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Sunday, November 25, 2007
Organisation Design And Profit - Sanjeev Pandiya
Ok, let's start with the clichés first. We all know that the profit motive is at the centre of capitalism, the raison d'être of an organisation. So profit is the purpose of an organisation and the shareholder (to serve whom the organisation exists) is the primary stakeholder.The organisation uses various resources to generate a profit. In economic terms, it uses land, labour, organisation and capital (LLOC) i.e. all the resources it uses can be classified in some way or the other into the above heads. If we take the 4 Ms: man, machine, materials and method, they are merely a re-statement of the above LLOC. Yet, most organisations I know tend to confuse this balance, i.e. they tend to focus excessively on one or the other of the above baskets. In some companies I have seen, I notice an excessive and almost myopic focus on labour i.e. doing things.
We have customers who tell us what to make from time to time. Through the TQM/ TPM/ six-sigma mindset that flows up and down the auto value chain, we all have this huge focus on the 4 Ms mentioned above. Most of the talk is about machine productivity, labour standards, (material) wastage, overall equipment uptime or line efficiency (OLE), inventory control etc. In other words maximising throughput per unit of capital employed. So either you reduce the capital employed for a given level of output (as in stagnating markets in the developed world where they use outsourcing and innovation to do this), or you maximise throughput for a given level of capital (as in developing countries, where demand is buoyant but capital is expensive and scarce). But the companies are only focused on doing things (i.e. labour) also called manufacturing in layman terms. Now compare this to a bank, as in, what does a bank do? Is there any physical transformation in its product? A bank captures 'profit' by ensuring that it raises funds cheaper than what it lends at (assuming it gets back all the money it lent out in the first place).
But this 'work' produces profit, which comes from managing capital, one of the four economic resources mentioned above. Let's look at organisation, often called management quality. The ability to capture and maintain a near-monopoly is the key skill for Microsoft's shareholders. Of course, the company's PR Department will argue that this skill comes under labour i.e. the ability to build the world's best software. But ask any user of Netscape and they will agree with my classification above. (Fortunately, this column is not read by people at Microsoft.) Or Berkshire Hathaway. A small group of wise men are brought and held together. They sit down around a coffee table and understand risk and opportunity better than anybody we know. Why and how do they stay together? I don't know, but this ability, which creates profit, must be put under the basket called organisation.
Under this head, I will also put the ability to handle risk and the other side of the coin, opportunity. A good insurance company, for example, (or a good derivative trading outfit, aka an investment bank) makes a profit because it charges more premium than it pays out. And it keeps enough risk capital on standby (either on or off its balance sheet) to make sure that it never goes bust, especially during those sudden cataclysmic crises that happen every so often these days.
Last, let's come to land. In Ricardian terms land used to mean anything whose supply was not controlled by human beings. The simplest example was land itself. In those days, if you owned land, you got to charge rent, from which came the term economic rent. These days, the concept covers every such situation where you earn profit merely because you are there. So if Tata Steel owns some fabulous mining leases in iron ore and coking coal, it can afford thrice the labour cost of its competitors. SAIL, which also has the same quality mines in iron ore, can afford four times the labour cost. This source of profit, a chunk of which is then lost to organised labour, is called land.
In the same spirit, Infosys 'mines' a seam of solid, mathematical/ logical skills to give itself nonpareil code-writing capability. This is a combination of land and labour, a good example of a case where an organisation starts with one source of profit, but goes on to build another one across the LLOC basket. Infosys started with a critical resource, code-writing skills, but has built skills to exploit another source of profit, business solutions, which is a skill layered over its generic capability. Yet, compared to a GE for example, I have not seen an Infosys use its balance sheet and its vast cash reserves to build a treasury. It is quite obvious that the company chooses to under-perform its profit potential. Perhaps it has weighed the profit potential (from treasury activities) against the risk and decided against exploiting it. I am told that early in its history, the company lost money in the markets. But to now get to the nub of my point. I don't think too many companies examine their organisation design, to see whether they are able to exploit all the sources of profit possible. Every external interface of the company creates an external stakeholder. Does the company examine each such interface to see how it is losing money or exploiting the relationship for profit?
For example, the company I used to work for earlier was one of the best-rated auto component companies, according to a CNBC poll. Yet, it was my personal opinion that we gave away 40-50% of our net profit by choosing to stay with a single-supplier of steel. One part of the management team argued that we cannot shift to multiple-suppliers without the customer's explicit approval. My counter-argument was that perhaps we, as management, were averse to building “strategic sourcing” skills that allowed us to scour the globe for alternate suppliers. How many vendor/ material-substitution proposals have we given to our customers in the past five years?
So we had chosen to stay 'ignorant' at the vendor interface, taking the prices we are given under the garb of customer interest. But in making this compromise, we have sacrificed shareholder interest.
And finally, I will establish the link with markets with yet another cliché. “Companies create wealth/value but markets measure them". I have often seen that markets don't value the various streams of profit differently i.e. the profits of an auto component company are measured on par with the profits of a bank/ insurance company. For a better understanding of the nature of profit, it is important to first analyse why (and how) the company makes money in the first place. For example, an auto component company makes profits from labour after losing whatever it does to its suppliers, bankers or even employees. It makes money (as in case of my company) after over-paying its suppliers, bankers etc. The residual profits are real and are less likely to be lost again. These profits are then redeployed into a set of real machines, plant, building, which will always have value, as long as the business has any role in society.
Compare this to a bank, which makes money during the boom because it borrows cheap and lends dear. The bank puts all its profits back into its balance sheet, leaving its past profits exposed to the same risk of default. Suddenly, after the recession hits, investors are left wondering how much of the past "profits" of the bank were real. The catch is that risk levels have stayed constant (or have increased) in the bank's balance sheet, while they have actually reduced in the autocomp co's balance sheet.
Yet, the market would value a typical bank at a P-E level higher than that of the typical autocomp co.
Let me summarise: profit is the objective of any organisation and it comes from the management of four key economic resources (LLOC). Most organisations are good at (managing) one or the other of the above (resources). Organisations need to grow in depth, i.e., learn to do things better, manage one resource. They need to grow in breadth i.e. know enough about managing other three resources better. What they know is wealth, what they don't is risk.
Showing Strength
The Sensex is currently showing range bound movement with positive inclinations. The main trend of the market remains bullish. The Sensex witnessed a correction since beginning of the week as the Subprime concerns hovered around the investor sentiment. The market saw a brutal sell-off on Wednesday as US Federal policy makers lowered their growth forecast for the next year to 1.8% from 2.5% as anticipated in June. The Sensex fell below 19K, shedding over 750 points during intra-day trades. Asian markets, too, collapsed over 2-3% as a stronger yen and a weaker outlook for the US economy dampening the investor sentiment. Oil prices also jumped over $99 for the first time on Wednesday as the dollar limped against the other currencies and energy supplies remaining tight globally. Despite pressure from the US, the OPEC opted not to raise its production until its next meeting in December.
The benchmark Sensex index showed strength on Friday by gaining over 327 points at close but overall the index slipped 780 points or 4% to 18,853 for the week ended 23rd Nov 2007. The broad based Nifty, too, saw a pullback on Friday but dropped 299 points or 5% to 5,609 for the week ended 23rd Nov 2007. However, the BSE Mid-Cap index showed a solid strength in previous week and hit the record high of 8730 on Monday, slipped 502 points or 6% at the end of the week. The BSE Small-Cap followed the suit and hit the record high of 10,691 on Tuesday but lost 501 points or 5% at the end of the week.
The shares of Deccan Aviation, jumped over 23% to a 52-week high on Wednesday on speculation that it will merge with Kingfisher Airlines Ltd and may show some profit in the second quarter of 2008. The real estate company Omaxe Ltd also rose to record high as company planned to develop properties overseas in places such as Dubai in the United Arab Emirates (UAE). Among the new listings, Religare Enterprises, a financial services provider led by promoters Ranbaxy Laboratories, listed on a premium of 75% at Rs323.75 and shot up to Rs600 despite the Sensex lost over 4% on that day.
During this week, the FII remained net sellers in equities as they sold over Rs3,321 crore stocks till November 21st while, the domestic mutual funds sold around Rs268 crore of stocks. The annual inflation based on the wholesale price index slipped to 3.01% in the week ended 10th Nov 2007 against expectations of 3.20%.
Tanmiyat to invest in Bangalore Realty
Saudi Arabia-based realty firm Tanmiyat group is planning an investment of around $3 billion in a township project in India, a top company official said.
The group has zeroed in on Bangalore for the project, its first-ever in the Indian market.
"We are in the final stages of fine-tuning our plans for this township project. We will be ready with the final blueprint within the next 2-3-months," Tanmiyat group's Managing Director Bharat Thakkar
This would be a mixed-use project and would be completed in phases over a five-year time span, he said.
The project would be distinctive and unique in many respects and "since this is our first venture in India, we will use the project to position ourselves rightly in the market to facilitate our growth thereafter," Thakkar said.
The group was still fine-tuning various aspects of the project, including the investment structure for it, he added.
"The equity component is still fluid and we have yet to decide whether we want to load a debt component onto the project," he said, adding that the average size of the group's projects has been in the range of $2.5-3 billion.
Being a mixed-use project, apart from residential accommodation, the project would also have commercial infrastructure.
"Bangalore is well-known for its IT, BPO and bio-tech establishments and these three would constitute focus areas for us," Thakkar said
Construction sector continue to benefit
Companies in the engineering and construction sectors have never had it better. With increasing allocation of funds towards infrastructure development, the fortunes of these companies have changed dramatically. The spill-over effect from these investments has also pepped up the outlook for the equipment industry. Offering a proxy play on the infrastructure growth story of India, the equipment industry appears set to grow at a blistering pace.
While the stocks in this segment enjoy premium valuations, the burgeoning order books stand testimony to strong prospects. What are the demand accelerators for this industry? How are the companies planning to take advantage of the demand? What are the key factors that will determine their success? Here are a few takes on the underlying trends.
Growth drivers in place
Demand for infrastructure and construction equipment (ICE) is set to increase, given the growing thrust on infrastructure development. The Eleventh Five Year Plan, entailing an investment of about $492 billion on infrastructure projects alone, is likely to be the main growth driver (incremental investment of about $40 billion annually).
While this will directly benefit engineering and construction companies, it will also buoy the demand outlook for the equipment industry. In addition to this, the fact that equipment costs typically constitute about 4-24 per cent of the total project cost also brings to fore the growth that this industry could witness. Notably, the equipment industry has grown by about 25-30 per cent annually over the past couple of years.
The availability of easy credit options to purchase infrastructure and construction equipment is also a positive. While in the past larger companies (equipment users) enjoyed easier access to credit from the big banks and other financial institutions, their smaller counterparts were not as lucky in tapping capital, and often forced to postpone their purchases. This scenario has changed with the emergence of equipment financing companies with focus on small and medium-sized contractors. Such financing options will not only help these companies get easier access to financing solutions but will also help expedite their purchase decisions.
For instance, the presence of companies such as SREI Infrastructure and Finance, Birla Global Finance and Cholamandalam DBS Finance, which cater to small and medium-sized contractors, has widened the financing options for the user companies. Interestingly, SREI also provides assistance to its customers throughout the lifecycle of the equipment. However, given the strong demand scenario, financing options in the market leave sufficient scope for expansion.
Going forward, exports can emerge as a strong growth driver, given the current domestic market bias of these companies. In this context, evolution of R&D capabilities and an established low-cost manufacturing base are likely to act as enablers. However, given the blistering growth in domestic demand, it could well take a few years before these companies decide to increase focus on exports.
Equipment rentals – the next trend
The purchase decisions of ICE also depend on the criticality of their function to the user’s business operation. In contrast to equipment acquisition, which burdens the purchaser’s balance sheet, hiring or leasing options by equipment rental companies for not-so-critical equipment offers an easier option for the user. Predominantly unorganised, the rental businesses could witness more action given the flexibility they provide the users.
In the organised market, players such as Quipo Equipment Rental and Sanghvi Movers have established their presence. Sanghvi, which rents out cranes, has a fleet size of about 260 cranes and enjoys a 50 per cent market share in the segment. Quipo has set up equipment banks across the country and provides equipment on rent. Additionally, it takes deposits of idle equipment and provides returns thereon to owners on their idle assets. The business model of Quipo, promoted by SREI Infrastructure and Finance with Ingersoll Rand, Swedfund and L&T as key stakeholders, has gained popularity. Its association with Ingersoll and L&T has also benefited the company by way of discounts on equipment purchases, after-sales support services and joint market development for rental services. Gremach Infrastructure Equipments and Projects is another player that rents out construction and earth-moving equipment.
Funding capacity expansion
Most of the ICE companies, in order to meet the rising demand, have embarked on capacity expansion. While the expansion in capacity has predominantly been focused on existing offerings, a few companies have also sought to expand their product portfolios. The funding of these capex plans has seen a differing trend across companies.
While companies such as Action Construction Equipment and Gremach Infrastructure tapped the primary market via an initial public offering, Bharat Earth Movers raised funds through a follow-on public offer. Given the overwhelming response to the public offers of these companies, more such companies could tap the primary market. Material-handling company Tecpro Systems, for instance, is slated to go the IPO way soon. Some companies, however, went the private equity way. Escorts Construction Equipment raised about $17 million from US-based Darby Overseas Investments. Quipo was another company that chose the private equity route; it attracted funding of about $50 million from GIC of Singapore and IDFC. Sanghvi Movers has also used debt to fund its expansion. Notably, Indian subsidiaries of MNC players have attracted increased investments from their parent company.
Foreign companies – eyeing the Indian pie
Given the growth prospects of this industry, it is not surprising that MNCs have marked their presence in this segment.
While some have set up Indian subsidiaries, others have formed strategic alliances with domestic players. The UK-based JCB and Germany-based Schwing Stetter have established proprietary businesses in the country. Notably, the Indian subsidiaries of both these firms have raked in significant business over the recent years — JCB India, for example, has evolved to become the group’s largest market, having recorded four times’ increase in sales over the last five years. Alternately, companies such as Terex Vectra, a 50:50 joint venture between Terex Corporation of the US and Vectra Ltd of the UK, have also etched their presence. Joint ventures and strategic tie-ups between global and domestic players has also been a popular model. While global equipment leader Caterpillar has an alliance with GMMCO, Komatsu has tied up with L&T. Hitachi Construction holds a 40 per cent stake in Telco Construction Equipment Company. This space could see more action with more foreign companies announcing plans to enter the Indian market. For instance, Scania of Sweden has announced its India entry with a tie-up with L&T. Yanmar Construction Equipment Company of Japan has also announced its India foray.
Critical success factors
The entry of several players in this space, while good for market expansion, has also increased the competition for existing domestic players. Further, increasing imports from low-cost countries such as China could also add to the pressure. In the light of increase in competition, factors such as distribution network, technology tie-ups, pricing strategies and after-sales service can emerge as key differentiators. While multinational companies have an edge over domestic ones when it comes to technology, the latter score in terms of the reach of their distribution network. Raw material cost, going forward, could also emerge as a significant challenge. In this context, global players with presence across various countries could be at an advantage if the cost dynamics were to shift in favour of some other country.
Market to remain volatile
The market may remain tentative ahead of the derivatives expiry on Thursday. The last few days have been choppy as the buying by domestic institutional investors was negated by the FII selling in both the cash and derivatives markets.
The signals on the derivatives front are mixed. The open interest in Nifty futures rose by 20 per cent to 34 lakh shares from 28 lakh shares last week. The PCR has been sliding and is currently 0.77 against 1.05 last week. This points to an oversold situation as more calls rather than puts are being written. But the implied volatility is still hovering around 30, which is higher than average, with both calls and puts trading at a premium. Implied volatility, which reflects expectations about future volatility, is lower when investor sentiment is bullish and tends to rise as bearishness and caution sets in.
There has been build-up in 5900 call options, which account for open interest of 26 lakh shares as on date. The open interest in the 6000 call options stands at 21 lakh shares. As far as the put open interest is concerned, the 5500 put saw a build-up of 20 lakh shares, while the figures for the 5600 put stood at 15 lakh shares. This demonstrates a wide trading range, in the immediate future.
Autos and FMCG stocks were the top gainers last week, whereas fertilisers and refinery stocks gave up some of their gains after the stupendous rally seen earlier.
Keep a watch on Escorts, Tata Tele and GMR as there was a huge build-up in open positions on these counters.
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