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FMCG biggies in acquisition-valuation fix

Published: Tuesday, May 15, 2007, 3:29 IST By Sindhu Bhattacharya

NEW DELHI: Are acquisitions the key to growth for fast-moving consumer goods (FMCG) companies?

The answer will be different for different companies. With many FMCG biggies still facing limited pricing power, steadily rising input costs and moderate near-term growth projections, analysts have begun looking at mergers and acquisitions (M&As) as a panacea for inducing robust growth in the FMCG business.

A look at the operating margins of the four biggies — Hindustan Lever Ltd (HLL), Dabur India, Godrej Consumer Products Ltd (GCPL) and Marico - make it clear that each company has seen margins fall in the January-March quarter this year.

And analysts are prescribing a simple remedy: acquisitions. Sample this: While analysing the healthy growth numbers reported by leading FMCG company Dabur India, Citigroup analysts

observed that “overall growth remains strong, we believe that current valuations … at the higher end of Dabur’s historical trading band cap re-rating potential for the stock. As such, we also do not see any near-term re-rating triggers, with the exception of a potential acquisition.”

Not only Dabur, even HLL is seen facing intense competitive pressure. Analysts at Merrill Lynch recently pointed out that with ITC expected to enter the soaps and shampoo categories in the near future and Procter & Gamble likely to launch its skincare business in India, HLL must brace for tougher times ahead.

“This implies a tougher competitive outlook for HLL… Margin outlook is dismal. We expect HLL’s margin to remain under pressure, owing to steep raw material inflation, likely new competition from ITC and P&G, and management plans to rebuild its foods business,” Merrill said.

This is perhaps why some FMCG firms are seeing some truth in advice of increased inorganic growth. GCPL, for example, bought UK-based Keyline Brands and then Rapidol hair colour brand last year. Marico acquired two soap brands in Bangladesh, another in the home market and Nihar hair oil business from HLL. And Dabur India has also been on the look-out.

Hoshedar K Press, executive director and president, GCPL, remains committed to acquisitions as a way to grow his business. “Hair colour is an area where we would like to make more acquisitions.”

What’s important here are the reasons for a company acquiring any other company or business? For instance, for Marico, acquiring Nihar hair oil business from HLL would mean further strengthening its market leadership position and building further on scale advantages.

On the other hand, GCPL’s acquisition of Rapidol, UK’s hair colour business in South Africa had a different intent. It provided company access to a large ethnic hair colour market, brands and also a springboard for the introduction of its other products in South Africa and

neighbouring markets. And notably, all that in a profitable way — Rapidol was a profit making entity.

Hence, what an acquisition means for a company is important to understand. Acquiring companies for the sole purpose of sustaining growth rates may also not help unless and until the acquisition fits well with the company’s strategic growth plans and vision. For the time being, the high valuations are also a big hurdle and are spoiling the M&A party for FMCG companies. Deepankar Sanwalka, executive director at KPMG, avers that the FMCG sector does need economies of scale. “But this need not necessarily come through M&As… given the current trend of high valuations for target companies, too much money is chasing too few brands. Companies need to figure out whether acquisitions would give them the necessary scale or is building own brands a more viable option”. So, the business also needs to come at the right price.

Dabur, despite being on the look-out for a suitable acquisition target, appears to have come across repeated roadblocks over the last two years, mainly due to exorbitant valuations. So, FMCG companies need to work out ways of solving this acquisition-valuation riddle in order to generate higher growth rates.

Meanwhile, there are other prudent ways of improving margins as well as sustaining growth rates. Says an analyst with a foreign brokerage: “I prefer process improvement and volume growth as better margins levers rather than acquisition. It is the onus of the market leader to drive the category growth, which would increase volumes. And then there is always a case to increase efficiencies and cut costs by better operational processes.” He avers, “Looking at the valuations, an acquisition is like buying topline, which is not very healthy.”

Mergers and Acquisitions Intro

At the beginning of the 21st century the future of the beverage and food industry seemed to be unclear.

With a slow growth rate of only 2% per year, food and beverage companies were desperately seeking the ways to enhance sales and profits. Many companies such as Kellogg's, Sara Lee, Quaker Oats and

others considered merging to be a solution and thus the turn of the 21st century was marked by $ 30.5 billion worth of mega-mergers . One of the largest mergers was the merger between PepsiCo and Quaker Oats which occurred on August 2,2001. This biggest strategic decision PepsiCo Corporation ever made added not only the necessary boost in sales needed to attain tremendous growth, but also positioned company as a dominating force in the food and beverage industry. Detailed analysis of this decision, its impact on productivity and cost is presented below.

Analysis

In order to understand clearly the motivating factors of this decision, it would be useful to describe the nature and position of the two companies on the global market arena prior to the merger. Quaker Oats was formed in 1901 in Raven, Ohio by joining several oat-milling companies. Before the merger, 92% of Quaker Oats' U.S. brands held number one and number two positions in their respective categories.

However, throughout its life, Quaker frequently tried itself in non-food industry, which all weakened the company's greatness and left little worse off. The primary reason was that Quaker could not handle the scale of big corporation. The biggest strategic decision that followed by a huge success was acquiring the rights to sell Gatorade, as it captured 84% of the sport drink market. In 1994, Quaker bought rights to sell Snapple, but the result was much worse than expected. Quaker bought Snapple for $1.7 billion and sold it in 1997 for $300 million, making a net loss of $1.4 billion . Due to this huge fiasco, Quaker could not survive independently any more and needed a financial bailout. Merger with PepsiCo was considered to be a solution and in the beginning of December, 2000 Quaker sealed the deal. The transaction was done in exchange of shares – 2.3 PepsiCo shares/1 Quaker Oats share, thus leaving the deal tax-free.

A North Carolina pharmacist Caleb Bradham founded PepsiCo in 1890 as a beverage company.

Throughout its history, PepsiCo developed and acquired many different products, merged with Frito-Lay Snack Company, bought Tropicana in 1998 that was one the smartest strategic decisions. Currently PepsiCo has revenues of about $27 billion and over 143,000 employees in over than 200 countries. Over the years PepsiCo has been competing with its major rival Coca Cola for being the leader in carbonated soft drinks in the marketplace, as it was the favorite choice of consumers. However, in recent years market conditions have changed and due to health trends, customers' attention turned to non-carbonated beverages. Demand for non-carbonated drinks increased significantly. It had a stable sales growth of 8%

- 9% a year in comparison with 2% - 3% of carbonated beverages. This condition explained where the major profit could be made. Before the merger, PepsiCo portfolio of non-carbonated beverages included Lipton teas, Tropicana juices and Aquafina water. Gatorade was worth of attention and despite Quaker's financial difficulties, commanded over 84% of the sport drinks market . It made clear that acquiring Quaker Oats would make PepsiCo a leader on the non-carbonated beverages market. That was one of the reasons to seal the deal between two corporations. Gatorade was not the only interest of PepsiCo.

On the contrary, Quaker Oats snack line, including granola bars, rice snacks, fruit and oatmeal bars perfectly completed an existing successful line of PepsiCo's Doritos and Tostitos corn chips. That gave two companies an ability to extend their pool of consumers.

Quaker Oats and PepsiCo completed each other not only in terms of their products but also in advertising strategy. PepsiCo strategy known as "Pepsi Generation" created an image that Pepsi products are for the youth market. Similarly, Gatorade was the product with greater impact on younger customers. From marketing point of view Gatorade perfectly fitted into PepsiCo's portfolio of products.

Merger between PepsiCo and Quaker Oats created important cost savings. Due to the similarities of each company's products, the distributional needs were close to each other. Merging with the major suppliers' channels of PepsiCo gave Quaker Oats additional benefits and savings. Warehouse forces were also combined that enabled to save time, space and manpower. Beverage manufacturing for Pepsi-Cola, Tropicana and Gatorade has been also consolidated, that gave operational benefits and valuable cost savings. Economies of scale resulted because certain components that comprise more than one of the beverages would be able to be produced on a larger scale. Thus, PepsiCo and Quaker now share warehouses and distributing system. It is the most important reason why this merger meets all cost

savings needs. Latest releases show that PepsiCo reduced its costs from $400 million annually to $230 million .

PepsiCo and Quaker Oats combined its forces not only in terms of production but also in terms of human capital. Pepsi allowed for the entire Quaker's management team to come to Pepsi to run Quaker's business. These managers have been responsible for Quaker's success before the merger through their rich experience. Pepsi wanted to keep that track and was relatively satisfied with the management and organization of the business in Quaker Oats before the merger. Thus, PepsiCo did not have a necessity to invest huge sums of money in improving the system and was just getting benefits from the additional asset the merger has provided. In combining their resources, PepsiCo and Quaker Oats save money and increase efficiency. All major criteria for raising productivity are met. Physical capital and human capital are combined. Costs from operations are significantly reduced. Increasing returns to scale are applied.

Result? Joy of merging!

Conclusion

Merging with Quaker Oats gave PepsiCo a strong, strategic and competitive product portfolio. Quaker Oats' Gatorade enables PepsiCo to be one of the leaders in non-carbonated beverage industry. Quaker Oats' snack line that is known as healthy wholesome eating completed the portfolio of salty and unhealthy food, produced by Frito-Lay, subsidiary of PepsiCo. PepsiCo allows Quaker Oats to keep its identity that is one of the most important factors of disagreement companies face with after merging. All these issues outline a winning merger, one that created $ 25 billion corporation that is the fifth largest in the country.