Mumbai: Expectations from Bharat Forge Ltd’s acquisition-led growth strategy have soured, at least as far as the stock markets go. The company had made a string of acquisitions in 2004 and 2005, which had taken its stocks to dizzying heights. Between January 2003 and March 2006, the stock outperformed the Nifty, the benchmark index of the National Stock Exchange, by nearly 400%; in other words, its returns were about four times higher than that of the Nifty.
But turning around the company’s overseas subsidiaries hasn’t been easy, especially with one of them having been bought from a bankruptcy court. Mint calculations show that the combined profit margin of Bharat Forge’s overseas operations has been on the decline. The upshot: The stock has underperformed the Nifty by over 60% from its highs in March 2006—that is, returns have been lower than that of the benchmark index by three-fifths.
The head of research at a foreign brokerage, who did not want to be identified, said the company had initially planned to improve overseas profit margins to double-digit levels within three to four years, but added that this target was always aggressive.
Given the touchy issue of labour, it is near impossible to shift work to the company’s low-cost unit in India. “The target was made more out of enthusiasm than experience,” he said. A slowdown in the developed world in the auto components business and a sharp rise in the cost of inputs such as steel have only made things more difficult for the company.
S.G. Joglekar, chief financial officer at Bharat Forge, didn’t concede that turnaround targets hadn’t been met, but said: “Market conditions play a role in the overall turnaround process and performance of companies.”
According to him, the company plans to achieve double-digit Ebitda margin (earnings before interest, taxes, depreciation and amortization, a measure of operating efficiency) over the next two to three years for its global operations. But an analyst with a domestic brokerage, who did not wish to be identified, said the target just keeps getting moved ahead. Operating margin of Bharat Forge’s overseas subsidiaries have fallen from 12.5% in fiscal 2004-05, the first full-year period after the company acquired German forgings company Carl Dan Peddinghaus GmbH (CDP) in January 2004, to 9.2% in FY06 and 7.7% in FY07. In the first nine months of the fiscal year 2007-08, their combined margin stood at 7.9%.
Bharat Forge’s apparent difficulty in improving profitability of overseas acquisitions is a grim reminder for others following a similar strategy, said an analyst at another foreign brokerage, who added that this was the reason he was concerned about Tata Motors’ acquisition of Jaguar and Land Rover from Ford Motor Co.
The chief difficulty Indian acquirers of overseas companies are facing is the inability to cut costs by shifting work overseas, thanks to strong labour unions and regulatory issues. Another acquisition that has soured is Dr Reddy’s Laboratories Ltd’s purchase of German generic drug maker Betapharm Arzneimittel GmbH about two years ago, with the company even writing off part of its investment earlier this year. Historical trends show that a majority of mergers and acquisitions fail, in terms of comparatively lower shareholder returns than what would have been achieved by the two companies separately.
CDP was Bharat Forge’s first major acquisition, and catapulted the company to the No. 2 spot in the global forgings business behind Germany’s ThyssenKrupp AG.
A supplier to commercial vehicles, Bharat Forge gained entry into the passenger car segment through this buyout, since CDP was a supplier of critical chassis components to the likes of Daimler AG, BMW AG, Volkswagen AG, Audi AG and Volvo AB.
Bharat Forge soon mopped up CDP Aluminium Technik GmbH and Co. KG in December 2004, Federal Forge Inc., US, in June 2005 and Imatra Kilsta AB, Sweden, and its wholly owned subsidiary Scottish Stampings, Scotland (together called Imatra Forging Group), in September 2005. These acquisitions added new customers, geographies and technologies to Bharat Forge’s stable, in line with the company’s policy of de-risking its business.
To establish itself in China, the company entered into a joint venture with FAW Corp., which also has car making joint ventures with Toyota Motor Corp. and Volkswagen, in December 2005.
Federal Forge was bought from a bankruptcy court with a loss of more than $1 million on its books, while the Imatra Forging Group had “unclear directives and processes”, as Joglekar of Bharat Forge put it.
Joglekar added that margins at the company’s German operations (CDP) “are better than the rest”. But he admitted that CDP is facing cost pressures arising out of higher input costs. CDP’s profit has improved by about 40% post-Bharat Forge’s acquisition of the company, Joglekar added.
At Bharat Forge America, the erstwhile Federal Forge Inc., the company discovered that the assets were not properly maintained, which not only led to lower productivity, but also a drop in employee morale.
As a result, Bharat Forge had to pump in $2-3 million to upgrade the machinery, in addition to $9 million it had paid to acquire Federal Forge by way of equity and debt.
Meanwhile, it was the opposite case at Imatra Forging Group—the two companies are now named Bharat Forge Kilsta and Bharat Forge Stampings. While the assets here were not of poor quality, performance suffered due to a lack of proper direction. “We’ve had to spend time and money to improve productivity and rationalize products and processes,” said Joglekar.
Analysts said Bharat Forge’s target of improving profitability in the next three years is not going to be easy, thanks to a slowdown in the commercial vehicles industry in the key US market and rising raw material costs.
The production of medium and heavy commercial vehicles in the US fell 45% in the December quarter. As a result, Bharat Forge’s revenues (excluding other operating income) in the US, which accounts for about 20% of overall revenues, was down 11.5% in the quarter ended December.
“Unless demand picks up, it will be difficult (for Bharat Forge) to achieve production efficiencies,” said Vaishali Jajoo, automotive analyst at Angel Broking Ltd. “Orders may not be picking up, and the next six months look difficult.” Joglekar countered that the company is “diversifying into products for passenger cars in the US market. These new products will come out in calendar 2008.”
Meanwhile, rising raw materials prices are denting profitability at not only Bharat Forge but also the global vehicle industry as a whole.
“Adding salt to the wound is steel prices,” said Vijay Sarthy, research analyst (auto) at JM Financial Ask Securities Pvt. Ltd. The price of steel, which makes up almost 60% of Bharat Forge’s raw material costs, has gone up by about 40% in the last 12 months.
The key for Bharat Forge, said analysts, is to leverage its domestic operations and take advantage of having operations in a relatively low-cost country such as India.
According to Angel Broking’s Jajoo, “The company would have to either shift production to low-cost countries or supply more components out of India in an environment of increasing cost pressures in overseas markets.”
But shifting production from overseas units may be easier said than done, given touchy labour issues in the West, especially when the alternative is outsourcing production to India.
Joglekar said that while there was no plan to shift production out of its US or European operations, there might be a case for some product rationalization, whereby products with low margins made in developed markets can be manufactured at low-cost production bases such as India to improve margins.
The company also needs to get into high-margin businesses such as machined components on high tonnage items, as JM Financial Ask’s Sarthy points out. This would be especially true for Bharat Forge’s European operations, where customers are much more quality-centric and perhaps among the most demanding in the world.