12 July 2018 05:05:25 IST

Diversified portfolio will de-risk earnings volatility

Diversified portfolio will de-risk earnings volatility, drive stable cash-flows

In June 2015, India’s biggest diversified natural resources company, Vedanta Resources plc, announced plans to merge two of its businesses — India’s largest private miner, Vedanta Ltd (Vedanta), and oil and gas exploration and production firm Cairn India Ltd. The merger, through a ₹146.12-billion (₹14,612 crore) all-share deal, would create India’s largest diversified natural resources company. But would they be a good fit, and will the merger pay off?

To find the answer, we adopted a methodology that involved identifying concerns for the merger, questioning why Cairn should accept it, and looking at the benefits for shareholders.

Concerns for the merger

How would the oil and gas business fit in with a ferrous and non-ferrous portfolio? The logic behind merging a hydrocarbons company with a metals player isn’t entirely convincing.

The merger is also expected to facilitate a repayment of debt to the $13-billion Vedanta Resources Plc, Vedanta Ltd’s parent entity, which had a net debt of $7.7 billion as of March, 2015.

Vedanta is relying on cash flows from Indian subsidiaries to service the debt since the Zambian copper operations were struggling with low profitability.

In May, this year, Moody’s Investors Service noted that “Vedanta Resources will have to strengthen its balance sheet in FY2016 to avoid further pressure on its ratings.

In January 2015, Moody’s changed Vedanta Resources plc’s outlook to negative from stable to reflect the sharp drop in crude oil prices and the resulting impact sustained lower prices will have on Vedanta’s credit profile.

Reason for merger

Cairn’s cash could have been funnelled to its parent through dividends, but that would have attracted taxes. Indeed, the merger is being seen as a ‘necessity’ for Vedanta, whose interest coverage on its borrowings is just 1.1 times, in an environment where commodity prices are weak.

Vedanta could now potentially dip into the ₹17,000 crore ($2.7 billion) cash lying with Cairn to pay off part of its ₹77,752 crore debt and to beef up its balance sheet.

The merger will help Agarwal own a diversified natural resources company like BHP Billiton.

Vedanta has very complex structure. In 2013, Agarwal had consolidated iron ore mining business by merging Sesa Goa Ltd with Sterlite Industries (India) Ltd, which ran copper and aluminium businesses. Vedanta Resources also transferred its 38.8 per cent per cent holding in oil producer Cairn India, including a debt of $5.9 billion, to the new company.

Cairn should accept swap ratio of 1.04:1 because:

In 2014, Cairn could use the cash on its books to boost capex at a time when production has been stagnating; capex has been lowered by 60 per cent to $500 million for current year. In a related-party loan, in July, 2014, Cairn had loaned Vedanta $1.2 billion at a return of just Libor plus 300 basis points.

Cairn India’s market capitalisation has more than halved to around ₹33,000 crore currently from close to ₹77,000 crore a year back, in the wake of a collapse in crude oil prices, the swap ratio might have been much more favourable to the oil producer’s shareholders had the merger taken place earlier.

The ₹21,000 crore ($3.3 billion) tax litigation that Cairn is embroiled in will now become a contingent liability for Vedanta shareholders and would have weighed on the swap ratio.

The IT authorities have asked Cairn to pay ₹10,500 crore for failing to withhold capital gains tax arising in 2006-08, in the hands of Cairn UK Holdings, and levied interest charges of ₹10,500 crore on the pending tax liability.

Benefits for Cairn India shareholders

Stable cash-flow supporting investment and dividends through the cycle, driving long-term value.

Offers Cairn India shareholders exposure to Vedanta Limited’s well invested Tier-I, structurally low cost, longer-life assets.

Being part of a larger entity will allow Cairn India to benefit from increased economies of scale and improved free float and trading liquidity.

The large equity share component allows Cairn India shareholders to participate in the upside potential at Vedanta Ltd as a result of the attractive growth profile and delivery of Vedanta Ltd’s on-going cost-saving initiatives.

Retains proven management team and decision-making framework, retaining the Cairn India brand.

Conclusion

As a mutual fund manager ,we voted for the merger of Vedanta Ltd with cash-rich Cairn India, as it is not only for refinancing its ₹77, 752-crore gross debt, but also to simplify the group’s business structure.

The rationale for this merger is that a diversified portfolio would de-risk earnings volatility and drive stable cash flows through business and commodity price cycles for Cairn India and ensure the minority shareholder’s future growth expectations in the backdrop of the economic slowdown.

(Ashutosh and Himanshu, students of PGDM Ebiz 2014-16 at Welingkar Institute of Management Development and Research, Mumbai, are the first runners-up in the case study contest)