Logical move

The merger of Reliance Petroleum with Reliance Industries will lead to higher operational efficiencies and better cash utilisation for the combined entity.

The decision to merge Reliance Petroleum (RPL) with Reliance Industries (RIL) did not come as a surprise for the markets, and in fact, is very much in line with RIL’s past track record. Notably, although the operational benefits from the merger of the two companies may not be significant in the near-term, the deal is a win-win for both companies.

Flashback

In the past, RIL has undertaken huge capital-intensive projects through separate companies, which enabled it to ring-fence itself from the risks that typically arise during the conceptualisation and execution stages including the potential to strain the balance-sheet and cash flows.

However, once the risks mitigated consequent to completion of projects and commencement of operations, RIL would merge the company with itself. In the last 15 years, RIL has merged three companies on these lines (excluding IPCL, which it took over).

To give an example, RIL’s existing 630,000 barrels per day (BPD) refinery was first housed in a separate entity. This company, which was also known as Reliance Petroleum, came out with an IPO in 1993, started commercial production in the year 2000 and was merged with RIL in 2002.

The new deal

As per the latest deal, one share of RIL will be issued for every 16 shares of RPL. Considering that RIL will purchase Chevron’s 5 per cent holding in RPL, and thereafter extinguish its entire 75.38 per cent holding in RPL, it will result in a fresh issue of 6.93 crore shares (equity capital of RIL will rise by 4.4 per cent to Rs 1,643 crore).

While the appointed date for the merger is April 1, 2008, it is estimated that the entire process (including issue of consolidated post-merger annual report) will take about six months.

Advantage RPL

While RPL as a standalone entity provides an option to buy into a pure refining business, the move to merge it with RIL makes good sense, especially given the current scenario.

With the advent of global economic slowdown, lower crude oil prices and weak demand, refining margins (GRMs) have already declined in the past few months. In RIL’s case (existing refinery), it slipped from about $15 a barrel in Q1FY09 to $13 in Q2 and further to about $10 in Q3.
 

MARGINAL GAINS
in Rs crore	FY09E

FY10E

Pre-mergerPost-merger% change Net sales158,938196,740196,740- EBIDTA23,50038,89038,890- Net profit14,92621,40623,0667.75 Equity1,5741,5741,6434.38 EPS (Rs)951361402.94 E: Analysts estimates
Difference in net profit is due to accounting of minority interest.
Rise in EPS is lower than net profit due to issue of shares to RPL shareholders

Although the benchmark Singapore GRMs were up (at $6-8 per barrel) in January 2009, analysts don’t expect them to sustain at higher levels due to the combined effect of weak demand as well as the increase in global refining capacity.

For RPL and RIL, their refineries are rated higher in terms of its complexity (which enable them to process heavier and cheaper crude oil) and thus, their GRMs are likely to be higher than the benchmark as the case in the past. Says Vinay Nair, research analyst, Khandwala Securities, “in the current scenario, for FY10, the GRMs for the combined entity are estimated at $10-12.”
 

DOWN MEMORY LANE
	Announced in	Merger ratio
Reliance Polypropylene	June 1994	4:01
Reliance Polyethylene	September 1994	3.3:1
Reliance Petroleum	April 2001	11:01
IPCL	April 2006	5:01
Source: ENAM report

With RIL on the verge of starting full scale gas production from its KG-basin, it would make sense to merge RPL with RIL, which in turn will provide RPL’s shareholders an exposure to the entire value-chain in the energy business; and to some extent, provide cushion from the volatility in the refining business. In the long run, given that integrated energy companies enjoy better valuations, RPL’s shareholders will also stand to gain on this count.

Two to tango

The operational gains from the merger are seen in areas like crude sourcing, product marketing, supply chain management and operations planning. However, most analysts believe that the gains would be marginal as RIL already has management control of RPL and also that the key functions were anyway expected to be optimised under the flagship company---with some of the core facilities being shared by both entities.

The benefits will thus, accrue in the form of elimination of any issues (like transfer pricing, etc) as well as easier management of operations (as a combined entity).

For the combined balance-sheet, the merger would however, lead to a marginal increase in RIL’s estimated debt-equity ratio by about 10-12 basis points, which is not seen as a concern.

Importantly, RIL will have higher freedom to use the cash flow generated by RPL. Consider this, if RPL were to remain a separate entity, it would have used the cash to retire debt or pay dividends to its shareholders; the latter would have also attracted a dividend distribution tax.

But, post-merger, RIL would have direct access to RPL’s cash flows (of about Rs 6,000-8,000 crore per annum at optimum capacity) and would prefer to use it towards capex in its existing businesses (especially oil and gas E&P and retailing). Additionally, says Nair, “The merger can improve the product slate of RIL with more focus towards light and middle distillates. It could also facilitate access to various quality of crude oil globally thus minimising cost. The product mix would be flexible enough to optimise production to earn better refining margins.”

Conclusion

While the merger of RPL with RIL will lead to marginal gains in the short-term, it is a logical move and will translate into significant gains for the two companies in the long run. The merger will also elevate RIL’s global ranking on various counts.

The moot question however, pertains to the future outlook, wherein the weak demand scenario and pressure on margins is likely to continue in the core refining and petrochemicals businesses. Thus, analysts haven’t changed their earnings estimates for RIL for FY10 and FY11; the merger is likely to positively impact consolidated earnings by only 1.5 per cent to 3 per cent in these two years.