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Disaggregate to grow

R. Jagannathan builds a case for why conglomerates should break up

September 27, 2012 / 07:48 PM IST

By R. Jagannathan

Indians make for great entrepreneurs but they often make a hash of it by being too greedy. Having cut their teeth during the licence-permit raj-when growth opportunities were few and far between-they have a tendency to make a grab for any passing business opportunity even if it has nothing to do with their skills and capabilities. They are driven by an unwarranted fear that if they pass up any opportunity, they may be losing out to someone else.

During the pre-1991 period, this grab-as-grab-can attitude did not matter much since obtaining a licence was often like a permit to print money. Any business would do for entry was anyway limited by what the babus allowed you to make.

Most Indian big businesses-from the Tatas to the Birlas and Reliance-have thus become conglomerates housing several kinds of businesses either under a group umbrella or under a single company. They diversified into anything and everything, which in the post-liberalization era made no sense.

The 2008 scramble for telecom licences shows that this greed hasn’t ended. Among those given licences by A Raja were builders and consumer goods players, including Unitech, DB Realty,
and Videocon.

The decline and fall of a handful of airline companies over the last 15 years-from EastWest to ModiLuft to Damania to Sahara, and possibly Kingfisher now - also shows how very few entrepreneurs think things through before getting into industries they are not equipped to succeed in.

While one can guarantee that none of them are serious players and will exit sooner or later, that still leaves many big diversifiers and conglomerates like Tatas, Birlas, Reliance and ITC who are too big to fail-or, in any, case, seem to have the resources to survive intact in the foreseeable future. While Reliance is into everything from textiles to oil exploration, refining, petrochemicals, retailing and telecom, ITC is, apart from its core business of cigarettes and tobacco, also into fast-moving consumer goods, paper, and hotels.

In the case of the Tatas and Birlas, their diversifications are often housed in different companies, but can even such big groups have the kind of cash to feed so many cash-guzzling businesses? For example, can the Birlas fund telecom, a global aluminum conglomerate, a worldwide fiber business and a cement business and still retain enough common shareholding to be called a group? Can the Tatas finance a huge automobile giant, a global steel giant, and many other megaliths and still remain one group?

Where the money lies
The point is this: To grow, businesses need capital-especially in the kind of industries that are capital-intensive. But no promoter can have infinite amounts of cash to invest and retain his stake. They have to tap the markets sometimes. When they do, they shrink their stakes.

In India, conglomerates and promoters have avoided this fate by subterfuge and behind-the-scenes help from politicians and bureaucrats. They have not only retained control, but have even increased it at a time when their companies have multiplied 10- or 20-fold in size and guzzled capital over the last 20 years.

The Reliance story, which predates liberalization, was built on easy money, but of a different kind: the money was generated by Dhirubhai Ambani’s creation of the equity cult in this country, which allowed him to fund his world-scale projects at very low costs. This is what propelled Reliance into several industries by integrating backward. From textiles, it started making textile intermediates like fibers and yarn, then backwards into the chemicals needed for fibers, and then further into petrochemicals, refining, and oil and gas exploration. When the vertical options ended, it sought horizontal room to grow by moving into unrelated areas like retailing and telecom.

In ITC’s case, diversification was prompted more by the need to move away from cigarettes and tobacco-products with very high margins but vulnerable to ever-rising taxation and public health concerns.

Three factors drove businessmen to become conglomerates through horizontal diversification into unrelated businesses or through vertical integration: one, as we have already mentioned, was the licence-permit raj. The second reason was multi-point taxation - both state and central taxes-which made it sensible to house all units in one company so that only one tax is paid on the final product instead of several taxes on intermediate products. The third reason, which relates to the last 20 years, was the availability of easy money after liberalization, and especially after 2003, when the world bought the India story. Everyone wanted to either lend to or invest in India Inc’s champs.

But now the reasons for the emergence of conglomerates have either disappeared or are about to. For example, the multi-point, multi-level taxation system has been replaced by value-added tax, which is uniform. With the arrival of the goods and services tax (GST) in the near future there will be only one or two uniform taxes. It will not matter whether you manufacture a product inside the same factory or buy it from someone else-you will end up paying the same tax. The tax you pay on your final product will be reduced by the taxes paid on the inputs you buy.

Vertical integration, Reliance style, is no longer necessary.

Diverse options
On the other hand, money is not going to be easy to come by in the current global atmosphere. Businesses, thus, have to focus, restructure, resize and rejuvenate. More specifically, if you do want to access money from investors or the capital markets, your businesses have to be understandable to analysts and investors. For example, a diversified business like ITC is a mixed bag. Its cigarette business makes more money than the rest of the businesses put together. It may not need more capital now but the mixed nature of its business makes its valuation less than it should be. ITC currently gets the same valuation as say a Hindustan Unilever in the price-earnings (P/E) ratio range of 30-35, but if its cigarette business were listed separately, it would get an even higher P/E. Investors want to know what they are buying and not being able to see what they are buying in a conglomerate hinders capital raising.

Horizontal diversification is not the best way to raise shareholder value.

Reliance is an interesting case as it is both vertically and horizontally diverse. By buying this share you are buying an oil company, a refinery, a textile company, a petrochemicals complex, a retailer, a future telecom services provider and possibly much more.

But what if I want to invest only in retailing and telecom, but not refineries and petrochemicals? I have to buy the whole bundle or nothing. This is one reason why even though the company is sitting on piles of cash-over Rs. 70,000 crore at last count - its share is not exactly on fire. Disaggregating its businesses, and selling off the duds would help.

Mukesh Ambani seems to have realized that to obtain higher valuation he has to sell or segregate his mature businesses. This is why Reliance announced in June that it will be offloading its textiles business, including the Vimal brand. Textiles is where Dhirubhai Ambani’s manufacturing journey began so dumping it is like disowning your heritage. But it’s got to be done.

Conglomerates have to become less mixed up in the future or they will fall by the wayside. As the world enters a period of simultaneous slowdown, as capital gets scarce, and as the operating environment gets tougher by the day, conglomerates will all have to shrink.

When money is easy, it is easy to keep extending yourself. When it gets tough, you have to focus, disaggregate the multiple businesses, sell some of the dogs, and keep the cash cows.
And survive.

© Entrepreneur India September 2012


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