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India 26 July 2010

Strategy
India Strategy 26 July 2010

Analysis of royalty payments in view of BSE500 ex-fin (32/500) margin impact of royalties

Maruti’s margin surprise

EBITDA Margin Pre-Royalty EBITDA Margin
30%

25%
Meaningful overhang on margins and valuations for foreign-
equity companies 20%

Maruti delivered a big negative surprise this weekend as Suzuki raised royalty 15%

payments by 150 bps from 3.6% to 5.1%. While the impact on Maruti is
10%
already discounted (stock down 10% today), we have looked at the other 2002 2003 2004 2005 2006 2007 2008 2009
companies in BSE-500 to ascertain the impact on broader Indian market. We
Source: Capitaline, RCML Research
find that that 75 (32 of them to foreign entities) companies in BSE500 pay
royalties largely dominated by automotive, capital goods, pharmaceuticals and BSE500 Royalties vs. SG&A and Dividends
FMCG sectors. R&T / SG&A R&T/Dividend
18% 75%
16% 70%
With the recent government regulation allowing for higher royalties, we could
14% 65%
see the Maruti case being played out in several of these players. While the exact 12% 60%
impact is difficult to quantify (as it will be case specific), we note that increase 10% 55%
8% 50%
in royalties could hurt margins substantially by 370 bps if implemented across
6% 45%
the board. We would closely watch out for more such announcements/changes 4% 40%
over the next few months. 2% 35%
0% 30%
2002 2003 2004 2005 2006 2007 2008 2009
Govt. allows companies to pay royalty under automatic route: The Govt.
recently allowed companies to remit royalty payments (upto 8% on exports, and Source: Capitaline, RCML Research

5% on domestic sales) on foreign technology collaboration under the automatic

route (With retrospective effect from Dec 2009, notes attached). Companies have
since raised royalty payments to foreign collaborators: Maruti raised royalty
payments to parent Suzuki Motor Corp by 150bps to 5.1% of sales this quarter.

15% of the BSE500 pays royalties, 32/500 to foreign equity holders: Royalty
payments are made by 75 companies in the BSE500 universe, and comprised
~19% of the overall SG&A costs in FY09, accounting for ~130bps on EBITDA
margins. The new notification affects companies (32/500) that have technical
collaborations with foreign (non-portfolio) equity-holders, and thus excludes
domestic companies that have no restrictions on royalty payments. Wholly-
owned foreign subsidiaries have no restrictions either.

Sector/stock focus: Royalty payments are generally made by companies in the

auto and capital goods (technical know-how and collaboration), pharma
(marketing rights) and FMCG companies (brand equity).

Margin Impact: Royalties for these 32 cos. constituted 11% of their SG&A,
accounting for 100bps at the EBITDA margin level (FY09 margin at 16%; FY10
figures available for 8 companies thus far). A quick sensitivity analysis shows that
a rise in payments to a blended 5% of sales would hurt margins by a further
390bps, i.e. margins would fall to 11.8%.

Royalty payments vs. dividends: Royalties paid amounted to more than 40% of
the total dividends declared in FY09. With little information on the actual value
of the technical expertise, or by way of equity of certain brands, a potential rise
in payments could raise questions on fair distribution of earnings to common
In the interest of timeliness this report has not been edited.
stockholders.

Dr Tirthankar Patnaik Manoj Singla RCML: Winner of LIPPER-STARMINE broker award for “Earnings Estimates in Midcap Research 2008” | “Honourable
(91-22) 6766 3446 (91-22) 6766 3401 Mention” in Institutional Investor 2009 | Voted amongst Top 5 most improved brokerages by Asia Money Poll
1 2009
tirthankar.patnaik@religare.in manoj.singla@religare.in RCML Research is also available on Bloomberg FTIS <GO> and Thomson First Call
 Analysis of royalty payments India Strategy 26 July 2010

Fig 1 - BSE500 – Ex-Financials: EBITDA Impact Fig 2 - BSE500 – Ex-Financials: SG&A Impact

EBITDA Margin Pre-Royalty EBITDA Margin R&T / SG&A R&T/Dividend

30% 18% 75%
16% 70%
25%
14% 65%
20% 12% 60%
10% 55%
15%
8% 50%
10% 6% 45%
4% 40%
5%
2% 35%
0% 0% 30%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capitaline, RCML Research Source: Capitaline, RCML Research

Fig 3 - Autos: EBITDA Impact Fig 4 - Autos: SG&A Impact

EBITDA Margin Pre-Royalty EBITDA Margin R&T / SG&A R&T/Dividend

17% 400%
350%
15%
300%
13% 250%
200%
11% 150%
100%
9%
50%
7% 0%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capitaline, RCML Research Source: Capitaline, RCML Research

Fig 5 - Capital Goods: EBITDA Impact Fig 6 - Capital Goods: SG&A Impact

EBITDA Margin Pre-Royalty EBITDA Margin R&T / SG&A R&T/Dividend

16% 45%
40%
14% 35%
30%
12% 25%
20%
10%
15%
8% 10%
5%
6% 0%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capitaline, RCML Research Source: Capitaline, RCML Research

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 Analysis of royalty payments India Strategy 26 July 2010

Fig 7 - Energy: EBITDA Impact Fig 8 - Energy: SG&A Impact

EBITDA Margin Pre-Royalty EBITDA Margin R&T / SG&A R&T/Dividend

70% 12%
60% 10%
50%
8%
40%
30% 6%
20% 4%
10%
2%
0%
-10% 0%
-20% -2%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capitaline, RCML Research Source: Capitaline, RCML Research

Fig 9 - FMCG: EBITDA Impact Fig 10 - FMCG: SG&A Impact

EBITDA Margin Pre-Royalty EBITDA Margin R&T / SG&A R&T/Dividend

23% 40%

21% 35%
30%
19%
25%
17%
20%
15%
15%
13% 10%
11% 5%
9% 0%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capitaline, RCML Research Source: Capitaline, RCML Research

Fig 11 - Materials: EBITDA Impact Fig 12 - Materials: SG&A Impact

EBITDA Margin Pre-Royalty EBITDA Margin R&T / SG&A R&T/Dividend

33% 80%
70%
28% 60%
50%
23%
40%
18% 30%
20%
13%
10%
8% 0%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capitaline, RCML Research Source: Capitaline, RCML Research

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 Analysis of royalty payments India Strategy 26 July 2010

Fig 13 - Pharma: EBITDA Impact Fig 14 - Pharma: SG&A Impact

EBITDA Margin Pre-Royalty EBITDA Margin R&T / SG&A R&T/Dividend
23% 30%
21% 25%
19%
17% 20%
15%
15%
13%
11% 10%
9%
5%
7%
5% 0%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capitaline, RCML Research Source: Capitaline, RCML Research

Fig 15 - Real Estate: EBITDA Impact Fig 16 - Real Estate: SG&A Impact

EBITDA Margin Pre-Royalty EBITDA Margin R&T / SG&A R&T/Dividend

10% 100%
5% 80%
0%
60%
-5%
-10% 40%
-15% 20%
-20%
0%
-25%
-30% -20%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capitaline, RCML Research Source: Capitaline, RCML Research

4
 Analysis of royalty payments India Strategy 26 July 2010

Fig 17 - Companies in BSE500 paying substantial Royalty

Royalty & Technical EBITDA Margin (%)
Company Name EBITDA Margin (%) R&T / SG&A (%) R&T/Dividend (%)
Fees @ 5% R&T/Sales
Maruti Suzuki 6,791 8.3 44.0 671.7 6.5
Sterlite Inds. 3,642 22.9 42.9 146.9 19.6
Hero Honda Motor 3,240 13.7 30.9 81.1 11.3
Hind. Unilever 1,162 10.4 3.0 7.1 5.9
ACC 990 29.0 5.8 22.9 25.2
Ambuja Cem. 873 27.2 6.0 23.9 23.4
ABB 790 8.1 17.6 186.5 4.4
Colgate-Palm. 717 16.7 16.7 35.1 15.9
Jindal Steel 651 47.2 11.1 76.3 42.7
Castrol India 631 25.2 14.9 20.4 22.8
Bosch 514 12.4 8.7 54.6 8.5
GlaxoSmith C H L 704 15.4 13.4 93.0 14.1
Cummins India 456 13.9 35.1 25.6 10.1
Moser Baer (I) 367 -1.5 17.0 362.9 -5.0
Alstom Projects 282 8.2 21.5 42.1 4.4
Larsen & Toubro 245 12.5 1.1 4.0 7.6
Asahi India Glas 238 11.7 14.3 8.6
Sesa Goa 135 47.2 9.3 7.6 42.5
Bata India 133 12.4 6.0 68.8 8.6
Motherson Sumi 103 9.9 5.2 21.5 5.3
Akzo Nobel 78 11.7 4.0 12.9 7.6
Gulf Oil Corpn. 56 1.4 3.9 44.4 -3.0
Exide Inds. 50 15.7 0.8 10.4 10.8
BASF India 49 6.5 3.5 24.9 1.9
Ranbaxy Labs. 22 8.5 0.1 3.5
Usha Martin 22 15.8 0.8 8.7 10.9
Zuari Inds. 15 0.9 0.6 16.4 -4.1
Biocon 11 6.9 0.9 1.9 2.0
Advanta India 8 1.7 0.4 49.4 -3.2
Arshiya Intl. 5 14.7 2.9 11.3 9.8
Hind.Oil Explor. 2 14.1 0.4 9.3
P & G Hygiene 418 21.3 16.1 57.2 21.7
Total 23,401 15.8% 11.0% 41.9% 11.9%
Source: Capitaline, RCML Research

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 Analysis of royalty payments India Strategy 26 July 2010

Annexure – I
Memo from Ministry of Finance, Government of India

MINISTRY OF FINANCE
(Department of Economic Affairs)
NOTIFICATION
New Delhi, the 5th May, 2010
Foreign Exchange Management (Current Account Transactions)
(Amendment) Rules, 2010
G.S.R. 382(E)- In exercise of the powers conferred by Section 5 and sub-section (1) and clause (a) of sub-section (2) of Section 46 of
the Foreign Exchange Management Act, 1999 (42 of 1999) and in consultation with the Reserve Bank, the Central Government,
having considered it necessary in the public interest, hereby makes the following further amendment in the Foreign Exchange
Management (Current Account Transactions) Rules, 2000, namely:- 1. (1) These rules may be called the Foreign Exchange
Management (Current Account Transactions) (Amendment) Rules, 2010.

(2) They shall be deemed to have come into force with effect from the 16th day of December, 2009.

2. In the Foreign Exchange Management (Current Account Transactions) Rules, 2000, in Schedule II, item number 8 and the entry
relating thereto shall be omitted.

Sd/-

Dr. K. P. KRISHNAN

Joint Secretary

Issued by:

Government of India

Ministry of Finance

(Department of Economic Affairs), New Delhi

[F.No. 1/1/EC/2004]

Explanatory Memorandum:- The Government of India reviewed the extant policy with regard to liberalization of foreign technology
agreement and it was decided to permit, with immediate effect, payments for royalty, lump sum fee for transfer of technology and
payments for use of trademark/brand name on the automatic route. Accordingly, Government of India issued a Press Note on
16.12.2009. Hence, the rule shall be deemed to have come into force with retrospective effect, i.e., from 16.12.2009.

1. It is certified that no person will be adversely affected by giving retrospective

effect to these rules.

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 Analysis of royalty payments India Strategy 26 July 2010

RBI Notification to Banks allowing remittances without prior approval of the Ministry of Commerce

RBI/2009-10/465
A. P. (DIR Series) Circular No. 52
May 13, 2010
To
All Category-I Authorised Dealer Banks

Madam / Sir,

Foreign Exchange Management Act (FEMA), 1999 - Current Account Transactions – Liberalisation

™ Attention of Authorised Dealer Category-I (AD Category-I) banks is invited to Foreign Exchange Management (Current Account
Transactions) Rules, 2000 notified vide Notification No.G.S.R.381(E) dated 3rd May 2000, as amended from time to time.

™ In terms of Rule 4 of the Foreign Exchange Management (Current Account Transactions) Rules 2000, prior approval of the
Ministry of Commerce and Industry, Government of India, is required for drawing foreign exchange for remittances under
technical collaboration agreements where payment of royalty exceeds 5% on local sales and 8% on exports and lump-sum
payment exceeds USD 2 million [item 8 of Schedule II to the Foreign Exchange Management (Current Account Transactions)
Rules, 2000]. The Government of India has reviewed the extant policy with regard to liberalization of foreign technology
agreement and it was decided to omit item number 8 of Schedule II to the Foreign Exchange Management (Current Account
Transaction) Rules, 2000, and the entry relating thereto.

™ Accordingly, AD Category-I banks may permit drawal of foreign exchange by persons for payment of royalty and lump-sum
payment under technical collaboration agreements without the approval of Ministry of Commerce and Industry, Government of
India.

™ The amendment to the Foreign Exchange Management (Current Account Transactions) Rules, 2000, in this regard has been
notified by the Government of India vide Notification No.G.S.R.382 (E) dated May 5, 2010 (copy enclosed).

™ AD Category-I banks may bring the contents of this circular to the notice of their constituents and customers concerned.

™ The directions contained in this Circular have been issued under Section 10(4) and 11(1) of the Foreign Exchange Management
Act, 1999 (42 of 1999) and is without prejudice to permissions / approvals, if any, required under any other law.

Yours faithfully,
(Salim Gangadharan)

Chief General Manager-in-Charge