The synergy myth: After HP split, India Inc should rush to demerge and divest

When Hewlett Packard announced a few days back that the company would split into two, The Wall Street Journal acknowledged that investor pressure is making companies realise that “big isn’t better.” However, it’s not just about size being inversely related to performance. The more important message is this: synergy is the enemy of focus. To deliver results you need focus more than synergy. Trying to do many different businesses means you may do all of them sub-optimally. Splitting brings back focus and, hopefully, improves performance.

HP’s decision should prompt new thinking in India’s conglomerate-ridden business groups, which have, for historical reasons, valued size and diversification over focus. Thus an ITC went from cigarettes to foods, toiletries and hotels; the UB group went from booze and jams and squashes to airlines; Reliance (owner of Network 18, which publishes Firstpost) is everywhere from oil and gas to infrastructure, retailing and telecom; Hindalco not only makes non-ferrous metals, but also generates its own power; Wipro ( till its own HP-like split two years ago ) also made soaps, lighting and medical systems; GMR runs airports and power plants; and so on.

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It is entirely doubtful that all these conglomerates are doing the best they can in terms of shareholder value. The chances are they are underperforming, but we don’t quite know it since the results they dish out are large aggregates. Size with diversity makes it difficult for investors to understand what business is making money and what isn’t.

It is investor pressure that probably forced Hewlett Packard to separate its cash-generating PCs and printers business (which will come under HP Inc) from Hewlett Packard Enterprise, which will have Meg Whitman as Chairman, and will focus on computer hardware, software and services. Analysts believe that in due course, both could be targets for acquisitions or merge with companies in similar businesses.

After HP, there is speculation that companies like Pepsi, DuPont, and even General Electric may come under pressure to demerge or divest some of their underperforming businesses, touching off a new wave of investor activism and M&A activity. One big investor is already chasing the DuPont management to break up.

Broadly speaking there are two approaches to business: one, spread your risks by not keeping all your eggs in the same basket; or, two, concentrate the risk by putting all your eggs in one basket, and then guard that basket like your life depended on it.

The advantages and disadvantages of the two approaches are this: in the first approach, risks and rewards are lower. You tend to underperform the best competitors, but stay off the bottom in terms of overall results. In the case of the latter, you either do very well or fall out of the race.

So, in theory, both approaches can be justified. However, in practice, what happens after companies grow to a certain size after diversification is that they build large bureaucracies and lose focus on what is important for the individual businesses. For example, a small but profitable business with high margins will be overloaded with corporate overheads when large, low-margin businesses will be the reason for those high overheads in the first place. The ideal thing would be to give less money to the big business and invest in the smaller one, but the human preference will be to give the bigger businesses more of it despite lower efficiencies - and justifications found for the same (number of dependent jobs, suppliers, etc). This sends overall results plummeting from high to average or below for the company as a whole.

In India, typically we have favoured the second approach, of diversification rather than focus. During the licence-permit raj, a licence was effectively a licence to print money. So it did not matter which business you got into as long as you could get the loans and licences.

But even after the licence raj ended, there were will good reasons to stay huddled in conglomerates.

First, the multi-state, multi-stage excise and sales tax regimes at centre and states meant that making everything in one place reduced hassles. Also, if you made everything from the basic raw material to the final product, your overall tax payment would be lower.

Second, state-run banks, manned by risk-averse bureaucracies, preferred to lend to big business groups. They saw safety in size, in the wrong belief that a big company won’t be allowed to go bust. Upto a point this was true, but this again gave businessmen a reason to build all their businesses in one company or group.

Now, both reasons are weakening. Value-added tax and the soon-to-be-introduced goods and services tax (GST) will ensure that whether you make just one product or the entire value chain, your taxes will be the same. And bankers have also realised that big groups are not risk-free borrowers (Bhushan Steel, Kingfisher Airlines, et al). Ultimately, it is their ability to evaluate credit risks that matters, not size or diversification.

Size also makes promoters take bigger risks than they should. The single-biggest reason for Mallya’s downfall was his decision to bankroll an aviation business with shares in the booze businesses. He is now going to be a truncated owner in the latter. The big realtors like DLF borrowed heavily and are now struggling to repay as property is not selling. Promoters with not even a nodding acquaintance with infrastructure bid for road, telecom and coal projects and then came a cropper.

A common fallacy is for businessmen to believe that if I run common overheads over two businesses, my overall costs will fall. Actually, they may find that the benefits of higher revenues from focus may outweigh the mythical synergies in spreading cost overheads.

The HP split should prompt Indian business to rethink their obsession with size and unrelated business synergies and opt for focus and growth. Pressured by banks, India Inc should demerge and divest unrelated businesses within one company first, and then within their overall groups.

It’s a merciless world out there. Synergy is not worth the candle. The three new mantras India Inc needs to learn are: focus, focus, focus.