Case Game: The Case Of Strategic Acquisition

CASE GAME
The Case Of Strategic Acquisition

Threatened by obsolescence and stagnant profits, Total's batteries division mulls an acquisition. Jardine Fleming's U.R. Bhat, Andersen Consulting's Mukul Gupta, and electricmela.com's S. Jain debate for and against the move.

By R. Chandrasekhar

Your plant is very impressive, Abhi,'' said Shankar Rao to a 30-something man sitting in a big leather chair. Rao, the promoter-owner of Zulfi Batteries, was addressing the CEO of Total Industries, Abhinav Kumar, whose family-owned empire comprised businesses as diverse as switchgears, consumer durables, soaps, and batteries. Rao was an old family friend, and had just returned from a trip to Total's zinc batteries plant.

''However,'' the old man added, ''you should see the Zulfi plant in Pune. It's as good as any alkaline batteries plant in India."

That was the third time in the last six months that Rao had tried to sell Zulfi to Kumar. As a second-generation, heir-less owner of Zulfi, Rao was keen on selling his company to a family he knew, and then spend the rest of his life in the Auroville ashram.

This time proved no different as Kumar hummed and hawed about the deal again. Although, truth be told, the president of Total's batteries division, Ratika Sahai, was already studying the proposal in detail.

''I wanted to make the first offer to you, Abhi. But in another month, I intend to advertise for sale,'' said Rao.

''Give me a week, I'll get back to you with a 'yes' or 'no','' said Kumar.

The next day, Kumar summoned a meeting of his senior executives. He gave them a quick recap of his meeting with Rao.

''The acquisition makes good commercial sense for us,'' Sahai rattled off, ''because it gives us the benefits of synergy.'' The presidents of the other divisions agreed with her.

''I am not sure if there's enough financial synergy in the deal,'' cautioned Vikas Singh, Total's CFO.

''At this stage, strategic synergies are more important than financial synergies,'' retorted Sahai.

Kumar looked at Mohammed Hussain, an institutional nominee on the Total board, who had worked on several M&As in his career. ''This is a common problem in all M&A debates,'' Hussain pointed out. ''Financial perspectives ignore the competitive and organisational considerations, while strategic perspectives are far removed from financial factorisation, which is so essential to the understanding of an investment decision. The issue is best resolved through an internal debate.''

The case for acquisition was rather strong. Total had a 550 million units a year batteries plant, which made a nice fit with its durables business. The business had witnessed a slump in the early '90s due to the gradual decline in the use of torches and transistors in the rural sector. However, a spurt in the sales of pagers, personal stereos, cameras, toys, and powered gadgets had ensured an average annual growth of around 12 per cent.

Thus, while sales were not a big problem, profits were. Net profits had been stagnating at between 5 per cent and 6 per cent of the division's turnover. And as batteries have low brand-loyalty and are bought only against need, product availability and visibility are big issues.

''The acquisition is critical because technology is becoming a key differentiating factor,'' said Sahai. ''All the six top players (Beready with a 22 per cent share of the month; Powerinfo with 20 per cent; CPL with 15 per cent; Powerpal with 12 per cent; Total with 10 per cent; and Zulfi with 6 per cent) go the zinc chloride route for making dry-cell batteries. Sure, today zinc batteries have a 95 per cent marketshare. But the future is alkaline.''

Sahai had a point. Although making alkaline batteries was technology and cost-intensive, the batteries scored higher on performance and reliability. Players like CPL had been importing alkaline batteries for domestic sales for years. Others were talking to foreign suppliers for technology.

Yet Zulfi, a new entrant in the batteries market, was the first to establish a state-of-the-art, 75-million-units-a-year plant at a cost of Rs 65 crore, with technical help from a Japanese major. And though Zulfi had a decent marketshare, it was slated to break even only in 2003.

''I think it's time we reduced our dependence on zinc batteries, and started focusing on the alkaline segment,'' opined Sahai.

''There are three options before us,'' pointed out Singh. ''One, we invest in a new plant; two, we acquire an existing plant; or three, go for strategic alliances in manufacturing or marketing.''

''You mean we should be open to all three options?'' queried Kumar.

Sahai, however, was sold on the acquisition route. ''An acquisition will allow us to hit the ground running. Setting up a new plant will take at least two years.''

''There's another point,'' added Srikant Suresh, the head of the durables business. ''An acquisition will generate cash from day one. A start-up won't.''

''Also, there's no project risk or workforce training involved,'' said Guneen Roy, president of the soaps division.

''Valid points, but merely acquiring a company does not guarantee success,'' argued Kumar. ''Acquisition is only one of the several alternatives that we should be examining. We should go for it only when it offers a better pay-off than other strategic alternatives.''

''If I may ask,'' Singh piped in, ''why are we so keen on acquiring Zulfi?''

Because Zulfi fits in well with our basic parameters (See The Acquisition Parameters),'' said Sahai. ''The promoters' stake is at around 12 per cent in an equity of Rs 12 crore, and the fundamentals are strong. Even the stock price is a healthy Rs 55. More importantly, Zulfi brings us 25 per cent share in the alkaline market.''

Suresh, who had been scribbling something on his notepad, looked up and said, ''The cost of setting up a new plant like Zulfi's today will be Rs 110 crore. To acquire a majority holding of 51 per cent of the company, we need only Rs 34 crore.''

''If my calculations aren't wrong, our current financial health allows us to pay up to Rs 110 per share,'' pointed out Manoj Kohli, the head of the switchgears business.

''We need to look at the numbers more closely,'' cautioned Singh.

''Vikas has a point,'' intervened Hussain. ''The success of an acquisition must be judged by its effect on the shareholder wealth of Total, and not merely the target company's replacement cost. Synergy is often a key to the success of an acquisition. Yet, look at what happened to Shaw Distilleries, the Calcutta-based liquor company. It acquired two companies-one making bread and the other salted snacks-within a span of three months. Ostensibly, the use of yeast in all the three products was considered synergy enough. What the company did not realise was that it was talking about three altogether different markets.''

''Which only supports my plea that we define synergy in terms of real and tangible improvements in competitive advantage,'' interjected Kumar.

Just then, Sahai's secretary popped in to hand her a piece of paper. ''This is interesting,'' Sahai said with a cryptic smile. ''If our regional manager in Pune is to be believed, CPL is planning to bid for Zulfi.''

''It's something we need to keep on our radar, but let's not make any hasty decisions,'' cautioned Kumar. ''I am not willing to get into the bidding game.''

''For all you know, this could be Zulfi's own way of putting pressure on us,'' said Sahai.

''Possible. But the most important question hasn't still been answered,'' reminded Kumar. ''Synergy to me should mean that two-plus-two adds up to not four-but five or six. Only then will the acquisition create value. Otherwise, it merely maintains it. It is only when it leads to geometric leaps in business results that synergy makes sense. And more importantly, justifies the payment of an acquisition premium.''

Singh also struck a note of warning about paying a high premium. ''When we pay a large premium for an existing asset and technology, we will be driving the profitability measures of both Total and Zulfi (and ultimately, the new entity's) downwards immediately. This is the so-called dilution effect. A premium payout raises the asset base of the acquired firm and causes an immediate drop in profitability. Just to break even, the net income needs to increase to an amount that brings the return on asset ratio back to pre-merger levels.''

''I don't know whether I want to buy Zulfi or not,'' noted Kumar, ''but I am sure about not wanting to fall into a synergy trap. I need to know what exactly are the issues involved and why the acquisition may not work, or when will it work. Unless I have the answers to these questions, I am not going to okay the deal.''