Investing in India (2 of 3) - Labor arbitrage+

Every rupee invested in Bharat Forge 3 years back would be worth over Rs. 12 today. Infosys’ profits have grown on average at 67% annually since 1999. A single investment in Spectramind returned ChrysCapital’s entire first fund. These and other impressive factoids stem from one underlying concept – labor arbitrage. The logic for this opportunity is simple – 40% of the world’s working age population is in India and China. And for most of the workforce, salaries are as low as 10-15% of those in US, Western Europe and Japan. And how large is this opportunity, to relocate jobs to these countries? Just look at the P&L of any company, for labor cost that is embedded into COGS, sales/marketing, G&A, R&D and overheads. It doesn’t end there. There is labor cost in their service providers’ billings – utility companies, telcos, banks, insurers employ large numbers of people to service their customers. Then, go one level deeper into each company’s salaries and see how their employees spend their money – retail, consumer goods, healthcare, hotels, airlines all have their own labor cost. As long as cost savings more than cover increased physical and virtual coordination costs, several labor-intensive activities (except a few high-touch and critical ones) can be performed remotely from low-cost countries such as India and China. And to restate the obvious, coordination costs have dropped dramatically over the last decade, allowing a thousand call centers to bloom!

Personally, this opportunity is the most boring and the most significant among the three that I mentioned. Boring, since these are simply existing products/services being delivered from a new location. Significant, since this can comfortably scale into the 100s of billions of $ over the next decade. India’s FY05 exports of IT, BPO, textiles, auto components and pharmaceuticals add up to $12.2 billion, $ 5.1 billion, $ 14 billion, $ 1.2 billion and $ 3 billion respectively. At a 30% growth rate, this would reach $100 billion in 4 years! For that much money, I can put up with some boring stuff! (FYI, China’s exports are 6x that of India).

All this is nice, but where do I invest? Let me start with manufacturing, for a change. Auto components offers great potential, since the opportunity is led as much by high-skill engineering as by low cost shop-floor labor. Industry cost pressures are immense, as reflected in this morning’s headlines on GM, Delphi and Dana. I’ve personally spoken to purchasing managers at global auto OEMs who have a target to move 30% of their components to low-cost countries (the math works out to $250 billion). With a premium on quality/precision, timely delivery directly to the production line and turning around new designs quickly, this plays to India’s advantages. The key is to look for companies that have strong in-house skills in product design, tool/die design, indigenization of capital equipment (this can reduce capital cost by as much as 5-10x) and a focus on high-precision components. Earlier this year, we invested in Rico Auto, for precisely these reasons. With industry exports at $1.2 billion, there is a lot of headroom left to grow.

Pharmaceutical exports, that leverage process chemistry skills, also offer similar scope. However, I do find a few concern areas here. To start with, product costs are a very small part of the final sale price, with R&D and sales/marketing being far larger cost heads. There are also regulatory risks in patent challenges that are very hard to assess. Unlike relatively stable car (and component) prices, drug prices tend to crash once they go off-patent, potentially squeezing margins more than anticipated. To address and/or bypass these risks, companies are evolving new business models around contract research, contract manufacturing and clinical trials. While I remain bullish on the sector, picking specific companies to invest in requires a thorough understanding of each of these risks, in the context of the company’s focus area and business model. I’ll be honest in admitting that I am not a pharma expert, and actively invite comments on this topic.

Textiles are India’s largest export category, in revenue terms. However, the China-factor looms largest here, especially in products with lower levels of value-add. I find the argument that ‘retailers will buy from India, to hedge their China concentration risk’ hard to accept as a sustainable demand driver. I would rather invest in companies that can sustain their market and profitability in their own right, through making finished garments that meet global design and quality levels, at a competitive price. Companies like Gokaldas and Zodiac are succeeding in doing this, and I see more of these emerging.

Now, services. I’ll pass on IT Services in this piece, since this is too well understood for me to say anything interesting. Further, most players are generating so much cash, that they don’t really need growth capital from external investors like us.

The 1st wave of BPO companies were funded in 1999-2000. I compare these to the first 15 overs of a one-day cricket match, played on the sub-continent. You’re in early. Huge opportunity (hardly any fielders outside the circle, docile wicket). The strategy is to get going quickly and make the most of it. Who cares about sound technique. Someone else can consolidate the innings later! My test for separating these first-15-overs deals from later ones is very simple – do a ctrl-F for words such as ‘profit’ or ‘margins’ in any press release on both the entry and exit. If you get zero results, there you go. These are top-line and potential driven, similar to internet deals in the days gone by. An astute reader would figure out that Skype falls into this category!

BPO today is more of a test match. Minor details such as cost and profitability matter. Consolidation and big-getting-bigger are imminent. While I wish I were investing 5 years ago, I have to live with what I have now. The basic horizontal services – data entry, customer service, transaction processing – are well covered by the incumbents. There is a second wave of more focused, niche BPO services companies that are emerging. I find the KPO phrase quite contrived (When was the last time you used the phrase ‘knowledge process’ in everyday conversation, with a straight face? If you did, my condolences!). Like web 2.0, it is a good catch-phrase that may yield higher valuations from the unsuspecting. The main challenges facing these niche-BPO companies are scalability, a much harder selling process and people-retention. Niches are called that for a good reason. Several such areas are amenable to companies reaching $10+ million revenue, but not a lot more. Further, individual contracts tend to be both project-like (as opposed to ongoing processes) and small (I’ve heard of 1 FTE contracts), in areas such as analytics and research. Such services are more core to what the client does, making it a hard-sell. Internal teams at the client themselves are fragmented and de-centralized (retailers and consumer goods companies have research/analytics people embedded into each business division/department, making outsourcing even harder). By definition, such BPO companies employ people with higher skills and commensurate aspirations. Such people are harder to retain. A good financial analyst would rather work in a client-facing role with an investment bank, than in a back-office, vendor set-up.

If you are running a niche BPO company, and have figured these out, what are you waiting for – give me a call!