There were no nasty surprises in the merger details announced by Reliance Industries Ltd (RIL) and Reliance Petroleum Ltd (RPL). The ratio of one share of RIL for every 16 shares of RPL is almost identical to the ratio one would have arrived at using the average traded price of the two companies in the past two weeks. Having said that, RPL shareholders may feel short-changed going by the relative price of the two companies in the past six months, as this would have resulted in a ratio of 1:14.5. If one were to use the traded prices in the past one year, the ratio would be 1:14. But, then, it’s important to note that the outlook for the refining business has weakened considerably in the past year. In RIL’s case, while the outlook for its refining and petrochemicals businesses has weakened, its valuations have been buoyed to some extent because of its exploration and production business. This is the reason RPL shares have underperformed those of RIL in the recent past.
The decision to cancel RIL’s 70% shareholding in its subsidiary is clearly the better option, since creating treasury shares would have led to higher dilution in RIL’s equity base.
When the company had merged its first Jamnagar refinery (which was also originally called Reliance Petroleum Ltd), it had chosen the latter option and the company still holds the treasurys that were created as a result. Now, the dilution is limited to 4.2% and the deal is earnings accretive.
From RIL shareholders’ perspective, things hardly change because of the merger. Their effective ownership of RPL would only rise marginally, after the company buys out the 5% stake held by Chevron Corp. Of course, one difference is that cash flows accruing from RPL would now come directly rather than through the delayed process of dividend payments. For RPL’s minority shareholders, the merger leads to a big change—from having a mere refining exposure, they would now be shareholders in an integrated energy company.
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So why has the company decided to go ahead with the merger now? The company’s version is that a merger would lead to many synergies and cost efficiencies. According to analysts, the chief reason is that RPL is about to generate free cash flow, and this can directly flow into RIL’s books.
It’s important to note here RIL isn’t constrained for cash, with cash and cash equivalents of Rs28,000 crore. While it is expected to end up with negative free cash flow in the current fiscal year, the next two fiscal years are expected to be free cash flow-positive, both for RIL and RPL, even after considering committed and estimated capital expenditure.
This is based on estimates made by CLSA Research. Needless to say, the additional cash flow from RPL will give the company added comfort with its planned capital expenditure.
One potential benefit of the merger is that RPL’s high depreciation can be used to offset some of RIL’s profit, in case the refinery’s profit generation is weak owing to market conditions.
From RIL’s perspective, the RPL venture has played out beautifully. The company invested about Rs8,300 crore in the venture at an average price of Rs23 per share for a 75% stake, sold about 5% for about Rs4,900 crore, bringing its net investment cost to less than Rs10 per share. Minority shareholders came in at Rs60 per share. With the merger, the payback period on its modest investment will only shorten.
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Graphic by Sandeep Bhatnagar / Mint