This month saw a huge controversy surrounding Tata Sons and its chairman Cyrus Mistry who was removed from his position unceremoniously. This has brought into sharp focus the acquisition strategy followed by the Tata group, as also the acquisition strategies followed by Indian corporates.
As investors, we focus on the cash flow statement of a company even more than we do its Profit and Loss Statement. This statement tells us about how cash is generated and how it is utilised during the year. The cash generated during the year, can be invested back in the business, returned to shareholders as dividends and buy-backs or be used to make acquisitions. This, called the capital allocation policy of the company, can become quite important in the evaluation of the total value of the business, over the long term.
Acquisitions can either be made using the cash generated over the years, or they can be funded by a combination of internal accruals and debt. While this is still nascent in India, debt funded buy-outs are quite popular in the developed countries, where a company takes on disproportionate debt to buy out another company. This was precisely what happened when Tata Steel acquired Corus, UK. In a levered acquisition, if the asset (company) purchased has enough cash flows to pay back the debt, it can be a huge win for the acquiring company – however, if the cash flows of the acquired entity are insufficient, it can place an onerous burden on the company making the acquisition. Examples of successful acquisitions in India, in the past include HUL – Kissan, Marico – Kaya, HDFC Bank – Times Bank, and many others. We also have examples of acquisitions which have placed a great burden on the acquiring company often leading to a difficult situation.
Any acquisition funded by a large amount of debt, raises the risk profile of the company making the acquisition. In the case of Tata Steel, in FY2006, the year prior to the Corus acquisition, Tata Steel had 10,000 cr of net worth (equity) and 3,400 cr of debt on its book – this is a reasonable debt to equity ratio of about 0.34 and does not expose the company to a very significant balance sheet risk. However, post the acquisition, the debt equity ratio in FY2008 had moved up to 1.6x. Over the next 8 years, Tata Steel’s India operations have made a total net profit of 41,000 cr – after deducting about 7,000cr for dividend paid out, this should have resulted in Tata Steel’s net worth going up by about 34,000 cr – instead what we find is that in FY2016, Tata Steel’s consolidated balance sheet had seen a contraction of its net worth by 6,000 cr to 28,000 cr and its debt had gone up from 54,000 cr in FY2008 to 86,000 cr in FY2016. It is no surprise that the situation is causing a stir in the Tata Sons’ board room.
For our investments we try to avoid companies that have a lot of debt on their balance sheet. We prefer if the investee company uses the cash it generates to invest back in its business, or make tuck-in acquisitions, with cash accrued over the years. If both these possibilities don’t exist, it would be better for the company to pay back the cash to shareholders as dividends or through equity buy-backs. Large debt funded acquisition are a strict no-no in our view, especially if you are looking for companies that generate shareholder wealth consistently over time. Organic growth, though slower than debt funded growth has the benefit of being slow and steady, and it also has the benefit of helping you sleep well.