A few years ago, a television advertisement promoting a popular brand of pan masala (flavoured betel nut), aptly captured the instincts of the Indian entrepreneur.
Driving along the streets of London, the suave Indian businessman in the advertisement is on the prowl to make a large acquisition. The jingle playing in the background loosely translates to “conquer the world”.
Over the last decade, Indian companies have made acquisitions valued at over $110 billion. As Indian companies achieved scale and size in the domestic market, seeking out the inorganic route overseas appeared to be the natural progression. Typically, often with the advise of consultants and investment bankers, senior management of Indian companies concluded that the best way to create shareholder value was to move up the value chain or go global.
In this essay, we seek to bust this myth and demonstrate that simplicity triumphs.
The reasons for various mergers and acquisitions (M&A) are quite predictable. Engineering companies attempted to match the technological prowess of the likes of ABB and Siemens by making global acquisitions. Information technology services companies sought to acquire consulting firms in the attempt to move up the value chain and emulate global competitors like Accenture.
Mobile telephony companies assumed that India’s low-cost model was easily portable to other parts of the emerging world. Manufacturing companies sought to take advantage of labour cost arbitrage by attempting to move high-cost operations from the developed world to India. Power utilities and steel manufacturers acquired mines, often underestimating the technical challenges and political risks in these countries.
Healthcare companies sought to foray into developed markets through acquisitions. State-owned oil companies competed against the Chinese to bid for exploration blocks with the intent of making India more self-sufficient in its energy needs. Or, simply the excuse for going global was that the tough environment in India had made it extremely difficult to grow business within the country.
In fact, it was not uncommon to see more than one Indian company competing to bid up the same overseas asset.
The M&A report card of the Indian corporate sector over the last decade, unfortunately, is not very encouraging. We evaluated 27 big deals (acquisition price higher than $500 million) with a total outlay of $56 billion. We estimated the current fair value of these acquired assets and compared them with the original acquisition cost, adjusted for an assumed annual cost of capital of 10%. Our conclusion is that apart from four deals that have added value, the remaining 23 have destroyed shareholder value to the tune of approximately $30 billion. That is a large sum of money to lose in a decade for a capital starved country like India.
The stock markets have sent a clear message that companies that keep their business models simple and focus on their core strengths in the domestic markets will get rewarded. Simplicity premium is investors’ tendency to pay more for stocks that are easier to analyse and value. Aswath Damodaran of the Stern School of Business, in his paper titled The Value of Transparency and the Cost of Complexity, argues investors give a higher discount to a complex business model over a simpler one.
Overseas acquisitions, among other things, often lead to innovative financing choices, creation of special purpose vehicles and the impact of multiple exchange rates, all adding to the complexity of the business. Over the last few years in the Indian markets, pizza franchisees, hair oil makers and pressure cooker companies have seen strong growth and an even stronger rerating in valuations, whereas the companies involved in globalizing have been derated. Some of the reasons for derating of these so-called globalized stocks are obvious, such as integration hurdles, overpaying for keenly bid assets, unanticipated regulatory risks and headwind created by global slowdown. The emotional quotient of the entrepreneur to stay focused and not succumb to the temptation of using the inorganic route as a short cut to growth becomes an important evaluation criteria for investors.
Indian stocks have one of the lowest dividend yield among the emerging markets. The oft-cited excuse has been that with better growth opportunities and higher return on equity (RoE), Indian companies are better off reinvesting cash flows into the business rather than increasing dividend payout. However, in the past few years, we have seen a reversal, namely, slower growth and falling RoE. It might be a better option for Indian companies to create shareholder value by increasing payout ratios rather than diversifying into unrelated areas.
We think Indian entrepreneurs and managers are amongst the most talented. After the spate of global acquisitions, a course correction, we believe, is already being discussed in boardrooms and we may see the results soon.
In conclusion, let’s bear in mind Stephen Covey’s words that can be applied to India companies: the main thing is to keep the main thing the main thing.
Amay Hattangadi and Swanand Kelkar are portfolio managers with Morgan Stanley Investment Management. These are their personal views.
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