some recent legislation
that’s capped interchange fees on debit cards. Ever wonder how banks can afford to offer incentives
and rewards for using their credit cards? Interchange! Merchants are assessed a higher interchange fee
when reward program credit cards are used to make purchases. Additionally, banks cover the cost by
charging membership fees.

Loans – For most banks, loans are the primary use of their funds and the principal way in which they
earn income. Loans are typically made for fixed terms, at fixed rates and are typically secured with real
property often the property that the loan is going to be used to purchase.

Part and parcel of a bank’s lending practices is its evaluation of the credit worthiness of a potential
borrower and the ability to charge different rates of interest, based upon that evaluation. When
considering a loan, banks will often evaluate the income, assets and debt of the prospective borrower,
as well as the credit history of the borrower.

What Types Of Risk Bank Has To Face?

Bank usually faces five types of risk:

Liquidity Risk: The liquidity risk of banks arises from funding of long-term assets by short-term
liabilities, thereby making the liabilities subject to rollover or refinancing risk.
Funding Risk

Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations. For banks,
funding liquidity risk is crucial. This arises from the need to replace net outflows due to unanticipated
withdrawal/ non-renewal of deposits (wholesale and retail)

Time Risk

Time risk arises from the need to compensate for non-receipt of expected inflows of funds i.e.,
performing assets turning into non-performing assets.

Call Risk

Call risk arises due to crystallisation of contingent liabilities. It may also arise when a bank may not be
able to undertake profitable business opportunities when it arises.

Interest Rate Risk

Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE) of an
institution is affected due to changes in the interest rates. In other words, the risk of an adverse impact
on Net Interest Income (NII) due to variations of interest rate may be called Interest Rate Risk. It is the
exposure of a Bank’s financial condition to adverse movements in interest rates. IRR can be viewed in
two ways – its impact is on the earnings of the bank or its impact on the economic value of the bank’s
assets, liabilities and Off-Balance Sheet (OBS) positions. Interest rate Risk can take different forms.

Gap or Mismatch Risk – A gap or mismatch risk arises from holding assets and liabilities and Off-
Balance Sheet items with different principal amounts, maturity dates or re-pricing dates, thereby
creating exposure to unexpected changes in the level of market interest rates.

Yield Curve Risk – Banks, in a floating interest scenario, may price their assets and liabilities based on
different benchmarks, i.e., treasury bills’ yields, fixed deposit rates, call market rates, MIBOR etc. In case
the banks use two different instruments maturing at different time horizon for pricing their assets and
liabilities then any non-parallel movements in the yield curves, which is rather frequent, would affect
the NII. Thus, banks should evaluate the movement in yield curves and the impact of that on the
portfolio values and income.

Basis Risk – Basis Risk is the risk that arises when the interest rate of different assets, liabilities and off-
balance sheet items may change in different magnitude. For example, in a rising interest rate scenario,
asset interest rate may rise in different magnitude than the interest rate on corresponding liability,
thereby creating variation in net interest income.
Embedded Option Risk – Significant changes in market interest rates create the source of risk to banks’
profitability by encouraging prepayment of cash credit/demand loans, term loans and exercise of
call/put options on bonds/ debentures and/ or premature withdrawal of term deposits before their
stated maturities. The embedded option risk is experienced in volatile situations and is becoming a
reality in India.

Net Interest Position Risk – Net Interest Position Risk arises when the market interest rates adjust
downwards and where banks have more earning assets than paying liabilities. Such banks will
experience a reduction in NII as the market interest rate declines and the NII increases when interest
rate rises.

Market Risk

The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market
movements, during the period required to liquidate the transactions is termed as Market Risk. This risk
results from adverse movements in the level or volatility of the market prices of interest rate instruments,
equities, commodities, and currencies. It is also referred to as Price Risk.

Forex Risk Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate
movements during a period in which it has an open position either spot or forward, or a combination
of the two, in an individual foreign currency.

Market Liquidity Risk – Market liquidity risk arises when a bank is unable to conclude a large
transaction in a particular instrument near the current market price.

Default or Credit Risk

Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to meet its
obligations in accordance with the agreed terms. In other words, credit risk can be defined as the risk
that the interest or principal or both will not be paid as promised and is estimated by observing the
proportion of assets that are below standard. Credit risk is borne by all lenders and will lead to serious
problems, if excessive. For most banks, loans are the largest and most obvious source of credit risk. It is
the most significant risk, more so in the Indian scenario where the NPA level of the banking system is
significantly high.

Counterparty Risk This is a variant of Credit risk and is related to non-performance of the trading
partners due to counterparty’s refusal and or inability to perform. The counterparty risk is generally
viewed as a transient financial risk associated with trading rather than standard credit risk.

Country Risk – This is also a type of credit risk where non-performance of a borrower or counterparty
arises due to constraints or restrictions imposed by a country. Here, the reason of non-performance is
external factors on which the borrower or the counterparty has no control.

Operational Risk

Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss resulting from
inadequate or failed internal processes, people and systems or from external events’. Thus, operational
loss has mainly three exposure classes namely people, processes and systems.

Managing operational risk has become important for banks due to the following reasons

1. Higher level of automation in rendering banking and financial services

2. Increase in global financial inter-linkages

Transaction Risk Transaction risk is the risk arising from fraud, both internal and external, failed
business processes and the inability to maintain business continuity and manage
information. Compliance Risk Compliance risk is the risk of legal or regulatory sanction, financial loss
or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the
applicable laws, regulations, codes of conduct and standards of good practice. It is also called integrity
risk since a bank’s reputation is closely linked to its adherence to principles of integrity and fair dealing.

How Banks Make Money Through Credit Cards?

To understand how credit cards works, which customer segments it serves, what it offers to its customer
segments, and how does it makes money from them, we need to get familiar with few terms. Credit
cards classifies the banks as either Issuers or Acquirers. Issuers issue cards to the cardholders, whereas
the Acquirers manage the relationship with the merchants.

The diagram below explains what happens behind-the-scenes when a cardholder presents a card for
payment to a merchant.

When a cardholder presents a card for payment to a merchant, the payment request is forwarded to
the acquirer. The acquirer contacts the issuer through the VISA network. The issuer shares the
information on whether sufficient balance is available to carry out the transaction. The information is
then routed to the merchant. In case sufficient balance is available, the payment is accepted. Else, it is
rejected. The issuer bills the cardholder on a monthly basis. The cardholder pays those bills then.

What Is Ignored In Diagram Is Explained Below In Detail

What the above diagram does not tell is how VISA and banks make money in the process. They make
money from the transaction fees charged to merchants. To understand how it works, imagine a $100
payment from a cardholder to merchant. In case the merchant fee is 2.4%, the merchant would get
$97.60 from the transaction. $2.40 would get unevenly split between issuer and acquirer, depending
upon the interchange fee. In case of an interchange rate of 1.8%, the issuer will keep $1.80 and acquirer
will keep $0.60. Issuer gets to keep more of the merchant fee because of a higher risk of payment default
from the cardholder.

VISA makes money on payment volumes, transaction processing, and value-added services.

How Individual Makes Money Out Of This Process Is Explained Below

VISA creates value for all its stakeholders during the process. Cardholders’ benefit because of
convenience, security, and rewards associated with card payments.
Merchants benefit from improved sales by offering payment method options to the customers. Banks
get new revenue streams through card fees, late payment interests, and transaction fee cuts.

Please refer to the diagram below.

Diagram explaining the business model for banking companies.

How To Measure The Stability, Performance And Risk Of A Bank?

Banks can be rated according to a CAMELS system that ranks performance in six general categories.
The letters refer to each rating category as:
Capital Adequacy (Soundness) – A bank should have sufficient capital to provide a stable resource to
absorb any losses arising from the risks in its business. Capital is divided into tiers (Tier I and Tier II)
according to the characteristics/qualities of each qualifying instrument. These categories represent
different instruments’ quality as capital. Tier I capital consists mainly of share capital and disclosed
reserves and it is a bank’s highest quality capital because it is fully available to cover losses. Tier II capital
on the other hand consists of certain reserves and certain types of subordinated debt. The loss
absorption capacity of Tier II capital is lower than that of Tier I capital. When returns of the investors of
the capital issues are counter guaranteed by the bank, such investments will not be considered as Tier
I/II regulatory capital for the purpose of capital adequacy. Tier II assets cannot be more than Tier I assets
in bank’s capital structure according to RBI guidelines.

Asset Quality (Asset Quality) – Deteriorating asset quality and low profitability is hurting Indian banks.
Credit, sectoral, and geographic concentration is important to look at. Quality, concentration, and
Resolution Structure (Legal/regulatory framework and term-sheet) is important. The quality of a bank’s
asset depends on the credit profile of the borrower, the quality of collateral (if applicable) pledged, and
the restructuring and resolution mechanism available in the country. Also, a well diversified bank asset
book geographically, sectorally, and credit-wise – mitigates the risk concentration on bank. Currently
Indian Banks are facing tough times with mounting NPAs and unfavourable business conditions. The
deposit and credit growth both are in declining mode.

Deposit And Credit Growth For Indian Banks

A primary measure to calculate the quality of assets is to determine the proportion of RWA (risk
weighted asset) of Total Assets.

RWA Density = RWA / *TA

* TA includes credit equivalent of off-balance sheet assets; Lower the ratio higher is the quality of assets.

Net Non-Performing Advances/Total Net Advances

The average standard restructured loans of our PSU banking universe as a % of advances has declined
from 5.9% in FY15 to 1% in FY18 and that of private banks in our coverage has moved from 2.5% to
0.4% during the same period, which gives a clear picture of slippages having peaked out. From the
below data on security receipts we can see that of all PSU banks, BOB has the lowest net SRs at ₹ 3.73bn,
in comparison to size of its corporate book. This is because it mostly prefers making sale of bad assets
to ARCs on cash basis, in order to reduce the risks associated with non-recovery of NPAs by the ARC
and resultant non-redemption of SR.
Management Quality (Efficiency And Efficacy) –The expertise, experience, and, capability of the
management. Ability to frame risk and policy governance structures and ensure its compliance.

This is critical in bank analysis as all else equal the management makes tremendous difference in bank
stability, sustainability, and profitability by taking timely decisions for winding-up, expansion, and
streamlining the business.

Earnings Quality (Profitability) – A bank’s/Financial Institution’s income profile can broadly be divided
into two categories: interest income and non-interest income. Interest income is generated by
lending funds while fee based income (guarantee commission, loan processing fees, dividend income)
and gains from trading/sale of assets form a part of non-interest income. The biggest expense for any
bank/financial institution is the interest expended on deposits and borrowings. Operating expenses of
a bank/FI primarily comprise employee cost and administration expenses. Other major charges to the
profit and loss account include provision for non-performing assets and provision for diminution in fair
value of investments.

Thus, earnings, earnings quality, and its sustainability for a bank depend upon:

1. Cost of funding
2. Efficiency of the business operations
3. Market opportunity (macroeconomic and demographic conditions, growth, and profit margins)

Liquidity – RBI requires every bank to have sound process for identifying, measuring, monitoring, and
mitigating liquidity risk. The liquidity standards to be maintained are:

1. Interbank Liability Limit

2. Call Money Borrowing Limit

3. Call Money Lending Limit

The liquidity coverage ratio is an important part of the Basel Accord, defining how the value of liquid
assets that are required to be held by financial institutions. The idea is that by requiring banks to hold
a certain level of highly liquid assets, they are less able to lend high levels of short-term debt.

High-Quality Liquid Assets for the Liquidity Coverage Ratio

The high-quality liquid assets include only those with a high potential to be converted easily and quickly
into cash. There are three categories of high-quality liquidity assets with decreasing levels of quality:
level 1, level 2A and level 2B assets.

Under Basel III, level 1 assets are not discounted when calculating the LCR, while level 2A and level 2B
assets have a 15% and 50% discount, respectively.

Level 1 assets include Federal Reserve bank balances, foreign resources that can be withdrawn quickly,
securities issued or guaranteed by specific sovereign entities, and government issued or guaranteed
securities.
Level 2A assets include securities issued or guaranteed by specific multilateral development banks or
sovereign entities, and securities issued by government-sponsored enterprises.

Level 2B assets include publicly traded common stock and investment-grade corporate debt securities
issued by non-financial sector corporations.

Liquidity Coverage Ratio (LCR) – The LCR refers to the proportion of High Quality Liquid Assets (HQLA)
to provide at least 100% coverage to the projected cash outflow over a period of 30 days. HQLA are
assets that are easily converted to cash even under stress situations.

Sensitivity Analysis And Stress Testing – Stress testing and sensitivity analysis are the risk
management tools for a bank to evaluate the potential impact of an event or movement in a risk factor
on firm’s assets quality, profitability, sustainability, or other financial variables. Stress testing of funding
liquidity and operational risk is common in banking sector today along with loan book stress testing.

Stress testing is needed for:

• Capturing the impact of exceptional but plausible large-loss events on a portfolio.

• Checking if the capital buffer is sufficient under stress conditions.

• Introducing forward-looking elements in the capital assessment process reducing reliance on model
parameters e.g. when historical correlation may no longer be valid.

• Ascertaining changes in the business environment, e.g. in liquidity.

• Reviewing changed horizons and liquidity of instruments.

• Supporting portfolio allocation decisions beyond the range of normal business conditions.

• Identifying hidden correlations within portfolios.

• Assessing the tail events beyond the level of confidence assumed in a given statistical model because,
under stress conditions, the following may occur – Less predictability in the behaviour of stress factors.
Rapid price movements and contagion may impact other markets. Shocks may spread across multiple
markets. Economic conditions in affected regions may suddenly deteriorate.
Indian Banking Sector – Current Landscape, Some
Facts & Figures
Posted on August 24, 2018Author Keval Shah
Indian Banking – Current Landscape, Some Facts & Figures

Before starting with article, if anyone is interested in studying banking sector, I’d like to encourage you
to visit the RBI website
(https://rbi.org.in/Scripts/Statistics.aspx & https://dbie.rbi.org.in/DBIE/dbie.rbi?site=home). The RBI
website has almost all the information/statistics one would want, and is fairly easy to search. Some of
the data in this article has been sourced from there.

Throughout the blog, we are taking top 5-6 banks in private and PSU banks segment. Top 5 PSU
banks account for ~60-65% of total PSU bank advances, and top 5 private banks account for ~80% of
the total private bank advances. This makes them fairly representative of their respective segment for
our analysis. This data-backed blog is going to be a long read, but it aims to help the reader
understand the history of entire Indian banking industry, its current situation and the recent updates
at a one stop location. So let’s begin!

Indian Banking Sector Over Last 25 Years :

Since 1994, the private banks have grown their advances at ~38% CAGR v/s. public banks growing it
at ~19%. That is twice as fast for two and half decade! We can see that in the below chart, how the
contribution of advances by the banking sector has been increased by the private banks.

Market Share in Advances :

Private banks’ share in credit by banking sector has increased from mere ~1.5% in 1994 to now
1/3rd of total banking credit over last two and half decade.
Despite PSU banks having twice the advances of that of their private peers, they enjoy just
1/3rdvaluations of that of private banks!

Bank Type Advances (Cr) Market Cap (Cr)

PSU Banks ~57,50,000 ~4,50,000

Pvt Banks ~28,00,000 ~15,00,000

Let us try and understand why such an anomaly exists:

Credit Growth :

We can see, consistently throughout the years since 1995, private banks have managed to grow their
credit at much higher rate than their PSU peers. When we consider credit growth, we should separate
post 2014 years from the past. The credit growth for PSU banks suddenly dropped from 22% CAGR
(1994-2014) to 2% CAGR (2014-2018). Whereas, the private banks continued to grow at 18-20% rate.
We can see that in the graph below:
When we break down the advances, we can see that PSU banks had heavily lent to corporates,
compared to their private peers focusing on retail lending. You would have understood from our
previous blog, that lending to corporates has higher NPA probability compared to retail lending,
mainly due to absence of measures like Insolvency & Bankruptcy Law in the past. We can see in the
below graph, the higher the ratio of corporate loans to consumer loans (X-axis), higher is the bank’s
NPA:

Source: Bloomberg Quint

Private Banks Enjoy Higher Return on Assets ( ROA ) :

As we know, retail lending is also the one with better yields, we can see how some top PSU and
private banks have fared in terms of their ROAs over the last decade. We can also notice how the
ROAs have turned negative for PSU banks in last couple of years due to higher provisions because of
their higher NPAs.

Reasons for High Return On Assets for private banks :

There are multiple reasons for private banks delivering better ROAs than their public peers.

 Credit Cards & Cross Selling : Cross selling includes selling of Bancassurance (Health and Life
Insurance), Asset Management, etc. Credit card and cross selling businesses are of high yielding
nature. These businesses have more stable fee and commission income, compared to the Interest
Income a bank earns which is more of a commodity type business and is susceptible to interest
rate volatilities. The private banks realized this benefit and have focused on growing these
businesses. Just as an example, private banks’ share in mobilising funds for mutual funds was nil
until 1993. However, within a matter of 6 years, their share rose to 80% by 1999, and has remained
80%+ since then. Also, we can see the number of credit cards issued by some top banks and their
growth over last 7 years:

(Note: The CAGR for HDFC bank is lower, but that is at a comparatively high base!)

Out of 2.5 crore credit cards issued in India, HDFC Bank alone has issued almost 1.1 cr credit cards !
That’s a whopping 40% market share in the credit cards. Also, HDFC Bank has issued 4 credit cards for
every 10 debit cards. That’s some serious cross selling, as most of these cards are issued to banks own
customers. Exact data is not available on the same.
On the other hand, SBI has issued almost 28 cr debit cards but only 65 lakh credit cards. For BOB the
ratio is even worse. Traditionally PSU banks have fared poorly when it comes to selling credit cards,
bancassurance, auto loans etc. And that’s where private banks have scored. Resulting in higher yield
assets & perhaps higher ROA / ROE profile. If PSU banks start cross selling various products to their
existing customers, they will enter a different league altogether, mainly due to their huge network &
customer base. But there is a big ‘IF’.

No Of Debit Cards Issued No Of Credit Cards Issued

Bank
(May-18) (May-18)

State Bank of India 28.3 cr 65 lacs

Bank of Baroda 5.3 cr 1.3 lacs

Punjab National Bank 6.4 cr 3.3 lacs

Canara Bank 4.5 cr 2.2 lacs

HDFC Bank 2.5 cr 1.1 cr

Kotak Mahindra Bank 0.9 cr 15.5 lacs

ICICI Bank 4.3 cr 52 lacs

Axis Bank 2.3 cr 46 lacs

IndusInd Bank 0.4 cr 8.2 lacs

Yes Bank 0.2 cr 3 lacs

 Non-Interest Income : Another way of looking at non-cyclical fee and commission income is the
‘Non-Interest’ part of the income of a bank. The higher it is, more stable and better quality income
it gets. Non-Interest Income is also known as ‘Other Income’.
 Retail Lending : Until 2014, private banks lent Rs 150 to corporates for every Rs 100 lent to the
consumer. Whereas, the PSU banks lent Rs 700 to corporates for every Rs 100 to consumers. This
higher exposure towards retail helps in improving a bank’s profitability.
 Cost to Income : Lower Cost Income ratio also aids in improving the ROAs of a bank. However, if a
bank is growing and incurring expenses for the same, the bank might have higher Cost Income
ratio. Generally, Cost Income ratio in the neighbourhood of 45 – 50% is considered to be good.
PSU’s in general have higher operational expenditures & lower retail business per branch, which
results in higher cost to income ratio. Private banks have done a good job in getting higher retail
business per employee / per branch, which keeps their cost to income ratio’s lower.

 Better Net Interest Margins :

Higher CASA certainly helps is lowering the cost of funds for any bank. A combination of higher CASA
& higher yield retail lending has resulted into better NIM’s for private banks. PSU banks have a solid
liability franchise that is built over decades. Their CASA / cost of funds is lowest amongst all banks.
However, higher share of corporate lending brings the NIM’s down.
Branch Network & Productivity Over The Last Decade :

This is something that all of us would have observed in our surroundings. The names of banks in our
vicinities during the 2000s and today are quite different. The total branches of all PSU banks has only
doubled since 2006 to ~90,000, whereas number of private bank branches have grown from 4400 to
28000 over the same time frame. A 6x increase ! However, even today, PSU banks have 3x more
branches than private banks. How well they can leverage this footprint is to be seen. The banks with
better branch network are more likely to show better CASA numbers.
Data of branch network of some top banks :

However, due to digitization, the rate of adding new branches has started to decrease for the banking
industry as a whole. Higher digitization and aggressive growth culture has resulted in the business
done per branch (Advances + Deposits) by private banks is way more than their PSU peers. Business
per branch is higher for private sector despite being retail banks, where ticket size is lower compared
to corporates. If PSU banks start growing their retail book i.e. Auto / housing / car loans with
aggression, then their business per branch can be at par with private banks.
Looking at Retail Advances per Branch gives a better view on how private banks have penetrated the
retail credit market. The per branch number of retail advances is way higher for private banks than
business per branch.

Employee Strength :

We can see the similar trend in number of employees. PSU banks have added just ~250,000 more
employees in last decade with total employee strength of ~850,000 today, whereas private banks have
more than tripled their employee strength to ~410,000 employees in the same period.
Deposits :

This aggressive expansion of branch networks by the private banks has benefitted them by increasing
their share in the pie of deposits.

CASA (%) :

In the table below, we can see, that amongst the top banks, the lowest private banks CASA of HDFC
Bank is comparable to the best PSU bank CASA of SBI. Better CASA leads to cheaper source of funds
for the banks helping in improving their NIMs and ROAs.
In the next blog, we will take a look at the current NPA mess, how insolvency & bankruptcy law is
changing the game, and whether the peak provisioning cycle is almost done with.
Indian Banking Sector – NPA Mess & The Way Out
Posted on September 7, 2018 Author Keval Shah 0

Indian Banking Sector – NPA Mess & The Way Out

This blog is in continuation to our blog series on Banking sector, where we have tried to explained the
Banking sector as whole from scratch (explaining the terms and jargons) and have deep dived into
how Indian Banking sector has evolved over decades. In the current blog we focus on the current
scenario of the sector, explaining NPA mess and the competition the sector is facing from Non-
Banking companies.

Recent Updates On Indian Banking Sector

The Gross NPA of Indian Banking sector has increased from ~2.5 lac cr in FY14 to over 10 lac cr. This
has lead to aggressive provisioning by banks. The provisioning by PSU banks itself has increased from
~75,000 cr in FY14 to ~250,000 cr in FY18. PSU banks have cumulatively provided ~10% of their FY18
advances in last 3 years!! (~5.5 lac cr +), whereas private banks have provided ~4% (1 lac cr +). The
cumulative provisions in last 3 years are more than the provisions in a decade from 2005 to 2014!!
Let us see the Gross NPA trajectory of these banks in the past :

FY09 Gross NPA

Bank FY14 Gross NPA (Cr) FY18 Gross NPA (Cr)
(Cr)

State Bank of India 15,714 61,605 2,23,427

Bank of Baroda 1,843 11,876 56,480

IDBI Bank 1,436 9,960 55,588

Punjab National Bank 2,767 18,880 86,620

Canara Bank 2,168 7,570 47,468

HDFC Bank 1,988 2,989 8,607

Kotak Mahindra Bank 689 1,059 3,825

ICICI Bank 9,649 10,506 53,240

Axis Bank 898 3,146 34,249

IndusInd Bank 255 621 1,705

Yes Bank 85 175 2,627

Cumulative Provisioning, Is The Worst Over ? : Let us have a look at cumulative provisioning post
2014 for few banks v/s. their provisioning during FY09 to FY14 period. You can see that most of the
banks have provided way more in last 4 years than what they had during FY09-14 period!

FY 2009 – 2014 Cumulative Provisioning FY 2015 – 2018 Cumulative Provisioning

Bank
(Cr) (Cr)

State Bank of
58667 1,60,739
India

Bank of Baroda 13507 43307

IDBI Bank 12147 44121

PNB 19494 67498

Canara Bank 11508 37166

HDFC Bank 11066 14321

Kotak Bank 1337 2859

ICICI Bank 16494 48083

Axis Bank 8607 33627

IndusInd Bank 1425 3328

Yes Bank 965 3223

There has been a bloodbath in PSU banks earnings. Their profits are wiped out since they had to
provide for non performing assets. With gross NPA’s at 16-17% of overall advances, and most of it has
been provided for. Steel sector is in a strong upcycle & domestic demand is getting stronger. Banks
will be able to get rid of steel assets at a reasonable haircuts. Steel is almost fixed & there could be
potential write backs by banks on that front. Unless we get some more negative suprises from real
estate – builder financing, housing loans or power sector, the gross NPA situation is somewhere near
peaking out.

Due to this mess created in the banking sector, government has taken number of steps like the
Prompt Corrective Action (PCA), Project Shashakt, SAMADHAN scheme, IBC, etc.

Prompt Corrective Action (PCA) :

PCA is like an intensive care unit where banks with weaker balance sheets are being cured with various
steps taken by the government and RBI. These banks are restricted from opening new branches, staff
recruitment and increasing the size of their loan book depending on the risk thresholds set in PCA
rules. Additionally, PCA banks are directed to disburse loans to only those companies whose
borrowing is above investment grade. Currently, there is a list of 11 banks which are currently under
PCA framework and 6 more PSU banks are under consideration to be added to the PCA framework.

PCA List Watchlist Non PCA

Allahabad Bank Punjab National Bank State Bank Of India

United Bank of India Canara Bank Bank Of Baroda

Corporation Bank Union Bank of India Indian Bank

IDBI Bank Syndicate Bank Vijaya Bank

UCO Bank Andhra Bank

Bank of India Punjab & Sind Bank

Central Bank of India

Indian Overseas Bank

Oriental Bank of Commerce

Dena Bank

Bank of Maharashtra
RBI has defined three risk thresholds for each parameter and it has linked specific corrective measures
to each threshold. Breach of any risk threshold would result in invocation of PCA. If the risk is higher,
then the corrective action will be tougher for the bank.

Banks would fall under different categories of risk based on their NPAs. The NPA range for adding a
bank to any risk category has been conservatively updated by the RBI from the earlier rules. So now
even at lower Net NPA range a bank would get added to the PCA list.

Net NPA Range Risk Category Earlier NPA Range

6–9% Category 1 10 – 15 %

9 – 12 % Category 2 15 % +

12 % + Category 3 NA

Shashakt Plan :

Video Link: https://youtu.be/0xbr7mLKhLE

It is a project recommended by a panel headed by PNB chairman Sunil Mehta. As per the plan:

 Bad loans of up to ₹50 crore: These accounts will be managed at the bank level, with a deadline of
90 days.
 Bad loans of ₹50-500 crore: The banks will enter an inter-creditor agreement, authorizing the lead
bank to implement a resolution plan in 180 days, or refer the asset to NCLT.
 Bad loans above ₹500 crore: The Sunil Mehta panel recommended an independent AMC,
supported by institutional funding through the AIF (Alternative Investment Funds). There are about
3.6 lac cr of loans in this range, with PSU banks exposure of around 3.1 lac cr.
SAMADHAN Scheme : Video Link: https://youtu.be/FvV6uBhsoKs

This scheme is targeted towards addressing stressed power assets. This scheme has shortlisted 11
power assets with an overall capacity of over 12 GW, which are either nearing completion or complete,
like Lanco Infratech’s Anpara power plant, Jaypee Power Ventures’ Nigrie power plant and KSK
Mahanadi plant in Chhattisgarh. The scheme attempts at saving these assets to be sold at Rs. 1-2 cr
per MW against investment of Rs.6-7 cr per MW, by assessing the sustainable debt in each of these
assets and converting the remaining unsustainable debt into equity (held by banks), with 24.5% to be
allowed to be remained by the promoters.

Insolvency and Bankruptcy Code (IBC) And Its Impact (Video link: https://youtu.be/DE6uxcD5Wgs)

Historically, banks used to prefer Corporate Debt Restructuring (CDR) or Joint Lenders Forum (JLF)
mechanisms for restructuring the debt of stressed borrowers. The objective of the extensively used
CDR seemed to have been to provide temporary relief to the borrower rather than efforts towards
reviving the business. CDRs had met with limited success of only 17% exits as of June 2016 due to
poor evaluation of business viability and the lack of effective monitoring.
Strategic Debt Restructuring (SDR) was introduced in June 2015. Until then, there was no such
mechanism that enabled the banks/lenders to play a direct role in the turnaround of stressed
borrowers. However, banks due to the expectation that the existing legal system would not allow a
change of management to take place smoothly, banks were skeptical of lack of protection from
existing and imminent litigations and this impacted the success of SDR.
Scheme for Sustainable Structuring of Stressed Assets (S4A) was introduced in June 2016. Under S4A,
existing promoter may continue to enjoy the control as long as 50% of the debt is ‘sustainable’. The
efficacy of S4A is yet to be evaluated, however, the lack of emphasis on a comprehensive turnaround
could possibly result in the problem just being postponed.
Before the introduction of IBC, many corporates used to quite easily get loans irrespective of their
capabilities of repaying the loans. Infact, many times the companies would get loans to service the
interest costs of their previous loans! The promoters did not have much fear of losing their company
in case of defaulting on the loans. This led to Crony capitalism and unhealthy credit quality in the
system. Also, this lead to over capacities in many industries leading to comparatively lower capacity
utilization. We can see in the industry wise capex funded by Banks/FIs, that most of the industries had
maximum capex during FY2009 to FY2014 period:

Industry wise Capex Funded by Banks/FIs – (Rs. Cr)

Industry 2017 Capex Max Capex Max Capex Year

Infrastructure 1,13,200 2,01,500 2011

i) Power 82,400 1,73,300 2011

ii) Telecom – 67,200 2010

iii) Ports & Airports 10,200 10,200 2017

iv) Storage & Water Management 6,600 6,600 2017

v) SEZ, Industrial, Biotech and IT Park 700 12,400 2008

vi) Roads & Bridges Construction 13,200 13,200 2017

Construction 21,600 47,100 2010

Metal & Metal Products 8,800 79,200 2011

Transport Equipment & Parts 7,900 9,300 2009

Textiles 7,300 13,400 2012

Cement 4,000 18,700 2009

Chemicals & Pesticides 3,800 6,700 2012

Hospitals & Health services 2,000 3,700 2010

Food Products 1,600 3,100 2009

Hotel & Restaurants 1,500 13,100 2011

Glass & Pottery 1,100 2,500 2012

Petroleum Products 900 17,200 2008

Transport Services 700 5,700 2010

Mining & Quarrying 700 10,200 2010

Sugar 200 3,700 2009

Electrical Equipment 400 7,500 2011

Others 7,100 19,100 2008

Total Cost of Projects 1,82,800

Also, the manufacturing capacity utilisation levels started to fall from 2011, due to addition of
capacities. The capacities were added way ahead of demand growth expectations as banks were
relentlessly lending. This is also a leading factor for lower capex from manufacturing side during past
few years as utilisation levels were already low and have just started catching up since a year.
It looks like we are past the trough in terms of investment cycle slowdown. Capacity utilizations across
heavy industries is picking up & a fresh capex cycle may start once we cross 85%-90% kind of a
number. Recently we saw Arcelor Mittal revising its bid for Essar Steel’s 10 MT plant from 37000 cr to
42000 cr. This could be the sign of things to come our way. Corporate sector seems to be confident of
the recovery.

And the best part is, all those crooks who looted the system, are all set to lose their empires just when
things are turning around.

IBC Could Be The Single Biggest Reform Of Modi Government !

 A certain path was taken – Original idea was to create a bad bank, where all bad loans will be
transferred. However PSU banks would not have learnt any lesson & they would have continued
with old practices. I
 BC was important to force a cultural change in how PSU banks operate. Under IBC regime banks
will be forced to write the assets down, industry wont get capital as PSU banks are under pressure.
Banks are quickly referring cases to NCLT & trying to recover the money.
 IBC enforces the principle of creative destruction. If companies fail, there will be no more ever
greening of loans. Companies will be auctioned / sold off & old entrepreneurs will lose control.
 This creates a rule based economy & which is a sign of a living and thriving business culture. The
old context of “nothing will happen even if we default” needed to be changed. And that’s what IBC
has achieved.
 Promoters will now have the fear of losing their company if they do anything wrong or cheat
banks.
Banks are in a much better position to recover their money in case of default.

India’s insolvency ranking before the approval of IBC was very bad, compared to other BRICS and
developed nations.

Also the recovery rates and the time taken for recovery was worse compared to other nations. Indian
banks took 4.3 years to recover the bad debts, which is longest compared to other nations. Also, only
25.7 % of stressed assets was being recovered.
IBC was approved by both houses of the Parliament of India and received presidential assent in May
2016 and it was made effective on 1 December 2016. The key difference between IBC and the current
regime is as following:
The IBC process in a nutshell is explained by the chart below:
Post the approval of IBC, the number of corporate undergoing insolvency resolution processes have
increased.
Indian Tyre Industry
(Akshay Satija)
Understanding The Indian Tyre Industry, Key
Players & The Road Ahead
Posted on October 23, 2018 Author Akshay Satija

Indian Tyre Industry

The Indian Tyre Industry is an integral part of the Auto Sector – It contributes to ~3% of the
manufacturing GDP of India and ~0.5% of the total GDP directly. So, let’s understand the dynamics of
the Tyre Industry in India.

Indian tyre industry has almost doubled from ~Rs 30,000 crores in 2010-11 to ~Rs 59,500 crores in
2017-18 of which 90-95% came from the domestic markets. The top three companies – MRF, Apollo
Tyres and JK Tyres have ~60% of the market share in terms of revenue. In terms of segmentation tyres
can be divided in two ways – based on end market and based on product.

Based On End Market

Replacement, OEMs & Exports

Indian tyre market is clearly skewed towards the replacement segment which contributes ~70% of
total revenues. Whereas in volume (tonnage) terms the replacement segment contributes ~60%
indicating realizations in the after-market are clearly higher than OEMs (Original Equipment
Manufacturer) market

Based On Products

Truck & Bus (T&B), Passenger Vehicle (PV), 2/3-Wheeler, Off-Highway Tyres (OHT) & Others
T&B tyres in India generates the major revenue i.e. 55% of total revenue whereas globally it’s the PCR
(Passenger Car Radials) contribute the largest portion of the revenue. This is mainly because of very
low penetration of passenger vehicles in India – below 20 per 1,000 people whereas in China the
number is ~69 per 1,000 people and 786 per 1,000 people in US. In terms of volume (tonnage) T&B
contributes around ~50% of the total volume

The demand from OEM’s is widely spread across the segment where T&B contributed ~35% and PVs
& 2/3 Wheeler’s contributed ~25% & ~22% respectively. In term of the replacement segment the
demand was more skewed towards the T&B tyres which contributed ~61% and PVs & 2/3 Wheeler’s
contributed ~14% & ~9% respectively.

Manufacturing Process :

A simple round looking tyre is manufactured by complex assembly of more than 250 raw materials
amongst which the major components include natural & synthetic rubber, nylon tire fabric, bead wire,
carbon black, reinforcing non-black fillers like silica, vulcanizing agents & anti-oxidants.
The process begins with the mixing of basic rubbers with process oils, carbon black, pigments,
antioxidants, accelerators and other additives, each of which contributes certain properties to the
compound.

These ingredients are mixed in giant blenders called Banbury machines operating under high heat and
pressure. They blend the many ingredients together into homogenized batch of black material with
the consistency of gum. The mixing process is computer-controlled to assure uniformity. The
compounded materials are then sent to the next stage of processing for further processing into
sidewalls, treads or other parts of the tyre.

Then the task of assembling the tyre begins. The first component to go on the tyre building machine
is the inner liner, a special rubber that is resistant to air and moisture penetration and takes the place
of an inner tube. Next comes the body plies and belts, which are often made from polyester and steel
– Plies and belts give the tyre strength while also providing flexibility. The belts are cut to the precise
angle and size specified by the tyre engineer to provide the desired ride and handling characteristics.

Bronze-coated strands of steel wire, fashioned into two hoops, are implanted into the sidewall of the
tyres to form the bead, which assures an airtight fit with the rim of the wheel. The strands are aligned
into a ribbon coated with rubber for adhesion, then wound into loops that are then wrapped together
to secure them until they are assembled with the rest of the tyre.

Radial tyres are built on one or two tyre machines. The tyre starts with a double layer of synthetic gum
rubber called an inner liner that will seal in air and make the tyre tubeless.

Then, come two layers of ply fabric, the cords – two strips called apexes stiffen the area just above the
bead. Next, a pair of chafer strips is added to resist the chafing from the wheel rim when mounted on
a car.

The tyre building machine pre-shapes radial tyres into a form which is very close to their final
dimension to check whether components are placed in proper position before the tyre goes into the
mold.

Now the tyre builder adds the steel belts that resist punctures and hold the tread firmly against the
road. The tread is the last part to go on the tyre and is pressed firmly together by automatic rollers.
The end result is called a “green” or uncured tyre, ready for inspection and curing.

The curing press is where tyres get their final shape and tread pattern. Hot molds like giant waffle
irons shape and vulcanize the tyre. The molds are engraved with the tread pattern, the sidewall
markings of the manufacturer.

Tyres are cured at over 300 degrees for 12 to 25 minutes, depending on their size. As the press swings
open, the tyres are ejected from their molds onto a long conveyor belt that carries them to final finish
and inspection bay.

However, technologically there are two types of tyres one is the radial tyre and the other is biased
ply :
Radial Tyres : To increase structural integrity, radial tyres are constructed with perpendicular polyester
plies and crisscrossing steel belts underneath the tread. This construction provides a smooth ride and
extends the life of the tyre. Radial tyres are generally used for long-haul towing, travel trailers, toy
haulers, larger boats and livestock.

Bias Tyres : A bias tyre’s construction consists of internally crisscrossing nylon cord plies at a 30 to 45-
degree angle to the tread center line. This design gives the tire a tough and rugged build and
increases sidewall puncture resistance. Bias technology is generally used for construction, agriculture,
marine and utility applications.

Radial tyre generally cost 20-25% higher compared to Bias tyres however, as larger amount of steel is
required the cost of manufacturing also slightly increases and it also increases the wear n tear of the
tyre.

Radialisation of T&B & LCV tyres has improved over last two years and is expected to improve further
as commercial vehicle OEMs have started using radial technology.

Cost Structure :

Tyre Industry is known for its capital-intensive structure where 60% to 65% of the revenues is raw
material cost. The other important cost involved are SG&A (selling general & administrative) which
roughly contribute from 6% to 12% of the revenues and employee cost contributing from 7% to 14%
of revenues.
Raw Material Costs :

As we saw above that around 250 different raw material are put together to manufacture a tyre but
the major cost generating raw materials are natural rubber, synthetic rubber and crude derivatives like
carbon black which contribute to ~80% to 85% of the total raw material cost. Hence, rubber and crude
price are key variable to tyre company’s profitability

Historical average gross margins vs rubber & crude prices :

The Indian tyre industry has been under raw material pressure for last two year due to increase in
rubber and crude prices which can be clearly seen in the above comparison charts. As per the
managements the pressure on the raw materials is expected to continue in the shorter term due to
increasing crude prices

Average SG&A & Employee cost (% of revenue):

A Quick Glance At A Few Indian Tyre Companies :

Capacity Expansion Plans :

The Indian tyre industry is expected to see significant capacity expansion in the upcoming two to
three years. All major players in the industry have announced their plans

MRF : MRF has announced to set up a new facility in Gujarat where it plans to spend ~Rs 4,500 crores
over next few years

Apollo Tyres : Apollo tyres laid foundation for their fifth Indian facility in Andhra Pradesh which they
will manufacture passenger vehicle tyres. The company is spending ~Rs 1800 crores in the first phase
of the project. The facility is expected to commence operation in two years from now. Apollo is also
planning to expand its T&B capacity at the Chennai plant which is expected to commence operations
in this financial year

JK Tyres : In 2016, JK Tyres acquired the Cavendish tyre business from the BK Birla group to enter in
the two-wheeler segment. JK Tyre now plans to expand its T&B tyre capacity by ~0.6 mn units at the
Cavendish facility by investing ~Rs 275 crores

CEAT : CEAT has announced a capex of ~Rs 3,000 to 4,000 crores over next 4 to 5 years. The company
is entering into the OHT (off-highway tyre) segment with a new facility in the Amber Nath. The
company has started its operations at a very small scale and plans to expand it further to capacity of
~100 MTPD. CEAT is also planning to expand its capacity significantly PCR with a greenfield expansion
in Chennai which Is expected to come online in line with Apollo’s Andhra greenfield facility. It also has
plans to expand it T&B and 2/3-Wheeler capacity by brown field expansion at Halol and Nagpur plant
Balkrishna Industries : Balkrishna Industries is coming up with an additional greenfield facility in the
US with a capex of $100 mn (~Rs 700 crores) which will manufacture 20,000 tonnes of OHT tyres every
year. The company is also spending ~Rs 500 crores in its domestic Waluj plant which will generate
incremental capacity of 5,000 tonnes every year. Balkrishna also plans to set up a 140,000 tonnes/year
carbon black facility

Bridgestone : Bridgestone India is planning to spend ~$304 mn to increase its current capacity of
15,000 tyres per day to 41,000 tyres per day

Looking at the above expansion plans it seems there could be a competitive scenario amongst the
tyre companies to gain market share as majority of the capacities have similar timelines. The tyre
companies might grow at a decent pace by selling more tyres however, their margins and return ratios
might take a hit in order to achieve market share

Important Financial Metrics To Look At :

We believe the most important metric while comparing / analyzing a commodity business is its unit
level economies, well tyre is no different. As different tyre companies manufacture different type of
tyres it is very difficult to compare realizations of one tyre company with other. The solution could be
comparing them on per ton basis

 Realizations per ton (Net operational sales/tons sold) : Comparing realization per ton could
help us understand which company can sell its products at premium compare to other tyre
companies. Looking at realization per ton over time could also help us understand the pricing
trend of the companies
 Cost per ton (COGS/tons sold) : Cost per ton could help us understand which company is
efficiently using its raw material
 EBITDA per ton (EBITDA/tons sold) : EBITDA per ton could help us understand which company
has been operationally more efficient (higher the better)

Opportunities :

Auto Industry

Tyre industry is integral part of auto industry. OEM tyre demand is directly related to auto production.
As per automotive mission plan 2026 (AMP 2026) the Indian automotive industry is expected to grow
3.5 to 4 times in value from its output of Rs 4.64 lakh crores in 2015 to Rs 16.16 to 18.88 lakh crores in
2026 with an average growth rate of 6%

Read more about AMP2026 – Link

The passenger vehicle and commercial vehicle sales are expected to grow due to increasing vehicle
penetration due to improvement of per capita income in the country
Concerns :

Raw Material

As mentioned above tyre industry is raw material intensive and India majorly depends on imports as
the demand for raw materials like rubber, crude & carbon black is more than supply by the domestic
manufactures.

In FY18, India produced ~694,000 tonnes and consumed ~1,112,000 tonnes of rubber whereas, the
gap was fulfilled by imports. India almost imported ~470,000 tonnes of rubber. Rubber imports in
India attract a duty of 25% or Rs 30 per KG whichever is lower increasing input costs further

India has sufficient capacities of carbon black. However due to increasing exports of carbon black the
demand-supply gap has increased in last two years leading to import of carbon black.

Inability To Pass Price Rise To OEMs

The ability to pass on sharp rises in raw material prices to OEMs remains a challenge for industry
players. Generally, many tyre manufacturers are unable to pass on higher raw material prices to OEMs,
due to bulk demand fearing loss of market share.

Rising Interest Rates

As many players in the tyre industry have plans to further expand their capacities which will be partly
funded by debt. As RBI has been recently increasing interest rates due to macro issues. The expected
increase in rate could lead to increase in finance costs of the companies.

Global Trend :
The global tyre industry has been witnessing a shift in the tyre manufacturing activity, with Asia
carving a much larger piece of the pie with regard to the number of plants. Almost 60% of the global
tyre plants are located in Asia today

Globally, ~$22 billion worth of investment have been planned between 2016-2021. Asia account for
the majority share with ~46% of the total investments. Overall Asian economies accounted for ~50%
of the global sales and China is the world largest tyre market

Among the advanced economies, the US tyre industry, both replacement market and OEM segment
has seen muted growth. Passenger car and light truck markets have witnessed a decline in both
segments. However, the medium and heavy truck tyre market has seen a rising demand across both
segments

The European tyre industry continues to register improving growth. Germany, the UK, France, Italy,
Spain and Poland are the major markets that contribute to more than 60% of the total Europe tyre
sales in terms of volume

In 2017, the global passenger car tyre demand grew by an estimated 2.7%. The OEM demand
sustained globally, except North America. The replacement tyre segment grew by estimated 3% with
most of the growth coming from Europe, Asia and South America

The global truck and bus tyre segment witnessed strong demand from OEM segment. Asia observed
increased sales of estimated 26% in the segment with most of the growth coming from China (~30%
Y-o-Y). The demand in North America grew by an estimated 10%, while Europe recorded a growth of
8%. Globally, replacement demand had muted growth, with most of the demand coming from North
America and Europe, while Asia observed almost stagnant growth.
Indian Steel Industry
(Zain Iqbal)
Understanding How Indian Steel Industry Works
Posted on September 19, 2017Author Zain Iqbal

Steel

A Simple Understanding of how Iron and Steel Industry in India Works. Globally, steel can be found in
a variety of products and structures – from personal vehicles to the Burj Khalifa: the world’s largest
skyscraper. But what is steel, and why is it so important? Steel is an alloy, meaning that it is made by
combining iron with another element, usually (but not always) carbon. This alloy can be up to 1,000
times stronger than iron, making steel an extremely useful and sturdy building material.

Currently, Indian steel industry has a steel capacity of 122 million tonnes (2015-16) and the world is
producing 1630 million tonnes of steel. India has an aspiration to take this capacity to 300 million tonnes
by 2030. Today steel industry contributes approximately 2% to our country’s GDP and employs 5 lakh
people directly and about 20 lakh people indirectly.

India has quickly touched the number three spot in terms of steel production, overthrowing many
industrialized developed nations such as the US, Russia and South Korea.

From the infographic below it is clearly evident where India stands and where China stands in terms of
capacities of crude steel installed. China is a powerhouse for infrastructure spending and things happen
at a very different scale there and a steel capacity of over 800 million tonnes is a testimony of that.
In Spite of being third largest steel producing country in the world, our per capita steel consumption is
nothing to be proud of, we are a developing nation having high resemblance with China but our per
capita steel consumption is one-eighth that of China at 63 kg per person, see the image to understand
per capita steel consumption across geographies.

National steel Policy 2017 has pledged a target of achieving 160 kg of steel per person from current
levels by increasing production capacities to 300 million tonnes.
World Steel Outlook of Steel Industry

Download (PDF, 893KB)

Steel finds applications in various sectors from infrastructure, automotive, electrical appliances to
mechanical equipment. The image below shows sectoral steel consumption across the globe. Generally,
the same pattern is seen in various countries around steel consumption and when we read India’s per
capita steel consumption as 63k kg’s, we can imagine very little infrastructure spending (roads, bridges,
highways etc) happening in our country of 1.25 billion inhabitants.

National Steel Policy of Steel Industry in India

Download (PDF, 893KB)

Steelmaking Process & Key Components in Steel Industry

The following Flowchart shows steps of steel making pictorially in a steel plant.

There are essentially 3 steps to steelmaking-

1. Ironmaking Process
2. Steelmaking Process
3. Continuous Casting Process
Iron Making Process in Steel Industry

This is the first step in the making of

steel, iron ore is extracted from the
earth and melted to turn into melted
iron.

The process begins with sintering

operation where iron ore particles
are heated till they become
aggregates and this is done for
proper heat transfusion to occur in
the blast furnace following this step.

In a similar fashion, just like iron

ore, we carry out coking
operation in coke oven for our
coking coal till they become lumpy
aggregates and this is also done to
ensure proper heat transfusion to
occur in the blast furnace following
this step.

Blast Furnace Operation

Sintered iron ore and coke are layered inside a 100 m long furnace, then hot air at 1200 degree Celsius
is blown into the blast furnace from the bottom causing the coal to burn and this heat, in turn, burns
the iron ore to create molten iron at a temperature of 1500 degree Celsius. This is also called hot
metal (pig iron) in the industry.
Steel Making Process

Today, two distinct processes make up bulk of worldwide steel production: Basic Oxygen Furnace
process and the Electric Arc Furnace process (EAF).

Basic Oxygen Furnace (BOF)

In basic oxygen furnace, iron is combined with varying amounts of steel scrap (less than 30%), after that
very pure oxygen is blown into the vessel causing a rise in temperature to 1700 degree Celsius. The
scrap melts, impurities are oxidized and carbon content is reduced by 90%, resulting in liquid steel.

Electric Arc Furnaces (EAF)

Electric Arc Furnace or mini-mill, does not involve iron making. It reuses existing steel (scrap), avoiding
the need for raw material and their processing. The furnace is charged with steel scrap, it can also include
some Direct Reduced Iron (DRI) and pig iron for chemical balance. The electric arc operates with an
electric charge between two electrodes providing heat for the process.

This furnace does not require coke as raw material but depends heavily on the electricity generated by
coal-fired power plant elsewhere in the grid.

How do the Two Processes Stack Up?

Although the BOF and EAF processes both produce steel as the end product, the varying means to this
end between the two processes give each certain economic advantages and disadvantages. The main
area of discussion centers on the supply side and the raw materials going into steelmaking. For BOF
firms, producing steel requires sourcing a variety of raw materials, namely iron, coal, and limestone. Due
to the necessity of securing these raw materials, large-scale steel firms like to vertically integrate its
production process backward into coal and iron ore mining.

On the other side, EAF steelmakers have a much simpler input process: EAF furnaces only require scrap
steel as the major input. As long as scrap steel remains plentiful in the market, these firms have easy
and cheap access to the required raw material.

For a BOF firm, the average cost per ton of capacity is $1,100, while the cost for an EAF mini mill per ton
of capacity is only $300. The barrier for entry is thus lower for EAF firms, which can in part explain the
rise of such “minimills” in India over the last decade with over 300 small players across the length and
breadth of the country.

Another reason of the adoption of BOF process over EAF is the quality of steel produced from it.
Generally speaking, steel produced from BOF process is regarded having higher strength and durability
than steel produced from EAF process giving it the pricing advantage.

Molten steel is now poured into molds and cooled into solid steel reaping semi-finished material ready
to be made into finished steel product. These semi-finished material are categorized into slabs, blooms,
and billets.

Slabs – Slabs are wide and flat and are mainly used to produce hot and cold rolled coils, heavy slabs,
and profiles.
Bloom – Bloom is rectangular bars used to make products such as springs, forged parts, heavy structural
shapes and seamless tubes.

Billets – Billets are bars from a square section of long steel that serve as input for the production of
wire rods and rebars.

Continuous Casting Process

The final stage of producing steel is the Continuous Casting Process where steel is forged into various
steel products.

Hot Rolled Product– When a slab is heated above 1100 degree Celsius and passed between rollers, it
turns into a thin and long sheet (hot rolled). This hot rolled product is widely used as a construction
material and pipes in various industries.

Cold Rolled Products – Cold rolled products are made by making hot rolled products thinner at room
temperature which is then used in making appliances, barrels and auto frames.

Coated Steel – Coated steel is made by coating cold rolled product with Zinc and it is used in high-end
appliances, office equipment, and automobile exteriors.

Electrical Steel Plates- Electrical steel plates are made by adding silicon in molten steel and find
applications in transformers and motors.

Wire Rods– When a billet is above 1000 degree Celsius and passed through a hole, it turns into a wire
rod which is used as automobile tire cord, wire for bridges etc.

Stainless Steel- Stainless Steel plants in steel industry are equipped with the additional production
facility. Nickel and chrome are added to steel to produce stainless steel products which are used in
kitchen appliances, medical equipment, exterior walls and roofs of the building.

Steel Making Process from Start to Finish

Factors Affecting Profitability of a Steelmaker

Steelmaking requires iron ore, metallurgical coke which is also called coking coal and limestone as input
ingredients, out of these three essential raw materials India is self-sustaining on iron ore and limestone
whereas about 85% of coking coal requirement of the domestic steel industry is being met through
imports.

What Does it Take to Produce a Ton of Steel?

Typically, it takes 1.6 tonnes of iron ore and around .450 tonnes of coke to produce a tonne of pig iron
or hot metal, the raw iron that comes out of a blast furnace.

Chinese Hammer

Raw material price volatility along with dampening demand for Indian steel because of Chinese imports
has taken our companies for one great ride of losses and has caused huge NPA’s problems for our state-
run banks.

Even after imposition of various tariffs by Government of India on cheaper Chinese imports, Indian
companies have to still battle the raw material price volatility across the globe, these price swings of
essential raw material like coking coal act like a hammer on the bottom line by further squeezing it
down.

What to Look for in the Financial Statements/Notes of a Steel Company?

Generally the entire financial storyline in a steel company revolves around the prices of coking coal and
iron ore as raw materials and the top line in a steel company depends on prices per ton of steel as
driven by market forces, the producers are in no position to set steel prices nor in a position to negotiate
on raw material prices from the suppliers, this puts margin/profitability under pressure. However,
procurement strategies and continuous cost reduction strategies can help a company to maintain
reasonable profitability in volatile market conditions.

Tata Steel – A Disciplined Steelmaker

The following table displays cost breakup in Tata Steel, an efficient player in the industry, Tata steel has
has been able to establish backward linkages in terms of procuring iron ore from captive mines and
fulfilling 35% of its coking coal requirement from captive and domestic sources, which helps it to bring
down raw material expense significantly compared to its peers.

Coke Expense and Currency Depreciation

A lot of money in a steel industry goes towards buying (coke) and this is not in control of the Indian
steelmaker because India is deficient of coking coal required for steel making, which it imports from
Australia, with huge coking coal imports, the steelmakers pay the suppliers in USD and a depreciating
rupee versus USD squeezes the bottom line further.

How can a Steel Maker Optimize his Profits

 Modernise the Blast Furnace operation in order to reduce power and fuel cost.
 Focus on backward integration for raw material security with special focus on coking coal
procurement strategy.
 Bidding for Iron ore mines in India during auctions in order to reduce iron ore cost and they have to
see that they don’t get drifted in the auction causing financial damage in terms of undercutting each
other.
 Investing in slurry pipeline projects to reduce freight cost, slurry pipelines can be constructed end to
end right from the iron ore mine to the steel plant.
 Staying lean all the time (hiring right).
 Focus on making premium products like stainless steel (utensils) and flats.
 Focus on building a brand in the consumer space, Tata steel has done a commendable job in brand
recognition, see below image-
Parameters to Judge/Analyse a Steel Company

Building and Infrastructure form the biggest Chunk (50%) of the steel demand in India and hence this
is the biggest demand driver in Indian Steel Industry. Housing has been growing at a steady pace. The
infrastructure sector adds to the much-needed growth pushed by the Government. So one needs to
judge uptick in demand.

Demand Scenario

 As a metric, check housing and infra sector expected demand growth

 Check whether the company has maintained or increased its market share with respect to the
overall demand.

Prices

 Are prices of the steel industry in the overall market heading up or down in the foreseeable future?
 Whether the company has a premium product in the portfolio which helps it to distinguish from its
peer in the marketplace.

Lowest Cost Producer

In a commodity type business, the low-cost producer wins. This is because the low-cost provider has
larger profit margins, which gives it more freedom to set prices at levels that drive out the competition.

In order to be lowest cost producer, the company must constantly make manufacturing improvements
that will keep the business competitive, this will require additional CAPEX, which tend to eat up earnings,
which might otherwise have been spent on new product development or acquiring new enterprises-
expenditures that would have increased the underlying value of the company.

Continuing with our study on steel, we are now publishing a video summary [ How The Indian Steel
Industry Works, Current Scenarion & Outlook ] on recently held Symposium on Steel in New Delhi, it
was organized by SIMA (Sponge Iron Manufacturers Association) in association with Centrum Capital.
It saw participation from the ISP (Integrated Steel Players like SAIL, JSW etc) and Secondary Steel
manufacturers (DRI, IF, EAF route) as well as Government Official representing the Ministry of Steel.

If you missed part 1 of the series, it is highly advisable to read it first in order to better understand the
industry.

Part One Link- https://www.alphainvesco.com/blog/steel-industry-in-india/

We have tried to be descriptive at the same time crisp in order to save a lot of time on hearing the hour-
long video’s.

Our video summary on Mrs Aruna Sharma (Steel Secretary) is of paramount importance because her
stance throughout the event showed confidence and a feeling of commitment from the Government.
Steel Secretary Aruna Sharma – Your Money In Steel Sector Will Not Sink

Video Link: https://youtu.be/pBfz9GBbzj0

She began her presentation by saying that the presentation is targeted to all holders of funds who have
not thought of investing into the steel sector. She further added that it is her responsibility to showcase
all opportunities that lie in the steel sector.

GOI has come up with two policies, NSP (National Steel Policy) and Mandatory Procurement of Steel by
the Government and its Agencies for steel made in India for all their investments. This robust support
by the govt will ensure that major tenders go to domestic steel manufacturers and it will also make FDI
go up.

She said that the share between MSME and ISP will not change much, keeping a target of 300 mt in
mind by 2030, currently, ISP’s (SAIL, Tata Steel, JSW etc) have close to 40% share in the steel sector and
rest is divided among the MSME or secondary steelmakers.

India already has 126 mt of installed capacity and in Fy17-18 the steel ministry expects 80-85% of
utilization.

SIMA – Sponge Iron Manufacturer Association, link – http://www.spongeironindia.in/, go through

the member area.

Further, the hon secretary talked about MSME Definition for Steelmakers to change from the general to
a specific where a steelmaker should have a CAPEX of at least 2000 crore and turnover of 1000 crore,
this categorization will give a boost to investments happening in MSME sector.

Domestic steel consumption has already gone up by 4.3 % in the first quarter. She further stressed on
the pace of growth the country has seen in the recent past with consumption rising from 60 kg per
capita to 64 kg’s and she did pointed out that it took 7 years for india to rise from 50 kg per capita to
60 kgs per capita and only 1 year to touch 64 kgs.

Rural consumption has only been 10 kgs per capita and now companies like Godrej are coming up
innovative steel products to boost steel consumption along with industry incumbents like SAIL, JSW,
Tata steel etc.

She then listed out bullet points to describe how the steel sector would be made stable for next 10 years
by bringing input cost lower and help it to come out of the cycle-

1. For coking coal, the ministry has already disaggregated the coking coal auction from normal coal
auction, and now it is with industry to react to it. Earlier coking coal was being sold with normal coal
and going forward they hope to reduce coking coal import dependence by 20% from current 85%
but she did say we as a country are not blessed by high-quality coking coal.
2. Washeries have been permitted. Washeries are basically used to reduce ash content in coal which
helps in a gain of Heat Value of coal.
3. Further coal ministry has also disaggregated sponge iron auction for coking coal vis-a vis for power.
Sponge iron manufacturers are able to bid separately for coal auction.
4. Iron ore and Pellets – The biggest breakthrough has been the permission given by the railway to
construct slurry pipelines along the rail lines and this will bring down the cost of fines from Rs 400
to Rs 50 and it will be reflected in the logistic cost of steelmakers.
5. With increased focus on slurry pipeline construction and heavy export duty on iron ore, pellet makers
need not look back.
6. NMDC and Railway have shown interest in investing in slurry pipelines for fine transportation as it
would help them reduce wagon making cost. Private steel makers like JSW and Essar steel have
invested in slurry pipeline projects.
7. Iron ore Pricing- Iron ore is deregulated and with the supreme court judgment, the ministry has an
opportunity to rewrite the MMDR Act and intervene into the rules of MMDR Act (Read it Below).
A report has to be formulated by the end of October, and ministry is confident that whatever new
regulation comes up, it will only ease the 2020 iron ore mine auction and this will make iron ore
price more predictable.
8. Natural Gas- Natural gas has been in contention for a very long time and natural gas is important in
the manufacturing of high-quality steel like- auto steel and also the secondary steel makers
manufacturing through the DRI route or pellet manufacturers are looking ahead for natural gas
availability. Natural gas is going to come up in the GST regime very soon and the moment it comes
in GST regime, it will come down to 5% rate under the New GST regime.
9. Availability of natural gas at an Affordable and Assured cost is being negotiated with the ministry of
petroleum and natural gas. Affordable rate of $5.41 has been worked out by GAIL India, which is
quite reasonable.
10. Cost of Power- Government of Punjab has come up with a policy to make power available at Rs 5
per unit to steelmakers specially to secondary steel manufacturers.
11. Import Duty- The ministry is trying to do away with import duty on coking coal, because of very high
duty revenue collected of the order of 800 crore, the department is a little shy to do away with the
revenue entirely but talks are on. If the Revenue Department sees additional revenue flowing into
the accounts of government after the GST implementation, then they will not shy away from doing
away with the import duty.

MMDR Act

Aruna Sharma addressed the mutual funds and said that your exposure to the steel sector is negligible
and further you are flushed with funds in the recent past as people are shying away from fixed deposits.
She said that mutual funds have the wherewithal to go through the phase of equity.

She assured that the steel sector is one sector where your money is not going to sink, a majority of the
plants are EBITDA positive in the range of 20 plus Percent, the worst Bhushan steel is at 23% and Essar
and Electrosteel are also at 20%.

In her view, the balance sheets are highly leveraged but assured steel sector will be resolved quickly.
Mutual funds capital will be safe provided it is given at an affordable rate of interest, you cannot be
erratic about the interest rates especially with a sector like steel where the prices have to be on par with
the international prices.

It is capital intensive business and she made a statement that 17-18% EBITDA is something the steel
sector can always guarantee, it will never come down below 18% EBITDA, with such an EBITDA your
interest rates cannot be more than 7%. More than 7% interest rate is not at all sustainable and in order
to pay 8-9% of interest cost steel makers EBITDA has to be 21-23% which is very difficult.

Ministry has a whole is trying to increase the domestic consumption so that realization is more and
more.

Government hopes the steel capacity in the country will touch 150 mt by 2020 from the current levels
of 126 mt and to touch 300 mt by 2030 will depend on two factors –

 Domestic consumption

 Rate at which credit will be made available to the steelmakers

Ministry is pushing to increase per capita steel consumption in the country but the credit terms
is in the hand of the lenders (banks and funds).

The NPA in Secondary Sector is less than 10% and exposure of credit to secondary sector is very low
and we are talking of plants with less than 5mt capacity, you can imagine the credit exposure needed
for secondary sector because we have 11 clusters in the country contributing 55% of 85 million tonnes
and going forward it will continue to provide the same. She said this to the bankers and lenders to make
fund flow easy to this sector and make it the topmost agenda.

So lenders should not ignore this sector specially the mutual fund lenders, who are flushed with funds
and they should provide funds to the ISP’s and Secondary steel manufacturers at 6-7% rate of interest.

Quality of steel produced by the secondary steel makers is of the highest standard because the steel
ministry has the highest BIS standards (33+3) and few more are in the offering and it is applicable to
all manufacturers, so in the sense that secondary sector steel quality has been taken care of, they cannot
produce substandard goods in the market.

BIS standards for steel

Aruna Sharma stressed again on the bankers to help in easy fund flow to the MSME’s and
secondary steel manufacturers, she pointed out that it takes 2000 crore/million tonne for
secondary sector to make a steel plant whereas an integrated plant (SAIL, JSW, Tata steel)
requires 6500 crore/ million tonne.

She stated “ This is one sector for 10 years I can guarantee is not going to look back”, and it is
upto to you to join the celebration and join it to give a boost also.

During the Q&A, one gentleman asked the Honorable Secretary to express views on the MSME
sector regarding quality standards, pollution etc, and in reply she repeated that the DRI route
(secondary sector) if you compare with the Blast Furnace route (ISP) is less polluting and with BIS
standards in place you can ensure high-quality steel also. The Secondary sector will be able to
compete on all tenders along with the ISP and would not be left behind for quality and pollution
norms. You cannot have only ISP fulfilling the much-needed capacity of 300mt by 2030.
Secondary sector by definition includes all plants (intermediary or ISP) with a capacity of less
than 5mt per annum.

Credit exposure to the secondary sector as a whole has been low and time has come to look upon
this sector and this was targeted to the fund houses sitting in the auditorium.

One gentleman from the audience representing the Raipur cluster which has about 300
manufacturers and a cluster capacity of 5 mt of steel said that currently the small steel makers
who add so much to the employment are rated BBB rated because they do not have captive iron
ore mine, and in last 10 years in the downcycle about 80% of the small steelmakers have not been
rated below BBB and that’s commendable.

The gentleman believes the secondary steel makers will get greater push once the MMDR act and
iron ore pricing issue resolves. He spoke a great length on non-coking coal resolution, (1:00:56)

Non-coking coal- the issue has been resolved, 25% of non-coking coal has been reserved for the
secondary sector and of that 25%, 10-12% is consumed by the secondary steel sector, which they
use for captive power generation and sponge iron making (DRI route). The secondary indian steel
sector is free of imports issues.

She made assuring statements on land bank availability across the country and mentioned that the crux
would be the linkage of iron ore mine to the steel producing plant and in the new MMDR policy they
are discussing separate auctions for the miners (NMDC) and end users (steelmakers like SAIl, JSW etc).

On a question on anti-dumping duties and MIP (Minimum Import Price) on steel imports, she clarified
that MIP’s are temporary in nature whereas anti-dumping duties are long-term measures and right now
there is an anti-dumping duty on 124 items and would continue for the next 5 years and can be
extended further if required.

The next video summary covers views of Chairman of the largest PSU bank in the country – SBI.

Arundhati Bhattacharya – Steel Sector Should Not Expect Any Interest Rate Cut

Video Link: https://youtu.be/8B7w1rUra3g

The session was essentially about cost of capital, the moderator of the session Mr. Saraswati Prasad who
is the financial advisor to the ministry of Indian steel industry kicked started the session by highlighting
the CAPEX required for a 1 million tonne capacity expansion which is of the order of Rs 6,500 crore and
interest cost prevailing today at full capacity utilization is Rs 6,500 per ton.

Mrs. Bhattacharya in defence for all banks clearly said that interest rates are a bugbear for all borrowers
and interest that banks pay to depositors is bugbear for all banks, and in a country like India banks are
de facto social security net, which essentially means that a lot of Indians after they retire live on interest
they receive on deposits they made to the banks.

In a country like India, a bank procures its resources (money) from individuals in the range of 97% unlike
the banks in developed countries where resources of a bank (money) come from both deposits from
people and markets.
So when the central bank lowers rate (REPO rate cut of the RBI) and if you are an overseas bank in the
US, you are able to transfer the benefit to the borrowers by reducing cost of capital but in India where
97% of resources are from deposits, you are not in a position to reduce the cost of capital in line with
the REPO cut because your depositors will flee away, so whatever cut you see from the banks is only on
the 3% of the resources sourced from market borrowings.

Only fixed deposit interest rate cuts are in line with the REPO rate cut by the Central Bank and the banks
have brought it down from the high of 9% to 6% today, now if you bring it down further than you are
adding catalyst to the agitation of the people who see banks as villains of peace.

This gives an understanding why you should not expect significant interest rate cuts for any borrower
in India (steel, cement, Infra, real estate etc).

Mrs. Bhattacharya said that on a home loan portfolio the bank is able to give 15 years to 30-year loan
at 30 bps above the MCLR rate but for steelmakers, i am giving at a much higher rate, why is that? The
reason is very simple, for the home loan portfolio, the NPA rates are 0.54% whereas NPA’s in the steel
sector are as high as 19%.

She further said that NIM (Net Interest margin) of SBI is in the 2.5% range and if the NPA’s in the home
loan portfolio are in the .5% range, the bank still makes a 2% profit.

She agreed that, there was a time when the PSU banks were seen as pillars of growth and pseudo-
Government Entity but it was long back, today PSU banks are told that if you need capital, you better
earn it by showing us that you are efficiently using the existing capital.

And even when you think of raising capital from the market you are questioned on exposure to various
sectors and remedies employed to deal with the huge NPA mess in the steel sector.

She however regarded the steel industry to be an important pillar of the economy in terms of
employment generation, especially by secondary steel producers.

So how should we go about meeting these challenges (NPA, cost of capital, cyclical downturns etc)

She then talked about ways which could help the Indian Steel industry-

1. Margin Expansion – Because of wafer-thin margins the industry is not able to support itself in a
downturn.
2. Transparency – Transparency of data is another issue which she believed should be looked into, she
said that there is a lot of fudging happening and this is one reason bankers have stopped trusting
the steelmakers.
3. Equity Infusion – More equity infusion has to happen in the industry because without it you will go
down in the downturn.
4. Business Model – Have a business model which shows that you have enough margin to undertake
some R&D because it is a problem of the industry that it is very slow in modernizing itself.
5. Modernization – Modernization of plants is of paramount importance.
6. Collaboration – Collaboration of smaller units to take advantage of each other’s strength. Smaller
units can collaborate on R&D, marketing etc.
Steelmakers can ask the govt for help not on interest subsidy but on things like giving Infrastructure
status to the industry, which would essentially help the steel manufacturers to raise capital for longer
terms.

She however stood firm on the fact that don’t expect interest rate cuts for your Industry, it won’t happen.

She showed her belief in the upside of the industry and said that we have to look into matters which
are holding back this industry.

On a question from the audience on how would banks come out from the mess? Mrs. Bhattacharya said,
there is a significant difference between the earlier cycle and this cycle-

1. Anti-Dumping duties are in place

2. Quality Control Certifications on Imports are in place

These initiatives are of paramount importance according to Mrs. Bhattacharya to support the industry.
Other positives by the govt are initiatives to increase the usage of steel in the construction of houses,
roads etc and preference is given to domestic steel manufacturer for tenders.

She said we are comfortable in providing you loans on condition that you have to show up in your
conservative business model that in spite of all the difficulty, you have margins in the business which
will enable you to withstand downturn and improve efficiency and if this behavior can be shown by
smaller steel manufacturers then banks have no issue and will support the industry.

Today the steel industry is at the mercy of Iron ore miners and coke miners in Australia, she wanted
more collaboration there, she however pointed out that initiatives like “Reverse Auction” are in place
but the players are killing themselves by bidding aggressively to win the mine that it becomes
uneconomical for them to extract minerals.

She is banking on an uptick in demand for this steel cycle to revive.

One gentleman in the audience threw light on industry dynamics and said that if the power cost is
reduced by Rs 1 per unit, then this saving adds Rs 1000 extra EBITDA to every ton of steel produced (37
min, see video).

Another Gentleman in the audience spoke about Banks recovering their due interest from the
manufacturers by giving Loans (fresh loans) and then withdrawing money from the freshly infused
capital to recover the due interest and then show it as a profit-making business in the books. (41 min,
see video)

To this blame Mrs. Bhattacharya said that the moment we infuse capital, our meter starts running and
if you have a time overrun, you will definitely have a cost overrun, cost overrun is the interest expense
and the inflation and if you have a delayed project of 3 years, you will have a stressed project and the
bank cannot turn off the interest meter. (43 min, see video).

A very interesting question came from the audience on the ‘Credit Appraisal’ mechanism by rating
agencies, the gentleman said that currently rating agencies have rated secondary steel manufacturers
(IF, EAF, DRI) BBB just because they don’t have captive iron ore and coke mines but the secondary
manufacturers don’t actually need captive mines, and this norm of the credit appraisal makes them to
pay higher interest for all their borrowings. (48 min, see video).
Mrs. Bhattacharya also stressed on the steel manufacturers to bring down the receivable days as it would
be an efficient use of capital and bring down the cost of capital.

Mrs. Bhattacharya throughout the session sounded tough on steelmakers and continuously spoke of
challenges lying in front of the banks for cleaning the NPA mess especially from the steel sector.
Indian Cement Industry
(Ashwini Damani)
Understanding How The Indian Cement Industry
Works
Posted on June 8, 2017Author Ashwini Damani

In this post, Ashwini Damani & Pradeep Jaiswal write on how cement industry in india works & what
should be the parameters while analyzing any cement company.

Ashwini is a chartered accountant & CFA. He has worked with Lafarge, one of the largest cement players
in India for more than 6 years. Prior to joining Lafarge, he worked with Ernst & Young, Deloitte. He is an
individual investor based out of Kolkata.

Pradeep has worked with Lafarge for more than a decade. He is hands on with Indian cement sector
dynamics. Pradeep is a chartered accountant & based out of kolkata.

Cement Industry in India

Basics of Cement Industry

Cement can be sold to two sets of customers

 Retail Customer – Trade Segment – Has Higher Margins

 Infra Customer – Non Trade Segment – Has Lower Margins

 As far as the retail customer is concerned – cement is a push market industry – so whoever is able
to push its product first to the customer, will be able to successfully sell it.

The reason being – at the end Cement is a commodity. A layman doesn’t differentiate between different
brands. The lead sales influencer is the mason and the shopkeeper.

He goes to buy Cement only when he immediately needs it, and will buy whichever is immediately
available. So it is important for a manufacturer that he is able to successfully push his product on the
shelf of shopkeeper (ship it on time) and incentivise the shopkeeper enough (discount and commission)
so that he sells your product.

 Sales Price is determined based on demand and supply. It’s a dynamic pricing market.
 Cement is a bulky material – hence handling this bulky material takes a lot of effort. It occupies a lot
of space and carries a lot of weight. Hence higher the distance a cement bag travels, higher is the
freight and handling cost involved and lower is the profit a manufacturer makes.

Therefore it is important that the manufacturer keeps his production unit as close as close as
possible to the end customer.

 Cement is basically is made by heating limestone (calcium carbonate) with small quantities of other
materials to 1450°C in a kiln. The resultant hard material which is recovered after heating limestone
and chemicals is called ‘Clinker’.
 Clinker looks like small lumps. These lumps are crushed with a small amount of gypsum into a
powdery form – which gives the final product – ‘OPC Cement’.

So in essence following components are compulsory for making OPC cement

 Limestone – Natural Reserve, extracted or mined from Mines

 Heat – requires heat of 1450°C , ideally obtained from Coal or its variants.
 Gypsum –a mineral compulsory for providing the binding nature to cement

However with time, people figured out that limestone can be substituted with other materials namely
Flyash or Slag, which will still provide the strength but to a lesser extent. The threshold limit of mixing
Flyash is maximum 33%

For big infra projects, limestone component of upto 95% is required, but for the daily homebuilding
use, the lower component limestone works fine enough.

 Thus, there are various varieties of Cement depending on the composition of materials, namely OPC
(Ordinary Portland Cement), PPC (Portland Pozzolana Cement) and PSC (Portland Slag Cement (PSC).

Items OPC PPC PSC

Clinker 95% 65% 45%

Gypsum 5% 5% 5%

Flyash – 30% –

Slag – – 50%

Total 100% 100% 100%

Margin profile for Lowest Margin Highest Margin

Higher Margin
manufacturer

 Flyash is a by-product of Thermal Power Production. Most power producers want to dispose of fly-
ash and one of the ways is by selling it to cement manufacturers who can substitute it for lime-
 stone in the cement making process. Similarly slag is a by-product of Steel making process and is
often sold to cement makers as a substitute for lime-stone in the cement making process.

Cement manufacturers often try to keep their plant near to a power plant, because neither slag nor flyash
can be transported across long distance. You have to be near to a steel or power plant to use Flyash or Slag
in the production process.

Cost Structure Of A Cement Company

*Please note that the above rates are indicative and can change if the Market or the product is
different.

So If A Cement Bag of Rs. 350 Rs is sold

 Indirect Taxes levied by the government form almost Rs. 75/ bag – Not to mention there are other
taxes which are levied during the manufacturing stage such as Entry Tax, Cement Cess, Royalty etc
 Dealer Margins typically are around Rs. 40/Bag (Rs. 25 as discounts and and Rs 15 as markup to
customer)
 Handling of Finished Goods costs almost Rs. 50/Bag
 Manufacturing Cost is almost Rs. 155/Bag
 In the end, a manufacturer earns Rs. 30/Bag on a Cement Bag which has MRP of 350
How Does A Cement Manufacturer Optimize His Profits

 Given the fact that it is a commodity industry, with little or no differentiation in the end product –
how does one manufacturer make a higher profit than his peers? Well let’s look at the formula

Sales – Govt Taxes – Discount – Freight – Manufacturing Cost = Profit

How To Maximize Sales

 So basically a manufacturer has to ensure that he realises maximum sales price. This he can do by :
 Selling in markets with Best Prices – Demand Supply Mismatch creates better. If competition sets
up a new plant in your market, the mismatch reduces and price falls.
 Trying to sell high margin products such as PPC and PSC – You have to be near the source of
Flyash or Slag to be able to do this
 Higher Volumes – Better the demand in the market , higher the volumes
 Better branding – Since it is a commodity – You need to ensure that brand recall is high when
customer goes for buying the product.
 Set up additional capacity
 Maintain the quality of the Product, Home building services
 Incentives schemes for Clearing and Forwarding Agents and Dealers

Manufacturing Costs

Limestone

 To make cement you have to first make clinker.

 So a plant has to first make Clinker
 Then Grind the Clinker with Gypsum to make Cement

 Limestone is the pre-requisite to make Clinker. Limestone is extracted from Mines. A company that
has its own mines is at an advantageous position than the one which doesn’t have mines. Limestone
cannot be traded, so a company which has no mines cannot make clinker.
 However limestone is a natural resource and more than 65% of India’s limestone comes from five
states of Madhya Pradesh, Rajasthan, Andhra Pradesh, Gujarat and Chhattisgarh.
 So companies have two options
 Make cement in the areas where limestone is available and the ship the finished good to those
parts of country that want cement, or
 Make only Clinker in the state where limestone is available, and then do the grinding of clinker
in the region which requires cement.

A unit which does both grinding and clinker manufacturing is called an Integrated Unit. A unit that does
only grinding work is called Grinding Unit.

 It may so happen that a company makes Clinker and directly sells it to another player who dies, but
these situations are rare.
 Mines are normally allotted through government auction and are leased to a company for time
periods extending upto 99 years. After expiry of the lease term, the mines are again re-auctioned.
Some companies like ACC have old legacy mines, allotted in 1960s with lease period of 99 years.

It also depends what amount of limestone reserves you have in the mines. Higher the reserves in your mines,
better the prospects of your plant. Typically 1.5 Tones of Limestone, gives 1 ton of Clinker. Output from
Clinker to Cement, depends on the blend of cement being manufactured (OPC, PPC or PSC)

 If the quality of limestone procured from mines is not of correct quality, then a company has to
add chemicals (Correctives) to make Clinker of desired quality.
 Note:

– Since mines are allotted by Government, they typically give a right of mining (by charging a hefty sum).
Companies capitalise this amount as an Intangible Asset. Hence an analyst can quickly check the Intangible
Assets Section in Balance Sheet to know if a company has a limestone mine.

– This Intangible is depreciated on the basis of Quantity of Limestone extracted as a proportion of Actual
Quantity of Reserves existing. So an analyst can actually do a reverse calculation to judge the life and quantity
of reserves a company has in their mines.

Heat

 High Temperature heat is the next biggest requirement in the manufacturing process
 This high temperature can ordinarily be obtained only from Coal or Petcoke.


 Coal can be procured from open market – generally costly, or
 Cheaper coal can be obtained through Government tendering – government rations a quota of
cheap coal to each industry, or
 Petcoke can be substituted for coal – which is less costly than Coal – but reduces the life of plant
– and increases maintenance costs
 Use of Alternate Fuel and new trend in the industry, like Rick Husk, Liquid Solvent, TDI Tar, Etc.
 Waste Heat Recovery is a mechanism which can lead to huge cost savings in Fuel cost.
Parameters To Judge / Analyse A Cement Company

Housing forms 65% of the cement demand in India and hence this is the biggest demand driver.
Housing has been growing at a steady modest pace even during lean period. The infrastructure sector
adds or restricts the much needed growth.So one needs to judge uptick in demand and more
specifically, the demand supply mismatch in the Micro Market where the Cement player is located.

Demand Scenario

 As a metric, analysts should check the expected demand growth in the micro market and if anything
is being done on housing or infra sector in the micro market, which can provide boost to volumes.
 Whether competition is setting up new capacity in the company’s region of operation? It is normally
observed that whenever a new player enters the micro market, they capture market share (through
better incentives) thus restricting volume growth of existing players.
 Whether the company has maintained or increase its market share, with respect to overall demand

Prices

 Are the overall prices in the company’s micro market, headed up or down?
 Whether the company has a brand good enough to charge premium pricing.
 Utilisation levels drive the price hikes – Sustainable price hikes hinges on high utilization level. Once
the utilisation level starts touching 80%+, the cement manufacturers start getting a lot of pricing
power. Optimal Capacity utilisation can only be driven by high infrastructure demand.

EBITDA/Tonne

The best metric to measure the profitability of a cement company is EBITDA/Ton. Most corporate deals
also use this as a measure of payment, and management too uses this metric to judge performance.
EBITDA/Ton is a result of lot of small things done right. It starts from better pricing power and ends at
better raw material costs and better overhead absorption. The following factors generally drive
EBITDA/Ton

 Whether company has better access to key raw materials viz Limestone, Coal, Petcoke, Flyash, and
Power. If a company has captive access to any or all of these factors, its cost of production is reduced
and realisations improve.
 Whether company is enjoying and Government incentive schemes and for what tenure
 Cost effectiveness in Power and Supply Chain Management.
 Larger the player, higher is his bargaining power with suppliers. So one should judge whether the
company is big enough to negotiate better with vendors.

An analyst should basically check, how much EBITDA growth does he expect and what is the market
building in?
Why Balance sheet Of A Cement Company Is Important

 Cement is a capex Heavy Business. The ROAs of a cement plant is close to 1. So a Cement plant with
5000 Crores of Capex can typically do a turnover of 5000 Crores only.
 Hence it is important, that not only does the company set up a plant in the best market (which offers
best prices), it should also ensure that cost of setting up the plant is cheapest.
 Further since the Cost of Setting up a plant is high; it can either be done by
 Taking debt or
 Through Internal Accruals

In both the cases, it is important that company should generate enough Free Cash Flows else they will
not be able to service the debt or set up additional new capacities in future.

 Size and spread of a company also matters because

 It allows a company to negotiate better with suppliers,
 More a company is spread across India, more can it minimise the freight costs and serve a higher
market – thus creating a even bigger brand.
 Working capital management and cash from operation are vital metrics to judge in this regard
JPC Report On The Steel Sector, 2017 – Snapshot
Posted on December 21, 2017Author Zain Iqbal

JPC (Joint Plant Committee) is the only institution in the country which is officially empowered by the
Ministry of Steel/ Government of India to collect data on Indian iron and steel industry and post 1992
it molded itself into a facilitator for the industry.

In the following article we are briefly touching upon what steel production India achieved in various
categories (BOF, EAF/IF Routes) in 2016-17 and what were the capacity utilization of top companies in
the sector as per the JPC committee. This will be a data heavy read, so buckle your seats belts.

Crude Steel Production And Capacity Utilization

India’s total hot metal production for the year 2016-17 was at 128.28 mt and after refining it we
generated crude steel of 97.94 mt, now when we say crude steel capacity and production, we do not
include companies which sell pig iron and sponge iron (DRI) to customers, we only include companies
which make end steel products (alloy & non alloy finished steel).

So when we calculate the capacity utilization we find that on an average the utilization of capacities in
the steel sector was at 76% which has marginally improved from the previous number at 74% in 2015-
16.

If we see the share of crude steel production by process (Basic Oxygen Route, EAF and IF) we find the
following breakup as given in the pie chart.

Public and Private sector companies shared 19:81 of the crude steel production in 2016-17 with SAIL
and RINL producing 18.46 mt and the rest was produced by the private sector.
Pig Iron

Pig iron production for sale was 9.39 mt and one should remember that pig iron is an intermediary
produced when you produce crude steel. Some companies like Kirloskar Ferrous and Sathavahana Ispat
do not further process this intermediary and sell it to various foundries. For these pig iron producers it
is their finished product, JPC committee separately accounts for the pig iron produced and sold by these
companies. Domestic consumption of pig iron stood at 9.04 mt for the year 2016-17.

Sponge Iron

Domestic Production of sponge iron (DRI) stood at 28.762 mt, one should remember that sponge iron
is further processed into steel in an EAF or IF furnace, the reason companies produce sponge iron is that
it does not require coking coal as a raw material which we heavily import and is very expensive, it
requires non coking coal or natural gas available in India and various reducing gases like Carbon
monoxide and hydrogen.

Currently non coking coal route accounts for 23.91 mt or 83% of 26.76 mt of the total production on a
capacity of 46 mt. Government is trying to push the production of crude steel via the DRI route as it
saves a lot on the forex, and in order to achieve this the government has already taking measures to
conduct non coking coal auction separately for the DRI producers which was earlier being amalgamated
with the power companies. The government is also trying to provide predictable and consistent supply
of natural gas for the producers.

Finished Steel Share Among Companies

Total production for sale of finished steel has abnormal division among big integrated players like
(SAIL,RINL,JSW, JSPL,TSL and ESSAR) and various other companies as shown in the pie chart below.

In the non alloy category we saw bar & rods consumption at (34.9mt), HRC at (24.12 mt) structurals at
(7.98 mt), GP/GC at (7.7 mt) and finally CRC at (8.56 mt).
Import & Exports

Although India is the third largest producer of steel but we used to import a significant quantity up until
2015-16 when the ministry imposed anti dumping duties and imposed Minimum import prices on
various steel products for the safeguard of the domestic industry from the cheap Chinese imports. With
these safeguard measures in place, India became a net exporter of steel in 2016-17 with exports being
8.242 mt and imports in the range of 7.226 mt.

China continued to be the largest supplier of steel and our largest export market was Belgium.

Availability And Consumption Of Finished Steel (Alloy And Non Alloy)

We saw a production of 91.13 mt of non alloy steel and simultaneous consumption of 76.96 mt. On
the alloy steel we saw a production of 9.65 mt and simultaneous consumption of 7.07 mt. One should
remember that alloy steel encompasses steels like stainless steel, electrical steel, special steel, ferro-
chrome steel etc whereas non alloy steel is rest of the steel consumed whether it be long or flat like
TMT, HRC, CRC, GP/GC etc. The bar chart below shows the breakup of it.

Iron And Steel Industry Capacity Utilization Process Wise

Currently we see that the demand for steel in the country is slackening and we see a lot of idle capacities
across the spectrum of the industry, Ministry of steel has an ambitious target to achieve 160 kg of steel
consumption per capita by 2030-31 and for this the first step is to run these plants at close to full or
beyond full capacities. The following table shows where all the laggards are in terms of capacity
utilization.
Category Wise Gross Production Of Steel In 2016-17

Non Alloy Net Production Of Steel 2016-17

In the non alloy category and further into the non flat sub category we saw the highest net production
for bars and rods (34.95 mt), structurals at (7.9 mt) and finally rails at (1.1 mt).

If we further look into the non alloy category and into the flat segment we will find a whole variety of
products sharing the space right from plates (4.71 mt), HRC (24.11 mt), CRC (8.56 mt), GP/GC (7.74 mt),
Pipes (2.1 mt) etc.

Please refer to the table below for details for the year 2016-17

Non Alloy

Likewise we have the Alloy category of steel which also has sub categories of flat and non flat and a
total production of 8.45 mt including the production of stainless steel which is used in producing utensils
and various other sophisticated tools.
The table gives an overview of net production of alloy steel in India in the year 2016-17.

Production Of Steel Route Wise Among Companies

One should keep in mind that large integrated steel players prefer BOF route of producing steel where
they start from the very basic raw material that is iron ore and coke and further process it into iron and
then into steel by refining it further, large integrated companies prefer this way even though it is capital
intensive is because it produces the finest quality of steel and you get into a position to serve large
demands. These plants are generally integrated both backward and forward to ensure raw material
security in terms of acquiring captive mines for iron ore and coke and also producing finished steel in
the form of HRC, TMT etc and not leaving it in mid way in the form of DRI or Pig iron like various other
producers. This integration is less complicated as you have little exposure to supply chain issues from
third party suppliers.

In case of DRI Route or Pig iron, there is one producer of sponge iron who produces sponge iron either
through coal based plant or natural gas based plant, then he supplies this sponge iron to various EAF
and IF mills where this sponge iron is again melted along with scrap in a furnace and heated with an
electrode made of carbon, likewise we continue and produce various grades of steel through EAF/IF
route by alloying it with various elements and we get finished steel product in the form of HRC, TMT,
CRC etc.

It is quite possible that there is a EAF producer who produces semi finished steel in the form of bloom,
billet and slab and leaves it there and sells this semi finished steel to secondary producers in the supply
chain which are the hot and cold rolling mills which then produce finished steel which can be used by
the industry like autos.
This huge supply chain in the DRI route ends up eating all the profits of not using coking coal unlike
BOF route and we find the steel produced through the DRI route equally priced in the market.

The cost of installing the furnaces is low but the long supply chain eats away all the profits.

We Have Put A Table Below Displaying Company Wise Steel Production Breakup-By
Technology
Can Plants Run At Capacities Beyond 100%

Yes Steel Plants can sweat themselves more and run at higher capacities and a lot of big integrated steel
plants are close to touch 100% capacity utilization as of 2016-17 unlike their smaller counterparts who
use DRI technology and they still have to achieve full capacity utilization on the existing capacities.

Very soon India will need additional capacities in the BOF route (SAIL, JSW, JSPL, TSL) and with increase
in interest of GOI for building infrastructure across the spectrum, whether it be railways, ports, defense,
highways, affordable housing etc, we see the demand for steel to rise in the coming years.

Along with the Government’s push to build infrastructure in the country you will see rising demand for
yellow goods and white goods which essentially encompass industrial equipments and heavy machinery
and also demand for white goods like refrigerator, microwave ovens and various other appliance will
rise as our disposable income rises.

Overall outlook looks positive for the steel sector in general but it is important to follow a bottom-up
approach when looking at companies within the sector, one should not lose sight and blindly fall in love
with the sector and buy a basket of companies in it, rather we should all perform all necessary due
diligence with care on individual businesses which are available at reasonable prices & can make most
of the opportunity.
Indian Sugar and Ethanol
Industry
(Keval Shah)
Understanding How The Indian Sugar Industry
Works
Posted on July 31, 2018Author Keval Shah

Indian Sugar Industry – A Brief Overview

Sugar Production Process

Globally, sugar is mainly extracted from either sugarcane or sugar beet. Around 80% of global sugar is
extracted from sugarcane, and remaining 20% from sugar beet. In India, sugar is extracted from
sugarcane.

Sugar extraction process has by-products which also can be sold / processed for additional source of
revenue. The process is as following:

Sugarcane from farmer is crushed to get sugarcane juice and Bagasse as the by-product, which can
further be used in power generation, partly used for captive consumption and remaining is sold. The
sugarcane juice is further processed to get sugar and Molasses, which can either be sold directly or
further processed in the distillery to give Alcohol. This Alcohol can either be Industrial Alcohol which is
sold to Chemical companies for industrial consumption or potable Alcohol (liquor); or Ethanol which
can be used for blending in the fuel. On an average, 95 kg of sugar and 10.8 litres of ethanol can be
produced from 1 tonne of sugarcane.

Sugar Industry

Global Sugar Industry

Top ten sugar producing countries are as following:

Brazil, India, EU and Thailand together account for over 50% global sugar production. India is 2nd largest
sugar producer in the world and the largest sugar consumer country. Brazil is the largest sugar producer
with 50-60% of sugarcane used for production of Ethanol as a substitute for the fuel.

Indian Sugar Industry

Indian sugar industry is worth more than Rs. 80,000 cr (from sugar and its by-products). The Indian sugar
industry supports ~5 crore sugarcane farmers across India and hence has high political importance as
well. Major statistics about Indian sugar industry can be found at the ISMA
website (http://www.indiansugar.com/Statics.aspx). As of 31st July 2017, there are 732 sugar mills in
India with total sugar production capacity of ~34 mn tons of sugar. Roughly 50% of the mills are private.
Indian sugar demand is around 25 mn tons. Indian per capita consumption of sugar was 18.8 kg v/s
world average of 23 kg as of 2016. Total acreage of India is ~47 lakh ha. Acreage of sugarcane crop in
different states is as follows:
Sugarcane Yield : It is the amount of sugarcane grown per unit area of farmland. Sugarcane yield of
Maharashtra (~75-80 tons/ha) is higher than that of UP (~67-73 tons/ha). Indian cane yield is ~70-72
tons/ha.

Sugar Recovery Rate : It is percentage of sugar produced in tons per ton of sugarcane crushed. Average
recovery rate in Maharashtra is ~11.5% v/s. that of ~10.5% in UP.

UP has ~115 sugar mills, with most of them being private mills. Whereas, Maharashtra has more of co-
operative mills. Also, average UP sugarcane crop age is 9.6 months v/s 12.85 months in Maharashtra.
So UP farmers can grow some other crops for remaining time, like Wheat & Paddy. Additionally, UP
cane requires 1/3rd of irrigation water compared to Maharashtra cane.

UP Sugar Industry

UP sugar industry accounts for more than 25% of Indian sugar production and is mainly comprised of
private mills. Out of ~10 mn tons of sugar produced in UP, only 1/3 rd is consumed by the state and
remaining is sold out of UP, mainly to Kolkata and North Eastern market. The cost of production of
sugar is higher in UP than other states in India.

The average per month return (Rs / ha) is highest for sugarcane crop compared to other crops like wheat
and paddy in combination (considering sugarcane is a completely irrigated crop, hence it is compared
with paddy and wheat cultivated as fully irrigated crops). However, sugarcane bears a longer risk cycle
as compared to wheat and paddy due to its duration of ~9-10 months in UP as compared to 3-4 months
for the latter. During 2010, the per month return of sugarcane in UP was Rs. 4,511 per hectare which is
more than the combined per month return of wheat and paddy. The net rate of return (%) is 80% in
sugarcane crop, whereas it is only 29% for wheat and 23% for paddy. Additionally, the Co 0238 cane
variety recently introduced in UP is more profitable for the farmers than the traditional crop, leading to
even higher inclination of farmers towards the crop. Last year ~35% of UP cane land was growing Co
0238 cane variety and by the end of this year ~50% of cane land is expected to grow Co 0238 cane
variety. This would lead to more sugar production from same acreage of cultivation.

Sugarcane Crop And Sugar Demand & Supply

Sugarcane crop is a ‘ratoon’ crop. The new crop is grown from the stubble of the crop already harvested.
So, the life of the crop planted is of multiple years, and generally new crop is not planted in the same
farm area for few years.

There are 3 variants of sugarcane crop in India:

1. Spring crop sown in March

2. Adsali crop sown in July
3. Autumn crop sown in September

Maturity time for adsali & spring crop is 18 months, whereas for autumn crop is 12 months. In India, the
sugar season (SS) is form Oct-Sept. So SS17 means Oct’16 to Sept’17, with harvesting beginning in
Oct’16. Total sugarcane crop production in India is ~300 mn tons.

Sugar Production And Consumption

State-Wise Sugar Production

For SS17-18, UP & Maharashtra produced ~10+ mn tons of sugar each, out of the total ~30 mn tons of
domestic sugar production, accounting for 2/3rd of Indian sugar production. State-wise sugar
production historically has been as following:

Key Variables And Sugar Cycles

Factors Affecting Sugar Realizations In India

Indian sugar industry is highly regulated. Quantity of sugar to be sold and exported by mills is decided
by the government, but at the same time government also bails out the industry with subsidies during
the bad times.

Sugar is a cyclical industry. If one needs to predict the sugar realisation, one should focus more on
supply of sugar than its demand, as the demand is more or less stable around 25 mn tons and is growing
slowly and steadily. ~70% of the sugar demand is B2B (FMCG sector) and only ~30%

demand is from B2C side. It is the supply of sugar which is more volatile and affects the sugar prices.
The same can be seen in the chart above showing the production and consumption of sugar. Eg: In
2016-17, when the sugar production (supply) was 20.3 mn tons compared to consumption (demand) of
25 mn tons, it lead to increase in sugar prices. The supply of sugar depends majorly on the following
factors:
2016-2017 Sugar Cycle

SS16-17 was a cycle when all the sugar stocks (specially UP based) gave multibagger returns. It was a
sweet situation for UP sugar mills as the Maharashtra sugarcane production halved to ~4.5 mn tons,
which lead to national level sugar supply shortage and increase in sugar price, and at the same time UP
had bumper productions, allowing all UP based sugar mills to improve its results tremendously. Entire
increase in realisation trickles down to PBT, as there is no parallel increase in prices, leading to margins
expanding exponentially. The same can be seen through some sugar companies’ reported financials:

Based on the sugar cycles, the market price of the sugar companies also fluctuate, and these price
movements are very quick. One can both make and lose money very quickly by investing in sugar
companies’ stock. Let us have a look at market cap of some sugar companies in past 2 decades. We can
see how market cap have already fallen by more than 50% even before the results of 1 st loss making
quarters had been declared by the companies. This is how much volatile are the prices of sugar
companies’ stock. We can see similar speed and volatility even while increase in stock prices during
industry uptrend.

Sugar cycle in a nutshell is explained by the following diagram:

Sugarcane Prices

From Oct 2009, the concept of Statutory Minimum Price (SMP) of sugarcane was replaced with the ‘Fair
and Remunerative Price’ (FRP) of sugarcane for 2009-10 and subsequent sugar seasons. FRP is the
minimum price that a sugarcane farmer should receive for his cane. Though, some states like UP have
State Advised Price (SAP) which is generally higher than the FRP.

FRP v/s. SAP in UP has been as follows:

Cane Arrears

Cane Arrears is the amount pending to be paid to the sugarcane farmer by the sugar mills. As per rule,
mills need to pay farmers within 14 days of receipt of sugarcane. If failed, interest rate of 15% per annum
is charged to the mills. Higher cane arrears discourages farmers to grow sugarcane in the next season.

By May’18 end, cane arrears had reached over Rs. 20,000-22,000 cr due to dramatic fall in prices on the
back of over production of sugar in this season. This 20,000 cr arrears is staggering ~25% of the total
80,000 annual amount to be paid to the farmers for their cane.

By-Products Of Sugar Industry

Cogeneration

1 tonne of sugar can produce ~300 kg of Bagasse which can be converted to ~130 KWh of power. The
power generated by an integrated sugar mill is partially captively consumed and remaining is exported.
India’s sugar industry has potential to export 7500 MW power, and total installed cogeneration capacity
in all sugar mills is ~4200 MW, of which ~3200 MW is being exported by sugar mills to the grid.
Ethanol

Ethanol is a very key by-product for integrated sugar mills. We will elaborate on Ethanol in detail in
our next blog.

Import/Export Of Sugar

A solution to over production of sugar is to export sugar. Our 2 neighbouring countries, Bangladesh
and Sri Lanka collectively import ~3.5 mn tonnes of sugar annually. Also, India has bilateral and SAARC
free-trade agreements with both the countries. So if India is able to export some amount of additional
production, it can help in stabilising the sugar supply and hence the sugar prices. Currently, the
government has allowed 2 mn tons of sugar export till September 2018 to clear up surplus sugar stocks.
If there is normal monsoon this year (CY2018), leading to production of another 32-33 mn tons of sugar
in SS2018-19, India will have to export 5-6 mn tons of sugar next year.

Rangrajan Committee

The Rangrajan Committee had made salient recommendation to the government in 2012 to stabilise
the sugar industry. The recommendations are as following:
Most of these recommendations have been approved by state governments of Maharashtra and
Karnataka. However, the recommendations are yet to be levied by the UP government.

Recent Regulatory Updates

Recently, due to oversupply of sugar, the prices of sugar have fallen leading to sugar mills selling sugar
at losses and hence the mills are finding it difficult to clear their cane arrears. Cost of production of
sugar is ~32-34 rs per kg (28-23 rs of sugarcane purchase cost and ~3-4 rs of conversion cost), so sugar
mills need to sell sugar at 34-35+ rs per kg ex-mill prices to make profits.

Currently the ex-mill sugar price is 26-27 rs leading to huge losses for sugar companies. The quantum
of loss is such that it undermines the EBITDA level profits from Cogeneration and Distillery division,
leading to even consolidated EBITDA level losses for the sugar companies. The cane arrears have
reached Rs. 20,000 + cr. To stabilize the situation, the government is considering following options:

 Cess on sugar (Rs. 1-1.5 per kg) to create a fund which will be used to clear the cane arrears.
 Production-linked subsidy on cane.
 Reduction of GST on ethanol from current 18% to 5%.
 Creating a buffer sugar stock of ~3 mn tons by the government.
 Fixing minimum ex-mill prices.

Going Forward

There seems to be a possible structural level change in the sugar industry via stable revenue from
ethanol. There is another blog elaborating on this possibility, which I would encourage you to read next.
Ethanol Industry – A Savior For Indian Sugar Mills ?
Posted on July 31, 2018Author Keval Shah

Ethanol Industry – A Saviour For Indian Sugar Mills?

Overview

Ethanol is a very key by-product for integrated sugar mills. On an average, 10.8 lt of Ethanol can be
produced from 1 tonne of sugar. B-Heavy molasses have better yield of Ethanol (explained in detail later
on in the article) than the molasses currently used for Ethanol production.

Ethanol is blended in the fuel to reduce the dependence of the country on crude imports generally, and
also ethanol is a cleaner fuel. ‘E20’ is a term to express 20% blending in the fuel.

India has ~330 distilleries which can produce over 4 bn litres of rectified spirit (alcohol) per year. Of
these, ~162 distilleries have the capacity to distil over 200 cr litres of conventional bio-ethanol. India
produces conventional bio-ethanol mostly from sugar molasses and partly from grains. Production of
advanced bio-ethanol is still in the R&D stage.

To understand the potential of ethanol, let us have a brief look on the Brazil sugar industry initially,
which is considered to have the world’s first sustainable biofuels economy.

Brazil Sugar Industry

Brazil has a sugar production of ~40 mn tonnes and consumption of ~10-11 mn tonnes. Most of the
sugarcane grown is used to manufacture ethanol for domestic gasoline blending and sugar for exports.
Past 4 Decades Of Brazil Sugar Industry

The Centre-South region (CS) constitutes for 90%+ of the total sugarcane production in Brazil. The
sugarcane production in Brazil has become 6x in last 35 years.

Ethanol production was virtually zero in Brazil during 1975. Ethanol production saw a sustainable jump
from ~7 mn tonnes to ~13 mn tonnes during the 1980-1985 period. However, ethanol production was
stagnant in Brazil from 1985 to 2000, after which the ethanol production jumped again rapidly.
We can see a similar trend in vehicular fleet in Brazil. Due to rise in oil prices around 1975, the Brazilian
government introduced ethanol based vehicles from 1980s, which were pretty much in demand, but
started getting replaced by gasoline vehicles around 1990 (probably because of stabilizing of oil prices).
However, there was again huge jump in usage of flex-fuel vehicles post 2004-2005 after another rise in
oil prices, and the flex-fuel fleet count has kept on rising in Brazil since then. Brazil has increased the
E20-E25 flex fuel fleet by over 5 times from 4.6 mn in 2007 to 26.2 mn in 2016, and parallely reduced
gasoline vehicles from 15.1 mn to 9.7 mn in the same time period.

The corresponding movement in oil prices can be seen below:

To encourage growth of ethanol based fuel, the Brazilian government took following steps:

 Guaranteed purchases of ethanol by the state-owned oil company Petrobras

 Low-interest loans to agro-industrial ethanol firms
 Lower excise taxes on ethanol than on petrol
 Fixing of hydrous ethanol prices at 59% of the government-set gasoline price at the pump

Other factors which benefited the growth were:

 Favourable climate
 Land availability
 Abundant low-cost labour

Less than 50% sugarcane is used for sugar production since 2000, with remaining sugarcane used for
ethanol production. The share of sugar from sugarcane over past 15 years can be seen in the following
chart:
Let us have a look at recent financials of a major Brazilian sugar company named Sao Martinho. ~90%
of sugar produced by the company is being exported and only ~10% sold domestically. At the same
time, ~90% of the ethanol produced by the company is for domestic consumption.
India imports 70% of its annual crude petroleum requirement (~110 mn tons). At 10% blending of
Ethanol, 313 cr litres of Ethanol is required. Additionally, 1 mn tons of sugar can be replaced by 60 cr
litres of ethanol. However, currently there is no policy to convert sugarcane directly to Ethanol.

There have been many attempts to stabilise the sugar industry by having a stable ethanol revenue, with
efforts being taken since over a decade. Additionally, our current import bill of crude oil is around Rs. 7
lakh crore, and the government plans to save atleast 1 lakh crore of this amount by shifting to higher
ethanol blending in the fuel. However, the government has not been successful in achieving higher
ethanol blending in the past since over a decade. Recently, the government has made statements on
targeting 10% ethanol blending (also called as E10).

Total Ethanol production capacity in India is 223.87 cr lt per annum.

140 cr lt of blending has been finalized by OMCs for 2017-18, which is highest ever done. At 140 cr lt of
ethanol, the blending would be ~4.5%, which is still way lesser than the targeted 10% blending which
would require 313 cr lt of Ethanol. In 2016-17, OMCs achieved a blend of only 2.3% against the
mandated 5%. However, the 140 cr lt (4.5% blending) being the highest ever blending proposal, there
are hopes that going forward higher ethanol blending targets might be successfully achievable.

Ethanol Generation From Different Sources

1st generation (1G) biofuels are made from sugar and vegetable oils; whereas 2nd generation (2G)
biofuels can be manufactured from lignocellulosic biomass or woody crops, agricultural residues or
waste like rice & wheat straw, cotton stalk, etc.

As the sugar mill’s capacity isn’t enough to supply the required 313 cr lt of ethanol for E10, government
is looking for 2nd generation ethanol production. Steps have been taken in that direction, and OMCs
(IOCL, BPCL, etc.) have already started placing orders for 2nd generation ethanol plants. These 2nd
generation plants will take atleast 18 months to come online. Parallely, some sugar companies are also
increasing their ethanol capacities to benefit from E10 blending.
B Heavy Molasses

Ethanol also can be extracted via B Heavy molasses route to get higher yield of ethanol per ton of
sugarcane. Conventionally, sugar is extracted in 3 stages, with very little sugar left to be extracted after
the 3rd stage. Left over after the 3rd stage is the molasses, which has very lesser sugar content left, and
this molasses is processed in a distillery for ethanol generation traditionally.

As per the B Heavy Molasses route, the sugar extraction process is stopped after the 2nd stage
extraction and the molasses post 2nd stage which are still rich in sugar content are used for extraction
of ethanol. B Heavy molasses has Ethanol yield of over 300 lt per MT of molasses, whereas the yield of
current molasses produced post 3rd stage is 230-250 lt per MT of molasses. Additionally, this process
leads to overall ~2% reduction in recovery of sugar. This can serve 2 purposes: 1) Blending of the fuel
by more ethanol; and 2) Conversion of extra sugarcane to ethanol rather than sugar which helps to solve
the issue of oversupply of sugar during the years of overproduction of sugarcane.

As of now there is no policy in place to extract ethanol from B Heavy molasses. Also, the B heavy route
is not possible from current distilleries. However, minor capex on existing distilleries would make them
capable of extracting ethanol via B Heavy route.

National Policy On Biofuels – 2018

The Union Cabinet, chaired by the Prime Minister Shri Narendra Modi has approved National Policy on
Biofuels – 2018 in May’18. The key points of the policy as are following:

 Funding: Policy would fund Rs. 5000 cr to 2G ethanol bio refineries over 6 years in addition to tax
incentives, higher purchase price compared to 1G fuels. (Note – These steps are similar to those
taken by Brazilian government to support the growth of ethanol as a bio-fuel market)
 Forex Savings: 1 cr lt of E10 would save Rs.28 cr of forex. So with current supply of ~150 cr lt of
ethanol for 2017-18, it will help to save ~Rs. 4000 cr of forex.
 OMC Capex: 100 KLPD bio refinery would cost ~Rs. 800 cr investment. Currently, OMCs are in process
of setting up 12 2G bio refineries with an total investment of Rs. 10,000 cr. This should lead to
capacity addition of ~1200 KLPD.
Brazil is a benchmark for ethanol production stabilizing the volatility of the sugar industry. Can Indian
sugar industry see ethanol evolving as a major stable end-product like it occurred in Brazil? If it happens,
it will lead to a structural level change in Indian sugar industry, making it comparatively non-cyclical to
some extent.

Going Forward

The Indian government has made many announcements recently to boost the ethanol blending and
save the import bill on crude imports. This would also include introducing new vehicles supporting
higher blending and also vehicles running 100% on ethanol.

If there is stable ethanol demand with stable prices, it will stabilize the sugar industry to great extent.
Also, if there will be stable on-time export of sugar during times of overproduction, it can help stabilize
the sugar prices.

With recent rise in crude prices, it makes even more sense to increase the blending of fuel with bio-
fuels and to save on higher crude prices. In the current scenario of over production of sugar in India
and on global level, it is a win-win situation to produce as much of ethanol as possible for India and
Brazil, and simultaneously lower the production of sugar. As we can see in the above graphs, it is exactly
what Brazil has done when crude prices have sky rocketed over past few decades.
Global & Indian Coffee Industry
(Zain Iqbal)
A Brief Overview Of Global & Indian Coffee Sector
Posted on October 31, 2018 Author Zain Iqbal

Coffee is world’s premiere caffeine provider, 2.5 billion cups are drunk everyday. It provides 54% of
the world’s total caffeine, followed by tea and soft drinks.

Coffee Plantation

Coffee plant is woody shrub that is grown in subtropical and tropical climates. Coffee beans are seeds
of this plant. There are two major types of coffee: Arabica and Robusta. Arabica coffee is generally
considered superior to Robusta. About two thirds of world production is Arabica and one third
Robusta. From planting, it takes three to five years before the coffee plant begins bearing cherries.
This long lead time can create periods of supply-demand imbalance, as farmers plant coffee when
prices are high but then do not produce a crop for several years, by which time circumstances may
differ.

Processing

Coffee beans are seeds of the coffee plant. Processing a coffee bean requires many stages of
processing before it can be brewed into a cup of coffee. Coffee cherries are either plucked by hand or
machine. The purpose of processing is to separate the coffee bean from the cherry and dry it.

Once dried, we call coffee bean ‘green coffee’.

In second stage of processing we have two methods:

1. Dry method
2. Wet method.
Dry method involves laying the coffee cherries in the open sun and letting them dry out. The seed or
bean is later separated by a process known as hulling.

The wet method involves the usage of water and seed or bean is separated from cherry before drying.
Wet method of separation produces higher quality and therefore higher priced coffee.

Almost all Arabica coffee is processed by wet method.

Next step in coffee processing is roasting. Roasting brings out the flavor we like in a coffee.

Roasting generally takes place in the importing country because once roasted the coffee beans begin to
lose their freshness. Importing nations will always have captive or domestic roasting facilities for coffee.

World Coffee Production

Coffee is produced in approximately 70 countries, but the world’s largest coffee producer by far is
Brazil. This makes the price of coffee sensitive to weather conditions in Brazil.

The countries of west Africa and Vietnam produce mostly Robusta coffee. Although Brazil produces
mostly Arabica coffee, it is actually world’s second largest Robusta producer, behind Vietnam.

Spot Prices : Average ICO indicator Prices (cents/pounds)

Coffee prices dynamically vary based on weather situations in major coffee producing nations such as
Brazil and Vietnam. In the year 1994, Arabica and Robusta coffee prices made new highs at 147 and
119 cents per pound due to frost damage in Brazil, frost in Brazil was followed by drought in 1997,
when again coffee prices touched 132 and 83 cents for Arabica and Robusta coffee respectively.
Coffee touched its low in the year 2002 when Arabica and Robusta were priced at 60 and 30 cents per
pound and this happened due to oversupply of coffee in the world market.

In the same period (2000-02), India dramatically produced 301,200 MT of coffee which encompassed
104,400 MT (35%) of Arabica coffee production and 196,400 MT (65%) of Robusta Coffee production.
Since 2002 and till 2018 India has grown from a nation producing 301,200 MT of coffee to a nation
producing 316,000 MT of coffee, a meager .28% of CAGR.

Coffee Prices again made a new peak although short lived this time in the year 2010-11 when there
were concerns about supply in Brazil and Columbia and it was followed by aggressive speculator
activity.

Arabica coffee prices touched 271 cents per pound and Robusta coffee touched 106 cents per pound
on the commodity exchanges that year.

Indian Coffee Sector – Area, Production & Productivity

Over a period of 68 years from 1951 till 2018, we observe that the area under cultivation for coffee has
gone up from 92,523 hectares in 1951 to 454,722 hectares in 2018. During this period the area under
cultivation for Arabica coffee as percentage of total area has decreased from 73% in 1951 to 50% in
2018, whereas the area under cultivation for Robusta coffee has gone up from 27% in 1951 to 50% in
2018.

Today (2018) we observe that Arabica coffee, despite covering 50% of the soil in India for production
produces only 30% of the volume (tonnage) and in value terms it is 39% ($256 million worth of
Arabica coffee at 135 cents per pound) and the rest is Robusta coffee which is 61% ($388 million
worth of Robusta coffee at 88 cents per pound).

It is no surprise that growing Arabica coffee is dragging Indian coffee sector behind when it comes to
optimally utilizing its resources (land and labor).

If we observe closely the productivity of a Arabica coffee farm land is decreasing (from 1971 to 2018),
India witnessed increased productivity of Arabica soil from 229 kg per hectare in 1951 to 725 kg per
hectare in 1971 and since then it has decreased gradually and today (2018), despite mechanization
and the best in class technology available, Arabica soil in india produces 478 kgs of coffee per hectare.

At the same time Robusta soil’s productivity has gone up gradually from 136 kg’s per hectare in 1951
to 1031 kg’s per hectare in 2018.
Karnataka’s Coffee Farms – Time To Mechanize

Karnataka accounts for over 50% of the coffee land under cultivation in India at 226,244 hectares and
it produced 222,300 MT of coffee in 2017-18. Karnataka also has the highest soil productivity at 983
kg’s per hectare in contrast to Tamil Nadu which has the lowest soil productivity among the three
states at 519 kg’s per hectare.

Although Kerala has the marginally low soil productivity at 774 kg’s per hectare but it has comparative
advantage versus Karnataka and Tamil Nadu in terms of labor utilization. Kerala employs an aggregate
~44,000 people in its coffee farm lands but at a unit level in terms of coffee produced per labor,
Kerala has the highest productivity at 1.5 tons of coffee production per labor.

Karnataka and Tamil Nadu states lag behind kerala on these metrics and this comparative advantage
of kerala is possible because of more mechanization of coffee farm lands versus that of Karnataka and
Tamil Nadu.

Coffee producers in Kerala will see operating leverage kicking in when coffee prices rebound as
there operations are less labor intensive versus coffee producers of Karnataka and Tamil Nadu.

Mechanization proves to be a major challenge considering the undulating terrain that coffee is grown
on. Much work needs to be done in this area.

In Brazil where coffee is cultivated on a flat terrain, mechanization is employed successfully where a
single worker covers 100 acres.
It is evident from the table above that wages in major coffee producing states such as Karnataka,
Kerala and Tamil Nadu are high with the highest wages in Kerala followed by Karnataka and Tamil
Nadu.

However kerala has the lowest labor density per hectare and per ton of coffee produced therefore the
blended labor cost would be lower for companies growing coffee in kerala.

Major Indian Coffee Exporters

Allanasons pvt ltd is the biggest exporter of Arabica coffee from India and its export volume for the
year 2018 stand at a staggering 10,719 tons or ~28 Million USD worth of exports of Arabica coffee.

Coffee Day Global ltd, parent of CCD stands second to Allanasons at 4,771 tons of Arabica coffee
exports or 12.8 million USD of exports. Tata coffee follows coffee day global at the third spot with 4.8
million USD of Arabica coffee exports.

The biggest exporter of Robusta coffee is Olam Agro India Pvt ltd at 17,640 tons or 31 million of
Robusta coffee exports.
Major Export Destinations For Indian Coffee Producers

India’s largest market in volume terms is the Italian Market and that too for Robusta coffee and so far
this year, India has exported 70,438 tons of coffee beans to Italy and of the total export of coffee
beans, Italian exports stand rock solid at 23%.

Other major export destination after Italy are Germany, Russia and Belgium

Striking observation in the table is that of Belgium which imports a staggering 7,770 tons of Arabica
coffee from India dwarfing other export destinations.

Modest Increase In Indian Coffee Consumption

Bulk of the Indian Coffee production is exported and the domestic industry focuses much of its
marketing effort on export promotion. There are signs that the popularity of coffee is increasing with
the spread of foreign and home grown coffee shops. However, exports continue to siphon large
amounts of coffee away from domestic market and consumption estimates are largely unchanged in
recent years.

While the coffee consumption is increasing moderately, it can be difficult to establish a repeatable
trend given the industry emphasis on exports, especially when the export demand is high.

Tea continues to be the hot drink of choice for many Indian consumers. Consumers in southern India,
where much of India’s coffee is produced, consume more coffee than in other areas of the country.
While there is a small but growing cafe culture.

Over the longer term, Indian coffee consumption is not likely to increase significantly until the practice
of home consumption becomes more common because the hard reality is that coffee consumption in
India has not budged beyond 100 gms in the last 4 years.
Coffee Market Explodes In China

Rapid increase in coffee consumption in China particularly from 2005 to 2013 can be compared to a
similar trend in Japan from the years 1964 to 1973. For japan, it took 30-40 years total to become a
recognizable coffee consumer and become the worlds fourth largest coffee consumer, China on the
other hand, is still in premature stages of coffee development.

Today China’s coffee sector is valued at $4.72 Bn and Starbucks dominates the sector with 58.6%
market share. Starbucks operates 3,400 cafes with each store generating $800,000 of sales per annum.
The starbucks management has a target to have 6,000 cafes by FY22.

While India and china have similar coffee consumption (120,000 MTPA, 2018), the rise in disposable
income which gives a boost to discretionary spending is driving growth in China. India would see
similar growth in the number of cafes and hence greater coffee consumption with rise in per capita
income.

Global Per Capita Consumption Of Coffee

Coffee Inventories In Importing Nations

Stocks of green coffee in importing nations, have remained at high levels in the last two years. After
reaching 17.94 million bags at the end of December 2010, stocks grew to record level of 26.44 million
bags at the end of June 2017 and as of June 2018, stocks of green coffee in importing nations have
been 24.64 million bags which is still high. High stocks of coffee in importing nations put downward
pressure on global coffee prices.

Key Indicators In Coffee

 While studying coffee, be watchful of production levels in Brazil, Vietnam and Colombia.
 Any weather disruptions in major coffee producers such as Brazil and Vietnam will impact global
coffee prices.

 Because importing nations import green coffee (Arabica or Robusta), they can store green coffee
in cool and dry warehouses and this inventory build up will have impact on global coffee prices.
Higher inventory levels in importing nations leads to downward pressure on coffee prices.

 Coffee consumption, however rising at 2% can see substitution by other caffeine rich beverages
like cold drinks and tea which will put downward pressure on coffee prices.