Reliance minus Vimal: is sum of parts greater than the whole?

Mukesh Ambani’s decision to put his textiles business, including the Vimal brand, on the block is yet another confirmation that strategies and business models evolved during the licence-permit raj cannot survive its impending demise.

Among the issues the group will have to examine are the following: how deep should a company or group integrate its businesses vertically (backward or forward); what are the tradeoffs between running a business with focus as opposed to creating a complex conglomerate which no one can understand every part fully; how should business groups that want to get into diverse areas really be structured?

Reliance Industries Ltd (RIL) is one of the world’s most vertically integrated and horizontally diversified groups - it has integrated forward and backward from textiles to oil exploration, and is into so many related and unrelated businesses (retail, telecom, textiles, petrochemicals, infrastructure development, etc) - that it is virtually impossible to run efficiently as one business entity.

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Other groups like the Tatas and Birlas are horizontally diverse conglomerates, and they too face similar problems of overextending themselves in areas they know less about. But Reliance has carried vertical integration and horizontal diversification in one company to an unprecedented level where its challenges are both more daunting and unique.

[caption id=“attachment_353745” align=“alignleft” width=“380” caption=“Today’s Reliance cannot deliver optimum value from the whole. It must be broken up.Reuters”]  [/caption]

The vertical integration was, in part, the result of a multi-point taxation system at centre and states and high tariff protection in the domestic market; the horizontal diversification was the result of the licence-permit raj, where major business opportunities were initially reserved for the public sector. So private businessmen took what they got from a wayward government. Often, receiving a licence meant receiving an okay to print money, never mind if it’s a business one doesn’t understand.

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This is what created the complex Reliance Industries as it exists today. One suspects that its extraordinarily high levels of integration and diversification - rather than any temporary issue over gas pricing or refining margins - are the real cause of its underwhelming performance over the last two years. Complexity breeds inefficiencies because they are invisible, hidden in parts of the business outsiders (and even insiders) can’t see.

But more of that later. First, let’s start at the beginning: the proposed sale of Reliance’s textiles business and the “Only Vimal” brand.

Reports in the media suggest that Reliance is looking to sell its textiles unit at Naroda near Ahmedabad and NM Rothschild has been given the mandate to find a buyer. DNA newspaper, quoting an industry source, says “the company is no more interested in this division; its contribution to the total turnover of RIL is very less.” The Economic Times, quoting an anonymous RIL group source, says that “the focus of the management is to invest in businesses where the returns are around 25 percent.” The textiles business obviously does not meet this basic criterion.

Reliance’s consolidated balance-sheet for 2011-12 reports a gross turnover of Rs 4,37,331 crore (Rs 3,68,571 crore net of inter-segment transfers), but textiles is a fleabite in this. So much so that it does not even figure in the company’s segmental reporting of businesses. It figures in the “others” category, lumped with retail (a future giant business), telecom (another growth area) and SEZ development (a stunted area, given land-related policy roadblocks). Textiles is the only business not worth the candle - and the turnover here is said to be less than Rs 2,000 crore per annum.

However, the real significance of Reliance’s decision to dump this business - its first claim to fame - is what it signals: that the old Reliance business model has reached its limits of utility and has to be trimmed, modified or even partially abandoned in the current economic and political environment.

Reason: Reliance is no longer only an Indian player. Nearly 60 percent of its business comes from abroad. Moreover, even in India, the game has changed. There are no high tariff walls to hide behind, and the tax structures no longer call for vertical integration.

But we need to understand what that model was in the first place. The late Dhirubhai Ambani’s strategy was to ensure backward and forward integration in all his businesses, aided by enormous amounts of capital raising, managing the policy and political environment to his advantage, and ensuring cost-effective project execution.

Consider how he went about it. Starting with trading in textiles and yarn, he went into manufacturing (textiles), and then integrated relentlessly backward from textiles to polyester yarn and fibre. Since yarn and fibre were manufactured from petrochemicals (purefied terephthalic acid, et al), he went into petrochemicals and plastics (polyethylene, polypropylene, PVC, paraxylene, ethylene, etc). The need to make petrochemicals took him further backwards to petroleum refining and retailing, which then took him further to oil and gas exploration. (At one point,Dhirubhai even tried buying Larsen & Toubro, an engineering and construction company that could oversee his frenetic plant and project construction activities, but he didn’t pursue the idea when the financial institutions balked at this, but that is another story).

In short, from textiles Dhirubhai integrated backward to oil exploration in what would be one of the world’s most serious efforts to control your entire supply chain from one end to the other.

This is actually a foolish idea - but it made sense during the licence-permit raj when policies were protectionist and socialist governments tended to tax all inputs heavily. The word “foolish” may sound harsh, but consider what it really implies when you backward integrate so much.

When you are a trader, the skills you need are the ability to understand seller and buyer prices and sourcing. You have to source whatever you buy from the cheapest seller and hawk it in the highest priced markets. You have to develop an acute sense of timing about when to buy or sell your product.

But when you integrate backwards from trading to manufacturing, the game changes. You are in a different business. Suddenly, you have to figure out many more things: how to keep project costs down, how to employ labour and manage them (the Reliance textile unit has loads of labour trouble now), how to create a distribution chain to sell your products, how to create a brand that will bring higher value realisation. This is one giant leap in skills. Not all successful traders can become successful manufacturers, but Reliance managed the transition well.

Now consider the next transition from textiles manufacturing to chemicals and petrochemicals. The idea is to control the cost of the inputs that go into polyester yarn and fibre, but when you build world-scale petrochemical complexes like Reliance did, you can’t consume all that you produce in your own textiles unit. You then need to develop b2b (business-to-business) skills and sell your products to people who are your competitors in the textiles business and beyond. So you are in one more business which needs a different mindset and skillbase.

Next, when you move back further into petroleum and refining, the ballgame again changes completely: you have to understand crude sourcing, petroleum cracking technologies, and petroleum product markets on a global scale. When you buy, say, Saudi crude, the optimal mix of products you can get from it is different from, say, Venezuelan crude. Unless you know which is the market you are selling the final product to - both the product market and the geographical region - you cannot know which crude to buy and which petro-products to produce and market (more diesel or more aviation fuel or kerosene).

If you go further backward into oil prospecting and production, you get into almost a gambling game: you have to bid for exploration blocks, and hope you dig the right holes to get gas or oil. Your success rate will vary from year to year, field to field. You also have to understand when to produce and how much, depending on trends in oil and gas demands worldwide. This is at the root of Reliance’s problems right now, as it fights with the oil ministry on investments and gas pricing.

The point is this: with every level of vertical or backward integration, you are essentially getting into a completely new business even though it sounds so simple: produce gas or oil, convert it to petro-products and petrochemicals, manufacture fibre and yarn, produce textiles, and sell it as “Only Vimal.”

If only it were that simple. The real risk in such deep vertical integration is that you have to understand several markets, and live with several business cycles, which may or may not coincide. You have to understand each one of them, and to really run efficiently, you have to operate each one of them as though they were separate businesses. If you don’t, it essentially means sub-optimal profit maximisation.

Let’s understand this with an example. If, for example, crude prices are rising strongly, to maximise profits you should be cranking up your production and selling oil to anyone anywhere in the world. But when you have your own refinery, you will probably underprice it to protect your refining business. So instead of maximising profits from crude, you will sell the oil to your refineries with the hope that you will recover the additional profits from the petrol and diesel your produce. But the two markets are different: crude prices and petrol prices may not rise commensurately: if petrol prices are crashing when crude is rising, your overall profits will fall.

We can expand the examples to many other products - but the result will be the same. The only way to maximise profits in a vertically integrated chain of manufacturing facilities is to run each individual part of the chain as a separate business. Thus if crude is more profitable, you sell crude and let the refining business fend for itself; if petrol is zooming, you should buy the kind of crude that optimises your petrol output rather than buy your own parent company’s output.

Of course, this begs the question: why did Reliance opt for so much vertical integration in the first place?

The answer lies partly in the licence-permit raj and the anomalous duty structures it created. When centre and states were levying high duties on various products at every stage of production (from raw materials to intermediate to final products), the only way to reduce the impact of cascading duties is to integrate vertically.

Again, an example will help: since excise duty is levied on a manufacturer’s product, it means if I make a chemical and sell it to Reliance to make yarn, I pay duty on the chemical and Reliance on the yarn. But if Reliance makes both in the same factory, it pays duty only on the yarn. It saves on the chemicals duty.

However, the introduction of value-added tax (VAT) at the state and central levels, and the impending arrival of a unified goods and services tax (GST) means that companies pay tax only on the value they add, and get deductions on the taxes already paid on their inputs.

So, it no longer matters if I buy a petrochemical from within the same plant or from someone else, since my GST depends on the difference between my purchase price of inputs and my final product selling price, minus the taxes already paid by my input suppliers.

Vertical integration is not longer justified only on tax grounds - though it may make sense in case there is going to be huge uncertainty over supplies of raw materials or whatever. In fact, vertical integration may be counter-productive unless a company can ensure that each part of the integrated business is being optimised for profits.

In a nutshell, one can state why Dhirubhai did all this: he integrated backward and forward to save on cascading taxes; he created bigger and bigger agglomerations of businesses in order to build size and scale in an India protected by tariff walls; size enabled him to raise more and more capital, both from lenders and the equity markets; and this capital enabled him to create global-scale capacities at lower cost than his competitors despite high import tariffs on capital goods, plant and machinery.

His did this by doing the following: he raised debt and converted it to equity at high premia to effectively reduce his cost of capital. And he ensured high share prices by two ruses: creating companies and then merging them into Reliance; and by ensuring his share prices remained high by constantly feeding his investor base with the prospect of higher returns.

Consider his saga: he floated two plastics subsidiaries (Reliance Polyethylene and Reliance Polypropylene, the so-called ilu-pilu twins), raised equity in both, and then merged them with Reliance. He floated Reliance Petrochemicals and merged it back; he bought IPCL from the government and Nocil from the Mafatlals and folded them into Reliance; he floated Reliance Petroleum and merged it with Reliance.

The strategy is crystal clear: float companies, raise capital and then merge the entities back into Reliance on terms favourable to the latter. The shareholder of the merged entity, though sometimes shortchanged, ultimately does not complain since he is now part of the cash-generating mother ship.

But investors are now demanding greater clarity from all companies. They do not want to look at opaque balance-sheets that tell you little about the underlying businesses. They may not even want to invest in a catch-all business. Investing in Reliance is like investing in a well-diversified mutual fund: you know how the whole fund is performing, but not how each investment has fared. (Did the fund manager miss a bet on tech stocks when he went for steel?) In Reliance’s case, we know how the overall company is doing (not so well, right now), but you cannot know whether greater inefficiencies are being hidden in a large pot of unrelated and related businesses.

The way ahead for Reliance is to do the opposite of what it has done in the past under Dhirubhai: disaggregate businesses and make them more visible. This means it has to start demerging some or all of its businesses, sell or consolidate them, and possibly refloat those that require more capital once again.

This is where the news on the sale of the textile business fits in. It is an indication that Reliance sees no point in running a marginal businesses where top management cannot give it the time to build scale and margins. It is not really about dumping a loser.

While unrelated businesses are surely worth floating separately - retail and telecom, for example - even the vertically integrated core oil-refining-petrochem-plastics business needs to be disaggregated to derive higher value from it.

Logically, Reliance should thus convert itself into some kind of holding company that merely allocates capital between its vertically disaggregated businesses in the oil to petrochem and plastics chain, and also its unrelated businesses in retail and telecom, among others.

Put another way, Mukesh Ambani has to do the opposite of what his dad did to extract value from his confusing empire: demerge, disaggregate, develop or dump. That’s a four-D strategy.

At the last annual general meeting of shareholders on 7 June, Mukesh Ambani said: “We will invest Rs 1 lakh crore over the next five years in India to build a stronger and more diversified Reliance. I have set myself the target to double the operating profit of your company in about five years.”

It’s possible, but to do this he will have to abandon his father’s everything-in-one-company approach. Today’s Reliance cannot deliver optimum value from the whole. The sum of the parts may be truly more valuable than the whole. Reliance must be broken up.

(Disclosure: The author and/or his family own shares in Reliance).