Is MNC outsourcing to subsidiaries always good for the Indian firms?

Is MNC outsourcing to subsidiaries always good for the Indian firms?

A trend towards outsourcing to Indian subsidiaries is gaining momentum among multinational capital goods makers. Parents of firms such as Siemens Ltd, Cummins India Ltd and ABB Ltd have in recent times shown an increasing commitment to expand their Indian operations. For instance, in December 2009 Germany’s Siemens AG announced capacity expansion worth 1,600 crore across six product lines in India over the next three years. Perhaps the post-2008 global slump put to the test the costs structures in developed countries. Falling volumes and high costs have squeezed the profitability of the parent firms in the last few years.

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In contrast, emerging markets such as India have seen high growth. India’s edge in high-technology areas compared with most other Asian counterparts has forced capital goods makers to outsource even critical/value-added products to Indian subsidiaries. For example, reports suggest that Siemens’ Indian operations will be among the 12 sourcing hubs for wind-power generators and turbines, in which the parent is a market leader. A report from Religare Capital Markets Ltd says that Cummins India will make heavy-duty engines and power generators to meet its global parent’s requirements.

Such globally strategic initiatives will certainly benefit Indian subsidiaries. Higher volumes will translate into higher revenue. For instance, as Cummins India’s exports jump to 30% of its revenue in the next two years, it is estimated that export revenue would be about Rs1,500 crore, thrice that clocked in fiscal 2010, boosting overall revenue.

But investors must be aware that this will not necessarily mean higher profitability for Indian subsidiaries. Profit margins would depend on the “transfer pricing" (adjustment of costs and charges between the parent and subsidiaries in this case). For example, while the parent may source some parts from its Indian operations on a cost-plus basis, it may also charge a royalty for technology transfer, which could eat into the profits of its Indian subsidiary. Besides, given that Indian corporate tax structures are relatively higher than those in developed countries, why would the parent want to book a higher profit in India and pay more tax?

Nonetheless, one cannot overlook the fact that outsourcing leads to value creation in the Indian entity, which benefits its shareholders. According to Dhirendra Tiwari, senior vice-president, infrastructure, utilities and engineering, Motilal Oswal Securities Ltd, “strong volume growth, scalability and access to technology are the positives" for Indian operations.

Hence, news of outsourcing has been welcomed by domestic investors where estimated revenue and profit expansion has translated into stock price appreciation, with Cummins and Siemens outperforming the Bombay Stock Exchange Sensex during this fiscal. These firms are expected to see 30% of their revenue accruing by way of outsourcing.

At the same time, investors must know that a dip in the sourcing market trends can affect the Indian subsidiary’s earnings. The European slump, for example, saw Cummins India’s exports halve in one year to 19% of revenue in 2010. Revenue contracted by 14% during the year and its net profit grew by a mere 2%.

Also, according to Tiwari, “a sudden change in the parent firm’s management strategy" is a big risk. This could be sale of a business or even its geographic preference, which can affect the Indian firm’s revenue and profit and consequently its stock price and investor return. For instance, in 2004, Ingersoll-Rand Inc. sold its drilling business to Atlas Copco AB for around $225 million (around 1,019 crore), as it wanted to focus on future growth areas. This included the sale of its factories in India, too, besides operations in the US, Japan and China, which affected the fortunes of the Indian subsidiary. Shares lost ground as news of the sale hit the markets.

More recently, a tough business environment in Europe led to Areva T&D selling its power transmission and distribution business worldwide to Alstom and Schneider. Areva’s Indian share price fell 17% from mid-2009 to February 2010 (period from when the intent of sale was announced till the actual sale). Analysts now anticipate strategic changes in the Indian entity’s business outlook given the management change.

It’s true that the trend towards outsourcing among capital goods firms will lead to higher revenue and profit over the next few years. But investors must be aware that the benefits for Indian operations and investor returns would hinge on global market patterns, the parent firm’s preference for India and hence its strategic policy towards its subsidiary.

Graphic by Yogesh Kumar/Mint

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