Should the merger proceed -- subject to approval, in a cashless all-stock transaction -- minority shareholders would receive one equity share and one 7.5% preference share in Vedanta Ltd for every share held in Cairn India.
Following completion of the transaction, Vedanta Resources' shareholding in its subsidiary Vedanta Ltd will reduce to 50.1% from 62.9%. At end-March 2015, Cairn India had $2.9 billion in cash and no external debt outstanding.
"The merger will provide Vedanta better access to Cairn India and its subsidiaries' current large cash balances of $2.9 billion and future cash surpluses as previous access was only possible through up-streaming of dividends," says Kaustubh Chaubal a Moody's Vice President and Senior Analyst.
"With current crude oil prices for Brent in the $64/barrel area, and weak LME prices for aluminum weighing on its EBITDA, the strengthening of Vedanta Resources' balance sheet -- which now seems plausible with improved access to Cairn India's cash -- is imperative to stave off further pressure on its rating," says Chaubal who is also the Lead Analyst for Vedanta.
"We also view the proposed Cairn India merger as a major step in the simplification of Vedanta Resources' complex structure, and in particular addressing some of the risks associated with the group's thinly capitalized but highly leveraged parent company," adds Chaubal.
At end-March 2015, Vedanta Resources reported consolidated debt of $16.7 billion, of which $7.7 billion of unsecured debt, rated at Ba3 negative, was held at Vedanta Resources and the balance at various operating and intermediate holding companies.
With access to Cairn India's cash and future cash flow, Vedanta Ltd could either repay debt or fund its other businesses. However Vedanta Resources' credit profile will only benefit to the extent that the additional cash and cash flow are used towards reducing the group's reliance on debt. Reduction of debt could be in the form of part repayment of Vedanta Ltd's external debt, or repayment in part of the $2.6 billion intercompany debt currently held at Twin Star Holdings Mauritius, which was in the form of a loan from Vedanta Resources. The latter will provide Vedanta Resources the liquidity to repay some of its unsecured debt, which will also improve consolidated leverage
Moreover, structural subordination of the senior unsecured debt at Vedanta Resources remains. Although the merger removes one layer between Vedanta Resources' senior unsecured debt and Cairn India's cash, Vedanta Resources remains without operating assets and dependent on up-streaming of dividends from the operating and intermediate companies. Moreover, with its shareholding in Vedanta reducing to 50.1% from 62.9%, cash leakage to minority shareholders will reduce Vedanta Resources' access to Vedanta Ltd's profits.
In order to narrow the notching between the corporate family rating and the issue rating, Moody's would look for total priority debt to be below 35%-40% of total consolidated debt, and for total priority debt to be less than 15%-20% of total group assets. As of 31 March 2015, the ratios stand at 53% and 24%, respectively.
Debt reduction following the merger will reduce rating pressure, although the merger increases the risk that Vedanta Ltd will ultimately be held accountable for Cairn India's $3.2 billion tax liability.
Vedanta Resources' ratings have been under pressure due to a sharp fall in crude oil prices that affected Cairn India's earnings, its largest contributor. This led to Moody's negative rating outlook on Vedanta Resources in January this year.
Crude prices fell to $85/barrel for the fiscal year ending March 2015 (FY2015), against $107/barrel in FY2014. As a result, Cairn India's EBITDA dropped by 40% to $1.5 billion.
While contributions from Vedanta Resources' other businesses such as zinc and aluminum have grown, the steep fall in Cairn India's EBITDA resulted in Vedanta Resources' adjusted leverage rising to 3.9x at end-March 2015 from 3.3x at end-March 2014.
In addition, Vedanta Ltd. is evaluating a transaction with the Government of India (Baa3 positive) in relation to acquiring minority stakes in Hindustan Zinc (HZL, unrated) and Bharat Aluminum Company (BALCO, unrated).
At end-March 2015, HZL had cash balances of $4.9 billion and no external debt, whereas BALCO had external debt of $767 million and no cash balances.
Moody's would change the outlook on Vedanta Resources to stable from negative if there was substantial debt reduction and improved operating performance.
Credit metrics indicative of this outlook change include (1) adjusted leverage reverting to less than 3.0x -- 3.5x; (2) cash from operations (CFO) less dividends / adjusted debt ratio improving to more than 20% - 25%; (3) EBIT interest coverage rising to more than 3x -- 3.5x, on a sustained basis, while generating positive free cash flow.
On the other hand we would downgrade the rating if the following credit metrics are maintained, on a sustained basis: (1) adjusted debt / EBITDA in excess of 3.5x -- 4.0x; (2) (CFO -- dividend) / debt ratio below 15%; (3) EBIT interest coverage less than 3.5x; or (4) if the company consistently generates negative free cash flow.
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