"This could be the biggest decision of my life. After founding Deepak Abrasives in 1963, I have never faced the kind of dilemma that I now face. While my company is still a formidable player in the domestic arena, size is becoming crucial in a market that has become global. Cheaper imports are compelling even my rivals to increase both the scale and scope of their operations. And if we don't respond to the changing paradigm of competitiveness fast, we will be marginalised. The best way to beat the competition is to acquire it. It is even better than setting up a greenfield project since an acquisition is a cheaper and a faster route to growth. Moreover, it has the potential to generate financial, operational, and strategic synergies. But I have some apprehensions about taking the plunge. My experiences in team-building has not been too happy. My managers have been keen on protecting turf rather than attaining strategic objectives. I only see problems in a merged entity, where cultures must mesh" That was the predicament that Ashutosh Mukherjee, the CEO of Deepak Abrasives, found himself in even as he was strategising for tomorrow. Wockhardt's Habil F. Khorakiwala and Tata Strategic Management Group's Raju Bhinge analyse Deepak Abrasives' threats, its immediate priorities, and the scope for synergy in its acquisition strategy. A BT Case Study.

The Diary Of Ashutosh Mukherjee, CEO, Deepak Abrasives:

March 15, 1997

Acquisition. Synergy. In the last two months, this has been the constant refrain in my mind. I have been thinking about making a bid for Zen Abrasives, a direct competitor. My A-Team--which manages the Rs 72-crore Deepak Abrasives for me--is excited. Its members suggest that we proceed without hesitation. Their reasoning sounds familiar: we will reap the benefits of synergy. But I am not so sure. Of particular concern to me has been the absence of functional synergy within our company: between strategic planning, on the one hand, and financial planning, on the other.

Despite the fact that all my managers have been put through team-building exercises as part of the Total Quality Management movement we launched 2 years ago, subtle undercurrents of turf and space persist, and they do not work in tandem. Financial perspectives ignore competitive and organisational considerations; strategic perspectives are devoid of the financial concepts that are essential to the understanding of an investment decision. For instance, I am told, identifying synergies is a strategic issue--not a financial issue. Similarly, arriving at an acquisition premium, they tell me, is not a strategic issue, but a financial issue! It's baffling.

March 20, 1997

It has been a long, long journey for me. In 1963, when I set up Deepak Abrasives, running a business was rather uncomplicated. There were none of the elaborate structures, systems, and other support-mechanisms that became imperative later as the organisation grew in size. I relied on gut-feel, going strictly by what I thought was the right thing to do. Of course, every successive step in the growth of the company has been a challenge. And the challenge has been its own reward. I would not trade it for any other pursuit. A company that began by making sandpaper has grown into the country's largest manufacturer of abrasives in a market which has about a dozen players and I, for one, am extremely proud of that.

I still recall learning about the technical aspects of the different kinds of abrasives that are used to smoothen rough surfaces. Their main constituents are electro-minerals, which we now manufacture in-house at our own plant in NOIDA, near Delhi, as part of our backward-integration strategy. The manufacturing process is rather fascinating. Electro-minerals are made by fusing bauxite and coke and then, pulverising them. The grains so obtained are graded according to size. They are then bonded, using resins or fibre-glass to yield bonded abrasives, or coated on speciality paper or cloth to form coated abrasives.

We now operate in a Rs 600-crore market, which, as our MBA recruits learn, is divided into 3 broad categories: coated, bonded, and super which account for 60, 30, and 10 per cent, respectively, of the market. We have been the market leaders in the coated abrasives segment--mainly used by tannery and leather companies--with a 40 per cent marketshare. Our nearest competitor, the Chennai-based Sunrise Abrasives, has a marketshare of 30 per cent, and is preparing to bridge the gap by increasing its capacity of coated abrasives from 18 million pieces per annum to 25 million pieces per annum, which will take it past our capacity of 22 million pieces per annum.

Moreover, Sunrise Abrasives is also diversifying into bonded abrasives--largely used by the automotive and auto-ancillary industries--by setting up a 5,000-tonnes per annum (tpa) plant at Hosur in Tamil Nadu. I understand that the plant will be commissioned by early 2000 by when we will still have only a small presence in that segment. There is also competition from imports, which have now become cheaper since the Customs duty on electro-minerals was brought down to 50 per cent in Budget 96. Our options for the future are crystal-clear: build new capacities, acquire existing capacities, or strike strategic alliances in manufacturing or marketing.

March 25, 1997

My managers seem to prefer the M&A route. Zen Abrasives, our quarry, has a 5,000-tpa bonded-abrasives plant right across the road from our NOIDA factory. My managers insist that an acquisition is the best way to get us off the ground fast since it will reduce the time involved in capacity-creation by at least a year. It will also help generate cash because we can get cash inflows from Day One from our customers. I appreciate their enthusiasm, but find it difficult to buy the rationale that an acquisition is guaranteed to succeed from the outset. If you do not factor in the possibility of failure even when there is every evidence to the contrary, you are missing something in your calculations. That is what I mean by the need to have a rounded business perspective. An acquisition is only one of the several alternatives we should be examining. We should go for it only when we are convinced that it offers a better pay-off than the others do. It is here that I think that my people are not doing their homework properly.

March 30, 1997

While discussing our M&A strategy at our Executive Committee meeting, two issues cropped up: Whom do we target? What are the fundamentals that we should keep in mind about the target company? We zeroed in on the 4 attributes that we would like in a potential takeover target:

• A net operating loss, but strong turnaround prospects. It does not matter if the company has a red balance-sheet.
• Cash-richness. We should look for companies with undervalued assets, such as real estate in a prime location.
• Low promoters' stakes in under-capitalised companies. This would be perfect for a hostile bid.
• Heirless family businesses, where the promoter wants to retire. Such companies would also have discord in their boardrooms.

Zen Abrasives fits into this matrix. The promoters' stake in the company is a little over 12 per cent, with the equity-base standing at Rs 12 crore. The company's fundamentals are sound, and its Rs 10-share is quoting at Rs 55 even in these depressed stockmarkets. It has a fairly strong presence in the global market, with exports accounting for nearly 25 per cent of its Rs 30-crore turnover. With its 9 per cent share of the domestic bonded-abrasives segment, our share of the market as a whole will go up by 5 per cent, strengthening our presence in the business.

The cost-equations are favourable too. While the cost of setting up a 5,000-tpa abrasives plant is around Rs 110 crore, to acquire a holding of 51 per cent in Zen Abrasives at the ruling market price of Rs 55, we will need to pay Rs 66 crore. When we worked this out, the sense of excitement among my managers was palpable. R.S. Divakar, our Vice-President (Strategic Planning), says that we have a lot of leeway. We can pay double, upto Rs 110 per share, and still not spend more than we will for a new plant. In fact, he believes that such a high premium is justified in view of the synergies that we will derive. But Shanker Rakesh, our Vice-President (Finance), is more cautious. He says that we need to look at the figures more closely.

April 2, 1997

I have been talking to Robert Williams, an investment banker whom I have known for years. His point is that it is incorrect to judge an acquisition decision on the basis of what it would otherwise cost the company to develop that business from scratch. Instead, the success of an acquisition must be judged by its effect on Deepak Abrasives' shareholders. He feels that the pursuit of synergy leads managers to justify bad acquisitions, and to the destruction of shareholder value.

Synergy, he believes, is often cited as key to the success of an acquisition, but it hardly works. He cited the example of the Calcutta-based Shyam Breweries, a beer-maker which acquired 2 companies within 3 months: one manufacturing bread and the other, salted snacks. What is more natural, its managers had argued, than combining the manufacture of beer, bread, and salty snacks? After all, they all use yeast. What they lost sight of was that the 3 products catered to different markets, had different ordering-schedules, and different distribution channels. I wonder whether we are making a similar mistake. Have we looked at the synergies we will derive from all possible angles?

Acquiring Zen Abrasives will give us a quick entry into a new market, but there are fundamental differences between automotive units and leather units as buyers. For instance, the former are more susceptible to external trends like a demand recession. And a feeder-industry like ours would be the first to be affected by a recession, and the last to recover from it. Zen Abrasives is our first attempt at an acquisition. And because an acquisition is not a day-to-day affair, there is a sense of elation in my people. It is easy to get carried away. The easiest way to lose perspective is by failing to define synergy in terms of real, measurable improvements in competitive advantage.

April 4, 1997

Divakar has information, albeit unsubstantiated, that Sunrise Abrasives is also planning a raid on Zen Abrasives. This is unsettling. I must find out more about it. And, perhaps, change my time-table too.

April 6, 1997

That was a false alarm. But it has only increased my apprehensions about the possible mistakes we might make. What, after all, are the synergies between the 2 companies? I see it as an increase in competitiveness, and resulting in higher cash-flows than the 2 companies could accomplish independently. Synergy means that 2 plus 2 should not make 4, but 5 or 6. Only then can it create value. Otherwise, it merely maintains the existing value. It is only when it leads to geometric leaps in results that M&A makes sense, and, more important, justifies the payment of an acquisition premium. A shareholder of Deepak Abrasives, like me, can directly buy Zen Abrasives' shares at the market price. So, why should managers spend shareholders' money to buy what the latter can buy more cheaply?

April 10, 1997

I told my A-Team yesterday that 4 organisational cornerstones must be in place for the synergy between Deepak Abrasives and Zen Abrasives to yield results:

• Strategic Vision.
• Operating Tactics.
• Systems Integration.
• Culture Fit.

They must be set from the beginning; post-acquisition is the wrong time to begin working out the details. One way to manage an acquisition successfully is to factor in the possibility of failure. An acquisition allows no test-runs, no trial-and-error. Since the entire money is paid up-front, there is no way you can--as you can when setting up a plant--withdraw by halting its funding mid-way through the project.

The costs of exiting a failing acquisition can also be high. The integration of the sales-force, the information and control systems, and the distribution systems are, often, difficult to reverse in the short run. We may run the risk of taking our eyes off our competitors, and lose the ability to respond to changes in a competitive environment. We also need to factor in the Dilution Effect in an acquisition. Consider the effect on Return On Assets (ROA = Net Income/Total Assets). Paying a premium on Zen Abrasives will raise our asset-base, and cause an immediate drop in our profitability. Just to break even, the net income will have to be raised to a level that brings the ROA back to the pre-acquisition levels.

April 11, 1997

There are several dilemmas that I still face. Integrating the financial and strategic functions at Deepak abrasives is important. Perhaps it will help if I appoint someone with direct responsibility for acquisitions, with a team to support him, and a budget of Rs 100 crore to strategise our expansion and diversification plans. There are several other options that we could pursue: backward-integration into the manufacture of aluminium oxide, or setting up a 20-mega watt captive power plant to reduce our costs, or diversifying into fibre-glass and ceramics. Or, even into auto-ancillaries No decision is easy

Is Mukherjee over-reacting? Are his apprehensions about the acquisition of Zen Abrasives justified? Is synergy a trap that you should be wary of in an acquisition? Does the acquisition have an in-built element of value-destruction as far as the shareholders of Deepak Abrasives are concerned? Is managerial enthusiasm in the organisation superseding shareholder commitment? Is Mukherjee's concern over the absence of functional synergy at Deepak Abrasives real? How should he assess Zen Abrasives' value? What should his M&A roadmap be?

SOLUTION A |   SOLUTION B

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