Some business combinations make immediate sense, both on a presentation slide and in real life. But some leave you feeling unsure—the Tata group’s reported move to combine its foods and beverages businesses, for instance.
Tata group chairman N. Chandrasekaran denied a concrete proposal was being considered, although he left a clue, saying investment bankers sometimes make such proposals or they come from within the companies.
The companies in question are Tata Chemicals Ltd, which makes chemicals but also sells salt under the Tata Salt brand, and Tata Global Beverages Ltd, which primarily sells tea and coffee. A chemical stock will typically attract a lower valuation than a consumer goods stock—hence, perhaps the need to consolidate all foods and beverages brands under one entity. And this seems as good a time as any— there is currently a mad rush to stock up on FMCG (fast-moving consumer goods) stocks in India, with their valuations defying logic.
The chart alongside shows that Tata Chemicals’ profitability may be higher than that of Tata Global in FY18, but the chemicals company trades at a price-earnings multiple of 12 times its FY18 earnings compared to 35 times for the beverages company. This holds true for other valuation ratios too (see chart).
Tata Chemicals’ vacuum salt revenue in FY18 was ₹ 1,275 crore, or 36% of the total, with soda ash contributing 40% and the rest from others, based on stand-alone financials. On a consolidated basis, which includes its overseas operations, the India salt business contributes to 12% of sales.
The salt business may sit much better in the foods company. Tata Global’s consolidated revenues could increase by 19%. And assuming this part of the business gets the same valuation as the company’s current valuation, the combined foods and beverages entity’s enterprise value could increase by nearly a third. This is assuming salt earns the same Ebitda (earnings before interest, tax, depreciation and amortization) margin as the overall chemicals business.
Practically speaking, however, this does not seem easy. For one, the salt business is part of the integrated operations of the chemicals site, which produces soda ash. It would be difficult to physically separate this part only and give it to Tata Global.
Of course, Tata Chemicals could produce the salt and supply it to Tata Global. However, an arms-length relationship means market pricing, which means lower margins for Tata Global. The big question that would arise then is why investors should value the salts business at a fancy FMCG multiple.
One might argue that the move makes business sense. Sure, both businesses could benefit by sharing functions, chiefly on the distribution and even marketing front, and perhaps from elimination of overlapping costs.
But both businesses are also unique. In salt, for example, the market growth mirrors population growth. Tata Chemicals’ annual report mentions the salt market is growing at 1.5-2% per annum. Its own salt business saw sales decline by 0.8% in FY18 in volume terms, but the fourth quarter saw sales rise by 5.9%. It has a market share of 25.5%.
Tata Chemicals has diversified into staples such as dal, spices and nutritional products. The potential for growth in these markets exists though it’s not easy. The opportunity lies in conversion of consumers towards branded products in these categories. The additional risk is that the underlying products are subject to commodity cycles, making it a volatile business. This business will require attention and investments, especially once it scales up.
At Tata Global, a similar picture emerges on the domestic front. It has a market share of 19.5% but sales growth was relatively low at 5% in FY18. The company is increasing its offerings to include beverages that are becoming popular such as green/herbal options and alternative drinks. In India, the market for black tea is still growing but alternatives are growing faster. In the developed countries where it operates, major markets are seeing a decline in black tea. And there is stiff competition from niche brands in the alternatives segment. In other words, it has its hands full.
Adding salt and a fledgling staples business to its portfolio at this point does not seem like a great idea. It may dilute management focus.
So is there an alternative? The two businesses can remain where they are but share certain functions. Foreign-owned companies operate with this structure commonly, where they have different firms in different segments for various reasons, but share functions such as marketing or distribution.
Tata Global could take over some of these functions for the salt business. It would get a fee in return, and while that will become an expense for Tata Chemicals, it may be cheaper than doing everything itself. And, the cost advantage enjoyed by the salt business of an integrated operation remains intact. This may be good for both businesses in the longer run, although it may not move the needle much on valuations. Still, that’s no reason to fix what’s not broken.