Can India Inc digest its large acquisitions?

DEBATE

Indian firms are getting catapulted into the big league as a result but their ability to gain value from these mega-mergers is the real question.

Shankar Sharma,
Director and Chief Global Trading Strategist,
First Global

What makes us uncomfortable is the scale of potential failure, if things go wrong, given the sheer relative size of the deals now.

There's a new corporate game in town: overseas acquisitions. Suddenly, Indian companies have become the must-ask whenever any company is put up for sale, almost anywhere in the world. And Indian companies have demonstrated tremendous courage by actually consummating many, many deals of significant sizes, even by global standards.

Are these deals going to be value-accretive? Or are these deals going to cause the next big bear market in Indian equities, as companies struggle to make these acquisitions work? Or are these deals going to go swimmingly, as Indian companies remake these acquisitions, slash costs, improve processes, access new customers, and then all stakeholders go home happy?

No matter what the outcome, one thing is for certain: corporate India has suddenly upped the stakes, has overnight become riskier, and consequently, stockholders of these Indian companies are suddenly being forced to deal with heightened risk on their investments. The benefits are nebulous, for now, anyway, but the risks and potential downsides are clear and present.

Take for instance, Tata-Corus. Tata Steel's EBITDA margins now run close to 40 per cent, and Return on Equity, in the mid-30s. In fact, Tata Steel's EBITDA margin is higher than that of Infosys, and way above Satyam, Wipro and HCL Tech. The point is: it really doesn't get any better than this in steel, margins and return-wise. To spend $12 billion at these cyclical highs of a sector's lifecycle, does seem a move fraught with danger. The same Tata Steel management had said a few years back that steel, as a business, can simply never generate EVA (economic value added)! Now, in its own words, steel has entered a 'new era'. We will see.

Tata Tea, another highly acquisitive company, has struggled with its Tetley acquisition. Its minority stake in the Glaceau deal doesn't quite make sense: if it had to buy, a majority had to be bought. A portfolio position makes little sense.

Kumar Mangalam Birla's comment on the Novelis acquisition is even more telling: that this will enable Hindalco to break into the Fortune 500. To minority stockholders, frankly, this carries no value. For promoters, it does. And herein lies the disconnect we are beginning to see: managements and stockholders' interests are diverging, for perhaps the first time in India since the bull market started in 2003.

Who is going to be proven right? Our sense is: for quite a while to come, managements of these acquiring companies will struggle to get things right. Culture integration will top the list of problem issues. While we don't subscribe to the general notion that mergers don't add value, generally speaking, what makes us uncomfortable is simply the scale of potential failure, if things go wrong, given the sheer relative size of deals now. The interesting thing is that the most globally integrated, and globalised sector in India, IT Services, has seen no mega-acquisition at all! What do our IT chieftains see that old economy chieftains can't?

The point is: even for very globalised companies, big mergers are a major headache: Daimler-Chrysler and Citigroup are just two cases in point. Both companies are struggling to fix the after-effects of mega-mergers. When the mergers were announced, they were hailed as mergers that would lead to economies of scale and savings. Now, there is about-turn talk that these companies are better off being leaner, slimmer and not attempting to be all things to all people.

Risk appetite in the world is high. Risk premia are low. Money is coming, thick and fast. Banks are laying off risk as quickly as they generate it. Mega deals are being easily financed. This is all so perfect.

The last thing we wish is that India's normally sensible managements succumb to this empire-building megalomania that has afflicted many, many managements across the world, and with disastrous consequences on many occasions.

S Mukherjee,
Managing Director and CEO,
ICICI Securities

With non-recourse debt, Indian firms are not too exposed, and the value creation is largely from shifting low-value work from abroad to India.

Over the last few years, India Inc's forays in global markets have made headlines for all the right reasons. Never before in our history has India Inc straddled the world so assertively. Awash with the confidence of the country on the rise, India Inc has increasingly asserted its presence on the global M&A scenario.

As the dust settles down on the headline-grabbing acquisitions, the question foremost in everyone's mind is: can Indian companies make a success of their acquisitions abroad?

Most Indian acquisitions have been for businesses that provide greater opportunity to turn around businesses and hence tend to have fewer bidders/lower valuations. Indian corporates continue to seek opportunities at reasonable valuations and that is one of the reasons why they have not made hostile bids that tend to be expensive for the acquirer.

A unique aspect of the Indian acquirer is that they do not typically look at generating value through any significant employee restructuring. Value and profits are generated by transferring lower value add processes to India, better price realisations for Indian product sales, technology transfer and leveraging the target customer and branding relationships for expanding the business overseas. In fact, the existing management is often retained for three-five years with specific bonuses and benefits. As a result the acquired entities benefit from the ability to focus on improving the overall performance both in India and overseas.

The global financial system currently has high levels of liquidity. Based on the steadiness of the targets cash flows and the quality of the Indian acquirer, Indian corporates have been able to raise non-recourse debt for four-seven times the EBITDA on the cash flows of the target entity. The exposure level of debt/equity to be raised in the Indian entity is therefore substantially smaller than the size of transactions and significantly mitigates the risk to the Indian operations.

Financial viability and size of the domestic balance sheet too is of prime importance in ensuring success especially if the industry scenario turns adverse. Here, credit must be given to Indian corporates for restructuring their balance sheets in the initial part of the decade before embarking on large-ticket overseas acquisitions.

The debt to equity ratio is less than 0.5 for companies under i-SEC coverage at present, and this provides enough leeway to leverage the balance sheet to pursue inorganic growth opportunities. Improvement in ratings to investment grade will also increase the ability to raise funds overseas at fine spreads. Even as it is early days to assess the impact of big ticket acquisitions on the financials of domestic companies but with share of non-recourse debt being high, the risk to domestic balance sheets, to that extent, stands mitigated.

Cultural integration is key to the success of M&A transactions. Empirical evidence of the last five years suggests that most acquisitions made by Indian corporates have been successful. The reason for this cross-Atlantic success lies in the Indian genius of making things work despite all odds. Geographical boundaries, language barriers and alien culture are aspects that Indian companies are very adept at facing and overcoming.

However despite the hype and the hoopla, India Inc must hasten slowly. The jury is still out as Indian corporates have only now started acquiring companies substantially larger than themselves. How they manage cost and complexities that come from owning established management teams, assets in multiple locations and with different systems is a test that needs to be passed. India Inc has not experienced the down cycle in developed markets in the last few years as well. Tata Tea faced this on its acquisition of Tetley where the industry cycle turned adverse and the company had to cope with a huge interest burden on its books. By accessing synergy benefits and through prudent financial management, Tata Tea sailed through that period.