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When firms chase growth but ignore risks..

Jun 18, 2013

Assessing the long term track record of companies is not just about tracking its financials over the years. Reviewing the strategic decisions of the management is equally vital. For that gives cues as to how the management approaches growth and profitability. Whether or not its focus is on keeping balance sheet strong and create shareholder wealth is also evident from such decisions. In the earlier article we reviewed cases where companies undertook unviable projects that eroded their profits. In this article, we shall review the cases of some capital goods companies that have chased inorganic growth at their own peril. In order to quickly achieve scale, companies often chase growth through inorganic route. Sometimes, the company over expands into new geographies and products without considering the looming risks and uncertainties. The risk becomes even more pronounced when the company does not even have prior experience either in the new territory or no expertise in the products that it has launched. It is a general belief that favorably or economically priced acquisitions can always strengthen a company's position. As a result, many companies opt for inorganic growth and develop new products and enter new markets during downturn also. This is because of the belief that they will have a competitive edge when the economy eventually bounces back. Voltas and Crompton Greaves (CG), for example, are bluechip companies that made such cardinal mistakes. They carried out acquisitions during economic downturn to elevate their growth. However, they failed to extract synergical benefits out of them. In turn, they ended up hurting their profits and destroying shareholder wealth.

Voltas - a case of trusting the target company's management

Voltas acquired 51% stake in Rohini Electricals and Industrial Limited (REIL) in 2008 and went on to increase it to 83.7% by 2010. The rationale behind the acquisition was that Rohini will enhance Voltas' presence in electrical contracts (switchyard projects). The acquisition was also supposed to help the company in providing a complete package for various Mechanical Electric and Plumbing (MEP) projects.

However, Voltas' decision to continue with the erstwhile management of REIL backfired. The subsidiary suffered from poor margins and losses from carry forward 'legacy' projects. Subsequently, Voltas replaced the management but it still carries the burden of the old management's mistakes. This is evident from the fact that despite Voltas fetching better margin orders and taking several initiatives to curtail the losses and streamline the operations, REIL continues to report loss. Currently, REIL constitutes just 2-3% of Voltas' sales but has impacted its EBIDTA and net income negatively due to continuous losses on its books.

Replicating Voltas, Crompton Greaves (CG) continued its inorganic growth despite slowdown in its target markets (i.e. Europe and US and Middle East and African countries)

CG has also had series of acquisitions over the past eight years. It started from Belgium-based power transmission equipment major Pauwels Group in 2006 and continued with ZIV- a Ukraine based smart grid automation company in 2011. CG's subsidiaries performed well until FY11. Thereafter however, their performance has been on a declining trend since FY12.

For instance, CG's Belgium based Pauwels subsidiary had profit after tax of Rs 610 m in 2006 but has posted a loss of Rs 50 m in FY12. While Pauwels is just a case in point; almost all its subsidiaries' performance has nosedived.

What is worrisome is that as a result of series of acquisitions, CG's consolidated debt has gone up from Rs 3.9 bn in FY11 (debt to equity 0.12 times) to Rs 18.5 bn (debt to equity 0.52 times) in FY13. Notably, ZIV acquisition in FY12 added another Rs 5 bn debt in CG's books.

The chief reason CG set on an acquisition spree was to bridge the gap in technology and product portfolio that it had with its competitors. And the strategy did prove to be fruitful as operating margins of these overseas businesses improved from around 5% in FY06 to close to 10% in FY11. However, as few more acquisitions followed; margins plunged to 4.4% in FY12 and CG reported an operating loss of Rs 23 bn in FY13.

The question that arises is whether the timing of acquisitions was wrong or was there a failure on part of management in integrating overseas operations. As the situation has worsened only over the last two years, the Euro zone crisis which began in 2008 cannot be entirely blamed for CG's overseas performance. So the management's inefficiency in integrating its operations well in time also shows up. Also, while a well timed acquisition can turn around a company's fortune, a misjudged one can negatively influence its fundamentals and impact its consolidated performance.

To conclude...

There is no doubt; these are challenging times for Voltas and Crompton as their premier business segments and subsidiaries are facing too many hurdles. We believe that a turnaround in the performance of Voltas' and CG's subsidiaries can only offer some breather to their diminishing earnings and returns. Also, it is essential that macro headwinds fade away in coming years; which may help these companies revive their glorious past. But most importantly, investors need to asses whether the managements have taken some lessons from their mistakes.

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