The end of conglomerates?

Standalone companies in high-growth areas have raced ahead in the past decade

The first thing that strikes an observer of Indian private sector business is the dominance of diversified business groups across industries. From metals to automobiles, energy to consumer products, retail to technology, business in India continues to be dominated by companies that are part of a large conglomerate, or a division or subsidiary of a large conglomerate company.
 
For example, five of the top six private sector companies in this year’s list of BS1000 companies are either part of a conglomerate, or are conglomerates themselves. The other four firms are central public sector undertakings (PSUs). There are 37 private sector or Indian subsidiaries of global multinationals among the top 50 BS1000 companies, of which 28 companies belong to diversified business groups, or are conglomerates themselves.

 
Winds of change
 

Conglomerates have been big beneficiaries of India’s economic reforms, which began in the 1990s, and the investment boom of the early 2000s. They increased their market share across industries largely at the expense of public sector companies and multinationals, which were conservative about committing large sums towards capital expenditure and diversification.
 
In all, conglomerates accounted for 56 per cent of the combined assets of all non-financial firms in India in 2015-16, up from 37.5 per cent in 2000-01. They accounted for nearly half of corporate India’s revenues and profits last fiscal. The analysis is based on a common sample of 662 companies belonging to BSE 500, BSE MidCap and BSE SmallCap indices, excluding banks and non-banking finance companies.

 
Not surprisingly, big always means conglomerate in corporate India. Conglomerates have the advantage of low-cost capital, as money earned from performing businesses can be invested in businesses for future growth. Manish Gupta, director-corporate ratings at credit rating agency Crisil, says, “Despite their recent problems, conglomerates have a role to play in the economy, given their access to low-cost internal and external capital that gives them the ability to seed new businesses.” In the Business Standard sample, conglomerates paid interest rates on their borrowings that were 200 basis points lower than those paid by standalone companies.
 
Family-owned conglomerates also have the advantage of quick decision-making. Shashank Tripathi, partner and strategy leader, PwC India, says, “They are able to take decisions faster and can take bets that many corporates would shy away from.”

 
However, things are changing fast in corporate India, as many standalone companies have emerged as industry leaders and quite a few of them are now bigger than many of the old conglomerates. Bharti Airtel, a telecom company, is an industry leader, and the country’s ninth largest company, with a global footprint. Maruti Suzuki, a subsidiary of Japan’s Suzuki Motor Corp, sells more cars than the rest of the industry put together. Sun Pharmaceutical Industries, founded by a first-generation entrepreneur, has become an industry leader in India and is among the top ten generics pharma companies in the world.
 

After 2000, Eicher Motors divested 13 of the 15 different businesses where it was present, to focus on two-wheelers and commercial vehicles, and it is now India’s most profitable two-wheeler maker and one of the most valuable automakers. Motherson Sumi is now the country’s largest automotive component maker and a global leader in its segment, and is bigger than many of its customers in terms of revenues. Mumbai-based UPL (formerly United Phosphorus) leads the domestic market for pesticides and agrochemicals, despite the presence of competition from some of India’s biggest conglomerates.
 
Markets prefer standalone firms

Stock markets love standalone and single industry-focused players, while many conglomerates and listed holding companies trade at a discount. In the last 15 years, standalone companies in the Business Standard sample have seen their combined market capitalisation grow at a compounded annual rate of 23.8 per cent, 3.80 percentage points higher than the growth recorded by conglomerates during the period. Standalone companies together accounted for nearly 28 per cent of the combined market capitalisation, significantly higher than the 16.2 per cent of fixed assets and 21.3 per cent of revenues in the combined sample.

 
There is a financial logic to equity investors’ preference for standalone and single industry-focused firms. Business models have been severely tested by demand slowdown and economic volatility after the 2008 global financial crisis and many conglomerates have failed the test. Standalone companies are pulling ahead of their diversified peers in terms of return on net worth, profitability and growth. In comparison, conglomerates are battling high debt, as many of their big bets went sour owing to a mismatch between project assumptions and market reality. In 2015-16, conglomerates had a net debt-to-equity ratio of 0.95, against 0.82 for standalone companies.

Champion within conglomerates
 
If the aggregate financial ratios of conglomerates still look respectable, it is because one leading business makes up for all the other underperforming businesses in the group. For example, Tata Consultancy Services (eighth rank in BS1000) accounts for nearly four-fifth of the combined market capitalisation of all listed Tata group companies. The software major accounts for nearly 90 per cent the group holding company Tata Sons’ dividend income, and has virtually funded the group’s growth for over a decade now.
 
Similarly, Aditya Birla group’s financial ratios would look bleak if Ultratech Cement and its parent Grasim Industries were to be excluded. Mukesh Ambani-owned Reliance Industries on the other hand is using the profits of its refining and petrochemical business to finance forays in retail and telecom. At Mahindra & Mahindra, the farm equipment division and the software business — Tech Mahindra — generate surpluses for the group’s investments in other sectors.

 
Many of the conglomerate groups wouldn’t be any poorer if they were to divest many of their underperforming companies and retain industry champions.
 
The relevance of groups
 
This raises the question about the relevance of the conglomerate or group model in India. However, experts say it is not an open-and-shut case. “It’s not easy to choose between conglomerates and industry-focused companies. Warren Buffett, one the world’s most successful businessmen, heads a conglomerate with interests ranging from Coca Cola to insurance to technology,” says Harish H V, partner at Grant Thornton.
 
According to him, the problem occurs when promoters seeks to build a business empire regardless of the strategic and financial rationale of their ambitions.

 
Some blame business cycles for the recent financial difficulties of conglomerates. “Quite a few of them do face financial and operational headwinds, but largely due to cyclical factors such as the global meltdown in the commodity cycle and financial difficulties in the infrastructure sector. Their numbers will improve once the commodity cycle turns around and the early signs are already visible,” says Crisil’s Gupta.
 
Others say that the conglomerates do face execution problems in fast-moving sectors, especially if the competition is from global companies with roots in that industry. “The biggest minus for conglomerates is their lack of focus. Some distraction is inevitable when four different industries to be managed are all looked after by professional managers. This sometimes makes it tough for conglomerates to differentiate themselves in the market place when competing against multinationals who have decades of global industry experience,” says PwC’s Tripathi.

 
Going forward, he suggests that conglomerates should undertake portfolio optimisation, to de-risk themselves from a potential slowdown in mature businesses. “Large conglomerates are here to stay for a long time, but to stay relevant, they need to keep rejigging their portfolio by divesting mature and slow-moving businesses and investing in sunrise sectors,” adds Tripathi.
 
History however, suggests that it not easy for an elephant to change its steps to new music. Most of the growth industries of the last two decades — information technology services, mobile telephony, pharmaceuticals, agrochemicals, automotive and consumer goods — are now dominated by multinationals or first-generation businesses with little representation from conglomerates.