Why this article?

We did a deep dive on India 4 times before, covering this dynamic economy from 4 different angles: 

1. The Indian Consumer
2. Indian Banks
3. Indian Urbanization
4. Healthcare in India

This time we’ll come at it from a slightly different angle. Why the shift? Well, it’s not exactly a “shift”, but a continuing build-up of our latticework of analysis on India. It’s time to enrich our India latticework, for 2 main reasons: 

1. Prime Minister Modi was re-elected with a convincing majority. This is his second term, which means he might rule with a freer hand. 
2. The new Modi government delineated its first Budget in the Parliament last month – this is the most formal representation of the Modi government’s intentions so far. It remains to be seen whether they will walk the talk.

Our theses about the Indian Consumer, the Indian Banking system, the Indian Urbanization play, and the Indian Healthcare story remain intact. With this new Modi mandate, it’s time to add to them. 

What will Modi do?

Narendra Modi, India’s prime minister for the last 5 eventful years, won a tremendous victory in the 2019 general elections, even more convincing than his victory in 2014. His party, the BJP, now has a clear majority, and does not depend on any alliance partner. The winning momentum may help the BJP and its allies attain a majority in the upper house of Parliament (Rajya Sabha) in the next 2-3 years. If that happens, Narendra Modi will effectively control the legislative process. He can become either a messiah or an unimpeded dictator. The next 5 years will be enormously significant for India’s economic history at a time when global growth is slowing, and uncertainty prevails all around. Most economic pundits have given Modi the benefit of the doubt, proclaiming that India will be the fastest growing economy during this period. 

However, Modi’s inheritance of the Indian economy from his own government has some red flags. Tax revenues fell below expectations in 2018-19 [ended March 2019]. Real GDP growth came in below expectations at 7%.  The Budget deficit will be higher than 3.6% of GDP as per the budget pronouncements. The Reserve Bank of India (RBI), in its Monetary Policy Statement of April 2019, states that it expects tax collections to rise back up in 2019-20, along with a GDP growth recovery to 7.2% and a further improvement to 7.4% in 2020-21. However, with the ballooning deficit, it expects inflation to rise. The problem may be further exacerbated if Modi follows through on populist measures like raising farm subsidies. If inflation spirals out of the RBI’s target range, it’ll face a tough conundrum of raising rates in an economy where job creation is the biggest policy imperative, given India’s young population. That would be a tough balancing act. 

The Modi government seems confident and undeterred. While the earlier BJP election manifesto of 2014 had a host of general statements, the 2019 manifesto has a lot more specifics. These are their bold proclamations:

1. India’s GDP will cross $5 trillion by 2025 and 10 trillion by 2032. That would make India the third largest economy in the world. World Bank data states that in 2017, India’s GDP, in current US Dollars, just topped $2.7 trillion. This means an average annual compound growth of 8% over the period 2017 to 2025 – a tall order, to put it mildly. The general consensus seems to be in the range of 7.5% in the next 2 years. Whatever the numbers pan out to be, this nation of young people will probably see rising incomes leading to a propensity to spend. At The Buylyst, we’re aware that in the investment arena nothing is inevitable, but consumption-led-growth in India comes pretty close. To keep fueling that vector, the economy needs to keep generating enough jobs. We’re not given too many details about how the Modi government will keep this fire alive. The obvious answer is a constant supply of decent-paying jobs. The path to get there is not so obvious.
2. Farm income will double by 2022, backed by a host of welfare programs aimed at the agriculture sector. This is where the budgets may be busted. The Fiscal Responsibility and Budget Management (FRBM) Act, 2018-19 was expected to ensure the central government to achieving a target of 3.0 per cent of the GDP for the gross fiscal deficit (GFD) by 2020-21. As always, the biggest risk from excessive government expenditure is inflation.
3. By 2024, INR 100 lakh crore (US $ 1.5 trillion) will be invested in infrastructure, including:
   • 50 cities to have metro railway
   • State and National Highways to be doubled
   • Renewable energy capacity to be increased 119 GW (Feb 2019) to 175 GW by 2022
   • Clean up Ganga project got left behind in the last cycle – remains “on”
   • Tourism to be a significant focus area

#3 is almost necessary to keep facilitate the grand ambition of a $5 trillion economy. But how does #3 stack up against the past?  Let’s take a look at India’s historic Government Capital Expenditure Spend on Infrastructure:

Over the last 5 years, India’s Capital Expenditure grew by about 16% annually. Even if the average rate of growth were to increase to 20% in the next 5 years ending 2023-24, we could be looking at about $700-800 billion. That’s just 50% of the target spend. So, where is the rest of the money going to come from? Can the government resort to large-scale Keynesian spending? There are limitations. Remember that on the other side of the equation, the government is committed to ensuring that the fiscal deficit narrows from the current level of 3.4%. Therefore, while the central and state governments will have to pick and choose their battles, they will need a healthy dose of FDI and other private sources to meet their aspirational infrastructure spend of $1.5 trillion. But there aren’t any meaningful signs of policy changes to attract more FDI.

What was in the 2019 Modi Budget?

The newly appointed Finance Minister of India Nirmala Sitharaman presented the budget for the financial year 2019-2020 on July 5, 2019, barely a few weeks after taking charge. She’s got her work cut out for her. This particular Budget highlighted the challenge:

1. GDP growth declined to 6.8% in 2018-19 from 7.2% in 2017-18, primarily driven by declines in both agricultural production and industrial production. 
2. Gross Tax receipts clocked in at 91% of initial estimates. This was, however, a small increase of 8.4% over 2017-18. While direct taxes showed an upward trend, indirect taxes fell sharply.
3. Subsidies increased by 3.1%. The central government deficit for 2018-19 came in at 3.4% of GDP (well above the aspirational level of 3%) and even above the budget by 0.2%. 
4. Trade deficit widened to $184 billion in 2018-19 from $162 billion in the previous year. While exports rose 8.6% from $303 billion to $ 329 billion, imports increased 10.2% from $465 billion to $513 billion. Oil and derivatives were the major culprits. 
5. Inflation was up 4.3% in 2018-19 as compared to 3% in 2017-18.

But there were some positive takeaways:

1. Private consumption has been holding steady in the last 3 years. This makes up about 60% of the GDP.
2. There has been a small uptick in Fixed investment from 9.3% of GDP in 2017-18 to 10% in the last financial year.
3. Bank credit started picking up after a hiatus following the disastrous buildup of non-performing assets.

Apart from a marginal downward adjustment of the corporate tax rate and permitting 100% foreign ownership of insurance distribution companies (not insurance) the budget did not attempt to take any bold step towards addressing FDI or the pressing areas of water and renewable energy (discussed at length later in this note). It did make aspirational statements towards substantial incentives for global investment in Renewable Energy plants [solar, batteries etc.]. And as a move to generate purchases of Electric Vehicles, an income tax benefit has been provided for interest on EV purchases. 

Overall, the Budget was greeted by the markets with skepticism. However, The Economic Survey this year, presented simultaneously, was refreshing in its approach. A new team led by K V Subramanian, a University of Chicago PhD and Emory faculty member, postulates that lessons from China and other successful Asian economies require India to emulate a virtuous cycle of Private Investment + Domestic Savings + Exports = Growth. FDI and domestic savings are recognized as keys to India’s growth. The survey calls for doing away with the failed policy of encouraging small scale industries through incentives, stunting overall growth and job creation with economies of scale. These policy prescriptions in The Economic Survey pass the common sense test. The Modi Government’s Budget said very little to encourage FDI, Savings and Exports.

It’s not a smart strategy to pin our hopes on a sudden change in policy towards FDI. We’d be better off focusing on things as they stand today. Among the aspirational goals listed in the Budget, we’re prepared to take only the point about Renewable Energy on face value. We’ll discuss why in one of the sections below. 

The other investment opportunity is closely tied to infrastructure spending – solving the water crisis. The government hasn’t specifically set aside capital for this problem, but it stares at them as we write this. In fact, water was one of the unsung heroes of the incredible Modi win this year. It was one of the ways the previous Modi administration touched peoples’ lives in a significant way. Voters didn’t forget. 

But there is more work to be done.

The Water crisis in India is untenable.

Let’s dive right in. Here are recent dire predictions by Niti AAyog [India’s Government think tank]: 

“India is suffering from the worst water crisis in its history and millions of lives and livelihoods are under threat. Currently, 600 million Indians face high to extreme water stress and about two lakh (200,000) people die every year due to inadequate access to safe water. The crisis is only going to get worse. By 2030, the country’s water demand is projected to be twice the available supply, implying severe water scarcity for hundreds of millions of people and an eventual ~6% loss in the country’s GDP….”

A recent report in CNN says that the problem is already here:

“Twenty-one major Indian cities are estimated to run out of groundwater by 2020 -- just a year away. As India develops and grows to support its 1.3 billion people, those on the front lines of the crisis say it's only going to get worse.”

Here’s a simple supply-demand chart that captures the problem:

The report goes on to say:

 “Droughts are becoming more frequent, creating severe problems for India’s rain-dependent farmers (~53% of agriculture in India is rainfed). When water is available, it is likely to be contaminated (up to 70% of our water supply), resulting in nearly 200,000 deaths each year. Interstate disagreements are on the rise, with seven major disputes currently raging, pointing to the fact that limited frameworks and institutions are in place for national water governance.”

The problem is that Water hasn’t traditionally been a priority for the central government. State governments were supposed to take care of the subject. But each state looked to its own problems alone in the absence of a central policy. 7 major disputes have occurred involving 11 states. There is very little coordination.

A major problem is Power Plants. Subsidized power provided to the agricultural sector (a lucrative vote bank) for years has diminished the water table in many parts of the country. A NASA Satellite shows that about 54% of India’s water wells show declining levels. That’s staggering in a country that faces a growing population and a increased urbanization.

Data from a joint study done by the World Health Organization and UNICEF map progress of all countries in the fields of water and sanitation over a 15 year period 2000 to 2015. India’s record is one of dismal progress in the first 15 years of this millennium:

What are some possible solutions? Most of them are “common-sense” solutions but they require coordination and intent from the central government.

1. Ground water rejuvenation especially in urban areas by capturing “storm-water”.
2. Focus on Irrigation. 
3. Introduce Drip Irrigation
4. Waste Water Treatment

On point #4: Only 50% of urban population in India gets a regular supply of drinking water, on average. In addition, urban untreated sewage finds its way to rivers or the water table, causing contamination with grievous healthcare implications. The national average for waste water treatment stands at around 33%. Israel is at 94%. This is a problem that can be fixed rather swiftly, if adequate capital is allocated to the problem. Again, capital follows intent. So far, that’s been missing. But the time has come.

Whether it’s the Central or Local governments, they need to get specialists to step in and arrest the problem before it becomes an embarrassment for them. The Modi government and the BJP know that this is a quickfire, tangible way to touch people’s lives before the next election. They’ve done it before; we’d be surprised if they don’t do it again. This is a big opportunity for investors. Which companies can solve this problem?

Renewable Energy is set to take off.

In the 9 years ended March 2018, overall installed capacity in India from all sources increased from 174 GW to 399 GW, an annual growth rate of 8.6%. Nearly 70% of the capacity came from Fossil Fuels, 18% from Wind and Solar, 11% from Hydro and about 1% from Nuclear. The actual power generated and available for supply increased at an annual rate of 5.7% during these 9 years. On the demand side, Government data states that in the 9 years ending 2018, electricity consumption grew at an annual compound rate of 7.4%.

Here’s the problem: India has been highly dependent on imports of fossil fuels to meet its burgeoning demand for energy.  Net energy import dependency reached as high as 40% in 2019. Adverse price fluctuations can play havoc on the Indian economy, its currency, and on the lives of its people. China stabilized its energy import dependency to 15% around 2015 and the number has been improving ever since. Even the USA, a traditionally energy-guzzling nation, that had a high dependency of around 30% in 2005, managed to bring it down to 7% in 10 years (thanks to the Shale revolution). India doesn’t have the luxury of Shale deposits, so we could cut it some slack. But India also has a unique problem. Energy dependence is also a national security risk. India’s “energy corridor” passes through Pakistan – a country with which it has fought 3 wars in the last 70 years. Pinning hopes on a permanent thawing of relations is wishful thinking. Renewable Energy seems to be the obvious solution. The Modi government has taken note – there are some encouraging signs.

The International Renewable Energy Agency IRENA, an intergovernmental organization that was formed under the aegis of a UN conference on Renewable Energy ranks top countries in terms of 2018 RE installed capacity. India is at #5, which is encouraging. But that’s just one/sixth of China’s installed capacity.

IRENA goes on to say: 

“The rapid deployment of solar PV, working in combination with high learning rates (for every doubling of cumulative installed capacity PV module costs decline by 20–22%) has led to dramatic cost declines in the last 10 years. Crystalline silicon (c-Si) PV module prices have fallen by more than 80% since 2010, driving reductions in installed costs. Utility-scale solar PV projects can now provide electricity that is competitive with other grid supply options, without financial support. In 2016 and 2017, new records for low-cost solar power purchase agreements were set in Chile, Mexico, Peru and the UAE….”

We’ve shown this chart in a few previous Worldview articles but it’s worth repeating the main reason why Renewables are now economically competitive: 

With serious government backing, India can become a beacon for Renewable Energy. In the land of the Sun, it’s only fitting that it becomes a Solar Energy powerhouse (pun intended). Mr. Modi talks the talk. But he needs to walk the walk.

Modi’s bold Renewable Energy ambitions.

India has a target of building up Renewable Energy capacity to 175 GW by 2022, up from 118 GW as of Feb 2019. These numbers exclude Hydropower. The breakdown of this capacity is 100 GW Solar (Photovoltaic cells + concentrated solar plants), 60 GW from Wind, and the rest from other sources (bio mass, marine etc.). If this plays out as planned, 22% of India’s projected generation capacity will be from Renewables. How likely is this? Can India’s power grid incorporate the projected Renewable Energy capacity within its need to effectively use Renewable power generated without needing to reduce capacity utilization in conventional plants? A study done by NREL (a USAID organization) and the Ministry of Power, Government of India says this is eminently possible. 

Is there a cost driver motivating a shift towards RE among other reasons? Yes indeed. Rapidly falling wind turbine costs, and solar panels are making deep inroads into the overall cost structure of electricity generation. We’ve already seen how battery prices have decreased dramatically.

And where will the funding come from? Indian Renewable Energy Development Agency (IREDA) a AAA-rated government sponsored company has been active in financing Renewables projects. It has been raising funds overseas by issuing long-term bonds listed on international exchanges; as has India’s Power Finance Corporation. Given the improving economics of the sector, international private equity is active and on the hunt for lucrative deals. Ernst & Young ranks 40 countries in terms of “attractiveness of their renewable energy investment and deployment opportunities”. It’s not surprising that the April 2019 revision ranks India at a close #4 after China, USA and France.

Maybe Mr. Modi and his government can pull it off.

It's all connected.

Burning Fossil Fuels exacerbates Climate Change. Climate Change manifests into wilder fluctuations in rainfall. A sub-par monsoon season in India causes major water crises. That’s because India depends heavily on groundwater for both agriculture and for drinking water in its growing cities. Then there’s the problem of pollution. In India’s capital, New Delhi, pollution seems to be reaching almost unlivable conditions. Renewable Energy seems to be the answer – at least on paper – to all 3 problems: Climate Change, Pollution and Water. Whether it’s too late to fix these problems or not remains to be seen.

Burning fossil fuels attacks water from another angle. Cooling methods in fossil fuel power generation plants is another important reason for depletion of ground water levels especially in arid zones. There is competition for water consumption among the living, irrigation and power generation. According to a joint study by IRENA (International Renewable Energy Agency) and Water Resources Institute, Power generation is expected to account for nearly 9% of national water consumption by 2050 (in a business as-usual scenario) – growing from 1.4% in 2025 (Central Water Commission, 2015). 

It seems to us that Renewable Energy gets to the heart of the biggest challenges facing the Modi administration: 

1. Dependence on fossil-fuel imports.
2. Water crises.
3. Job Creation for a young population.

At The Buylyst, we believe that the best investments are the ones that solve real problems facing our civilization. Climate Change and Water are on top of that list. These problems are more pronounced in India than in most other parts of the world. And if India is serious about tacking these problems head-on, there are some investable companies in the world that will gain massively from it.

So, what should we do?

At The Buylyst, we’ve approached India in 2 ways: 

1. Invest directly in Indian companies. 
2. Invest in American and International companies that do business in India. 

#1 is the more difficult path for foreigners investing in India. The laws make it cumbersome to invest directly in shares listed on Indian exchanges. And so, we’re limited to a handful of American Depository Receipts (ADRs) or Global Depository Receipts (GDRs) of Indian companies listed abroad. At The Buylyst, we have one Indian ADR – HDFC Bank – with a Watch Rating. That’s because we like the company and how it’s harnessing the Indian growth story tailwind. But at the time we wrote the HDFC investment thesis, we thought the stock was a bit overpriced for our comfort. It’s time to do another deep-dive on them. 

#2 is how we’ve primarily participated in the India story. The predominant thematic trigger was our view that Urbanization in India is an unstoppable force. As a result, we looked at 3 companies that could see significant upside from this theme: 

1. Caterpillar
2. Eaton
3. Xylem

Of these, Xylem is the most interesting to us. As you may have noticed from our Commentary Section, we’ve been tracking the water crisis in India. And we just discussed how it’s untenable. If the Modi government is serious about solving this problem, Xylem should benefit.

But there are other companies that are making inroads into India. Another big Water company – Suez – has been knocking on India’s doors with some success. Yet another French player is Veolia, which seems to have some presence in India, but we’ll need to dig in to understand the potential of that business. Among American competitors to Xylem, Evoqua and Flowserve top the list. But they’re significantly smaller companies and it’s unclear whether they can compete with the French biggies or with Xylem for projects in India. Before we dig in to any of these companies we’ll be sure to check their basic financial health including: 

1. Return on Equity
2. Debt Level
3. Free Cash Flow profile

On Renewable Energy, if the Modi government is serious about it, we should see a significant surge in Wind Energy auctions in India. Indeed, India recently became the largest Renewable Energy Auction market in the world. This is the process by which a government body allots Wind and Solar Energy capacity for future developments. Developers can bid for contracts and those developers then buy Wind Turbines and Solar Panels from manufacturers. The Buylyst is already invested in a Wind Turbine manufacturer – Vestas. 

Vestas reported that just about 5% of its installed capacity in 2018 was in India. Most of its business still comes from the US and Europe. However, it has been making some inroads this year. But its main competitor – Siemens Gamesa – seems to have a much more prolific business in India. Based on its 2018 Annual Report, India is its third largest customer (based on installed capacity) behind the US and Spain (its home country). It’s been more than a year since The Buylyst dug into Siemens-Gamesa’s books. At the time, we went with Vestas instead – an investment that has yielded a healthy double-digit return so far. But if these numbers are sustainable, Siemens-Gamesa could be better positioned for an India boom in Wind Energy.

In Solar, we recently issued a “Watch” Rating for Canadian Solar. Its India business is still limited to less than 10% of its revenue. But we think there is a lot of room for upside. It’s strange that in India – the land of the Sun – Solar Power isn’t being treated as the default method of electrification in rural areas.

Between Water and Renewable Energy, we have a handful of names to investigate. Suez, Veolia and Siemens-Gamesa top the list. While we dig into these stories, we will also do a deep-dive on HDFC – a stock that has done well for all the reasons why we thought it was a “comfortable company” a year ago. Have the facts changed enough that we now think it’s at a comfortable price? 

We now have 6 vectors in our latticework of India: 

1. Retail
2. Banking
3. Urbanization
4. Healthcare
5. Water
6. Renewable Energy

Every time we expand our latticework of mental models on India, we’re that much better equipped to find investment opportunities there. We’ll follow up this worldview analysis with an investment thesis in the next few weeks.