Net Gains

When do acquisition strategies work? the strategist examines some high-profile deals of the past few years

In end-January 2006, steel magnate, L N Mittal launched his most ambitious takeover attempt ever, when he announced a $ 23 billion bid for Arcelor, the world's second-largest steel maker. Mittal is already the largest steel maker in the world.

So why was the deal, which forced even governments from Luxembourg to India to take a stance, important for him? In a snapshot, the Mittal-Arcelor combine would have an even larger share of the global steel market (11 per cent) and would be able to get a better grip over steel pricing.

Even before Mittal's bid, acquisitions have been thriving. In 2005, companies across the world paid $2,607.9 billion (an astounding Rs 115,63,454 crore) for acquisitions. India, too, was part of the shopping spree: an impressive Rs 69,191.4 crore exchanged hands as Indian companies acquired or sold businesses within the country and abroad (source: Bloomberg).

QUICKBITE: Real Value

The reasons to acquire a company range from industry consolidation, customer acquisition, forward or backward integration, synergy with existing businesses, extension of the product range and so on. But do companies pay a fair value for the acquisition? There's a roundabout answer.

While sellers expect a certain value for their business, a lot depends on what value buyers see in these assets. "Valuation of assets is relative, because every buyer will have different reason for his acquisition," says an investment banker.

While the financial performance, product portfolio and the market share of the company forms the basis for most valuations, other parameters like talent pool are also important, especially in a knowledge-intensive business.

But for many companies there's more to an acquisition than just managing the new talent pool. It is also about learning new business tricks. For instance, when Godrej Consumer Products Limited (GCPL) acquired the UK-based Keyline Brands in 2005, GCPL had much more than market expansion in its mind. The company also wanted to learn how Keyline did business with large format retailers and so on.

Companies also pay for the inherent value of the acquisition, something that could be realised in the near- to long-term. NRI Anil Agarwal's UK-based Vedanta group follows the acquisition strategy of picking up companies at a low value, pumping in investments and mining for growth.

Vedanta acquired companies that were not doing too well, but the industry in which they operated had a clear potential to grow. The acquisition of ailing public sector aluminium company Balco and Hindustan Zinc are cases in point.

An acquisition can also be driven by a desire to preempt the competition. This is where issues like what value a rival would derive from the company under attack comes into play. In this context, industry experts point out to the recent acquisition of Hindustan Lever's hair care brand Nihar, by Marico Industries.

If Marico did not bag the deal, Nihar could have gone to GCPL, which is also looking at consolidating its presence in the hair care segment. Similarly, when Indian Oil Corporation acquired IBP, it was to prevent private players from getting access to IBP's retail presence in the post-administered price mechanism regime.

Often, after the completion of any major acquisition, doubts are raised if the deal was overpriced. Perhaps it's not just about valuation, but perceived valuation.

But do most acquisitions justify the steep price tags? There is no single correct answer. "It depends on what buyers are looking for," say most investment bankers. If no two buyers think alike, that's because they acquire for different reasons.

Companies, or their investment bankers, may assign a different value to their acquisition targets. But there is strong consensus on one point: "The value of the deal is not that important, vis-a-vis the success or failure of acquisition. What justifies the value is how well one integrates the acquired entity with the existing business," says Amit Mukherjee, partner, Ambit Corporate Finance.

It's still too soon to declare how the 2005 deals will turn out, but a keener look at the impact of acquisitions by Indian companies since 2000 could probably provide pointers on what makes acquisitions work. the strategist examines three high-profile acquisitions by Indian companies and considers their impact.

Forward block

ONGC bought MRPL (Mangalore Refineries and Petrochemicals Limited) for a little under Rs 60 crore in March 2003 (a paltry Rs 2 a share). At the time, after three consecutive years of losses and operating margins of 3.48 per cent in 2002-03, MRPL was bleeding. But ONGC had a plan. It was already in the oil exploration business and had bagged the licence to open 1,100 retail outlets for petroleum products. The only piece missing in its picture was a refinery.

But MRPL had more than its share of problems. In 1999, the company nearly trebled refining capacity by adding a 6 million tonne capacity expansion (total capacity after expansion was 9.69 million tonnes) that was to be financed in a debt equity ratio of 1:1.5.

MRPL was to raise Rs 700 crore from the market to fund the Rs 3,900 crore expansion. But the issue was a non-starter since the stock market was in the doldrums. The result: the project was completed with money raised through debt.

Meanwhile, MRPL was also reeling after the administered price mechanism for refining was dismantled in 1998. This was a company that had never approached the market to procure or to sell; instead MRPL had depended almost completely on stakeholder HPCL.

And once competitive market conditions prevailed, refining margins between 1999 and 2002 started sinking. "There was no adequate duty protection," says L K Gupta, vice president, finance, MRPL.

Unfortunately, optimum capacity utilisation was also bad news. In 2002-03, MRPL's capacity utilisation was in the range of 60-70 per cent. But margins were in the range of $1.5-2 a barrel, while the interest cost was $4 a barrel.

ONGC had to act fast. Within three weeks of acquiring MRPL, ONGC put a debt restructuring package in place. Within 10 months, interest costs dropped from 9.15 per cent to 6 per cent. Then, ONGC gave MRPL access to crude supply from Mumbai High, which otherwise is available only to public sector enterprises. This gave MRPL a price advantage over other varieties of crude, by up to $1.5-2 a barrel.

Streamlining processes led to an increase of thruput. In 2003-04, the first full year of acquisition, production soared to 10.04 million tonnes, an increase of 38 per cent over the previous year (the company expects to close the current fiscal at 12 million tonnes).

MRPL was also able to increase the energy efficiency in thruput. Fuel loss in the refinery (in the conversion of crude into products) came down from 7.68 per cent in 2002-03 to 6.89 per cent the following year. That itself resulted in huge savings, especially given the 38 per cent increase in production.

From 9.77:1 in March 2003, MRPL's debt-equity ratio is currently less than 1:1. Its return on capital employed has significantly improved to touch 27.06 per cent while operating profit margins have soared from 1.69 per cent in 1999-2000 to 11.38 per cent in 2004-05. At present, MRPL's stocks are at around Rs 45. Clearly a case that the acquisition has worked.

Prove your metal

The Vedanta group's acquisition of sick or ailing public sector units like aluminium manufacturer Balco and Hindustan Zinc had clear reasons. First, the deal was an important part of the group's diversification strategy from producing copper to other metals like zinc.

Then, it had to consolidate other businesses like aluminium (Balco, the first of the PSEs to be divested, added to the group's aluminium capacities). "We identify companies that have an ability to grow but are run less efficiently. Then we invest capital and focus on long term returns," explains a company executive.

Take the case of Hindustan Zinc. When Vedanta acquired the company, production cost was around $850 a tonne. It's now down to $700 a tonne, with plans to bring production cost to below $600 a tonne by next year.

Meanwhile, significant investments have been made in increasing capacities. While the capacity of Hindustan Zinc will touch 400,000 tonnes a year by 2006-07, up from 280,000 tonnes in 2005-06, money has also been poured into other avenues, like $400 million for a new power plant.

Operating profit margins have soared from 20.43 per cent in 2000 to 46.42 per cent five years later, as a result of increasing operational efficiency (cutting down costs and increasing capacities). Even the return on capital employed has jumped from 18 per cent to 39 per cent over the same period.

Or consider Balco, the first public sector company to undergo privatisation. Even here, Vedanta saw a clear opportunity in bringing down the cost of production of aluminium from $1,650 per tonne to $1,250 per tonne.

Over Rs 4,000 crore was pumped into the company in 2002 to increase capacity from 100,000 tonnes to 350,000 tonnes. Vedanta also ensures that the cost of setting up projects is nearly 30-40 per cent lower than the international benchmarks.

More importantly, the cornerstone of the Vedanta group's strategy is to acquire its assets when the industry is on a downturn. Consequently, it is ideally positioned to take advantage of the upswing in fortunes when that happens.

Of course, such a strategy is not without its risks. Company executives agree: "There is no guarantee that the industry will not go further down," says one. But going by the success rate of both Balco and Hindustan Zinc, this strategy has clearly worked.

Tea story

In March 2000, Tata Tea acquired the Tetley brand for £271 million (Rs 1,900 crore). The mismatch: Tata Tea was half the size of its acquisition (Rs 900 crore in 1999-2000). The Tata group had several reasons to justify the price to be paid. "Globally, there was room for consolidation," says Percy Siganporia, managing director, Tata Tea.

Then, a bulk of Tata Tea's revenue (more than 80 per cent) came from the commodity part of its business "" plantations. If the company had to establish a huge presence in the branded arena, it needed to strengthen its own brands and also acquire established international brands.

"Commodity business has no value. Tetley came as a saviour to Tata Tea since plantations as a business was stagnating," says an investment banker. Tata-Tetley's net profits have doubled from under Rs 105 crore in 2002-03 to Rs 235 crore in 2004-05, while turnover has jumped from Rs 2,871 crore to Rs 3,039 crore in the same period.

And if the market share increase of Tetley post the acquisition is an indicator, the acquisition has definitely paid off. For instance, company executives claim that in the UK, which is the largest market for Tetley, market share has climbed from 22 to 28 per cent.

In Canada, Tetley has raced ahead from 32 per cent to 44 per cent share of the market. Australia and France, too, have seen market share gains.

But market share isn't a sufficient condition for success. In the UK, Tetley has become the No. 1 tea brand, but turnover in the country has fallen. From £263.9 million in 2003, revenue was down to £233.2 million in 2005; operating profits, too, have slipped: from £36.5 million to £35.7 million.

Of course, as says Ambit's Mukherjee, "The success of mergers and acquisitions should be also looked at from the perspective of the acquirer as to how well he integrates the deal." Going by that logic, the Tata Tea-Tetley deal is a sure winner: Tata Tea is now a Rs 3,000 crore company.