Goodbye, Vimal: Why Mukesh Ambani is selling his father's first major business

Reliance Industries yesterday (9 December) took the first step away from the business that more or less established it as a big business in India: textiles and the Vimal brand.

In a deal with China’s Ruyi Science and Technology Group, Reliance agreed to transfer its textiles business and the Vimal brand for an undisclosed amount of cash and a 49 percent ownership stake. A new joint venture, where Reliance will still hold 51 percent, will probably be the route through which this disinvestment will finally go through, if all things fall into place. The deal comes nearly a year-and-a-half after rumours first surfaced that Reliance under Mukesh Ambani wanted to get out of the business his father, the late Dhirubhai Ambani, started out with.

As a Business Standard story points out , Vimal has little more than “sentimental value” for the promoters of the group, as it accounts for little more than 0.3 percent of turnover (around Rs 1,500 crore of turnover). Since the group has always believed in scale and size, this bit of its overall business is too small for management to expend its energies on.

As this writer has noted before , Reliance’s decision is additional confirmation that strategies and business models evolved during the licence-permit raj cannot survive its steady demise.

Textiles can be a big business in itself, but years of diversification have led the group into areas that are much bigger in scope, scale and growth potential - from oil exploration to refining to retail to telecom services - than just textiles. The only choice before it was to either grow the textile business itself in scale globally, and integrate forward and backward through additional brand purchases (as the Birla group has done with Madura Garments), or to exit it altogether. Mukesh Ambani has obviously decided to take the latter route.

Among the issues the group will have to examine in future 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 few analysts can understand fully; how should business groups that want to get into diverse areas really be structured?

Reliance Industries (RIL) is one of the world’s most vertically integrated and horizontally diversified groups - from its origins in trading in polyester and fibres to a move into textiles and branded showrooms, it has integrated forward and backward into textile intermediates, including fibre, petrochemicals, naphtha crackers, plastics, refining, and oil exploration in stages. More recently, it has diversified into unrelated areas like retail chains, media (Network 18, which published Firstpost) and telecom (through Reliance Jio, which will be launched in 2015.)

Running so many businesses in one company not only makes Reliance a company difficult for investors to comprehend, but also one difficult to as efficiently as one with a sharper focus.

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.

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 and its subsequent abolition. During the licence-permit days, private businessmen took whatever licences they got. Once licensing was abolished in 1991, they got into whatever they thought they had missed out on or where they saw an opportunity.

This is what created the complex Reliance Industries as it exists today.

First, let’s start at the beginning: the proposed sale of Reliance’s textiles business and the “Only Vimal” brand to a joint venture with a Chinese partner. The real significance of Reliance’s decision to partially offload this business is what it signals: that the old Reliance business model has reached its limits of utility and has to be trimmed or modified in the current economic and political environment.

Reason: Reliance is no longer only an Indian player. More than 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. With the coming of GST (the goods and services tax), Reliance no longer needs to house all its businesses which feed into one another in one company. Whether they are in one company or in many, the indirect taxes will be the same under a value-added tax like GST.

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 into 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. Shedding the textiles business tells us that his son wants to tweak the old strategy in a new era.

The new, competitive world calls for focus more than integration because each area of operation need specialist skills and knowledge.

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 had loads of labour trouble in the past), how to create a distribution chain to sell your products, how to create a brand that will bring higher value realisation. This is a different set of skillsets. 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 set of business challenges 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 them all 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 and, anyway, there may be price controls: if petrol prices are stagnant 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.

However, the introduction of value-added tax (VAT) at the state and central levels, and a future with the 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 no 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 every year.

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.

But investors are now demanding greater clarity from all companies. They do not want to look at confusing balance-sheets that tell you little about the underlying businesses. They may not even want to invest in a company that is all over the place. 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, but you cannot clearly understand 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 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.

(Disclosure: Firstpost and Firstbiz are part of Network 18, which was taken over by the Reliance Group earlier this year. Some parts of the above article were published in Firstbiz when the Vimal sale rumour was first doing the rounds in 2012).