According to a McKinsey report, India's consumer goods market is expected to reach $400 billion by 2010, which would place it among the five largest markets in the world.
Yet few subjects elicit both optimism and skepticism as much as the Indian consumer does. To the optimists, India represents a huge, untapped middle market, critical to any company with global aspirations. To the skeptics, India is still too poor by global standards -- with most people living on less than $1 per day -- for mass-market retailers to rush in.
Members of a panel titled, "Retail & Consumer Technology: Selling to the New Indian Consumer," at the recent Wharton India Economic Forum suggested that, broadly speaking, both the optimists and skeptics are right. However, generalizations about the Indian consumer can be misleading. Trying to connect with consumers on an "Indian" level is a mammoth task. For one, India is a diverse country, with 23 official languages and more than 1,000 dialects.
Although attitudes have shifted toward consumerism, being individually poor but collectively rich fundamentally differentiates India from developed markets. Despite having a large consumer base that is growing steadily, the market is complex and the propensity and capacity for Indian consumers to spend depends on a unique blend of price and value. According to the panelists, the companies -- domestic or foreign -- that understand this complexity will be the most successful at selling to Indians, and stand to reap enormous benefits of scale.
Understanding the Indian Consumer
Sunil Dutt, head of Samsung Mobile India, opened the panel discussion with a quote from India's first prime minister, Jawaharlal Nehru: "India, poised as she is, will either account for a great deal, or nothing at all." India's economic growth has accelerated significantly over the last two decades, along with the spending power of its citizens. Real average household disposable income has roughly doubled since 1985. With rising incomes, household consumption has increased, and a new Indian middle class has emerged.
As Indian incomes rise, the shape of the country's income pyramid will also change dramatically. More than 291 million people will move from desperate poverty to a more sustainable life, adding a number of first-time consumers to the market. While much of this new wealth and consumption will be created in urban areas, rural households will also benefit. According to Dutt, "Indian spending patterns have evolved, with basic necessities such as food and apparel declining in relative importance, and categories such as communications and health care growing rapidly. Much of this shift can be attributed to the consumer electronics and telecom sectors that have provided a platform to increase consumer awareness. In fact, the mobile-phone's penetration and impact on the Indian economy have earned it the new title of FMCD" -- or fast-moving consumer durable, versus the traditional marketing category of fast-moving consumer goods.
Awareness around the power of information technology to solve problems, create employment and improve lives has trickled down to the lowest socio-economic class. India has close to 261 million mobile subscribers, many of whom live in rural areas. "The connectivity, communication and literacy leap that India has gone through over the past decade has been a major driver of aspiration," said Rajeev Karwal, founder and CEO of Milagrow Business and Knowledge Solutions, a Gurgaon-based venture-capital firm geared to small and medium-size businesses.
Through word of mouth, their own observation and the media, consumers now can visualize a better life, and they demand it, Karwal said. The historical pattern in India -- and in most developing economies -- shows that as incomes rise, consumers spend proportionately less on basic necessities. As millions of deprived households move into the "aspirant" segment, they will begin to be able to afford products and services beyond their immediate needs for food and clothing.
Arvind Singhal, chairman of the Gurgaon-based management consulting firm Technopak, said that "it is a myth that rural India is less aspirational. There might be a larger distribution of wealth in the cities, but there is no demographic-based difference in aspiration. In fact, rural India has been badly served; most large retailers have concentrated on the top 200 cities, with very few even having distribution channels in the villages."
Most companies have not tapped the vast rural consumer base for two reasons. First, the volume of potential customers, based on income, is small as a proportion of the total rural population. "Tier 1 and 2 cities will continue to control and drive approximately 62% of consumption of high-end products in 2025," Karwal said. Second, the rural population is scattered over a vast geographic area, making them hard to locate and expensive to target, given the country's poor infrastructure. However, "new technologies like the Internet and wireless broadband can solve both these problems," Karwal noted, "making it economically viable for companies to offer a range of services such as banking, distance education and health care to rural India. This, in turn, will transform the expectations, aspirations and economy of the rural consumer."
Although price and value are important considerations, recent research shows that Indian consumers increasingly demand brands that are relevant to their experience and that reflect local preferences. For several years, leading multinationals attempted to sell global brands in India at global prices. Companies were confident that the country's consumers would move in a premium direction because of the technological sophistication that the IT boom engendered. They also chose not to establish well-planned marketing and sales channels, assuming that brands alone were strong enough to attract consumers. This assumption turned out to be wrong: Over time, companies tailored their products and production methods to Indian market conditions and slashed prices by more than 50%.
Karwal cited the mobile phone as an example of a product that offers a high degree of functionality at a good price. "It is equipped with features such as a dust-resistant keypad and a built-in flashlight that not only aid truck drivers on India's poorly lit highways, but also take away the villager's embarrassment over the lack of electricity. Customized to the Indian market and reflecting the importance of price and value rolled into one, the mobile phone now serves as a great benchmark for market penetration. It is no wonder that the number of mobile phone subscribers far outweighs the number of Internet or credit card users in India."
Getting the price right is just as important. Although income levels are rising, Indian consumers still have many competing demands on their modest budgets. Winning companies have learned the importance of affordability. "India has the fastest-growing mobile phone market, and handsets are sold cheaper than anywhere else in the world," Dutt said. "Steep and continual price cuts have led to levels of market penetration that took television sets 25 years to achieve."
The Road to Consumption
India's consumer demand structure is fundamentally different from that of developed markets. Since 1990, the country's economy has grown on an average of 5.7% per year. Its per capita income has nearly doubled in real terms. But different consuming classes drive market growth in different ways, and an appropriate mix of strategies is required to capture this growth.
An estimated 1.2 million affluent households sit atop the Indian income and consumption pyramid. These consumers buy branded products and behave like their counterparts in developed markets. Moreover, they are largely concentrated in the top eight cities. At the bottom of the pyramid are the large but poor segments. Struggling households number more than 100 million, followed by 40 million destitute households that are poorer still. The real drivers of the growing consumer goods market occupy the center of the pyramid -- India's 40 million middle-income households, which purchase more than just the basics.
"A 1% change in income opens up a $25 million retail opportunity," Karwal said. "As economic growth occurs, the destitute will transform into aspirants and enter the consumption arena. Aspirants will become climbers with increased per capita consumption, creating an automatic volume growth for several categories. The socio-economic transformation of consumers offers a large window of opportunity for marketers, as 100 million to 150 million consumers have just begun their journey, while another 100 million are on the road to consumption."
The population's demographic profile also plays a role. Indians constitute a fifth of the world's citizens below age 20. So a youthful, exuberant generation, nurtured on success, is joining the ranks of Indian consumers. These people are deeply rooted in Indian culture and traditions yet connected to and curious about the outside world. Their incomes may be growing but their budgets are still limited. Together, these characteristics have big implications for the product categories and brands they select. With basic needs satisfied and the future taken into consideration, these consumers will consider purchasing products that represent "the good life."
"In the past, youth were perceived to be disconnected with no consideration for value," Dutt said. "However, a closer look reveals that they are extremely discerning individuals who know what they want. The challenge facing manufacturers is to come up with products and services that appeal to this group of consumers who have a short attention span coupled with rapidly changing needs and preferences. We need to understand them and synchronize our products with their aspirations."
Additionally, youth often spend beyond their means. They are willing to experiment with high-end brands because they have a high level of disposable income. "Unlike the previous generation who witnessed slow economic growth, young Indians have been raised in the post-liberalization era of fast growth and underlying optimism, and are thus more confident about the future," said Y.V. Verma, director of human resources and management support for LG Electronics India.
Expansion of Organized Retail
When India opened its economy to the global marketplace in the early 1990s, many multinational corporations rushed in to pursue its middle-class consumers, only to confront low incomes, social and political conservatism, and resistance to change. "In the past, retail conglomerates avoided the Indian market because they did not find the large investment a worthwhile opportunity, as India accounts for a very small percentage of the U.S. market in pure dollar terms," said Technopak's Singhal. India also lacked the infrastructure, supply chain, foreign direct investment regulations and value-added tax required for retailers to succeed.
"If the government permits foreign direct investment in retailing, consumer goods companies would have greater opportunities to sell products in the modern formats they understand," Karwal said. "Currently, about 60% of all purchases are made in the food and grocery segment, which has a unique supply chain that multinationals don't understand. The optimal retail format in India mimics a local bazaar experience, vastly different from the neat aisles and structured store layout present in other countries."
Skeptics point out that even if government policy works in favor of large retail, understanding of the consumer's psyche is paramount to cracking the Indian market. Karwal went on to say that "most bleeding happens at the front end, as real estate prices are exorbitant. To combat these expenses, companies such as Zara and Best Buy have set up their own buying houses in India. If foreign retailers are able to get their back end in order while regulation evolves and rental prices cool down, the government policy is likely to work in their favor."
At the same time, the government has a responsibility to make sure that foreign inflows do not disrupt employment or functioning of smaller, homegrown players. Karwal minimized that concern: "Even though large conglomerates have a 7% to 10% buying advantage, small retailers benefit from the close proximity to customers. The necessity to buy fresh food due to a lack of electricity and inefficient public transportation systems serves to check the displacement of traditional retail. The network of local retailers will remain an important segment for years, even if modern retail continues to grow at the current pace."
Friday, June 13, 2008
The Next Frontier for India's Outsourcing Industry? The Domestic Market
Earlier this year, Genpact, the largest business process outsourcing (BPO) player in India, gave Harpreet Duggal a new role: responsibility for developing and executing the company's domestic BPO strategy. Duggal is already well into discussions with potential customers, and is finalizing operating locations. He's moving fast because Genpact isn't the only Indian company interested in this space. For many reasons, the domestic BPO market is one that no one can afford to ignore anymore.
Duggal primarily is targeting two sets of potential customers: existing global customers who are looking to increase their presence in India and require the same systems and processes they have elsewhere; and Indian companies with global aspirations, both by way of moving beyond Indian boundaries and by providing a global experience in the Indian market. These require world-class processes and systems. Says an upbeat Duggal: "We believe that India is a very exciting market to be in."
Having been on the periphery, the domestic BPO business is steadily moving onto everyone's radar. Companies including IBM Daksh, Firstsource Solutions, MphasiS BPO and Intelenet Global Services are looking to significantly increase their presence. Others, such as Wipro BPO and Infosys BPO, are waiting for the right time to enter the space as part of a total outsourcing solution along with their IT arms. And, firms such as 24/7 Customer have no immediate plans to enter but are watching the space keenly.
What has brought about this growing interest in India's BPO market? Industry players and analysts cite multiple factors. These include reduced costs of connectivity, the scorching pace of the Indian economy, the phenomenal growth of companies in sectors including telecommunications and financial services, rising customer expectations, Indian firms' global aspirations, and global firms entering the Indian market. The changing rupee-dollar equation and the slowdown in the U.S. economy, which is forcing players to look at other markets, have added to the momentum.
Wharton management professor Saikat Chaudhuri says the factors driving that trend are the "tremendous growth" of India's domestic markets, the slowdown in Western markets, and the dollar's weakness against the rupee. He notes that a whole new class of medium-sized companies outside of the well-established and large industrial houses like those of Tata, Birla, Ambani or Goenka is looking at farming out noncore activities to increase efficiencies and focus on core competencies. "These companies are becoming customers of Oracle, Cisco, SAP and so forth," says Chaudhuri.
According to Ravi Bapna, assistant professor at the Indian School of Business, "It's now become profitable to address this market and the industry is set to take off."
A glance at the Indian BPO industry's growth helps put the dynamics of the domestic market in perspective. At a compound annual growth rate of around 37% over the last few years, BPO exports have been the fastest-growing segment of the Indian IT-BPO sector. They have grown from $3.1 billion in fiscal 2004 to $11 billion in 2008 and currently account for 37% of the global business process offshoring pie. They sustain an employee pool of more than 700,000.
Players have tried over the years to add quality and efficiency to their original labor arbitrage sales pitch. They have been moving from low-end, non-core activities to more complex processes. Now, in a move further up the value chain, they are looking at becoming transformational partners to their clients, making an impact on business metrics.
A recent study by the National Association of Software and Services Companies of India (Nasscom) and the Everest Group estimates that in a "business as usual" mode, India's BPO exports will grow to $28 billion to $30 billion over the next four to five years. With proactive measures, the report says, they have the potential to reach $50 billion by 2012, with a maximum addressable opportunity of $220 billion to $280 billion.
Traditionally, Indian BPO vendors have relied largely on English-speaking geographies as their markets. North America and the United Kingdom together account for about 87% of their export revenues. North America, primarily the United States, accounts for roughly two-thirds of the market alone. While this dependence on the U.S. market is expected to continue, players have been expanding their footprints in other markets, notably continental Europe and the Asia-Pacific region. With the slowdown in the U.S. economy, rupee-dollar fluctuations, and growth in other markets, this move to tap other geographies not only acts as a natural hedge against currency fluctuations, it's simply a good business strategy.
India's Growth Beckons
That's where the Indian market comes into play. India's economy is growing too fast for any industry not to want to share in its growth. From less than $100 million in 2002, BPO demand in the domestic market grew to $1.1 billion in 2007. In the last year, it is estimated to have grown to between $1.6 billion and $1.8 billion. The Nasscom-Everest study estimates the potential addressable market at around $15 billion to $20 billion over the next five years. Realizing even half of this potential would be significant.
In many ways it would change the nature of the industry. As it stands, close to 80% of the industry comprises captive shared service centers. The rest of the industry is highly fragmented. Estimates suggest that 400 to 500 firms constitute the unorganized sector. As the industry gains in size and stature, a fair bit of consolidation is expected. Third-party service providers, many whose revenues are growing around 100% a year, are expected to increase their market share significantly.
Telecommunications and financial services have been key verticals spurring domestic demand, followed by consumer goods and airlines. Going forward, government, travel and hospitality, retail, and media and entertainment are expected to attract significant demand for BPO services in India.
Ravi Aron, senior fellow at Wharton's Mack Center for Technological Innovation and an expert on outsourcing trends, points out how BPO firms in India will find the domestic market more challenging than those in developed countries. For starters, he says Indian companies in several services industries including those in the BFSI (banking and financial services industry) segments are wholly owned by the government. BFSI companies have tended to be the biggest opportunity for outsourcing services providers in Western markets, he adds.
"Although these companies present the right opportunity for BPO firms, state-owned banks and insurance companies like the State Bank of India and General Insurance Corp. of India are going to be very slow to start outsourcing on a large scale," says Aron. "That is because of the extraordinary pressure they will face from their unions, who don't want their jobs to go to the private sector."
The second challenge BPO firms will face in India stems from the fact that any company's decision to outsource its needs is "heavily embedded in its technological architecture," says Aron. "Indian services companies in either the public or the private sector are heavily underinvested in technology on a per-capita and per-sale basis compared to those in the U.S. and Europe. Indian services companies are far more labor intensive, and don't have the technology platforms that will facilitate outsourcing, excluding [financial services companies like] an ICICI or HDFC."
Aron talks of the "3 Ps" of information architecture -- platforms, processes and people -- "where Indian companies are not streamlined." He says internal processes at most Indian services companies are "idiosyncratic" and not standardized as in large retail companies like Wal-Mart or U.S. health care companies.
Gaurav Gupta, country head of the Everest Group, points out that with the phenomenal growth in these industries, the name of the game for most companies is to gain market share and grow the top line. The competitive landscape is straining companies' operational models. So companies in these industries are turning to vendors who can help them overcome some of the challenges associated with fast growth, like managing huge volumes and providing a large network that can reach out to different corners of the country rapidly. Says Gupta: "The present systems and processes are nowhere near adequate, either by way of scale or expertise, to sustain the kind of growth that companies are seeing in India. These require tremendous ramping up. Otherwise they will become severe bottlenecks." Adds Susir Kumar, chief executive officer of Intelenet Global: "At this stage of growth, companies would rather use their capital in building their brands, acquiring customers, and focusing on their core competencies and outsource whatever is possible."
'Productivity Arbitrage'
Aron agrees that big opportunities lurk behind those shortcomings at Indian services companies. BPO firms could help standardize and automate processes at Indian companies and achieve "extraordinary productivity gains of up to 35% over 18 to 24 months," he adds. "That is why doing BPO in India for Indian companies makes a lot of sense. Instead of wage arbitrage, start thinking about productivity arbitrage."
Even as companies busily increase their customer base they realize that, with the Indian economy becoming more globally integrated, customers are ever more demanding. The "new" Indian customer is not satisfied with anything less than world-class levels of product and service quality. Take the Indian telecom industry. It is among the most complex in the world, with new products being introduced practically every day. It is becoming imperative for companies to get it right the first time. Customer service is seen as a key differentiator in the crowded marketplace. Customer service, in fact, accounts for two-thirds of revenue in the domestic BPO market, followed by finance and accounting and human resource outsourcing. As Nasscom vice president Rajdeep Sahrawat says: "There is very little to differentiate companies from the product point of view and therefore offering very high quality, personalized, 24/7 customer service is critical. This requires scale, flexibility and expertise."
Bharti Airtel, India's largest mobile services provider, is an often-cited example. Bharti was one of the first and biggest Indian companies to outsource on a large scale. In August 2005, the company signed a mega deal with four global BPO companies -- IBM Daksh, MphasiS, TeleTech and Hinduja TMT -- to outsource its call centers. Bharti had already outsourced its IT and cellular networking requirements to IBM and Ericsson, respectively. These strategic moves allowed Bharti to focus on its core areas of product innovation, marketing and brand building. Bharti has a mobile subscriber base of around 60 million and is adding around 2 million subscribers a month. It is a beacon for others targeting high growth. Says Ramesh Gudalur, president of MphasiS BPO: "Companies like Bharti who look at outsourcing as an integral part of their business strategy are completely changing the way Indian companies have traditionally run their businesses. This is putting pressure on others, both in their own industries and in other sectors, to follow suit."
Opportunities await BPO firms also in providing specialized services to newly emerging industries like retail, fashion apparel or automobile components, such as customer relationship management (CRM), market research, accounting, and inventory and supply chain management, says Aron. "Many of these specialized services companies have the money, but not the managerial capacity or bandwidth to automate their processes and extract efficiencies," he adds. He sees a new trend emerging in the next two to three years of "platform-based BPO" that provide niche services in areas like credit card fulfillment, mortgage loan processing and loan refinancing, and property & casualty insurance.
Delivering Value
Increased capability in the supplier community is also encouraging Indian companies to move toward outsourcing. Having grown via the export market, many large suppliers have developed end-to-end capabilities that are large enough to attract the domestic players looking at huge volume growth. More important, the suppliers now have the capability to deliver value by way of technology platforms or process expertise that goes well beyond just cost.
This doesn't mean that the cost advantage that Indian companies enjoy by outsourcing their business processes is insignificant. Cost, as Sandeep Soni, chief executive officer of Spanco BPO, points out, remains an important driver by sheer virtue of the economies of scale that a vendor brings in. However, it is unlike the export market, where labor arbitrage was the key factor in the industry's early days and continues even today to play a dominant role.
Chaudhuri argues that BPO services companies could still play the wage arbitrage card to a significant extent in India's domestic markets, but differently. "That is because there are many inefficiently run companies in India, and the BPO companies have not just the expertise but also the scale to perform functions across the board at a much lower price," he says. "While the wage arbitrage in India's domestic markets may not be as attractive as it is in the west, certainly the volume of activity can make up for it."
Sabyasachi Satyaprasad, senior director at advisory firm NeoIT, says the absence of a strong labor arbitrage in the domestic market will in fact compel vendors to offer a higher-value proposition, such as solving business problems for their domestic clients. This, he says, could well result in the domestic BPO industry leapfrogging some of the growth stages that vendors had to go through in the global market. Industry players agree. Says Pavan Vaish, chief executive officer of IBM Daksh: "When one is operating in a market where there is no arbitrage benefit, you have to innovate and add value to the customer. When we started out in 2005 we had thought that our international business would give us a lot of insights into our India business. But what we are finding is that it is our India business where a number of amazing innovations are happening."
BPO companies that have concentrated on serving Western markets may not feel the need to reorient themselves as they look to serve domestic Indian companies, says Chaudhuri. While these BPO companies developed their "global delivery model" for Fortune 500 companies, he notes, many of them were "born and bred" in India, including Wipro Spectramind and Genpact's predecessor company. "The outsourcing model has been designed keeping Indian constraints in mind from the very beginning, which allows for very healthy margins when they deal with foreign clients."
The only significant difference BPO companies will encounter In India's domestic market is the need to offer simplified services, according to Chaudhuri. "The BPO companies targeting the Indian market are not going to sell $300 million or $1 billion contracts for five years," he says. "They will have a lot more projects that are in the $1 million, $5 million and $10 million range. They are well-positioned for that because they started small themselves." He says these BPO companies could also replicate the dedicated units they set up with some clients.
This presents its own challenges. While their global education is valuable, vendors must create a proposition that is relevant to their domestic clients' immediate needs. According to Sanjeev Sinha, senior vice president of operations at Firstsource Solutions: "In many cases the India market has requirements that are rather different from the global markets, so vendors need to adapt and customize the solutions to the local situation. A cut and paste of the global solution will not work."
Vendors also need to think ahead of the curve regarding their very business models. With India, an extremely price-sensitive market, pricing models need to be innovative. Vendors must build capabilities that allow them to adapt to the changing expectations of a fast-growing and competitive marketplace. As Anirudha Prabhakaran, chief operating officer of 3i Infotech, points out: "This is a market which not only negotiates very hard on the efficiency front but also constantly raises new demands."
One potential obstacle Aron sees is a "huge divide" that exists between managerial personnel and the clerical staff at Indian companies in the ability to efficiently use technology in processes. While Indian managers are able to use technology to access data, analyze it and create reports, for instance, clerical workers tend not to use computing capabilities to their fullest extent, he notes. "You don't see that sharp divide in the U.S.," says Aron.
Variation in Margins
There are other challenges, too. India, as it is well-known, is not a homogenous market. It has myriad regional languages, varied cultures and remote corners. For players who are looking at scale and who have national ambitions in the domestic BPO market, this means managing a range of complexities. Also, for the economics to be viable, players will have to move from larger cities and set up operations in Tier 2 and Tier 3 locations. It is true that the domestic market does not require that BPO agents be trained by way of voice, accent and culture; therefore it is less expensive and easier for service providers to move into the smaller cities. But the challenges posed by infrastructure and the availability of senior management must still be dealt with.
The biggest challenge, however, could be around profitability. Although the costs by way of infrastructure, wages and training are lower for the domestic market, so is the pricing. Pricing in the India BPO market is estimated to be anywhere between 30% and 60% less than in its global counterpart, though more experienced players insist that their domestic BPO margins are comparable to their global business or only marginally lower. With the outsourcing market in India still not mature, the readiness to pay for world-class services remains a challenge. But as Duggal of Genpact points out: "Even in the global markets the variation in margins is phenomenal." It all depends on how effectively vendors are able to deliver by way of cost structure, people management and value creation.
Chaudhuri says BPO companies focused on India's domestic market could continue to enjoy cost advantages because many of them are extending operations outside of the big cities to cheaper, second-tier cities. They could also use their Indian base to supply markets in other developing countries, he adds. "It's like the Tata Nano [the Tata group's newly launched small car], where the first foreign markets are in Africa, Southeast Asia and European countries that have road density problems, and some parts of Latin America," he says.
Chaudhuri sees other, longer term gains for BPO companies in all this. As service providers to India's new class of business houses that are expanding globally, they "could follow their clients to foreign markets," says Chaudhuri. "The Japanese banks followed the Japanese conglomerates, and U.S. telecommunications companies like Verizon did the same thing, following their financial services clients overseas."
Duggal primarily is targeting two sets of potential customers: existing global customers who are looking to increase their presence in India and require the same systems and processes they have elsewhere; and Indian companies with global aspirations, both by way of moving beyond Indian boundaries and by providing a global experience in the Indian market. These require world-class processes and systems. Says an upbeat Duggal: "We believe that India is a very exciting market to be in."
Having been on the periphery, the domestic BPO business is steadily moving onto everyone's radar. Companies including IBM Daksh, Firstsource Solutions, MphasiS BPO and Intelenet Global Services are looking to significantly increase their presence. Others, such as Wipro BPO and Infosys BPO, are waiting for the right time to enter the space as part of a total outsourcing solution along with their IT arms. And, firms such as 24/7 Customer have no immediate plans to enter but are watching the space keenly.
What has brought about this growing interest in India's BPO market? Industry players and analysts cite multiple factors. These include reduced costs of connectivity, the scorching pace of the Indian economy, the phenomenal growth of companies in sectors including telecommunications and financial services, rising customer expectations, Indian firms' global aspirations, and global firms entering the Indian market. The changing rupee-dollar equation and the slowdown in the U.S. economy, which is forcing players to look at other markets, have added to the momentum.
Wharton management professor Saikat Chaudhuri says the factors driving that trend are the "tremendous growth" of India's domestic markets, the slowdown in Western markets, and the dollar's weakness against the rupee. He notes that a whole new class of medium-sized companies outside of the well-established and large industrial houses like those of Tata, Birla, Ambani or Goenka is looking at farming out noncore activities to increase efficiencies and focus on core competencies. "These companies are becoming customers of Oracle, Cisco, SAP and so forth," says Chaudhuri.
According to Ravi Bapna, assistant professor at the Indian School of Business, "It's now become profitable to address this market and the industry is set to take off."
A glance at the Indian BPO industry's growth helps put the dynamics of the domestic market in perspective. At a compound annual growth rate of around 37% over the last few years, BPO exports have been the fastest-growing segment of the Indian IT-BPO sector. They have grown from $3.1 billion in fiscal 2004 to $11 billion in 2008 and currently account for 37% of the global business process offshoring pie. They sustain an employee pool of more than 700,000.
Players have tried over the years to add quality and efficiency to their original labor arbitrage sales pitch. They have been moving from low-end, non-core activities to more complex processes. Now, in a move further up the value chain, they are looking at becoming transformational partners to their clients, making an impact on business metrics.
A recent study by the National Association of Software and Services Companies of India (Nasscom) and the Everest Group estimates that in a "business as usual" mode, India's BPO exports will grow to $28 billion to $30 billion over the next four to five years. With proactive measures, the report says, they have the potential to reach $50 billion by 2012, with a maximum addressable opportunity of $220 billion to $280 billion.
Traditionally, Indian BPO vendors have relied largely on English-speaking geographies as their markets. North America and the United Kingdom together account for about 87% of their export revenues. North America, primarily the United States, accounts for roughly two-thirds of the market alone. While this dependence on the U.S. market is expected to continue, players have been expanding their footprints in other markets, notably continental Europe and the Asia-Pacific region. With the slowdown in the U.S. economy, rupee-dollar fluctuations, and growth in other markets, this move to tap other geographies not only acts as a natural hedge against currency fluctuations, it's simply a good business strategy.
India's Growth Beckons
That's where the Indian market comes into play. India's economy is growing too fast for any industry not to want to share in its growth. From less than $100 million in 2002, BPO demand in the domestic market grew to $1.1 billion in 2007. In the last year, it is estimated to have grown to between $1.6 billion and $1.8 billion. The Nasscom-Everest study estimates the potential addressable market at around $15 billion to $20 billion over the next five years. Realizing even half of this potential would be significant.
In many ways it would change the nature of the industry. As it stands, close to 80% of the industry comprises captive shared service centers. The rest of the industry is highly fragmented. Estimates suggest that 400 to 500 firms constitute the unorganized sector. As the industry gains in size and stature, a fair bit of consolidation is expected. Third-party service providers, many whose revenues are growing around 100% a year, are expected to increase their market share significantly.
Telecommunications and financial services have been key verticals spurring domestic demand, followed by consumer goods and airlines. Going forward, government, travel and hospitality, retail, and media and entertainment are expected to attract significant demand for BPO services in India.
Ravi Aron, senior fellow at Wharton's Mack Center for Technological Innovation and an expert on outsourcing trends, points out how BPO firms in India will find the domestic market more challenging than those in developed countries. For starters, he says Indian companies in several services industries including those in the BFSI (banking and financial services industry) segments are wholly owned by the government. BFSI companies have tended to be the biggest opportunity for outsourcing services providers in Western markets, he adds.
"Although these companies present the right opportunity for BPO firms, state-owned banks and insurance companies like the State Bank of India and General Insurance Corp. of India are going to be very slow to start outsourcing on a large scale," says Aron. "That is because of the extraordinary pressure they will face from their unions, who don't want their jobs to go to the private sector."
The second challenge BPO firms will face in India stems from the fact that any company's decision to outsource its needs is "heavily embedded in its technological architecture," says Aron. "Indian services companies in either the public or the private sector are heavily underinvested in technology on a per-capita and per-sale basis compared to those in the U.S. and Europe. Indian services companies are far more labor intensive, and don't have the technology platforms that will facilitate outsourcing, excluding [financial services companies like] an ICICI or HDFC."
Aron talks of the "3 Ps" of information architecture -- platforms, processes and people -- "where Indian companies are not streamlined." He says internal processes at most Indian services companies are "idiosyncratic" and not standardized as in large retail companies like Wal-Mart or U.S. health care companies.
Gaurav Gupta, country head of the Everest Group, points out that with the phenomenal growth in these industries, the name of the game for most companies is to gain market share and grow the top line. The competitive landscape is straining companies' operational models. So companies in these industries are turning to vendors who can help them overcome some of the challenges associated with fast growth, like managing huge volumes and providing a large network that can reach out to different corners of the country rapidly. Says Gupta: "The present systems and processes are nowhere near adequate, either by way of scale or expertise, to sustain the kind of growth that companies are seeing in India. These require tremendous ramping up. Otherwise they will become severe bottlenecks." Adds Susir Kumar, chief executive officer of Intelenet Global: "At this stage of growth, companies would rather use their capital in building their brands, acquiring customers, and focusing on their core competencies and outsource whatever is possible."
'Productivity Arbitrage'
Aron agrees that big opportunities lurk behind those shortcomings at Indian services companies. BPO firms could help standardize and automate processes at Indian companies and achieve "extraordinary productivity gains of up to 35% over 18 to 24 months," he adds. "That is why doing BPO in India for Indian companies makes a lot of sense. Instead of wage arbitrage, start thinking about productivity arbitrage."
Even as companies busily increase their customer base they realize that, with the Indian economy becoming more globally integrated, customers are ever more demanding. The "new" Indian customer is not satisfied with anything less than world-class levels of product and service quality. Take the Indian telecom industry. It is among the most complex in the world, with new products being introduced practically every day. It is becoming imperative for companies to get it right the first time. Customer service is seen as a key differentiator in the crowded marketplace. Customer service, in fact, accounts for two-thirds of revenue in the domestic BPO market, followed by finance and accounting and human resource outsourcing. As Nasscom vice president Rajdeep Sahrawat says: "There is very little to differentiate companies from the product point of view and therefore offering very high quality, personalized, 24/7 customer service is critical. This requires scale, flexibility and expertise."
Bharti Airtel, India's largest mobile services provider, is an often-cited example. Bharti was one of the first and biggest Indian companies to outsource on a large scale. In August 2005, the company signed a mega deal with four global BPO companies -- IBM Daksh, MphasiS, TeleTech and Hinduja TMT -- to outsource its call centers. Bharti had already outsourced its IT and cellular networking requirements to IBM and Ericsson, respectively. These strategic moves allowed Bharti to focus on its core areas of product innovation, marketing and brand building. Bharti has a mobile subscriber base of around 60 million and is adding around 2 million subscribers a month. It is a beacon for others targeting high growth. Says Ramesh Gudalur, president of MphasiS BPO: "Companies like Bharti who look at outsourcing as an integral part of their business strategy are completely changing the way Indian companies have traditionally run their businesses. This is putting pressure on others, both in their own industries and in other sectors, to follow suit."
Opportunities await BPO firms also in providing specialized services to newly emerging industries like retail, fashion apparel or automobile components, such as customer relationship management (CRM), market research, accounting, and inventory and supply chain management, says Aron. "Many of these specialized services companies have the money, but not the managerial capacity or bandwidth to automate their processes and extract efficiencies," he adds. He sees a new trend emerging in the next two to three years of "platform-based BPO" that provide niche services in areas like credit card fulfillment, mortgage loan processing and loan refinancing, and property & casualty insurance.
Delivering Value
Increased capability in the supplier community is also encouraging Indian companies to move toward outsourcing. Having grown via the export market, many large suppliers have developed end-to-end capabilities that are large enough to attract the domestic players looking at huge volume growth. More important, the suppliers now have the capability to deliver value by way of technology platforms or process expertise that goes well beyond just cost.
This doesn't mean that the cost advantage that Indian companies enjoy by outsourcing their business processes is insignificant. Cost, as Sandeep Soni, chief executive officer of Spanco BPO, points out, remains an important driver by sheer virtue of the economies of scale that a vendor brings in. However, it is unlike the export market, where labor arbitrage was the key factor in the industry's early days and continues even today to play a dominant role.
Chaudhuri argues that BPO services companies could still play the wage arbitrage card to a significant extent in India's domestic markets, but differently. "That is because there are many inefficiently run companies in India, and the BPO companies have not just the expertise but also the scale to perform functions across the board at a much lower price," he says. "While the wage arbitrage in India's domestic markets may not be as attractive as it is in the west, certainly the volume of activity can make up for it."
Sabyasachi Satyaprasad, senior director at advisory firm NeoIT, says the absence of a strong labor arbitrage in the domestic market will in fact compel vendors to offer a higher-value proposition, such as solving business problems for their domestic clients. This, he says, could well result in the domestic BPO industry leapfrogging some of the growth stages that vendors had to go through in the global market. Industry players agree. Says Pavan Vaish, chief executive officer of IBM Daksh: "When one is operating in a market where there is no arbitrage benefit, you have to innovate and add value to the customer. When we started out in 2005 we had thought that our international business would give us a lot of insights into our India business. But what we are finding is that it is our India business where a number of amazing innovations are happening."
BPO companies that have concentrated on serving Western markets may not feel the need to reorient themselves as they look to serve domestic Indian companies, says Chaudhuri. While these BPO companies developed their "global delivery model" for Fortune 500 companies, he notes, many of them were "born and bred" in India, including Wipro Spectramind and Genpact's predecessor company. "The outsourcing model has been designed keeping Indian constraints in mind from the very beginning, which allows for very healthy margins when they deal with foreign clients."
The only significant difference BPO companies will encounter In India's domestic market is the need to offer simplified services, according to Chaudhuri. "The BPO companies targeting the Indian market are not going to sell $300 million or $1 billion contracts for five years," he says. "They will have a lot more projects that are in the $1 million, $5 million and $10 million range. They are well-positioned for that because they started small themselves." He says these BPO companies could also replicate the dedicated units they set up with some clients.
This presents its own challenges. While their global education is valuable, vendors must create a proposition that is relevant to their domestic clients' immediate needs. According to Sanjeev Sinha, senior vice president of operations at Firstsource Solutions: "In many cases the India market has requirements that are rather different from the global markets, so vendors need to adapt and customize the solutions to the local situation. A cut and paste of the global solution will not work."
Vendors also need to think ahead of the curve regarding their very business models. With India, an extremely price-sensitive market, pricing models need to be innovative. Vendors must build capabilities that allow them to adapt to the changing expectations of a fast-growing and competitive marketplace. As Anirudha Prabhakaran, chief operating officer of 3i Infotech, points out: "This is a market which not only negotiates very hard on the efficiency front but also constantly raises new demands."
One potential obstacle Aron sees is a "huge divide" that exists between managerial personnel and the clerical staff at Indian companies in the ability to efficiently use technology in processes. While Indian managers are able to use technology to access data, analyze it and create reports, for instance, clerical workers tend not to use computing capabilities to their fullest extent, he notes. "You don't see that sharp divide in the U.S.," says Aron.
Variation in Margins
There are other challenges, too. India, as it is well-known, is not a homogenous market. It has myriad regional languages, varied cultures and remote corners. For players who are looking at scale and who have national ambitions in the domestic BPO market, this means managing a range of complexities. Also, for the economics to be viable, players will have to move from larger cities and set up operations in Tier 2 and Tier 3 locations. It is true that the domestic market does not require that BPO agents be trained by way of voice, accent and culture; therefore it is less expensive and easier for service providers to move into the smaller cities. But the challenges posed by infrastructure and the availability of senior management must still be dealt with.
The biggest challenge, however, could be around profitability. Although the costs by way of infrastructure, wages and training are lower for the domestic market, so is the pricing. Pricing in the India BPO market is estimated to be anywhere between 30% and 60% less than in its global counterpart, though more experienced players insist that their domestic BPO margins are comparable to their global business or only marginally lower. With the outsourcing market in India still not mature, the readiness to pay for world-class services remains a challenge. But as Duggal of Genpact points out: "Even in the global markets the variation in margins is phenomenal." It all depends on how effectively vendors are able to deliver by way of cost structure, people management and value creation.
Chaudhuri says BPO companies focused on India's domestic market could continue to enjoy cost advantages because many of them are extending operations outside of the big cities to cheaper, second-tier cities. They could also use their Indian base to supply markets in other developing countries, he adds. "It's like the Tata Nano [the Tata group's newly launched small car], where the first foreign markets are in Africa, Southeast Asia and European countries that have road density problems, and some parts of Latin America," he says.
Chaudhuri sees other, longer term gains for BPO companies in all this. As service providers to India's new class of business houses that are expanding globally, they "could follow their clients to foreign markets," says Chaudhuri. "The Japanese banks followed the Japanese conglomerates, and U.S. telecommunications companies like Verizon did the same thing, following their financial services clients overseas."
The Ranbaxy-Daiichi Deal: Good Medicine, or a Harbinger of Future Ills?
Published: June 12, 2008 in India Knowledge@Wharton
Just a few days before announcing that he had sold his family's 34.8% stake in Ranbaxy Laboratories to Japanese pharmaceutical firm Daiichi Sankyo, Ranbaxy's CEO and managing director, Malvinder Mohan Singh, said his company was on the hunt for its own acquisitions.
He told the New Delhi-headquartered business daily, the Business Standard, that he had "de-risked" and charted a strategy for the company to make acquisitions of its own. "When you are the leader, you have to set the pace for the industry," he declared.
So, Indian investors and pharmaceutical industry leaders were astounded by the June 11 announcement. To be sure, the markets were aware that something was afoot between Ranbaxy, India's largest pharmaceutical company, and Daiichi Sankyo, Japan's second largest, but investors were expecting no more than a sale of a strategic stake of about 10% or so to shore up an alliance between the two companies. The sale of the Singh family's entire stake came as quite a shock. Asked one journalist after the announcement: "Haven't you sold the family silver?"
Singh contends that this is just what the doctor ordered. "[This] puts us on a new and much stronger platform to harness our capabilities in drug development, manufacturing and global reach," he said. "Together with our pool of scientific, technical and managerial resources and talent, we will enter a new orbit to chart a higher trajectory of sustainable growth ... in the developed and emerging markets, organically and inorganically. This is a significant milestone in our mission of becoming a research-based international pharmaceutical company."
Daiichi Sankyo president and CEO Takashi Shoda said the two companies are a good fit: "The proposed transaction is in line with our goal to be a global pharmaceutical innovator and provides the opportunity to complement our strong presence in innovation with a new, strong presence in the fast-growing business of non-proprietary pharmaceuticals." He added: "While both companies will closely cooperate to explore how to fully optimize our growth opportunities, we will respect Ranbaxy's autonomy as a standalone company as well." Not only will Singh stay with the company, Shoda said, he will also be chairman of its board of directors.
Getting into the Generic Market
Wharton marketing professor Jagmohan Raju, who has consulted with pharmaceutical companies including Wyeth and Johnson & Johnson, says that while Daiichi Sankyo will find it easier to enter the Indian market with Ranbaxy, its bigger goal would be in securing a strong presence in the global market for generics. "Ranbaxy has a good foothold in the worldwide generics market, which is lucrative and growing," he says.
Singh has been a pugnacious leader, pursuing takeovers in India and abroad. Among his foreign acquisitions are the unbranded generic drug business of Allen SpA (a division of GlaxoSmithKline) in Italy; Terapia in Romania; Ethimed, a generics company in Belgium; the Mundogen generic business of GSK in Spain; and Be-Tabs Pharma in South Africa.
Singh has taken over or acquired strategic stakes in a host of domestic companies such as Zenotech Laboratories, Cardinal Drugs, Krebs Biochemicals and Jupiter Biosciences. He was recently involved in a raid on the Chennai-based Orchid Chemicals. Although he denied it was a hostile takeover, the promoter of the beleaguered company didn't agree.
Singh has also been taking on the world's big names in pharmaceuticals in court cases all over the globe. This includes Pfizer for Lipitor, GSK for Valacyclovir and AstraZeneca for Nexium. (Many of these patent battles have recently been settled out of court.)
After such an acquisitive strategy, why would Singh suddenly agree to be acquired? The answer is not immediately clear. Raamdeo Agrawal, co-promoter and non-executive director of Motilal Oswal Securities, speculated that there may be problems with the Indian drug industry that analysts are not fully aware of. "We need to look at the sector again," he said. Others expressed surprise and disappointment. "It's a landmark deal for the pharma industry. But I can't help feeling a twinge of regret about an Indian MNC becoming a Japanese subsidiary," Mahindra & Mahindra chairman Anand Mahindra told The Economic Times.
The Deal
Singh is selling his 34.8% stake for around Rs. 10,000 crore ($2.4 billion) at Rs. 737 ($17) per share. Daiichi Sankyo will pick up another 9.4% through a preferential allotment. According to Securities & Exchange Board of India (Sebi) norms, it will have a make an open offer to the shareholders of Ranbaxy for another 20%. There could also be a preferential issue of warrants to take the Daiichi Sankyo stake up by another 4.9%. That will come into play if the ordinary shareholders don't respond to the open offer and Daiichi Sankyo needs another way to raise its stake to 51%.
At the end of the exercise, scheduled to be completed by March 2009, Ranbaxy will become a subsidiary of Daiichi Sankyo. Despite all the denials from Ranbaxy leadership, an Indian icon will vanish. (Similar circumstances drove Sunil Mittal of Bharti Airtel to walk out of a deal with MTN of South Africa; he wouldn't compromise the Airtel brand which had become "the pride of India.")
What will Singh be doing with his $2.4 billion? He says that major investments are needed in Religare and Fortis, the group's forays into financial services and hospitals. But both are really part of the herd in their sectors while Ranbaxy was number one.
Ranbaxy, with $1.6 billion in global sales in 2007, had a profit after tax of $190 million, a gain of 67% over the previous year. It has a footprint in 49 countries and manufacturing facilities in 11. It has 12,000 employees, including 1,200 scientists and has been pouring money into R&D, though obviously not on the same scale as the Western majors. Ranbaxy is among the top 10 global generic companies. Its stated vision has been to be among the top five global generic players and to achieve global sales of $5 billion by 2012. How much of that survives the Daiichi Sankyo regime remains to be seen.
Indeed, there is a question over whether Singh himself will survive. He said that Ranbaxy is in his genes and there is no question he will remain CEO and, now, chairman. But will he be able to make the transition from a promoter to a professional CEO? He may have delivered Ranbaxy to Daiichi Sankyo, but now he has to deliver the goods.
Daiichi Sankyo is the product of a 2005 merger between Sankyo and Daiichi. In the financial year ended March 2008, it had net sales of $8.2 billion and a profit after tax of $915 million. It has a presence in 21 countries and employs 18,000 people. It is the second largest pharmaceutical company in Japan. The company can trace its roots back to 1899, though the formal entity today is relatively new. Daiichi Sankyo makes prescription drugs, diagnostics, radiopharmaceuticals and over-the-counter drugs.
The combined company will be worth about $30 billion. The acquisition will help Daiichi Sankyo to jump from number 22 in the global pharmaceutical sector to number 15. "The deal will complement our strong presence in innovation with a new, strong presence in the fast-growing business of non-proprietary pharmaceuticals," according to Shoda.
The combination has other benefits for the Japanese company. It gets a stake in a major player in generics, an area that is becoming increasingly important in Japan. According to the 2008 Japanese Pharmaceuticals & Healthcare Report (2nd quarter), the country's pharmaceutical market is currently valued at $74.4 billion and is the most mature in the Asia-Pacific region. By 2012, the market will grow to $82 billion. The country's generics sector is one of the most promising. "In an effort to control ballooning healthcare costs, the ministry of health plans to raise the volume share of generics within the total prescription market to at least 30% by 2012," says the report. "The current value of the sector is $5.5 billion, which equates to 7.3% of total medicines sales. Changes to prescribing procedures and the influx of foreign firms with low-cost goods will provide a stimulus to the generic drug sector." The comparative figures of volume share of generics for the U.S. and the UK are 13% and 26%, so there is some way to go.
Getting into Japan
Ranbaxy will gain easier access to the much-coveted Japanese market by operating from within the Daiichi Sankyo fold, says Raju. "Ranbaxy could bypass a lot of European and U.S. companies that are finding it difficult to enter the Japanese market, where safety and testing requirements are a lot higher." He notes that Pfizer has done a smart thing in forming an alliance with Eisai of Japan to jointly market the former's drug Aricept, which treats Alzheimer's disease. "No other Alzheimer's drug sells well in Japan," says Raju.
Daiichi Sankyo's proposal is to make the much cheaper generic drugs the default option over branded drugs. The ministry stamp of approval will eliminate the problems patients have been facing with health insurance claims; some insurers have not been accepting generic drugs as valid medicines. Indian pharmaceutical companies have been aware of this opportunity. Some have started their preparations. Last October, the Mumbai-based Lupin Ltd acquired an 80% stake in a Japanese generic pharmaceuticals company, the $70 million Kyowa Pharmaceutical Industry Co Ltd. Orchid Chemicals & Pharmaceuticals has set up a wholly-owned subsidiary in Japan called Orchid Pharma Japan.
The Ahmedabad-based Zydus Cadila group initially entered the Japanese generics market with Zydus Pharma in 2006. This U.S. company's mandate was to market formulation generics and look for alliances with Japanese companies. Last year, Zydus acquired a 100% stake in the Tokyo-based Nippon Universal Pharmaceutical Ltd. Zydus Cadila had earlier taken over Alpharma of France. In India, its acquisitions include Recon Healthcare, German Remedies, Banyan Chemicals and Liva Healthcare.
As much smaller companies than Ranbaxy have gone to Japan, shopping bag in hand, why didn't Singh try to purchase Daiichi Sankyo instead of selling? Domestic laws make Japanese companies difficult to take over. But there surely could have been an equivalent in Europe or the US. The Tatas and the Birlas have successfully targeted foreign companies several times their size. Why did Ranbaxy follow a different prescription?
The answer may be in the fact that that Ranbaxy was on a much weaker wicket. The official version talks of synergies. Says a joint company statement: "Daiichi Sankyo and Ranbaxy believe this transaction will create significant long-term value for all stakeholders through:
* A complementary business combination that provides sustainable growth by diversification that spans the full spectrum of the pharmaceutical business.
* An expanded global reach that enables leading market positions in both mature and emerging markets with proprietary and non-proprietary products.
* Strong growth potential by effectively managing opportunities across the full pharmaceutical life-cycle.
* Cost competitiveness by optimizing usage of R&D and manufacturing facilities of both companies, especially in India."
But beyond these positive results from the alliance lie problems that could have faced Ranbaxy had it chosen to continue alone. First, the company has thrived on selling off-patent drugs in the U.S. But this has become a much more expensive proposition because of litigation. Second, there is growing competition in generics at home and abroad. Finally, even as the Indian government has been insisting on stringent quality norms, it is extending its regime of price controls. The industry contends that it simply cannot make adequate returns on various products. "If the promoters of India's largest drug company felt it better to exit the business after many years of attempts to make it one of the largest in the world, then there must be serious issues with our drug policy," Swati Piramal, director of strategic alliances at Nicholas Piramal told the Business Standard.
Coming of Age
For Daiichi Sankyo, there are huge benefits in getting access to Indian research capabilities, said Vivek Wadhwa, executive-in-residence at Duke University.
"People are underestimating what is happening in India and China, where companies have rapidly come of age as they play on the world stage," says Wadhwa, adding that Daiichi Sankyo's selection of Ranbaxy underscores that trend. "The Japanese companies have a lot of money but not much by way of innovation. China, India and Indian companies are a very good way forward for them." He says Daiichi Sankyo is banking not just on the cost advantage Ranbaxy would bring, but also its research capabilities. "Japanese companies are shifting a lot of their R&D to India also," he says. "They don't have enough scientists and India has them in abundant supply right now."
There are fears that the Daiichi Sankyo takeover could be a sign of the times. The pharmaceutical industry has turned into a nervous place overnight. Earlier, one likely danger was perceived to be Ranbaxy itself. In March-April this year, it had launched a raid on the Chennai-based Orchid Chemicals and picked up a stake close to 15%.
An analysis shows that several mid-size companies are vulnerable to takeovers. Ankur Drugs, Avon Organics, Lyka Laboratories, Strides Arcolab, Surya Pharmaceuticals and Venus Remedies top the list of pharmaceutical companies in which the promoters have less than a 25% stake. "Indian generic players with established global businesses are definitely a target for multinational companies to beef up their businesses," Ranjit Shahani, vice-chairman and managing director of Novartis India, told the Business Standard.
Does the Daiichi Sankyo acquisition of Ranbaxy signal a countertrend to that exhibited by Indian corporations lapping up companies in foreign markets, like Tata Steel's purchase of European steelmaker Corus? "It's a two-way street," said Wadhwa. "Indian companies are becoming world class, they are growing fast, and they have competent management and technological abilities. The Ranbaxy-Daiichi Sankyo deal is one data point. You are going to see many more of these in the future."
Just a few days before announcing that he had sold his family's 34.8% stake in Ranbaxy Laboratories to Japanese pharmaceutical firm Daiichi Sankyo, Ranbaxy's CEO and managing director, Malvinder Mohan Singh, said his company was on the hunt for its own acquisitions.
He told the New Delhi-headquartered business daily, the Business Standard, that he had "de-risked" and charted a strategy for the company to make acquisitions of its own. "When you are the leader, you have to set the pace for the industry," he declared.
So, Indian investors and pharmaceutical industry leaders were astounded by the June 11 announcement. To be sure, the markets were aware that something was afoot between Ranbaxy, India's largest pharmaceutical company, and Daiichi Sankyo, Japan's second largest, but investors were expecting no more than a sale of a strategic stake of about 10% or so to shore up an alliance between the two companies. The sale of the Singh family's entire stake came as quite a shock. Asked one journalist after the announcement: "Haven't you sold the family silver?"
Singh contends that this is just what the doctor ordered. "[This] puts us on a new and much stronger platform to harness our capabilities in drug development, manufacturing and global reach," he said. "Together with our pool of scientific, technical and managerial resources and talent, we will enter a new orbit to chart a higher trajectory of sustainable growth ... in the developed and emerging markets, organically and inorganically. This is a significant milestone in our mission of becoming a research-based international pharmaceutical company."
Daiichi Sankyo president and CEO Takashi Shoda said the two companies are a good fit: "The proposed transaction is in line with our goal to be a global pharmaceutical innovator and provides the opportunity to complement our strong presence in innovation with a new, strong presence in the fast-growing business of non-proprietary pharmaceuticals." He added: "While both companies will closely cooperate to explore how to fully optimize our growth opportunities, we will respect Ranbaxy's autonomy as a standalone company as well." Not only will Singh stay with the company, Shoda said, he will also be chairman of its board of directors.
Getting into the Generic Market
Wharton marketing professor Jagmohan Raju, who has consulted with pharmaceutical companies including Wyeth and Johnson & Johnson, says that while Daiichi Sankyo will find it easier to enter the Indian market with Ranbaxy, its bigger goal would be in securing a strong presence in the global market for generics. "Ranbaxy has a good foothold in the worldwide generics market, which is lucrative and growing," he says.
Singh has been a pugnacious leader, pursuing takeovers in India and abroad. Among his foreign acquisitions are the unbranded generic drug business of Allen SpA (a division of GlaxoSmithKline) in Italy; Terapia in Romania; Ethimed, a generics company in Belgium; the Mundogen generic business of GSK in Spain; and Be-Tabs Pharma in South Africa.
Singh has taken over or acquired strategic stakes in a host of domestic companies such as Zenotech Laboratories, Cardinal Drugs, Krebs Biochemicals and Jupiter Biosciences. He was recently involved in a raid on the Chennai-based Orchid Chemicals. Although he denied it was a hostile takeover, the promoter of the beleaguered company didn't agree.
Singh has also been taking on the world's big names in pharmaceuticals in court cases all over the globe. This includes Pfizer for Lipitor, GSK for Valacyclovir and AstraZeneca for Nexium. (Many of these patent battles have recently been settled out of court.)
After such an acquisitive strategy, why would Singh suddenly agree to be acquired? The answer is not immediately clear. Raamdeo Agrawal, co-promoter and non-executive director of Motilal Oswal Securities, speculated that there may be problems with the Indian drug industry that analysts are not fully aware of. "We need to look at the sector again," he said. Others expressed surprise and disappointment. "It's a landmark deal for the pharma industry. But I can't help feeling a twinge of regret about an Indian MNC becoming a Japanese subsidiary," Mahindra & Mahindra chairman Anand Mahindra told The Economic Times.
The Deal
Singh is selling his 34.8% stake for around Rs. 10,000 crore ($2.4 billion) at Rs. 737 ($17) per share. Daiichi Sankyo will pick up another 9.4% through a preferential allotment. According to Securities & Exchange Board of India (Sebi) norms, it will have a make an open offer to the shareholders of Ranbaxy for another 20%. There could also be a preferential issue of warrants to take the Daiichi Sankyo stake up by another 4.9%. That will come into play if the ordinary shareholders don't respond to the open offer and Daiichi Sankyo needs another way to raise its stake to 51%.
At the end of the exercise, scheduled to be completed by March 2009, Ranbaxy will become a subsidiary of Daiichi Sankyo. Despite all the denials from Ranbaxy leadership, an Indian icon will vanish. (Similar circumstances drove Sunil Mittal of Bharti Airtel to walk out of a deal with MTN of South Africa; he wouldn't compromise the Airtel brand which had become "the pride of India.")
What will Singh be doing with his $2.4 billion? He says that major investments are needed in Religare and Fortis, the group's forays into financial services and hospitals. But both are really part of the herd in their sectors while Ranbaxy was number one.
Ranbaxy, with $1.6 billion in global sales in 2007, had a profit after tax of $190 million, a gain of 67% over the previous year. It has a footprint in 49 countries and manufacturing facilities in 11. It has 12,000 employees, including 1,200 scientists and has been pouring money into R&D, though obviously not on the same scale as the Western majors. Ranbaxy is among the top 10 global generic companies. Its stated vision has been to be among the top five global generic players and to achieve global sales of $5 billion by 2012. How much of that survives the Daiichi Sankyo regime remains to be seen.
Indeed, there is a question over whether Singh himself will survive. He said that Ranbaxy is in his genes and there is no question he will remain CEO and, now, chairman. But will he be able to make the transition from a promoter to a professional CEO? He may have delivered Ranbaxy to Daiichi Sankyo, but now he has to deliver the goods.
Daiichi Sankyo is the product of a 2005 merger between Sankyo and Daiichi. In the financial year ended March 2008, it had net sales of $8.2 billion and a profit after tax of $915 million. It has a presence in 21 countries and employs 18,000 people. It is the second largest pharmaceutical company in Japan. The company can trace its roots back to 1899, though the formal entity today is relatively new. Daiichi Sankyo makes prescription drugs, diagnostics, radiopharmaceuticals and over-the-counter drugs.
The combined company will be worth about $30 billion. The acquisition will help Daiichi Sankyo to jump from number 22 in the global pharmaceutical sector to number 15. "The deal will complement our strong presence in innovation with a new, strong presence in the fast-growing business of non-proprietary pharmaceuticals," according to Shoda.
The combination has other benefits for the Japanese company. It gets a stake in a major player in generics, an area that is becoming increasingly important in Japan. According to the 2008 Japanese Pharmaceuticals & Healthcare Report (2nd quarter), the country's pharmaceutical market is currently valued at $74.4 billion and is the most mature in the Asia-Pacific region. By 2012, the market will grow to $82 billion. The country's generics sector is one of the most promising. "In an effort to control ballooning healthcare costs, the ministry of health plans to raise the volume share of generics within the total prescription market to at least 30% by 2012," says the report. "The current value of the sector is $5.5 billion, which equates to 7.3% of total medicines sales. Changes to prescribing procedures and the influx of foreign firms with low-cost goods will provide a stimulus to the generic drug sector." The comparative figures of volume share of generics for the U.S. and the UK are 13% and 26%, so there is some way to go.
Getting into Japan
Ranbaxy will gain easier access to the much-coveted Japanese market by operating from within the Daiichi Sankyo fold, says Raju. "Ranbaxy could bypass a lot of European and U.S. companies that are finding it difficult to enter the Japanese market, where safety and testing requirements are a lot higher." He notes that Pfizer has done a smart thing in forming an alliance with Eisai of Japan to jointly market the former's drug Aricept, which treats Alzheimer's disease. "No other Alzheimer's drug sells well in Japan," says Raju.
Daiichi Sankyo's proposal is to make the much cheaper generic drugs the default option over branded drugs. The ministry stamp of approval will eliminate the problems patients have been facing with health insurance claims; some insurers have not been accepting generic drugs as valid medicines. Indian pharmaceutical companies have been aware of this opportunity. Some have started their preparations. Last October, the Mumbai-based Lupin Ltd acquired an 80% stake in a Japanese generic pharmaceuticals company, the $70 million Kyowa Pharmaceutical Industry Co Ltd. Orchid Chemicals & Pharmaceuticals has set up a wholly-owned subsidiary in Japan called Orchid Pharma Japan.
The Ahmedabad-based Zydus Cadila group initially entered the Japanese generics market with Zydus Pharma in 2006. This U.S. company's mandate was to market formulation generics and look for alliances with Japanese companies. Last year, Zydus acquired a 100% stake in the Tokyo-based Nippon Universal Pharmaceutical Ltd. Zydus Cadila had earlier taken over Alpharma of France. In India, its acquisitions include Recon Healthcare, German Remedies, Banyan Chemicals and Liva Healthcare.
As much smaller companies than Ranbaxy have gone to Japan, shopping bag in hand, why didn't Singh try to purchase Daiichi Sankyo instead of selling? Domestic laws make Japanese companies difficult to take over. But there surely could have been an equivalent in Europe or the US. The Tatas and the Birlas have successfully targeted foreign companies several times their size. Why did Ranbaxy follow a different prescription?
The answer may be in the fact that that Ranbaxy was on a much weaker wicket. The official version talks of synergies. Says a joint company statement: "Daiichi Sankyo and Ranbaxy believe this transaction will create significant long-term value for all stakeholders through:
* A complementary business combination that provides sustainable growth by diversification that spans the full spectrum of the pharmaceutical business.
* An expanded global reach that enables leading market positions in both mature and emerging markets with proprietary and non-proprietary products.
* Strong growth potential by effectively managing opportunities across the full pharmaceutical life-cycle.
* Cost competitiveness by optimizing usage of R&D and manufacturing facilities of both companies, especially in India."
But beyond these positive results from the alliance lie problems that could have faced Ranbaxy had it chosen to continue alone. First, the company has thrived on selling off-patent drugs in the U.S. But this has become a much more expensive proposition because of litigation. Second, there is growing competition in generics at home and abroad. Finally, even as the Indian government has been insisting on stringent quality norms, it is extending its regime of price controls. The industry contends that it simply cannot make adequate returns on various products. "If the promoters of India's largest drug company felt it better to exit the business after many years of attempts to make it one of the largest in the world, then there must be serious issues with our drug policy," Swati Piramal, director of strategic alliances at Nicholas Piramal told the Business Standard.
Coming of Age
For Daiichi Sankyo, there are huge benefits in getting access to Indian research capabilities, said Vivek Wadhwa, executive-in-residence at Duke University.
"People are underestimating what is happening in India and China, where companies have rapidly come of age as they play on the world stage," says Wadhwa, adding that Daiichi Sankyo's selection of Ranbaxy underscores that trend. "The Japanese companies have a lot of money but not much by way of innovation. China, India and Indian companies are a very good way forward for them." He says Daiichi Sankyo is banking not just on the cost advantage Ranbaxy would bring, but also its research capabilities. "Japanese companies are shifting a lot of their R&D to India also," he says. "They don't have enough scientists and India has them in abundant supply right now."
There are fears that the Daiichi Sankyo takeover could be a sign of the times. The pharmaceutical industry has turned into a nervous place overnight. Earlier, one likely danger was perceived to be Ranbaxy itself. In March-April this year, it had launched a raid on the Chennai-based Orchid Chemicals and picked up a stake close to 15%.
An analysis shows that several mid-size companies are vulnerable to takeovers. Ankur Drugs, Avon Organics, Lyka Laboratories, Strides Arcolab, Surya Pharmaceuticals and Venus Remedies top the list of pharmaceutical companies in which the promoters have less than a 25% stake. "Indian generic players with established global businesses are definitely a target for multinational companies to beef up their businesses," Ranjit Shahani, vice-chairman and managing director of Novartis India, told the Business Standard.
Does the Daiichi Sankyo acquisition of Ranbaxy signal a countertrend to that exhibited by Indian corporations lapping up companies in foreign markets, like Tata Steel's purchase of European steelmaker Corus? "It's a two-way street," said Wadhwa. "Indian companies are becoming world class, they are growing fast, and they have competent management and technological abilities. The Ranbaxy-Daiichi Sankyo deal is one data point. You are going to see many more of these in the future."
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