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India's Consolidation saga: A snapshot

  Even though the concept of consolidation is quite common, it has gained a lot of buzz in recent times in the Indian context. In this article, we explore what consolidation is, what it implies, and the reasons behind the spate of consolidation activities in India.

Amarendra Singh
Mentor, Business Head - goFYI.in

Since the liberalisation in 1991, the Indian economy grew on an average by 8%, and is expected to reach US$ 2.85 trillion in value in 2018. With this growth came opportunities in various industries, and we also witnessed the emergence of new industries. As expected, companies – both domestic and foreign saw an opportunity to either enter the Indian market, or strengthen their position, and performed mergers and acquisitions leading to industry consolidation. The trend that started then has not yet stopped and is expected only to gain momentum as the conditions are ripe for more consolidation.

Mergers and Acquisition (M&A) activity in India has crossed US$ 56 bn. 2017 and is predicted to maintain at least at the same level in 2018 as well. There are many reasons for this spike in M&A activities, and one important reason is consolidation among domestic players.

Table 1:
The Merger Mania - M&As in India, 2017
Target Industry M&A Value ($mn) Share of M&A Nos. of Deals
Telecom 18,481.1 33% 31
Financials 9,602.1 17.2% 240
High Technology 6,524.6 11.7% 162
Industrials 3,997.0 7.2% 146
Healthcare 3,273.6 5.9% 87
Real Estate 3,262.8 5.8% 61
Energy & Power 2,703.6 4.8% 80
Consumer Products & Services 1,841.5 3.3% 160
Materials 1,784.1 3.2% 143
Media & Entertainment 1,700.9 3% 85
Retail 1,675.9 3% 52
Consumer Staples 1,085.9 1.9% 128
Total 55,933.1 100% 1,375
Source: Thomson Reuters

Mergers and Acquisitions are one of the extremely important strategies that companies use to either expand their position in their existing markets, or enter new markets.  For example, the proposed merger of Vodafone and Idea Cellular makes for an ideal example of how the threat of a new, powerful entrant (in this case, Reliance Jio) can disrupt the market and precipitate the need for the incumbents to join forces to safeguard their market position.

It must be understood that M&As are just one of the many ways in which companies join forces, or in other words, the industry consolidates. So the question is: Why should an industry consolidate? For that, we must understand the concept of ‘industry consolidation life-cycle’. 

In 2002, Graeme K. Deans, Fritz Kroeger and Stefan Zeisel published an article, titled, “The Consolidation Curve” in the Harvard Business Review.  According to them, an industry will move through four stages of consolidation.

In the beginning, most new industries are crowded and fragmented, and they must consolidate as they mature. This consolidation is a predictable process and follows a clear life cycle, spread across four stages as explained in the figure.

Figure 1 – Industry Consolidation Life Cycle

(graph)

 

Stage 1: Opening
Stage 1 starts with perhaps a single company, usually a start-up, which has a monopoly stake in the industry. However, the company’s monopoly position quickly vanishes, as more and more players see the opportunity and seize the market.

One such example in the recent Indian context is the e-commerce industry. While, it is hard for the writer of this article to point out which company was the first-mover in this space, the industry itself came to the fore with eBay and Flipkart. However, soon, several other players, backed with cash-rich private equity firms entered and crowded the market. The industry, which was valued at less than US$ 4 billion in 2009, reached US$ 24 billion in 2015!

In this stage, the mandate to these companies was very clear — focus on the revenue, rather than the profits, and gain market share. Not surprising, then, is the fact that none of the e-commerce companies made any profits during this period.

Stage 2: Scale
Stage 2 is all about scalability. The hallmark of this stage is the emergence of big players, buying up competitors. Several companies that found it difficult to operate in the stiff competition scenario in the e-commerce space simply shut shop or sold out to their bigger rivals. For example, Flipkart acquired eBay India, while eBay global acquired an equity stake in Flipkart in exchange. In the latest development, the American retail major, WalMart Inc. is said to be in the process of acquiring majority (51%) stake in Flipkart while this article is being written.
In this stage, top players are expected to have up to 50% market share among them, as the industry itself consolidates rapidly. Also, these companies must build their skills in M&A, post-merger integration and other such challenges that come with mergers. Companies also start having a relook in to their core capabilities, and start focus on profitability. At present, the Indian e-commerce industry is in Stage 2, which is expected to last a few more years.

Stage 3: Focus
Once the consolidation of Stage 2 ends as explained above, Stage 3 begins. Companies utilise and expand their core business to outgrow the competition. In this stage, the top players are expected to control 40% - 70% of the market among them. Also, by this time, there are very few significant players left in the market. In this stage, one can expect large or even mega-deals to happen. 
Companies are expected to follow the classical economics path of focus on profits, focus on their core capabilities, divest weak businesses, etc. Underperformers are expected to face stiff competition. The incumbents also look out for start-ups that may disrupt their markets, and may choose to crush them, acquire them, or simply emulate them.

Stage 4: Balance and Alliance
In Stage 4, the industry looks pretty matured, with very few, large companies. The top companies may control as much as 70%-90% of the market. Growth at this stage plateaus, and therefore, companies forge alliances with their peers. It is important to note that companies don’t move through this stage, rather, they stay in it. The only option for the incumbents, therefore, is to defend their positions. Companies find new ways to grow their core business in this mature industry. They might grow by bringing in new businesses or services to industries that are in the early stages of consolidation.
Consolidation, therefore, is a normal part of any industry. They help establish efficiencies that drive down the cost of goods & services and make the marketplace more competitive, and hopefully, affordable for consumers. A company’s long-term success depends on how well it rides the consolidation curve. The agility to understand where they are in the consolidation curve, and the speed to respond, is everything.

Understanding the terms
Merger:
Merger is full joining of two previously separate companies. In mergers, both the companies must dissolve and fold their assets and liabilities into a newly created third company. A merger involves the ‘mutual decision’ of two companies to combine and become a third entity and can also be seen as a decision made by two ‘equals’.
Example: Idea Cellular and Vodafone India coming together is an example of a ‘merger’. The deal size is almost US$ 23 bn. and creates India’s largest telecom operator.
Acquisition:
Acquisition is taking possession of another company (may also be sometimes referred to as a Takeover or a Buyout). Acquisitions may happen through share purchase, where the ‘Acquirer’ buys the target company’s shares from its shareholders, or by asset purchase, where the acquirer buys the target company’s assets. The acquirer acquirers the target company with all its assets and liabilities. An acquisition is characterized by the purchase of a company by a more resourceful company, and this does not have to be ‘mutual decision’.
Example: Uber’s Southeast Asian business was acquired by their Singapore-based rival Grab, arguably the largest acquisition completed by a Southeast Asian company. The deal allowed Uber to own 27.5% stake in the merged entity.
Joint Venture:
Joint Venture (JV) is two or more businesses joining together under a contractual agreement to conduct a specific business enterprise, and sharing profits and losses. The JV is for a specific project or purpose only, rather than for a continuing business relationship.
Example: TireHub LLC, one of the largest tire distributor and wholesalers, is the result of joint venture between The Goodyear Tire & Rubber Company and Bridgestone Americas, Inc.
Strategic Alliance:
Strategic Alliance is a partnership of one company with another in which it combines efforts to achieve a specific objective. For example, securing a better price by ordering in bulk together. The ultimate objective of such alliances is to reduce risk and increase leverage.
Example: Spotify, the music, podcast, and video streaming service partnered with ride-hailing service Uber to create ‘a soundtrack for your ride’. This was a great example of a Strategic Alliance between two very different companies with same objective – to earn more users.
Partnerships:
Partnerships are businesses in which two or more companies or individuals carry on a continuing business for profit as co-owners. It must be noted that legally, a partnership is not regarded as a single entity.

Advantages and disadvantages of industry consolidation
Industry consolidation can benefit the players mostly from the profitability point of view. The incumbents achieve profitability through the following ways.
Economies of Scale: The ‘consolidated’ companies gain from lower operating cost, lower SG&A, and lower material costs. At the same time, they are able to reach a wider market.
Market Power: As explained earlier, consolidations help companies in gaining more market share, resulting in a company’s monopoly power and enabling higher prices. However, this is also the reason why governments regulate such consolidations under the Anti-Trust Laws. It must be understood that companies may achieve bigger market share objectives, only if it happens in the same industry.
Improved Products: Theoretically, a stronger company will have more resources to spend on research & development (R&D), which may result in newer and more beneficial products. However, as a counter-argument, a strong company may not need to invest in product innovation and improvement if it operates near monopoly level, simply because it has no incentive to do so.
There are some disadvantages of consolidation too, as listed below.
From the consumers’ point of view, more market competition is a good thing, because they are able to secure attractive prices for their purchase. However, as industry consolidates, the incumbents start to gain more power, thereby making purchases costlier for the consumers. When the industry reaches Stage 4, the industry functions more like an ‘Oligopoly’, a state of limited competition, in which a market is shared by a small number of producers or sellers. The market players can collude and ‘settle’ for the final price of their goods and services.
     For example, at present, the Indian Telecommunication market structure can be seen as an oligopoly, which is being disrupted by Reliance Jio, forcing the incumbents to react in unprecedented ways.
A very large company may get too big, unwieldy and difficult to manage and therefore, none of the expected synergies and economies of scale may actually pay out.
Industry consolidation many also lead to reduced choices for consumers. This outcome is closely related to the first point (above) in the disadvantages. For several industries, especially fashion or apparel, retail, food, etc, choice making is as important as price for consumers.
A merger can lead to job losses. This is a particular cause for concern if the merger in question is an aggressive takeover by an ‘asset stripping’ company (or a firm, which seeks to merge and get rid of under-performing sectors of the target firm). On the other hand, other economists may argue that this ‘creative destruction’ of job losses will only be temporary job losses and the unemployed will find new jobs in more efficient firms.

What is driving the current Indian industry consolidation?
In India, the industry consolidation at present is driven more by financial distress than anything else. There are financially stressed assets in each industry. An analysis based on the 316 non-financial BSE 500 companies for the financial year 2016-17, carried out by Mint newspaper, found that the proportion of debt held by Indian companies unable to meet their interest obligations has risen to its highest level since the global financial crisis of 2008-09.

Table 2: Percentage of overall debt held by companies
Year Profit-making companies; unable to pay debt covenant Loss-making companies; unable
to pay debt covenant
2008 6.13% 8.25%
2009 10.94% 10.74%
2010 12.72% 9.34%
2011 7.27% 7.99%
2012 19.15% 5.06%
2013 17.64% 12.61%
2014 20.45% 4.32%
2015 23.32% 9.22%
2016 20.61% 10.17%
2017 22.46% 11.46%

It is also important to note that the profitability situation of the financially stressed companies show no sign of improvement. In the analysis done by Mint, it was found that the companies that are able to meet their debt obligation usually have the return on capital employed (RoCE)1 level of ~14%, while the companies that are financially stressed have RoCE level of ~1.5% only. While there is a marginal improvement in the overall debt level, the debt and equity ratio for the companies that are not able to meet their debt obligations is far higher than those that are able to meet their debt obligations.
These observations are most pronounced in Telecom and Real Estate companies. The Real Estate sector had an ‘interest coverage ratio’ of 0.98 in the financial year 2017. Interest Coverage Ratio is used to determine how easily a company can pay its interest expenses on loan/debt. When a company’s interest coverage ratio is 1.5 or lower, its ability to meet interest expenses becomes questionable. For the Telecom sector, the interest coverage ratio was 0.76. Other sectors with high leverage and low profitability are Capital Goods and Infrastructure, and Utilities sector (including electricity / power companies). Not surprising, then, that the Anil Ambani-led Reliance Communications Limited was purchased by Mukesh Ambani’s Reliance Jio, as the former may have defaulted on its debt obligations.

Outlook for industry consolidation
This is a remarkable situation, one that indicates an unprecedented opportunity for industry consolidation. As demonstrated above, there are financially stressed companies in multiple sectors, and therefore, consolidation through mergers and acquisitions, is expected to happen at greater frequency in coming times.

Table 3: Sectors with very high likelihood of consolidation in the next 2-3 years
Industry Characteristics Industry Consolidation
Life Cycle Stage
Health & General
Insurance
Highly competitive; No product differentiation; Capital intensive; Top 5 players have ~75% market share. Stage 2
e-Commerce Highly competitive; Focus has been on customer acquisition and top-line growth; Crowded market space. Stage 2
Telecom Sector had been a stable industry prior to the entry of Reliance Jio – a powerful market disrupter. Stage 4
Banking Government mediated mergers, primarily to achieve higher operating efficiencies, in the wake of increasing NPAs. Stage 4
Pharmaceuticals Companies are seeking scalability; The industry is experiencing slowdown in growth and therefore, reduced profitability. Stage 2
Real Estate Almost all companies are facing serious financial distress; A few policies have permanently impacted the industry; Capital intensive; Small players can only survive if they have serious cash infusion. Stage 3
Power &
Utilities
Companies are facing long-term financial distress; The industry consolidation may be precipitated by National Company Law Tribunal (NCLT). Stage 4
Oil & Gas Government mediated merger; Merged entities are seeking greater operating efficiencies. Stage 4

The inability of several companies to pay their debt covenants will also force companies to sell off their non-core and / or non-profitable businesses. This will bring much needed financial and operational discipline, resulting in industries operating at optimal levels, and improved return on investment. Consolidation is already underway in the Telecom sector. Very soon, Real Estate, Capital Goods and Infrastructure, Utilities, and Life & General Insurance companies too will join the trend. The Indian insurance sector is highly fragmented — there are 24 players, and the top 5 players control about 75% market share. The industry is highly competitive and capital-intensive. In this scenario, and with no tangible differentiation, it is obvious that many companies in the insurance space will be able to sustain themselves.
The effect of domestic consolidation will eventually lead to a reduction in the total number of players in some sectors, making them more efficient and profitable. This will also increase competition amongst the surviving players. While there is a positive expected impact on these companies, it is hard to say whether the customers and consumers in these sectors will actually gain any benefits as argued above. Whatever the case may be, consolidation among the domestic companies will play a very important role in redesigning the country’s industrial landscape.
We can expect more industries to ride this consolidation wave in 2018 as well. While it may be very exciting for managers in these companies and those in finance and investment banking sectors, firms must be aware of the fact that they will require substantially greater integration than the industry has historically tackled. In that regard, companies must plan for post consolidation integration planning. In many cases, it may require substantial restructuring of investments, distribution, and operations.