Indian M&As: Why They Have Worked So Far

M&As

Do mergers work? The Indian evidence so far seems to be fairly positive. One reason for this could be that the real big mergers have been within cohesive business groups, and not between companies from diverse cultures. This means that there may have been fewer post-merger power struggles and internal clashes of the kind that have stymied mergers abroad.

A cursory listing of headline-grabbing mergers in the post-liberalisation era shows that the trend began with the merger of Reliance Petrochemicals Ltd with Reliance Industries Ltd (RIL ) in 1992. This was followed by the three-way merger, again involving the Reliance group, of Reliance Polypropylene, Reliance Polyethylene and RIL in 1995. Then came the mega-merger of Hindustan Lever Ltd (HLL) with Brooke Bond Lipton India Ltd (BBLIL) in 1996. More recently, the Indian banking sector has witnessed a period of consolidation through the mergers and acquisitions (M&A) route, notable among which have been the merger of Times Bank with HDFC Bank and the just consummated reverse merger of ICICI with ICICI Bank. This was preceded by ICICI Bank's own merger with Bank of Madura.

Groups such as Godrej, Videocon, BPL and Dr Reddy's Labs have been on a similar merger and consolidation spree. And in the works is the biggest in-house merger of them all - the one between Reliance Petroleum and RIL that will create a Rs 60,000 crore behemoth (and a Fortune 500 contender).

Our sample study of five post-reform mergers since 1992 shows that four of the five managed to improve operating and financial synergies (see page 76). The only exception was Sterlite Industries' merger with Sterlite Communications, where margins and returns on capital employed showed declining trends.

To assess whether mergers work, it is necessary to examine the motives and reasons underlying the move before evaluating the results. First question: why do companies seek to merge? There are several theories which try to explain this phenomenon. The most popular among them is that M&As are the fastest route to growth. That growth is vital for a firm's survival is indisputable. Corporate finance theory holds that growth and the value of the firm are related and all share valuation models factor growth into their analysis.

Traditional economic theory holds that a firm will expand its output to the optimum size at the lowest point on the average cost curve for a given product. That is when the firm will be in equilibrium, the basic assumption being that output is limited to a specific product and market. But when this assumption is relaxed, growth becomes inevitable and represents the firm's ability to avail itself of existing or new opportunities.

Growth can be achieved in one of two ways - internal or external expansion. While internal expansion takes place by building new capacities or utilising existing ones (both physical and managerial capacities) within the organisation, external expansion takes place through M&As. Some of the advantages of external growth over internal growth are listed below:

* Some corporate goals and objectives can be achieved more speedily through external acquisition. For example, foreign oil companies may want to bid for Hindustan Petroleum or Bharat Petroleum because they already have a marketing infrastructure in place.

* The cost of building an organisation internally may exceed the cost of acquisition. Conversely, it may be cheaper to buy undervalued shares of a company instead of building assets and capabilities internally.

* Apart from lower costs, there may be fewer risks and quicker increases in marketshare due to the leap-frogging effect of acquisitions.

* Tax advantages and increased leverage may also favour the acquisition route.

According to Weston, Chug and Hoag, who present a general hypothesis to explain the merger phenomenon in their book "Mergers, restructuring and corporate control", merger movements occur during times of high economic growth because, in their view, "...mergers represent resource allocation and reallocation processes in the economy, with firms responding to new investment and profit opportunities. Mergers, rather than internal growth, may sometimes expedite the adjustment process and, in some cases, be more efficient in terms of resource utilisation."

According to them, the reason why mergers are concentrated in periods of high business activity may be that firms are not motivated to make large investment outlays when business prospects are not favourable. It is only when future benefits are expected to exceed the cost of acquisition that merger action takes place. Such favourable business prospects, combined with changing competitive conditions, stimulate M&A activity.

Whatever be the motives, the fact remains that mergers should be effected only when one can achieve performance that would otherwise not have happened if the firms had remained independent. "Mergernomics" (or merger economics) hinges on the theory that the combining of two or more entities results in synergies which would not have otherwise been possible.

THREE-PRONGED APPROACH

Broadly , there are three theories which try to explain the rationale for mergers. The efficiency theory of mergers holds that M&As are driven by the search for synergies - operational, financial, distribution, R&D, etc. The resource dependence theory suggests that M&As are a result of organisational interdependence. Horizontal mergers attempt to reduce competition, vertical mergers reduce the symbiotic interdependence between the buyer and seller, and conglomerate mergers are a response to dependence on others' organisational resources. The agency theory, on the other hand, holds that M&As are an outcome of managerial desire for power and higher salary.

Merger motives can be classified into the following categories: improved efficiency, increased market power, operating synergy, financial synergy, tax motives, risk reduction through diversification, and increasing promoter stakes

TYPES OF MERGERS

There are broadly four types of mergers that have been visible in the Indian scenario. These are horizontal, vertical, conglomerate and reverse mergers.

Horizontal mergers involve two firms operating in the same kind of business activity, usually in the same stage of production. The acquiring firm and the target firm usually belong to the same industry.

The main purpose of such mergers is to obtain economies of scale in production by eliminating the duplication of facilities and operations, broadening the product line, reducing working capital investments, reducing competition and/or increasing marketshare. The Glaxo-SmithKline Beecham merger, which followed the global merger of these two entities, makes it a mega player in the pharmaceuticals industry by virtue of its sheer market clout.

Vertical mergers involve two or more companies at different stages of production. These usually take the form of backward (towards sources of supply) or forward (towards market outlets) integration wherein the output of one becomes the input of the other. The objective is reduction of inventories and working capital investment. Example: The merger of Nocil with Polyolefins Industries was a vertical merger with backward integration for raw material supplies.

Conglomerate mergers involve firms engaged in unrelated business activities. The basic purpose is risk reduction through diversification as well as utilisation of financial resources and increased leverage. A case in point is the merger of Brooke Bond Lipton with Hindustan Lever. While the former was mostly into foods, the latter was into detergents and personal care.

Reverse mergers occur when businessmen want to take advantage of tax savings under the Income Tax Act (under Section 72 A), so that a healthy and profitable company is allowed the benefit of carryforward losses when merging with a sick company. This process, which ensures survival of the sick unit by merging it with a healthy one (which loses its identity), is called a reverse merger.

Although the healthy unit supposedly becomes extinct and loses its name, usually the company reverts to the original name within a year or so. Kirloskar Pneumatics merged with Kirloskar Tractors, a sick unit, and initially lost its name but after a year changed it back to its pre-merger name. Another example is Godrej Soaps, which merged with the loss-making Gujarat Godrej Innovative Chemicals. By using the tax benefits provided by the reverse merger, it improved its post-merger profit performance.

Reverse mergers can also occur when regulatory requirements need you to become one kind of company or another. For example: the reverse merger of ICICI into ICICI Bank. ICICI wanted to become a universal bank, and the only way this could have been done is through a reverse merger with its banking subsidiary.

Efficiency theory states that the more efficient firms will acquire less efficient firms and realise gains through improved managerial efficiency. A good example is the merger of Enfield with the more efficient Eicher Motors which sought to turn around the ailing Enfield through better management.

Market power theory suggests that merger gains result from increased concentration, leading to collusion and monopoly benefits. Increased market power may be in terms of higher marketshare or operating in monopoly or near monopoly conditions. The merger of Aban Lloyd with Hitech Drilling is a case in point which catapulted the company into a leading market player with no competition worth the name.

Operating synergies theory holds that mergers achieve levels of activity at which economies of scale or scope can be achieved due to synergies in technical, marketing, commercial or research activities between the acquiring and target firms. The most commonly mentioned merger motive is an improvement of the company's bottomline through operating synergies by lowering operating expenses/input costs, eliminating or reducing common overheads and effective utilisation of facilities.

For the Nocil-Polyolefins merger, which was a vertical merger with backward integration, the synergies arose from the integration of two successive points in the value chain. Polyolefins Industries used to buy 40,000 tonnes of ethylene per annum from Nocil. With the merger, the company's sales tax and excise duty came down substantially and improved the bottomline.

The HLL-Brooke Bond Lipton merger is also a good example of mergers for synergistic motives. Operating synergies resulted in cutting down employee costs by 10 per cent, resulting in a post-merger increase of eight per cent in net profit. It also generated financial synergies for the company. In 1995, HLL had generated cash profit of Rs 264 crore and had surplus funds of over Rs 200 crore. Operating in the mature market for personal care products such as soaps and detergents, the company had few investment requirements.

On the other hand, Brooke Bond Lipton, with its presence in the growing packaged foods market, had a constant need for investment in new products, increasing manufacturing capacities, brand building and sales exercises involving an outlay of over Rs 350 crore over three years, whereas its pre-merger cash profits were a meagre Rs 62 crore. The merger of the two companies enabled BBLIL to utilise HLL's cash pile for its investments.

Financial synergy assumes complementarities between the merging firms in the availability of investment opportunities and internal cash flows. For instance, a firm in a declining industry might have large cash flows with few investment opportunities. A growth industry, on the other hand, has more investment opportunities but less cash to finance it. If two such firms merge, the merged entity will have lower cost of capital due to lower cost of internal funds (no floatation costs) as also due to higher leveraging capacity, leading to tax-efficient funding. Similarly, the merger of Mafatlal Fine Spinning with Mafatlal Industries helped the latter use the combined net worth of the two companies to optimise funds utilisation through increased leverage.

Tax motivated mergers occur due to tax savings achieved by merging a high-tax-bracket company with a loss-making or low-tax-bracket company. Financial engineering through mergers can be attained by offering the creditors of a sick company equity stakes in the healthy company in view of their dues. For instance, apart from tax writeoffs, Murugappa Electronics, which merged with EID Parry, created a company with a near zero tax burden.

Videocon, on the other hand, sought risk reduction through diversification of product lines by building a multi-product company which would immunise it from business cycles. By providing comfort to the lender, it opened up more favourable lines of credit.

Increasing promoter stakes has also been an incentive for mergers, as in the case of Escorts Tractors. The Nandas increased their stake from a pre-merger level of 20 per cent to 40 per cent post-merger. Similarly, Reliance Industries' stake increased from 23 per cent to 33 per cent in the RPPL-RPEL-RIL merger.

In the case of the RIL-Reliance Petroleum merger, the motives are multi-fold. The vertical integration has helped RIL to insulate the petrochemicals business against price volatility in naphtha, a feedstock for its cracker unit. It has also helped create financial leverage through a bigger and healthier balance-sheet which will help it raise funds for investments in a distribution network, and for its expansion and acquisition plans in infocom and the oil sector.

Thus, merger motives are manifold. What we need to evaluate is whether the projected benefits actually accrue after the merger. And in reasonably quick time. As most mergers look for synergistic benefits, it is worthwhile taking a quick look at the post-merger performance of some companies from this angle.

Given the type of operating and financial synergies sought, the actual synergies achieved (if any) should logically get reflected in the post-merger performance in one of the following three ways: operating synergies through sales, earnings or margin increases as well as through cost reduction; financial synergies through increased cash-flows or leverage; and risk reduction.

The first part of the analysis has been done by studying the increase in operating profit margins (OPM), net profit margins (NPM) and return on capital employed (ROCE) post-merger. The cost savings are reflected in the cost of production (COP) as a percentage of sales pre- and post-merger. The second part, i.e. the financial synergy, has been studied through operating cash flows (OCF) and debt/equity ratios (D/E).

The third part of the analysis studies the risk reduction aspect. Risk here is defined as variability of earnings taken as the average profit after tax (PAT), three years before and after the merger, for which standard deviation and coefficient of variation (COV) are considered as representative measures; the latter being better by virtue of being a relative measure. For the purpose of this analysis, five companies (which adopted the merger route for synergistic reasons) have been taken up for study. These are: Hindustan Lever Ltd (with Brooke Bond Lipton India Ltd), Reliance Industries (with RPPL & RPEL), Sterlite Industries (with Sterlite Communications), Nocil (with Polyolefins Industries) and Eicher Ltd (with Eicher Tractors). The analysis covers a period of three years after the merger, with the data being sourced from CMIE's Prowess.

The HLL-BBLIL mega-merger was effected primarily to gain financial synergies and improve cash flows. As can be deduced from the above table, the operating cash flow (OCF) has trebled from its pre-merger level of Rs 312 crore to Rs 934 crore post-merger and further to Rs 1,111 crore in the year after that.

The debt-equity ratio has also significantly increased in the year of merger. Some operating synergies have been realised, as reflected in the decreasing trend of cost of production (COP) to sales. Consequently, the return on capital employed (ROCE) is higher post-merger. Profit margins, both NPM and OPM, declined in the year of merger but increased thereafter.

As regards the risk aspect, the coefficient of variation (COV) post-merger was 34 per cent as compared to a pre-merger level of 31 per cent, which indicates higher volatility of earnings post-merger. This is surprising, since this was an unrelated product diversification and the reverse should have been true.

But, on the whole, the company was able to attain its objective of financial synergy although its performance on the other two fronts - operating margins and risk reduction - is not significant.

The motive for the Reliance-RPPL-RPEL merger was to gain operating synergies in view of the related product lines of the companies. All the indicators show post-merger improvement - OPM, NPM, ROCE and COP/sales as well as OCF. This means the synergies have actually been translated into post-merger performance improvement and hence the merger goals are achieved. Apart from the benefits mentioned, the merger also resulted in stabilising the earnings of the company post-merger as is reflected in the COV of profit after tax, which reduced from 53 per cent to 13 per cent post-merger.

The Nocil-PIL merger was a case of backward integration for rationalising raw material supplies. As can be observed from the table, operating synergies are realised in the form of cost savings as reflected in the COP/sales ratio. Margins and ROCE have both shown significant improvements in the two years after the merger. Operational cash flows have also substantially improved. Risk measure too showed a reduced COV of 16 per cent against a pre-merger level of 22 per cent. Thus, on all operating fronts, the merger may be termed as successful.

The Sterlite-Sterlite Communications merger was intended to enable the company to change its focus from jelly-filled telephone cables to optic fibre cables and continuous cast copper rods which accounted for a higher proportion of its revenues. However, as is evident from the indicators, the intended synergies did not materialise with all margins and ROCE showing declining trends. Though operating cash flows appear to have improved, the costs have increased, eating into margins. The COV of PAT has come down to 11 per cent from a pre-merger level of 46 per cent. Overall, the post-merger operating performance does not reflect significant synergistic gains.

In the merger of Eicher Ltd with Eicher Tractors, while OPM and ROCE have increased post-merger as also OCF, the NPM did not increase correspondingly, possibly on account of higher interest burden in the post-merger years (Rs 0.50 crore pre-merger to Rs 12 crore post-merger). Earnings variability also reduced post-merger, indicating improved post-merger performance. Thus it is apparent that in all the above cases (except Sterlite Industries ) the intended synergies have been realised and to this extent their merger objectives have been met.

Synergy or no synergy, in the ultimate analysis any strategic or financial decision must eventually add to shareholder value. Else it cannot be justified. Mergers, by virtue of being both strategic and financial in nature, thus need to be benchmarked against this cornerstone of corporate performance. It would be interesting to see whether these synergies of mergers have actually been translated into shareholder returns in the case of these five companies.

For this purpose, the parameter used is return on equity (ROE). The model adopted is the basic Du Pont model of return on investment (ROI) as modified by Weston and Brigham linking ROI to ROE. While Du Pont's ROI is a function of asset turnover and profit margin, Weston and Brigham have incorporated the equity multiplier into the model to compute the ROE.

Du Pont's ROI = Net profit margin x Asset turnover ratio = NP/Sales x Sales/Assets = NP/Assets

W&B's ROE = NP/Assets x Equity multiplier = NP/Assets x Assets/net worth = NP/Net worth

Therefore, ROE =Net profit margin x Asset turnover ratio x Equity multiplier

As can be seen from the above model, the equity multiplier is nothing but the ratio of assets being financed by common equity. The basic premise in applying the equity multiplier to the ROI is that, if only equity financing is used, the ROI would have been equal to ROE . However, since in reality a part of the funding of assets is done by debt financiers while the ROI goes entirely to shareholders who put up only a part of the capital, the ROE would be higher than the ROI to the extent of the equity multiplier.

In other words, this model allows us to study ROE as a function of the three parameters, namely net profit margin, asset turnover and equity multiplier. The primary advantage of this model is that it enables an analysis of not only the effect of mergers on ROE but also gives further insights into the variables at work on the resultant figure.

Using this model, an analysis has been presented for the five companies. Data for three years before the merger and three years after have been used. The ROE has been computed for each year using Weston & Brigham's multiplicative model using NPM, asset turnover and equity multiplier (after preference dividend adjustment). The pre- and post-merger averages have been compared to analyse whether shareholder returns have improved post-merger.

The factors contributing to the result are also looked at to give an insight into the synergistic aspects of the merger. The results of the analysis are given below:

The numbers clearly bring out the winners. Four of the companies show a positive improvement in the post-merger ROE. It is only Sterlite Industries which has not improved shareholder returns post-merger. A closer look at the factors contributing to the success of the other four merger cases reveals that NPM has been the significant variable which has improved post-merger.

The asset turnover and equity multiplier have not had much of an impact on shareholder returns. It is only in the case of Eicher that all the three variables have improved post-merger. And as far as Sterlite is concerned, none of the variables showed an improvement post-merger, which means no synergistic gains have been realised from this merger.

A further refinement to this exercise would be to take a look at the industry performance during this period to see if these companies have outperformed the industry. Industry averages for the relevant industries for the same period (three years pre-merger and three years post-merger) reveal that only two companies, viz. HLL and Eicher Ltd, could outperform the industry. In the case of Reliance and Nocil, the industry gave better returns to the shareholder.

Thus, in conclusion, one can say that though synergistic motives drive most mergers, they are not always achieved, and even if achieved, they do not necessarily translate into improved shareholder returns. However, there is a higher probability of shareholders benefiting from the mergers if the synergies are actually realised post-merger. Therefore, pre-merger due diligence assumes greater significance from the perspective of accurately assessing the synergies possible. Otherwise, it could end up eroding rather than adding to shareholder wealth.

(This article appeared in the June 2002 issue of Indian Management magazine)