final report - spidi2.iimb.ernet.inspidi2.iimb.ernet.in/~networth/ccs/2005/577 term v ccs... ·...

A Study of Corporate Diversification in the Indian Context:

Does theory explain success stories?

Guided By

Prof. J Ramachandran Prof. Sourav Mukherjee

Indian Inst i tute of Management Bangalore

Final Report

Submitted On

November 21, 2006

In partial fulfillment of the requirements for the Contemporary Concerns Study Course

in the Post Graduate Programme in Management

Study done by Hariprasad Pichai 0511087 Lakshminarainan R 0511096

A Study of Corporate Diversification in the Indian Context: Does theory explain success stories?

Term V CCS by

Hariprasad P (0511087) and Lakshminarainan R (0511096)

2

Table of Contents

Abstract............................................................................................................................... 3

1. Introduction................................................................................................................... 4

2. History of ITC Limited................................................................................................. 7 2.1 Competition and early acquisitions........................................................................... 9

2.2 Changing with the political tide................................................................................ 9

2.3 Independent India and taxation woes...................................................................... 10

2.4 The turmoil of the 1960s......................................................................................... 11

2.5 Fighting in the marketplace .................................................................................... 12

2.6 Indianization ........................................................................................................... 12

2.7 Diversification......................................................................................................... 14

2.7.1 Early lessons in diversification ........................................................................ 14

2.7.2 Entry into the Core Sector................................................................................ 17

2.7.3 ITC on the "decade of transformation" ............................................................ 18

2.8 ITC's results today .................................................................................................. 24

3 Does theory explain ITC's evolution? ........................................................................ 26 3.1 Diversification - First principles ............................................................................. 26

3.1.1 Competencies and Strategic Assets ................................................................. 27

3.1.2 Diversification: Relatedness and Organization................................................ 29

3.2 ITC's diversification - The emerging markets perspective ..................................... 30

3.3 Idiosyncrasies and the Corporate Finance view of expropriation........................... 31

4. Conclusion ................................................................................................................... 34

References ........................................................................................................................ 36


Term V CCS by


3

Abstract

The objective of this study is to study corporate diversification in the Indian context, with

specific emphasis on ITC Limited. We begin by analyzing the history and evolution of the

company over the years, and its diversification moves at various times. We, then subject

the company to three different kinds of analytical lenses. The first, deals with viewing the

diversification of the firm under the resource-based perspective. We, then analyse the

firm from the emerging markets perspective. Finally, we also subject the company to a

study with respect to its idiosyncratic risks, viz. its core business which has been

rendered weak by non-market forces. Our conclusions draw upon the factors and

elements of available academic literature that seem to suitably explain the success of the

company, and draw inferences for the future course of the firm.


Term V CCS by


4

1. Introduction

The rationale behind corporate diversification in the developed world over the

decades has been well documented. By relaxing the assumption of perfect markets with

no transaction costs, various paradigms on value addition and destruction emerge, as we

observe multi-business firms through the lenses of management complexity, resource

allocation, availability and exploitation of synergies and strategic assets or core

competencies. Accordingly, we are able to identify related and unrelated diversification

strategies. Firms develop into conglomerates and business groups by venturing into new

and unrelated high growth business areas to chase top-line growth (by leveraging on

existing managerial or financial capital) or by employing strategic assets, resources and

core competencies to diversify into related areas. In either case, diversification demands

that the business group has a well articulated corporate strategy, even which needs to be

transcended towards defining a sense of “purpose” or an overarching vision, as the

business group spreads wings and enters diverse industries, geographies and markets.

However, these studies suffer from two shortcomings. The first is the difficulty to

distinguish related diversification from unrelated strategies, when observing the evolution

of a conglomerate. Often “relatedness” stems from hidden sources of competitive

advantage that help to generate value across businesses. It may also stem from a change

in the company’s own perception of the industries it sees itself operating in. Publicly

available information about a company may not give away the common uniting thread,

from preliminary inspection. The second problem has its basis in the changed contextual

setting, once we shift geographies to emerging markets, with tremendous untapped

potential and various sources of inefficiencies. It has been argued that multi-business

firms have strong incentives to defy theory and engage in seemingly unrelated

diversification in such economies. Further, factors which are unique to the economy, and

opaque to the rest of the world, may help gel two businesses together successfully under a

corporate centre.

For these reasons, there is a tremendous scope for moving beyond generic

frameworks and study individual conglomerates in the emerging economies, especially in


Term V CCS by


5

India. This will help us usefully identify gaps in management thinking, and help fine-tune

perspectives differently when applying strategic lenses across contexts.

Scope of this study

The scope of this present work is to study Corporate Diversification in the Indian

context, with ITC as the principal business group for analysis. The choice has been

motivated by the company’s rapid growth in the last few years, its multinational linkages,

the regulatory setting and constraints which are unique to the industries it operates in, the

distinct challenges imposed on the supply and distribution chains in various businesses

and the sheer diversity of its businesses.

Structure of the study

The report shall briefly analyse the historical evolution of ITC as a company,

attempting to study the contextual changes over the years and the reactive responses from

the company. This would be followed by tracing the company's early diversification

moves and its successes and failures in these moves. This would be followed by a study

of the second set of diversification, with an eye towards their entry into businesses as

varied as paper boards, processed foods, hotels and apparels among others. By attempting

to identify existing and developed competencies and strategic resources that ITC employs

across businesses, we speculate on the synergies and positive value that they added to the

corporate centre.

We begin our review of academic literature by examining Levitt (1960), one of

the earliest works that urged strategic thinking by firms to identify their precise scope of

operations. Porter (1987) and Prahalad and Hamel (1990) are the two widely-cited

seminal works that attempt to explain why and how should firms diversify. Based on

these studies, we examine some common opinions about diversification ranging from

Goold and Luchs (1993), Markides (1997), Collis and Montgomery (1998) and David


Term V CCS by


6

Garvin (2004). Noting these, we examine academically cited strategies for related (2005)

and unrelated (2005) diversification.

Beginning with Khanna and Palepu (1997), serious academic studies began to

emerge on the applicability of diversifications strategies in the emerging markets. The

frameworks suggested were extended in further studies by the Khanna, Palepu and Sinha

(2005) and Khanna and Palepu (2006), which form the focal point for our comparisons

with ITC's evolution over the years. We contrast these views with a more contemporary

study by Kali and Sarkar (Nov 2005), who claim that Khanna and Palepu's assumptions

of firms in emerging markets diversing to fill institutional, may no longer be valid in the

Indian context. We study ITC through these lenses and attempt to see if these academic

notions explain the firm's evolution.

When using ITC as a company for comparing emerging market strategies, it is

important also to consider the idiosyncratic characteristics of its core business that drives

its needs for diversification. Various studies including Stulz (2005) and Jensen (1986)

have theorized the incentives for managers and corporate insiders to diversify in a

scenario where the businesses run the risk of expropriation by various means. The studies

have been followed by Beneish and others (2006), who have tried to explain

diversification motives in the tobacco industry. In applying these frameworks, we attempt

to better understand the term "relatedness", when applied to activities that are not covered

under conventional literature, and see if ITC's diversification activities have been related

in this context.


Term V CCS by


7

2. History of ITC Limited

ITC's history is over a hundred years old. In September 1902, two of the biggest tobacco

firms in the world, American Tobacco Company and Imperial (Great Britain & Ireland)

agreed to end their decade-long price wars across the Atlantic on each other's soils, which

was eroding each other's margins. Under the terms of the agreement, the companies

decided to utilise each other's brands in their exclusive areas of dominance, and set up a

third entity called British American Tobacco (BAT) to handle trade outside the UK and

the US. Compelled by the terms of its constitution, BAT, quickly began to explore world

markets, and it was not long before it set its eyes on India. Though tobacco was

introduced to India at the end of the sixteenth century by the Portuguese, it was smoked

either in the chillum of a hookah or as "bidis" (raw tobacco rolls) or was simply chewed.

It was not until the late years of the nineteenth century, that cigarettes became popular

forms of tobacco. As various firms from Great Britain and America began to realise the

existence of a vast, untapped market in India, they began exporting and selling cigarettes

through selling agents.

Soon after BAT entered India as a unified entity, BAT moved ahead to establish its

manufacturing arm - the Peninsular Tobacco Company and established a factory in

Mungher, a backward town in the eastern state of Bihar, chosen for its proximity to

tobacco cultivating areas. The setting up of a local manufacturing arm served BAT's

interests because of increasing duties on manufactured cigarettes in the UK and the

subsequent decline in profits for imported cigarettes. Faced with increasing demand for

locally manufactured cigarettes, Peninsular Tobacco set up its second factory in

Bangalore. In 1924, a third factory came up in Saharanpur in UP. BAT soon realised that

procurement of local tobacco and processing it to make it fit for cigarette manufacturing

was cumbersome and operationally intensive, and decided to set up a separate entity to

handle these critical processes. This entity, established in July 1912, was called the Indian

Leaf Development Company (ILDC). ILDC also established itself in tobacco-growing


Term V CCS by


8

areas of the southern belts of what is today the state of Andhra Pradesh, called the South

India Leaf Area (SILA).

On 24 August 1910, signaling its seriousness in the Indian market, BAT set up the

Imperial Tobacco Company of India Limited, a full-fledged selling organization as its

third Indian subsidiary, with an authorized capital of Rs. 1000. It is this company that

would metamorphose itself into ITC, one of the biggest companies in the Indian

corporate landscape, with a market capitalization of over USD 3 billion by 2006. Imperial

Tobacco, handled BAT's brands and goodwill assets and the selling operations in India,

Burma and Aden. It began to operate out of a small leased office in Calcutta (the then-

capital of colonial India). It took 16 years for the company to purchase its first plot of

land at the busy Chowringhee Lane for a princely sum of Rs 310,000. It is on this plot of

land that Imperial Tobacco built "Virginia House" - the building that serves as ITC's

headquarters till date. Imperial Tobacco, was one of India's first ever pioneers of branded

advertising. Its first task was to "educate the people about the pleasures of smoking

cigarettes", and promoting the brands that were both imported and locally manufactured

out of its Indian factories using direct selling through enthusiastic salesmen and mass

advertising. Sales soared and Imperial Tobacco

In the next couple of decades, BAT reorganized its operations in India, and Imperial

Tobacco acquired all assets of BAT - including its holdings in Peninsular Tobacco and

ILDC, and effectively became its single largest subsidiary in India, handling the entire

gamut of BAT's tobacco operations. By the late twenties, Imperial Tobacco had set up an

extensive distribution chain, which was necessary for cigarettes, which by its nature was

a perishable product, and whose frequency of purchase was many times that of other

consumer products in vogue. The company wired the length and breadth of the company,

adding sub-streams to existing channels, as volume of sales increased until it managed to

reach hamlets and villages, hitherto inaccessible, thereby providing a key strength that it

continued to exploit for years to come.


Term V CCS by


9

2.1 Competition and early acquisitions

The success that Imperial Tobacco enjoyed in the initial years was soon eclipsed by the

political storm that was pervading the country. The Civil Disobedience movement of

1930's, launched by nationalists against foreign owned products in their struggle for

Indian independence brought its selling machinery to a standstill. Alarming decline in

sales, led to a shutting down of the Saharanpur factory and heavy retrenching of staff.

The damage suffered because of the 1934 earthquake by its Mungher factory added to the

company's woes. It was in this atmosphere that a little known company called Vazir

Sultan based out of Hyderabad began manufacturing a brand of cigarettes called

Charminar that quickly became a hit with the country's smoking population, and

threatened Imperial Tobacco's near monopoly of the Indian market. Threatened with

extinction, BAT moved in to buy out the company. Similarly, Carreras (India), a

company with British origins began to challenge Imperial's dominance of the cigarette

market with its Craven A brand. Carreras and its Kidderpore factory (which today

produces the Scissors brand) were also soon acquired.

However, acquisition could not be the universal route to responding to competition, as

Imperial soon learnt. Godfrey Phillips, the UK firm, carved for itself a niche segment in

the cigarette market in North India, with its elite brands. National Tobacco, an indigenous

company set up during the 1930s, was yet another company that competed with Imperial

in many of its target segments. The principal thorn in Imperial's flesh was Golden

Tobacco, the company that was engaged in a bitter battle with Imperial's brands with its

Panama brand for a good part of the next fifty years. By the time of Indian independence

in 1947, Imperial had realised that the competition was here to stay, and was engaged in a

number of political and strategic battles to keep its hold on the cigarette market.

2.2 Changing with the political tide

During the Second World War, demand for cigarettes peaked, and Imperial's production

machinery were running at peak load. The increased business as a principal supplier to

the warfront, there was a new-found self-reliance that was seen in the company. The


Term V CCS by


10

company was grappling with shortage of availability of raw materials to its cigarette

factories. The government had during and after the war, declared cigarettes as a non-

essential industry, and had expressed serious reservations at allowing the continuous

import of raw materials to sustain production of cigarettes. The company was heavily

reliant on imported raw materials, and the difficulties in mobilizing supplies during the

war, forced it to look inward for substitutes. By entering into co-operative arrangements

with local suppliers, with occasional equity investments into joint ventures, the company

began to satisfy its paper, boards, foil and viscose film requirements - key ingredients

which go into the making of cigarette cartons. The next few decades witnessed the

company adopting the country's move to substitute imports and began to look for local

substitutes for raw materials, for which it was heavily dependent on suppliers abroad.

Imperial Tobacco's share of imports (of materials other than tobacco) fell from 80% to

30% between 1940 and 1950, and further down to just 5% by 1957. The company was

clearly moving along with the political tide, and an indirect effect of this was an

inevitable drift from the practice of consulting BAT on every single issue and reduction

in the extent to which the parent company micro-managed its affairs. This was the first

step towards decentralization of the company, which would have a significant impact in

its path to growth in the coming decades.

2.3 Independent India and taxation woes

With Indian independence and partition, came the company's own experience in the

division of its market and assets. The company's East Bengal and West Pakistan

operations were handled by a newly set up entity called Pakistan Tobacco Company. The

new political system in India, with a focussed nationalist and socialist mindset, was a

wake up call for a company that had been enjoying a virtual monopoly in a seller's

market and high profitability. The government quickly moved in to establish industries

locally to promote competition, and put in place regulatory control mechanisms to

oversee the reduction of balance of trade bill. In 1948, cigarettes were subjected to excise

duties (a form of taxation on the gross revenues). This was followed by heavy regulation

on import of raw materials and finished cigarettes into India. The company initially

reacted to the imposition of additional duties with a willingness to comply and an attitude


Term V CCS by


11

of transparence in revealing statistics to the government. However, this was largely

crippling to the tobacco industry, which found it to be a source of huge revenues to the

government that could not be resisted by any means. In an environment of decentralized

taxation, various states and even municipalities began to levy sales taxes and duties on

the sale of cigarettes. The government found that the revenue generated on taxation on

non-essential commodities like cigarettes helped to finance its five-year plans to develop

the Indian economy, and no amount of lobbying could achieve the withdrawal of ever-

increasing taxation on tobacco items. Within a short period, excise duties were to become

the single largest element in cost of production of cigarettes, and were a major drain on

profitability of Imperial's operations. The company's key competitive strength - its

extensive distribution system, was also stretched to the limits by this time. The company

had to move away from the cash-based system in its earlier years, to a credit-based

system for its distributors. This mandated that the company would pay for the inventory

burden almost unto the point at which manufactured stocks reached the retailers. The

increase in excise duties, was not only a drain on the profitability of the company, but

also had a significant impact on the working capital requirements of the firm.

2.4 The turmoil of the 1960s

Imperial Tobacco, had adopted a production-oriented approach till the regulations hit it

hard, and was comfortably perched in a monopolistic and highly profitable business. It

had a market share of 70% of the cigarette market, and a large part of the remaining pie

was in the hands of BAT's other subsidiary Vazir Sultan. Any new launch was an

inevitable success in a market with limited choices, and brand decisions were largely

arbitrary. The company's marketing machinery had been secure in its belief in the

unassailability of its brand leadership, market standing and profitability and did not sense

the need to ramp up its efforts with innovative campaigns. Firm in its belief that its

brands will continue to rule the roost, the company raised prices on its brands steeply to

levels much above its competition to sustain its profitability that began to erode on

continued taxation pressures. However, the moves backfired and very quickly, several of

Imperial's brands were wiped out overnight, their places taken by less-priced brands from

local players like Golden Tobacco and National Tobacco. The company's market share


Term V CCS by


12

fell to less than 40% in 1961. This trend coincided with the company's adoption of a new

distribution system introducing stockists and eliminating wholesalers, with a view to

reduce the cash cycles. This system, highly resented by the channel further aggravated

the troubles for the company.

2.5 Fighting in the marketplace

Beginning with 1960s, Imperial could not ignore the pangs of competition. Traditionally,

players like National Tobacco displayed greater innovation and resilience to competition

to the firmly established Imperial Tobacco. National Tobacco, besides being the

produced of filter-tipped cigarettes also was the producer of the first menthol cigarettes. It

also drove various bold pack design changes in various segments of the market that

continued to threaten Imperial's position. Godfrey Phillips, also innovated with branded

lifestyle advertising with Four Square Kings (a strategy that ITC would adopt later with

its Wills brand) and made inroads into the high-priced segment. In contrast, ITC firmly

believed in established trade marks and marketing practices and it was not until the

seventies, that it woke up to the realities of the marketplace, and innovation became a

new weapon against its competitors. The change in the culture of the company was

dramatic. The complacence of the early fifties gave way to a healthy attitude of criticism

and self-appraisal. By overhauling its market research, product development, printing and

packaging and distribution, ITC began to fashion itself to face the future as a dynamic

organization

2.6 Indianization

In 1968, Imperial Tobacco undertook a bold decision to promote Ajit Narayan Haksar,

the Director of Marketing as its first Indian chairman. In 1970, Imperial Tobacco changed

its name to India Tobacco Company Limited, commonly abbreviated as ITC. It appeared

that BAT and ITC were on a conscious effort to rebrand the firm as Indian, in tune with

the nationalistic undercurrent that was sweeping the country and the government in the

post 1969 nationalization phase. However, things were not as successful as ITC would

have hoped it to have been. All industries were subjected to heavy licensing regulations,


Term V CCS by


14

2.7 Diversification

ITC's second element in its strategy to grow a sustainable organization was to divest into

various high growth businesses. By 1975, ITC already had leaf, printing and packaging

and papers businesses under its fold, though these were considered integral divisions of

the company which served its cigarette production operations. Under the MRTP act, large

companies were heavily regulated and restricted from entering new businesses - even

those where they do not automatically enjoy monopoly or dominance. They were

however permitted to enter into sectors defined as core such as cement, fertilizers or

heavy machinery. However, BAT, the majority shareholder remained skeptical of

investment in capital-intensive industries, which it believed would necessitate further

equity infusion which would dilute its stake, and the long gestation period would put a

tremendous strain on an already dipping profitability. ITC found itself caught between

two different priorities - managing the shareholder's interests along with the conflicting

goals of the government.

In 1975, ITC decided on three priority areas for diversification - a decision which was

influenced by its ability to earn substantial foreign exchange. The three areas were

Hotels, General exports and Marine foods. Marine foods and general exports were

expected to rake in immediate foreign exchange earnings, while the hotel business which

had a long gestation period would be the investment for the future, catering to the tourism

sector in addition to generating employment.

2.7.1 Early lessons in diversification

2.7.1.1 Marine foods business

In 1971, ITC went ahead with its marine foods business. Within four years, the business

generated foreign exchange revenues worth Rupees 4.7 crores. However, within the next

few years the division collapsed as export sales dwindled. Lack of experience in the

marine business, had prompted the company to engage external processors to handle

processing and exports of the company. Lack of supervision, and negligible quality


Term V CCS by


15

control resulted in large-scale rejection of consignments from importing countries and as

these were perishable commodities, such losses could not be recovered. Unethical

practices like concealing processing charges by the contracted parties further added to the

losses, and the firm decided to take matter into its hands and handle operations by it. By

purchasing and operating trawlers and handling the entire processing operations, ITC

managed to cut down the losses. The company had to learn the ropes of managing

operations of perishable products. Trawling for fish was described as akin to drilling for

oil, and the unpredictable nature of the catch was compounded by requirements of a

round-the-clock processing facility, to make the proceeds fit for exports. Absence of a

widespread network and lack of bargaining power in the international markets led to

dwindling scale of the operations and export earnings fell sharply to Rs. 1 crore by the

end of the decade. In 1979, ITC closed down the marine products business after intense

discussions among the management.

2.7.1.2 General Exports

ITC's second area of diversification was in general exports. Sensing a huge potential for

growth and foreign exchange revenues in this business, ITC rationalized its entry on the

basis of its superior marketing expertise in its core businesses. It believed that its

excellent relationships and negotiation skills with suppliers, wholesalers and distributors

could prove to be crucial assets in this business. ITC decided to specialize in garment

exports and engaged associate companies in the finishing business of completed

garments. However, soon it became clear that ITC's traditional skills were not

transposable when engaging with a whole new set of partners. Garment exports, were

sensitive to fast changing fashion trends and were in some sense "perishable

commodities". Without adequate exposure to market trends in the importing countries,

ITC could not plan operations for the future. It dealt with this problem by setting up a

joint venture in the US with local dealers called David Page Limited. However, this

enterprise was soon mired in lawsuits brought about by its partners in the US, and had to

be abandoned. Several steps to increase efficiency and control of operations were taken,


Term V CCS by


17


Term V CCS by


19

1982, ITC divested the printing and packaging business as a separate division, handling

various customers for their packaging and printing needs.

2.7.3.2 Paper and boards

Paper business was literally forced down the company's throat by political circumstances.

During the second world war, faced with increased demand, Imperial tobacco found itself

short of raw material supplies for which it was heavily reliant on imports. The company

turned to local suppliers and despite initial difficulties, it was able to utilise local

suppliers to satisfy almost its entire requirements for cigarette paper. This proved not

only to be a successful cost-effective strategy for the company, but also exposed and

facilitated local suppliers to the quality requirements of international players, and spurred

them to upgrade their technology to the requisite sophistication. In the post-war period, in

1950, BAT realised the potential of sourcing paper, and set up a separate entity to supply

to Imperial's operations as well as to cater to exports.

The boards business had a similar history. Bolstered by the Government of India's policy

of import substitution in the post-war period, Imperial Tobacco invested heavily in

sourcing bamboo pulp, and manufacturing duplex boards. Imperial's efforts to develop a

specially designed corrugated fiberboard container (CFC) had far-reaching applications,

beyond making cigarette packaging materials. Several industries began to adopt CFCs,

which proved to be cheaper and of much better quality than wooden cases. However, ITC

did not formally enter the paperboards business until the late 1970s. As ITC faced

continued pressures from the government to enter capital-intensive industries, it finally

decided to enter into the paperboards sector. ITC was assured of excise reliefs, sales tax

concessions, and stability of power during the gestation periods for any new ventures.

However, due to the familiar concerns over the impact on the balance sheet, ITC decided

to keep the entity as a separate subsidiary without internal funding. In 1977, it set up the

Bhadrachalam Paperboard Limited (BPL) with facility in the Godavari river belt in

Andhra Pradesh with an installed capacity of 40,000 tonnes at a cost of Rs. 44 crore. ITC

held 32% equity in the venture, financial institutions held 39.57% and the remaining


Term V CCS by


20

share equally divided between BAT-controlled Vazir Sultan and the public. With ITC's

proven expertise in papers and boards from its packaging experience, a modern plant that

was set up in a record time, professional management and committed workforce,. The

factory quickly achieved excellent productivity from 71% in its first year of operation to

131% in 1983-84. However, efficient operations did not translate into profitability as the

governments failed to deliver on tax concession promises. Though BPL's EBITDA

continued to be the best among comparable paper and paperboard industries, it was

struggling at the bottom-line. as it continued to add capacity and by 1992 had achieved a

capacity of 62,500 tonnes - around 75% of the licensed capacity. As ITC itself was a

huge consumer of paperboards, the venture managed to stave off the vagaries of demand

and supply.

2.7.3.4 Agricultural Businesses

ITC's agri businesses can be broadly divided into agricultural exports (broadly through

the eChoupal initiative) and more importantly its leaf tobacco development division. The

leaf tobacco division (ILTD) is the largest buyer, processor and exporter of cigarette

tobaccos in India with a presence of over 90 years. With export of over a 100 million kgs

of tobacco to over 37 countries, the division has assisted farmers in growing quality

cigarette tobaccos. In the recent past, having proven its competencies in the procurement

of agricultural products, storage and supply chain management, ITC-ILTD is venturing

into the spices business. The entry into branded spices will further boost ITC's efforts to

export India's agricultural products.

2.7.3.5 The eChoupal initiative

Many of Y C Deveshwar's initiatives within ITC were actually seeded before he began

his stint as the CEO. ITC's non-tobacco businesses like hotels, paper boards and

packaging were doing reasonably well even as he assumed charge. When he took over, he

cleaned up the mess inherited in the agricultural businesses (sold to Conagra) with huge

write-offs.


Term V CCS by


21

In 1999, ITC was on the verge of closing its international business division (IBD). The

eChoupal initiative came from S. Sivakumar, CEO of IBD who decided to give it one last

try. While sourcing soya in Madhya Pradesh, the IBD team used to see farmers lug their

produce in trailers to the local mandi. Then, ITC would buy the produce from the mandi

and bring it to its processing hub. Not only did ITC end up paying each intermediary at

the mandi, but the farmers also got cheated at the mandi. The insight for the e-Choupal

idea came from a need to re-engineer this supply chain so that both the farmer and ITC

gained.

At the annual planning meet in 1999, Sivakumar presented an alternative business plan

which made a bet that information and communications technologies would help source

agri commodities efficiently. At first glance, it wasn't a simple idea to grasp. But

Deveshwar, his chief financial officer and his IT head spent several hours reviewing the

plan with Sivakumar, before giving him the go-ahead to experiment. ITC’s International

Business Division, one of India’s largest exporters of agricultural commodities,

conceived e-Choupal as a more efficient supply chain specifically designed to tackle the

challenges posed by the unique features of Indian agriculture, characterised by

fragmented farms, weak infrastructure and the involvement of numerous intermediaries,

among others. The backing provided by Y C Deveshwar was crucial.

The eChoupal model works with a judicious blend of click & mortar capabilities for

information access and actual supply chain activities: the e-choupal can be thought of as

an Internet kiosk, village gathering place and e-commerce hub all rolled into one. Real-

time information and customised knowledge provided by ‘e-Choupal’ enhance the ability

of farmers to take decisions and align their farm output with market demand and secure

quality & productivity. The aggregation of the demand for farm inputs from individual

farmers gives them access to high quality inputs from established and reputed

manufacturers at fair prices. As a direct marketing channel, virtually linked to the

‘mandi’ system for price discovery, ‘e-Choupal’ eliminates wasteful intermediation and

multiple handling. Though repeatedly beset with problems like recruiting Sanchalaks


Term V CCS by


22

(who play a critical role), infrastructural hurdles like power, connectivity issues and an

apparently overambitious goal of covering 100,000 villages in five years, ITC gained

considerable credibility among the masses by a focused value proposition: that of

delivering better prices to the farmers for their produce, be it soya, shrimps or wheat.

To enhance the productivity of the choupal network, ITC has started distributing the

products of 45 companies in the public and private sectors with products ranging from

FMCG goods to agricultural inputs. It also used the same network to distribute financial

products like life and weather insurance policies. The rural distribution initiative's

channel transaction value was worth nearly Rs. 100 crores. Furthermore, the eChoupal

initiatives helped ITC mount a direct challenge to HLL's five decade long position as the

most respected consumer product marketer in India. In an effort to pry open these rural

markets, the two firms have launched divergent models (ITC e-choupal intervention and

the HLL Shakti initiative) that claim themselves to be sustainable and scaleable.

The rural retail chains followed the distribution network. ITC, in an effort to pry open the

rural market, launched the rural hypermarket 'Choupal Saagar' in a little known place in

Madhya Pradesh in 2005. The malls would be a replacement to the age-old kirana or

retail shops. The concept was extended to three states by 2006 and was intended to set

new benchmarks in the shopping experience offered to rural consumers. Built at a cost of

Rs. 5 crores each, the Choupal Saagar would double up as a shopping centre and a farmer

facilitation unit providing facilities like soil training, soil testing, health clinics, cafeteria,

bank, investment counters and fuel stations. The malls are linked to the e-choupal

network and are designed to sell everything from fertilisers and hair oil to mixer-grinders

and tractors.

Close on the heels of the eChoupal initiative, ITC also launched the Sunehra Kal (Golden

Tomorrow) initiative directed at improving the lives of the rural people with focus on

cattle, finding market and bank linkages for livelihood activities, water harvesting and

water management etc., Though not directly related to ITC's businesses, it was felt that


Term V CCS by


23

this was the best way to spend the money allocated for Corporate Social Responsibility

and use this mechanism to improve rural areas.

2.7.3.6 FMCG - Foods business

ITC made its entry into the branded & packaged Foods business in August 2001 with the

launch of the Kitchens of India brand. A more broad-based entry has been made since

June 2002 with brand launches across the Confectionery, Staples and Snack Foods

segments. Despite being a low-margin business with high built-in overheads for large

companies and demands for a strong supply chain, ITC went ahead with the launch. ITC's

foods business is today divided into the four categories: Ready-to-eat foods, Staples,

Confectionary and Snack foods with strong brands like Kitchens of India, Aashirvaad,

Sunfeast, Mint-O and Candyman. Key to the foods venture was ITC's growing

effectiveness in leveraging its knowledge of the supply chain for agricultural product. Its

e-choupal initiative enhanced its ability tonsure quality supply for its wheat products like

Aashirvaad Atta, which quickly became the national leader in the organized atta market.

ITC also quickly moved in to build outfits foods portfolio by acquiring brands like Mint-

O in categories that it was not present earlier. It also adopted regional marketing

techniques to popularize its SunFeast biscuits range which grew to garner 7% market

share in 2 years.

Even though the foods business was not profitable in the initial years, ITC persisted with

the business. From outsourcing its foods processing / manufacturing to over 25 units, ITC

is moving to its own manufacturing plants in tax-exempt zones to further reduce the

overheads. In FY 2005, ITC recorded a growth of 87% over the previous year. Product

portfolio was further augmented to offer over 100 distinct food products. The Ashirvaad

Atta range increased its market share to 45% establishing itself as the clear leader in the

market. ITC has so far taken on the entrenched players Parle, Britannia and HLL

successfully across multiple categories by consistently backing the foods venture.

However, competition was bound to intensify with the planned entry of players like

Reliance and smaller regional players who had similar reach and capabilities in


Term V CCS by


24

distribution. In 2006, ITC foods, generating revenue of Rs. 1011 crores was poised for

the next big push in delivering value to the Indian customer under various categories of

products.

2.7.3.7 Lifestyle Retailing

ITC started out its foray in the ready-to-wear apparel market by extending its most

valuable cigarette brand 'Wills' in 2000. It marked its entry into Lifestyle retailing

business with its first store in Delhi and scaled up to 48 stores across the country by 2002.

The key idea behind the Wills Lifestyle chain stores was to have a test bed for the

clothing market, understand consumer preferences and use this as a launching pad for

other new brands along with Wills for different segments of the ready-to-wear market.

ITC's current portfolio of product offerings spans the entire range of usage segments

under different extensions of the Wills brand: Wills Classic, Wills Clublife and Wills

Sport. ITC expanded its offering by establishing a significant presence in the high-growth

mid-priced segment with its 'John Players' range sold through more than 3000 multi-

brand outlets across the country.

Leveraging the Wills Brand was a logical choice. According to the chairman YC

Deveshwar, "We wanted to build on the brand that is already well-known". Earlier

government restrictions on advertising for tobacco products had also placed ITC at a

disadvantage while foreign brands were still able to advertise on international channels

beamed into Indian households.

In 2006, Wills Lifestyle also launched a slew of lifestyle products including perfumes and

other accessories. Post the dismantling of the quota regime in garments; the business

commenced the exports of garments. In the long run, the Wills trademark was to be

positioned as "the leading Indian international brand with a significant global presence".

2.8 ITC's results today


Term V CCS by


25

In 2006, ITC Limited, reported gross revenues of INR 16500 crores (USD 3.77 billion).

The company's pre-tax profit of Rs. 3269.19 crores (USD 740 million) was the third-

highest among those posted by Indian private sector companies. The company generated

for its shareholders an annual return on equity of around 25%, and had a strong balance

sheet with near zero debt. The company had a diversified presence across various

businesses ranging from Cigarettes, Hotels, Paperboards & Specialty Papers, Packaging,

Agri-Business, Packaged Foods & Confectionery, Information Technology, Branded

Apparel, Greeting Cards, Safety Matches and other FMCG products. In July 2005, ITC

Limited announced that it will be entering into personal care products.


Term V CCS by


26

3 Does theory explain ITC's evolution?

3.1 Diversification - First principles

Levitt (1960) sought to explain why industries perceived as in the declining phase, appear

to be so, not so much because of the factors in the environment changing, but as a result

of "myopic management" who narrowly define the scope of industries that their firms

should be operating in. The paper discussed the importance of the firms to be oriented

towards the customer in order to spot the ground beneath their feet shifting quite early.

The customers might just be shifting to a product that is not presently under the field of

vision of the firm or industry, thereby creating an illusion that the market is on a decline.

While Levitt explained the existence of myopia, he did not probe if and how a firm can

take corrective steps to rectify this defect. Porter (1987) sought to focus on corporate

strategy as that which makes a conglomerate of multiple businesses adds up to more than

the sum of its parts. Corporate strategy, (as differentiated from competitive strategy of a

single business firm) seeks to address two different questions: what businesses the firm

should be in, and how the corporate office should manage those businesses. Porter notes

that corporate strategy should grow out of and reinforce competitive strategy, and should

nurture the success of every business unit. By noting that diversification by companies

have obvious and hidden costs that accrue discounts in valuation, and that shareholders

can diversify themselves to match their risk profiles and preferences, he argues that there

should be a really solid argument for companies to diversify. The new industry must be

attractive, the future profits from the acquisition should not be capitalized by the entry

costs and there should be some level of synergy in either the new unit or the old units as a

result of the acquisition. In Porter's view, if a firm seeks the portfolio management route,

it would require that the firm is able to spot industries, which is out of reach to the

average shareholder, which lack only capital and otherwise show great promise in the

form of excellent operations and management.


Term V CCS by


27

When ITC ventured into marine foods and general exports, it went ahead by pouring in

capital and contracting the operations and management to outside parties. This suffered

because of two distinct reasons:

• The new industries required an entirely different set of skill levels that ITC was

not equipped with.

• A hands-off management style in itself was flawed in an industry where intense

operational and management control was required.

By first principles, it seems retrospectively obvious that ITC's first two entries would not

have been successful.

3.1.1 Competencies and Strategic Assets

Prahalad and Hamel (1990) extended the thinking on diversification further by suggesting

that firms should stop thinking in terms of strategic business units or core businesses but

instead concentrate on building competencies that

a) Provide access to a wide variety of markets

b) make a significant contribution to perceived customer benefits

c) be inimitable by competitors.

When applied to ITC, one can identify two distinct candidates for core competencies -

strong customer-orientation (being the pioneer among market research in the Indian

markets) and a strong supply chain. ITC's moves to extend itself from "satisfaction to

leisure", when entering the hotels business and later into the FMCG goods businesses are

notable move to leverage on its customer-orientation. Its ability to construct a world class

sourcing chain removing information hurdles in the agro businesses, and thereby locking

in on key resources may be argued as furthering its sourcing and distribution advantages

in a product market whose success was increasingly being decided in the rural market.

Goold and Luchs (1993) further speculate that apart from synergies (emphasized by

Porter) and core competencies (as espoused by Prahalad and Hamel), businesses need a


Term V CCS by


28

fit between the new businesses and both the dominant logic and management style of the

firm. By signaling a strong shift towards the FMCG industries in the late 1990s, ITC

Limited's top management sought to project the entire operations of the firm as focussed

towards strengthening the supply chain across fast moving, perishable products that

formed the basis of almost all its industries. This overarching perspective fit well with

their new agro and foods businesses and allowed the company to take on these two

businesses without major conflicts with its tobacco business.

ITC's sourcing and distribution chain and customer orientation were the twin strategic

assets that seemed to have answered the concerns of Markides (1997) as well. By

ensuring that the new businesses nurtured and not break these critical strategic assets,

ITC ensured that it was just not a new player in the FMCG foods business, but could give

its competitors a run for their money. ITC is well-poised to take advantage of arguably

the most critical question in Markides' argument - "What does the firm learn by

diversifying and is it sufficiently organized to learn it?” ITC's branded foods business has

taken strong, positive steps to avoid the pitfalls of the mindless brand extension practiced

by HLL, induced by internal organizational pressures. Its phenomenal success in the

biscuits segment, a test market for its "Sunfeast" brand would help it to extend

judiciously into related customer products. The understanding of the customer achieved

out of its e-choupal initiative, will pave the way for it to enter the rural retail market in

the form of "Choupal Sagars". This studied but committed movement into various inter-

related businesses are in sync with the three phases (Experimentation, Expansion and

Integration) as suggested by Garvin (2004). ITC seems to have crossed the

experimentation phase in the FMCG business, having firmly unlocked not only for itself,

but for the entire industry, the potential to make money in the legendary "bottom of the

pyramid", both on the sourcing and on the distribution side of the value chain. It is now

involved in the expansion phase addressing key questions as to how should further

investments be made, new resources obtained and achieve a quick break-even point. As

of November 2006, none of its non-tobacco businesses are cash-positive (arguably due to

heavy investments). It remains to be seen if ITC can successfully lead its portfolio of

activities to the integration phase, leading itself to long-term success.


Term V CCS by


29

3.1.2 Diversification: Relatedness and Organization

Another traditional way to look at diversification is to see if it is related or unrelated. This

is probably where Levitt's initial idea of marketing myopia has been fine-tuned over the

years. As Collins and Montgomery observe, "relatedness", today is defined in terms of

resources and not the products. This is corroborated from the evolution of strategic

thought, as observed from the later works of Prahalad and Hamel and Markides -

decidedly towards the resource-based view. If ITC's strategic assets or resources in terms

of strong supply chain and customer orientation are to be considered as related across

multiple businesses, they can be subjected to the questions raised by Anand (2005). The

motive for ITC to expand into FMCG seems to be both defensive, escaping a weak core

(caused by the non-market effects of being in the tobacco business) and offensive (taking

advantage of the current strong flows from the tobacco business to enter promising

growth opportunities). In addressing the attractiveness of the agro products and the non-

tobacco FMCG industries, ITC has distinctly identified the supply chain, as the key

component, where it can change the context by its superior operation skills and add value.

Entry into lifestyle retailing provides a strong identity with the tobacco brands, as

surrogate advertising (though it could prove to be unsustainable in the long run), thereby

providing for some level of scope synergies.

We can argue that ITC has not reached a phase where it could answer the last two

questions, (which touches upon Garvin's third phase - integration). If ITC is to become a

full-fledged FMCG company, with cigarettes as one of its arms, at some stage it has to

move away from the SBU-driven model to a functional one. The reason why it has not

done so already could be the different phases of maturity in each of its businesses - while

it experiments with consumer products, and expands its foods business, it is treading

cautiously on cigarettes on which the future non-market trends are not clear. At some

stage, ITC Limited will be forced to look at the three businesses as a single entity, if it

has to become a serious FMCG player that has truly arrived on the scene. At this

integration phase, will lay the critical challenge for ITC, when it tries to straddle the three

arms of corporate strategy - Resources, Businesses and Organization (Collins and


Term V CCS by


30

Montgomery, 1998). ITC currently nurtures and employs key resources to businesses (to

gain competitive advantage), and is in the process of framing a suitable organizational

model to employ these resources in co-ordination. In the integration phase, when each

business becomes self-sufficient, will come the crucial question at the third node, how to

gel the organization with the businesses to achieve a suitable control from the corporate

centre. The degree, measure and effectiveness of control will decide at this phase, if

diversification has been ultimately successful, and if the businesses are indeed adding

value to the corporate whole. This will require suitable adaptations to the three arms, with

specific emphasis on the corporate office size.

3.2 ITC's diversification - The emerging markets perspective

Khanna and Palepu (1997) proposed that conglomerates can be seen to add value in

emerging markets because of the absence of well-endowed institutions that can help

nurture the market systems. In particular, they help by filling the institutional voids in

product, capital and labour markets. They followed it up with their study (2005) which

provided a checklist of factors that can help to spot institutional voids in the product,

capital and labour markets, as well as in the overarching political and social system and

the openness of the host country for ideas from other markets. Once, these voids have

been identified, the choices facing the firm is to adapt and work around these voids,

without compromising on its key competitive advantage, change the context or to exit.

ITC's early evolution strongly suggests its diversification to be motivated by the

existence of institutional voids. Scarce foreign exchange reserves and lack of

infrastructure motivated it to move into exports, cements and hotels.

Though, it is sometimes argued that ITC was motivated to hark on its eChoupal initiative

to fill up an institutional void, we argue that this may not be entirely true. While ITC has

definitely employed information technology to iron out traditionally existing lumps in the

distribution chain, its primary motivation to move into the FMCG business was, (as

argued earlier under various frameworks), a strategic choice that helped it to avoid the

non-market issues facing cigarettes and the extension of its resources into allied

businesses. Once, the entry had been decided, ITC saw itself operating in a market where


Term V CCS by


31

it could work around institutional voids better than any other competitors. The e-choupal

experiment was a method for ITC to test the waters in the "local" and the "BOP" segment

in the four-pyramids view of the market, which seems to have taken off well. This view is

supported by the recent stance taken by Khanna and Palepu (2006), which explains the

rise of ITC as a giant in the local context, leading up a strong challenge to HLL (and all

set to take on P&G). The other factor, as explained by the authors could be the

commitment to execute and govern the organization efficiently. The applicability of

Khanna and Palepu's theory of diversification to fill institutional voids have been recently

questioned by Kali and Sarkar (2005), who postulate that recent data throws up other

factors. They suggest that business groups in India are able to generate positive value

because of (among others) the ability of cash-rich businesses to "prop up" the starving

ones, through the period of growth by capital infusion. In ITC's case, this argument

definitely finds favour. ITC's cash-rich tobacco business is propping up the expanding

foods business.

Further, if we are to assume that ITC's diversification, indeed follow the institutional

voids argument; it is subject to threats proposed by Anand and Jayanti (2005), which is

the continuous improvement of the markets and from internal organizational challenges.

The sustainability of the e-choupal model has been questioned publicly by internal

sources (by none less than the CEO of the IBD) precisely on these counts, as there is only

so much that can be improved in the supply chain. However, the advantage that ITC

Limited has built in with e-choupal can be valued as much more than temporary increase

in efficiency. The relationship and trust with farmers, the access to channels, knowledge

of their preferences, will be tremendously useful in further strengthening its distribution

chain and in setting up the retail network of Choupal Sagars and when ITC enters the

personal products business. Seen from this perspective, ITC's evolution and

diversification is no longer satisfactorily explainable under Khanna and Palepu's

institutional void theory, and is increasingly explained by the conventional resource-

based views of related diversification and core competencies.

3.3 Idiosyncrasies and the Corporate Finance view of expropriation


Term V CCS by


32

When choosing ITC as a benchmark firm to study diversification in the Indian context,

we run the risk of overtly generalizing, if we do not consider certain idiosyncrasies of the

firm. ITC's single biggest motive to diversify was its weakness of its core business -

tobacco, which is continuously attacked by non-market forces. Tobacco businesses

around the world are subject to expropriation by the state in various ways - excise duties

and taxation, being one of the most critical of them. Jensen (1986) proposed the problem

of agency problems in industries with huge cash flows, including oil and tobacco. The

understanding was extended by Stulz (2005), who proposed that firms in such

expropriable businesses are subject to "twin agency problems" - the risk of expropriation

by both the corporate insiders (manager-controllers) and the state. The insiders choose to

invest in negative NPV projects that are beneficial to the economy, to reduce state

expropriation risks. ITC's early entry into hotels is a perfect fit under this argument. As

Stulz proposes, these firms engage in projects with complicated arrangements, and raise

debt financing in order to place an additional disincentive for governments to attack the

core business (the seniority of debt-holders makes expropriation difficult). When ITC

chose to raise debts for financing its hotels business, financed by various government-run

institutions, the motivation was multi-pronged. It invested in real assets, which provided

collateral to the financial institutions, it promised to generate employment for a large

number of people, it was a significant investment in a priority sector, and it locked in a

breed of debtors including the government institutions. All these factors created a

disincentive for the government to further expropriation of ITC (in the form of excise

duties).

Beneish and others (2006), in applying the argument to tobacco industries postulate that

diversifying in fact creates positive value by building political capital and by changing

the firm's composition of assets. As the firm diversifies into a number of industries and

geographical areas, it is able to forge multiple new relationships with politicians and

legislators and influence their actions. Also, by increasing the number of employees in

various segments, the firm is able to keep its core "sin business" untouched, as

governments do not want to run the risk of being shown in a poor light. By changing the

composition of assets, free cash flows are diverted to long term investments (usually in


Term V CCS by


33

infrastructure and socially responsible schemes). Such investments face lesser risk of

expropriation by the state rather than when turned over to the shareholders or to when

invested in other financial assets creating "deep pockets". In ITC's case, dividend

payments to BAT in the form of foreign exchange were hugely unpopular in the late

1960s, which triggered equity divestment, and diversification. By keeping the profits

within India, for further investment, and by investing in hotels and factories all over

India, ITC seemed to have followed Beneish's argument to the book. By folding in loss-

making entities like ITC Bhadrachalam into its balance sheet, the company has sought to

reduce the impact of expropriation by taxes at various times. Its e-choupal initiative may

also be a satisfactory answer in terms of building political capital. Thus, ITC's

diversification, when seen from this strategic perspective has created positive value for

the firm as a whole.


Term V CCS by


34

4. Conclusion

ITC's diversification can be viewed under three conventional lenses - analysis by first

principles, analysis from the emerging market perspective and analysis by idiosyncrasies

and through the corporate finance view of expropriable firms. We find that each of these

frameworks provide useful insights into the way ITC has evolved and diversified over the

years.

The corporate finance view of expropriable firms and the idiosyncrasies explain why ITC

moved to diversify in the first place. It explains sufficiently a few choices and modes of

expansion. Beneish and others explain ITC's expansion moves as one to arrest

expropriation by building up political capital that reduces the risk of expropriation and by

changing the composition of assets into a form that is not easily expropriable by the state.

The emerging markets view is able to explain the choices of expansion in the early stage.

Khanna and Palepu's theory of diversification to fill institutional voids was the dominant

force behind state polices. The involvement of ITC into initiatives like e-choupal is also

passively related to but not completely explained by this argument. e-choupal seems to be

yielding to ITC, long-term strategic advantages and core competences like understanding

the rural markets, which can be translated to other businesses like retailing in the future.

This is in contrast to the short-term sustainability of the institutional void theory.

The resource-based view seems to be the best suited to explain ITC's choices of

diversification in the later stage. Key resources and strategic assets like consumer-

orientation and supply chain, built over the years through its cigarette business has helped

ITC to move into other businesses. We argue that the diversification has been largely

"related", as we can club almost all its diversified activities under these two resources, a

view supported by Collins and Montgomery. As we trace the maturity of ITC's

diversification, we find that apart from the cigarette business, other businesses are in the

expansion mode and a few in the experimentation mode. Under these circumstances, ITC


Term V CCS by


35

has organized divisionally. However, to be able to extract synergies across FMCG

businesses, it has to, at some point in time move to a functional structure. This will occur

when Garvin's third stage of integration is reached. At this point, we speculate that ITC

will face the familiar pangs of diversification in developed economies - viz. the size of

corporate centre, and the control and coordination mechanisms. Only on the successful

completion of this stage, can we call ITC's diversification a successful story.


Term V CCS by


36

References

1. Anand, Bharat A. “Strategies of Related Diversification”, Case study, 9-705-481, Rev. Apr 11,

2005, Harvard Business School publication

2.


Term V CCS by


37

20. Company material:

a. ITC: A decade of transformation

b. Transforming Lives and Landscapes: ITC’s rural development philosophy at work

c. ITC: Chairman’s Speeches: 1996-2005

final report - spidi2.iimb.ernet.inspidi2.iimb.ernet.in/~networth/ccs/2005/577 term v ccs... ·...

Documents