How to profit from India's M&A battle

published 13 April 2007

India's firms need to grow quick in 2007 and the easiest way is through acquisitions. But there will be plenty of competition, says Rohit Chawdhry of New Delhi-based Oxus Investments. Buy into the targets to profit from the trend

Mergers and acquisitions (M&A) were big news for India in 2006, and in 2007 that should continue. Tata Group's battle with Brazil's CSN for UK steel giant Corus is still bubbling away, while the latest story to hit the headlines is Vodafone's bid for India's fourth-largest mobile group, Hutchison Essar, that some analysts think could fetch up to $20bn.

The sheer growth of volume in Indian M&A deals is mind boggling. In 2005, Indian firms were involved in 467 deals worth $18bn in total. But in 2006, the number of deals soared to 740, with a total value of $26bn. And it's not just about domestic players buying each other up. Tata Tea, with sales of $350m last year, acquired two companies in the US for close to a billion dollars. Meanwhile, Bangalore-based telecoms consultant Subex Systems bought the UK's Azure Solutions for $140m, mainly by offering its shares. In total, overseas deals were worth $16bn in 2006 and yet as recently as 2002, acquisitions by Indian groups in foreign countries were worth just $200m, according to Grant Thornton.

What's driving the Indian takeover boom?

The reasons seem straightforward. India's real GDP growth has averaged 8.5% over the last three years a significant increase on its earlier typical rate of 5.5%-6%. Strong global growth, declining tariff rates in India and a more competitive exchange rate (the Indian rupee is undervalued by 22% on some measures) have driven this trend.

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But one of the main reasons for the rise has been a decline in real interest rates by 500 basis points between 1998 and 2003. This has seen Indian firms clean up their balance sheets: the typical debt-to-equity ratio has fallen from 0.9 to 0.4, while the amount of cash companies hold as a percentage of their total assets has doubled from 6% to 12%. "Most Indian firms have strong cash flows and low gearing," says Sanjiv Basin of Rabo Bank. This makes it easy for them to raise debt for acquisitions. And, of course, the rise of private equity means there is no shortage of backers eager to get in on the action. As James Abraham of Boston Consulting Group says: "Fundamentally, Indian firms are in sound shape, and investors are convinced that they will be able to add value to the acquired company. That's why they're prepared to back them."

Can the good times last for Indian companies?

Well, here's the interesting part. Indian companies are currently working flat out capacity utilisation for most industries in India is close to its maximum, according to a recent survey from India-based think tank the National Council of Applied Economic Research.

In other words, if companies want to grow further, they will have to get hold of extra capacity and fast. And one of the easiest ways to do this rapidly is to buy another company.

On the financing side, an important indicator for the future outlook for takeovers is the health of Indian banks. Between 1996 and 2005, the ratio of net non-performing assets (NPA) to total assets at Indian banks has collapsed from 3.3% to 0.7%; implying lots of scope for financing further takeovers.

As India develops and industrialises, the need to grow through acquisition will keep mounting. A recent study from the United Nations Conference on Trade and Development suggests that, by the end of the decade, Indian firms could be buying more than 370 firms from around the world every year.

Who will benefit from the Indian takeover trend?

Evidence suggests that the present takeover trend in India may last a lot longer than anyone currently imagines. In the long term, there seems to be potential for further buyouts across most industrial sectors from retail to textiles and real estate and media.

One of the sectors most likely to see fierce M&A activity is pharmaceuticals. India has the fourth-largest pharmaceuticals industry in the world, yet its healthcare spending per head is among the lowest in the world the US spends $5,750 per person, compared to just $27 in India. So as the middle class grows and demands a better standard of healthcare, there's plenty of room for growth. Indian companies are also keen to get further exposure to European and Japanese markets, where rapidly ageing populations promise strong demand for drug companies' products.

There has already been plenty of action in the sector. Last year, generic drug maker Dr Reddys, a company with total sales of less than $440m, bought German drug maker Betapharm for $550m. And already this year,

Ranbaxy, India's biggest drugs maker, looks set to bid for German giant Merck's generic drugs unit, which analysts reckon could go for up to $5.2bn. The deal could turn Ranbaxy into the third-biggest generics drug manufacturer in the world but it promises to be a tough fight, with competition expected from European rival Novartis and Israel's Teva Pharma.

The other main sector of interest is technology. India's technology firms are increasingly looking at acquisitions as a way to acquire expertise in specific areas, add new business lines, or to gain access to new clients or regions. We look at some potential targets in the box below.

Investing in India: Three possible takeover targets

One Indian technology firm that has found itself the subject of persistent bid rumours is Satyam (NYSE: SAY). The group is India's fourth-biggest IT company, offering IT services and support across the globe. It is also one of the most obvious potential takeover targets in the sector.

Its larger rivals Infosys, TCS and Wipro are unattractive for various reasons; shares in Infosys and Wipro are concentrated among management and founders, for example, whereas the majority of Satyam's shareholders are foreign investors. There has been persistent speculation that IBM is interested in the firm, though both companies deny it. In any case, the stock trades at around 25 times 2006 earnings and with bottomline growth of 40% likely next year, that makes it a buy.

Another potential technology target, this time based in the US, is Syntel (Nasdaq: SYNT), which looks to be on the radar of all the Indian technology majors. The group, which has 6,300 employees and annual sales of more than $226m, has a substantial presence in India. It was one of the first US-based companies to offer what has become known as the Global Delivery Model' to clients whereby software developers at various offshore sites are connected to project managers based at the client's premises combining the cheapness of offshore labour with efficient management. Of the firm's revenues, 40% come from financial services, a sector in which Indian software companies are traditionally strong. Potential bidders could include Infosys, Satyam, or TCS. Syntel currently trades on a forward p/e of around 23.

An area where further bids from Indian companies seems very likely is the generic drugs sector. Acquisitions in Europe and the US offer higher profit margins and ready-made distribution networks to Indian firms, and with Ranbaxy targeting Merck's German unit, omens look good for others in the sector, such as Stada (FRA: SAZ). The group is one of Germany's top generic drugs makers, with annual sales of around e1.8bn. The firm trades on a hefty p/e of around 29 times, but any attempt to bid for the group would almost certainly be hotly contested, with both Iceland's Actavis and Israel's Teva recently expressing interest in the company .

Is India going too far, too fast?

In the short-term, India's mergers boom looks set to continue but the economy shows signs of overheating, says The Economist. Is now really the best time to buy? The trouble with India, The Economist argues, is that infrastructure constraints mean it cannot grow as fast as China without sparking inflation. Consumer prices are already rising at around 6%-7% year-on-year, and shortages of skilled labour can only make the problem worse. The money supply has exploded in recent years India's key interest rate has risen by just 1.5 percentage points to 6% over the past two years, meaning that inflation has kept real interest rates negative.

This suggests that it could well be cheap capital rather than economic fundamentals that is driving the boom.

The impact of this loose fiscal and monetary policy is being felt across the economy. Share prices on the Bombay Sensex stock index have quadrupled since 2003 and property prices in major cities have more than doubled in two years. Markets certainly look very vulnerable to a correction, whether local or global. The slump in stockmarkets across the world in late spring last year saw the Sensex fall by nearly a third from its May high (though it rapidly recovered), demonstrating how exposed the country remains to changes in sentiment among foreign investors. We could see something similar, or worse, this year; Marc Faber of The Gloom, Boom and Doom Report has said he expects a "severe correction" in global markets in a matter of months, and advises investors to avoid the more fashionable emerging markets, including India, for now.

Nevertheless, India remains attractive in the long term. Hundreds of millions of new Indian consumers are likely to shake off poverty, fuelling a multi-decade investment and spending boom, says Tom Stevenson in The Daily Telegraph. The number of households enjoying an income of $3,000 the level widely seen by economists as the benchmark for a consumer society is expected to double to 116 million by 2010. And despite the immediate risks, India is likely to become an economic superpower in the next 20 to 40 years, says David Fuller on Fullermoney.com.