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Directionally positive amid concerns

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The Vedanta group’s move to unlock value by consolidating Industries, (VAL), Malco, and its holdings in Cairn India into a new combined entity, Sesa Sterlite, by December 2012, has drawn mixed response from market experts. While experts say there are gains for both, there are a few concerns too. In the immediate term, there are gains for Vedanta Resources, given its debt related to Cairn acquisition and VAL expansion will now reflect in Sesa Sterlite’s books (rating agency Moody’s had cut Vedanta’s bond rating last month due to high debt), while there are gains for the two listed entities as well. For instance, Sesa Sterlite will emerge as the world’s seventh-largest globally diversified natural resources major by Ebidta. It will also enjoy higher weightage in broader indices, besides a possible re-rating and the benefits from owning a diverse business portfolio. On the flip side, the main concern pertains to the swap ratio (three shares of Sesa Goa for five shares of Sterlite) and the logic of bringing the loss-making VAL into Sesa Sterlite.

Jagannadham Thunuguntla, strategist and head of research at SMC Global, observes: “Prima facie, the merger ratio appears to be slightly in favour of Sterlite shareholders and a bit detrimental to Sesa Goa’s shareholders. Sesa Goa may feel some heat on the bourses and correct four-five per cent from the current levels of Rs 227.53.” Elara Capital’s Ravindra Deshpande, who tracks Sterlite industries, says: “The move will be positive for Sterlite.” He has also raised his target price for Sterlite from Rs 130 to Rs 140.



Responding to Business Standard’s question on the concerns over the swap ratio, the Vedanta management says, due diligence has been done while arriving at the swap ratio. Chairman says: “Independent valuations were done by Grant Thornton and KPMG while ‘Fairness’ opinion was sought from Citi Group Global Markets and DSP Merrill Lynch.”

Group Director (Finance) Tarun Jain says: “Standard methods have been used. A weightage of 40 per cent has been given to DCF (discounted cash flow) methodology, 40 per cent to market price and 20 per cent to NAV (net asset value), while arriving at the swap ratio.” He adds that looking at the one-year average price of the stocks, the Sesa Goa-Sterlite exchange ratio of 0.6 times is justified. In that context, it is surprising why the value of Vedanta’s holding in Cairn India (at Rs 390 a share, against the closing price of Rs 381 on Friday) was not taken on the basis of the average price.

 

SUMMING UP THE PARTS
In Rs crore
Key financials
Sesa 
Goa
Sterlite
Indus.
Cairn
India
Vedanta
Aluminium
Malco Adjustment ** Sesa
Sterlite
Revenue 9,090 40,204 11,864 5,653 325 -705 66,431
Ebitda 4,201 10,618 9,586 497 51 - 24,953
Net income # 2,995 5,476 8,209 -2,346 68 -3,431 10,971
Gross debt 4,413 12,363 1,252 19,892 0 28,797 66,717
Cash & investments 141 21,546 7,710 197 187 - 29,781
Net debt @ 4,272 -9,183 -6,458 19,695 -187 28,797 36,936
Net interest expense -201 -1,824 -639 2,031 -25 1,634 976
Net debt / Ebitda (x) 1.0 0.9 0.7 39.6 3.7 - 1.5
Net debt / Equity (x) 0.3 -0.2 -0.1 NM -0.3 - 0.5
Interest coverage (x) * 20.9 5.8 15 0.2 2.0 - 25.6
Note: Pro forma financials in the 12 months ended December 2011. Market data as of 24 February 2012;   VAL, and Cairn India fully consolidated into Sesa Sterlite; @ Sterlite FCCB conversion price/entitlement ratio to be adjusted based on share swap ratio; * Ebitda/ Net interest; ** Synergies and other adjustments # Post Minorities; Sesa Sterlite, post the deal, will have 2,965 million shares outstanding translating into an earnings per share of Rs 37 
Source: Company

Apart from the swap ratio, the merger of VAL is also being looked at with scepticism, since it brings along with it a debt of $5.9 billion. VAL, the aluminium producer that reported a loss of Rs 2,346 crore for 12 months to December 2011, lacks on the backward integration (bauxite mines) front. The allocated bauxite mines are awaiting environmental clearances, the timeline for which is not clear. This impacts its profitability (the high cost of production, currently at $2,000 a tonne, is responsible for its losses). The costs, however, can be brought down to Rs 1,000-1,200 a tonne if captive bauxite mines are available. The company, thus, continues to run at just 30 per cent of its capacity.

Jain, however, says the equity valuation of VAL for the purpose of transfer to Sesa Sterlite is just $476 million, which is the cost of investments (52 million shares in Sesa Sterlite being being issued to VAL). And, the valuation of VAL’s assets at current prices is in excess of $10 billion (which is higher than the combined value of debt and equity). Anil Agarwal believes, in the next 2-3 years, VAL will turn around and the group will become a leading aluminium producer.

On the positive side, while Sesa Goa’s cash was earlier (last year) utilised to buy a 20 per cent stake in Cairn India, thereby drying up its cash reserves, the latest deal involving the transfer of Vedanta’s 38.8 per cent stake in Cairn India (along with $5.9 billion of related acquisition debt) will increase the direct holding of Sesa Sterlite in Cairn to 58.9 per cent. Jain says, after considering the interest outgo (about 5 per cent annually) on account of the entire holding, the earnings accretion for Sesa Goa would still be big (estimated at $500 million annually).

Cairn India has huge oil and gas reserves in its Rajasthan block that are generating strong revenues and profits (see table). While this block is expected to see a ramp-up in oil output, the potential of its Sri Lankan assets is also being looked at positively, all of which should lead to strong cash flows going ahead.

For Sesa Goa’s shareholders, the consolidation move also means owning a diverse portfolio. Its iron ore business has been impacted due to the Karnataka iron ore export ban. The Goa mines are also under scanner and rising export duties have impacted the profitability of the company. However, its international assets (being developed) should add to its fortunes in the long run.

Sesa Goa Managing Director P K Mukherjee says they (Sesa) will benefit from diversification while an increased scale will reduce volatility of earnings and cash flows through the commodity cycle.

While some worries also stem from the huge gross debt of Rs 66,717 crore that will reflect on the books of the combined entity, the management isn’t worried. The net debt-to-Ebitda ratio of Sesa Sterlite will be 1.5. Jain says this can be easily addressed, given an annual Ebitda of nearly Rs 25,000 crore. The internal accruals should also prove sufficient to part-finance the $6.1-billion (Rs 30,000 crore) capex plans of the combined entity over the FY13-14.

Meanwhile, Sesa Sterlite, with an estimated market capitalisation of $14-15 billion, should enjoy better weightage in the Sensex and Nifty, when the revision takes place in mid-2012. Also, with simplified structure (only Konkala Copper Mines now remains with Vedanta Resources Plc), it should enjoy better price-to-earnings multiples. Thunguntala says: “The restructuring increases the probability of the group, getting positive rerating by the markets.”

Tarun Jain adds, with most expansion projects over, the company should grow two-fold during the FY12-15 period, aluminium and oil & gas being major growth drivers. The move should also deliver cost benefits to the tune of Rs 1,000 crore a year. Net-net, the deal has near-term implications for Sesa Goa’s shareholders, but gains seem larger from a longer-term perspective.

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