"I am proud of the conglomerate that I have managed to create. Half a century old, generating Rs 3,650 crore in sales, embracing four businesses, Alpha--the company that my father founded--would not have grown into a giant without inherent strengths. But, as the corporation keeps stretching, it strains--and the weaknesses are suddenly visible. My belief in diversified businesses has been shattered with the collapse of the chaebol in South Korea, which is largely ascribed to the unproductive use of capital. I wonder whether Alpha is wasting both financial and managerial resources in its pursuit of growth without creating shareholder value. Amidst my obsession with size, I have even failed to benchmark my divisions against their competition. Now I find that my core business, steel, is becoming uncompetitive because of the group's multiple business interests. Its survival may well hinge on my getting out of the peripheral businesses" For ceo Vinayak Chowdhury, a smaller, sharply-focused company meant changing the way he managed the organisation. RPG Enterprises' V.S. Krishnan, Price Waterhouse Associates' Shakti Saran, and Videocon's V.N. Dhoot investigate Alpha's options and assess its future. A BT Case Study.

Chairman's Meeting, Alpha Steel Ltd (Alpha)
DATE: April 22, 1998
TIME: 4.00 p.m.
VENUE: Alpha House, Mumbai
PRESENT: Vinayak Chowdhury, ceo; Rakesh Pandey, Nominee Director, idbfci; Ashutosh Dey, President (Steel Division); Girish Rao, President (Telecom Division); Manohar Mantri, President (Power Division); Bhaskar Pradhan, President (Planning & Control); Raj Sharma, President (Finance)
AGENDA: Deconglomeration

Vinayak Chowdhury: Good evening, gentlemen. Our agenda is to finalise the annual results of our company for the year ended March 31, 1998, which were made available to us by our auditors yesterday. I want to utilise this opportunity to discuss how we should prune our debt, which stands at a crushing Rs 5,050 crore. While the turnover of the company--comprising the steel, power, aluminium, and energy divisions--has risen by 4 per cent to Rs 3,650 crore in 1997-98, its net profits have fallen by 16 per cent to Rs 129 crore. Interest costs continue to be a source of concern for us. The net margins of our core steel business have dipped to an abysmally-low level of 0.40 per cent of turnover. It is true that all the steel majors, both local and global, have been going through a bad patch, characterised by three trends prevalent since the first quarter of 1995: a slump in steel prices, a glut in supplies, and the lack of demand due to a recession in user-industries like white goods. We also face the additional problem of dumping by foreign steel-manufacturers. Locally, the industry is growing at a paltry 5 per cent per annum. Although end-prices have begun to rise slowly, I see no indications of a revival in demand unless there is a surge of investment in infrastructure. But we need to examine the basis of allocating overheads to our business divisions. The steel division bears the brunt of our interest costs because interest is allocated on the basis of divisional turnover. I am sure there are similar cost-allocation anomalies across the organisation. To get our focus on costs and revenues right, I feel we must treat each division as an independent profit-centre

Ashutosh Dey: Precisely. We face a paradox as far as the cost-revenue profile of steel is concerned. We are among the world's lowest-cost producers of steel. This stems from two factors: state-of-the-art technology, and high labour productivity. But our cost-leadership does not extend beyond the conversion stage. At $260 (Rs 10,400) per tonne, our conversion costs compare favourably with the global benchmark of $280 (Rs 11,200). The conversion cost of US Steel, for example, is $313 (Rs 12,520), and that of Nippon Steel, $300 (Rs 12,000). Our gross margins per tonne, at $170 (Rs 6,800), work out to 39 per cent, which compares favourably with tisco (20 per cent) and the Steel Authority of India (11 per cent). But add interest--and the final cost per tonne of steel shoots up to $341 (Rs 13,640), making Alpha a loser.

Clearly, the advantage of one of the best gross margins in steel is negated by the high cost of capital employed. Our Return On Capital Employed, at 2.70 per cent, is less than half the risk-free rate of return. It is only when we can get a grip on the interest costs--of around $81 (Rs 3,240) per tonne of steel--that we can become truly cost-competitive. So, the immediate priority should be to bring down the debt, and reduce our interest costs. Unless we do that, we will flounder. But how do we proceed?

Rakesh Pandey: This issue came up at a meeting of our consortium of lenders last week, which was concerned about your debt-burden. Already, you have had to reschedule your loan-repayments twice. The flagship business has been used as an investment-vehicle for setting up projects in power and oil. Its resources have been drained not only because you have expanded into capital-intensive areas in quick succession, but because the execution of projects has been hampered by time- and-cost overruns. It is true that the company has diversified into segments which will grow, and offer an assured market for all its products. But, according to the consortium, you are running the risk of diffused management focus. Which can be addressed only by sticking to what you are good at, and divesting businesses that are peripheral to the core business of steel. Your operational efficiency in steel is, no doubt, comparable to the best in the world, but the profitability--and the survival--of the company depends on how quickly you can reduce the debt-burden.

We examined two specific measures that Alpha has initiated. One of them is to raise low-cost, long-term debt to pay off its high-cost, short-term borrowings. You have completed a $135-million (Rs 540 crore) export-advance at 1 percentage point over the London Inter-Bank Offered Rate (LIBOR) for three years. You also plan to issue Rs 350 crore of 14-per- cent convertible debentures to pay off part of the money Alpha owes in the Inter-Corporate Deposits market. But that merely postpones the problem. The question of deconglomeration came up as an alternative, but it did not find favour with the members of the consortium. As you are all aware, us financial institutions put great store by the size of a business. We feel safe in diversity because we believe that the losses in some businesses can be made up by the gains in others. Of course, my view is different. I feel that Alpha should spin off all its non-steel businesses into independent companies, and allocate the debt to them. That would reduce its financial burden--and, hence, interest costs--making your steel business profitable

Chowdhury: Interesting, that the opinion of Rakesh, who has had several years of association with us, is personal, and does not represent the view of the financial institutions. I was talking to a group of equity analysts recently. We were discussing the steps that we could take to reduce our debt. Their verdict was unanimous: break up Alpha by spinning off its peripheral businesses into independent companies, and then, release its stake in the subsidiaries to make it profitable. Evidently, fund-managers hold a view quite different from those of institutional lenders. They prefer focused companies to a conglomerate as it is easier to track pure plays. Diversified businesses are difficult to monitor because they defy sectoral classification

Bhaskar Pradhan: I am surprised that equity analysts and fund-managers are so limited in their quantitative skills that they cannot effectively value a multi-sector company. It is obvious that they have been getting our value wrong, and have failed to recognise the true potential of a company with a diversified business portfolio. If the valuation is done properly, there is no reason why conglomerates should be trading at p-e (price-to-earnings) multiples below those of comparable pure plays

Pandey: There is a conglomerate discount at work as far as fund-managers are concerned just as you have a conglomerate premium as far as lenders are concerned. Viewed in that light, I feel that the stockmarket has been getting it right all through by providing for that discount

Girish Rao: We have to look at our options in the light of the depressed capital markets in the country. I am not sure if the convertible debenture issue will sail through. Our merchant bankers are still not confident that the issue will be fully subscribed to. Our shareholders are concerned about the decline in Alpha's market capitalisation. They are unlikely to view last year's results with favour. Our share prices have dipped from a peak of Rs 120 in September, 1994, to Rs 14--the lowest in our history--today

Pandey: This issue of shareholder value came up during my interaction with the analysts. I asked them what Alpha should do to raise its stock-price. They looked at the disparate portfolio, and said: "Break up." In fact, worldwide, the main reason behind a break-up is the need to boost your share-prices. A break-up induces the stockmarket to value a share fairly. But let us look at the flip side of deconglomeration also

Chowdhury: All right, suppose we float a subsidiary for each of our businesses, which will be 100 per cent-owned by Alpha to start with and, gradually, is spun off into a focused business. A sharply-focused business has the potential to attract buyers. Our power unit, which produces 515 mw of power, might interest a larger power utility. A pure play is more likely to invite a takeover bid, which may be good for shareholders--such acquisitions always occur at premiums to market prices--but bad for the management because it reflects its inability to deliver value to shareholders

Manohar Mantri: If we break up, the company would shrink in size, and be deprived of the strength of a large balance-sheet. And growth opportunities for managers would shrink. But the over-riding rationale against a break-up is the need for a balanced portfolio. We are good at steel, but the future lies in sunrise sectors, like energy. So, we should be in energy too. At a fundamental level, it is important to remember that our shareholders invested in us because we are well-diversified. I don't think we should be concerned about focus because that is not the reason why investors came to us in the first place

Chowdhury: What is the upside of it all?

Pandey: Well, we will be able to raise money, which will help us bring down our debt to a reasonable level. It will reduce interest costs, and make our steel operations profitable. A break-up also eliminates the executive influence of the corporate office, which does not understand the nuances of every business and, often, second-guesses operating managers. Once we break up, the corporate office--which costs us 1 per cent of sales approximately--could devote its time not to interfering with the day-to-day business of the divisions, but to developing senior managers ready to take on global responsibilities

Chowdhury: Yes, we have, as you are aware, made bids for steel plants in the CIS and the Far East, for which we need managers. The corporate office must help us prepare for tomorrow. It could also focus on managing external relationships, creating a common corporate culture, providing business vision, and playing the role of a catalyst throughout the organisation. In fact, as an extension of the financial restructuring, we could form joint ventures in the satellite businesses that provide inputs for manufacturing steel. For instance, Oxygen International PLC of the UK is keen on taking over our oxygen plant. We would be guaranteed an assured supply of oxygen for a fee lower than our operating costs. The joint venture would also distribute surplus oxygen and industrial gases. That would release an immediate cash inflow of Rs 100 crore. Similarly, we can transfer our iron-pelletisation plant to a separate subsidiary, which would rake in about Rs 300 crore

Mantri: If the rationale for breaking up our conglomerate is to reduce costs, we must remember that it comes at a price. For instance, once the power unit becomes an independent company, I see no reason why I should sell power to the steel business at the present subsidised price of Rs 2.70 per unit; I would do so at a rate closer to the market price of Rs 4.10

Chowdhury: These issues need to be discussed in detail. Let us first turn to the audited results

Is deconglomeration an effective way of reducing the debt of the company? Does it lead to an improvement in the competitiveness and profitability of individual businesses? How can Alpha control its interest costs? Is its debt-burden really the most critical issue? Or is the company's top management focusing on an immediate problem, and losing sight of strategically compelling issues? Is there a valid reason for deconglomeration? What are the flip-sides of a break-up? Will Chowdhury be able to convince his managers of the need to shrink? Can he change the mindset of an organisation that has become used to size? Will small really prove to be beautiful for Alpha?

SOLUTION A |   SOLUTION B  |  SOLUTION C

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