Marcellus: Dissecting the Economic Slowdown in India

The reset is now well understood…
Most people now understand that India is gradually transitioning from:

 (a) a country where it was easy to transact in cash to a country where it has become hard – albeit not impossible – to transact in cash;

(b) a country where SMEs routinely used to evade taxes to a country where such routine tax evasion has become much harder;

and (c) from a country where the scope of operation for 90%+ companies was local/regional to a country where a far higher proportion of companies is operating on a nationwide scale courtesy much improved transport & communication networks & due to an integrated nationwide framework for indirect taxes (GST).Plenty has been written on these subjects. For instance on 13^th August 2018, we said in our note to clients, “Small/informal businesses flourish in an underdeveloped economy where due to the lack of availability of electricity, good roads, reliable communication networks and affordable credit, businesses can operate only a small scale and that too within the confines of their immediate locality….India seems to be going through period comparable to what America went through in the 50 years post the Civil War. Over the past ten years, the length of roads in India has increased from 3.9 million km to 5.6 million km (implied CAGR of 4.2%). The number of mobile phone subscribers has increased over the same period from 234 million to 1.2 billion (CAGR of 20%)…These factors have made it easier for smaller companies to build pan-India franchises….It goes without saying that not every small firm will be able to build a national niche. The winners will be those who have: (a) the work ethic to build a pan-India brand and national distributor-dealer networks; (b) the capital allocation skills to rationally & patiently invest in building long term competitive advantages….”…but the economic slowdown is misunderstood
And yet, although everyone understands that we are in the throes of change, most people – investors & companies alike – find it hard to understand how this change will play out. Who will be the winners & losers? How long will the transition to the new world take? How painful will the transition be? In this note, we offer our few paisa worth of wisdom regarding these questions.The economic slowdown that is impacting India can be broken down into its constituent components:

Challenge 1: The capex conk-off a decade ago – The Indian economy’s slowdown started within three years of 2008 Great Financial Crisis. Ever since 2012, India’s earnings growth started decelerating arguably because the era of crony capitalism (during which promoters got easy money from Indian banks and/or global financial markets) ended with the unveiling of the 2G spectrum scam in 2010. As capex growth gradually decelerated, earnings growth for the Nifty started sliding – see chart above created using data from Bloomberg.The impact on growth of this capex conk-off was buffered by households’ savings rate falling from around 25% of GDP ten years ago to around 17% now. Basically, as corporates lost the appetite to borrow, lenders focused their efforts on convincing consumers to borrow for homes, cars and washing machines. Obviously, such a savings conk-off could not continue indefinitely. Hence as the household savings rate bottoms out, and by implication consumption (as a % of GDP) tops out, the economy feels the full impact of a conked off capex engine. Let’s label this conk-off in demand as S% CAGR.

Challenge 2: Three shocks in three years (2016-2018) – The impact of three big shocks in three successive years – the latest shock being the NBFC meltdown – has impacted demand further (over and above the demand conk off identified in Challenge 1). This impact is multi-faceted and deserves to be disaggregated carefully:

1. The end consumer: At a psychological level, the endless talk of jobless growth, NPAs, corporate fraud, etc seems to have had some impact on consumers’ willingness to spend. We can see this in our social circles wherein affluent people are throttling off on discretionary spend on holidays, marriage related spend, cars, etc. Furthermore, given the nature of the Indian economy, many consumers are dealers, distributor or manufacturers of something or the other (see the impacts discussed in the following bullets). Hence it is but natural that they have throttled off on spending as they see their businesses hit by the slowdown. Let’s label this conk-off in demand as J% CAGR.
2. The dealer: This guy is your typical local shopkeeper. All his life he has hidden most of his profits from the taxman (i.e. his profits are black money). Now, in the post-GST world, he is reluctant to show all his revenues in white as that will invite scrutiny from the taxman of the prior years. His next challenge is working capital financing of his inventory – all these years his inventory was financed through black money. Now he needs white money channel financing but no lender will provide the same as the dealer’s white money profits have historically been negligible. As a result, we have heard from several companies that the dealer does not have money to finance his purchase of inventory. The dealer’s predicament has a multiplier impact on demand because he’s part of the pipe through which goods reach the consumer (and the triple shocks of the last 3 years has basically squeezed the pipe). Let’s call this multiplier K where K is a number greater than 1. The cumulative impact therefore becomes (S%+J%)xK where K amplifies the demand conk-off.
3. The distributor: The impact of GST on the distributors’ margins do NOT appear to be anything as serious as the impact on the dealers’ margins. The distributors’ problem appears to be the late payment of GST credit which has resulted in distributors’ operating cashflow being crunched. That in turn has meant that the distributor is ordering less from the manufacturer. Think of this as another multiplicative factor, M (where M>1), which squeezes the pipe through which goods reach the consumer. The cumulative impact therefore becomes (S%+J%)xKxM where K & M amplify the demand conk-off.
4. The manufacturer: Like the distributor, the manufacturers’ operating cashflows too are impacted by the withholding of GST credit. In addition, the NBFC conk-off hits the ability of the SME manufacturers to borrow to finance their working capital needs. More obviously, as demand conks-off, operating leverage works in reverse to crunch profits even more than the fall in demand. Let’s call operative leverage P where P is a multiplicative factor (and P>1). Hence the conk-off in manufacturers’ profits is (S%+J%)xKxMxP where K, M and P are factors amplifying the demand slowdown.

What is transient and what is structural?

Clearly Challenge 1 is NOT transient. Barring 1994-97 and 2004-10, India has not seen a capex boom ever. Hence it is unlikely that the capex cycle will turn around in a pronounced manner (i.e. 2004-10 style) anytime soon. Furthermore, thanks to the Insolvency & Bankruptcy Code, the crony capitalists who financed India’s capex historically can no longer default on their loans in the manner in which they are historically accustomed to. Therefore, it seems likely to be while before we see a proper capex boom in India.

However,most of the issues pertaining to Challenge 2 appear to us to be transient provided the Government (or the global economy) does not deliver yet another adverse shock. Three weeks ago the Finance Minister promised to address the GST credit issue which is bedevilling the entire distribution chain. Secondly, we are aware that several lenders are working on providing channel financing constructs which address the needs of dealers. Thirdly, the falling prices of steel, rubber, land and capital mean that prices should come off for most products thereby allowing the economy to adjust to a lower level of demand. This is how free market economies adjust to demand shocks. This is how the Indian economy is likely adjust.

Overall therefore whilst the S% conk-off appears unlikely to go away, K, M, P & J% look likely to be gradually addressed over the coming year. Hence we do NOT buy the argument that something fundamental is broken in the Indian economy and structural reforms are the need of the hour. In fact, we would argue rapid structural reform has resulted in many of the issues highlighted above! To ask for more structural reform at present is therefore misguided. That being said, a logical response to the reduced demand highlighted above would be for the RBI to highlight a glide path towards significantly lower interest rates over the next 12 months. We reckon as much as 200bps of repo rate cuts over the next two years could be warranted given the severity of the two challenges outlined in the note.

Investment implications: how can we make money in this slowdown?

1. Companies for whom the distribution channel is non-existent will be less impacted by the slowdown. One can see this clearly in the way the slowdown has not impacted Asian Paints, Berger Paints, Trent and Westlife (McDonald’s). Similarly, Amazon, Flipkart and DMart are NOT experiencing any slowdown. See https://www.business-standard.com/article/companies/amazon-and-flipkart-on-the-same-page-say-no-economic-slowdown-in-india-119091601535_1.html
2. Companies which sell essential products (eg. baby milk powder (Nestle), blood tests (Dr Lals), adhesives (Pidilite)) will be less impacted by the slowdown as households throttle off on discretionary consumption. Basically, for them S% and J% will be much lower for companies selling essential products (than it is for companies selling discretionary items). If such companies have managed their channel properly, then K, M & P would also be lower for them.
3. Companies which finance SMEs’ working capital needs will be severely impacted by the slowdown. Such lenders are feeling the amplifying impact of K, M and P. Many of these lenders seem likely to go out of business before Challenge 2 subsides. At the same time a massive brand new opportunity – channel financing for dealers, distributors, manufacturers operating in the white economy – will open up for smart, well capitalised lenders. We reckon Kotak Bank, HDFC Bank and Bajaj Finance can capitalize on this opportunity.
4. Companies which are able to pull market share from their competitors will be less impacted by the slowdown. Basically, these firms will use market share gains to negate the impact of S% and J%. Structurally, the biggest winners across sectors are companies who are able to understand the drivers of the changes highlighted above and move adroitly to consolidate market share in their sectors. We have tried our best to pack our clients’ portfolios with such stocks. Earnings of the companies in our portfolio grew 17% in Q1 FY20. However, given the complexity of the changes outlined above we cannot afford to let our guard down in this time of flux. You can see here how our CCP portfolio is doing: http://marcellus.in/newsletter/why-consistent-compounders-outperform-during-market-stress/