Business Analysis Guide Vol. 1

www.drvijaymalik.
com
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Copyright © Dr Vijay Malik. All Rights Reserved.

www.drvijaymalik.com
Business Analysis Guide

(Vol. 1)
By
Dr Vijay Malik
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Copyright © Dr Vijay Malik.
All rights reserved.
This e-book is a part of services of www.drvijaymalik.com
No part of this e-book may be reproduced, distributed, or transmitted in any form or by any means, including
photocopying, recording, or other electronic or mechanical methods, without the prior written permission
of Dr Vijay Malik.
Printed in the Republic of India
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Important: About the book

This book contains guidelines to do a business analysis of companies belonging to different industries. The
book aims to highlight key factors that influence the business of companies in the covered industries.
After reading this book, an investor will learn, which factors she should focus on while analysing companies
belonging to the mentioned industries. She will be able to understand what puts certain companies in these
industries in an advantageous position over others.
The learning from this ebook must be complemented with detailed financial, management, and valuation
analysis of companies before making any investment decision.
All the best for your investing journey!
Regards,
Dr Vijay Malik
Regd. with SEBI as a Research Analyst
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Table of Contents
Important: about the book ............................................................................................................................. 4

1) How to do business analysis of pharmaceutical companies ..................................................................... 6
2) How to do business analysis of hospitals ............................................................................................... 54
3) How to do business analysis of diagnostic labs ...................................................................................... 71
4) How to do business analysis of chemical companies ............................................................................. 85
5) How to do business analysis of agrochemical (pesticide) companies .................................................. 114
6) How to do business analysis of fertilizer companies ............................................................................ 129
7) How to do business analysis of IT services companies ........................................................................ 150
8) How to do business analysis of auto ancillary companies .................................................................... 163
9) How to do business analysis of paper manufacturing companies ........................................................ 192
10) How to do business analysis of textile companies .............................................................................. 222
How to use screener.in "export to excel" tool ........................................................................................... 261
Premium services ...................................................................................................................................... 286
Disclaimer & disclosures .......................................................................................................................... 302
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1) How to do Business Analysis of Pharmaceutical Companies
After reading this chapter, an investor would be able to differentiate pharmaceutical companies based on
the strength in their business model. She would be able to have an informed view of the possible future
business scenarios that any pharma company may face.
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Segments of pharmaceutical industry: A detailed analysis.

Whenever any investor starts to analyse any pharmaceutical company, then the first thing she should
attempt to know is what segment of the industry it operates in. There are different divisions of the
pharmaceutical industry, which are primarily based on the place a company occupies in the supply chain.
It becomes important to know the segment of the company because; different segments of the
pharmaceutical industry have different business characteristics and face different challenges.
1) Bulk drugs/active pharmaceutical ingredient (API) manufacturers: These companies make drugs as
bulk chemicals and operate at the basic step in the pharmaceutical supply chain. For example, in the case
of manufacturing Paracetamol, these companies make tons of pure Paracetamol and provide it to other
companies (formulations manufacturing companies) for further processing.
2) Formulations manufacturing companies: These companies buy pure drug chemicals from bulk
drug/API manufacturers and then convert them into tablets, injections, syrups etc. These companies make
the pure chemicals into final drugs, which are ready for human consumption. Formulation manufacturing
companies may sell the drugs in the market under their own brand names.
The formulation manufacturing segment is further divided into companies that do research and
invent/discover new drugs themselves and sell these patented drugs (called innovator companies) and those
companies that sell drugs invented by others, whose patents are expired (called generic companies).
Even in the generics segment, companies may sell patent-expired drugs by putting their own brand names
(called branded generics) e.g. Dolo for Paracetamol, or sell only under the name of the chemical in the drug
e.g. drug tablets labelled only Paracetamol (called generic generics).
3) Contract research and manufacturing services (CRAMS): These are companies who provide
research services to innovator companies in their new-drug development programs and also provide
contract manufacturing services where the innovator company shares the technology with them and then
CRAMS companies manufacture the drug by putting the brand labels of the innovator company. Thereafter,
the innovator company acts as a marketing agency that sells these drugs under its own brand using its sales
and distribution channel.
4) Pharmaceutical distributors: These are the companies, which take the final drug from the formulation
manufacturing company to the consumers. These include clearing and forwarding agents (C&F agents),
CIF (cost, insurance, and freight) agents, super-stockiest, stockiest, sub-stockiest and retailers.
Understanding the place of any company in the pharmaceutical supply chain is important because
companies in each of the above-mentioned segments face different business dynamics. For example, API
and contract manufacturers may act like commodity chemical manufacturing companies with efficient low-
cost manufacturing becoming their main strength. On the contrary, formulation manufacturing companies
act as “brands” where sales, marketing, advertising, and acquiring customer mind space become key
determining factors.
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In real-life situations, an investor would find companies that are pure API manufacturers, pure formulations
manufacturers or pure CRAMS players. However, she would also find players who have integrated
operations i.e. formulation companies who manufacture APIs as well and do CRAMS for other players as
well etc.
Let us now try to understand the business dynamics of each segment of the pharmaceutical industry in detail
so that we can understand the strengths and challenges faced by each of these segments.
1) API manufacturing business seems like any commodity chemical

manufacturing business; fragmented industry, intense competition, capital
intensive, and no pricing power:
When an investor analyses bulk drug/active pharmaceutical ingredients (API) manufacturing companies,
then she notices that the business of these companies is similar to commodity chemical manufacturing
companies.
API manufacturers produce the basic ingredients of the drugs e.g. Paracetamol in bulk, which is essentially
a commodity chemical. Paracetamol made by one API manufacturer is indistinguishable from the
Paracetamol made by another API manufacturer. Therefore, the buyers of bulk Paracetamol can easily
switch from one API manufacturer to another without a significant impact on their business.
An investor would appreciate that the original patent to manufacture is owned by the innovator
pharmaceutical company, which made Paracetamol for the first time. After the expiry of the patent, every
API company is able to manufacture Paracetamol without any product patent protection. Therefore, every
company, which can put in the required investment can enter the business with many technological
challenges and add to the competition in the API industry.
Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February
2020, page 3:
bulk drug (API) industry is also fragmented with low entry barriers
As a result, the API manufacturing segment is fragmented with intense competition. Apart from dedicated
API manufacturers, these companies also face competition from the in-house API units of formulation drug
manufacturers who apart from reducing their own API purchases, may also sell excess API in the open
market.
2020, page 3:
The bulk drug players also face competition from in-house API manufacturing of large formulation
players for captive consumption as well as sales to external formulation players.
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The competition to the API manufacturers is not limited to domestic producers because; due to the
commodity nature of their products cheaper imports also provide strong competition.
Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 3:
bulk drug/API companies are relatively capital intensive & fragmented in nature with threats from
cheaper imports;
An investor would appreciate that if a company operates in a commodity market with non-differentiable
products, then the company loses its pricing power over its customers. This is because the customer can
easily switch from one API manufacturer to another without a significant impact on its business.
2020, page 4:
API manufacturers may face pricing pressure on account of commoditization and face risks related
to high capital intensity and usually limited product portfolios.
In such commoditised businesses with low pricing power, the key source of competitive strength comes
from being the lowest cost producer. In such cases, economies of scale help the most in lowering the cost
of production.
Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page
5:
Factors affecting market position for bulk drug manufacturers: Given the intense competition,
market position is largely determined by pricing ability that is linked to the company’s operating
efficiencies and economies of scale.
2020, page 3:
bulk drug (API) industry…entities ability to develop low cost manufacturing, high process
chemistry skills and requisite manufacturing facilities defines their competitive position.
In order to create large plants for benefiting from economies of scale in the volume-driven API segment,
the company attempt to create very large plants to benefit from operating leverage. This makes their
business very fixed-capital intensive.
2020, page 5:
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Entities engaged in CRAMS / APIs business require significant upfront investments in creating
manufacturing / research infrastructure
In addition, the companies end up having a lot of inventory in order to ensure uninterrupted supply to their
customers to become their reliable partners.
An investor would appreciate that companies dealing in commoditised products with no pricing power have
to give a longer credit period to their customers. This in turn makes their operations working-capital
intensive.
2020, page 8:
API players have relatively high level of working capital intensity led by the need to maintain
critical raw material inventory levels for maintaining uninterrupted supply.
From the above discussion, an investor would appreciate that most of the bulk drugs/APIs are commodity
products and the product of one API manufacturer is non-differentiable from another API manufacturer. As
a result, they are price takers with very low negotiating and pricing power over their customers.
In such a situation, in order to create competitive advantages, API manufacturers try different methods like
becoming the lowest cost producer (economies of scale and operating efficiency) and becoming the most
reliable partner of their customers (keeping high inventory for uninterrupted supply, giving longer credit
periods etc.).
Let us discuss other steps that API manufacturers take to strengthen their competitive position.
1.1) Expand the product portfolio:
API manufacturers try to expand their product portfolio so that the customers do not need to deal with many
API manufacturers for their needs. As a result, the customers can deal with only a few large API
manufacturers for all their needs.
5:
Factors affecting market position for bulk drug manufacturers: Product range: According to
CRISIL Ratings, diversity of the product range…mitigate competitive pressures and support
performance in terms of sales growth and profitability.
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1.2) Manufacture complex products:
To increase their competitive strengths, some API manufacturers attempt to focus on making chemicals,
which are relatively complex to manufacture so they have to compete only with a small number of players
that are able to manufacture those complex products.
7:
A product that requires a high degree of complexity to manufacture, such as that involving
fermentation technology, is typically characterised by high entry barriers and thereby, presence
of fewer players.
5:
Factors affecting market position for bulk drug manufacturers: According to CRISIL
Ratings…presence of molecules that are complex to manufacture significantly mitigate
competitive pressures and support performance in terms of sales growth and profitability.
Therefore, an investor would appreciate that by the way of expanding the size of their operations via large
capital expenditures, using economies of scale to become the lowest-cost producers, opting for working-
capital intensive operations to become a reliable supplier, expanding the product range and manufacturing
complex products, an API manufacturer may gain competitive advantages in an otherwise fragmented
industry with price-based intense competition around non-differentiable products.
To understand these strategies of API manufacturers, an investor may read our detailed analysis of Laurus
Labs Ltd, which despite being the largest producer of HIV drugs’ APIs in the world had very low pricing
power. Therefore, the company expanded its product portfolio to Hepatitis-C, Oncology, custom synthesis,
formulations etc.: Analysis: Laurus Labs Ltd
2) Formulations manufacturers have two contrasting business models:

Formulations players manufacture ready to consume drugs and sell them in the market. They are at a higher
level in the pharmaceutical value chain and are supposed to have a better business profile than API/bulk
drug manufacturers.
Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, June 2017, page 7:
Formulation manufacturers, being closest to the market, are at a higher point in the
pharmaceutical value chain compared to API and intermediate manufacturers and hence, are
likely to have a superior business risk profile
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When an investor analyses companies that manufacture formulations i.e. the ready to consume drugs, then
she notices that this segment consists of two very different sub-segments. One of these consists of the
innovator companies, which invent/discover new drugs and the other group is generic companies, which
sell old drugs whose patents have expired.
2.1) Innovator companies:
These companies are at the top of the overall pharmaceutical industry. They spend a large amount of money
on developing new drugs, get their patents registered, sell the successful drugs in the market and earn high
profits on the sale of those successful drugs.
However, behind the financial performance showing high profits from selling successful drugs, these
companies face a lot of challenges in delivering a consistent line-up of successful drugs. This is because;
out of about 5,000 new drugs discovered by innovator companies, only one reaches the stage of commercial
launch. And out of all the commercial launches, only about one-third of the drugs recover the money spent
on their research & development (R&D) i.e. only 1 out of 15,000 discovered drugs turns out to be
economically viable.
Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, January
2009, page 16:
Drug manufacturing is a high-risk business: For every 5,000 compounds discovered, only one
ever reaches the pharmacist’s shelf. The odds against making a profit are steep: Less than one-
third of marketed drugs achieve enough commercial success to recoup their R&D investment.
An investor is able to appreciate such a low probability of economic success of new drugs when she notices
that it may take up to $500 million (about ₹3,750 cr @₹75/$) to develop, test and commercialize a new
drug.
Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH,
Germany, January 2022, page 4:
Pre-funding of R&D, selling and distribution expenses can easily total more than USD 500m over
several years before the first sales for the new drug come in.
The requirements of high-cost innovator-R&D have led to such companies spending about 15%-20% of
their revenue on R&D.
Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April
2014, page 6:
R&D costs are substantial, typically 15% to 20% of revenues.
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Moreover, the fact that the patent protection period, which grants the exclusive rights to the innovator
company for selling the drug starts from the date the drug is discovered and not from the date on which it
is launched in the market as a drug safe for consumption. Therefore, all the years used by the innovator
company in studying and testing the drug are reduced from its patent protection period.
A patent’s life usually stretches over 20 years. It starts at a ‘raw’ molecule’s invention, not at the
drug’s approval – i.e. after an average R&D period of about 10-12 years. Around half of the patent
life is already used up before the drug becomes lucrative (provided it clears the regulatory
approval hurdle).
Therefore, an investor would notice that almost half of the patent life for any drug is used up in its
development. Thereafter, the company gets an exclusive period of about 10-years to recover its R&D costs
and earn profits. The limitation of this period is an important consideration for pharmaceutical companies
because the generic companies, which sell old patent-expired drugs are always attempting to launch their
products at the earliest opportunity.
Once the generic drugs enter the market, the price of the innovator drug (i.e. patented drug) in the market
declines by 85-90% i.e. reduces to 10-15% of the original price.
As a rule of thumb, generic prices in the US for traditional pills get slashed to about 10%-15% of
the former protected drug price
Within one year of entry of generic drugs in the market, they capture about 95% of the market share by
volume.
2014, page 5:
When patent protection ends, generic drugs can capture 95% of prescription volume in the first
year.
Moreover, the generic pharmaceutical companies do not always wait until the expiry of the patent of the
innovator drugs. Under Para-IV, they apply for selling generic drugs even before the patent expires. An
investor would notice that such applications of approval of generic drugs within the patent period lead to
many litigations, which increases the costs of the innovator companies.
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2009, page 16:
The increasingly competitive industry environment is leading to an epidemic of legal challenges

to the validity of patents, especially from generics manufacturers seeking to broaden their markets.
This means mounting legal expenses for the companies defending them.
Therefore, an investor would appreciate that if the business model of innovator pharmaceutical companies
contains high risk. In fact, at times, inefficient R&D had been one of the biggest problems faced by the
innovator pharmaceutical companies, which even led them to reduce their R&D budgets.
2009, page 8:
Large, expensive, and inefficient research programs have been a major issue for Big Pharma.
Many companies have undertaken radical restructuring and cost-cutting in R&D, but the
increasing complexity and cost new discoveries in a slower sales growth environment mean R&D
cost pressures remain a major issue.
In addition, nowadays, the focus of most of the innovator drug companies has shifted to finding new drugs
based on antibodies (i.e. biological drugs), which is more difficult to create/discover than traditional
chemical-based drugs. As a result, finding new drugs has become more difficult and costly.
Rating methodology for the pharmaceutical sector by the credit rating agency Rating and Investment
Information, Inc., Japan, February 2022, page 2:
With a shift in therapeutic drugs from low-molecular compounds to those derived from
antibodies that are more difficult to develop, success rates of drug development are on a downward
trend. Development is taking longer and becoming even more costly.
Despite all these challenges in the business of developing new drugs, the innovator pharmaceutical
companies spend a high amount of money on R&D because; if the new drug becomes successful (a
blockbuster drug with sales of more than $1 billion per year), then the profits compensate for the R&D
spending.
2009, page 16:
However, when a drug maker launches a new compound that receives patent protection and is
widely accepted in the marketplace, the economic rewards can be immense. This is the primary
reason for the industry’s hefty profit margins.
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The probability of making very high profits if the drug under-development becomes successful has led to
pharmaceutical companies paying very high prices to acquire potential drug candidates who show a high
potential of becoming a blockbuster drug (more than $1 billion annual sales).
A new motivation for M&A activity in the sector is emerging in the form of the high multiples paid
for single pipeline asset companies in ‘hot’ areas such as immuno-oncology or rare diseases. One
example is Gilead’s USD 11bn acquisition of Pharmasset Inc in 2011 for one hepatitis C molecule,
which later became known as Sovaldi after approval.
In light of the above discussion, an investor would observe that the business model of innovator
pharmaceutical companies involves very high R&D costs, which may extend to multiple thousands of
crores rupees in the development phase. Even after that only about 1 out of 15,000 drugs becomes
financially viable. The companies do get exclusive sales rights under patent protection. However, almost
about half of the patent period gets used in drug development and once the period is over, the generic drugs
flood the market leading up to a 90% decline in the market price of the drug.
In light of this high risk, most of the Indian pharmaceutical companies have stayed away from investing a
lot of money in new drug development. As a result, the Indian pharmaceutical market consists of about
97% of drug sales (by value) from generic drugs.
The market study on the pharmaceutical sector in India by Competition Commission of India (CCI),
November 2021, page 7:
The pharmaceutical market within India predominantly comprises generics, which account for
around 97% of drug consumption in the country in terms of value.
In contrast, in the US markets, instead of generics, the patented-innovator drugs constitute about 90% of
the value whereas they form only about 20% of volume. Looking from another angle, the generics drugs in
the US constitute about 80% of the volume but only 10% of the value.
Consequently, generic companies generate only 10% of market sales with 80% of the total volume,
illustrating the considerable price differential between innovative drugs and off-patent copies.
This is because, despite the presence of generics, many physicians and patients continue to prefer the
branded drug.
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2014, pages 5-6:
Even after a drug has faced generic competition for years, it may still enjoy price flexibility on the
remaining volume used by patients (and prescribed by physicians) who continue to prefer the
higher-priced branded drug.
This shows that even if a large part of the pharmaceutical market in the US is dominated by generics; still,
most of the value/profits are earned by patented-innovator drugs. Such market dynamics continue to
motivate the innovator pharmaceutical companies to keep spending money on R&D to discover new drugs.
2.2) Generic drug companies:
Another segment of formulations manufacturing companies is generic drug companies, which focus on
manufacturing patent-expired drugs.
An investor would appreciate that because these companies do not have to spend money on inventing new
drugs and instead rely on producing already existing drugs; therefore, their R&D costs are very low when
compared to innovator drugs. As a result, they are able to produce drugs at a very low cost, which is the
main reason for generic drugs selling at a discount of up to 90% from the original innovator drug price.
Due to the lower cost of generics drugs, they find wide support from governments, politicians and other
entities who wish to replace branded drugs in the market with generic drugs.
2014, page 5:
Third-party (government and private) payors, political leaders, distributors, and

retailers encourage the substitution of generics for branded drugs.
From the above discussion, an investor would notice that due to a lower ability to spend money on R&D
for new drug development, the Indian pharmaceutical industry primarily comprises generic drug
manufacturers. Almost all the Indian formulations manufacturing companies are generics manufacturers.
An investor would appreciate that all the generic drugs are merely copies of the patent-expired innovator
drugs. Therefore, effectively all the generic drugs are supposed to be similar in their therapeutic effect on
the body. As a result, all the generic drugs are effectively non-differentiable commodities.
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By definition, generics have active ingredients that are identical to the patented/originator drug
and are low cost, functionally undifferentiated products, which make generic markets
structurally highly competitive.
Therefore, until the time, the generic drugs are produced as per the approved manufacturing process, one
generic copy of any innovator drug should be exactly similar to another generic copy of the same drug i.e.
a generic Paracetamol 500mg tablet from all the companies should lead to equal levels of Paracetamol in
the blood of the patients and should lead to a reduction in fever.
An investor would appreciate that if the product manufactured by the generic companies are functionally
non-differentiable from each other, then in a fair market, the generics companies would end up competing
on prices because; the customer can easily switch from the generic drug of one company to the generic
copy of the same drug from another company.
An investor would also note that preparations of generic formulations are a comparatively low-technology
activity as the formulations manager has to take the API/bulk drug and mix it with inert material
(excipients), pack and sell it. Therefore, an investor would notice that the generic formulations business is
low on technology and investments.
7:
Making formulations involves mere physical processes such as mixing, adding binders and
packaging, with relatively small capital requirement.
The traditional generics business model does not involve spending on R&D or innovation. Instead, it was
focussed on fast execution to bring a generic version of the patent-expired drug as soon as possible and to
distribute it as widely as possible, which is a typical characteristic of commodity, non-differentiable
products.
traditional generic business model, which previously did not involve innovation or R&D costs and
relied exclusively on fast execution and distribution as key success factors.
As a result, the generics formulations industry has low barriers to entry.
2020, page 3:
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Indian formulations industry is largely a branded generic industry with presence of a limited
number of patented drugs, predominantly self-reimbursing in nature, low entry barriers and
largely physician-influenced.
Globally also, various countries have deliberately kept entry barriers to generics low and they actively
promote and encourage generic drugs because these reduce the overall healthcare cost of the society.
Barriers to entry are still lower in the generic industry relative to innovative pharma because the
initial pre-sale investment is not as high. In addition, generic market penetration has political
support in most countries, as it greatly alleviates the burden of ever-increasing costs of healthcare
and drugs in the context of tight state budgets.
Therefore, an investor would appreciate that the generics formulations business is fragmented and intensely
competitive with many players producing the same generic drugs.
2020, page 4:
formulators may face high competitive intensity on account of relatively less fixed capital intensity
In such a situation, the generics players would end up in the price war leading to continuously declining
profit margins as they do not have pricing power over their customers.
One of the most striking differences between innovative and generic pharmaceuticals is the
latter’s lack of pricing power, which gives it much lower attainable operating margins.
On average, the generics companies have an EBITDA (earnings before interest, tax, depreciation and
amortization) margin of about 10%-25% whereas the EBITDA margin of innovator pharmaceutical
companies may reach 45%.
Generic companies’ EBITDA margins usually range between 10% and 25% in mature markets.
This contrasts with EBITDA margins for speciality pharma companies, which can be as high as
45%.
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However, generic companies use many strategies for creating competitive advantages and earning higher
profits. Let us discuss some such strategies.
2.2.1) Focus on complex drugs like biosimilars:
As the common generics drugs have high competition and low-profit margins, the companies have started
investments in making relatively high technology products like complex generics and biosimilars,
injectable, transdermal patches, extended-release drugs etc. These drugs are relatively difficult to make and
therefore, offer higher profit margins.
5:
Furthermore, companies are also focusing on niche segments of biosimilar and specialty
pharma segments, which have relatively lower competition and high profit margins.
2014, page 14:
ability to produce specialized or more complex products, such as injectable medicines, topical
drugs, transdermal patches, extended release drugs, and biosimilars is a positive attribute, which
diversifies its business.
As complex generic drugs like biosimilars are difficult to make, therefore, the companies need to spend a
lot of money on R&D.
Generic forms of biological drugs (known as ‘biosimilars’ as they do not overlap 100% with the
original) are more complex to make and require the company to invest in R&D before regulatory
approval can be obtained.
As a result, many Indian formulation companies have started to invest money in R&D in order to develop
biosimilars, which provide a higher profit margin than simple generic drugs.
Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, May
2015, page 4:
Many of the large Indian pharmaceutical companies are allocating substantial budgets towards
biosimilars.
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However, an investor should note that getting approvals for biosimilars is equally tough as getting approvals
for any new drug because; in the development of biosimilars the formulation companies have to conduct
all the development steps like clinical trials.
2014, page 5:
For makers of generic biologic drugs (a.k.a. biosimilars), for which clinical trials are required,
the costs, risks, and entry barriers are similar to those for makers of branded drugs.
In fact, the Competition Commission of India found that the term biosimilars is a misnomer because; the
regulatory authorities effectively treat biosimilars as a new drug while assessing it for approval. As a result,
only a few large players have been able to get approvals for biosimilars.
Making markets work for affordable healthcare, a policy note by the Competition Commission of India
(CCI), October 2018, page 21:
The term “biosimilars” is a misnomer: most national regulatory authorities insist that competitors
not only conduct Phase 1 and 2 trials, but also comparative studies in the final phase, before they
receive final regulatory approval. Often, this dual requirement of treating each biological
medicine from a non-originator source as a new drug, with the additional requirement of proving
bio similarity, takes so much time and investment that barely a handful of companies compete with
pharma giants thereby muting competition and resulting in monopoly prices.
In addition, in the development of biosimilars, the generic formulation companies face tremendous
resistance from the innovator (patent-holder) pharmaceutical companies.
The Competition Commission of India found that innovator (patent-holder) companies are nowadays the
patent-holder companies start creating obstructions at the generic development stage itself. Patent holding
companies even refuse to provide samples to the generic companies to test bio-similarity and even file cases
against the regulators if they grant approvals to biosimilars.
Traditionally, the patent holders used to block generic companies after applying for regulatory
approval. However, now the patent holders seek to block generics at the development stage itself.
The innovators block access to pharmaceutical reference products for bioequivalence testing
by not providing sample of their products, thereby delaying/denying generic entry. Innovators
using distribution safety protocols impede generic/biosimilar drug development; and challenge
the marketing approval granted by the drug regulatory authority to prevent biosimilar products.
For example, in India, Roche sued Biocon and Mylan to stop them from selling the biosimilar of
Trastuzumab, its breast cancer medicine. In addition to filing a case against Biocon and Mylan, Roche also
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sued the regulatory authority. (Source: Beyond IP Protection: New Tactics Blocking Generic/Biosimilar
Market Access: Biosimilar Development, September 21, 2017)
Among the multiple opportunities that innovator companies now use is challenging the decisions
of the drug regulatory authority. In India, Roche sued Biocon and Mylan to restrain them from
selling their biosimilar of breast cancer medicine Trastuzumab. Roche also challenged the drug
regulator for approving the biosimilar. It won, but lost on appeal through an interim order. The
parties have sued each other for contempt. Subsequently, Biocon and Mylan claimed abuse of
dominance by Roche before the competition authority. The competition authority ruled prima
facie abuse of dominant position and ordered an investigation. Roche has challenged the
investigation order
Therefore, an investor would note that due to tough processes in getting approval from govt. authorities and
simultaneous severe hurdles created by innovator companies, only a few companies are able to produce
biosimilars. As a result, the biosimilars field has less competition and high-profit margins.
Lastly, speciality manufacturing capabilities, such as for generic vaccines or biosimilars, are
further positive rating drivers, as this field is much less competitive and offers higher potential
margins than the traditional generic business
Apart from focusing on manufacturing complex generic drugs, companies attempt to become the first ones
to get approval for their generic drugs in the US market.
2.2.2) Target exclusive-sales period for the first approved generic drug in the US:
In the US markets, the first generic drug that is approved gets an exclusive sales period of 6-months after
the expiry of the patent of the innovator drug where other generics players are not allowed to sell their
products in the US markets.
As a result, the first generic drug is able to sell at a much higher price than the price when all the generic
drugs enter the market.
On average, after an entry of generic drugs, the prices decline to about 10%-15% of the innovator (patented)
drug price; however, during the 6-months exclusivity period, the first approved generic drug can enjoy 3x-
4x price i.e. 40%-50% of the innovator (patented) drug price.
in the US, where the first generic company to file is rewarded with a six-month exclusivity
period that blocks other suppliers from the market…As a rule of thumb, generic prices in the US
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for traditional pills get slashed to about 10%-15% of the former protected drug price, while
the first generic copy in the market can retain about 40%-50% of the initial level.
Therefore, if a company is able to become the first generic company to get approval, then it can earn
substantially higher profits than its other peers.
However, soon after the end of the exclusivity period, the high-profit margins witness a steep decline.
2020, page 5:
In the past, some of the Indian pharma entities focused on filings that targeted marketing
exclusivity resulting in significant jump in revenues and earnings in the years such products were
launched followed by steep contraction as other players forayed resulting in steep pricing
pressure.
Usually, the generics companies wait to launch their generic drugs until the patent expiry date of the original
patented drug. However, at times, they even attempt to invalidate the patent of the innovator company and
try to launch its generic drug before the expiry of the patent.
2.2.3) Try to launch generic drugs even before the patent expires; Para IV filings:
An investor would note that the incentive for the generic drug makers to give competition to the patented
drug is so much that generic companies do not wait for a launch of their generic drugs until the patent expiry
date. The generic drug companies do file for approval under Para IV, which allows them to launch generic
drugs before the expiry of the patent.
An investor would appreciate that the patent holder innovator pharmaceutical company would fight hard to
protect its exclusivity rights under the patent. As a result, the Para IV filings lead to a lot of litigations and
costs for both, the generic and innovator drug companies.
The companies having ANDA filing under Para – IV are subject to significant litigation risk as
they look to invalidate the innovator company’s existing patent before its expiration.
Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, 2007, page 5:
Para IV filings, which provide profitability, have been aggressively and successfully challenged
by patent holders, resulting in large R&D and litigation losses for Indian companies.
One of the well-known incidents of the legal dispute under Para IV approval was the first-to-file approval
got by the Indian company Ranbaxy against Pfizer’s multi-billion-dollar cholesterol-lowering drug Lipitor
(generic name Atorvastatin). It led to a long battle between Ranbaxy and Pfizer in courts in multiple
countries. (Source: Ranbaxy Contests Pfizer Mega Drug Patent In US: Financial Express, Aug 23 2003).
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However, as per credit rating agency, ICRA, nowadays, the attractiveness of Para IV filings is declining
for the generic formulations manufacturers.
Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, May
2015, page 4:
The attractiveness of Para IV filings however have reduced in recent years, on account of
1) authorised generics supported by innovators; 2) shared exclusivity between multiple players
filing on the same day.
Nevertheless, while assessing companies applying for approvals under Para IV that are involved in
litigations, an investor should try to estimate their contingent liabilities because outcomes of patent
litigations are uncertain and any penalty on the company may have a material financial impact.
Now, let us see what steps generics companies take to improve their profit margins in the domestic market.
2.2.4) Launch of branded generics in the domestic market:
From the above discussion, an investor would note that if made by following good manufacturing practices,
then all the generic copies of a patented drug are supposed to be equally effective i.e. a tablet of Paracetamol
500 mg is expected to lead to the same effect of reduction of fever for the patient irrespective of which
generic copy of Paracetamol he takes.
In such a situation, it is expected that all the generic companies, which are selling functionally similar and
non-differentiable generic copies of the patented drug would lose their pricing power and end up competing
on price resulting in lower profitability.
However, an investor notices that the generic pharmaceutical companies have introduced a new product
class called “branded generic”. Under branded generics, pharmaceutical companies give a name, “brand”
to their generic drug e.g. Dolo is a famous brand name for the generic drug Paracetamol in India.
Now, generic drug manufacturers spend money on sales & marketing, and brand building in order to sell
them at a higher price for better profit margins.
CARE Ratings looks favourably at companies having branded generic formulation as they
command higher margins with better market positioning in particular therapeutic segments in
light of low entry barriers.
An assessment of the marketing strategy of the branded-generic manufacturers would reveal to the investor
that the companies tend to create a differentiation for their brand based on an impression that the “branded”
generic drug is better in efficacy (i.e. the effect on the patient) than other generic drugs.
23 | P a g e

branded generics are marketed and prescribed based on the perceived higher efficacy and
therapeutic advantage associated with them.
CCI, in its study, found that branded-generics companies had created a false notion of branded generics
being better in quality because CCI found that the same branded generics companies produced multiple
brands of the same generic drug at significantly different prices.
companies offering a portfolio of different brands of the same formulation with identical dose and
strength…In other mature markets, such as amoxicillin & clavulanic acid, a combination
antibiotic, there are multiple instances of five to six brands being supplied by the same company
for the same formulation of same dose and strength.
One company which manufactures amoxicillin + clavulanic acid (125/500 mg, tablet), prices
of two brands marketed by it stood at Rs. 18.27 and Rs. 73.17
Moreover, the CCI also found that most of the generics formulation companies act only as marketing
companies and outsource the drug manufacturing to third parties who accept orders for making the same
drug for multiple companies. In addition, there have been instances where the same generic formulations
company manufactures branded-generic and unbranded-generic drugs at the same plant.
Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November
2021, page 19:
the trend of multiple brands of the same molecule being marketed by the same company at different
price points runs counter to the proclaimed brand name-quality correlation. They added that
brand names of generic drugs can hardly signal quality, as several prominent players who market
these brands often get their products manufactured through third–party or contract
manufacturing, and the same third-party manufacturer accepts orders from multiple pharma
companies.
often, the same companies produce unbranded as well as branded versions of the same generic drugs at
the same plant.
it is not uncommon that the same company manufactures the same salt (pharmacopeial name of
the drug) on the same production line but sells it under different brand names at different prices.
24 | P a g e

Therefore, in its studies, CCI has found that the generics formulation companies have created the “branded-
generics” based on the artificial notion of superior drug quality.
As a result, the CCI study recommended the implementation of a “one-company-one drug-one brand name-
one price policy” to curb the practice of generics companies creating an artificial differentiation in the
otherwise non-differentiable generics drugs.
This practice of creating artificial product differentiation for exploitation of consumers, needs to
be addressed through a one-company-one drug-one brand name-one price policy.
Therefore, an investor may note that the govt. authorities have recognized that the artificial differentiation
created by branded-generics formulation companies is one of the reasons for high healthcare costs in the
country and the authorities are in continuous discussion to reduce the cost of medicines. Steps like “one-
company-one drug-one brand name-one price policy”, if implemented, may be steps in this direction.
If an investor analyses the pharmaceutical markets of foreign countries that faced a similar situation of
increased costs due to branded generics, then she comes across the example of Germany, which used to be
a market dominated by branded generics. In order to reduce the cost of healthcare in the country, the German
govt. implement reforms, which converted the German market from a branded-generics market to a tender-
based market. This change led to a significant fall in the prices of medicines and as a result, the European
operations of many companies became financially unviable (i.e. loss-making).
2020, page 5:
for instance, German market that was a branded generic market turned into a tender based
market with healthcare reforms being implemented) on account of budget constraints of healthcare
payors resulted in significant pricing pressures. Thus, the European operations of many players
became unviable.
To judge the impact of such reforms that led to the change in the nature of the market from branded-generics
to tender-based, an investor may compare the price of drugs in the Indian retail market with the price at
which the govt. procures drugs directly from the manufacturers.
In its market study, the CCI found that the cholesterol-lowering drug, Atorvastatin, was procured by the
govt. agency from the manufacturers at ₹0.21 whereas the manufacturer was selling it to the stockiest at
₹3.43 and the drug was selling in the market at a price of ₹5.1.
2021, page 16:
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Atorvastatin (10 mg tablet), a cholesterol–reducing agent, is procured by the procurement agency

at Rs. 0.21 (21 paise) while the same is sold at Rs. 5.1 in the private
retail segment…The manufacturer sells this product to stockiest at a mean price of Rs. 3.43.
Therefore, an investor would note that if the govt in India brings in health reforms like Germany and moves
forward to break the artificial differentiation created by branded generics in otherwise non-differentiable
generic drugs, then the prices of generic drugs may decline by even more than 90%.
The same thing happened in Germany when the business of many branded-generic sellers became
financially unviable and loss-making.
Even in a country like the US, generic drugs primarily compete on price and the prices keep on declining
as more and more competitors enter the market.
2014, page 6:
Generic drug producers typically have significantly lower margins than producers of branded
drugs because generics, to a large degree, compete on price. Generic prices and margins follow
a pattern that echoes the experience for branded drugs. Prices and margins fall as more
competitors enter the market.
Therefore, an investor would appreciate that the Indian generics drugs market has been made inefficient by
the artificial differentiation of generic drugs by “branded-generics” by the formulation companies.
Moreover, the govt. has acknowledged that such a practice by the formulation companies is leading to
higher healthcare costs for the country.
The credit rating agency, ICRA in its rating guidelines for the pharmaceutical sector in July 2020, page 2,
highlighted this risk prominently.
Government focus on driving generic prescription through policy change may entail change in
business model for domestic formulation companies.
An investor should always keep this aspect in her mind when she starts to project the current profit margins
of branded-generic players in India.
Apart from launching branded generics, companies use the peculiarities of the pharmaceutical trade channel
to gain a higher market share for their drugs despite keeping their drug prices high.
2.2.5) High incentives to the supply chain/trade channel:
From the above discussion, an investor would note that generic formulation companies are able to charge
a higher price for their branded-generic drugs by creating an artificial differentiation based on brand names
despite the ingredients being non-differentiable generic drugs. Such kind of artificial differentiation is
26 | P a g e

possible because the end-consumer, the patient is not educated enough to make an informed decision about
the product that she should buy.
2021, page 16:
As consumers are not in a position to make an informed choice and the quality/efficacy of drugs
is intrinsically unobservable, they follow doctors’ brand prescriptions, which are often influenced
by aggressive brand promotion by pharmaceutical companies.
Generic pharmaceutical companies have exploited the unawareness of the end-consumer by providing a
higher incentive to the retailer and to the prescribing doctors so that the sales of their branded-generics
drugs increase despite the contents being non-differentiable generic chemicals.
2021, page 30:
High retail margins are set by manufacturers as financial incentives for chemists to stock and
dispense their brands in the presence of multiple branded generic drugs available in the market
for each molecule. Given their space constraint and/or the need to minimise cost,
retailers/chemists cannot typically stock all brands available for a formulation. They have an
interest in stocking brands that offer them the highest margins. For non-scheduled drugs outside
the scope of price regulation, high retail margins can simply be ensured through higher MRPs.
Thus, competition between manufacturers on retail margins does not imply competitive prices for
consumers. Rather, this creates a systemic upward pricing pressure, eroding the benefits of
generic competition
2021, page 31:
The doctor-run pharmacies, on the other hand, reportedly dispense brands prescribed by the
owner-doctors, which too, entail higher retail margins. Thus, in these set ups, high margins create
perverse incentives that influence prescription patterns as well.
As a result, of aggressive sales & marketing of branded generics by formulation companies, the generics
formulation industry has created artificial differentiation in its products. This is despite the generics drugs
being simply a copy of the innovator patent-expired drug.
Ideally, in an industry producing non-differentiable, commodity products, the manufacturers should

compete on price leading to lower profit margins. However, CCI found that due to the artificial
differentiation created by branded generics, in India, the highest-priced branded-generic drug has been
observed to have the highest market share.
2021, page 31:
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As evidenced by the formulation-level data on prices and market shares, market leadership
position is often enjoyed by brands that command the highest or relatively higher prices. On the
other hand, the lowest-selling brands are often the lowest-priced.
CCI noted that the reasons for high priced drugs sustaining high market share is due to financial incentives
to the chemists that influence sales of drugs.
2021, page 45:
As mentioned earlier, setting high margins does not necessitate lowering of the manufacturers’
price, as it may be done by increasing the final price of the product. Such increases in retail
prices do not lead to erosion of market share and rather, help increase share in the retail market
by incentivising retail sale. This competitive tool focused on chemists is palpably not aligned with
consumer interest.
In addition, CCI also observed that the high incentives given by the generic pharmaceutical companies to
the trade channel are the reason for the high drug prices in India.
One major factor that contributes to high drug prices in India is the unreasonably high trade
margins.
In order to bring down the healthcare cost in India, the govt. has started to acknowledge the need to control
the high trade margins. In this direction, it has implemented two steps to control the trade margins.
First, for the drugs under the Drugs Price Control Order (DPCO), the trade margin is fixed at 24%, which
includes 16% for the retailer and 8% for wholesalers.
2021, page 28:
In India, scheduled drugs (under Drugs Price Control Order, DPCO) attract a statutory trade
margin of 24% – 16% for retailers and 8% for wholesalers.
However, for the remaining drugs, which are outside DPCO, the generic pharmaceutical companies used
to give a very high trade margin to the extent of 37%.
2021, page 29:
The median wholesale margin and retail margin were estimated to be around 9% and 28% of
customer price respectively,
28 | P a g e

As a result, as the second measure to control the trade margin and thereby the cost of healthcare, the govt.
has put up a reduced limit on the maximum trade margin for a few anti-cancer drugs. The govt. has
implemented as a trial case before it extends the trade margin caps to other drug categories.
2021, page 32:
In 2019, the National Pharmaceutical Pricing Authority (NPPA), India’s drug price regulator,
invoked Para 19 of the Drugs Prices Control Order, 2013 to rationalise trade margins in select
anti-cancer drugs… Under this price capping mechanism, trade margin was restricted to
a maximum of 30%. This exercise of trade margin capping on oncology medicines was undertaken
as a pilot for ‘Proof of Concept’ before further extension into other therapeutic segments.
Therefore, an investor may note that the govt. has been trying to reduce healthcare costs by limiting trade
margins. As a result, going ahead, giving higher trade margins may not remain a sustainable strategy for
branded-generics formulation players. An investor needs to keep this aspect in her mind before she analyses
generics formulation companies.
Let us now understand the business dynamics of another emerging segment of the pharmaceutical industry,
CRAMS.
3) Contract research and manufacturing services (CRAMS):

CRAMS, CMO (contract manufacturing organisations), CRO (contract research organizations) players act
as outsourcing parties mainly for innovator drug companies. CMOs manufacture formulations (finished
drugs), which are then sold by the innovator drug companies in different markets. CROs act as outsourcing
points mainly for innovator drug companies who outsource research work in drug development including
clinical trials to CROs in order to lower their cost of drug development.
In recent years, Indian pharmaceutical companies are getting a lot of outsourcing in contract research and
manufacturing field due to lower costs of production.
2020, page 3:
India is emerging as a major destination for CRAMS, driven by strong chemistry capabilities,
skilled manpower, cost value proposition with low R&D cost and large patient population
providing a diverse pool for clinical trials for New Chemical Entities (NCE).
The CRAMS players do not own any technology as the technology to manufacture drugs is provided by the
innovator drug company. As a result, the key requirement from the CRAMS player is to put in investment
in the manufacturing plant or clinical research setup.
29 | P a g e

As a result, the CRAMS field has low entry barriers and the market is fragmented, which leads to intense
price-based competition among contract manufacturers.
2020, page 3:
the domestic CRAMS market remains fragmented.
2014, page 11:
CMOs generally have limited competitive advantages because the market is extremely
fragmented, highly competitive, and price-sensitive. These market dynamics give much more
bargaining power to pharmaceutical companies that outsource manufacturing relative to the
contract manufacturers.
As the business of a contract manufacturer is capital intensive with low barriers to entry; therefore,
generally, the CMO players have very low negotiating power over their customers and suffer from low-
profit margins.
2014, page 6:
CMOs generally lack pricing power, which contributes to their relatively low profit margins.
Pharmaceutical company customers often have two CMO sources and have considerable power
in negotiating contracts with CMOs. The CMO business is also fairly capital-intensive, which can
hurt profit margins when revenues dip.
For any CRAMS player, winning a customer is a very tedious task as every customer performs a variety of
checks on the CRAMS player before it shares its drug manufacturing technology with it. As a result,
CRAMS players usually end up working with only a handful of customers resulting in customer
concentration who bear a high negotiating power over them.
2020, page 5:
Customer diversification remains a challenge given the long lead time associated (on account
of process validation, technology transfer and site audits by pharmaceutical marketing entities)
for business awards.
2014, page 14:
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CMO:…these companies are especially exposed to risks of customer and product concentration.
A customer could cancel production of a product and select a different CMO for the next-
generation product, or choose to manufacture it in-house.
An investor may note that in the CRAMS industry, due to the absence of own technology, lack of pricing
power, and intense competition in a fragmented industry leads to low profitability. Therefore, CRAMS
players focus on multiple strategies in order to improve their profitability and bring in competitive
advantages.
Let us discuss these strategies.
3.1) Become large-sized players – economies of scale:
Due to the near commoditised nature of CRAMS services with very low pricing power, only the lowest
cost CRAMS players perform well in the market. As a result, similar to API manufacturers who also face
the same challenges, CRAMS players also focus on growing large and benefiting from economies of scale
and deriving other benefits.
2020, page 4:
for players engaged in CRAMS particularly, large scale enhances their ability to offer different
product extensions / delivery systems and supports faster product filings on account of regulatory
expertise.
In addition, if CRAMS players develop capabilities to serve their customers in multiple

countries/geographies, then the customers prefer dealing with only a handful of contract manufacturers.
Therefore, large size with a presence in multiple geographies acts as a competitive advantage for CRAMS
players.
2014, page 5:
increasingly prefer fewer CMO vendors and they seek vendors that can provide a wide range of
services in multiple geographic markets.
Apart from becoming a large player for any product they manufacture, CRAMS players also try to
manufacture as many products as they can i.e. expand their product portfolio within their resource
constraints.
3.2) Expand the product range:
CRAMS players who offer multiple products to their customers allow them the benefit of dealing only with
a few CRAMS players for their needs.
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2020, pages 4-5:
CRAMS players (contract manufacturers) with reasonably diversified product portfolio across
growing therapeutic segments, delivery systems…ability to offer products across dosage
forms (solids, liquids, injectables, creams, gels, ointments) and ability to launch new products/
combinations/ dosages are also critical.
Let us now discuss the key segment of the pharmaceutical industry, its distribution channel, which many
times stays oblivious despite playing a very important role in the overall impact of the pharmaceutical
industry in healthcare.
4) Pharmaceutical distribution companies:

In recent times, many corporates have entered retail distribution of drugs like Apollo Pharmacies. In
addition, there are many companies, which have entered the field of online pharmacies like 1mg,
Pharmeasy, Netmeds etc.
In light of the same, it becomes important for the investor to understand the dynamics of companies making
up the pharmaceutical supply chain.
From the above discussion, an investor would remember that the pharmaceutical distribution chain plays
an important part in the sales and marketing strategy of branded-generic drug manufacturers. This is
because; such companies tend to offer a high retail margin to the chemists who then push these products to
the patients.
For drugs outside DPCO, the generic pharmaceutical companies give a very high trade margin to the extent
of 37%.
2021, page 29:
The median wholesale margin and retail margin were estimated to be around 9% and 28% of
customer price respectively,
As a result of these high retail margins, many corporates have entered the pharmaceutical distribution; both
offline and online.
Online pharmacies tend to source the drugs directly from the manufacturers or C&F agents representing
them and in turn, cut down on the supply chain. In this way, they are able to save on margins of multiple
distributors, which they pass on to the customers in terms of discounts.
2021, page 35:
32 | P a g e

online pharmacies integrate their warehousing functions with carry and forwarding agents, who
are the immediate front line for drug companies. The stocks that online pharma companies procure
from manufacturers are delivered to consumers directly. The advantage of this model is
a truncated supply chain with fewer intermediaries, allowing for higher margin and higher
consumer discounts.
Let us now try to understand how pharmaceutical distribution companies are able to get high trade margins
from drug manufacturers.
4.1) Anti-competitive practices of pharmaceutical distribution companies:
As per CCI, it has received multiple complaints (about 43) in the past against pharmaceutical distribution
companies and their association for anti-competitive practices where after investigation, it found evidence
of wrong-doing where the existing associations played the role of gate-keepers in the supply and thereby
blocking the competition.
As a result, CCI has ordered them to stay away from anti-competitive practices like mandatory NOC from
the associations for the appointment of stockiest by drug manufacturers, collective determination of trade
margin and control by the associations over discounts offered at wholesale and retail levels of sale.
2021, page 26:
With the purported goal of self-regulation, the apex association and its local affiliates were found
to essentially play a gatekeeper role at various levels of the distribution chain, making
pharmaceutical markets impervious to the incentives of competition.
Self-regulation and lack of competition in the distribution and retail of drugs are major reasons
why drugs are sold at printed prices, which are many times more than the manufacturers’ prices
In addition, an investor would also remember that the high retail margins to the chemists do not come at
the cost of profit margins for the manufacturers because the drug manufacturers increase the maximum
retail price (MRP) of the drugs. This nature of arrangement of the supply chain in the pharmaceutical
industry has led to a situation where high priced drugs get sold the most by the sales channel and in turn,
they get the highest market share.
Effectively, CCI stated that the current arrangement of pharmaceutical distribution channels is not aligned
with the best interests of the customers/patients.
2021, page 45:
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setting high margins does not necessitate lowering of the manufacturers’ price, as it may be done
by increasing the final price of the product. Such increases in retail prices do not lead to erosion
of market share and rather, help increase share in the retail market by incentivising retail sale.
This competitive tool focused on chemists is palpably not aligned with consumer interest.
The govt has acknowledged that unreasonably high trade margins in the pharmaceutical sector are one of
the key reasons for the high healthcare costs in the country. As a result, the govt. has started taking steps to
control the margins of the distribution companies.
2021, page 32:
In 2019, the National Pharmaceutical Pricing Authority (NPPA), India’s drug price regulator,
invoked Para 19 of the Drugs Prices Control Order, 2013 to rationalise trade margins in select
anti-cancer drugs… Under this price capping mechanism, trade margin was restricted to
a maximum of 30%. This exercise of trade margin capping on oncology medicines was undertaken
as a pilot for ‘Proof of Concept’ before further extension into other therapeutic segments.
Moreover, when CCI studied 27 OECD (Organisation for Economic Co-operation and Development)
countries, then it found out that all of these countries controlled the pharmacy margins.
2021, page 45:
study of 27 OECD nations suggested that all of them regulated pharmacy margins
Therefore, an investor may note that the govt. has been trying to reduce healthcare costs by limiting trade
margins of pharmaceutical distribution companies. As a result, she should keep this aspect in her mind
while analysing pharma distribution companies and while projecting their profit margins in the future.
Let us now try to understand the fate of pharmaceutical distribution companies in developed countries to
assess whether the current scheme of things in the drug distribution channels in India are sustainable.
4.2) Consolidation in the pharmaceutical distribution companies in the foreign markets:
While analysing the fate of pharmaceutical distribution companies in overseas countries, an investor notices
that the low-profit margins of the trade channel have led to a consolidation in the supply chain in many
countries.
In the case of Japan, the pharmaceutical distribution companies underwent consolidation and as a result,
only four wholesale companies were left in Japan.
Rating methodology for pharmaceutical sector by Japan Credit Rating Agency, December 2011, page 1:
34 | P a g e

With a significant market reorganization since the late 1990s in a bid to offset falling margins with
cost cutting, there are now just four pharmaceutical wholesalers.
As a result of consolidation, the competition among the Japanese pharmaceutical wholesalers has become
very severe and there is price-based competition.
Competition among the four integrated groups of pharmaceutical wholesalers is severe. When
pharmaceutical wholesalers were the group companies of pharmaceutical manufacturers, their
product lineups were weighted in favor of certain products. Following industry reorganization,
however, each group now handles almost a full range of products of pharmaceutical companies.
These changes also meant that, because pharmaceutical wholesalers cannot differentiate
themselves from their competitors in terms of their product lineups, they often engage in price
competition.
The Japanese wholesaler group have witnessed the prospective returns from their core business decline to
such an extent that they are forced to venture into other business areas like drug manufacturing.
Pharmaceutical wholesaler groups are expanding into the pharmaceutical

manufacturing business and dispensing pharmacies operations. As a result of a peaking of the
recent industry reorganization, the growth potential of the core businesses has, in fact, been
falling.
The consolidation of the supply chain is not limited to Japan. Globally, in multiple companies the
pharmaceutical trade channel witnessed consolidation in order to improve their profit margins.
in the prominent developed markets, it is witnessed that the consolidation of supply chain in the
hands of few large distributors also puts pressure on product pricing.
Even in the US market, the pharmaceutical distribution business underwent significant consolidation during
FY2017-FY2019 in order to improve the bargaining power of the trade channel. It led to significant pricing
pressure on the formulation companies.
2020, page 5:
Indian pharmaceutical entities with presence in largest generic markets of USA faced steep pricing
pressure during FY2017-2019 period owing to supply chain consolidation
35 | P a g e

Therefore, an investor would appreciate that in many developed markets, the pharmaceutical supply chain
companies earn much lower margins than what they earn in India. As a result, in order to improve their
bargaining power, they undergo consolidation. However, despite consolidation, in Japan, the wholesalers
are not able to earn a high return due to which they have to enter into businesses like pharmaceutical
manufacturing etc.
As a result, while analysing pharmaceutical distribution companies, an investor should keep in her mind
that as a business, the supply chain globally does not earn a high margin. As per CCI, the high trade margins
in the Indian pharma supply chain is due to anti-competitive practices, which are now under the scrutiny of
the govt.
Therefore, the pharmaceutical distribution companies in India might witness a decline in their trade
margins. Going ahead, an investor should keep a close watch on the same.
With the above overview of pharmaceutical companies, let us now understand the key characteristics of the
pharmaceutical business and the factors affecting the companies.
Key factors influencing the business performance of pharmaceutical companies
1) Pharmaceutical industry is less impacted by general economic cycles:

An investor would appreciate that the demand for drugs arises from the prevalence of sickness. Illnesses do
not depend upon the state of economic cycles. If a person gets sick, then in all probability, she would go to
a doctor/pharmacist and get drugs for health improvement. Therefore, the financial performance of
pharmaceutical companies is relatively less dependent on the boom & bust phases of the general economic
cycle.
pharmaceutical industry is considered as one of the defensive sectors, largely immune to the
economic cycle.
Rating methodology of the pharmaceutical sector by the credit rating agency, Rating and Investment
Information, Inc., Japan, page 2:
pharmaceuticals are products related to health and human lives, and demand is
fundamentally unaffected by the economic ups and downs.
If an investor thinks deeper, then she may find a little correlation of demand for pharmaceutical products
with the economic cycles in the countries where insurance penetration is high and most of the healthcare
expenses are paid by employers’ group health insurance plans. In such situations, during economic declines,
there are job losses and people lose the coverage of health insurance. Such situations may lead to a decline
in healthcare expenditure during economic declines.
36 | P a g e

2014, page 4:
In the U.S., demand can be slightly sensitive to the employment rate, in part, because lack of a job
may mean lack of drug insurance for people of working age and their children…Patients may defer
routine check-ups (where drugs are prescribed), ration drugs, or seek lower-cost therapies for
economic reasons.
However, despite the above slight correlation, the cyclicity of the pharmaceutical industry’s revenue and
profit margins has been very low.
As per credit rating agency, Standard and Poor’s, the average decline in the revenue of pharmaceutical
companies during 1952-2014 had been 0.2%. The decline in revenue in the 2007-2009 global recession was
only 0.4%. Moreover, the average decline in profit (EBITDA) margin of pharmaceutical companies during
1952-2014 was 4.0%. During the 2007-2009 global recession, the decline in EBITDA margin was 1.8%.
2014, page 4:
Historical data supports this view, showing very low cyclicality of revenues and low cyclicality of
profitability, which are the two key measures used to derive an industry’s cyclicality assessment.
Based on our analysis of global Compustat data, pharmaceutical companies experienced
an average peak-to-trough (PTT) decline in revenues of only 0.2% during recessionary periods
since 1952, and a PTT decline of 0.4% during the severe 2007-2009 recession. The EBITDA
margin of pharmaceutical companies experienced an average PTT decline of 4.0%, and a modest
decline of 1.8% in the 2007-2009 recession.
Therefore, an investor would notice that the performance of the pharmaceutical industry is less linked to
the phases of general economic cycles. Instead, the variations in the performance of pharmaceutical
companies are more linked to their own business performance like the life-cycle stage of its drugs, new
drug launches and their success etc.
2014, page 4:
Volatility in a pharmaceutical company’s revenues and profitability is more likely to reflect its own
new product launches and the market entrance of competing products, rather than broad
macroeconomic conditions.
The pharmaceutical industry is not cyclical in a macroeconomic, short-term context. If anything,

it is exposed to longer-term cyclicality which can result from a drug’s life patterns or patent expiry.
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Therefore, an investor may keep in her mind that as an industry, the demand for the products of the
pharmaceutical industry does not change much with boom and bust phases of the general economic cycle
because it is dependent on the health needs and prevalence of sickness.
2) Very high regulatory risk:

An investor would appreciate that the products of the pharmaceutical industry have a direct impact on
human health. As a result, the industry is one of the most regulated across all the countries irrespective of
developed or developing countries.
3:
highly regulated worldwide, by virtue of its direct bearing on public health.
The regulations require the company to meet strict manufacturing and process standards, which impose
significant costs on the companies.
5:
compliance with ‘current good manufacturing practices’ requires higher capital and R&D
investments,
2020, page 6:
Upgrading and maintaining a manufacturing facility that meets the standards of the regulated
markets call for significant financial commitments.
If companies are not able to meet strict regulatory standards, then the cost of re-inspections for approval
and the loss of business in the interim can lead to significant costs for the companies.
Since the legal cost of any such litigation and the time for re-inspection are high, the revenue and
profitability of the companies may be impacted; hence, trigger of such regulatory-concerned
events are critical from the credit perspective
Moreover, in recent times, even the most reputed Indian and global pharmaceutical companies have
received notices of non-compliance by regulators indicating that the countries are going for very strict
implementation of regulations.
2020, page 6:
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With the heightened scrutiny levels and stringent product quality standards evident from
imposition of warning letters/ import alerts by USFDA even for reputed Indian as well as global
generic entities, maintaining manufacturing standards has become critical for players with
sizeable exposure to the US and Europe
In the recent past, an increase in the strictness of regulations in China had a significant impact on the
pharmaceutical sector in China as well as overseas markets like India.
Recent changes in environment rules in China have led to disruption in production in China and
in turn increased the cost of raw material for Indian pharma companies.
Apart from the requirement of meeting strict regulatory guidelines, the pharmaceutical companies also face
risks of existing good-selling drugs and combinations coming under regulatory scrutiny, which may have
a significant impact on their sales. In 2016, India banned many drug combinations, which impacted the
business of pharma companies.
4:
In 2016, the union health ministry banned 344 fixed-dose combination (FDC) drugs (including
several antibiotics and analgesics) on the recommendations of an expert committee as these were
allegedly irrational combinations.
3) Continuous pricing pressure on pharmaceutical products across the world:

An investor would appreciate that pharmaceutical products form one of the major portions of the healthcare
costs. As a result, countries across the world attempt to control the prices of drugs either directly or
indirectly so that the burden of the healthcare costs on the govt. and the population can be reduced.
In countries like India, the govt. controls the price of essential drugs directly by way of the Drug Price
Control Order (DPCO), which is implemented by the National Pharmaceutical Pricing Authority (NPPA).
In India, by 2017, almost 20% of all pharmaceutical sales were under price control.
4:
Subsequent revisions added more drugs to this list, and brought nearly a fifth of the
pharmaceutical market by value, under price control by fiscal 2017.
Therefore, while analysing any pharmaceutical company, an investor should try to find out how much of
its revenue is from the drugs under the price control list because; it puts limitations on its pricing power.
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CARE Ratings analyses the company’s revenue and the percentage share of revenue it derives
from NLEM products which restricts its pricing flexibility.
Nevertheless, in India, apart from the list of drugs directly under price control, for other drugs also, the
pharmaceutical companies have limits on how much price increase can be implemented.
2020, page 2:
As for pricing controls…in the form of price cap on essential drugs…as well as maximum
permissible annual price increases (price control) on rest of the portfolio.
An investor would note that the price controls are not only limited to India or other emerging economies.
Almost all the developed countries implement price controls on pharmaceutical products in one form or
another.
2020, page 3:
All developed countries have been focusing on driving generic prices down through various price
control measures such as faster approvals or compulsory price cuts or tendering system among
others. This has led to high competitive intensity with downward pressure on prices
The phenomena to bring down the prices of generics formulations through various price
control measure is also observed in the developed markets
We noticed in our previous discussion how Germany made the business of many pharmaceutical companies
unviable when it converted its market from branded-generics to tender-based. Similarly, other European
countries also implement price controls.
2014, page 5:
The European region also has policies on direct or indirect price control that vary across countries
In countries like Japan, the govt. directly controls the prices of drugs and revises them downwards every
two years. This downward pressure on drug prices has made the Japanese market unattractive for its own
pharmaceutical companies, which are now looking overseas for growth opportunities.
Prices of pharmaceuticals (drug prices) are official prices that are set by the government and that
are, in principle, revised once every two years…As the government aims to cut drug costs… the
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growth of the domestic pharmaceutical market has been sluggish. In response, pharmaceutical
companies have been focusing on developing operations in overseas markets,
However, an investor gets to know that the price controls on pharmaceutical products are the least in the
US.
2014, page 5:
drug price controls exist in nearly all countries except the U.S.
Therefore, it does not come as a surprise when an investor notices that almost all the companies across the
world attempt to sell drugs in the US irrespective of their country of origin.
Let us now discuss another key characteristic of pharma companies, which is research & development
(R&D) and the role it plays in their business model.
4) Focus on R&D, new drug development, complex generics:

From the above-detailed discussion on understanding different segments of the pharmaceutical industry, an
investor would appreciate that research and development (R&D) plays an important role in determining the
competitive advantage of all the pharmaceutical companies whether they are innovator companies,
generics, API or CRAMS players.
4.1) In the case of innovator companies, the focus of R&D is to develop new drugs that may become
blockbuster drugs (more than $1 billion annual sales) or find new delivery mechanisms of existing drugs
like insulin delivery via nose instead of injections.
At the apex of the R&D pyramid is research pertaining to New Chemical Entity (NCE) and NDDS
Novel Drug Delivery System (NDDS). This involves development of a novel drug which is a likely
candidate for being granted a patent and becoming a blockbuster drug. This also may entail
development of a novel delivery system for an existing drug.
Innovator companies, largely based in developed countries spend about 15%-20% of their revenue on R&D.
2014, page 6:
R&D costs are substantial, typically 15% to 20% of revenues.
The very high spending in the R&D, as well as clinical trials and registrations in multiple countries needed
for new drug development, creates entry barriers for new players and in turn, puts innovator companies in
a position of significant competitive advantage.
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These high costs protect the industry by creating relatively high, de facto entry barriers: pre-
funding of R&D, selling and distribution expenses can easily total more than USD 500m over
several years before the first sales for the new drug come in.
2014, page 5:
A new branded drug must be approved by regulators in each country. Its efficacy and safety must
be demonstrated in extensive clinical trials. The costly and time-consuming approval process,
combined with patent protection, forms a major barrier to entry.
An investor would appreciate that for the innovator pharmaceutical companies, high R&D expense provides
competitive advantages. However, the R&D expense apart from being the highest expense becomes a
necessary expense. This is because an innovator drug company cannot reduce the R&D expenses for short-
term profits without a significant decline in its competitive position.
Rating methodology of the pharmaceutical sector by the credit rating agency, Rating and Investment
Information, Inc., Japan, page 4:
Cost structure: For a branded drug manufacturer, R&D spending is the largest
expense category…Such outlays provide the lifeline for maintaining and enhancing
competitiveness, and a company cannot significantly reduce R&D spending in order to gain short-
term profits. The cost structure of branded drug manufacturers lacks flexibility.
4.2) In contrast, other companies like generics, API and CRAMS players do not have the financial
strength to spend on R&D expenses needed for new drug development. However, these companies operate
in business segments that make commoditised, non-differentiable products leading to intense price-based
competition.
As a result, in order to avoid price-based competition and resulting low-profit margins, these companies
focus on complex generics e.g. biosimilars, which are difficult to make and have lower competition.
However, the development of complex generics like biosimilars requires spending money on R&D.
5:
Furthermore, companies are also focusing on niche segments of biosimilar and specialty
pharma segments, which have relatively lower competition and high profit margins.
5:
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Factors affecting market position for bulk drug manufacturers: According to CRISIL
Ratings…presence of molecules that are complex to manufacture significantly mitigate
competitive pressures and support performance in terms of sales growth and profitability.
Similarly, the API and CRAMS players also have to continuously spend money on R&D primarily for their
process and operating efficiency improvements.
2020, page 6:
API entities R&D efforts is focused in the areas of new products for renewing product portfolio
and introduce derivatives with market potential as well as improve process efficiencies to become
more competitive as the products mature.
For companies offering CRAMS, R&D is focused on process research, synthetic chemistry and
other services that they offer to global pharma companies for partnering them for early stage drug
discovery and developments
As a result, an investor would notice that Indian pharmaceutical companies are also spending a significant
amount of their revenue on R&D even though it is still lower than the money spent by innovator drugs on
R&D.
Generally, mid to large-sized pharmaceutical companies in India spend nearly 6%-9% of their
annual sales towards R&D activities
Since the change of patent regime from earlier process-based patents to current product-based patents, some
Indian companies have also started to invest in R&D for new drug development (NCE: new chemical
entity). However, from the above discussion, an investor would remember that developing new drugs is an
extremely expensive proposition where a company may have to spend up to $500 million (about ₹3,750 cr
@₹75/$) before the drug can make any sales.
As a result, most of the Indian companies focusing on new drug development only participate in a part of
the overall drug discovery process. They develop the molecule to a certain stage and then sell it to other
innovator companies who develop it further and then take it to the market.
Due to such collaborative research, the financial risk of new drug development gets distributed across many
firms.
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Since new drug development activity is characterised by huge cost and low success rates, it is
generally not feasible for a single company to take a molecule from the lab to market. Hence, it
considers exploring for partners to do so by out-licensing a molecule after a certain stage of
development to another company which takes up further development of the drug and eventually
to the market. This arrangement helps the companies to mitigate the risk to certain extent.
2020, page 6:
While most Indian entities lack the balance sheet size to carry on NCE research, some of the
entities have been somewhat successful in NCE research, adopting early monetization route for
its investments by out-licensing or milestone based payments based on research outcomes
Collaboration with other companies in order to reduce the risks associated with new drug development has
ensured that it is not only Indian companies who collaborate with other innovator companies. Instead, the
big pharmaceutical companies of developed countries also actively look for collaborating with capable
companies from emerging markets.
2014, page 5:
The costs and specialized skills needed for late-stage development encourage market entrants to
seek established partners, rather than try to compete with them.
For example, the Japan Credit Rating Agency highlighted that Japanese pharmaceutical companies actively
look towards acquiring new drug chemicals, which are under-development and have the potential to become
a successful drug.
Often, pharmaceutical companies will acquire candidate chemical compounds externally to

strengthen their drug pipelines. In these cases, the companies usually make initial lump-sum
payments and milestone payments in accordance with the stage of development.
Apart from developing new drugs for formulation companies and new processes for bulk drug & CRAMS
companies, R&D also helps in overcoming another key factor impacting revenue and profitability of drug
companies, the lifecycle of drugs.
5) Lifecycle of drugs:
An investor would appreciate that any new drug follows a typical lifecycle.
In the first stage, it is introduced in the market as a novel/innovator drug where the patent-holder company
has exclusive rights to sell it at a price appropriate to recover its R&D costs and earn profits.
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In the second stage, the patent expires and generic drugs enter the market capturing almost 90% of sales
volume and leading to about 85%-90% decline in the drug’s price.
In the later stages, the innovator pharmaceutical companies develop drugs, which are a better alternative to
the old drug and we witness a decline in the demand and profitability of the old drug, which slowly leads
to its natural death.
While analysing any pharmaceutical company, it is essential to determine at the stages of the drug lifecycle
where its products are.
Usually, any generics or API player, who manufactures products early in their lifecycle would be able to
earn a higher profit than the players who manufacture matured/late-stage products.
2020, page 7:
For APIs and generics, profitability is also influenced by the particular stage a product has
reached in its lifecycle (mature, commoditised products usually offer low margins) and the time of
its market entry (early entry often yields a relatively large market share and hence higher
margins).
Usually, the comparison of the annual volume as well as value growth rate of the pharmaceutical products
of any company gives an idea to the investors about the stage of drug lifecycle of its products.
CARE Ratings also analyses the year-on-year growth rate of existing products in terms of value
as well as volume which indicates the product’s life cycle.
An investor would appreciate that the stage of the lifecycle of any drug plays an important role in the profits
that its manufacturers would make. Therefore, to make good profits sustainably, every company, be it an
innovator pharmaceutical company or generics/API/CRAMS player, need to continuously work on
generating a pipeline of drugs at different stages of the product lifecycle.
To manage the drug lifecycle risk, the innovator companies continuously work on new drug candidates at
different stages of development. In addition, they continuously work to extend the life of product patents
by developing derivatives as well as new dosage forms of the existing drugs nearing patent expiry.
The basic strategies for companies mainly specializing in original drugs to compete with generic
drugs are…to carry out appropriate lifecycle management (the extension of product lives mainly
by adding new efficacy and improving dosage forms).
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In the case of generics companies, in order to have a continuous pipeline, they start targeting innovator
drugs whose patents are going to expire many years (7-8 years) down the line.
2020, page 6:
To develop a healthy pipeline of drugs, entities need to draw up their R&D investments well into
the future, targeting products with patent expiry of upto 7-8 years into the future.
To assess the effectiveness of the product pipeline of any generics company, an investor may have to assess
various regulatory filings done by it in different countries.
Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA,
December 2017, page 6:
A proxy for the product pipeline can be represented by regulatory filings (DMFs, ANDAs, NDAs,
marketing authorisation applications, certificate of suitability of the European Pharmacopoeia or
CEP, etc). Assessing the diversity of the pipeline (nature of filings, for instance, ANDAs with Para
IV certification, NDAs filed targeting exclusivity under 505 (B)(2) for improvised/ new delivery
systems in the US market etc.), however, remains critical.
Now, let us take forward our earlier discussion on the benefits seen by drug companies on the sale of drugs
to regulated/developed markets and why every company, be it formulation, API or CRAMS, wants to sell
to developed countries, especially the USA.
6) Selling drugs in the regulated markets (especially US) offers higher profits:
An investor notices that most of the Indian pharmaceutical companies whether they are formulation
manufacturers or API or CRAMS companies, attempt to focus on the developed markets, which have higher
regulations like the US, European Union, Japan etc.
In fact, the Indian pharmaceutical industry (IPI) exports about 50% of its production and about 30% of
exports go to the USA.
Exports form a significant portion of the IPI and account for about half of the industry’s
sales…Exports to USA account for about 30% of the total outbound shipments.
The main reason for such a focus on regulated markets is that these markets provide an opportunity high
risk with high returns. The high risk is due to the challenges of meeting stricter regulations.
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For exports to the regulated market, companies earn a higher profitability; however, they are
required to follow more stringent regulation compliances related to patent and drug laws of those
countries.
5:
Regulated markets such as the US and Europe, which are characterised by high entry barrier,
offer a substantial premium over realisations in other markets.
Due to high returns offered by the exports to regulated markets over the Indian market, most of the
pharmaceutical companies with good capabilities expand into export markets over time.
companies having better capabilities gradually diversify revenue stream to exports market over
the years.
Though the share of revenue from domestic market has been declining for most top
pharma companies due to diversification to export markets,
In the recent past, many Indian pharmaceutical companies have acquired overseas
assets for expanding their product/ market reach and gaining access to intellectual property of
such companies.
An investor notices that almost all the govt. across the world put some price controls on pharmaceutical
products. However, in the US market, these pricing controls are the lowest. As a result, companies that
supply mostly to the US are in a better position to earn higher profits and are supposed to have a competitive
advantage.
2014, page 12:
size of the U.S. market and its absence of price controls make it especially attractive. Therefore
a high concentration of sales in the U.S. is usually viewed favorably.
highest geographical diversification is achieved when a company’s structure reflects that of the
global market: about 50% in the US, 25% in Europe, and 25% for the rest of the
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world…importance we place on the US segment is due to our belief that this market affords
the potential for higher profitability – in turn a reflection of better pricing
Moreover, in a market like the US, generics drugs are promoted by the distribution chain as they get a
comparatively higher margin selling generic drugs than branded innovator drugs.
2009, page 10:
In the U.S., generic drugs generate a much higher profit margin (more than three times) for drug
wholesalers, pharmaceutical benefits managers, and drug stores than branded drugs, so there is
an incentive along the distribution chain to promote generics over brand-name medications.
In contrast, the semi-regulated developing countries with lenient regulations provide low barriers to entry,
which leads to intense competition. As a result, companies supplying to developing countries typically have
low-profit margins.
2020, page 7:
Margins are also typically moderate for players targeting less regulated markets, as relatively
lenient requirements for product registration and manufacturing facility approval also imply low
entry barriers and therefore intense competition.
Therefore, an investor would appreciate that the pharmaceutical companies, which have a higher share of
the revenue from developed markets, especially the USA, are in an advantageous position.
An investor would remember from our previous discussion that for the companies dealing in API/bulk drug
and CRAMS, becoming bigger in size brings competitive advantages. Let us now try to understand how
becoming big creates a loop where size brings advantages, which help pharmaceutical companies to grow
further.
7) Big gets bigger in the pharmaceutical industry:

From the above discussion, an investor would notice that pharmaceutical companies across the world are
under continuous pricing pressure. In addition, multiple segments of the industry like API and CRAMS
players do mainly commodity work and therefore, do not have any pricing power over their customers.
As a result, one of the ways for almost every pharma company to improve its profitability is to become the
lowest-cost producer. In this regard, increasing the size of the organization helps the company in obtaining
many competitive advantages, especially economies of scale.
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size and market position, including market share, are strong rating drivers for generic companies.
This is because the size of operations creates the potential to benefit from size-related
economies for cost types, such as production and distribution, in a volume-driven industry.
Large pharmaceutical companies have comparatively higher bargaining power over their suppliers and
customers. Due to their large size, they can invest more money in R&D, do more capacity additions, and
fight litigations effectively.
2020, pages 3- 4:
Scale of Operations and Market Position: Large scale typically provides better bargaining
power with suppliers and also allows improvement in competitiveness by way of entailing cost and
manufacturing process efficiencies. Moreover, it enables better equity with prescribers as well as
distribution channels for branded formulation entities. Additionally, large pharmaceutical entities
are able to negotiate better pricing with the drug wholesalers and drug payors for their developed
market operations. Ceteris paribus, a large scale pharmaceutical company is likely to be better
positioned to
 make continued investments in R&D for maintaining a healthy product pipeline

 undertake capacity additions to support future growth
 allocate budgets for litigations relating to product filings (pertaining to Para IV in the
US market) and
Moreover, the large companies are better able to spend the resources needed to meet the strict compliance
requirements of lucrative-regulated markets, which acts as an entry barrier for smaller companies.
Entry into regulated markets requires strict compliance with patent and drug laws of those
countries and serves as an entry barrier for small and mid-size pharmaceutical companies.
In addition, large-sized companies whether they are formulations, API or CRAMS players, when they are
backward or horizontally integrated, are able to have better pricing flexibility leading to significant
competitive advantages.
7:
Backward integration helps improve operating margin, pricing flexibility and control on
quality standards, compared with smaller players.
The integrated nature of operations of large Indian pharmaceutical companies has helped them report profits
on the sale of generic drugs in developed markets despite a more than 90% decline in drug prices.
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2020, page 7:
Backward integration is an increasingly crucial factor in sustaining cost advantages in exports

especially for commodity generics in regulated markets. For instance, some Indian manufacturers
have been able to sustain profitability even after over 90% price erosion on generics
In the pharmaceutical industry having a large size is so important that credit rating agencies like Standard
and Poor’s have stated that it does not give its highest credit rating to small and mid-sized pharmaceutical
companies despite their very good performance.
2009, page 14:
Smaller and medium-size companies usually are precluded from reaching the highest
ratings levels, despite having strong profitability and financials characteristics, because of lack of
products, market, and geographic diversification. Global operators usually have stronger
diversification and economies of scale, which let them offer more comprehensive and varied
services to varied customer segments.
All these competitive advantages ensure that large pharmaceutical companies perform better than smaller
ones and in the long-term, the big companies become bigger.
With this, we have come to the end of our elaborate discussion on the business dynamics of the
pharmaceutical industry. Let us now try to revise our key learnings in the summary.
Summary
The pharmaceutical industry is one of the most essential industries that benefit from the sustained demand
across economic cycles. As a result, it is known as a defensive sector without boom and bust phases. The
industry is divided into different segments like formulations, API/bulk drugs, CRAMS, and distribution, all
of which show very different business dynamics.
The formulations segment, which sells the ready to consume drugs is the largest segment of the industry. It
primarily includes the innovator drug companies that invent/discover new drugs, which have helped defeat
many dangerous diseases for mankind. However, the new drug discovery process is very costly as it
involves investments of thousands of crores of rupees before the drug can generate any revenue. As a result,
countries grant patents to innovator drug companies, which provides exclusive rights to sell the drug at a
profit and recover the cost of drug development. Successful drug discoveries have proved to be extremely
profitable for companies; therefore, they invest millions of dollars in drug development despite a low
probability of success.
After the drug patents expire, then another segment of formulations companies, “generic companies” come
into the picture. These companies mass-produce off-patent drugs at a very low cost because they did not
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need to spend large money on drug discovery. As a result, once generics enter the market, the prices of
drugs fall by up to 90% and drugs become affordable to the majority of the population. Due to the low cost
of generic drugs, most governments promote them through policy initiatives.
Even though all the generics drugs are the non-differentiable replica of the original drug; however,
companies create artificial differentiation by branding their generic drugs as “branded generics”. Govt.
authorities in countries like Germany and India have found that artificial differentiation by branded generics
lead to increased cost of healthcare and is not in consumers’ best interest.
As a result, Germany converted its market from branded generics to tender-based and operations of many
generics players became loss-making. India is also recognizing the harmful impact of branded generics and
solutions like “one-company-one drug-one brand name-one price policy” are being discussed. An investor
should keep in mind the impact of the elimination of branded generics on the business model of generic
formulation companies while she projects their future performance.
As such generic formulations companies and API/bulk drug, and CRAMS players provide non-
differentiated commoditised products and services and have low barriers to entry. Therefore, these segments
are fragmented and face intense price-based competition. To generate competitive advantages, these
companies attempt to make complex generics, biosimilars and technologically difficult APIs, which have
less competition and a high-profit margin. However, the innovator pharmaceutical companies create a lot
of hurdles to restrict competition from biosimilars.
Pharmaceutical distribution companies have been earning very high trade margins over the years, which
has attracted corporate players in offline as well as online pharmacy retailing. Govt. authorities have
realized that the relationship between drug manufacturers and distribution companies, which provides
unreasonably high trade margins due to which the retailers push the sales of high priced drugs, is not in the
best interests of the consumer. Due to this relationship, high priced drugs have the highest market share and
in effect increase the cost of healthcare. As a result, the govt. has started taking steps to control the
unreasonably high trade margins.
In countries like Japan and US, the distribution trade margins are minimal, which has led to consolidation
in wholesalers and even forced them to enter other businesses like drug manufacturing because the core
business of drug distribution is not very profitable. However, on the contrary, in India, the pharmaceutical
distribution companies act as a cartel where they control the entry of new stockiest by mandatory NOC and
control the trade margins by directions of associations. These practices have been held anti-competitive by
CCI and the distribution companies and organizations are ordered to stop doing it.
The pharmaceutical industry directly deals with human health; therefore, it faces stringent regulations.
Drugs and their combinations routinely get banned if found unsafe. Getting approval for new drugs is very
cumbersome, which acts as a barrier to entry for new players.
All the countries want to lower the cost of healthcare; therefore, each country attempts to control drug prices
directly or indirectly. There is continuous downward pricing pressure on the pharmaceutical industry by
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way of direct govt. order or by generics approvals. As a result, the companies continuously need to invest
money in R&D to keep discovering new drugs, delivery mechanisms, new processes so that they may get
patent protection and earn high profits.
Continuously high R&D costs are also necessitated by the drug lifecycle, which leads to lowering of
revenue and profits from a drug as it grows older and matures. Innovator companies work hard to find new
blockbuster drugs and generics drugs work hard to make generics of drugs 7-8 years before their patents
expire. The quest to gain profits lead to legal battles where generic companies challenge patents of innovator
companies even before expiry. The innovators create every possible hurdle to stop the entry of generics and
even sue regulators who approve generic drugs.
Generic drug manufacturers attempt their best to gain entry in the developed-highly-regulated countries as
these provide higher profits. However, it also necessitates a high investment in meeting stringent regulatory
requirements. Despite spending a lot of money on meeting the guidelines, even the most reputed names
have been denied approvals and issued notices of non-compliance. Selling in regulated markets is a high
risk-high reward game.
Succeeding in the pharmaceutical industry is a highly expensive game. New innovator drugs are the most
profitable but may need spending of thousands of crores rupees without any assurance of success. Meeting
regulatory guidelines is costly. Creating large plants to produce non-differentiable generic drugs is capital-
intensive. Becoming the lowest cost producer in the segment is expensive. Creating a broad portfolio of
drugs to diversify risks is costly. No wonder in the pharmaceutical industry, the big gets bigger.
In essence, when an investor analyses the pharmaceutical industry, then she notices some key
characteristics:
 Stable demand: It is an evergreen sector with stable demand. People get sick and buy drugs
whether it is an economic upturn or downturn.
 Regulatory risk: Getting regulatory approvals is difficult and expensive. Maintaining them is
also neither easy nor cheap. On one fine day, authorities may ban your blockbuster drug and your
business is shut.
 Pricing pressure: Everyone wants drugs cheap, whether govt. or the consumer. Govt. directly
orders to sell essential drugs at a cheaper price and controls price increases on others.
 R&D: The need to spend money on R&D never ends. A company cannot stop R&D even if it
wants.
 Drug lifecycle risk: Companies need to renew their product portfolio otherwise revenues and
profits would decline.
 Selling in highly profitable markets comes at high risk: Regulated markets offer an
opportunity to create higher returns but it comes at very high risk. Entry to developed markets
comes after stringent approvals and intense legal battles with innovator drug companies who sell
the original drugs at a very high price.
 Need deep pockets to succeed: Whether a company is an innovator or generics or API or
CRAMS, it needs a lot of capital to succeed in its field. To reduce risks and lower costs of
production (economies of scale) it needs to increase its size, which again demands more
investment.
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 Artificial product differentiation of branded generics may not last forever. Germany broke
the practice of branded generics to kill this business model. India may follow suit.
 Drug manufacturer-distributor nexus of the manufacturer giving high trade margins to the
retailer and the retailer pushing sales of high-priced drugs may not sustain.
Therefore, an investor may keep these points in her mind while she analyses any pharmaceutical company
and projects its performance in the future.
Regards,
Dr Vijay Malik
P.S.
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53 | P a g e

2) How to do Business Analysis of Hospitals
After reading this chapter, an investor would know the factors that make any hospital a strong player. She
would also know how the operating environment for Indian hospitals may evolve in the future to change
their pricing power and competitive landscape.
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The hospital industry is classified into multiple segments based on the level of specialized care and the size
of the hospital represented by the number of beds e.g. primary care/daycare centres, secondary care/a few
specialities and tertiary care/referral centres.
However, from a simplistic understanding perspective, an investor may divide hospitals into two groups.
The first is large super-speciality hospitals providing complex healthcare that may also have medical
colleges attached to them and the second group is smaller hospitals and daycare centres that provide simpler
healthcare services.
During the current article, we would discuss the business characteristics of the hospital from the perspective
of these two segments i.e. large super-speciality hospitals and other smaller hospitals because, in many
aspects, these two groups have slightly different business strengths and challenges.
Key features impacting the business model of hospitals
1) Low cyclicity in the demand for healthcare services:

The demand for healthcare services is not linked to general economic cycles of boom and bust. This is
because people get sick and therefore avail services of hospitals irrespective of the state of the economy.
As a result, healthcare services providers face a low cyclicity in the demand for their services.
Rating methodology for hospitals, ICRA, September 2020, page 3:
ICRA considers the low cyclicality associated with the hospital business favourably as demand for
healthcare services is largely insulated from macroeconomic cycles.
As per the credit rating agency, Standard & Poor’s (S&P), in the past recessions, the revenue of the
healthcare services industry did not witness any decline whereas the profit margin declined only in the
range of about 3% to 6%, which indicates a low level of cyclicity in the industry.
Key credit factors for the health care services industry, Standard & Poor’s, April 2014, pages 3-4:
Historical data supports this view, showing no cyclicality of revenues and low cyclicality of
profitability, which are the two key measures used to derive an industry’s cyclicality assessment.
Based on our analysis of global Compustat data, health care services companies experienced no
peak-to-trough (PTT) decline in revenues during recessionary periods since 1968, including the
severe 2007-2009 recession. The EBITDA margin of health care services companies experienced
an average PTT decline of 6.2% during the longer period, and a smaller decline of 3.8% in the
2007-2009 recession.
Some segments of healthcare services, especially lifesaving and life-sustaining procedures do not face any
cyclicity. It includes emergency services and procedures like kidney dialysis etc. In these segments, a
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person cannot postpone the treatment. Therefore, healthcare services have nearly stable demand irrespective
of the stage of the economic cycle.
Some of the segments like dental services or other elective procedures may witness a decline in demand
during an economic slowdown. This is especially true in countries where a large amount of healthcare
expenditure is paid by insurers and during an economic slowdown, people lose insurance due to job losses.
Key credit factors for the health care services industry, Standard & Poor’s, April 2014, page 4:
Demand for health care services is somewhat shielded from general macroeconomic
cycles because disease occurrence and prevalence (in developed countries) do not vary with the
economy…overall demand is modestly sensitive to the employment rate, in part, because lack of a
job may mean lack of health insurance…Routine check-ups and elective procedures may
be deferred for economic reasons.
Therefore, even though during economic slow-downs, job losses may lead to a decline in elective and non-
critical procedures; nevertheless, a major portion of healthcare services continues to see stable demand. As
a result, the healthcare services sector has a low level of cyclicity.
India has sustained demand for almost healthcare service institutions because currently, the penetration of
quality healthcare in India in terms of proportion of beds or healthcare spending by Govt. is very low than
global standards.
The country currently has 7 beds per 10,000 of the population compared to 38 beds per 10,000 in
the US, 23 in China, 22 in Brazil and the global average of 27.
India spends about 3.6% of its GDP on healthcare, which is significantly lower than the US
(16.9%), Brazil (9.2%), South Africa (8.1%), Russia (5.3%), China (5%) and the global average
of 8%.
Low investment in the healthcare sector in India has led to a high burden on the existing healthcare
institutions, which also leads to a high-sustained demand and a low cyclicity.
2) Capital intensiveness:
Establishing a hospital is an expensive project. The company needs to find out a suitable land parcel at a
prominent location, and invest a significant amount of money in buildings, and expensive medical
instruments. This is especially true for large super-speciality hospitals that attempt to have the latest
equipment including robots and employ highly qualified medical professionals.
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The capital investment required for setting up a hospital is high, due to requirement for land and
building in an easily accessible location and need for expensive medical equipment and
infrastructure
In addition, when a new hospital is set up, then for the initial period of operations called the gestation period,
the earnings of the hospital are not sufficient to cover its investments and expenses; therefore, it suffers
losses during the gestation period. During this phase, the investors need to put in more money to sustain the
operations of the hospital, which adds to the capital intensiveness of a hospital.
Rating methodology – hospital industry, CARE, August 2020, page 2:
commitment of the promoters not only in the form of equity but also their ability to continuously
support during the initial years of operations for loss funding
Moreover, a hospital needs a continuous investment of money to expand and upgrade its services, which
puts a lot of strain on the financial strength of the company.
Hospitals have significant re-investment requirements for expansion and upgradation of facilities
Investments in the continuous upgradation of facilities are essential for hospitals because an ability to
provide complex healthcare services with the latest equipment leads to better profit margins for the hospital.
complex medical service offerings improve a hospital’s pricing power and leads to better margins.
Therefore, establishing a hospital is a capital-intensive project, which creates a barrier to entry for new
players.
Due to high capex requirements and a multitude of approvals required to set up a hospital,
the barriers to entry are considerable.
3) In the hospital business, size matters the most; big gets bigger:
Large super-speciality hospitals have a significant competitive advantage over the smaller hospital with
limited healthcare facilities.
3.1) Diversification:
Large hospitals are usually much diversified in terms of service offerings, patient profile as well as
geographical coverage.
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Large super-speciality hospitals are able to offer treatment under many different specialities as well as both
basic and advanced level healthcare, which helps the hospital earn high margins as well as earn stable
revenue. For example, cardiology and neurology provide high-margin whereas gynaecology & obstetrics,
paediatrics and radiology provide a lot of stable revenue to the hospital.
healthy mix of speciality-wise diversification is important for hospital entities, as while some
specialities such as cardiology and neurology are high-margin contributors whereas others such
as gynecology, pediatric, and radiology contribute most to the occupancy.
In addition, the presence of many specialities, as well as the ability to provide advanced-level complex
healthcare, allows large super-speciality hospitals to prevent referral of patients outside their hospital and
earn a higher share of the healthcare expenditure of the patients.
Rating methodology – hospital industry, CARE, July 2019, page 2:
A higher level hospital is able to keep more patients and not required to refer out patients for
services not provided by it.
Similarly, large super-speciality hospitals are able to maintain a healthy mix of patients from
insurance/institutional sources, self-paying domestic and international patients.
Institutional patients like govt. schemes (CGHS, EHS, ECHS etc.) as well as govt. departments (centre/state
govt. employees /defence or PSUs) usually provide a lot of patient business to hospitals; however, these
agencies usually negotiate lower/competitive prices of treatments with the hospitals. Therefore, this
segment of patients is a high-volume low-margin business for the hospitals, which ensures increased
utilization of hospital infrastructure. In addition, these agencies make payments after some time to the
hospitals.
institutional patients that are Government scheme-linked or institution-linked may provide lower
pricing and longer payment cycles but may generate healthy volumes, which provide a cushion in
absorbing the high fixed costs of running a facility.
On the contrary, out-of-pocket paying patients, insured patients as well as international patients provide
high margin business to hospitals.
Non-institutional patients such as the out-of-pocket patients, insurance-paid patients and walk-
in international patients provide hospitals with better pricing and collection cycles but these may
or may not provide the requisite volumes to attain optimal occupancy.
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An investor may note that until now in India, hospitals are able to earn a high-profit margin from insured
patients; however, as we would discuss later in this article, the experience of the developed world indicates
that, over time, as the insurance coverage increases, the negotiating/pricing power shifts from the hospitals
to the insurance companies.
Nevertheless, a diversity of patient profiles help the hospital bring stability to its business.
Apart from a better diversification of speciality services and patient profiles, large super-speciality hospitals
are also able to open a chain of hospitals across many different markets. It protects them from risks arising
from the geographical concentration of revenue like calamities e.g. earthquakes, fire etc., labour strikes etc.
A hospital with a large revenue base is more likely to have a diversified operational profile,
thereby lending stability to operations. Further, large hospitals tend to exhibit stronger
earnings profiles, providing necessary resources to expand and invest.
Smaller clinics/hospitals may not get such kind of diversification benefits, which increases their business
risk as well as volatility/fluctuations in their financial performance.
A larger revenue base is viewed as a positive factor, as smaller hospitals tend to exhibit higher
revenue volatility due to their dependence on a few specialities or consultants, indicating high
concentration risk.
3.2) Pricing power:
Large super-speciality hospitals enjoy a high pricing power over their customers i.e. patients.
hospitals with multi-speciality are better placed as compared to a single speciality in terms of
pricing power.
The size of the hospital provides benefits in many other operational aspects as well. For example, a large
hospital has better bargaining power with its suppliers as well as with highly-skilled medical professionals.
Hospital industry – key success factors, credit rating agency Pefindo, Indonesia, November 2021, page 1:
Strong market position will also lead the company to have favorable bargaining power in
negotiation process with the doctors and its suppliers, and to become more flexible in pricing
adjustment.
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Skilled medical professionals prefer to work at established super-speciality hospitals because they get them
more patients.
Rating methodology – hospital industry, CARE, July 2019, page 2:
Also specialists tend to prefer recruitment at such hospitals as they gain more patients.
Better pricing power with the patients, suppliers, as well as medical professionals, helps large multi-
speciality hospitals earn a better profit margin than smaller hospitals.
3.3) Barriers to entry and competitive intensity:
The hospital segment is very fragmented where numerous small doctor-owned clinics form the major part
of the industry. Therefore, the competition level in the industry is high.
The industry is highly fragmented, with more than 80% of the hospitals being standalone, owned
and operated by medical professionals or trusts.
However, the two segments of the hospital industry, large super-speciality hospitals and smaller hospitals
face a very different levels of competitive intensity in their business.
Large super-speciality hospitals have high barriers to entry due to large capital requirements, first, to make
the hospital and then to fund losses in the initial phase. On the contrary, small hospitals/clinics do not need
a lot of capital to establish; therefore, have very low entry barriers.
Therefore, small clinics/hospitals see a frequent entry of new players whereas large super-speciality
hospitals usually command a dominant position in an area.
Smaller players can enter and cater primarily to low complexity cases, which also requires
relatively low capital investment while larger players enjoy a dominant position in the complex
and high value cases
Therefore, an investor would appreciate that large super-speciality hospitals have multiple advantages over
small clinics like stable revenues backed by a diversified revenue base, a high pricing power as well as high
entry barriers for new competitors.
3.4) In-house talent pool:
Large super-speciality hospitals that also have medical education institutions are at a much better
competitive position because they are able to have easy access to medical professionals, which is otherwise
a scarce resource.
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The scarcity of medical professionals in India is one of the factors that has delayed full capacity utilization
of hospitals and as a result, has led to subdued financial performance.
Rating methodology for hospitals, ICRA, July 2018, pages 1-2:
Concerns such as high real estate costs, increasing equipment and operating costs, and shortage
of medical professionals have resulted in elongated payback periods.
As a result, those hospitals that have attached medical colleges, which are usually large super-speciality
hospitals are at a big advantage over small clinics/hospitals.
ICRA also favourably considers entities that have access to a captive source of talent pool through
the operation of educational institutions, which also augments research capabilities.
4) Old-established and mature hospitals have a lot of competitive advantages:

Establishing hospitals is a capital-intensive business, which has a high proportion of fixed costs. Therefore,
in the initial phase of operations, when the patient footfall is low, hospitals end up making losses. However,
as their occupancy/utilization levels increase, then the fixed costs spread over a larger number of patients
and the profit margins of the hospital improve significantly indicating a high level of operating leverage.
Therefore, mature hospitals have a high-profit margin than newly established hospitals.
Hospitals have a high operating leverage due to significant fixed costs in the operating
structure. Newly built facilities take time to ramp up and face pressure on profitability during the
initial years of operations. On the other hand, a mature facility will have a stable and moderately
growing revenue profile with an established track record of operations.
CARE also looks at the mix of revenue from matured and recently established hospitals as matured
hospitals tend to provide better profitability with stable revenue.
As a result, mature/old-established hospitals have strong competitive advantages over new players and
while planning new hospitals, investors look for areas away from old-established hospitals.
Rating methodology for hospitals, ICRA, May 2016, page 2:
Healthy market share for incumbents also acts as a barrier to new entrants in the region,
particularly given the considerable outlay required towards infrastructure, technology and
marketing in the business.
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A mature-established large super-speciality hospital combines the advantages of large size as well as
operating leverage; therefore, it has strong competitive advantages over both new large entrants as well as
other smaller hospitals.
Hospitals need large investments regularly for the upgradation and expansion of their facilities. However,
most of the time, hospitals do not readily approach capital markets for money. Moreover, they face
challenges in getting long term funding from banks. As a result, many hospitals end up using short-term
loans for investing in facilities, which creates cash flow mismatches.
hospital industry remains highly dependent on the banking system to meet its funding
requirements, with limited access to capital markets, except for a few large corporate entities.
Significant dependence on short-term borrowings to meet increasing investment in infrastructure
exposes hospitals to funding mismatches and refinancing risks
Established large super-speciality hospitals, which have sustained strong earnings are able to generate free
cash flow for expansion and upgradation of facilities. The matured status of an established super-speciality
hospital helps it in meeting its investment requirements from both its own free cash flow as well as from
financial institutions, which acts as a strong competitive advantage.
5) Increasing insurance coverage is a double-edged sword for hospitals:

India still has a low penetration of health insurance even though the penetration is increasing steadily. In
India, about 50% of healthcare spending is done by people from their pocket i.e. is not covered by insurers
or employers (Source: Per capita out-of-pocket health expenditure declines from ₹2,336 to ₹2,097, says
report: The Hindu, November 29, 2021)
As a share of total health expenditure, OOPE has come down to 48.8% in 2017-18 from 64.2% in
2013-14.
In comparison, in developed countries like the USA, only about 12% of total healthcare expenditure is done
by the patients from their own pocket.
in the U.S. in 2012, patients or a family member paid for only 12% of health care services
Therefore, India has a lot of scope for further health insurance penetration. From the above discussion, an
investor would remember that insured and institutional patients constitute the major business for large-
super-speciality hospitals. Therefore, it may seem that increasing insurance penetration would be a boon
for the hospitals.
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However, an analysis of developed countries with a high insurance penetration shows that as insurance
penetration increases, the pricing power shifts from hospitals to insurers. As a result, the hospitals become
price-takers.
Key credit factors for the health care services industry, Standard & Poor’s, April 2014, pages 5 & 6:
Health care services providers have limited, if any, price flexibility because of powerful third-
party payors. This is sometimes called “reimbursement risk.”
Providers are truly price-takers from government payors for some services in some
countries…Third-party payment or reimbursement rates are not a function of supply and demand.
When insurance penetration in society increases, then insurance companies (payors) control where patients
undergo treatment. Insurers force hospitals to accept lower rates of treatment to enter into their network-
hospital list. If any insured patient undergoes treatment at an out-of-network hospital, then the insurers put
a penalty on the patient.
In the U.S., an insured patient often bears an economic penalty if he chooses an out-of-
network provider (which has not agreed to accept a discounted price from the insurer)…Providers
choose to accept lower payment rates in the expectation of higher volume.
In the developed countries with a high insurance penetration, the insurers hold such a high bargaining power
that even well-established mature hospitals, which can perform complex procedures do not enjoy any
superior pricing power.
little weight to competitive advantage, which is appropriate because competitive advantages often
don’t confer premium pricing in this industry.
Apart from pushing down the reimbursement rates for the medical procedures, insurers also delay the
payment to the hospitals. In the case of walk-in patients who pay from their pocket, the hospital gets advance
or immediate payment. Therefore, hospitals used to have a very low working capital requirement. However,
as the share of insured/institutional patients is increasing, the hospitals are witnessing delays in collecting
their receivables.
The working capital cycle in general is getting longer for the sector as the share of cash paying
patients is reducing and that of insurance-paid patients is rising, leading to longer receivable
cycle. The Central Government, state governments, armed forces and the PSUs operate various
healthcare schemes for their employees (along with their dependents) and empanelment with these
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public-sector schemes enables a hospital in attaining reasonable volumes…However, the payment

cycle of these public-sector schemes is long and in some instances in the past has
become significantly stretched, which leads to cash flow mismatches, high working capital
intensity of operations and in some cases, stretched liquidity position.
Therefore, while analysing the future of the Indian hospital industry, an investor should note that with
increasing health insurance penetration, the pricing power of the hospitals will decline, which may impact
their profit margins and revenue and elongate their receivables days leading to a stretched working capital
position.
6) Regulatory risks on pricing power, anti-competitive practices, aftermarket

abuse of patients:
The hospitals/healthcare services sector is highly regulated because it directly affects the health and lives
of people. Therefore, almost all governments control every aspect of the healthcare industry including
operations standards as well as prices of products and services. One of the aims of such pricing interventions
is to reduce the spending done by people on healthcare. Therefore, hospitals face a risk of a sharp decline
in profits due to changes in regulations (“stroke of a pen” risk).
Let us see some examples of how govt. is attempting to reduce the cost of healthcare services by regulations.
6.1) Direct control of prices:
In 2017, the Indian govt. put a limit on the pricing for cardiac stents and knee transplants by reducing their
prices by about 70%. It impacted the revenues and profit margins of hospitals. (Source: After cardiac stents,
government now caps knee implants price, cuts prices by up to 69%: Economic Times, August 17, 2017)
Out of 1.5-2 crore patients who require arthroplasty interventions, only around a lakh are in a
position to pay for the procedure every year, NPPA stated
This decision is expected to lead to a saving of Rs 1,500 crore per year for the people of India
NPPA’s order comes around six months after it slashed the prices of coronary stents by up to 85%.
This decision (a stroke of a pen) led to a reduction of the revenue of the hospital by about ₹1,500 cr.
6.2) Controlling anti-competitive and exploitative practices by hospitals:
The govt. /policymakers recognise that when a customer/patient approaches a hospital for treatment, then
due to the specialized-life-saving nature of services, the customer does not have a strong negotiating power
over the hospital. The govt. has acknowledged that some hospitals take advantage of such a position by
forcing the customer to buy products and services from them at very high prices.
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For example, hospitals force patients to buy medicines at high prices from in-house pharmacies despite
these medicines being available at a cheaper price in outside shops. Also, hospitals reject the diagnostics
test done at outside laboratories and force patients to repeat all tests at in-house laboratories.
There are instances where the patient is forced to purchase consumables such as medicines,
syringes etc. at printed MRP from the in-house pharmacy of the hospital when the same is
available at significantly lower prices outside the hospital premises.
It has also been observed that hospitals commonly reject even recent reports of diagnostic
tests conducted outside the hospital and mandates repeat tests from their in-house diagnostic labs.
Hospitals are able to force such anticompetitive practices on patients because the switching costs for a
patient from one hospital to another can be very high.
Further with no regulatory framework that ensures and governs portability of patient data,
the switching cost for a patient becomes high.
Govt. authorities have taken action against anti-competitive practices of hospitals.
For example, in one case against Dr. L.H. Hiranandani Hospital, Powai, Mumbai, the CCI penalized the
hospital (referred to as OP hospital in the order) with a ₹3.8 cr penalty and cancelled its exclusive agreement
with a stem-cell storage company. The CCI found that hospitals enter into such exclusive agreements only
to earn a high commission, which increases the cost for the patients.
CCI order against Hiranandani Hospital, February 2014, pages 8 & 11:
A collective reading of the successive tie-up agreements (between Life Cell and OP hospital from
2009-2011 and between Cryobanks and OP hospital from 2011 onwards) shows that commission
paid by the stem cell banking company to OP hospital was the sole and important criteria in
selecting the stem cell banking company. Though Life Cell was paying Rs. 8000/- per enrolment
for 2009-10 and Rs. 10,000/- per enrolment in 2010-11, Cryobank offered Rs.18000/- per
enrolment in 2011-12 and Rs.20,000/- in 2012-13.
Such exclusive arrangements do not accrue any benefit to the consumer and are rather at the cost
of consumer… This actually kills all competition replacing competition culture by commission
culture.
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The hospital argued that the patient was free to leave at any time and take treatment from another hospital.
The CCI rejected this argument by terming it as “flimsy” stating that once patients develop trust in a doctor,
then they do not change doctors for saving a few rupees and therefore resign to their fate of exploitation by
the hospital.
CCI order against Hiranandani Hospital, February 2014, page 12:
When at the last stage of pregnancy, the woman is told, if she wants stem cell banking of her
choice, she has either to change the hospital or to engage the Cryobank with whom OP hospital
had agreement, no woman admitted in a super speciality hospital, to save few rupees will change
the hospital….Thus, the argument of OP hospital that the patients were free to leave the hospital
is a flimsy argument, not worth any weight.
As a result, the CCI cancelled the exclusive agreement of Hiranandani hospital with Cryobank and put a
penalty of ₹3.8 cr on it.
6.3) Acknowledging after-market abuse of patients by hospitals:
The CCI is currently investigating the use of anti-competitive practices by large-super speciality hospitals
in Delhi. In a case against Max Super Speciality Hospital, the CCI found that the hospital (OP-2) had forced
its admitted patients to purchase medicines at exorbitant prices.
CCI order against Max Super Speciality Hospital, August 31, 2018, pages 4, 5 & 6:
OP-2 had earned huge profit margins ranging from 269.84% to 527% in the financial year 2014-
15…Further, it has been found by the DG that OP-2 has been compelling its in-patients to
purchase products only from its in-house pharmacy once they are admitted to OP-2…there is a
reference to OP-2’s alleged conduct as being akin to ‘aftermarket abuse’
In such a situation, the patients do not hold any countervailing buying power and they
are completely dependent on OP-2.
It is common knowledge that this practice of exploitative pricing from the locked-in patients is
followed with impunity by most of the hospitals.
As a result, the CCI directed an investigation into the aftermarket practices of all super-speciality hospitals
in Delhi, which is currently in progress.
An investor may appreciate that in many other cases like the cement industry, paper industry, tyre industry
etc., the CCI has taken a strong view against anti-competitive practices and in some cases put very heavy
penalties.
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An investor should closely monitor the developments in the said investigation into aftermarket practices of
hospitals because it may have a significant impact on the way hospitals charge their admitted patients. It
may have a significant impact on the revenue and profit margins of the hospitals.
7) Key man risk/manpower costs:

Employee costs including super-specialist consultants’ costs are the main expense for any hospital. They
are the main pull factor to the patients for any established mature hospital. A hospital needs to maintain a
fine balance of its expenditure on its consultants/doctors.
A large expense on the consultants/doctors may impact profit margins whereas a low expense on
consultants/doctors would deteriorate patient experience and the hospital’s reputation.
Having many doctors on the hospital’s payroll improves patients’ experience due to easy doctors’
availability, but it increases the fixed expenses and deteriorates the hospital’s profitability. On the contrary,
having many visiting consultants reduces the fixed costs for the hospital but dilutes the brand of the hospital
because doctors are not readily available.
Therefore, many hospitals go for revenue-sharing agreements with key consultants, which protects the
hospital during phases of low demand and rewards the consultants during periods of high demand.
Key consultants typically tend to have higher revenue share as remuneration along with a
minimum monthly guaranteed payment…A variable remuneration structure makes the interest of
the key consultants better aligned with that of the entity and it also reduces cost pressure in case
of a fall in revenues/volumes.
Therefore, managing manpower costs is one of the key challenges for the hospitals due to the scarcity of
experienced super-speciality consultants and the trade-off between saving costs and the hospital’s
reputation.
8) Criteria specific to the hospital industry for measuring performance:

Some key parameters are unique to measuring the performance of the hospital industry. Let us understand
some of them.
8.1) Average revenue per occupied bed (ARPOB):
ARPOB is a parameter similar to the average revenue per occupied room for a hotel. Large super-speciality
hospitals providing complex medical care usually have a higher ARPOB than smaller clinics/hospitals. A
higher ARPOB usually represents a higher pricing power for the hospital.

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The average revenue per occupied bed day (ARPOB) is the metric used by ICRA for understanding
the pricing power and complexity of the speciality mix
8.2) Average length of stay (ALOS):
ALOS measures the average duration of stay for an admitted patient in the hospital. Hospitals try to keep
ALOS short because most of the revenue from any patient is earned during the initial period of stay when
the patient undergoes multiple tests for diagnosis and the surgical procedures for treatment. Thereafter, the
patient enters the recovery/monitoring phase when the earnings of the hospital from the patient decline.
lower ALOS helps in faster turnaround of beds which results in more patients being treated from
the current facilities. In addition to this, it also helps the hospitals to increase their income as most
of the revenues are made by hospitals in the initial few days of the patients’ treatment.
Moreover, if any hospital has a higher average length of stay (ALOS) even in cases when the
treatment/procedures are simple, then it indicates weaker operating efficiency.
Rating methodology for hospitals, ICRA, May 2016, page 3:
ALOS management also plays a role in asset utilization, where lengthening ALOS not backed by
corresponding increase in complexity of service rendered indicates weak operating efficiency.
8.3) Hospital construction expense: Investment per bed:
While assessing the construction cost of a hospital, usually, its construction cost per bed is measured and
compared with similar other hospitals. It forms a key parameter to assess whether the hospital construction
is cost-efficient or has suffered from cost overruns.
Summary
The hospital industry in India faces a high demand because due to low public investment in healthcare, it
has a lower proportion of beds than the global average. As a result, the industry has a low cyclicity and
performs independently of general economic phases of boom and bust.
It is a capital-intensive industry where companies need to spend a large amount of money on building,
infrastructure, medical equipment etc. and then fund losses during the initial long-gestation period. As a
result, large super-speciality hospitals have a strong barrier to entry.
In addition, large super-speciality hospitals enjoy other competitive advantages like diversification in terms
of specialities/branches of healthcare, patient profile as well as geographical diversification, which protects
them from many risk factors. Large hospitals also enjoy better bargaining and pricing power over their
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customers/patients, suppliers, insurers as well as consultant doctors who prefer to work in these hospitals
because they give them access to a large number of patients.
Large hospitals, usually, also have attached medical education facilities, which give them easy access to in-
house medical professionals. All these factors put large super-speciality hospitals at a higher competitive
advantage than smaller clinics/hospitals, which are very fragmented and see a large churn in terms of
opening and closing of clinics.
The capital-intensive nature of large hospitals makes their operations fixed-cost intensive. As a result, they
have large operating leverage where the profit margins of the hospital increase significantly as its capacity
utilization increases. Therefore, old-established & mature large hospitals have strong competitive
advantages over new entrants.
Hospitals like other segments of healthcare services like pharmaceuticals face strong regulatory challenges.
Govt. controls many aspects of operational standards as well as pricing of key products and services to
make healthcare affordable to citizens. In the past, govt. has ordered a sharp reduction in the prices of stents
and knee replacement implants. In addition, the govt. has been looking into the anti-competitive practices
and exorbitant pricing charged by hospitals from its admitted patients.
Increasing health insurance coverage helps hospitals because it brings more patients to hospitals and
increases their capacity utilization. However, as insurance coverage increases in society, the pricing &
bargaining power shifts from hospitals to insurers. Insurers force patients to take treatment in their network
hospitals that have agreed to a lower price for treatments. In addition, insurers delay payments to hospitals,
which increases the working capital requirement of hospitals.
Senior medical consultants are the key resource of any hospital, which act as the major pull factor for
patients to the hospital. As a result, they are one of the biggest costs for the hospitals. A hospital has to
maintain a fine balance between the manpower cost and the profitability because a higher number of payroll
doctors reduces profit margins but improves the hospital’s reputation due to better patient experience. On
the other hand, a lower number of doctors on payroll and a higher number of visiting doctors reduce costs
but impact the hospital’s reputation because doctors are not readily available.
While analysing a hospital an investor needs to focus on multiple aspects including average revenue per
occupied bed, the average length of stay, construction expense per bed etc. to assess whether a hospital has
pricing power or is working efficiently or not.
Therefore, in the hospital industry, usually, old-established & mature large super-speciality hospitals have
a very strong competitive advantage over new entrants. However, going ahead, an investor needs to closely
monitor development related to CCI investigation and policy measures about anti-competitive practices by
hospitals because any adverse policy decision against the industry may significantly impact the revenue
and profit margin of hospitals. The investor should be well prepared to witness moderation in profit margins
of hospitals as insurance penetration in society increases.
The following key factors determine the key business characteristics of hospital companies.
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 Low cyclicity of demand

 Capital-intensive business
 Big becomes bigger: economies of scale and size matter a lot
 Old-established and mature large-super speciality hospitals have strong competitive advantages
 Increasing insurance coverage would reduce the pricing power of hospitals
 A large regulatory risk. Profits for hospitals can decline on the stroke-of-a-pen by regulators
 Managing scarce senior medical consultants is a key challenge
We believe that if an investor keeps the following factors in her mind while analysing any hospital, then
she would be able to assess the true business strengths of the company.
Regards,
Dr Vijay Malik
P.S.

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3) How to do Business Analysis of Diagnostic Labs
After reading this chapter, an investor would understand the factors that impact the business of diagnostic
labs and the characteristics that differentiate a fundamentally strong diagnostic lab from a weak one.
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Classification of diagnostics labs

There are usually three kinds of diagnostics labs based on their ownership/corporate structure.
1. Large corporate laboratory chains

2. Standalone labs in the unorganised sector
3. In-house labs for hospitals/clinics
From the functional aspect, the labs are classified under the following segments:
1. Pathology labs: conduct tests on the blood, urine, stool and biopsy samples
2. Radiology labs: conduct imaging tests like x-ray, ultrasound (USG), CT scan, MRI, PET-CT scans
etc.
3. Integrated labs, which offer all the services including pathology, radiology, preventive healthcare
and wellness segment etc.
While doing the business analysis of diagnostic lab companies, we would understand them from these
perspectives.
Key characteristics of the business of diagnostic labs
1) Low level of cyclicity in demand:

Diagnostics labs perform a key role in the healthcare segment because the results of the tests produced by
them are essential for doctors in deciding the disease and its treatment. As a result, diagnostics labs are a
necessary service in healthcare. Therefore, just like other key healthcare segments
like hospitals and pharmaceuticals, the demand for diagnostic services does not fluctuate with general
economic cycles of boom and bust.
Rating Methodology for Healthcare Diagnostic Service Providers, ICRA, March 2016, page 8:
The revenue growth of diagnostic players although not generally vulnerable to cyclicality due to
diagnostics being a necessary and integral part of healthcare
This is because people get sick and visit hospitals for check-ups irrespective of the phase of the economic
cycle and diagnostic tests form an integral part of the identification and treatment of the disease.
2) Highly fragmented industry:

The Indian diagnostics lab industry is highly fragmented where standalone labs from the unorganized sector
constitute the major portion. These labs are primarily family-owned with only a regional presence catering
to the local population within small geography.
Rating Methodology for Healthcare Diagnostic Service Providers, ICRA, July 2020, page 2:
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The Indian diagnostic industry is highly fragmented with many small unorganised standalone
service providers. The organised players face stiff competition from unorganised as well as in-
house diagnostic departments of hospitals.
Let us try to understand the reasons for the large size of the unorganized segment in a sector performing a
critical role in the healthcare segment
2.1) Lack of stringent regulations in the operations of diagnostics labs:
Diagnostic services fall under the authority of the state govt. As a result, different states end up framing
different rules for diagnostic labs. Moreover, even in cases where certain rules are the same across states,
their implementation and enforcement differ across states. Due to a weak regulatory environment, numerous
labs open up near hospitals and in densely populated areas.
In addition, the accreditation with bodies like NABL (National Accreditation Board for Testing and
Calibration Laboratories), which ensures standard operating procedures, is not mandatory for all the labs.
In India, only the labs under CGHS (Central Govt. Health Scheme) and in govt. hospitals are mandated to
take NABL accreditation.
Ministry of Health has mandated NABL accreditation compulsory for only medical laboratories
empanelled by CGHS and the laboratories under the Centre and State Government hospitals.
Even in the situations where any accreditation is made mandatory, it is claimed that such accreditations are
not enforced strictly.
As a result, in India, unorganized standalone labs and in-house labs of hospitals and clinics dominate the
sector and occupy about 85% of the market share.
In India, the unorganised format is more prevalent, where privately-owned standalone labs span
metros as well as small cities and towns. Their growth has flourished because
acquiring accreditation is either not mandatory in most states or not enforced effectively.
Credit rating report of Metropolis Healthcare Ltd by CRISIL, October 2021, page 2:
These diagnostic chains face intense competition from hospital-based and standalone centres,
which together comprise a dominant share (about 85%) of the industry.
2.2) Moderate capital intensity of standalone diagnostics labs:
Most of the standalone diagnostic labs are small in size and service a small geographic area. This is unlike
large corporate diagnostic lab chains, which establish large reference/central labs that conduct a very large
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volume of tests catering to a very large geographic region. In addition, standalone labs usually restrict
themselves to conducting simple standardised tests, which require technologically simple equipment.
As a result, small standalone diagnostic labs are able to start their business without a significant investment
in their business. Moreover, such labs do not need to do marketing to a large customer audience via channels
like print & online media or television etc. These labs usually do tie-ups with local clinics to get business.
Therefore, the fixed capital intensity of small-standalone diagnostic labs is not high. Moreover, the business
of diagnostic labs is not working-capital intensive because usually customers make upfront payments and
their inventory requirements are also not high.
working capital intensity of a diagnostic services provider is relatively low, with less
inventory and majority upfront cash receipts,
Moderate capital intensity has contributed to the growth of small unorganized standalone labs.
The diagnostics industry faces moderate entry barriers on account of average capital intensity,
resulting in the emergence of a large number of diagnostic centres.
The credit rating report for SRL Diagnostics Private Ltd. by CRISIL, February 2022, page 2:
Limited capital requirement for starting a diagnostics laboratory has led to emergence of several
diagnostic centres.
Therefore, due to moderate capital requirements and relaxed regulations, a large number of standalone small
diagnostic labs occupy a large portion of the industry.
3) Non-differentiable, commoditised service, intense competition with a low

pricing power:
In the diagnostic labs, almost all the players whether large corporate diagnostic chains or standalone labs
or in-house laboratories of hospitals essentially provide the same output to the patient. A sample from the
patient is taken and then a report is provided.
Therefore, unless and until any lab is able to provide any such test or radiology imaging service, which is
not available at any other lab, for a patient, functionally, almost all the labs are the same. For example, if a
patient has to check her haemoglobin (Hb) level, then any lab is going to take her blood sample and provide
her with a report of her Hb level.
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Due to such commoditised nature of service, patients become indifferent to the lab where they get the test
done. Unless there is a specific reference to any particular lab from the doctor or the hospital, a patient may
prefer the lab charging a lower price.
Moreover, a large segment of the industry is dominated by small standalone labs, which being unorganized
are able to operate at low costs. As a result, they charge comparatively lower prices to the customers than
large organised corporate laboratory chains.
Although small, unorganised labs lack infrastructure, technology, skilled professionals or

resources to expand, they are able to garner customers on the basis of the cost advantage derived
from their lean cost structure. This is especially applicable/true for standardised tests, where
a meaningful price difference between players can result in the switching of customer loyalty.
As a result, most diagnostics labs end up competing on pricing to gain customers. This increases the pricing
pressure on the whole of the industry.
Credit rating report of Dr Lal Pathlabs Ltd by CRISIL, February 2022, page 2:
Intense competition in the diagnostic services market, which has several players offering similar
services, results in pricing pressure.
As a result, in order to gain business, diagnostic labs do tie-ups with doctors and hospitals as it ensures a
steady flow of patients.
Referral tie-ups with or on-site labs at renowned doctor clinics and hospitals are factored in
positively, as they assure revenue visibility owing to the credibility of the doctor or hospital.
4) New asset-light business model of operations:

In the past, whenever any diagnostic lab wanted to gain a large scale of operations, then it used to focus on
a hub-and-spoke model where it would establish a few large central/reference labs and multiple smaller
labs spread across the country. Nearly all the large corporate diagnostic chains like Dr Lal Pathlabs Ltd,
Metropolis Healthcare Ltd etc. follow this model.
pan-India network of 231 clinical laboratories (including national reference lab in Delhi and
regional reference lab in Kolkata)
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As on March 31, 2021, it had a global reference lab in Mumbai, 12 laboratories (13 regional labs)
and 2,731 service centres.
This business model was capital-intensive because establishing large central/reference labs, which can
handle a large number of routine tests as well as do many special/complex tests, which other labs cannot
do, is an expensive project. In addition, expanding the network of regional labs, which could help in a quick
turnaround time from sample collection to report production, is also an expensive project.
As a result, previously, establishing large diagnostic labs with wide geographical reach used to be a very
capital-intensive business and companies needed to raise a lot of capital to build them.
Given the high fixed overheads’ nature of the diagnostics industry and their aggressive expansion
plans, organized players have also been fairly active in raising equity funding either through
private equity route or IPOs
However, nowadays, new players use the already present numerous standalone and corporate labs to build
their business. Such players outsource the testing of samples to existing labs and therefore, do not have to
spend money on creating laboratories.
Recently, there has been an emergence of players offering diagnostic services but instead of setting
up a reference lab, they outsource the services to existing organised diagnostic companies. The
companies benefit by offering complete healthcare services to customers and by getting new
business without having to invest in reference labs.
As a result, large corporate lab chains have also started using asset-light strategies to expand their business.
For example, Dr Lal Pathlabs Ltd has invested money in creating labs; however, it has outsourced its
collection centres to franchisees.
DRLPL operates its own path labs, while collection centres are run on franchisee model.
Similarly, another new business model of aggregators is coming up where new players act as a platform
where patients can compare prices of standalone local labs and get their tests done.
The competitive intensity in the industry has further increased with the advent of online diagnostic
service aggregators who utilise the facilities of unorganised single lab diagnostic companies
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These diagnostic service aggregators usually have a very limited ground presence and acquire customers
digitally/online. Their business model is comparatively asset-light because they have a very limited offline
presence for customer acquisition and no investment in setting up labs. As a result, these aggregators are
able to offer discounts to customers by negotiating deep discounts with standalone local labs. It has further
increased the pricing pressure in the diagnostics labs industry.
The diagnostic service aggregators offer significant discounts to gain market share, thereby
leading to pricing pressure in the industry. They also benefit from the fact that they offer a diverse
range of tests in the imaging as well as diagnostic segment. The unorganised labs benefit from a
wider reach
The credit rating report for SRL Diagnostics Private Ltd. by ICRA, Nov. 2021, page 3:
the entry of online aggregators that offer discounts to attract customers has put significant
pressure on pricing
Therefore, the diagnostic labs face strong pressure on their pricing, especially in the routine standardised
test segments.
Let us now see what some labs do to maintain some pricing power in their business.
5) Continuous investment in technology and supply chain:

One of the ways in which large labs differentiate themselves is by offering complex tests, which require
investing in the expensive latest technology. Complex/specialized tests provide a pricing power to the labs.
Labs that offer niche and complex tests and services command premium pricing and also possess
pricing flexibility, thus reflecting product differentiation
It is important to note that tests that are complex and specialized today may become routine in future and
then these labs would lose their pricing power. Therefore, to maintain an edge, labs need to continuously
invest in the latest technology, which makes their operations capital-intensive.
In addition, large corporate labs also focus on an efficient supply chain supported by a large number of
collection centres closer to customers and investments in software solutions. The aim is to reduce the
turnaround time i.e. time from sample collection to delivering the report to the customer.
Due to quick turnaround i.e. home collection of samples and online report delivery, large labs are able to
gain customers despite charging a premium pricing.
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The brand strength of a diagnostic chain is further supported by continuous investments in

technology and supply chain management (through network of collection centres and reference
labs) which facilitates accuracy of tests, a faster turnaround time and wider reach.
despite the relatively higher price competition in routine test segments, certain diagnostic labs in
Tier I cities, with a strong brand name known for timely, accurate and standardised practices and
hygienic and efficient test processing, are more likely to get repeat customers.
As a result, due to intense competition, continuous investment in technology and supply chain becomes
essential for diagnostic labs, which aim to grow big and gain a large market share.
6) Large size of operations, economies of scale:

To gain pricing power, diagnostic labs invest in large reference labs, technology, numerous collection
centres, and strong & efficient logistics solutions. This makes their operations fixed capital-intensive.
As a result, these labs need to achieve a certain level of business operations to achieve profitability and
thereafter, operating leverage comes into play where the fixed expenses get distributed across a larger
business volume.
Having a large business size helps the diagnostic labs in multiple ways as they can negotiate favourable
terms with suppliers, employees as well as customers.
a higher scale would enable an entity to achieve higher bargaining power to negotiate favourable
rental rates, avail discounts through bulk raw material purchases (primarily reagents), and attract
the most qualified and technically sound personnel to drive operational efficiency to sustain its
leadership position.
Therefore, when any lab starts to invest money in technology and supply chain systems to improve its
competitive advantages and pricing power, then it becomes important for it to grow its size to benefit from
economies of scale.
Moreover, a large business size provides diagnostic labs with the financial strength to open new labs at
prominent locations as well as buy technology for specialised tests.
Companies with a large scale are better placed to invest in new diagnostic centres, technology
and equipment while introducing specialised tests/services in their portfolio… a large diagnostic
chain would have greater financial flexibility to grow fast, establish labs at prominent locations,
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Small standalone labs are at a competitive disadvantage as they do not have sufficient financial strength to
acquire technology and manpower for specialised tests and also do not have higher bargaining power over
their suppliers & customers.
small unorganised companies are unable to offer a diverse range of tests or specialised
tests requiring advanced technology, have limited skilled technicians and limited bargaining
power with suppliers owing to low levels of scale.
7) Diversification:
7.1) Product mix of diagnostic labs:
To create a differentiation, large diagnostics labs opt for diversification where they offer services across
pathology, radiology, and preventive healthcare & wellness segments. Once a lab starts providing services
across these segments, then it becomes a one-stop solution for its customers both retail and corporate.
Integrated labs have comparatively higher bargaining power over their customers because they can offer
test packages to their customers, which leads to better pricing.
a presence in both pathology and radiology increases the bargaining power and eventually,
the profitability of the entity, as it can bundle offerings to cater to all customer requirements…
Further, ICRA notes the ability of a player to maintain sufficient depth in each therapeutic test
category that enables better customer service, thereby ensuring repeat customers.
Until now, large corporate laboratory chains had focused on pathology services and avoided the radiology
segment because of higher investment requirements as well as the usual practice of establishing a radiology
segment inside a hospital instead of standalone labs. As a result, in the radiology segment, standalone labs
had a higher market share.
The share of the unorganised sector is higher in the imaging segment as many of the organised
diagnostic providers do not offer integrated imaging and radiology services at their diagnostic
centres. This is primarily due to the high capital costs associated with setting up an imaging centre.
This is primarily because the organised players have initially focused more on the
pathology segment to scale up their business while the imaging segment is more integrated within
the hospital infrastructure.
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However, nowadays, large corporate lab chains have also started integrating their operations by offering
both pathology and radiology services e.g. SRL Diagnostics Pvt Ltd.
The credit rating report for SRL Diagnostics Private Ltd. by ICRA, Nov. 2021, page 4:
SRLD is one of the few diagnostic centre chains offering pathology and radiology services on a
pan India level.
In addition, some large corporate lab chains have also started medical education programs where they train
students in diagnostics skills. It provides these labs with an in-house talent pool to hire competent
employees.
Recently, some large diagnostic chains have ventured into academia, which provides an additional
source of revenue, by extending courses and fellowships in advanced diagnostics. These chains
can capitalise on this by recruiting quality students from these courses, thereby aiding talent
management.
7.2) Customer-mix of diagnostic labs:
Large labs also focus on a diverse mix of customers as another aspect of diversification. They focus on both
B2C (individual customers) as well as B2B (corporate customers as well as hospitals & other labs) where
companies offer facilities for preventive health check-ups for their employees and hospitals & other labs
outsource their testing to large labs.
Direct customers (B2C) offer a higher profit margin and make immediate payments. On the other hand,
corporate customers (B2B) negotiate lower prices as well as make payments after a period.
The diagnostic chains that derive a higher share of revenues from the B2C segment have a low
customer concentration risk and generally high profit margins. Tie-ups with B2B players such as
hospitals, laboratories and corporate clients provide a wider reach and higher revenue visibility to
diagnostic chains. While this improves the absolute levels of profits, however, the long-term nature
of the contracts and bulk offerings result in relatively lower prices and lower profit margins.
When the share of the B2C segment in the overall revenue of any diagnostic lab increases, then its operating
profit margin increases. For example, the operating performance of SRL Diagnostics Pvt Ltd improved in
9M-FY2022 over the previous period because the company witnessed a significant improvement in the
share of B2C in the revenues.
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Improving operating performance: This improvement was driven by the consolidation of DDRC
in April 2021 and higher B2C revenue mix of 52%, compared with 46% a year earlier.
There have been times when a higher share of B2B business impacts the profit margins as well as
receivables position significantly and the diagnostic labs actively work to reduce its share in their business.
The B2B segment has contributed to most of the revenue in the last three years, resulting in
a stretched receivables cycle. While the management has taken steps to reduce dependence on the
B2B segment, it still contributes to ~53% of the revenue.
Nevertheless, lab companies attempt to have a healthy mix of retail and corporate customers because the
retail customers provide healthy profits and corporate customers provide volumes leading to higher
utilization of their reference lab.
7.3) Geographical diversification:
Large corporate laboratory chains diversify across India and even overseas to mitigate risks associated with
any particular region as well as earn better pricing in foreign locations.
good geographic coverage (regional, national and international) is a positive credit factor as it
provides access to a larger clientele and reduces the vulnerability of revenues to disease cycles in
a particular region.
The entity diversifying internationally also benefits from better pricing and higher capacity
utilisation of domestic labs via test send-backs.
For example, Metropolis Healthcare Ltd has diversified overseas into eight countries, while keeping its
largest reference lab in India.
It also has overseas presence in eight countries, including Sri Lanka, Ghana, Tanzania, Kenya
and Mauritius
Another India large corporate laboratory chain, SRL Diagnostics Pvt Ltd. has an international presence in
the Middle East.
It also has international presence through subsidiaries in the Middle East, contributing around
5% of overall revenue.
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8) Business Risks:
8.1) Regulatory risk:
Diagnostic labs are a necessity in the critical healthcare segment. Therefore, governments keep a check on
the pricing charged by the laboratories for essential tests especially during epidemics when a large part of
the population may have to get the tests done. It is visible during the coronavirus pandemic where the prices
of different Covid tests (RTPCR as well as antibody tests) are controlled by state governments.
The cap on prices for diagnostic tests (for instance, testing of Covid-19), introduced by the
government, has impacted players adversely.
Still, as the regulation of diagnostic labs is under state governments; therefore, all the states may not impose
price controls at the same time. As a result, labs with a geographical diversified presence may get less
impact than single location standalone labs.
This again stresses the benefit of diversification in the diagnostics labs’ business.
Maintaining a high degree of diversification is crucial as it leads to lower revenue volatility, less
susceptibility to regulatory or market changes, provides competitive advantages and ensures
higher profitability on the back of product/services differentiation.
8.2) Real estate expenses risk:
Rental expenses, as well as the cost of owned premises, are one of the major expenses for any diagnostic
lab. Therefore, any major increase in the lease rentals for a diagnostic lab may impact its profitability
significantly because diagnostic labs face intense competition and do not have the pricing power to increase
the cost of tests at will. This is especially true in the case of small standalone labs providing routine/standard
tests.
Apart from the cost of procuring specialised equipment and hiring technically adept manpower,
rental cost is one of the key factors influencing the breakeven level for a lab.
In addition, delays by developers in handing over commercial premises can lead to cost overruns while
setting up new labs.
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In India, the growing demand for retail space coupled with lack of proper infrastructure has
pushed up commercial rentals in many locations to uneconomical levels for diagnostic players…
stretched roll-outs due to delays by developers in case of greenfield expansions. This is
a significant risk and can lead to cost overruns.
Therefore, labs prefer to set up their operations on the premises of existing hospitals/doctor’s clinics as it
protects them from risks related to the real estate market and also provides them with a business from the
outdoor and indoor patients of the hospital. This is an asset-light strategy of expansion and labs usually
enter into revenue-sharing arrangements with hospitals for it.
Another format of diagnostic operations encompasses labs operating in public or private hospitals.
These are either overseen by the hospital itself or there is a tie-up, in the form of a revenue-
sharing agreement between the hospital and the diagnostic service providers. The volume of
business and revenue visibility in hospital labs is relatively higher than other labs due to their
linkage to the hospital’s operations that include the out-patient department (OPD) as well as the
in-patient business.
Summary
Diagnostics lab services are critical for healthcare because they play an important part in disease
identification and treatment. Therefore, their demand remains almost stable during economic cycles. Indian
diagnostic lab segment is highly fragmented with numerous small standalone laboratories dominating the
sector. Key reasons for a large presence of labs in the unorganized sector seem to be the moderate capital
intensiveness and relaxed implementation of regulations by state governments.
Almost all the diagnostic labs provide similar, and non-differentiable services; therefore, customers usually
switch to low-cost standalone labs that are significantly cost-effective when compared to large corporate
lab chains. The emergence of online aggregators and new players with asset-light business strategies has
increased the already intense price-based competition in the sector.
To differentiate themselves, large diagnostic labs invest in the latest technology for conducting
complex/specialised tests, which provide a high-profit margin and pricing power. In addition, large labs
also spend significant money on improving the supply chain by establishing collection centres closer to the
customers and reducing the turnaround time between sample collection and report generation. Such steps
are a continuous requirement for large labs and make their operations capital intensive.
A large investment by a corporate lab chain requires them to achieve a significant utilization of capacity to
earn profits after which operating leverage comes in. Therefore, corporate labs attempt to expand their
business size with geographical expansion across India as well as overseas. In addition, labs also diversify
into all diagnostic segments like pathology, radiology, preventive healthcare and wellness. It helps the labs
to provide packages to their customers and ensures repeat business and some pricing power.
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Large labs are also able to get a higher bargaining power over their suppliers, employees and customers.
Therefore, economies of scale become an essential criterion for corporate lab chains to succeed.
Diagnostic tests are in very high demand during epidemics and a large part of the population needs them.
Therefore, governments control the prices of essential tests directly like recently in the case of Covid tests.
Therefore, labs face regulatory risks to their profits. In addition, any policy measure to mandate
accreditation of labs with the certifying agencies like NABL will impact the business of small standalone
labs significantly.
Rental expense is one of the major expenses for diagnostic labs both for existing centres as well as new
planned locations. Therefore, changes in the real estate market impact diagnostic labs significantly because
an increase in lease rentals may make their business unviable and delay in builders in handing over new
buildings may lead to cost-overruns and delay the lab’s break-even.
Therefore, an investor should keep in mind these multiple aspects for diagnostic labs to understand the true
picture of their business position.
 Low cyclicity/stable demand

 A highly fragmented sector with numerous small standalone labs
 Lack of stringent regulations and moderate capital intensiveness
 Non-differentiable services, intense price-based competition
 New players with asset-light business strategies are putting further pricing pressure on the sector
 Large labs have capital-intensive business due to continuous investment in technology and supply
chain to achieve differentiation
 Diversified players with good product and customer mix as well as geographical diversification
are better placed
 Regulatory and real estate risks are major concerns for diagnostic lab companies.
We believe that if an investor analyses any diagnostics lab by considering the above parameters, then she
would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.

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4) How to do Business Analysis of Chemical Companies
After reading this chapter, an investor would be able to identify the key strengths as well as the challenges
faced by chemical companies. She would get to know the features that make any chemical company a strong
player.
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Whenever an investor comes across any chemical company, then first, she should try to find out whether it
is a bulk/commodity chemical manufacturer or a specialty chemical manufacture. This is because, bulk and
speciality chemicals are the two key segments of the chemical industry, which have very different business
characteristics.
Classification of chemical companies

As discussed earlier, we can classify chemicals into bulk chemicals and specialty chemicals.
1) Bulk chemicals:
Bulk chemicals are also known as materials, integrated chemicals, upstream chemicals as well as
commodity chemicals. This is because these chemicals are always produced and used in large volumes
(bulk); these are used as key building blocks (raw materials) in end-user industries; their manufacturing
plants are usually large integrated chemical complexes where many intermediate products are made in-
house (integrated chemicals). Moreover, these chemicals are a commodity in nature i.e. the product from
one manufacturer is non-differentiable from the product of another manufacturer.
These chemicals primarily include organic chemicals like petrochemicals: polyvinylchloride (PVC), high-
density polyethylene (HDPE), low-density polyethylene (LDPE), polypropylene (PP) and methanol, as well
as inorganic chemicals such as caustic soda and soda ash.
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 1:
Notable examples of commodity chemicals are petrochemicals such as polyvinylchloride (PVC),

high-density polyethylene (HDPE), low-density polyethylene (LDPE), polypropylene (PP) and
methanol, and examples of inorganic commodity chemicals such as caustic soda and soda ash.
2) Specialty chemicals:
Specialty chemicals are also known as functional chemicals, as well as downstream chemicals. These
chemicals are used to bring in specific properties or changes to the main chemical products. As a result,
these are used in a very small quantity in the final products of end-consumers.
The consumers of specialty/functional chemicals expect these chemicals to provide a specific outcome in
their manufacturing process for which a lot of research & development (R&D) is done by the specialty
chemical producers.
Specialty chemicals include products like adhesives, catalysts, water treatment chemicals, leather
chemicals, pigments, surfactants etc.
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Specialty chemicals, on the other hand, include certain types of adhesives, catalysts, water
treatment chemicals, leather chemicals, pigments, and surfactants.
An investor should remember that even though at any point in time, various chemicals can be classified as
bulk/commodity chemicals or specialty chemicals. However, if an investor studies any particular chemical,
then she would notice that it follows a lifecycle. In this lifecycle, the chemicals go through a journey from
specialty chemicals to becoming commodity chemicals.
The Japan Credit Rating Agency classifies the lifecycle of any specialty chemical into three phases: initial
phase, product growth phase and stable product phase. Each phase of the lifecycle brings in different
characteristics in terms of acceptability from the customers and challenges from the competition.
In the initial product stage, there is a risk of whether the customers would accept the new product and its
technology. In the product growth phase, the product is accepted by the customers; however, many
competitors also enter the market. In the stable product phase, many competitors also master the technology,
which results in intense price-based competition.
Rating methodology for the chemicals sector, Japan Credit Rating Agency, March 2012, page 2:
In most cases, however, various types of competition arise at each stage of product growth. At
the initial stage, a product faces competition in the establishment of a technology. At this stage,
there is a risk that the product will not be continuously adopted by the users, which tends to be a
restrictive factor in assessing credit rating. In the product growth stage, increased sales in
response to growth in demand for the product can be expected. However, many competitors
expand their production capacity to capture the demand, which often increases the burden of debt.
In addition, when an item enters the stable product phase, it is required to note that there is a risk
that an increasing number of competitors will catch up with the required technological level,
intensifying the price and other types of competition while reducing the profit margin.
Therefore, an investor would note that over time, a chemical, which starts as a specialty chemical with new
technology and a few producers, ends up becoming a commodity chemical with many established producers
competing on price. Therefore, after some time, the specialty chemicals get commoditised as they are
duplicated by many manufacturers.
specialty chemicals also get commoditised within a few years post-launch because of duplication
by others.
German credit rating agency, Scope, in its credit rating methodology document for the chemical industry,
states that over time, chemicals that were once classified as a specialty have become commodities due to
many producers entering the market. Moreover, many other products like pigments and additives are on the
verge of becoming commodities.
Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 4:
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due to the market entrance of new producers and expanded production, several products
previously classified as specialty chemicals have increasingly become commoditised over the past
few years or are likely to become a commodity product, e.g. pigments and several types of
additives.
Therefore, an investor would appreciate that any classification of chemicals as bulk/commodity or specialty
is at any given point in time. This is because, over time, the chemicals that are currently specialty chemicals
will become commodity chemicals.
Let us now discuss the key characteristics of the business of chemical companies.
Key characteristics of the business of chemical companies:
1) Pricing power and competitive intensity:

An investor would note that in the case of bulk/commodity/integrated chemicals, the products made by one
company are non-differentiable from the products of another company. As a result, a customer can easily
switch the chemicals from one manufacturer to the chemicals from another manufacturer. For example, if
a customer needs 99% purity phenol then she can use 99% phenol from any manufacturer and it would
serve her purpose.
Due to such commoditization and non-differentiation of products, the bulk/commodity/integrated chemical

producers face very intense competition and do not have any pricing power over their customers. They are
effectively price takers in the market where the lowest cost producer sets the market price and all the
producers have to match that price otherwise their customers would shift to buying from the lowest-cost
producer.
According to our definition, integrated chemical companies engage in the manufacturing of

products made in large volumes with limited to no pricing power. The product pricing process is
transparent with a well-functioning market, resulting in producers being price takers. Therefore,
the respective cost structure is a critical success factor.
This is primarily because the commodity chemicals are easily switchable and any customer can easily
switch its suppliers. As a result, most of the commodity chemical producers end up competing on the prices.
Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, page 3:
Pricing competition is high in most commodity chemical segments. Because of

the interchangeable nature of commodity chemicals and the lack of product
differentiation, competition is primarily based on price.
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The pricing position of commodity chemical producers is so weak that even the most established players in
the industry do not get any pricing advantage. Such established players may have a strong long-standing
relationship with their customers; however, the customer is unlikely to give them a high price because of
the same.
Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, pages 4
& 6:
Commodity chemical companies that are able to defend or grow market share are unlikely to gain
a pricing advantage, but might enjoy a more favorable cost position or better relationships with
suppliers and customers.
However, because commodity chemical products are not differentiated, existing producers do not
have an inherent advantage over new entrants.
To see a live example of such a situation of commodity chemical manufacturers, an investor may read our
analysis of an API (active pharmaceutical ingredient) manufacturer, NGL Fine Chem Ltd. APIs are
commodity chemicals, which are used by drug companies to make ready to eat medicines.
In the July 2020 conference call, the management of NGL Fine Chem Ltd highlighted that it is into B2B
(business to business sales) where the buyer is very educated and knows what she is buying. The buyer
knows to evaluate the quality of its purchase and thereafter prefers to buy from whoever sells the lowest
price. The buyer is indifferent to the brand of the seller until the time the product is of acceptable quality
and is priced cheap.
July 2020 conference call, page 20:
Rahul Nachane: So see we are selling to, it’s a B2B business… The purchaser is also very
educated and very well experienced person. I have not come across any buyer who is willing to
give a higher price because of any brand recall of that sort. Only thing what he will do is, all
things being the same he will give preference but he will first challenge on the pricing.
Therefore, an investor would appreciate that in the commodity chemicals space, a customer would not pay
a premium pricing to its suppliers. The suppliers have to match the price available in the market.
Therefore, marketing exercises like branding does not have any positive impact on the financial
performance of commodity chemical companies.
Commodity chemical companies do not benefit from product differentiation or brand

identification.
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However, the entire picture of pricing power changes when an investor shifts her attention from commodity
chemical space to specialty chemicals.
From the above discussion, an investor would remember that the specialty chemicals are a result of
significant R&D in order to produce specific desired changes/properties in the overall product. Specialty
chemicals are used in very small quantities in the overall manufacturing process; however, they have a very
high impact on the final properties of the end-product.
Therefore, the customers of specialty products are very particular about choosing a specialty chemical
product and its supplier. Any lapses/defect in the specialty chemical can lead to poor quality of a very large
quantity of final product of the customer. As a result, any customer undertakes a lot of testing before they
approve any specialty chemical supplier for their manufacturing process.
Therefore, the customers do not switch their specialty chemical suppliers for a minor price difference. This
is because the monetary benefits from switching to a low-cost specialty supplier may not be much; however,
the risk it carries is huge. As a result, there is a huge switching cost/risk when any customer decides to shift
its specialty chemicals supplier.
As a result, the speciality chemical producers are somewhat protected from intense competition and they
get a pricing power where they are able to pass on any increase in their input costs to their customers.
Key credit factors for the specialty chemicals industry by Standard and Poor’s, December 2013, page 3:
Pricing competition is not typically a significant factor for specialty chemical companies. The
price sensitivity of customers tends to be limited because specialty chemicals often represent
a small proportion of customers’ overall cost of production…In addition, in certain highly
engineered or regulated end markets, customers can face very high switching costs once a product
is specified.
customers are typically reluctant to switch specialty chemical products because they tend to
impart specific and integral performance attributes, which cannot be easily replicated, and they
usually represent a small portion of total production costs.
An investor can see a real-life example of high switching costs influencing customers’ behaviour when she
analyses Deepak Nitrite Ltd. She comes across a situation where Deepak Nitrite Ltd started producing
a speciality chemical, optical brightening agent (OBA); however, despite its best efforts for many years,
the company was not able to run the OBA division profitably.
This was because the customers are very cautious before approving any new supplier for OBA. As per the
company, any problems in the OBA may lead to the rejection of millions of meters of cloth for a textile
mill or millions of tons of paper for a paper mill.
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Conference call, May 2016, page 15:
Somsekhar Nanda: OBA business actually is not a bulk business, it is a specialized performance
chemical and very-very specialized, it has to perform its quality…if chemical is not working as per
their satisfaction or as per their chemical perception they might lose a million meters of cloth or
million tons of paper. So very-very difficult.
As a result of the very strict approval process by the customers, Deepak Nitrite Ltd faced many challenges
in getting approvals for its OBA products.
From the above example, an investor may note that in the case of speciality chemicals, customers do not
change their suppliers just because any new supplier is offering the product at a cheaper price. This is
because it might turn out to be a situation of “penny-wise and pound-foolish” for the customer.
As a result, the specialty chemical producers are able to charge a premium pricing to their customers and
are able to pass on any increase in their input costs. Moreover, they are able to charge pricing as per the
value generated by their products to the customers.
Companies are generally able to offset the impact of higher input costs via higher selling
prices and maintain or improve profitability.
Because of their differentiated and value-added nature, many specialty product lines enjoy higher
sustained profitability levels than commodity products.
Therefore, an investor would recognize that specialty chemical companies produce a small quantity of
chemicals, which is very important for the customers and is not easily replaceable. Therefore, these
companies are not price-takers but are price-setters. Low cost of production or economies of scale is not
one of the key performance criteria for specialty chemical companies.
Compared with integrated chemicals companies, economies of scale are less important for
specialty chemicals companies, given their greater pricing-setting power (they are not ‘price
takers’).
The high focus of specialty chemical players on R&D and their strong customer relationships ensure that
despite their small size and fragmented industry, they have strong entry barriers against new players.
Barriers to entry in the specialty chemical industry are typically high. The specialized nature of
products leads to significant differentiation. Substantial research and development (R&D)
requirements, technical know-how, capital intensiveness, service capabilities, customer
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relationships, and engineered or regulated specifications also create important barriers to

entry…. Because of this, even fragmented industry sectors tend to be protected against new
entrants.
An investor would appreciate that the products of specialty chemical companies are highly differentiated
from each other. As a result, such companies benefit from branding, especially in segments where direct
purchases by retail consumers form a significant part of sales.
Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page
10:
subsectors like decorative paints, construction chemicals or adhesives, a company’s market

positioning is strongly influenced by the strength of its corporate brand portfolio. As these
subsectors tend to a generate a considerable share of their revenue in the consumer sector
Therefore, an investor would note that the commodity chemical companies face intense competition and
are price-taker with no pricing power over their customers. On the contrary, the specialty chemical
companies are relatively protected against intense competition and are price-setters with a high pricing
power over their customers.
In fact, a specialty chemical player must have a higher profit margin than a commodity chemical player. In
case, the profit margins of a specialty chemical player start declining, then it may indicate a situation where
its so-called specialty products have now started to become commodity products and it has started losing
its pricing power.
For specialty chemical companies, ICRA would evaluate the stability of their operating
margins over a period of time to ascertain the extent to which their pricing power has remained
intact.
revenue or margins trends that are at odds with prevalent industry conditions or that of other
competitors can be indicative of an improving or deteriorating competitive advantage.
Therefore, an investor can assess the current status of the pricing power of a specialty chemicals player by
analysing its operating profit margins.
2) Lowest cost producer; economies of scale:

An investor would remember from the above discussion that the commodity chemical companies compete
with each other on prices as their products are non-differentiable commodities and the customers can easily
switch from one supplier to another. The technology to make commodity chemicals is mature and is widely
available.
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Rating methodology for the chemical sector, CRISIL, February 2021, page 11:
Bulk chemicals: The technology is easily available and typically there is more than one way to
manufacture a particular product.
As a result, the key competitive strength for any commodity chemical producer comes from being the lowest
cost producer in the market. This is because, in the long term, the lowest-cost producer sets the market price
and all other players have to match that price to gain business.
Cost-competitiveness: Because most commodity chemical products are hard to clearly

differentiate using technology, competition relies heavily on cost competitiveness.
Commodity chemical companies undertake many strategies to become low-cost producers like locating the
plant near the key raw material source like a refinery for petrochemicals, or near the key customers for
lower transportation costs, or long-term take-or-pay agreements with their suppliers, and efficient
utilization of by-products of the manufacturing process. However, the biggest impact on the cost structure
of a commodity chemical producer comes from in the form of economies of scale where it increases its size
of operations by capacity expansion.
For commodity chemicals, in general, an entity with superior economies of scale and efficient
utilisation of by-products would have a lower cost of production than a smaller entity.
As the size of the commodity chemical player increases, its fixed costs are spread across a higher volume
of production, which reduces its overall per-tonne cost of production and provides a competitive advantage
over other smaller players.
Economies of Scale: The chemical industry being capital intensive, achieving economies of
scale and having a competitive cost structure are of considerable importance. Some Indian players
who have built up relatively large capacities benefit from the resulting competitive advantages. In
addition large capacities may also bestow the company a healthy market share and greater
bargaining power with suppliers as well as customers.
Therefore, in the case of commodity chemical manufacturers economies of scale for cost advantages
become essential to sustain in the industry. This is because lowering the cost of production seems to be the
only competitive advantage for commodity chemical players.
As per the Japan Credit Rating Agency, the size of the commodity chemical company is one of the key
indicators of its competitive advantages.
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Business size: In commodity chemicals, JCR focuses on the indicators related to the business
size or a market position, which have a significant effect on the competitiveness of the company.
Pefindo, the Indonesian credit rating agency, in its rating criteria for the chemical industry, highlighted the
importance of economies of scale for maintaining sufficient profit margins of commodity chemical
companies.
Rating methodology for the chemicals sector, Pefindo Credit Rating Agency, Indonesia, November 2021,
page 1:
Economies of scale together with a large market share and volume production are critical to
maintain cost leadership and ensure sufficient margin, which include the analysis of raw material
sources and costs, especially for commodity chemical companies, which primarily compete on the
basis of prices due to the inability to differentiate products by performance.
On the contrary, for specialty chemical industries economies of scale are not very important because of the
following reasons.
First, the market size of any specific specialty chemical is not large because they are used in small quantities
in their customer’s manufacturing process. So the total market size itself for any particular specialty
chemical may not be large enough to justify a very large plant.
Market sizes for specialty chemicals are often small to medium. We consider the absolute size of
many specialty materials markets to make the large investments required to develop new
products less attractive for bigger chemical players.
At times, the market size of specialty chemicals is so small that the companies produce many specialty
chemicals on the same production line to use the facilities optimally.
For speciality products, small volumes generally do not translate into cost-efficient operations
and are thus typically produced along with other products sharing common facilities.
Second, as discussed above, specialty chemical companies have the ability to pass on the increase in input
costs. Therefore, they do not need to be the lowest-cost producer in the industry to sustain their business.
Third, specialty chemical companies can price their products as per the value they provide to their
customers. Therefore, specialty chemical companies may earn a high-profit margin despite not being a low-
cost producer in the market.
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Specialty products are small-volume chemicals, which perform some critical function in the user
industry…prices are not driven by demand-supply equations alone, but also by functionality and
utility to the user.
Therefore, an investor would note that in the case of commodity chemicals, the products are non-
differentiable and easily switchable. As a result, the companies have to compete on pricing and they attempt
to become the lowest-cost producers to earn sustainable profit margins. On the contrary, the specialty
chemical companies aim to be meet the specific requirements of the customer by selling high-technology
small-volume chemical solutions. They have a high customer stickiness; therefore, they do not need to be
very cost-competitive to survive in the market.
An investor would appreciate that for the commodity chemical companies, having low production costs is
essential to remain profitable. Moreover, a low production cost is a direct result of the high capacity
utilization of the manufacturing plants. As a result, the commodity chemical companies attempt to run their
plants at high utilization levels even if they have to accept orders at slightly lower prices. This strategy of
commodity chemical players reinforces the price-based competition between them and reduces their
pricing/negotiating power over customers.
For bulk chemicals, the cost of production is directly related to capacity utilisation. Thus, it
becomes important to maintain high capacity utilisation.
Commodity chemical businesses generally require large capital expenditures, which makes it
important to appropriately capture the demand and maintain a high rate of facility operation.
The importance of high capacity utilization by a bulk/commodity chemicals player becomes more evident
when an investor notices that the cost of procuring raw material for most of the bulk chemical producers is
nearly the same and the operating leverage that comes from running the plant at a high utilization level may
be the biggest determinant of competitive advantage.
Because most commodity chemical products are hard to clearly differentiate using technology,
competition relies heavily on cost competitiveness. The cost of procuring raw
materials generally depends on market conditions and so doesn’t really vary among individual
companies.
Therefore, an investor would note that for commodity chemical producers, their
high fixed cost structure, non-differentiable products and high raw material/input costs lead to
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a situation wherein to become the lowest-cost producers to gain profitability, the companies end
up weakening their pricing power.
3) Capital intensiveness and R&D costs:

From the above discussion, an investor would note that commodity chemical companies usually have a
large manufacturing plant to benefit from economies of scale to run cost-efficient operations.
In fact, the requirement of being a large player where economies of scale help in lowering the cost of
production is so important for the commodity chemical industry that it is believed that a
commodity/integrated chemical manufacturer needs to achieve a basic minimum size before it can even be
relevant for its industry.
We believe that an integrated chemical company has to have a minimum critical size in order to
be market-relevant.
Therefore, an investor would appreciate that in the commodity chemical space, a company must create a
sizable plant to sustain, which makes a large-sized investment mandatory to run its operations successfully.
As discussed above, the technology for making commodity chemicals is widely available; therefore, a high
investment in R&D by commodity chemical companies is not highly fruitful and do not add any significant
competitive advantage. Large-sized cost-competitive plants are the biggest advantage for them. It makes
the commodity chemical sector a capital-intensive sector.
Product innovation and R&D intensity are of lower importance in a market with commoditised
products. The vast majority of products in this industry are late in their life cycle stage and largely
have commodity characteristics, from a return on invested capital point of view, making large
R&D investments unattractive. Consequently, the commodity chemicals industry is dominated by
large-sized corporates.
Moreover, the requirement of large-sized investment for commodity chemical companies does not end with
the creation of a new manufacturing plant. They need to continuously spend money on working capital as
well as meeting the stringent guidelines for safety and environmental norms.
Beyond the large capital expenditures typically required to build large-scale production facilities,
further capital expenditures result from working capital and the obligations to meet safety and
environmental protection requirements.
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In order to sustain/increase their market share, commodity chemical players need to continuously add
investments in new plants and to maintain/upgrade their existing plants.
The commodity chemical business is capital intensive…a multi-product entity is also expected
to continually upgrade/add new capacities (for commodity chemicals) to keep cost structure
competitive and meet stricter environmental norms along with maintaining market specifications
of the newer products.
An investor may appreciate that on an overall basis, the commodity chemical companies do not have very
strong entry barriers to restrict the entry of new players. The requirement of large capital investment forms
the only significant entry barrier for new players. Nevertheless, the industry is so sensitive to new entrants
that many times, the entry of a single new player can seriously impact the profitability of existing players.
The effectiveness of barriers to entry in the commodity chemicals industry is

typically limited. Capital requirements necessary to set up new processing plants can act as a
barrier to entry…Moreover, because of sensitivity to supply and demand balance, even a single
new entrant can cause changes in industry conditions that have a significant impact on the
profitability and cash flows of existing participants in an industry segment.
On the contrary, the specialty chemicals require a relatively small investment in their manufacturing plants
because the plants are usually smaller in size and cost-competitiveness is not the only determinant of
competitive strength. Therefore, the specialty/functional chemical players do not have a large capital
investment burden.
Rating guidelines for the chemical sector by the credit rating agency, Rating and Investment Inc., Japan,
June 2021, page 4:
In general, per-plant cost-efficient output of functional products is smaller than that of materials,
and the capital investment burden of the functional products sector is light.
However, an investor would appreciate that in the specialty/functional chemicals segment, the competitive
advantage of the players arises from their technical knowledge and R&D.
Manufacturers of specialty chemicals are also well protected from potential competitors. Key entry
barriers are the need for large investments in R&D to acquire intellectual property for customised
specialty chemicals
Specialty chemicals players need to spend a lot of money in R&D to create products. The technology is
usually patented. At times, the technology is developed in-house is kept a trade secret. As a result, specialty
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chemical companies also face the risk of technology theft. Therefore, they very closely guard the
technology, which is the main source of their competitive advantage.
Speciality chemicals: Technology is typically developed in-house with the critical equipment being
outsourced. The process is closely guarded as it can typically be duplicated. This exposes these
companies to risks of technology theft.
Actually, the complexity of the technology determines the extent of competitive advantage for specialty
chemical players. Competitors find it difficult to copy complex technology and as a result, the specialty
player can continue to earn high-profit margins by selling its products.
complexity of the technology used by the entity to assess the extent of entry barriers present in the
segment. The more complex the technology, lesser the possibility of re-engineering, and,
therefore, lower the probability of the product becoming a commodity within a short span of time.
Specialty chemical players solve specific problems of the customers and produce high-value adding
products. As a result, specialty chemical players have strong relationships with their customers and
customer stickiness is very high.
In addition to investments in R&D, further barriers to entry for the specialty chemical sector come
in the form of bespoke solutions and applications with long-term customer relationships which
new entrants find difficult to destabilize. Specialty chemicals account for only a small proportion
of the final product costs. Therefore, switching costs for customers in the specialty chemicals
industry are high, resulting in reluctance to switch to realize only slight gains (customer
‘stickiness’).
Therefore, an investor would note that the key competitive strength of specialty chemical players is their
R&D. In fact, the need to continuously invest in R&D is so high for specialty chemical players that it
becomes almost a fixed expenditure for them.
June 2021, page 5:
For functional products, the burden for depreciation and amortization and other fixed costs
normally is lighter than in the case of materials. Even so, a certain level of R&D spending is
required regardless of the rise or fall in sales, turning this expenditure into something of a fixed
cost.
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Specialty chemicals often require substantial investment in research and development

to continuously improve the level of technology.
page 1:
New product formulations at the customer level require constant development at the chemical
company. Consequently, a company should make a commitment for a Research and Development.
An investor would appreciate that a specialty chemicals company cannot reduce its R&D spending for
reporting short-term profit benefits. A reduction in R&D will have a significant impact on its competitive
strengths. In contrast, the technology for commodity chemicals is mature, is widely available and more
investment by commodity players in R&D may not give any outsized benefits.
Therefore, an investor would note that chemicals sector players whether commodity or specialty, need to
continuously invest money in their business. The commodity chemical players need to invest a large amount
of money in creating a big manufacturing plant initially and then subsequently for its expansion and
upgradation. In addition, they need investments for working capital as well as safety & environment
protection needs.
On the other hand, the specialty chemical players need to invest significant money in R&D because it is
their biggest competitive advantage. They need to maintain R&D spending irrespective of any decline in
the business, making it a fixed expense for them. On average, specialty chemical companies spend about
3% of their revenue on R&D.
10:
Over the last decade, R&D expenditures as a percentage of sales (R&D expenditures/sales), in the
specialty chemical industry were about 3% on average per year.
Therefore, an investor would appreciate that the business operations of chemical companies are capital
intensive whether they operate in the commodity chemicals space or the specialty chemicals space.
4) Cyclicity and volatility of performance:

The chemical industry especially the commodity chemicals segment faces very high cyclicity i.e. boom and
bust phases. The prices of bulk/commodity chemicals are very volatile.
As per the credit rating agency, Standard and Poor’s, the revenue and profitability of commodity chemical
companies show a high cyclicity. The revenue of commodity chemical players declines on an average by
7% during recessions with a maximum decline of 23%. The profitability (EBITDA) margins of commodity
chemical players declined on an average by 15% with a maximum decline of 28%.
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Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, pages
3-4:
We view commodity chemicals as a “moderately high risk” industry under our criteria, given its
“moderately high risk” cyclicality and “moderately high risk” degree of competitive risk and
growth…average peak-to-trough (PTT) decline in revenues of about 7% during recessionary
periods since 1950…with the steepest decline (23% drop in revenues) occurring during the most
recent downturn…average PTT decline in EBITDA margin of about 15% during recessionary
periods…the largest decline (28%) occurring during the 1989-1992 recession.
The bulk chemical industry shows high cyclicity due to the following reasons.
First, the raw material costs are the single largest expense for chemical companies whose prices are very
volatile.
raw material cost is the single largest component of the cost structure of a chemical entity
Industry profit margins are heavily affected by exposure to changes in input costs. Many raw
material inputs experience significant pricing volatility, and commodity chemical companies
have limited ability to pass on this volatility to customers because of the competitive nature of the
industry.
Most of the time, the chemical manufacturing process is very energy-intensive, which makes energy costs
one of the major input costs for commodity chemical players. An investor would appreciate that energy
costs, which usually follow crude oil prices are very volatile in nature. As a result, high energy requirements
also increase the cyclicity in the profit margins of commodity chemical players.
Some commodity chemical companies require a large amount of energy during the production
process and, thus, are susceptible to fluctuations in energy prices.
Second, the prices of the final chemicals produced by bulk chemical producers depend on their global
demand and supply situation and have no linkage to the cost of raw material/inputs of these chemicals. As
a result, many times, bulk chemical producers are stuck in a situation where the raw material prices have
increased and the final product prices have declined. Therefore, their profit margins are very volatile.
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Trends in prices of raw materials and finished products do not necessarily coincide, and the spread
(the difference between the price of raw materials and the price of a finished product) generally
tends to be unstable.
Bulk chemicals are pure commodities and prices tend to be very volatile, with little or no relation
to the cost of production of a specific manufacturer.
The third reason for the cyclicity in the business of commodity chemical companies is the dependence of
the demand for chemicals on the general economic situation in the country. In fact, the demand for
commodity chemicals increases sharply during the up-cycle phase of the economic cycle and the demand
declines sharply during the down-cycle phase.
Industry revenue and earnings growth generally outpaces global GDP growth during peak periods
and falls below global GDP growth during trough periods.
The dependence of demand of the chemical industry on economic growth is true even for developed
economies like Japan.
June 2021, page 5:
Demand, in other words, is influenced by the activity of the entire economy.
Therefore, an investor would appreciate that bulk chemical players witness a high cyclicity in their business
performance. They frequently face boom and bust periods i.e. periods of good performance frequently
follow periods of poor performance and vice-versa.
The fact that bulk/commodity chemical players are usually large plants with substantial investment in fixed
assets increases the impact of cyclicity on their profit margins. Due to high fixed costs, during the phases
of low demand when the capacity utilization declines, then the companies face reverse operating leverage
i.e. the high fixed costs are spread over lower volumes and the profit margins of the company decline
sharply.
Higher capital investment in bulk chemicals subjects them to more pronounced cycles compared
to speciality chemicals.
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Cyclical demand declines can lead to intense price competition, and lower production volumes
can significantly reduce fixed cost absorption and profit margins.
In fact, the bulk chemical industry witnessed so much cyclicity linked to the economic growth of a country
that at times, consumption of base/bulk/commodity chemicals is seen as an advance/leading indicator for
an upcoming slowdown in the economy.
Base chemicals are a key leading indicator for potential slowdowns in economic activity, as they
are used in virtually all end-markets and base chemical product sales volumes are highly sensitive
to demand changes.
This is in sharp contrast to the specialty chemical players who witness a much lower cyclicity in their
business performance when compared to bulk/commodity chemical players. There are many reasons for
the same.
First, as discussed previously, the specialty chemical players are able to pass on pricing pressures from their
input costs and in turn are able to maintain their profit margins, which helps them beat the cyclicity.
For many specialty chemical producers, cyclicality can be exacerbated by volatility in energy costs
or the price of raw materials, which are often commodity chemicals .many specialty producers
have the ability to mitigate this volatility with pass-through provisions or value-added pricing.
Second, the raw material costs form a smaller part of the overall costs of a specialty chemicals company
when compared to a commodity chemicals company. As a result, an increase in the input costs has a smaller
impact on the business performance of a specialty chemical company than a commodity chemical company.
Speciality chemicals: Prices do not undergo cyclical changes as raw materials do not constitute
a major cost.
The production of specialty chemicals typically requires limited quantities of raw materials which
results in lower sensitivity to input price changes. In addition, higher feedstock prices (input
prices) for several specialty chemicals are commonly automatically passed on to customers.
Instead of raw material costs, one of the key costs that specialty chemicals players is required to control is
the employee costs because these companies usually have a large sales and marketing team.
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page 1:
On the other hand, specialty chemical companies are more labor-intensive and have bigger sales
and customer services forces, so that controlling selling and general & administrative expenses is
imperative.
Third, due to relatively lower fixed investment, specialty chemical companies are able to sustain their
profitability even at lower demand/production levels. As a result, even in the economic down-cycle phases,
the specialty chemical companies continue to get a certain amount of business from their key customers as
well as from aftermarkets.
specialty chemicals companies face medium cyclicality risks. Specialty materials often account for
a small share of production costs where those specialty chemicals are used (such as in automotive
coatings) and the production of these end-products continues at lower volumes even in periods of
weaker economic demand.
In contrast, we believe that the specialty chemical sector has medium cyclicality. This is
because aftermarkets require lower quantities of specialty chemicals in their product processes
and prices tend to be negotiated individually.
Therefore, an investor would note that the commodity chemical companies witness a high cyclicity in their
business performance. The cyclicity may be externally driven i.e. induced by fluctuating demand, raw
material prices etc. However, at times, the cyclicity/downturn in the industry has been induced on its own
by the chemical players when the capacity additions are not planned properly.
Many times, bulk chemical players who work with large capacity plants, announce capacity expansions,
which are going to commence operations after a couple of years. At the time of announcing the expansion,
the companies are not certain what would be the level of demand when the new capacities would become
functional.
Often, companies must make decisions to add capacity well in advance of the start of commercial
production. Such decisions expose these companies to uncertain demand.
Therefore, there were instances when the capacity expansion plants of multiple players became operational
at the same time, which led to an oversupply in the market and led a crash of prices. An investor would
remember that the commodity chemical producers work on low-profit margins and a decline in the product
prices may force many players out of business.
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12:
In the past, several downturns in the chemical industry were caused by significant oversupply in
the aftermath of large capacity coming online.
Most of the time, the companies attempt to reduce the cyclicity in their business by diversifying into
different products, geographies etc. so that they may mitigate the impact of the downturn in any one product
or country.
page 1:
For those players, which are engaged in the commodity segment, a diversification would be a
critical thing to do in an effort to reduce the cyclicality of any one product.
Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, pages
7-8:
Product, end-market, and raw material diversity are important factors for commodity
chemical companies, because a narrow focus can make a company more vulnerable to cyclical
pressures
Geographic diversity can offer enhanced growth prospects through exposure to developing
regions with higher growth rates than more mature markets. Such diversity of sales and
production limits exposure to economic or political risk in any given nation or region.
At times, the commodity chemical players diversity by producing specialty products as well to mitigate
cyclicity in their business.
The portfolios of these large-sized corporates often include a substantial proportion of specialty
chemicals operations, improving diversification and mitigating cyclicality risks to earnings.
As the raw material costs are the largest input costs for a commodity chemicals company; therefore, an
ability to change the raw material as per market dynamics is very helpful to deal with raw material price
fluctuations i.e. when costs of a raw material increase, then use a different raw material or use a different
grade of the same raw material.
Companies that are able to use different inputs—whether entirely different inputs or different
grades of the same material–can enhance profitability and improve their competitive
positions relative to peers that do not benefit from the same flexibility.
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5) Integration of operations:
An investor would appreciate that the chemical producers especially the bulk chemical players need to be
very cost-competitive to generate sustainable profit margins. Previously, we noted that companies employ
economies of scale as a primary means of becoming low-cost producers of commodity chemicals.
Apart from large manufacturing capacities of any chemical, the bulk chemical producers also go for vertical
integration (both forward and backward) in order to retain a higher value of the supply chain within the
company. Integration also becomes a source of competitive advantage for chemical producers and improves
their profit margins.
page 1:
Well-integrated firms can also benefit from an ability to add value along the supply chain and can
realize some opportunity to differentiate products, which can be translated into higher margins.
A higher level of integration also helps in reducing the volatility of the earnings of the manufacturers
because, they are able to generate a lot of intermediate products in-house, which protects them from the
volatility of prices of these products in the open market. Integration of operations helps the companies to
avoid the risk of unavailability of the key raw material, especially for raw materials, which do not witness
much trading/are not easily available.
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, pages 3-4:
Level of Vertical Integration: A high level of vertical integration lowers earnings volatility and
protects against raw material unavailability risks and volatility in prices. Globally, there is
relatively lower merchant trade in some petrochemical building blocks such as ethylene and
propylene. Thus, plants dependent on external supplies of these chemicals are exposed to
relatively high business risks in the form of availability and price volatility.
An investor would appreciate that most of the bulk chemical plants operate 24*7. It helps them get the
maximum capacity utilization of their plants and in turn, be very cost-competitive. However, the round the
clock operations of chemical plants increase the impact of the unavailability of any raw material/feedstock
at any stage. This is because the unavailability of raw material may lead to the shutting down of the
production line.
Feedstock Risks: Availability is particularly important, considering that most chemical companies
operate continuous process plants and an unplanned shutdown can have severe cost implications.
Therefore, an investor may think that vertical integration is always a good strategy for chemical producers.
However, it is not so. There are times when vertically integrated firms, which produce their raw
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material/intermediate products themselves become at a disadvantage to the firms that buy such intermediate
products from the open markets.
An investor would note that the prices of chemicals are very volatile and are not related to their input costs
i.e. the cost of production. Therefore, there are times, when the chemical products are available in the open
market at a lower price than the price at which an integrated chemical player can produce them.
Rating Methodology for Entities in the Chemical Industry, ICRA, December 2014, page 3:
if intermediates prices in the market are lower than captive production due to supply-demand
mismatches, that can impact the overall profits of vertically integrated companies, unless they
have the flexibility to use market sourced intermediates, through either imports or domestic
purchases.
Therefore, despite being vertically integrated, a chemical company may be at a cost disadvantage. As a
result, it must develop the ability to start its manufacturing process from the intermediate steps by procuring
the low-priced intermediate products from the open market if their prices are lower.
Similarly, on the downstream (end-product) side, there might be times when the prices of intermediate
products increase so much that selling the intermediate product may provide higher profitability than selling
the final product. In such a situation, the chemical player needs to be versatile where it may sell the
intermediate products in the market and not wait to convert them into the final product before selling it.
A high level of integration usually results in a better cost structure. However, in the event of sharp
price movements in inputs or outputs, the company is exposed to adverse market circumstances.
Thus, CRISIL Ratings looks into the flexibility available to the manufacturer to start from various
stages in its production process in case of adverse price movements in its upstream products. The
ability to market intermediate products in the event of sudden price movements in downstream
products is also assessed.
Therefore, an investor would note that in the case of commodity chemical producers, being vertically
integrated helps in becoming more cost-competitive, improves profitability. It also helps to avoid the
unavailability of critical raw materials. However, the company needs to be flexible in its manufacturing
process so that when market prices provide opportunities, then it may start the manufacturing using
intermediate products or sell intermediate products without waiting for the production of final products.
From the above discussion, an investor would note that the speciality chemicals players usually have small
manufacturing plants because their target market size is small. Therefore, economies of scale and vertical
integration, though beneficial, are not very critical to generating competitive advantages for specialty
chemical players. They depend more on R&D and technology to generate competitive advantages.
6) Regulatory protection/tariffs:
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The chemicals sector is one of the sectors, which involves a lot of tariffs related activity. There are import
duties, anti-dumping duties etc. in order to provide a level-playing field to the domestic producers when
compared to the nations with an oversupply of different chemicals especially when such nations resort to
exporting their chemicals to India below the cost of production.
The linking of the Indian chemical industry with the global market was initiated in a big way in the 1990s
when India aligned its import tariffs in line with the opening up of the economy.
Rationalisation of import tariffs during the 1990s has linked the domestic market to international
cycles.
From then, the prices of chemicals in India started following global prices because companies started
pricing chemicals at import parity prices.
since most commodity chemicals are priced on an import parity basis, in a scenario of depreciation
of the Indian rupee against the US dollar, the domestic players get a protection that partly
mitigates the impact of declining import duty protection levels.
In fact, the chemicals company globally is now almost fully integrated and the companies of almost every
country face global competition. The same is true for India as well as other developed countries.
The global nature of the industry also exposes producers to new competition from regions that
offer lower-cost raw materials or labor.
Nevertheless, India provides protection to the chemical manufacturers, especially against the dumping of
products at very low prices by foreign companies.
The level of import duties on different bulk chemicals is so important that the profit margins of the
companies are highly dependent on the prevalent tariffs. Credit rating agencies give a lot of importance to
the prevailing tariffs and their continuation while determining the future financial position of chemical
companies.
Duty protection and pricing: The differential between import duties on raw materials and finished
products is also an important determinant of pricing for domestic manufacturers. CRISIL Ratings,
therefore, analyses the movement in import tariffs and the sensitivity of margins to changes in the
protection levels. This is an important aspect in the rating of bulk chemical companies.
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An investor may read our detailed analysis of various chemical companies like Deepak Nitrite
Ltd, NOCIL Ltd, and National Peroxide Ltd to see real-life examples of companies that benefited from
the imposition of anti-dumping duties by the Govt. of India on low-priced imports from foreign countries.
7) Location of the manufacturing plants:

An investor would note that in the case of bulk/commodity chemical manufacturers, the intense price-based
competition leads to low-cost production becoming the best competitive advantage. The commodity
chemical players are price-takers with very low or nil pricing power.
As a result, apart from having large-integrated plants (economies of scale), the bulk chemical manufacturers
also attempt to reduce their costs by way of reducing their transportation costs. It may be a substantial
factor, especially for low-value adding chemical products that do not have sufficient profit margin for
transportation over long distances.
Therefore, it is seen that in the case of low-value chemical products, the chemical companies attempt to
make them near to their consumers.
For low-value chemical commodities such as chlor alkali products (caustic soda, chlorine, soda
ash) the locational factor, among others, could play a significant role in determining the
competitive advantage of a chemical entity. As the freight cost as a percentage of the landed cost
to the final consumer can be high, if the product is transported from a longer distance, proximity
to major end-users could impart strength to the manufacturer.
It is a situation similar to cement plants where cement being a bulky low-value adding commodity, is
difficult to transport over long distances. Therefore, companies attempt to construct the cement plants at
such locations where they can minimize transportation costs.
On the contrary, for high-value chemicals, the companies attempt to keep their plants near the raw-material
sources to keep their input costs low.
For units producing high-value commodities, proximity to raw material sources (examples:
petrochemical units located near a refinery; alcohol-based chemical units located in a sugar belt;
and units dependent on imported raw materials located near a port) could impart competitive
advantage via competitive feedstock costs.
In India, most of the chemical producers are present in the states like Gujarat and Maharashtra (the west
coast). One of the key reasons for the same is easy access to the ports, which serve both for easy access to
cheap raw material overseas (imports) and easy access to high-paying customers present overseas (exports).
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Though the chemical industry is spread across the country, there is relatively a high concentration
along the west-coast, largely due to the proximity to raw materials and ports.
Location on the west coast of India also benefits Indian chemical producers, which are able to easily
integrate with the large chemical manufacturing units existing and upcoming in the Middle East region.
Large, new plants, using ethane—a major component of natural gas that is far less costly than
naphtha—are being built, one after another, in the Middle East
Therefore, while analysing any bulk/commodity chemical company, an investor should note that the
location of the manufacturing plant provides a key competitive advantage to the company. If due to any
reason, a bulk chemicals company finds itself in a locational-disadvantaged situation, then it would be very
difficult for the management to overcome its challenges.
In addition, proximity to key end markets can have a considerable impact on transportation costs
for bulky or hard-to-ship chemicals.
8) Environment and safety regulations:

Chemical manufacturing is a very environmentally sensitive process because it generates a lot of effluents,
which have the potential of damaging the environment and causing pollution. As a result, the companies
need to invest a significant amount of money in treating the effluents before recycling them or releasing
them back into nature.
An investor would remember from the above discussion that a continued requirement to spend money to
meet ever-changing environmental/pollution-control regulations is one of the reasons that make chemical
manufacturing a capital-intensive process.
Beyond the large capital expenditures typically required to build large-scale production
facilities, further capital expenditures result from working capital and the obligations to meet
safety and environmental protection requirements.
In the past, there have been many instances where chemical manufacturers have to pay penalties or shut
down their operations because they failed to meet the environmental protection guidelines.
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Environmental Risk Mitigation: In the past, several chemical plants have been shut
down internationally or have had to pay high penalty, having failed to comply with the relevant
pollution control norms.
The environmentally damaging nature of the chemical manufacturing industry became clear to the whole
world during 2014 onwards when China which is the world’s largest chemical manufacturer tightened its
environmental regulations and as a result, a significant number of Chinese chemical plants shut down. This
was because these plants found that spending money to become compliant with environmental regulations
was economically unviable. During this period, when India also increased the enforcement of
environmental regulations, then many small chemical units in India also shut down.
As a result, the chemical exports from China declined suddenly and the chemical manufacturers in other
countries including India got an opportunity to fill in the gap created by Chinese manufacturers.
An investor may read the example of Bodal Chemicals Ltd, which produces dyestuff, which produces a
lot of effluents. In FY2014, the company indicated that its profitability has improved due to the reduced
supply of dyestuff in India because of declining manufacturing in China. The dyestuff production in China
had reduced due to strict enforcement of environmental protection regulations, reduction in export
incentives and electricity subsidies.
The FY2014 annual report of Bodal Chemicals Ltd, page 2:
Furthermore India and China are the major supplier at globe level. Both countries are now strict
in following the implementation of various environment and pollution norms and provide
environment safety and this has lead the players to either exit or reduce the size of operations by
many small units in India and forced shutdown of many dye intermediate units in China.
The reduced supply of the dyestuff from China has reduced the competition in the industry and as a result,
Bodal Chemicals Ltd is able to get higher prices for its products in the market. This has resulted in the
improvement of the OPM for the company.
To understand the problems faced by an Indian chemical manufacturer who had to repeatedly shut down
its operations when it was found lacking in meeting the water-pollution norms, an investor may read the
analysis of NGL Fine Chem Ltd in the following article: Analysis: NGL Fine Chem Ltd
Therefore, while analysing any chemical company, an investor should pay due attention to the aspect of
compliance with environmental regulations. She should analyse its track record of meeting the guidelines
in the past, any shutdown or penalties imposed on it by Govt. or any investments done by it for meeting
pollution control norms to understand whether the company takes environmental preservations
responsibilities seriously.
Meeting environmental guidelines is essential because, in the current times when awareness in the society
about pollution-related issues is very high, any noncompliance may lead to shut down of the business of
the company.
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Summary
The chemical industry is one of the most important parts of any economy. The strong linkage of chemical
consumption with economic growth makes it an indicator of upcoming slowdowns. It is divided into two
key segments: bulk/commodity chemical producers and specialty chemical producers. Both these segments
have very contrasting business characteristics.
Commodity chemicals are non-differentiable products; have an intense price-based competition where the
manufacturers do not have any pricing power. On the contrary, specialty chemicals are niche products made
after significant R&D that are difficult to replicate by competitors. Specialty chemical players have strong
pricing power and earn high margins.
Commodity chemical manufacturers despite having a large market share or after being in the business for
a long-time, do not enjoy any sustained advantage. They are price takers and have to focus on reducing
production costs to have sustainable profit margins. Large plants with economies of scale are their main
competitive advantage. Specialty chemicals need to focus on improving technology, and higher spending
on R&D to solve customers’ specific problems. Lowest-cost of production may not matter much for
specialty chemical players.
Bulk/commodity chemical manufacturers need to create large integrated plants to become meaningful
players in the industry. Their technology is mature and widely available. Significant spending on R&D by
them on commodity players may not be very fruitful. Even branding may not give outstanding results. On
the contrary, specialty chemical players cannot avoid spending on R&D. Improving technology is their key
for survival in the ever-changing world. R&D spending is like a fixed expense for them.
Commodity chemical players face very high cyclicity in their business performance. Their input costs and
final product prices are very volatile. Companies do not have any control over both of them making their
profit margins very uncertain. High fixed costs due to large plants make their profits very volatile. Whereas
specialty chemicals can manage volatility by passing on increases in input costs. Customers use their
products in small amounts and gain very high value from them. So, they do not mind paying a high price
for specialty products. Cyclicity in the performance of specialty chemical players is much less than bulk
chemical players.
Vertical Integration is one of the key ways for commodity chemicals to counter cyclicity and poor
profitability. It ensures the availability of key raw materials as well though it may create challenges if raw
materials in the open market become cheaper than in-house production. Specialty chemical players have
small plants where they make many specialty chemicals on the same production lines. Large integrated
plants are not important for them.
Low cost of production is essential for chemical players. Many bulk chemicals are low-value adding and
cannot afford transportation over long distances. High raw material costs may make them economically
unviable; therefore, the location of chemical plants is very important. It is very difficult to overcome
locational disadvantages.
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Low profitability and global competition make the business model of bulk chemical producers highly
vulnerable. In economic downturns, many players go out of business. As a result, foreign companies try to
kill local production by dumping commodity chemicals at very low prices. Govt. acknowledges such
practices and protects domestic producers by tariffs and duties. In fact, regulatory protection is a very
significant aspect of the competitive strength of commodity chemical players. An investor should always
be aware of the benefits of any protective duty used by the bulk chemical players. Otherwise, she may face
negative surprises when protection like anti-dumping duty expires.
Rising environmental awareness has increased the cost burden on chemical players. Stringent
implementation of pollution control norms has closed down many chemical manufacturing plants.
Complying with updated environmental regulations involves a lot of investment and an investor should
always keep it in her mind when she estimates the future investment needs of any chemical company.
Overall, while analysing any chemical company, an investor should keep in her mind the following
characteristics of a chemical business.
 Pricing power: Commodity chemical players are price takers; specialty chemical players are
price-setters.
 Capital-intensive: Commodity chemical players need to invest a lot of money in large-integrated
plants and thereafter on maintaining/upgrading them.
 R&D: Specialty chemical players need to invest a large amount in research to survive. It is
almost a fixed expense for them.
 Cyclicity: Commodity chemical players face very high cyclicity when compared to specialty
chemical players.
 Regulatory protection/tariffs: Always be aware of any tariff protection enjoyed by the chemical
players. Unawareness of the same may be detrimental for the investor as her investee company
may lose all of its competitive advantages overnight.
 Environment protection costs: Be aware and ready to see companies spending a large amount of
money on pollution control measures. This is essential if they want to continue in the business.
Also please keep in mind that over time, specialty chemicals become commodity chemicals.
We believe that if an investor focuses on these points while analysing any chemical company, then she may
be able to assess the true business picture of the company.
Regards,
Dr Vijay Malik
P.S.

Videos
Analysis Excel
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5) How to do Business Analysis of Agrochemical (Pesticide) Companies
After reading this chapter, an investor would understand the factors that impact the business of pesticide
companies and the characteristics that differentiate a fundamentally strong pesticide company from a weak
one.
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Similarities with Pharmaceutical Industry

Agrochemicals/pesticides industry is very similar to the pharmaceutical industry in its structure. Just like
human drugs, pesticides are drugs for crops. Let us understand the similarities between the two industries,
which would help any investor attempting to analyse any pesticide company for the first time.
1) Classification into technical and formulations segments:

The agrochemicals industry is divided into technical products and formulation products. Technical products
are bulk drugs like active pharmaceutical ingredients (API) in the pharmaceutical industry. These are
concentrated chemicals, which form the base of pesticides; however, are not yet suited for direct application
to the crops.
Formulation products in the pesticide industry are similar to pharmaceutical formulations (ready-to-
consume drugs), which are made by adding various solvents etc. called formulants to the technical
pesticides to make them ready for application on crops.
Rating Methodology – Pesticide Companies by CARE, November 2020, page 1:
Pesticides can be manufactured and sold mainly in two forms- Technical and
Formulations. Technical is the first stage of manufacture where the chemical is concentrated and
unsuitable for direct use. This is then processed with other materials known as formulants to
develop the finished pesticide, known as formulation.
Moreover, as in the case of the Indian pharmaceutical industry, where most Indian players focus on
formulations by importing the APIs from China; similarly, in the agrochemical industry also, most Indian
manufacturers are formulators who import technical products from China.
In fact, China produces more than 90% of the world’s technical production and has a very large
overcapacity.
India is one of the major producers for pesticide formulations, however, it still imports
technicals to a large extent which serve as the base chemical for the end-product, viz,
formulations. China is the world’s largest producer of agrochemical raw materials, supplying
90% of the world’s technical raw material requirements
2) Huge investment of money and time in developing new pesticides; patents and
generics:
Just like pharmaceuticals, pesticides also affect human health because from the crops they enter the food
chain and human body; therefore, companies need to conduct many studies/trials to ascertain their safety
before the products are approved for commercial use.
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As a result, it takes a long period from the identification of any new pesticide to its commercial use on the
farms, which is usually about 10 years.
All these studies take a significant investment of money and other resources. Therefore, countries grant
patents to companies investing in research & development (R&D) of pesticides, which gives them a period
of exclusivity for selling that particular pesticide to recover their investment in R&D and earn a profit.
After the patent protection of any successful pesticide is over, then just like in the pharmaceutical industry,
many other companies start producing that pesticide, which is called a generic version. However, even the
generic companies need to establish the safety of their product by conducting safety trials, which also takes
significant time. As a result, it may take generics companies about 5 years to register their product.
Rating methodology – agrochemicals by ICRA, June 2022, page 5:
Being a regulated industry, it takes almost 10 years for an entity to bring a new molecule into the
market and almost five years to get a generic product registered.
Moreover, patented pesticides sell at a higher price and at good profit margins due to limited competition
during the exclusivity period. The prices decline sharply when numerous generic companies enter the
market. As a result, generic pesticides have lower profit margins. An investor may notice the same dynamics
in the pharmaceutical industry.
3) Requirement of registration with authorities:

Just like the pharmaceutical industry, every pesticide needs to be registered with govt. authorities before it
can be sold in any country. Registrations are country-specific and a company needs to register its product
in every target country.
Just like the pharmaceutical industry, the registrations take time and money. In the pesticide industry, the
registration process of a product in developed markets like the USA/EU may take about 3-5 years and a
cost of about USD 10-15 mn whereas a registration in India may take about 1-3 years and a relatively lower
cost. The requirement of registrations and the time & cost involved in the same may act as an entry barrier
for new players.
Rating Methodology – Pesticide Companies by CARE, June 2017, pages 3-4:
Registering agrochemical generics in US / EU is a time-consuming process since it requires

various types of studies to be carried out. One product registration takes about 3-5 years and costs
about USD 10-15 mn. Registration process in India takes roughly 12-36 months. The investments
both in terms of time and money act as effective entry barriers
Such registration requirements act as an entry barrier for newer players because in certain developed
countries getting registration is very difficult with a very high rejection rate.
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An agrochemical company, Sharda Cropchem Ltd faced a lot of difficulties in getting registration in
Germany where the rejection rates are very high.
Conference call by Sharda Cropchem Ltd, July 2017, page 10:
Ramprakash Bubna: in Germany the things are very difficult. Our rate of success of registrations
in Germany is very, very low.
In addition to the low success rate, the registration processes are also very costly because apparently
nowadays, the govt. authorities have started to look at them as a profit-generating activity.
Conference call by Sharda Cropchem Ltd, October 2020, page 11:
Ramprakash Bubna: The cost of registrations is exponentially high. The government authorities,
the sourcing authorities, who used to charge nominal fees, they now started at looking some more
kind of profits in these regions because they feel the operators and players in the market are getting
profits then why not the government
Obtaining registrations, especially in developed countries has become a challenging activity. As a result,
the ability to obtain registrations is considered a key competitive advantage.
CARE views the ability of a company to obtain registrations in different countries as per their
regulatory requirements and higher number of patents, product registrations and acquisitions in
the global market as major strengths for sustainable growth.
An investor would appreciate that pharmaceutical companies face the same challenges when attempting to
get registrations in different countries.
4) Demand is primarily influenced by local/domestic factors:

In the pharmaceutical industry, the demand for drugs in India or in any country is primarily driven by the
local factors/diseases prevalent in that area and may not be influenced by global factors. Similarly, in the
case of agrochemicals as well, the demand is influenced by local factors and not global dynamics.
The prospects for domestic pesticide sector depends on multitude of factors like monsoons, crop
yield, incidence of pest attack, etc. and is relatively detached from the global dynamics.
Looking at all these similarities between the two industries, if an investor has not analysed the pesticide
industry before; however, she has analysed the pharmaceutical industry, then she can apply her learning of
the pharmaceutical industry here.
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Let us now understand the key characteristics of the business of agrochemical (pesticide) companies and
understand the major factors impacting them, so that we may understand, which pesticide companies have
a stronger business model than others.
Key factors influencing the business performance of agrochemical (pesticide)

companies
1) Seasonality, uncertainty and wide fluctuations in local demand:

Consumption of specific pesticides depends on the sowing of specific crops, which is seasonal in nature.
Therefore, the demand for these pesticides peaks up during a couple of months of a particular crop season
and declines sharply after the crop season.
Even within the season, the demand for pesticides fluctuates widely depending upon factors like rainfall
(monsoon), pest attacks, pest resistance etc. Therefore, a company may be ready with full inventory;
however, there might be a rain deficit leading to lower acreage of crops and less demand for pesticides.
Demand may also get affected if a particular pest attack may not happen in any year or the pest becomes
resistant to the existing pesticide.
Therefore, it is very difficult for agrochemical companies to decide the exact demand for their products in
any year. However, they need to keep sufficient stock of pesticides so that they do not run out of the product
when the demand comes.
Due to the seasonal nature of the business and the uncertainties related to timing and coverage of
monsoon, level of pest infestation, etc., the level of inventories needed by the companies to stock
is large.
In addition, due to the seasonal nature of demand, if any quantity of pesticide is not sold in the current
season, then it is left unsold as inventory until the onset of the next season, which might be many months
away.
Conference call by Sharda Cropchem Ltd, May 2017, pages 16-17:
Ramprakash V. Bubna: …it does take time to get rid of the inventories in agrochemical business
these are seasonal businesses for some reason because of the weather or any other impact there
has been a less demand, the companies are compelled to carry their inventory forward and then
the next time is possibly after six or eight months.
Therefore, the seasonality and uncertainty in the demand for pesticides lead
companies to keep an excess buffer of stock to meet the fluctuating demand and be ready to
carry it over to the next season. This significantly increases the inventory requirem ents of
agrochemical companies and makes their operations working capital-intensive.
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2) Fragmented industry with intense competition and low pricing power:

In India, most of the pesticide players are formulators who import technical pesticides from China and then
produce formulations in India. This business model does not require a large investment in manufacturing
plants etc. because producing formulations is low capital intensive whereas producing technical products
is highly capital intensive.
formulations business is not capital and technically intensive…Technical and capital intensity is
higher in case of production of technicals, which are generally higher value-added products.
Due to low capital requirements and easy availability of technical pesticides from China, the Indian
pesticide industry has a presence of numerous formulation players making the industry highly fragmented.
domestic agrochemicals industry is highly fragmented with more than 60 technical grade
pesticides being manufactured indigenously by about 125 manufacturers, including almost 60
large and medium scale enterprises (including 10 MNCs), about 800 formulators and more than
145,000 distributors spread all over the country.
Moreover, the majority of these players produce generic pesticides, which are commodities i.e. the product
of one company is non-differentiable from the product of another company.
Most Indian companies manufacture and market generic and off-patent pesticides, which comprise
~80% of the technicals being produced by the domestic industry.
As a result, the Indian agrochemical industry has intense price-based competition, where many players
undercut the prices of their competitors.
industry is characterized by overcapacity and low offtake leading to intense price

competition among players.
Such intense price-based competition reduces the profit margin of the entire generics agrochemical
industry.
Generics are commodity products and hence, competition is intense with a large number of players
present in the segment. Margins remain low in generics manufacturing
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Only the innovator agrochemical companies whose products are protected by the exclusivity granted by
patents are able to protect their profit margins.
3) Price-sensitive consumer without any brand loyalty:

The key consumer of the pesticide industry in India, the farmer community is not very rich and has to
manage with limited resources. As a result, they are very price conscious in their pesticide purchase
decisions and are unwilling to pay a high price for any specific brand.
As a result, even though marketing spending by pesticide companies creates awareness about their products
and may give them a slight premium in their pricing; however, they cannot price their branded pesticides
at a significant premium because then the demand would shift to low-priced competitors’ products, which
are already available in the market.
the market for pesticides is low brand conscious and highly price sensitive. Due to dominance of
generic products, there are several ‘me too’ and spurious products available in the market.
4) Fluctuating raw material prices impacting profitability:

Most of the raw materials used as inputs for the production of technical products and subsequently
formulations are derivatives of crude oil. As a result, the raw material costs of agrochemical companies
witness a lot of fluctuation as the crude oil prices are very volatile.
However, generic agrochemical companies find it difficult to pass on the increase in costs to their customers
because of low bargaining power. These companies sell generic-commoditized pesticides, where any
increase in product prices would shift the customer to buy competitors’ products.
Commodity price risks: Prices of most chemicals are exposed to input price cyclicality, which
renders the profitability of the end-product vulnerable to these fluctuations. Given that many of
the technical are produced from derivatives of crude oil, prices of the raw materials have witnessed
fluctuation over the years as crude oil prices have remained volatile.
Companies, which have a high R&D strength and enjoy protection either due to patented drugs or exclusive
marketing arrangements with innovator MNCs, are better at protecting their profit margins in the face of
volatile raw material costs.
few Indian entities also manufacture specialty products in-licensed from larger MNCs wherein the
entities sign exclusive manufacturing and marketing arrangements with the MNCs in-lieu
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for royalty paid to the MNC. As a result, these entities face lesser competitive intensity and hence,
profitability is protected to that extent
5) R&D: Companies must renew their product portfolio regularly:

Pesticide companies face a significant challenge of product obsolescence. There are multiple reasons for
obsolescence.
First, over time, the pests develop resistance to existing pesticides that stop working. As a result, newer
pesticides need to be developed, which requires a significant investment of money and time in R&D.
Also, due to growing pest resistance and newer pest attacks/diseases, it is essential for the
companies to introduce new products/molecules at regular intervals and provide newer solutions
to crop problems
Second, R&D by innovator companies keeps bringing out newer pesticides, which are safer for plants and
humans. Therefore, governments ban the older version of more harmful pesticides. As a result, companies,
which are significantly dependent on old pesticides for their business face a big challenge.
Due to these reasons, agrochemical companies must invest resources to continuously maintain a pipeline
of newer pesticides so that they may stay relevant in the fast-changing business environment.
An investor would appreciate that developing a pipeline of newer pesticides would require a large
investment in R&D. Therefore, the companies who spend significant money on R&D to develop new
drugs/generics are in a competitively better position than others.
Entities with strong R&D capabilities and high budgetary allocation for R&D work will be better
placed in terms of tapping the opportunity arising from patent expirations.
Unfortunately, most Indian agrochemical companies have a small R&D budget and spend only 1%-2% of
their revenue on R&D in comparison to multinational companies (MNCs), which spend about 11%-12% of
revenue on R&D.
Currently R&D expense as a percentage of turnover in India is about 1% compared to 11-12%

globally.
One method by which Indian companies mitigate the risk of product obsolescence is by entering into an
exclusive marketing arrangement with innovator MNC agrochemical companies so that they continue to
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get access to the latest pesticides to sell in the Indian market and maintain a healthy business with good
profitability.
Therefore, an investor should analyse the R&D spending by the company along with its tie-ups with
innovator MNCs to assess whether the company would be able to counter product portfolio obsolescence.
6) Working capital intensive business:

Agrochemicals (pesticide) business is working capital intensive because it requires maintaining high
inventory as well as a large amount of trade receivables.
As discussed earlier, the demand for pesticides is seasonal as well as highly uncertain. Therefore, companies
need to keep a large stock of pesticides to meet demand in case the rains and crop sowing are good while
running the risk of large unsold inventories if there is a rain deficit, fewer pest attacks or lower crop sowing.
Rating methodology – agrochemicals by ICRA, November 2017, page 7:
Due to seasonal nature of demand, unpredictability of pest attacks and high dependence on
monsoons, agrochemical players have to maintain high level of inventory to meet the seasonal
requirements.
Moreover, the sale of pesticides happens in a specific season; however, the companies need to run their
plants throughout the year, which adds to the inventory and the working capital levels of agrochemical
companies.
Working capital intensity of the agrochemical players (especially formulations) tends to

remain moderately high owing to the long operating cycle as production and placement of
products happens throughout the year while the sales of the product happen majorly during the
cropping season.
In addition, agrochemical companies need to sell pesticides with a large credit period to customers. This is
because farmers buy pesticides at the last stage of the crop sowing cycle after they have already spent their
money on preparing fields, seeds etc. By this time, the farmers are already low on resources. Therefore,
usually, they buy pesticides on credit with a promise to pay for them after the crop is harvested.
Rating methodology – agrochemicals by ICRA, November 2017, page 7:
Agro-chemical entities normally have high debtor days owing to i) long credit period extended to
the customers ii) sales made at the onset of the crop season with realisation from the same mostly
coming post-harvest.
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Agrochemical companies also need to offer a higher credit period to customers because they mostly sell
commoditised generic products, which are non-differentiable from each other. As a result, offering a longer
credit period offers an incentive to the customer to buy their product instead of competitors’ products.
However, the long credit period hurts the agrochemical companies because in the case of bad harvest, poor
monsoon etc. the farmer is unable to pay the money.
Furthermore, the industry needs to offer long credit periods to farmers due to intense competition
and low offtake. Also, farmers tend to have little surplus money left for purchasing pesticides,
as applying pesticides is the last leg in the agriculture operation. This leads to higher bad debts
in events of crop failure or poor monsoon.
7) Large and diversified companies have an advantage; big gets bigger:

The demand for pesticides is crop-specific, seasonal, and prone to obsolescence. Therefore, any
agrochemical company, which is significantly dependent on any one product or geography is at a high risk
of business disruption.
As a result, agrochemical companies, which sell many products in different geographies are at a
comparative advantage because any deficit in rainfall, pest attacks, pest resistance etc. would not harm their
business significantly.
Pesticide companies having large market share, wide distribution setup and geographic spread in
the domestic markets are at an advantageous position to withstand the uncertainties due to
monsoons and regional seasonality.
Moreover, in case, the govt. decides to ban any pesticide, then a diversified agrochemical player with a
large product portfolio would not be impacted significantly. In contrast, concentrated agrochemical players
relying on a single product may go out of business due to such a ban.
This risk is especially high for companies who have most of their products under the red label (extremely
toxic) and yellow label (highly toxic) instead of products under the blue label (moderately toxic) and green
label (slightly toxic).
entities which are highly dependent on red and yellow triangle pesticides run the risk of losing
their source of revenue from products falling under banned category.
In addition, diversified companies, which are usually large in size also have advantages because they have
higher bargaining power over their suppliers as well as customers and distributors.
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Large-scale typically leads to greater bargaining power with suppliers and dealers, besides
enabling superior competitive position on the back of cost and manufacturing process efficiencies.
Large agrochemical companies also benefit from economies of scale i.e. operating leverage resulting in
cost competitiveness. These companies are better able to compete against other domestic as well as foreign
players. One reason Chinese technical producers dominate the world of agrochemical technical is their large
size resulting in cost-competitiveness due to economies of scale
economies of scale play a big role in reducing cost of production and hence, domestically produced
technicals have faced tough competition from imported technicals as manufacturers in countries
like China operate on a very large scale giving them an advantage over domestic producers.
Large agrochemical players are able to enjoy the strength of a well-established distribution network, which
acts as a competitive advantage as such companies are able to push their products close to as many
customers as possible and are able to educate them for their use.
While the formulations business is not capital and technically intensive, the profitability of the
entities depends on their ability to develop a strong brand and distribution network, which
may entail significant time and cost and act as key competitive strengths.
Moreover, if they are integrated players i.e. produce technical products as well as formulations, then they
are able to capture a higher share of the value chain and earn a high-profit margin in addition to better
control of the supply and quality of raw material.
Integrated entities may have better protection against such risks due to better control on supply of
technical and better profitability margins.
Geographical diversification by agrochemical companies in exports helps them as they can sell their excess
production capacity due to the seasonality of domestic demand in foreign countries. In addition, the exports
provide a better price and lower credit period as well as tax incentives from the Indian govt.
Increased export focus of the Indian pesticide industry is a consequence of seasonal demand, better
price realization in the export markets, global outsourcing opportunity, low credit periods in
export markets, domestic overcapacity and tax sops.
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Until now, Indian companies have been able to perform well in the export market due to their lower cost of
production as a result of the easy availability of a skilled workforce.
India has the advantages of being a low-cost manufacturing hub with technical competence and
manpower availability for producing quality agrochemical products, which has led to a
substantial increase in exports over the past few years, primarily to the US, Europe and Africa.
8) Risk from organic farming, genetically modified seeds as well as fake-spurious

products:
Organic farming promotes growing food without the use of agrochemicals like pesticides, fertilizers etc.
However, in the absence of these additive factors, the production yield of organic crops is low, which results
in a high market price for organic products.
If going ahead, improvement in technology and processes leads to an improvement in the production yields
of organic farming, then a resultant decline in the price of organic products may lead to a large section of
the population shifting to consuming organic foods. It may lead to a decline in the demand for
agrochemicals like pesticides.
innovations in the organic farming techniques, which could lead to increase in yields and lowering
of the pricing premium for organically grown products, in the long term could weigh on
agrochemicals demand.
Currently, a lot of agricultural research is focused on making crops resistant to pests by modifying their
genetic composition. These crops called genetically modified (GM) crops have proved to be a success in
the case of cotton, soybean and corn. In 2013, most of the crops sowed in the USA for corn, cotton and
soybean were genetically modified.
FY2015 annual report of Sharda Cropchem Ltd, page 11:
As of 2013, GM seed weightings in the US have reached 90% for corn, 90% for cotton, and 93%
for soybeans.
As GM crops are resistant to pesticides, therefore, increased usage of GM crops leads to lower utilization
of agrochemicals like pesticides. In fact, after the introduction of GM crops, the agrochemicals industry
witnessed a long-term decline, which was evident from 1998 to 2006.
Red-herring prospectus of Sharda Cropchem Ltd, September 2014, page 46:
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Following the initial introduction of GM crops in 1996, the market experienced a period of decline
in real terms between 1998 and 2006. This reflected the increase in uptake of GM technology,
particularly in North America and Latin America where a rapid switch to crop varieties containing
traits conferring glyphosate tolerance and insect resistance led to declines in selective herbicide
and insecticide applications
Even in the Indian context, it is expected that increased usage of GM crops would lead to a decline in the
usage of agrochemicals.
Growing acceptance for the BT cotton which would adversely impact the pesticide demand and
widespread use of GM seeds in other crops like soyabean, maize, canola, etc., makes it imperative
for the companies to focus on other crops besides cotton, for future growth.
Apart from GM crops and the increasing trend of organic foods, agrochemical companies are severely
impacted by fake/spurious pesticides present in the market, which as per some estimates constitute about a
third of all pesticide sales.
The industry is also plagued with spurious pesticide products which account for over one-third of
the domestic market size
Therefore, an investor should be cautious about the possible impact of GM seeds, organic food and
fake/spurious products on the business of agrochemical companies.
Summary
Overall, the agrochemical (pesticide) industry seems an essential segment of the economy like the
pharmaceutical industry, which is essential to prevent damage to food crops due to pests. Developing newer
pesticides is a very resource-intensive exercise due to multiple safety trials because pesticides enter the
food chain and affect human health. This also makes it a heavily regulated industry.
Companies with higher R&D spending are at an advantage because they are able to get an exclusive period
to see their products at a profitable price to recover their R&D expenses. However, once the patent period
ends, then many generics players enter the market and bring down the prices as well as profitability.
Most of the agrochemical companies in India are generic formulation players that produce commoditised
products, which is not a capital-intensive process. As a result, the industry is highly fragmented and
intensely competitive where many players compete on the price to gain customers. Moreover, the customers
are also highly price conscious with low brand loyalty. All this leaves a very low pricing power in the hands
of generic agrochemical players.
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Demand for pesticides is seasonal and uncertain due to weather changes and pest resistance. As a result,
companies need to keep a large inventory to meet the seasonal increase in demand. In addition, companies
need to update their product portfolio to meet regulatory and market demands for newer and safer pesticides.
Agrochemical operations are working capital intensive due to large inventory and trade receivables
requirements. Farmers use pesticides at the end of crop sowing operations when they have consumed almost
all their resources. Therefore, they need a credit period to pay after the harvest is over. If the crop is bad,
then they are not able to pay leading to bad debt for companies.
As a result, large agrochemical companies with a significant R&D budget and a diversified product
portfolio and extensive distribution are at a competitive advantage. These companies can develop new
products, enter into an exclusive alliance with innovator MNCs, sell in different geographies, educate
customers about their products as well as generate resources for working capital needs. Effectively, in the
agrochemical industry, big players have a ready stage to become bigger.
The agrochemical industry is facing threats from the growing use of GM seeds, preference for organic food
as well as the growing presence of fake/spurious products in the market, which may affect the business of
agrochemical companies going ahead.
Therefore, an investor should keep in mind these multiple aspects for agrochemical pesticide companies to
understand the true picture of their business position.
 Seasonality, uncertainty and wide fluctuations in local demand

 Huge investment of money and time in R&D for developing new pesticides, patents and generics
 Requirement of registration with authorities
 A fragmented industry with intense competition and low pricing power
 Price-sensitive consumers without any brand loyalty
 Fluctuating raw material prices impacting profitability
 Working capital-intensive business
 Large and diversified companies have an advantage; big gets bigger
 The risk from organic farming, genetically modified seeds as well as fake-spurious products
We believe that if an investor analyses any agrochemical pesticide company by considering the above
parameters, then she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.
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6) How to do Business Analysis of Fertilizer Companies
After reading this chapter, an investor would understand the factors that impact the business of fertilizer
companies and the characteristics that differentiate a fundamentally strong fertilizer company from a weak
one.
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Types of fertilizers
Fertilizers are classified based on the key nutrient that they contain: Nitrogenous (N), Phosphoric (P) and
Potassic (K).
There are simple fertilizers, which primarily contain one nutrient like Urea (nitrogenous), Single Super
Phosphate (SSP, phosphoric) and Muriate of Potash (MoP, potassic). In addition, there are complex
fertilizers, which contain more than one nutrient like diammonium phosphate (DAP) and nitrogen,
phosphorous and potassium (NPK).
From the perspective of understanding the industry, an investor may simply classify them into two groups.
First is Nitrogenous fertilizers of which Urea is the most prominent and the second is Phosphoric & Potassic
(P&K) fertilizers because these two groups of fertilizers have slightly different dynamics within the
fertilizer industry.
Urea is the most used fertilizer constituting about 55% of total fertilizer consumption.
Ratings criteria for the fertiliser industry by CRISIL, February 2018, page 3:
urea accounts for more than half (~55%) of the fertiliser consumption in India
Let us now understand the business environment under which the fertilizer companies operate.
Increasing regulations and tightening subsidy support

The first aspect of the fertilizer industry that an investor should know about is regulations and subsidies. In
fact, it seems that there is no existence of fertilizer industry without govt. support and control. Govt.
influences every aspect of the industry including demand, supply, distribution, pricing, and supply of raw
materials.
The primary reason for such high govt. control is that fertilizers are sold to farmers at a significant discount
to their actual market price. Urea is sold at a discount of about 70%-80% and Phosphoric & Potassic (P&K)
fertilizers are sold at a discount of about 30%. This discount is reimbursed by the govt. to fertilizer
companies in the form of subsidies.
Rating methodology – fertilisers by ICRA, March 2022, page 3:
 Urea: Subsidy as % of total realization = ~70-80%

 P&K: Subsidy as % of total realization = ~30%
The huge amount of subsidy provided by the govt. for providing fertilizers at a cheaper price to farmers
distorts the whole fertilizer market.
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Govt. provides such a high amount of subsidy on fertilizer with two primary objectives. The first is to
ensure food supply to the population at a cheaper price and the second is to increase the income in the hands
of the farmers who are also a large politically important segment.
Every kilogram of fertilizer, which is produced puts a monetary burden on the govt. finances; therefore,
govt. influences every aspect of the industry including supply of raw material, sale, distribution, operating
efficiency etc.
India has been a large consumer of fertilizers where almost always demand has exceeded supply. In
addition, increased consumption of fertilizers has also increased the subsidy burden on the govt. Therefore,
govt. has implemented different regulations for the fertilizer industry at different times based on its vision
and objectives in this field like increasing production and reducing subsidy burden.
In 1977, Retention Price Scheme (RPS) was introduced for the fertilizer industry, which was aimed at
increasing fertilizer production within the country. Therefore, govt. promoted investments in the industry
with an assured return to the entire fertilizer industry.
Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 13:
Introduced in 1977, the RPS, with the objective of achieving self-sufficiency and providing
adequate returns to fertiliser companies, has been primarily responsible for the growth in domestic
fertiliser capacity and production.
As fertilizers were sold at a discount/subsidised price to farmers; therefore, as the production of fertilizers
increased, the subsidy burden on the govt. also increased. As a result, govt. gradually removed fertilizers
from the RPS scheme. P&K fertilizers were taken out of RPS in 1992 and Urea was taken out in 2003.
The commissioning of large capacities, persuaded by the promise of assured returns under RPS,
and a marginal rise in farm-gate prices compared with production costs, however, resulted in
a ballooning subsidy burden.
Phosphatic and potassic fertiliser makers were governed by the Retention Price Scheme (RPS)
till 1992, and urea players till March 2003.
Later on govt. kept bringing different regulations with the twin objective of increasing fertilizer production
in the country and controlling its subsidy burden.
a) P&K fertilizers:
For P&K fertilizers, the govt. almost freed the retail prices and introduced nutrient-based subsidy (NBS),
which provided these fertilizer companies with a fixed amount of subsidy while leaving retail prices to
fluctuate in line with import parity prices.
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While retail prices of urea continue to be regulated, prices of non-urea fertilisers were deregulated
in April 2010.
Currently, non-urea fertilisers are governed by the nutrient based subsidy (NBS) scheme,
introduced in 2010, wherein the subsidy component is fixed and domestic prices are allowed to
vary in line with international prices.
Therefore, with NBS, the govt. could put a limit on the subsidy that it would provide on the sale of P&K
fertilizers. However, it could not free the retail price of Urea because it is the most used fertilizer and has a
very high component of subsidy in its realization. Therefore, unlike P&K, where the subsidy amount is
fixed and the retail price is variable, for Urea, the strategy has been to fix the retail price and let the subsidy
amount be variable.
Essentially, extant regulations fix the retail price of urea and subsidy is dependent on cost of
production (which in turn would have commodity linkages).
b) Urea:
In the urea segment, the policy guarantees a minimum return on investment by fertilizer companies.
Therefore, the aim of the govt. has been to force the companies to reduce their operating/production costs
so that the govt. has to pay them a lower subsidy amount for the guaranteed return (a return on equity of
12%).
Rating methodology – fertilizer companies by CARE, May 2020, page 1:
Urea is a controlled fertilizer and is sold at a statutorily notified uniform sale price. This price
is lower than the cost of production and the difference is reimbursed as subsidy to
manufacturers by the government, enabling the manufacturers to earn a reasonable return.
Rating methodology – fertilisers by ICRA, December 2016, page 3:
This is to ensure, in principle, that a normative return (post tax 12% Return on Equity or RoE) on
fixed costs is earned by the urea players.
In addition, to reduce the imports and promote domestic production of urea, the govt. incentivizes domestic
urea companies to produce even more than their reassessed capacity (RAC) by assuring to buy it at a
predetermined pricing framework till the time such purchase price for the govt. does not exceed the import
parity price.
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As per the NUP-2015, units producing more than its re-assessed capacity will be entitled to get
their respective variable cost and ~Rs. 2,300/MT…subject to a cap of the import parity price plus
a weighted average of other incidental charges (transportation and handling charges, etc.), which
the GoI incurs on imported urea on its own account (~$25/MT).
Therefore, after urea was taken out of RPS in 2003, govt. implemented multiple stages of the new price
scheme (NPS) and in 2015, it implemented New Urea Policy-2015 (NUP). This scheme has aimed to reduce
the subsidy per unit of urea sold.
The key strategy behind these regulations has been to force/incentivize the fertilizer companies to be more
efficient and then take benefit of resultant savings to reduce the subsidy amount on Urea production.
Urea pricing is governed under the new pricing scheme (NPS) from April 1, 2003…Pre-set energy
consumption norms were specified…and capital costs were also reassessed. These resulted in
a decline in industry profitability during the period.
In May 2015, the government announced the New Urea Policy-2015 (NUP-2015)…with the
objective of maximising indigenous urea production, promoting energy efficiency in urea
production by changing the prescribed energy norms and rationalising subsidy burden on the
government by mopping up energy savings by the industry.
Fertilizer production is an energy and capital-intensive process; therefore, govt. primarily focuses on the
energy efficiency of urea companies to reduce its subsidy costs.
Fertilizer production is an energy and capital intensive process
Previously, different urea manufacturing units used different raw materials to make urea like naphtha, coal,
natural gas etc. To improve the production process, govt. mandated the use of natural gas for urea units.
Government policies in the recent past have encouraged the use of gas as feedstock for the
manufacture of urea.
As India started producing natural gas domestically, it was priced cheaper than imported gas. As a result,
companies that could get a large supply of domestic gas were in a beneficial position due to the lower cost
of production than those companies using imported regasified liquid natural gas (RLNG).
To provide a levelling field to all the urea producers, the govt. introduced a gas pooling mechanism and
made the energy costs uniform across all urea producers irrespective of the fact whether they used cheaper
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domestic gas or costlier imported regasified liquid natural gas (RLNG). As a result, now, all the urea
producers who are linked to the national gas grid get uniform gas pricing.
Rating methodology – fertilisers by ICRA, March 2022, pages 6-7:
The GoI implemented gas pooling, for all the fertiliser units connected to the natural gas pipeline
network, in July 2015 resulting in levelized gas cost for the entire fertiliser sector. For players
which were earlier operating using domestic gas only witnessed an increase in their cost of
production while players using R-LNG witnessed a decline in their cost of production
In addition, the govt. classified urea producers into groups based on their energy efficiency. As almost all
the producers use the same production processes; therefore, the energy efficiency primarily depends upon
the vintage/age of the plant. Older plants using old processes are less efficient than newer plants using new
processes.
Energy consumption is a function of the vintage of the unit, process technology adopted, and
maintenance practices followed. With very few process technology suppliers to choose from, the
process technology differentiation has mainly been determined by the plant vintage.
The Govt. has classified Urea producers into three groups based on energy efficiency (primarily vintage-
based) and has set fixed energy norms for each group.
all the urea units are classified under three categories with normative norm of 5.5 Gcal/MT, 6.0
Gcal/MT and 6.5 Gcal/MT
Govt. provides a fixed reimbursement to companies in each of these groups. Therefore, those companies,
which are more energy efficient within their group earn higher profitability and those that are energy
inefficient, earn lower profitability.
The companies whose energy efficiency is inferior to the pre-set energy norms of its respective
group under NUP 2015 would have lower profitability on account of lower subsidy entitlement.
As the govt. has specified fixed payments based on energy consumption benchmarks, all the companies try
to be more energy efficient to increase their profitability. However, as the energy efficiency of many
companies in the group increases, the govt. further tightens the energy consumption benchmarks and
reduces the subsidy outgo.
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GoI has been progressively tightening the normative energy norms for the urea industry over the
years. The tightening of the energy norms results in lower subsidy outgo for the GoI and
improvement in the energy efficiency of the urea industry.
Moreover, the govt. has been cutting down the subsidy burden even in the cases where companies have
been producing urea more than their reassessed capacity (RAC).
Originally, the companies producing more than RAC received their variable cost + ₹2,300 per MT and
incidental charges. However, in recent times, it has been reduced to variable cost + ₹1,635 per MT and
incidental charges.
As per the NUP-2015, units producing more than their re-assessed capacity are entitled to get
their respective variable cost and ~Rs. 1635/MT…subject to a cap on the import parity price plus
a weighted average of other incidental charges
As the retail price of urea is much less than the cost of production; therefore, there were instances of urea
meant for farmers finding its way into factories as a raw material for producing other goods. This pilferage
meant that the subsidy did not reach the intended beneficiary. As a result, the govt. started neem coating of
urea, which made it unsuitable for industrial use.
The proportion of urea in overall fertiliser consumption is expected to come down on account of
government policies such as neem coating of urea (which improves absorption in to soil and
prevents its diversion to other chemical industries by making it unfit for non-fertilising use),
Therefore, from the above discussion, an investor would notice that in both the segments, urea as well as
P&K fertilizers, the govt regulations are high due to significant subsidy contribution and in both the
segments, the govt. aims to cut its subsidy burden, which reduces the profitability of fertilizer companies.
In P&K, under a nutrient-based subsidy scheme, the govt. has already fixed its subsidy burden whereas
letting the companies change the retail price in line with changing costs of production whereas in the urea
segment, the govt. still decides the retail price and reimburses money to urea producers to ensure that they
earn a reasonable return on their investment. However, over time, the govt. is forcing urea manufacturers
to be more efficient and is using these efficiencies to reduce its subsidy burden.
With this background in the fertilizer industry, let us understand the key business dynamics under which
fertilizer companies operate.
Other factors influencing the business performance of fertilizer companies
1) Very low pricing power:

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As the price of fertilizers directly affects the farmers and their income; therefore, govt. has hardly given
fertilizer producers any power to earn large profits.
In the case of urea, the govt. directly controls the retail price (farm-gate price) and gives the companies
subsidy that determines their return on investment. Therefore, as discussed earlier, the only way for urea
companies to increase their profitability is to be more efficient in their production. Moreover, as the urea
industry becomes more efficient, the govt. reduces the subsidy payments, which in turn puts a check on the
profitability of urea manufacturers.
In fact, for urea manufacturing units the govt. has determined a range of returns on equity that companies
can earn. If there are profits higher than this range, then govt. updates the policy and takes the benefits
away.
GoI introduced the New Urea Investment Policy-2012 (NIP-2012) which assured a floor and
ceiling of post-tax RoE of 12% and 20% respectively through the policy measures.
In the case of phosphoric and potassic (P&K) fertilizers, even though the prices were freed/deregulated in
2010; still, govt. interferes in the retail prices by controlling the selling price of fertilizers by public sector
fertilizer producers. This, in turn, forces the private players to match the price offered by public sector
companies.
Rating methodology – fertilisers by ICRA, October 2019, page 7:
Government intervention in the pricing decisions for a supposedly deregulated P&K market is a
credit negative for the industry…For example, in July 2016, the Fertiliser Ministry, announced its
decision to reduce the retail prices for P&K fertilisers, cutting prices through the public sector
undertakings (PSUs) and suggested that the private players follow suit. Due to these price cuts,
players suffered inventory losses as the high inventory in the system (with companies, distributors,
dealer and retailer) aligned with the reduced prices.
Even otherwise, despite deregulating the P&K prices, the govt. wants to ensure that P&K fertilizer
producers charges prices within a reasonable range. To ensure it, govt. regularly audits their input costs.
P&K segment was partially decontrolled during 2010, following which the players have been able
to freely price such decontrolled fertilisers as per their cost structure and the demand-supply
dynamics. However, the GoI still monitors the reasonableness of the retail prices by auditing the
input costs.
The control of govt. on the profitability of fertilizer companies is so much that in the past when some
fertilizer companies earned outsized returns due to usage of domestic gas, then govt. stopped their subsidy
payments and is looking for recovery of “undue benefits”.
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In some fertilizer units, the Government of India (GoI)…has issued office memorandum
for recovery of ‘undue benefits’ accrued with use of domestic gas for production of P&K fertilizers
and chemicals. GoI has withheld subsidy in such disputed matters.
Therefore, fertilizer producers are not able to charge customers as per their will. The govt. continues to
influence the pricing of fertilizers either directly or indirectly. Therefore, fertilizer companies have very
low pricing power.
To increase profitability, fertilizer companies sell nonregulated products like seeds and agrochemicals
(pesticides) in their outlets.
Companies can offer unregulated farm inputs like seeds, agrochemicals etc. along with fertilisers
which enables them to realise higher profits.
Players attempt to increase their profitability by providing other value-added products like customized
fertilizers suited to local soil health.
Companies offering customized fertilizers based on the type of soil and crop are expected to
gain competitive advantage with increased focus on soil health report by the government.
Due to the commoditised nature of fertilizer products, companies attempt to differentiate themselves by
branding and offering other farm-related services, which build some competitive advantage by trying to
generate some brand loyalty.
Additionally, though the fertilizer business may be a commodity business, product differentiation,
branding and provision of farm support services are expected to gain greater importance.
2) High capital intensity:

Operations of fertilizer companies require high capital investment in both, working capital as well as fixed
capital.
The primary reason for high working capital is that receivables from the govt. in the form of subsidy for a
major part of cash inflow for the companies and these subsidy payments are usually delayed.
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The key reason for delays in subsidy payments is overall inadequate subsidy budgets. In addition, the
problem intensifies especially during the second half of the year when the annual subsidy budget is
exhausted.
Delays have been observed in subsidy payment to fertilizer companies on account of inadequate
subsidy budget. The shortfall in subsidy budget usually affects the cash flow position of companies
in second half of the financial year when the subsidy budget gets exhausted and thus companies
have to resort to short-term borrowing to fund extended subsidy receivables.
Recently, the initiation of direct benefit transfer (DBT) by the govt. has added to the problem of delays in
the recovery of subsidy.
Previously, companies became eligible for a subsidy when the fertilizer was produced and dispatched from
the factory. However, now, under DBT, they become eligible for subsidy only after the fertilizer is
purchased by the farmer. Therefore, the period between the dispatch of the fertilizer from the factory and
the purchase by the farmer i.e. the duration spent by the fertilizer in the entire distribution channel is added
to the estimation of subsidy entitlement, which increases the working capital requirements of the
companies.
The government has rolled out direct benefit transfer (DBT) for subsidy payment from February
2018 where in the subsidy would be transferred to the manufacturers after the fertilizer is sold to
the farmer which is expected to increase the working capital intensity of the companies as under
the earlier regime subsidy was largely linked to the point of dispatch, and under DBT, it is linked
to the point of retail sales
The working capital intensity of urea producers is higher because subsidy forms a higher portion (70%-
80%) of total realization than 30% of total realization for P&K fertilizers.
The urea manufacturing plants have higher working capital intensity than other decontrolled
fertilizers since subsidy comprises higher portion of the sales price for urea.
Nevertheless, companies get working capital borrowing from banks against subsidy receivables at low-
interest rates because these are receivables from govt and in effect have a sovereign guarantee.
Currently, the lending institutions have been funding subsidy receivables up to 240 to 360 days due
its sovereign nature
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Still, delays in the recovery of subsidy receivables add to the costs of the company due to increased interest
costs.
In FY2021, govt. cleared all the pending subsidy dues of fertilizer companies. However, it remains to be
seen whether going ahead, companies will get prompt payments of subsidy receivables from govt.
by the end of FY2021 the GoI cleared the subsidy backlog that had built-up over the years
In addition to delays in subsidy payments, the fluctuations in the fertilizer demand due to uncertainty in
monsoon performance also increase the working capital burden on the companies due to higher inventory
requirements.
Rating methodology – fertilizer companies by CARE, May 2020, page 7
This leads to higher fertilizer sales during the normal monsoon period while low sales during
drought or low rainfall period. During the period of low rainfall, the fertilizer companies may be
impacted in terms of increased channel inventory which may also impact its working capital
borrowings and can also lead to increase in discounts and larger credit period to increase sales.
Therefore, most fertilizer companies have a high working capital debt on their books.
In the terms of the requirement for fixed capital also, the intensity of the fertilizer industry is high. Plants
for the production of urea and DAP need a large amount of capital.
urea and DAP plants are characterised by high capital intensity, while the NPK complexes and
SSP plants are relatively less capital intensive.
In addition, due to consistent pressure from the govt. on fertilizer companies to improve their operating
efficiencies, they need to consistently make investments in more energy and cost-efficient equipment
leading to consistent capital requirements.
GoI has been progressively tightening the normative energy norms for the urea industry over the
years. The tightening of the energy norms results in lower subsidy outgo for the GoI and
improvement in the energy efficiency of the urea industry. However, to meet the lower energy
norms, urea units have to incur capital investments
Therefore, fertilizer companies need to invest a large amount of money in the business both in the fixed
capital as well as working capital.
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Going ahead, an investor should keep a watch on the govt. policies about changes in the DBT. If the policy
changes to direct transfer of subsidy to the accounts of a farmer like LPG, indicating that farmers purchase
fertilizers by paying the full price to companies, then the subsidy receivables will decline sharply for
companies releasing the money stuck in working capital.
3) Operating/cost efficiency is the key:

India is a fertilizer deficit country; therefore, almost all the fertilizer companies are assured of the sale of
whatever amount they produce. However, there is intense pressure on the companies to perform as
efficiently as possible.
In the case of urea, as govt provides the key raw material, natural gas to all the companies at a uniform
price via a gas pooling mechanism; therefore, govt. provides a fixed reimbursement of their costs by
grouping the companies into three groups based on energy efficiency.
Within a group, a company is going to get a fixed reimbursement of variable costs irrespective of its actual
operating efficiency. If a company is more cost-efficient, then it will earn a high profit whereas if a company
is poor in cost-efficiency, then it may not earn any profit or become unviable.
The feedstock cost for all the domestic urea players, which have gas pipeline connectivity,
is uniform and is a pass-through to the GoI up to the normative energy norm. Profitability gets
negatively impacted for the urea units having energy consumption higher than the normative
energy norm while positively impacted for urea units with energy consumption below
normative energy norms
In the case of phosphoric & potassic (P&K) fertilizers, the retail prices are deregulated (market-determined)
and the subsidy component is fixed. Therefore, companies, which are cost-efficient earn a higher profit.
NBS regime has changed the structure from fixed MRP and variable subsidy to fixed subsidy and
variable MRP. As a result, control over raw material prices such as phosphoric acid, rock
phosphate, ammonia, sulphur and MOP and energy efficiency in conversion to finished goods is
important to drive profitability.
3.1) Competition from imports:
For urea manufacturers, govt provides assurance of purchasing fertilizers only up to the reassessed capacity
(RAC) of a unit. The govt. would purchase any production beyond RAC only if it costs cheaper than the
imports.
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While the urea production up to the re-assessed capacity (RAC) has an assured offtake under the
urea policy, the profitability on the urea production beyond the RAC is a function of the prevailing
international prices and the cost structure of the urea unit.
Therefore, urea companies have to become more cost-efficient than imports, especially during periods of
commodity price increases when it might become cheaper for the govt. to import urea than procure it from
domestic companies producing above RAC.
Rating methodology – fertilisers by ICRA, March 2022, pages 5-6:
The energy consumption of the urea units also determines the competitiveness of production
beyond the re-assessed capacity against imported urea. Lower the energy consumption, the higher
is the competitiveness against imports
Effectively, the GoI is encouraging the domestic manufacture of urea until the time its subsidy
outflow does not exceed its opportunity cost of importing urea.
As P&K fertilizers are deregulated; therefore, whenever domestic market prices increase beyond imports,
many traders and importers emerge as competitors as they can import P&K fertilizers from abroad and sell
them profitably at the market price in the domestic market because for the subsidy, govt. treats both
imported and domestically produced fertilizers as the same.
The subsidy on imported fertilizers is similar to the subsidy on domestically produced fertilizers.
Thus, the phosphatic fertilizer manufacturers have to efficiently control their cost of production
since the imported fertilizers can be cheaper than the domestically manufactured fertilizers with
easy access to lower-cost raw materials and higher plant efficiencies. Some de-controlled
fertilizers also have the risk of becoming unviable if their IPP is cheaper than the price of
domestically manufactured fertilizer.
Therefore, imports, if cheaper than domestically produced fertilizers, affect the profitability of Indian
fertilizer companies both in urea as well as P&K segments.
4) Large-sized operations and economies of scale help:

Large fertilizer plants gain cost efficiency from multiple aspects like operating leverage where the fixed
costs of the plant are spread across a large volume and in turn, reduce the per-unit production costs.
While subsidy under NPS is expected to be progressively tightened, players with low energy
consumption levels, competitive cost structure and economies of scale are expected to fare better
in the long term.
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A large scale of operations brings in other benefits as well like a higher bargaining power over their
suppliers, which brings in cost savings in raw material procurement.
In case of P&K players, however, players with large requirement for raw materials have
relatively better bargaining power and can save on some costs.
Large companies are also able to enter into long-term contracts for raw materials with suppliers, which is
essential in the case of phosphoric fertilizers where most of the raw material is imported.
In the case of phosphatic fertilisers, the degree of import dependence is high with most raw
materials such as phosphoric acid, rock phosphate, muriate of potash, sulphur and ammonia being
imported…In such a scenario, players with assured long-term supply of raw materials at stable
prices or with domestic facilities for phosphatic fertilisers tend to have stronger credit risk profiles.
In the case of potassic fertilizers, most of the finished products are imported because India has very little
domestic production of potassic fertilizers. In such cases also, large-scale importers/traders benefit as they
can get a better price from their suppliers.
Potassic fertilizers are not produced in India and the entire requirement of the same is imported.
Even in the case of Urea, fertilizer manufacturers face a shortage of key raw materials like natural gas.
Therefore, large-sized companies find it comparatively easier to have long-term supply tie-ups.
Fertilizer units in the country today are faced with gas shortages and under such circumstances,
CARE reviews the ability of the company to have long-term tie-ups for its gas requirements at
competitive rates.
Large-sized companies also benefit as their operations are spread over many geographies, which protects
them from adverse agro-climatic events like a failed monsoon because the possibility of monsoon failure
in all the geographies in one year is low.
players that cater to a larger number of states would be relatively better placed as they would
be less susceptible to uneven monsoon.
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Fertilizer companies with large and well-established distribution network would also be less
susceptible to the regional demand-supply fluctuations.
5) Other cost efficiency measures:

Being an energy-intensive industry, most of the time, energy costs gain the maximum importance in
determining cost efficiencies of fertilizer companies However, other aspects of cost efficiency are also
important like locational advantages of plants, backward integration etc.
5.1) Locational advantages:
Fertilizer plants, which are located close to their customers are at an advantage because the transportation
cost of finished fertilizers is higher than its raw materials. However, P&K plants, where imports are an
important source of raw material/ready potassic fertilizers are established near the coast.
The location of the units near major consumer markets augurs well as the cost of transporting the
raw material is lower than that of the finished goods. An exception to it is the P&K fertilizer
units which are usually located in coastal regions.
5.2) Backward integration:
Efficiency improving measures like backward integration are very important for phosphoric fertilizers,
which face a shortage of some raw materials even at global levels.
Of the raw materials/ intermediates, phosphoric acid and rock phosphate are in short supply in
the global market and hence durable tie-ups with producers in overseas countries could be a
source of competitive advantage for the units
Therefore, if any company is either able to secure supplies of phosphoric acid or is able to backwards
integrate into the production of phosphoric acid from rock phosphate, then it gets a competitive advantage.
ICRA also favourably factors in backward integration in the manufacturing of phosphoric acid
and sulphuric acid. Since rock phosphate, which is a key raw material for manufacturing
phosphoric acid, is available more easily compared to phosphoric acid, which has limited
international suppliers, it enables the entity to produce phosphoric acid and achieve cost
advantage over imported phosphoric acid.
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5.3) Flexible manufacturing plants:
In addition, companies with flexible manufacturing plants that can use easily switch between the basic raw
material and intermediate products for making fertilizers are at an advantage because they can choose the
most cost-effective starting material based on the prevailing pricing scenario.
Additionally, players with flexible manufacturing facilities that enable them to shift between
sourcing of intermediates and basic raw materials, depending on the cost economics, are usually
able to minimise cost increases.
Therefore, whether it is nitrogenous (urea) or P&K fertilizers, staying cost competitive is essential and
companies must attempt to be as cost-efficient as possible to remain competitive. In fact, in the case of urea
producers, in light of assured offtake and subsidies, any poor performance is always due to poor cost
efficiency.
The under-performance of the units would largely be a derivative of higher energy

consumption than the normative parameters, lower capacity utilization and non-approval of any
fixed cost by the regulator.
6) Risks:
The fertilizer industry is currently facing risks from different aspects. Let us understand some of them.
6.1) Volatile raw material prices and forex risks:
Raw material prices of all the fertilizers be it urea or P&K are imported whether directly or indirectly. P&K
fertilizers are directly dependent on imports for their raw material whereas, for urea plants, the key raw
material like natural gas is influenced by the international price of crude oil.
The key raw materials, for manufacturing of complex fertilisers e.g. ammonia, phosphoric acid,
rock phosphate, muriate of potash, sulphur, are largely imported. Although some players
manufacture phosphoric acid and ammonia to meet their requirements partially while sulphur is
available indigenously as well from oil refineries, the raw material to produce these products is
also largely imported leading to indirect import dependence
As a result, the raw material prices of fertilizer companies are impacted by both
the commodity cycles and foreign exchange (forex) movements and are volatile.
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In the case of nitrogenous fertilizers (urea), the forex changes, as well as raw material price changes, are a
pass-through to the govt. under variable costs. However, in the case of P&K fertilizers, as the amount of
subsidy is fixed, any increase in raw material costs hurts their profit margins.
Urea players are protected from foreign currency fluctuations due to the pass-through nature of
the subsidy regime although it does impact the working capital requirements. However, P&K
players are exposed to the currency risk as almost entire raw material is imported and in situations
of steep currency depreciations, the industry may find it difficult to pass on the currency impact to
the farmers.
For urea plants, any increase in raw material costs is a pass-through to the govt. as it increases the amount
of subsidy entitlement. However, subsidy recovery is usually delayed; therefore, it increases the working
capital burden on the companies to fund the subsidy receivables by borrowings and increases the interest
costs.
Rating methodology – fertilizer companies by CARE, May 2020, pages 8-9:
For urea units in circumstances where the feedstock prices are on an increasing trend, the working
capital intensity stretches due to fixed farm gate price inducing pressure on liquidity, gearing and
interest burden.
In the case of P&K fertilizers, any increase in raw material costs, apart from hurting their profitability
directly also intensifies the competition from imports. This is because any attempt by P&K fertilizer
companies to increase prices to recover higher costs makes imported fertilizers cheaper. As a result, as
discussed earlier, many importers and traders launch their products in the market at a cheaper price.
As a result, especially in the case of P&K fertilizers, large raw-material-storage facilities and efficient
handling operations become a key competitive advantage.
The raw material handling facilities of the players and ability to store these are other key operating
efficiency determinants, given that raw materials are imported and their prices are volatile.
6.2) Environmental risks and organic farming:
Manufacturing of urea is an environmentally sensitive process because of the usage of a large amount of
natural gas, which is a petrochemical.
As an alternative, govt. is planning to mandate the usage of green hydrogen for manufacturing urea;
however, it would require additional investments by an already capital-intensive business.

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Fertiliser manufacturing, particularly urea, has a significant carbon footprint as natural gas is
the key raw material…With the GoI exploring the passing of a mandate for the procurement of
green hydrogen by refineries and fertiliser plants
Excessive usage of fertilizers also has an impact on soil health, which in association with growing
awareness against using the chemical for producing food is giving growing acceptance of organic foods,
which are grown without the usage of pesticides and fertilizers.
Currently, such foods are costly because the production yields of organic farming are lower. However, as
newer innovations lead to improvements in the yields of organic food, which would reduce their premium
pricing, they will gain more acceptance. It might have an impact on the demand for fertilizers by farmers.
Changing consumer preference towards use of organically-grown products wherein no chemical

fertilisers are used could pose a social risk for fertiliser demand.
6.3) Sharp regulatory changes with excesses and reversals:
Like any highly regulated segment, the fertilizer industry is prone to regulatory flip-flops. Many times,
regulations may turn out to be conducive to the industry and as a result, may not benefit the industry.
Whereas the subsequent changes may lead to too much incentive that the govt. has to roll back the measures.
The fertilizer industry has seen such reversals multiple times in the past and it may see it in the future as
well.
In the past when govt introduced Retention Price Scheme (RPS) in 1977 to increase fertilizer production to
achieve self-sufficiency in the country, then the subsidy burden increased so much that it had to move P&K
fertilizers out of it in 1992 to reduce the subsidy outgo.
Thereafter, the prices of P&K fertilizers increased. However, urea was still under RPS making its price
much cheaper than P&K fertilizers. As a result, farmers used too much urea and it created a nutritional
imbalance.
In the early to mid-1990s, demand for phosphatic fertilisers was considerably impacted following
the decontrol (1992) and flip-flops in government policies, resulting in highly decontrolled farm
gate prices as against urea, which was then governed by RPS and was, therefore, subsidised. High
phosphatic fertiliser prices distorted the consumption patterns in the country in favour of
nitrogenous fertilisers, thereby creating a nutrient imbalance.
The use of urea by the farmers had exceeded too much from the advised benchmarks.
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The ideal nutrient composition, too, favours nitrogen, and hence, urea. The perfect NPK ratio of
soil stands at 4:2:1. However, due to indiscriminate urea use, this ratio stood at 6.9:2.7:1 in fiscal
2016
Once the govt. started focusing on reducing the subsidies, then it could not timely revise its investment
guidelines for the sector. Therefore, for a very long time, no new urea manufacturing capacity came up in
the country, which led to a very sharp increase in imports of urea to meet the continuously increasing
demand.
On account of unfavourable investment policies, capacity additions were absent in the urea
segment – leading to a surge in urea import (from 0.5 million tonne [MT] in fiscal 2000 to 6.9 MT
in fiscal 2008).
domestic urea industry did not witness any capacity additions in the past two decades
Therefore, the govt. revised its investment policy for the urea segment; however, the first policy in 2008
proved insufficient and did not get a good response. As a result, the govt. revised it in 2012 and this time,
gave so many incentives that the investment proposal received could create an oversupply of urea in the
country. Now, the govt. had to cut down on the incentives especially, the clause for an assured offtake of
production.
The government introduced the urea investment policy in 2008, which saw muted response as no
assurance was provided for gas prices and returns were not linked to gas costs. This was addressed
in the updated policy in 2012, which linked realisations to costs and assured minimum return on
networth of 12% to the companies. This policy led to a rush of applications, which would have
resulted in overcapacity in the industry. Consequently, the policy was modified to remove the
assured offtake clause.
Now, due to the removal of the assured offtake clause, the new urea plants are seeing sales risk because
their production costs are anticipated to be higher than imports.
new urea plants being set up under New Urea Investment Policy-2012: these plants are exposed
to offtake risk as well, given that the GoI replaced the assured offtake clause in the NIP-2012.
Since the cost of procurement from these plants will be higher than the imported urea, these plants
are exposed to the off-take risk.
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Therefore, an investor would appreciate that like any other highly regulated sector, the fertilizer industry is
also exposed to the risks of regulations and incentives moving towards excesses in each direction like a
pendulum. It has happened in the past and may happen in the future as well. Therefore, an investor should
be cautious of these risks while assessing fertilizer companies.
Summary
Fertilizers are a very essential product to ensure food security as well as farm income. Therefore, govt.
attempts to provide them below their cost price to farmers. It results in a huge subsidy outflow from the
govt. to fertilizer manufacturers. As a result, the govt. control fertilizer industry heavily by regulations
controlling almost all aspects like retail prices, raw material prices, operating efficiencies, production
incentives etc.
India is a fertilizer deficit country and almost the entire domestic production of fertilizers is consumed.
However, the companies cannot take undue benefits from this assured demand. Govt. influences how much
return these companies can make and if companies start making large profits, then govt. takes away these
benefits by reducing the subsidy amount.
In essence, the aim of govt. regulations is to increase fertilizer production in India and control its subsidy
burden. As a result, over the years, the industry has been under continuous pressure to improve efficiencies
and in turn, help govt. in reducing its subsidy burden.
Fertilizer companies do not have any independent pricing power. Govt. influences retail prices either
directly (urea) or indirectly (P&K fertilizers). Companies have to resort to selling nonregulated items like
seeds, and pesticides (agrochemicals) in their outlets to increase profitability.
The pressure on the companies to improve efficiency is immense because govt. frequently keeps tightening
the efficiency norms, which in turn, reduces the profitability of inefficient firms. It requires fertilizer
companies to invest money in more efficient equipment in an already capital-intensive industry.
Even though govt. promises subsidy payments to ensure a reasonable return to fertilizer companies;
however, subsidy payments are usually delayed putting pressure on their working capital. However, banks
are ready to provide funding for these receivables considering that they have a sovereign guarantee.
Fertilizer companies compete with each other on operating efficiency because govt. has made their input
costs almost uniform by measures like gas pooling. More cost-efficient companies earn more profits than
inefficient companies. Various efficiency measures like economies of scale, better raw material
procurement, long-term sourcing contracts, backward integration, better storage and handling capacities,
large distribution channel, geographic diversity, flexible manufacturing, locational advantages etc. are
especially important for fertilizer companies.
Competition for operating efficiency is not limited to domestic producers. If imports are more cost-efficient,
then all fertilizer companies be it P&K or urea, suffer. Govt. buys urea above reassessed capacity only if it
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costs lower than imported urea. In P&K fertilizers, as imports become cheaper than domestic prices, traders
and imports start selling products at a cheaper price. Therefore, attempts to control raw material prices and
forex risks are important.
Due to rising environmental awareness, the fertilizer industry faces risks from growing acceptance of
organic food as well as a transition from natural gas to green hydrogen. Nevertheless, one of the biggest
risks faced by the industry is regulatory flip-flops where frequently incentives and harsh measures go to
extremes.
Therefore, an investor should keep in mind these multiple aspects for fertilizer companies to understand the
true picture of their business position.
 Continuously increasing regulatory environment with tightening subsidies

 Very low pricing power
 The utmost importance of cost efficiencies in business operations
 Benefits of large size and economies of scale
 Risk of volatile raw material prices and forex fluctuations
 Risks from green movements, organic foods
 Regulatory flip-flops
We believe that if an investor analyses any fertilizer company by considering the above parameters, then
she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.

Videos
Analysis Excel
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7) How to do Business Analysis of IT Services Companies
After reading this article, an investor would understand the factors that impact the business of information
technology (IT) services companies and the characteristics that differentiate a fundamentally strong IT
services company from a weak one.
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Key Parameters for Analysis of IT Services Companies
1) Size of the company:

Most of the IT companies in India are service companies and not product companies. This means that most
Indian IT companies help their customers by doing a part of the customers’ business for them at a cheaper
cost. The majority of Indian IT companies have not created their own software products, which they can
sell to business or individual consumers.
While thinking of an IT product, an investor may think of Microsoft Windows or Android as operating
systems. These are software products, which Microsoft and Google make and sell to different computer and
mobile manufacturers. In India, there are very few IT companies, which have created such IT products.
Most of the IT companies in India approach other foreign as well as other Indian companies (customers)
that want to use information technology in their business to improve their products/ increase profits etc.
Then the Indian IT companies propose different solutions to these customers. These solutions may include
BPO solutions like running customers’ entire departments at a lower cost like product design department,
human resource department, or customer care department etc. at a lower cost. Otherwise, the solutions may
include contributing only to a part of customers’ large business operation like designing a wing/tail for an
aircraft manufacturer.
Customers opt for collaborating with IT companies providing such services because Indian IT companies
can provide them with an acceptable level of service at a lower cost. Taking forward the example of
designing parts of an aircraft, if the customer puts her 20 employees in the USA to design it, then the cost
of those employees would be higher compared to the scenario when an Indian IT company employs 20
employees in India to design that part. An investor needs to appreciate that the employees in India are as
capable as employees in the USA are in terms of knowledge, efficiency, and calibre. In addition, the
customers of IT companies do a rigorous assessment of these companies to satisfy themselves about their
ability to do work of good quality.
An investor would appreciate that if an aircraft manufacturer wishes to lower down its cost in each of the
design department/company function, then it would have to outsource a lot of work to other IT companies
like the ones from India. In such a situation, if the customer has to select a different IT company to outsource
each of its work, then it becomes very cumbersome work to deal with and manage multiple IT companies.
As a result, most of the customers like to deal with only a few but large IT companies, which can make
things easy for the customer by taking over a lot of their work in one contract.
This means that an IT company, which can provide design work, human resource work, customer care
work, manufacturing work etc. presents a better option to the customer than the situation where the customer
has to find many different companies to do these works.
As a result, customers prefer large IT companies, which can provide multiple solutions to small IT
companies, which can provide only a handful of solutions.
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An argument may say that a small IT company may provide a unique solution, which a large IT company
may not have in its skills and as a result, the small IT Company will stand a good chance of getting many
orders in its niche area. This is true. However, an investor should also keep in mind that the large IT
companies keep on looking for such gaps in their services, which these small IT companies try to exploit.
Whenever a large IT company finds such a gap in its services, then the large IT Company plugs it by either
developing this new skill in house by either research & development or by hiring trained employees from
outside or many times by buying out the small IT companies that have this new skill.
It is due to this continued effort of large IT companies to provide the maximum amount of solutions to their
customers that the large IT companies keep on acquiring small IT companies providing unique
skills/solutions. As a result, the information technology (IT) sector witnesses a large number of mergers &
acquisitions.
Moreover, a large IT company can afford to keep many spare employees who can be quickly assigned to
new orders/projects and in turn provide quick solutions to customers than small IT companies, which may
not be able to afford a large number of spare employees all the time. The small IT companies may have to
hire new employees when they win many/large contracts and this may increase the time taken by them to
finish the projects.
Therefore, an investor would appreciate that a large IT company stands a higher chance of getting more
business from its existing customers as well as winning new customers.
2) Location of employees of the IT Company i.e. Onsite-Offshore mix:

From the above discussion, an investor would appreciate that the key business proposition offered by Indian
IT companies to their customers is to provide solutions of acceptable quality at a lower cost. This is because,
if the price of the services quoted by the IT companies is the same as what the customer gets by doing the
project on its own, then the customers may not give the work to other IT company. Therefore, an investor
would appreciate that the IT Company, which can provide acceptable quality work at the lowest cost stands
the best chance to win orders.
In today’s internet-connected world, it is possible to do a lot of work in India and then after completion,
send it to the customers in foreign locations over the internet. This provides the biggest advantage that the
IT companies can hire good employees at a comparatively lower cost in India who can provide good quality
skills at a lower cost than the employees in foreign countries like the USA can. Therefore, IT companies,
which can get the maximum work done in India, can provide services/solutions to their customers at the
lowest costs.
However, if a customer in the USA has to choose between two companies (offering the same price for
services), one of which has its employees sitting far in India (a different time zone) and the second company,
which has its employees in the USA, then the customer would prefer the second company. This is because;
the customers can get access to the IT Company’s employees during its own office hours and call them to
its office to co-ordinate etc. The customers’ preference of dealing with IT companies, which have
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employees in customers’ country like the USA makes it necessary for the IT companies to have employees
in USA etc. because it improves their chances of winning orders/repeat business. The offices of IT
companies in foreign countries are under the name of delivery centres/sales/marketing offices etc.
From the above discussion, an investor will appreciate the dilemma faced by IT companies in terms of the
countries in which they should hire their employees.
 Having maximum employees in India (Off-site location) lowers the costs and in turn, improves the
profitability of IT companies. However, it does not provide the best coordination opportunity with
the client.
 On the contrary, having maximum employees in a foreign country (Onsite location) provides good
interactions with the client and in turn, increases chances for winning new/repeat orders. However,
it increases the cost of IT companies because the employees in foreign countries come at a higher
cost. This, in turn, lowers the profitability of the IT Company.
Therefore, most IT companies try to achieve a fine balance between their employee strength in India
(Offsite) and the employee strength in a foreign country (Onsite).
However, an investor would appreciate that an IT company having most of the employees in India (Offsite)
will have higher profitability than the IT company having most of its employees in a foreign country
(Onsite). However, the investor would also appreciate that the company with most of the employees “Onsite
(like the USA)” will have higher growth opportunities than the IT company with maximum employees
“Offsite (in India)” as the company will higher onsite presence will have higher chances of winning
new/repeat orders.
Let’s look at the below example of an Indian IT company, Cyient Ltd, which witnessed a steep decline in
its profit margins in FY2011 when its net profit margin (NPM) declined from 17% in FY2010 to 11% in
FY2011. (FY2011 annual report, page 103):
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While analysing the reasons for the decline in the profits, an investor notices that the employee costs of
Cyient Ltd had increased sharply in FY2011 to 61% of its total revenue from 54% in FY2010. Upon further
analysis of the FY2011 annual report, an investor notices that in FY2011, the company had a sharp jump
in its onsite work (employees based in a foreign country).
FY2011 annual report, page 31:
Looking at the above table, an investor would appreciate that in FY2011, the share of onsite work (i.e.
employees working in foreign location) increased sharply to 51% from 44% in FY2010. As discussed
above, an investor understands that a higher number of employees in a foreign country (onsite location)
means higher employee costs and lower profit margins.
Therefore, an investor would appreciate that the IT companies with a higher number of employees in India
(offshore location) will have higher profits but lower growth opportunities whereas the companies with
more employees in foreign countries (onsite location) will have lower profits but higher growth
opportunities.
3) Nature of Business Contracts: Time & material contracts vs. Fixed price
contracts:
In the IT sector, companies usually get their order in one of the two forms.
a) Time & material contract:
In these contracts, the customer pays the IT Company based on the amount of time taken to complete the
project and the amount of material (number of employees) used to complete the project. It means that the
IT Company charges the customer based on the number of employee hours consumed to complete the
project.
An investor would appreciate that in Time & material contract, the IT Company will always charge the
customers a premium over what it costs to hire & train the employees and make them work on the
customer’s project. There is very little possibility of the IT Company making a loss in time & material
contracts.
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b) Fixed price contract:
In a fixed-price contract, the customer assigns a value to the work to be done by the IT Company as a
project. After giving the order to the IT Company, the customer is not concerned about how many
employees the IT Company has employed to complete the work. In fixed-price contracts, the customer is
concerned with the quality of the work and the timeline for completion of the work.
In case of a fixed-price contract, the IT Company can manage resources at its end to get more work done
by employing efficient workers and other cost-cutting measures to complete the work at the lowest cost and
in turn, make maximum profit from the contract. However, if due to any reason, the IT Company is not able
to complete the work in a given time or the most efficient employees leave the company, then it may have
to bear a loss as well. This is because the customer may not pay the IT Company for failure to give
acceptable quality work within the promised time.
Looking at the above discussion of time & material contracts and fixed-price contracts, an investor would
appreciate that the time & material contracts are low-risk-safe contracts. As a result, the customers also
negotiate hard on the pricing of time & material contracts and the IT companies that primarily rely on time
& material contracts usually have lower profitability.
On the contrary, in fixed-price contracts, the IT companies have the scope of lowering their costs by
improving efficiency and in turn, enjoy higher profits. However, such high profits come with a risk of
making losses as well in the case; the IT Company is not able to deliver acceptable quality of work within
the promised time.
The IT companies provide a breakup of the nature of their business contracts in terms of time & material
contracts and fixed-price contracts in their annual report. E.g. Cyient Ltd has provided this breakup in its
4) Mergers and Acquisitions:

From the above discussion on the scale of the IT companies, an investor would remember that the large IT
companies enjoy an advantage over smaller IT companies in winning new/repeat orders because a large IT
Company can provide solutions of multiple business problems to the customer.
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In order to strengthen their advantage further, the IT companies are continuously on the lookout for skills,
which can further improve their value addition to customers. Whenever, IT companies come across a small
IT company, which has mastered a unique technology/skill, which the large IT companies can provide as
an added solution to their clients, then many times, the large IT companies acquire the small IT company
with unique skill/technology. This addition of new skill helps the large IT Company in providing new/better
solutions to its existing clients as well as win new orders. IT companies also acquire other companies to
gain access to the customers of these companies.
Therefore, an investor would appreciate that established IT companies keep on acquiring new small
companies on a continuous basis. Many times, large IT companies may acquire many small companies
within one year.
However, an investor would also appreciate that along with the advantage of better business opportunities,
a high merger & acquisition activity opens the door for malpractices like syphoning of money by marking
up the price of acquisition or accounting juggleries where accounting frauds go undetected for many years
under the cover of complex merger accounting.
In recent times, an investor would remember the case of one such acquisition by a large IT company when
Infosys Ltd acquired a small Israeli IT company, Panaya for ₹200 million in 2015 (Source: Infosys).
 At that time, Vishal Sikka, CEO of Infosys said:
“The acquisition of Panaya is a key step in renewing and differentiating our service lines. This
will help amplify the potential of our people, freeing us from the drudgery of many repetitive tasks,
so we may focus more on the important, strategic challenges faced by our clients. At the same time,
Panaya’s proven technology helps dramatically simplify the costs and complexities faced by
businesses in managing their enterprise application landscapes.”
 However, after some time, a whistle-blower raised questions on this acquisition stating that the
acquisition was overvalued. (Source: MoneyControl: Whistleblower questions Infosys board on
accountability for Panaya acquisition)
 Mr Narayan Murthy, one of the founding promoters of Infosys Ltd., took up this issue with the
board of directors. This incident created many issues for the company’s promoters, board, and
management. Subsequently, Mr Vishal Sikka resigned from Infosys Ltd in 2017.
 In 2018, Infosys decided to sell off Panaya at a 59% discount to the purchase price
(Source: livemint: Infosys struggles to sell distressed asset Panaya)
 However, the company could not find a buyer for Panaya and it apparently shelved the plans to
sell Panaya in 2019 (Source: livemint: Infosys drops plan to sell Panaya, Skava)
Therefore, while analysing companies in the information technology (IT) sector, an investor should be
prepared to witness a lot of mergers & acquisitions, which may prove valuable to the business in terms of
new skills and customers. However, these mergers & acquisitions also bring with them the possibility of
misdeeds by management by syphoning off the money by the overvaluation of acquisition as well as
covering up accounting frauds in complex merger accounting.
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5) Productivity: Revenue and profit per employee, utilization level of employees,

attrition levels:
An investor would appreciate that the business of IT companies is very people-centric and is not based on
the amount of fixed assets (plant & machinery) owned by these companies. The employees are the main
sources of productivity and therefore, efficient management of employees is one of the most essential
activities for any IT Company.
In the case of IT companies, the following parameters take significance:
1. Revenue and profit per employee

2. Utilization level of employees
3. Attrition level of employees
Companies disclose these parameters in different public disclosures like annual reports, investor
presentations etc. Let us take the example of Cyient Ltd.
a) Revenue and profit per employee:
b) Utilization level of employees:
At any point in time, an IT Company has employees who are involved in project work for the customers as
well as those employees who are currently not working for any customer project. The employees who are
currently not working on any customer project form the “Bench” strength. These employees are available
as a readily available resource, which the company can quickly deploy on any project and in turn provide
a quick solution to customers.
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If an IT company does not have spare employees on the bench, then it may face a situation that the company
has won a new project but it is not able to commence it on time, as it does not have ready skilled employees
to initiate the project. The company may have to hire new employees and train them for a specific project,
which will take time and delay the project completion. This situation also holds true in cases where an
existing project suddenly demands more resources or many employees from an existing project leave the
company.
Therefore, to provide optimal work speed to the customer, an IT Company needs to have spare employees
on the “bench”.
However, an investor would also appreciate that spare employees who are not working on any customer
project are a cost to the company, which is currently not earning any revenue. This is because the IT
Company has to pay salaries to these spare employees irrespective of the fact that they are currently not
working on any customer project.
Therefore, all IT companies attempt to reduce the number of spare employees on the “bench” so that it may
save on costs whereas having sufficient spare employees so that they do not run the risk of timely
completion of existing projects and quick initiation of new projects.
Therefore, the IT companies have to maintain a fine balance between the number of employees working on
customer projects and the number of spare employees on “Bench” so that they may provide the best services
to their customers at the lowest cost.
The utilization ratio is the total number of employees/employee hours of the IT Company, which worked
on customer projects during any period. IT companies disclose this information in their public disclosures.
E.g. Cyient Ltd, investor’s presentation dated April 25, 2019, page 42:
c) Attrition level of employees:
An investor would appreciate that an IT Company is highly dependent on its employees as a departure of
any key resource/skilled employee may put a customer project in jeopardy and it may take some time for
the company to find a replacement for the key employee. Moreover, hiring a new employee and training
her to meet expected skill levels may involve additional cost and time, which will hurt the customer project
in terms of cost and timeliness of completion.
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Therefore, it is essential that an IT Company keep its attrition level at a low level. IT companies provide
the attrition levels of their employees in their public disclosures. E.g. Cyient Ltd, investor’s presentation
dated April 25, 2019, page 43:
Monitoring employee productivity in terms of revenue & profits per employee as well as utilization and
attrition levels is essential in cases of IT Companies because any disruption at the employee level can cause
a delay in the completion of customer projects, which apart from monetary loss also hurts the reputation of
the company. It also has an impact on the chances of winning new/repeat business for IT companies.
We may see an example of Cyient Ltd, which lost revenue opportunities in FY2019 primarily due to
attrition and inability to find required talent in its remaining employees. Cyient Ltd, April 25, 2019
conference call, page 10-11:
Pankaj Kapoor: Krishna, during this year FY2019 we had at least a couple of quarters in which
what we guided for versus what finally came in, there was a reasonable gap. So I am just trying
to understand that how who have looked at this issue and have you made any changes to the way
you try to forecast the business outlook….
Krishna Bodanapu: ……I think we are typically focused really on the demand side and if there
was demand we thought that fine we will be able to achieve it, but I think the key challenge that
we faced, which is what happened more or less in Q4 is the supply side did not really stood up.
That is also the case of, say, the DLM. We had the demand we were not able to supply it because
of various reasons. In the case of Aerospace & Defence, for the most part, the demand was there,
and it was locked in. It was just the supply could not be made because of attrition challenges in
some case, etc.
Pankaj Kapoor: So just one clarification on this. So basically you are saying it was more of a
fulfillment challenge that you faced because of absence of the supply pool or the talent
availability rather than anything on the client or demand side.
Krishna Bodanapu: I said 75% of it was on that, 25% was demand being pushed out.
Therefore, an investor would appreciate that employee management is one of the most critical aspects of
an IT Company.
6) Percentage of repeat revenue:
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The business model of IT companies is to provide acceptable levels of business solutions to the customers
at a low cost. Therefore, a customer usually sticks to an IT Company until the time the solution/service
provided by the IT Company is at an acceptable cost and quality.
Due to the highly competitive nature of the information technology services industry, the customer will
continuously get a business proposal from other competing IT companies. If the price charged by an IT
Company to its existing customers turns out to be higher than the market price, and the customer finds value
in the new proposals after factoring in the switching costs from IT Company to another IT Company, then
the customer will shift to the new IT Company to save on costs.
In the light of intense competition, if an IT Company is able to get repeat orders from its existing customers,
then it indicates that the services provided by the IT Company to its customers are of acceptable quality
and at an acceptable price. Moreover, for the IT Company, it is easier and cost-effective to get repeat
orders/new projects from existing customers than to find new customers.
Therefore, the IT companies, which have high repeat revenues from existing customers, usually have a
strength in their business model and a competitive advantage over their peers.
IT companies disclose the amount of repeat revenue i.e. revenue from existing customers in various public
disclosures. E.g. Cyient Ltd, FY2012 annual report, page 13:
7) Foreign exchange risk management:

Indian IT companies earn most of their revenue from customers located outside India. They earn this
revenue in currencies like the US Dollar, the Euro etc. In such cases, the impact of the movement of the
Indian Rupee against foreign currencies may play a major factor in increasing or decreasing the earnings
of the IT Company in Indian Rupees even if the IT Company has earned the same revenue in US Dollars
or Euro.
Let us take an example of Cyient Ltd, which grew its revenues by about 18% in FY2014. However, when
an investor does a deeper analysis, then she realises that out of 18% growth, about 12% is only due to Rupee
depreciation. Cyient Ltd, FY2014 annual report, page 82:
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Looking at the above table, an investor may feel happy that the company has benefited a lot due to rupee
depreciation against foreign currencies. However, an investor will appreciate that if an IT Company does
not have a good and effective foreign exchange hedging policy, then it can easily lose significant money in
case of rupee appreciation against foreign currencies.
8) Geographical and business segment diversification:

Like any other industry, diversification of revenue in terms of different countries/markets as well as
different customer industries helps an IT Company to survive a downturn in any particular
geography/country or industry.
After the above discussion, an investor would appreciate that the following parameters form a key aspect
of analysing the business of an IT services company:
1. Size of the company

2. Onsite-offshore mix of employees
3. Nature of business contracts: time & material vs. fixed-price contracts
4. Mergers & acquisitions
5. Productivity parameters like revenue & profits per employee, utilization level of employees and
attrition levels
6. Percentage of repeat revenue
7. Foreign exchange risk management
8. Geographical and business diversification
Regards,
Dr Vijay Malik
P.S.
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8) How to do Business Analysis of Auto Ancillary Companies
After reading this article, an investor would understand the factors that impact the business of auto ancillary
companies and the characteristics that differentiate a fundamentally strong auto ancillary company from a
weak one.
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Auto ancillary or auto component sector is one of the important sectors for both the economy as well as
investors. There are hundreds of companies from auto ancillary listed on Indian stock exchanges. Many of
them have achieved big scale with manufacturing plants located all over the world.
In the current chapter, we aim to highlight the key aspects of the business model of auto ancillary
companies, how it becomes challenging for new players to get business from large auto manufacturers
(OEMs), how the large auto manufacturers put continuous pressure on their suppliers, how profits of auto
ancillary companies get squeezed between large customers and even larger raw material suppliers (metal
producers).
We aim to highlight to an investor how various auto ancillary companies aim to become an indispensable
partner for the original equipment manufacturers (OEMs), which are large automobile manufacturers. What
steps the auto ancillary players take to establish their market position, diversify to protect their profit
margins, tie-up with foreign players to gain additional business and at the same time face the risk of
becoming obsolete if they do not upgrade their technology continuously.
This chapter will help every investor who is thinking of investing in the auto ancillary sector or is analysing
any company from this sector. After reading this article the investor would be able to determine where any
auto ancillary companies stand in the industry, whether the company is taking the right steps to establish
itself as a long-term player or it is going in a direction that may cause problems down the line.
We have provided real-life examples of auto ancillary companies along with details of their business
decisions in the article so that an investor may understand the discussions better.
Let us now highlight the key characteristics of the business model of auto ancillary companies.
1) Cyclical business performance:

When an investor analyses an auto ancillary company, then she would notice cyclicity (fluctuations) in its
business performance. The cyclicity is present in sales i.e. periods of increasing sales would be followed
by periods of declining sales. The cyclicity is present in the profit margins as well i.e. periods of increasing
profit margins are followed by periods of declining profit margins and vice versa.
This is the norm for most of the auto ancillary companies analysed by us. In case, an investor comes across
any auto ancillary company, which has a long history of continuously increasing sales and profit margins,
then she should recognize that it is an exception and not the norm.
Moreover, out of the many different segments of auto ancillary companies, the companies that primarily
depend on the commercial vehicles segment show a higher level of cyclicity.
1.1) Real-life examples of cyclical business performance of auto ancillary

companies:
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An investor may see the cyclicity in the business performance of Jamna Auto Industries Ltd, which
produces springs/suspension parts for commercial vehicles.
In the below table showing the sales and operating profit margin of Jamna Auto Industries Ltd from FY2011
to FY2021, an investor would notice the periods of declining sales as well as profit margins FY2012-
FY2014 and FY2019-FY2021. The cyclicity in the business performance of an auto ancillary player comes
out clearly in the performance of Jamna Auto Industries Ltd.
To take another example, an investor may observe the financial performance of India Nippon Electricals
Ltd, a TVS group company, manufacturing electrical ignition systems for automobiles and gensets
(portable generators).
An investor may notice that the operating profit margin (OPM) of India Nippon Electricals Ltd has followed
a cyclical pattern. The OPM declined from 14% to 9% over FY2012-FY2014, then increased to 14% over
FY2015-FY2018 and then again declined to 9% from FY2019-FY2021. An investor may also notice the
decline in sales of the company during FY2019-FY2021.
From the above two examples, an investor would be able to appreciate the cyclicity in the business model
of auto ancillary companies. Cyclicity reflects in the pattern of the rise and fall of the profit margins as well
as sales.
1.2) Reasons for the cyclical business performance of auto ancillary companies:
When an investor tries to understand the reasons for cyclicity, then she notices that out of three key customer
segments served by auto ancillary companies, the largest segment is original equipment manufacturers
(OEMs), whose performance fluctuates cyclically in line with economic phases.
CARE Rating Methodology for auto ancillary companies by the credit rating agency, CARE, July 2020,
page 1:
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The industry’s sales to OEM segment contributed to 56.4% of its total turnover, while exports and
replacement market contributed to 26.7% and 16.9%, respectively.
The OEM segment of the automobile industry represents the production and sale of new vehicles. An
investor would appreciate that purchase of a new vehicle is not an emergency/essential purchase and any
customer can defer the purchase in times of economic downturns.
An auto ancillary company, Minda Industries Ltd, a leading Indian auto component manufacturer
producing switches, horns, lighting, alloy wheels and other auto ancillary products, highlighted this aspect
in its FY2020 annual report, page 94:
Auto industries are discretionary in nature. Amidst slowdown, spending on new vehicles is often
curtailed or postponed by user, making the industry a cyclical.
Another credit rating agency, ICRA, highlighted the cyclical aspect of the business of auto ancillary
companies, especially those commercial vehicle segment in its rating guidelines for the sector in Oct. 2020,
page 2:
The auto industry operates in a cyclical environment, leading to periods of low profitability and
revenues for auto component manufacturers. This is more pronounced in ancillaries catering to
the CV segment.
Therefore, an investor would notice that the dependence of the automobile industry on the general economic
environment for its sales leads to cyclicity in the auto ancillary companies. The discretionary nature of
automobile purchases is one of the key reasons for the cyclicity in its demand and thereby the business
performance of all the dependent sectors.
In addition, there is one very important factor, which leads to cyclicity in the profit margins of auto ancillary
companies. This factor is very low, almost nil negotiating/pricing power of auto ancillary companies with
their customers (OEMs) as well as their suppliers (large metal producing companies).
2) Very low bargaining and pricing power of auto ancillary companies with
their customers and suppliers:
While analysing the business of many auto ancillary players, an investor notices that the automobile
component manufacturers do not enjoy a high pricing power on their customers, which are much larger
original equipment manufacturers (OEMs). Also, most of the auto component manufacturers do not have
high bargaining power over their suppliers, as the suppliers are also large metal players.
ICRA rating guidelines for the auto component sector, August 2018, page 2:
Most auto component manufacturers, moreover, do not enjoy adequate bargaining power with
their much larger OEM customers or with their large raw material (metal) suppliers.
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As a result, the automobile component manufacturers find it very difficult to protect their profit margins
whenever the raw material prices increase or when the demand slows down. This is because, when raw
material prices increase, then they are not able to pass on the costs to the OEMs. The OEMs are very large
companies compared to auto component manufacturers who have multiple suppliers for each component
that they purchase.
In addition, the auto component manufacturers face intense competition among each other as well as from
the unorganized sector.
CARE Rating Methodology for Auto Ancillary Companies, July 2020, page 1:
With most auto ancillary companies being smaller in size and largely dependent on OEMs, they
have limited bargaining power. Furthermore, competition has been intense due to the sizeable
presence of unorganised players.
Therefore, the auto component manufacturers can’t get a price increase each time the raw material costs
increase. In fact, as per ICRA, the margins earned by auto ancillary players from the Indian OEMs is the
least when compared to other segments of aftermarket and exports.
ICRA rating guidelines for the auto component sector, Oct. 2020, page 1:
Margins from the domestic OEM segment are the least as ancillaries do not enjoy adequate
bargaining power with their much larger OEM customers.
Also, the auto component manufacturers buy raw material like steel, aluminium, plastic etc. from suppliers
like steel plants, refineries etc. who also are very large when compared to the auto component
manufacturers. Therefore, the auto component manufacturers are not able to enjoy any bargaining power
from their suppliers as well.
As a result, during tough times, the profit margins of the auto component manufacturers are squeezed
between the increasing cost of raw material from metal suppliers and the pricing pressures from the OEMs.
This is the key reasons for the cyclical fluctuations in the profit margins of auto component manufacturers.
It is said that the OEMs keep a track of the operating margins of all their vendors and whenever there is an
increase in operating margins due to any reason e.g. lower raw material cost etc., OEMs demand a price
cut/discount from vendors. Such tough business dynamics with intense competition is one of the main
reasons for muted operating margin levels of almost all the auto ancillary players except a few.
As any improvement in the profitability margins of auto ancillary companies is commonly followed by
requests for discounts by OEMs; therefore, auto ancillary companies find it difficult to have high
profitability margins.
2.1) Real-life examples of auto ancillary companies with low pricing power:
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While reading the annual reports of different auto ancillary companies, an investor would come across
multiple instances where companies have highlighted the continuous pricing pressure from customers and
their inability to get price hikes even when raw material prices increase.
Let us see the example of India Nippon Electricals Ltd, a TVS group company, manufacturing electrical
ignition systems for automobiles and gensets (portable generators).
While analysing the financial performance of India Nippon Electricals Ltd, an investor would notice that
over FY2011-FY2021, the operating profit margins of the company showed a cyclical pattern with periods
of decreasing profit margins followed by periods of increasing profit margins.
While analysing the annual reports of the company, an investor comes across multiple instances where the
company highlighted its inability to get price increase from its customers (OEMs) leading to a decline in
profit margins.
Profit before tax and exceptional items, as a percentage of sales, dropped by around 1.70% over
the previous year mainly, due to increase in material and conversion costs given to suppliers not
recouped, in full by the customers.
Although metal prices are softening, costlier imports due to weak rupee as well as increase in
power cost are pushing up the cost of production which is not adequately compensated by
customers.
The profit margins of the company are always at the discretion of the large automobile manufacturers. The
automobile manufacturers enjoy the benefits of multiple suppliers for each product creating intense
competition among the suppliers. In addition, OEMs have the option of importing components from
overseas suppliers from China or South East Asia etc.
ICRA rating guidelines for the auto component sector, Oct. 2020, page 3:
Competitive Intensity: Often, the OEMs have multiple vendors for same components,
which restrict the pricing power of component suppliers. Moreover, imported components,
particularly for bought-out components and child parts, could act as alternate sources of supplies
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for the OEM and limit pricing flexibility for suppliers. Organised players witness intense
competition from the unorganised segment and spurious parts in the replacement segment.
As a result, the company always finds it difficult to pass on the increase in production costs like cost of raw
material, wage etc. to the customers.
Likewise, prices of steel and products made of steel went up. To recoup the cost increases fully
from the customers is becoming increasingly difficult due to competitive pressures.
An investor may believe that the above competitive landscape of the industry may represent an old picture
of FY2010, which marked the end of a difficult business period for the company (FY2005-2009). However,
reading the later annual reports also indicates the similar business position of India Nippon Electricals Ltd
where it finds it difficult to pass on the full extent of the increase in raw material costs to the customers due
to intense competition.
While on one hand the input costs are going up, the intensifying competition for the range of
products manufactured by the company on the other hand creates pressure on customer pricing.
These pose challenges to maintain the profitability, as customers may not fully offset the cost
escalations.
Auto ancillary companies face tough competition. This is because every OEM prefers to keep multiple
suppliers for each component. In addition, they face competition from imports from China and other South-
East Asian countries, many startups as well as the unorganized sector.
Risks and concerns: Protectionist measures adopted by few countries, global trade war and entry
of startups in providing efficient engineering solutions continue to haunt the industry.
Similarly, rising trend in raw material prices in steel, copper and petroleum products result
in increasing product costs. Minimum wages policy pushes the cost of operation up. It
poses challenge to maintain the profitability as customers may not fully offset the cost escalations.
Frequent changes in emission norms make the customer postpone their purchases and makes few
existing products obsolete.
As a result of such intense competition, the only way available for an auto ancillary player to gain a higher
market share is to reduce prices, which impacts its profit margins.
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The cost increases on account of costlier imports and other cost increases like diesel price
increases, power cost etc. have not been adequately compensated by customers. On the other hand
the competitive intensity of the market is forcing lower selling prices to gain new business.
And if a company wants to increase its profitability, then the only way available to it is to reduce its costs
because it cannot expect the OEMs to give it a higher price without the risk of losing business to other
competitors.
Your Company is focusing on development of newer range of products which offer customers good
value propositions, improving productivity and cost reduction in every possible area of
operation to protect the bottom line.
The credit rating agency, CRISIL, has also highlighted in its rating guidelines for auto ancillary companies
(April 2016, page 5) that OEMs know that auto component suppliers are dependent on them for business.
Therefore, there is hardly any pricing power left for auto component manufacturers. As a result, the only
way to improve profitability, at times, is to control the costs.
The fortunes of auto component suppliers are linked to those of the auto OEM industry.
This constrains the supplier’s bargaining and pricing power. The key to improving profitability,
is, therefore, cost (especially raw material cost) control.
Therefore, an investor would appreciate that the auto ancillary companies operate in a very tough business
environment where they do not have pricing power over their customers, which are much larger automobile
OEMs. Simultaneously, they do not have pricing power over their suppliers who are also very large metal
producers (steel, aluminium, copper etc.).
As a result, auto ancillary companies face a challenge to maintain their profit margins and in turn, face
cyclicity in their business performance where periods of poor performance follow periods of good
performance.
2.2) Impact of low bargaining power of auto ancillary companies on the working
capital:
While analysing auto ancillary companies an investor realizes that apart from the profit margins, the low
bargaining power of auto ancillary companies impacts many other aspects of their business as well. For
example, auto component manufacturers find it very difficult to manage their working capital especially
the inventory position.
OEMs prefer to maintain an asset-light business model. One of the approaches that OEM follow to stay
asset-light is the “just-in-time” approach. Under this approach, OEMs ask the auto ancillary company to
deliver its products just before it is about to be used by the OEM. Such an arrangement ensures that OEM
keeps only very minimal inventory with itself (sometimes only for one shift of operations) whereas the auto
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ancillary company has to keep a lot of inventory to ensure that it is able to deliver the goods to OEM
whenever demanded. Any failure by an auto ancillary company to deliver goods “just-in-time” may involve
loss of market share as well as financial penalties.
Minda Industries Ltd, a leading Indian auto component manufacturer producing switches, horns, lighting,
alloy wheels and other auto ancillary products, highlighted this aspect of the business of auto ancillary
players in its prospectus for QIP in March 2017, page 39:
We typically commit to order raw materials and sub-assembly components from our suppliers
based on our customer recommendations, forecasts and orders. Cancellation by customers or any
delay or reduction in their orders can result in a mismatch between the inventory of pre-
constructed components, raw materials and the manufactured product that we hold. This could
also result in excess inventory and increased working capital.
In addition to the working capital intensive business model due to the “just-in-time” approach of OEMs,
the auto ancillary companies also have to enter one-sided agreements favouring the OEMs while doing their
production planning.
The almost complete dependence of auto component manufacturers on the OEMs for business exposes
them to many risks with respect to inventory management as the OEMs can order less than contracted
quantity leaving the auto component manufacturer with excess inventory. Moreover, due to their higher
bargaining power, usually, OEMs do not face any financial penalty for ordering a lesser quantity of
products.
QIP prospectus of Minda Industries Ltd, March 2017, page 39:
In most instances, our OEM customers agree to purchase their requirements for specific products
but are not mandatorily required to purchase any minimum quantity of products from us. Further,
such conditions provide flexibility to our customers to place order for a lesser quantity of products
in the purchase orders in spite of a higher number being specified in the contract.
An investor should note that the presence of a high amount of inventory with the auto ancillary company is
a problem as it may increase the costs for the company.
ICRA rating methodology for auto component companies, Oct. 2020, page 7:
High levels of receivables and inventory may be reflective of poor quality earnings, which may
require write-offs in the future. A high inventory level increases the holding cost and working
capital requirements while inadequate inventory might lead to a market share loss.
Therefore, an investor would appreciate that the lack of bargaining power of auto ancillary companies puts
them in a very tough business position both with respect to profit margins as well as inventory planning.
Nevertheless, even in the challenging business environment, auto ancillary companies compete with each
other to become a preferred partner for the OEMs. Each of the companies attempts to become a dependable
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partner for the OEMs where they aim to get deep integration in OEMs’ operations, new product
development etc. The auto ancillary companies do this to make the OEM dependent on them. This, in turn,
provides them preferred treatment in the form of reasonable price increases and also makes it tough for the
OEMs to switch any of business away from them.
Let us now see what steps auto ancillary companies take to become a dependable supplier to OEMs who
get preferred treatment.
3) Grow big. OEMs prefer large suppliers. In auto ancillary sector, big becomes
bigger:
While reading about the factors influencing the business of auto component manufacturers, an investor
notices that increasingly the OEMs are trying to reduce the number of suppliers they deal with i.e. the
OEMs are consolidating their supplier base. OEMs prefer to deal with a few suppliers who can give them
a lot of products rather than negotiating with many suppliers who give them one product each.
As a result, large suppliers get better bargaining power over OEMs and in turn, they also better purchasing
power over their suppliers.
The following observations by the credit rating agency ICRA in its rating guidelines for auto component
manufacturers (August 2018) would help an investor in this regard.
To improve operational efficiencies and strengthen the overall supply chain network, OEMs are
increasingly focusing on consolidation of their vendor base. Consequently, a supplier of multiple
products could benefit as it will be easier for an OEM to manage a single vendor with multiple
product offerings rather than negotiate with several small vendors with single products.
Large scale of operations generally reflects greater market penetration, improved bargaining
power and higher purchasing efficiencies,
The size of an auto component manufacturer is crucial as larger suppliers typically

receive preferential treatment from OEMs, which generally results in a relatively superior wallet
share with OEMs as compared to their smaller peers.
The credit rating agency, CRISIL has also highlighted in its rating methodology for auto component
suppliers, April 2016, page 4 that the OEMs are trying to reduce the number of suppliers they source from.
Auto OEMs have significantly pruned the number of component suppliers they source from, in line
with the global trends. Tier-I suppliers, on account of their direct interface with OEMs and larger
number of value-added offerings, have better bargaining power and operating margins than other
suppliers do.
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Another credit rating agency, CARE, has also highlighted that large auto ancillary companies that supply
directly to OEMs (i.e. tier I suppliers) get a higher bargaining power over OEMs as compared to smaller
players or tier II (supply to tier I) and tier III suppliers (supply to tier II). Large suppliers have a strong
relationship with OEMs and enjoy better profitability than the smaller suppliers.
entities with large scale of operations reflecting greater market share, higher bargaining and
purchasing power. A strong market position is a reflection of strength of its relationship with
OEMs and a key driver of operational flexibility. CARE Ratings also analyses whether the
company falls into Tier I auto component manufacturer or Tier II or III auto component
manufacturer.
On account of direct relationship with OEMs and higher degree of inter-dependence for supply of
components in addition to being engaged at product development stage, Tier I companies enjoy
higher profitability and are considered superior over Tier II and III companies.
3.1) Real-life example of auto ancillary companies benefiting from large size:
The auto ancillary company, Minda Industries Ltd, a leading Indian auto component manufacturer
producing switches, horns, lighting, alloy wheels and other auto ancillary products, provides a good
example of this case. The company has 62 plants located around the world.
When an investor analyses the financial performance of Minda Industries Ltd over the last decade, then she
notices that during FY2011-FY2014, the OPM of the company declined from 9% to 5%. However, after
FY2015, the OPM of the company has increased significantly from 5% to 11%.
While analysing the business performance of Minda Industries Ltd, an investor would notice that during
the last decade, the company has increased the size of its business by multiple aspects. The company did
capacity expansions in its existing line of businesses like switches. In addition, it increased the size of its
offering to the OEMs by acquiring the horn and lighting business of European companies, and starting new
lines of businesses like alloy wheels and fuel caps etc.
Currently, Minda Industries Ltd is the largest supplier of switches and horns and the third-largest supplier
of lighting in India.
ICRA credit rating report of Minda Industries Ltd, October 2018, page 1:
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In the domestic automotive market, the company is positioned as the largest player in
switches (both in passenger vehicles or PV and two wheelers or 2W) and horns in terms of market
presence and in PV alloy wheels in terms of installed capacity, and the third largest player in
lighting products.
The company had continuously kept on investing in making one manufacturing plant after another as well
as expanding its existing plants to increase its size of operations so that it could become a reliable partner
for the OEMs. The following information will help an investor to understand the continuous project
execution work done by Minda Industries Ltd.
 In FY2010, the company completed a lighting project at Chakan, Pune (FY2010 annual report,
page 30).
 In FY2013, the company completed a switches plant in Hosur, TN and a fuel caps plant in Manesar,
Haryana (FY2013 annual report, page 16).
 In FY2015, the company expanded the capacity of the lighting division at Manesar, Haryana
(FY2015 annual report, page 25).
 In FY2016, the company completed alloy wheel and rubber hoses plants at Bawal Haryana
(FY2016 annual report, page 4).
 In FY2018, the company under JV Minda Kosei started production at another alloy-wheel plant in
Gujarat (FY2018 annual report, page 91).
 In FY2021, the company completed the sensors plant (June 2020 presentation by the company,
page 7) and 2-wheeler alloy wheels plant completed (August 2020, Q1-FY21 press release).
The presence of plants in multiple auto clusters of India like Gurgaon (Haryana), Pune (Maharashtra), Hosur
(Tamil Nadu) and Gujarat enables the company to supply to multiple OEMs quickly with a lower lead time
i.e. fulfil the requirements of OEMs to send the products just-in-time with a minimal idle inventory.
The credit rating agency, ICRA has highlighted the benefits of having multiple plants in the auto-clusters
near OEMs in its rating guidelines for the sector, Oct. 2020, page 5, like competitive advantages, flexibility,
just in time supplies etc.:
location diversification of manufacturing units, closer to the OEMs’ manufacturing units,

results in lower overhead logistics and reduced lead time for supplies which can lend a competitive
edge. Multiple manufacturing units also provide the flexibility to shift production to another
manufacturing unit in case of disruption in one unit (could be due to a labour strike or any other
force majeure event). This is important in cases where an auto component manufacturer is a just-
in-time supplier to an OEM and any delays in supplies could lead to production line stoppages.
Many times, an investor would notice that auto ancillary companies have to chase the OEMs whenever the
OEMs decide to open a new plant whether it is at another location within India or in a foreign country. The
auto ancillary companies have to put up a plant at the new location whenever the OEM decides to do so.
Moreover, at times, when the OEMs change their plans at a later stage, then the auto ancillary companies
end up with unused investments at the new location.
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3.2) Decisions of chasing the OEMs’ manufacturing plants gone wrong for auto
ancillary companies:
An investor may look at the example of an auto ancillary company, India Nippon Electricals Ltd, which
had to buy land in Indonesia as well as Uttarakhand when its OEM customers decide to put up their plants
in these locations. However, later on, the plans of the OEMs did not work out and India Nippon Electricals
Ltd was stuck with unused land at these locations.
The company had to create a subsidiary in Indonesia when its largest customer, TVS Motors, started its
production facility in Indonesia. However, the production volumes of TVS in Indonesia did not reach
sufficient numbers. As a result, India Nippon Electricals Ltd did not start to create any plant in Indonesia
and instead, it supplied products to TVS Indonesia from its Indian manufacturing units. Currently, the
company only has the land parcel in Indonesia that it had purchased to create the plant there.
Your company acquired land in Indonesia through its subsidiary company, PT Automotive Systems
Indonesia, with a view to establish manufacturing operations to support TVS Motors. However, as
the volumes have not reached our expectations, we cannot proceed with the same.
The investment by the company in Indonesia did not yield any results, as TVS Indonesia does not have the
required production volumes. Moreover, local automobile manufacturers have their own supplier networks.
As a result, India Nippon Electricals Ltd has decided to liquidate the subsidiary company.
However, as mentioned in the previous report, the manufacturers of two wheelers in that country
have their own sources for the products in the subsidiary’s range of manufacture and it has been
decided to take necessary steps to liquidate the subsidiary.
On similar lines, India Nippon Electricals Ltd purchased land in Uttarakhand in the last decade when one
of its customers planned to open up a manufacturing plant there. However, in FY2010, the company
intimated its shareholders that it had to defer the plans to start manufacturing in Uttarakhand due to a change
in the customer’s plans.
Your Company has deferred commencement of manufacturing at Uttarakhand due to changes in

the customers’ plans. Manufacturing will commence at an appropriate time depending on volumes.
Meanwhile, your Company is meeting customers’ requirements from its unit at Rewari.
Therefore, an investor would notice that many times, auto ancillary companies have to make investments
in locations where later on they might not manufacture products because either the OEM customers change
their plans or the customers could not do well.
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Coming back to the example of Minda Industries Ltd, an investor would notice that to grow bigger, it is on
a continuous lookout to increase the range of products that it can supply to OEMs. In its quest to widen its
product basket, it announced the acquisition of Harita Seating in February 2019, which is still under process.
If successful, the acquisition would further add scale to the business operations of Minda Industries Ltd.
The Board of Directors of your Company had its meeting held on 14 February 2019,
approved acquisition of Harita Seating Systems Limited (“Harita”), by way of composite scheme
of amalgamation, which is the leading manufacturer of seating systems in India
The increasing size of the business of Minda Industries Ltd has acted as an important factor where it could
get preferential treatment from its customers (OEMs) in terms of additional business leading to an even
larger scale of operations and better pricing power. This is another factor leading to the increased profit
margins of the company during FY2014-FY2019.
An investor would appreciate that a large auto component manufacturer benefits from economies of scale.
They can purchase from their suppliers at cheaper prices and can produce goods more cost-effectively in
their plants. As a result, they can offer their products at very competitive prices to OEMs. This, in turn,
makes things further difficult for new and small players to gain scale in the industry.
ICRA rating methodology for auto component companies, Oct. 2020, page 3:
Effectively, a large scale enables better cost absorption and greater ability to offer competitive
pricing to buyers. The size of an auto component manufacturer is crucial as larger suppliers
typically receive preference from the OEMs during source selection, which generally results in a
relatively superior wallet share with them compared to their smaller peers.
The credit rating agency, CRISIL has also highlighted the benefit of big size/market share for auto ancillary
companies in its rating guidelines (April 2016):
A strong market share generally translates into larger business volumes, thus helping
players benefit from economies of scale (through a better coverage of overheads) and thus,
to compete better on prices.
As a result, an investor would notice that in the case of auto ancillary companies, it is the big who have a
higher chance of getting bigger in future.
Let us see what are the other factors that help auto ancillary players get preferential treatment from OEMs.
4) Technology, Research and Development:

In the auto ancillary businesses, the products vary from simple products like sheet metal parts to
technologically complex and critical products like engine/drive transmission system and fuel systems. The
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companies producing technological complex products are more important for the OEMs and in turn, get
preferential treatment.
While reading about the dynamics affecting the business of auto component manufacturers, an investor gets
to know that, the players who manufacture technologically advanced products benefit in many ways. These
companies get better attention from OEMs in terms of intensive coordination on product development,
preferential treatment in orders, better pricing terms etc.
Credit rating agencies ICRA and CARE have highlighted the technological superiority of the products as
one of the key features for any auto component manufacturer.
ICRA rating guidelines for auto component manufacturers, Oct. 2020:
Auto component manufacturers producing technology-intensive products where competitive

pressures are benign are relatively better placed for passing on raw material price increases to
customers compared to players with the presence in relatively lower value-added components.
Suppliers that have proprietary knowledge, tend to enjoy superior profitability metrics, relative to
those that cater to customer-provided designs.
CARE rating guidelines for auto component manufacturers, July 2020:
The more critical, complex and technology-intensive the product is, higher is the extent of
coordination called for between the auto ancillary and the OEM, and higher is the pricing
power enjoyed by the ancillary.
The credit rating agency, CARE as well as CRISIL, also highlighted many other aspects of auto ancillary
companies producing technologically advanced products. Technology acts as an entry barrier for new
companies. Technology also lowers the substitution risk. Technologically complex products also enjoy
higher profit margins.
companies manufacturing technologically-intensive products face lesser substitution risk as

the technology acts as an entry barrier. Thus, companies with a strong in-house R&D team or
access to new technology or foreign technical collaborators / parent and producing products in
the higher end of the value chain are viewed favorably.
CRISIL rating guidelines for auto ancillary companies (April 2016):
Product complexity also limits the risk of price erosion and discourages new entrants, thus
strengthening the supplier’s market position.
Moreover, OEMs realize that the auto ancillary companies producing technologically complex and critical
products are essential for uninterrupted operations of the OEM plants. Therefore, they strengthen the
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relationship with such auto ancillary companies by taking an equity stake in them, investing money in their
manufacturing plants or giving them favourable credit terms etc. All these steps make it difficult for the
OEM to switch to other auto ancillary companies.
ICRA rating guidelines for auto component manufacturers, Oct. 2020 (page 5):
There are instances where the OEMs enjoy a strong relationship or have high dependency for
supplies of critical components. They may have an equity stake in the suppliers in certain cases.
In certain cases, the OEMs have also made sizeable investments in tooling and other
processes along with vendors, resulting in high switchover cost for the OEMs and consequently
stable wallet share for vendors.
Therefore, an investor would appreciate that those auto ancillary companies that spend money on R&D and
attempt to improve the technology of their products get better pricing for their products and favourable
treatment from the OEMs and in turn enjoy improving, higher margins.
4.1) Real-life example of auto ancillary companies benefiting from technology and
R&D spending:
An investor may again look at the example of Minda Industries Ltd, which continuously increased its
spending on research and development over the last 10 years.
The expenditure on R&D in the standalone entity increased from ₹15 cr in FY2011 to ₹91 cr in FY2019.
In the last 10 years (FY2011-2020), the company spent a total of ₹491 cr on R&D, which is about 2.9% of
its standalone revenue.
The company also entered into many technological tie-ups for technological improvement of its products
like lightings (AMS, Korea), horns (FIAMM, Italy), fuel caps (Toyoda Gosei), alloy wheels (Kosei, Japan),
high-end sensors (Sensata, USA), speakers (Onkyo, Japan), printed circuit boards (Katolec, Japan) etc.
Additionally, Minda Industries Ltd acquired many companies to get access to the superior technology of
these companies like horns (Clarton, Spain), lighting (Rinder group of Spain and Delvis), ECUs and
controllers (iSYS RTS), Telematics AIS 40 technology (from KPIT Engineering) etc.
While analysing the business of Minda Industries Ltd, an investor comes across many instances where the
preferential treatment of the company by OEM customers becomes evident. At times, the company has
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received minimum offtake commitment for its products from OEMs and at other times, the OEMs gave it
confirmed orders even before its manufacturing plant became operational.
In 2017, when the company increased the capacity of its alloy wheel plant at Bawal, Haryana, then it had
confirmed orders from its largest customers, Maruti Suzuki India Ltd (MSIL).
ICRA credit rating report of Minda Industries Ltd, September 2017, page 4:
many of the newly incorporated companies like Minda Kosei scaled-up on the back of confirmed
off-take from its customers
Minda Kosei is exposed to business risks, though mitigated to some extent by the confirmed
business orders from MSIL.
Later on, in 2019, when the company was setting up another alloy wheel plant for 2-wheelers, then it had a
confirmed order from another 2-wheeler OEM.
ICRA credit rating report of Minda Industries Ltd, September 2019, page 4:
Though the investment in setting up the alloy wheels facility is sizeable, the business risk is
mitigated partially by a confirmed order from a leading 2W OEM.
An investor would appreciate that confirmed orders even before the plant is
operational indicate the special treatment large players like Minda Industries Ltd get from
OEMs. Such confirmed orders help the companies to do better production planning leading to the
best utilization of resources and thereby better profit margins.
4.2) Loss of revenue if auto ancillary companies do not upgrade technology:

Moreover, an investor also needs to keep in mind that a strong focus on technological development is
required by auto component manufacturers to maintain their competence as well as profitability. This is
because; the OEMs include periodic price reduction clauses in their contracts with auto component
manufacturers.
ICRA credit rating guidelines for auto component manufacturers, August 2018, page 5:
Further, since most OEMs stipulate periodic price reduction through the life of their supply
contracts, auto component manufacturers must continuously work at improving operational
efficiencies and undertaking ‘value analysis and value engineering’ projects to optimise product
costs.
Therefore, if an auto component manufacturer does not continuously upgrade its technology on time, then
it will miss the high profit-margin new contracts from OEMs and the supplies on the existing contracts
would become less profitable as those vehicles models become old.
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As a result, auto ancillary companies are under continuous pressure to improve their technologies.
An investor would appreciate that technological developments are expensive investments and may require
significant spending in the form of research & development (R&D) spending. Every auto component
manufacturer may not afford a high R&D budget or the long-time it may take to develop a product.
Therefore, many times, auto ancillary companies do technical tie-ups with global players, which already
have the technology.
5) Technical tie-ups with global players and acquisitions:

An investor would appreciate that in the automobile field, the technology in the vehicles advances at a very
fast pace. Many times, global innovator companies bring in new advancements, which are highly value-
adding for the customer comfort that all the OEMs demand their suppliers to upgrade their products.
At times, the govt. forces OEMs to upgrade the technology of their products by regulatory changes e.g.
Indian govt. forced all the automobile manufacturers to meet BS-VI norms directly by upgrading from BS-
IV norms. As a result, the automobile industry had to take a big jump in technological advancement as it
had to skip BS-V norms altogether.
At such times, if any auto ancillary company is not able to upgrade its products to meet the required
advancements like meeting BS-VI norms, then it faces the risk of losing a significant amount of business.
An investor may look at the example of an auto ancillary company, Gandhi Special Tubes Ltd, a
manufacturer of welded and seamless steel tubes, cold-formed tube nuts and fuel injection tube assemblies
for automobile and other industries.
While analysing Gandhi Special Tubes Ltd, an investor notices that one of the components made by the
company, the fuel injection tube, is a critical component of the engine of the vehicle. Therefore, the
company must upgrade it to meet the new norms, if it plans to retain its market share.
However, an investor notices that the company does not have the required technology to make parts meeting
the new technological requirements.
Threats: Tightening of emission norms could see change in technology and could impact demand
for Company’s one line of products i.e. fuel injection tubes only .With the introduction of BS IV
standards from 1st April, 2017, there is a major change in specifications for high pressure fuel
injection tubes which is one of the applications for which company’s products are
used. Technology to manufacture CRDI TUBES is currently not with the Company.
On the contrary, companies, which have already developed the technology to upgrade their products as per
new requirements feel much more confident about maintaining their market share.
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An investor may look at the example of another auto ancillary company, Sharda Motor Industries Ltd,
which could develop BS-VI compatible versions of its products by research and development. The company
would be able to sell these products to OEMs at a higher price and earn good profits.
Credit rating report of Sharda Motor Industries Ltd by CRISIL, February 2017:
Continued focus on R&D, process automation, and value engineering: Substantial investment
in research and development (R&D) infrastructure has enabled the company to achieve significant
improvement in the production process, and launch products that match the stricter emission
norms of Bharat Stage-VI. This has led to improved operating efficiency and various OEMs have
placed orders for exhaust systems for new launches, scheduled over the next 12-18 months. These
high value-added products will be sold at a significant premium over the existing ones.
Therefore, an investor would appreciate that keeping up the technology of the products is essential for auto
component manufacturers. However, most of the Indian auto ancillary companies are not able to spend a
large amount on R&D.
As per credit rating agency, CRISIL, Indian auto component manufacturers spend less than 1% of their
revenue on R&D whereas auto component manufacturers in the developed countries spend 8% – 10% of
their revenue on R&D. Therefore, many times, when the companies are not able to develop the technology
in-house, then they plan to tie-up with global players in order to get access to the new technology.
The credit rating agency, ICRA, highlighted the benefit of such tie-ups with global companies for Indian
auto ancillary companies in its rating guidelines (Oct. 2020, page 4):
Research & development (R&D) expenses in the Indian auto component industry remain low (<1%
of revenues) compared to the developed markets, where some of the larger players invest ~8–10%
of their revenues in R&D. In India, several auto component manufacturers have entered
into technical collaborations with international Tier I manufacturers for the transfer of technical
knowledge; or have formed equity partnerships with foreign players to meet the OEMs’ technical
requirements.
At times, the steps to gain technology by a tie-up with global players also help the companies gain additional
business. This is because, global OEMs, which have their manufacturing plants in India look favourably at
those Indian auto ancillary companies, which have tie-ups with global auto ancillary companies that supply
to the global plants to these OEMs.
The credit rating agency, CRISIL has also highlighted the benefit of such tie-ups with global companies for
Indian auto ancillary companies in its rating guidelines (April 2016, page 5):
Technology partners have greatly influenced OEM decisions in finalising auto component
vendors, especially when the former are suppliers to the concerned OEMs’ international
operations, making validation easier.
ICRA, rating guidelines for auto ancillary companies (Oct. 2020, page 4):
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The presence of a strong technology partner not only mitigates technology obsolescence risk to an
extent, but in some cases also provides additional business opportunities to domestic
establishments of the partner’s global customers.
5.1) Real-life example of auto ancillary companies focusing on technological tie-

ups:
From the discussion on Minda Industries Ltd, an investor would remember that the company tied up with
numerous other players to gain access to the required technology and strengthen its position in the Indian
auto ancillary sector.
The company entered into many technological tie-ups for technological improvement of its products like
lightings (AMS, Korea), horns (FIAMM, Italy), fuel caps (Toyoda Gosei), alloy wheels (Kosei, Japan),
high-end sensors (Sensata, USA), speakers (Onkyo, Japan), printed circuit boards (Katolec, Japan) etc.
However, an investor would appreciate that in such technological tie-ups, the foreign partners usually share
their existing technologies with Indian auto ancillary companies. Such tie-ups do not force the global
partner to develop technologies as per the need of Indian companies. Therefore, at times, Indian auto
ancillary companies find that the tie-ups are not fulfilling their needs.
In such a situation, many times, the Indian auto ancillary companies have to resort to outright acquisitions
of foreign companies with the required technology.
Minda Industries Ltd faced such a situation when one of its technological partner from South Korea did
not perform as per expectations and the company had to look for other places to gain the required
technology. It found a company in Europe, which met its requirements. As a result, it acquired the European
company (Delvis) to improve its in-house design and development capabilities.
October 2019 conference call on the acquisition of Delvis, page 7:
Sunil Bohra: …there has been dependency in terms of specifically LED lamps on one of our TLA
partner and to be very honest we wanted them to do lot more, but obviously it was since they are
not a partner or a JV partner you cannot force them right, so information development use to
happen but then we could do much more and we could sense that opportunity, which you could
not capitalize and I think with this acquisition and technology in-house we should be able to
capitalize on the technology and we should see a faster growth in our lighting business.
The result of all these efforts to improve the technical aspect of its products seems to have led to Minda
Industries Ltd becoming an important supplier for the OEMs. Therefore, it seems that the company could
get frequent price increases from the OEMs whenever raw material costs increased and as a result, it could
improve its profit margins over the years.
While analysing the acquisitions by Indian auto ancillary companies, an investor would appreciate that over
the years, apart from access to the technology, companies have benefited by getting new products,
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customers and markets. In fact, as per credit rating agency, ICRA, acquisitions are a common way of growth
by Indian auto ancillary companies.
Besides capacity expansion, acquisitions have been a common strategy for growth pursued by
large Indian auto component manufacturers. Acquisitions typically help expand product lines and
provide access to new markets/segments/customers. Acquisitions by Indian auto component
manufacturers in the past were primarily in Europe and North America, aimed at technology and
marquee customer acquisition.
5.2) Acquisition led growth strategy by auto ancillary companies: Challenges for
investors:
One of the side-effects of the acquisition led growth strategy is that many auto ancillary companies end up
having a very complex corporate structure with numerous subsidiary, associates and joint ventures.
If an investor looks at the auto ancillary company, Minda Industries Ltd, then she would notice that the
company has 42 subsidiaries, associates and joint ventures. The presence of so many entities in the corporate
structure presents a few challenges for the investors.
The biggest challenge of a complex corporate structure is that the investors are not able to assess the
performance of the group as a whole. In many such instances, even the consolidated financials are not able
to capture the overall group position leaving the analysis of investors incomplete.
In the case of Minda Industries Ltd, the consolidated financials for FY2020 show revenue of ₹5,465 cr.
However, in the FY2020 annual report, on page 10, the company has declared that the total turnover of
UNO Minda group is ₹7,200 cr.
In the case of complex corporate structures, another aspect that complicates an investor or analyst’s job is
that the management uses a lot of discretion in determining what should be included in consolidated
financials and what should be excluded. An investor would appreciate that most of the times; the
management would tend to exclude loss-making companies from consolidation to present a better financial
position to the investors.
In the case of Minda Industries Ltd, in the FY2012 annual report, the auditor highlighted that in the previous
years, the management did not consolidate some JVs and associate companies in its financials. Had the
company consolidated those companies, then its reported profit would have been lower.
Without qualifying our report, attention is drawn to note 50 of the Consolidated Financial
Statements that during the previous periods, the management had not consolidated certain joint
ventures and associates as part of their consolidated financial statements. Accordingly, during the
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current year, management has adjusted the effect of the same with the current year profits in
accordance with Accounting Standard – 5 ‘Net Profit or Loss for the Period, Prior Period Items
and Changes in Accounting Policies’. Had these joint ventures and associates been consolidated in
the previous periods, the profit for the current year would have been lower by Rs. 340.20 lacs.
Therefore, an investor would appreciate that in the case of companies with a complex corporate structure,
it is always a possibility that the consolidated financial statements presented to the investor may not
represent the complete financial position of the company. If this is the case, then the analysis done by the
investor or the investment decisions taken by the investor may be erroneous.
In the case of companies that have a large number of subsidiaries, JVs and associates, investors face a
problem that many times, there are investments done by the company in different entities that are present
in the tables in the notes to financial statements; however, there is no explanation about them in the
directors’ report or management discussion & analysis section. As a result, the investor is not able to judge
the purpose of the investment done by the company in those entities. In such instances, the assessment of
the investment decisions by the investor becomes mere guesswork.
Therefore, the strategy of auto ancillary companies to grow by making acquisitions and creating numerous
subsidiaries, associates and joint ventures in the process, complicates the analysis process for the investors.
An investor would notice that in order to expand their business and also to protect themselves from the
cyclical and tough business environment while supplying to OEMs, many auto ancillary companies take
steps for business diversification.
Diversification by auto ancillary companies:

Companies attempt to diversify in terms of more clients in order to protect their business from risks and
gain bargaining power.
CRISIL rating guidelines for auto ancillary companies (April 2016, page 3):
Diversity in clientele also strengthens bargaining power in negotiating supply contracts
However, many times, the diversification attempts do not provide desired protection because the Indian
automobile market has a few large players dominating each segment like 2,3,4 wheelers and commercial
vehicles.
However, each individual segment of the Indian automobile industry is currently an oligopoly with
a few OEMs accounting for a major share of the market. Hence, auto component manufacturers
can achieve meaningful client diversity, largely by catering to multiple segments of the industry
or by having significant exports.
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Therefore, the auto ancillary companies have to diversify across different product segment like 2, 3 & 4-
wheelers, different geographies like exports, revenue segments like the aftermarket/replacement market.
Even in the case of exports, Indian auto component manufacturers primarily target the replacement market
because it becomes very difficult for them to get a breakthrough into OEMs or tier-I suppliers of OEMs
because global companies change their suppliers very infrequently.
Indian auto component exports are often targeted at the overseas replacement market, which is
relatively diversified and stable compared to exports to the global OEMs or their Tier I suppliers.
However, auto component manufacturers are often dependent on a few customers when the exports
are to the Tier I/ OEM segment because of infrequent supplier additions/switches by the global
OEMs
As a result, many auto ancillary companies attempt to build their presence in the aftermarket segment i.e.
replacement market whether in India or overseas.
However, while analysing different auto ancillary companies, an investor notices that the aftermarket
segment is highly challenging and not all the companies are able to achieve success in the replacement
market.
6) Aftermarket or replacement market is not as easy as it seems:

While reading about the factors that strengthen the business model of an auto ancillary company, an investor
notices that the aftermarket/replacement segment provides a much better opportunity to the companies.
The aftermarket segment has better profit margins. This is because when raw material prices come down,
then unlike supplies to the OEM segment, in the case of the aftermarket segment, the auto ancillary
companies can retain some of the benefits to themselves. Whereas in the case of OEMs, the purchase
managers of the OEMs squeeze out all the benefit of reduction in raw material prices from the auto ancillary
companies.
The aftermarket (AM) segment is also more profitable, for it is less exposed to pricing
pressure than is the case with supplying to the OEMs.
Strong aftermarket presence benefits auto component manufacturers during volatile commodity
prices and cushions profitability during a declining commodity price scenario, as some benefits
from raw material price decline can be retained.
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The demand for products is less cyclical in the aftermarket segment than the OEMs where customers
postpone the purchase of new vehicle during the economic downturn. In the aftermarket, people have to
take care of the wear and tear of their existing vehicles.
During an economic slowdown, an auto component manufacturer with a strong presence in

the aftermarket can withstand pressure on the top-line and profitability much better than those
supplying predominantly to OEMs.
Replacement market sales command higher margins and at the same time provide revenue
stability as it is not correlated to the performance of the OEMs and production of vehicles, which
can be volatile.
In addition, for some products, the aftermarket segment is even larger than the OEM segment.
In certain components like automotive batteries and tyres, replacement demand is larger than the
OEM market size.
Looking at the benefits of a strong presence in the aftermarket/replacement segment, quite a few auto
ancillary companies start to make investments for the distribution channel, sales & marketing teams
anticipating that these higher expenses may be compensated by the higher profit margins in the aftermarket
segment.
In terms of margins, the replacement segment is the highest, followed by exports.…To establish a
strong replacement footprint, auto component manufacturers will require investments for setting
up a distribution network and incur sales and marketing expenses, which may be compensated by
relatively superior contribution margins, earned from replacement sales as compared to sales to
the OEMs.
However, to be successful in the aftermarket segment, the investments required to create the large
distribution channel and additional sales and marketing teams are substantial. Many times, these
investments may not be economically viable considering that the margins in the aftermarket segment may
not be high enough to recover additional investments. This is because, the aftermarket segment has very
intense competition from the unorganized sector, imports as well as spurious/duplicate products. Moreover,
most of the purchasers in the aftermarket are very price-conscious and may not choose to pay a premium
for the branded products from organized players.
CARE rating guidelines for auto component manufacturers, July 2020, page 3:
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However, a large distribution network is required to cater to the replacement market, so the costs
incurred may not be justifiable at times, as the buyers in this segment are extremely price
sensitive and may not be brand conscious.
Besides creating a significant presence in the aftermarket takes a large amount of management bandwidth
as well as resources. Therefore, an investor may come across companies that could not establish a
significant aftermarket presence despite making it a priority even for 10-years.
6.1) Real-life example of an auto ancillary company unable to achieve desired scale
even in 10-years:
An investor may look at the example of Jamna Auto Industries Ltd, which produces springs/suspension
parts for commercial vehicles. The company started to highlight its focus on the aftermarket segment in
FY2009.
The company decided to increase its share in the domestic and export replacement markets. We
are happy to inform that we have increased our share in the domestic replacement market.
In FY2012, the company again emphasized that growth in the aftermarket segment is essential for the future
growth strategy of the company.
An aggressive ramping up of sales in the After-Markets – India/Export and a higher proportion of

Parabolic sales is crucial to our growth strategy.
However, even more than 10-years after declaring its focus on the after-market segment, even in FY2020,
the company has not yet achieved a meaningful scale in the aftermarket segment.
Credit rating report of Jamna Auto Industries Ltd by ICRA, March 2020, page 3:
Despite the management’s initiatives to develop a widespread network for the after-market
segment, its ability to scale up its after-market supplies to a level that can offset any sharp decline
in CV OEM volumes in case of any downturn, is yet to be demonstrated.
Therefore, investors should appreciate that even though the aftermarket segment looks like a solution to
many problems faced by auto ancillary companies in the OEM segment. However, establishing a presence
in the aftermarket segment is not an easy task. Companies like Jamna Auto Industries Ltd despite being the
largest producer of suspension springs in India, could not build the desired scale in the aftermarket segment
even in 10-years.
6.2) Challenges of aftermarket business in the auto ancillary industry:

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Apart from the difficulty to create the distribution channel, sales and marketing teams, the aftermarket
segment has other challenges as well like a higher working capital requirement, prolonged receivables, and
credit risk to recover the dues etc.
Component suppliers selling largely to the AM segment, on the other hand, have larger working
capital requirements, given the longer payment cycles involved.
On the contrary, auto component manufacturers which primarily deal with OEMs are better placed because
the OEMs make prompt payments when it is due.
Typically, component suppliers that are predominantly dependent on the OEMs for revenue have
lower working capital requirements. That is because the OEMs follow just-in-time practices in
procurement, and make prompt payments.
In addition, most of the OEMs are known to clear their dues to the supplier on time and do not default on
payments. As a result, at times, auto component suppliers have claimed that they have never suffered any
loss of receivables.
An investor may look at the example of India Nippon Electricals Ltd, a TVS group company,
manufacturing electrical ignition systems for automobiles (two-wheelers, three-wheelers), and gensets
(portable generators).
The company gets 98% of its revenue from large customers like TVS Motors (63%), Hero Motocorp (25%)
and Crompton Greaves (10%). In its annual report, the company highlighted that it had never lost any
money on receivables.
The Group’s receivables are predominantly from its related parties and large Original Equipment
Manufacturers. The Group has never experienced doubtful debts in earlier years, therefore, there
is no credit risk and thus no allowance for expected credit losses have been made.
Therefore, an investor would notice that even though many times, auto component companies communicate
to their investors that they plan to make a big business from the aftermarket segment, then the investor
should be aware that it is easier said than done.
Establishing a significant aftermarket business comes with many challenges like:
 Large investment to create a distribution channel

 Significant expense on marketing and advertising
 Intense competition with imports, unorganized players and spurious/duplicate/counterfeit products
 Highly price-sensitive buyers who are not brand-conscious
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 Large working capital requirements due to inventory stocking and delayed payment cycles
 Risk of non-recovery of trade receivables
In the light of the above discussion, an investor would notice that in the auto ancillary sector, a company
needs to have a very strong relationship with the OEMs in order to gain good business terms. For any auto
ancillary player, it might require large investments of money and management bandwidth in increasing
business size, technological upgradation, R&D, technical tie-ups, acquisitions etc. in order to become an
important partner for OEMs.
However, there is one segment of the auto ancillary industry, which automatically gets favourable treatment
from OEMs without as much hassle as other players.
This segment of the auto ancillary industry is the companies belonging to the OEM group, either their
subsidiaries or their promoter-group-companies, which supply products to the parent OEM. These
companies get favourable business terms, assured business, access to new technologies, newer markets,
distribution channel, aftermarket sales as well as help in sourcing raw material at the best prices from the
OEM.
CARE rating guidelines for auto component manufacturers, July 2020, page 1:
Companies belonging to groups with established presence in the industry either as OEMs or
ancillaries stand to gain because of the association. Strong parentage enables access to various
aspects like new markets, technology, personnel, distribution networks, raw material sourcing,
etc.
Therefore, the auto ancillary companies belonging to the OEMs or their promoter groups enjoy a lot of
benefits because of the promoter linkages.
However, for all other auto ancillary companies, it is a tough business to stay relevant in the intensely
competitive business characterised by low negotiating/pricing power, forever changing technology and
regulations requiring significant investment to upgrade to new standards.
An investor would appreciate that the auto ancillary companies end up investing a lot of capital in their
business in the form of multiple plants near OEM clusters, as large inventory holding for just-in-time
delivery to OEMs, and extended payment terms. This creates a situation where most of the auto ancillary
companies end up with a financial picture of low-profit margins, negative free cash flow (post-meeting
capital expenditure) and increasing debt.
When we analysed the financials of numerous auto ancillary companies as a part of our exercise to analyse
all (2,800+) companies with a market capitalization of more than ₹10 cr listed on Indian stock exchanges,
then we noticed that most of the auto ancillary companies presented the following financial picture.
 Most of the companies had an operating profit margin (OPM) in the range of 6-10%. In fact, 10%
seemed to be the upper limit that original equipment manufacturers (OEMs) seemed to have set for
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their vendors. OPM of most of the auto ancillary players used to peak at 10% and then again decline
in the cyclical pattern characteristic of the auto industry.
 In almost all the cases, the CFO for the last 10 years for auto ancillary players was significantly
higher than PAT. This was primarily due to high depreciation and interest on debt on their balance
sheet.
 In addition, almost in all the cases, the capital expenditure done by the auto ancillary players was
higher than their CFO, which led to a negative FCF. These players, in turn, had to raise more debt
to meet the capital expenditure requirements.
This was irrespective of the fact that the companies operated in such diverse segments like manufacturing
steering wheels, suspensions, die-casting, locking system, fabrication etc.
Therefore, in our assessment of numerous auto ancillary players, we noticed that most of them had
fluctuating OPM within the 7-10% range, negative FCF with capital expenditure funded by debt.
Though an investor would also find a few players that defy this trend with either higher OPM, low debt
etc.; however, we noticed that it was an exception rather than a norm.
With this, we have come to the end of this article in which, we have attempted to put together all our
learning from in-depth analysis of numerous auto ancillary companies listed on Indian stock markets.
Summary
To summarize, the business of almost all auto ancillary companies presents the following key features:
 In most cases, the business performance is cyclical. Periods of increasing sales and profit margins
are followed by periods of declining sales and profit margins.
 Almost all auto component manufacturers have very low/negligible bargaining and pricing power
with both, their customers (OEMs) and their suppliers (large metal producers). As a result, auto
component manufacturers face low fluctuating profit margins, high working capital (high inventory
and receivables), and even unused investments in land or plants.
 In auto ancillary business, usually, the big gets bigger. OEMs like to deal with large players who
can supply them with as many products as possible and as quickly as possible (just-in-time) in all
of their multiple plants in various auto-clusters. OEMs give favourable pricing and credit terms to
such players.
 Auto ancillary players have to continuously upgrade their technology to stay relevant in the
business and maintain their market share. The companies have to invest a lot of money in R&D or
technical tie-ups or acquisitions in order to gain access to newer technologies.
 However, despite all these efforts, auto ancillary companies face tough times with low profitability
and return on their assets. In order to earn higher profits and safeguard themselves from business
cycles, many auto ancillary companies look towards the aftermarket segment. However,
establishing a large presence in the aftermarket segment requires large investments, which many
times is not justified because the customers are price sensitive and indifferent to brands. Therefore,
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many times, companies have failed to create significant aftermarket business despite efforts of more
than 10-years.
Most of the auto ancillary companies analysed by us seem to face the above-mentioned business features.
We believe that keeping these learnings in mind while analysing any auto ancillary company would help
an investor in her own analysis of companies from this sector.
The above key learnings would help an investor to focus on key aspects of the business model to understand
how the company is performing with respect to auto ancillary companies in general. Therefore, she would
be able to identify whether the company, which she is analysing, is doing something different from the rest
of the sector or it is just following the well-trodden path being followed by numerous other auto ancillary
companies.
By following the above learnings, the investor would be able to make a better and insightful opinion about
any auto ancillary company.
Now it is your turn to let us know how you feel about this article. Let us know your feedback in the
comments below. Please also share whether, during your analysis of auto ancillary companies, you have
found any common feature across the industry. Please also share any other inputs that you feel may be
useful for all the readers and the author.
Regards,
Dr Vijay Malik
P.S.

Videos
Analysis Excel
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9) How to do Business Analysis of Paper Manufacturing Companies
The current chapter aims to highlight to an investor what she needs to analyse while assessing the strength
in the business model of paper manufacturing companies.
After reading this chapter, an investor would know the key parameters that differentiate one paper
manufacturer from another. Additionally, the investor would also get to know the key strengths and the
challenges of the paper manufacturing industry that any company has to face.
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Whenever an investor comes across any paper manufacturing company, then the first thing that she should
try to find out is what kind of raw material it uses to produce paper. This is because; the business dynamics,
challenges, strengths etc. for paper-manufacturing companies depend a lot on the kind of raw material they
use to produce paper.
Segments of paper manufacturing companies

Paper manufacturing companies mainly use three different kinds of raw material to produce paper:
1. Wood (also classified as the chemical pulp)

2. Recycled paper
3. Agricultural residue (Sugarcane bagasse, rice straw, wheat straw etc.)
The kind of plants required to produce paper, the investment requirements, the competitive strengths,
barriers to entry, financial needs etc. all differ a lot between the paper manufacturers using wood as raw
material and those who use recycled paper and agricultural residue as raw material.
The business challenges faced by the two primary segments of paper-manufacturers i.e. wood and non-
wood (recycled paper & agro-residue) are so different that both set of players have their separate industry
organizations:
 Indian Paper Manufacturers Association (IPMA) represents wood-based paper manufacturers

who are the largest of paper-manufacturers and
 Indian Agro & Recycled Paper Mills Association (IARPMA) represents the non-wood paper
manufacturers i.e. recycled paper and agro-residue based paper manufacturers.
Therefore, throughout this article, while analysing the dynamics of the paper industry, we would see how
paper manufacturers from each of these segments differ from each other.
Let us now attempt to understand the key business dynamics of the paper manufacturers.
Factors affecting the business of paper manufacturers
1) Shortage of raw material

All the paper manufacturers in India whether wood-based or non-wood based, face a shortage of raw
material to manufacture paper.
Wood-based paper manufacturers face a shortage of wood due to many reasons like:
 Environmental concerns on the cutting of natural forests for getting wood,

 Limit on the land that a company can own to grow trees for getting wood,
 The hesitation of farmers to opt for farm-forestry to produce wood because; it is a long-gestation
period process taking 3-5 years to get earnings.
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Rating Methodology for Paper Industry, ICRA, November 2015, page 3:
The domestic paper industry irrespective of the nature of raw material being used suffers
from significant fibre shortage. The wood based paper mills suffer from constraints via
government policy to restrict land holdings and the ability to source wood from captive plantation.
…constraints of longer cash-flow cycle in farm forestry as it can take upto 3~5 years before farmer
generates cash by undertaking farm-forestry.
Therefore, whenever the paper industry witnesses capacity addition by wood-based paper-manufactures,
then the shortage situation becomes acute and the prices of wood increase and the industry has to rely on
expensive imported wood, for example during 2009-2014.
Simultaneous capacity expansions during the last few years (2009-2014) lead to severe
competition among mills for wood procurement and consequently an increase in wood
prices leading to requirements for importing wood without a corresponding increase in product
realisation.
This shortage of raw material to manufacture paper is not limited to wood. Other manufacturers using
recycled paper as well as agro-residue also face raw material shortages.
In India, the collection of waste paper for recycling is low; therefore, the industry is not able to meet its
requirement from domestic sources. As a result, paper manufacturers have to import waste paper.
Similarly, due to low collection rate of waste paper, ~50% of the waste paper requirements are
imported by the industry.
Paper manufacturers using agro-residue face challenges because; the raw material is available in specific
seasons and in addition, it can be used for purposes like making ethanol from sugarcane bagasse for mixing
with petrol.
Also due to the alternate use of agri-residues as fuel and their seasonal availability, the ability to
source them at competitive prices also remains a challenge for the mills. As a result, the prices of
all the raw materials have consistently increased over time.
Therefore, an investor would notice that all the paper manufacturers whether wood-based or non-wood
based, have faced continuously increasing raw material costs.
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In light of a continued shortage of raw material for producing paper, the mills that can use multiple types
of raw material are in a better position than others that rely only on one form of raw material to produce
paper.
Rating Methodology for Paper Industry, CARE, November 2020, pages 3-4:
The companies who have the ability to use different raw materials and whose mills are located
closer to raw material sources are viewed favourably.
However, whenever a company shifts from wood-based paper production to non-wood based paper
production, then usually, the quality of products suffer.
Rating Methodology for Paper Industry, CRISL, February 2021, page 20:
However, a high usage of non-forest-based fibre resources limits production capabilities to

the lower end commodity grades of paper.
As a result, an investor would have to understand the trade-off faced by the paper producers when they
choose between using wood-based pulp and non-wood based pulp e.g. from recycled/waste paper and
agricultural residues.
2) No pricing power and intense competition due to low value-adding,

undifferentiated commodity products:
The products made by paper manufacturers are without any significant differentiation i.e. a customer can
easily switch from the products of one company to another without any impact on her business.
For example, a person can easily switch a notebook made from paper of one manufacturer with the notebook
made from the paper of a different manufacturer and she will not face any challenges in writing. Similarly,
a person can easily switch using the tissue papers made by different manufacturers without any problems.
The same is true for almost all the paper products like copier paper, newsprint, paperboard packaging boxes
etc.
Therefore, an investor would appreciate that when manufacturers in any industry made products, which are
undifferentiated and easily switchable, then the manufacturers lose their negotiating power with the
customers.
Rating guidelines for the paper industry by the credit rating agency, Rating and Investment Information,
Inc., Japan, a subsidiary of Nikkei Inc., page 5:
Because many pulp and paper products are by nature highly general, however, achieving
differentiation based on product quality is difficult. Consequently customer continuity and stability
are somewhat low on the whole.
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As a result, the paper manufacturers have very low pricing power over their customers and most of the time,
the players compete with each other based on lower prices to get business.
For example, while reading the order of the Competition Commission of India (CCI) against the non-wood
based paper-manufacturers dated November 17, 2021 (click here), an investor notices that for one of the
orders, Century Pulp and Paper, a division of Century Textiles and Industries Ltd quoted a very low price
below the market price. The company quoted a price of ₹39.80 per kg for a product, which is being sold in
the market for a price of ₹44-46 per kg.
CCI Order, Nov. 17, 2021, pages 36-37:
Presently the said products are sold in market in the range of Rs. 44.00/- per Kg to Rs. 46.00 per
Kg. All condemned unilaterally about the unethical pricing policy of Century paper & pulp who
quotes abnormally low rate. Citing the recent example for 1800 MT order from Star Educational
books, Delhi the said firm has quoted Rs. 39.80/- per kg which is inclusive of all tax, transportation
component, F.O.R. Delhi. Such moves give negative feedback in the market, and traders demand
such deals from Agro based mill that are already in loss.
The credit rating agency, Standard and Poor’s in its guidelines for rating paper manufacturers, also
highlighted the price-based competition in the paper industry:
S&P rating guidelines for the paper industry, page 4:
Highly competitive industry, with competition based primarily on price
Therefore, an investor would appreciate that in the paper industry, the players compete on pricing because
most of the products are a commodity in nature, which are undifferentiated from each other.
Moreover, in the case of selling paper products, the manufacturers rely on the channel of dealers in addition
to selling some quantity directly to corporate customers and govt. departments via tenders.
Paper is largely consumed by many small printers who work on behalf of various
publishers/FMCG companies; hence most of the sales of the paper mills are typically through
dealers/indentors who source orders from these printers and act as an interface between the mill
and the customers.
The dealer channels deal with the final customers and in turn, have a high negotiating power over the
manufacturers. When an investor analyses the developments in the paper industry around the world, then
she notices that in the foreign locations, the dealers have come together to collaborate with each other and
in turn further increase their negotiating power over the manufacturers. As a result, in foreign countries like
Japan, many paper manufacturers have started to create their own agencies/supply networks.
Rating methodology for the paper industry by Japan Credit Rating Agency, May 2020, page 2:
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Companies in the paper distribution market have also merged, in response to the intensified
competition, into three large agencies selling the products of multiple large paper manufacturers
and having strength in broad product lines. In addition, some large paper manufacturers have
been strengthening their direct agencies
Therefore, an investor would appreciate that the products of the paper-manufacturing companies are
primarily undifferentiated-commodity products where the customers/dealers have a high negotiating power
over them.
Only a few products of paper manufacturers are directly purchased by end consumers, which offer an
opportunity for building a brand and gaining some pricing power like the copier paper.
Within all the paper product segments, copier paper is the main product, where it is directly
consumed by the end customer and hence product branding in this segment provides some pricing
power.
The credit rating agency, S&P in its guidelines for rating paper manufacturers also highlighted that the
paper products are commodities and creating a brand with a pricing power is very difficult. Therefore,
primarily, the players compete on pricing.
Paper and packaging products are essentially commodities and producers are subject to intense
price competition with barriers to entry from meaningful product differentiation and brand identity
generally difficult to achieve.
S&P highlighted that only for a few products like tissue paper, a manufacturer may create a brand and have
some competitive power.
…in some cases–such as the tissue papers segment–issuers may be able to build up significant
barriers to entry (depending on products and markets) through branding.
Therefore, from the above discussion, an investor would appreciate that in the case of paper manufacturers,
most of the products are undifferentiated-commodity products where a customer can easily switch between
the products of different companies. Moreover, the sale channel is focused primarily on large dealers.
As a result, the paper manufacturers are not able to gain pricing power for most of their products like writing
& printing paper, paperboard, Kraft paper and packaging products. The paper manufacturers are able to
create a brand and in turn, gain pricing power only in the case of a few products that are directly purchased
by the retail customers.
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Rating Methodology for Paper Industry, CARE, November 2020, page 2:
Paper and paper products have very limited scope for product differentiation which limits the
pricing strategy. This in turn results in intense price competition with low barriers to entry.
While assessing the factors leading to the competitive strength for the existing players or barriers to entry
to newer players, an investor notices that the factors are capital intensiveness, closeness to sources of raw
material and customers and economies of scale etc.
However, new entrants may be discouraged by the substantial capital investments needed to build
new mills and from access to raw materials (such as wood or recycled fiber). In
addition, economies of scale are important because larger mills are often more efficient than
smaller ones.
An investor would note that in the barriers to entry for new players, she does not see the mention of factors
like technological intensity, customer stickiness etc., which are present in industries where the quality of
the product is paramount and switching costs for the customers may be high.
As a result, the paper producers have low pricing power over their customers and find it difficult to pass on
the increase in their input costs to their customers.
High volatility among key input costs such as energy, pulp, and transportation costs, with limited
possibilities to pass these on to customers in terms of higher prices.
During 2009-2014, when India witnessed a significant increase in capacities of wood-based paper
manufacturers, the wood prices increased sharply; however, the mills could not pass on the same to the
customers.
Simultaneous capacity expansions during the last few years (2009-2014) lead to severe
competition among mills for wood procurement and consequently an increase in wood
prices leading to requirements for importing wood without a corresponding increase in product
realisation.
The inability of paper producers to pass on an increase in inputs costs is a global phenomenon. In Japan,
the credit rating agency, Rating and Investment Information, Inc. highlighted that the profitability of the
paper manufacturers is poor and they face the risk of losses if input costs increase.
Inc., Japan, page 10:
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The profitability of print media, packaging materials and materials for daily living is generally
low, partly because of their relatively low added value and intense completion. Manufacturers
face a risk of failing to achieve profitability and making losses when product markets deteriorate
or raw material and fuel prices rise.
Therefore, an investor would appreciate that paper manufacturers make low value-added, undifferentiated,
commodity products. As a result, they have very low pricing power and, in turn, face a lot of challenges in
passing on any increase in their input costs.
In light of undifferentiated commodity products, the paper mills, which are able to produce products from
different segments like writing paper, newsprint, paperboard, packaging, Kraft paper, tissue paper etc., are
better placed as they can handle the slowdown in any one product category without a lot of difficulties.
The ability to alter the product mix (to shift between NP and WPP (writing and printing paper),
for instance, or within the various commodity grades in WPP) according to market trends will be
a crucial factor, especially in a highly cyclical industry.
The ability to produce different types of paper products is also essential because different segments of paper
are currently facing different types of demand dynamics.
An investor would appreciate that a shift of information distribution to electronic medium has impacted the
printing paper demand for newspapers, magazines and other information brochures.
Publishing paper products face high substitution risks and long-term demand declines because of
shift away from printed to electronic sources.
On the contrary, the paperboard products used in packaging are witnessing an uptrend in consumption
because of demand from e-commerce players who use it extensively in the shipping of products.
Packaging materials, which are used for the transportation and storage of various products
including foods, beverages and daily necessities, enjoy steady demand even during economic
slowdowns.
An investor would appreciate that the paper manufacturing companies have a low pricing power due to
intense competition, fragmented industry and commodity products. However, the situation is complicated
further by the threat of competition from imports faced by the market with a growing paper consumption
like India when many paper manufacturing companies around the world are facing a decline in paper
consumption in their home countries.
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2.1) Threat of competition from imports:
While analysing the different product segments of the paper industry, an investor notices that in the case of
value-added products, domestic mills face competition from imports from overseas paper producers. As a
result, in the current scenarios of declining import duties, it becomes essential for the domestic paper mills
to be very cost-efficient.
Rating guidelines for the paper industry by ICRA, November 2015, page 9:
product segments because of their high-value added nature are also the most vulnerable to
import threats especially during periods of declining international prices. Hence the ability to
maintain competitive prices vis a vis imports, while maintaining a competitive cost structure to
compete with imported products amid declining import duties remain the key driver of the
profitability for the companies in these product segments.
An investor notices that in the past, Indian paper manufacturers benefited from high import duties and were
protected from the threat of imports.
Rating guidelines for the paper industry by CRISIL, 2007, page 1:
The domestic manufacturers have been able to operate profitably in the past despite these inherent
constraints; this is owing to factors such as the high degree of tariff protection that has helped
keep the threat from imports negligible.
However, now the import duties have declined and the threat from imports has increased.
The threat of imports from overseas producers become more apparent when an investor analyses the
situation of paper industries of other countries.
In developed countries Japan, the paper industry is facing a troubled time where the domestic demand is
constantly declining. As a result, looking at business opportunities in the international market for Japanese
paper producers has been an essential survival strategy.
Rating guidelines for the paper industry by Japan Credit Rating Agency, May 2020, page 1:
Business environment is severe in the domestic market where demand for paper mainly printing
and information paper has been declining. In these circumstances, major paper manufacturers
have been seeking opportunities in overseas markets with high growth potential and focusing
on businesses other than pulp and paper for growth.
From the above paragraph, an investor would also note that the business environment is so stressed in the
Japanese market that the paper producers are also looking at businesses other than paper manufacturing.
The stress in the Japanese paper market is leading the paper producers to cut down capacities in order to
lower their fixed costs.
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Rating guidelines for the paper industry by Japan Credit Rating Agency, May 2020, pages 2 and 3:
A reduction in production capacity and reviewing sales strategies are in progress centering on
large paper manufacturers
It is necessary to keep capacity utilization at above a certain level through reduction of production
capacity and expansion of exports in order to maintain and improve the competitive strength of
factories over a medium term in the face of declining demand mainly for printing paper.
Rating guidelines for the paper industry by Japan Credit Rating Agency, June 2018, page 2:
In this situation, a reduction in production capacity, including the shutdown of paper machines,
is progressing. It is assumed that it will take time to eliminate the oversupply and that fierce
competition will continue for the time being
The fear of overcapacity in the Japanese paper market is so severe that when the paper mills go for
modernization of the plants to be cost-competitive, then such decisions are seen cautiously because they
increase the plant capacity, which further complicates the oversupply problem.
Rating guidelines for the paper industry by Japan Credit Rating Agency, May 2020, page 3:
The installation of new machines is an optional measure to resolve the obsolescence of facilities,
but this often leads to increased production capacity. When installing new machines, therefore,
attention must be paid to the effect on domestic demand and market conditions.
In Japan, it is estimated that a reduction in the domestic paper demand is inevitable and the development of
overseas markets is essential for paper manufacturers to sustain.
Inc., Japan, page 3 and 11:
In the medium to long term, however, demand contraction will be unavoidable in the domestic
market, making the development of overseas markets an imperative issue for sustainable growth
For medium- to long-term growth, a manufacturer needs to have advanced manufacturing

facilities, expand into overseas markets
Even if an investor looks at other developing economies, she notices that the paper industry of countries
like Indonesia is also finding international markets more attractive than their domestic market.
Rating guidelines for the paper industry by Pefindo, Indonesia, page 1:
In general, the export market offers higher consumption and product diversity than the domestic
market
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In light of the above-discussed scenarios, when an investor looks at the Indian paper products market, then
she notices that in India, the consumption of paper products is increasing. This is because of the current
low per capita consumption of paper in India as compared to global averages.
Given the low per capita paper consumption in India in relation to global averages as well as
compared to various other peers, India has witnessed steady growth in paper consumption, which
is in contrast to many developing countries, which have seen demand contractions.
Rating guidelines for the paper industry by CARE, November 2020, page 1:
With the per capita paper consumption in India being low at around 13 kg when compared with
the global average of 57 kg, the growth is expected to be higher in the domestic market when
compared with the world growth rate.
Therefore, an investor would appreciate that a growing market like India will always attract competition
from overseas paper producers who are facing declining paper demand in their home countries.
An investor would now understand that the paper industry faces intense competition from numerous players
in the fragmented domestic industry as well as from paper producers overseas. In such a severely
competitive environment, it becomes difficult for any company to earn a respectable return on its capital
because the pricing based competition would always drive the prices of paper products lower.
However, an analysis of the history of developments related to competition in the paper industry in India
as well as overseas shows that on numerous occasions, the paper manufacturing companies have resorted
to cartelization and price-fixing so that the competing paper mills coordinate their pricing strategy and
increase prices as a group.
2.2) Price-fixing cartelization by paper manufacturers:
From the above discussion, an investor would appreciate that the paper industry is highly fragmented and
intensely competitive, which produces undifferentiated commodity products. As a result, none of the
companies has any sustained competitive advantage to command a higher price or higher margins.
An investor would appreciate that in such an industry, the lowest cost producer survives.
The credit rating agency, S&P, has highlighted in its rating guidelines that the paper industry produces
commodity products wherein the long-term, the product prices are determined by the cost of the most
efficient producer.
…most forest and paper products are commodities and the price of a commodity is determined in
the long run by cost levels of the most efficient producers.
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Therefore, the companies with the lowest cost of production set the market prices and others have to follow;
otherwise, the rest of the companies would lose business to the lowest cost producer and in turn, they will
have to go out of business.
To survive the continuous pricing pressure, the paper companies have attempted to form a cartel where the
competing firms sit together and mutually decide the prices of their products.
Competition Commission of India (CCI) had recently concluded its investigation and hearing for the price-
fixing by non-wood based paper manufacturers. CCI found that many paper manufacturers mutually
decided the prices and put pressure on their peers to increase their prices. As a result, the CCI put a penalty
on some of the non-wood based paper manufacturers and their industry association, the Indian Agro &
Recycled Paper Mills Association (IARPMA), for their anti-competitive business practices.
CCI order, November 17, 2021, page 61:
Commission concludes that OPs had indulged in cartelisation in fixing prices of writing and
printing paper as detailed in this order, by participating in the meetings convened under the
umbrella of the platform provided by their trade association and discussing prices and
the roadmap for coordinated increase, besides monitoring the decisions taken in such meetings.
CCI also found that due to cartelization, some of the players like Ruchira Papers Ltd increased their product
prices even when their cost of production had declined.
The parallel behaviour of OP-12 by making an overall increase of Rs. 6000/- PMT between
September 2012 to March 2013, coupled with an increase in prices despite fall in cost of
production is strongly indicative of OP-12 being part of concerted conduct resorted to by non-
wood based paper manufacturers, who increased prices after discussions in a coordinated
manner.
In the CCI order, as per details on page 1, the opposite party 12 (OP-12) refers to Ruchira Paper Ltd.
An investor may read our detailed analysis of Ruchira Papers Ltd along with the issue of warrants issued
by the company to its promoters where the promoters seem to have benefited at the cost of minority
shareholders, in the following article: Analysis: Ruchira Papers Ltd
As per the CCI order, one of the paper manufacturers, Trident Ltd (opposite party 21) accepted its role in
cartelization and price-fixing.
Yes, it is true that competing paper mills used to meet, discuss and arrive at a consensus on
prices of paper to be increased and the quantum of discount to be offered.
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Yes, on a few occasions we did implement the price increase decided in such meetings unaware of
the consequences of this Act.
An investor should note that the above-discussed order by the CCI is related to non-wood based paper
manufacturers. Currently, an investigation by the CCI for price-fixing by the bigger wood-based paper
manufacturers and their industry association, Indian Paper Manufacture Association (IPMA), is underway
(Source: CCI orders probe into alleged cartelisation by big paper makers: Economic Times, August 29,
2014)
The companies under probe include ITC Bhadrachalam Paper Board, Andhra Paper Mills
of International Paper, Singhania Group-promoted JK Paper Mills, West Coast Paper Mills and
Thapar Group’s Ballarpur Industries among several others. CCI has also directed its investigation
officer to include industry body Indian Paper Manufactures Association (IPMA) in the
investigation.
The information disclosed by CCI in its order dated November 17, 2021, also indicates the price-fixing by
the large paper manufacturers and pressurising smaller players to follow the same.
CCI order, November 17, 2021, pages 25, 27, 38 and
A number of other OPs have stated that it were the big paper manufacturing companies that
actively participated in discussions and decided on implementing the prices.
The market leaders and big paper manufacturers facing cartel investigation in the existing cases
are imposing/enforcing the cartel and ensuring its compliance by OPs. That bigger players of
market created such compelling circumstances so that small players were left with no other option
but to abide by their dictates to act as a cartel.
In the meeting it was decided Rs. 1/- per Kg increase should be done by all member mills effective
from 1st of December. It was also decided that to closely watch recently proposed IPMA meeting
outcome about their price strategy.
Therefore, investors should closely watch the outcome of the currently undergoing investigation by CCI in
the allegations of price-fixing and cartelization by the large wood-based paper manufacturers.
While analysing the history of paper manufacturers around the world, an investor notices that in other
countries also including developed countries like Japan, paper manufacturers have engaged in price-fixing.
Japan Fair Trade Commission conducted on-site inspections of some manufacturers in 2012
on suspicion of price cartel activity
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In 2008, the Japan Fair Trade Commission ordered many paper manufacturing companies to stay away
from price-fixing.
Cease and Desist Order against Eight Paper Manufacturing Companies: Japan Fair Trade Commission,
April 25, 2008
When an investor comes across instances of cartelization and price-fixing by the players of any industry,
then she should note that the prices charged by them may not represent the true market prices. As a result,
the profit margins, return on investment etc. may be inflated and may not sustain going ahead when the
cartel breaks.
Therefore, an investor should keep a close watch on the outcome of the CCI investigation on the large paper
manufacturers in India and should accept the data of their profit margins and return ratios with a bit of
caution.
3) Cyclicity in the paper manufacturing industry; the boom and bust cycle:
The paper industry is cyclical in nature where the performance of the players goes through alternating
phases of improving performance followed by declining performance.
The cyclical nature of industry performance is linked to two factors.
The first factor is the dependence of paper consumption on the general economic growth of the country
where during the phases of high economic growth, the paper consumption increases and during the phases
of economic slowdown, the paper consumption declines.
The second factor, which is more important for the paper industry is its boom and bust cycle where during
periods of high demand, many players announce capacity expansions. The new capacities become
operational simultaneously after a few years leading to an oversupply situation in the industry. As a result,
prices of paper products decline and many mills become economically unviable and shut down their
operations. As a result, the oversupply situation changes to less supply, which leads to improvement in the
product prices. Thereafter, the paper players once again announce new capacity additions. This cycle of
boom and bust keeps on repeating in the paper industry.
The paper industry is highly cyclical and depends on general economic conditions as well as the
industry demand and supply. There is a bunching up of new capacity additions which in turn
results in higher supply when compared to the demand growth.
Rating Methodology for Paper Industry, CRISIL, February 2018, page 3:
The industry is also highly cyclical, mainly on account of the bunching up of capacity additions,
resulting in temporary demand-supply imbalances, rather than fluctuations in absolute demand
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The credit rating agency, S&P also highlighted the nature of boom and bust phases seen in the paper
industry in its rating guidelines for the sector. S&P highlighted that in the paper industry, the phases of
supply shortages lead to a lot of capacity addition, which results in oversupply and a decline in prices for
paper products.
Rating Methodology for Paper Industry, S&P, page 4:
The industry has a history of boom-and-bust behavior, where supply shortages traditionally
trigger capacity expansion and subsequently overcapacity and pricing pressure.
When an investor analyses the dynamics of the Indian paper industry over the last 15 years, then the phases
of boom and bust clearly come out in the way the industry progressed over the years.
Let us see an example of the cyclicity of the paper industry by analysing the business environment faced
by a paper manufacturing company over the years.
3.1) Cyclical business environment faced by Century Textiles and Industries Ltd:
During our analysis of Century Textiles & Industries Ltd, when we read its annual reports since FY2007,
then we noticed that the pulp and paper business is a purely cyclical business where the industry undergoes
periods of demand and supply mismatch.
At times, the demand for paper exceeds its supply in the market. As a result, the prices of paper products
increase and the paper manufacturers increase their supply significantly. When the new manufacturing
capacities start functioning, then the industry faces a situation of oversupply. This leads to price wars when
manufacturers undercut prices to stay in the business. During this phase of decline of paper prices, many
small & unorganized players find it difficult to survive and in turn, go out of business. The resulting
shutdown of plants by these small & unorganized players reduces the supply in the market and the prices
of paper products increase.
This seems to be a recurring phenomenon in the paper industry. While reading the developments of the
paper industry over the years in the annual reports of Century Textiles & Industries Ltd, an investor can
easily understand this cycle of the paper industry.
In FY2007-08, the paper industry in India was facing a shortage of supply. As a result, the country was
importing a lot of paper and in addition, many Indian players were expanding their capacities.
The Indian paper industry is highly fragmented with numerous small players. The industry is
witnessing a healthy demand and its financial performance has also improved. Most players are
augmenting capacities, which are expected to come on stream over the next two to three
years………With steady demand for paper in India and a surging requirement for higher quality
paper, foreign players are exporting to India in a major way.
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During this phase when the demand for paper exceeded the production, Century Textiles & Industries Ltd
also announced capacity expansions. In FY2007, the company had completed one expansion project and
simultaneously, it announced another expansion project to produce tissue paper.
The expansion of our paper unit for manufacturing paper from waste paper has
been commissioned from 03.02.2007 with a capacity of 211 tonnes per day and the plant is now
running smoothly.
It has been decided to set up a 100 tonnes per day Prime Grade Tissue Paper Plant at a total
capital outlay of Rs.175 crore based on imported softwood and our own hardwood pulp as raw
material…..is expected to be operative by about September, 2008.
The very next year in FY2008, Century Textiles & Industries Ltd announced its plans to establish a multi-
packaging board plant along with a fibreline plant.
We are setting-up a Multilayer Packaging Board Plant, with a capacity of 500 tonnes per day.
This development, requiring a total capital outlay of about Rs. 775 crore, is expected to be
operational by December 2009. Additionally, we are planning to set up a Paper Grade Pulp Plant
(Fibreline) to produce superior quality wood pulp. The plant demands a capital outlay of Rs. 495
crore and is anticipated to commence operations by December 2009.
An investor would expect that during good times, individuals, as well as companies, become very
enthusiastic. As a result, the manufacturers see only the positives. An investor gets a similar feeling when
in the FY2009 annual report, Century Textiles & Industries Ltd mentioned to its shareholders that the
demand for paper would only go up from here.
Due to favourable Government policies such as the thrust on education, a growing economy and
young population, increasing urbanization, a clear preference for print media and widespread
interest in books and publishing, consumption of paper can only increase…
However, an investor would appreciate that paper is a cyclical industry where the demand rises and falls
over time. In the very next year, FY2010, the upcycle phase of the paper industry was ending and Century
Textiles & Industries Ltd saw a reduction in the demand for paper.
The Paper Business was under severe pressure due to a substantial increase in the prices of raw
materials and reduced demand.
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The intense competition in the industry did not allow the company to pass on the increase in raw material
costs to its customers. As a result, the company had to take a hit on its profit margins in the paper division.
The prices of bagasse and wood which constitute major raw materials for pulp and other input
costs have considerably increased without a sizable appreciation in selling prices. This has
adversely affected the performance of this Division for a major part of the year.
By FY2012, almost all of the previously announced capacity expansion plants by the paper industry,
including the expansion plants of Century Textiles & Industries Ltd were operational. As a result, the
industry started facing a situation of oversupply. Century Textiles & Industries Ltd also acknowledged that
the paper industry is cyclical in nature.
The output from several new manufacturing facilities has further increased finished
product supply, flooding the market and it will take some time for demand to catch up with these
additional quantities.
Being in the commodity sector, the paper industry is cyclical in nature and is strongly co-related
with global economic factors.
The very next year in FY2013, Century Textiles & Industries Ltd reported a net loss.
However, due to higher depreciation in the current year on account of commissioning of

Multilayer Packaging Board and Fiberline Plant (Pulp plant) in the Pulp & Paper Division, the
Company has incurred a net loss.
By 2014, the paper industry had so much oversupply that the situation of dependence on imports to meet
the demand in FY2008 had now given way to exports of paper from India. Due to oversupply, the company
was not able to pass on the increase in inputs costs to the customers and as a result, had to take a hit on its
profit margins.
FY2014 annual report, page 24-25:
Further, apart from rising production and consumption, erstwhile import dependent India has
achieved self-sufficiency and also has witnessed an increase in exports.
While raw material costs have been increasing, the selling prices could not be increased to offset
entirely the rising costs which resulted in an adverse financial performance.
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By FY2015, the oversupply situation in the paper industry had worsened to such an extent that the small,
B-grade, unorganized players started to go out of business and a price war was prevalent in the market.
With new installed capacities coming online in the second half of the year, the demand supply
equilibrium in the Indian market shifted towards excess supply. This led to players dropping prices
to remain competitive…..
The biggest threat for the Indian paper industry is from imports of paper products from China and
duty free paper products from the ASEAN region. Products from these regions have priced out
many domestic manufacturers and this has resulted in a price war in the Indian market across all
grades.
This impacted the profitability of the Indian paper industry, as well as economic viability of ‘B’
grade paper mills.
Soon enough, the newly started division by Century Pulp & Paper, the multilayer packaging board business
also experienced oversupply.
…..two newly installed capacities becoming operational by other players in the Multilayer
Packaging Board business. With new capacities, the demand supply equilibrium in the domestic
market shifted towards excess supply.
By FY2017, the oversupply situation in the Indian paper industry has taken its toll on the paper
manufacturers. A few of them had to shut down their business. Now, it was time for the demand to exceed
supply and the future of the industry started to look bright.
Based on the recent shut down of some domestic capacities and expected growth in the country’s
GDP, it is likely that the domestic paper industry will grow at a reasonable pace along with the
economy, from a medium to long-term perspective.
By FY2019, the paper & pulp division of the company had started to contribute healthily to the company’s
performance and became one of the key reasons for the improving operating profit margins of Century
Textiles & Industries Ltd.
Pulp & Paper and Real Estates Divisions have primarily contributed to this growth.
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The demand in the paper industry exceeds supply and in FY2020, India met about 20% of its paper demand
from imports.
Investor presentation, June 2020, page 34:
Total Demand- 19.8 Million MT in FY 20-21
Total Supply:
 Domestic: ~15.8 Million

 Imports: ~4 Million
In FY2020, the paper division of the company operated with 100% capacity utilization. Press release for
Q4-FY2020 results:
Pulp and Paper Business operated at 100% capacity for FY20.
In light of the same, it does not come as a surprise to the investor that the paper manufacturers have again
started increasing the manufacturing capacities. Century Textiles & Industries Ltd announced its plans to
expand the manufacturing capacity in FY2019.
The Company has undertaken a project to expand the Prime Grade Tissue Paper Plant
capacity from 100 tonnes per day to 200 tonnes per day with an Anchor GSM of 19 grams at a
total capital outlay of ₹100 crores at the existing Pulp and Paper Plant at Lalkua, District Nainital,
Uttarakhand.
The credit rating agency, CRISIL, in January 2020, acknowledged that the paper division of Century
Textiles & Industries Ltd has displayed significant improvement in performance over the last 3 years.
Paper segment’s revenue and profitability have consistently improved, backed by increased
capacity utilisation and realisation over the last three fiscals. This is expected to continue over the
medium term, with completion of capex in high margin tissue segment and de-bottlenecking,
despite some headwinds in realisations.
From the above report, an investor would notice that CRISIL expected that the good performance of paper
division will continue over the medium term.
The management of the company is also giving a positive outlook about the performance of the paper
division.
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With increased demand for value added products and an improved order booking position, in
future, we are hopeful of having further improvement in the business.
From the above discussion about the development in the paper industry, an investor would appreciate that
the paper industry is cyclical in nature where demand and supply undergo phases. In FY2007-2008, in the
Indian paper industry, demand exceeded supply and many manufacturers announced expansion plans. In
good times, Century Textiles & Industries Ltd said to the shareholders that the paper demand would only
increase. However, soon thereafter, the industry turned into an oversupply situation where price wars broke
out. Paper manufacturers started reporting losses and many players went out of business and shut down
capacities. As a result, the oversupply corrected itself.
As per S&P, during a cycle of the paper industry, on an average, the sales of any company may decline by
6% and its profits may decline by about 20%; even though in the USA, during a cycle, the highest decline
in revenue had been 16% and the highest decline in profit margins had been 42%.
Rating Methodology for Paper Industry, S&P, page 3:
Based on our analysis of global Compustat data, forest and paper products companies experienced
an average peak-to-trough (PTT) decline in revenues of about 6% during recessionary periods
since 1968…with the steepest decline (16% drop in revenues) occurring during the downturn in
1979-1982. In addition, forest and paper products companies experienced an average PTT decline
in EBITDA margin of about 20% during recessionary periods since 1952…The largest PTT drop
in profitability totaled 42% and also occurred in the 1979-1982 recession.
Based on the insights about the cyclical nature of the paper industry, an investor should be cautious before
she starts projecting the good performance of any paper company into the future. She should be aware that
the paper industry is cyclical where the down-phase follows the upcycle phase and vice versa.
4) Highly capital intensive wood-based paper mills:

In the case of wood-based paper manufacturing, the players need to have an access to a large and assured
supply of raw material i.e. wood or chemical pulp. As a result, most of the wood-based paper manufacturers
go for integrated plants, which have a pulp manufacturing unit in addition to the main paper making plant.
Moreover, the product of chemical pulp from wood produces an effluent called black-liquor, which can be
used as a fuel to produce power. Therefore, in order to make the operation more efficient and cost-effective,
a wood-based paper manufacturer is also forced to install a captive power plant.
Backward integration, including pulping and power generation capacities, is more critical in case
of a wood-based mill to ensure a steady supply of raw materials at a relatively lower cost.
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Creating an integrated paper manufacturing plant with an associated pulp-making unit and a captive power
plant becomes a necessity for a wood-based paper manufacturer because, in the paper industry where all
the players compete on pricing, it is essential to be as cost-efficient as possible.
Due to captive pulp capacities, the chemical-pulp based paper mills have the highest level of
backward integration, as they also need captive power generation capacities to consume the black-
liquor generated as a part of the pulping process.
On account of cyclicality, lack of product differentiation associated with the paper industry as well
as presence of import threats, the cost competitiveness is very critical to maintain the profits.
The credit rating agency, S&P, has highlighted in its rating guidelines that the paper industry produces
commodity products where during the long-term, the product prices are determined by the cost of the most
efficient producer.
…most forest and paper products are commodities and the price of a commodity is determined in
the long run by cost levels of the most efficient producers.
The credit rating agency of Indonesia, Pefindo, also highlighted the importance of managing operating costs
in its rating guidelines for paper manufacturers.
Rating guidelines for the paper industry by Pefindo, Indonesia, page 8:
Efficiency in managing operational costs is necessary to mitigate the fluctuation of profitability

margins, as forest, pulp, and paper products are commodities
Therefore, to survive, a paper producer has to be as cost-competitive as possible. And for a wood-based
paper manufacturer, it means that it has to necessarily invest in a pulp-making unit and a captive power
plant as well.
An investor would note that the need to have a large integrated paper manufacturing plant with a pulp-
making unit and captive power plant makes creating a wood-based paper making plant a very capital
intensive project.
A large amount of capital needed to create a wood-based integrated paper manufacturing plant as well as
access to limited raw material sources of wood create a barrier to entry for new players in wood-based paper
manufacturing.
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In India, as per credit rating agency, ICRA, there has not been any new entrant in wood-based paper making
for many decades.
Greenfield wood/chemical-pulp based paper mills; due to its high capital cost, constraints in
securing a suitable location having abundant forest reserves, water availability and environmental
clearances, pose as significant entry barriers for new entrants.
Accordingly, ICRA has noticed no new entrant in this segment, and all the existing players in this
segment have been present for over decades. Accordingly, there is a relatively higher level of
consolidation within this segment of the industry with ~10 players accounting for almost the entire
production capacities based on chemical pulp.
A highly consolidated industry position in the wood-based paper manufacturers is not only limited to India.
In the case of developed markets like Japan as well, the paper industry has not seen new entrants.
Japan’s domestic pulp and paper market is mature and has no new entrants.
Therefore, an investor would appreciate that in the case of wood-based paper manufacturers, installing an
integrated paper-making plant along with a pulp-making unit and a captive power plant is essential to reduce
production costs. This makes the creation of a new plant highly capital-intensive and creates barriers to
entry.
However, in the case of non-wood paper manufacturers using waste/recycled paper or agro-residue as raw
material, there is no need for an integrated pulp and power plant. This makes installing a non-wood paper
making plant a cheaper option with low entry barriers.
Unlike chemical-pulp based mills, wastepaper-based mills have lower entry barriers and hence
have a higher degree of fragmentation. Low entry barriers arise on account of low capital costs as
the need for captive pulp manufacturing capacities as well as need to necessarily have captive
power plant are negated.
Similar to wastepaper-based mills, the entry barriers in agro-residue (such as wheat straw,
sugarcane bagasse, rice straw etc) based paper mills are lower than chemical pulp-based paper
mills.
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This is in contrast to waste-paper/agro-residue based paper mills, which don’t require captive
pulping capacities and the need to have a captive power plant is optional as the plant can be
operated on grid power.
As a result, an investor would appreciate that the non-wood based paper making segment is highly
fragmented with numerous players with small paper mills competing with each other.
As per the credit rating agency, ICRA, the average size of a wood-based paper manufacturing plant is more
than 300,000 MTPA whereas the average size of non-wood based paper making plants is much lower at
about 13,000 MTPA.
Wood/chemical-pulp based mills: As per ICRA’s estimates, the average size of the paper mill in
this segment will be upwards of ~3.0 lakh tonne per annum, which is significantly higher than the
overall average for the paper industry.
Waste Paper based mills: Accordingly, as per ICRA’s estimates, this segment witnesses mills
ranging from 5000 MTPA capacities to 3 lakh MTPA capacities and average mill size of ~13000
MTPA.
Agro-residues based mills (without chemical bleaching): the average mill size in these categories
typically tend to be even lower than waste paper based mills.
Therefore, an investor would notice that establishing a wood-based paper mill, which is on an average of a
much higher size than a non-wood based paper mill is comparatively very high capital-intensive than non-
wood based paper mills.
As a result, the wood-based paper mills have a high barrier to entry and new players enter very rarely in
this segment. Whereas, the non-wood based paper mills are much cheaper to install and therefore, there are
numerous small players in this segment making it very fragmented and crowded.
From the above discussion, an investor would remember that in the wood-based paper mill segment, about
10 players own the entire production and there has not been any new player in decades. On the contrary,
the non-wood based paper mill segment has more than 800 mills.
CCI Order, Nov. 17, 2021, pages 31-32:
there are nearly 800 non-wood based paper mills in India, with approximately 40 players that sell
in North India.
This leads to an intense competition where frequently, new players keep coming and old players keep going
out of business.
Nevertheless, as a result of the low capital requirements of non-wood based paper mills, their share in the
overall paper production has increased significantly over the years.
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As per ICRA, in 2015, non-wood based paper mills contributed about 65% of paper production; recycled
paper (44%) and agro-residue based paper mills (21%) whereas wood-based paper manufacturing
contributed about 35%.
As per industry data, based on the raw material mix, ~35% of the capacity is based on chemically
bleached pulp (either from wood or agri-residues); ~44% capacity is based on waste paper and
~21% of production capacities are based on agri-residues.
In 2020, as per CARE, the share of non-wood based paper mills had increased to about 75% of paper
production; led by recycled paper (58%) and agro-residue based paper mills (17%) whereas wood-based
paper manufacturing contributed about 25%.
An investor would note that the significant increase in the contribution of non-wood based paper
manufacturers is due to a low requirement of capital for establishing the mills.
Nevertheless, after a paper mill is established, it needs to continuously spend money in upgrading its
machines because; old machines become inefficient. This increases its cost of production when compared
to other mills and it starts losing out on getting the orders. As a result, the paper mills whether wood-based
or non-wood based, need to continuously spend money on upgrading their plants.
The paper machines though can be operated for decades after periodic rebuilding and regular
maintenance. However such machines may also have operational inefficiencies such as high
power/ steam consumption norms in relation to new mills. This apart, the product quality and
machine utilization may also suffer from breakdowns resulting in operational in-efficiencies. Very
old machines thus may not result in a sustainable cost advantages in longer run.
In addition, to remain cost-competitive, in a growing paper market like India, the paper producers need to
continuously invest money in their production capacities to maintain their market share.
Developing economies usually experience high growth in demand; manufacturers, therefore, need
to constantly add capacities to retain market share. In addition, the commoditised nature of the
business requires regular modernisation of production facilities in order to remain competitive.
With business being highly capital-intensive, the incremental funding requirement for capacity
augmentation and modernisation tends to be enormous.
Therefore, paper mills irrespective of being wood-based or non-wood based, have to continuously
spend money on the modernization of their machines, which increases the capital consumption.
An investor needs to be cautious of this continuous capital requirement of paper mills whenever
she starts analysing a paper manufacturing company as it will impact its free cash flow generation.
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4.1) Large integrated paper manufacturing plants, a double-edged sword:
From the above discussion, an investor would remember that in the paper industry, a manufacturer must
focus on being as cost-competitive as possible because in this industry with undifferentiated, commodity
products, the lowest cost producer wins.
As a result, it becomes necessary for the wood-based paper making plants to go for an in-house pulp making
unit as well as a captive power plant.
This results in a decline in per-unit cost of production for the paper mill and stable profitability for the
company because it is able to produce most of the inputs like pulp and power in-house and is saved from
the fluctuations of these inputs in the external market.
Rating guidelines for the paper industry by CARE, November 2020, page 3:
Backward integration, including pulping and power generation capacities, is more critical in case
of a wood-based mill to ensure a steady supply of raw materials at a relatively lower
cost…Although this kind of integration is capital intensive resulting in high fixed costs for a
company, it results in stable profitability for a company.
The non-wood based paper producers usually do not have the pulp production and power plant integration
as they can easily source these inputs from the outside market.
This is in contrast to waste-paper/agro-residue based paper mills, which don’t require captive
pulping capacities and the need to have a captive power plant is optional as the plant can be
operated on grid power.
In addition, the large size of the integrated wood-based paper plants helps them achieve economies of scale
and in turn, produce goods at a lower cost.
Rating guidelines for the paper industry by S&P, page 7:
A forest and paper products company’s size typically brings competitive advantages from greater
breadth and scope of operations and economies of scale, contributing to better profitability.
The sheer large size of an integrated wood-based paper production plant also helps it achieve a better
bargaining power with the counterparties when compared to the smaller non-wood based paper mills.
Large-integrated wood-based paper producers have a lower working capital intensity because due to their
comparatively higher negotiating power, they are able to negotiate a lower credit period to their customers
and a higher credit period from their suppliers.
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Overall, the working capital intensity of paper mills in the wood segment averages ~ 20% of their
revenues and ~25% of revenues for the waste paper mills.
Receivable Cycle: …larger mills (mainly based on chemical wood pulp) having better bargaining
power with its dealers, extending a credit period of ~30~35 days as against smaller mills (largely
waste paper based) with relatively lower bargaining power offering average credit period of ~45
days.
Payable Cycle: The payable period for the larger wood based mills typically averages around ~80
days as against ~45 days for waste paper based mills due to the better bargaining power of the
larger mills
The comparatively better-negotiating power of the large integrated wood-based paper mills with their
customers and suppliers compensates for a higher inventory holding requirement when compared to the
smaller non-wood based paper mills.
Inventory Holdings: The inventory holding for the larger wood based mills typically averages
around ~90 days, and is higher than ~ 45~50 days of inventory held by wastepaper-based mills.
Therefore, an investor would appreciate that the integrated large wood-based paper mills are fixed-cost-
intensive but enjoy stable profitability because they benefit from economies of scale and are not impacted
by an increase in the pulp or power prices in the open market. They also enjoy a better working capital
position due to a higher negotiating power than the smaller mills.
On the contrary, the non-wood based paper mills are comparatively asset-light; but they are exposed to high
input cost volatility in the open market and in turn, fluctuating profitability as well as having a higher
working capital intensity.
However, the stability in the profit margins and better working capital efficiency of large integrated wood-
based paper mills comes at a cost. Let us see such situations where the large integrated plants of wood-
based paper mills put them at a disadvantage.
4.1.1) Inability to benefit from a decline in the raw material costs in the open market:
As the integrated wood-based paper plants use in-house pulp and power; therefore, when the pulp and
power prices decline in the open market, then these mills are not able to take an advantage of the lower raw
material costs. In contrast, the non-wood based paper mills are able to take advantage of the same.
Rating guidelines for the paper industry by CRISIL, February 2021, page 19:
During downturns in the industry, when pulp prices tend to be lower, integrated manufacturers
are unable to take advantage of this.
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For example, in FY2010, during the global recession, when the pulp prices declined globally, then the large
integrated paper mills could not take advantage of the same whereas the waste paper-based mills benefited.
In contrast, when the pulp prices declined internationally in FY10 due to a global economic
slowdown, the integrated paper mills were not able to take the advantage of the decline in input
costs, whereas the waste paper mills benefited.
4.1.2) High vulnerability during industry slowdowns:
An investor would appreciate that due to the high fixed-cost intensity of large integrated paper mills, they
need to run their plants at a high capacity to earn a return on their money. Additionally, because they have
a large component of the costs as fixed, they need to earn a high operating profit margin to cover their fixed
expenses.
During the industry uptrend, it is possible for the large integrated plants to run at a high capacity utilization
as well as to earn high-profit margins. However, during the industry slowdown, they suffer on both fronts
i.e. their capacity utilization falls and additionally, their operating profit margins also fall because the prices
of all the paper products decline due to intense competition between manufacturers to keep their plants
running.
In contrast, the non-wood based paper mills, due to lower fixed costs, are able to sustain industry downturn
better because, a reduction in their plant utilization levels also reduces a large part of their overall costs,
which is not the case with the large integrated wood-based paper mills.
Rating guidelines for the paper industry by CRISIL, February 2021, page 19:
Units that are fully integrated, from pulping to conversion, will be more fixed-cost intensive,
resulting in higher breakeven volumes. In contrast, manufacturers with a lesser degree of
integration are better positioned to withstand downtrends owing to their lower fixed-cost intensity
While backward integration provides better profitability margins, high capital costs also increase
the vulnerability of mills to any declines in capacity utilization levels or profitability in comparison
to waste paper based mills.
Therefore, an investor would appreciate that even though a paper mill can reduce its cost of production by
becoming a large integrated player with economies of scale and in turn create strong barriers of entry for
new players; still there are multiple trade-offs it needs to face.
5) Environmental and pollution risks faced by paper manufacturers:
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The paper manufacturing process especially from wood has the potential of significantly impacting the
environment. This is because; it uses wood as a raw material, which involves cutting of forests & trees, it
uses a lot of water in the pulp and paper production, it uses a lot of chemicals and power during
papermaking, which is environmentally damaging and it leads to a lot of effluents, which if not disposed of
properly, may lead to environmental damage.
Therefore, wood-based paper manufacturers face a lot of challenges in getting the approvals for setting up
new mills.
A large amount of water as well as various chemicals are used for manufacturing paper and paper
products. Therefore, any player in paper manufacturing industry irrespective of size of
operations is exposed to varying degrees of regulatory oversight, including environmental
standards in terms of scrutiny of disposal of raw material wastes and level of carbon emissions.
Looking at the history of events faced by paper manufacturers, an investor gets to know that despite
obtaining govt. permission including environmental approvals for installing the paper mills, the
manufacturers keep facing intermittent challenges on environmental and pollution control fronts.
When India signed the Montreal Protocol limiting the use of Chlorine to protect the Ozone layer, then the
paper companies had to make investments in their production processes to reduce the use of Chlorine in the
papermaking process.
Rating guidelines for the paper industry by CRISIL, 2007, page 2:
in line with the Montreal Protocol, the paper industry is required to eliminate the use of chlorine in
bleaching by 2010. To comply with this environmental regulation, manufacturers will need to
incur further capital expenditure for their existing facilities.
Later on, in 2013, the paper manufacturing units in Uttar Pradesh were asked to close their operations to
prevent pollution of the river Ganga in light of the upcoming Kumbh Mela.
Recently in February 2013, various paper mills in the state of Uttar Pradesh, despite having
consent from pollution control boards to operate, were issued a notice of temporary closure to
prevent water pollution in river Ganga amid the Kumbh pilgrimage event.
Therefore, an investor would appreciate that the paper manufacturing process puts a lot of strain on the
environment. As a result, paper mills continuously keep on facing newer challenges and guidelines in order
to meet the expectations of regulators.
Therefore, the paper mills need to continuously spend money on their plants to make them environmentally
more efficient.
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They also expend on various cost-efficiency measures for remaining competitive as well as
for adherence to environmental norms.
An investor should keep the requirement of paper mills to continuously spend money for meeting
environmental norms in her mind while she assesses the future capital expenditures of paper manufacturing
companies.
Summary
Overall, an investor would note that paper manufacturing is a cyclical business where the players make low
value-added, undifferentiated, and commodity products. There is very low customer stickiness because the
customer can easily switch from one manufacturer to another without significant challenges. Paper mills
have hardly any pricing power over their customers.
Paper manufacturing is a highly fragmented industry with intense price-based competition among the
players. Increasing consumption of paper in India amid declining demand for paper in the developed and
many developing countries makes India an attractive export market for overseas paper mills. Therefore, the
players face a lot of competition and only the ones with a low cost of production survive. As a result, cost
competitiveness becomes the biggest competitive advantage for the manufacturers.
Paper manufacturers tend to go for integration (forward as well as backward) i.e. pulp making and captive
power plants to achieve the lowest cost of production along with large size plants to benefit from economies
of scale. However, creating a large integrated plant increases the fixed costs and, in turn, makes the break-
even high. Therefore, even though, the large integrated plants mostly use wood as raw material, achieve
stable profitability due to in-house pulp and power production; however, they need to operate at a high
capacity utilization with high-profit margins to cover their costs and earn a respectable return on their
capital.
During an industry slowdown, both the capacity utilization as well as profit margins take a hit leading to
difficulties in surviving the economic downturn for large integrated plants. As a result, in the downturn,
many plants shut down leading to reduced supply and a resultant increase in product prices. This in turn
leads to the announcement of new capacities by the paper mills that have survived the downturn. Usually,
all these newly announced capacities commence production simultaneously leading to oversupply and a
decline in product prices resulting in another industry downturn.
This cycle of boom and bust is played in the paper manufacturing industry again and again.
Large wood-based integrated paper plants create a strong entry barrier for new players due to high capital
needs, access to inputs like wood and power, low-cost large efficient plants, and a strict approval process
for environmental and pollution control regulations. As a result, hardly any new player has entered into
wood-based paper manufacturing in decades.
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In contrast, smaller plants using waste paper or agricultural residues do not need in-house pulp and power
plants. Therefore, they are less capital intensive and have lesser entry barriers making the industry crowded
with hundreds of small non-wood based paper mills.
High competition in the paper industry has taken away their pricing power. As a result, both in India and
overseas, there are incidences of competing paper manufacturers acting as a cartel and coordinating their
price increases as a mutually agreed strategy. Under such scenarios, an investor should be cautious because
the market prices of paper products may be rigged and in turn, the profitability and the return ratios may be
inflated.
Paper production is very environmentally sensitive because it uses wood as raw material, uses a lot of water
and power, and releases a lot of effluent chemicals.
The companies need to keep spending a lot of money in upgrading their plants to keep them in line with
newer environmental regulations, keeping the machines efficient for low-cost production and in a growing
market like India, to increase capacities for maintaining their market share. An investor should keep in mind
the continuous capital investment needed by the companies to sustain this business.
Key points of paper manufacturing companies:
1. Shortage of raw material irrespective of wood, recycled paper or agro-residue

2. No pricing power and intense competition due to low value-adding, undifferentiated commodity
products, threat of imports leading to cartelization and price-fixing
3. The industry is cyclical with a repeating boom and bust cycle
4. Highly capital intensive wood-based paper mills offer barriers to entry but suffer in the downturns
5. Environmental and pollution risks faced by paper manufacturers necessitate continuous
investments
Regards,
Dr Vijay Malik
P.S.

Videos
Analysis Excel
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10) How to do Business Analysis of Textile Companies
After reading the current chapter, an investor would know what makes any textile company a strong or a
weak player. She would understand the features of fundamentally strong textile companies and how to find
them.
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Textile companies cover entities across the whole supply chain, which includes growing the fibre, spinning
it into yarn, preparation of the plain cloth (fabric) and then manufacturing and sale of garments (apparel).
Therefore, whenever an investor comes across any textile company, then she should, first, assess which
segment of the textile value/supply chain, it belongs to.
Classification of textile companies

As discussed above, the textile sector is divided into different segments starting from growing the fibre to
the selling of readymade garments. Before analysing any textile company, an investor needs to ascertain
the role the company plays in this value chain because companies in the different sections of the textile
sector face different business challenges.
1) Fibre growers/manufacturers:
Textile fibre is mainly divided into natural fibre and man-made fibre. Natural fibre mainly consists of
cotton; however, there are other kinds of natural fibre also like hemp fibre, stinging nestled fibre, coffee
ground fibre, pineapple fabric piñatex, banana fibre, lotus fibre etc. Nevertheless in the natural fibre
category, cotton is the most widely used fibre in the world.
Textile industry risk analysis by VIS Credit Rating Company Limited, Pakistan, January 2022, page 2:
The risk of substitution for cotton fibre is extremely low, as there is a natural lack of an alternative
raw material for the manufacture of textile products. However, internationally developments have
been made for more sustainable innovations in the industry, that also provide alternatives to cotton
fiber, e.g., Hemp fiber, stinging nestled fiber, coffee ground fiber, pineapple fabric piñatex, banana
fiber and lotus fiber.
Manmade fibre is of two types: synthetic and cellulosic. Synthetic fibres are primarily produced from
petrochemicals and therefore are derivatives of crude oil. They mainly constitute polyester staple fibre
(PSF), acrylic staple fibre (ASF) and nylon staple fibre (NSF). Cellulosic fibre is made from cellulose
(wood) and mainly constitutes viscose staple fibre (VSF). Among the manmade fibres, polyester forms the
major (about 80%) portion.
Rating Methodology for Manmade Yarn Manufacturing, CARE, December 2020, page 1:
Manmade fibres (MMF) can be broadly categorised under two heads- Synthetic and Cellulosic.
Under the Synthetic fibre segment, there are three types of major fibres- polyester staple fibre
(PSF), acrylic staple fibre (ASF) and nylon staple fibre (NSF); whereas under Cellulosic, viscose
staple fibre (VSF) constitutes the major proportion…Polyester segment accounts for more than
80% of the total MMF industry.
Further, natural and manmade fibres are mixed (blended) in different proportions to give unique properties
to the yarn and the cloth to be manufactured from it.
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In India, cotton constitutes about 70% of yarn while the remaining comprises primarily manmade fibre.
This is in sharp contrast to global yarn production, in which manmade fibre comprises 65%.
Rating methodology – textiles (spinning) by ICRA, March 2022, page 3:
Manmade fibre accounts for ~65% share in the world’s fibre consumption… In
contrast, cotton yarn accounts for nearly 70% of the total spun yarn production in India.
Such a sharp difference in the pattern of yarn consumption in India vis-à-vis the world is primarily due to
govt. policies. The manmade fibre in India attracts higher taxes than cotton, which has pushed the textile
industry toward cotton. As a result, cotton is the most available fibre in the Indian market.
Due to abundant availability of cotton fibre and relatively higher indirect taxes on the
manmade one which impact export competitiveness, the Indian spinning industry is largely skewed
towards the cotton spinning and cotton yarn accounts for ~70% of the total spun yarn production
in the country
Cotton is an agricultural product, whose production depends on numerous factors like minimum support
price (MSP) by govt., weather, demand-supply in India as well as international market etc. Cotton is mainly
available in the market during its harvest season (October-March) every year. Growing cotton is covered
under the agricultural sector instead of the textile sector.
Manmade fibres are primarily crude oil derivatives and their raw material are produced by refineries. Their
prices are dependent on crude oil prices and their demand-supply situation in the Indian and international
markets. Their raw material is covered under the petrochemical industry instead of the textile industry.
Therefore, the scope of the textile industry begins with the first step where natural or manmade fibre is
converted into threat i.e. yarn.
2) Spinning – yarn/thread makers:

Spinning involves making thread/yarn from fibre. Spinning mills buy cotton from farmers/manmade fibre
from refineries and convert it into thread. Depending upon the requirement of customers, spinning mills get
specialized in making cotton yarn, manmade yarn or blended (mixed) yarn.
3) Knitting – fabric/cloth makers:

Fabric makers (knitters, weavers) buy yarn from spinning mills and convert it into cloth. Fabric makers
mainly sell the cloth to garment manufacturers as a B2B sale who in turn, make readymade garments for
selling in the market. However, some fabric manufacturers sell their cloth directly to customers (B2C) by
creating their own brands and sales channel (e.g. Raymond) that meet the need of people who do not buy
readymade clothes and instead like to get it stitched from tailors.
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4) Garmenting – apparel manufacturing and retailing:

The garments/apparel sector constitutes the final stage in the textile value chain where the cloth prepared
by knitters/weavers is converted into garments and sold to customers. It includes two segments: apparel
manufacturing which makes the clothes and apparel retailing which sell the clothes in the shops. Some
players do exclusive apparel manufacturing or apparel retailing; however, some players do both,
manufacturing as well as retailing.
An investor would appreciate that companies in each part of the textile value chain: spinning, knitting and
garmenting face different business challenges and therefore, it is essential for an investor to assess at what
stage of the textile value chain a company operates before she does its detailed analysis.
Now, let us understand the key characteristics of textile companies and understand how each business factor
affects textile companies in different segments of the value chain.
Key characteristics of business model of textile companies
1) Commodity nature of products:

In the value chain of the textile industry, spinning and knitting lead to commodity products.
In the case of spinning, the characteristics of the yarn are specified by the fabric maker in the terms of the
type of fibre, count number, blend ratio etc. Once these specifications are finalized then the yarn produced
by one spinning mill is not very different from the yarn produced by another spinning mill. Therefore, most
of the yarn produced in the industry is commodity yarn and the fabric maker can source the yarn from any
supplier who is willing to offer it at acceptable terms.
The Indian spinning industry is highly fragmented…given the commoditized nature of the product
with limited product differentiation
Nevertheless, many spinners try to differentiate themselves by producing yarn, which is of premium quality
(i.e. of higher counts) as well as by producing value-added yarn like compact yarn, slub yarn, mélange yarn
etc.
However, companies manufacturing value-added yarn such as compact yarn, slub yarn, mélange
yarn etc. can command premium pricing and differentiate the products to some extent.
CRISIL Ratings’ criteria for the cotton textiles industry, February 2021, page 11:
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A key factor distinguishing players in the commodity yarn market is their count range…yarn
realisations in the finer counts are generally less elastic than cotton prices, and are substantially
higher than those in coarser counts.
CRISIL Ratings takes a positive note of value addition in products, including twisted yarn, dyed
yarn, gassed and mercerised yarn, and compact and melange yarn, as these fetch better
realisations,
Similarly, the fabric segment is also dominated by commodity products. Once a manufacturer provides the
specification for the fibre in the terms of quality of yarn, colour etc., then there is not much difference in
the fabric produced by one fabric manufacturer and another.
Rating methodology for entities in the textile industry – fabric making, ICRA, April 2020, page 2:
High level of fragmentation and commoditised nature of product results in high competitive
intensity
Nevertheless, a few players are able to differentiate themselves by way of making fabric of premium quality
with respect to specifications like grams per square meter (GSM), picks per inch etc. and by producing
fabric that needs less processing before manufacturing garments.
The fabric that needs least processing before it can be used in garmenting will have the least price
elasticity. This is applicable for woven and knitted fabrics.
A few fabric producers create a brand for their products by selling them directly to customers (B2C) unlike
sales to garment manufacturers (B2B). By creating a brand in the B2C segment (e.g. Raymond Ltd), these
fabric players are able to differentiate their products and in turn, earn a better profit.
In addition to being sold to garment manufacturers, fabric is sold directly to customers who
prefer customised stitching over ready-made garments. Thus, entities focusing on the B2C model,
which are able to establish their brand…they have higher profit margins compared to entities
which are mostly present in the unbranded commoditised segment.
Therefore, an investor would appreciate that in spinning and knitting (fabric making) segments, most of the
textile industry produces commoditised, and non-differentiable products. Once the characteristics like type
of fibre, blending, counts etc. are finalised after that the product of one manufacturer is not very different
from the product of another.
Nevertheless, a few spinning mills and a few fabric producers are able to differentiate their products and
earn a high-profit margin.
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In the case of the garment-making (apparel) segment, the products are not commoditised. This is because,
in the garment segment, an apparel manufacturer can differentiate its products by its design abilities.
CRISIL Ratings’ criteria for the cotton textiles industry, February 2021, pages 11-12:
Garmenting is the final stage of manufacturing in the textile industry. This segment is generally not
commoditised
Rating Methodology for Entities in the Textile Industry – Apparels, ICRA, April 2020, page 1:
differentiation can be achieved based on design capabilities
Design abilities form the basis of branding in the direct B2C apparel segment. The garments/apparel
segment has many brands both Indian and international at almost every price point offering different choices
to customers. Branded apparel are able to earn a higher price than commoditised unbranded garments.
2) Competitive intensity and pricing power:

The textile industry as a whole is highly fragmented with many small players dominating each of the
segments of the textile value chain i.e. spinning, fabric-making and apparel. One of the major reasons for
such composition of the textile industry is govt. policies that promote small scale industries in the textile
sector, which is driven by the large employment generation in the textile sector.
Other major reasons for the highly fragmented nature of the textile industry are very low entry barriers
because the technology, raw material and labour are easily available.
Rating methodology for textiles sector by India Ratings, August 2020, page 2:
The industry is highly fragmented due to low-entry barriers and easy availability of raw material
and labour, leading to a large unorganised sector participant and only a few large players.
An investor would appreciate that when an industry is fragmented with many small players producing
primarily commodity goods, then it would have very high competition, which in turn would impact the
pricing power of the players. As a result, the majority of players in the textile industry do not have pricing
power over their customers.
Rating Methodology for Cotton Textile Manufacturing, CARE, November 2020, page 1:
The entire cotton textile value chain is highly fragmented in nature having both small and large
players operating, thereby making the industry highly competitive.
In the spinning segment, an investor would note that even though India has the world’s second-largest
(20%) spindle capacity at 50 million spindles; however, still the average size of a spinning unit in the
country is only about 30,000 spindles. As per ICRA, the industry is so fragmented that the largest spinning
player has only 3% of the industry capacity.
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Rating methodology – textiles (spinning) by ICRA, March 2022, pages 1 & 3:
India has the second largest spinning capacity in the world after China, with more than 50 million
spindles, equivalent to ~20% of the global spun yarn capacity.
Overall, the Indian spinning industry is highly fragmented, with the largest player in the industry
accounting for less than 3% of the overall installed capacity of the country. As per ICRA’s
estimates, installed capacities in the Indian spinning sector average at ~30,000 spindles per unit
The manmade fibre mills segment is no different from cotton spinning mills. The manmade fibre spinning
mills segment is also fragmented.
The manmade yarn industry is relatively fragmented compared to the MMF industry, with both
small and large spinners operating in the segment.
An investor would appreciate that a large number of small spinning mills that produce primarily
commoditised products would have intense competition among themselves and very low pricing power
over their customers. This is because the customer can easily replace yarn from one spinning mill with
another mill.
The Indian spinning industry is highly fragmented…Moreover, given the commoditized nature of
the product with limited product differentiation, the competitive intensity is high with minimal
pricing power.
The fabric segment of the Indian textile industry is no different from the spinning segment in terms of
fragmentation of supply capacity. One of the reasons for the presence of a largely unorganized sector in
fabric manufacturing is the active promotion of small scale industry by the govt. using incentivising
policies.
Indian fabric industry is highly fragmented, dominated by a large number of small-scale units in
the unorganised sector due to the Government’s earlier policy of promoting the small-scale
sector through tax and fiscal incentives and favourable labour policies.
As a result, in the fabric making segment, about 85% of the industry capacity is in the unorganized sector.
The domestic fabric manufacturing industry is fragmented with ~85% of the fabric
production concentrated in the small-scale units in the unorganized sector. The share of large
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mills which comprises integrated composite mills is only ~3-4% in the total domestic fabric
production (with balance accounted by the handloom sector).
An investor would appreciate that a fragmented industry with a large number of unorganized players
producing commoditised and non-differentiable products would have a very high competitive intensity and
a very low pricing power over their customers.
High level of fragmentation and commoditised nature of product results in high competitive
intensity and limited pricing power.
As discussed above, only a few players in the entire fabric making industry who produce premium fabric
and those who have created their own brands in the B2C segment are able to enjoy some pricing power.
However, players in the branded and premium fabric segment, enjoy some pricing flexibility and
thereby better margins.
The garment/apparel segment of the textile industry was reserved only for small-scale units by the Govt. of
India in the past. As a result, this segment is also highly fragmented in terms of market share owned by
different suppliers.
Indian apparel manufacturing industry is highly fragmented and is characterised by a large

number of small-scale units. This in turn is attributable to the Government’s earlier policy
of reserving the sector for the small-scale units, which had a specified cap on investments in plant
and machinery (the sector was fully de-reserved from CY2005).
The unorganized sector dominates the Indian apparel manufacturing as well as retailing segment due to the
easy availability of raw material (fabric), low cost of production, and active govt. support for small scale
industries in the sector.
This has led to a very high level of competition in the sector even though its products are not commodities
and many brands are present in the market. Nevertheless, the majority of the players do not have pricing
power.
As the apparel manufacturing and retailing sectors are fragmented and unorganized,
the competitive intensity is high and the pricing ability is restricted to large retailers and strong
apparel brands, besides niche boutique/ designer stores. While given the low cost of
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production and sufficient availability of raw material, a large chunk of domestic apparel
requirement is met from domestic manufacturing, apparel imports have also grown
An investor would note that only some of the established apparel brands have some pricing power.
Nevertheless, most brands have to follow the market in terms of sales and match the discounts to their
competitors.
The Indian branded apparel retail industry is intensely competitive, with the presence of several large
domestic and international brands, as well as smaller, regional brands.
This is because even the branded apparel sector is highly competitive in India with many domestic
and international brands competing
An investor may note the example of Monte Carlo Fashions Ltd, which highlighted to its investors that
each brand; whether Indian or international, whether strong or weak, has to adjust to the market and cannot
survive without discounts.
Conference call of Monte Carlo Fashions Ltd, May 2018, page 5:
Sandeep Jain: Sir I think in today’s scenario, we see all the leading brands not only Indian brands
but the international brands also, no brand can survive without discounts so when it is end of
season discount sale every brand be it a strong brand or a weak brand has to adjust to the market
conditions.
Therefore, from the above discussion, an investor would appreciate that almost the entire textile value chain
including spinning mills, fabric makers and apparel manufacturers and retailers, is highly fragmented where
many small players providing non-differentiable products and services compete with each other. As a result,
most of the players do not have any pricing power.
The credit rating agency, ICRA stated that out of the hundreds of textile players analysed by it, the average
net profit margin (NPM) of spinning mills is about 1% whereas the NPM of fabric and apparel players is
about 3%.
Rating methodology – textiles (spinning) by ICRA, January 2018, page 5:
For the spinning mills rated by ICRA, the average OPBDITA margins have averaged ~12-13%
with net profit margins of ~1% over the past five years.
Rating methodology for entities in the textile industry – fabric making, ICRA, March 2018, page 5:
For the ~100 fabric entities rated by ICRA during the past five years, the average OPBDITA
margins have remained at ~11% with net profit margins of ~3%.
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Rating Methodology for Entities in the Textile Industry – Apparels, ICRA, March 2018, page 3:
For more than 100 apparel manufacturers/exporters rated by ICRA, the OPBDITA margins have
averaged ~9% with net profit margins of ~3% over the past five years.
Therefore, an investor would appreciate that the pricing power of the textile players is low resulting in very
nominal profit margins. Only a few players are able to differentiate their products in a predominantly
commoditised marketplace and able to earn a high profit margin in the textile sector.
3) Impact of changing raw material prices:

While an investor analyses various companies in the textile value chain, then she realizes that the raw
material costs whether it is cotton or manmade fibre or the fabric or garments form the largest portion of
its operating costs.
Raw material cost constitutes the largest portion of the total operational cost in the entire cotton
textile value chain.
Raw cotton constitutes about 60% of the operating costs of a spinning mill.
CRISIL Ratings’ criteria for the cotton textiles industry, May 2013, page 3:
Raw cotton, the primary input for spinning units, constitutes about 60 per cent of the units’ cost of
production
As per the credit rating agency, ICRA, for the fabric manufacturers, yarn costs are about 60% of their
operating costs.
The fabric industry is raw material intensive with yarn cost accounting for nearly 60% of the total
operating costs
While analysing the apparel manufacturers, an investor notices that it is even more raw-material intensive
and the fabric costs consume about 60% of its revenue.
apparel manufacturing industry is raw material and labour intensive with the fabric (raw material)
cost accounting for ~60% of the total revenues
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Therefore, an investor would notice that almost the entire textile value chain is very raw material intensive
and any factor impacting the prices or availability of its raw material would have a significant on the textile
players.
Out of all the textile players, cotton spinning mills are most sensitive to the raw material price and
availability changes. This is because; first, cotton is primarily available in the harvesting season (Oct. to
March) and the cotton-spinning mills have to stock cotton appropriately looking at their order book and
expectations of availability and prices of cotton during the non-harvest season. Therefore, the cotton-
spinning mills end up having a high level of inventory stocking during the harvest season.
Procurement of cotton by spinning mills start from October every year (with the start of cotton
harvesting) and continues till February – March. Spinning mills usually procure cotton fibre stock
during the harvesting season to ensure optimisation of operations during the non-harvesting
season.
Second, cotton prices are very volatile and depend upon good or bad weather, the minimum support price
(MSP) declared by the govt., demand and availability of cotton fibre in the Indian as well as the international
market because fibre is a globally-traded commodity and domestic and international cotton prices move
together with a lag, expectations of next season’s crop as well as the prices of manmade fibre, which also
act as a substitute etc.
Rating Methodology for Cotton Textile Manufacturing, CARE, November 2020, pages 1-2:
Prices of cotton fibre are highly volatile…Cotton, being an agricultural commodity, its availability
and price are dependent on the vagaries of nature, international demand and supply, expectation
of crop during the on-going season and also in the next season, Minimum Support Price
(MSP) fixed by the Government, time of procurement, prices of polyester fibre/yarn and also by
the distance of the cotton spinning unit from the major cotton fibre sourcing centre.
Rating Methodology for Cotton Textile Manufacturing, CARE, May 2013, page 3:
parity between domestic and international prices. Both prices move in tandem, albeit with a brief
time lag.
Third, as discussed earlier, cotton spinning mills have very low pricing power over their customers because
the spinning segment is highly fragmented and produces mainly commodity products. Therefore, the ability
of the spinning mills to pass on increases in the input costs is very low.
Fragmented and competitive nature of the industry and competition with the manmade yarn fibre/
yarn (where prices are governed by crude oil prices) limits the ability of cotton spinning companies
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to completely pass on any major increase in the prices of raw cotton to their customers and can
hence affect their profitability margins.
The low pricing power of spinning mills and their inability to pass on the increased costs to their customers
was visible during FY2020 when the cotton prices increased substantially without a proportionate increase
in yarn prices. As a result, the profit margins of most of the spinning mills declined in FY2020.
Spinning mills producing yarn from manmade fibre are comparatively less exposed to inventory risk as
they do not have to stock inventory for the non-harvesting season like cotton-spinning mills. This is because
manmade fibre is available round the year. Nevertheless, manmade fibre spinning mills are exposed to
fluctuating raw material prices because the prices of manmade fibre are linked to crude oil prices, which
are very volatile.
Manmade yarn manufacturers do not face seasonality risk like their cotton counterparts. Despite
that, inventory management plays a crucial role owing to the linkage of the raw material with
crude oil prices, etc… Owing to the competitive nature of the industry, any adverse inventory
fluctuation can have an impact on the overall financial risk profile of a company.
Being derivatives of crude oil, PSF prices are inherently volatile in nature, making the margins of
the spinners susceptible to adverse fluctuations in the fibre prices.
Another factor that puts manmade-fibre (MMF) spinning mills in an adverse situation is that the MMF
production in India is highly concentrated because MMF producers are very large corporates like Reliance
group, Aditya Birla group etc. whereas the MMF spinning mills are very small fragmented units. As a
result, the MMF spinning mills do not have any bargaining power against large MMF suppliers.
The MMF capacity in India is highly organised with Reliance Industries, Indo Rama Synthetics,
Bombay Dyeing, and Grasim holding nearly 95% of the total capacity. The manmade yarn
industry, on the other hand, is relatively fragmented compared to the MMF industry
Such composition of the MMF industry puts the manmade-fibre yarn producers in a very disadvantaged
position and the increasing cost of their raw material becomes a factor that can push them out of business
as well.
In a series of orders against Grasim Industries Ltd, which is the only producer of viscose stable fibre (VSF)
in India and has more than 85% market share, the Competition Commission of India (CCI) found that the
company was involved in unfair business practices (read here: CCI order March 2020, CCI order August
2021).
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CCI found that Grasim (opposite party 2, OP-2) was arbitrarily charging a higher price to those customers
who bought a higher quantity of VSF. It was also charging a higher price to those mills who were selling
VSF yarn in the domestic market and a cheaper price to mills who were exporting VSF yarn in the export
market.
on many occasions, a buyer who purchases a larger quantity of VSF has to pay a higher price as
compared to another buyer who sources a lesser quantity from OP-2.
OP-2 and its pricing policy failed to reasonably justify the reasons for higher net prices recovered
from domestic spinners as compared to other segments.
CCI also found that Grasim was keeping a tight check on the VSF utilization by the spinning mills by
forcing them to share their production data with Grasim in order to block any attempt by its VSF customers
to sell the VSF in the market by trading or exporting it.
The act of OP-2, with respect to seeking from its customers’ details of VSF bought and used for
production of VSF yarn in the garb of offering discounts as a condition for sale of VSF can be
interpreted as not only preventing the resale of VSF by its customers in India but also preventing
the export of VSF by its customers as a competitor to OP-2 in the export market. By seeking the
details of production and sale from its customer, OP-2, has been controlling the entire market in
its favour.
In one of the cases, CCI found that Grasim had charged such high prices to a VSF spinner that it had to shut
down its VSF spinning business because it could not compete with other VSF spinners whom Grasim was
selling VSF at a cheaper price.
withdrawing/providing no discounts/credit notes to a VSF spinner and at the same time selling
VSF at discounted prices/adjusting through credit notes to other domestic spinners who are all
competitors in the downstream domestic VSF yarn market. Owing to the said conduct, Informant
No. 2 had to cease production of VSF yarn/blended VSF yarn.
Due to these anti-competitive practices, CCI put a penalty of ₹301.61 cr on Grasim Industries Ltd and
ordered it to stop abusing its dominant position on VSF spinners.
Therefore, an investor would appreciate that the relatively low bargaining power of MMF spinners against
MMF producers puts them in a seriously disadvantaged position.
While analysing fabric and garment manufacturers, an investor would notice that even though, raw material
prices are a significant cost for them, still, the volatility of their raw material prices i.e. yarn cost for fabric
manufacturers and fabric cost for apparel manufacturers does not have a very high impact on them. This is
because they manufacture goods only after getting confirmed ordered and they price their products by
factoring in the current ongoing prices of raw material (yarn or fabric).
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For fabric and garment manufacturers, the susceptibility of margins to fluctuations in the raw
material prices remains low as the manufacturing is generally order backed where prices are fixed
as per the prevailing market price of the raw material. Companies manufacturing against
confirmed orders, fixing the prices taking into account the prevailing raw material prices,
and maintaining raw material inventory position commensurate to their order book positions,
are insulated from the fluctuations in raw material prices.
An investor may read out a detailed analysis of Montel Carlo Fashions Ltd, in which we observe that the
company has always been able to pass on the increase in its raw material costs by way of increasing the
prices of its garments to its customers.
Conference call, August 2021, page 3:
Sandeep Jain:…As far as your question about the high cotton prices are concerned yes there have
been increase in the cotton prices but fortunately, we have been able to pass all the cost increase to
our garments
Moreover, fabric and apparel manufacturers benefit from the year-round availability of their raw materials
i.e. yarn and fabric, unlike raw cotton. Therefore, they do not have to stock a high raw material inventory
like cotton-spinning mills, which reduces their susceptibility to fluctuations in their raw material prices.
The susceptibility of a fabric-maker’s profitability to fluctuations in raw material prices is

generally low because of the limited yarn stocking by the units, as yarn is readily available
throughout the year.
Therefore, an investor would appreciate that due to high raw material costs, low pricing power, and intense
competition between fragmented-industry players, companies in the textile industry are exposed to a
significant risk of fluctuations in the raw material prices. The risk is highest in the case of spinning mills.
However, the fabric and apparel manufacturers are able to mitigate raw material prices risk by
manufacturing goods only against confirmed orders where prices are quoted after factoring in ongoing raw
material prices.
Nevertheless, if fabric and apparel manufacturers accept long-period fixed price orders then they may also
get exposed to a higher raw-material price fluctuation risk.
Nevertheless, the vulnerability to raw material price fluctuations increases if the entity
accepts long-term fixed price orders.
4) Cost competitiveness, economies of scale:
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From the above discussion, an investor would remember that almost all the segments of the textile industry
are highly fragmented and dominated by small players. Therefore, all the players face intense price-based
competition. An investor would appreciate that in such a situation, the players with the lowest cost of
production gain major competitive advantages.
As most of the products made by textile value chain are non-differentiable commodities in nature, except
garment-manufacturing; therefore, customers can easily switch from products of one manufacturer to
another. In such a market, the lowest cost producers determine the market price and other players have to
match the prices (price-takers) irrespective of their cost structure.
Cost position is an important factor in differentiating between companies as domestic producers

are the price takers for finished goods and profitability will be highly dependent on the cost
position.
In the textile segment, the raw material cost is the largest cost component, which is not under the control of
the players. As a result, the main method for the players to reduce their costs is operating leverage i.e.
economies of scale in which companies increase their manufacturing capacities. As a result, the fixed costs
get spread over a larger volume of production and per-unit cost of production declines.
Rating Methodology for Cotton Textile Manufacturing, CARE, September 2018, page 4:
The cotton spinning industry is characterized by cyclicality, fragmentation and high capital
intensity. Raw material cost forms a major component of cost and players operate at very low
margins. Economies of scale and level of integration are the key to profitable operations.
As a result, small players in the textile value chain are at a competitive disadvantage and are highly
vulnerable during economic downturns.
large players are likely to have more stable market and customer bases, whereas small players
would be more vulnerable to competition and raw material price volatility even when the demand
is stable.
In the spinning segment, it is essential to have a large spindle capacity. If a mill has a smaller spindle
capacity than the industry average of 28,000 spindles, then the mill would find it difficult to be cost-efficient
and would be at a competitive disadvantage.
Rating methodology – textiles (spinning) by ICRA, September 2015, page 1:
During the last 15 years, the average size of the spinning unit in India has increased from
~24000 spindles to ~28000 spindles. Companies below this average unit size may find it difficult
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to have a competitive cost structure in the commoditized yarn market, unless the capacity is
recently added, as it will have a better level of modernization.
Similarly, in the fabric-making segment as well, having a lower cost structure by way of economies of scale
is essential because of high competition in the commoditised market.
Given the intense competition and limited product differentiation, larger capacities in fabric
manufacturing offer benefits of economies of scale, thereby resulting in a better cost structure.
In the apparel manufacturing and retailing section as well, the cost efficiencies developed by a large size
are essential to support profit margins.
a large revenue base leads to economies of scale in terms of cost efficiencies in procurement and
administrative functions, thereby supporting the margins of the retailer
Moreover, as a garment manufacturer grows big, then it is able to sell directly to big brands and gain large
orders offering higher profit margins, which brings strength to its business model.
For the garment manufacturers, apart from cost advantage, large capacities allow the mills to
deal directly with the large domestic or international end-customers rather than selling the
products through dealers/ distributors.
Moreover, an investor would appreciate that established international brands take a long time to approve
vendors due to a focus on maintaining the consistency in the quality of their products. As a result, a long
approval process by international brands becomes an entry barrier for new entrants. As a result, a textile
company having economies of scale and catering directly to big brands seems to have many competitive
advantages.
companies supplying to international brands require a long lead time for new vendor approval,
thereby creating an entry barrier for new players.
Therefore, an investor would appreciate that in the entire textile value chain whether it is spinning, fabric
or apparel manufacturing, due to intense competition and almost non-differentiable products, companies
have to focus on lowering their cost of production and large capacities with economies of scale help a lot
to achieve it. Smaller players are at a competitive disadvantage even during times when demand is stable.
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large players are likely to have more stable market and customer bases, whereas small players
would be more vulnerable to competition and raw material price volatility even when the demand
is stable.
5) Capital intensive nature of operations:

The textile industry is a capital intensive sector, which needs large capital both for installing plants &
machinery as well as for managing working capital due to the raw-material intensive nature of the business.
Owing to the capital intensive nature of business, companies having operations in the industry
typically have high reliance on external debt to fund their fixed capital expenditure and working
capital requirements.
Out of all the segments of the textile value chain, spinning is the most capital intensive; both from the
perspective of fixed capital (manufacturing plant) as well as working capital (inventory and receivables).
The cotton yarn spinning industry is highly capital intensive, faces acute cyclicality, has extremely
fragmented capacities, and is intensely competitive on account of the commoditised nature of the
product.
Given the fixed capital as well as working capital-intensive nature of the spinning business,
the funding requirements are typically high in the spinning sector.
As per the estimates by the credit rating agency, ICRA, a spinning plant with an industry-average size of
about 25,000 spindles needs about ₹90-100 cr for installation and produces a revenue of about ₹90-110 cr
indicating a fixed asset turnover ratio of 1, which is low in comparison to other manufacturing industries.
Spinning is a highly capital-intensive industry requiring significant investments in plant and

machinery. A typical spinning plant with ~25,000 spindles involves a capital outlay of ~Rs. 90 to
100 crore – depending on land cost, degree of automation and nature of expansion, i.e. greenfield
or brownfield. A spinning unit of this scale has the potential to generate revenues of ~Rs. 90 to
110 crore, depending on the fibre usage and yarn count being produced by the mill.
An investor would remember from the above discussion that in India, almost 70% of the yarn spinning units
use cotton. Cotton is an agricultural commodity, which is harvested from October to March. Spinning mills
have to buy most of their cotton during the early part of this harvesting season because the best cotton is
available only during the start of the season.
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While cotton arrivals are spread over a six-month period from October to March, quality cotton
is usually available in the first few months.
Moreover, during the non-harvesting months, April to September, the availability of cotton is lower and
additionally, the cotton prices start reflecting the expectations of the cotton crop in the next harvesting
season. Therefore, the quality, availability and price of cotton become uncertain during the non-harvesting
season.
volatility in cotton fibre prices after the harvest season can be driven by the estimates of crop
production in the next season
As a result, cotton companies prefer to stock cotton during the harvesting season as per their order estimates.
In fact, spinning companies, which can procure a large amount of cotton are at an advantage as they can
maintain the quality of their yarn
The companies which are capable of procuring large quantities of similar quality cotton fibre are
looked at favourably as it enables them to maintain uniformity in the quality of yarn manufactured.
The practice of buying a large amount of cotton during the harvesting season leads to a large requirement
of inventory by spinning mills, which makes their operations working capital intensive. In addition, it also
puts them at the risk of inventory losses if the prices of cotton decline later on.
Spinning mills usually procure cotton fibre stock during the harvesting season to ensure
optimisation of operations during the non-harvesting season. This, however, exposes the players
to adverse fluctuations in the raw material prices. Any significant decline in the prices of the fibre,
especially for the entities having excess inventory on their books, can lead to inventory losses.
In fact, in the past during FY2012, cotton prices did decline sharply and most of the spinning mills faced
inventory losses. As a result, the cotton mills started cutting down on their inventory levels and reduced it
to about 2-3 months of inventory FY2017 onwards from earlier levels of about 6 months of inventory.
After the inventory losses incurred in fiscal 2012, cotton spinners are cautious on stocking cotton
for long periods. Thus, most have shifted to a leaner inventory cycle of 2-3 months in fiscal 2017,
as against the earlier norm of 6 months.
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In comparison, the working capital intensity of spinning mills based on manmade fibre is lower than cotton-
spinning mills because manmade fibre is available round the year without any seasonality. As a result,
manmade fibre-spinning mills do not need to do excess stocking. On average, manmade fibre spinning mills
maintain an inventory of 1-months as compared to an inventory of 3-months for cotton-spinning mills.
fiscal year-end inventory levels average close to ~three months for cotton-based spinners and
typically stand at ~1 month (at year-ends) for mills based on manmade fibre.
Therefore, an investor would notice that the spinning mills segment is highly capital intensive both from
the perspective of fixed capital as well as working capital.
When an investor looks at the fabric making segment, then she notices that fabric manufacturing is also
capital intensive and needs significant investment in plant and machinery as well as working capital.
Given the fixed capital as well as working capital-intensive nature of the fabric-making business,
funding requirements are typically high in the sector.
As per ICRA, a fabric-making unit of about 100 looms needs an investment of about ₹70-90 cr and produces
a revenue of about ₹100-150 cr indicating an asset turnover of about 1.5 to 1.7, which is low considering
other manufacturing industries.
Fabric manufacturing is somewhat capital intensive and requires significant investment in plant
and machinery. A typical modern fabric-manufacturing (weaving) unit with ~100 looms will have
a capital cost of ~Rs. 70 crore to ~Rs. 90 crore, depending on the nature of expansion, i.e.
greenfield or brownfield. The high fixed capital intensity is also reflected in the operating
income/gross block, which typically remains at ~1.5-1.7 times for fabric manufacturers. In
addition, fabric manufacturing operations are working capital intensive.
A fabric-making business is working capital intensive because it needs to maintain an inventory of about
2.5-3 months and additionally receivables of about 1.5-2 months are stuck with customers at any point in
time indicating a significant requirement of money for working capital.
Typically, the inventory holding period for fabric-manufacturing entities averages ~2.5-3 months
receivables position and the turnover period, which typically remains ~1.5 to 2 months for fabric-
making entities
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On the contrary, when an investor analyses the apparel segment, then she notices that both apparel
manufacturing, as well as apparel retailing, are not capital intensive. In fact, they are labour intensive
operations that need a significant number of people and a large amount of raw material to manufacture and
sell clothes.
Garment manufacturing, on the other hand, is not as capital intensive as yarn spinning;
apparel manufacturing industry is raw material and labour intensive with the fabric (raw material)
cost accounting for ~60% of the total revenues and manpower cost accounting for ~8~9% of the
total revenues.
Therefore, an investor would appreciate that even though the apparel business is not fixed capital intensive
(manufacturing plants); still, it is highly working capital intensive because apparel manufacturers, as well
as retailers, need to keep a large amount of inventory.
The apparel industry is working capital intensive, primarily on account of the high inventory
levels.
An apparel manufacturer needs to keep a large amount of inventory as it has a long manufacturing cycle.
Apart from the usual need of keeping the required amount of fabric for uninterrupted operations and work-
in-progress, the apparel units need to keep a large stock of garments of different designs, colours, sizes
(SKUs: stock keeping units) in their warehouses so that they may supply to the retail shops as and when
needed. This makes apparel manufacturing an inventory-intensive business.
The inventory levels for the entities involved in apparel manufacturing are on account of the long
manufacturing cycle, which involves multiple processing stages, starting from order-backed fabric
stocking, processing and stitching to finished apparels in transit to port/customers or awaiting
shipment, pending the completion of the entire lot size.
The apparel retailers have to keep a large amount of stock with different designs in the shop and in the store
to meet changing customer expectations.
For an apparel retailer, the inventory is because of the requirement to stock apparels for multiple
designs, colours and sizes in the stores, which typically averages ~three to four months of store
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sales, stock apparels in warehouses to ensure good fill rates in the stores and inventory on account
of season leftovers.
The inventory requirements of the apparel company increase further in case, it has both manufacturing and
retailing divisions instead of only manufacturing or retailing.
For an apparel retailer having in-house apparel manufacturing, the inventory levels are even
higher and thus pose higher working capital requirements compared to entities which are involved
in only manufacturing/ retailing.
An apparel manufacturer/retailer usually keep an inventory of about 100 days and in addition have
receivables outstanding of about 65 days of sales, which makes their business working-capital intensive.
Rating Methodology for Entities in the Textile Industry – Apparels, ICRA, March 2018, pages 5 & 7:
On an average, for the last five years, for more than 100 apparel entities (manufacturers and
apparel retailers) rated by ICRA, the overall inventory levels have remained close to ~100 days.
receivables position, which on an average has remained at ~65 days for more than 100 entities
rated by ICRA
Apparel companies follow different business models to sell their garments to end customers i.e. multi-brand
outlets (MBO), and exclusive brand outlets (EBO) that can either be company-owned or franchise-owned.
Each of these models has different fixed and working capital requirements.
From a fixed-capital perspective, company-owned EBOs are the most expensive because the company has
to spend all the money on owning/leasing the shop, its interiors, staff and utilities. However, in the case of
franchise-owned EBOs and MBOs, the company does not need to spend these costs and the store owners
make these spending. Nevertheless, an investor needs to note that franchise-owned EBOs may demand a
minimum guaranteed return on their investment, which nullifies a lot of the gains from savings in the capital
expenditure.
Rating Methodology for Entities in the Textile Industry – Apparels, ICRA, March 2018, page 3:
In contrast to the owned-EBO distribution model, entities retailing through MBOs and franchisee-
managed EBOs require limited fixed capital investments, in-store interiors and fixtures besides
limited fixed overheads such as rentals, employee salaries, electricity charges etc. They are
accordingly able to withstand downturns better, scale up easily during demand upturns and
also command higher returns on investment. However, if the franchisee-managed EBOs have an
arrangement of minimum guaranteed returns, the said benefits get offset to a large extent.
From the working-capital perspective, the company-owned EBOs are most capital-intensive because the
garments until sold to the end customers remain an inventory of the company. On the contrary, in the case
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of MBOs and franchise-owned EBOs, the company sells the garments to the shop under the sale-or-return
(SOR) or outright sale model, which reduces its obligations for the unsold inventory significantly.
When the apparels are retailed through entity-managed EBOs, the apparel inventory remains with
the entity till it is sold to the final customers. However, in case of retailing through distribution
partners, i.e. MBOs and franchisee-managed EBOs, the entity enters into either/or mix of the sale
or return (SOR) model or an outright sale model with their distribution partners.
In the sale or return (SOR) model, all the unsold inventory at the end of the season is taken back by the
company. However, in the outright sale model, the company’s risk of unsold inventory is eliminated as
there is no provision for the return of unsold garments to the company. However, in such situations, the
shops ask for a longer credit period to compensate for the higher inventory risk undertaken by them.
In some cases under the SOR model, the sale is recognised when the entity transfers the inventory
to the channel partner, and the unsold inventory with the channel partners at the end of the season
is taken back by the entity and is reflected as sales returns.
In the outright sale model, the apparels once sold to the channel partners are not taken back. High
proportion of sales on an outright sale basis keeps the inventory levels under control as there are
no unexpected returns at the end of the season; however, the outright sale model is analysed for
the pace of debtor collection, as sometimes, the entities tend to extend a longer credit period, if
the sales at the end of channel partner are slow.
Nevertheless, an investor would appreciate that the garment designs become out of fashion very soon and
therefore, it is difficult to sell garments from the previous season. As a result, the unsold garments lose their
value fast. Therefore, inventory management is very critical for apparel manufacturers and retailers.
Given the fast-changing fashion trends, apparels can face fast obsolescence and witness a sharp
decline in their realisable value, if not sold within the marketing season they were manufactured
for. Accordingly, inventory management is most critical for the profitability of an apparel retailer.
Companies need to run aggressive end-of-season sales to get rid of unsold inventory, many times at steep
discounts. Therefore, at times, even under the outright sale model, the shops may request the company to
share discounts as the monetary loss due to discount sales and unsold inventory can be huge.
ICRA also notes that in the case of the outright sale model, large unsold inventories at the
MBOs/franchise managed the EBOs can impact the future sales of the entity and thus the policy
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on inventory liquidation through discount sharing with channel partners is also compared with
other players.
Therefore, an investor would appreciate that in the textile value chain, the spinning segment is the most
fixed-capital intensive, and fabric making is somewhat fixed-capital intensive. However, garment
manufacturing is not much fixed-capital intensive instead it is a more labour-intensive business.
From a working capital perspective, both spinning and fabric-making are working capital intensive;
however, garment manufacturing and retailing are much more working-capital intensive in comparison. In
addition, the risk of inventory obsolescence is also highest in the garment/apparel business.
An investor would also appreciate that the textile industry needs regular modernization of plants &
machinery to keep them efficient. Modernization itself adds to the capital-intensive nature of textile mills.
Modernising a textile unit is fairly capital intensive, and in general, the industry has lagged behind
other cotton exporting nations in this respect; only a few financially strong companies resort to
continuous modernisation.
Another factor that makes textile companies capital intensive is their high power requirements. Spinning
mills are the most power-intensive segment of the textile value chain. For a spinning mill, power costs are
about 10% of revenue.
Power cost also forms a fair component of cost (about 10% of sales)
Many times, to ensure uninterrupted and good power supply, textile companies install captive power plants,
which increases the capital intensiveness of their business.
captive generation have an assured and uninterrupted supply of power. However, the
same increases their capex requirement.
In order to reduce their power requirements, textile companies go for modernization of plants as
technologically new plants are power-efficient. However, as discussed above modernization of plants is
also a capital-intensive activity.
Moreover, an investor would also appreciate that textile operations, especially garment manufacturing, are
labour intensive. As per CRISIL, labour cost forms about 6% to 14% of operating costs for textile
companies.
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labour costs vary from 6 per cent to 14 per cent among CRISIL-rated companies
Labour intensive operations expose textile companies to problems like strikes, labour unrest etc., which
force companies to have multiple manufacturing plants so that labour problems at one plant may not affect
the tight delivery schedules of customers.
However, given the labour intensity of the sector, large units can also face challenges related
to manpower issues, such as strikes, labour unrests etc.
In order to reduce the dependence on labour, usually, textile companies go for modernization of plants
because the new machines with better technology are more automated and reduce the dependence on labour.
mills having higher level of modernisation, have lesser reliance on labour and are viewed
favourably
However, as discussed above, the modernization of textile units is a capital-intensive exercise.
Therefore, an investor would appreciate that installing, running, maintaining and modernising textile units
is a capital intensive activity. As a result, it may seem that only deep-pocketed entities would be able to
enter this sector. However, an investor would also note that the textile sector is one of the largest employers
in India, second only to agriculture. Therefore, governments, both centre and state, support the creation,
maintenance and modernisation of textile mills via their policy and fiscal incentives.
Government of India provides various fiscal incentives [Amended Technology Upgradation Fund
Scheme (TUFFS), Scheme for Integrated Textile Parks (SITP), Rebate of State and Central Taxes
and Levies (RoSCTL), etc.] to companies operating in the textile value chain. These
incentives constitute a major portion of the profitability margins of the companies and are looked
at closely. In addition to that, in order to promote investment, certain State governments also
provide fiscal incentives in the form of capital or interest subsidy to players setting up new textile
units or undertaking modernisation at their existing units.
In fact, despite being a capital intensive sector, due to the support received from the govt. in the form of
fiscal incentives and subsidies, textile companies routinely go for modernization and capacity expansions.
Being capital intensive and given the availability of various fiscal incentives for capital
investments, capacity expansion has been a regular feature for industry participants.
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In the apparel manufacturing segment, companies get significant incentives from govt. like subsidies to
expand capacities.
apparel manufacturers continue to have access to capital subsidies for eligible benchmarked
machinery at a higher rate of 15% (with a cap of Rs. 30 crore) under TUFS, vis-à-vis 10% under
the earlier scheme.
Therefore, an investor would appreciate that despite being a capital intensive sector, even the small-scale
textile players have added and modernised capacities because the govt. has supported them by way of
various incentives and subsidies.
Going ahead, an investor should always keep in mind the capital-intensive nature of the textile business and
the role of govt. incentives whenever she analyses any textile company. Any reduction in the govt.
incentives may impact the financial position of the companies and their ability to do capital expenditure.
6) Cyclicity and seasonality in the textile industry:

An investor would appreciate that the demand in the textile sector is linked to the macroeconomic conditions
in the country. This is because the purchase of fabric/garments is linked to consumer confidence, spending
power and discretion. As a result, the demand for textile products undergoes cyclical changes in line with
the general economic cycles (boom and bust phases).
performance of fabric-making entities is closely linked to macro-economic conditions, consumer

confidence and spending patterns, considering the discretionary nature of the end use products,
from a demand perspective.
Performance of apparel entities is closely linked to macro-economic conditions, consumer

confidence and spending patterns, particularly considering the discretionary nature of their
products.
As per credit rating agency, Standard and Poor’s (S&P), the apparel industry faces both price and volume
cyclicity. As per S&P, the price-cyclicity is more in the non-branded apparel segment and lesser in the
premium branded apparel segment.
Key credit factors for the branded nondurables industry, S&P, July 2015, pages 2 and 3:
For apparel companies, price points may be higher, especially for luxury items, and these items
tend to be more discretionary in nature. There can be some price cyclicality related to changes in
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consumer discretionary spending patterns for nonluxury apparel, but it tends to be less cyclical
for luxury goods.
For apparel and related companies, volume cyclicality exists because of the more discretionary
nature of the products.
Moreover, if an investor observes the key raw material whose costs have the most impact on the textile
industry, then these are cotton and manmade fibre. Cotton, as well as manmade fibre (depending on crude
oil prices), are volatile commodities following their own demand and supply cycles.
Spinning industry is cyclical in nature, given that its performance is linked to the level of volatility
in commodity prices (oil or cotton).
In addition, the textile sector sees a high level of seasonality where most of the sales are seen in the winter
season. There are two factors contributing to the same. First, the shopping for garments increases in the
festive season, which happens in winter. Second, winter garments are usually more high-value in nature
than summer garments. As a result, the sales of the textile industry especially apparel pick up in winter
every year.
The apparel sales are seasonal with most of the sales in the second half of the year
during festival season in both the domestic and export markets, and the sale of higher value winter
wear apparels.
Therefore, an investor may note that on average the value of garment sales increase during the second half
of the year in the winters and declines during the first half of the year in the summers.
Apart from cyclicity linked to general economic cycles and the seasonality during the year, many times, in
some segments of the textile industry, the boom and bust cycles are due to suboptimal capacity planning
by the players.
For example, in the denim segment, the cyclicity is driven by capacity additions. During the boom phases,
many companies start capacity additions, which take time to get complete. When these capacities start
operations simultaneously, they lead to overcapacity in the industry. As a result, the capacity utilization
falls leading the companies to compete on prices to get orders to run their plants. As a result, every player
witnesses a decline in realizations.
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The cyclicality in denim fabric manufacturing industry, which is a small segment of the weaving
industry, is also driven by capacity additions as strong growth results in capacity addition, leading
to over-capacity and depressing the capacity utilisation & realisations.
7) Diversification, Premiumization and Integration:

From the above discussion, an investor would appreciate that the business of textile companies is cyclical
with low-profit margins. This is true for all the segments i.e. spinning, fabric and apparel.
In order to improve the profit margins and reduce the cyclicity and seasonality risks, many textile companies
go for different strategies like diversification in operations, focusing on premium business segments as well
as vertical integration of operations i.e. forward or backward integration.
7.1) Diversification:
An investor would notice that most of the textile companies in the fragmented industry producing
commodity products running a capital-intensive business with very low pricing power are running a very
fragile business. This is evident by the fact that many small scale textile units go out of business in each
economic downturn, which is common due to the cyclical nature of the textile business.
One strategy used by the textile mills to reduce the risk in their business is to diversify. Companies diversify
their business in the terms of different products, customers, market geographies, sales channels etc.
Spinning mills diversify their product range by bringing in flexibility to use different fibres (cotton,
manmade, blended etc.) as well as producing yarn of different count ranges. Such companies can effectively
handle the challenges in any one product segment by shifting production to another segment, which might
be doing good.
Product diversification: Players having a diversified product portfolio tend to have more stable
revenues…Companies having capacity to produce multiple count yarns have better product
flexibility. Further, companies producing blended yarn rather than only cotton yarn, can efficiently
tackle the cyclicality in the cotton yarn demand.
Also, cotton spinners which are capable of producing multiple counts/ varieties of
yarns using different varieties of cotton fibres are viewed favourably as it allows them to shift from
one variety to the other in case of price fluctuations in one variety.
Similarly, a fabric manufacturing unit can diversify its product range by becoming flexible to use different
kinds of yarn like cotton or manmade or blended. In addition, the fabric maker can diversify its product
range by producing fabric of different specifications like grams per square meter (GSM), knitted, woven or
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for products like suiting, shirting, denim, home textiles as well as other features like colour/dyed and
finishing like wrinkle-free etc.
Rating methodology for entities in the textile industry – fabric making, ICRA, April 2020, pages 3-4:
For a fabric unit, diversification relates not only to fibre content and type of yarn (spun vs filament)
but also to the gsm range, pick range, width, variety and finishing of the fabric manufactured.
A diversified product portfolio includes a presence across the type of fabric manufactured (knitted/
woven), product category (suiting, shirting, denim, towels, bed sheets etc.), material used (cotton,
polyester, rayon, blends, etc), and finishes (grey, yarn dyed, dyed, value-add finishing such as
wrinkle free, water/oil resistant, etc)
Having the flexibility to alter the product range as per the ongoing market demand helps a fabric
manufacturer to handle cyclicity in different product segments better.
In the case of the apparel segment, companies usually diversify by catering to different customer segments
by launching multiple brands focusing on different price points, age groups etc.; so that a slowdown in any
target segment or any challenges faced by one of the brands would not hurt the whole business significantly.
Brands: A retailer with diversified brand offerings catering to different target markets on the lines
of price points, customer segments, age groups etc. will be less prone to loss of business from a
particular brand owing to factors such as reputational risk and customer perception issues, vis-à-
vis a retailer with a concentrated portfolio.
Therefore, an investor would notice that all the textile companies, be it spinning mills, fabric or apparel
units attempt to diversify their product range and bring in flexibility to reduce risk in their business model.
Apart from product diversification, companies also focus on targeting different geographical markets and
customers so that they may protect themselves from issues related to any particular market/customer.
Diversified customer base helps mitigate the risk of business getting affected in case financial
health of the counterparty deteriorates. This holds increased importance due to the cyclical
nature of the textile industry.
Many times, textile companies also focus on the mix of sales channels i.e. direct sales to customers or via
dealers to diversify their business risks and improve their profitability.
Direct sales to the customers are usually more profitable because such sales save on the commissions paid
to dealers. However, such sales come with an added burden for the companies in the terms of order sourcing,
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customer servicing, the credit risk of non-payment by customers etc., which is avoided when companies
engage with dealers.
Direct sales to the end customers can lead to better profitability margins for the textile companies
vis-à-vis sales made through the dealer network or through buying houses. However, the same can
lead to elongated payment terms and exposes the companies to credit risk of the end customers,
especially if major sales are being derived from a particular set of customers. Sales through the
dealer network, on the other hand, can result in bulk production for the mills and timely
payment realisation.
Many times, textile mills, which are mostly small scale units prefer not to handle these sales & marketing
activities and in turn, they route even the direct orders received by them via dealers. Dealers add further
value by acting as financiers for textile mills by making them faster payments even before they are received
from customers. In addition, dealers also share the credit risk for the textile companies on behalf of the
customers brought in by them.
Rating methodology for entities in the textile industry – fabric making, ICRA, April 2020, pages 3-4:
ICRA notes that dealers play an important intermediary role for fabric units like order
aggregation, customer service and sometimes financing as well by making faster payments to the
units. Dealers also add value by sharing the fabric player’s credit risk. As a result, sometimes,
even direct sales are routed by the entities through dealers for client servicing, faster payments
and for managing the credit risk. Nevertheless, direct relationships typically act as positive
attributes and result in better profitability by saving on dealer commissions.
However, doing business via dealers reduces the bargaining power of textile companies because the dealers
may create a higher price-based competition among the mills by choosing a supplier based on the lowest
price.
Rating Methodology for Entities in the Textile Industry – Apparels, ICRA, April 2020, pages 3-4:
However, sourcing orders through dealers/ buying houses also results in limited bargaining
power for manufacturers as buying houses can source from different suppliers on the basis of
the lowest pricing.
Therefore, an investor would appreciate that dealers in the textile industry have built their place in the
system by solving the problems of small scale textile companies related to sales & marketing, financing
and customer credit. Therefore, an investor may keep this in mind while assessing the sales strategy of any
textile company.
Apart from diversification, another strategy used by textile companies to strengthen their business model
and survive cyclicity associated with the economic downturn is the premiumization of their product range.
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7.2) Entry into premium and value-added products:
From the above discussion, an investor would appreciate that most textile companies produce commodity,
non-differentiable products where a customer can easily switch from one supplier to another. Such a
business takes away the pricing power of companies and results in intense price-based competition in the
industry. As a result, their business model is very weak.
However, some textile companies from each of the segments of spinning, fabric and apparel venture into
value-added and premium products to strengthen their business model.
Value-added products (VAPs) bring in customer stickiness where the customer faces a high switching cost
if she intends to replace one supplier with another.
VAPs also offer the possibility of a strong degree of integration with customers. The tailoring of
products to meet specific end-customer needs can make it more difficult for these customers to
easily switch suppliers and adds stability to producer earnings
To focus on the premium segment, spinning mills focus on producing yarn of higher counts. Fine quality
yarn of higher counts is used in premium apparel and therefore, has a high realization and profit margins.
In addition, the demand for premium apparel does not decline with moderate changes in its price i.e. price
inelastic. As a result, the textile companies get room to increase prices in case their input costs go up without
a significant decrease in the demand for their products.
spinners manufacturing finer-quality yarns, measured by counts, are less vulnerable to raw
material price changes as end-product higher realisations are less elastic to raw material price
movements
players having ‘finer count’ yarn or ‘higher thread count’ fabric in their product mix, cater to
the elite market segment where demand is relatively price inelastic and margins are high.
In the case of fabric makers, apart from making premium fabric and selling it to apparel manufacturers
(B2B), a few players sell their fabric directly to customers (B2C) who wish to get their clothes stitched
instead of wearing readymade garments. Such companies usually create brands around their B2C offering
and are able to earn a high price and profit margin.
Brand strength: In addition to being sold to garment manufacturers, fabric is sold directly to
customers who prefer customised stitching over ready-made garments. Thus, entities focusing on
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the B2C model, which are able to establish their brand in the markets by virtue of their designs,
quality, product range and other requisites, are able to command superior pricing
power and higher realisations. Thus, they have higher profit margins compared to entities which
are mostly present in the unbranded commoditised segment.
Similarly, apparel manufacturers attempt to create strong brands, which can give them pricing power, high-
profit margins and customer stickiness.
Brand strength: For branded apparel retailers, brand strength manifests itself in the form of
pricing power and the ability to grow.
An investor would appreciate that strong brands whether in the fabrics or apparel space have higher pricing
power, realizations, and profit margins over unbranded commoditized products. The demand for products
of strong brands is usually price-inelastic i.e. the demand does not fall when there is a moderate increase in
prices. As a result, companies can pass on the increase in their input costs to their customers and strengthen
their business model.
Additionally a strong brand, due to its premium pricing and high-profit margins, allows companies to handle
economic downturns better by offering discounts, which maintains sales during the tough time from existing
customers as well as other customers who buy products at a reduced cost during discounts.
Strong and established brands enjoy a premium pricing over others and also have better pricing
power. In addition, because of the strength of the brand, the demand is relatively less price elastic,
which provides flexibility to pass on the increase in the input costs to maintain the profit margins.
Moreover, given the premium pricing, strong brands have the cushion to offer discounts during
economic downturns to sustain the demand from existing customers and potential customers who
were earlier reluctant to buy because of higher prices.
Therefore, an investor would appreciate that entry into the premium segment, offering value-added products
and creating strong brands helps companies in strengthening their business model.
Apart from diversification and premium offerings, textile companies also attempt to integrate their business
operations to make their operations cost-effective and resistant to cyclical changes in the economy.
7.3) Vertical Integration:
An investor would appreciate from the earlier discussion that the textile industry is intensely competitive
where most of the companies operate at a very low-profit margin. As a result, the companies’ business is
very sensitive to any changes in the demand or raw material prices. Numerous small players go into losses
during economic downturns and even shut their businesses.
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In order to improve their profitability, reduce the volatility and reduce the impact of fluctuating raw material
prices, a few textile mills opt for vertical integration, both forward and backward integration so that they
may perform more value-adding steps in-house leading to higher profitability. In addition, they are able to
control the supply and quality of raw material as well as save on transportation and packaging costs of raw
material.
companies which have integrated nature of business (from yarn-to-fabric/ from fabric-to-garment/
or, from yarn-to-garment) are generally benefitted by the synergies associated with lower raw
material procurement cost/lower logistics cost and are viewed positively.
In the case of spinning mills, the companies go for both backward as well as forward integration. Under
backward integration, spinning mills may engage farmers for contract farming of cotton and own in-house
ginning facilities for preparing cotton for yarn.
Spinning mills having their own ginning facilities or engaged in contract farming of cotton get the
advantage of uniformity in raw material quality. Such companies ensure regular supply of quality
cotton.
As mentioned above, in the case of forward integration, spinning mills may go to the extent of yarn-to-
fabric or yarn-to-garment integration and use their in-house production of yarn to make fabric or apparel.
Such a forward integration is better for the spinning mills as it leads to stability as well as an improvement
in profit margins because the company saves on many components of raw material costs and benefits from
relatively stable profit margins of the fabric business.
While the prices of fabrics also tend to fluctuate in relation to the yarn prices, the profit margins
in fabric-making are steadier vis-a-vis yarn manufacturing, considering higher raw material
holding requirements as well as greater exposure to volatility in prices of raw materials (cotton/
polyester) in the yarn business. Besides diversification benefits, captive yarn availability for in-
house consumption results in savings in transportation, packing and selling costs. Hence forward-
integrated mills with sizeable in-house yarn consumption tend to witness lower volatility in
margins than a standalone spinning mill.
Along similar lines, fabric makers go for backward integration in spinning as it reduces their raw material
costs and provides better control on the quality of yarn available to make the fabric.
Fabric manufacturers having backward integration with spinning units save on to their freight
expenses, selling cost and packaging expenses apart from having better control on the quality.
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Fabric manufacturers who go for forward integration into the apparel/garmenting business earn a better
profit margin and simultaneously reduce the cyclicity in their business operations.
Fabric manufacturers, who integrate forwards into garmenting will therefore face lesser
cyclicality risks and command better margins.
From the above discussion on the capital-intensiveness of textile businesses, an investor would remember
that out of all the segments, spinning and fabric-making are fixed capital intensive whereas garment
manufacturing is not fixed capital intensive. Instead, garment manufacturing is a labour-intensive process.
Therefore, apparel manufacturing units do not prefer to opt for backward integration into the capital-
intensive fabric and spinning units.
The integration assessment is primarily applicable to the spinning, fabric and home textiles sub-
sectors. Apparel manufacturers are not expected to have a high level of integration due to the
asset-light nature of their business model.
Moreover, most apparel retailing companies tend to keep their business as light as possible because it keeps
their investments in the business low, which improves their return on capital. Additionally, these companies
are better able to handle demand slowdowns due to their lower fixed costs and are able to increase sales
fast during recovery phases as they can increase the outsourcing of garments to meet the high demand.
Rating Methodology for Entities in the Textile Industry – Apparels, ICRA, March 2018, pages 2-3:
Apparel entities with an asset-light business model, involving outsourcing of manufacturing,

have lower fixed capital requirements (investment in building and plant & machinery) as well
as lower working capital requirements in comparison to those entities which have entire
manufacturing in-house, as the need for stocking raw materials/work-in progress gets eliminated.
As a result, such entities are better equipped to face the demand slowdown because of lower fixed
overheads. On the positive side, during an upturn in demand, with outsourcing systems in place,
the operations can be scaled up with increased outsourcing / adding new suppliers to cater to the
demand, without missing out on market opportunities.
Nevertheless, whenever apparel-manufacturing units choose to go for backward integration into the fabric
of yarn making, then it is mostly the large players, which can afford to spend significant money on the plant
and machinery. As the companies are now able to capture more value-adding steps in-house; therefore,
backward integration improves the profit margins of garment units.
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A garment manufacturing unit can also have backward integration with a fabric or a yarn
manufacturing unit (though restricted to large players only because of the capital intensive
nature). The same generally leads to relatively higher profitability margins owing to the presence
of more number of value-added jobs in-house. For a garmenting unit, backward integration with
a fabric manufacturing unit also allows it to have better control on the quality at the weaving and
processing stages.
Therefore, an investor would notice that in general, any vertical integration for spinning, fabric as well as
garment manufacturing units helps the companies in increasing their profit margins as well as reducing the
volatility in the margins.
Nevertheless, an investor would appreciate from the earlier discussion that in the textile value chain, the
spinning mill segment is much higher capital-intensive than fabric and apparel businesses. In addition, the
spinning mills need to stock cotton for the non-harvest season leading to high inventory levels and increase
risk of inventory losses.
Therefore, a company that is primarily a yarn manufacturer i.e. spinning mill and forward integrates into a
fabric and garment making business, then it is moving into segments, which are less capital intensive and
with easy to manage inventory levels.
On the contrary, when fabric or garment making units backwards integrate into the spinning business, then
they enter into a segment, which is much more capital intensive with difficult inventory management.
Therefore, many times, when fabric and garment units attempt to backwards integrate into the spinning
section, then these companies face many challenges.
For example, when a fabric maker enters into the spinning business, then it is a segment with different
business risks and a higher inventory risk and higher volatility of margins linked to raw-material price
fluctuations. As a result, when cotton prices in the open market decline, then the integrated fabric player
(fabric + spinning) faces inventory losses whereas if it had stayed a standalone fabric maker, then it would
have benefited from lower raw material costs.
While integration is a positive, it poses challenges as well such as reduction in operational

flexibility in responding to market conditions and heightened business risks…The risk to
profitability is particularly higher in the case of backward integration into cotton yarn spinning.
overall profit of an integrated fabric manufacturer is exposed to the risk of inventory loss in times
of declining cotton prices, whereas non-integrated fabric manufacturers would benefit from the
procurement of lower-cost yarn from the market in such times
Similarly, when garment manufacturers decide to enter into backward integration to the level of spinning,
then their risk to profitability increases.
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The risk to profitability is particularly higher in case of backward integration into cotton yarn
spinning.
As a result, garment manufacturers usually limit their backward integration only to fabric manufacturing,
which provides most of the benefits of integration and the companies do not need to mandatorily integrate
spinning into their business because the high-quality yarn is easily available in the market.
backward integration for apparel entities is largely restricted to fabric weaving and processing
and not as much in yarn spinning. This in turn can be explained by larger quality control
requirements in the weaving and processing stages and abundant availability of quality yarn in
the domestic market.
Whenever we come across yarn to garment integrated players, they are mostly the cases of originally
spinning players who had forward-integrated into apparel manufacturing and rarely, garment manufacturers
who have backwards-integrated into spinning mills. Usually, the apparel manufacturing divisions of such
forward-integrated spinning mills are very small in comparison to the spinning operations.
While some of the spinning entities have forward integration into apparel manufacturing, however,
given the large scale of their spinning operations, the extent of such forward integration is limited
with apparel manufacturing consuming only a small percentage of their yarn production
Nevertheless, from the above discussion, an investor would notice that the integration of operations by
textile players helps the companies improve their profit margins because, now, they can perform a higher
number of value-adding functions in-house and they can save on costs like packaging and transportation of
raw material.
8) Export uncompetitiveness of Indian textile companies:

While analysing different markets that the Indian textile industry caters to and the competition they face,
an investor gets to know that Indian textile companies are at a disadvantage compared to many other nations.
One of the primary reasons for such cost disadvantages hurting the Indian textile industry is the duties
imposed by the govt.
The sector is exposed to international competition where domestic players have constrained
pricing power due to differential duty structures.
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As a result, when an investor assesses the competitiveness of Indian cotton spinning mills with respect to
the producers in China and other South-East Asian countries, then she notices that Indian spinning mills
are less competitive on the global scale.
the Indian spinning sector compares poorly with that of China and Southeast Asian countries, thus
constraining global competitiveness.
The poor competitiveness of Indian spinning mills is not limited only to cotton yarn. In fact, in the manmade
fibre (MMF) yarn as well, Indian yarn producers are not competitive enough. Higher taxes and adverse
custom duties levied by the Indian govt seems to have put Indian MMF yarn producers at a disadvantage.
On the contrary, the favourable environment experienced by Chinese MMF yarn players has led them to
have large capacities and benefits from economies of scale improving their cost competitiveness.
The MMF segment’s growth in India in the past has been marred by the adverse indirect tax
structure on the manmade fibres against cotton. Besides being taxable at higher rates, the MMF
segment has an inverted duty structure which affects competitiveness of players in the segment.
weak competitive positioning vis-a-vis international players (like those in China) which have
significantly larger manufacturing capacities for manmade fibre and benefit from economies of
scale.
As a result, Indian manmade fibre yarn producers are not able to export their yarn and most of the production
of India’s manmade yarn is consumed domestically.
Due to lack of competitiveness in the export market, manmade yarn produced in India is
largely used for domestic requirements and consumption
Indian apparel manufacturers also face a challenging environment where they have witnessed a reduction
in export incentives. As a result, their profitability and in turn export competitiveness has come down.
Apparently, the govt. has to reduce the export incentives to comply with the directions of the World Trade
Organisation (WTO).
in recent years wherein frequent revisions in the export incentive rates, partly to make the export
incentive structure compliant with the World Trade Organisation (WTO) norms, have affected
profitability of the Indian apparel exporters.
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Export incentives usually contribute about 2% to 7% of the revenue of exporters in the textile sector.
Changes in the government’s export policy and incentives schemes may impact the earnings profile
of exporters as export incentives account for 2%-7% of their revenue.
From the earlier discussion, an investor would remember that as per ICRA, in the last 5 years, spinning
mills had a net profit margin (NPM) of 1% whereas fabric makers and apparel manufacturers had a net
profit margin of 3%. In light of the low net profit margins of textile companies, any change in export
incentives that contribute 2%-7% of revenue may push the company into losses.
It seems that the export incentives to the textile sector in India are less than the incentives like favourable
duty structure available to textile companies in Vietnam, Sri Lanka, Bangladesh and China. As a result,
textile companies of these countries are able to export to India and give a lot of competition to Indian textile
companies in the Indian market.
Global and Local Competition: The Indian textile industry faces tight competition from local
players as well as from companies in Vietnam, Sri Lanka, Bangladesh and China, which have cost
advantages (labour, power, taxes) as well as a favourable duty structure on exports
Therefore, an investor would appreciate that despite all the fiscal incentives and subsidies given by the
Indian govt., in the export market, the Indian textile sector seems to be at a disadvantage when compared
to China and other South Asian and South-East Asian countries.
Summary
The Indian textile industry is characterised by intense competition between numerous small-scale players.
Large-integrated players constitute only a very minor portion of the industry. Most of the textile players,
be it spinning mills, fabric or garment/apparel manufacturers produce commodity products, which are non-
differentiable from each other; therefore, customers can easily switch from one supplier to another.
The commodity nature of products has led to intense price-based competition between textile companies,
which has taken away the pricing power of the companies. As a result, nearly all textile companies earn
very low-profit margins. During economic downturns, demand slowdowns, and phases of raw material
(cotton or manmade fibre) price increases, many textile players go into losses and even shut their businesses.
The business model is very fragile. Only the largest players with economies of scale and low cost of
production are able to earn sustainable profit margins.
The spinning segment is highly capital-intensive with a large investment needed to install the mills and a
large investment in inventory stocking during the cotton-harvesting period. It is a power-intensive business
where companies need to continuously spend money on the expansion and modernization of plants to make
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them more efficient. Until now, the capital and interest subsidies by the govt. have supported the capital
expenditure by textile companies.
Small-sized commodity yarn producers face many challenges to sustain their business under intense
competition; however, large players and those who focus on value-added and premium yarn (high count
range) are able to earn a high-profit margin and develop competitive advantages. A few yarn producers do
vertical integration in contract farming, ginning units, fabric and apparel manufacturing divisions to
improve their profit margins. Some also diversify to become flexible in using different yarn inputs, produce
fibre of different count ranges etc. to mitigate the impacts of cyclical phases.
Fabric making is also a capital-intensive business; however, it has relatively lower inventory intensity
because the good quality yarn is available throughout the year unlike cotton, which has harvesting seasons.
Nevertheless, fabric making is also a commodity business where the pricing power is low and the business
is susceptible to cotton and crude oil prices (for manmade fibre yarn).
However, the volatility of profit margins of fabric makers is lower than spinning mills because, first, fabric
makers do not have to stock yarn for full-year production and second, they produce fabric mostly after
getting confirmed orders, which are priced after factoring in current yarn prices.
A few fabric makers go for diversification into processing different types of yarn (cotton or manmade) and
produce different kinds of fabric (GSM, colour, texture, wrinkle-free water/oil resistance etc.) to mitigate
the impact of the cyclical business environment. To improve their profit margins, fabric producers focus on
the premium segment with price-inelastic demand. A few players sell fabric directly to consumers under
their own brand name. These steps give some pricing power to the fabric manufacturers where they can
pass on the increase in yarn costs to their customers.
Some fabric makers also go for vertical integration into spinning mills as well as garment making to earn a
higher profit margin. However, entering into the spinning division is risky because it is much more capital
intensive and has different inventory management dynamics. During times of lower cotton prices, an
integrated fabric maker suffers losses on its cotton stock whereas a standalone fabric maker would benefit
by buying cheaper yarn from the open market. Therefore, most of the time, fabric makers do forward
integration and limit backward integration.
Garment manufacturing, as well as retailing, has low fixed-capital intensive nature; however, it is raw
material and labour intensive because stitching garments need a lot of manual intervention and the company
needs to stock a lot of fabric as well as finished garments of different designs, sizes and colours to supply
to retail shops.
Unbranded garments are near commodities where the companies do not have any pricing power. However,
branded garment makers differentiate themselves by design and product quality. As a result, established
brand companies have some pricing power backed by price-inelastic demand where garment manufacturers
produce clothes after getting confirmed orders and price them by factoring in the latest fabric/yarn/cotton
prices. Therefore, the pricing power in the apparel segment is limited to established brands; however, it is
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not a very strong pricing power because all the brands whether Indian or International have to offer
discounts and match them with the competitors to attract customers to their shops.
To improve profit margins, garment manufacturers also do vertical integration like extending into fabric
production and yarn spinning. However, most of the time, backward integration is limited to fabric making
because the control over fabric making serves most of the benefits as the quality yarn is easily available.
Moreover, spinning yarn is a capital intensive business with a lot of inventory stocking, which exposes
integrated garment manufacturers to a lot of business risk.
Apparel players prefer to stay asset-light because they can easily outsource garment manufacturing to
capture a high demand and the low fixed-cost nature of the business helps them survive economic
downturns better.
Therefore, while analysing any textile company, an investor should focus on the following points:
 Premium/value-added products: Whether it deals in commodity products or focuses on the

premium and value-added segment. Premium players have a relatively strong business model.
 Large and integrated operations: Whether it is a small-scale player or is a large player with a
big manufacturing capacity and integrated operations. Large integrated players have a stronger
business model.
 New modern plants: Whether its plants are new and modern or are old. New modern plants are
cost-efficient. Moreover, old plants would need capital-intensive modernization to stay
competitive.
 Diversified business with flexible production: Whether it is focusing on a single product
segment or is diversified with the flexibility to use a variety of inputs and produce a variety of
products. Diversification and flexibility in the production process bring strength to the business
model.
We believe that if an investor focuses on these factors while assessing the business of any textile company,
then she would be able to get a more realistic picture of its business strength.
Regards,
Dr Vijay Malik
P.S.

Videos
Analysis Excel
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How to Use Screener.in "Export to Excel" Tool

Screener.in is one of the best resources available to equity investors in Indian markets. It is a website, which
provides investors with key information about companies listed on Indian stock exchanges (BSE and NSE).
We have been using screener.in as an integral part of our stock analysis and investments for the last many
years and have been continuously impressed by the tools offered by it that cut down the hard work of an
investor. Some of these features, which are very useful for equity investors are:
 Filtering of stocks based on multiple objective financial parameters. Investors can share these
parameters in the form of “Saved Screens”.
 Company information page, which collates the critical information about a company on one single
page including balance sheet, profit & loss, cash flow, quarterly results, corporate announcements,
links to annual reports, credit rating reports, past stock price movement etc. A scroll down on the
company page provides an investor with most of the critical information, which is needed to make
a provisional opinion about any company.
 Email alerts to investors for new stocks meeting their “Saved Screens”
 Email alerts to investors on updates about companies in their watchlist.
All these features are good and have proved very beneficial to investors. However, there is one additional
feature of screener.in, which we have found unique to screener.in. This feature is “Export to Excel”.
“Export to Excel” feature of screener.in lets an investor download an Excel file containing the financial
data of a company on the investor’s computer. The investor can use this excel file with the data to do a
further in-depth analysis of the company.
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The most important part of the “Export to Excel” feature is that it allows the investor to customize the Excel
file as per her preferences. The investor can create her own ratios in the excel file. She can arrange the data
as per her preferred layout in the excel file and when she uploads her customized excel file in her account
at screener.in, then whenever she downloads the “Export to Excel” sheet for any company, she gets the data
of the company in her customized format with all her own ratios auto-calculated and presented to her in her
preferred layout.
The ability to get the financial data of any company in our customized format with our key ratios and
parameters auto-calculated has proved very useful to us in our stock analysis. “Export to Excel” feature of
screener.in allows us to analyse our preferred financial ratios of any company at the click of a mouse, which
makes it very easy for us to make a preliminary view about any company within a short amount of time.
Sometimes within a few minutes.
We have been using the “Export to Excel” feature for the last many years and it has become an essential
part of our stock analysis. It has helped us immensely while doing an analysis of different stocks and while
providing our inputs to the stock analysis shared by the readers of our website. Investors may read the
“Analysis” articles at our website on the following link: Stocks’ Analysis articles
Over time, more and more investors have started using the “Export to Excel” feature of screener.in and as
a result, we have been getting a lot of queries about it at the “Ask Your Queries” section of our website.
These queries have been ranging from:
 Why is there a difference between the data provided by the screener and the company’s annual
report?
 How does screener calculate/group the annual report data in the “Export to Excel” tool?
 What is the source of the data that screener.in provides to its users?
 How to customize the “Export to Excel” file?
 How to upload the customized file in one’s account at screener.in
We have been replying to such queries based on our understanding of screener.in, which we have gained
by using the website for multiple years and based on our learning by listening to the founders of screener.in
(Ayush Mittal and Pratyush Mittal) in June 2016 at the Moneylife event in Mumbai.
In June 2016, Moneylife arranged a session, “How to Effectively Use screener.in” by Ayush and Pratyush
at BSE, Mumbai in which Ayush and Pratyush explained the features of screener.in in great detail. This
session was recorded by Moneylife and has been made available as a premium feature on their private
YouTube channel.
The recorded session can be accessed at the following link, which would require the viewers to pay to view
it:
https://advisor.moneylife.in/icvideos/
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(Disclaimer: we do not receive any referral fee from Moneylife or Screener.in to recommend the above
video link to the session by Ayush and Pratyush. For any further information about the video, investors
may contact Moneylife directly)
As mentioned earlier that we have been replying to investors’ queries related to the “Export to Excel”
feature on the “Ask Your Queries” section of our website. However, in light of repeated queries from
different investors, we have decided to write this article, which addresses key aspects of “Export to Excel”
feature of screener.in.
The current article contains explanations about:
 The financial data provided by screener.in in its “Export to Excel” file and its reconciliation with
the annual report of companies
 Steps to customize the “Export to Excel” template by investors
 Steps to upload the customized Excel file on screener.in so that in future whenever any investor
downloads the “Export to Excel” file of any company, then it would have the data in the customized
preferred format of the investor.
Financial Data
The “Export to Excel” file of screener.in contains a “Data Sheet”, which contains the financial data of the
company, which in turn is used to calculate all the ratios and do in-depth analysis. As informed by Ayush
and Pratyush in the Moneylife session, screener.in sources its data from capitaline.com, which is a
renowned source of financial data in India.
The data sheet contains the data of the balance sheet, profit & loss, quarterly results, cash flow statement
etc. about the company.
We have taken the example of a company Omkar Speciality Chemicals Limited (FY2016: standalone
financials) to illustrate the reconciliation of the data provided by screener.in in its “Export to Excel” file
and data presented in the annual report.
Read: Analysis: Omkar Speciality Chemicals Limited
Let’s now understand the data about any company, which is provided by screener.in.
Balance Sheet:
This is the section, where investors get most of the queries as screener.in groups the annual report items
differently while presenting the data to investors. Let’s understand the data in the balance sheet section of
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the “Data Sheet” of the “Export to Excel” file taking the example of FY2016 data of Omkar Speciality
Chemicals Limited:
Balance Sheet Screener.in "Data Sheet"
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Balance Sheet (Annual Report FY2016)
 Equity Share Capital: It represents the paid-up share capital taken directly from the balance sheet
(₹20.58 cr.).
 Reserves: It represents the Reserves & Surplus taken directly from the balance sheet (₹160.87 cr.).
 Borrowings: It represents the entire debt outstanding for the company on March 31, 2016 (₹185.76
cr.). It comprises the following components:
o Long-Term Borrowings: ₹79.23 cr taken directly from the balance sheet.
o Short-Term Borrowings: ₹95.49 cr. taken directly from the balance sheet.
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o Current Liabilities of long-term borrowings: ₹11.04 cr. taken from the notes to the
financial statements. This data is included as part of “Other Current Liabilities” of ₹15.89
cr. under “Current Liabilities” in the summary balance sheet. In the annual report of Omkar
Speciality Chemicals Limited, “Current Liabilities of long-term borrowings” can be found
in Note No. 7 on page 89 of the FY2016 annual report.
o Sum of these three items: 79.23 + 95.49 + 11.04 = ₹185.76 cr. Investors might find a small
difference for various companies, which might be due to rounding off.
 Other Liabilities: It represents the sum of the rest of the liabilities (₹79.52 cr.) like:
o Deferred Tax Liabilities: ₹8.04 cr. taken directly from the balance sheet
o Long-Term provisions: ₹2.42 cr. taken directly from the balance sheet
o Trade Payables: ₹50.52 cr. taken directly from the balance sheet
o Other Current Liabilities net of “Current Maturity of Long-Term Debt”: ₹15.89 - ₹11.04
= ₹4.85 cr. is considered in this section.
o Short-Term Provisions: ₹13.69 cr. taken directly from the balance sheet
o Sum of these items: 8.04 + 2.42 + 50.52 + 4.85 + 13.69 = ₹79.52 cr. Investors might find
a small difference for various companies, which might be due to rounding off.
 Net Block: It represents the sum of Tangible Assets (₹ 77.75 cr) and Intangible Assets (0.15 cr.)
taken directly from the balance sheet. The total netblock in the “Data Sheet” is ₹77.90 cr, which is
the sum of the tangible and intangible assets.
 Capital Work in Progress: It represents the paid-up Capital Work in Progress taken directly from
the balance sheet (₹112.67 cr.).
 Investments: It is the sum of both the Current Investments and the Non-Current Investments
presented on the balance sheet. The Current Investments are shown under “Current Assets” in the
balance sheet whereas the Non-Current Investments are shown under “Non-Current Assets” on the
balance sheet.
o In the case of Omkar Speciality Chemicals Limited, there are no current investments,
therefore, the “Investments” (₹13.91 cr.) in the “Data Sheet” of “Export to Excel” file is
equal to the Non-Current Investments in the balance sheet (₹13.91 cr.)
 Other Assets: It represents (₹242.25 cr.) the sum of rest of the assets:
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o Long-term Loans and Advances: ₹26.53 cr. taken directly from the balance sheet
o Inventories: ₹61.78 cr. taken directly from the balance sheet
o Trade Receivables: ₹102.26 cr. taken directly from the balance sheet
o Cash and Cash Equivalents: ₹6.63 cr. taken directly from the balance sheet
o Short-term Loans and Advances: ₹44.14 cr. taken directly from the balance sheet
o Other Current Assets: ₹0.89 cr. taken directly from the balance sheet
o Sum of these items: 26.53 + 61.78 + 102.26 + 6.63 + 44.14 + 0.89 = ₹242.23 cr. The
difference of ₹0.02 cr. in this sum and the figure in the “Data Sheet” of ₹242.25 cr. is due
rounding off.
It is important to note that certain additional items, if present in the balance sheet, are usually shown by
screener.in as part of “Other Liabilities” or “Other Assets” depending upon their nature (Liability/Assets).
E.g. “Money Received Against Share Warrants” is shown as a part of “Other Liabilities” in the “Data Sheet”
in the “Export to Excel” file.
Profit and Loss:

Let us now study the reconciliation of the profit and loss data of the company provided by screener.in in
the "Data Sheet" of "Export to Excel" and the annual report:
Profit & Loss Statement Screener.in "Data Sheet"
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Profit & Loss Statement Annual Report FY2016
 Sales: It represents only the “Revenue from Operation” of ₹300.02 cr. taken directly from the P&L
statement.
 Raw Material Cost: It represents the sum of Cost of Material Consumed (₹167.09 cr) and Purchase
of stock in trade (₹73.42 cr.) taken directly from the P&L statement.
o Sum of these two items: 167.09 + 73.42 = ₹240.51 cr. Investors might find a small
difference for various companies, which might be due to rounding off. In the case of Omkar
Speciality Chemicals Limited, the difference is ₹0.01 cr.
 Change in Inventory: ₹12.93 cr. taken directly from the P&L statement: “Changes in Inventories
of Finished Goods, Work in progress and Stock in Trade”.
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o It is to be noted that if the inventories have increased during the period, then this figure
would be negative and if the inventories have decreased during the period, then this figure
would be positive.
o A negative figure (increase in inventory) indicates that some material was purchased whose
cost is included in the Raw Material Cost, but this material is yet to be sold as finished
goods because this material is still lying in inventory. That’s why this cost is not the cost
for this period and thus deducted from the expenses of this period.
o A positive figure (reduction in inventory) indicates that some amount of finished goods
sold in this period were created from the raw material purchased in previous periods.
Therefore, the raw material cost of the current period does not include the cost of these
goods whereas the sales of this period include the revenue from these sales. That’s why the
cost is added to the expense of this period.
 Power and Fuel, Other Mfr. Exp, Selling and admin, Other Expenses: together constitute the
“Other Expenses” item of the P&L statement. The breakup of “Other Expenses” is present in the
notes to financial statements in the annual report.
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o Sum of these four items in the “Data Sheet”: 1.45 + 4.74 + 4.08 + 5.87 = ₹16.14 cr. is equal
to the “Other Expenses” figure in the P&L statement. Any small difference might be due
to rounding off.
o Many times, there are 10-30 items, which come under “Other Expenses” in the annual
report and it becomes difficult for investors to segregate, which of these items are grouped
by screener under “Other Mfr. Exp” or under “Other Expenses” or under “Selling and
admin” etc. E.g. in the case of Omkar Speciality Chemicals Limited, the Power and Fuel
costs of ₹1.45 cr. seem to include both the “Factory Electricity charge” of ₹1.28 cr. and
“Water Charges” of ₹0.17 cr.
o Therefore, an investor would need to put some extra effort into the analysis in case the
“Other Expenses” item is a large number.
 Employee Cost: ₹12.93 cr. taken directly from the P&L statement
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 Other Income: ₹8.89 cr. taken directly from the P&L statement. For some companies, it might be
shown as non-operating income in the P&L statement.
 Depreciation: ₹4.28 cr. taken directly from the P&L statement.
 Interest: ₹16.52 cr. taken directly from the P&L statement.
 Profit before tax: ₹33.37cr. taken directly from the P&L statement.
 Tax: It represents the sum total of all the tax-related entries in the P&L statement including all
credits, debits and previous year adjustments. E.g. for Omkar Speciality Chemical Limited, the tax
for FY2016 (₹11.16 cr.) represents the sum of:
o Previous year adjustments of ₹0.50 cr.
o Current Tax of ₹6.99 cr.
o Deferred Tax of ₹5.81 cr.
o MAT Credit Entitlement of negative ₹2.14 cr. This effectively adds to the profit of the
company for the period.
o Total of all these entries: 0.50 + 6.99 + 5.81 – 2.14 = ₹11.16 cr. is equal to the “Tax” in
“Data Sheet” in screener.in. Investors might find a small difference for various companies,
which might be due to rounding off.
 Net profit: ₹22.21 cr. taken directly from the P&L statement.
 Dividend Amount: It represents the entire dividend paid/declared/proposed for the financial
year without considering the dividend distribution tax. We may get to know about this figure
from the Reserves & Surplus section of the annual report. E.g. for Omkar Speciality Chemical
Limited, the dividend amount (₹3.09 cr.) in the “Data Sheet” of screener.in has been taken from
the reserves & surplus section of the annual report on page 88:
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Cash Flow:
 The data for three key constituents of the cash flow statement i.e. Cash from Operating Activity
(CFO), Cash from Investing Activity (CFI) and Cash from Financing Activity (CFF) are taken
directly from the cash flow statement in the annual report
 Net Cash Flow is the sum of CFO, CFI and CFF for the financial year.
 Sometimes, investors may find small differences in the data, which might be due to rounding off.
Cash Flow Statement Screener.in "Data Sheet"
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Cash Flow Statement Annual Report FY2016
Quarterly Results:
Quarterly Results Screener.in "Data Sheet"
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Quarterly Results March 2017, Company Filings to Stock Exchange
 Sales: it represents the revenue from operations from the quarterly results filing of the company.
E.g. for Omkar Speciality Chemical Limited, the sales of ₹91.56 cr. in the March 2017 quarter
represents the revenue from operations from the March 2017 results of the company.
 Expenses: it represents all the expenses from the quarterly results filing except finance cost and
depreciation. “Expenses” in the “Data Sheet” of screener.in includes the exceptional items if any
disclosed by the companies in their results. E.g. for Omkar Speciality Chemical Limited, the
“Expenses” in the data sheet of the amount of ₹135.84 cr. is the sum of:
o Cost of material consumed: ₹50.09 cr.
o Purchase of stock in trade: Nil
o Changes in Inventories of Finished Goods, Stock in Trade, Work in progress and Stock in
Trade: ₹12.75 cr.
o Employee benefits expense: ₹2.11 cr.
o Other expenses: ₹7.68 cr.
o Exceptional Items: ₹63.21 cr.
o Total of all these entries: 50.09 + 12.75 + 2.11 + 7.68 + 63.21 = ₹135.84 cr. is equal to the
“Expenses” in “Data Sheet” in screener.in. Investors might find a small difference for
various companies, which might be due to rounding off
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 Other Income: (₹5.47 cr.) taken directly from the quarterly Statement. For some companies, it
might be shown as non-operating income in the quarterly statement.
 Depreciation and Interest: are directly taken from the “Depreciation and Amortization Expense”
of ₹0.99 cr. and “Finance Costs” of ₹5.14 cr. in the quarterly statement.
 Profit before tax: Loss of ₹55.89cr. taken directly from the quarterly statement.
 Tax: It represents the sum total of all the tax-related entries in the quarterly statement including all
credits, debits and previous year adjustments. E.g. for Omkar Speciality Chemical Limited, the tax
for the March 2017 quarter (positive change of ₹11.59 cr.) represents the sum of:
o Current Tax of negative ₹5.37 cr. This effectively adds to the profit of the company for
the period.
o Previous year adjustments of negative ₹6.75 cr. This also effectively adds to the profit
of the company for the period.
o MAT Credit Entitlement of ₹1.14 cr. This also effectively adds to the profit of the
company for the period.
o Deferred Tax of ₹1.67 cr.
o Total of all these entries: -5.37 – 6.75 – 1.14 + 1.67 = - ₹11.59 cr. is equal to the “Tax” in
“Data Sheet” in screener.in. The negative tax effectively adds to the profit of the company
for the period.
o Investors might find a small difference for various companies, which might be due to
rounding off.
 Net profit: Loss of ₹44.29cr. taken directly from the quarterly statement.
 Operating Profit: represents sales – expenses (as calculated in the description above). E.g. for
Omkar Speciality Chemical Limited, the operating profit for March 2017 quarter (loss of ₹44.28
cr.) represents the impact of:
o Sales of ₹91.56 cr. less Expenses of ₹135.84 cr. = Loss of ₹44.28 cr.
With this, we have come to the end of the current section of this article, which elaborated the reconciliation
of the data presented by screener.in with the annual report and quarterly filings of the companies. Now we
would elaborate on the steps to customize the default “Export to Excel” template sheet provided by
screener.in.
Customizing the Default “Export to Excel” Sheet

Customizing the “Export to Excel” template and uploading it on screener.in in the account of an investor is
the feature, which differentiates screener.in from all the other data sources that we have come across.
We have used premium data sources like CMIE Prowess, Capitaline during educational and professional
assignments in the past as part of the subscription of MBA college and the employer. These premium
sources as well as other free sources like Moneycontrol etc. provide the functionality of data export to excel.
However, the exporting features of these websites are primitive, which provide the data present on the
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screen to the investor in an Excel or CSV file on which the investor then needs to separately apply the
formulas etc. to do the analysis, which is very time-consuming.
Screener.in is better than the above-mentioned sources in terms that it allows investors to customize the
Excel template and upload it on the website. The next time any investor downloads the data of any company
from the screener.in website, the downloaded file has the data of the company along with all the formulas
put in by the investor auto-calculated, which saves a lot of time for the investor in doing in-depth data
analysis.
Steps to customize:
Once the investor downloads the data of any company by clicking the “Export to Excel” button from the
screener.in website, then she gets the data of the company in the default Excel template of screener.in.
The default Excel template contains the following six sheets:
 Profit & Loss

 Quarters
 Balance Sheet
 Cash flows
 Customization and
 Data Sheet
The “Data Sheet” contains the base financial data of the company, which has been described in detail in the
above section of this article. It is not advised to make any change to this sheet otherwise all the data
calculations might become erroneous.
"Customization” sheet contains the steps to upload the customized sheet on the screener website in an
investor’s account. We will discuss these steps in details later in this article.
Rest of the sheets: Profit & Loss, Quarters, Balance Sheet and Cash Flows contain the default ratios along
with formulas etc. provided by the screener.in team for the investors.
An investor may change all the sheets except the Data Sheet in any manner she wishes. She may delete all
these sheets, change formulas of all the ratios, put in her own ratios, create entirely new sheets and create
her own preferred ratios and formulas in the new sheets by creating direct linkages for these new formulas
from the base data in the “Data Sheet”. The investor may do any amount of changes to the excel sheet until
she does not tinker with the Data Sheet.
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Given below is the screenshot of the “Profit & Loss” sheet of the default “Export to Excel” template
provided by screener.in
Given below are the changes that we have done to the “Export to Excel” template to customize it as per our
preferences by creating a new sheet: “Dr Vijay Malik Analysis”
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(For large resolution image of this sheet: Click Here)
Further Reading: Stock Analysis Excel Template (Screener.in): Premium Service
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The above-customized template helps us to do a very quick assessment of any company on the checklist of
parameters that we use for stock analysis. This is because this customized template provides us with our
preferred ratios etc. in one snapshot like a dashboard, which makes decision making very quick and easy.
Readers would be aware that we use a checklist of parameters, which contains factors from Financial
Analysis, Business Analysis, Valuation Analysis, Management Analysis and Margin of Safety calculations.
The customized template screenshot shared above allows us to analyse the following parameters out of the
checklist in a single view:
Financial Analysis:
 Sales growth
 Profitability
 Tax payout
 Interest coverage
 Debt to Equity ratio
 Cash flow
 Cumulative PAT vs. CFO
Valuation Analysis:
 P/E ratio
 P/B ratio
 Dividend Yield (DY)
Business Analysis:
 Conversion of sales growth into profits

 Conversion of profits into cash
 Creation of value for shareholders from the profits retained: Increase in Mcap in last 10 yrs. >
Retained profits in last 10 yrs.
Management Analysis:
 Consistent increase in dividend payments

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Margin of Safety:
 Self-Sustainable Growth Rate (SSGR): SSGR > Achieved Sales Growth Rate
 Free Cash Flow (FCF): FCF/CFO >> 0
Operating Efficiency Parameters:
 Net Fixed Asset Turnover Ratio (NFAT)

 Receivables Days
 Inventory Turnover Ratio
The ability to see the above multiple parameters in one snapshot for any company for which we download
the “Export to Excel” file, allows us to have a quick opinion about any company that we wish to analyse.
It saves a lot of time for the investors as she can easily determine, which companies have the requisite
strength that is worth spending more time on them.
We believe that to fully benefit from the great resources available to the investors today, it is essential that
investors should use screener.in to the fullest and therefore must customize their own “Export to Excel”
templates as per their preference and upload it to their accounts at the screener.in website.
Uploading the Customized “Export to Excel” Sheet on Screener.in Website

The “Customization” sheet of the default “Export to Excel” template file provided by screener.in contains
the steps to upload the customized Excel file on the screener.in website. We have described these steps
along with the relevant screenshots below for the ease of understanding:
 Once the investors have customized the excel file as per their preference, then they should rename
it for further reference. The excel file that we have used for illustration below is our customized
excel template, which is named: “Dr Vijay Malik Screener Excel Template Version 3”
 Once the investor has saved her customized excel file with the desired name, then she should visit
the following link in the web-browser: https://www.screener.in/excel/. She would reach the
following screen:
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 It is required that the investor is logged in the screener.in website before she visits the above
link. Otherwise, the browser will direct her to the login/registration page like below:
o If the investor is directed to the above page to register and she does not have an account
on screener.in website, then she should create her new account by providing her details
on the above page and clicking “Register”
o However, if she already has an account on screener.in, then she should click on the
button “Login here”. In the next page, the investor would be asked to provide her
email and password to log in and after successfully logging in, the website will take
her to the Dashboard/home page of screener.in
o Now the investor would have to again visit the page: http://www.screener.in/excel/ to
upload the customized Excel. To avoid this duplication, it is advised that the investors
should visit the page: http://www.screener.in/excel/ after they have already logged in
the screener.in the website.
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 Once the investor is at the Excel upload page, then she should click the button: “Choose File”
 Upon clicking on the button “Choose File”, a new pop-up window will open. In the newly opened
window, the investor should browse to the folder where she had saved her customized excel sheet
and select it:
 Upon selecting the customized Excel file of the investor, in our case the file “Dr Vijay Malik
Screener Excel Template Version 1.6 (Unlocked)”, the investor should click on the button “Open”
in this pop-up window.
 Upon clicking the button “Open”, the pop-up window will close and the investor would see that
on the web page, there is a summary of the name of her customized excel file near the “Choose
File” button.
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 The presence of the file name summary indicates that the correct file has been selected by the
investor for the upload.
 Now, click on the button “Upload” on the webpage.
 Clicking on the “Upload” button will upload the excel file customized by the investor in her
account on the screener.in website and take her to the homepage/dashboard of the screener.in
website.
From now on whenever the investor downloads the data of any company from screener.in by clicking the
button “Export to Excel”, then she would get the data in the format prepared by her in her customized Excel
file containing all her custom ratios and formulas, formatting and the layout as selected by her.
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This concludes all the steps, which are to be taken by an investor while uploading her customized excel file
on the screener.in website.
Updating/Changing the already uploaded customized sheet:
 In future, if the investor wishes to make more changes to the excel file, then she can simply do all
the changes in the Excel file without making any changes to the “Data Sheet’ and save it.
 She should then repeat the above steps to upload the new excel file in her account on the screener.in.
 Uploading the new file will overwrite the existing template and henceforth, screener.in will provide
her with the data in her new Excel file format upon clicking the “Export to Excel” button for any
company.
Removing the customizations:
 However, in future, if the investor wants to delete her customized excel file and go back to the
original default excel template of screener, then she again would need to visit the following
link: http://www.screener.in/excel/ and click on the button “Reset Customization”
 Upon clicking the button “Reset Customization”, the web page will ask “Are you sure you want to
reset your Excel customizations?”
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 If the customer is sure about deleting her customized excel file, then she should click on the button
“Confirm Excel Reset” on the web page.
 Clicking the “Confirm Excel Reset” button will delete the customized Excel file from the
investor’s account and reset the excel file to the default Excel template file of screener described
above.
 From now onwards, whenever the investor downloads the data of any company from screener.in
by clicking the button “Export to Excel”, then she would get the data in the default Excel format of
screener.in.
There is no limit on the number of times an investor can upload her customized excel file or change it or
delete it by resetting the customization. Therefore, an investor may do as many changes and iterations as
she wants until she gets her preferred excel sheet prepared, which would help her a lot in her stock analysis.
With this, we have come to an end of this article, which focussed on the key feature of the screener.in
“Export to Excel”, the reconciliation of the financial data in the “Data Sheet” with the annual report,
quarterly results file etc. and the steps to customize the Excel file and upload the customized Excel file in
the investor’s account on screener.in.
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Premium Services
At www.drvijaymalik.com, we provide the following premium services to our readers:
1. Dr Vijay Malik’s Recommended Stocks

2. Peaceful Investing - Workshop Videos
3. Stock Analysis Excel Template (compatible with Screener.in)
4. E-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
5. "Peaceful Investing" Workshops
The premium services may be availed by readers at the following dedicated section of our website:
https://premium.drvijaymalik.com/
Brief details of each of the premium services are provided below:
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1) Dr Vijay Malik’s Recommended Stocks

Subscribers of this service get access to a list of stocks with buy/hold/sell recommendations that we believe
provide a good opportunity to grow shareholders’ wealth.
We have selected these stocks after doing an in-depth fundamental analysis covering financial, business,
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Over time, we have received multiple feedback and queries from our subscribers like:
 Can we let them know our reasons for buying or selling any stock?
 Can we inform them which stocks are in buying range or outside the buying range?
“Recommended Stocks” provide an answer to such queries as these stocks have buy/hold/sell
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views about any stock.
What a subscriber will get in this service:

 A list of fundamentally good stocks, which we believe have the potential to build wealth for
shareholders. There will be a crisp investment rationale explaining our views about the company
backing our recommendation.
 The stocks will be labelled as:
 Buy: where we believe that the stock presents a good investment opportunity at the current
price.
 Hold: where we believe that the stock price has risen above comfortable valuation levels;
however, the stock does not deserve to be sold.
 Sell: where it is advised to reduce the exposure from the stock; mostly because we believe
that the fundamentals of the company have deteriorated and the stock has lost our confidence.
Rarely, it may be due to overvaluation; however, please note that it would be a rare
occurrence.
 Under Review: at times, a stock may be put under review when a significant event has taken
place and we need some time to form our view about the stock.
 Once a month email from us commenting on the ongoing market scenario especially from the
perspective if something significant has taken place leading to a change in views from a long-term
investing perspective. Please note that it will not be a general mailer/newsletter describing the
economic situation. There might be situations where according to us nothing significant has
happened to change our views and the email may just state that.
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 To get an idea of the monthly email, you may read our letter of July 2022: Our Investing
Philosophy, Interest Rates and Inflation (July 2022)
 As a new subscriber, you will get access to all the previous monthly letters written by us.
 Even though we may mostly communicate with you via monthly emails; however, please note that
we will continuously monitor the Recommended Stocks and communicate via email whenever our
views about the stocks change whether positively or negatively.
What a subscriber will NOT get:

 Any separate detailed voluminous research report will not be provided for stocks. The short
investment rationale and updates present on the “Recommended Stocks” page will be the only
reading material available to the subscribers.
 Any target price for the recommended stocks will not be provided. This is because we believe in a
long-term investment horizon stretching over decades throughout boom and bust phases of markets
and the economy and do not believe in selling stocks over short-term price or business performance
changes. We do not provide any return expectations. Good stocks are expected to provide good
returns over a long period of time. We continuously monitor the stocks and usually sell when the
fundamentals of the company deteriorate. Whenever any stock deserves selling, then we will update
the same on the page and send an email update to the subscribers.
 Regular quarterly or annual reviews of stocks after results will not be provided. This is because
instead of quarterly/annual reviews, we monitor stocks continuously and will update the subscribers
whenever our views about the company change. If our views about the company stay the same,
then we may not provide any updated review about the company even for many quarters. On the
contrary, if our views about the company change, then we will immediately update the subscribers
and not wait for the quarterly or annual results declaration by the company. The aim is to
communicate with subscribers only when there is something necessitating a change in our views
and not inundate the subscribers with regular reviews etc.
 Reviews based on every corporate action, event etc. will not be done. Most of the events/corporate
actions may not change our views about the companies; therefore, we do not provide any
updates/reviews based on very corporate actions/events. However, please rest assured that we
continuously monitor the companies and in case there is any significant event/action, then we will
provide a review/update.
 No on-demand/on-request updates on the recommendations would be provided. We would update
the recommendations on our own when our views change.
 One-to-one discussion about the “Recommended Stocks” with subscribers will not be done.
 Replies to subscribers’ queries about the “Recommended Stocks” will not be provided. If there is
any development about the stock where we believe that an update needs to be provided, then we
will provide it on our own.
 Any advice about allocation to the stocks in the list will not be provided. Subscribers need to take
this decision on their own.
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Instructions to subscribers:
 It is a subscription service. The access to “Recommended Stocks” will expire after the subscription
period gets over unless a renewal is done.
 Please note that once this premium service is availed, then there is no provision of any refund of
fee or cancellation of service during the period of subscription.
Frequently Asked Questions
Q: How many stocks are currently there in the “Recommended Stocks” list?
On June 11, 2022, the list contains 7 stocks. The latest information about the number of stocks and
recommendations is available only to subscribers.
Q: Do you advise any minimum capital for investment in “Recommended Stocks”?
We do not provide any guidance about any minimum capital for investment. An investor needs to make
this decision on her own.
Q: How often do you add new stocks or remove existing stocks from the recommended stocks list?
Adding new stocks: We follow a very stringent stock-selection process. Only when a stock clears our
parameters, then we add it to the recommended list. My experience shows that usually, I add one new stock
in a year. This is the pattern for the last many years. However, it may or may not stay the same in the future.
Nevertheless, as the stock prices are very volatile; therefore, buying opportunities keep on arising within
the existing stocks in the recommended stocks’ list. We will monitor the stocks continuously and update
the recommendation whenever our views about the stocks change.
Selling existing stocks: We follow a very long-term investment horizon, which extends into decades.
Therefore, we keep very strict stock selection criteria. As a result, for most of the stocks we select, we do
not need to sell them and the stocks will continue to be in the recommended stocks until they stay
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fundamentally good. Only when any stock loses our confidence, then we remove it from the list. Our
experience indicates that we may remove a stock every 2-3 years; however, it may or may not stay the same
in the future.
Q: Do you prefer any sector or market capitalization segment etc. while making stock
recommendations?
We prefer to find stocks, which show growth opportunities with good profit margins where the companies
can finance the growth from their profits without raising a lot of debt or equity. In this process, we do not
differentiate stocks based on any market cap. Whenever we find any good stock meeting our stringent
selection process, then we add it to the recommended list irrespective of its market cap. It has been our
experience that most of the time, such stocks belong to the mid or small-cap segment. However, it is not an
intentional focus on mid or small caps and we tend to focus on the fundamental qualities of the stocks
without ignoring any market cap segment.
We follow a bottom-up approach for stock selection. Therefore, we do not prefer any sector when we make
a stock selection.
Regards,
Dr Vijay Malik
P.S. Please note that the information received through this premium service is for the sole use of the
subscriber and is not to be shared with anyone else.
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2) Peaceful Investing - Workshop Videos
This service allows access to the videos of full-day fundamental investing workshop elaborating our stock
analysis approach “Peaceful Investing”.
The workshop covers all the aspects of stock investing like how to shortlist and analyse stocks in detail,
which stocks to buy, what price to pay, how many stocks to buy, how to monitor the stocks, when to
sell a stock etc. The workshop focuses on key concepts needed for stock analysis both for a beginner and
seasoned stock investor using live companies as examples.
Peaceful Investing - Workshop Videos has been launched primarily with two objectives:
1. To allow the investors across the world to watch the complete full-day “Peaceful Investing”
workshop ONLINE on their laptop/mobile phone at any time & place of their convenience at their
own pace, as many times as they can, during the period of subscription.
2. To allow an opportunity for past participants of “Peaceful Investing” workshops to revise the
workshop and refresh the learning.
You can watch a FREE Sample Video (16 min) of the workshop where we have discussed the basics of
balance sheet along with fund flow analysis on the following link:
Peaceful Investing - Workshop Videos
Subscription to this service provides access to the videos of the full-day workshop having a total duration
of about 9hr:30m.
These videos are divided into the following subsections for easy access and revision:
1. The Foundation:
 A) Introduction to Peaceful Investing (24m:31s)
 B) Demonstration of Screener.in website and its Export to Excel Feature (28m:56s)
 C) Using Credit Rating Reports for Stock Analysis (38m:11s)
2. Financial Analysis:
 A) Analysis of Profit & Loss Statement (1h:12m:37s)
 B) Analysis of Balance Sheet (27m:14s)
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 C) Analysis of Cash Flow Statement (27m:24s)

 D) Combining Different Financial Statements (22m:40s)
3. Business & Industry Analysis (21m:55s)
4. Valuation Analysis (20m:17s)
5. Margin of Safety Assessment: Deciding what price to pay for a stock (1h:08m:03s)
6. Management Analysis (1h:15m:07s)
7. Portfolio Management: (How to monitor the stocks, How many stocks to own, When to sell, Stocks
which are ideal for Part-Time investors) (51m:54s)
8. Q&A (1h:24m:38s)
We believe that a person does not need to have an educational background in finance to be a good stock
investor and the workshop has been designed keeping this in mind. The workshop explains the financial
concepts in a simple manner, which are easily understood by investors from a non-finance background.
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3) Stock Analysis Excel Template (compatible with Screener.in)

We use a customized excel template to analyse stocks as per our preferred parameters by using the data
downloaded from the screener.in website. The template acts as a dashboard of key analysis parameters,
which help us in making an opinion about any stock within a short amount of time (sometimes within a few
minutes). We have used this excel template and the analysis output in many stock analysis articles published
on this website.
You may read about various stock analysis articles written by analyzing companies using the excel template
in the "Author's Response" segments on the following link: Stock Analysis Articles
In the past, many readers/investors have asked us to provide a copy of this excel file. However, until now,
we have not put the excel template in the public domain for download. We have always advised investors
to customize the standard screener excel template as per their own preferences and their learning about
stock analysis from different sources. Customization of excel template on her own can be a very good
learning exercise for any investor.
However, due to repeated requests for sharing the excel template, we have decided to make the customized
excel stock analysis template, which is compatible with screener.in and provides stock data as a dashboard,
as a paid download feature.
Investors who wish to get the customized excel stock analysis template may download it from the following
link:
The structure and sample screenshots of the stock analysis excel template file are as below:
1) Analysis sheet:
This sheet presents values of more than 40 key parameters in the form of a dashboard. These parameters
cover analysis of profitability, capital structure, valuation, margin of safety, cash flow, creation of wealth,
sources of funds, growth rates, return ratios, operating efficiency etc.
Having a quick look at these parameters in the form of the dashboard helps in a quick assessment of the
company, its historical performance and its current state of affairs.
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Screenshot of large resolution output of the Analysis Sheet: Click Here
2) Instructions sheet:
This sheet contains details about the steps by step approach to getting started with this sheet on the
screener.in website, change in settings for Microsoft Excel to resolve common issues and other instructions
for the buyers.
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Screenshot of the Instructions Sheet: Click Here
See the step by step guide for uploading the excel sheet on Screener.in with screenshots: How to Use
Screener.in Export to Excel tool
3) Version history:
This sheet contains details about the changes/updates made in each of the new versions of the sheet.
Users'/Investors' Feedback about this Stock Analysis Excel Template:

The stock analysis excel template was initially made available for download on July 11, 2016. Hundreds of
investors have downloaded the same and quite a few of them have provided their inputs about the excel
template. Here are some of the responses sent by the users of this template:
“This is a great tool for getting down to the heart of a company's financials.
When I was doing my MBA at NYU I had a valuation professor who encouraged everyone in the class of
60 to make their own customized sheet similar to what you've made. I was a fan of Buffett so I remember
keeping some of his metrics in view and creating a sheet! Of course, yours is head and shoulders above
anything else I've seen - kudos!”
- Uday (via email)
The excel template is quite useful. It makes things easy for us in not doing the hard labour and calculating
all vital data for each company separately.
- Ashish
“Thank you Dr. Malik. The tool is indeed very useful and super-fast to use. God bless you for creating it!
Please use this as part of your training to perform financial analyses of different types of companies in
different performance contexts across industries. I am sure others will also love it.”
- Harsh (via email)
"Dear Sir, I have downloaded the excel. It's simply AMAZING, EFFORTLESS and AWESOME. Kudos
to you and your team for wonderful creation.”
- Vikram (via email)
“Very good tool created for Stock analysis. Very helpful. Thank you sir”
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- Jiten (via email)
For further details please read this article:
Stock Analysis Excel Template (Screener.in)
P.S: Please read all the instructions on the payment page, carefully before making the purchase of the excel
template.
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4) e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock

Investing"
This book contains our key stock investing articles covering all aspects of stock investing including stock
selection, portfolio management, monitoring, selling etc.
Who should read this e-book:
Any person interested in learning a simple step by step approach of analysis of companies, their business,
financials, and management. The reader of the e-book will learn
 to analyse whether a company is financially strong or not and whether it has business strength to
sustain its growth.
 to find out any red flags in the company’s performance.
 to identify whether the management of the company is shareholder-friendly or not. Also whether
the management is taking the money out of the company for personal benefits.
 our method of deciding the ideal price to pay for any company.
 how to monitor stocks in the portfolio and how to decide about selling the stocks.
Reviews about the book:
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Table of Contents
The “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing” book contains the following
articles:
1. Getting the Right Perspective towards Investing

2. Choosing the Stock Picking Approach suitable for you
3. Why I Left Technical Analysis And Never Returned To It!
4. Shortlisting Companies for Detailed Analysis
5. How to conduct Detailed Analysis of a Company
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6. Understanding the Annual Report of a Company

7. How to do Financial Analysis of a Company
8. 7 Signs to tell whether a Company is cooking its Books: “Financial Shenanigans”
9. Self-Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company
10. How to do Valuation Analysis of a Company
11. Hidden Risk of Investing in High P/E Stocks
12. How to earn High Returns at Low Risk – Invest in Low P/E Stocks
13. 3 Principles to Decide the Investable P/E Ratio of a Stock for Value Investors
14. How to do Business & Industry Analysis of a Company
15. Is Industry P/E Ratio Relevant to Investors?
16. Why Management Assessment is the Most Critical Factor in Stock Investing?
17. Steps to Assess Management Quality before Buying Stocks (Part 1)
20. 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing
21. 7 Important Reasons Why Every Stock Investor should read Credit Rating Reports
22. Final Checklist for Buying Stocks
23. 5 Simple Steps to Analyse Operating Performance of Companies
24. How to Monitor Stocks in Your Portfolio
25. Understanding & Interpreting Quarterly Results Filings of Companies
26. How Many Stocks Should You Own In Your Portfolio?
27. Trading Diary of a Value Investor
28. When to Sell a Stock?
29. 3 Guidelines for Selecting Stocks Ideal for Retail Equity Investors
30. How to Use Screener.in “Export to Excel” Tool
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5) e-Books: Business Analysis Guides

These ebooks contain guidelines to do business analysis of companies belonging to different industries.
After reading these ebooks, an investor will learn which factors influence the business of companies in
these industries. You will learn to identify what makes a company stronger than others in these industries.
This knowledge will help you in selecting fundamentally strong companies for investment.
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6) “Peaceful Investing” Workshops

“Peaceful Stock Investing” workshops are full-day workshops (9 AM to 6 PM) held on selected Sundays.
The workshops are focused on stock selection and analysis skills, which would make us much more
confident about our stock decisions. It ensures that our faith would not shake with day to day market price
fluctuations and we would be able to reap the true benefits of stock markets to fulfil our dream of financial
independence.
The workshops focus on the fundamental stock analysis of stocks with a detailed analysis of various sources
of information available to investors like annual reports, quarterly results, credit rating reports and online
financial resources.
You may learn more about the workshops, pre-register/express interest for a workshop in your city by
providing your details on the following page:
Pre-Register & Express Interest for a Stock Investing Workshop in Your City
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Disclaimer & Disclosures

Registration Status with SEBI:
I am registered with SEBI as a Research Analyst.
Details of Financial Interest in the Subject Company:
Currently, on the date of publishing of this book, August 22, 2022, I do not own stocks of any of the
companies discussed in this book.
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