Many Indian producers are hopeful that the recently announced performance linked incentive (PLI) scheme could be the manufacturing sector’s equivalent of the Green Revolution for agriculture in the early 60s.

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Already, the PLI scheme for manufacturing mobile phones in India has generated a lot of buzz.

Producers get incentives on the incremental sales they generate over five years. For instance, if their incremental sales was 20 percent in the first year, they will get an incentive as a proportion of that.

For mobile phone makers, the incentive is 6 percent in the first two years, 5 percent in the following two, and 4 percent in the fifth year. Already, investors have pitched proposals indicating a total output of Rs 11.5 lakh crore over 5 years.

Of this, Rs 7 lakh crore of production is for exports and Rs 4.5 lakh crore for the domestic market. Global investors like Apple’s partners and Samsung are the frontrunners, accounting for Rs 9 lakh crore of the indicated business.

Domestic mobile makers have proposed around Rs 2 lakh crore and component manufacturers account for the remaining Rs 45,000 crore.

The figures may appear ambitious, but even the minimum incremental revenue generation being achieved translates into an additional Rs 1.56 lakh crore of mobile manufacturing output.

The global players will get incentives on production on phones priced Rs 15,000 and above. The incentives for sub-Rs 15,000 phones is only for domestic players. This segment is also about 75-80 percent of the domestic market, with a large chunk made up of 2G phones, commonly known as feature phones.

In 2019, smartphone sales grew 8 percent, according to International Data Corporation’s Mobile Tracker. In comparison, sales of feature phones declined. This makes the domestic sales target of Rs 4.5 lakh crore appear stiff.

The export opportunity is another matter. The 'China plus one' de-risking strategy has already seen global manufacturers shifting capacities—mostly to Vietnam, Indonesia and Thailand—and this trend may continue for a bit.

In fact, reports suggest that Samsung was already considering a $500 million display manufacturing facility in India while battery-maker Amperex was weighing a facility in Haryana before the PLI scheme was announced. The scheme just made the proposition much more attractive.

A Play for the Big

Industry insiders say the scheme is targeted at global biggies, by positioning India as an export base. In his media briefing, Telecom and IT Minister Ravi Shankar Prasad said the scheme would help Apple and Samsung expand their India presence manifold. And that’s the carrot.

Domestic manufacturers like Dixon Technologies and Micromax will be given exclusive incentives for making mobile phones in India priced at less than Rs 15,000, and given that this is the bulk of the domestic market, it can give them a short-term edge. But remember, the incentives, for now, are only for 5 years. While the Chinese brands haven’t applied under the PLI scheme, most of them like Xiaomi, Vivo and OPPO have assembly units in India. In fact, that holds true for the leading brands, with only some of their models being imported as complete units. So, Chinese competition may not just vanish.

Where the PLI scheme will help, is in increasing the value-addition in India.

The number, which is 15-20 percent right now, could rise to 30-35 percent. And most of the substitution will likely happen in the lower-cost, lower-value components rather than in the high-end inputs for smartphones. But this industry players suggest won’t necessarily be very different from China, where the value add is about 30-35 percent--as much of the components are imported from other manufacturing bases like Taiwan, South Korea and Japan. Here, Samsung’s display unit may be a high-end addition, but we will unlikely see a processor making facility come up in India in the near term.

There are other risks.

What if the PLI scheme is not extended beyond 5 years in some form and the current India cost disadvantage of 8.5-11 percent due to infrastructure, supply chain, logistics, power supply and high finance costs is not suitably and adequately addressed within the period?

What if there is a level playing field after 5 years for the less than Rs 15,000 phone?

And, what if there is a thaw in geopolitics and the anti-China stance moderates?

Any of these could change the overall picture.

Some domestic players are confident that the 5-year period will be enough to emerge globally competitive.

That remains to be seen. Consider this: the global majors need to invest at least five times more money than the domestic players under the scheme. They also need to generate at least five times higher incremental revenues. Given the vastly varying scales of expansion, one wonders how the local makers will compete if and when the fields are levelled—it is obvious that the global players will enjoy better economies of scale.

And even if the two co-exist, it is more likely that the local players will operate in the lower, less profitable end of the segment. Not exactly comforting.

Besides, the entire mobile and electronics manufacturing business is highly competitive and marked by frequent technology disruptions and upgrades. Every new model or technology launch erodes the prices of existing products. That calls for further capex to upgrade to the new technology and stay in the game. And these shifts are dictated by the top brands like Apple and Samsung who spare no expenses when it comes to innovation and R&D. The big money is made by these brands, not their vendors. They are the price setters, their vendors are price takers. And we need to keep this in mind while evaluating any investment in the sector.

The Dixon Story

Given the above backdrop, let’s now focus more specifically on Dixon Technologies. The company is a contract manufacturer of home appliances like washing machines and consumer electronics like LED TVs for leading brands like Samsung, Xiaomi, Panasonic, Godrej and Lloyd, besides lighting (LED bulbs etc), set-top boxes and mobiles. Its reverse logistics division also offers repairs and refurbishment services for set-top boxes, TVs and mobile phones.

The company’s revenue growth over the past five years has been impressive—by 3.5 times to more than Rs 4,400 crore at the end of the last fiscal. EBIDTA margins have improved from about 3 percent to 5 percent.

Impressive, but much lower than the 8 percent that Amber Enterprises is able to squeeze out. Also, Dixon’s net margins have stayed under 2 percent for most years, improving to 2.7 percent only last fiscal. This clearly highlights the wafer thin spreads contract manufacturers need to work with.

Free cash flow numbers too are far from impressive. Dixon managed to generate positive free cash flow in the last fiscal, but hardly any in the past 5 years. Operating cash flow generation too has been dismal at around 5 percent of sales for the last fiscal (Amber fared a tad better on this count in most years). These aspects reflect the hurdles in the business—a need for continuous cash deployment in capex, high levels of inventory and receivables to sales, though this is partly offset by high trade payables.

To get a perspective here, we looked at the operating cash to revenues ratio of Foxconn. The global partner of Apple enjoys an EBIDTA margin of about 13 percent and generates operating cash flow of a little under 13 percent of sales. Samsung generates 20 percent operating cash flows on its sales. This clearly highlights the divide.

Despite these challenges, Dixon manages to deliver strong return on equity (26 percent) and capital (33 percent)—far superior to Amber. Here, Dixon’s high sales to gross block ratio at about 10x stands out. The company attributes it to its highly flexible production line and best-in-class technology—at par with global leaders like Foxconn. Oddly, though, Foxconn’s revenues to gross block ratio is at about 3x, for Amber this is around 2.5x even Samsung is under 2x. A look at the ratios for some of Dixon’s clientele in India also shows they don’t manage such numbers, despite outsourcing. That’s a mystery to be solved later. For now, let’s focus on the investment proposition.

Some analyst reports suggest that Dixon may already be seeing traction in mobiles with the PLI scheme—keep in mind other segments like TVs and appliances are also benefiting from sops on fresh investment and higher import duties—and a couple of big brands are expected to sign-on. This would provide a sentiment uplift and a topline boost in the near term, but the question to ask, if you are a long-term, buy-and-hold investor, is: what value can the business create in the long term?

A past example can be a guide. If you remember a company called Samtel Color, you’d recall that in the early 90s it was seen as one of the world’s largest picture tube manufacturers with 70 percent market share in India. It boasted a client list including LG, Samsung, BPL, Videocon and Onida—the big names in Indian televisions then. The company had 9 facilities, employed over 6,000 people and clocked revenues of over Rs 1,200 crore—factor in the time-value-of money, and that’s a much larger number in today’s rupee terms. But the likely fast-changing dynamics of the industry, coupled with the operational challenges and competition have today seen it morph into a player focused on serving the display needs of the defence and aviation sectors in alliances with Hindustan Aeronautics, BEL and the world’s top defence company, Thales.

The purpose of sharing this example is simply to highlight that for a company like Dixon, the future is not in trying to take on a Foxconn—that’s a huge leap. Trying to build its own consumer brand could be one way to go—remember Apple has been one of Samsung’s biggest clients, since well before the Korean major made its big mark in the smartphones business as a brand. The other, would be to find niches that will help it exploit its expertise for better margins.

As things are, investing in Dixon Technologies may not be the best play on growth in the Indian mobile sector. The best way to play this theme is via the brands (because that’s where the profits are). Unfortunately though, none of the big names like Apple or Samsung are listed here. There is a possibility here, that like its plans to list other businesses, Reliance may also list its smartphone business at some point. In fact, the big risk for players like Dixon, which are eyeing the sub-Rs 15,000 smartphone market opportunity in India, is that Reliance’s entry could upend the business.

A read through of Mukesh Ambani’s statements on the subject provide an indication of what might come. Here’s what he said: “We believe we can design entry-level 4G, or even 5G smartphone, for a fraction of its current cost. But, to power such a value engineered smartphone, we also need an equally value-engineered smartphone operating system, and such an operating system must be designed with India in mind. Google and Jio are partnering to build an Android-based smartphone operating system. Through this partnership, we are confident that we can accelerate the national mission of putting a smart device in the hands of every Indian. As India is standing at the doorsteps of the 5G era, we should accelerate the migration of 350 million Indians, who currently use a 2G feature phone, to an affordable smart phone. They should not be deprived of the benefits of the digital and data revolution. Jio is determined to make India 2G-mukt.”

No Valuation Comfort

Given the uncertainties and the challenging nature of the business, a contract manufacturing business like Dixon should be valued at a discount to the brands it serves. This is not just because of margins, but also because of revenue resilience—while one client addition can bring in a lot of business for a player like Dixon, the reverse also applies. For brands, revenue streams don’t see sharp swings.

A look at the forward earnings multiples of contract manufacturers like Foxconn, Wison and Pegatron (11-14x) show that they trade at less than half those of their clients like Apple (34x). Even Samsung trades at 15x forward earnings. In comparison, Dixon trades at well over 35x FY22 earnings estimates by most analysts. Even if you give a generally more generous PE accorded to Indian listed stocks, at twice its global peers valuations—22-28x—it doesn’t seem to offer valuation comfort.

So, aren’t there other ways to play the PLI scheme gains? Bank of America in a recent report suggested looking at companies in segments like infrastructure, power and logistics to ride the move. Besides, the Government is likely to unveil such schemes for more sectors and there might be better plays there. So, be patient and look beyond the obvious short-term beneficiaries for investment in what could be India’s manufacturing resurgence.

First Published:Aug 9, 2020 8:07 PM IST