Revisiting the Cairn Vedanta Merger debate…

As we write this blog, the price of Vedanta (formerly Sesa Sterlite) has corrected almost 60% from the highs achieved last year. In fact, since the merger between Cairn and Vedanta was announced a couple of months back, Vedanta has corrected close to 30% and is already at a yearly low. The merger deal has run into rough weather because of large shareholder institutions like LIC and United India Insurance Company (UIIC) raising doubts about the validity of the 1:1 swap ratio.

Understanding the objections raised

Both LIC and UIIC have objected to the Cairn-Vedanta merger due to the higher book value that Cairn enjoys. Also, the objections are based on the premise that Vedanta derives an inordinate advantage from the merger as it can write off a large part of its debt against the free cash flows of Cairn India. The institutions are also objecting to the deal saying that the valuation of Cairn India has been underplayed due to the $3.2 billion tax dispute that is pending against Cairn UK. Interestingly, the liability, if it fructifies, rests on Cairn UK and not on Cairn India. The only objection that the Tax Department has taken to Cairn India is the non-deduction of TDS while repatriating the profits to the parent company.

Do the institutions need to be a little more pragmatic?

The objections raised by both the institutions are entirely valid. But the institutions also need to look at it from a slightly more pragmatic perspective. The debt levels of Vedanta are surely high. But with a broad palette of commodities under its belt like Copper, Zinc, iron ore and oil, Vedanta is much better placed to use idle funds. The institutions also need to appreciate that oil prices are on a downtrend since June 2014 and now back to the $50 / barrel mark. In the past, oil price bounce used to happen due to OPEC exercising substantial control over oil supply and prices. No longer! With US and Russia now producing as much oil as Saudi Arabia, that advantage no longer exist. Nobody understands that better than Saudi Arabia, who has continued to supply oil even at lower prices just to maintain market share. Cheap oil is never a great time for companies like Cairn India and sustained downtrend in prices is worse. Probably, we are close to a situation where the market may get flooded with oil assets looking for a buyer. That may be to the disadvantage of Cairn India. With respect to the tax dispute, although the impact of the tax may be on Cairn UK, the incidence may be on Cairn India if the Tax department wants to penalize Cairn India for non-deduction of TDS. A little more pragmatism is surely called for, in the light of these circumstances.

What is the road ahead for both the companies?

To be fair, the swap is not exactly 1:1; it is slightly better than 1:1 as the shareholders of Cairn India also get an attached preferential share with dividend along with this swap. Hence the actual swap ratio is slightly better than 1:1. There are 3 likely ways forward.
Firstly, the merger may not go through and the status quo will be maintained. Vedanta already holds almost 60% in Cairn India and it is already the largest contributor to Vedanta’s annual consolidated profits. Of course, without the merger, Vedanta will not be able to use the cash reserves of Cairn India, and Cairn will continue to be a pure oil-play in India. It is unlikely to be beneficial to both parties.

Secondly, the merger goes through smoothly after the large shareholders are convinced that it is a win-win situation for both the companies. That looks unlikely at this point of time.

Last, but not the least, Vedanta does agree to sweeten the deal. LIC has been insisting on a more favourable swap ratio as well as a higher dividend on the preference shares. A sweeter swap ratio looks unlikely. Firstly, the shareholders have already got a 7.3% premium plus a preference share. Also, as a result of this merger the shareholding of Vedanta PLC in Vedanta Ltd will go down from 62.9% to 50.1%. This is the bare minimum holding that they need to retain to continue their Premium Class I Holding Company listing on the LSE. However it is a lot more likely that the terms of the preference share may be sweetened, either in terms of the ratio or in terms of the dividend payable.

That in a nutshell seems to be way ahead. The stakes are too high for both the companies to let go the merger opportunity. It is likely that Vedanta may sweeten the bid by raising the preference share terms and conditions a little more favourably for shareholders of Cairn India. Eventually, it will turn out to be value accretive for shareholders of both the companies.

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